WORLD TRADE  
ORGANIZATION  WT/WGTDF/W/27 
24 November 2004 
 (04-5106) 
Working Group on Trade, Debt and Finance Original:   English 
  
 
  
COMMUNICATION FROM UNCTAD 
  
 The following communication, dated 22 Nove mber 2004, from the UNCTAD Secretariat, is 
being circulated in advance of their presen tation to the Working Group on 10 December.
  
  
_______________ 
 
  WT/WGTDF/W/27 
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 ECONOMIC POLICY CHALLENGES IN AN OPEN ECONOMY: 
COHERENCE BETWEEN TRADE AND FINANCE
1 
 
Presentation prepared  by Heiner Flassbeck 
Officer-in-Charge 
Division on Globalization and Development Strategies 
    
CONTENTS 
 
 
PAGE 
I.
 TRADE AND FINANCE IN THEORY..................................................................................2  
II. A PRAGMATIC SOLUTION:  THE CO NCEPT OF COMPETITIVENESS...................4  
III. CONDITIONS FOR COMPETITIVENESS AT THE MICROECONOMIC 
LEVEL:  THE KEY ROLES OF INNOVATIVE INVESTMENT......................................6  
IV. COMPETITIVENESS OF FIRMS AT THE LEVEL OF THE NATIONAL ECONOMY ........................................................................................................................ .......7
 
V. TRANSMISSION MECHANISMS BETWEEN THE NATIONAL AND THE 
INTERNATIONAL ECONOMY ............................................................................................9  
VI. MEASURING COMPETITIVENESS:  THE REAL EXCHANGE RATE......................12  
VII. UNDERVALUATION AS A GE NERAL SOLUTION? .....................................................13  
REFERENCES .................................................................................................................... ................17 
  
 
I. TRADE AND FINANCE IN THEORY 
1. After the end of the Second World War the cr eation of a coherent international economic 
order was understood to integrate aspects of the financ ial or monetary order with the order of the trade 
flows and future steps towards a full liberalisation of  goods and capital flows.   The architects of the 
new Bretton Woods arrangements fully understood that without that integration of money and trade a 
stable and, in terms of sustainable growth and jobs , successful order could not be built.  In May 1944, 
Lord Keynes, speaking in the House of Lords about the coming world economic order, said:  
"To begin with, there is a logical reason for dealing with the monetary proposals 
first.  It is extraordinarily difficult to fr ame any proposals about tariffs if countries 
are free to alter the value of their curren cies without agreement at short notice.  
Tariffs and currency depreciations are in m any cases alternatives.  Without currency 
agreements you have no firm ground on which to discuss tariffs.  In the same way, 
plans for diminishing the fluctuations in international prices have no domestic meaning to the countries concerned until we have some firm ground in the value of money.  Therefore, whilst the other schemes are not essential as prior proposals to 
the monetary scheme, it may well be argued, I think, that the monetary scheme gives 
                                                     
