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Industrial structure, competitiveness, and trade
Industrial Structure, Competitiveness, and Trade SVEN W. ARNDT ABSTRACT This paper examines the effect of sector-specific growth on real exchange rates, competitiveness, and the trade balance. Growth and accumulation in export- and import-competing industries exert their primary effect on the trade balance, while the direct effect of accumulation in non-tradables is on the real exchange rate. Thus, exchange-rate policies that are incompatible with non-tradables equilibrium are bound to fail. Furthermore, growth policies with strong biases toward tradables are often inferior to more balanced strategies, due to their adverse implications for real-exchangerate movements and the trade balance.
When two economies are linked through trade, industrial change in one of them has inevitable implications for the other. Economic interdependence may be measured in a number of ways, but interconnectedness among countries' industrial structures is a key element. Even a small country can be large in terms of its influence over another's industrial structure by influencing the relative prices that determine the allocation of resources. This feature of interdependence has long been o f concern to the countries of Latin America, many of whom have had to live in the economic shadow of the United States. Their preoccupation with the giant to the north has, on occasion, led them to underestimate the effects of their own policies on specific industries and sectors in the United States. This paper examines the role of exchange rates and growth strategies in determining industrial structure and competitiveness. It evaluates the widely held belief, based in part on the experiences of certain Pacific Rim countries, that successful economic development depends on export-led growth, or at least on growth among tradables industries, and that exchange rate and growth policies must make the tradables sector their priority. It shows that international competitiveness and the sustainability of real exchange rates are governed by developments in what has variously been called the "domestic" economy, the "nontradables" sector, or the "sheltered" sector.
SvenW.Arndt • DepartmentofEconomics, Crown College, UniversityofCalifornia, SantaCruz, CA95060. North American Review of Economics & Finance, 1(2):217-224 Copyright © 1990 by JAI Press, Inc. ISSN 1042-752X All rights of reproduction in any form reserved.
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REAL EXCHANGE-RATE SHOCKS AND INDUSTRIAL STRUCTURE The real exchange rate is commonly defined as the nominal rate adjusted for relative price movements, where prices are measured in terms of consumer prices or other equally broad price or cost aggregates. As such, the real rate is used as an indicator of overall or economy-wide competitiveness. Figure 1 presents three measures of the real exchange rate between Mexico and the United States. All three measures suggest that Mexican competitiveness improved in the 1980s, with relative wholesale prices showing the least and relative hourly compensation the greatest improvement. Parenthetically, the decline in relative earnings underscores the cost in terms of foregone real income suffered by Mexican workers as a result of the debt crisis. Another measure of competitiveness that is very closely followed in developing countries is the terms of trade. The terms of trade reflect the cost of imports in terms of exports. A rise in the relative price of exports is seen as an improvement in the terms of trade and hence in competitiveness. There is some dispute among experts over the secular tendency of the terms of trade of developing countries. In what follows, the terms of trade are assumed constant, so that exports and imports, as well as all goods for which they are good substitutes, may be combined into the single category of tradables. It is convenient to think of total national output as comprising two broad categories of goods, one tradable, the other non-tradable. The former consists of goods that are actually traded and goods that compete directly with them, but may not be traded. Non-tradables make up the rest of an economy's output of goods and services. Products commonly included among tradables include manufactures, mining products, and some agricultural produce. In some contexts, the industries producing these goods
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Figure 1. The real exchange rate between Mexico and the United States as measured in terms of WPI, CPI, and hourly compensation. [Note: The vertical axis measures the real exchange rate, expressed as dollars per peso multiplied by the ratio of Mexican to U.S. prices (wholesale, WPI; or consumer, CPI) or the ratio of hourly compensation.]
