External factors of economic growth in the transition economies of the Baltics and Central Asia


Doctoral Thesis / Dissertation, 2007

250 Pages, Grade: 1,0


Excerpt


Contents

Abstract (in German)

Abstract (in English)

List of figures

List of tables

List of annexes

Acknowledgments

Acronyms

Introduction

Chapter 1 Theoretical Foundations of Growth and Development
1.1 Growth-theoretical approaches
1.1.1 General background
1.1.2 Concepts and approaches
1.2 Concepts of trade and development
1.2.1 General background
1.2.2 Industrialization and trade
1.2.3 Trade, resources and institutions
1.3 Growth in an open economy

Chapter 2 Economies in Transition
2.1 Transition in Europe and Central Asia
2.1.1 Transition and its meaning
2.1.2 Initial conditions
2.1.3 Reform strategy
2.1.4 Macroeconomic performance
2.1.5 Social sector
2.1.6 External sector
2.1.7 Institutions
2.2 Transition processes in the economies of the Baltics
2.2.1 The Baltics before transition
2.2.2 Reform strategy and accomplishments
2.2.3 Price liberalization and monetary reforms
2.2.4 Privatization
2.2.5 External sector
2.3 Transition processes in the economies of Central Asia
2.3.1 Central Asia before transition
2.3.2 Reform strategy and accomplishments
2.3.3 Price liberalization and monetary reform
2.3.4 Privatization
2.3.5 External sector

Chapter 3 External Factors of Economic Growth in the Baltics
3.1 Estonia
3.1.1 Trade
3.1.2 Capital flows
3.1.3 Other factors
3.2 Latvia
3.2.1 Trade
3.2.2 Capital flows
3.2.3 Other factors
3.3 Lithuania
3.3.1 Trade
3.3.2 Capital flows
3.3.3 Other factors

Chapter 4 External Factors of Economic Growth in Central Asia
4.1 Kazakhstan
4.1.1 Trade
4.1.2 Capital flows
4.1.3 Other factors
4.2 Kyrgyz Republic
4.2.1 Trade
4.2.2 Capital flows
4.2.3 Other factors
4.3 Uzbekistan
4.3.1 Trade
4.3.2 Capital flows
4.3.3 Other factors

Chapter 5 The Balance of Payments Constrained Growth Framework: The Baltics and Central Asia Compared
5.1 The BPCG Framework: Theoretical Foundations
5.1.1 Background
5.1.2 The Model
5.2 Empirical Evidence
5.2.1 Rationale
5.2.2 Estimation of functions
5.2.3 Data
5.2.4 Interpretation of results
5.2.5 Calculation of effects
5.3 Comparative and Descriptive Analysis
5.4 An Intermediate Summary

Chapter 6 Regional Integration Processes
6.1 The Baltics and the European Union
6.1.1 Integration rationale and initial options
6.1.2 Accession benefits
6.2 Economic Integration in Central Asia
6.2.1 Integration rationale and initial options
6.2.2 Attained progress, potentials and policy implications

Conclusion

Bibliography

Annexes

Zusammenfassung

Im Kontext der zunehmenden Verflechtung von Volkswirtschaften konnen AuBenhandel und Kapitalstrome von besonderer Bedeutung sein, wenn die Wirtschaftswachstumsperspektiven der Lander in Betracht gezogen werden. Diese Aussage findet ihre Bestatigung in entgegengesetzten Wachstumsentwicklungen der baltischen und zentralasiatischen Transformationsokonomien, welche seit den fruhen 1990er Jahren bedeutsame Anderungen hinsichtlich Wirtschaftsstruktur und Handelsmuster erfahren haben.

Unterschiedliche Wachstumsraten aufweisend, divergierten die Okonomien dieser zwei Regionen in ihrer Entwicklung. Momentan beobachtete Variationen in Wachstumsraten sowohl zwischen als auch innerhalb der beiden Regionen dienen als Motivation fur den Vergleich dieser Okonomien, was deren Wachstumsdynamik, Aubenhandel und Investitionsleistung anbelangt.

Diese Arbeit untersucht, welche Rolle exteme Faktoren im Wirtschaftswachstumsprozess in den Transformationslandern des Baltikums (Estland, Lettland und Litauen) und Zentralasiens (Kasachstan, Kirgisistan und Usbekistan) spielen. Dementsprechend lautet die Leitfrage dieser Untersuchung: Sind die betrachteten Wachstumsratenunterschiede in den

Transformationslandern des Baltikums und Zentralasiens auf unterschiedliche Entwicklungen in ihren extemen Sektoren zuruckzufuhren?

Um diese Frage entsprechend zu beantworten, werden die Lander hinsichtlich der einzelnen zum Wachstum beitragenden Komponenten verglichen. Diese werden empirisch durch das Anwenden des Modells des durch die Zahlungsbilanz beschrankten Wachstums ermittelt. Mit der einfachen Version des Modells lasst sich die Wachstumsleistung der betrachteten Okonomien mit deren Handelsverhalten, d.h. Exportkapazitaten und Importzwangen verbinden. Die erweiterte Version des Modells ermoglicht, die Wachstumsraten in deren Komponenten - den Effekt des realen Tauschverhaltnisses, den Effekt des Exportwachstums und den Effekt der Kapitalzuflusse - zu zerlegen.

Aus den empirischen Ergebnissen kann geschlossen werden, dass die hoheren zu beobachtenden Wachstumsraten der baltischen Okonomien - verglichen mit denen der zentralasiatischen Okonomien - in der Periode von 1994 bis 2005 auf hohere Werte der Gesamtheit von Exportwachstum, Kapitalzuflussen und relativen Preisentwicklungen zuruckzufuhren sind. Die Wachstumsunterschiede innerhalb der betrachteten Regionen konnen analog erklart werden.

Femer, ist davon auszugehen, dass die unterschiedlichen Ergebnisse hinsichtlich der angestrebten regionalen Integration bei der Erklarung der unterschiedlichen Wachstumsleistungen des Baltikums und Zentralasiens in Betracht gezogen werden sollten. Das Baltikum war erfolgreicher nicht zuletzt dank der gegluckten Integration mit den Okonomien der Europaischen Union. Zentralasien hat diesbezuglich hingegen weniger erreicht.

Abstract

In the context of increasing interrelatedness of economies, foreign trade and capital flows may prove crucial when considering their growth perspectives. This assertion is corroborated by contrasting growth experiences of the Baltic and Central Asian transition economies, which have undergone significant transformations in terms of their economic structure and trade patterns since the early 1990s.

Exhibiting different growth rates, the economies of these two regions have diverged from each other. Currently observed variations in growth rates both across and within the regions in question provide a rationale for comparing these economies in terms of economic growth dynamics and foreign trade along with investment performance.

This dissertation inquires into the role external factors play in the process of economic growth in the transition economies of the Baltics (Estonia, Latvia and Lithuania) and Central Asia (Kazakhstan, the Kyrgyz Republic and Uzbekistan). Accordingly, the main research question is whether observed differences in growth rates across the transition economies of the Baltics and Central Asia may be attributed to diverse developments in their external sectors.

To provide a proper answer to the above question, the economies are compared in terms of their growth constituents’ contributing shares. These are defined empirically through employment of the ‘balance of payments constrained growth’ model with its basic and extended versions. The basic version of the model enables to link growth performance of the considered economies with their trade behaviors, embodied in exporting capacities and necessity to import. The model’s extended version makes possible to break down growth rates of the economies into their constituents - the effect of real terms of trade, the effect of exports growth and the effect of capital inflows.

Deriving from empirically obtained results, it may be inferred that higher growth rates observed in the Baltic economies - compared to those in the Central Asian economies - in the period from 1994 to 2005 are due to larger values of a compound of exports growth, capital inflows and relative price developments. Growth differences within the regions concerned are explained in a similar manner.

Moreover, it is suggested that contrasting outcomes of their endeavors in fostering regional integration processes should be taken into consideration, when explaining differences in growth performance of the Baltics and Central Asia. The former performed well, not least due to its succeeded integration with the economies of the European Union. The latter has attained rather negligible results on this front.