 
1 This paper (sections 2-7) is mainly based on Chapter IV of UNCTAD's Trade and Development 
Report (TDR) 2004.   The introduction expresses the opinion of the author and does not necessarily reflect the 
views of UNCTAD.  WT/WGTDF/W/27 
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 a firm foundation on which the others can be built.  It is very difficult while you have 
monetary chaos to have order of any kind in other directions." 2 
2.  Unfortunately, after the breakdown of the Br etton Woods system at the beginning of the 
1970s, the world monetary system slipped back into the kind of "monetary chaos" that had characterised the pre-war period and its dismal eco nomic and political outcomes.  Nevertheless, the 
liberalisation of the trading system, even after the end of the Bretton Woods system, was pushed 
forward by policy makers as if a consistent approach  on the monetary side, i.e. a coherent monetary 
order, would have existed.  Only recently, with th e Asian crisis as well as with the Latin American 
currency turmoil, the shortcomings of the "moneta ry chaos" and its repercussions on the trading 
system have been acknowledged, even by mainstream economic theory and the WTO. 
3. The inherent instability of the system of mu ltiple exchange-rate systems, ranging from free 
floating to absolutely fixing, has led many observers  to ask for a global approach in monetary affairs 
or, at least, for improved regional co-operation.  But instability is only part of  the story.  Given the 
frequent overshooting of exchange rates since the co llapse of the Bretton Woods agreement, the more 
pressing question is about the real allocative distor tions and the disincentives to invest stemming from 
the monetary side of the economy.  If exchange ra te movements follow a random walk, i.e. if changes 
in the international value of money are in no wa y related to the fundamentals of countries with open 
markets for goods and capital, traditional trade theo ries quickly lose their grasp on reality and trade 
liberalisation loses much of its alleged justification. 
4. The philosophy of trade liberalisation on a global scale is still mainly based on the doctrine of 
"comparative advantage" or "comparative costs".
3 In a two country-two goods world with a common 
currency, like the Gold Standard, the logic of this doctrine is simple and irrefutable.  David Ricardo 
wrote in 1821: 
"Two men can both make shoes and hats, and one is superior to the other in both 
employments; but in making hats, he can onl y exceed his competitor by one fifth or 20 
per cent - and in making shoes he can excel him by one third or 33 per cent; will it 
not be for the interest of both that the superior man should employ himself exclusively 
in making shoes, and the inferior man in making hats?" 4 
5. The example should prove that even countries laggi ng behind in terms of absolute cost in the 
production of both goods had a chance to participat e in the division of labour and income.  But 
countries, even with a common currency, do not al ways share the same ch aracteristics as persons 
living in the same country.  Obviously, Ricardo’s exam ple is conclusive if both men receive the same 
wage despite their different skills.  Across countries  this is not necessarily the case.  If labour is 
immobile and the wage of each man in his country ex actly reflects his productivity, i.e. if the wage of 
the superior man is much higher than the one of hi s inferior competitor, the result of competition is 
not as simple.  Moving to a multi-goods, multi-country world increases the complexity further.   
6. With differing wage and productivity levels be tween products and countries, the "comparative 
advantage" cannot easily be identified.  In the real  world absolute advantages regarding the wage level 
and/or the technology (productivity) in the producti on of a certain good may be much more important 
than the construct of comparatively lower costs under Ricardo’s assumptions.  Moreover, if prices and 
costs in money terms are the main determinants of  trade, and if capital is mobile, countries with 
relatively low wages have huge advantages, prod ucing even products of the high-wage country 
spectrum, like computer chips, if they are able to import and to apply the high-wage country 
                                                      