Industrial Structure, Competitiveness, and Trade
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are said to be relatively "exposed" to foreign competition. Non-tradables, on the other hand, are dominated by public and private services, retail and other trade, and construction. They are said to be relatively "sheltered" from foreign competition. Objections have been raised against this classification scheme on grounds that all goods are tradable in the long run. That argument, although correct, is of little relevance. It is true, of course, that even haircuts are tradable in the long run, because barbers migrate from low- to high-wage countries or because customers go abroad to have their hair done. There exist, nevertheless, substantial differences in substitution elasticities; this is what matters for present purposes. For present purposes, non-tradables are represented by markets in which discrepancies between domestic supply and demand cannot be accommodated during the relevant time period by exports or imports. Those markets must therefore be cleared by movements in domestic prices. In markets for tradables, on the other hand, domestic demand and supply need not be equal even in equilibrium, because discrepancies between them are resolved through trade. The ratio of tradables to non-tradables prices is a key relative price in determining industrial structure, competitiveness, and the real exchange rate. It is well known that movements of the real exchange rate as defined above and movements in relative tradables prices are closely related. For small, price-taking countries they are the same thing, so that a real appreciation is matched by a relative decline in tradables prices. For large countries, the relationship is more complicated, but changes in the real exchange rate are substantially reflected in movements of relative tradables prices. It is not always easy, of course, to find suitable published data to create the proper relative price series. A commonly used first approximation is the ratio of wholesale to consumer prices. 2 Wholesale prices reflect mainly the prices of manufactures and so are taken as a rough indicator of the movement of tradables prices. Consumer prices, however, include in addition a wide variety of non-tradable goods and services. A rise (fall) in the ratio between the two indexes thus suggests that tradables prices are rising (falling) relative to non-tradables. In this context, then, a nominal devaluation of the Mexican peso against the dollar would be expected to bring about an improvement in competitiveness. That expectation is confirmed in Figure 1 where all three versions of the real exchange rate show improved competitiveness for Mexico beginning in the early 1980s. In addition, the fact that the real rate in terms of consumer prices falls more than in terms of wholesale prices suggests that tradables prices are rising relative to non-tradables in Mexico. The real depreciation is accompanied by a relative rise in tradables prices. A permanent rise in relative tradables prices in Mexico, brought about by the real depreciation of the peso against the dollar, creates incentives for resource redeployment from non-tradables to tradables, while the permanent fall in relative tradables prices in the United States should set in motion redeployment in the opposite direction. Consumers, on the other hand, would be expected to substitute non-tradables for tradables in Mexico and vice versa in the United States. The combined effect of shifts in production and consumption, therefore, is to improve the trade balance in Mexico and to make it worse in the United States. This outcome is quite consistent with the result predicted by the conventional interpretation of the real exchange rate as the relative price between home and foreign goods. A permanent change in the real exchange rate, therefore, alters the optimal allocation of resources in favor of industries whose relative prices have risen. A movement in the
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real exchange rate is thus more than just a change in relative foreign and domestic prices. Each real exchange rate represents an optimal mix between tradables and non-tradables in total production. Permanent changes in real exchange rates have permanent effects on economic structure. In equilibrium, therefore, the real exchange rate and industrial structure must be compatible. Exchange-rate policies are doomed to fail unless targets for the real exchange rate are compatible with relative prices determining industrial activity. A country can choose its real exchange rate or its preferred mix of tradables and non-tradables--that is, the degree of its openness--but not both. This fact has important implications for management of the public sector, since it plays an important role in determining the evolution of demand and supply in the non-tradables sector. Countries cannot conduct real exchange rate policies independently of policies governing public-sector output and expenditure. A real devaluation can be quickly nullified by a rise in public-sector expenditures relative to output. Inasmuch as the public sector is in many developing countries a significant component of non-tradables, policymakers may choose the size and growth of the public sector or the real exchange rate, but not both.
THE REAL EXCHANGE RATE AND NON-TRADABLES EQUILIBRIUM The relationship between the real exchange rate and non-tradables equilibrium may be seen in Figure 2, where the relative price between tradables and non-tradables is measured vertically, quantities of tradables horizontally to the right of the origin, and quantities of non-tradables horizontally to the left of the origin. Demand and supply in the tradables sector are measured conventionally in the right-hand panel, while demand and supply in the non-tradables sector appear in the left-hand panel with their positions reversed, so as to properly reflect the definition of the relative price, p. As already noted, a key difference between the two sectors is that demand and supply of non-tradables must be equal in equilibrium, while international trade allows demand and supply in tradables to deviate from each other. The equilibrium relative price between tradables and non-tradables, therefore, is the price that clears the non-tradables market. Hence, the equilibrium real exchange rate is the rate that clears the non-tradables markets at home and abroad. At that exchange rate, trade between the two countries may or may not be in balance. The central role of the non-tradables sector in determining the equilibrium exchange rate is apparent. Nominal devaluation will not alter the real exchange rate if the new rate is incompatible with non-tradables equilibrium. In terms of Figure 2, a nominal devaluation initially raises the relative price, p, by raising tradables prices (to, say, p'); this, in turn, creates excess demand for non-tradables, causing their prices to rise as well. Equilibrium is restored when non-tradables prices have risen to match the devaluation, leaving the real exchange rate unchanged. The importance of non-tradables in exchange-rate adjustment means that real currency values may be altered by policies that have little direct effect on the tradables market itself. A policy that shifts the demand for non-tradables outward [to D(n')] in Figure 2 will cause relative prices to fall to p" and the currency to appreciate in real terms. Indeed, we see that only policies that shift demand and supply in non-tradables can change the real exchange rate, while policies that shift demand and supply in tradables change the trade balance. Policies that affect only demand and supply in the tradables sector change the balance of trade, but not the real exchange rate.
