Trade, Finance, and Development: Getting the Institutions Right

16 February 2017

What should policymakers do to improve the enabling environment for trade and finance to better contribute to sustainable development?

The primacy of economic institutions as determinants of economic growth and development is a key empirical regularity that has emerged from the past two decades of research. The mechanisms through which trade and finance affect development do not escape this pattern. A country’s institutional environment – where institutions are understood in their economic (and not political) sense in terms of social and regulatory structures, such as the rule of law or the protection of property rights – is thus central for economic activity to develop and flourish.

Broad agreement was reached among the members of the E15 Expert Group on Trade, Finance and Development, convened by ICTSD and the World Economic Forum in partnership with the Center for International Development at Harvard University, that strengthening the enabling environment through concrete policy proposals in the trade and finance arena is one of the most important ways of advancing the 2030 Agenda for Sustainable Development. Members of the group were also aware of the fact that, to be politically acceptable, its proposals would have to pass the “market failure test.” Namely, any meaningful policy recommendation would have to be justified on the basis of the underlying problem not being adequately dealt with by the private market system.

Correcting market and institutional failures thus constitutes the crux of the Expert Group’s policy options, which are primarily directed at low-income economies. Policy-makers and developing country governments dealing with trade and finance must concentrate on “getting the institutions right.”

Conceptual framework

One of the leading explanations for poverty in the world today is that it is partly a product of departures from Pareto-optimality. When markets, firms, and households are subject to market, institutional, and informational imperfections, Pareto-inferior equilibria occur, leading to deviations with respect to the first-best optimum. This manner of seeing the world holds that inefficiencies lie at the heart of underdevelopment. If one takes this view as the point of departure, the big questions for the realm of trade, finance, and development are the following: what are the main sources of deviations with respect to the first-best optimum, and what can be done to tackle these deviations in concrete policy terms? All of the policy options put forward by the expert group lie squarely within at least one of the canonical types of market, institutional, or informational failure:

  • Externalities, particularly network externalities, including international standards and other problems of coordination failure;
  • Public goods and common property resources, which includes the regulatory and enabling environments, as well as other sundry institutions;
  • Natural monopolies, in which problems are more efficiently solved at the regional rather than at the national level;
  • Asymmetric information, which can be on the side of the country (lack of capacity) or on the side of the firm (unreliable information available to foreign investors).

A benefit of using the market failure framework is that all of the policy options that emerged from the expert dialogue process correspond to problems that will not be solved by the market mechanism. The options, grouped under the four market failure headings, aim at improving economic institutions—national and supranational—in some shape or form.

Externalities and coordination failure

Externalities arise when the private cost or benefit of an activity is not equal to its social cost or benefit. Four policy options fall under this category.

Strategic use of ODA and blended finance

The analysis of trends in financial flows to least developed countries (LDCs) reveals that official development assistance (ODA) has played a relatively marginal role, in comparison to domestic public and private finance, in underwriting the Millennium Development Goals (this policy option refers explicitly to LDCs). However, ODA enjoys a number of unique developmental advantages over other forms of financial flows, with concessionality being one of the most important. Strategic use of this scarce resource will be one of the main challenges for LDCs as they position themselves to implement the Sustainable Development Goals in their domestic context. There is a need to focus ODA in a manner that increases its marginal productivity, often through a focus on building institutions that strengthen the enabling environment, as well as by using it to leverage private sources of capital through blended finance. There is also the potential for improving the productivity of domestic financial resources. In basic economic terms, the social benefit of ODA is significantly higher than its private benefit, and current arrangements fail to “internalise” this potentially valuable positive externality, including ODA’s role in helping to ensure a stable macroeconomic environment.

Mobilisation of domestic resources through tax revenue

Tax policy is a key determinant of the behaviour of firms, be they domestic or multinational. In order to increase the capacity for domestic resource mobilisation of poor countries, major efforts—both at the international and domestic level—need to be made in terms of revamping policies aimed at combatting “base-erosion and profit-shifting” (BEPS). Corporate tax from multinational enterprises (MNEs) is an important source of government revenue in many developing countries, particularly the poorest. Tackling BEPS by MNEs could substantially increase tax collection. A particular challenge arises from “transfer mispricing.” A major portion of global trade takes place within firms, and tax authorities need to be able to discover the transactions that have taken place, assess whether the correct amount of tax has been paid, and collect any tax due. It can be difficult for a tax administration to know about offshore transactions, so a high level of international cooperation between tax authorities is required. For developing countries, more support is thus needed in two areas: (i) strengthening domestic institutions and legal arrangements so that they can implement new international standards on BEPS measures initiated by the OECD; and (ii) strengthening the international tax system so that it facilitates the work of developing country tax authorities.

