Author: J.E

Sherillyn Raga (Senior Research Officer, ODI)

5 July 2019

Last weekend, the G20 Leaders discussed a range of important global economic issues from innovation to climate change, among many others. Of particular interest to many, however, was how the G20 Leaders might apply political pressure to halt the ongoing US-China trade tension, given its impact in and beyond G20 member countries. This blog examines how a prolonged trade war might spillover to non-G20 low and middle income countries through lower global demand, changes in bilateral trade patterns, possible dumping and changes in relative exchange rate positions, and hence prospects for economic transformation. To address the possible consequences of the trade war, regulators should consider calibrating targeted sectoral interventions and forward-looking policy toolkits, diversifying external trade and investment partners, and building fiscal and balance of payment space moving forward.

Trade war spillover channels: short-term risks, medium-term implications

While the G20 Leaders Declaration emphasises the importance of a “free, fair, non-discriminatory, transparent, predictable and stable trade and investment environment”, the Leaders were unable to convince Presidents Trump and Xi to end their protracted trade dispute. Given the size of these two economies, persistent trade tensions will inevitably disrupt growth and prospects of economic transformation in the following ways.

Moderated global demand and activity

A worsening of the trade war and an increase in retaliatory tariffs will drive up prices of imports and goods with intermediate imported inputs, consequently lowering US and Chinese consumption. The US and China alone are responsible for 22% of global imports and contribute 40% to global GDP.  Lower US and Chinese consumer demand will thus drive down export production and investments abroad, reducing overall global income and activity. This is reflected by the deceleration in global economic growth which coincided with the imposition of US and then Chinese tariff increases in 2018, from 3.8% in the first half to 3.2% in the second half of 2018.

The IMF estimates that the current trade spat will cost 0.5% of global GDP in 2019. If the planned US-China tariffs are extended to all traded products from both countries, the IMF expects that global output will be further reduced by 0.3% in 2020. Continued weak global performance and outlook can disrupt the momentum in high-productivity exports, foreign direct investment and global value chain (GVC) firms, thereby affecting the process of economic transformation globally.

Change in bilateral trade patterns

While the global economy will lose out in net terms from the US-China trade war, Chart 1 shows some exporters are well placed to gain temporarily. For example, US imports from Vietnam rose by 40% year on year (yy) over the year to January – April 2019, while US imports from China fell by 13% during the same period, according to the Financial Times. In particular, as of the second quarter of 2019, processing of industrial products and manufacturing is Vietnam’s fastest growing sector at 9.15% growth yy, followed by services at 6.9%, and agriculture at 2.9%–an indication of how the trade war is accelerating the movement of Vietnamese resources to high productivity sectors. Overall, the ADB estimated that if the US-China trade war escalates further, Vietnam could potentially gain up to a cumulative of 2% of GDP in the next 3 years primarily because Vietnam exports many of the Chinese products affected by the US tariffs. Cambodia’s garment manufacturers were also assessed to gain from the trade war, and this may have contributed to the 32% yy growth in the value of Cambodian export goods in 2018. While statistics are pointing to gains for Cambodia and Vietnam, analysts suggest these gains may be short-lived because of domestic risks, such as Cambodia’s high labour costs, lack of business-supporting infrastructure and relatively lower productivity as well as the risks surrounding Vietnam’s real-estate boom and higher dependency on foreign capital.

Meanwhile, China’s imports from the US sharply moderated to 0.9% growth in 2018 from 14.2% growth in 2017. China’s tariffs targeted mostly US agricultural products such that trade diversion is evident in the 63% quarter on quarter growth of China’s largely soybean imports from Brazil in the last quarter of 2018. Even prior to the US-China trade war, Brazil was a top global soybean exporter. In anticipation of added demand from China, Reuters reports that Brazil’s soy plantations have expanded by 2 million hectares, while sugar cane land have shrunk by nearly 400,000 hectares. Brazil is consequently at risk of“de-industrialisation” as a result of shifting its resources to agriculture. Since this shift is focused heavily on soybeans, the absence of vertical and horizontal diversification could make the Brazilian economy vulnerable.

China’s export oversupply and dumping in developing countries

If the changing bilateral patterns have led to the sourcing of tariff-affected imports from sources other than China and US, then who will consume American agricultural exports and Chinese intermediate manufactured goods? In the US, soybean prices have become much cheaper and those that cannot be exported are mostly stored. The government has also earmarked US$12 billion to help its farmers weather the fall-out. But what about excess supply from China?

