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Equity, foreign investment and international competitiveness in Latin America.

I. INTRODUCTION

International competitiveness is a favorite topic in the recent economic literature. As Krugman (1995) has noted, there is an outright obsession with this issue. Krugman claims that this obsession is, in fact, dangerous. It is commonly believed that there is a relationship between differences in productivity, the basis for competitiveness, and the variation in the standard of living across countries. Krugman, however, rejects this belief on both logical and empirical grounds. He argues that the standard of living of a country depends only on its absolute productivity, not its productivity relative to other countries.

Is there a relationship between competitiveness and equity? Could it be that equity also depends only on absolute productivity and not relative productivities, i.e., on the level of competitiveness? Or perhaps the opposite holds, it may be that competitiveness depends on the degree of equity in society. There are large, distinct literatures in economics that discuss equity and competitiveness in isolation from each other. There are very few pieces that investigate possible relationships between them. This article aims to fill this void.

A country's productivity is important in determining how competitive it is in international markets. But, what is the relationship between productivity and equity? In order to answer this key question, this paper develops a theory in which the degree of equity appears in the production function. Then the predictions of the theory are to put an empirical test using data from Latin America. These are the topics of Sections II to IV. Section V discusses the role of endowments in the relationship between equity and competitiveness. This discussion also addresses the endowments of unskilled labor. Section VI draws some conclusions, and offers a final point of view on the relationship between equity and competitiveness.

II. EQUITY AND PRODUCTIVITY

One can define a nation's competitiveness as its ability to stake out positions in distinct international markets. Theory tells us that, in the long term, this ability depends on the country's relative productivity. What are the factors that determine a nation's relative productivity? Here one may consider a set of theoretical hypotheses.

To begin with, productivity would depend upon the entire productive system. Just as in the Technological System of Leontief, one sector's productivity cannot be independent of the productivities of all the other sectors. The highway network, transport services, ports, and communications systems also affect a country's productivity. These factors have all been recognized in various studies in Latin America. Several studies by ECLAC on Equity with Productive Transformation argue that productivity is systemic in nature. If one accepts that the productive system is composed of intertwining interrelations, like those of Leontief's Technological System, then the conclusion is unobjectionable. Even the concepts of "factor intensity" would have to be defined with respect to the total content, both direct and indirect, of labor and capital per unit of output. This definition is quite distinct from the common practice of defining it only in terms of the direct coefficients.

Second, the productivity of the economy would depend not only on the factor intensities but also on the quality of these factors and the level of technological advancement. The quality of human capital is especially important.

Third, productivity would also depend on the quality of the business class. This factor could be the most important. "Walrasian managers" are required. These managers continually revise their production techniques and adopt new technologies that come from outside the firm, like new products. But most crucial are the "Schumpeterian entrepreneurs" who develop new methods of production, new uses for inputs, new products, new markets and new sources of inputs.

The institutional framework in which firms operate is equally important for efficiency. Thus, Schumpeterian entrepreneurs are needed for the public sector as well! They could generate the institutional innovations that would permit the productive system to raise its level of productivity.

The factors mentioned thus far have all been discussed in the economic literature. This study introduces a new theoretical proposition. Productivity is determined by investment which, in turn, depends on social and political stability. The latter two factors depend on the degree of equity in society. The challenge lies in introducing equity into the production function.

We begin with a production function of the form

[Q.sub.t] = F([L.sub.t];[S.sub.t-1],[Z.sub.t-1]) (1)

where Q is the quantity of a good produced in period t and [L.sub.t] is the labor input in the same period. S is a vector that represents the stock of private productive factors such as land and capital. Z is a vector that indicates the stock of public productive factors. Both stocks are measured at the end of the last period.

In this way, we introduce "public goods" into the production function. This category will include not only technological knowledge and infrastructure but also social order. We maintain that social order is a public good. Once it is present, no one can be excluded from consuming its benefits. Social order enters the production function because without it, the production process could not repeat itself period after period.

