Select Committee on Economic Affairs First Report


Note on Globalisation prepared for the Select Committee on Economic Affairs by Mr Martin Stewart and Professor Anthony Venables, London School of Economics

This note outlines some of the economic changes associated with globalisation. Section 1 addresses the forces driving globalisation - changes in trade policy and technology. Section 2 looks at the consequent changes in trade flows, and section 3 turns to foreign direct investment. The note does not attempt an assessment of the effects of globalisation, merely offering an introduction to some of the driving forces and direct impacts.

1. Driving forces

Economic transactions of all sorts - trade flows, investment flows, technology transfers - depend on distance, and are much lower between two distant countries than between two close ones. For example, doubling distance cuts trade flows by more than half so, on average, two countries 8000km apart only have 7% of the bilateral trade volume of two countries 1000km apart. However, both policy changes (tariffs and trade barriers) and technical changes (in transport and new technologies) have contributed to a substantial decline in the costs of distance and in the costs of crossing most borders.

1.1 Tariffs and trade barriers

Tariff and other trade barriers have been reduced by a series of successful GATT/WTO trade rounds, by unilateral trade liberalisations, and by the formation of regional integration agreements. Table 1 illustrates how developed countries' average tariffs on industrial products have been dramatically cut in the postwar period from an average of about 40 percent in the 1940s to less than 4 percent today. Average agricultural tariffs in 1999 stood at 17.3 percent in the EU and 11 percent in the US, although in the Uruguay Round developed countries agreed to an average reduction of 36 percent and developing countries agreed to a 24 percent cut over a 10-year period (WTO, 2001). Since the formation of the WTO in 1995, negotiations have been further expanded to incorporate trade in services.

Table 1:   Industrial countries' import tariffs on manufactures
Period Average tariff rates (%)
1940sPre-GATT/WTO 40.0
Late 1970sPre-Tokyo Round 7.1
Late 1980sPost-Tokyo Round 4.7
Late 1990sPost-Uruguay Round 3.8

sources: WTO, Kenen (1994)

Alongside multilateral reductions in tariffs, there has been a move towards increased regionalisation. This trend has been especially pronounced in the past decade or so, with developments in Europe (EU enlargement and bilateral agreements), the Americas (NAFTA, MERCOSUR and numerous bilaterals), Asia (development of the ASEAN free trade area, the South Asian free trade area, and APEC), and Africa (the formation of new regional agreements and the rejuvenation of old ones). As of mid-2000, 114 RIA's had been notified to the WTO and were in effect. More than one-third of world trade now takes place within such agreements, and almost 60 percent of world trade if the Asia Pacific Economic Cooperation (APEC) is included (World Bank, 2000).

Other measures in the policy environment - liberalisation of foreign ownership restrictions, investment agreements, and simplification of frontier procedures - have had significant effects on trade and investment. For example, after China changed its policy stance toward foreign investors in 1982, foreign direct investment (FDI) as a percent of GDP rose from what was effectively a zero base to 4 percent in 1999. Meanwhile, India's share stagnated at about 0.05 percent until it started economic liberalisations in 1999, then rising to 0.5 percent by 1999.

1.2 Transport costs

Transport costs have fallen in recent decades, but remain important. In the mid-1990s, freight expenditure for the US was only 3.8 percent of the value of imports, but was higher for many other countries; for example, equivalent numbers for Brazil and Paraguay are 7.3 percent and 13.3 percent (Hummels 1999, from customs data). These values incorporate the fact that most trade is with countries that are geographically close, and in goods that have relatively low transport costs. Looking at transport costs unweighted by trade volumes gives much higher numbers. The median freight charge between all country pairs for which data is available is 28 percent of the value of imports.

Technical change has reduced the costs of transport and slashed the cost of communications. Estimates of the changes in these costs are given in Figure 1. This shows the continuing rapid fall in the costs of transmitting digital information, and declines in the costs of ocean shipping and airfreight that appeared to bottom out in the 1960s and 1980s respectively. These figures almost certainly understate the true fall in trade costs, which include not only freight and insurance charges, but also the costs of time in transit. Hummels (2000) estimates that the cost of time in transit is around 0.3 percent of the value of goods shipped per day, around 30 times larger than the interest charge alone. In this case the speeding up of ocean shipping (due to containerisation and faster vessels) combined with the rising share of airfreight, has cut transport costs on US imports over the post war period by an amount equal to an 11-12 percent tariff reduction.

source: Baldwin and Martin (1999)

1.3 Digital trade

New information and communications technologies (ICT) have made a class of activities 'weightless' - they can be digitised and shipped at essentially zero cost. These include software and media products, and 'IT-enabled services' such as call centres, some accounting services, medical transcription, and so on.