Industrial Structure, Competitiveness, and Trade
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Consider, for simplicity, a policy that raises tradables demand, represented by an outward shift of the demand curve in the right-hand panel [to D(t')]. Since the disturbance leaves the non-tradables equilibrium unchanged, the real exchange rate will also remain unchanged. The trade balance, however, will deteriorate (showing a deficit equal to ab). A policy that increases demand for non-tradables [to D(n')], on the other hand, will bring about a real appreciation and a deterioration of the trade balance (showing a deficit equal to cd). Of course, policy shocks and other disturbances are not normally confined to just one sector. Most affect excess demand in both sectors, but still their impact on the real exchange rate depends on their effect on non-tradables equilibrium. Their action through the rest of the economy moves the trade balance rather than the real exchange rate. This is a very important conclusion for policy purposes, because it shows that governments wishing to alter the real exchange value of their currencies must look beyond intervention in tradables industries. Indeed, as the preceding suggests, "trade" policies that have little effect on excess demand for non-tradables will have little effect on the real exchange rate. They will, of course, change the trade balance. A shock in the real exchange rate originating in one country, even one that is compatible with equilibrium in that country's non-tradables sector, may not be sustainable if it disrupts non-tradables equilibrium in another country. This is an important feature of economic interdependence. Long-run sustainable changes in the real exchange rate must be compatible with non-tradables equilibrium at home and abroad. A small country in isolation will not disturb equilibrium abroad by its exchange rate policies. But large countries, as well as small countries acting together, must take into account the foreign repercussions of their policies. This finding is relevant to the discussion of structural adjustment among heavily indebted countries. Many adjustment proposals have been advanced, and most foresee considerable industrial restructuring on the part of debtor countries. In a number of these cases, relative tradables prices will have to change in creditor countries as well and those countries must
D(n) D
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Figure 2.
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Relationship between real exchange rate and non-tradables equilibrium.
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be prepared to undertake their own structural adjustment if economic reforms among debtors are to succeed.
COMPETITIVENESS The real exchange rate is, as we have seen, a standard measure of a country's international competitiveness. The trade balance serves as the actual indicator, so that a widening trade deficit is taken as evidence that the currency may be overvalued. A trade deficit or a worsening trade deficit may not be a reliable sign of overvaluation, however. An exchange rate that is accompanied by a trade deficit may nevertheless be an equilibrium exchange rate if it clears the market for non-tradables. Whether it is sustainable in the long run is, of course, another matter. When the non-tradables market is in equilibrium, nominal devaluation will not bring about a real devaluation unless it is properly supported by other policies. Above all, monetary accommodation must be avoided, so that the interest rate may rise, thereby shifting both demand curves inward. Non-tradables prices will then rise, but by less than the nominal devaluation, thus permitting the relative price, p, to rise. Output of non-tradables will fall, while that of tradables will rise. The trade balance will improve, of course, creating the impression that competitiveness has been improved. International competitiveness is thus linked to the sector that is not directly involved in international competition. It may seem paradoxical that a country's competitiveness should be shaped by activities not directly related to trade. The real exchange rate is, however, a key relative price and one that plays a major role in the allocation of scarce resources. The conventional treatment of the real exchange rate as the relative price between home and foreign goods has obscured its importance in determining the internal allocation of a country's productive resources. To be viable, therefore, an exchange rate must be compatible with allocative equilibrium in the domestic economy.
GROWTH, INDUSTRIAL STRUCTURE, AND THE REAL EXCHANGE RATE It is generally believed that economic growth in tradables is needed to build or maintain international competitiveness. Growth in tradables affects the S(t) curve in Figure 3 directly by shifting it out to S(t'). It has an indirect effect on demand for both types of goods through its effect on domestic income. Suppose that growth in tradables shifts tradables demand to D(t') and non-tradables demand to D ( n ' ) . 3 The direct effect on S(t) tends to raise a trade surplus or reduce a trade deficit; the indirect effect on tradables demand tends to inhibit that trade balance improvement. Neither change, however, affects the relative price, p. The main influence on the relative price and hence on the real exchange rate comes from the shift in non-tradables demand [to D(n')] as growth in the tradables sector raises income throughout the economy. The currency appreciates in real terms and exerts a further effect on the trade balance. The net effect of these various influences is to create a trade surplus of ab. In the popular discussion, the trade-balance improvement is seen as an improvement in competitiveness, while the appreciation is seen as impairing competitiveness. Overall, however, countries with trade surpluses and appreciating currencies are perceived as "strong" and competitive.