One possibility is to offer China’s excess exports to other markets at very competitive prices, including below the price at which these products could have been sold in the Chinese market (i.e., dumping). Supply of relatively cheaper imports not only increases a country’s trade deficit, but importantly, also pushes consumers away from relatively expensive domestic counterpart products. This depresses prices in the import-competing sector, creating a trigger to lay off employees or shut down operations if firms cannot absorb the impacts of competition. This is already happening in India, where an Indian Parliamentary report from July 2018 estimated that dumping of Chinese solar panels resulted in a loss of 200,000 jobs. The report also suggested that an increase in Chinese import shipments across various sectors has forced several micro, small and medium-sized enterprises to exit the market—a setback to India’s target of stimulating its manufacturing sector to at least 25% of GDP.

Exchange rates and risks of financial market contagion

The US has a trade deficit with China (i.e., US imports more than they export to China). At least by magnitude and in the medium-term, the decline in tariff-affected US imports from China will more than offset the loss in US export revenues due to China’s retaliatory tariffs. This will narrow the US trade deficit and induce dollar appreciation. A stronger dollar will strain payment of foreign-denominated debt, especially for countries that already have high levels of debt. As of May 2019, 6 out of the 7 LICs considered to be in high debt distress and 12 out of 25 LICs considered to be at  high risk of debt distress are in Africa.

Conversely, the Chinese Renminbi (RMB) is expected to weaken with the decline of export receipts from the US. This is reflected by movements in the real effective exchange rates in July 2018 when US and China first began to raise tariffs (Chart 2). A weaker RMB makes Chinese products more competitive compared to the rest of the world[1]. This puts pressure on other emerging market currencies to depreciate, especially value chain suppliers to China and Chinese competitors. Given the high exposure of East Asian countries to China and their relatively flexible exchange regimes, currencies in the region have been able to absorb the shock and closely followed the movement of RMB against the US dollar (Chart 3).

However, if tariffs are extended to all traded products between China and US, further depreciation in East Asian currencies will dampen investor appetite for emerging market assets in general. As investors reallocate their portfolios amidst trade uncertainties, fast-moving capital would first be withdrawn from investments in high-risk markets (mostly in LICs) and moved to safe havens. In the case of South Africa, the stock market index lost more than 3% and the Rand depreciated by 4% month-on-month in May 2018 following the US’ hike in tariffs for US$200bn worth of Chinese imports. If global business optimism continues to decline, capital may also flow out from government bonds and FDIs—investments that are critical for sustaining public services and creating jobs in many LICs.

How to address the effects of the US-China trade war in the poorest economies?

An effective, rules-based international trading system would prevent such trade disputes and unfair practices. But as the G20 Summit outcome suggests, even an economically powerful group such as the G20 leaders can barely put pressure on Presidents Trump and Xi to change their respective sovereign policies on trade. With no strong signal of an end to the trade war in sight, we suggest the following approaches for low and middle income countries:

Calibrate a targeted and forward-looking policy approach. While it is tempting for developing economies to weaken their currencies to counteract possible competition or dumping, caution is important. Apart from raising exports, a weak currency also drives up import prices, and this move can be inflationary for net-food importers, a grouping which includes many countries in Africa. Public policies should support productivity-enhancing exports and manufacturing sectors that are directly affected by the trade war. Such policies could include expanding credit lines or providing incentives to sustain operations and investments in technology and skills amidst the trade war. The use of forward-looking policy toolkits such as macroprudential regulations and capital flow management are targeted approaches that can also reduce specific vulnerabilities in the financial sector.

Diversify external partners. China is increasingly becoming a major trading partner, source of FDI, and creditor to governments in African and less developed Asian countries. For these countries, it is unsurprisingly hard to manoeuvre policy options economically and politically, for example, for Uganda to raise the issue of dumping against China. One solution is to balance sources of growth, capital and trade through other bilateral and regional partners. In the case of Africa, boosting partnerships with countries and groupings beyond the US and China, including the African Union/African Continental Free Trade Area and Commonwealth is a starting point.

