Africa and China – and a grave misunderstanding of real world free trade

An African political leader criticising China for its engagement in Africa is a rare event. What Mallam Sanusi, the Nigerian central bank president has done in the Financial Times is bold and would be highly welcome as a contribution to open and frank debate of a hot matter if his main point would be valid. Unfortunately, it is not. Bashing China for swamping other developing countries with manufactured goods means to miss the wrongdoer and to misunderstand the role of foreign direct investment (FDI) in shaping new patterns of international trade for some decades already.

Surprisingly enough, despite a long history of FDI and the increasing role of a certain type of FDI its implications for international trade flows and for the edifice of the free trade dogma are not well understood. A huge amount of FDI in developing countries, in particular so-called greenfield investment in fixed capital, is searching for cheap factors of production (cheap labour in particular). This kind of FDI moves technologies with a rather high capital intensity, at least a capital intensity much higher than hitherto applied in the low-wage countries, to a low wage location. If labour in the receiving country is rather mobile or wages are following the productivity trend of the country as a whole, the overall level of wages in the country of destination is influenced by the import of this kind of FDI only marginally, namely to the extent that the individual investment improves the overall level of productivity a tiny little bit.

In this case, unit labour costs for the production unit applying the new imported technology will normally drop remarkably. For example, a producer of manufactured goods in a developed country moving sophisticated technology to a developing country like China can dramatically increase competitiveness. If the plant has an average productivity (value added per hour) of 40 Euros and employs labour for an average hourly wage (including all sorts of taxes) of 27 Euros at home unit labour costs are 0.67 (27 divided by 40). Moving such a production to a low cost location like China or India may cut the average wage to be paid by the foreign investor to a twentieth of the German level, i.e., 1.35 Euros per hour. Even if the productivity of the plant falls slightly in the low wage location, e.g., by 20 percent to 32 Euros, which may be due to losses incurred by less efficient workers or lack of efficient logistics in the developing country, the new level of unit labour costs realized in the low-wage location will be only 0.042 (1.35 divided by 32). This implies that even if labour costs account only for 25 percent of overall cost in a manufacturing plant, a product sold at 100 dollars before could be sold now for less than 80 without touching the profit margin.

For China, this explains much of its overall success. Though declining over time, the products swamping the world market from China are to a very large extent the products of this kind of hybrid production processes realized by affiliates of foreign companies but not by Chinese firms. Even if, as is the case in China, FDI is an important contributor to huge jumps in productivity in the overall economy and induces sharply rising nominal and real wages in manufacturing and in the overall economy, the monopoly position of the foreign investor melts off only slowly as the process of catching-up takes many years or even decades, given the low original level of wages and the low domestic capital stock in many developing countries compared to the most advanced economies.

The absolute competitive advantage accrued by these foreign investors, who are able to combine high technology with low wages in a low-wage location is putting enormous pressure on competitors in developed economies (with the same level of capital equipment) but also on competitors in developing countries (with a similar low level of wages) who do not have access to the most sophisticated technology. However, if developing countries are losing out against these competitors they should understand that it is the free trade doctrine that forces them to accept the long-lasting monopolies created in this way. Developing countries, competing to attract FDI by offering low taxes or cheap real estate in addition to cheap labour are hardly consistent with complaints about those who were the most successful in this race to the bottom.

But the dilemma of the laggards in Africa raises more fundamental questions. It has to be kept in mind that there are few other successful strategies to catch-up quickly. Early industrializers along these lines in Asia (Japan and Korea) have not relied on FDI but on strong support from the government to combine a well-educated labour force with imported high technology. Their method to conquer foreign markets as well as the new FDI lead approach distort the traditional model of foreign trade. Negative spill-overs of this kind could only be prevented if governments in developing countries would strictly tax monopoly rents appropriated by foreign investors and make the proceeds available to its own population. However, the appropriation of a large part of the rent can only be successful if such a strategy is applied by all or the most important countries with a similarly low level of wages as otherwise footloose foreign investors would just move to less taxed locations.

Absolute competitive advantages resulting from cheap factor searching FDI raise many difficult questions for economic theory and for trade policy. If the monopoly rents are not heavily taxed in the producing country the importing countries could easily justify the protection of their domestic industries against this kind of “unfair” competition. The free trade argument is clearly based on competition without monopoly rents. It is assumed that the wage level in each country is exclusively determined by the capital/labour ratio, which implies (in the neoclassical setting) that production technologies (in domestic and foreign firms) would be designed according to the level of wages in relation to the price of capital. This would result in a much more labour intensive way to produce goods for the world market compared to the actual capital-intensive production in low wage locations.

No doubt, cheap factor searching FDI on a large scale questions the rules on which the whole edifice of “free trade” is built. That does not mean to question free trade per se. But it fundamentally questions the assumption that free trade is automatically efficient trade. Or, to turn it the other way round, to justify free trade under these circumstances asks for new and convincing arguments. The task ahead is to explain why the arrangements as they are can be considered efficient even if the ideas behind the arrangements are fundamentally flawed.

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