Guidelines for broadly used private standards affecting trade

The road to diversification, value addition, and industrialisation in a modern economy involves linking up effectively with global supply chains. In some of these, important purchasing firms act together and establish industry-wide standards that affect a large number of suppliers. These standards may be conflicting or even contradictory. For many developing country exporters, private standards are more significant constraints than official sanitary and phytosanitary standards or technical barriers to trade. There is a manifest issue of coordination failure involved when it comes to international standards set by dominant private firms, and which cannot be solved in existing fora such as the WTO. The adoption of standards is a typical example of a situation where coordination, in order to achieve a socially efficient outcome, is paramount: in the absence of outside involvement, coordination failure is likely. The gains to adopting well-crafted standards can also be characterised as a situation where there are significant positive network externalities to be internalised. For private industry-wide standards not to be a constraint but rather a conduit for effective participation in global supply chains, particularly for small and medium-sized enterprises, existing limitations need to be tackled.

Duty-free and quota-free preferences and rules of origin

There has been a distinct lack of coordination (and political will) in terms of duty-free and quota-free (DFQF) preferences when it comes to LDCs. The United States, first and foremost, and large emerging markets should grant such access where they have not, and include liberal and simple rules of origin with extended cumulation provisions to maximise preference utilisation by LDCs.

Public goods

At the intra-country level, economic institutions are the key public good. Public goods and services possess two characteristics. First, they are non-exclusive: once they are provided, they are available to all irrespective of whether or not they were involved in their financing. Second, they are non-rival: the consumption of the good or service by a given agent does not reduce its consumption by others. As such, they are the best example of goods, services, or institutional structures that will be underprovided by the market mechanism and where outside intervention is needed. The group formulated five policy options that fall under the public goods heading. All are typical examples of institutional public goods that would go a long way towards improving the enabling environment in low-income countries, allowing them to harness the development potential of international trade.

Development-led legal and regulatory reform

Within institutions such as the WTO, current approaches to trade and development have focused primarily on access to developed country markets through trade preference programmes and special and differential treatment for developing economies—which are important but not sufficient to achieve economic diversification and poverty reduction. What is missing is a process (both top-down and bottom-up) for effectively assessing the development benefits of trade policy at the national and regional levels, addressing non-tariff measures from a development perspective, and applying a more widespread, inclusive, and coordinated system for implementing trade frameworks through legal and regulatory reform. Without a well-functioning legal and regulatory framework, economic activity will not develop, but these structures have to be better adapted to developing country circumstances. While this is not a policy recommendation per se, it should be kept in mind when designing concrete legal and regulatory policy options.

Trade facilitation framework for services

Given the pro-poor bias of the services sector, and in light of the fundamental contribution which efficiency in the services sector will make to the realisation of the Sustainable Development Goals, WTO members should urgently embark on a joint process to establish a comprehensive Framework for Trade Facilitation in Services. This Framework should encompass both cooperative and negotiating mechanisms, complemented by capacity building and technical assistance, through which the multilateral trading system can spur concerted action. The Framework should include arrangements for public-private dialogue with services stakeholders and allow for the implementation of measures on a regional, plurilateral, and multilateral basis.

Aid for Trade funding for services

The incentives that determine the sectoral allocation of Aid for Trade funds, which currently tend to ignore the services sector, need to be modified. Insufficient attention is given to services trade in Aid for Trade, especially via multilateral mechanisms, including the Enhanced Integrated Framework. This constitutes a misallocation of funding given the significant development dividends available from services growth. Boosting growth in the services sector is largely about getting the regulatory setting right, so that public policy objectives can be met without unduly increasing the costs of doing business. Regulatory regimes in services are often complex and overlapping. There is a need to fund country studies to address policy and regulatory failures and to develop well-tailored reforms to reverse those failures – including mechanisms geared towards helping governments apply the guidance set out in recent World Bank regulatory toolkits designed to boost services competitiveness. Aid for Trade funds should be applied to this problem.

