Chapter 31 ：

Relationships between
countries
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Lesson Contents 01

Contents

The importance of
01 external resources in
development

02 Trade and investment

03 Overseas aid

04 Foreign direct investment

05 External debt

The Bretton Woods

06 institutions
1. The importance of external resources in development

SmartStudy
Syllabus 06

11.5 Relationship between countries at different levels of development

A.
The importance of external resources in development

For both developed and developing countries, the potential productive capacity of the economy depends
fundamentally on two things:

• The quantity of factors of production available within the economy,

• The efficiency with which they are utilised.

By increasing the quantity and/or quality of the factors of production and their productivity, the aggregate supply
curve can be shifted to the right.

For low-income countries, the problem is magnified because of lack of resources.

• Human capital is low, and there are limited resources to devote to education, training and improving health.

• Capital tends to be scarce, and markets do not operate effectively to allocate resources efficiently.

A high reliance on primary production limits the possibility of raising productivity, but to industrialise requires
imported capital in the form of plant and machinery.
The importance of external resources in development

When incomes are low, savings will also tend to be low, so that
funds for productive investment are likely to be limited.

For many less developed countries (LDCs., there is also a

shortage of foreign exchange that would give access to imports
of needed capital goods. In this situation, an LDC may need to
look to attract funds from outside in order to achieve economic
growth.

There are four possible routes to obtain resources from outside:

 Engage in international trade

 Use overseas aid

 Attract foreign direct investment

 International borrowing
 2. Trade and investment

SmartStudy
Syllabus 06

11.5.2 trade and investment

A.
B.
Trade and investment

The theory of comparative advantage indicates that all countries can benefit from free trade as long as there are
differences in opportunity cost ratios -- International trade will therefore lead to an increase in world output and this
will ultimately lead to an improvement in the quality of life and economic welfare in all countries.

However, economically developing economies have experienced particular problems, which means that they have
not gained from international trade as much as might have been expected. These problems include the following:

• Some economically developing economies rely on a single commodity for over half of their export earnings. The
problem is that the prices of primary products have declined relative to the prices of manufactured goods

• Prices for primary products are usually less stable than for manufactured goods

• The PED and PES for primary products is more inelastic than is the case with secondary products.

• The YED for many primary products, such as different types of food, is more inelastic than demand for
manufactured goods.

• Much of the investment in economically developing economies has come from multinational companies whose
profit is repatriated back to their home countries
Trade and investment

Trade policy for LDC

Some economically developing economies, given these problems, have actually introduced a number of different
forms of trade protection to bring about import substitution in their economies - aiming to replace imports with
domestically produced goods.

Some economically developing economies, however, recognising the enormous potential offered by free trade, have
taken a different approach and have aimed for an export-led strategy in order to benefit from free trade.
Trade and investment

Trade policy for LDC

import substitution policy

- To boost domestic production of goods that were previously imported, thereby saving foreign exchange.

A typical policy instrument used to achieve this is the imposition of a tariff.

A major problem is that it requires a large effective domestic market if producers are to be able to tap into
economies of scale. This is not often available in many LDCs.

Furthermore, LDCs often lack the capability of producing the capital goods that they need to promote economic
growth.
Trade and investment

Export promotion
Export promotion requires a more dynamic and outward-looking approach, as domestic producers need to be able
to compete with producers already established in world markets.

The choice of which products to promote is critical, as it is important that a new pattern of comparative advantage is
found if a country is to benefit from an export promotion strategy.

For primary producers, a tempting strategy is one that begins with existing products and tries to move along the
production chain. This would seem to be a good idea because it makes use of existing products and moves the
industry into higher-value-added activity.

However, producers adopting this approach may find that they face higher tariffs on processed goods than on raw
materials and they may meet strong competition from existing, more experienced producers in higher-income
countries.
Trade and investment

Trade policy for LDC

It should also be remembered that there will always be dangers in trying to develop new kinds of economic activity
that may entail sacrificing comparative advantage.

This is not to say that LDCs should remain primary producers for ever, but it does suggest that it is important to
select the new forms of activity with care in order to exploit a potential comparative advantage.
 3. Overseas aid

SmartStudy
Syllabus 06

11.5.1 international aid:

A.
B.
C. •
•
•
forms of aid
reasons for giving aid
eff ects of aid
• importance of aid
Overseas aid

Forms of aid
International aid refers to any form of assistance by one country or institution to another. It is usually given by
economically developed to economically developing economies and it can come in various forms.

These can include:

• Bilateral - involving just two countries.

• Multilateral - involving a number of countries and/or agencies, such as the World Bank.

• Humanitarian assistance - aid for medical or educational reasons.

• Emergency or short-term aid - after a sudden disaster.

