The World Economy (2007) doi: 10.1111/j.1467-9701.2007.00877.

TWEC Oxford, World 0378-5920 January O 1 30 GOVERNMENTS, CHRIS riginal 2007 Economy ALEXANDER Blackwell UK Article 2007 Publishers EXPORTS and KEN Ltd and WARWICK (aGROWTH Blackwell Publishing Company) Blackwell Publishing Ltd

Governments, Exports and Growth: Responding to the Challenges and Opportunities of Globalisation
Chris Alexander and Ken Warwick
Department of Trade and Industry

that We live discourage in an increasingly greater participation globalisedby world. rms Trade in international has consistently markets. grown It also faster considers than GDP whether and this has approach been an important needs to be driver adapted of world given growth. current What trends role in should globalisation, government concluding play inthat thisa process? continued This emphasis paper considers on openness the and rationale addressing for government market failures actionwill and be the welfare merits enhancing. of various policies focusing on the UKs experience: the benets of openness to trade and overseas investment and the merits of tackling barriers

1. INTRODUCTION

OR many centuries, governments around the world have encouraged exports in the belief that they contribute in some way to improved economic performance. From the crude mercantilist doctrine that exports were a good thing because they increased the ow of gold or silver bullion into the country, the rationale for government support for exports has evolved to include arguments based on scale economies, productivity spillovers, batting average effects, terms of trade gains, information failures and the role of government as a trusted intermediary with the ability to bridge gaps in private sector networks and provide access to knowledge and contacts through its network of embassies and consulates overseas. Moreover, there has been increasing recognition of the benets of openness, more widely dened, for growth, leading to policies based not just on facilitating exports, but on removing barriers to imports and encouraging inward and outward investment. The current approach of the UK is to pursue open markets and improved market access through the EU and WTO and, in order to overcome market failures, to provide (via UKTI, the UKs trade and investment promotion organisation) support for UK companies doing business internationally and overseas enterprises seeking to set up or expand in the UK. This paper considers the traditional arguments in favour of exporting and openness before moving on to analyse the implications of globalisation for governments and their commitment to openness. The next section presents some

The authors are writing in their personal capacity and the views expressed in the paper should not necessarily be taken as representing those of the DTI. The authors are grateful to colleagues and anonymous referees for helpful comments on the text.
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stylised facts about recent developments in international trade and investment. Section 3 then considers the case for government intervention in exporting, and Section 4 does the same for openness more widely dened. Section 5 considers some recent trends in globalisation and their implications and Section 6 offers conclusions for government policy in response to changes in the pattern of international trade and investment.

2. TRENDS IN INTERNATIONAL TRADE AND INVESTMENT SOME STYLISED FACTS

a. The Importance of International Trade and Investment Although it has become commonplace to be told that we live in an increasingly globalised world, the phenomenon is hardly new, as waves of globalisation can be traced back at least to the 1870s and even earlier.1 This is particularly true of the scale of exporting activity, which of course is only one of the many dimensions to globalisation. With the exception of the period between the two world wars, exports have consistently grown faster than GDP. From less than ve per cent of world GDP in 1870, merchandise exports had risen to the equivalent of one-fth of world GDP by 2003. Exporting has been an important channel through which some emerging economies have been able to boost their prosperity as rst Japan, then the Asian tigers and now China emerged as major international economies. b. The Changing Composition of World Trade in Goods and Services Whilst growing exports have been a fairly consistent story for over a century, in recent years we have seen some new developments. We have seen developing countries providing a growing share of world exports, a shift to more global sourcing as rms outsource and offshore more and a wider range of activities, an increase in intra-industry trade and an increasing amount of FDI into service sectors. Governments need to consider the implications of these changes and how they may want to respond. In 1990, developing countries accounted for around 27 per cent of world trade. By 2004 this had risen to 36 per cent. The main driving force behind this shift was originally the Asian tigers (Korea, Taiwan, Singapore, Hong Kong, Malaysia and Thailand) and is now increasingly China and to a lesser extent India. Chinas share of world exports of goods increased from 1.2 per cent in 1983 to 2.5 per cent in 1993, 4.0 per cent in 2000 and 6.5 per cent in 2004. It appears that much of Chinas recent growth in exports has been replacing exports from other Asian
1 Many different denitions of globalisation are used. In this paper it is taken to refer to the movement of goods, services, capital, people and information across national boundaries.

