Tag: Dependency Theory

A fourth distinguish characteristics of developing countries is that their trade tends to be dominated by the export of primary commodities and the import of manufactured goods.

This has consequences for the terms of trade of developing countries, the distribution of the giants from trade between developed and developing countries, and the balance of payments situation, all of which may adversely affect real income per head. The trade of Africa, the Middle East, Latin America and the Caribbean is still dominated by primary commodities. Only Asia and the Pacific have made headway in reducing dependence on commodity exports.

The barter terms of trade measure the ratio of export price to import prices. There has been a historical tendency for the terms of trade of primary goods relative to manufactured goods to deteriorate over the last 100 years or so by about 0.5 per cent per annum on average. This tendency is known in the literature as the Prebisch-Singer thesis. The falling price of exports relative to imports reduces the real income of a country because more exports have to be exchanged to obtain a given quantity of imports.

A second point to note is that the income elasticity of demand for primary commodities in world trade is less than unity, while the income elasticity of demand for manufactured goods is greater than unity. This means that as world income grows, the demand for primary commodities grows at a lower rate, but if developing countries grow at the same rate as the world economy their demand for manufactured imports grows at a faster rate.

As a consequence, developing countries specializing in the production of primary commodities suffer acute balance of payments difficulties. Often, the only means available to developing countries to adjust the balance of payments is to slow down their economies in order to reduce the growth of imports.

The prices of primary commodities are also more cyclically volatile than the price of manufactured goods. This can also cause havoc to a country’s balance of payments and its government’s tax revenue if it relies heavily on trade taxes. The resulting instability makes planning difficult and may deter private domestic investment and investment from overseas.

For all those reasons, the structure of trade poses severe problems for many developing countries and may keep countries poor than they would be if they were able to produce and export more industrial goods. It is not possible to understand the growth and development process — and the perpetuation of divisions in the world economy —without reference to the unequal trading between rich and poor countries and the balance of payments consequences of specializing in primary commodities.

In general, it seems to be the case that the more natural resources a country has, the poorer it performs. This phenomenon is referred to in the literature as the ‘curse of natural resources’ (Sachs and Warner, 2001; Gylfason, 2001). There is a very strong negative relationship and the regression coefficient of -0.0871 indicates that a country with a primary sector share 11 percentage points above the average has experienced a growth of per capita income of one percent below the average (controlling for the initial level of per capita income). This represents a substantial loss of welfare.

The same negative pattern emerges when the growth of per capita income is regressed against the export of natural resources as a share of GDP; and the negative relation persists even when controlling for other variables such as differences in the level of investment between countries, and for climate and geography.

Most countries that have grown rapidly in recent decades started as resource poor, not resource rich. There are exceptions to this general rule — countries such as Malaysia, Thailand, Indonesia, Botswana, for example — but most of these exceptional countries have grown fast not through the exploitation of natural resources but through diversification into manufacturing industry.

Curse of natural resource

What lies behind this‘curse of natural resource’?A number of factors fan be mentioned, which interrelate with each other, that seem to affect adversely may of the important determinants of development. Glyfason shows a negative relation across countries between the share of the primary sector in the labour force and export performance, domestic and foreign investment and education, and a positive relation with the size of external debt, the level of protection, corruption and income inequality.

We have already seen why primary production can lead to poor export performance because many natural resources are income inelastic and suffer terms of trade deterioration, by why should natural resources abundant countries neglect investment and education, and be more corrupt? There are two major explanations.

Firstly, natural resource abundance may ‘crowd-out’ other activities ‘through two mechanisms:

(1) higher wages or earnings in the natural resources sector impairing entrepreneurial activity and innovation in other sectors, and

(2) revenues from natural resources exports keeping the exchange rate artificially high which makes the rest of the economy uncompetitive.

This is known as the Dutch Disease, so named because of the effect that the discovery of natural gas in Holland in the 1960s had on the exchange rate and other sectors of the economy. Sachs and Warner (2001) test this ‘crowding out’ hypothesis across 99 countries and find a positive correlation between natural resource abundance and the domestic price level. The higher relative price level is then found to impede the export growth of manufactured goods. It could also be that a country rich in natural resources simply neglects to develop other sectors of the economy.

A second major explanation why natural resource abundance may lead to poor performance is that the rents from natural resources may be misused by politicians and bureaucrats. Democracy and the rule of law seem to be inversely related to natural resource abundance, and Gylfason (2001) shows corruption to be more widespread in natural resource abundant countries.