Industrial Structure, Competitiveness, and Trade
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Developing countries, however, should be net importers rather than exporters of goods and capital. Competitiveness as defined above is therefore less than relevant to their purposes. Indeed, the foregoing shows why development strategies based on growth in tradables industries, or worse, on export-led growth, may be ill-advised. At the least, growth in tradables and in non-tradables should be managed in such a way as to maintain a neutral trade balance. If, however, mobilization of foreign saving is an important part of a country's development strategy, then growth in non-tradables is needed (in addition to tradables growth) in order to add directly to the demand for tradables inputs and to provide for real depreciation of the currency over time. In practice, markets are subject to a variety of demand and supply shocks during the development cycle. Demand shocks tend to lead supply shocks in the early phases, but the distribution of their effects between tradables and non-tradables depends on the importance of the respective goods as production inputs. During these phases, the currency is likely to come under pressure of real appreciation, while the trade balance tends to deteriorate. Then, as capital formation creates new capacity, supply shocks dominate; still, demand in both markets increases as national income increases. The trade balance is now likely to improve, either because growth in tradables capacity increases supply relative to demand or because growth in non-tradables capacity raises the relative price of tradables. The real exchange rate may appreciate or depreciate, depending on whether growth occurs mainly in tradables or in non-tradables. 4 Hence, if it is the objective of policymakers to avoid trade surpluses and real appreciation while nevertheless fostering industrial development, investment in non-tradables must be an integral part of any development strategy. During the growth process, real exchange rates may be subject to considerable volatility, as demand and supply shocks in turn move the relative price ratio. This volatility raises questions about the optimal policy for the nominal exchange rate during the development
D
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D(t) D(t')
S(t) ,)
P p'
Qn (nontradables) Figure 3.
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Effect of growth in tradables on the S(t) curve.
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cycle. When the nominal exchange rate is fixed, the burden of relative price adjustment falls on non-tradables prices. During periods when the currency must depreciate in real terms, a fixed nominal exchange rate requires non-tradables prices to fall relative to tradables. In the services sector, that means falling nominal wages. Strong labor unions in non-tradables and especially in the public sector may fight such adjustments, in which case a policy of flexible nominal exchange rates is to be preferred.
CONCLUSION The existence of a close relationship between real exchange rates and relative tradables prices implies that exchange rate policies and policies affecting industrial structure cannot be conducted independently of each other. A given deployment of resources between tradables and non-tradables places limits on the freedom of movement of the real exchange rate. Given the nature of non-tradables equilibrium, the real exchange rate is essentially determined by movements of demand and supply in the non-tradables sector, while the trade balance is determined substantially, but not uniquely, by movements of demand and supply in the tradables sector. Exchange-rate policies that ignore the non-tradables constraint are bound to fail. The conventional belief that export-led growth policies represent the optimal development strategy is misplaced in light of the role played by non-tradables. Development policies that are strongly biased in favor of tradables bring about real appreciation and premature trade surpluses. They produce results that are undesirable from the perspective of the developing country because they squander resources. They are also dangerous in that they may provoke protectionist responses on the part of trading partners. They are, finally, unnecessary because industrialization can be achieved without large surpluses of tradables by judicious mixing of growth in tradables and non-tradables.
NOTES 1. 2. 3. 4.
But see Edwards (1988) for a treatment that includes movements in the terms of trade. See Arndt and Bouton (1987) for further detail. It may also have indirect effects on the S(n) curve, but those are ignored here. See Arndt (1989). See also Bruce and Purvis (1985); Edwards (1988); and Lal (1984).
REFERENCES Arndt, S.W. 1989. "Structural Adjustment in Semi-Industrialized Economies." Washington: World Bank (mimeo). Arndt, S.W. and L. Bouton. 1987. Competitiveness: The United States in World Trade. Lanham, MD: UPA, Inc. Bruce, N. and D.D. Purvis. 1985. "The Specification of Goods and Factor Markets in Open Economy Macroeconomic Models." In Handbook of International Economics, Vol. II, edited by R.W. Jones and P.B. Kenen. New York: North-Holland. Edwards, S. 1988. "Terms of Trade, Tariffs, and Labor Market Adjustment in Developing Countries." The Worm Bank Economic Review, 2. Lal, D. 1984. "The Real Effects of Stabilization and Structural Adjustment Policies." Washington: World Bank Staff Working Paper, no. 63.
