WORLD TRADE
ORGANIZATIONWT/WGTDF/W/13
30 September 2002
(02-5214)
Working Group on Trade, Debt
and FinanceOriginal:  English
COMMUNICATION FROM THE IMF
The following communication, dated 27 September 2002, has been received from the
International Monetary Fund.
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WORLD ECONOMIC OUTLOOK—SEPTEMBER 2002
ESSAYS ON TRADE AND FINANCE AND
TRADE AND FINANCIAL INTEGRATION SUMMARY
Chapters II and III Executive Summary
I. WORLD ECONOMIC OUTLOOK—SEPTEMBER 2002: CHAPTER II
A. HOW WORRISOME ARE EXTERNAL IMBALANCES ?1
1. With the U.S. current account deficit remain ing in the range of 4 percent of GDP—an
historical record—there is continuing concern that the dollar may be overvalued. As one country’sdeficit is another country’s surplus, it is best to look at the issue of potential currency and current
account misalignments from a broader multilateral perspective. New perspectives from this approach
include focusing on: movements in relative saving and investment across industrial country regions,
rather than trends in the United States alone; whether growth can be maintained through a smooth
rotation of demand from countries with deficits to those with surpluses; looking at the consequencesof exchange rate developments for global wealth holdings, and the implications of current account
surpluses and deficits across industrial countries for the developing world. Relative to the size of trade
flows, the present nexus of current account imbalances in surplus countries in continental Europe and
Asia (dominated by the euro area and Japan, respectively), and deficit countries (dominated by the
United States) has risen to levels almost never seen in industrial countries in the post-war era. Thefirst essay in Chapter II assesses the risks that these imbalances will unwind quickly, resulting in
larger, and potentially disruptive, short-term exchan ge rate movements than if the imbalances unwind
slowly.
2. The essay asks the following questions:
                                                     
1 By Tamim Bayoumi (Division Chief), and Marco Terrones (Senior Economist), World Economic
Studies Division, IMF Research Department.WT/WGTDF/W/13
Page 2
• Why should policymakers be concerned about these external imbalances if they reflect private
sector decisions? Current accounts matter for a number of reasons.  First, despite all the talk aboutglobalization, the levels of integration between countries remain moderate, thus relatively small
external adjustment is likely to be accompanied by significant changes in the tradable good sector.
Second, rapid changes in the exchange rate are li kely to lead to disruptive changes in the
macroeconomy, through its effects on wealth, in vestment, corporate profits and assets prices.
Third, the fact that capital flows reflect private sector decisions does not guarantee that they are
efficient. To take a recent example, the fina ncial excesses associated with the information
technology (IT) revolution has clearly led to many costly mis-allocations of resources.
• Why have the imbalances expanded over recent years?  The essay concludes that the expansion in
the imbalances in the deficit countries reflected faster growth combined with financial excessesinvolving buoyant expectations about future economic prospects associated with the IT
revolution. Buoyant profit expectations in the de ficit countries drew la rge capital inflows that
allowed the real exchange rate to appreciate, thus facilitating the growth of current account
deficits.
• Are the current nexus of deficits and surpluses viable over the medium term?  Existing external
imbalances are unlikely to be viable over the medium term and a rapid adjustment of these
imbalances cannot be ruled out. First, current account forecasts of the WEO imply that net foreignasset positions of the United States and Japan, both as a ratio to GDP, will continue to diverge,
even though the existing differences in net asset positions are difficult to explain with economic
fundamentals. Second, the adjustments needed to stabilize net foreign asset positions as a ratio to
GDP are large, over 3½ percent of GDP in Japan, the United States, and the United Kingdom.
Third, historical experience with large imbalances suggests that the reduction in external currentaccount imbalances over the next few years is likely.
• Will the eventual rotation in real demand growth away from these countries to continental Europe
and east Asia occur in a smooth manner or not?  In the late 1980s, the deceleration in real
domestic demand in the deficit countries was cushioned by buoyant demand in the euro area and
Japan (largely reflecting German unification and an asset price bubble, respectively), whichproved unsustainable, and led to recessions in the euro area and Japan in 1992–93, as well as
problems that linger to this day. Given existing structural impediments in the euro area and east
Asia, it appears unlikely that these regions are currently in a position to significantly offset a rapid
deceleration in demand elsewhere. The implication is that, in current circumstances, a rapid
reduction in imbalances would most likely lead to a slowing of global output.