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countries, especially Japan whose share of world exports declined from 9.9 per cent in 1993 to 6.2 per cent in 2004. This is consistent with the hypothesis of more global sourcing with activity being shifted within Asia, as rms restructure their production chains with more labour-intensive activities relocated to cheaper labour locations. The rapid growth of Chinas exports has also been accompanied by rapid import growth, with around half of Chinas imports estimated to be used for processing and re-export (Anderson and Ho, 2004). Projections suggest these trends could continue and that China could become the worlds largest economy within the rst half of the twenty-rst century.2 Whilst all such estimates are dependent on their assumptions, such as convergence and the avoidance of economic or political crises, they demonstrate the potential for further shifts in the pattern of world trade and prosperity. This could be given a further boost by the completion of a successful WTO round given the DDAs development aims. Another important trend has been the increase in intra-industry trade, including within regional groupings such as the EU. Seventy per cent of intra-EU trade is now intra-industry trade (OECD, 2002). New trade theory suggests this can be driven by factors such as imperfect competition and scale economies and that such a structure may limit the scope for conventional specialisation.3 However, the gures can also be consistent with more intensive specialisation. Rather than having countries specialise in broad categories of products, there may instead be fragmentation of production into different sub-sectors with different price/quality/ technology levels in which countries specialise and then trade. Such specialisation may only be temporary. For example, in sectors with rapid changes in technology and limited benets from experience/learning, a competitive advantage can be quickly overturned. The net effect is that there continue to be benets from countries specialising and trading; but the pattern of specialisation may be complex and subject to change. Trade in services has grown steadily over the years. However, since increasing slightly in the late 1980s, services share of world trade has held relatively constant at just under one-fth, well below the share of commercial services in developed countries GDP. This reects a mix of factors from the continued presence of barriers to trade in services, arising for example from standards/ regulations, to the fact that not all services can be traded internationally in the same way as goods.4 Many services require a local presence to be delivered, one of the factors driving the increasing amount of overseas investment in services.

For example see Wilson and Purushotothaman (2003). See for example Krugman (1980). 4 Whilst standards can bring important benets e.g. through providing information for consumers, environmental protection and compatibility among related goods and services, they can also be used as a form of protectionism. See WTO (2005) for a more detailed discussion.
3

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Reecting this, services share of world FDI stock has risen steadily. In 1988 services accounted for 42 per cent of the stock of world outward investment, less than manufacturings 46 per cent. By the end of 2002 it is estimated that services share of the worlds stock of outward FDI had risen to 66 per cent (UNCTAD, 2004). Partly this reects liberalisation of restrictions on overseas ownership. But it also reects the increased internationalisation of some services notably business and nancial services due to improvements in IT and communications.

3. GOVERNMENTS, EXPORTS AND GROWTH

Historically governments have long been involved in setting and policing the framework for international trade and investment. They have also been active to varying degrees in facilitating or encouraging exports. The forms of assistance and objectives have evolved over time. For example, in the UK there has been a shift away from promoting exports to addressing the market failures that hinder rms participation in international markets. Drawing on UK experience, we consider the rationale for government action, the merits of various policies and whether they may need to change in response to developments in the pattern of trade. a. The Case for Intervention As a general rule markets should provide the most efcient method of allocating resources. Governments main role should therefore be to facilitate the effective functioning of markets by providing a stable macroeconomic framework, an effective framework of corporate governance and commercial law and, at a micro level, supply-side exibility. But markets can have their limits. The assumptions under which free markets lead to Pareto-optimal outcomes are not always met, in which case there can be a case for government intervention to address market failure. For government intervention to be benecial it needs to satisfy several criteria. First, there must be a problem that the government can address more effectively than other parties. Second, it must be clear that government intervention is effective, i.e. that the benets outweigh the costs.5 Whilst addressing such market failures is not the only justication for government intervention for example, another rationale might be to achieve distributional objectives it is the only justication that will be explored in this paper.

5 This in turn requires good and proportionate appraisal and evaluation techniques, as set out in The Green Book Appraisal and Evaluation in Central Government (HM Treasury, 2003).