2 Keynes, J.M.  (1980), p. 5. 
3 Viner (1975), p. 451. 
4 Ricardo (1951), p. 136. WT/WGTDF/W/27 
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 technology.  With "high-tech" and low wages, pr oduction of high-tech products in the low-wage 
country yields an extra-profit or a rising market share for domestic producers or foreign investors.  This extra-rent, ignored by mainstream trade theory  and trade policy, may be an important source of 
catching up of developing countries. 
7. Regarding the puzzles faced by the pure trade cum comparative advantage approach, dealing 
with nominal costs and prices, including differing wage and productivity levels as well as exchange 
rate changes is more promising.  Nevertheless, de veloping countries with low wages, even in this 
world, export a certain number of goods produced at the low productivity end, thereby exploiting 
lower costs.  The industrial countries export at th e higher end of the productivity scale despite higher 
wages.  But regardless of this rough pattern, ther e is no simple rule explaining the international 
division of labour.  Manufactures are exported by de veloping countries that can be produced cheaper 
because of lower wages and desp ite lower skills of labour.  Th e production of these products may 
incorporate high technology as well as low technology with no clear rule at hand.  Finally, the whole process is, in a world of "monetary chaos", perman ently overlaid by monetary  shocks and huge gaps 
between imports and exports stemming mainly from real exchange-rate movements.   
8. The classical idea that trade advantages and disadvantages reflect different "endowments" 
with labour, capital or natural resources, has lost explanatory power, as the assumptions on which the 
idea had been based no longer apply.  It introduces  a divide between real analyses on the one hand 
and monetary analyses on the other hand, suggesti ng to policy makers both areas could be tackled 
separately.  However, trade flows in the real world are distorted by huge differences in wage 
formation, inflation rates and, even more important , wide over- and undervaluation of exchange rates.  
In fact, many kinds of "monetary or nominal" di sturbances distort the division of labour between the 
industrial and the developing world.  If exchange ra tes change by 20 % in a week or if countries or 
regions manage to keep their currency (with fixed or  with flexible rates) undervalued by 10-20 % over 
periods of 5 to 20 years, an analysis based on the classical paradigm is misleading. 
9. The main objective of this paper is to discu ss conditions at the micro- and macroeconomic 
levels, as well as in the transmission process betwee n the national and the international economy that 
must apply for entrepreneurs to enjoy benefits fro m innovative investment.  After a brief discussion of 
the concept of the competitiveness as used in this paper and its ap plicability to developing countries, 
sections 3 to 5 concentrate on these conditions.  Section 6 discusses measures of competitiveness.  
Section 7 discusses the possibility of using cu rrency undervaluation as a general solution to 
maintaining competitiveness, and the last secti on presents conclusions and policy implications. 
II. A PRAGMATIC SOLUTION:  THE CONCEPT OF COMPETITIVENESS 
10. Historical evidence shows that countries raise the standard of living of their population by 
raising labour productivity.  This is associated with  a substantial change in the sectoral pattern of 
production and employment, from agricultural to indus trial products, and a shift from labour-intensive 
activities to a growing range of capital- and technol ogy-intensive activities.  The production structure 
of an economy is of key importance for the devel opment process, because, at any point in time, both 
the level of productivity and the potential for technical progress and productivity growth vary 
significantly across agriculture, industry and services, as well as within these sectors. 
11. Transformation of the production structure re quires entrepreneurs who are capable and 
willing to invest in activities that are new to the domestic economy.  Indeed, Schumpeter (1911) 
pointed to the importance of innovative investment  for economic development, and Baumol (2002) 
argues that innovation, and the consequent rise in pr oductivity, account for much of the extraordinary 
growth record that has occurred in various parts of  the world since the Industrial Revolution.  He 
suggests that market pressures arising from olig opolistic competition force firms to integrate 
innovative investment into their routine deci sion processes and activities – thus, the innovation  WT/WGTDF/W/27 
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 process is neither largely autonomous nor largely fo rtuitous.  Market forces achieve much of this 
through financial incentives, by providing higher pay-o ffs to those firms that are more efficient and 
whose products are most closely adap ted to the wishes of consumers. 
12. However, the occurrence of innovative invest ment is not automatic; it could encounter 
structural and institutional impediments.  More over, the macroeconomic environment could be 
inappropriate for encouraging and supporting investors seeking to  create or expand productive 
capacity and, in particular, to increase productiv ity and international competitiveness.  The main 
incentive for investors to discover a more efficien t way of producing an existing good or to produce a 
new good arises when they can appropriate at least pa rt of the rent generated by the creation of new 
knowledge.  Within this framework, for an innovativ e entrepreneur to enjoy such benefits, a number 
of conditions must apply at different levels. 
13. Linkages between investment, productivity growth, successful integration into the 
international trading and financial systems, and economic developm ent have been seen in recent years 
through the lens of international competitiveness.  A wide range of criteria and measures of the 
competitiveness of countries have been elaborated, some  of which have been extensively publicised.  
Indeed, "competitiveness" has become not only a manage ment buzzword, but also a term widely used 
in economics and economic policy-making. 
14. The concept of competitiveness can contribute to  an understanding of the distribution of 
wealth, both nationally and internationally, if it is recognized that: (i) it can be applied at both the 
enterprise and the country level, (ii) when applied at the enterprise level, it relates to profits or market 
shares, (iii) when applied at the country level, it re lates to both national income  and international trade 
performance, particularly in relation to specific indus trial sectors that are important in terms of, for 
example, employment or productivity and growth pote ntial, (iv) it is based on a Schumpeterian logic 
that sees the nature of capitalist development as a se quence of innovative investments associated with 
dynamic imperfect competition and productivity gains, and that sees a major role for public policy in facilitating productivity-increasing investment,
5 and (v) not all countries can simultaneously improve 
the competitiveness of their firms or sectors relative to other countries, but all countries can 
simultaneously raise productivity and wages to improve their overall ec onomic welfare without 
altering their relative competitive positions. 
15. If new technology in the form of added capital per worker (or embodied technological 
change) is at the heart of the development pro cess through which nations become rich, and if 
embodied technological change is driven by i nvestment based on either innovation of domestic 
entrepreneurs or putting imported cap ital equipment to efficient use, then approaching the concept of 
competitiveness in the context of economic developmen t needs to take account of the interdependence 
of investment, trade, finance and technology. 
16. Looking at competitiveness from the perspective of  interdependence, two key questions relate 
to how different price, wage, exchange-rate and tr ade arrangements (i) influence the determinants of 
innovative investment, and (ii) determine whether pr oductivity gains of individual firms translate into 
benefits for the overall economy, as reflected in ri sing living standards, while maintaining external 
balance. 
17. Emphasizing interdependence also  implies that competitiveness in international markets is 
determined by both real and monetary factors.   Competitiveness may increase as a result of the 
relatively strong productivity performance of companies or the national economy as a whole; but 
greater competitiveness can result also from a deprecia tion of a country’s real effective exchange-rate 
                                                      