3. The policy implications are the following:
• Given the unpredictability of exchange rate movements over the short term, macroeconomic
policies should not be directed to a specific current account balance. Nevertheless, it is essential
to anticipate the potential risks and costs that may be associated with sudden current account
reversals and disruptive exchange rate movements. To be prudent, policy makers should orienttheir medium-term objectives with a view to minimizing the risk of less benign current account
adjustments, particularly if this achieves other desirable medium-term objectives.
• In the deficit countries, this analysis reinfor ces the argument for credible plans for medium-term
fiscal consolidation, as a tighter fiscal policy appears to diminish the likelihood of a rapid
adjustment of large current account deficits.  At the same time, consideration could be given to
other structural issues, including reforms of accounting rules and enforcement procedure aimed at
maintaining investor confidence, where recent re forms in the United States (which houses theWT/WGTDF/W/13
Page 3
world’s largest and most dominant equity markets) provide a good start, as well as other policies
to encourage private saving in a non-distortionary manner.
• In the surplus countries, the main policy imperative is to press ahead rapidly with needed
structural reforms to make economies more flex ible, boost potential growth, and support demand.
In continental Europe, the main priorities are reducing labour markets’ rigidities and increasingcompetition in product markets, and in east Asia pushing ahead with banking and corporate
reforms. By creating a more dynamic environment,  such reforms would increase the likelihood of
a smooth rotation of demand from the deficit countries to the surplus countries.
B. H
OW DO INDUSTRIAL COUNTRY AGRICULTURAL POLICIES AFFECT DEVELOPING
COUNTRIES ?2
4. Recent interest in assisting development and liberalizing agricultural trade under the auspices
of the Doha trade round have put industrial-country farm support under intense scrutiny because of
the impact on farmers in poor countries. Such support by rich countries encourages excess production
by their farmers, lowers world food prices, and hurts other farmers and their own consumers.
Notwithstanding these problems and declarations in favor of reform, recent policy decisions have sent
a mixed message on the possibility for agricultural reform under the Doha trade round. In the UnitedStates, while the granting of “fast track” negotiating authority to the administration has been a boost
for the trade round, the 2002 Farm Bill undoes much of the progress made on agricultural trade
liberalization in recent years. Also, the United States and the European Union (EU) have made
reductions in their agricultural support conditional on similar reductions in other countries.
5. Against this background, the second essay in Chapter II finds:
• Support provided to the agricultural sector in industrial countries is extremely high compared to
output.  In 2001, industrial country governments and consumers provided farmers with over $300
billion in explicit and implicit support, amounting to over 30 percent of farmers’ income and 1.3
percent of GDP. Generally, support is highest in net food importers, such as Japan, Korea, and
Switzerland, and lowest in food exporters, es pecially Australia and New Zealand. The United
States and the EU fall between these extremes. Over the last 15 years, the situation has improvedmodestly, with support falling somewhat and the form of support becoming less distorting,
notably in the EU.
• Removal of agricultural support in industrial countries would produce significant welfare gains
for the world.  The world would gain at least $100 billion a year, with most of these gains accruing
to industrial countries—illustrating the well-k nown result that most of the gains from trade
liberalization accrue to the liberalizers themselves. Developing countries as a group also gain, in
an amount equal to 1/6 of aid flows. The gains are particularly large for food exporting regions
such as sub-Saharan Africa (where many of the world’s poorest live) and Latin America. Only
one region, the Middle East and North Africa, loses mildly as it is a heavy importer of food.
• These calculations are conservative, in that they only consider the easily quantifiable gains from
liberalization.  So-called dynamic gains through faster productivity growth, greater investment in
agricultural sectors, and a decrease in price variability could result in gains that are 2 or 3 times
greater.
                                                     
2 By Stephen Tokarick (Senior Economist), World Economic Studies Division, IMF Research
Department.WT/WGTDF/W/13
Page 4
• Removing agricultural protection by developing countries provides even larger benefits to the
developing world.  This underlines the importance of removing support in a multilateral manner.
Indeed, if agricultural support were removed in all countries simultaneously, welfare would
increase in all regions of the world.