When two economies are linked through trade, industrial change in one of them has inevitable implications for the other. Economic interdependence may be measured in a number of ways, but interconnectedness among countries' industrial structures is a key element. Even a small country can be large in terms of its influence over another's industrial structure by influencing the relative prices that determine the allocation of resources. This feature of interdependence has long been o f concern to the countries of Latin America, many of whom have had to live in the economic shadow of the United States. Their preoccupation with the giant to the north has, on occasion, led them to underestimate the effects of their own policies on specific industries and sectors in the United States. This paper examines the role of exchange rates and growth strategies in determining industrial structure and competitiveness. It evaluates the widely held belief, based in part on the experiences of certain Pacific Rim countries, that successful economic development depends on export-led growth, or at least on growth among tradables industries, and that exchange rate and growth policies must make the tradables sector their priority. It shows that international competitiveness and the sustainability of real exchange rates are governed by developments in what has variously been called the "domestic" economy, the "nontradables" sector, or the "sheltered" sector.
SvenW.Arndt • DepartmentofEconomics, Crown College, UniversityofCalifornia, SantaCruz, CA95060. North American Review of Economics & Finance, 1(2):217-224 Copyright © 1990 by JAI Press, Inc. ISSN 1042-752X All rights of reproduction in any form reserved.
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REAL EXCHANGE-RATE SHOCKS AND INDUSTRIAL STRUCTURE The real exchange rate is commonly defined as the nominal rate adjusted for relative price movements, where prices are measured in terms of consumer prices or other equally broad price or cost aggregates. As such, the real rate is used as an indicator of overall or economy-wide competitiveness. Figure 1 presents three measures of the real exchange rate between Mexico and the United States. All three measures suggest that Mexican competitiveness improved in the 1980s, with relative wholesale prices showing the least and relative hourly compensation the greatest improvement. Parenthetically, the decline in relative earnings underscores the cost in terms of foregone real income suffered by Mexican workers as a result of the debt crisis. Another measure of competitiveness that is very closely followed in developing countries is the terms of trade. The terms of trade reflect the cost of imports in terms of exports. A rise in the relative price of exports is seen as an improvement in the terms of trade and hence in competitiveness. There is some dispute among experts over the secular tendency of the terms of trade of developing countries. In what follows, the terms of trade are assumed constant, so that exports and imports, as well as all goods for which they are good substitutes, may be combined into the single category of tradables. It is convenient to think of total national output as comprising two broad categories of goods, one tradable, the other non-tradable. The former consists of goods that are actually traded and goods that compete directly with them, but may not be traded. Non-tradables make up the rest of an economy's output of goods and services. Products commonly included among tradables include manufactures, mining products, and some agricultural produce. In some contexts, the industries producing these goods
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Figure 1. The real exchange rate between Mexico and the United States as measured in terms of WPI, CPI, and hourly compensation. [Note: The vertical axis measures the real exchange rate, expressed as dollars per peso multiplied by the ratio of Mexican to U.S. prices (wholesale, WPI; or consumer, CPI) or the ratio of hourly compensation.]