These stocks accumulate through private and public investment. We will suppose that it takes one period to convert an investment into a stock. This "time to build" explains the lag that appears in the production function. We will also assume that private and public investment give rise to the accumulation of both old and new productive goods. For this reason, it is not possible to aggregate vectors from distinct periods because they contain stocks of heterogenous capital. The quality of labor also differs over time due to investment in human capital.

Thus, in a dynamic economy the production function could quantitatively express only the relationship between output and the number of workers, where investment changes the form of that relationship from one period to another. This is the type of production function applied in this paper.

If we accept that social order should enter the production function, we must find the factors that determine social order. In another study, Figueroa (1993) developed a theory in which social order was fundamentally determined by the degree of inequality in the distribution of wealth. The axiomatic proposition is that not all wealth distributions are socially tolerable. Only a strict subset of the possible distributions are socially acceptable. If the economy moves toward a solution that is outside of this range, then society enters a distributive crisis, i.e., social disorder. All societies need a Rawlsian social contract to function. If society surpasses the limits of tolerance to inequality then this transgression breaks the social contract.

The distributive crisis depends not only on what results from exchange in markets but also on the State's social policy. Public social spending is a mechanism through which the State could lessen the inequality that is produced in the markets. In this fashion, the State could ensure social order.

An increasing pauperization of the masses, in either absolute or relative terms, which causes a distributive crisis would generate a new set of informal rules of production and distribution that are distinct from those of the market. A distributive crisis would elevate the levels of violence, corruption and uncertainty faced by economic agents. All of these factors would imply economic costs for society. In the short run, the costs of personal security and protection of private property, along with the costs of strikes and all types of social disorder, would rise. These costs would be passed on to firms. Thus, part of these social costs would result in higher per unit production costs for firms, thereby lower competitiveness.

In the long term, the economic costs of the distributive crisis would include lost private investment. l A decline in the quality of labor would also arise. For example, with the pauperization of the masses, there would be an increase in infant malnutrition. It is well known that people's ability to learn is largely determined in their infancy. Moreover, the quality of tomorrow's labor is determined today. And it is much more costly to raise the productivity of a worker tomorrow who has been neglected as an infant today. Both the rates of failure in school and morbidity would rise. Thus, the required investment in health and education that would be necessary to obtain a particular quality of labor force would be larger.

In sum, among other factors, productivity would depend upon the sociopolitical stability of the society. This last factor, in turn, depends on the degree of economic equity that is present in society. When the degree of equity falls, there is a larger risk of falling into social and political disorder and productivity decreases. Equity E should be an argument in the production function for goods.

In the short term, for given stocks of private and public goods and a level of technology, one can write the production function as,

[Q.sub.t] = nF([L.sub.t]) (2)

where n = n(E) and

[Mathematical Expression Omitted] (3)

There is a distributive crisis when equity, E, takes a value below the threshold social tolerance level, [E.sup.*] . When the threshold is crossed, businesses must use more resources to protect private property to offset the higher transactions costs. The rise in transactions costs includes those due to the increased risk associated with the labor market, i.e., the heightened tensions in labor relations. Labor productivity would fall in a distributive crisis. The function F would be shifted down.

By substituting equity for the real wage, it is possible to express this in a more conventional fashion employing efficiency wage theory (Solow, 1990). If real wages fall below a threshold, then labor productivity should fall. According to this theory, labor productivity depends on the level of the real wage and not the reverse as maintained in a standard microeconomic model.

It is possible to express the long-run production function as

[Q.sub.t] = mF([L.sub.t]) (4)

where m [greater than] 1. We suppose that the function F is shifted upward as m increases. The productivity of labor depends on the value of m.

What are the factors that determine m? We propose the hypothesis that the variables that move the function F are private investment I, and public investment G, since these determine the stocks of public and private productive factors. We assume that technological advancement, which is obtained through investment, is incorporated in physical and human capital. So we have,

[m.sub.t] = m([I.sub.t-1], [G.sub.t-1]) (5)

We assume that public investment is exogenously fixed, but that private investment is determined endogenously. It should be clear from the relationships presented thus far that, since public and private investment shift F upwards continuously in the long term, labor productivity depends on these investments. But what determines private investment in a country in the long run? We need a theory of investment.