• In sub-Saharan Africa, the benefits from liberalization by industrial countries are estimated to be
somewhat greater than those from liberalization by all developing countries.  This reflects
relatively low support levels for agriculture in the region and the terms of trade deterioration
implied by the liberalization in all developing countries. That said, sub-Saharan Africa could reap
considerable further benefits by reducing its very high levels of protection outside of agriculture.
In addition, sub-Saharan Africa could magnify the gains from all forms of domestic liberalization
significantly by improving governance and reducing rent seeking.
• Looking at individual commodities, some poor countries in Africa and in the CIS group would
benefit from liberalization of cotton. Liberalization of beef would benefit some rich as well as
poor countries, including some in Latin America.  Liberalization of grains (corn and wheat) would
hurt poor net grain importers.
• Countries that are significant net importers of food, including some poor countries, may be
harmed by the increase in world food prices following liberalization. This concern arose in the
context of the Uruguay Round and special provision was made for these countries through greateraid and perhaps, financial assistance from the IMF.
6. The policy implications are the following:
• Given their wealth and the small size of their agricultural sectors, industrial countries are clearly
best placed to take the lead in agricultural trade liberalization.  There are substantial gains to be
realized from industrial country agricultural trade liberalization both for themselves and the restof the world. Elimination of such support, of course, will involve difficult political decisions, and
probably some transitional compensation to the losers.
• Reforms are best achieved in a multilateral setting, although if this is not achievable, unilateral
liberalization can provide significant benefits. Global gains are at least $128 billion a year, with
dynamic gains possibly several times larger, and all regions of the world benefit. In addition,
multilateral agreements with well-defined rules may be the best way of neutralizing political
economy constraints to reform.
• A few poor countries that are heavily dependent on imported food may lose from the increase in
world food prices as a result of liberalization.  The value of these losses is small in absolute terms,
as these countries are often small, as well as poor, and these losses are dwarfed by the benefits to
the finances of industrial countries. As was recognized in the Uruguay Round, considerationshould be given to providing assistance to these countries, possibly through building on initiatives
to increase and better target aid taken at the recent summit in Monterrey.
C. C
ORPORATE FINANCIAL STRUCTURE ACROSS EMERGING MARKETS3
7. The Asia crisis in 1997 and successive crises in Latin America have underlined the role of
healthy corporate and bank balance sheets in maintaining financial stability. The Asia crisis, in
particular, led to difficult but necessary reforms of the corporate and financial systems in that region
of the world. More recently, difficulties in obtaining corporate finance has exacerbated the difficult
                                                     
3 By Luis Catão and Hali Edison (Senior Economists), World Economic Studies Division, IMF
Research Department.WT/WGTDF/W/13
Page 5
situation in Brazil. The third essay in Chapter II looks at two main issues: What determines the level
of corporate health across emerging markets? Are there significant differences in balance sheet
indicators between east Asia, Latin America and emerging Europe?
8. The essay finds the following:
• Corporations in east Asian emerging markets ha ve a significantly higher leverage than their
Latin American and emerging European counterparts.  These level differences continue to be
significant, even though there has been some narrowing of the gap over time, including some
decline in corporate leverage in some east Asian countries since the 1997/98 crisis.
• East Asia has also been considerably more reliant on short-term debt – a reliance that has been
remarkably stable over the past ten years and not significantly reduced since the 1997/98 crisis.
• By contrast with these differences, valuation indicators show a similar declining trend across
emerging markets from the mid-1990s.  This seems to reflect both cyclical developments and some
“flight to quality” in the wake of the various emerging market crises of recent years. The good
news about the decline in stock valuations in emerging markets is that many of these firms now
appear to be less vulnerable to sharp stock market corrections.
9. The following factors explain these trends:
• Financial development plays an important but complex role.  Leverage tends to be lower in
countries with lower levels of domestic financial development. This is because firms have a
harder time in borrowing and thus have to finance themselves mostly through accumulated
earnings. But as countries become financially more developed, leverage rises significantly (as is
the experience of many Asian countries), before declining again at higher levels of financial
development. In other words, the relationship between leverage and financial development seems
to follow an inverted U-shape.
• Economies that are more open tend to have lower leverage and lower short-term debt. This is
because firms in more open economies can more easily attract foreign equity investors and
borrow from international capital markets at longer maturities.
• Legal system and factors associated with investors’ protection matter.  Our findings confirm
previous researchers’ results that, in countries where investors’ protection is low, leverage is
higher, and so is reliance on short-term debt.