Although these activities have expanded rapidly, they still only account for a relatively small share of world GDP. World Bank data puts the figure at just under 7% in 1999, which includes spending on information technology products and telecommunications. The OECD estimates that all software and computer related services accounted for 2.7 percent of US GDP in 1996, and half that figure in other OECD countries. Software products and computer services combined accounted for just 0.8 percent of US exports in 1996 (OECD 1999). Even in such a fundamentally weightless activity as banking, it is estimated that only some 17-24 percent of the cost base of banks can be outsourced (Economist, May 5th 2001). Another way to get a sense of the magnitude of these activities is to look at the recent experience of the highly successful Indian software and IT-enabled services sectors. The value of all Indian software and related services output in 2000 was around $8bn, with exports of $4bn. Indian IT-enabled services exports to the US are $0.26bn, predicted to grow to $4bn by 2005 (Economist, May 5th 2001). These are substantial size activities compared to total Indian exports of $45bn in 2000, but are less than 1 percent of total US imports of around $950bn.

Although it is difficult to quantify the share of the economy that is, or is likely to become, weightless, one fundamental point can be made. As activities are codified and digitised, not only can they be moved costlessly through space, but also they are typically subject to very large productivity increases and price reductions. Thus, the effect of ICT on airline ticketing (for example) has been primarily to replace labour with computer equipment, and only secondarily to allow remaining workers to be employed in India rather than the US or Europe. Technology that can capture voice or handwriting may well make the booming Indian medical transcription business obsolete.

1.4 Costs of managing remote operations (production networks)

ICT has also reduced the cost of managing and monitoring supply chains, enabling firms to better 'fragment' their production processes. This fragmentation has been partly organisational (sub-contracting within a country) and partly geographical (purchasing from or producing in multiple locations). The extent to which this has become possible varies widely across sectors. Information concerning routine operations can be codified and digitised, allowing remote operation. However, for many activities information transmission still requires face-to-face contact and the difficulties of writing and enforcing fully specified contracts puts a premium on keeping many activities within the firm.

2. Trade flows

The cost changes outlined above have led to changes in trade and investment flows, which we outline in this and the next section.

2.1 The growth of trade

Trade in goods in both industrial and developing countries has grown consistently faster than GDP. In Figure 2 the upper panel gives the ratio of exports to GDP for high-, middle-, and low-income countries from 1980. There has been a substantial increase in this ratio for low-income countries, and a modest increase for high-income countries. Increases in trade to income ratios are modest largely because of the increasing importance in GDP of service sector activities, which are largely non-tradable. An alternative measure of the trends in goods trade is the ratio of merchandise exports to merchandise value-added (merchandise being agriculture, mining and manufacturing). This is reported in the lower panel of Figure 2, and indicates a much more substantial increase. For high-income economies this ratio grew from 44 percent to 59 percent over the period. For middle-income countries the increase was from 32 percent to 58 percent, and low-income from 19 percent to 30 percent.

sources: NBER World Trade Database, World Bank World Development Indicators

The figures for the UK are broadly in line with the trends in high-income countries as a whole - a slow-growing trade to GDP ratio but faster growth in the merchandise trade ratio (see Figure 3). The total trade ratio grew from 22 percent in 1970 to 27 percent in 1980, and it has remained relatively stable at that level since. The merchandise trade ratio, however, grew from 41 percent in 1970 to 53 percent in 1980 and to 71 percent in 1999

sources: NBER World Trade Database, World Bank World Development Indicators, Feenstra (1988)

2.2  Directions of trade

As trade volumes have increased so there have been changes in the geographical sourcing of imports and direction of exports. Table 2 indicates the substantial increase in high-income countries' imports of merchandise from developing countries, expressed relative to high-income countries' GDP. The share has more than doubled (from 0.48 percent to 1.22 percent), but remains extremely small. Imports from other high-income countries are over ten times larger, although the rate of increase in this share is much less.

