so too do their imports of machinery, equipment, technology, and intermediate supplies.
In these nations it is common to note a process of deindustrialization as the export sector
grows while the local manufacturing base shrinks and ownership shifts even more to the
Table 14.5 Exports of manufactured products from developing nations (percentage)
Share of world exports Share of world manufacturing value-
1980 1997 1980 1997
10.5 26.5 16.6 23.8
82.3 70.9 64.5 73.3
Latin America 1.5 3.5 7.1 6.7
(Mexico) (0.2) (2.2) (1.9) (1.2)
Newly industrialized Asiana 5.1 8.9 1.7 4.5
(Korea) (1.4) (2.9) (0.7) (2.3)
ASEAN-4b 0.6 3.6 1.2 2.6
1.1c 3.8 3.3 5.8
Source: UNCTAD 2002: 81.
a Hong Kong, Korea, Singapore, Taiwan.
b Indonesia, Malaysia, Philippines, Thailand.
474 The Process of Economic Development
The result of these processes is that value-added at the local level actually declines,
meaning that there are few or no indirect or multiplier effects to be captured or enjoyed as
FDI rises. But this is not the whole story: In Asia the ability to insert a national strategy into
the process demonstrates that there is no inevitable fate for host nations. As active partici-
pants they can increasingly experience the positive effects of FDI. Thus note the dramatically
different patterns exhibited by the top Latin American exporters and the eight Asian nations
that have actively pursued national linkage strategies. Note the standout position of Mexico,
commonly hailed as the success story of free trade: ‚Äúbetween 1980 and 1997 Mexico‚Ä™s share
in world manufacturing exports rose tenfold, while its share in world manufacturing value
added fell by more than one-third, and its share in world income by about thirteen percent‚ÄĚ
(UNCTAD 2002: 80). In Asia only Hong Kong has been losing ground in terms of value-
added, and this may be the result of its leanings toward the neoclassical free trade model and
away from the developmental state approach.
Export promotion and the fallacy of composition
Critics of the TNCs have maintained that while the TNCs may well be in a position to
expand exports, if a strategy of promoting FDI is employed at one time in a large number of
nations, it must fail for all or many of these nations. The argument is straightforward. If the
less-developed world, as a group, suddenly floods global markets with new manufacturing
exports, prices could fall, and it is presumed that what is lost as prices fall might not be
made up through the increasing volume of sales. In any case, price trends (falling or slowly
rising) for exports would not be matched by equal price trends for imports from the indus-
trial nations. In other words, the terms of trade for labor-intensive low-technology manufac-
tured goods exports from the less-developed world would deteriorate, leaving the developing
countries, as a group, worse-off.
There is evidence that this has been occurring. International Monetary Fund data show
that the terms of trade for less-developed country manufactured goods exports fell by ‚ą’0.88
percent per year between 1967 and 1987 (IMF 1988). This is a disturbing trend, which
appears to have continued from 1990 to 2001 according to recent research. In a study
of eighteen developing nations (including China and India) Arslan Razmi and Robert
Blecker found evidence that developing nations heavily involved in the export of manu-
factured products are now competing with each other in low-technology production
(Razmi and Blecker 2008). To gain market share nations will have to devalue against
other nations and/or suppress their wage levels, which will lead to reciprocal actions
generating ‚Äúrace to the bottom‚ÄĚ strategies. Thus, not only do most low-income coun-
tries suffer from declining terms of trade for their primary products, but it appears that
the tendency for the terms of trade to decline extends to the low-technology manufac-
tured goods of the less-developed countries, according to recent research by the United
The empirical evidence strongly suggests that global competition for labor-intensive
manufacturing activities has risen over the past few years. This coincides with the shift in
the mid-1980s of several highly populated, low income economies towards more export-
oriented strategies. The countries with the lowest proportion of technology-intensive
manufactures and the greatest proportion of low-skill labor-intensive products in their
manufactured exports have faced declining terms of trade in manufactures.
(UNCTAD 2002: 119‚Ä“20)
Transnational corporations and economic development 475
Long-term costs of TNCs: the potential for environmental degradation
The overall impact of TNCs on the environment is difficult to determine, because research
in this area is relatively recent and incomplete. Drawing inferences from the logic of
transnational production is also somewhat problematic. On the one hand, it is very often
true that TNCs have leverage with host governments which may allow them to engage
in environmentally unsound activities which would be prohibited at home. From a cost-
minimizing standpoint, they often have a strong incentive to function as environmental
predators if permitted to do so. On the other hand, however, the TNCs are visible targets,
and they have become deeply involved in presenting themselves as ‚Äúenvironmentally
conscious‚ÄĚ producers in the advanced nations. As such they can be harmed by evidence
of environmental insensitivity, both in their ‚Äúhome‚ÄĚ market and in the less-developed
Furthermore, TNCs, particularly TNCs which operate stand-alone production facilities
dating from the early days of ISI policies, operate a full range of technologically diverse
industries which tend to create most of the industrial pollutants found worldwide. For
example, TNCs play a major role in the production of substances which account for approxi-
mately 80 percent of anthropomorphic greenhouse-gas generation (UN 1992: 226).
‚ÄĘ TNCs are the primary producers and consumers of chlorofluorocarbons, the principal
cause of stratospheric ozone depletion;
‚ÄĘ TNCs account for at least 15 percent of greenhouse gas emissions;
‚ÄĘ the twenty largest TNCs producing pesticides accounted for 94 percent of agrochemical
sales in 1990 (UNCTAD 1994: 226);3
‚ÄĘ TNCs have extensive involvement in the most highly polluting industrial activities, such
as the production of industrial chemicals, synthetic resins and plastic products, non-
ferrous metal products, iron and steel, petroleum production and refining, and paper
manufacturing. The portion of FDI involved in pollution-intensive industries ranges
between 20 and 50 percent (UN 1992: 231);
‚ÄĘ several studies conducted in Asian nations indicate that TNCs maintain lower envi-
ronmental standards in developing countries than these same companies uphold in
developed nations, but that these lower standards are nevertheless higher than those of
locally owned firms (UN 1992: 233‚Ä“4).
Host nations generally have strong laws and regulations governing environmentally
damaging forms of production, but do not always have the versatile scientific capacity to
actually monitor and enforce the laws which already exist. Depth of scientific know-how,
particularly at the level of monitoring officials needed to supervise the TNCs and local firms
which are, in fact, much more numerous, is in short supply. Governing the environmental
behavior of producers, including TNCs, is one of the most immediate and pressing problems
facing developing nations today. Fortunately, consciousness of environmental degradation is
spreading rapidly throughout the developing world (see Focus 14.2).
Export processing zones and the problems of small nations
Critics of TNCs have highlighted the role of export processing zones (EPZs), for they tend to
illustrate the most undesirable consequences which may arise when a less-developed nation
uncritically turns to FDI hoping for the potential benefits (see Focus 14.3). EPZs are special
476 The Process of Economic Development
FOCUS 14.2 TNCS IN THE LOGGING bUSINESS
Tropical forests are of two types. First, there are tropical rainforests which currently cover
more than 1.5 billion hectares. Two-thirds of the rainforests are in Latin America, princi-
pally Brazil. Second, there are tropical dry forests, principally in Africa. They also occupy
approximately 1.5 billion hectares of land.
In both types of forests, extensive ecological change is taking place. Current estimates
suggest that 20 million hectares per year are being deforested, for a variety of reasons.
Approximately 60 percent of the annual deforestation is due to conversion to agricultural
uses. Access to this land often occurs as a result of logging operations. Land is frequently
claimed by giant agribusiness TNCs or companies which contract with these TNCs.
Another 20 percent of annual deforestation is the direct result of the logging industry.
The logging industry encroaches, directly or indirectly, on the forests at a rate of roughly
4 million hectares per year.
About 15 percent of the world‚Ä™s commercial lumber comes from the rainforests. The
tropical dry forests are the main source of industrial wood products. Thus the activities of
the logging industry are particularly important to understanding the destruction of large
regions of Africa.
The available research indicates that US TNCs had withdrawn from nearly all direct timber-
cutting operations in the tropical forests by the early 1980s. In contrast, European TNCs
remain extensively involved in much of the logging that is conducted throughout the devel-
oping world. This is particularly the case in Africa, where European corporations control 90
percent of the timber-cutting in Gabon, 77 percent of these operations in the Congo, nearly
100 percent of such activities in Liberia, and 88 percent of logging in Cameroon. The Japa-
nese are extensively involved in logging operations throughout South-East Asia.
Aside from depletion of the forests, logging quite often leads to climatic changes which
give rise to desertification or reduced rainfall. Silting of streams reduces or eliminates
stream aquatic life, and could reduce fishing in oceans or lakes.
Sources: UN 1992: 228; World Bank 1992: 57‚Ä“8
geographic areas, usually at or near ports or borders, where the normal ‚Äúrules of the game‚ÄĚ
regarding foreign investors are relaxed by host governments. As a general rule, products
entering and leaving EPZs are exempt from all import and export taxes, corporate and other
taxes, license fees are waived for firms operating in the zones, labor unions are excluded, and
even existing labor laws are not enforced, including, sometimes, minimum wage laws (see
Focus 14.4). EPZs often attract foreign companies by offering a ‚Äútax holiday,‚ÄĚ suspending
all corporate taxes for a multi-year period.
Furthermore, physical structures often are erected and leased at modest, typically below-
market, rates in industrial parks in the EPZs. Good infrastructure, such as roads, is often
offered at no cost or at highly subsidized rates. Such benefits can include below-market
prices for electricity, gas, water, and waste disposal not available to firms outside the zones.
Sometimes labor training and housing for workers is provided and/or subsidized.