III. A SIMPLE THEORY OF THE RATIONAL INVESTOR

There are three theories of private investment: (1) investment is endogenous to the economic process; (2) it is endogenous to both the economic process and the socio-political process; and (3) it is totally exogenous. In the first case, the theory establishes that private investment depends on the interest rate and the expected returns which, in turn, are determined only by relative prices (Barro, 1990). The second introduces the assumption that the expected returns also depend on the degree of stability in the socio-political system (Alesina and Perotti, 1993; Figueroa, 1993). In the last case, investors are simply guided by "animal spirits," as Keynes argued.

Here we adopt the second theory. We will assume that the investment decision depends not only on the economic process but also on a society's sociopolitical process, that is to say on the degree of social order. To adopt the third theory would imply that economic growth depends on the state of mind of capitalists, about which economic policy has nothing to say.

An investors' investment decision should depend on the expected return and her/his capacity to bear risk. As this capacity increases, the investor will enter into games with higher expected returns even though they are more risky. We will assume that this capacity is determined by the amount of wealth that the investor has. That is to say that the degree of risk aversion is determined by the constraints and not by preferences. Investors with more wealth will take more risks (Figueroa, 1993).

We will assume that capital is mobile across countries. But, how do investors decide upon their portfolio over different countries? Here we present an oversimplified model to answer this question. We will consider two types of risk, the product risk and the country risk, since the investor must decide in which product and in which country to invest. In each case, the investor faces two events. In the first case, the return could be either good ([r.sub.1]) or bad [(r.sub.2]). Hence, the expected return of the investment is

[r.sup.e] = [P.sub.1][r.sub.1] + [P.sub.2][r.sub.2], (6)

[P.sub.1] + [P.sub.2] = 1 (7)

[r.sub.1] [greater than] [r.sub.2] [greater than] 0 (8)

where [P.sub.1] and [P.sub.2] are the probabilities of the events.

We will suppose that the private and public productive factors are complements. Thus, for a given probability distribution, the expected return will depend on public investment G.

In the country decision, we will also suppose that there are two events. Country j could be in a state of either socio-political stability or in chaos. The probabilities of these events are [V.sub.1] and [V.sub.2] respectively and [V.sub.1] + [V.sub.2] = 1. If the first event occurs then the investor obtains [r.sup.e]. But if the second happens, the return is zero. Hence, the expected return, taking into account the effect of the country risk is

[Mathematical Expression Omitted]. (9)

In terms of expected return, the investor would invest in the country with the highest value of [Mathematical Expression Omitted], that is to say in the country with the level of socio-political stability.

In this model the rate of expected return of the product is independent of the country. If one relaxes this assumption then the return for country j would be

[Mathematical Expression Omitted] (10)

The investor will still invest in the country that offers the highest expected return. However, now a country with relative instability, i.e., a low value of [V.sub.1], could attract investments if the value of [Mathematical Expression Omitted] is relatively high.

In both models the risk is the same. One loses the entire investment if the event of socio-political instability occurs. Thus, the country risk factor determines the risk. If the investor has the capacity to absorb this loss, then she/he would make an investment in the country with the highest [R.sup.e]. If she/he does not have this capacity, then she/he will not invest in any country.

By introducing into this system the theoretical proposition that the probability of having socio-political stability, i.e., social order, depends on the degree of equity, one obtains that the return to the investment, [R.sup.e], is not independent of the degree of equity in society. Thus, private investment would depend on the degree of equity in society, E, and on the level of public investment as well. The investment function would be of the form

[Mathematical Expression Omitted] (11)

where [E.sup.*] is the lower bound of equity tolerated in society.

