Friday, May 13, 2011

How many flat-screen TVs can you buy for a shipload of iron ore?

One of the best-known ideas in development economics is the Prebisch-Singer hypothesis, which states that the terms of trade between primary products and manufactured goods tends to deteriorate over time. The hypothesis, which dates back to the early 1950s, asserts that countries exporting primary commodities (minerals and/or agricultural products) would be able to import fewer and fewer manufactured goods for a given amount of exports, and hence would become progressively worse off, or fall further behind developed countries. A common policy recommendation based on this idea is that developing countries should strive to diversify their economies and reduce dependence on primary commodity exports by developing manufacturing activities.

The hypothesis is closely linked to the idea that most countries follow a natural progression from producing mainly primary commodities, moving on to manufacturing and eventually to services.

The progression from primary commodities (minerals) to manufacturing has underpinned much of Botswana’s thinking on industrialisation and diversification, and the manufacturing sector has benefitted from incentives and special treatment by government. And yet the policy has been largely unsuccessful, in that manufacturing has shown only sluggish growth rather than dynamism. There are only a few examples of manufacturing firms that have demonstrated long-term sustainability, while many more have collapsed once subsidies or special treatment was withdrawn.

But perhaps the Prebisch-Singer hypothesis is wrong, or at least not as applicable as it once was. Two major developments suggest that it may be less relevant today.

First, the commodity “supercycle”, whereby an increase in the demand for primary commodities, driven by higher global economic growth, leads to sustained higher commodity prices;

Second, the steady fall in the prices of many manufactured goods, associated with a shift in the locus of global manufacturing production from developed to developing countries.

These two trends, if sustained, suggest that the reverse of the original hypothesis may now be true, and that the terms of trade of primary commodity producers are now improving, rather than deteriorating, and that a given level of primary commodity exports can now buy an increasing amount of imports of manufactured goods.

The importance of this was recently illustrated by the Governor of the Reserve Bank of Australia, a country that mainly exports primary commodities and imports manufactured goods. Five years ago, Governor Stevens noted, a shipload of iron ore bought 2,200 flatscreen TVs; now it buys 22,000. A long term trend of declining terms of trade seems to have been reversed, with Australia’s terms of trade improving by 42% since 2004.

The fact that commodity prices – for both minerals and foodstuffs – have resumed their upward trend after a temporary interruption in 2008-9 following the global financial crisis, suggests that this may well be a long-term development. Rising mineral prices are being driven, to a large extent, by demand from emerging market economic, especially India and China, which is likely to persist for some time, even if they eventually move to a less resource-intensive growth path. And while the decline in the prices of manufactured goods may be slowed as wages start to rise in China, there is still scope for manufacturing to move to other low-wage Asian economies.

What does this mean for Botswana? Certainly the focus of industrial development and diversification policy needs to change, with manufacturing no longer the centre of attention. But it also means that continued reliance on minerals, especially if the mining sector can itself become diversified, as seems to be happening, is not necessarily a bad thing.

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