The role of export subsidies in balance-of-payment crises
Introduction
It has been estimated by Low (1993) that in 1998, export subsidies amounted to 0.9% of GDP in Japan, 0.9% in the United States, and 2.5% in the European Union. Prior to the early 1960s, commercial policies protected domestic import-competing industries in many developing countries. However, due to limited domestic markets and resources, especially in the East Asian economies, the import-substitution policy changed in the late 1960s to be more export-oriented. Export subsidies were used in these economies to penetrate foreign markets and promote domestic growth.
The literature provides several arguments in support of a policy of export subsidies. An export subsidy lowers the world price but raises the domestic price. From an interest group viewpoint, domestic producers gain at the expense of consumers. However, as indicated by Gardner (1996) with regard to US subsidies of wheat exports, the general public remains supportive of export promotion and no buyers of wheat have raised politically significant objections to the subsidy program. In addition, from the social welfare perspective, arguments made to justify export subsidies include: neutralization of export subsidies by trading partners, temporary protection of infant industries, and second-best considerations related to credit-market imperfections.1
Many policy economists view export expansion as a key channel for promoting economic growth, and export subsidies are instruments for achieving export growth. Nonetheless, Rodrik (1997) suggested that export-led growth in the East Asian economies is mainly due to investment booms. In resource-scare and technologically laggard economies (e.g., South Korea in the 1960s), the domestic capital-goods industry is poorly developed.2 Increases in investment mostly come from the imports of foreign capital, which is possible because of foreign exchange provided by exports. Although this linkage between investment, exports, and the trade balance has a crucial role in development process, it remains by and large ignored in the literature. The purpose of this paper is to fill this lacuna by examining the consequences of an export-promotion policy on capital accumulation, income distribution, and the trade balance.3
We shall view the home country as using imported capital to produce a single exportable good. Financing of capital imports comes from domestic savings and/or borrowing abroad. A policy of export promotion, such as export subsidies, initially raises intertemporal prices of the exportable good and, thus, leads to more usage of domestic savings for capital investment. However, over a longer period, the increased exports apply downward pressure on the world price of the exportable good. If the deterioration of the terms of trade weakens the intertemporal price gain and reduces domestic savings, the country has to finance domestic investment through foreign borrowing. This suggests that an export-oriented strategy may cause an over-expansion in the imports of capital goods and, thus, deteriorate the country's trade balance. This potential danger of export subsidies should not be overlooked in the longer run.
The description above is consistent with a consensus that at the beginning of the 1980s, lower export prices combined with the higher world interest rates caused a foreign-debt problem in some developing countries.4 The 1997 financial crisis in South Korea is an example. South Korea achieved high growth due to government subsidization and intervention. At the same time, rapid growth generated domestic investment demand higher than savings. Banks and firms actively borrowed abroad to accommodate the excess of investment over savings, manifested in current account deficits. The loans were, however, mostly short term; 80% of foreign exchange transactions had a maturity date of 7 days or less. On the other hand, there was intensive export competition globally. Korea's terms of trade were declining in particular because of competition from China. As a result, merchandise exports grew by less than 4% in 1996, which was a sharp change from the 30% growth rate of a year earlier. The fall in export growth and the increase in current account deficits by 1995 and 1996 made South Korea vulnerable to the external shocks of an increase in world interest rates or a fall in aggregate demand.5
We proceed now to a model that demonstrates these considerations. In Section 2, an open-economy growth model is developed. 3 Steady-state equilibrium and dynamics, 4 Effects of export subsidies examine the transitional and steady-state effects of export subsidies. Section 5 provides concluding remarks.
Section snippets
The model
We consider an open economy producing a single, tradable good, Y. Individual firms use capital (K) and labor (L) to produce this good by a Cobb–Douglas production function: Y=αK̄1−βKβL1−β, with a spillover externality generated from the aggregate capital stock, K̄.6 Here, α>0 and β>0. By assuming no population growth, we can set L to be unity. Because K̄=K in equilibrium, the above production function can be written as
This is the well-known AK
Steady-state equilibrium and dynamics
The dynamics of the economy can be described by the movements of the state variables of K and Z, together with their co-state variables of q and λ, described in , , , . To express the economy in terms of the stationary variables, it is convenient to define c=C/K and z=Z/K as consumption and foreign bonds in terms of per unit of capital, respectively. Note that α=Y/K according to Eq. (1), and, thus, α>c.
From Eq. (8) and using Eq. (11), we obtain:where ω(c)=[ε(1−γ)(
Effects of export subsidies
In this section, we examine the steady-state properties of export subsidies. The steady-state equilibrium is reached when ċ=q̇=ż=0 in , , , and can be expressed as follows:where p̃*=φ(α−c̃) by Eq. (2), and “~” represents the variable in steady state. Because the system above is recursive, q̃, c̃, and z̃ can be solved sequentially from , , . Note that from Eq. (22), q̃ is a constant number related to the gap
Concluding remarks
We have shown how export subsidies can result in deterioration of the trade balance, and thereby in balance-of-payment crises. In particular, we propose our model to explain financial crises as occurred in South Korea. In these cases, crises arise because of a government's intervention through export subsidies and firms' over-investment.13
A study by the World Bank (1993) points to the role of export-promotion policies in high-growth Asian economies.
Acknowledgements
We are indebted to an anonymous referee and an editor for useful comments. The usual caveat applies.
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Cited by (1)
Exchange rate pass-through: A generalization
2010, Journal of Mathematical EconomicsCitation Excerpt :A couple of other interesting extensions can include merging our model with the constructs of Beladi and Chao (2003), Marjit et al. (2007) and Batra and Beladi (2008).