Table 2:   Sources of high-income countries' imports of merchandise (percent of high-income countries' GDP)
YearLow-income countries Middle-income countriesHigh-income countries
19700.48 1.678.55
19971.22 3.0314.10

source: NBER World Trade Database, World Bank World Development Indicators

Figure 4 looks at the geographical pattern of UK trade in more detail. The most significant development is the reorientation of UK trade towards EU partners. Less than one-third of UK exports and imports in the early 1970s were to countries that comprised the EU12 countries (the 1990 membership), yet by the late 1990s this share had risen to over one-half. The share of total trade with the US has remained relatively stable over the same period at around 13 percent, while the share of other high-income countries fell from 31 percent in 1970 to 21 percent in 1997. Middle-income countries' share fell from 18 percent to 12 percent, and that of low-income countries fell from 7 percent to 3.5 percent.

source: NBER World Trade Database

2.3 Commodity composition of trade

The most rapidly growing elements of trade have been manufactures and services. From 1980-1998 real world trade in manufactures increased at an average 6.3 percent per annum, trade in services increased at 6.6 percent per annum and primary products (agricultural raw materials, food, ores and metals, fuel) at 2.8 percent per annum. The shares of these sectors in trade flows is given in Figure 5, both for the world as a whole and for UK exports and imports. Over 60 percent of world trade is now in manufactures, as it is for the UK's exports and imports. Services account for almost 21 percent of world trade, a similar proportion of UK imports and just over 28 percent of UK exports.

2.4 Qualitative changes

A comparison is often made with trade to income ratios pre-1913, a period of close international integration founded on the technologies of the railroad, steamship and telegraph and on open trade policy. For some countries, these ratios were higher then than they are today - for the UK, the ratio of trade to GDP in 1913 was 29.8 percent compared to 22 percent in 1995, and the ratio of merchandise trade to merchandise value-added was 76.3 percent compared to 78 percent in 1995. However, present day trade is different in several respects.

First, it involves higher levels of 'intra-industry' trade, rather than 'inter-industry' trade. Prior to 1913 the bulk of trade was inter-industry, as countries exchanged the products of one industry for those of another - and often manufactured goods for primary goods. For the last 50 years there has been a steady increase in intra-industry trade, as countries both import and export products from the same industry - for example, the exchange of one model of car for another model.

Second, over the last 20 years or so there has been rapid growth of trade in parts and components as firms increase their outsourcing and become involved in international production networks. Yeats (1998) estimates that 30 percent of world trade in manufactures is trade in components rather than final products. Hummels, Ishii and Yi (2001) measure trade flows that cross borders multiple times, such as when a country imports a component and then re-exports it embodied in a downstream product. They find that (for 10 OECD countries) the share of imported value-added in exports rose by a third between 1970 and 1990, reaching 21 percent of export value. Much of the growth of this vertically specialised trade is concentrated in a few countries neighbouring existing centres - in Asia, Europe and America.

source: World Bank World Development Indicators

3. Foreign direct investment

Accompanying trade growth has been even more rapid growth of foreign direct investment (FDI). Arguably, FDI is a more important mechanism of international interaction than is trade; the overseas production of affiliates of US firms is now three times larger than total US exports. Of course, trade and investment are inter-related; in the mid 1990s, 66 percent of total US exports were undertaken by multinational firms, and 45 percent of these exports went directly to affiliate companies

3.1 The growth of foreign direct investment

FDI has grown much faster than either trade or income; whereas worldwide nominal GDP increased at a rate of 5.3 percent per year between 1980 and 1999 and worldwide imports at 5.6 percent, worldwide nominal inflows of FDI increased at 16.1 percent. These figures comprise the financing of new investments, retained earnings of affiliates, and cross border mergers and acquisitions. Mergers and acquisitions are a large proportion of the whole (especially among the advanced countries), with their value constituting 49 percent of total FDI flows in 1996 and 58 percent in 1997 (UNCTAD, 1998).

The predominant sources of supply of FDI are high-income countries which, in 1999, controlled 86.5 percent of worldwide FDI stock, compared to 13.5 percent for the developing and transition countries. FDI flows are given in Figure 6, by source (top panel) and destination (lower panel). As can be seen in the top panel, recent FDI flows show some decline in the dominance of the high-income countries; whereas during the 1980s they accounted for almost 94 percent of total FDI outflows, this share had fallen to 88.7 percent in the 1990s. Within advanced countries, the major single investor is the US, which in 1999 controlled 23.9 percent of the world's FDI stock, compared to 47.9 percent for all the European Union 15, and less than 4 percent for Japan. Japanese and European flows boomed during the late 1980s, although they have now fallen back to a position broadly in line with existing stocks.