List of figures:

Figure 0.1 Structure of the work

Figure 1.1 Growth, trade, resources and institutions

Figure 2.1 Transition economies of CEE and the CIS: private and official capital flows, 1990-2005

Figure 2.2 Transition economies of CEE: composition of private capital flows, 1990-2005

Figure 2.3 Transition economies of the CIS: composition of private capital flows, 1990- 2005

Figure 2.4 Transition economies of CEE: FDI stock as of 2005

Figure 2.5 Transition economies of the CIS: FDI stock as of 2005

Figure 2.6 Baltic economies: output growth rates, 1991-2005

Figure 2.7 Baltic economies: inflation rates, 1995-2005

Figure 2.8 Baltic economies: EBRD index of trade liberalization, 1991-2005

Figure 2.9 Baltic economies: net FDI flows, 1993-2005

Figure 2.10 Central Asian economies: output growth rates, 1990-2005

Figure 2.11 Central Asian economies: inflation rates, 1997-2005

Figure 2.12 Central Asian economies: EBRD index of trade liberalization

Figure 2.13 Central Asian economies: net FDI flows, 1993-2005

Figure 3.1 Estonia: sectoral distribution of FDI stock, 2003

Figure 3.2 Estonia: breakdown of exports and imports in line with stages of technological processing, 2005

Figure 3.3 Estonia: progress of transition, 2006

Figure 3.4 Latvia: sectoral distribution of FDI stock, 2003

Figure 3.5 Latvia: breakdown of exports and imports in line with stages of technological processing, 2005

Figure 3.6 Latvia: progress of transition, 2006

Figure 3.7 Lithuania: sectoral distribution of FDI stock, 2003

Figure 3.8 Lithuania: breakdown of exports and imports in line with stages of technological processing, 2005

Figure 3.9 Lithuania: progress of transition, 2006

Figure 4.1 Kazakhstan: sectoral distribution of FDI stock, 2002

Figure 4.2 Kazakhstan: breakdown of exports and imports in line with stages of technological processing, 2005

Figure 4.3 Kazakhstan: progress of transition, 2006

Figure 4.4 Kyrgyz Republic: sectoral distribution of FDI stock, 2002

Figure 4.5 Kyrgyz Republic: breakdown of exports and imports in line with stages of technological processing, 2005

Figure 4.6 Kyrgyz Republic: progress of transition, 2006

Figure 4.7 Uzbekistan: sectoral distribution of FDI stock, 2006

Figure 4.8 Uzbekistan: breakdown of exports and imports in line with stages of technological processing, 2005

Figure 4.9 Uzbekistan: progress of transition, 2006

List of tables:

Table 2.1 Transition economies: initial conditions (selected indicators)

Table 2.2 Transition economies: economic growth and its constituents

Table 2.3 Transition economies: geographic distribution of trade flows

Table 2.4 Baltic economies: economic growth and its constituents, 1996-2006

Table 2.5 Baltic economies: liberalization of economic spheres

Table 2.6 Transition economies of Central Asia: economic growth and its constituents, 1991-2006

Table 2.7 Central Asian economies: liberalization of economic spheres

Table 3.1 Estonia: Exports by commodity group, 1996-2004

Table 3.2 Estonia: Lafay index and world exports shares

Table 3.3 Estonia: imports by commodity group

Table 3.4 Estonia: main trading partners in 1994 and 2005

Table 3.5 Estonia: net capital flows

Table 3.6 Estonia: foreign direct investment (FDI) overview

Table 3.7 Latvia: exports by commodity group

Table 3.8 Latvia: Lafay index and world exports shares

Table 3.9 Latvia: imports by commodity group

Table 3.10 Latvia: main trading partners in 1994 and 2005

Table 3.11 Latvia: net capital flows

Table 3.12 Latvia: foreign direct investment (FDI) overview

Table 3.13 Lithuania: main composition of exports, 1998-2005

Table 3.14 Lithuania: Lafay index and world exports shares

Table 3.15 Lithuania: main composition of imports, 1998-2005

Table 3.16 Lithuania: main trading partners in 1994 and 2005

Table 3.17 Lithuania: net capital flows

Table 3.18 Lithuania: foreign direct investment (FDI) overview

Table 4.1 Kazakhstan: exports by commodity group

Table 4.2 Kazakhstan: imports by commodity group

Table 4.3 Kazakhstan: main trading partners in 1994 and

Table 4.4 Kazakhstan: net capital flows

Table 4.5 Kazakhstan: foreign direct investment (FDI) overview

Table 4.6 Kyrgyz Republic: exports by commodity group

Table 4.7 Kyrgyz Republic: imports by commodity group

Table 4.8 Kyrgyz Republic: main trading partners in 1994 and 2005

Table 4.9 Kyrgyz Republic: net capital flows

Table 4.10 Kyrgyz Republic: foreign direct investment (FDI) overview

Table 4.11 Uzbekistan: exports by commodity group

Table 4.12 Uzbekistan: imports by commodity group

Table 4.13 Uzbekistan: main trading partners in 1994 and 2005

Table 4.14 Uzbekistan: net capital flows

Table 4.15 Uzbekistan: foreign direct investment (FDI) overview

Table 5.1 Estimated income and price elasticities of imports: the Baltics and Central Asia, 1994-2005

Table 5.2 Contributing effects, predicted and actual growth rates: the Baltics and Central Asia, 1994-2005

Table 5.3 Distribution of exports and imports in line with stages of processing: the Baltics mid Central Asia, 2005

List of annexes:

Annex 1: Estonia at a glance

Annex 2: Latvia at a glance

Annex 3: Lithuania at a glance

Annex 4: Kazakhstan at a glace

Annex 5: Kyrgyz Republic at a glance

Annex 6: Uzbekistan at a glance

Acknowledgments

The present research project has been carried out at the Institute of Economics and Statistics of the University of Oldenburg during my three-year sojourn in Germany. For the completion of the research project I am indebted to numerous persons who - in one way or another - have provided their invaluable contributions.

My main thanks are extended to Prof. Dr. Hans-Michael Trautwein, my supervisor, under whose guidance this work has been written. Being generous with his time and insight, he provided an essential input into this research project. I benefited very much from his well-rounded advice and support during the whole research period.

Furthermore, I owe special thanks to Prof. Dr. Klaus Schuler, whose constructive suggestions have proved particularly useful, especially regarding this work’s “econometric stuff’. In addition, I have benefited greatly from attendance of his classes.

I would like to express my gratitude to numerous members of the Institute for their critical suggestions during our PhD workshops. I want to thank the team of PhD students, in particular Ole Christiansen and Dirk Ehnts, for their support and assistance during my research stay.

Moreover, I would like to express my appreciation of the financial support, provided jointly by the German Academic Exchange Service (DAAD) and the Open Society Institute (OSI). This research endeavor would not have been possible without this scholarship.

Last but not least, I owe general debt of gratitude to my parents, brother and sister for their moral support during the whole research time.

Acronyms

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Introduction

In the field of economic research, the place of issues related to economic growth and development has always been a special one. Currently dominating theoretical ap­proaches emphasize various aspects of growth and development. For instance, the neo­classical growth model stresses the importance of accumulation of production factors along with an exogenous nature of technological progress (e.g. Solow, 1956). Theories of economic development set a stress on structural characteristics of an economy, which determine its growth perspectives and resulting character of its interaction with other economies via trade (Prebisch, 1950; Singer, 1950). Models of endogenous growth in their turn emphasize the innate trait of technological progress in the process of accumu­lation of factors of production, where human capital’s role is deemed essential (Romer, 1986; Aghion and Howitt, 1998).

In view of growing interrelatedness of economies, special attention should be paid to an element of their openness, which is apt to influence their growth dynamics and development paths (Romalis, 2005). Interacting in numerous ways, economies may exert influence upon each other’s growth patterns through trade links (Ventura, 1997; Arora and Vamvakidis, 2004) or other channels, which may comprise capital move­ments (Borensztein et al, 1998; Cuadros et al, 2001), migration of labor resources along with technology and knowledge flows (Kuznets, 1966). This implies that an economy’s external sector may be of great significance, when its growth prospects are drawn into consideration.

Since the onset of transition processes across the region of Central and Eastern Europe and the Former Soviet Union in the early 1990s, the issues related to economic growth and its external determinants have come to the fore anew, for this economic transformation implied a reintegration of these economies into the world trading system (Michalopoulos, 1999) along with significant changes in terms of their external sectors (Sachs and Warner, 1995).

Thus, significant alterations in terms of their output composition, economic structure and, therefore, geographical distribution in conjunction with structural make­up of trade flows in the countries of Central and Eastern Europe (Caetano, 2005) and the Former Soviet Union (Havrylyshyn and Al-Atrash, 1998; Elborgh-Woytek, 2003) have occurred throughout transition period. These two country groups have proved rather heterogeneous in terms of the economies’ performance since the onset of trans­formation (Svejnar, 2001).

The regions of the Former Soviet Union have performed differently throughout transition in terms of the pace of implemented reforms (De Broeck and Koen, 2000). For instance, the Baltic states have been quick in overcoming numerous shortcomings in their economic structure and stood out for a rapid pace of implemented reforms (Shen, 1994) setting on the course of accelerated reorientation of its trade flows and attracting foreign investment from abroad (Sorsa, 1994, 1997).