Hence, private investment cannot be independent of the degree of equity tolerated in society. If the degree of equity is in the range above the threshold social tolerance level, then investment is not affected by changes in equity. However, if the degree of equity falls below the cutoff, or is likely to fall below it, then investment should fall. A sufficient condition for generating a curve in which the relationship between investment and equity is positive until [E.sup.*] is that investors have distinct capacities to absorb losses(2) The lower the equity, and social stability, the larger the risk of the investment. Thus, only the large investors with the capacity to absorb the eventual losses would invest. To the extent that equity increases, the risk falls and investors with lower capacities to absorb losses would enter. It is clear that above [E.sup.*] the curve becomes flat.(3) One empirical prediction of this theory is that in very unstable countries, transnational companies will have a large share of total investment.

Investors would make their way towards exploiting the absolute advantages, the comparative advantages and the competitive advantages of a country. Their logic in these decisions would be guided by the model developed here. But through their investments, investors would also be developing these advantages for the future. This generates a dynamic effect. If the productive process of a good is less intensive in social stability, then the investment may be less sensitive to the country risk. In this case, investments may be aimed at producing the good in enclaves, such as mines, oil, maquilla manufacturing and tourist centers. But if the product in question is intensive in social stability, then the country risk factor could be very important and even preclude investment in this good. Due to the country risk factor, behind which lies the degree of social equity, the comparative advantages of a country may not be developed.

Thus, given the system of Equations 4, 5 and 11, the production function should be of the form

[Q.sub.t] = f([L.sub.t],[G.sub.t-1],[E.sub.t-1) (12)

The levels of production and labor productivity should depend on the quantity of workers employed in that period and the levels of public investment and equity in the previous period. Here it is supposed that E [less than] [E.sup.*].

In this formulation, public investment is exogenous, equity is the result of the functioning of the markets in the previous period and the social policies of the government which are exogenous. What are the factors that determine the quantity of workers? This variable is endogenously determined together with the general equilibrium of the system. But the important conclusion of the theoretical proposal here is that increases in labor productivity ultimately depend on increasing public investment and changes in equity.

The long-run international competitiveness of a nation depends on the productivity of the productive system. An increase in this productivity implies an increase in the country's net exports. Thus, international competitiveness depends on, among other factors, the level of equity in the country in question. Everything else equal, a country with greater equity would attract more private investment with which it could raise its productivity and gain a better position in international markets. This is the empirical prediction that emerges from the theory. It should be put to an empirical test.

IV. EMPIRICAL EVIDENCE

The World Bank (Deininger and Squire, 1996) has recently presented a new data base on equity which contains a sample of 108 countries with observations from the 1950s until the 1990s for a total of 682 observations. In the sample, Latin America, with a subsample of 20 countries and 100 observations, is the region with the highest degree of inequality in the world, as can be seen from Table 1. The Gini coefficient has a mean of .50 while that of the advanced capitalist countries is .33 and the mean for the Asian Tigers is around .35. The order remains the same if one uses as a concentration index the ratio of income share of the bottom quintile to that of the top quintile of the distribution.

From the beginning of the 1960s, the group of Asian countries has shown accelerated growth along with increased equity. Although much has been written about the trajectory of these countries, very little has been said about the initial conditions at the time of takeoff. For example, there is only one tangential mention [TABULAR DATA FOR TABLE 1 OMITTED] in the well known World Bank (1993) study. Few have argued that Taiwan and Korea applied policies aimed at reducing inequality in the 1960s (Ranis, 1996). In effect, Deininger and Squire's data show that one initial condition of the Asian Tiger economies was a low level of inequality. In contrast, Latin America at the beginning of the 1960s had a high degree of inequality. In reality, there are two interesting results that emerge from Deininger and Squire's data. First, the inequality ranking of the regions remains the same over time. Second, there are no drastic changes in the Gini coefficients in each region.(4) The distinct trajectories of the Southeast Asian and Latin American groups of countries in terms of growth, equity and competitiveness are then consistent with our hypothesis.
Table 2. Latin America: Foreign Direct Investment

Thousands of Dollars
                                   1981-1985   1986-1990   1991-1995

All Countries                           50         155         209
Developing Countries                    13          25          72
Latin America and the Caribbean          6           8          19
Latin America and the Caribbean
as a % of Developing Countries        46.2        32.0        26.4
Latin America and the Caribbean
as % of All Countries                 12.0         5.2         9.1

Notes: The data are averages of yearly observations. Included are
new capital and reinvested capital, except for repatriated capital.