This is not surprising since limiting access to a resource provides a rent, and where the state owns the resource, bureaucrats^,will take bribes in return for exploitation rights. Tent earners may not be interested in schooling and education, having lined their own pockets, and those of their children, without acquiring an education. Thus, rent seeking leads to low levels of expenditure on education and school enrolment. it is also the case that the primary sector of an economy does not have the same educational needs as a more diversified economy.

Economies cannot function in an institutional vacuum; otherwise there is economic (and political) chaos. At the very minimum there has to be the rule or law; the protection of property rights and constraints on power and corruption if private individuals are to be entrepreneurial, to take risks and invest.

In many developing countries, the rule of law and the protection of property rights is still rudimentary, and politicians (and bureaucrats abuse their powers. Many economists have recently argued that it is weak institutional structures that are the fundamental causes of underdevelopment because the character of institutions is the determinant of all the proximate causes of progress such as investment, education, trade and so on.

Three main ones are highlighted: the extent oflegal protectionof private property; the quality if governance (including the strength of the rule of law) and the limit placed on political leaders. Attempts have been made to distinguish economically the relative importance of institutions compared with other factors (including geography) in explaining different levels ofper capita incomeacross the world, with interesting, but controversial results.

Rodrick et al (2002) take a large sample of developed and developing countries, measuring the quality of institutions mainly by a composite indicator or a number of elements that, capture protection afforded by property rights, and conclude ‘our results indicate that the quality of institutions overrides everything else.

Controlling for institutions, geography has, at least weak direct effects on income …similarly trade has no direct positive effect on income,” Easterly and Lavine (2002) also test the influence of institutions compared with geography and policy variables across 75 rich and poor countries and find that institutions seem to matter most as the determinant of per capita income. Even countries with ‘bad policies’ do well with good institutions.

Defining and Measuring Institutions

What do we mean by institutions?

The term institution has been defined in different ways. Douglass North (1990) describes institutions very broadly, as the formal and informal rules governing human interactions. There are also narrow (and easier to grasp) definitions of institutions that focus on specific organizational entities, procedural devices and regulatory framework.

At a more intermediate level, institutions are defined in terms of the degree of property rights protection, the degree to which laws and regulations are fairly applied, and the extent of corruption. It is narrower than North’s definition, which includes all of the norms governing human interactions. Much of the recent research into determinants of economic development has adopted the intermediate definition.

How is institutional quality measured?

Recent empirical analyses have typically considered three relatively broad measures of institutions, the quality of governance, including the degree of corruption, political rights, public sector efficiency, and regulatory burdens; the extent of legal protection of private property and how well such laws are enforced; and the limits placed on political leaders.

The measures themselves are not objective but, rather, the subjective perceptions and assessment of country experts or the assessment; made by residents responding to surveys carried out by international organizations and non-governmental organizations.

The first of these measures, i.e, the aggregate governance index, is the average of the six measures of institutions developed in a 1999 study by Daniel Kaufman, Art Kraay and Pablo Zoido-Lobaton. These measures include

(1) voice and accountability the extent to which citizens can choose their government and have political rights, civil liberties and an independence press;

(2) political stability and absence of violence – the likelihood that the government will not be overthrown by unconstitutional or violent means

(3) government effectiveness – the quality of public service delivery and competence and political independence of the civil service

(4) regulatory burden – the relative absence of government controls on goods markets, banking systems, and international trade;

(5) rule of law – the protection of persons and’ property against violence and theft, independence and effective judges, and contract enforcement; and

(6) freedom from graft – public power is not abused for private gain or corruption.

A second measure focuses on property rights. This measure indicates the protection that private property receives. Yet another measure, constraints on the executive, reflects institutional and other limits placed on presidents and other political leaders. In a society with appropriate constraints on elites and politicians, there is less fighting between various groups for control of the state, and policies are more sustainable.

It is recognized, however, that the correlation found between institutions and economic development could reflect reverse causality, or omitted factors. We need to find a source of exogenous variation in institutions where institutions differ or change independently of other factors.

Acemoglu et el (2001) argue that the different experience of colonization is one exogenous source where at one extreme colonizers set up exclusively extractive institutions (to exploit minerals and other primary products) such as slavery and forced labour, which neither gave property rights to inhabitants nor constraints the power of elites.

This was the experience in Africa and Latin America, At the other extreme, colonizers created settler societies, replicating the European form of institutions protecting private property and controlling elites and politicians in countries such as Australia, New Zealand and North America.