• The macroeconomic environment also matters. We also conjecture that the more volatile
macroeconomic environment in Latin America increases the riskiness of leverage and short-termdebt, so that Latin American firms tend to shy away from them, whereas Asian firms, which tend
to operate in a more stable macroeconomic environment, may be more sympathetic to short-termdebt.
10. The two main policy implications are the following:
• Countries in the transition from low to higher levels of financial development (such as many
emerging markets) should be particularly attentive to the consequences of higher leverage and
tighten financial supervision and prudential requirements accordingly.WT/WGTDF/W/13
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• Openness helps, although regulatory care must be taken to avoid that extensive international
borrowing results in large currency mismatches, increasing corporate vulnerability to sharpexchange rate movements.
II. WORLD ECONOMIC OUTLOOK—SEPTEMBER 2002: CHAPTER III
A. T
RADE AND FINANCIAL INTEGRATION4
11. The current wave of globalization has been characterized by rapid increases in trade and in
financial links. The historical experience suggests that  this pattern is typical, with trade integration
and financial integration moving together over time and across countries. At a time when the costs
and benefits of globalization are the subject of fierce debate, Chapter III of the current World
Economic Outlook examines the links between liberalization of trade and finance.
12. The chapter comes to the following conclusions:
• Integration in both trade and finance is necessary to reap the full benefits of globalization.
Empirical evidence in the chapter indicates that countries with balanced patterns of integration—
countries that are open to both trade and finance—have smaller risks of external financial crises
and lower macroeconomic volatility compared with  countries that are less integrated in both
spheres. Countries that are open to trade but not finance still face significant macroeconomic
volatility, as capital flows are unable to dampen shocks. Similarly, countries that are open to
international finance but are closed to trade remain subject to significant risk of financial crisis, astrade may not generate sufficient foreign exchange to counter volatile capital flows. In short, the
sum of trade and financial integration is greater than the parts.
• The need for balanced integration is especially relevant for the current period of globalization,
which has been driven by eliminating policy-related barriers to trade and financial integration.
The sequencing of policy reforms are clearly of more importance when they are drivingintegration. By contrast, in the last major episode of globalization from 1870–1914, international
economic integration was driven primarily by technological advances in transportation and
communication technology.
• Recent experience clearly illustrates the risk of imbalanced integration, especially for the case of
financial integration leaping ahead of trade integration.  Many countries in Latin America fit the
latter category, which explains in part the increased frequency of financial crises or financial
market turmoil more generally in this region. Latin America also illustrates the perils of high
levels of external debt, which tend to reduce the benefits of financial openness.
• The recent experience with uneven integration dynamics in Latin America begs the question of
why some countries are more integrated into the world trade system than others are.  In a detailed
empirical analysis, the chapter looks at the role of geography (i.e. closeness to trading partners),
development (richer countries tend to trade more with each other as they have more diverse
demands), and policies in determining levels of trade. The results indicate that both geography
and development are important determinants of levels of trade. In addition, however, artificial
barriers to trade remain a serious impediment to trade in most developing regions, especially inLatin America, the Middle East and North Africa, and South Asia.
                                                     
4 By James Morsink (Deputy Division Chief), Thomas Helbling (Senior Economist), and Silvia Sgherri
(Economist), World Economic Studies Division, IMF Research Department.WT/WGTDF/W/13
Page 7
• Eliminating artificial barriers would increase world trade flows substantially. According to some
illustrative calculations, the removal of all remaining trade barriers in all countries would increaseNorth-North trade by about 30 percent, North-S outh trade by about 40 percent, and South-South
trade by about 50 percent. In addition, full liberalization of capital account transactions could
increase North-North trade by about 7 percent, North-South trade by about 15 percent, and South-
South trade by about 30 percent.
13. The policy implications are:
• The full benefits of globalization come from liberalizing both trade and finance. With the launch
of the Doha round last November, and the recent approval of “fast-track authority” in the UnitedStates, trade liberalization is rightly once again a central focus of international economic policy.
Nevertheless, focusing only on trade liberalization would be short-sighted. Indeed, trade and
financial integration tend to reinforce each other, as trade needs additional finance, while finance
is enhanced by trade links. As in so many other areas of economic policy, a comprehensiveapproach to opening up to the rest of the world produces the best results.
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