The incentive for nations to establish EPZs is that they gain often badly needed foreign
exchange, though this typically is limited to labor‚Ä™s value-added, that is, wage income, in
production. Most of the employment is in labor-intensive manufacturing and assembly proc-
esses, thereby creating new jobs which can be very important to host nations. Unfortunately,
EPZs generally fail to create either forward or backward linkages to local production; in fact,
in most countries, firms located within EPZs are prohibited from having any but minimal
sales to the internal market, so forward linkages are typically impossible. But neither do the
firms locating in the EPZs form many backward linkages to potential supplying firms in the
Transnational corporations and economic development 477
FOCUS 14.3 WOMEN WORKERS IN EXPORT PROCESSING
Between 70 and 80 percent of the workers in EPZs are women. They tend to be young,
inexperienced, poorly educated and poorly trained, and single. Their employment condition
is insecure, with extremely high turnover rates, sometimes 200 percent per year. Unions are
usually non-existent, and those that exist are dominated by the employers in the zones.
The plants tend to be modern, clean, well-ventilated and well-lit. Nevertheless,
researchers have noted a wide range of employment-related problems, suggesting wide-
spread hazardous working conditions. Some of the difficulties include exposure to radia-
tion and toxic substances, chemicals used without adequate training or warnings, and
inadequate safety equipment. Other research mentions common occurrence of eyesight
deterioration, ulcers and other nervous disorders, puncture wounds, chemical burns, and
electric shocks. The pace of work is demanding; workers sometimes repeat the same oper-
ations every five seconds, 7,200 times per day. Pay rates tend to be quite low by global
standards, from approximately 45 cents (US) per hour to a few dollars per hour. But wages
can also be much lower, with the National Labor Committee finding wages in the late 1990s
at 9‚Ä“20 cents per hour in Bangaladesh, 25 cents per hour in Pakistan and ten cents per
hour in Indonesia. With benefits, which can include one or two meals, transportation to and
from work, and some medical care, the employee cost to the firm may, however, be closer
to double the wage.
Employers have often mentioned factors such as ‚Äúa pliant nature,‚ÄĚ ‚Äúnon-union,‚ÄĚ ‚Äúnimble-
fingered‚ÄĚ and ‚Äúdocile‚ÄĚ in stating their preference for women workers. One study of elec-
tronics TNCs operating in Mexico‚Ä™s EPZ found that women workers constituted above 70
percent of the labor force, with the average age ranging between eighteen and twenty-four
years. Average education received was six years, the average experience level was three
years, and direct wages were 85 cents per hour.
In comparison to employment outside the EPZs, the work day tends to be 25 percent
longer, with wages as much as 50 percent less than the industrial wage paid in similar oper-
ations. Within the EPZs, women tend to do the direct assembly work, while men operate
and maintain complex equipment. Some EPZs now operate high-tech plants where men
are increasingly being employed in direct production in preference to women workers.
Sources: Barry 1992: 144; Shaiken 1990: 91;
Sklair 1989: 172; UNCTAD 1994: 203
local economy. In one of the largest EPZ countries, Mexico, indigenous products other than
labor constitute less than 5 percent of the value-added of the production in the EPZs. Often
the national contribution over and above direct labor consists of little more than janitorial
There were nearly 551 EPZs in 1998, employing nearly 27 million workers. Some of these
workers were in developed nations in North America and Europe or in transition economies
in Eastern Europe, but the vast majority were in developing nations (ILO 1998a). Nearly
one-third of the total number of workers employed by TNCs in the less-developed world
were employed in TNC operations in an EPZ. In 1998, seventy-four nations had one or more
EPZs, or were planning on adding such zones. While TNCs have played a crucial role in the
establishment of the EPZs, in some of the older EPZs in Asia national businesses now play a
vital role. Thus not all of the workers in the zones are employees of the TNCs, their subcon-
tractors, or their subsidiaries. The EPZs continue to grow, sometimes very rapidly.
For example, by 1995, over 600,000 workers were employed in such zones in Mexico,
but by early 2001 there were 1,300,000 such workers. Malaysia had 99,000 EPZ workers
478 The Process of Economic Development
FOCUS 14.4 UNIONS UNDER INTEGRATED PRODUCTION
Unions can be effective agents for reducing economic discrimination against women
workers and for enhancing the health and safety conditions in the workplace. One study
of Mexican workers showed that in the non-union sector, women with identical skill and
experience levels were paid 18 percent less than male workers. But in the unionized
sector, there was no difference in pay between men and women workers. Labor unions
have demonstrated that they can play an active and forceful role in enforcing health regu-
lations and work standards.
Unions, however, play a smaller role in developing nations because 40 to 80 percent of
production takes place outside the formal economy. In both agriculture and the informal
sector, labor contracts are non-existent. Within the formal economy, unions have often
become well established in nations with TNCs within their industrial sectors. Research
indicates that the stand-alone subsidiaries of manufacturing TNCs typical of the ISI era
generally paid manufacturing workers substantially more than did local employers.
However, the recent rise of the globally integrated system of production raises deep
questions regarding the relationship between TNCs and unions. Integral to the new
system is widespread subcontracting, often in export processing zones. Subcontractors
are small, formally independent firms, operating in a dense web of intra-firm production
relations organized by large transnationals, particularly in electronics and textile produc-
tion and assembly. Employing perhaps 12 million low-wage workers, subcontractors are
not the visible nationalist targets which TNCs constitute. As small manufacturers, they
rarely operate within a sector where laborers‚Ä™ interests are independently represented by a
union, however. There is evidence suggesting that subcontractors, the instruments of the
giant TNCs, tend to sidestep unions, ignore workplace health and safety standards, often
pay sub-minimum wages, and often fail to follow labor standards.
A few large garment-making TNCs have voluntarily imposed corporate codes of conduct
to try to insure fair labor standards practices are adhered to by their subcontractors oper-
ating at the lower end of global commodity chains of production. Even consumer groups
are getting involved, refusing to purchase products of major retailers whose suppliers
refuse to conform to reasonable labor standards for their workers.
Sources: UNCTAD 1994: 193‚Ä“4, 198‚Ä“9, 201, 325‚Ä“7;
World Bank 1995: 76, 81
in 1990, and 200,000 in 1997. Sri Lanka‚Ä™s EPZ employment soared from 71,000 in 1990 to
280,000 in 1998.
Outpacing all nations, China added 1,100,000 EPZ workers just between 1990 and 1992!
In 1990 the number of EPZ workers was estimated at roughly 4 million (UNCTAD 1994:
190). Another sample covering only ‚Äúlarge‚ÄĚ programs with data drawn from the 1992‚Ä“4
period, detailing employment in only thirty-one nations found employment totals of 5.5
million (ILO 1998b: 27‚Ä“9).
We can see just how rapidly the EPZs are proliferating by noting that in the late 1990s the
estimate of total employment had risen above 20 million ‚Ä“ more than five times the level esti-
mated in 1990 (ILO 1998c: 1). EPZs are scattered around the world, with the largest cluster
in Asia, and a second, much smaller cluster in Mexico, Central America, and the Caribbean.
In 1997 Mexico had 107 EPZs, Central America and the Caribbean 92, South America 41,
the Middle East 39, Asia 225, and Africa 47.
Transnational corporations and economic development 479
EPZs in small nations as a special case
EPZs have often been envisioned as the ‚Äústarter‚ÄĚ for the export engine of growth of an
indigenous manufacturing sector. For this to occur, however, the TNCs operating in the EPZs
must be embedded in a production structure which forges ever-more profound linkages to the
national economy of the host nation. Only in Korea and Taiwan has such a ‚Äúvirtuous circle‚ÄĚ
been created with export-oriented TNCs. Furthermore, in these nations, the EPZs became
important sites for national capitalists to produce and export from, not simply for TNCs.
What is most notable is the emphasis in South Korea and Taiwan on increasing the degree
of local sourcing of inputs as a condition for firms remaining in the EPZs and reaping the
benefits of the exclusions from taxes and tariffs. However, this reward structure should no
longer surprise. Korea‚Ä™s and Taiwan‚Ä™s industrial policies have been noted (see Chapter 10)
for their monitoring of the effects of their policies and for the successful use of performance-
based subsidy structures that reward results, in particular greater efficiency, while penalizing
rent-seeking, unproductive behavior. Furthermore, as wages have increased in East Asia,
these nations have proved adept at creating new forms of specialization to supplant the loca-
tional advantage of cheap labor which allowed them to attract FDI in those areas where FDI
When nations fail to force production linkages to the broader economy onto firms in the
EPZs, as has most often been the case, then the EPZ becomes little more than an ‚Äúexport
platform,‚ÄĚ and TNC investment will remain an enclave, disarticulated from other sectors of
the local economy. What the local economy provides in such cases is limited to cheap labor
power and an attractive investment climate, both of which contribute to a higher level of
profit for the TNC, but without substantially improving the probability that a locally directed
growth process will be initiated in the poor nation. This situation is particularly acute in
The vertically integrated manufacturing TNCs that small economies are able to attract
maintain established, risk-reducing worldwide sourcing and distribution networks. These
networks involve the transfer and sale of inputs, semi-processed goods, and final products
among far-flung subsidiaries of the parent corporation. Existing networks are quite difficult
to penetrate, particularly for new or potential firms in a less-developed economy with limited
experience in dealing with the immense corporate structures characteristic of the TNCs.
Even when there is sufficient know-how, the TNC is not always ready to admit linkages
with its subsidiaries, particularly when doing so increases the exposure of the TNC to local
instability, or, more likely, because in small economies the difficulty of attaining scale econo-
mies may raise the cost of locally produced inputs above those which the TNC can provide
via its existing external supply network. Furthermore, the deficiency of a production culture
among domestic entrepreneurs accustomed to a protected ISI climate will often be apparent
by a low level of quality control and/or an inability to maintain production and delivery
schedules, though these transitional inefficiencies can be overcome.
The indigenous infrastructural system may make it all but impossible to offer reliable
deliveries, as roads, rail, and waterway carriers can be extremely ineffective. In any case,
the TNC often will resist local purchases under purely market-driven conditions, since to do
so would be to reduce the profitability of a portion of their own productive apparatus. Such
linkages were once forged through domestic content requirements or domestic hiring quotas
in those areas for which the country feels it can provide inputs and from which the greatest
possibility for positive external learning effects exist. Creation of the World Trade Organiza-
tion in 1994 has made it difficult for nations to utilize domestic content restrictions, but the
480 The Process of Economic Development
WTO‚Ä™s strictures do not prevent nations from creating conditions wherein the local content
Nations need to encourage foreign affiliates of TNCs to (1) provide managerial and labor
training to local supplier firms, (2) build an environment wherein foreign affiliates will be
rewarded for sharing production information, (3) assist local suppliers by furnishing finan-
cial support, perhaps through advance payment for production and/or prompt payment on
delivery, (4) transferring technology and know-how to supplier firms.
