An import driven development as a road into periphery – the evidence from the Eastern European Countries. Justyna Schulz, University Bremen The transformation process of the Eastern European Countries was based on the assumption that the best way to catch-up with the developed economies is to import technology, knowhow and capital from the West. The current financial crisis has revealed the vulnerabilities of this strategy. The thesis of this paper is that the import driven development increases the economic dependency on foreign capital inflows. It means that the central decisions regarding investment, production and income distribution are controlled by the external actors or depends on foreign investors’ decisions. The analysis combines the balance-sheet framework with the theoretical explanation of the Ownership Economics. It focuses on the Visegrad Group Countries: Czech Republic, Hungary, Poland and Slovakia. The paper proceeds as follows. The subsequent section describes the neoclassic perspective on the macro-economic development. Following, this perspective is critically discussed from the point of view of Ownership Economics. This approach points to the priority of monetary transactions to the real economy. The monetary contracts depend, however, on collaterals necessary to back them. Based on these assumptions, the monetary explanation balance of payment mechanism is presented. Against this theoretical background, the development in the Visegrad Countries is analyzed. The focus is put on macro-economic indicators such the current and financial accounts as well as the international investment position; magnitudes which record the changes in the assets ownership-position. In conclusions, it is stressed that capital import driven development can have a positive impact on the economic performance if it contributes to the increase of countries’ assets-position. Thus, the negotiable assets secure the access to finance and as a result the ability to initiate investment and income.

Macroeconomic imbalances from the neoclassic perspective

1

The economic transformation of the Visegrad Countries is based on the neoclassic ideas which offer a coherent model focusing on the real sphere. In this narrative the economy is based on individual efforts to overcome the constraints resulting from scarcity of resources in order to satisfy consumptive preferences. All constraints are real in nature: resources, labor, capital goods or real savings. The market mechanism is analyzed as a general barter, facilitated by the intermediation of money. The monetary sphere is interpreted as a neutral “veil” about real economy. The neutrality of money is expressed in the assumption that money stock is an exogenous variable, determined solely by the monetary authority. Commercial banks channel the given stock of money from savers to investors. Through lending they can redistribute but not change the amount of money in circulation. The lending ideal would be if banks were not grant loans exceeding the amount of deposits they have previously collected. Thus, the equality between savings (S) and investment (I) is assumed. I=S

(1)

The constraints resulting from scarcity of savings can be overcome through government spending (G) and import of foreign savings (Km). I = S + G + K(m)

(2)

While the government spending was viewed in the transformation as a source of last resort, the capital import has been enhanced to the crucial supplier of finance not only to bridge-up the gap in the domestic savings but also to secure the technological convergence of the economy. Particularly foreign direct investments (FDI) have been and still are viewed as an accelerator of the economic development due to the implicit transfer of technology and knowhow. Accordingly to these assumptions, the economic policy has been mostly focused on attracting the foreign capital inflows. It happened through building of tax-free zones for foreign direct investors and through high interest rates for portfolio investors. At the same time the access of the domestic actors to credit has been restricted due to the assumption that there has been a tradeoff between monetary stabilization and the increase in the domestic credit. The neoclassic narrative believes that foreign borrowing helps to build an industrial and service sector able to generate export revenues in future in order to repay foreign debts. Further, it assumes that the main motivation behind the capital export is to secure the access to goods and services in future. One day–the argument goes–countries importing capital will run surpluses and export them to their current creditors. 2

These theoretical assumptions correspond little with the real economy. They rule out two empirical monetary facts. Firstly, investments can be debt-financed through the endogenous expansion of the money supply by banks. So, domestic investments are not restricted by existing savings. Secondly, the access to finance is limited by conditions of creditor-debtor contracts. These elements are theoretically addressed by Ownership Economics.