5 Fagerberg, Knell and Srholec (2 004) present a similar argument. WT/WGTDF/W/27 
Page 6  
 
 following either a depreciation of its nominal effec tive exchange-rate or a smaller rise in the ratio 
between wages and productivity (i.e. unit labour costs) than in other countries.
6 
III. CONDITIONS FOR COMPETITIVENESS AT THE MICROECONOMIC LEVEL:  
THE KEY ROLES OF INNOVATIVE INVESTMENT 
18. Linkages between capital accumulation, technological progress and structural change 
constitute the basis for rapid and sustained productiv ity growth, rising living standards and successful 
integration into the international economy.  Investme nt holds a central place in this interplay, because 
it can simultaneously generate income, e xpand productive capacity, and carry strong 
complementarities with other elements in the gr owth process, such as technological progress, skills' 
acquisition and institutional deepening. 
19. However, a given rate of investment can genera te different growth rates, depending on its 
nature and composition as well as the efficiency  with which production capacity is utilised.  
Particularly important for productivity  growth and structural change is investment in new techniques 
and/or new products.  This is because new procedures generally reduce production costs of 
established products, while new products are often mo re attractive to consumers than any of the 
previously available alternatives.  Assuming consta nt wages, successful innovative investment will be 
reflected in growing market shares, if the investor  chooses to pass on innovation rents in the form of 
lower prices; or it will lead to (temporary) monopol y profits, if the investor chooses to leave sales 
prices unchanged and enjoy innovation rents from th e rising revenue-cost ratio until competitors 
succeed in imitating the innovator.  Which of these strategies the investor chooses will depend on the 
intensity of competition.  This means that in th e microeconomic sphere, changes in competitiveness 
relate to changes in relative labour productivity acr oss different firms, and that technological progress 
and the ensuing growth in labour productivity (i.e. the drivers of sustainable rising competitiveness) 
are associated with oligopolistic, rather than perfect, competition. 
20. Innovative investment in developed countries exte nds the technological frontier.  By contrast, 
in developing countries it generally relates to the adoption, imitation and adaptation of technology 
invented elsewhere.  While this does not aff ect the key importance of productivity-enhancing 
investment for competitiveness at the firm level, or significantly alter the determinants of investment 
decisions, there are three issues that specifically concern productiv ity-enhancing investment in 
developing countries.  First, in building their i ndustrial capacity and competitive strength, newly 
industrializing countries must typically import a large volume of capital goods and intermediate 
inputs.  However, an inability to obtain additional export earnings (i.e. if the country’s products are 
not competitive on international markets or face prohi bitive market access or entry barriers), and thus 
to finance these imports, may be a serious constraint  on the industrialisation process.  The extent of 
this balance-of-payments constrai nt and dependence of developing countries on foreign technologies 
embodied in imported capital goods are perhaps greatest  during the initial stages of industrialisation.  
However, the need for large-scale imports of mach inery and equipment persists throughout much of 
the industrialisation process, especially when catch ing up is based on imitating technological leaders. 
21. Secondly, in addition to directly facilitating a ri se in the level of technology used by domestic 
firms, developing-country imports of goods that  embody foreign technology positively affect 
domestic imitation and innovation.  For example, a notable feature of the process of technological 
improvement in the East Asian economies in the ear ly stages of their industrialisation was their 
                                                      