• Conditional or tied aid - a grant or loan with conditions attached.

• Unconditional or untied aid - a grant or loan without any conditions.

• Charitable aid - funded by donations from organisations such as Oxfam.

Overseas aid

Reasons for giving international aid

There are a number of reasons for giving international aid, including the following:

• It helps countries fight diseases.

• It helps countries to respond to disasters and

humanitarian emergencies.

• It helps countries affected by a hunger crisis.

• It helps countries to improve their health and

education systems.

• It helps to save the lives of people living in poverty.

• It helps countries around the world to improve their infrastructure - in relation to water supply.
Overseas aid

The effects of international aid

International aid can assist the social and economic development of a country and/or help it to respond more
effectively to a disaster.

However, there have been a number of problems in relation to international aid, including the following:

• Some aid used in investments which have become relatively unsuccessful.

For example, some major construction projects, such as dams, have been criticised for not being in the long-term
interests of particular countries.

• The aid money may be spent on defence, rather than on education, healthcare or improving the water supply.

• Some aid has been counterproductive and has made the situation worse — for example, supplies of large
amounts of food to some countries have reduced the prices in the local economy, lowering incomes and making it
difficult for local farmers to survive.

• Some of the aid has been ‘tied’ in some way — there are conditions attached to the aid, so the receiving country
has not been totally free to decide how to spend the money.
Overseas aid

The effects of international aid

• There has been corruption in the receiving country, much of
the money has been kept in the hands of a few, rather than
spread across the whole economy.

• The interest rate charged on the aid has been at market

rates of interest.

• The loan repayments have been difficult for the

economically developing countries to pay, although some
debts have been rescheduled or cancelled.
Overseas aid

The importance of international aid

International aid has been of importance for a number of reasons, including the following:

 It helps the economy of the receiving country to grow.

 It helps to improve the level of employment in a country.

 It helps a country to improve its balance of payments position.

 It allows for experts to come into a country to provide technical advice and assistance.

 It can save the lives of millions of people living in poverty around the world.

 It helps to address health, education, infrastructure issues.

 It helps to address humanitarian emergencies.

 It helps to promote international trade.

 It helps to redistribute global wealth.

 4. Foreign direct investment

SmartStudy
Syllabus 06

11.5.3 role of multinational companies (MNCs.:

• defi niti on of MNC

• acti viti es of MNCs

A.
B.
C.
D. • consequences of MNCs
11.5.4 Foreign Direct Investment (FDI.:

• defi niti on of FDI

• consequences of FDI
Foreign direct investment

The role of multinational companies

A multinational company (MNC) is one that has facilities and
other assets in at least one country other than its home country.
It generally has factories and/or offices in different countries.

The activities of multinational companies MNCs are involved in a

range of activities in different countries, including:

• producing and selling goods and services

• exporting goods and services

• making significant investments in those countries

• buying and selling licences

Foreign direct investment

The consequences of multinational companies

The advantages of MNCs The disadvantages of MNCs
They can bring jobs, creating more income, which can
They may use capital-intensive methods of production, which
contribute to a local multiplier effect, reducing
means that not many local jobs are created.
unemployment.

They can lead to an increase in tax revenue for the domestic The jobs that are created may be relatively unskilled
government, such as from taxes paid on profits. - they are sometimes known as ‘screwdriver’ jobs.

They can provide more choice for consumers, leading to a Much of the profit may be repatriated back to the MNC’s
higher standard of living. home country and not reinvested in the local economy

They can stimulate economic growth. They may damage the environment.

They can bring technical knowledge that could lead to higher They may try to influence the government of the country,
levels of productivity. leading to the possibility of corruption.

If the output produced is exported, this could lead to an

When a MNC leaves a country, the void created could be
improvement in the current account of the balance of
worse in the long run than if it had never been there.
payments.
Foreign direct investment

Foreign direct investment

Foreign direct investment (FDI) is investment in a country by an
investor from another country. It is a form of entry into a foreign
market.

The Organisation of Economic Cooperation and Development

(OECD) defines control when the foreign investor owns 10% or
more of the business.

The UN Conference on Trade and Development (UNCTAD) has

identified three main reasons for FDI:

» market seeking

» resource seeking

» efficiency seeking
Foreign direct investment

The consequences of foreign direct investment

Advantages of foreign direct investment Disadvantages of foreign direct investment
It can be a hindrance to domestic investment because the
Foreign expertise can be an important factor in the
investor is investing elsewhere than in the investor’s home
improvement of the existing technical processes in a country.
country.

It can help improve the quality of products and processes in Political issues can quickly arise, making FDI potentially very
particular sectors of an economy. risky.

It can help in the creation of jobs and so reduce the level of A government could decide to take control of the investment
unemployment in an economy. for political purposes.