Ownership Economics’ explanation

The Ownership Economics 1 rejects the idea that bank lending is restricted by collection of deposits. This theoretical approach stands in the tradition of the endogenous concept of money which assumes that money is created by banks to satisfy the liquidity demands of investors. It partly follows Schumpeter who argued that it was an old prejudice that banking system would be unable to make any loan without collection of deposits. Just a simple look at the banking technique contradicts this idea. However, for Ownership Economics the creation of money is “not out of nothing” 2 as Schumpeter and the successors of the credit-basedmoney assume. Ownership Economics points out that all financial instruments which enjoy market acceptability and stay in circulation represent a claim on issuers’ property. They have to be backed by marketable collaterals. A standard creditor-debtor-contract proceeds as follow. For the purchase of capital goods, investor needs money. He gets access to an account if he offers the bank a negotiable asset– mortgage, bonds, bill of exchange or property charge– to secure the credit. The asset represents a claim title on investor’s property. The bank gets a credit-assets secured by investors’ collateral. In return, it creates an account at the disposal of investor. It means that the bank generates deposits. They are secured by the claim title on investor’s property and underwritten by blocked capital of the bank. For blocked capital, the bank is paid with interest. The physical side of investor’s property is not involved in by this contract. From this perspective, the Schumpeter’s vision of the credit creation “out of nothing” is a perversion of the creditor-debtor-contracts. It violates the principle that issuer of financial means have to be liable for them by his property. The current financial crises and the “loops” in the balance sheets caused by assets not properly backed support the importance of collaterals in the financial contracts. 1

Gunnar Heinsohn and Otto Steiger, Eigentumsökonomik, Marburg: Metropolis, 2006. Joseph A. Schumpeter, The theory o economic development: an inquiry into profits, capital, credit, interest and the business cycle, Cambridge, Massachusetts: Harvard University Press, 1934, 73. 2

3

The question arises to what extent these theses are relevant to transitional economies. This scheme illustrates, firstly, that the real world lending is not a transfer of deposit money to investors. Rather the loans create deposits. Secondly, the fears that the domestic credit will lead to inflation is baseless if the contracts are secured by collaterals. The disposal of foreclosure-able and negotiable collaterals determines the extent and the limits of the credit expansion. Accordingly, the neoclassical quotation assuming the equality between savings and investment must be extended as follows: I=S+G+A

(2)

where S is prior savings, G is government spending and A is a stock of activated assets in creditor-debtor contracts. These three sources of finance are not economically neutral. Only assets activation in creditor-debtor-contracts put into operation a mechanism which enforces savings in course of investment. It is due to the fact that collateral-pledging investors are under stress to lose collaterals if debt incurred to purchase capital assets cannot be serviced and repaid from the cash flow generated by the investment. Therefore, debt-financing investors are strongly motivated to innovate, to modernize or to save costs in order to be able to deleverage successfully and avoid the assets-foreclosure. It has to be pointed out that the economic process starts with leverage backed by collaterals and ends with deleverage. The more investors activate assets, get into debts and due to their competiveness successfully repay their financial obligations, the more dynamically the economic system develops. The precondition for the participation in these monetary contracts is the disposal of marketable collaterals. Everyone who can offer pledge-able assets can initiate investment and generate income. The assets-activation can be made by foreign or by domestic agents. It can be provided by assets selling, assets pledging, issuing equities or securities. In the course of these legal transactions financial instruments emerge such as bank accounts, equities, debt securities, bill of exchange or derivates. All these instruments open for their issuer the opportunity to initiate investment and generate income. At the same time they oblige him/her to compete for money on the market in order to free the pledged property. The ability to enter monetary contracts is a privilege and at the same times an obligation. 4

Taking this in consideration, the capital movement should be analyzed from the point of view of the ownership-position of the country. It is the monetary–not the real–point of view. In the real economy, money matters. The ability to generate money matters even more.