Build buffers. Developing countries and LICs are structurally diverse and hence external shocks affect economies differently and through various channels. Moving forward, a very effective strategy to shield a country from the unintended consequences of non-economic disturbances is to have buffers (e.g., ample foreign reserves, healthy fiscal balance position) that provide space for monetary and fiscal policies to support high productivity domestic sectors and ensure economic transformation is not derailed by unfavourable external (and in the case of this trade war, also political) developments.

[1] This scenario is more probable at least in the short-term while traders from both sides are holding decisions (e.g., whether they will relocate, divert trade, or change preferences) and government do not intervene heavily in the foreign exchange market.

Photo: Flags of the G20 nations. CC BY-NC-ND 2.0.

Dirk Willem te Velde (Principal Research Fellow, ODI)

24 April 2019

Unless Cambodia addresses a number of short- and long-term challenges related to the impact of trade, technology and China, future pathways for inclusive economic transformation are at risk. As we discuss at greater length in a new SET scoping note in co-ordination with CDRI and support by Australia’s Department of Foreign Affairs and Trade, Cambodia has been the sixth-fastest growing country in the world over the past two decades. It has reduced poverty and inequality significantly and it graduated to lower-middle-income country status in 2015. It has achieved remarkable growth in exports of garments, attracted record numbers of tourists, expanded agricultural land leading to significant exports of rice, benefited from high commodity prices and recently witnessed a construction boom. It has also shown signs of diversification into bicycles, footwear and, to some extent, maize, vegetables, sugar and palm oil. Special economic zones (SEZs) have played a crucial role in kickstarting manufacturing. However, Cambodia currently also faces major challenges to its hitherto successful growth model and these need a response. The challenges can be summarised as trade, technology and China. In the coming months, ODI and CDRI will examine the implications of digital technology for Cambodia’s future transformation in greater detail, building on our recent consultations.

Trade

Cambodia faces the removal of trade preferences in the coming year, if the EU decides to withdraw Everything But Arms preferences as a result of human rights considerations. Cambodia’s exports to the EU make up two fifths of total goods exports. Most-favoured nation tariffs in the EU are 12% on garments and between 8% and 17% for footwear, but so far Cambodia faces zero tariffs. Garments support 700,000–800,000 mostly female low-skilled jobs. Anything that affects the garment sector has direct implications for inclusive economic transformation.

Our interviews in Cambodia for the scoping paper suggest that preferences are perhaps not as important as previously considered, at least in the short run. If firms can absorb a change in minimum wages from $60 in 2010 to $182 per month currently, they may also be able to absorb the (smaller) changes in preferences. However, it is likely that a loss in preferences would lead to lower sectoral growth than would otherwise have been the case. Hence, Cambodia needs urgently to improve competitiveness by enhancing skills, improving infrastructure and streamlining regulation and licences (and in addition to improving its human rights record).

Digital technology

The digital economy is advancing rapidly globally, and low- and lower-middle-income countries will not be excluded. Cambodia aims to become a digital economy, although this may take some time. Rather than fearing the labour impact of digitalisation on labour-intensive SEZs and garment activity, Cambodia needs to harness the digital economy for its competitiveness. One core element in this is the importance of ensuring the appropriate skills are available (especially cognitive skills to undertake non-routine tasks).

Our discussions in Cambodia suggested there is no agreed policy framework within which to consider how Cambodia can prepare for a digital economy in a comprehensive way. Cambodia needs to consider the future of specific sectors and activities; who would be the main gainers and losers from this; how skills can be developed to prepare for a digital economy; and especially how the poorest can also benefit from digitalisation. Interviews with manufacturing firms suggest there is still little awareness of the changes that may come sooner rather than later.

Prime Minister Hun Sen recently held a speech at a Cambodia Development Resource Institute conference on digital transformation. He argued that actions to date include the development of the Cambodia Information and Communication Technology Masterplan 2020, the drafting of the Cambodia e-Government Master Plan, the establishment of a Data Management Centre and the promotion of a legal framework for the digital ecosystem. But there are also challenges, such as building infrastructure to support the digital sector; developing an e-payment system and logistics network; creating a digital platform and developing an ecosystem; and promoting government digitalisation, entrepreneurship, digital literacy and open data. The Supreme National Economic Council has established a working group to formulate a digital economy policy framework. Cambodia needs to act urgently to become more engaged in the digital economy.