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There are a number of market failures that can limit rms willingness to export or enter international markets.6 There may be externalities, when actions by a rm create benets or costs that cannot be contained within the rm. For example, there may be demonstration effects where a rms decision to enter overseas markets encourages other rms to follow suit. Imperfect or asymmetric information may lead to sub-optimal international activity by rms. Inexperienced exporters, in particular, may underestimate the uncertain benets of exporting and so when faced with the costs of entering export markets may decide not to take the risk. The public good nature of some information suggests the market might not provide it in sufcient quantities.7 A frequently heard argument is that government should intervene to create a level playing eld for its exporters. The economic case for this is far from clear-cut. Matching other countries subsidies or other forms of assistance is not necessarily welfare-enhancing. There is, however, the possibility that assistance to create a level playing eld might be benecial if it enables the entry of exporters into a market that would otherwise have remained closed. This may especially apply in activities where there are self-reinforcing agglomeration effects or substantial learning from doing, although such cases need to be analysed very carefully to ensure there is a genuine long-run barrier to entry. There are also a number of arguments stemming from the unique role of government. Only government, for example, is in a position to perform certain functions such as setting the rules of the system (structures, laws, etc.) to enable international markets to function effectively. Government agencies can also have better access to their ofcial counterparts abroad and so may be able to provide access to information that otherwise would not be available and to provide credibility to rms seeking partners in a transaction. An important role for government is that of trusted intermediary. If rms and individuals are heterogeneous and information is limited, markets may not be able to function efciently without such an intermediary. For example, consider an institutional model in which all transactions involve considerable uncertainty.8 Trust now becomes important, but how do rms know whether they can trust their counterparties? Various options exist. Insurance could be a solution, but it is expensive and not always available. Firms could rely on networks such as local institutions, e.g. chambers of commerce. Or they could use personal contacts or knowledge their immediate social network. Alternatively they may have a credible threat of retaliation such as potential damage to the counterparties

For a discussion of the market failures involving trade and investment see DTI (2004). In many cases, information has the characteristics of a public good. Once provided, it can be used by more than one consumer (non-rival) and others cannot be prevented from using it (non-excludable). 8 See for example Casson (2000).
7

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reputation or the possible loss of future contracts. In practice, rms are likely to use a combination of such measures. Whatever combination is adopted, networks are likely to be an important part of this process. Networks are regarded as providing an important mechanism for the transmission of knowledge.9 But networks are likely to be stronger near a rms home base. In geographically and culturally distant markets, rms may lack access to such networks or understanding of the networks that do exist. The private sector alone may not be willing to develop or support networks to redress this lack. Networks have some of the characteristics of public goods and so can suffer from free-rider effects. Firms may fear that private sector networks might reect the interests of incumbents and be used as a barrier to those outside the networks. Governments may also be advantageously positioned to run networks, given their wide range of possible contacts. These factors could provide a rationale for government intervention, especially when existing contacts are limited. Providing such an intermediation service is certainly one of the main roles currently undertaken by UKTI. This argument ts with recent analysis suggesting a positive association between having embassies/consulates in a country and the level of exports to that country (Rose, 2005). Embassies perform many other functions to help exporters such as providing information about markets and identifying sales opportunities. Although the growth of the Internet and communication channels means that basic information is now commonly accessible elsewhere, what these other channels struggle to deliver is help in interpreting and sifting information ows and providing a guide to the reliability or trustworthiness of the counterparties to a transaction. UKTI, through its ofces at British embassies and consulates abroad, can full this trusted intermediary role. b. Links between Exporting and Growth Addressing market failures that hinder participation in export markets is important, but are there any other reasons why we should be so concerned with exporting? Are exports intrinsically any more valuable than domestic sales and what are exports contribution to growth? The mercantilist belief that exports deserved special attention because of their contribution to a trade surplus that would add to the countrys stock of gold or silver bullion has long since been discredited. However, there are still likely to be benets to countries from being open to trade and exporting. First, there are static gains from trade. Some of these will come from specialisation. Assuming the usual Ricardian assumptions hold, total

See for example DTI (2003).