6 The concept of competitiveness as defined here is relevant for countries where economic success 
depends on investment that leads to sustained improvements in productivity.  This excludes many of the poorest 
countries, where capital accumu lation can help raise per capita income a nd living standards simply by allowing 
a fuller use of underutilized labour and natural resources without altering the efficiency with which resources 
are utilized.  WT/WGTDF/W/27 
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 emphasis on research and development (R&D) spending,  not only for backward engineering but also 
to match or surpass the product quality of fore ign manufacturers by adapting and improving imported 
technology.  The former enabled firms, for exam ple, to fully assess the merits of a new foreign 
technology and thus to determine whether to secu re a licence or not, and to unbundle foreign 
technology, thereby enhancing their bargaining power in negotiating with suppliers.  As the 
industrialisation process unfolded and firms came to master imitation, an increasing share of R&D 
spending was channelled into own innovation ( TDR 1994 , Part Two, chapter one).  Taking a wider 
geographical perspective, and looking at a large number of countries from all developing regions, a 
recent empirical study (Connolly, 2003) also reveals the positive impact of technology imports from developed countries on domestic imitation a nd innovation in developing countries. 
22. Thirdly, the realisation of technological impr ovements in developing countries is closely 
related both to the skill level of their labour force – which determines the amount and degree of 
sophistication of technology that can be adopted and efficiently used – and to managerial capabilities, 
which must meet the requirements to function effectively in new sectors and new markets.  As such, technological upgrading in developing countries is  usually associated with a painstaking and 
cumulative process of technological learning.  Human capital formation, including through learning, 
is instrumental in preventing a decline in the marg inal product of capital, despite the rapid growth in 
the capital-labour ratio generated by rapid accumulati on of physical capital.  It also helps prevent a 
decline in the marginal product of labour, despite the rise in wages that results in a higher standard of 
living. 
23. The competitiveness of affiliates of foreign tran snational corporations (TNC) is likely to be 
significantly higher than that of domestic firms.  Labour productivity in TNC affiliates tends to be 
higher than in their domestic counterparts, because they can combine the comparatively lower general 
level of labour costs in the host country
7 with the advanced production technology and management 
techniques used in their home countries, and with  supplies of raw materials and intermediate 
production inputs from the cheapest sources.8 Indeed, in the context of the concept of 
competitiveness, the decision of a foreign company to invest abroad is generally based on the 
objective to reduce unit labour costs in production.  Setting aside other host country characteristics 
(such as income or corporate tax treatment or provisi on of infrastructure), this implies that for FDI to 
occur, the investor must expect the ratio between labour productivit y and wages in the affiliate to 
exceed that in the parent company.  In other words,  if expected unit labour costs in the host country 
are lower than in the TNC’s home country, the TNC will consider moving part of its production 
activities abroad. 
IV. COMPETITIVENESS OF FIRMS AT THE LEVEL OF THE NATIONAL ECONOMY 
24. At the level of the national economy, the decisi ve factor for realising technological upgrading 
and productivity-driven structural change is the ab ility of investors to sell the products resulting from 
their product or process innovations without a signifi cant change in cost conditions (i.e. to enjoy a 
(temporary) monopoly profit).  In other words, if an economy is characterised by high domestic 
labour mobility and by a similar level of wages fo r workers with similar qualifications across the 
economy, its dynamic development will be driven by profit differentials, rather than wage 
differentials.  Indeed, as noted by Keynes (1930: 141) , "the departure of profits from zero is the 
                                                      
7 If labour mobility within the host country is high, the wage level will be determined by the economy-
wide average level of labour productivity, rather than by marginal labour productivity. 
8 The development effect of foreign direct investment (FDI) for the host economy depends on a range 
of factors, including the amount of tech nological spillovers from affiliates to  domestic enterprises, the creation 
of forward and backward linkages, and the effects on dome stic investment.  The large body of literature on this, 
including successive UNCTAD World Investment Reports , provides ambiguous findings, and shows that much 
depends on host-country characteristics and the way foreign affiliates operate. WT/WGTDF/W/27 
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 mainspring of change in the ...  modern world.  ...  It is by altering the rate of profits in particular 
directions that entrepreneurs can be induced to produ ce this rather than that, and it is by altering the 
rate of profits in general that they can be i nduced to modify the average of their offers of 
remuneration to the factors of production." 
25. Hence, the closer actual conditions on the labour  markets get to the law of one price, the 
stronger will be the effects of profit differ entials on the evolution of economic systems.
9 The observed 
asymmetry between uneven productivity growth and the more even growth in wage rates across 
enterprises or industrial sectors is frequently emphasized as providing an important source of both structural change in the domestic economy and changes in the comparative cost advantages of different countries in specific industrial sectors.  Un even productivity growth across firms, combined 
with more even growth in wage rates, implies that workers in industries with relatively higher 
productivity growth are not fully compensated. 
26. Under this scenario, innovative investors may decide to leave sales prices unchanged and 
obtain a sizeable extra profit equal to the differe nce between their productivity gain and the economy-
wide average growth in productivity.  Alternatively,  they may prefer to reduce sales prices by the 
amount to which their profit per unit of output rises, and thus, assuming normal price elasticities of 
demand, increase their market share.  This will lead to a rise in their absolute level of profits in line 
with the rise in sold output.  This potential for extra profits is the major incentive for starting the 
process of "creative construction" or "destruction"  along Schumpeterian lines, and hence for making 
innovative investments.  By contrast, if wages in each firm rise more in line with firm-specific productivity gains, innovative investors will obtain a much lower extra profit, which will be much less 
of an incentive for innovative investment. 
27. Enterprises whose productivity gains fall shor t of the national average will experience 
shrinking profits if labour costs rise at equal ra tes across firms.  These enterprises will therefore 
attempt to raise the sales prices for their goods so as not to risk a complete erosion of profits.
10 This 
implies that sectorally uneven productivity gains, combined with even labour  cost increases across the 
entire economy, generate price pressures in non-innova tive sectors.  However, the net impact of this 
supply-side effect on price pressure depends on e ffects originating from the demand side.  Rising 
labour productivity induces increase s in income, and hence consumption.  If demand for innovated 
and non-innovated goods were to grow at the sa me rate, demand effects would not skew price 
pressure towards one or the other group of goods, thus the supply-si de effect would dominate.  By 
contrast, if demand for the innovated good were to grow faster than for the other goods, the supply-
side effect would be offset, partly or complete ly.  And if demand were biased towards goods for 
which productivity gains were low (such as services) , the demand effect would reinforce the supply 
effect.  This will be the case particularly when prod uctivity gains are high in the traded sector, while 
domestic consumption demand is bi ased towards non-traded goods. 
28. A second important condition for innovative invest ment to govern the evolution of the 
economic system is that firms should have access to  reliable, adequate and cost-effective sources for 
financing their investments.  This condition is best  met when profits themselves are the main source 
of investment financing.  Indeed , if an investment-profit nexus ca n be ignited, profits from innovative 
                                                      