Industrial Structure, Competitiveness, and Trade
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are said to be relatively "exposed" to foreign competition. Non-tradables, on the other hand, are dominated by public and private services, retail and other trade, and construction. They are said to be relatively "sheltered" from foreign competition. Objections have been raised against this classification scheme on grounds that all goods are tradable in the long run. That argument, although correct, is of little relevance. It is true, of course, that even haircuts are tradable in the long run, because barbers migrate from low- to high-wage countries or because customers go abroad to have their hair done. There exist, nevertheless, substantial differences in substitution elasticities; this is what matters for present purposes. For present purposes, non-tradables are represented by markets in which discrepancies between domestic supply and demand cannot be accommodated during the relevant time period by exports or imports. Those markets must therefore be cleared by movements in domestic prices. In markets for tradables, on the other hand, domestic demand and supply need not be equal even in equilibrium, because discrepancies between them are resolved through trade. The ratio of tradables to non-tradables prices is a key relative price in determining industrial structure, competitiveness, and the real exchange rate. It is well known that movements of the real exchange rate as defined above and movements in relative tradables prices are closely related. For small, price-taking countries they are the same thing, so that a real appreciation is matched by a relative decline in tradables prices. For large countries, the relationship is more complicated, but changes in the real exchange rate are substantially reflected in movements of relative tradables prices. It is not always easy, of course, to find suitable published data to create the proper relative price series. A commonly used first approximation is the ratio of wholesale to consumer prices. 2 Wholesale prices reflect mainly the prices of manufactures and so are taken as a rough indicator of the movement of tradables prices. Consumer prices, however, include in addition a wide variety of non-tradable goods and services. A rise (fall) in the ratio between the two indexes thus suggests that tradables prices are rising (falling) relative to non-tradables. In this context, then, a nominal devaluation of the Mexican peso against the dollar would be expected to bring about an improvement in competitiveness. That expectation is confirmed in Figure 1 where all three versions of the real exchange rate show improved competitiveness for Mexico beginning in the early 1980s. In addition, the fact that the real rate in terms of consumer prices falls more than in terms of wholesale prices suggests that tradables prices are rising relative to non-tradables in Mexico. The real depreciation is accompanied by a relative rise in tradables prices. A permanent rise in relative tradables prices in Mexico, brought about by the real depreciation of the peso against the dollar, creates incentives for resource redeployment from non-tradables to tradables, while the permanent fall in relative tradables prices in the United States should set in motion redeployment in the opposite direction. Consumers, on the other hand, would be expected to substitute non-tradables for tradables in Mexico and vice versa in the United States. The combined effect of shifts in production and consumption, therefore, is to improve the trade balance in Mexico and to make it worse in the United States. This outcome is quite consistent with the result predicted by the conventional interpretation of the real exchange rate as the relative price between home and foreign goods. A permanent change in the real exchange rate, therefore, alters the optimal allocation of resources in favor of industries whose relative prices have risen. A movement in the
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real exchange rate is thus more than just a change in relative foreign and domestic prices. Each real exchange rate represents an optimal mix between tradables and non-tradables in total production. Permanent changes in real exchange rates have permanent effects on economic structure. In equilibrium, therefore, the real exchange rate and industrial structure must be compatible. Exchange-rate policies are doomed to fail unless targets for the real exchange rate are compatible with relative prices determining industrial activity. A country can choose its real exchange rate or its preferred mix of tradables and non-tradables--that is, the degree of its openness--but not both. This fact has important implications for management of the public sector, since it plays an important role in determining the evolution of demand and supply in the non-tradables sector. Countries cannot conduct real exchange rate policies independently of policies governing public-sector output and expenditure. A real devaluation can be quickly nullified by a rise in public-sector expenditures relative to output. Inasmuch as the public sector is in many developing countries a significant component of non-tradables, policymakers may choose the size and growth of the public sector or the real exchange rate, but not both.
THE REAL EXCHANGE RATE AND NON-TRADABLES EQUILIBRIUM The relationship between the real exchange rate and non-tradables equilibrium may be seen in Figure 2, where the relative price between tradables and non-tradables is measured vertically, quantities of tradables horizontally to the right of the origin, and quantities of non-tradables horizontally to the left of the origin. Demand and supply in the tradables sector are measured conventionally in the right-hand panel, while demand and supply in the non-tradables sector appear in the left-hand panel with their positions reversed, so as to properly reflect the definition of the relative price, p. As already noted, a key difference between the two sectors is that demand and supply of non-tradables must be equal in equilibrium, while international trade allows demand and supply in tradables to deviate from each other. The equilibrium relative price between tradables and non-tradables, therefore, is the price that clears the non-tradables market. Hence, the equilibrium real exchange rate is the rate that clears the non-tradables markets at home and abroad. At that exchange rate, trade between the two countries may or may not be in balance. The central role of the non-tradables sector in determining the equilibrium exchange rate is apparent. Nominal devaluation will not alter the real exchange rate if the new rate is incompatible with non-tradables equilibrium. In terms of Figure 2, a nominal devaluation initially raises the relative price, p, by raising tradables prices (to, say, p'); this, in turn, creates excess demand for non-tradables, causing their prices to rise as well. Equilibrium is restored when non-tradables prices have risen to match the devaluation, leaving the real exchange rate unchanged. The importance of non-tradables in exchange-rate adjustment means that real currency values may be altered by policies that have little direct effect on the tradables market itself. A policy that shifts the demand for non-tradables outward [to D(n')] in Figure 2 will cause relative prices to fall to p" and the currency to appreciate in real terms. Indeed, we see that only policies that shift demand and supply in non-tradables can change the real exchange rate, while policies that shift demand and supply in tradables change the trade balance. Policies that affect only demand and supply in the tradables sector change the balance of trade, but not the real exchange rate.
