TRADE AND CAPITAL FLOWS

Trade

The sustained and buoyant growth in world trade (both exports and imports of goods and services) has been one of the most striking features of the global economy in the 1990s; this has been discussed at some length in several previous issues of the Survey. Between 1990 and 1997, for example, world trade in goods and services increased by 52 per cent in dollar values, from $4.3 trillion to $6.5 trillion. In volume terms, the average growth rate of global trade, at 6.7 per cent annually, significantly outpaced the expansion in global production, at 3.0 per cent per annum, during the same period. By 1998, the ratio of world trade in goods and services to global GDP had increased from 19 per cent in 1990 to 23 per cent.

The growth trends in world trade, however, decelerated sharply in both value and volume terms in 1998; and so did the rate of global production. A sharp decline in trading volumes in the wake of the crisis in Asia, accompanied by lower commodity prices, contributed to the steepest decline in the nominal value of world trade since 1982, growth in volume terms being 3.6 per cent in 1998, and 9.9 per cent a year earlier (tables I.1 and I.2). The price of manufactured goods also fell but by less than that of raw materials, thus causing significant losses in the terms of trade for countries producing raw materials, and fuel exporters in particular (terms of trade declined by 20.2 per cent for these exporters relative to 6.9 per cent for developing countries as a group). Up to the third quarter of 1999, world trade had grown marginally in value terms compared to the same period in 1998; as a whole, the recovery from the contractionary level of the previous year's trade values and low growth in volume is expected to be modest in 1999. A faster pace of world trade will be more likely in 2000.

The above estimates embody a combination of diverse movements. Domestic production and exports were picking up in the crisis economies of Asia, and so the value of imports could be running significantly higher in the second half of 1999. On the other hand, however, a reduction in import demand in Latin America can be expected, given the contraction in output in the region in 1999, as discussed earlier. Among the developed countries, the United States economy has been the source of much of the buoyancy in import demand over the past several years. Economic growth remains robust in 1999, but it is unlikely that there will be any significant increase in United States import demand for the year compared to that of 1998. Asymmetrically, however, a slowdown in this economic powerhouse could have a sharp impact on import demand, and on the import of consumer goods especially. This is perhaps the biggest and most uncertain element in global trade in the coming years. A stronger performance in EU and Japan could provide a boost to world trade growth in both volume and value terms, but is unlikely to compensate for any major decline in import demand in the United States.

The recent trends in global trade deserve a few comments. The significant depreciations in the exchange rates of the Asian crisis economies since late 1997 have improved their export competitiveness, but this was not reflected in higher levels of actual export earnings until well into 1999. The positive impact was delayed because of weakened external demand for all major commodity groups; such weaknesses had become evident in 1998 and persisted well into the middle of 1999. The export prices of manufactured goods, with only some minor exceptions, were also affected adversely by the regional and global economic slowdown and poorer demand and, perhaps, price competition among developing country exporters.

These unfavourable price trends were reversed, most dramatically in the case of oil, from March 1999 onwards (figure I.1). By November 1999, for example, oil prices were almost 100 per cent higher than the levels prevailing up to mid-1998. This upturn was largely the result of production cuts by the members of the Organization of the Petroleum Exporting Countries. Other commodity prices, especially those of food and non-food agricultural commodities, also experienced a renewed upswing, albeit of a much more modest magnitude; export prices of metals were beginning to firm up as well. Lower stocks and inventories of commodities and recovery-led increases in demand were the major causes of the reversal and upturn in commodity export price trends in the latter part of 1999.

At present, the gains in oil prices are tied in with production restraints. Their impact in terms of higher export earnings can be large only with a sustained expansion in external demand to offset the lower volumes traded. Some exporting countries could opt, in the first instance, to replenish reserves; the windfall gains in export earnings may not translate into higher imports for some time. In the oil-importing countries, on the other hand, higher oil prices could lead to lower non-oil imports, especially of consumer goods, as oil demand is relatively more price-inelastic. The hikes in production costs and domestic prices resulting from higher prices of oil and other commodities could conceivably trigger a tighter policy stance to reduce fiscal and external account deficits, and choke off any incipient inflationary pressures. This could affect overall economic performance in both the developed and the developing regions.

The buoyant expansion in world trade and the deepening interdependence among countries led to considerable efficiency gains. These have served to underpin the high rates of global and regional economic growth for most of the current decade. But it is also apparent that the benefits from the globalization of goods, services, finance and ideas have been highly uneven. The substantial anticipated gains have proved elusive or modest for many developing countries, particularly the least developed countries and other disadvantaged economies. Moreover, the downside risks of policy liberalization and globalization are real even for the strongest developing economies; they are also far greater than was presumed generally, as has been demonstrated by the experience in East and South-East Asia and Latin America (see box I.1).¹²

Capital flows

Among the ripple effects of the financial crisis in Asia was the ensuing turbulence in the Russian Federation and in Latin America and, temporarily, even in the financial markets of developed countries. Initially, alarms had been sounded by many observers about the breadth and the depth of the impact of the Asian crisis on the global economy. Indeed, fears were raised of a possible global recession through a generalized credit crunch and the reversal of capital flows to emerging markets in developing countries. The latter apprehension was not entirely unfounded. The net private capital flows to emerging markets were estimated at $66.2 billion in 1998, compared to $148.8 billion in 1997. Those channelled to the five Asian crisis economies, namely Indonesia, Malaysia, the Philippines, the Republic of Korea and Thailand, were $29.6 billion and $22.1 billion respectively during these two years.¹³

In the event, however, the highly adverse repercussions as anticipated did not materialize. There was a fairly rapid return to stability in most financial markets, including those of the crisis economies. The impact of the crisis on global growth, with its ripple effects was short-lived (table I.1). A generalized credit crunch did not materialize and, by the third quarter of 1999, cross-border capital flows had recovered more or less to their level of 12 months earlier. Gross private financing to emerging markets in the developing region stood at $103.6 billion as of August 1999, compared to $148.5 billion for the whole of 1998 (table I.3).