9 Looking at developed countries, Scarpetta and Tressel (2004) point out that in addition to wage-
bargaining regimes, two main aspects of labour-market pol icy and institutional settings are closely related to the 
incentives for firms to undertake investment with a vi ew to expanding and inno vating production facilities: 
(i) the stringency of employment protection legislation, which influences the costs of hiring and firing, and (ii) the possible interactions between this legislation and in dustry-specific technology ch aracteristics.  However, a 
discussion of the importance of these factors for developing countries is beyond the scope of this report. 
10 Note that this example assumes that the innovative and the non-innovative firms operate in different 
sectors, so that they are not in direct competition.  If they operated in the same sector, an attempt to raise sales 
prices would make the non-innovative firm even more likely to be driven out of the market.  WT/WGTDF/W/27 
 Page 9 
 
 
 investments simultaneously increase the incentive for firm s to invest and their capacity to finance new 
investments.11 When enterprises are heavily dependent on  borrowing to meet their needs for fixed 
investment and working capital, as is the case for ne w enterprises, the stance of domestic monetary 
policy is of crucial importance, because high levels of nominal and real interest rates tend to increase 
production costs.  In addition to its adverse impact on the cost of capital, a restrictive monetary policy 
may bias investment decisions in favour of fina ncial assets, or fixed investment in production 
activities with known cost and demand schedul es over innovative production activities for which 
investors face uncertainty as to the volume of sales and the true costs of production. 
V. TRANSMISSION MECHANISMS BETWEEN THE NATIONAL AND THE 
INTERNATIONAL ECONOMY 
29. Entrepreneurs invest in the industrial sector of th at country in which they expect to realise the 
highest return on their investment.  Cross-country differences in the expect ed return on investment 
expressed in a common currency are determined by a number of factors, including relative rates of income growth; relative wages and labour productiv ity, macroeconomic and institutional factors that 
influence the average level of nominal labour co sts in an economy as a whole; relative costs of 
intermediate production inputs; relative tran saction costs associated with information, 
communications, transportation and distribution; an d the use of different currencies.  Moreover, 
market access and entry conditions and the availa bility of trade finance also determine whether 
improved cost competitiveness translates into improve d export performance.  This shows that a wide 
range of conditions must combine for firms that are competitive on the domestic market to become 
successful exporters. 
30. The availability of adequate transport and co mmunications infrastructure and information 
systems has a crucial influence on the ability of developing-country firms to conduct trade and to 
successfully compete in foreign markets.
12 Innovative investors in economies with comparatively high 
communication, transport and information costs may n eed to offset this disadvantage by paying lower 
wages or reducing costs elsewhere in the production pr ocess in order to be able to compete in world 
markets.  Firms in countries that are landlocked or geographically distant from major international 
shipping routes are particularly disadvantaged in this respect.  While this is a well-known problem, 
the impact on trade flows of other forms of trade facilitation, such as the availability of networked 
information technology and compliance with product standards, has gained in importance over the 
past few years. 
31. Secondly, trade finance provides the liquidity for firms to bring their products to the market.  
Exporters with limited access to working capital of ten require credit to buy imported raw materials 
and intermediate production inputs, as well as fina ncing to manufacture products before receiving 
payments.  Trade finance may be provided directly through loans from commercial banks, pre-payments by buyers, and delayed payments by sellers , or indirectly from either export-credit agencies 
(in the form of guarantees, insurance and government -backed loans), private in surance companies, or 
multilateral development banks. 
32. Thirdly, assuming constant nominal exchange rates, preserving the international cost 
competitiveness of domestic firms requires that the ratio of average nominal labour cost growth and 
average domestic productivity growth in the domestic economy does not rise faster than in the rest of 
the world.  Macroeconomic and institutional factors pl ay an important role in fulfilling this condition.  
                                                     