China

Cambodia has turned to China in recent years for economic support. On the one hand, this can lead to significant benefits. China brings billions of dollars of investment to Cambodia (responsible for much more than half of foreign direct investment in recent years), catering to 2 million Chinese tourists in Cambodia; investing in hotels and casinos; investing in SEZs whose firms utilise low-cost labour and trade access in the EU and US; and offering a large market for Cambodia’s exports.

But such engagement increases dependencies and may fail to bring significant benefits for Cambodia’s economic transformation. For example, the firms in the Sihanoukville SEZ have few incentives to upgrade, and have few linkages with the local economy, posting questions related to transformation in the future. The casino economy may cater to Chinese tourists, but it is not clear how this helps transform Cambodia’s economy. Complementary policies (e.g. innovation policies, skills development, casino taxes) are crucial to ensure engagement with China supports economic transformation.

The SET programme will in the near future engage around Cambodia’s economic transformation, especially with respect to the opportunities and threats of the digital economy and the implications for policies.

Photo: The Special Economic Zone in Khan Posenchey, Phnom Penh. Chhor Sokunthea/World Bank. License: CC BY-NC-ND 2.0.

Neil Balchin (Former Research Fellow, ODI), David Booth (Senior Research Associate, ODI) and Dirk Willem te Velde (Principal Research Fellow, ODI)

9 April 2019

A new Gatsby Africa-ODI paper detailing sector transformation in eleven African and Asian cases shows how sector dynamics depend crucially on:

• • • Correct identification of the economic opportunities;
    • Conducive political-economic conditions at the sector level
    • Credible commitments to investors
    • Reasonably good provision of public goods
    • Specific efforts to tackle investment coordination problems; and
    • Taking advantage of a moment of unusual opportunity.

The paper examines six experiences of successful sector transformation: air transport and logistics services in Ethiopia; the automotive industry in South Africa; the revival of the cocoa sector in Ghana; the staple food revolution in Indonesia; garments in Bangladesh; and sector-based strategies in Mauritius. It also considers five cases where sectors did not transform or where a promising initial transformation was not sustained. These cases of relative failure are cashew nuts in Mozambique; pineapples in Ghana; maize subsidies in Malawi in the years 2005–2008; President Kikwete’s rice initiative in Tanzania; and Malaysia’s faltering manufacturing sector.

What did the research find about the factors behind sector transformation?

Correct identification of economic opportunities is a common feature in all the successful transformation examples, although on a variety of different grounds. These range from successful identification of market access advantages for Bangladeshi garments or opportunities to serve Asian markets through Ethiopian air transport services, to supply opportunities in South Africa presented by the global sourcing strategies of original equipment manufacturers (OEMs). However, economic opportunity factors alone do not make it possible to distinguish successes from failures.

All successful cases exhibited positive political-economic relations, at least at the sector level. But the type of relationship varied across the successful transformation experiences, from centralised economic planning enabling state-led development of an airline in Ethiopia or exceptional democratic unity post-apartheid and an effective alignment of interests facilitated through dedicated sector-specific structures and support organisations around South Africa’s automotive industries, to the development of a consensus view across elites and the wider public and private sectors around a strategic direction for the Mauritian economy.

In the failed or disappointing experiences, these relations soured over time, or were weak or entirely absent. Political-economic causes of failure also took a variety of forms, but in almost all cases these were the most decisive factors, either directly or by weakening the public actions required to stimulate or support the investments. In Mozambique, there was a lack of consensus among different actors about necessary reforms in the cashew nut sector. In Ghana, there was little government interest in pineapple production, leaving pioneer investors in the sector to attempt, ultimately in vain, to address the growing infrastructure and learning requirements of remaining internationally competitive. Similarly, the maize sector in Malawi suffered from weakening political support for maize. In Malaysia, dissolving political conditions after the Asian financial crisis and the politics of ethnicity undermined attempts to improve manufacturing performance.

In several of the successful cases, favourable balances of political and economic interests supported transformation because they resulted in credible commitments to investors. In Ghana, this took the form of cross-party political support for the cocoa sector, and the key sectoral institution. In Mauritius, high-level political backing for a consensus view on the desired future direction of the economy was important. In Ethiopia, state investments in air transport were backed by a long-term policy vision designed by a regime that is relatively secure. In South Africa, multi-year policy visions provided a credible platform for long-term planning in the automotive sector. Technically proficient planning and macroeconomic management provided a predictable investment environment for staple agriculture in Indonesia. In Bangladesh, credible commitments came externally in the form of clear international commitments providing market access for Bangladeshi garments.