Macroeconomic imbalances – the monetary explanation It is not by accident that the interpretation of the balance of payment mechanism starts typically with the current account which represents the real exposure of an economy to the rest of the world. The explanation is based on the assumption that the welfare increase depends on the expansion of the consumer and capital goods. Therefore, the trade deficits in goods and service account are viewed as being conducive to build-up the capital stock in catching-up countries. The financial account is supposed solely to follow the current account developments. It is said that countries with trade deficits in goods and services profit from the surplus output produced by foreigners who even transfer their real savings in order to finance this process. This interpretation could apply if the economy were really only about how to satisfy the preferences of consumers. Then, the increase of goods at the disposal of the economic agents could be interpreted as a better economic performance. If the economy is about how to secure the access to liquidity in order to initiate investment and income, the interpretation of the balance of payment mechanism should start with the financial account. The financial account reflects changes of ownership in financial assets and liabilities. Additionally, the development of the international investment position should be taken in consideration as it records the ownership status of the country vis-à-vis the rest of the world. Trade deficits in goods and services are financed by foreign capital inflows, which however, are not free of charge. Money is flowing against collaterals which are not a part of the neoclassic narrative neither in micro nor in macro context. Collaterals are crucial as they define the access to finance. The key point is that capital import implies the export of assets while capital export corresponds with assets accumulation. The driving idea behind the capital export seems to be the expansion of the ownership/creditorposition through the control of assets such as equities, bonds or credits, and not–as the neoclassic presupposes–the transfer of real savings in order to secure future goods and services inflows. Depending on securities, the investor/capital exporter secures his/her influence on foreign markets. (S)he can control the production and investment processes. (S)he gets a claim on income streams. All these commitments are not real but monetary in 5

nature. They correspond with the general economic purpose not to lose liquidity. As Peter Drucker stresses, the capital export more than capital import seems be a foundation for future current account surpluses: "International trade theory takes for granted that investment follows trade. Most people think ‘international trade in goods’ when they hear the words ‘international trade’. But increasingly today trade follows investment. International movements of capital rather than international movements of goods have become the engine of the world. (...)Even if a lower exchange rate improves a country`s exports, it also weakens a country`s ability to invest abroad. And if trade follows investment, lower foreign exchange rates for a country`s currency diminish exports within a few years. This is what happened to the United States: the cheaper dollar increased American manufactured exports in the short term. But it also impaired the ability of American industry to invest abroad and thus to create export markets for the long term. 3 Economic agents who run surplus in current account not only expand the sale of their products and services on foreign markets but they import assets which increase their creditworthiness and as result their capability to generate investment and income. That is at the core of the economic transactions. The conclusion that capital export can be a conducive strategy for catching-up countries is/seems unsustainable; especially given the fact that the main obstacle for those countries is viewed in the lack of domestic capital. There is, however, a historical evidence of this strategy. All countries successfully catching-up in the past such as Germany in 19 century as well as after 1945, Japan, Korea, Taiwan and nowadays China managed it through capital export.

Macro-economic development of the Visegrad-States

The development strategy adopted by the Visegrad Countries is called an export-led growth model. 4 However, it does not refer to the balance sheet but solely to the fact that the countries are integrated in the supplier chain of the international companies and export components or

3 4

Drucker, 1997, 167. Joachim Becker, Wachstumsmodell und Krisenmuster in Osteuropa, WSI Mitteilungen 6/2011.

6

finished products mostly for motor vehicles, electronics or light industry. 5 In the current account, the import of goods and services still exceeds the export. Regrettable, the macroeconomic structures of the Visegrad countries are characterized by two alarming qualities: persistent current account deficits (Graph 1) and the decreasing of the international ownership position (Graph 2). The last point was already stressed in the report prepared by the IMF in 2008 on the eve of the financial crisis. The authors pointed out that the Central and Eastern European countries are the only region in the world where current account deficits went hand in hand with the decrease of the international investment position. The Asian region for example compensated the sale of assets and liabilities to foreigners by purchases of foreign assets. The same regards the US. Recently, also the EU seems to be concerned about the international investment position of its members. In the Alert Mechanism Report prepared in reaction on the Euro-crisis, it is recorded: “Currently, the NIIP [net international investment position] positions exceed the indicative threshold of -35% in a number of Member States: Bulgaria, the Czech Republic, Estonia, Spain, Hungary, Latvia, Lithuania, Slovakia, Poland, and by small margin in Slovenia.” 6 The problem lies in the fact that there is a tradeoff between the development of net investment position and the policy focused primarily on attracting foreign capital inflows and assumed that capital export reduces the investment potential of the country. The real consequence of this policy is the increasing dependency on foreign capital inflows and on the decision taken by the external ownership. However, the capital import can positively contribute to the economic development if it enforces savings. For this purpose, the capital import has to be canalized to the domestic entrepreneurships who are liable for the repayment with their collaterals. In this sense, the foreign capital enables transfer of the domestic collaterals into liquidity in order to invest. For this purpose, however, companies must be able to offer collaterals. And that is the next shortcoming of the economies in the Visegrad Countries. The private bond market almost does not exist (Table 1). The portfolio inflows are canalized to Treasuries and finance mostly budget deficits. Therefore, the biggest challenge in the Visegrad countries is to enter the monetary contracts. The constraints are manifold: •