 
11 As argued by Akyüz and Gore (1996), the presence of such an investment profit nexus played an 
important role in East Asian industrialisation.  The investment profit nexus played an important role also in the 
growth performance of Western Europe during th e three decades after the Second World War. 
12 Local wholesale and distribution co sts also affect trade costs.  Bu t since they apply to both imports 
and domestic goods, they do not affect relative pr ices to buyers and international competitiveness. WT/WGTDF/W/27 
Page 10  
 
 For example, the pressure for sharp general wa ge increases in an economy approaching full 
employment is likely to be higher than in an economy with substantial unemployment.  Moreover, 
indexation of wage rises based on factors other than  productivity growth is likely to cause substantial 
and lasting divergence between wage  and productivity developments.
13 
33. Fourthly, stable nominal exchange rates are perhaps the single most important condition for 
the transmission of domestic productivity improveme nts to gains in international competitiveness.  
Exchange-rate movements alter the relative competitiv e position of firms in different countries.  On 
the one hand, this implies that a currency apprecia tion will wipe out improvements in the international 
competitiveness achieved by innovative firms on the basis of improved labour productivity if the 
change in the exchange rate exceeds the gain in productivity.   If technological progress relies on 
cumulative and incremental innovations that individually lead to comparatively small productivity 
gains, it does not take exchange-rate chang es of a spectacular size for this to occur.14  On the other 
hand, this implies that currency depreciation can give a further boost to the international 
competitiveness of an innovative firm and main tain the relative competitive position of non-
innovative enterprises in the short run.   However,  there can be little doubt that long-term economic 
success and maintaining international compe titiveness depend on sustained improvements in 
productivity.  Moreover, resorting to currency de preciation may allow for some breathing space to 
adjust to changes in the relative competitive position of foreign competitors, but it also entails the risk 
of igniting a process of competitive devaluations. 
                                                      
13 This is the case, for example, if wage increases ar e indexed to inflation, and if external supply shocks 
such as price increases of imports (e.g. oil) have a strong impact on inflation. 
14 For example, according to Gordon  (2003: 208), the average annual  rate of growth of labour 
productivity in the United States during the period of the information and communications technology boom 
(1995–2000) was about 2.5 per cent.  WT/WGTDF/W/27 
 Page 11 
 
 
  
Box: Cost competitiveness at the ent erprise level and export performance 
To understand how the mechanisms  discussed in this paper work in practice, it is useful to 
consider a two-country world comprising a devel oping country, with a low average level of both 
labour costs and labour productivity,  and a developed country, with a high average level of labour 
costs and labour productivity.  Expressed in a co mmon currency, these levels are assumed as 5 and 10 
in the developing country and 50 and 100 in the developed country (case 1 in the table).  Furthermore, 
assuming that in both countries the average level of  labour costs reflects the average level of labour 
productivity, firms in both countries face the same av erage level of unit labour costs (i.e. 0.5 currency 
units).  If labour is the only internationally imm obile production factor, these assumptions imply that 
firms from both countries are, on average, internationally competitive.  Moreover, if firms set sales 
prices on the basis of a mark-up of 100 per cent over la bour costs, the absolute level of profits in the 
developed country will be 10 times highe r than in the developing country.15 
 