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welfare will be higher.10 Second, there can be additional benets from trade if rms can generate higher value added from exporting than selling to domestic customers. Third, there can be scale effects. Apart from possible efciency gains if there are economies of scale in production, the opportunity of selling into bigger markets increases the potential returns to investment and innovation. Finally, encouraging exporting may lead to an increase in the output of exporters. If we assume a world with heterogeneous rms and xed costs to enter international markets, only the stronger (i.e. more productive) rms can afford to engage in exporting and only the strongest in international investment, with its higher costs/risks than exporting (see, for example, Helpman et al., 2004). As exporters are likely to be more productive than non-exporters, then their expansion should have a positive batting average effect on the countrys GDP (see, for example, Bernard et al., 2004). This can occur even if such expansion is at the expense of other domestic rms, as a recent study of Swedish industry demonstrates (Falvey et al., 2004). In addition to these static benets, exporting may also generate dynamic benets. Exports provide one channel through which rms can learn. Overseas markets can provide exposure to new approaches and work practices. Exporting involves rms in more competition so should spur innovation. When rms learn from exporting it is possible that their knowledge might then be transmitted to other domestic rms if they can observe the changes that have occurred in the learning rm, or possibly through the requirements of supply/purchasing agreements, or through the movement of skilled staff. c. Evidence of the Benets of Exporting Many studies have found a positive association between an export-oriented trade policy and growth at the macroeconomic level. But there is a debate about whether there is a signicant causal relationship, partly because of the difculty of dening and measuring liberalisation and modelling its relation with growth. Much of this work and debate focuses on the potential for exporting to help developing countries grow faster. The evidence strongly suggests that exporting is only one element of a countrys development strategy and has to be properly integrated to achieve maximum impact. There is an increasing amount of analysis at a micro level of the impact of exporting on individual rms performance in developed countries. Exporters are generally more productive and tend to have higher wages than non-exporters. But, there is uncertainty about causality. Evidence suggests that the link is at least partly due to self-selection, i.e. that high-productivity rms are more likely to start
10

The possibility of the relaxation of these assumptions, e.g. international mobility of capital, is examined later.

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exporting. This is consistent with the view already discussed that exporting involves additional costs and hence that only more productive rms will nd it protable to engage in exporting (see, for example, Greenaway and Kneller, 2004a). Some research also suggests that rms may learn from exporting, i.e. that exporting causes higher productivity. The evidence on this is mixed. Greenaway and Kneller (2004c) found evidence in four out of 12 studies they examined. Since then Baldwin and Gu (2004) have found signs of post-entry performance improvement for rms in Canada and a further study by Greenaway and Kneller (2004b) of UK rms suggests that the benet may vary across rms. Specically, they found that learning was most likely in rms not already exposed to competition, especially international competition, in their domestic market. The scope for learning could also be affected by factors such as the characteristics of overseas and home markets rms that have a small domestic market potentially have more to learn from overseas markets than those from a large domestic market such as the US. A study for the UK by Girma, Greenaway and Kneller (2004) shows that the mean total factor productivity (TFP) for exporters is 3.7 per cent higher than the industry mean. But, it is not clear why. Research commissioned by UK Trade and Investment (2003) concluded that productivity growth for rms entering export markets was higher after market entry than for rms with comparable levels of productivity and characteristics who did not enter export markets. Using a matching analysis technique, it found that productivity growth is between two and four per cent faster in the year of entry than in the period before entry. It is possible that both self-selection and learning could apply and explain the stronger performance of exporters. To the extent that it has been assessed directly, the evidence on learning is mixed. Whilst one study suggests that learning effects are strongest amongst new exporters, another nds learning only signicant for established exporters.11 There is also evidence that learning effects may be correlated with the degree of rms exposure to export markets. This is an area where more research is needed before judgement can be made. d. Evidence of the Effectiveness of UK Government Policies Assuming that exporting brings benets, there is then the issue of the effectiveness of government policies in addressing the market failures that hinder rms participation in international markets. Direct causality is difcult to establish. There have been many evaluations, and their results were summarised in a recent UKTI review (2005). A recent study (DTI, 2006) has extended the methodology used previously to examine the effect of government encouragement of exporters and its impact on the UK economy through tracing the impact of UKTIs inputs in
11

Kraay (1997) and Greenaway and Yu (2004).