Differing considerably in terms of transformation paths, the economies of Cen­tral Asia, in contrast, have attained rather moderate results since they have embarked on their transition (Aslund, 2003). The region’s performance stands in rather stark contrast to that of the Baltics in many respects. In terms of the pace of implemented reforms, output recovery and institutional transformation the countries of Central Asia are second to those of the Baltics (Berg et al, 1999).

Observed differences across these two regions in their initial conditions, taken paths in reforming their economies along with attained results throughout transition may prove a sensible rationale for a comparison at both regional and country levels. What is more, thorough consideration of their contrasting growth patterns may help shed light upon significant determinants of growth. Among determinants of the two regions’ eco­nomic growth external ones should be considered important in view of the small sizes of the economies concerned.[1]

Furthermore it may be assumed that observed differences in the growth perform­ance of the Baltic and Central Asian economies are to some degree attributable to their external sectors’ differing performance. Therefore, one of the principal objectives of the work is to reveal the contribution of external factors into economic growth of the Baltic and Central Asian economies. To put it differently, this work will inquire into the ques­tion, whether existing differences in growth rates of the Baltic and Central Asian economies may be explained through differing outcomes of their foreign trade and in­vestment activities.

To provide an appropriate answer to the above stated question, a suitable method is to be employed. It is suggested that the so called ‘balance of payments constrained growth’ framework would deliver well in this case, since it enables to take a closer look at the workings of growth in conjunction with foreign trade and capital flows.

The present thesis touches upon an array of diverse aspects, which include - but are not limited to - growth and development, economic transition, importance of an economy’s external sector and integration issues. It provides a review of theoretical fundamentals of growth and development concepts, covers an array of issues related to foreign trade and openness. In addition, these issues are investigated in the context of transition economies.

Furthermore, an application of the ‘balance of payments constrained growth’ framework to the realities of transition economies may be considered as another unas­suming contribution of this work[2]. In addition, it expands by this time large and diverse literature on the importance of external conditions for an economy’s growth dynamics, economic growth in the context of transition economies, comparison of economies’ growth performance at both country and regional levels.[3]

The thesis has got a somewhat unconventional structure (See Figure 0.1), which is yet subordinate to the main logic of the material that is to be covered to attain the main objective of this inquiry.

Thus the work is organized as follows. Chapter 1 focuses on theoretical basics of growth and development (section 1.1), the role of trade in the process of development (section 1.2) and economic growth in an open economy (section 1.3).

Chapter 2 first deals with the issues related to economic transformation in the countries of Central and Eastern Europe and the Former Soviet Union (section 2.1); it then shifts the focus to the economies of the Baltics (section 2.2) and Central Asia (sec­tion 2.3).

Chapter 3 narrows the scope of inquiry further and provides a comprehensive description of external determinants of growth in the economies of the Baltics - Estonia (section 3.1), Latvia (3.2) and Lithuania (3.3). Each of the sections depicts in details external factors such as trade, capital flows along with other external factors of eco­nomic growth in the countries concerned.

Chapter 4, being identical to the preceding one in terms of its structure and con­tent, shifts the focus to the economies of Central Asia. The chapter first considers exter­nal factors of economic growth of Kazakhstan (section 4.1), then moves to those of the Kyrgyz Republic (section 4.2) and closes with a detailed description of Uzbekistan’s external sector developments (section 4.3).

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Chapter 5, while drawing into consideration the ‘balance of payments con­strained growth’ framework, aims at providing a comprehensive comparison of the economies of the Baltics and Central Asia both at country and regional levels in terms of their external factors’ contribution to economic growth. Presentation of theoretical foundations of the ‘balance of payments constrained growth’ framework (section 5.1) is followed by an empirical part (section 5.2). A comparative analysis (section 5.3) along with policy implications of the economies of the regions (section 5.4) make up the con­cluding part of the chapter.

Chapter 6 concentrates on integration processes in both regions. Integration of the Baltic economies with those of the European Union is covered first (section 6.1); these are then followed by a part devoted to the regional integration processes in Central Asia (section 6.2).

Conclusion provides a concise outline of the issues discussed in the chapters of the work.

Chapter 1 Theoretical Foundations of Growth and Development

The present chapter covers an array of issues related to theoretical underpinnings of economic growth and development. Its opening part focuses on theoretical concepts of growth and development (section 1.1), which is then followed by a part devoted to a set of issues of trade and development (section 1.2), whereas matters related to growth is­sues in the context of an open economy are covered in the chapter’s closing part (sec­tion 1.3).

1.1 Growth-theoretical approaches

1.1.1 General background

The world economic system is to be considered as a patchwork rather than a picture comprising relatively uniform elements, for it is made up from countries that differ from each other in many respects. Presently, economies exhibit fairly diverse characteristics, as regards their structure, supplying capacity, participation in the international labor di­vision, etc. Living conditions have diverged greatly across countries over time not least due to a stubborn work of the compounding effect resultant from output increments.

Numerous theorists of the past epochs have been trying to solve the puzzle of the determinants of human-being’s welfare. In the course of recent decades the term of economic growth has become a catchphrase among economists and practitioners. This fact is to be considered as no wonder for the phenomenon of economic growth exerts direct influence on the living conditions of the people dwelling in all countries irrespec­tive of their current state of development. Thus, developing economies, which make up about four-fifth of the world’s population, see economic growth as an indispensable means of improving the well-being of their residents. In addition, the experience of many developed countries shows once anew that economic growth has been the main source of welfare growth, which has taken place in these economies in recent decades.

The body of this research field has expanded rapidly especially in the last two decades. An impressive amount of works of scholars devoted to the issues of growth and development prove the statement yet again that these issues occupy one of the cen­tral stages of economic theory and praxis. Since the phenomenon of economic growth is rather multifaceted containing a variety of aspects, it is no surprise that there are numer­ous approaches to the issues related to it. In fact, each of these approaches stresses one of many aspects of economic growth. Thus, there are schools of economic thought that stress, for instance, the importance of accumulation of factors of production (e.g. physi­cal capital or labor resources) (Solow, 1956), another school would emphasize an im­portant role human capital plays in the process of economic growth (Romer, 1986; Aghion and Howitt, 1998); yet another school would highlight the importance of institu­tions and geographical issues (Acemoglu, 2003).

The significance of economic growth may be inferred from the fact that it is con­sidered as one the principal objectives of economic policy due to its capability to facili­tate easier attainment of other goals, such as higher employment rates or lower inflation. What is more important, however, is its ability to improve living conditions and in­crease the level of well-being of people in poverty-stricken areas. Not coincidentally, the notions of sustainable growth and development have lately got much attention. These imply that economic progress is achieved only then, if growth is brought about in line with social and environmental concerns.

Growth and development

A clear distinction is made between growth and development in the economic literature. This distinction whereby growth is to be considered as a quantitative increase of income (usually expressed either in GDP or GNP) per capita, whereas development has a quali­tative dimension and is associated with institutional and structural changes.

However, numerous economists, mainly representing the modem mainstream, do not draw a clear dividing line between these notions and are often inclined to treat these as conceptually interchangeable. In their works, for instance, Rostow (1953) and Kuznets (1966) held these two concepts synonymous. This fact is to be explained by the focus of the neoclassical methodology primarily on the static character of analysis, in accordance with which a considered economy is deemed stable with relatively stable variables. Hence, it becomes evident that static analysis is concerned with transforma­tions within a stmcture but not with stmctural changes, whereas dynamic analysis, in contrast, focuses rather on the progression of stmctural transformation, the process dur­ing which one stmcture gives way to another (Brinkman, 1995).

Furthermore, Ray (1998) points to a wider scope of ‘development’ compared to ‘growth’. According to his view, most of the developing economies are trying to ac­complish their development what most of the developed countries have already done.

Development, therefore, implies the structural evolution of an economy, where primar­ily qualitative aspects of this process are stressed. By contrast, the term of economic growth emphasizes nominal increments of a county’s output and income.

Definition and measurement

Economists habitually use real per capita income to measure how well off residents of a given country are. No doubt, people also are inclined to care about other matters besides the income at their disposal, which secures certain level of their consumption. These typically include democratic liberties, education and health issues, environmental con­cerns and patterns of income distribution within the country concerned. Therefore, a fine yardstick of living standards has to account for a rather wide array of aspects. How­ever, most of them would be hard to measure and prove rather cumbersome.[1] Therefore, economists use for the most part real per capita income, although it is itself an aggregate indicator that is incapable of displaying subtler details of life quality of a country’s resi­dents.

Income levels and income growth rates

How fast the well-being of residents in a given country changes across time is also a matter of concern to economists. In this case the growth rate of per capita income is apt to give a clear picture. This is the very place where economic growth wields direct in­fluence upon living conditions of the country’s residents, since it is defined by the rate of change of real per capita income. As stated earlier, even very small differences in rates of per capita income growth lead to quite impressive differences in their levels over time.

