Economic View: Where investment outweighs trade in free markets

There used to be no ambiguity about it. From colonial times until about 10 years ago the links between the developed economies and the developing ones - "North" and "South" - consisted of a straight-forward spillover. Good times in the North made for good times in the South too, and vice versa, so dependent were the poorer countries on exports to the richer ones.

But times have changed. Not only are there more "reverse linkages" from the economies of the South to the exporters of the North, but the newly industrialising countries have actually shed their dependence on the pace of growth in the industrial world. So concludes a new working paper from the International Monetary Fund*.

The most interesting aspect of the new research, however, is its analysis of why the links have changed. For it highlights an important change in the nature of trade, which has changed the meaning of free trade and the politics of free trade versus protectionism.

The synchronisation of Northern recession with slower Southern growth appears to have broken down in the late 1980s. Although this is too recent to draw firm conclusions, there seems to have been a structural change in the economies of the developing world, and mainly in South-east Asia. Northern growth has begun to depend on economic expansion in the South. According to the IMF, growth in the North would have been about half a point lower if Asia's GDP growth had remained constant in the early 1990s rather than climbing from below 6 to above 8 per cent.

The paper puts forward three related explanations for the fact that Asia managed to buck the early 1990s recession in the industrialised world. These are trade liberalisation and other structural reforms introduced by the region's most successful economies, their increasingly diversified exports and a huge increase in capital inflows. The first two are fairly obvious. Liberalisation has both helped improve productivity growth and made emerging financial markets more attractive to overseas investors. Diversification away from commodities and limited ranges of manufactured goods has made the economies less vulnerable to the business cycle in developed country markets.

Yet it is the third, the increase in overseas investment, which is the most significant. Capital flows from North to South have risen dramatically since the late 1980s, with the increase in their value far outweighing the growth in the value of trade over the same time. For the first time, a large proportion of this investment consists of private capital. Much of it, whether direct or portfolio investment, reflects the deliberate diversification by international investors outside their own slow-growing economies. The foreign direct investment, in particular, has helped give the newly industrialising Asian countries access to advanced production technology and a broader export base in a relatively short time.

This investment directly helps explain the rapid growth in some developing countries during the early 1990s. Increased direct investment by multinationals offsets some of the traditional impact of the recession in the industrial countries.

Overseas investment by Northern companies has grown far faster than exports and imports, as the chart shows. An article in the latest issue of the Organisation for Economic Cooperation and Development's magazine argues that it is the growth of investment rather than trade as the international means of doing business which characterises "globalisation". It goes on to point out that the notion of market access, fundamental to free trade and enshrined in international trade agreements, needs to change in scope. It needs to include the freedom to set up business on equal terms within a country's borders as well as the freedom to ship goods across the borders. "The promotion of such neutrality between trade and investment - access and presence - as a means of doing business marks the realisation that they have become inherently complementary means of contesting markets."

The OECD is drawing up a "multilateral agreement on investment" to try to set the ground rules for free trade when investment rather then exports and imports becomes the means of access to overseas markets. It is due to present a draft to ministers next May.

However, obstacles to foreign companies doing business on equal terms are pervasive and often deeply embedded in the host country's culture. It is enough to list the sorts of factors that unlevel the playing field to see how difficult the levelling might be: tax systems, labour and environmental standards, industrial, competition policy.

The difficulties are reinforced by the growing importance of services as opposed to goods in conventional trade. For example, trade in cross- border engineering consultancy services is to be liberalised under the General Agreement on Services. To be effective, it ought to be accompanied byliberalisation in government procurement, mutual recognition of professional licensing regimes, deregulation of temporary entry for personnel and the duty-free entry of the software and equipment they need.

The OECD concludes that the momentum towards free trade in a world where services and investment are more important will prove a real test of governments' commitment to competition.

In fact, the changing nature of international linkages sharpens the classic dilemmas posed by progress towards free trade. These are acknowledged in a new history of free trade by free-market Chicago professor Douglas Irwin**. The theoretical case for free trade - that all countries can be made better off by trade - overlooks the likelihood that within countries there will be winners and losers. It also ignores the fact that some countries can shift the terms of trade in their favour - raise the price their exports command overseas - by restricting trade. Free trade redistributes between countries as well as within them, even if one nation's gain from protection would be dwarfed by other countries' losses.

There is clearly a line of thought in some industrial countries that restricting the new forms of trade - say, the location of programming services in India by companies from a country advanced in the computer industry - will prevent unwanted redistribution of one kind or the other. High programming costs would favour the dozen countries with a significant software industry. Slower overseas investment could preserve manufacturing jobs in the North.

Those who support these arguments tend also to make labour and environmental standards a battleground. Nobody thinks child or slave labour is acceptable, but it is those of a protectionist inclination who want to use multilateral trade agreements to outlaw it.

Some multinationals are in hot water in the US for using Third World factories perceived to be exploitative - such as Nike, which imports its running shoes from Indonesia. These areas, along with tax and competition policy, will prove the thorniest issues in international economic relations during the next decade. But the scale of foreign direct investment in the South suggests the tide is already too strong to be held back.

* 'Have North-South Growth Linkages Changed?' IMF Working Paper, May 1996. ** 'Against The Tide: An Intellectual History of Free Trade', Douglas Irwin, Princeton University Press.