While this may sound utopian, case-studies involving Malaysia, Thailand, China, and
Singapore in the late 1990s demonstrate that a committed, active state can engineer vital
changes that lead to deep linkage effects in spite of the new barriers to local content legisla-
tion erected by the WTO (UNCTAD 2001: 149‚Ä“214). Thus in the 1990s local sourcing of
electronics inputs were only 28 percent in Mexico, but were 62 percent in Malaysia and 40
percent in Thailand ‚Ä“ the difference accounted for by the existence of policies to stimulate
linkages in Malaysia and Thailand (UNCTAD 2001: 135). The gap between those nations
who have built linkage programs and the bottom-end EPZ nations is growing, with most
nations able to supply only 5‚Ä“10 percent from local content. Only nations with a broad devel-
opment strategy are able to build linkage programs. More generally:
Many MNCs have supplier development programmes in host developing countries ‚Ä¦
The intensity of knowledge and information exchange in buyer-supplier relationships
tends to increase with the level of economic development of host countries, particularly
in complex activities, and where technological and managerial gaps with suppliers are
not too wide.
(UNCTAD 2001: xxii)
Vertically integrated TNCs and development prospects
The multiplier effects of backward linkages from TNC investments can be expected to be
quite small unless a country is extremely diligent in helping local businesses to forge links
with the TNCs. The International Labour Organization‚Ä™s research suggests that, generally,
for every five EPZ jobs only one new (additional) job is created in the domestic economy ‚Ä“ an
extremely low job multiplier (ILO 1998b: 8). To the extent that export-platform promotion is
a major component of a nation‚Ä™s overall development strategy, even wages paid will have a
reduced multiplier effect when a significant quantity of consumption goods, including agri-
cultural goods, are imported. To visualize this process, Figure 14.1 presents a stylized circuit
of capital for a typical manufacturing TNC attracted to an EPZ in a small nation.
The production process is initiated outside the country in which the export subsidiary is
located. Money capital (M) is used to purchase produced means of production and raw mate-
rials (MP) and labor (L), for the first stage of production (P1). From this comes a partially
transformed output or new means of production (C‚Ä≤) with a value as yet unsold or ‚Äúunreal-
ized‚ÄĚ greater than the initial outlay, M. With the completion of the first stage of production,
C‚Ä≤ is shipped by the TNC to its export subsidiary in the small, export-platform economy.
There the semi-processed product is combined in the local production process (P2) with
unskilled, cheap labor.4 Now, the subsidiary of the TNC produces final or partially assembled
commodities, C‚Ä≥, which are then re-exported. Their value is realized, and the profit from
production is accumulated not in the country where the EPZ is located, but elsewhere within
the international structure of the TNC. Production (P = P1 + P2) and realization take place
only on an international scale, in which many individual subsidiaries of a TNC in widely
Transnational corporations and economic development 481
EPZ host nation
Figure 14.1 An EPZ circuit of capital.
scattered locations ultimately may participate. C‚Ä≥ > C‚Ä≤ > C and M‚Ä≤ > M, where the difference
M‚Ä≤ ‚Ä“ M = S, is the level of gross profit.
Structurally articulated internally with its own subsidiaries and already linked to estab-
lished sourcing and distribution networks, the TNC‚Ä™s subsidiary (or affiliate) in a small
nation is sectorally and structurally disarticulated from the local economic structure. The
local economy is but a production point, and then for only a fragment, P2, of the complete
production process within the TNC. The manufacturing export-platform economy provides
no more than a convenient physical location, albeit one that is frequently quite profitable.
It is the non-specific locational bias of the purely export-oriented TNC, as opposed to the
locationally specific food, raw material, mineral, and ISI manufacturing corporations of the
past, which results in small host governments having reduced leverage when attempting to
pressure the TNCs in EPZs to create or permit backward and forward linkages when they do
not emerge spontaneously.
EPZs can create the appearance of industrialization and development in a country, without
the substance. The location of the P2 phase of production in a poor nation will almost always
contribute to a higher GDP, though the net contribution of such production will be less than
the gross effect to the degree that local production is adversely affected, especially in agri-
culture or other sectors which lose labor to urban areas near the EPZs where people migrate
in hopes of finding employment. Moreover, the contribution of the TNC to the country‚Ä™s
GNI will be less than its contribution to GDP by the level of repatriated profits, interest, and
dividends. Even after taking such effects fully into account, the net contribution of the TNC
will be overstated in a static analysis.
Given that the P2 process is not location-specific, it can usually be transferred rather easily
by the ‚Äúfootloose‚ÄĚ export-only manufacturing TNCs. And, to the degree that the new host
nation provides a greater array of incentives to locate in its EPZs, the relocation costs to the
TNC are correspondingly reduced. Furthermore, EPZs are unlikely to contribute to the break-
down of stultifying social structures which continue to thwart movement away from the low-
productivity trap of the ‚Äúplantation economies‚ÄĚ still characteristic of many small nations.
Enclave EPZs do not spontaneously contribute to the expansion of the ‚Äúindustrial arts‚ÄĚ in
a dynamic process of creative destruction that breaks down restraining internal barriers to
482 The Process of Economic Development
progress. This is partly so because the TNCs seek to maintain the low-wage sector that, with
reasonable levels of productivity, contributes strongly to their global profits.
Bargaining with the TNCs
There are, however, nations which have made substantial economic and social progress while
selectively and constructively interacting with TNCs. In bargaining with TNCs, particularly
TNCs of the ‚Äústand-alone‚ÄĚ type which desire to enter a nation in order to sell in that nation‚Ä™s
home market, the host nation can exert some leverage. This is particularly the case for a host
nation which has achieved embedded autonomy, as demonstrated by their successful pursuit
of not only ISI but export substitution strategies (see Chapters 7, 9 and 10).
At the same time, some host nations have increasingly been able to exercise some bargaining
strength because there has been a rapid dispersion of the power formerly exercised by US
TNCs. A quick glance back to Table 14.2 will demonstrate that, while US TNCs controlled
approximately half of the stock of FDI in 1960, their share of this capital fell dramatically to
one-quarter of the total in 1992. As a consequence of this shift, some host nations have been
able to improve the terms of engagement with TNCs because, more and more, when foreign
firms seek to become involved in these nations it is likely that TNCs from other nations will
also be interested. This competition among TNCs to locate in any country can work in favor
of the host country.
In 1992, the United Nation‚Ä™s Transnational Corporations and Management Division
published a benchmark work subtitled ‚ÄúTransnational Corporations as Engines of Growth‚ÄĚ
(UN 1992). This study drew together literally hundreds of research documents in order to
address the crucial question of the links between FDI and economic development. Notice
that the conclusions to this study, summarized below, do not address a number of thorny
issues, such as the impact of TNCs on the environment (see Focus 14.5), or the intermediate-
term effects of FDI on the balance of payments discussed above under the heading ‚ÄúIncome
Transfers via TNCs,‚ÄĚ or transfer pricing issues. Some of their key conclusions are worth
careful scrutiny, for there are major lessons to be learned. The following quotation and the
subsequent summary deal only with the quantity and quality of physical capital formation:
The evidence indicates that FDI (foreign direct investment) inflows make a positive
contribution to the quantity of new physical capital in developing countries, and that this
quantitative contribution appears more significant in industries that are crucial to growth
and development, such as manufacturing. Local purchasing by MNCs has, in many host
developing nations, provided a stimulant to local investment. evidence of the qualitative
contribution of MNCs to host country investment is less clear cut. ‚Ä¦ MNC management
practices provide a model for efficient organization of production that can be learned by
host country producers.
The evidence on MNCs and host countries suggests that the benefits from the presence
of MNCs may depend as much on host country conditions as upon the assets brought by
foreign firms. ‚Ä¦ When MNCs produce largely in export processing zones, their ability
to stimulate domestic production is reduced.
The general conclusion is that MNCs have had a positive influence on domestic
capital formation in host developing countries ‚Ä¦ the evidence for such a conclusion is
drawn from a small number of developing countries, most of which are large and have
had some success in stimulating growth.
(UN 1992: 124‚Ä“5)
Transnational corporations and economic development 483
FOCUS 14.5 ENVIRONMENTAL PRObLEMS IN MEXICO‚Ä™S EPzS
With more than one million employees (in 2002) working in over 3,000 foreign-owned
plants along the nearly 2,000-mile US‚Ä“Mexican border, the environmental effects of Mexi-
co‚Ä™s EPZs have received considerable attention.
Mexico has a body of laws and an environmental ministry, SEDESOL, which attempt to
regulate the environmental effect of production in the EPZs. At best, SEDESOL is able to
inspect one-third of the assembly plants in a given year, and enforcement is lax. Some of
the effects noted by researchers are as follows.
‚ÄĘ The city of Tijuana, just below San Diego, California, has experienced a 119 percent
population increase as workers have flocked to the more than 550 EPZ firms. Industrial
waste from the plants and household waste from the population are beyond the sewage
treatment capacities of the city. As a result, 12 million gallons of untreated waste flow
daily into the Tijuana River and then into the Pacific Ocean.
‚ÄĘ In Nogales, Mexico, seventy-five assembly plants, along with the supporting popula-
tion, daily discharge 18 million gallons of untreated waste. The Nogales Wash contains
mercury, lead, and a variety of industrial solvents utilized by furniture assembly compa-
nies. Carcinogenic chemicals found in underground aquifers have forced water-well
closings 10 miles north of the border.
‚ÄĘ In Matamoros, one plant was found to be releasing xylene, an industrial solvent, at
levels 6,000 times above that thought to be safe in drinking water. Another plant regis-
tered concentrations 53,000 times above the safe level. Releases of toxic hydrofluoric
acid at one plant led to a ban on future worker settlements within 1.5 miles of the plant.
Yet workers who already lived within this perimeter were permitted to remain there.