To capture the workings of compounding effects, economists often use the so called ‘rule of 70’, with the help of which it is possible to calculate the time required for an economy’s per capita figure to double. For instance, if per capita income grows steadily at the rate of 2 percent annually, it will take approximately 35 years this econ­omy to double the existing incomes of its residents; whereas a country growing twice as faster would double the incomes in just 17 to 18 years. This diminutive description makes evident that even quite small differences in growth rates could change over time the welfare landscape drastically.

1.1.2 Concepts and approaches

The classical school

Currently dominating theoretical approaches have been developed upon the concepts put forward by scholars of the past. These concepts, building the bedrock of today’s theory of growth and development, reflect general economic developments of the time, as they had been developed. Being in one or another manner related to the mechanics of economic growth, their insights continue to shape modem research in this very field.

Smith (1776) was one of the first scholars to stress the importance of competi­tion and division of labor as needed requirements for accumulation of physical capital, leading towards higher productivity (either through employment of a more advanced technology or increase of efficiency in using the present one). Furthermore, he empha­sized the importance of institutional frame (e.g. property rights on the means of produc­tion, certain degree of property protection, etc.) in the process of development and growth.

Other scholars (e.g. Malthus, 1798; Ricardo, 1789; Marx, 1867) paid increased attention to an important role distribution of material affluence (embodied in produced goods and means of production) may play in the process of economic growth and de­velopment. Furthermore, with their concepts of absolute and comparative advantage, Smith (1776) and Ricardo (1789) accentuated the importance of international trade for nations’ growth dynamics. Hence, foundations of the theory of growth and development have been laid by a number of distinguished scholars representing the classical school of economic thought.

Neoclassical growth models

With the onset of the neoclassical (marginalist) revolution in the last quarter of the nine­teenth century, scholars shifted their attention from ample macroeconomic issues of growth and development towards narrower problems of efficient utilization of resources within a given institutional organization. This far-reaching shift of focus induced the issues of growth and development to disappear from the central stage of economic re­search, until they got once anew plenty of attention from a number of leading econo­mists in the second third of the twentieth century. Upon assisting economies to abscond from quagmires of the Great Depression, economists started again to focus on a wide array of issues related to growth. The growth model forged by Harrod (1939) and Do- mar (1946) along with the growth theoretical framework conceived by Solow (1956) and Swan (1956) became an outcome of these endeavors.

Harrod-Domar model

In the 1940s, Harrod (1939) and Domar (1946) independently from each other offered their explanations of the cumulative growth process. Since then this model has been ex­tensively utilized by economists active in development economics to explain an econ­omy’s growth rate in terms of the level of savings and capital productivity (Hosseini, 2003). Although the model was first devised to analyze business cycles, it was later adapted to explain the workings of economic growth. The following statements express the model’s main implications: i) economic growth depends on the abundance of labor and capital, and ii) higher rates of investment lead to capital accumulation, which in their turn trigger production growth.

The model envisaged that the equilibrium growth rate was very instable. Once the economy does not grow at exactly the rate anticipated by investors, who in their turn depend on the savings within the economy, then it is inclined to grow either too fast, causing higher inflation rates, or too slow, resulting in increased underutilized capacity and higher unemployment rates.

To fix this kind of problems, the government intervention in form of state in­dicative planning and built-in stabilization measures is required. The main policy impli­cation was thus to increase the level of saving and investment2 and place investment ef­ficiently to further technological progress. The Harrod-Domar model was the forerunner to the exogenous growth model, devised by a number of economists representing the neoclassical school of thought.

Solow-Swan model

The exogenous growth model, which aims at explaining economic growth in the long run, has become a result of contributions of a number of neoclassical economists who intended to fix a few irregularities envisaged by the Harrod-Domar model’s framework. The exogenous growth model, elaborated primarily by Solow (1956)[3] and Swan (1956), has become a workhorse model for numerous empirical studies devoted to the issues of growth in the long term.

The model has embraced its predecessors’ features and offered a number of im­provements in its theoretical body. In contrast to the Harrod-Domar model's framework, the Solow approach has introduced labor as an additional production factor, and implies that returns to labor and capital diminish, and the state of technology varies over time. While considering the bedrock of the Solow model, the following points should be men­tioned: in the long run the growth rate of an economy is determined exogenously and is supposed converge to its steady state, which depends upon the rate of technological progress and the growth rate of its population.

One of the main inferences to be made is that economies less well endowed with physical capital per capita are likely to exhibit higher growth rates of income in com­parison with nations possessing large stocks of physical capital, provided rates of saving and investment along with growth rates of population remain invariable over the con­sidered period.

Theories of economic development

Most of the previously devised models aspired to focus on the issues of growth in the capitalist economies with their already established and well functioning institutional framework. However, with the reconstruction in Europe in the 1950s being completed and the emergence of the new independent states in Africa and Asia, more and more economists began raising issues of development in the underdeveloped part of the world.

In the wake of such developments, Rosenstein-Rodan (1943), Nurkse (1949), Hirschman (1958), Lewis (1949) and Rostow (1960) were among the first economists to embark upon the ‘quest for growth’ in the less developed world. Being for the most part of practical character, their theoretical works put an emphasis on the more practical and historical approach towards the issues of growth and development in the less developed regions of the world.

Generally, these theoretical frameworks reckoned that the workings of growth were not that difficult and catching up of the less developed parts of the world with its richer ones was supposed to be a matter of time. In the course of their development so­cieties were deemed to go through certain stages, which included ‘preconditions for take-off, the take-off, ‘drive to maturity’ and ‘the age of affluent consumption’ (Rostow, 1960).

Furthermore, industrialization was reasonably assumed to be the force capable of triggering and sustaining the process economic growth along with required structural changes. One of the ways to implement such changes was the scheme of ‘big push’ (Rosenstein-Rodan, 1943), which envisaged large-scale industrialization via parallel implementation of copious investment projects capable of furthering synergetic interaction between and across affected sectors. In this process, state was supposed to coordinate the increase of capital invested and utilized in an array of industries and pro­vide further support, for instance, in form of ‘infant industry’ policies (Nurkse, 1949). Thus, via proposed balanced growth these schemes aimed at attaining a match of supply of a significant number of industrial branches with a large-scale increment of demand initiated by this expansion.

A slightly differing approach has been offered by the so called ‘unbalanced growth’ option, which implied creation of disequilibria in the economy by redistributing resources across its sectors (Hirschman, 1958). This should lead to bottlenecks, which, in general, generate incentives for investments into disadvantaged sectors. In this con­text, the workings of backward and forward industrial linkages[4] are supposed to facili­tate of intended attainment of the intended structure of an economy, the former of which implied linkages of a sector to its suppliers, the latter meaning linkages of a sector to sectors demanding its output.

Furthermore, implementation of structural changes and economic development are in part favored by the dualistic character of the economies of the developed world. The dualistic character of developing economies, implying the existence of relatively weakly interacting sectors (agriculture and industry), harbored certain opportunities for an appropriate implementation of structural changes required for the take-off of these economies (Lewis et al, 1949). Reallocation of labor resources from agriculture to in­dustry suggests that with costs and prices for industrial products remaining low, further accumulation of physical capital in the industrial sector seems no difficult task. This scheme is considered to be an appropriate way to escape poverty and attain higher living standards.

Institutionalism

Representing another approach to the issues of economic development, institutionalism emphasized the importance of institutional constituents (embodied in the form of pro­duction organization, legal framework, educatiosn, culture, etc.) of the process of eco­nomic development. In general, these constituents were seen as determinants and out­comes of the development process at the same time. In addition, development was seen to be interrelated with diverse aspects of societal life.

Against this background, being closely linked to the character of social stratifi­cation, distribution patterns of affluence in societies was inclined to influence the de­mand structure prevalent in the economy. This in turn determined behavioral along with consumption patterns and, hence, gave further impetus and directions of production pat­terns (Veblen, 1915). In addition, the nature of interaction between economic actors was deemed crucial for further paths of economic development. Defined by institutional ar­rangements, such interactions determined final outcomes of individual or cooperative endeavors (Commons, 1934).

Such differences across regions in terms of their institutional frame are to be seen as main determinants of existing differences in economic development. In the course of time, gaps between regions may increase or decrease depending whether spread or backwash, effects stemming from their interaction with each other, are in place (Myrdal, 1949). Transformation of ‘attitudes and institutions’ is considered as one of the surest ways to accelerate development in poor regions. This is attainable through fundamental institutional transformation. This kind of institutional transition has to be accompanied, however, by appropriate changes in knowledge and technology, what pre­supposes a proper expansion of education capable of increasing the stock of human capital[5] (Ayres, 1944).