Industrial Structure, Competitiveness, and Trade
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Consider, for simplicity, a policy that raises tradables demand, represented by an outward shift of the demand curve in the right-hand panel [to D(t')]. Since the disturbance leaves the non-tradables equilibrium unchanged, the real exchange rate will also remain unchanged. The trade balance, however, will deteriorate (showing a deficit equal to ab). A policy that increases demand for non-tradables [to D(n')], on the other hand, will bring about a real appreciation and a deterioration of the trade balance (showing a deficit equal to cd). Of course, policy shocks and other disturbances are not normally confined to just one sector. Most affect excess demand in both sectors, but still their impact on the real exchange rate depends on their effect on non-tradables equilibrium. Their action through the rest of the economy moves the trade balance rather than the real exchange rate. This is a very important conclusion for policy purposes, because it shows that governments wishing to alter the real exchange value of their currencies must look beyond intervention in tradables industries. Indeed, as the preceding suggests, "trade" policies that have little effect on excess demand for non-tradables will have little effect on the real exchange rate. They will, of course, change the trade balance. A shock in the real exchange rate originating in one country, even one that is compatible with equilibrium in that country's non-tradables sector, may not be sustainable if it disrupts non-tradables equilibrium in another country. This is an important feature of economic interdependence. Long-run sustainable changes in the real exchange rate must be compatible with non-tradables equilibrium at home and abroad. A small country in isolation will not disturb equilibrium abroad by its exchange rate policies. But large countries, as well as small countries acting together, must take into account the foreign repercussions of their policies. This finding is relevant to the discussion of structural adjustment among heavily indebted countries. Many adjustment proposals have been advanced, and most foresee considerable industrial restructuring on the part of debtor countries. In a number of these cases, relative tradables prices will have to change in creditor countries as well and those countries must
D(n) D
D(
n)
D(t')
S(t)
p! _P_
Qn (nontradables)
Figure 2.
0
(tradables)
Relationship between real exchange rate and non-tradables equilibrium.
Qt
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be prepared to undertake their own structural adjustment if economic reforms among debtors are to succeed.
COMPETITIVENESS The real exchange rate is, as we have seen, a standard measure of a country's international competitiveness. The trade balance serves as the actual indicator, so that a widening trade deficit is taken as evidence that the currency may be overvalued. A trade deficit or a worsening trade deficit may not be a reliable sign of overvaluation, however. An exchange rate that is accompanied by a trade deficit may nevertheless be an equilibrium exchange rate if it clears the market for non-tradables. Whether it is sustainable in the long run is, of course, another matter. When the non-tradables market is in equilibrium, nominal devaluation will not bring about a real devaluation unless it is properly supported by other policies. Above all, monetary accommodation must be avoided, so that the interest rate may rise, thereby shifting both demand curves inward. Non-tradables prices will then rise, but by less than the nominal devaluation, thus permitting the relative price, p, to rise. Output of non-tradables will fall, while that of tradables will rise. The trade balance will improve, of course, creating the impression that competitiveness has been improved. International competitiveness is thus linked to the sector that is not directly involved in international competition. It may seem paradoxical that a country's competitiveness should be shaped by activities not directly related to trade. The real exchange rate is, however, a key relative price and one that plays a major role in the allocation of scarce resources. The conventional treatment of the real exchange rate as the relative price between home and foreign goods has obscured its importance in determining the internal allocation of a country's productive resources. To be viable, therefore, an exchange rate must be compatible with allocative equilibrium in the domestic economy.
GROWTH, INDUSTRIAL STRUCTURE, AND THE REAL EXCHANGE RATE It is generally believed that economic growth in tradables is needed to build or maintain international competitiveness. Growth in tradables affects the S(t) curve in Figure 3 directly by shifting it out to S(t'). It has an indirect effect on demand for both types of goods through its effect on domestic income. Suppose that growth in tradables shifts tradables demand to D(t') and non-tradables demand to D ( n ' ) . 3 The direct effect on S(t) tends to raise a trade surplus or reduce a trade deficit; the indirect effect on tradables demand tends to inhibit that trade balance improvement. Neither change, however, affects the relative price, p. The main influence on the relative price and hence on the real exchange rate comes from the shift in non-tradables demand [to D(n')] as growth in the tradables sector raises income throughout the economy. The currency appreciates in real terms and exerts a further effect on the trade balance. The net effect of these various influences is to create a trade surplus of ab. In the popular discussion, the trade-balance improvement is seen as an improvement in competitiveness, while the appreciation is seen as impairing competitiveness. Overall, however, countries with trade surpluses and appreciating currencies are perceived as "strong" and competitive.