Most of the difference between the advanced and developing countries is accounted for by sheer economic size, and the difference in outflows relative to GDP is perhaps less than might be expected. Outward flows from the advanced countries averaged 1.8 percent of their GDP in the 1990s, with the EU having much the highest rate (almost 3 percent of GDP), largely on the basis of intra-EU investments. For developing countries, outward FDI flows averaged 0.6 percent of their GDP during the 1990s, compared to 0.1 percent in the preceding decade, a six-fold increase.  

sources: UNCTAD FDI/TNC Database, World Bank

Turning to the destination of FDI in the bottom panel of Figure 6, most FDI goes to the advanced industrial countries. Since 1980, the developed countries received fully 69 percent of FDI flows. Inevitably most of this is advanced-to-advanced country FDI. Of the G-7 countries, France, Germany, Italy and the UK sent more than three-quarters of their 1997 FDI flows to the rest of the OECD; Canada, Japan, and the US sent more than 60 percent. This pattern of reciprocal FDI shows up strongly at the industry level as well, with a large share of flows appearing as intra-industry investment.

While intra-OECD investment and intra-industry investment within the OECD have been long-established facts, an emerging trend is the rise of FDI to developing countries. The share of worldwide FDI received by the developing and transition economies jumped from 22.4 percent in the 1980s, to over 30 percent in the 1990s. The picture is more dramatic if we look at FDI relative to the size of the host country's economy, as shown in the bottom panel of Figure 6. During the 1980s, advanced countries received FDI inflows at an average annual rate of 0.9 percent of their GDP, while developing and transition countries received FDI at an average annual rate of less than 0.1 percent of their GDP. By the next decade, the inflow rate of developing and transition countries had risen six-fold to almost 0.6 percent of GDP, while that for the advanced countries had only doubled to 1.8 percent of GDP.

Among developing countries, the distribution of FDI is quite uneven. Only 12 countries accounted for two-thirds of all inward flows during the 1990s (Argentina, Bermuda, Brazil, Chile, China, Hong Kong, Indonesia, Malaysia, Mexico, Poland, Singapore, Thailand). China alone accounts for much of the increase in flows to developing countries, with its share of world total FDI flows rising from 1.6 percent during the 1980s to over 7 percent in the 1990s. In nominal dollar terms, inward direct investment to China increased from $57 million in 1980 to $40.3 billion in 1999. The source of all these flows, about four percent of China's GDP in 1999, remains hotly debated. The main sources are considered to be Chinese business groups resident in Asia, Chinese businesses resident in China that send their money out and then bring it back to get certain benefits available to foreign investors (the so-called 'round trippers'), and investors from the advanced industrial economies.

In contrast, all of sub-Saharan Africa, including South Africa, received an annual average of 3.6 percent of all flows to developing and transition countries in the 1990s, a decrease of almost 2.5 percentage points from the annual average of 6.1 percent during the previous decade. Relative to world inflows, sub-Saharan Africa's share fell less sharply from around 1.4 percent in the 1980s, to around 1.1 percent in the 1990s. This is also reflected in its inflows of FDI relative to host country income, as in Figure 6, where we see some increase in FDI to Africa, but at levels dwarfed by inflows to East Asia and Latin America.

3.2 What does FDI do?

An important distinction in the analysis of FDI is between 'horizontal' and 'vertical' investments. Horizontal occurs when FDI is essentially for the purposes of getting better market access. It takes the form of investments that duplicate facilities in the home country in order to sell to the host country, for example, plants in different countries assembling essentially the same car. Vertical occurs when firms split their production process, moving unskilled labour-intensive parts of the process to low wage countries, research-intensive parts to locations with large research communities, and so on.

Through most of the postwar period FDI was largely horizontal, almost all between high-income countries, although there was some 'tariff jumping' into low-income countries. Recent years, however, have seen rapid growth of vertical FDI, associated with production networks as discussed in section 2 above.

4 Conclusions.

This note has sketched some of the facts concerning the growth of trade and foreign direct investment during the current era of globalisation. Descriptions of continuing developments are reported annually in the World Bank's publication, Global Economic Prospects, and UNCTAD's World Investment Report.

22 November 2002


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