Theories of endogenous growth

In the 1980s the emergence of the so called endogenous growth theories proved to be natural, since previously devised theoretical frameworks could not explain starkly dif­fering patterns of economic development of the economies of South-East Asia and Latin America. Aspiring to cope with this task, theories of endogenous growth shifted focus to a number of other important aspects of economic growth.

Thus, these models put an emphasis on the innate character of technological progress in the growth process, in which the role of human capital is deemed essential (e.g. Romer, 1986; Lucas, 1988; Aghion and Howitt, 1998). Furthermore, while reject­ing the neoclassical assumption of diminishing returns to capital and labor, the endoge­nous growth theories posited that a larger share of investment in human and, in part, physical capital was likely to bring about externalities and synergies leading towards higher growth rates. Consequently, physical capital accumulation was not seen as a dominant determining factor of economic growth. Therefore, an appropriate expansion of education along with R&D was considered as a required condition for sustaining ap­propriate high growth rates in the long-term perspective, which would enable to sustain growth rates in the long run, while setting free spillover effects and, thus, obviate dimin­ishing returns.

1.2 Concepts of trade and development

The causes which determine the economic progress of nations belong to the study of in­ternational trade... Marshall (1890)

1.2.1 General background

Throughout history trade has been playing an indispensable part in the process of eco­nomic growth and development. Rich countries of nowadays owe a good deal of their affluence to the trade they used to conduct and continue doing so with other regions of the world. No rich nation of nowadays has become such without undergoing the indus­trialization process and being involved in international trade. Due to differences in re­source and factor endowments, nations always had and have to conduct trade to keep their welfare levels higher than they otherwise would have been.

When considering the development issues, one naturally takes into consideration the countries that underwent substantial transformations in terms of their economic structure. This is valid for the earlier stages of what is now developed world presently comprising industrial countries of Western Europe and, slightly later, its offshoots, Pa­cific Rim, most of today’s transition economies (formerly COMECON economies), and most recently in China, Vietnam and South Asia.

At the outset of the nineteenth century the industrializing countries managed to trade their industrial products in exchange for cheaper primary products (food, raw ma­terials, etc.) and further develop their production facilities. Providing an outlet for their abundant resources and agricultural products, the regions constituting the periphery of that time have also benefited from the very exchange and maintained relatively high per capita incomes.

It is also apparent that trade facilitated and contributed substantially into an es­tablishment of currently existing patterns of production and specialization. By and large, in line with these patterns economic structure and the make-up of exports in developed countries are dominated by industrial goods and services, whereas developing countries’ economic structures are still dominated by primary products (Grilli and Salvatore, 1994). This notwithstanding, poor economies should not give up their trade links with other economies, but instead try to rearrange their currently existing trade patterns to be able to accrue gains from their participation in the international labor division. There­fore, developing economies should not seek answers to the question whether to trade or not to trade. Instead they should be concerned with the question in what and how to produce and trade.

Furthermore, it is manifest that in the process of industrialization international trade is assumed to have played a significant role, since it would have been impossible to increase substantially productivity levels of newly established industrial sectors just orienting to domestic markets. There is a significant rationale for changing an econ­omy’s structure and trade profile (Grilli and Salvatore, 1994). As a matter of fact, coun­tries that produce and export predominantly goods of primary sectors and, therefore, have to import a set of industrial goods tend to experience instabilities in their terms of trade. Consequently, industrialization should be seen as a means to achieving and creat­ing a more robust economic structure with trade patterns capable of securing higher in­come levels of an economy’s residents.

In general, development implies a significant transformation of the economic structure. A general scheme implies that the agricultural (primary) sector gives way to the industrial (secondary) and services (tertiary) sectors in terms of value added and employment. Consequently, this process is accompanied by an appropriate migration of labor from the country side into urban sites. Successfully completed industrialization is supposed to induce productivity gains in all sectors implying higher incomes and im­proved living standards. Further transformation of an economy leads even to higher paths of development implying further reallocation of resources in favor of the tertiary sector. To maintain that an economy undergoing such kind of transformation processes is secured from adverse price developments of its exportables and importables, appro­priate alterations in its patterns of production and exports seem expedient.

It would be shortsighted to reckon presently existing export structure of trading countries to be unchangeable and perpetual reflecting an optimal organization of and participation in international labor division, as envisioned by Ricardo (1789) in the the­ory of comparative advantage. Instead, the existing patterns of trade links are to be con­sidered as just one state of affairs in a long series of actions.

As shortly mentioned in the previous section, it was the rural migration that en­abled to foster industrialization and establish tight links between economy’s formerly non-interacting sectors. Since most of developing economies were dominated by the traditional sector with substantial labor reserves, there were impressive potentials hid­den within these economies, which could be naturally freed and realized through the intermediary of international trade. Trade was supposed to assist developing nations to create dynamic comparative advantage in labor-intensive manufacturing based on their lower wage levels (Lewis et al, 1949).

1.2.2 Industrialization and trade

The above described scheme reveals the workings of a tense interaction of trade and in­dustrialization occurred in an evolutionary manner (i.e. happening ‘naturally’ through market mechanisms). Most of Western European economies along with their off-shoots got industrialized in this manner (Kuznets, 1973). By contrast, the experience of newly industrialized economies of South-East Asia provides an example of such transforma­tion implemented via wide state engagement. This in turn implies that industrial trans­formation may be conducted at a rapid pace (e.g. Kuznets, 1994).

In general, the process of industrialization may be implemented in accordance with certain schemes, which, as a rule, comprise several stages. Hence, an appropriate timing and right sequencing of these stages are indispensable if an economy’s industri­alization endeavor is to prove successful.

Nations that successfully pursued industrialization made use of import substitu­tion industrialization (ISI) measures to expand their domestic industrial sectors.[6] With this strategy in place, domestic production replaces a number of imported goods. Typi­cally, in the initial stages ISI touches upon the production of fairly primitive non­durable items requiring undemanding technologies (Alavi, 1996).

Since employed technologies in such sectors are deemed unchallenging and rela­tively labor-intensive, no significant obstacles are likely to hinder the process of absorp­tion of labor force from rural areas. Therefore, the initial stage of ISI should be viewed as a start in creating new comparative advantage in more promising kinds of production, which would bring certain gains in productivity and income growth.

Hence, ISI brings the transforming economy into a stage, where higher standards of living may be attained due to ever evolving industrial structure, significant changes in the employment of labor resources and altering patterns of exports and imports (Kuznets, 1973). To establish new comparative advantages in certain types of produc­tion, any society has an array of inputs at its disposal, which make up resource endow­ment of a given economy.

Furthermore, every nation is able to increase the stock or upgrade the quality of its reproducible factors of production. This is valid, in particular, for human capital, technology and physical capital, whose structure, quality and quantity are exposed to permanent changes. It is also quite obvious that the government policy may exert cer­tain influence upon the evolution of the resource endowment of a nation (Weiss, 1994). Therefore, it is a high priority of public policy to maintain appropriate composition and quality of inputs that would enable to attain and retain the competitive edge in certain types of production and, thus, secure higher living standards. When implementing poli­cies of industrialization based on import substitution, countries often employ a number of instruments to manage and sequence the process of transformation. These may in­clude tariff protection, undervalued exchange rates, managed credit allocation, planned government procurements, tax incentives for training and investment, etc.

The first stage of ISI itself brings potential gains that could pave the way for fur­ther steps on the transformation path of an economy. Thus, this stage of ISI facilitates job creation and assists in upgrading human capital, which could prove crucial for fur­ther positive externalities across various sectors of the economy. What is more, throughout this phase of industrialization indispensable entrepreneurial skills are ac­quired, which in their turn may positively influence business ethics and habits.

The first stage of ISI enables countries to move to a higher level of economic development. Upon completing the initial stage of industrialization an economy reaches a point, after which there are two different paths. One of these paths promises greater potentials for further dynamic effects resulting from physical and human capital accu­mulation. The other path lessens such potentials for continued and sustainable economic development. It is worth noting that this stage provides only limited opportunities for development, since diminishing returns in the sectors affected by import substitution policies pose constraints for further expansion of an economy. In this case, industrial expansion, which is required for further economic development, is likely to be just lim­ited to the population growth and its purchasing power expansion.

In addition, during and immediately after the first stage of ISI, the composition of imports changes in favor of more sophisticated investment products, which an econ­omy cannot produce yet but needs them to have its industrial sector run. Therefore, the dependence of an industrializing economy on trade with other nations is deemed even more intensified. With this necessity to switch to imports of more capital-intensive products, an economy undergoing industrialization deals with foreign exchange short­ages. Either because of rather instable prices of their primary commodities or due to steadily unfavorable development of their terms of trade, the exports revenues of these economies are not likely to cover the whole scope of imports that the economy requires for sustaining its further development.