Weak institutional Structures

What determines why some countries were settled and others not? Acemoglu et al argued that the major determinant was the mortality rate faced by the early settlers, and that there is both a negative correlation between past mortality rates and current institutional quality (because institutions persisted) and between past mortality and the current levels of per capita income.

In fact, over 50 per cent of the variations In per capita income across the 75 countries is associated with variation in one particular index of institutional quality whichmeasures ‘protection against expropriation.’ The authors conclude ‘There is 3 high correlation between mortality rates faced by soldiers, bishops and sailors in the colonies and European settlements; between European settlements and early measures of institutions, and between early institutions and institutions today.

We estimate large effects of institutions on income per capita using this source of variation.’ They say that this relationship is not driven by outliers, and is robust controlling for latitude, climate, current disease environment, religion, natural resources, soil quality, ethyl linguistic fragmentation, and current racial composition’. But this is where the controversy starts because presumably his mortality rates of the early settlers, which affected the nature of institutions, was strongly influenced by geography as it affects disease. in the same vein Sachs (2003) argues that the findings of Acemoglu et al.

Concerning the negative relation between mortality rates 200 years ago and per capita income today is simply licking up the pernicious effects of malaria (which stir persists), not institutions. Development is not simply about good government and institutions. institutions might make anti-poverty policies more effective, but that is all.

Poor countries need resources to fight disease; to provide education and infrastructure, and all the other resource prerequisites of development. Sachs classified three types of countries combining institutions and geography, which is a sensible approach:

• Countries where institutions, policies and geography are all reasonably favourable, e.g. the coastal regions of East Asia
• Countries with favourable geography, but weak institutions, e.g. many of the transition economies of Eastern Europe.

Countries impoverished by a combination of unfavourable geography, such as landlocked countries and those plagued with disease and poor governance, e.g. many of the countries of sub-Saharan Africa.

It is important to mention from the start that developing countries are characterized by a number and varied features. Moreover, we should remind that developing countries are homogenous and as such do not exhibit similar features in their totality. However, what we intend to do in this unit is to focus on a number of features that are more or Tess common to developing countries.

As a way of recasting our thoughts on the current topic reference is made to Thirwall (2006) who maintains that there cannot be an increase in living standards and the eradication of poverty without an increase in output per head of the working population,oran increase in labour productivity. ForThirwall, this is asince qua nonof development. He goes on to argue that rich developed countries have high levels of labour productivity; while poor developing countries have low levels of labour productivity.

The questions that naturally arise are: what are the major causes of productivity, and what are the primary sources of productivity growth? In this article, therefore, we outline some of the distinguishing characteristics of developing countries that contribute to the low levels of labour productivity and poor economic performance. The following are some of such features:

• The dominance of agriculture and petty services
• Low level of capital accumulation
• Rapid population growth
• Exports dominated by primary commodities
• The curse of natural resources
• Weak institutional structures

The Dominance of Agriculture and Petty Services

One of the major distinguishing characteristics of poor countries is the fact that their economies are dominated by agriculture and petty service activities. There is very little by way of manufacturing industry. This therefore means that most of the population in developing countries finds employment in the agricultural sector. Available statistics (Thirwall 2006) indicate that 65 per cent of the labour force still relies on agriculture to make a living. This compares with just under30 per cent in the middle income countries and 5 per cent in the high-income countries.

Furthermore, most of the people employed in agricultural production in third world countries either operate at a subsistence level, or they are tenant farmers, or landless labourers. However, this is not to say that there is a lack of commercial farming or commercial agriculture. Commercial agriculture does exist, but it is only a tiny fraction of the entire agricultural sector. This being the case then, it is important to mention that the dominance of agriculture has certain implications. What are these? They include the following:

• Agriculture is adiminishing returnsactivity
• On the demand side, the demand for most agricultural products (and other

primary products derived from the land) isIncome elastic.

Low level of Capital Accumulation

A second major distinguish characteristic of developing countries is their low level of capital accumulation — both physical and human. Physical capital refers to the plant, machinery and equipment used in the production of output. Human capital refers to the skills and expertise embodied in the labour force through education and training. (The role of education in the development process will be discussed later in the unit).

Low levels of capital accumulation are a cause of low productivity and poverty, but are also a function of poverty, because capital accumulation requires investment and saving and it is not easy for poor societies to save. The process of development can be described as a generalized process of capital accumulation, but the levels and rates of capital accumulation in poor countries are low.