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changing rms behaviour and then linking these to changes in rms performance. The study covered both rms directly assisted and those that might be affected by spillovers and made allowance for non-additionality. Some care needs to be taken in interpreting the results as techniques for evaluation of the economic impact of such policies are still at an early stage of development. Costs are partly estimated and benets are derived from the views of respondents. Nevertheless, it provides a method by which the impact of government intervention can be tested. Many users reported signicant benets in terms of higher output, prots or greater access to ideas as a result of receiving UKTI support to venture into international markets. More than half of users reported they had increased their skills or changed their behaviour, for example, by improving their products or services as a result of exporting. Such changes, for example, tailoring products for new markets, could result in improvements for all customers, not just those in the new markets. Some of these changes occurred as a result of learning in the pre-export research/exploration phase, others as a result of their experience in overseas markets. Respondents also considered that accessing international markets increased their return on innovation, especially for SMEs for whom access to international markets may be necessary to earn an adequate return on their investment in R&D. There was limited reporting of spillovers, especially of direct impacts on customers or suppliers, although slightly more of knowledge sharing. However, this may reect the difculty in capturing such information. More research is needed in this area. Over 80 per cent of rms reported facing at least one signicant barrier to entry to international markets such as lack of contacts, xed costs of market entry, legal or regulatory barriers, language/cultural issues, home country bias in procurement or the difculty of gathering information. There was little reported difference between the barriers in accessing international markets experienced by heavier exporters compared to rms with a lower level of export intensity, although non-users of UKTI services unsurprisingly reported facing fewer barriers. Additionality was reported as very high with less than ten per cent of rms considering they could have obtained similar support elsewhere and even then many of the sources cited would involve links to UKTI. The evaluation concluded that there was a clear rationale for government intervention and found positive evidence of the benets from its support, although evidence gaps remain, especially in the identication of spillovers.

4. THE BENEFITS OF GENERAL OPENNESS

In the previous section, we focused mainly on exports. But many of the potential gains from exporting can also be realised by encouraging other aspects of
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openness, such as import liberalisation. Many of the arguments that apply to trade also hold for foreign direct investment (FDI), both inward and outward. Indeed, the potential for learning and positive externalities may be higher, at least for certain types of FDI, than from trade. Trade and foreign investment are sometimes seen as substitutes, in the sense of being alternative means of accessing overseas markets. Although investment involves higher costs and risks and greater commitment, foreign direct investment can be an alternative strategy to exporting for the most productive rms who are condent of being able to protect their competitive advantage. But trade and investment can also be complements, for example, when FDI is being used to build an efcient supply chain (i.e. vertical rather than horizontal or market access FDI). As we see more global sourcing, it would be understandable if a stronger positive correlation between FDI and exports were to emerge. It is not surprising that inward investors are often signicant exporters. a. Evidence of Benets of Import Liberalisation There is a substantial literature about the association at a macro level between openness to trade and growth (see DTI, 2004). At its most basic level, the case for import liberalisation rests on efciency gains generated through a reallocation of resources to more productive activities. However, specialisation, dynamic gains from learning and international competition may equally be generated by importing as well as by exporting. These dynamic gains may be quantitatively more signicant than the traditional static gains. There is broad agreement that, while openness is not a sufcient condition for growth, the balance of the evidence from individual country studies, computable general equilibrium modelling and cross-country regressions suggests it has a positive impact on growth, especially when supported by appropriate complementary policies. The various simulations of possible outcomes of the current WTO round suggest that there could be substantial gains from signicant trade liberalisation. b. Evidence of Benets of Foreign Direct Investment Inward investment can improve productivity in the host country through a number of different channels. First, because foreign rms often have high productivity relative to domestic rms (Helpman et al., 2004), their presence will, all else being equal, boost average productivity in the economy. Second, inward investors productivity advantages may spill over to domestic rms, raising their productivity. Positive spillovers can be generated through: the transfer of knowledge or skills, the impact of increased competition, the impact on the domestic supply chain and improved access to overseas markets.
