External Openness and Employment: The Need for Coherent International and National Policies DESA Development Forum on Productive Employment and Decent Work New York, 8-9 May 2006 Rolph van der Hoeven and Malte Luebker (ILO, Geneva)

2 Facets of external openness External openness has two important facets: Trade liberalization; financial openness. Trade liberalization has been on the political agenda since the 1960s, financial openness since the 1980s. Both are part of Washington Consensus policy prescriptions and structural adjustment programmes.

3 Trade liberalization Some signs of convergence in the debate on the social impact of trade liberalization: Proponents of trade liberalization see their initial optimism disappointed and concede that trade liberalization alone does not create growth and employment. Critics accept that integrating countries have not entered a ‘race to the bottom’, but that non- integrating countries have continued to have serious problems.

4 Trade liberalization However, trade liberalization can… entail considerable adjustment costs and job churning, and can lead to greater wage inequality (experience especially in Latin America). Benefits of trade liberalization depend on initial conditions and successful management of process (Lall).

5 Financial openness and employment “The consequences of mistakes in financial markets, where capital is volatile and mobile globally, far exceeds the consequences of mistakes in the labour markets, where labour is largely immobile across national lines.” Richard Freeman (Harvard & LSE)

6 The rationale behind financial liberalization Assumption: Investment in developing countries is constrained by the lack of capital. Freeing up the international movement of capital will give developing countries access to capital, and therefore increase investment, raise growth, and create employment.

7 Financial liberalization since the early 1990s: Capital account Widespread capital account liberalization since the early 1990s. Many countries have removed all restrictions on international capital flows. Countries with Capital Controls, (in % of total IMF membership) Source: IMF.

8 Trends in international capital flows and investment Rapid expansion of international capital flows (both gross private capital flows and FDI). Stagnation or fall in worldwide investments (GFCF). Gross Fixed Capital Formation and FDI, (World) Source: World Bank.

9 Distribution of private capital flows FDI Inflows by Economic Grouping, (in billion current US$) Source: UNCTAD. Private capital flows are skewed towards high- income countries, and some middle- income countries. A similar trend can be observed for FDI (see graph).

10 World GDP growth,

11 Direct growth effects of financial liberalization No solid relationship between capital account liberalization and growth performance can be established (IMF and UNCTAD research). Only some middle-income countries appear to have small growth impact through capital account liberalization. Growth performance mainly depends on other factors, such as good institutions and an adequate policy framework.

12 Indirect growth effects though increased reserve holdings Financial openness makes larger foreign reserve holdings necessary. Opportunity cost of reserve holdings is high: Funds cannot be used for investments with higher returns. Reserve Holdings by Developing Countries, (in % of GNI) Source: World Bank.

13 Volatility and financial crises  Financial liberalization in developing countries is associated with higher consumption volatility and increased growth volatility compared to developed countries (Prasad et al. 2004). Financial openness has made countries more vulnerable to crises, e.g.: Argentina 1995 and Brazil and Chile Indonesia, Rep. of Korea, Malaysia, Philippines and Thailand Mexico Turkey 1994, and 2001

14 Impact of financial crises on long-run growth Financial crises have a large, negative impact on GDP. Countries typically do not return to their old growth path (IMF research). GDP loss is largest for poor countries. Typical Growth Path after Financial Crises in Rich and Poor Countries Source: Cerra and Saxena (2005: 24)

15 Impact of financial crises on employment Labour market consequences are evident from a number of indicators: Higher unemployment; increase in share of informal employment; falling real wages and falling incomes; higher poverty (e.g. in South-East Asia, the number of working poor rose from 33.7 million before the crisis to 50.6 million in 1998).

16 Impact of financial crises on employment (examples) Recovery of social indicators generally lags the economic recovery by several years. Thailand (Financial Crisis in 1997/98) GDP per capita (1997 = 100, left scale) Unemployment rate (in %, right scale)

17 Impact of financial crises on the labour share Financial crises, and exchange rate crises in particular, lead to a decline in the share of wages in national income: On study reports an average drop in the wage share of 5 percentage points per crisis. There is only a modest recovery after a crisis (three years later, the wage share is still 2.6 percentage points below the pre-crisis level). The frequency of financial crises is one factor that contributed to the accelerating decline in wage shares since the early 1990s.

18 Building a stable int. financial system for growth & employment “Our goal should be to build a stable financial system that stimulates global growth, provides adequate financing for enterprises, and responds to the needs of working people for decent employment.” (World Commission on the Social Dimension of Globalization, 2004, para. 404)

19 Three broad policy areas for policy coherence 1.Policies in industrialized countries 2.Multilateral rules 3.Policies in developing countries

20 1. Policies in industrialized countries Greater G3 exchange rate coordination. Increased attention to stimulating growth in Europe (e.g. IMF stance on Growth and Stability Pact in EU) Recognition of the importance of employment in financial policies. Increase of development aid and other sources of innovative international finance.

21 2. Multilateral rules Developing countries should be integrated into the financial system: They are not adequately involved in reforms Progress is slow and limited New codes may make financial market access more difficult Need for equitable mechanisms of debt resolution Capital account liberalization should depend on a country’s circumstances. Reduce financial volatility and contagion in emerging markets: Supply of emergency financing should be speeded up.

22 3. Policies in developing countries: The policy trilemma Nationally policy space circumscribed by so-called policy trilemma: Open capital account Stable exchange rates Independent monetary policy Something has to give? Or can we avoid the corner solutions? Or can we add more instruments?

23 Avoiding corner solutions: Active RER regime The positive effect of an active real exchange rate regime on employment works through three channels: Higher capacity utilization in times of unemployment (requires combination of macroeconomic and fiscal policies). Stimulate output growth (combination with industrial policies). Contribute to increased employment elasticity (shift in sectors). Rodrik (2003): Growth Strategies. NBER Working Paper No ; Frenkel (2004): Real Exchange rate and Employment in Argentina, Brazil, Chile and Mexico. Paper presented at the XIX G24 Technical Group Meeting.

24 Adding ‘new’ instruments: Social pacts Social pacts can lead to a more coherent economic and social policy, foster stability and hold inflation down. To reach consensus more attention needs to be given to distributional issues – the missing element of the current development debate (e.g. MDGs)