In failures, such commitments were typically uncertain, undermining investor confidence. For example, the government’s credibility in the case of cashews in Mozambique was undermined by poor communication, the perception that the policy reforms were World Bank-driven and the knowledge that processing could be profitable only with government protection. In Tanzania, the power of food-importing businesses undermined the credibility of the presidential rice initiative and the East African Community’s tariff rules. Political changes in Malaysia removed support for export processing zones and undermined the credibility of investment incentives.

The success cases often included reasonably good provision of public goods. This ranged from coordinated public infrastructure investments in Ethiopia or investments in the construction of automotive industrial parks and targeted transport infrastructure in South Africa to major investments in rural public works in Indonesia and improved telecommunications and power in Bangladesh and Mauritius. In Ghana, the development of quality control systems helped maintain the international price advantage of domestically produced cocoa.

The absence of adequate public goods provision, or related support, was almost always one of the proximate causes in the cases of relative failure. For instance, poor rural roads and weak extension services affected the maize sector in Malawi, while failure on the part of district governments to maintain medium-size irrigation works hampered the presidential rice initiative in Tanzania.

In the successful cases, specific efforts were made to tackle investment coordination problems. In Ethiopia, there was coordination and sequencing of investment in public infrastructure alongside the airline’s own capital investment in key areas such as cargo and maintenance facilities. The South African government devised well-coordinated policies – including import duty credits and productive asset allowances – for subsidising investment in exporting cars. The Indonesian government had a well-staffed national planning agency, which handled the coordination issues surrounding the uptake of improved rice and the utilisation of oil revenues in an effective way. There was some coordination among garment firms in Bangladesh, for example to capture spillovers from firm-level learning and establish strong links between education institutes and the private sector.

In failures, unsolved coordination problems had deleterious effects. For instance, little effort was made to coordinate investments to boost raw cashew nut production after export liberalisation in Mozambique. In Ghana, there was a lack of coordinated investment in post-harvest handling and other infrastructure to support pineapple production.

In certain success cases, support was provided to investors, and sometimes directed to specific first-mover firms. For example, tax incentives available to all investors and tariffs helped attract OEMs to South Africa, and similar incentives had the effect of attracting foreign investors to export zones in Malaysia. Support was provided to first-mover firms in Bangladesh’s garment sector, while support was provided to whole sectors through targeted support for innovation in Mauritius.

In the failure cases, support was often provided and then withdrawn. In Mozambique, the government removed export restrictions without investing in firm capabilities. In Malawi, subsidies were not sustained long enough, or supported with sufficient complementary measures, to pull off a profitability breakthrough.

The evidence in these cases shows that interventions at sector level, coordinated around a targeted set of activities, in a politically smart way, and set in a competitive framework can be an important driver of economic transformation. Targeting specific sectors that have strong basic conditions for competitiveness and where political economy factors are not going to be strongly detrimental is critical. The development of specific competitive sectors has been key to dynamic growth periods and hence to long-term transformation, even in countries where wider aspects of economic governance have not improved. This implies it is possible to develop dynamic, competitive sectors even when broader conditions in the economy are unfavourable. This insight has implications for actors looking to support economic transformation.

The factors set out above operate primarily as transmission mechanisms, meaning it is the function rather than the form of support at sector level that matters most. They are crucial mechanisms by means of which a favourable or unfavourable political-economic configuration influences the transformation outcome. In other words, once an economic opportunity has been identified, the political economy really matters.

And, finally, what matters about the political economy may be a temporary configuration, a moment of unusual opportunity – and it is also likely to be sector-specific. Transformation breakthroughs can and do occur in systemic contexts that are generally unfavourable. This places a premium on the ability to identify moments and sectors of opportunity in a timely fashion. Given the high level of uncertainty that must accompany such judgements, this also points to the importance of having the flexibility to recognise initial errors and change course when necessary.

Photo: Young Bangladeshi women being trained at the Savar Export Processing Zone Bangladesh 2016. Dominic Chavez/World Bank. CC BY-NC-ND 2.0.