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Empirical studies of the impact of inward investment conrm that foreignowned rms are typically more productive and pay higher wages than their domestic counterparts. The superior performance of foreign direct investors means they are likely to raise average UK economic performance, although estimation of their net impact needs to consider the displacement of domestic economic activity that they can cause in addition to the cost of attracting them. Many studies also report spillovers and productivity gains from inward investment to domestic rms but the evidence on the prevalence and strength of these effects is mixed. Gains are not universal and the probability that they will occur is dependent on many factors, reecting the diverse motives of inward investors, which can include seeking market access, exploiting a rm-specic advantage, maximising supply-chain efciency or acquiring technology skills from a local cluster (Drifeld and Love, 2002). Another important factor is variation in the absorptive capacity of local rms, arising, for example, from the extent of the technology gap between them and inward investors, sector characteristics and the origin of investment. There can also be different impacts on rms within the investors industry compared to rms within its supply chain, both suppliers and customers (see, for example, Girma, Grg and Pisu, 2004). A further source of difference lies in the methodologies used in different studies. In particular, it is possible that some cross-sectional studies may have had problems in distinguishing productivity spillovers as a result of inward investment from time-invariant differences in productivity across sectors if they happen to be correlated with foreign presence. On the other hand, some studies may have had problems distinguishing competition effects and displacement from genuine technological spillovers. The varied results of empirical studies are shown in a review of the literature by Grg and Greenaway (2004). Taking the whole world, studies are roughly split between those that nd a positive impact on productivity and wages from inward investors and those that nd no signicant impact. In those studies that nd a positive impact this generally falls once the studies control for other sources of differences, e.g. rm size, sector, capital intensity, etc. Over half the studies of developing and developed countries report signicantly positive productivity spillovers, but the studies of transitional economies found few signs of positive benets. Whilst externalities can potentially exist in all sectors, UK evidence is stronger for manufacturing. Although there is less research on services, Grifth et al. (2004) found that foreign multinationals are more productive than UK multinationals, but the gap is smaller in services than in manufacturing. Hubert and Pain (2001) suggest there is evidence of technical diffusion for commercial services, but at a lower level than for manufacturing. An inward investors country of origin may make a difference. Several studies have found that US multinational enterprises (MNEs) typically emerge with
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signicantly higher productivity than other multinationals (although the advantage may have declined over time).12 These differences persist even after factors such as rm size and sector are controlled for. There could be a variety of reasons for this. For example, US MNEs may possess greater rm-specic advantages superior technology, management, brands, etc. They may structure their overseas subsidiaries in a different fashion, for example if they subcontract more work they are likely to have higher labour productivity; or there may even be some sort of global scale effects if they benet from being part of larger MNEs. Or it may simply be that US rms may have acquired higher productivity UK businesses (Haskel et al., 2002). An important factor is likely to be the absorptive capacity of local rms. There is a developing empirical literature considering the role of absorptive capacity. In the UK where the absorptive capacity (based on technology of rms relative to industry leader) of manufacturing rms lies within a given range, inward investment boosts the productivity growth of domestic rms (Girma, 2002). Outside a given range of absorptive capacity, inward investment-induced productivity begins to decline. Other studies, which nd that positive spillovers only accrue to exporters and to R&D-intensive rms, conrm that absorptive capacity is important.13 Indeed the importance of absorptive capacity might be one of the most robust ndings of the literature (Saggi, 2000).