The amount of physical capital that labour has to work with in a typical developing country is no more than one-twentieth of the level in Europe and North America. This reflects the cumulative effect over time or much higher savings and investment ratios in the rich countries.

Domestic investment can differ from domestic saving owing to investment from abroad. The figures for low-income countries are distorted by China, which is 2002 saved over 40 per cent of its national income. If we exclude China the savings ratio of the low-income countries is less than half that of the middle- and high-income countries, although their investment ratio is still relatively high because of capital inflows from abroad. These are not always stable, however.

The distinguish development economist, Sir Arthur Lewis, once described development as the process of transforming a country from a net 5 per cent saver and investor to a 12 per cent saver and investor. Rostow, in his famous book The stages of Economic Growth (1960), defines the take-off stage of self- sustaining growth in terms of critical ratio of savings and investment to national income of 10-12 per cent.

What is the significance of this ratio? It has to do with a very simple growth formula, which originally came from the growth model of the famous British economist (Sir) Roy Harrod. The formula is the growth of output is the savings ratio (S/Y) and is the incremental capital – output ratio – that is, how much investment needs to take place in order to increase the flow of output by one unit. Substituting these definitions of s and c into (3.1) shows that in an accounting sense the formulation is an identity since in the national accounts.

Now, for the level of per capita income to rise, output growth must exceed population growth. If population growth is 2 per cent per annum, output growth must exceed 2 per cent per annum. It can be seen that how much saving and investment as a proposition of national income is required for growth depends on the value of the incremental capital, output ratio. It 4 units of capital investment are required to produce a unit flow of output year by year over the life of the investment, then c = 4, so s must be at least 8 per cent for the growth of output to exceed 2 per cent.

A net rate of saving and investment to national income of at least 8 percent or more is therefore necessary if there is to be sustained growth of per capita income. In most developing countries, the net savings and investment ratio is above this critical magnitude, but the fact remains that a major cause of low productivity and poverty in developing countries in the low level of capital that, labour has to work with. In case example 3.1 the difference in the savings and investment climate between India and China is highlighted and discussed.

Rapid Population Growth

A third distinguish feature of most developing countries is that they have a much faster rate of population growth than developed countries, and faster than at any time in the world’s history (see Chapter 8 for a full discussion). This can confer advantages but it also imposes acute problems.

Population growth in the low-income countries as a whole average 1.8 percent per annum, resulting from a birth rate of 29 per 1,000 population (or 2.9 per cent) and a death rate of 11 per 1,000 population (or 1.1 per cent). The rapid acceleration of population growth compared with its historical trend is the result of a dramatic fall in the death rate without a commensurate fail in the birth rate. Population growth in developed countries averages no more than 0.7 per cent per annum.

It takes 10 permits to start a business in India against six in China, while the median time it takes is 90 days in India against 30 days in China. A typical foreign power project requires 43 clearances at central government level and another 57 at a state level. These obstacles are far smaller in China.

In restriction on the hiring and firing of workers, India ranked 73^rdout of 75 countries in the Global Competitiveness Report for 2001. China ranked 23^rd. Bankruptcy is almost impossible for large business. Sixty per cent of liquidation processes before the Indian High Court have continued for more than 10 years. Public administration is also poor. It takes an average of 10.6 days to clear goods at customs into India, against 7.8 into China.

As important as regulatory barriers to competition is India’s poor infrastructure. Paved roads are only 56 percent of the total, against over 80 per cent in China. Shipping a container of textiles to the US costs 35 per cent more than from China. Because of power shortages, 69 percent of Indian companies have their own generator, compared with just 33 per cent in China.

These comparisons are bad news for India in one way, but good news in another. If India can sustain growth of 6 per cent a year when so much does not work very well, imagine what could be achieved if it did.

Rapid population growth, like low capital accumulation, may be considered as both a cause of poverty and a consequence. High birth rates are themselves a function of poverty because child mortality is high in poor societies and parents wish to have large families to provide insurance in old age. High rates also go hand in hand with poor education, lack of employment opportunities for women and ignorance of birth control techniques. Population growth in turn helps to perpetuate poverty if it reduces saving, dilutes capital per head and reduces the marginal product oflabour in agriculture.

The pressure of numbers may also put a strain on government expenditure, lead to congestion and overcrowding, impair the environment and put pressure on food supplies, all of which retard the development process, at least in the short run. In the longer run, population growth may stimulate investment and technical progress, and may not pose such a problem if there are complementary resources and factors of production available, but the short run costs may outweigh the advantages for a considerable time.