Passage of the North American Free Trade Agreement (NAFTA) in 1993 created new
hope for an environmental clean-up of Mexico‚Ä™s EPZ plants. However, fraud and decep-
tion continue to overcome the attempt to control the disposal of toxic substances, with
only 20 percent of the 12,500 tons of toxic solid wastes inspected for proper disposal.
Sources: Russell 1994: 254‚Ä“60; Scheeres 1996
These summary conclusions are derived from several substantive findings.
‚ÄĘ Manufacturing matters; attracting manufacturing TNCs can raise the total stock of
capital available for production.
‚ÄĘ Local sourcing of inputs matters; attracting foreign manufacturing capital is neither a
necessary nor a sufficient condition for economic growth. The creation of backward
linkages to the local production process is central to the benefits to be gained from
TNCs. TNC capital must be compelled to link with local production sources.
‚ÄĘ Host country conditions matter and are fundamental; host nations must be active partici-
pants in defining and revising the conditions under which foreign capital is permitted to
operate in the domestic economy; market-driven passivity is inadequate if the potential
gains from foreign capital investment are to have a chance of being realized.
‚ÄĘ EPZs matter, but in a negative way; they have not been a viable basis for physical or
human capital accumulation and for sustained growth.
‚ÄĘ Host country size matters; relatively large nations have, as a rule, been most successful
in controlling the interactive process of foreign investment and in being able to reap
more of the potential benefits of FDI; there are exceptions, however. The Latin Amer-
ican countries have been less successful in this regard, partly because of a more laissez-
faire approach to FDI, rather than a more activist and cooperative approach.
484 The Process of Economic Development
‚ÄĘ History matters; successful, or relatively successful, nations in dealing with TNCs have
had a history of fostering development through ISI.
FDI in asia and Latin america: a Historical Case Study
As we have noted in earlier chapters, a great deal of comparative research has been conducted
on the East Asian ‚Äúmiracle‚ÄĚ economies and the largest Latin American nations. Another
contrast to be noted is the manner in which the Asian nations have addressed the issue of the
role of foreign capital. To begin to survey some of this research, it is useful to note the rela-
tive insignificance of TNCs at the top of the production pyramid in both Korea and Taiwan
in the 1980s. In contrast to the large Latin American nations, private nationally owned firms
clearly dominate the most important sectors of production, with state-owned firms holding
a rather distant second-place position (see Table 14.6). In Latin America, by contrast, the
TNCs have a very strong position among the leading corporations, while nationally owned
firms hold a relatively small share of production compared to Korea and Taiwan.
In an attempt to account for the relatively strong performance of two of the Asian miracles,
South Korea and Taiwan, in relation to the two largest Latin American nations, Brazil and
Mexico, Barbara Stallings scrutinized the differing approaches to, and experiences with,
foreign capital. She reached the conclusion that ‚Äúthe issue at stake is whether the State‚Ä™s
choice of development strategy determines the role of foreign capital or whether foreign
capital determines development strategy‚ÄĚ (Stallings 1990: 80). Stallings found that:
‚ÄĘ in South Korea and Taiwan the overall importance of foreign capital had declined over
time; FDI had continued, but at a moderate rate;
‚ÄĘ in Latin America, the importance of foreign capital increased from the 1960s, with the
implementation of secondary ISI, until the 1980s, when the debt crisis virtually halted
Table 14.6 Relative share of TNCs among the largest firms (percentage of total in each category, 1987)
Country State-owned National TNCs
top 10 10 90 ‚Ä“
top 25 n.d. n.d. n.d.
top 10 40 60 ‚Ä“
top 25 32 56 12
top 10 60 10 30
top 25 40 32
top 10 40 40
top 25 44
Source: Gereffi 1990: 92‚Ä“5.
n.d. = no data.
Transnational corporations and economic development 485
‚ÄĘ the East Asian nations have had a relatively lower reliance on FDI for capital and
‚ÄĘ the East Asian nations have favored borrowing from foreign governments, with rela-
tively easy repayment requirements, to having FDI;
‚ÄĘ the East Asian nations have been able to maneuver between Japan and the United States,
thereby improving their bargaining position in determining the conditions under which
FDI has taken place;
‚ÄĘ the East Asian nations had ‚Äústrong‚ÄĚ and cohesive states which were willing to operate
strategically and plan strategically in pursuit of national development;
‚ÄĘ the East Asian nations continued to weigh the relative merits of FDI against bank loans
and other forms of credit, maintaining a balance between these in their favor;
‚ÄĘ the Latin American nations tended to adopt one strategy regarding FDI, and foreign
capital, to the exclusion of dynamic combinations regarding, first, openness to FDI
versus protection and closure of certain key industries, and second, FDI versus bank
Some of the creative and versatile strategies adopted by South Korea and Taiwan in their
search to gain maximum advantage from FDI and foreign capital in general are summarized
[F]oreign capital took two main forms. One was direct investment, often in export
processing zones that provided tax incentives and exemptions on import duties as long
as output was exported. The other was marketing, typically through subcontracting
arrangements with international retail chains.
Both the South Korean and Taiwanese governments were strong, centralized institu-
tions, which used a combination of incentives and regulations to deal with foreign capital.
The South Koreans had a more top-down approach and privileged loans over FDI since
loans gave them greater control. The Foreign Capital Inducement Law of 1960 and its
subsequent amendments set out procedures and guarantees for attracting foreign loans.
Direct investors were also offered tax incentives, but they were never really encouraged
during this period. In addition, the South Koreans were especially sensitive to the issue
of dependency on the United States, and the normalization of relations with Japan in
1965 provided an opportunity to play off South Korea‚Ä™s two most important allies. ‚Ä¦
Taiwan was more willing to let foreigners acquire equity participation in the economy.
Much of this was initially carried out through EPZs. ‚Ä¦ Nevertheless, the government
maintained substantial control by ownership of upstream industries, including banking,
and by targeting chosen sectors for investment. In both countries, the governments
used their power to protect the interests of local firms as well as to regulate foreign
(Stallings 1990: 77)
Analyzing the period from the mid-1950s to the late 1980s, Stallings noted that the reli-
ance on foreign capital increased in the Latin American nations, while domestic savings rose
in South Korea and Taiwan, thereby lessening the need for foreign capital flows (see Focus
14.6). In the 1950s and 1960s, the Latin American nations relied heavily on FDI, but they
paid a price in terms of the loss of economic and political power by the central government
and of a reduction in the importance of national capital. Meanwhile, the East Asian nations
were able to access loans and aid funds which went directly to a clearly developmentalist
486 The Process of Economic Development
FOCUS 14.6 MANAGEMENT OF FDI: THE CASE OF TAIWAN
Taiwan‚Ä™s experience with foreign capital, particularly with FDI, is instructive. Taiwan consti-
tutes an important case-study of the potential benefit from having well-designed foreign
investment guidelines concerning the terms of entry, interaction, and exit of foreign capital
in the host nation.
Like Japan and South Korea, Taiwan has imposed important conditions on foreign
capital, but these conditions have been somewhat less restrictive than in other countries
of the region. When Taiwan has considered the entry of foreign capital, the state attempts
to ascertain the degree to which such capital will contribute to new exports, particularly to
the penetration of new markets. Other important considerations are the degree to which
the foreign capital will create forward and backward linkages or input‚Ä“output links and the
likelihood of significant transfers of needed technologies. Taiwan is concerned with how a
given investment project will enhance its chances of attracting future FDI which will fit into
its development strategy.
Local content requirements
As has been the case in many other nations which have sought to manage FDI, Taiwan
has emphasized local content legislation which has forced TNCs, even those operating
in EPZs, to make significant and growing use of locally produced inputs. Research from
the 1980s indicated that local content in the EPZs was slowly raised to approximately
20 percent. In Mexico, in contrast, local content has been trivial in the EPZs, less than
5 percent. (Since the creation of the World Trade Organization in 1994 it has become very
difficult to impose foreign content legislation, but many nations in Asia have found creative
ways to circumvent the WTO requirements.)
Creating new comparative advantage
Taiwan has repeatedly revised its FDI conditions as the nation‚Ä™s economy has evolved.
Thus in the 1970s it began to discourage labor-intensive FDI, while simultaneously working
to provide a mass of well-trained engineers, scientists, and managers which could spear-
head a drive into high-technology, capital-intensive industrial activities of the secondary
ISI/secondary export substitution stage of industrialization.
Nations with sizeable, if not huge, populations may find that the key to development rests
with the expansion of domestic demand. Intermediate and small nations will generally
find that exports must play a vital role, but not necessarily the central role, in a viable
development strategy. As Robert Wade points out, Taiwan has made constructive use
of export requirements when considering the admission of foreign capital, while simul-
taneously inhibiting access to the domestic market, which has been largely reserved for
Taiwan has sometimes been portrayed as a free trader, but is nonetheless willing to use
both assured access to the domestic market and protection against imports to attract the
kind of FDI which will enhance its growth strategy.
Import protection is important too, and here the subtlety of the approval mechanism
is valuable. Firms which are highly sought after may be told that since Taiwan is a free-
trading country it cannot offer sizeable tariffs or import bans; but that the government
will ensure that the firm nevertheless gets an ample domestic market. What is being
said, in effect, is that hidden protection via the approval mechanism will be given,
while the outward appearance of little protection is maintained.
(Wade 1990: 152)
Transnational corporations and economic development 487
In summary, Taiwan has, thus far, demonstrated how trade-related investment measures
(known as TRIMS) and a dynamic adaptation to new forms of comparative advantage can
be combined in a successful development strategy. This does not mean, of course, that
the Taiwanese experience can or should be duplicated exactly in other nations. But it does
point to the possibilities of constructive interaction with foreign capital, indicating that a
cohesive cadre of state managers can, as Robert Wade points out, govern the market,
rather than adapting to a strategy of merely following and being buffeted about by market
signals, as they are transmitted through the impulse of foreign capital.
Sources: Grunwald and Flamm 1985: 230; Wade 1990
state, as we saw in Chapter 10, thereby permitting the state to channel resources first toward
an easy ISI strategy and later to provide the incentives for a strategy switch toward export
substitution. Reviewing the differing growth experiences of the Latin American nations and
the East Asian economies, Stallings arrives at an incisive conclusion regarding the role of
foreign capital in economic development.