Industrial Structure, Competitiveness, and Trade
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Developing countries, however, should be net importers rather than exporters of goods and capital. Competitiveness as defined above is therefore less than relevant to their purposes. Indeed, the foregoing shows why development strategies based on growth in tradables industries, or worse, on export-led growth, may be ill-advised. At the least, growth in tradables and in non-tradables should be managed in such a way as to maintain a neutral trade balance. If, however, mobilization of foreign saving is an important part of a country's development strategy, then growth in non-tradables is needed (in addition to tradables growth) in order to add directly to the demand for tradables inputs and to provide for real depreciation of the currency over time. In practice, markets are subject to a variety of demand and supply shocks during the development cycle. Demand shocks tend to lead supply shocks in the early phases, but the distribution of their effects between tradables and non-tradables depends on the importance of the respective goods as production inputs. During these phases, the currency is likely to come under pressure of real appreciation, while the trade balance tends to deteriorate. Then, as capital formation creates new capacity, supply shocks dominate; still, demand in both markets increases as national income increases. The trade balance is now likely to improve, either because growth in tradables capacity increases supply relative to demand or because growth in non-tradables capacity raises the relative price of tradables. The real exchange rate may appreciate or depreciate, depending on whether growth occurs mainly in tradables or in non-tradables. 4 Hence, if it is the objective of policymakers to avoid trade surpluses and real appreciation while nevertheless fostering industrial development, investment in non-tradables must be an integral part of any development strategy. During the growth process, real exchange rates may be subject to considerable volatility, as demand and supply shocks in turn move the relative price ratio. This volatility raises questions about the optimal policy for the nominal exchange rate during the development
D
)
D(t) D(t')
S(t) ,)
P p'
Qn (nontradables) Figure 3.
0
(tradables)
Effect of growth in tradables on the S(t) curve.
Qt
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cycle. When the nominal exchange rate is fixed, the burden of relative price adjustment falls on non-tradables prices. During periods when the currency must depreciate in real terms, a fixed nominal exchange rate requires non-tradables prices to fall relative to tradables. In the services sector, that means falling nominal wages. Strong labor unions in non-tradables and especially in the public sector may fight such adjustments, in which case a policy of flexible nominal exchange rates is to be preferred.
CONCLUSION The existence of a close relationship between real exchange rates and relative tradables prices implies that exchange rate policies and policies affecting industrial structure cannot be conducted independently of each other. A given deployment of resources between tradables and non-tradables places limits on the freedom of movement of the real exchange rate. Given the nature of non-tradables equilibrium, the real exchange rate is essentially determined by movements of demand and supply in the non-tradables sector, while the trade balance is determined substantially, but not uniquely, by movements of demand and supply in the tradables sector. Exchange-rate policies that ignore the non-tradables constraint are bound to fail. The conventional belief that export-led growth policies represent the optimal development strategy is misplaced in light of the role played by non-tradables. Development policies that are strongly biased in favor of tradables bring about real appreciation and premature trade surpluses. They produce results that are undesirable from the perspective of the developing country because they squander resources. They are also dangerous in that they may provoke protectionist responses on the part of trading partners. They are, finally, unnecessary because industrialization can be achieved without large surpluses of tradables by judicious mixing of growth in tradables and non-tradables.
NOTES 1. 2. 3. 4.
But see Edwards (1988) for a treatment that includes movements in the terms of trade. See Arndt and Bouton (1987) for further detail. It may also have indirect effects on the S(n) curve, but those are ignored here. See Arndt (1989). See also Bruce and Purvis (1985); Edwards (1988); and Lal (1984).
REFERENCES Arndt, S.W. 1989. "Structural Adjustment in Semi-Industrialized Economies." Washington: World Bank (mimeo). Arndt, S.W. and L. Bouton. 1987. Competitiveness: The United States in World Trade. Lanham, MD: UPA, Inc. Bruce, N. and D.D. Purvis. 1985. "The Specification of Goods and Factor Markets in Open Economy Macroeconomic Models." In Handbook of International Economics, Vol. II, edited by R.W. Jones and P.B. Kenen. New York: North-Holland. Edwards, S. 1988. "Terms of Trade, Tariffs, and Labor Market Adjustment in Developing Countries." The Worm Bank Economic Review, 2. Lal, D. 1984. "The Real Effects of Stabilization and Structural Adjustment Policies." Washington: World Bank Staff Working Paper, no. 63.