Source: CEPAL (1995), Table II.l page 55 and CEPAL (1997), Table 1,
age 9.


Latin America's share of direct foreign investment has fallen. Regardless of whether it is measured relative to all other countries or just other developing countries, Latin America's share of direct foreign investment has fallen consistently since the first five years of the 1980s. This can be seen in Table 2. The data are also consistent with the hypothesis that investment flows towards more egalitarian societies.

The relationship between equity and investment is a structural equation, Equation 11, in our theoretical system. Alesina and Perotti did a study that puts this relationship to a statistical test. In a sample of 70 countries with observations from 1960-1985, they found a negative correlation between equity and socio-political instability. They also found a negative correlation between sociopolitical instability and investment. In this sample, the 16 Latin American countries had the highest levels of inequality and socio-political instability, as well as the lowest rates of investment.(5)

The interpretation that Alesina and Perotti make from their results and the policy conclusions that they draw, however, have a logical flaw. In their model they take the distribution of income to be an independent variable, that is to say that they assume it to be exogenous to the economic process. There is no economic theory that endorses such a proposition. The manner to resolve this logical difficulty would be to consider a dynamic system like that developed here. Investment this period depends on the level of socio-political stability this period. Also, the level of socio-political instability depends on the degree of equity in the previous period. In this dynamic system, the distribution of income can be used as an initial condition in the time path of the endogenous variables.

In fact, in their actual statistical analysis, they use the distribution of income of the initial period of the sample, 1960. And for the other variables, they use the means over the period 1960-1985. Thus, the interpretation of the results is not that investment depends on inequality, as they claim: "income inequality increases socio-political instability which in turn decreases investment" (Alesina and Perotti, 1993, p. 18). Both are endogenous variables. If one takes these data as being generated by a dynamic system, then the causal relation would have to be otherwise. The high concentration of income, taken as an initial condition, increases the risk of socio-political instability which in turn takes the system down a path with lower investment and growth.

Their policy conclusion would also have to be reformulated. They conclude that the redistribution of income has an unpredictable net effect because the increase in taxes required for a redistribution will reduce the incentives to invest. But the tax change affects the level of investment and not the rate. This confusion is similar to the one that surrounds international barriers to commerce based on protective tariffs which are also tax rates but are believed to affect the rate of economic growth. As Lucas (1988, pp. 12-13) points out, liberalizing these barriers would have a level effect but not a growth effect. If we apply Lucas's distinction and assume that the distribution of income has a growth effect, then the logical conclusion of Alesina and Perotti, in light of our reinterpreting their empirical results, would have to be different. It would be that a redistribution of income as a change in initial conditions would take the economy to a distinct path with higher investment and growth, i.e., it would have an effect on the growth rate.

As measured by its share of world trade, Latin America has lost competitiveness since the 1970s. Table 3 clearly shows this trend. In 30 years, the region has reduced its relative share by nearly one half, from 7.7% in 1960 to 3.7% in 1992. Trade between developed countries accounts for most of world trade and their share has grown. But the group that has had the largest increase in competitiveness is known as the Asian Tigers, which is composed of Korea, Taiwan, Singapore, Hong Kong, Malaysia, Thailand and Indonesia.
Table 3. Latin America's Percentage Share of World Trade

              Latin          Developing        Asian
Year         America         Countries         Tigers         Others

1960           7.7              65.9             3.4           23.0
1970           5.5              70.9             3.0           20.6
1980           5.5              62.6             6.0           25.9
1990           3.9              71.4            10.1           14.6
1992           3.7              71.5            11.5           13.3

Note: The Asian Tigers are South Korea, Taiwan, Singapore, Hong
Kong, Indonesia, Malaysia and Thailand.

Source: CEPAL (1995), Table 1.4., page 35.