FDI can sometimes have an influence on exchange rates to

It provides a source of tax revenue to a government.
the advantage of one country and the detriment of another.

Investment in some countries could be relatively expensive

It provides a source of external capital for a country that can
and it may be more expensive to locate production abroad
improve its level of economic development.
than to export goods.
 5. External debt

SmartStudy
syllabus 06

11.5.5 external debt:

A.
B.
C.E.
D. • causes of debt
• consequences of debt
External debt

The nature of external debt

External debt (= foreign debt) refers to the portion of a country’s debt that
has been borrowed from foreign lenders, including commercial banks,
governments and international financial institutions.

External debt represents the amount that a particular country owes to

other countries.

• It includes both public sector debt and private sector debt.

• It also includes both short-term liabilities

- loans that need to be repaid in the near future, such as within 1 year

• and long-term liabilities

- loans that need to be repaid over a longer period of time.
External debt

The causes of external debt

• Outstanding loans to foreign private sector financial institutions, including the outstanding interest

• Payments due to international organisations, such as the International Monetary Fund

• Outstanding payments for a balance of payments deficit

The consequences of external debt

To precise the problem caused by external debt we would look the ability of a country to meet the interest payments
on the external debt. These payments will need to be met from:

foreign currency earnings from exports

foreign currency reserves

gold reserves

further borrowing
External debt

The consequences of external debt

The existence of external debt can be a significant obstacle to the economic growth and economic development of a
country.

The repayment of the debt can become a major burden and there is an opportunity cost involved: the funds used to
repay the debt could have been used in other ways that would have been more productive, such as spending on
healthcare and education.

It is as a result of the problems caused by the repayment of external debt that the following institutions have been
established:

• the International Monetary Fund

• the World Bank

 6. The Bretton Woods institutions

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syllabus 06

11.5.6 role of the International Monetary Fund (IMF).

A.
B.
C.E.
D.F.
11.5.7 role of the World Bank
The Bretton Woods institutions

The Bretton Woods institutions

Towards the end of the Second World War in 1944, a conference was held at Bretton Woods, New Hampshire, USA,
at which John Maynard Keynes was an influential delegate.

In addition to establishing the exchange rate system that operated until the early 1970s, the conference set up
three key institutions with prescribed roles, in support of the international financial system.
The Bretton Woods institutions

International Monetary Fund (IMF)

- Set up to secure international monetary cooperation, to
stabilise currency exchange rates, and to expand
international liquidity through access to hard currencies.

It was set up with a specific brief to offer short-term

assistance to countries experiencing balance of payments
problems.

Thus, if a country were running a deficit on the current

account, it could borrow from the IMF in order to finance the
deficit.
The Bretton Woods institutions

International Monetary Fund (IMF)

The IMF aims, in particular, to:

• reduce the extent of global poverty

• encourage international trade

• secure financial stability

• promote sustainable economic growth

• promote high employment

• foster global monetary cooperation

The IMF achieves these aims by overseeing economic development, lending and capacity development.

It has played a significant role in stabilising exchange rates and thereby facilitating international payments.

It has also helped to enforce monetary discipline among its member countries.
The Bretton Woods institutions

World Bank
- The World Bank Group comprises five different
institutions, of which one key department is the
International Bank for Reconstruction and
Development.
The Bretton Woods institutions

World Bank
The World Bank aims to:

• provide low-interest loans, interest-free credit and grants to middle- income and low-income countries to reduce
the extent of poverty

• improve the health, education and infrastructure facilities of countries

• modernise the financial sector, agriculture and natural resources and

environmental management of different countries

The World Bank has set two goals for the world to achieve by 2030:

• end extreme poverty by decreasing the percentage of people living on less than US$1.90 a day to no more than 3%

• promote shared prosperity by fostering the income growth of the bottom 40% for every country
The Bretton Woods institutions

World Trade Organization

Initially, Bretton Woods set up the General Agreement on
Tariffs and Trade (GATT), with a brief to oversee international
trade. This entailed encouraging countries to reduce tariffs,
but the GATT also provided a forum for trade negotiations
and for settling disputes between countries.

The GATT was replaced by the World Trade Organization

(WTO) in 1995.

Between them, these organisations have presided over a

significant reduction in the barriers to trade between
countries – not only tariffs, but other forms of protection
too.
KEY TERMS
foreign direct investment (FDI): investment undertaken in one country by foreign companies based in other
countries

multinational company (MNC): a company whose production activities are carried out in more than one country

International Monetary Fund (IMF): multilateral institution that provides short-term financing for countries
experiencing balance of payments problems

World Bank: multilateral organisation that provides financing for long-term development projects

World Trade Organization (WTO): multilateral body responsible for overseeing the conduct of international trade
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