[The] differing trends over time, toward a lesser need for foreign capital in East Asia
and a greater ability to control it, add up to an objective set of reasons for East Asian
specialists to be more positive than their Latin American counterparts about the role
of foreign capital. The key to understanding the different experiences centers on
the issue of host country autonomy, an issue that also links the two debates being
considered. Regardless of its form ‚Ä“ direct investment, private bank loans, or public
sector credits ‚Ä“ the purpose of foreign capital is to further the interests of those
who provide it. Development of the host country is a fortuitous side effect at best,
which will only come about if the host government maintains enough autonomy and
control to guarantee that the benefits are shared between providers and recipients of
(Stallings 1990: 82)
Summary and conclusions
While FDI has expanded tremendously since the 1980s it is impossible to demonstrate one
unique pattern between host developing nations and TNCs. Outcomes vary primarily in
accordance with the strategies and tactics adopted by host nations. A passive strategy yields
meager results, while nations that actively engage TNCs have demonstrated that dynamic
policies to capture gains from FDI are possible. It would be impossible to offer a superior
summary of the lessons that have been learned regarding FDI and development than that of
the World Investment Report:
there is no ideal universal strategy on FDI. Any strategy has to suit the particular
conditions of a country at a particular time, and evolve as its needs change and its
competitive position in the world alters. ‚Ä¦ Making effective strategy requires above
all a development vision, coherence and coordination. It also requires the ability to
decide on trade-offs between different objectives of development. In a typical struc-
ture of policy-making, this requires the strategy-making body to be placed near the
head of government, so that a strategic view of national needs and priorities can be
formed and enforced.
(UNCTAD 1999: 326)
488 The Process of Economic Development
Questions and exercises
1 Over the long period 1945‚Ä“2007, global trade has generally grown much faster than
the annual average rate of growth of global GDP. Proponents of an ‚Äúexport-led growth‚ÄĚ
strategy have argued that, with this growth of global trade, concerns over the ‚Äúfallacy of
composition‚ÄĚ argument regarding trade as an engine of growth are exaggerated ‚Ä“ that
is, export growth has plenty of room for maneuver. Analyze this dispute, with particular
reference to the possible duplications of the cases of Korea and Taiwan. What percentage
of world exports is currently produced by less-developed countries? You can find this
data at the UNCTAD website in the annual book of statistics.
2 Construct a chart listing the potential effects of inward direct foreign investment on
developing nations. In one column, list the possible positive benefits of FDI; in a second
column list the possible negative effects FDI can bring to a host nation. Some of these
effects may be political, others economic, social, or environmental. Briefly explain each
potential benefit and each potential cost.
3 You have been hired (at ¬£500/day!) to advise on the establishment of an export processing
zone in a Middle Eastern nation. Your task is to write a brief (500-word) outline entitled
‚ÄúPitfalls to Avoid and Benefits to Capture in an EPZ.‚ÄĚ
4 A large TNC, heavily involved in subcontracting its production to various low-income
nations, has become the target of an adverse publicity campaign which has centered
on the low labor standards of its subcontractors. Your task is to compose a ‚ÄúCode of
Conduct‚ÄĚ which the TNC will impose on its subcontractors in the future. What rules
would you include?
5 Summarize what is known about the potential for spillovers or technological transfers
arising from FDI. Show that the degree of success a nation may have in this area with
foreign investors is a function of national policies and capacities.
1 For example, more than any other factor, the political economy of oil has determined the modern
economic history of the Middle East. At the epicenter of a vast and complex historical transformation,
one finds the overwhelming influence of the huge oil-producing transnationals. John Blair‚Ä™s classic, The
Control of Oil, continues to be the best introduction to the role of the oil industry in the Middle east, and
to the nature of the largest single group of TNCs, the oil and chemical corporations (Blair 1978).
2 This shows, too, why international convergence of income, as discussed in Chapter 8, is perhaps
not evident. Poorer countries are different from more developed nations; even among the less-de-
veloped nations themselves, there are differences. They do not have the same production functions,
so the fact that they have less physical capital does not mean that the return to capital is higher, as
the law of diminishing returns would suggest. Physical capital in the poorest countries is less effec-
tive, because the complementary inputs, like human capital, technology, government policies, and
so on, that make such capital more productive are missing or but poorly formed.
3 Drawn to India by the market potential for fertilizers created by the Green Revolution, one pesticide
manufacturer, Union Carbide, began production of chemicals and pesticides in Bhopal in 1970. In
December 1984, Bhopal became an international symbol of environmental catastrophe when a
pesticide product, methyl isocyanate (MIC), was released into the air in massive amounts. Safety
conditions at the plant were totally inadequate, and 200,000 people in the city of 800,000 suffered
from gas inhalation. Thousands died, and over 25,000 were treated by medical professionals. No one
knows the long-term effects on the survivors, many of whom can no longer work (Gupta 1988: 55).
4 Wages in the EPZs tend to be one-tenth or less than average hourly wages in the advanced industrial
nations for roughly similar work. Although productivity measured as output per hour is usually
lower in the EPZs ‚Ä“ often half that of the advanced nations and sometimes above 80 percent ‚Ä“ the
profitability of such production can be quite high.
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15 Macroeconomic equilibrium
The external balance
after reading and studying this chapter, you should better understand:
‚ÄĘ what the balance of payments is measuring and why it is so important to economic
‚ÄĘ the connections between internal macroeconomic disequilibriums and external
‚ÄĘ the components of the current and capital and financial accounts of the balance of
‚ÄĘ the importance of official foreign exchange reserves;
‚ÄĘ what is meant by a ‚Äúbalance of payments problem‚ÄĚ;
‚ÄĘ the difference between ‚Äúgood‚ÄĚ and ‚Äúbad‚ÄĚ current account deficits;
‚ÄĘ the importance of monitoring the balance of payments accounts so as to anticipate
‚ÄĘ bilateral exchange rates and currency appreciation and depreciation;
‚ÄĘ how fixed, floating and managed-float exchange rate regimes function and the
impact of changing economic conditions on each exchange rate regime;
‚ÄĘ how exchange rates are affected by inflation;
‚ÄĘ the interrelation between exchange rates and the balance of payments;
‚ÄĘ the impact of over-valued and under-valued exchange rates on the balance of
payments and economic progress.
In an increasingly global economy, where barriers to trade and financial flows among nations
have been lowered since the early 1970s, policy-makers must be ever vigilant in ensuring
that their country‚Ä™s balance of payments and exchange rate evolve in ways that create the
possibility of expanded and sustained economic growth and development. In modern
economies linked by virtually instantaneous and twenty-four-hour flows among the world‚Ä™s
financial markets in London, Paris, Frankfurt, Tokyo, Hong Kong, Seoul, Sydney, Mexico
City, Buenos Aires, Toronto, and New York, disequilibrium situations that are not corrected
can lead to severe crises over the longer term.
It is no exaggeration to suggest that in the current context of economic policy-making,
it is the external equilibrium condition imposed by the balance of payments which is one
of the most important values to be monitored by nearly every economy. If this constraint
492 The Process of Economic Development
is not prudently respected, a balance of payments disequilibrium can thwart other positive
steps policy-makers and society have taken on the road to becoming more developed. This
is why an understanding of the workings of the balance of payments accounts is essential for
coming to grips with the challenges facing many economies today.
This chapter considers the relation between a country‚Ä™s exchange rate, its balance of
payments position, and the links between the macroeconomic internal balances, espe-
cially the rate of inflation, and these external balances. To understand how balance of
payments difficulties may arise, it is necessary also to consider how exchange rates
are determined under different possible exchange rate regimes ‚Ä“ floating, fixed, and
managed float ‚Ä“ and the connection between a nation‚Ä™s exchange rate and its balance of
Let us begin by considering the balance of payments accounts.
The balance of payments
For most countries, disequilibrium in the balance of payments is often the ultimate binding
constraint on policy-making. Good policy-makers learn to monitor their country‚Ä™s balance
of payments accounts for signs of impending difficulties, and they take steps to modify their
economic, social, fiscal, and monetary policies to correct problems before they erupt into
full-blown crises. In effect, good policy-makers use the evolution of the balance of payments
accounts as a signaling device for judging the effectiveness of their other interventions into
the economy. The ability to adjust to disequilibrium situations in an agile fashion seems to
have been one of the hallmarks of the success of the East Asian economies in a wide range
of situations, and adjusting to balance of payments problems before they reach a crisis stage
is another of those instances.
What, exactly, is the balance of payments all about?
Very simply, the balance of payments measures all the outflows and inflows of foreign
currency across the national borders of a country in transactions with the rest of the world
(ROW) over some period of time, usually a year, but often calculated quarterly or even monthly.
Simplifying somewhat, the balance of payments measures what a country earns and ‚Äúborrows‚ÄĚ
in foreign exchange terms from the ROW and what it spends in and ‚Äúlends‚ÄĚ to the ROW in
foreign exchange. The balance of payments is focused on accounting for all these flows of
foreign exchange, that is, foreign currency, that take place between one nation and the rest of
Just as for individuals, families and firms, a nation‚Ä™s spending in the ROW will be exactly
equal to what it earns from the ROW, plus any net borrowing (= borrowing ‚ą’ lending) that
it does from the ROW. Nations thus ultimately can only import goods and services or travel
or invest in other countries to the extent that other countries purchase their exports or travel
or invest in their country. In the final analysis, spending in the ROW by any country is, over
time, limited to the income earned from the ROW.
The balance of payments (B of P) is composed of three parts: the current account balance,
the capital and financial account balance, and net errors and omissions. Because of double-
entry accounting, the following statement is always true.
B of P = current account balance + capital and financial account balance
+ net errors and omissions = 0 (15.1)
What this means is that all the inflows of foreign currency into a country are exactly matched
Macroeconomic equilibrium 493
by an equivalent outflow of foreign exchange from the economy. Always. The components
of the balance of payments always sum to zero by definition.