[TABULAR DATA FOR TABLE 4 OMITTED]

A sample of eight Latin American countries indicates the same regional pattern. Although there are differences in degree, it is important to note the loss of the share in world trade. This is shown in Table 4. The fall in the participation in international trade has been especially severe in Argentina and Peru and less severe in Colombia and Costa Rica. Chile saw its share fall from 1964 to 1984, and although it then started to climb it never recuperated to its level at the beginning of the 1970s. Paraguay has maintained nearly the same level. Brazil was a successful case from 1964 to 1984, but since then its share has fallen to a level similar to that it enjoyed at the beginning of the 1970s. The relatively successful case is that of Mexico. Between 1964 and 1976, its share fell, between 1977 and 1985 it gained substantially only to lose some of these gains again between 1986-1989 and then stabilize afterwards. Its final level is above what it held in the 1970s. In sum, there is no country comparable to the "Asian Tigers" in our sample.

V. THE ROLE OF NATURAL RESOURCE ENDOWMENTS

The importance of equity in the determination of private investment can depend on the degree of integration of the export sector with the national economy. Private investment seeks to exploit absolute, comparative and competitive advantages according to the initial conditions of a country in both resource endowments and equity. A society with natural resource endowments and a high level of initial inequality can only give rise to investments that exploit its absolute advantages and some of its comparative advantages. But these investments would increase income inequality and decrease the level of socio-political stability. Thus, the country would find it more and more difficult to escape its social instability trap, unless the State applies policies that modify its initial resource endowments.

A natural resource endowment for a country can only be a girl of the devil. A society would find it difficult to develop on the foundation of absolute advantages. The exploitation of a country's absolute advantages does not require that this country have social and political stability. Exports can be made from an enclave. The more integrated the export sector is with the rest of the productive system, the more important is social order and, for this reason, equity for the private investment that develops the export sector.

What are the goods in which Latin America has specialized? For nearly all of its history, until the end of the 1970s, the region has specialized principally in primary products such as minerals, petroleum, fish and a few agricultural products. Its biodiversity permits it to produce fish products, cocoa, coffee, cotton, sugar, asparagus and wool, that is to say products that cannot be produced anywhere in the world or in whatever season. Tourism is also exporting a natural resource that is based on climate or that takes the form of a historical resource.

A combination of absolute and comparative advantages is the basis for this specialization. But, with the exception of a few agricultural products, the exploitation of natural resources has not signified that the region exports goods that are labor intensive, although labor is its most abundant factor. Minerals, metals, and combustibles are all relatively capital intensive. With these goods, Latin America exports goods where the economic rent is high. This implies that an important part of exports do not depend on variations in international price, nor the exchange rate, nor the real wage - at least for a significant range - but on investment.

Everyone accepts that agricultural production is relatively labor intensive, especially unskilled labor. However, this export has lost relative importance in a drastic fashion, as can be seen in Table 5. In absolute terms, the data indicate that the volume of agricultural exports increased 4% annually in the 1970s but then fell by 2.3% in the 1980s (CEPAL, 1995, p. 70).

Although it is true that manufacturing exports from the region have grown, the data in Table 5 hide the stark differences across countries. Nearly 75% of manufacturing exports in 1993 came from only two countries, Brazil and Mexico. Without these countries, the simple average for the region is 18% instead of the 39% that appears in Table 5 (CEPAL, 1995, Table III.5, p. 77).

Within manufacturing it is possible to distinguish a sector of traditional goods which is relatively labor intensive. Such is the case of textiles, clothing and footwear. Here the relative abundance of labor appears to play an important role in competitiveness. The decision of some multinational companies to locate maquilas to produce these products in various countries of the region is precisely based on the existence of cheap labor.

H1: Investment in primary sectors requires less socio-political stability.