lack of pledge-able collaterals resulting from o not-existing legal property titles caused by unresolved property questions, outdated legal registers or titles in disputes

5

Jan Drahokoupil and Martin Myant, International integration and resilience to crisis in transition economies, 2010, 4. 6 Alert Mechanism Report, European Commission, 2012, 8.

7

o lack of enforceability of the legal titles due to the dysfunctional judiciary system and social policy deteriorating the collateral-function of property •

capital weakness of the domestic financial sector controlled by foreign investors

•

Restrictive monetary policy of central banks refusing domestic securities as collaterals in money supplying policy.

Unfortunately, all these constraints cannot be addressed by capital inflows. On the contrary, if capital inflows are not canalized to the entrepreneurship, they can even worsen the macroeconomic situation. They lead to the increase in consumption, finance budget deficits and contribute to the over-liquidity in the financial system. The last point even restricts the conditions on which domestic agents could enter financial transactions. Under such institutional framework, it is justified to be afraid that capital import driven development will lead to higher foreign debts and the reduction of the international investment position.

Conclusions The key question for all economic models is about the source of economic growth and prosperity. The neoclassic theory which underpinned the transformation process in the Central and Eastern Europe stresses the importance of real factors: the increase in consumer and investment goods or real savings. From this perspective, the import driven development strategy seems to be logical to build up the stock of real factors. In contrast, Ownership Economics points out that the development potential is not determined by real factors. It is defined by the capability of market participants to back financial contracts with legal title-side of property in order to initiate investment and produce real factors. From this standpoint, all activities are welcomed which contribute to the increase of the negotiable assets at the disposal of the economic agents. In this context, the aftermaths of the capital import strategy have to be considered more differentiated. Firstly, it should be taken into account that capital import does not address the crucial restraints companies in the region are confronted with. They result from the scarcity of negotiable collaterals due to dysfunctional legal systems. Secondly, under given legal framework, capital import reduces the amount of assets the domestic agents can dispose of in order to initiate investment and to generate income. Thus, the collaterals which back capital inflow are controlled by foreign investors. It can therefore 8

not surprise that the countries in the region are confronted with the “copying paradox”. 7 The more intensively they follow the recommended model, the bigger external deficits emerge and the more they depend on the import of foreign capital. They experience the process of a growing marginalization as their financial, production, investment and income-building structures are dominated by external owners. In the end, after more than twenty years of transformation, they are richer in terms of consumer goods and services but they are still not able to generate sustainable and endogenous investment and income. As a result, the region plays a role of a peripheral “low-wage hinterland” for the highly developed European “core” hoping to catch up in near future. It should be feared that the continuation of this policy will catch the countries in the trap of over-indebtedness. If capital inflows are not canalized to the productive sectors, they increase consumption. In the end, the so called foreign investment is an illusion. In reality, it is a dis-investment financed by the sale of collaterals. In this context, the European policy towards peripheral countries such as the Visegrad States should concentrate on the constraints which hinder the economic agents in those countries to enter financial contracts. At the core of this policy must be a legal framework securing the enforceability of contracts, equality before law and the existence of the legal property titles.

Appendix:

Source: Eurostat 7

Erkki Karo and Rainer Kattel, "The Copying Paradox: Why Converging Policies but Diverging Capacities for Development in Eastern European Innovation Systems?" Working Papers, (Tallinn: TUT Institute of Public Administration, 2009).

9

Source: Eurostat

Source: Eurostat

10