Thus, the evidence suggests that the contagion of financial crises can indeed spread to virtually all corners of the globe. Their overall effect, however, can be contained partly by acquired depth and sophistication of global financial market centres, and partly by policy responses at both the international and the national level. For example, the highly developed state of the financial markets in the United States underpinned the attraction of dollar-denominated assets (such as government bonds and corporate equities). Besides, policy initiatives in the form of the three reductions in interest rates in October and November 1998 bolstered fragile investor confidence at an especially vulnerable stage.

Largely as a result, the stock and bond markets in the United States had recovered virtually all their losses by the end of 1998; the former also reached record levels in the first half of 1999. There were some downward movements and renewed bouts of nervousness but, by and large, the overall market sentiment remained bullish. However, as the United States economy continued to grow strongly for much of 1999, the downward trend in interest rates was reversed so as to pre-empt overheating. Indeed, the strong pace of expansion of the United States economy and relative weakness of the EU economy led to expectations of still higher interest rates in the former and lower interest rates in the latter. Such expectations probably played their part in the depreciation of the euro, thus enhancing somewhat euro-zone export competitiveness in the course of 1999. But there were certain adverse developments within EU itself. The money supply expanded towards the third quarter of 1999 at a faster rate than originally expected and, in addition, signs of inflation in asset prices were emerging, especially in the stock markets. All this culminated in the imposition of a half-point increase in the refinance rate by ECB in November 1999.

Initially, Japan was worst affected by the crisis in Asia; the yen also weakened considerably in the aftermath. The successive packages of fiscal stimuli and large injections of liquidity served to reduce the nominal interest rates to almost zero and, at the same time, to raise bond yields significantly in Japan. The latter effect, coupled with a weaker yen, however, induced a substantial flow of external funds into Japanese financial assets; the process thus generated large gains in stock market prices as well as a considerable strengthening of the yen against the dollar. An appreciating yen at this particular juncture poses several adjustment problems. It could hamper the economic recovery in Japan via reduced export competitiveness. The consequent stagnation in corporate earnings and profitability could also limit consumption expenditure and ratchet up savings rates for precautionary purposes, adding to deflationary pressures. An appreciating yen could also necessitate adjustments in the exchange rates of major currencies across the globe, which might be an additional source of instability in the international financial markets.

The achievement of historically low rates of inflation in the developed economies is a striking feature of the 1990s; this stands in contrast to the relatively large volatility in the costs of money across space (exchange rates). The maintenance of low inflation is certainly a desirable objective of policy. However, it may have a bearing on the volume and pattern of capital flows from the developed to the developing countries. One particular concern in this regard is the induced fall in the prices of assets which serve as collateral for bank lending. A rise in real interest rates caused by a period of declining inflation can have a large negative impact on the value of such collateral. In turn, this could lead to a tightening of credit conditions, affecting both domestic and cross-border lending.

The experience of Japan since the early 1990s indicates that asset price deflation can exert a negative impact on the liquidity position of the banking system and induce highly risk-averse behaviour in lending operations. Such risk-averse intermediation, by and large, has characterized international financial markets in both the capital-exporting and the capital-importing economies in recent times. This is well illustrated by the trends in private financial flows to emerging markets (table I.3). The gross volume of such inflows in 1999 is unlikely to have exceeded the previous year's level by any substantial amount. The terms and conditions involved have also proved more onerous.

One bright feature in the above context of risk preoccupation is the improvement in the share of private capital flows to the emerging markets in Asia. The relative proportion reached almost 37 per cent as of August 1999, compared to 23 per cent for the whole of 1998. Such a relative gain translates into only a marginal improvement in absolute terms and implies a corresponding tightening of the flows to other emerging markets outside Asia.

The patterns of foreign direct investment (FDI) flows have exhibited rather different characteristics. Contrary to most expectations, the global volume of gross FDI grew from $464.3 trillion in 1997 to $643.9 trillion in 1998 in spite of difficult economic and financial conditions; such flows are projected to have expanded further in 1999.¹⁴ This observed buoyancy in FDI was confined totally to transactions among developed countries. To a considerable extent, it was driven by cross-border merger and acquisition activities in many diverse fields; these have ranged from resource-based industries in oil and gas to corporate enterprises in banking, finance, and information and communications technologies. As long as merger and acquisition activities represent a consolidation of sunk investment, they are replacing possible new investments in the fields or industries under consideration, regardless of the modalities or sources of financing.

The upward trend in the share of developing countries in world FDI flows was reversed by a fall of some 4 per cent in the volume of FDI channelled to these countries, the gross amount being $165.9 billion during 1998, compared to $172.5 billion a year earlier. The largest cut was experienced in Asia, totalling some 12 per cent (or $10.5 billion), with Hong Kong, China; Indonesia; Malaysia; and Taiwan Province of China bearing much of the fall.¹⁵ Nevertheless, under the circumstances, FDI flows have remained surprisingly resilient in several of the crisis economies as well as in the rest of Asia. In fact, the Philippines, the Republic of Korea and Thailand were among those countries which recorded a considerable increase in FDI inflows in 1998.

Merger and acquisition activities are relatively cost-effective for transnational corporations because of the ready availability of good productive assets at low or heavily discounted prices in the countries affected by the crisis. They also proved a convenient substitute for investments in new projects.

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