5. IMPACT OF RECENT TRENDS IN INTERNATIONAL TRADE AND INVESTMENT

The developments in the pattern of trade and FDI discussed earlier may lead to signicant changes in the structure of world production. Governments need to consider the likely size, nature and impact of the changes brought about by globalisation when formulating their responses to these trends. a. Does the Traditional Model Still Apply? One issue that needs to be considered is what happens if the assumptions of xed terms of trade and limited capital mobility underlying the Ricardian model no longer hold. One concern is that improvements in the communication of technical progress could enable developing countries to increase their productivity in products in which developed countries specialise sufciently rapidly to drive down the international price of such products. In this case the deterioration in developed countries terms of trade could be sufcient to offset their gains from specialisation (Samuelson, 2004).
12 13

For example see Oulton (2001) and Martin and Crisculo (2003). See Barrios and Strobl (2002) and Kinoshita (2001).
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However, whilst possible, this outcome seems unlikely. Although the price of some technological products has fallen sharply in recent years this has tended to be conned to specic products that have been easy to commoditise. Specialised products and, in particular, specialised services have shown few signs of such price deation. Bhagwati et al. (2004) discount the possibility of signicant terms of trade changes following productivity changes and skill accumulation abroad. What of the assumption of limited capital mobility? There is no doubt that we are in an era of signicant international capital ows. The world stock of overseas investment (FDI) reached the equivalent of 23 per cent of world GDP in 2003 compared to less than six per cent in 1980 (UNCTAD, 2004). If capital can ow freely, if other factors of production land and labour are available in sufcient quantities, if transport costs are limited and there are no signicant barriers to trade, then there is a risk that production would move to the cheapest possible locations. There should be a limit to this process as wages and other factor prices adjust, but the adjustment could be difcult (for example, if nominal wages in developed countries are sticky). But, again, extreme shifts seem unlikely in practice. There are many factors that inuence rms location decisions, beyond the availability of capital. As knowledge becomes increasingly important, the need to protect IPR or to draw upon local skills can be vital. Agglomeration benets or culture can keep rms tied to traditional locations, as can the need to be near customers. Other factors could include tax policies or a desire to diversify risks by spreading production. Whilst capital is certainly more mobile than it used to be, there are still restrictions in place on overseas investors, especially in many developing countries. Between them they host only 28 per cent of the worlds stock of overseas direct investment, with 11 per cent of this in one country, China (including Hong Kong). So it seems likely that comparative advantage will remain the driving force behind the pattern of international trade and that the benets of specialisation will mean that exporting, trade and foreign investment will continue to contribute to growth. b. The Pace of Change in Manufacturing However, the rapid pace of technical change and innovation, improved communication, reduced transport costs and the reduced barriers between markets means that the pattern of specialisation is likely to change and change more rapidly than in the past. Changes will not be conned to developed countries; there can also be rapid shifts between developing countries and within developing countries. For example, there has already been a signicant shift of IT production and mobile phone rst to Asia and now within Asia. The pace of change can be seen in the changing structure of Chinas exports. In 1993, these were dominated
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by textiles and clothing. But, within ten years machinery and equipment, especially ICT equipment and parts, had become the largest element in Chinese exports. There is likely to be a continuing fragmentation of the manufacturing production chain, with labour-intensive activities increasingly shifted to countries with lower wages. This may involve frequent shifts of production, with activities being moved to the next low-wage economy as costs rise, as seems to have happened with ICT assembly. Such changes will always be uncomfortable for those directly affected. Countries and individuals will therefore need to be exible to adjust to the changes, to minimise the transition costs and to be prepared to move into higher value-added activities. This will be a challenge not only for developed countries but also for developing countries. There are other uncertainties beyond the pace of change of specialisation. One is that there may be changes in the type of activities that are globally sourced. Historically these have often been lower value added, labour-intensive activities. But, China and India have the physical and human capital to supply higher value-added products and there are plenty of rms eager to make such a transition. Whether and how rapidly such a shift might occur will be a function of many factors such as the labour supply, relative factor prices, relative productivity and the ease of transferring knowledge. In the short term, at least, there would appear to be a large pool of underemployed, low-skilled labour in developing countries. So the conditions are likely to remain in place for them to continue to specialise principally in labour-intensive activities. c. The Increasing Tradability of Services Another potential shift could be to greater global sourcing of services. Historically trade has been dominated by goods, despite the fact that services account for a greater share of national income. Improvements in telecommunications and IT means that more activities, especially services, can now be carried out remotely. Whilst many services will still need to be carried out face-to-face, relaxation in restrictions on investing in services would enable more international delivery (via FDI) of even these services. There is evidence of this occurring. As argued earlier, it is one of the factors driving the rapid growth in services FDI, especially in business services. There has also been dramatic growth in exports from India and other countries of the type of service most likely to be associated with global sourcing, though often from a low base. Some jobs have been relocated overseas. There has been considerable interest expressed by rms in the possibility of outsourcing services, not just in areas such as back-ofce services and call centres, but also in activities such as R&D and other higher value-added service functions. However, studies suggest that so far the impact has been limited (see, for example, Amiti and Wei, 2004). There are certainly many reasons why companies
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might decide not to outsource services such as the impact of regulation, e.g. data protection, issues of quality control and effective management. Such uncertainties and costs are why studies of outward investment suggest that rms need to identify signicant cost savings (3040 per cent plus) before it becomes an attractive option. Of course, such data are backward looking. Past experience may not necessarily be a good guide to the future, if we are at a point where behaviour shifts. It is possible that services could repeat manufacturings experience of outsourcing, with eventually signicant shifts in the distribution of employment and potentially in wage differentials if a shift in low value-added activities to low-cost locations leads to a rise in the skill premia in developed countries. Unfortunately it will remain difcult to determine whether such a shift is occurring because of the problems of distinguishing the impact of global sourcing from other factors driving the behaviour of wages and employment.