It is not possible to rely on data to put the hypothesis that investment in primary sectors requires less socio-political stability to a statistical test. But there is a case that serves to illustrate the hypothesis. Cusiana, Colombia is the largest oil field discovered in Latin America in the last 20 years. The required investment is $6 billion. The foreign oil company had to interrupt its exploration on one occasion because the guerillas invaded the camps and destroyed it with dynamite and grenades. To repel the guerrillas, soldiers have been assigned to Cusiana (El Comercio, 1996). This oil field will be exploited immediately in spite of the fact that Colombia is a country plagued with poverty, political chaos, guerillas and narcotics trafficking. It appears that there are no prerequisite levels of socio-political stability in order to exploit oil reserves. It is produced in a physical and economic enclave.
Table 5. Latin America and the Caribbean: The Structure of Exports

                                1962    1970    1980    1990    1992

Agriculture Products            52.4    47.1    31.2    28.3    29.8
Metal and Minerals              13.1    18.2    10.4    11.7     9.7
Fuels                           29.1    22.9    40.6    26.5    21.6
Manufacturing                    5.2    11.5    17.3    32.9    38.5
Others                           0.2     0.3     0.5     0.6     0.4

Total                          100.0   100.0   100.0   100.0   100.0

Note: All numbers are percentages.

Source: CEPAL (1995), Table 1.6, page 39.


H2: Distinct factor endowments give rise to different patterns of trade and distinct degrees on distributive equity. Specifically, the investments necessary to develop an export sector based on natural resources increases the concentration of income.

The hypothesis was empirically tested by Bourguignon and Morris (1989, Chapter II), in a cross-sectional analysis from 1970. The sample includes 20 developing countries, six of which were Latin American countries.(6)

The endogenous variables in Bourguignon and Morrison's statistical study were the income shares of several deciles of the income distribution. The exogenous variables were the level of trade protection, the share of agriculture in a nation's GDP, the fraction of GDP held by minerals and petroleum, and the structure of land ownership and education. Their results show that protection has a negative effect on equity. They also find that specialization in natural resources has a negative effect, except in the case where the agricultural good exported comes primarily from small producers. Income inequality will increase if the trade pattern is based on absolute advantage. If the trade pattern is based on a comparative advantage in agriculture, then income inequality will rise or fall depending on the initial concentration of land holdings.

These results can be reinterpreted in light of our theory. Unequal societies should attract investments aimed principally at exploiting their natural resources. These investments will tend to ensure that these societies continue to be unequal and unstable.

This proposition would seem to be consistent with the case of Peru. In Peru there was a significant increase in direct foreign investment in the period of 1994-1996. In these years nearly $4.8 billion of direct foreign investment entered the country. This amount includes investment in new equipment, sales of stock in Peruvian companies to foreigners and privatization. A third of these investments was aimed at the communications industry, another third at the natural resource sector and the remaining third went to the other sectors. Only 15% went towards manufacturing.

VI. CONCLUSIONS

The question that has guided this study is whether a society can become developed beginning from a high degree of inequality. In particular, can a country be competitive in international markets independent of its present degree of inequality?

If a country starts with high degree of inequality then the high country risk factor should steer investment towards its absolute advantages that can be exploited in enclaves. The probable social instability should deter investment that would increase factor productivities and develop comparative advantages. Thus, it is likely that this country's international trade pattern would be increasingly based on absolute advantages. So trade would not create conditions for reducing the excess supply of labor, especially unskilled or minimally skilled labor. If this analysis is correct, then there is not much hope that trade could be a mechanism to increase equity in the countries of the region.

If there is some relationship between trade and equity, it would be in the other direction. Since investment is the foundation of competitive advantage, it would seem that the development of competitive advantages requires that a country have a less pronounced degree of inequality. This conclusion is derived from the logic of investors. They would put their investments in countries that have relatively high levels of socio-political stability. Stability depends on the degree of equity. Exports do not increase growth, as is commonly said. Investment generates growth and higher productivity and this is how competitiveness is gained. The more intensive in social order the export goods from a country are, the larger the effect of social equity should be on net exports. The international competitiveness of a country depends on its degree of inequality. This is the theory developed in this paper.

T1: The more social order intensive exports are the larger the effect of social equity should be on net exports.