It is possible to do away with the shortage of foreign exchange either through first-stage export promotion or second-stage import substitution. Either of the ways taken leads to fairly different outcomes in terms of a country’s industrial structure, pat­terns of its exports and imports, the ‘balance of payments’ issues, and long-run devel­opment perspectives. It should be also noted that almost all economies that successfully completed their industrialization and development processes went through both of the proposed strategies. It’s expedient to find an optimal sequencing of both.

Upon elimination of infant-industry tariffs, formerly infant industries can opt to export their products. This endeavor is often supported by government measures, such as slightly undervalued exchange rate, international marketing activities, education sub­sidies, etc. (Amsden, 2000). Such steps aim at earning additional foreign exchange to maintain appropriate development of the domestic economy via importing more capital­intensive products required for deepening its industrialization. What is even more note­worthy is that exports composition is changed in favor of industrial goods, thus, de­creasing dependence on revenue originating from exports of primary goods.

Increased exports might also bring further positive effects in terms of productiv­ity and employment. Rising exports will doubtlessly assist in maintaining high growth levels. Operation in foreign markets brings further experiences that would further aug­ment the knowledge stock, which can be transferred to other domestic sectors via spill­over effects. Therefore, there emerge favorable conditions for both forward and back­ward linkages in new types of industries enhanced by further deepening. In short, during the first stage of export promotion an economy manages to transform its export profile. Exports of manufactures appear to be more than just an addition to the primary product export base.

It is essential that a country produce such goods for which there would be an ex­panding demand over extended periods of time, what would secure ample of value- added for its domestic economy. All in all, while aspiring to dynamic (created) com­parative advantage, economies ought to find an export composition comprising goods with positive and, preferably, greater than unity income elasticity.

The well arranged and successfully implemented industrialization strategy in a number of East Asian economies including Japan confirms that an appropriately devised and realized sequencing of industrialization from the first stage of import substitution to the second phase of export promotion enables to develop additional dynamic compara­tive advantages.

Unlike the economies of East Asia, most Latin American countries moved from the first stage of ISI straightforwardly to its second stage, discarding the first-stage ex­port promotion pursued by the East Asian economies. The second stage of ISI is as­sumed to further domestic industrialization by expanding the scope of importables to be substituted, which, as a rule, include durable consumer items, intermediate products, equipment and the like (Alavi, 1996).

The move to this stage of industrialization is motivated by two intertwined facts. Firstly, the previous stage has already exhausted its potentials to maintain further devel­opment. Secondly, steadfast trade deficits lead to the balance-of-payments difficulties.

Therefore, the intention to reduce the import bill through further measures of import substitution seems quite reasonable. The logic behind this step is founded on the as­sumption that the amount of foreign exchange saved by a deepening of ISI equals to the amount of foreign exchange earned thanks to export promotion measures.

However, there are also other issues and aspects that are to be taken into consid­eration. In the long run, the second stage of ISI may prove a shortsighted step, if launched prematurely, in view of an abundance of gains its alternative - first-stage ex­port promotion - secured for the economies of South-East Asia.

These two different paths taken have brought contrasting results, which in their turn determined further development trajectories of the economies concerned. Letting alone potentially attainable gains, the path taken by Latin American economies pre­vented them from exploiting the scope of advantages and gains brought about during the first stage of ISI (Corbo, 1994). A swift shift from labor-intensive to more capital­intensive kinds of production undermined further absorption prospects of labor moving from the country side to cities, furthermore, economies could not have exploited poten­tialities of the formerly emerged entrepreneurs who would have definitely brought in a great number of positive externalities provided the first stage of export promotion had been in place.

In contrast to the experience of Latin American economies, the East Asian economies have undergone transformations of another type (Bradford, 1994; Hong, 1993). The first stage of export promotion enabled these economies to further absorb large volumes of labor force from the country side, while fostering additional accumula­tion of physical along with human capital and, thus, reaping benefits and creating new comparative advantage from operation in international markets.

Producers in a large number of Latin American countries, India and a few other countries during the second stage of ISI started ‘benefiting’ from high levels of protec­tion of industry from foreign competition, what prevented them from growing and en­hancing their competitive edge (Corbo, 1994; Dubey, 1994; Kiely, 1998).

However, in the 1970s, there has been one more switch in strategies both in the economies of South-East Asia and Latin America. This strategy change once again led to slightly differing development paths. In the economies of South-East Asia, with sub­stantial government guidance the strategy of second-stage import substitution has been fairly implemented. These economies succeeded in establishing new production lines and industries now putting out more sophisticated and capital-intensive products that they had to import previously. All the process has been accompanied by well-rounded indirect support of the government, with an intention to even further expand the stock of knowledge (through R&D activities) and foster the process of physical and human capi­tal accumulation. Once the newly established firms reached the needed productivity lev­els, the infant industry tariff protection was to be lifted. With enhanced stocks of inputs, these economies could already successfully compete both in the domestic and foreign markets.

Upon implementing the second stage of ISI aimed at solving the balance-of- payments difficulties, most of the Latin American economies saw their imports rise too, as the economies were not capable of producing all needed products in demanded quan­tities or qualities. Therefore, to be able to earn additional foreign exchange, they had to start pursuing the strategy of export promotion. The strategy of export promotion, unlike that of export substitution, had to just add some additional items to the list of ex­portables. This type of export promotion was implemented rather in form of particular subsidies provided to multinational corporations residing in the economies of Latin America to sell part of their products in international markets.

Timely well arranged and rightly combined, import and export substitution poli­cies enabled the East Asian economies to climb up the technology ladder by moving towards industries that bring even higher value added in the production activities em­ploying both knowledge- and capital-intensive technologies. These industries, involving cutting-edge technologies, provide good opportunities for future development.

These experiences of structural transformation evince the ability of small economies to undergo industrialization, while focusing just on a small number of im­portable items to be substituted and consequently switching to exporting as productivity rises to appropriate levels. Therefore, regional trade arrangements would provide smaller economies with ample opportunity to get access to regional markets and, thus, attain economies of scale and reap benefits stemming from leaming-by-doing effects. Larger economies with greater domestic demand are inclined to have better prospects for strategies of import substitution and export promotion, facing, however, also more difficulties, particularly if they are abundantly endowed with land and natural resources.

1.2.3 Trade, resources and institutions

Gains from trade

As already discussed in the previous section, a country’s development patterns are sub­ject to the influence of trade, the character of which is to a great extent determined by its endowment with factors of production (e.g. workforce, physical capital, natural re­sources). Economic development, implying an increase of a given society’s welfare, is sustained by increments of goods and services available for consumption. This augmen­tation of products is due to growth of domestic production capacities or imports from abroad, both of which are subject to the influence exerted by trade’s static and dynamic effects. Increased domestic production implies, among other things, increased revenues from exports allowing for more imports. This chain of events is well explained by the interplay of effects of trade resulting in gains. In theory scholars distinguish between the two main types of gains (or effects) stemming from conducting trade. These are static and dynamic gains from trade.

Static gains are the benefits that a trading county accrues from exploiting its al­ready established comparative advantage. It is assumed that this sort of gains stems primarily from inter-industry specialization (Grimvade, 2000). Economies being vari­ously endowed with production factors will find themselves better off, if they specialize in goods they can produce with lower costs to trade them in exchange for goods they themselves would have to produce with higher costs. Specialization in line with the foundations of comparative advantage enables to make the most of the given resource and factor endowments, and results in welfare gains of trading economies. This type of gains is rather obvious: their effect is seen right away in the increased level of welfare. However, these static gains do not make up all benefits a country is capable of reaping from conducting trade with other nations. In addition, there are also some other gains that ensue from trade.

Dynamic gains provide another rationale for conducting trade, even if there are no static gains in place (Thirlwall, 2003). Dynamic gains are the benefits to be accrued from the impact of trade on an economy’s production structure and possibilities and contribute to the establishment of incremental comparative advantage. Dynamic gains appear to be somewhat latent, since they provide an economy with an impetus to adjust and, thus, induce it to undergo needed transformation and changes. It is the workings of these dynamic gains that play a significant role in the development process, since through trade economies may more easily accumulate resources. This is valid particu­larly for small economies that are incapable of accumulating enough capital as speciali­zation is limited by the extent of their domestic markets. Briefly, dynamic effects enable countries to expand their production possibilities and modify their comparative advan­tage, for instance, through industrialization based on import substitution and export promotion policies. Thus, benefits gained from static and dynamic effects provide a ra­tionale for conducting trade.