What, then, can it possibly mean to say that a country has a balance of payments problem
if there is always a zero balance no matter what policies a country may follow? Before
answering that question, we shall quickly review the elements entering into the different
parts of the balance of payments account, one-by-one.
The current account: foreign exchange earnings and spending
The current account of the balance of payments measures the outflows (‚Äúspending‚ÄĚ) and
inflows (‚Äúincome‚ÄĚ) of foreign exchange of a country vis-√†-vis the rest of the world for current
transactions, such as the purchase of cars or insurance, or contracting services, or payments on
international loans. Throughout our discussion of the balance of payments, it will be helpful
to keep in mind that all transactions creating inflows of foreign exchange to an economy
will have a positive value. All transactions resulting in outflow of foreign exchange from an
economy will be recorded with a negative value. What the balance of payments does is to
sum all those transactions, some of which are positive values (inflows of foreign exchange)
and some of which are recorded as negative values (outflows of foreign exchange).
Table 15.1 lists the major components of the current account.1 In a rough-and-ready sense,
the current account is simply a measure of an economy‚Ä™s spending and income balance with
For most countries, the largest item in the current account is the balance of trade. The
overall balance of trade measures the net trade of all goods and services of a country with
the rest of the world (ROW); these are the sum of entries A to D shown in the last line of
Section I of Table 15.1. Note that when these items are added, merchandise imports, item
B, and service imports, item D, have a negative sign attached to their value, indicating
that these items create an outflow of foreign exchange from an economy. Exports (items
A and C) create an inflow of foreign exchange, so the value of those items have a positive
sign attached to them, indicating there is an inflow of foreign currency generated by these
A surplus in the balance of trade means that the foreign exchange earned from all exports
sold to the ROW exceeded the foreign exchange spent on imports from the ROW (trade
surplus = + $X ‚ą’ $M > 0). When a country spends more foreign exchange on imports than it
earns from its exports, the country will have a deficit in the balance of trade (= + $X ‚ą’ $M < 0).
Again, the value of imports is given a negative sign, because imports result in an outflow of
foreign currency from an economy.
It often is of some interest to disaggregate the balance of trade by separately determining
the balance on merchandise trade and the balance on service trade. The balance on merchan-
dise trade (A ‚ą’ B in Table 15.1) includes the export and import values of all real, tangible
merchandise or goods, such as motor cars, oranges, rice, computers, computer programs,
mattresses, golf clubs, wine, and so on.
The balance on service trade includes exports and imports of all services (C ‚ą’ D) that
create flows of foreign exchange between countries, such as banking, insurance, advertising,
film, television, video rentals, technology and product licensing, contracting and building
services, and shipping plus all flows of foreign currency due to travel and tourism that takes
place between a country and the ROW.2
Section II of the current account in Table 15.1 (items E and F) measures the income
earned (a positive value) in foreign currency and the payments of foreign exchange (an
494 The Process of Economic Development
Table 15.1 The current account of the balance of payments
Item Transactions creating an Transactions creating an
inflow of foreign exchange outflow of foreign exchange
A Merchandise exports X
B Merchandise imports
Balance on merchandise trade = A ‚ą’ B
C Service exports
D Service imports
Balance on service trade = C ‚ą’ D
Balance of trade = A ‚ą’ B + C ‚ą’ D
II Factor income receipts and payments
E Receipts from ROW of interest, profit X
and dividends, and employee
F Payments to ROW for interest, profit X
and dividends, and employee
Balance of factor income = E ‚ą’ F
III Current transfers
G From ROW X
H To ROW X
Balance of current transfers = G ‚ą’ H
Balance on the current account = A ‚ą’ B + C ‚ą’ D + E ‚ą’ F + G ‚ą’ H
outflow, hence a negative value) from flows of interest, profits and dividends, and employee
compensation that are the result of loans and investments made in or by other countries.
For example, borrowing by the Brazilian government from US and other foreign banks in
the 1970s created an outflow of foreign currency on Brazil‚Ä™s current account as interest was
paid to the United States and other lenders. At the same time, an identical transaction was
recorded on the current account of the lending economies, albeit as a positive inflow of
foreign exchange comparable to income earned from exporting a good or a service. It is just
that these are flows of foreign exchange income and foreign exchange spending that result
from prior investments and loans rather than from the current sale of goods or services.
In a similar way, countries which are hosts to foreign multinational firms or which have
foreign investors involved in their domestic stock or bond markets are likely to experience
an outflow of foreign exchange (an ‚Äúexpenditure,‚ÄĚ recorded as a negative value) on item F
of the current account as foreign exchange payments flow to the foreign owners of those
assets. These are income payments compensating for the current value of the services of past
loans and investments. We shall see in Chapter 16 and Focus 16.2 that such movements of
income payments can be quite important for some countries, especially those which incur
large amounts of external debt.
Items G and H in Section III of the current account measure any transfers of foreign
Macroeconomic equilibrium 495
exchange that take place between nations. These are unilateral transactions, that is, one-way
flows, of foreign exchange between economies. There is no corresponding equal and oppo-
site flow of a good or service in the other direction, as is the case for all other items in the
current account balance. For example, when Great Britain provides a package of aid worth
¬£50 million to Kenya to build an electrical generating facility for the capital city of Nairobi,
this would appear as a positive inflow of foreign exchange on Kenya‚Ä™s current transfers
account and a negative entry of the same value on the UK‚Ä™s current transfers account.
Another example of a current unilateral transfer would be the remittances of income that
Turkish immigrant workers earn in Germany or Mexican immigrants earn in the United
States that are sent to family in their native countries. Such remittances create an outflow of
foreign currency from the German and US economies that are recorded as negative values
in the current transfer section of their current accounts while simultaneously creating a posi-
tive inflow of foreign exchange (‚Äúincome‚ÄĚ) from the ROW for Turkey and Mexico in their
current transfer balance.
Deficits and surpluses on the current account balance
The current account balance is equal to the sum of items A ‚ą’ B + C ‚ą’ D + E ‚ą’ F + G ‚ą’ H in
Table 15.1.3 Alternatively, we can equivalently say that the
Balance on the current account = balance of trade + balance of factor incomes
+ balance of current transfers.
There is a deficit on the current account when the current account balance is less than zero,
i.e. when ‚Äúthe balance of trade + balance of factor incomes + balance of current transfers < 0.‚ÄĚ
In a very rough but reasonable sense, we can say that an economy with a current account
deficit has spent more foreign exchange in the ROW than it has earned from the ROW. When
there is a current account deficit, foreign exchange outflows to the ROW exceed foreign
exchange inflows from the ROW.
How can a country spend more foreign exchange in the ROW than it has received from the
ROW? Just as for a family or business, foreign currency expenditures of a country in the ROW
can only exceed foreign exchange income from the ROW if the difference (a) is borrowed,
(b) is financed out of past savings, or (c) is financed by selling off some assets or wealth. In
other words, a country that runs a current account deficit can only do so by going into debt or
reducing its existing international foreign exchange assets to be able to spend more than its
current foreign exchange income. There are no other alternatives. We shall examine more what
such borrowing means and what the implications are of such borrowing in the next section.
In a similar fashion, a current account surplus means a country has earned more foreign
exchange from the ROW than it has spent in the ROW. A surplus on the current account
occurs when the sum of A ‚ą’ B + C ‚ą’ D + E ‚ą’ F + G ‚ą’ H > 0, which means that the ‚Äútrade
balance + the balance of factor incomes + the balance of current transfers > 0.‚ÄĚ
A country with a current account surplus will find that it has accumulated foreign exchange
savings (= foreign exchange income from the ROW not spent in the ROW), some of which
may even be lent to other countries needing to finance current account deficits. Countries
running a current account surplus will be accumulating international assets vis-√†-vis the rest
of the world (see Focus 15.1 on the evolution of the current accounts of various regions).
They will have foreign exchange income earned from the ROW that was not spent on goods
and services, transfers or factor services in the ROW.
496 The Process of Economic Development
FOCUS 15.1 EXPLORING CURRENT ACCOUNT bALANCES
While aggregation can hide what is happening to individual countries, it is still useful to
consider the evolution of the balance of payments by region to see if there are any obvious
tendencies. The top row for each region shows the current account balances for select
years. The emboldened row shows net factor income payments (i.e., E‚ą’F from Table 15.1).
All values are in billions of US dollars.
1987 1990 1995 2000 2005
East Asian economiesa 32.8 17.0 12.1 40.1 92.2
‚ą’0.6 4.1 6.0 4.1 14.9
Africa ‚ą’4.4 ‚ą’3.0 ‚ą’17.3 6.5 6.5
‚ą’14.2 ‚ą’17.3 ‚ą’14.6 ‚ą’23.4 ‚ą’40.2
Latin America and the Caribbean ‚ą’11.1 ‚ą’2.0 ‚ą’31.2 ‚ą’47.8 3.8
‚ą’31.9 ‚ą’38.4 ‚ą’45.2 ‚ą’53.0 ‚ą’69.6
a Hong Kong, Singapore, South Korea and Taiwan.
Africa and Latin America incurred persistent current account deficits until very recently,
while the four East Asian countries (Hong Kong, Singapore, Taiwan, and South Korea) have
run current account surpluses for decades. One important contributing factor to current
account deficits in Latin America and Africa has been interest payments on external debt
(discussed more fully in Chapter 16).
The figures in bold type show the net or balance of factor income for each region,
which include the sum of payments (an outflow of foreign exchange) and receipts (an
inflow of foreign exchange) of interest, profits, and dividends (and small amounts for
labor services). The largest component of income payments is for interest on external
debt which was accumulated to finance past current account deficits. These factor
income payments would be recorded as a negative value for item F in Table 15.1. For
Africa and Latin America, this net outflow of income payments has been consistently
negative and increasing.
For example, even though Africa had a positive trade surplus of $18.3 billion in 2000
(not shown in the table), much of this net inflow of foreign exchange earned from the ROW
(plus net current transfers from the ROW of $11.6 billion, also not shown) was used to pay
the $23.4 billion in net factor income payments to the ROW, resulting in an overall current
account surplus of only $6.5 billion (= $18.3 billion trade balance ‚Ä“$23.4 billion balance of
factor income + $11.6 billion current transfers balance). Most of the $29.9 billion positive
inflow of foreign exchange due to trade and transfers ended up being used to pay for the
negative outflow of foreign exchange required to repay the $23.4 billion in interest and
profits on past debt obligations in the ROW.