Correspondent-banking availability

Heightened regulatory requirements in the financial sector (e.g. Know Your Customer, Anti-Money Laundering) have led many low-income countries to become functionally cut off from international financial markets by the simple lack of a correspondent (international) bank. The consequence of this financial exclusion is particularly serious when it comes to the exchange of goods and services since, without the ability to exchange information or funds, local companies struggle to enter into the contractual obligations that underpin international trade. Solving this problem in the short run, which is both feasible and relatively low cost, would make a significant contribution to facilitating international trade for firms located in low-income countries. The proposal is that each country should house at least one local bank with a fully-fledged correspondent-banking arrangement with international financial institutions.

Coordination efforts for trade and supply chain finance

A comprehensive global coordination mechanism for trade and supply chain finance is needed. It is recommended that a working group be established (within the E15Initiative or as part of another international coalition of experts and institutions) to propose ideas and commission studies that could contribute to improved global coordination efforts in this area.

Natural monopolies at the regional level

Natural monopolies occur when it is socially efficient, from the cost standpoint, to have a single supplier for a given good or service. The productive efficiency argument immediately begs the question of how to regulate the ensuing monopolistic structure. For the two policy options that fall under this heading, the natural monopoly framework is used in a slightly less restrictive form. The main point is that there are a number of key institutional failures that are more efficiently dealt with at the regional, rather than national, level because of the importance of underlying economies of scale and scope.

Regional regulatory cooperation in financial services

Regional mechanisms dealing with the regulatory aspects of cross-border financial services need to be strengthened. The integration of financial services has generally received insufficient attention in regional integration efforts. This has made it difficult for banks and other financial entities to operate regionally and support their customers so that they can enjoy the benefits of diversified, efficient, and cheaper financial services. It is important to ensure that the full extent of benefits arising from the economies of scale accrue to those in need of finance, such as micro, small and medium enterprises. Access to finance has been highlighted as the single most important constraint for such enterprises to face the competition of an integrated regional market and connect with the global economy. Key issues to be addressed include the heterogeneity of regulatory frameworks and restrictive market access, significant checks on the mobility of talent, and constraints on cross-border data flow and offshoring regulatory structures.

Enhancement of regional aid for trade

Given the many small markets in developing countries, it is clear that sustained economic growth needs to rely in part on creating larger, more viable markets through the rule-based sharing of resources and production assets. Deepening economic integration via regional cooperation has thus emerged as a key priority in the reform strategies of most developing economies. Implementing regional aid for trade initiatives is often complicated by: technical standards and financing issues; mistrust among parties; membership of overlapping regional organisations; non-implementation of regional agreements; poor articulation within national strategies; and, national and regional capacity constraints. This creates significant problems in terms of ownership, mainstreaming, and aligning national strategies around regional aid for trade priorities. Bridging these gaps by enhancing regional aid for trade initiatives through appropriate incentives is thus an important policy recommendation.

Asymmetric information

Asymmetric information arises when, in a bilateral relationship, one party knows something that the other does not. In the market failure framework, this can be interpreted as there being a missing market for the underlying information, which can lead to severe inefficiencies. The two policy options grouped under this heading involve: (i) strengthening the capacity of developing country governments to negotiate and implement public-private partnerships (PPPs); and (ii) providing low-income countries with access to world class advice as well as in-country capacity building geared towards improving their position when in comes to designing and negotiating sovereign bond issuances and restructuring. In both of these areas, low-income countries are currently at a serious informational disadvantage vis-à-vis their international interlocutors.

Technical advice on PPPs and sovereign debt contracts

Demographic trends together with anticipated robust economic growth in low-income countries is increasing demand for physical infrastructure. Financing this infrastructure will require enormous amounts of capital in the coming decades, and only part of this can come from domestic savings or aid. Developing country governments are increasingly turning to PPPs in a bid to attract foreign investment and address this gap. However, they face two types of problems in realising the benefits that can accrue from PPPs. First, despite the potential for high social rates of return, relatively small amounts of private foreign capital are flowing into infrastructure in developing countries. The obstacles include: investments that are large and lumpy; construction risks that are high; returns that are reliant on regulatory agencies and the creditworthiness of national governments; and, individual infrastructure projects that require complex legal arrangements often involving multiple parties and government agencies. Second, even when foreign investment does arrive, many PPPs fail in practice to deliver high public benefits. High-quality PPPs are complex to design, negotiate, and manage. Developing country governments face very substantial resource and informational challenges. These include: asymmetries in cost and technology information; insufficient institutional capacity to conduct solid prefeasibility studies or to structure contracts effectively; and, public sector liabilities triggered by PPPs that can be very sizeable (an aspect of PPPs that is very important in the context of rising developing country external debt profiles). Consequently, the institutional capacity of developing country governments to design, negotiate, implement, and evaluate PPP projects in all sectors, with a particular focus on infrastructure, should be strengthened.