In addition, there is another kind of benefits that can be accrued, when trade is to be considered as a 'vent for surplus'.[7] The existence of the ‘vent for surplus’ gains are ascribed to the fact that regions are unevenly endowed with resources and inputs. This type of gains imply benefits ensuing from exports of excessively available resources that would otherwise lie idle and not be used altogether if demand were limited to do­mestic consumption only.

Revenues yielded from these exports can be easily spent for imports required by the economy. The ‘vent for surplus’ approach to trade and development focuses on the essential insight that trade is capable of triggering growth and putting an economy on an appropriate development path. In addition, it is suggested that the scope of welfare gains stemming from appropriate expansions of exports of primary goods and mobilization of previously idle resources may exceed that of benefits originating from a reallocation of presently given and previously entirely utilized resources (Ros, 2003). Being apt to widen the market, trade fosters further labor division and increases the level of produc­tivity.

Natural resources and development

The ‘vent for surplus’ approach implies primarily trade with resources, which are obvi­ously distributed rather unevenly among regions. What role should be ascribed to re­sources in the process of development? Theorists are not unanimous in providing their answers to this question, which range from facilitating growth to impeding it. Against this background, the ‘staples thesis’ states that exports of resource-intensive goods may prove indispensable for further economic development, whereas ‘Prebisch-Singer the­sis’ states that specialization in resource-intensive exports may hamper economies’ growth prospects (Ros, 2003).

Other approaches point to further important aspects of the link between trade in resources and development patterns. Sachs and Warner (1997) along with Arezki and van der Ploeg (2007), for instance, argue that resource abundance, measured by the stock of natural capital, is apt to slow down economic growth and, hence, development. This notwithstanding, it would be shortsighted to ascribe success or failure in economic performance of countries only to their resource endowment[8]. Since resources and raw materials of one country demanded elsewhere could become a good source of foreign exchange, it is up to a nation to either dissipate the earned windfall or smartly allocate it by investing in establishing new production facilities or modernizing the existing ones.

Deriving from fairly positive experiences in development through trade in pri­mary products of countries, such as Canada, Argentina, South Africa, Australia and New Zealand,[9] one must note that this kind of trade with the then industrializing Europe paved the way for productivity growth in mining and agriculture, and a bit later also in labor-intensive industries.

The ‘staples thesis’ corroborates the aforementioned. Initiated in the work of Canadian economic historians, the staples thesis postulates that exports of resource­intensive goods may serve as an engine of development and transformation by inducing manufacturing industries and transport networks to expand, which are supposed to have important linkages with other domestic industries, a scheme a la Hirschman, implying potentials for backward and forward linkages (Ros, 2003).

As already shortly mentioned, the virtue of abundantly available natural re­sources demanded by other regions can, in fact, quickly turn into curse. Excessively large revenues from exports may deluge domestic economy and induce the exchange rate to rise, what leads to the loss of competitiveness of local manufacturing industry both within the country and abroad. This phenomenon has been dubbed ‘Dutch disease ’ in the literature, after the Dutch manufacturing industry suffered from adverse effects triggered by the real currency appreciation as a result of the natural gas discoveries in the 1970s. During the same decade, after the oil price shocks, a number of oil-exporting economies have been adversely affected by analogous ‘disease’. This shows that there is a trade-off between the exports of resources and successful performance of an industrial sector.

The successfully undergone processes of industrialization in the offshoots of Europe before the 1930s were to a certain degree conditioned by favorable price devel­opments for primary products and high demand for them, enabling them gradually to accumulate required inputs and, later, switch to needed substitution patterns. Therefore, the main points of the ‘staples thesis’ approach seem plausible at earlier stages, when countries were much more involved in the inter-industrial type of trade exchanging in­dustrial products and primary goods. Currently, the bulk of international trade is con­ducted between developed countries and is in fact of intra-industrial type. By and large, the resource intensity of goods has declined persistently, what has led to the decreased demand and lower prices; whereas skilled-labor intensity increased considerably, what makes this input more demanded and more expensive. This circumstance leaves small room for today’s developing economies intending to develop through trade in resources.

Production and trade patterns, being closely interlinked constituents, have led to the currently existing economic order, on the origins of which a number of theorists tried to provide their explanations. In fact there are several approaches that tackle the issues of development and trade as tightly interrelated phenomena. For instance, Pre- bisch (1950) and Singer (1950) offered their view on the backwardness nature of devel­oping economies in a theoretical framework what is now called ‘Prebisch-Singer the­sis’. In line with their concept, the world consisting of two groups of countries - indus­trial core and traditional periphery - engaged in trade was not allegedly able, so goes the argument, to fairly distribute gains from trade. Less developed countries are inclined to suffer from steadfast decline of their terms of trade (due to their production and trade specialization in primary products, whose prices are supposed to continually fall). The way out is seen in import substitution industrialization, the main workings of which have been mentioned afore.

Bhagwati (1958) also cast doubt on the consistency of strategies based upon ex­ports of primary goods and put forward the notion of immiserizing growth, which im­plied that a growing economy exporting primary goods might find itself worse off de­spite or, to be more correct, because of growth of commodity exports, so that their prices would plummet down. This case is valid for countries possessing large shares in international commodity markets.

The framework of an ‘export model of regional growth rate differences’ com­bines insights of Prebisch (1950), Seers (1962) and Myrdal (1963) on trade and devel­opment patterns by outlining the workings of growing disparities among countries en­gaged in exchange of products. According to this approach, trade is alleged to set off progress, since once one region gets developed, it will impede the development of other regions by attracting required inputs to further sustain its growth.

In this context the workings of Verdoom’s Law[10] are of primary significance. Growth in output in a trading country induces productivity growth that in turn is apt to generate further increases of exports. Therefore, this sequence of events deprives less developed economies of their possibilities to get to higher paths of development by set­ting their ‘hidden potentials’ free. Structural changes in the composition of exports, at­tained first by import and, then, export substitution strategies, were proposed to break up the existing constraints on growth and development.

Institutions and development

The aforementioned makes obvious that despite a large number of approaches con­cerned with the interplay of resource endowment and development, it is still not so clear whether being rich in resource is a virtue or a curse. Therefore, there must be something else in place, what contributes to the successful outcome of this endeavor - getting rich through utilization of available resources.[11]

Geography12 and institutions make up important fundamentals exerting strong influence on countries’ long-run growth and development (Acemoglu, 2003). Both of these constituents are tightly intertwined with the stage of development of a country. Some scholars adhere to the view that both institutions and resources to certain extent influence each other, and their joint interplay determines the pace of economic devel­opment.[13] In this context, embodied in a wide array of arrangements, laws, norms, be­havior patterns, attitudes, and the like, institutions are believed to matter for the process of economic development (Olson, 1982). In general, natural resources are believed to exert influence upon growth through ‘positive’ and ‘negative channels’ (Stijns, 2005). The main channels of such influence are depicted in Figure 1.1, which shows the way the fundamentals of geography and institutions, while interacting with the so called proximate determinants of growth - factor endowments (labor force and physical capi­tal) and productivity - exert influence upon income growth. In addition, it must be noted that in this context the role of trade is an essential one.

Proper institutions are believed to facilitate growth and development, being at the same time their ‘by-product’. A comparison of East Asia’s economic performance with that of Latin America stresses the importance of sound congruence of public poli­cies with long-term interests of the private sector’s agents. Thus, institutions, seen as an important complement to the constituent of resources, do matter a lot for the process of economic development.

Figure 1.1 Growth, trade, resources and institutions

illustration not visible in this excerpt

These two constituents of the development process can be hardly modified within a short time span. However, gradual but persistent changes favored by external conditions may lead to substantial improvements in country-specific policies and institutional framework. In the form of trade, external conditions, for instance, may set free and bail out regions, whose development was previously limited by the locally prevailing dis­couraging institutions, since these may specialize in sectors least exposed to ‘bad poli­cies’. It must be emphasized, however, that such kind of seemingly obvious links be­tween international trade, institutions and economic growth are currently not proved empirically or in a more formalized way due to numerous difficulties in specifying de­terminants and resultants (Dollar and Kraay, 2003).

This notwithstanding, as Belloc (2006) argues, international trade and institu­tions are reasonably assumed tightly interrelated, where the latter should be seen as a determinant of an economy’s competitiveness and trade patterns. These features are deemed essential for a country’s sustainable economic growth that presently further en­hanced by the exchange of produced items and factors of productions. The issues of economic growth in an open economy are the subject of the next section.

1.3 Growth in an open economy

The possibility of foreign trade and other peaceful in­ternational flows increases the variety of choices avail­able as to the sectors and means by which the modern economic growth of a given nation will be induced...