The situation in Latin America and the Caribbean in 2005 was even more severe. Finally,
the region was running a current account surplus (actually beginning in 2003). But how
was it able to do so? Look at the $69.6 billion dollar outflow of foreign exchange needed
to pay income to the ROW for interest on past external debt and for profits and dividends.
This completely swamped the positive trade balance of $32.4 billion (not shown), and
if it had not been for a positive inflow of foreign exchange equal to $41.0 billion from
current transfers in 2005, the current account could easily have been in deficit. The current
account balance was positive, but only because the sum of the trade surplus plus net
current transfers (= $73.4 billion) generated an inflow of foreign exchange large enough to
fund the outflow of $69.6 billion paid as net factor income to the ROW.
Macroeconomic equilibrium 497
For some countries current account deficits which resulted in borrowing from abroad
over a series of years can contribute to future current account deficits, requiring further
borrowing or other financing. On the other hand, the East Asian economies have had
positive net inflows of income payments (except for 1997 when there was a brief crisis),
even though they too, especially Korea, incurred external debt obligations in the past.
It is somewhat disturbing that economies like those in Latin America that are success-
fully expanding their exports and actually are generating significant trade surpluses, as
economists have been recommending that they do, are not able to benefit from their
efforts. Instead, a significant proportion of net foreign exchange earnings from trade end
up flowing to the already-developed nations as income payments on past debt.
The differences in the evolution of the current account balances and net income
payments between Africa and Latin America and the Caribbean, on one side, and the East
Asian economies on the other, highlight the importance of past decisions on structural
transformation, industrialization, human capital accumulation, technology acquisition and
a good policy environment for successful development. One does not have to go back too
far in time to find the East Asian economies with persistently large current account deficits
too. We will be considering what they did and what other economies might do to improve
their balance of payments situation so that trade earnings are available for the purchase
of exports and not just the servicing of debt.
Sources: IMF 1995: 159‚Ä“60; 2002: 195‚Ä“8; 2005: 237, Table 25, 240,
Table 27, 243‚Ä“4, Table 29
The capital and financial account: foreign exchange borrowing and
From statement 15.1 above, the second major component of the balance of payments is the
capital and financial account. You will remember we said that in a very simplified sense we
can think of the current account as a way to measure an economy‚Ä™s spending in and income
from the ROW. It is useful to think of the capital and financial account in a similar simplified
manner as measuring an economy‚Ä™s borrowing from and lending to the ROW.
Before we consider the details of the capital and financial account, let‚Ä™s consider the relation-
ship between the current account and the capital and financial account using a simple numer-
ical example. Assume a country‚Ä™s balance of payments accounts look like the following:
I current account balance = ‚ą’$11.5 billion
II capital and financial account balance = + $8.5 billion
III net errors and omissions = + $3.0 billion.
From statement 15.1, we know that the three parts of the balance of payments must sum to
zero, as they do in this example. What does the current account balance of ‚ą’$11.5 billion
mean? If you said it means there is a current account deficit, good; but what does that mean?
A current account deficit means that this economy spent more foreign exchange in the ROW
than it earned from the ROW for all the types of transactions shown in Table 15.1. Outflows of
foreign exchange exceeded inflows of foreign exchange, so that overall the current account had
a negative value, indicating a net outflow of foreign currency from the economy to the ROW.
How can an economy spend more foreign exchange than it has earned? If you answered
‚Äúborrow,‚ÄĚ you are right again. What must be borrowed, remember, is foreign exchange and
that means borrowing foreign currency from another country, a foreign bank or some other
entity which creates an inflow of foreign exchange into the economy. This borrowing of
foreign exchange is what is being measured in the capital and financial account.
498 The Process of Economic Development
From this simple example, you can see that this economy ‚Äúborrowed‚ÄĚ more foreign
exchange from the ROW than it ‚Äúlent‚ÄĚ to the ROW, since the sign of the capital and financial
account balance is positive, indicating a net inflow of foreign exchange into the economy.4
There also was a net inflow of foreign exchange into the economy from net errors and omis-
sions (what this is all about will be explained below). The current account deficit of ‚ą’ $11.5
billion, which means this economy spent more foreign exchange than it earned, would not
have been possible without the net positive inflows of foreign exchange from borrowing and
errors and omissions that ‚Äúfinanced‚ÄĚ the excess of spending above income by generating a
net inflow of foreign exchange equal to + $11.5 billion.
We thus often find that economies that run current account deficits and are spending more
foreign exchange than they are earning will have positive capital and financial account
balances that reflect the necessary ‚Äúborrowing‚ÄĚ to finance the current account deficit. Simi-
larly, economies that have positive current account balances, meaning they are earning more
foreign exchange than they are spending, typically may be expected to have negative capital
and financial account balances which indicate that they are ‚Äúlenders‚ÄĚ of foreign exchange to
the ROW (remember: ‚Äúnegative‚ÄĚ here does not necessarily have a ‚Äúbad‚ÄĚ connotation; in the
balance of payments it simply means an outflow of foreign exchange).
Table 15.2 summarizes the items included in the capital and financial account.
While the capital account is important, it is in the financial account that some of the most
important long-term flows of assets across national borders are recorded, and it is on those
items we will focus.
Table 15.2 The capital and financial account of the balance of payments
Item Transactions creating Transactions
an inflow of foreign creating an outflow
exchange of foreign exchange
IV Capital account
I Net capital transfersa X X
V Financial account
J Loans from ROW X
K Loans to ROW X
L Investments from ROWb X
M Investments in ROWb X
N Sale of official foreign exchange X
O Purchase of official foreign exchange X
Balance on the capital and financial account = l + J ‚ą’ K + L ‚ą’ M + N ‚ą’ O
a This includes debt forgiveness and other types of capital movements not included in the financial account. This
item is not one we will focus on, and it is typically small for most economies.
b Investments include both foreign direct investment (FDI) and portfolio investment.
c These are purchases and sales by the central bank of foreign currencies, gold, and IMF special drawing rights
(SDRs), a kind of international currency created by the International Monetary Fund and allocated to nations for
use in settling transactions between countries.
Macroeconomic equilibrium 499
Items J and K measure the inflows and outflows of foreign currency resulting from
international loans. When one nation receives a foreign currency loan from another nation or
when an individual, business or government acquires a loan from a bank or other financial
intermediary or even another individual located in a foreign country, a positive inflow of
foreign exchange is recorded on Item J of the financial account of the borrowing economy.
For the lending country, there is an outflow (a negative value) on item K of the financial
account identically equal to the amount of that lending. For example, when Japanese citizens
buy US$1 billion of US Treasury bonds in the US bond market, Japan is making a loan to the
United States that creates a foreign currency inflow (= + US$1 billion) to the United States
and an equivalent outflow (= ‚ą’US$1 billion) from Japan.
Similarly, items L and M measure investment transactions that create inflows or outflows
of foreign currency as the result of financial investments or foreign direct investment (FDI)
in productive facilities. An inflow of investment can be considered a type of loan as the
inflow of foreign exchange contributes to total investment in the country, increases income
and thus, potentially, permits an expansion of current consumption and investment. It also
must be ‚Äúpaid‚ÄĚ for in the sense that if profits are earned or dividends paid, there will be an
outflow of foreign exchange from the borrowing economy. Thus when a country has a posi-
tive inflow on items J or L in the financial account, this inflow of foreign exchange due to
borrowing will contribute to a future outflow of foreign currency in the ‚ÄúFactor incomes‚ÄĚ
portion of the current account as these loans and investments are repaid or earn profits and
If the sum of J ‚ą’ K + L ‚ą’ M > 0, this means that there is a net inflow of foreign currency
from the ROW and that the country is a net borrower from the ROW. If the value of this part
of the financial account is < 0, then this means that there is a net outflow of foreign currency
to the ROW and that the country is a net lender to the ROW.
Official foreign exchange reserve assets
One especially important part of the capital and financial account is an economy‚Ä™s use of its
total official foreign exchange reserve assets, items N and O. Total official foreign exchange
reserves are holdings by the central bank of foreign currencies plus gold and SDRs.5 It is
useful to think of an economy‚Ä™s total official foreign exchange reserves as a form of ‚Äúsavings‚ÄĚ
in the form of foreign currencies.
Why does a country hold on to foreign currency reserves? These are retained to pay for
needed imports or other foreign currency needs a country might have in periods when, for
one reason or another, there is a short-fall of foreign exchange earnings. For example, export
income might be hurt by a down-turn in prices or bad weather, making it difficult to pay for
imported goods. Countries thus always desire to hold some quantity of foreign exchange
reserves, often the equivalent of at least five to six months of import expenditures, as a
cushion or buffer in case of unexpected events.
Official foreign currency reserves ‚Ä“ which are held by the government and are not circu-
lating in the economy, that is, they are outside the economy ‚Ä“ can be used to finance foreign
exchange outflows when the government makes these available to the economy by running
down its total official reserves and injecting these into the economy‚Ä™s spending stream.
Foreign exchange ‚Äúsavings‚ÄĚ can be used along with any net borrowing from the ROW to
pay for foreign exchange expenditures that exceed foreign exchange earnings on the current
account, just as an individual‚Ä™s or a family‚Ä™s savings and borrowing can be used to pay for the
purchase of things above and beyond what their current income would permit.
500 The Process of Economic Development
Item N in Table 15.2 records the sale of official foreign exchange reserves by the
government from existing holdings of foreign currencies and/or gold and SDRs. Such sales
create an inflow of foreign currency into the economy as some of the government‚Ä™s official
foreign reserves are traded on the foreign exchange market. This means a country is injecting
some of its own previously accumulated foreign exchange assets into the economy to be
used to pay for imports or to finance some other expenditure that is not being met by current
foreign exchange income or borrowing of foreign exchange.