Adoption of model solvency schemes and restructuring approaches

A striking new trend in international finance is that the governments of many low-income countries are issuing sovereign bonds to finance public debt. Developing countries are entering uncharted territory as they turn towards international financial markets, which offer credit on harder terms than “traditional” donors and present new economic and political risks. While such bonds can provide funding for large projects, create domestic financing space for the private sector, and can be less costly than local issuance, they also come with refinancing risk, re-pricing risk, and exposure to exchange rate fluctuations. In some countries there has been a deterioration in sovereign balance sheets amid expansionary fiscal stances that have led (in some cases) to the rebuilding of debt stocks, with mounting concerns about debt sustainability. As global yields normalise, there is the real risk of sovereign debt difficulties in developing countries. Yet there is a dearth of suitable mechanisms for dealing with defaults and restructurings in an orderly, timely, and fair manner. In practice, restructurings have been conducted under various frameworks without a consistent approach that normalises local laws and provides clarity for investors. Issuing governments have found themselves vulnerable to competing stakes that carry inherent conflicts of interest. Dependence on the market has led to restructuring outcomes that are counterproductive for the policy initiatives of the sovereign issuer. The precise legal provisions in bond contracts can make a very substantial difference for developing country governments, and the contracts that underpin many issuances are weak. These governments should be supported to strengthen the legal underpinnings of the bonds they issue—including through the adoption of model legal language.

Next steps and measuring progress

The policy options presented above range from ambitious recommendations, in that they will most probably only be feasible in the long term, to options that should technically (if not politically) be easy to implement in the short term. In all cases, work on these options should start immediately.

Short-term options

Three options deserve immediate attention in that they can deliver benefits rapidly. First, ensuring correspondent-banking availability depends on mobilising the international banking community. In addition, the two capacity-building options (technical advice on PPPs and adopting model solvency schemes and restructuring approaches) are relatively shortterm ventures, although they do involve coordinating a broad range of players at the international and domestic levels.

Medium-term options

The two services-centred options (implementing a trade facilitation framework for services and encouraging Aid for Trade funding) should be actively pursued in international fora for medium-term implementation. In addition, expanding DFQF and simple rules of origin (with extended cumulation) to all LDCs depends on nudging major preference givers. At the regional level, where there may in some instances be a greater convergence of interests, enhancing regional aid for trade and improving mechanisms for regional regulatory cooperation in financial services have a good chance of being adopted—perhaps by having successful regional groupings, such as ASEAN, mentor less successful ones. Providing guidelines for broadly used private standards affecting trade could be taken up by international organisations such as the International Organization for Standardization.

Long-term options

Options that involve the revamping of part of the international trade and finance architecture are long-term in nature and require the buy-in of a plethora of players. This is the case for the proposals on making strategic use of ODA and blended finance, and constructing a global coordination mechanism for trade and supply chain finance. Finally, two of the options (fostering development-led regulatory reform and mobilising domestic resources) are also long-term and (largely) need to be implemented at the national level. Perhaps a limited number of “test case countries” could be identified in which the political will for such reforms is likely to exist.

Measuring progress

A central element of the empirical literature on the impact of institutions on income per capita and growth is the use of protection against expropriation risk as the main indicator for economic institutions. The work of the Expert Group suggests that alternative indicators of what can be termed the “enabling environment” could be constructed. Based on the weaknesses in country-specific trade and finance characteristics identified through the proposed policy options, the constituent elements of this new index could be the following: a Herfindahl index of concentration in the banking sector; the existence of a functioning antitrust authority; an indicator of fluidity of visa policy; the number of correspondent foreign banks; the existence of a national or regional credit bureau and/or a rating agency; and, the legal system under which sovereign bond issuance takes place. This list of indicators could be complemented with data from the World Bank’s Doing Business survey, and standard composite indicator methods could then be applied to arrive at an aggregate index of “institutional readiness.” This is work in progress, and it is proposed that a working group be set up to operationalise the construction of this index.

Author: Jean-Louis Arcand, Director of the Centre for Finance and Development and Professor, Graduate Institute, Geneva.

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