Kuznets (1966: 293)

Due to achievements of modern technology and its impact on the means of communica­tions and infrastructure, modem economies, interacting with each other in a number of ways, have become more interdependent. The term ‘globalization’ has become central in the recent time, which signifies this process of economies’ ever increasing depend­ence on what happens internationally. In addition, there is also a process of regionaliza­tion in place that leads to increased integration of the economies intending to form an integration bloc. Such endeavors are aimed at facilitating the trade in goods and services along with flows of capital, labor and know-how.

Significant volumes of products and inputs flowing between economies are straightforward consequences of this process. However, countries are to different degree engaged in these exchanges of goods and services, as well as factors of production. Therefore, it makes sense to identify different groups of economies in line with their openness. Using a number of indicators, one distinguishes between autarky and open­ness. The former implies that an economy is completely closed and does not have links with the rest of the world and is rarely encountered in economic reality. The latter sug­gests that an economy is linked with other regions either through trade or input flows or both.

Open economies may be linked to other economies in two forms of interaction, the first of which is trade embodied in the exchange of goods and services, and the sec­ond is the flow of factors of production. These forms of interaction are supposed to con­tribute to the income levels of economies’ residents as well as their growth rate either directly - through the workings of factor accumulation - or indirectly, i.e. through changes in productivity. This in turn enhances processes of convergence across the economies, which, for instance, participate in an integration grouping.

Therefore, it is to infer that growth in an open economy is subject to the factors stemming from its environment. Among external determinants of economic growth it is expedient to accentuate the following:

[...] first, the worldwide stock of useful knowledge, to which the given nation may have contributed but necessarily only in part; second, the various interna­tional flows of economic resources or goods, either in exchange as in the case of foreign trade, in borrowing and lending as in the case of capital flows, or in uni­lateral receipts or payments as in the case of grants or, more important, immigra­tion and emigration; third, acts of aggression by the given nation against some other part of the world, whether such acts constitute extraction of special privi­leges, exercise of colonial domination, or outright annexation.

Kuznets (1966: 285)

From the abovementioned it becomes evident that a country’s growth is influenced through numerous ties with other countries, what implies its higher dependence upon the dynamics of the rest of the world.

Measurement of openness

Hitherto scientists have produced an abundance of theoretical and empirical works de­voted to the issues of openness and growth. Most of these works, being supported with a rich variety of empirical methods, corroborate the view of favorability of openness for growth. However, the things are not as clear as they might seem to be presented due to the existence of a lot of unresolved issues.

Among these unresolved issues is the measurement of openness. In this context, one may employ one of the two main approaches to the measurement of openness of economies. Some economists focus on the volumes of goods (or inputs) flowing in and out of an economy to measure how open it is in terms of the exchange of products (or production factors).[14] However, countries might be open and pursue fairly liberal trade policies and still don’t conduct trade because of the absence of incentives to do so. This case made the present approach void.

This shortcoming may be overcome with the help of another approach. This one is based on the workings of the law of one price, which suggests that the less the prices of two economies differ, the more open the economies should be considered. In this case prices signify prices of goods and services, factors of production, interest and ex­change rates. If these differences in prices of the economies exceed trade costs, then there appear incentives for conducting trade.

Openness and size

What is more, the degree of openness may also vary across economies due to their sizes. Ceteris paribus, larger economies tend to trade less than smaller economies. Hence, there is a negative link between foreign trade proportions and the size of an economy measured by its GDP. For instance, it is quite natural that small economies, aspiring to maintain certain level of consumption of a fair variety of goods, have to rely more on trade than large economies would have to. Therefore, it is quite understandable that...

[...] small countries can attain economic growth only through heavy reliance of foreign trade, as indicated by high proportions to national product - although clearly this is a necessary but not sufficient condition; whereas the larger coun­tries can attain economic growth with much lower foreign trade proportions, so that reliance on proportionally large material flows to and from the rest of the world is not a necessary condition, although it may occur...

Kuznets (1966: 302)

Openness and factors of production

As already stated above, economies may be open to trade with goods and to the ex­change with factors of production. These types of openness are closely interrelated through the mechanisms of factor price equalization. This implies, in accordance with the main inferences of the Heckscher-Ohlin model of international trade, that even if a country is relatively closed to the exchange of inputs into production, after engaging in trade and continuing conducting it, an economy would come to roughly similar results in terms of compensation of employed factors of production, if it had been also open to the exchange of factors of production.

Furthermore, the basic models of economic growth have also their own implica­tions, when analysis is directed to an open economy. For instance, within the frame of the neoclassical approach with its workhorse model, where the rate of saving and the rate of population growth are of significance, the flows of capital (or of population) would lead to a new unified steady state.

Accordingly, in one of his works Ventura (1997) continued along this path in order to validate the ever increasing interdependence, which was essential for explana­tion of the existing differences in the growth performance of various countries. He ex­emplified the experiences of South-East Asia to support the idea of the possibility to obviate potential losses stemming from diminishing returns on capital. Hence, the economies of this region had an opportunity to either start exporting capital or shift into more capital intensive types of production.[15]

In the case of endogenous growth models, there is an effect in place that justifies the involvement of an economy into international trade. Since this type of models dis­misses the assumptions of the neoclassical growth model of perfect competition and diminishing returns on reproducible inputs concentrates on the externalities that enable to neutralize the effect of diminishing returns on reproducible factors of production, it is evident that increases of the market size - an indispensable outcome of the involvement in trade - would lead to the augmentation of positive externalities, which would lead to higher welfare levels either through higher quality or larger variety of products to be consumed.

Additionally, there is an array of further effects stemming from the involvement of an economy into international trade, which are well devised by endogenous growth models. Omitting details, involvement in trade could also produce positive spillovers across export industries, which could then be embraced by other industries of an econ­omy. Often, trade leads also to reallocation of resources within economies causing over time transformations in their specialization patterns.

Despite all the brought about justifications of openness as a virtue for growth, there is an implication that the more open an economy, the more volatile it becomes. For instance, Calderon et al (2004) argue that greater openness to trade and capital movements entail higher vulnerability degrees for an economy.

[...]


[1] This feature has been proponed and thoroughly discussed by Kuznets (1966).

[2] Thus far primarily due to data issues, most of the works have focused on developed and developing countries. See, for instance, McCombie and Thirlwall (2004).

[3] This method was favored by Kuznets (1949) when considering determinants of and explaining differ­ences in growth rates.

[1] For instance, the United Nations Human Development Index (HDI) represents a compound of equally weighted income, health and education (Mazumdar, 2003).

[2] It is alleged that all savings are transformed into investment.

[3] In 1987 Solow was awarded a Nobel Prize in Economics for his contributions to the theory of economic growth.

[4] Backward linkages are linkages of a sector to its suppliers, whereas forward linkages represent its ties to sectors demanding its output.

[5] The new growth theory has extensively stressed this feature.

[6] Great Britain that was the first nation to industrialize was an exception, since there were no economies from which the newly established industries were to be protected.

[7] The concept has been originally formulated by Smith (1776) and thoroughly developed by Myint (1958).

[8] There is definitely another variable making the difference in the outcome, namely institutions in its broadest sense; Arezki and van der Ploeg (2007) state that allowing policies aimed at more trade openness and establishing good institutions may diminish the negative ‘impact of resource curse’.

[9] These countries were among the richest at outset of the 1900s.

[10] The law, named after Dutch economist P. J. Verdoom, reveals the long-term positive relationship be­tween the rate of output growth and productivity growth due to increasing returns.

[11] Diverging paths of rich in resources Canada, Australia, New Zealand, the American West, on the one hand, and Argentina along with other regions of Latin America, on the other, point to the existence in this setup of another variable capable of making the difference along the path of development.

[12] In this context the notion of geography implies natural resources.

[13] North et al (2000) argue that institutional framework influences the pattern of region’s specialization to a great extent.

[14] In this case, the volume of trade turnover (exports plus imports) is related to GDP.

[15] Here the interplay of the two sources of growth is evident: on the one side, accumulation of inputs (la­bor and capital), and on the other, productivity resulting from higher quality of inputs (higher educated labor force, better technologies) and efficiency (superior institutional frame).

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Details

Title
External factors of economic growth in the transition economies of the Baltics and Central Asia
College
Carl von Ossietzky University of Oldenburg  (Institut für Volkswirtschaftslehre und Statistik)
Grade
1,0
Author
Year
2007
Pages
250
Catalog Number
V90180
ISBN (eBook)
9783638038256
ISBN (Book)
9783638934602
File size
21560 KB
Language
English
Keywords
External, Baltics, Central, Asia
Quote paper
Dr. rer. pol. Eldar Madumarov (Author), 2007, External factors of economic growth in the transition economies of the Baltics and Central Asia, Munich, GRIN Verlag, https://www.grin.com/document/90180

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