6. CONCLUSIONS AND IMPLICATIONS FOR GOVERNMENT POLICY

The current world trade and investment system is imperfect. Barriers still exist to trade and foreign direct investment and government policy needs to be framed in the context of externalities, information asymmetries, network problems and other market failures that affect decisions made by those involved in international trade and investment. Policy needs to be rmly based on evidence. However, whilst there has been a welcome expansion in the evidence base on trade in recent years, especially with more theoretical and rm-level empirical work, evidence is still incomplete and often disputed. Even when associations such as that between trade and growth are long established, causation can be contested. Facing such uncertainty, policy needs to be as robust as possible, not just reecting the balance of current evidence but also exible enough to adjust if the existing interpretation turns out to be wrong. So what should governments try to do? For many decades policy in the UK and many other countries has been characterised by: A commitment to openness. Openness is not sufcient for growth. But there are few if any examples of strong closed economies, whilst there are some prominent examples of economies that have combined openness with rapid growth. Within such a general commitment, the focus may vary, but in general multilateral liberalisation is superior to regional or bilateral. This has been supported by economic evidence. Awareness of the costs of protectionism was a signicant inuence behind the formation and expansion of the GATT/ WTO and driver of multiple rounds of trade liberalisation. The benets identied in the
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trade and growth literature helped build a consensus in favour of liberalisation. However, it was also recognised that trade liberalisation on its own was not sufcient for prosperity and was not costless. There was a need for appropriate supporting frameworks and exibility to help economies adjust to the changes brought about by liberalisation. A framework that addresses market failures that hinder greater participation by rms in international markets. Removing barriers to participation in international markets and correcting market failures can generate efciency gains from increased specialisation and higher value-added activities. It may also generate dynamic gains through increasing rms exposure to foreign markets and competition. Benets can arise from all forms of engagement in international markets from outward as well as inward investment and from imports as well as exports. The gains from trade predicted in classical models have long underpinned the UKs policy of tackling barriers to rms participation in international markets. The development of rm-level models explaining rms behaviour reinforced this stance by suggesting that internationalisation could also generate additional dynamic benets for the UK economy. Recognition of the importance of networks and governments role in facilitating networks has also been a factor in the renement of UKTI services to concentrate on knowledge transfer and partnership. The focus is on helping rms develop their skills and capabilities to tackle such market failures, rather than on simply promoting exports. As regards FDI, early studies suggesting substantial wider benets from inward FDI helped underpin support for promoting inward investment. As more recent, rm-focused, studies with their more nuanced results have emerged, there has been a renement in UKTIs approach, with an increasing focus on seeking high-quality foreign investment. Given the uncertainties in the empirical evidence, systematic evaluation of the effectiveness of government policies is especially important. The recent UKTI evaluation of the relative benets of support for trade and inward investment has conrmed the general benets of recent policies, though further research is required. Against this background, how should governments respond to potentially signicant but uncertain shifts in the pattern of international trade and investment discussed in the previous section? A continued emphasis on openness and addressing the market failures that limit participation by rms in international markets are likely to continue to generate higher welfare. Programmes to encourage such participation need to evolve to reect changing needs and circumstances for example, to cover both trade and investment, to pay due attention to the importance of networks and to develop the skills and capabilities rms need to compete internationally. Indeed the more open international markets become, the greater may be the benets from engagement. As patterns of specialisation change and the worlds wealth
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increases, competitive rms can benet from the opportunities generated by these shifts. Indeed they may even be able to utilise global sourcing to develop new products and services that were previously uneconomic. However, the possibility of substantial changes in the distribution of activities means that close attention also needs to be paid to adjustment. A full treatment of the adjustment issues would require a separate paper, but there is an important role for government in facilitating adjustment, for example, through encouraging greater exibility in the economy. This involves addressing supply-side issues, building up individuals skills and capabilities and encouraging innovation to enable rms to remain competitive and to be able to exploit new opportunities that arise. In this respect, globalisation is just one of several important trends such as technological development, changing demographics, increased pressure on the environment and resources that will drive long-run trends in the global economy and require exibility in the UK economy in order to facilitate adjustment (HM Treasury, 2004). We live in an increasingly globalised world, with signicant changes occurring in the pattern and composition of exports and investment. Such changes are likely to be benecial for the world economy as a whole and governments should not try to discourage or prevent these developments. There needs to be an awareness of the need to assist transition and in particular to promote exibility and help those affected to adjust. But, this should be set in the context of a commitment to openness and the removal of barriers to rms to participate in international markets.
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