Put to an empirical test, this theory shows an acceptable degree of consistency with data from Latin America. One prediction is that a country's economic performance depends on the degree of equity and on the initial factor endowments. At the beginning of the 1960s, Latin America had a pronounced level of inequality and abundant endowments of both natural resources and cheap, unskilled labor. Korea and Taiwan had the opposite conditions, they started off with greater equity and an endowment of human capital. The path of growth, equity and competitiveness has been in line with the theory's predictions. Today we speak of Asian Tigers and not Latin American Tigers.

T2: A country's economic performance depends on the degree of equity and on initial factor endowments.

That capital flows to more egalitarian countries is another prediction of our theory that is consistent with the trends in the world economy. At the present time, there is increasing global economic integration, especially in the financial sector. Controls over exchange rates have been relaxed and there is a process of globalization in the capital markets. According to a study by the OECD, the world flows of direct foreign investment increased in recent decades in unprecedented proportions. The study estimates the rate of increase to be between three to five times the rate of growth in the international trade of goods and services (Oman, 1996, p. 26). The effect of this change is that countries, including those of the third world, cannot be considered to be distinct by their capital endowments. Capital can be considered to be internationally mobile.

In an economy endowed with natural resources, foreign investment will come even if income inequality is high. However, this investment will not help to reduce inequality. The export sector will operate in enclaves.

In this theoretical perspective, public social spending can be seen as an instrument to place income and welfare "floors" for the population in order to facilitate stability in the socio-political system. These actions can be denominated the "social policy." But these floors must be established as a set of rights. This implies that those goods and services in this bundle of rights would have to be removed from the marketplace and the short-term election game. Social stability, like democracy, is a public good. Thus, it is evident that social public expenditure is an investment in a public good, social stability.

However, the Latin American experience is not headed in this direction. A study by CEPAL (1994) shows that in the 1980s and the beginning of the 1990s, social public spending in a group of countries from the region was not significant relative to GDP. Moreover, variations in social spending were not anti-cyclic relative to GDP and its distributive effect was not significantly progressive.

In sum, the relative productivities between countries, which have been defined here as long-term competitiveness, depend on the distribution of investment across countries. These investments depend on public investment and the degrees of socio-economic stability in the countries, which in turn depend on equity. Thus, competitiveness depends on equity. Since socio-political stability depends on the level of organization of society for maintaining a tolerable distribution, it is clear that competitiveness is not simply a microeconomic or sectorial question. Rather, it is a social question. Societies compete with each other to attract private investment in order to become competitive. But they compete with, among other factors, their degrees of equity.

Acknowledgment: This paper was prepared for the Conference of the Latin American Studies Association held in Guadalajara, Mexico on April 17-19, 1997. I would like to thank David Drukker for his comments and suggestions in the preparation of this paper. This paper was completed during my visit as Tinker Professor in the Economics Department and the Institute of Latin American Studies, University of Texas at Austin, Fall 1997.

NOTES

* Direct all correspondence to: Adolfo Figueroa, Departamento de Economia, Universidad Catolica del Peru, Apartado 1761, Lima, Peru.

2. Hicks (1989) would call these "distinct disaster points."

3. At excessive levels of equality, the curve could become decreasing. Then the curve would have the form of an inverted U, where the turning point is a long flat spot.

4. These results are derived from the data that appears in their Figure 1. Even at the country level, there is notable stability in the Gini coefficients. For those countries with more than 10 observations, the Pearson coefficient of variation does not rise above 12%. These empirical data raise some interesting questions. Is equity a structural characteristic of society? Is it an initial condition that is difficult to significantly change? Or, is the observed stability a property of the Gini coefficient which does not change much when the corresponding Lorenz curves intersect, which the authors maintain occurs frequently?

5. These results appear in their Tables 4 and 5.

6. The Latin American countries were Argentina, Chile, Colombia, Costa Rica, Peru and Uruguay.

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Title Annotation:The Changing Role of International Capital in Latin America
Author:Figueroa, Adolfo
Publication:Quarterly Review of Economics and Finance
Date:Sep 22, 1998
Words:7108
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