Trade and FDI as instruments for structural transformation 1 Instrumentalizing trade to advance structural transformation

Integration into the international economy through both trade and financial relations can be a powerful instrument to advance structural transformation. The issue for policymakers is not whether, but how to pursue such integration. In many LDCs, exports have increasingly contributed to GDP growth in recent decades. In certain periods they have even driven GDP growth (LDCR 2008: ch.1). However, imports have risen in tandem and in many instances, even faster than exports. Thus, it is important to prevent a widening of trade deficits and the increased dependence on capital inflows that accompanies it. If export earnings do not grow fast enough and in a sufficiently stable way to match the growing import requirements at the early stages of structural transformation, economic growth will be threatened by the accumulation of external debt that may eventually become unsustainable (LDCR 2004: Part Two, ch.1).

Export growth plays a central role in the structural transformation process for two reasons. First, export earnings are essential to finance the import of machinery, equipment, technology and the intermediate inputs needed for the expansion of productive capacities. Second, external demand helps to fully utilize productive capacities, achieve economies of scale and stimulate investment in productive capacities (UNCTAD 2016: ch.2).

However, export expansion will not be possible without the expansion and diversification of productive capacities. The successful integration of a LDC into the international economy therefore requires a trade strategy that evolves with the level of productive capacities achieved and the capacity of existing institutions and industries, rather than through precipitated trade liberalization. Gradual trade integration presupposes the emergence of a virtuous circle during which profits generated by exports stimulate new investments, which in turn expand export capacities. The impact of trade on structural change also depends on whether exporting firms are integrated domestically through a network of forward and backward linkages.

It is also important to recognize that export growth does not always imply faster overall growth, let alone poverty reduction, because the incomes and livelihoods of most people in LDCs are largely disconnected from the export sector and the international economy (UNCTAD 2016: ch.2). Thus, if trade is to contribute effectively to income growth and poverty alleviation, it is important that LDC trade policies are based on the understanding that trade integration and export growth are means in a broader and long-term strategy for structural transformation, rather than objectives in of themselves.

Export opportunities for LDCs do not only lie in the world market and in the more advanced countries. They also exist in neighbouring and other developing countries. In many cases, these opportunities are likely to be easier to grasp, especially for smaller and domestically-owned firms in LDCs. This is an important reason for governments to engage in regional cooperation. Regional integration among developing countries also widens the scope of private sector activities and their diversification in terms of investment, production and factor mobility and can prepare the ground for their integration into the wider global economy (EDAR 2009) (o ch.VI.D).

5.2 The importance of the trade structure

In LDCs, it is typically commodity export earnings that provide the bulk of foreign currency to finance the import of the machinery, equipment and technology needed for productivity growth in the primary sector, particularly in agriculture, and for the expansion of productive capacities in manufacturing industries.³

Exports contribute primarily to structural transformation and employment generation when their product composition becomes more diversified, with an increasing share of manufactures and in some cases, services (UNCTAD 2016: ch.2). The LDCs with the highest long-run GDP growth have been those that managed to export manufactured goods at an early stage. The LDC performers that have lagged furthest behind are exporters of food and agricultural products, as well as mineral exporters (LDCR 2014:

ch.4). An increasing share of manufactures in total exports also reduces the vulnerability of LDCs to the volatility of international primary commodity markets.

A development strategy incorporating the management of international trade as an instrument for enhancing structural transformation must also consider that the structure of imports matters as much as the structure of exports. The balance-of-payments constraint on building productive capacities can also be reduced by favouring the allocation of scarce foreign currency earnings to the import of capital goods. The balance-of-payments constraint can further be addressed by preventing imports that are not essential for poverty reduction and structural transformation, and substituting imports, when economically viable, with domestic production.

5.3 The role of FDI and global value chains for trade integration

LDC policies for building productive capacities must consider the opportunities offered by FDI and integration into global value chains (GVCs). However, the benefits of these cannot be taken for granted, since they depend on how well the profit interests of foreign partners can be reconciled with the societal interest in structural transformation.

FDI may help mitigate the constraints arising from shortages of domestic capital, modern production and management techniques and international marketing know-how and networks. In LDCs, FDI inflows were often responsible for the increase in capital formation. However, there are several reasons for LDC policymakers not to overestimate the potential of FDI for accelerating the process of structural transformation.

First, FDI flows have been concentrated in only a few LDCs and did not always lead to faster output growth (LDCR 2008: ch.1; LDCR 2014: ch.6). Second, a large part of FDI in LDCs is usually undertaken in capital-intensive extractive industries, which typically have very few linkages with the rest of the economy. In this case it is often difficult for the State to appropriate a fair share of the considerable rents that have been generated (LDCR 2014: ch.6) (o ch.VI.B). Similarly, FDI attracted by low labour costs in LDCs’ manufacturing industries is often confined to externally-oriented enclaves, such as export processing zones, where imported inputs are assembled for re-export. The same applies to tourism enclaves, which are often supplied through imports (LDCR 2008: ch.2; EDAR 2017).

Third, experience has shown that FDI is often difficult to integrate into domestic strategies aimed at structural transformation. What matters for the contribution of FDI flows to structural transformation is not the quantity, but rather the type of FDI and its insertion into the domestic economy. It is therefore imperative that the costs of attracting FDI are carefully assessed against the benefits that can be expected from a specific foreign investment project. Such costs can occur not only in the form of fiscal incentives and other concessions in favour of foreign investors, but also as lower domestic investment or a perpetuation of existing production structures.

Fourth, LDC governments must be aware of the increasing competition among developing countries to attract FDI in labour-intensive sectors, which weakens their position vis-à-vis potential foreign investors.

Similarly, policies to help domestic manufacturing firms integrate into GVCs must form part of the overall strategy to build productive capacities and reduce poverty (LDCR 2007: ch.1). GVCs are international production networks dominated by large lead companies, mostly from developed countries, that subcontract different stages of value addition to producers in different countries, depending on the different cost advantages from each segment. This is an increasingly frequent entry point into export-oriented manufacturing activities for LDCs, whose firms operate as low-cost suppliers in the least sophisticated, but most labour-intensive stages of a value chain. However, participation in GVCs may place LDC firms at risk of becoming trapped in that position when they are not given the opportunity to build up the appropriate skills and technological capacity that will enable them to move up the value chain or to achieve functional upgrading (LDCR 2007: ch.1; LDCR 2013: ch.5; and EDAR 2013: ch.4).

Against this background, policies to optimize the effects of FDI and GVCs on structural transformation, such as trade policies, must be closely integrated into strategies for building productive capacities. They must be designed in such a way that economic activities within these frameworks have a strong direct employment effect and allow for an upgrading of these activities into higher-value-added segments over time. In addition, they should foster continuous skills development and the building of technological capacities in the respective firms and support integration with other sectors of the economy (EDAR 2011: ch.4; LDCR 2013: ch.5; UNCTAD 2013a: ch.IV).

Manufacturing FDI and GVCs tend to be oriented towards countries with an already established track record of long-term positive trends in productivity growth, supply reliability and the development of managerial, technological and labour skills (LDCR 2016: ch.1). Therefore, the extent to which FDI and GVCs can help advance structural transformation depends on incentives for potential partners to engage in these forms of cooperation with LDCs. It is also partly endogenous in the process of structural transformation and thus a by-product of improved domestic productive capacities.