The injection of foreign exchange into the economy from the government‚Ä™s reserves is
recorded as a positive (+) value on item N in the capital and financial account, since it is
an inflow of foreign exchange into the economy. Prior to that, this foreign exchange was
outside of the economy in the sense that it was not available for spending, since it was held
as ‚Äúsavings‚ÄĚ as part of the government‚Ä™s official foreign exchange reserves. This positive
inflow of foreign exchange reserves into the economy, however, means that the country‚Ä™s
total official exchange reserves have decreased, since this inflow of foreign exchange came
from the total foreign exchange savings of the central bank. This interpretation can often be a
source of confusion, so re-read this paragraph carefully to be sure you understand. An inflow
of foreign exchange that comes from official foreign exchange reserve assets is recorded as a
positive value on item M, and it means that total official reserve assets have decreased by that
amount since these reserves were drawn down to make this injection of foreign exchange
into the economy.
Item O in Table 16.3 has the opposite interpretation to item N. When there is a purchase
of official foreign exchange reserves, that is recorded with a negative (‚ą’) value in the capital
and financial account. This means there has been an outflow of foreign exchange from the
economy in the sense that it is leaving the economy‚Ä™s spending stream and is unavailable
for use, but this foreign exchange is being added to the central bank‚Ä™s total official foreign
exchange reserves. There thus will be an increase in total official foreign exchange reserve
holdings of a country due to this transaction.
Countries via their central bank and the normal channels where foreign exchange deals
are transacted are continually both selling from and adding to their foreign exchange
reserves. What is most important is the change in the net position on official foreign
exchange holdings over time, that is, the difference between the value of N and O. When
N ‚ą’ O > 0 ‚Ä“ meaning the sales of foreign exchange from official reserves exceed the
purchases of foreign exchange added to official reserves ‚Ä“ the country will suffer a net
decrease in its total official foreign exchange assets. Perhaps this seems counterintuitive,
but a net positive value for N ‚ą’ O means that foreign exchange has entered the economy.
And since this foreign exchange ‚Äúentered‚ÄĚ from the government‚Ä™s official foreign exchange
reserves, this must mean that those reserves are smaller than they were before. A decrease
in official foreign exchange reserves is equivalent to dissaving by the country and thus
occurs when N ‚ą’ O > 0.
When N ‚ą’ O < 0, a country experiences a net increase in its total official foreign
exchange reserves. A net negative value for the change in official foreign exchange
reserves means that foreign exchange is leaving the economy, and in this case it is
‚Äúleaving‚ÄĚ to be added to the government‚Ä™s total official foreign exchange reserves. An
increase in official foreign exchange reserves represents a form of national saving since
it is foreign exchange that has been taken out of circulation of the local economy in the
sense that it is not available for spending but rather has been added to total official foreign
What happens to an economy‚Ä™s total official foreign exchange reserves is extremely
Macroeconomic equilibrium 501
important, and we shall see that changes in official reserves are a gauge of the ‚Äúhealth‚ÄĚ of the
balance of payments, so be sure you understand this section!
Net errors and omissions
The third and last major component of the balance of payments is ‚Äúnet errors and omis-
sions.‚ÄĚ This could just as easily be called the ‚Äústatistical discrepancy,‚ÄĚ because the value of
net errors and omissions is whatever it needs to be to make statement 15.1 sum to zero, that
is, so that ‚Äúthe current account balance + capital and financial account balance + net errors
and omissions = 0.‚ÄĚ
To illustrate using our simple example from the previous section, the net errors and omis-
sions value of + $3.0 billion was determined as a residual. How? When the current account
balance (‚ą’ $11.5 billion) and the capital and financial account balance (+ $8.5 billion) were
added together, the sum equaled ‚ą’$3.0 billion. Since by definition 15.1 and the principles
of double-entry bookkeeping we know that the inflow of foreign exchange must equal the
outflow of foreign exchange and that the sum of the current account, the capital account
and the net error and omissions must equal zero, then the value of net errors and omissions
must be +$3.0 billion for that to be true. In this way, the balance of payments ‚Äúbalances‚ÄĚ
in the sense that inflows and outflows of foreign exchange are made equal and the sum of
the components of the balance of payments is zero, as it must always be.
Nonetheless, net errors and omissions is an important component of the balance of payments
accounts. It does ‚Äúmeasure‚ÄĚ some very important transactions. It is not just a ‚Äúspillover‚ÄĚ
category. First, it is a measure of all those legal transactions that get missed in some way in
the normal collection of statistics due to errors of bookkeeping, misreporting, human error,
and a whole host of other possible reasons. With millions of individual transactions taking
place between a country and the ROW every year, even the best designed accounting and
reporting systems will not be completely accurate. So, first of all, the net errors and omis-
sions portion of the balance of payments recognizes that there inevitably will be inaccuracies
in the records that must be accounted for so that all inflows and outflows of foreign exchange
are equal, as they must be.
Secondly, however, the net errors and omissions portion of the balance of payments is one
way to capture a whole range of transactions between one country and the rest of the world,
mostly if not always illegal, that no official statistics will ever be able to capture: the marketing
of illegal drugs and narcotics, gun-running, money-laundering operations, and capital flight.
For example, Pakistan has a thriving trade in opium and heroin, all of it illegal. This ‚Äútrade‚ÄĚ
creates a substantial inflow of foreign exchange into the economy. This inflow of foreign
currency is not recorded in the current account under exports, of course, since it is illegal.
So, how does this inflow of foreign exchange that is available to pay for imports, to make
loans to other countries, to be used for foreign investments, and for other financing other
outflow of foreign currency get accounted for? Since there are outflows of foreign currency
that are taking place that do not have a corresponding and balancing inflow of foreign
currency elsewhere in the balance of payments, those inflows are imputed to ‚Äúnet errors and
omission.‚ÄĚ In fact, variations over time in the size of the net errors and omission portion of
the balance of payment are one means by which governments and international agencies
can track the illegal drug trade, illegal arms movements, and illegal flows of financial funds
to and from economies. This part of the balance of payments is thus measuring something
quite real but which is not counted directly in any of the other accounts of the balance of
502 The Process of Economic Development
What does it mean to say that a country has a balance of payments
Now that we have looked at the various components of the balance of payments, what does it
mean to say a country has a balance of payments problem? If the sum of the current account
balance + capital and financial account balance + net errors and omissions always sum to
zero, how can we know if a country has a problem?
Let‚Ä™s think about this. If a country is running a current account deficit it means that
the country will be obliged to borrow foreign exchange from the ROW or reduce its own
official foreign exchange reserves to finance the excess of foreign exchange spending over
foreign exchange income. Whether the borrowing takes the form of loans from foreign
governments, banks, multinational corporations, individuals, or some other institution, the
loan is denominated in a foreign currency and must be repaid in that same foreign currency
in the future. If the borrowing takes the form of portfolio or direct foreign investment, there
is still a foreign exchange obligation in the future to pay profits and dividends to the foreign
If a country cannot borrow foreign exchange from the usual sources in the international
market or its foreign exchange reserves become dangerously depleted, then the country will
be unable to run a current account deficit. Why would a country be unable to borrow foreign
exchange from the ROW? The inability to borrow would likely be due to concerns by inter-
national lenders that the country was accumulating ‚Äútoo much‚ÄĚ foreign exchange debt and
was becoming a greater risk for default. While it is not correct to claim that every current
account deficit is a problem, any country with persistent and large current account deficits
may be signaling to international lenders possible future problems and underlying weak-
nesses in the economy that continue to result in such deficits.
Once a country cannot borrow any more foreign exchange, the possibility of continuing to
run current account deficits will be limited by the size of its official foreign exchange reserve
assets, which are obviously finite. Official reserve assets cannot be a source of continued
spending of foreign exchange above what is earned. In fact, declining official foreign
exchange reserves over some period of time is a pretty good indication that an economy has
a balance of payments problem, especially as those reserves drop below a couple of months
of import spending.
Thus, when the possibility of borrowing and of using foreign exchange reserves to finance
a current account deficit are both exhausted, a country will no longer be able to run a current
account deficit, and this typically marks a full-blown balance of payments crisis. Costly
adjustments to the economy will need to occur when borrowing options are exhausted and
foreign exchange reserves are tapped out, as will be discussed in the last two chapters.
Current account deficits that persist over time, then, may be signals of future difficulties in
the balance of payments if the borrowing burden becomes excessive. Rapidly declining offi-
cial foreign exchange reserves, however, are a sure sign that there is a balance of payments
crisis in the works or looming.
On the other hand, countries that manage to run current account surpluses are unlikely to
have future balance of payments problems (though not every current account surplus is a
good thing, as we shall see). So, even though the accounts in the balance of payments always
sum to zero, the specific values in each account are important and why they are what they
are remains important to examine if we are to grasp when there may be potential problems
and when there are not. More will be said on this below in considering ‚Äúgood‚ÄĚ and ‚Äúbad‚ÄĚ
current account deficits. Hopefully, as you gain more experience in looking at the balance of
Macroeconomic equilibrium 503
payments accounts by doing the exercises at the end of the chapter, your understanding of
some of these subtleties will be enhanced. Let us now turn to understanding exchange rates.
A country‚Ä™s bilateral exchange rate is the number of units of a foreign currency that can be
obtained for each unit of the domestic currency or, alternatively, the number of units of the
domestic currency required to buy one unit of some foreign currency.6 Table 15.3 shows the
bilateral exchange rates for a number of different currencies with the US. The values shown
are the number of units of each national currency received for one US dollar or, alternatively,
the number of units of the national currency that must be paid to buy one US dollar. These
values are exclusive of any exchange rate conversion charges.
The table tells us, for example, that 1 US dollar exchanged for 4,026 Cambodian rieles on
February 4 2002 and 4,142.8 rieles on May 14 2007. Or, vice versa, the table tells us it took
4,026 rieles on February 4 2002 to buy 1 US dollar and 4,142.8 rieles to buy one US dollar
on May 14 2007.
each country has many bilateral exchange rates, one for each country with which it trades,
has financial transactions, or to which its citizens travel or from which visitors arrive. The
table lists only a few of the more than 160 bilateral exchange rates between various coun-
tries and the United States stated in terms of the number of units of currency exchanged