Case 2 in the table introduces the effects of innovative investment by assuming that 
productivity increases by 20 per cent in innovative firms of both countries.  If the weight of these 
firms in their domestic economies is too small for th ese productivity gains to have a marked impact on 
the economy-wide average level of productivity, nominal labour costs will remain unchanged, and 
unit labour costs in the innovative firms will decline by 20 per cent.  Profits per unit of output will 
also remain unchanged if the innovative firms reduce th eir sales prices in line with the decline of their 
unit labour costs.  This implies that the inno vative firms from both countries will experience an 
increase in both their export-market shares and thei r absolute level of profits.  By contrast, non-
innovative firms will suffer a decline in export-market  shares and in profit levels due to the increase in 
their sales prices relative to those of the innovative firms. 
Case 3 in the table shows that affiliates of TNCs can gain considerable advantages in 
international competitiveness by combining develo ped-country technology wi th developing-country 
labour costs.  The levels of the affiliate’s unit labour costs will be substantially lower than of either its 
parent company in the developed country or of domes tic firms in the developing country.  While it is 
unlikely that the relatively less e ducated workers in the developing country can match the productivity 
level of workers in the developed country, it is probable that the TNC will experience a strong 
reduction of its unit labour costs by moving its la bour-intensive production activities to a low-wage 
country. 
 
Changes in the nominal exchange rate that are caused by "autonomous" capital flows (i.e. that 
are unrelated to the flow of goods) can offset th e effects discussed above.  In case 1, export-market 
shares will move from firms of the country whose cu rrency appreciates towards firms of the country 
whose currency depreciates, even though none of the firms has undertaken productivity-enhancing 
investments and unit labour costs, measured in dome stic currency units, have not changed in any of 
the firms.  More importantly, the innovative firms in  case 2 will lose, rather than gain, export-market 
shares if the appreciation of the exchange rate ex ceeds productivity gains.  For example, assuming the 
currency of the developing country to appreciate by more than the productivity gains achieved by 
innovative firms, these firms will lose export-market  shares to both the innova tive and non-innovative 
firms of developed countries.  This example shows that adverse external monetary shocks can wipe 
out the gains resulting from an improvement in the international competitiveness of developing-
country exporters based on innovative investments and a decline in unit labour costs. 
 
                                                      
15 However, the developed country will tend to employ a higher stock of capital in production than the 
developing country.  Thus the rate of return over capital (i.e. the absolute profit relative to the value of the 
capital stock) may be very similar in the two countries.  In other words, the example relies on the assumption that the internationally immobile factor – labour – ab sorbs the entire wealth difference between the developed 
and the developing country, while the internationally mobile factor – capital – obeys the law of one price. WT/WGTDF/W/27 
Page 12  
 
 Innovative investment, exchange rate changes, and international  
competitiveness:  a numerical example  
 
 Case 1 Case 2 Case 3 
 No innovative 
investment Innovative firm averagea Non-innovative firm 
average TNC affiliate investing n 
developing-country 
export-oriented 
production 
 Developing 
country Developed 
country Developing 
country Developed 
country Developing 
country Developed 
country  
Productivity 10 100 12 120 10 100 120>productivity>10 
Nominal labour costs 5 50 5 50 5 50 5 
Unit labour costs 0.5 0.5 0.4 0.4 0.5 0.5 0.5>ULC>0.04 Profits per unit of 
output 5 50 5 50 5 50 115>profits>5 
Price 1 1 1-x 1-y 1+x 1+y 1-z 
1.   Unchanged nominal exchange rate      
Export market share unchange d unchanged up up down down up 
2.   Nominal exchange rateb      
 appreciation by more than 20 per cent      
Export market share down up downc upc downc upc up 
3.   Nominal exchange rateb      
Export market share up down upc downc upc downc up 
Source :  Authors' calculations. 
Note:  x and y are the shares of the innovative investor s' products in total consumption of their respective 
economies. 
z is the share of the multinational firm's reimported product in total consumption of the economy of the parent company. 
a  The scenario in the table is based on the assumption that innovative investors fully transmit gains in profits 
per unit of output into price reductions. b  Developing-country currency/developed-country currency. 
c  The net effect depends on the relation between the gain in productivity and the exchange rate misalignment.   
The assumption for the effects noted in the table is th at the misalignment is far greater than the gain in 
productivity. 
 
 
VI. MEASURING COMPETITIVENESS:   THE REAL EXCHANGE RATE 
34. Given the complexity of the issue of compe titiveness, it is not surprising that there is a 
multitude of competitiveness indicators.  Some an alysts use competitiveness indices that combine 
several dozens of individual measures spanning across a wide range of economic and non-economic 
factors.  The probably two best-known comp etitiveness indices, contained in The Global 
Competitiveness Report of the World Economic Forum and in The World Competitiveness Report of 
the International Institute for Ma nagement Development, are frequently invoked in policy discussion 
and economic policy making.  However, the way these indices combine the very large range of  WT/WGTDF/W/27 
 Page 13 
 
 
 individual indicators is not transparent and, more importantly the complex theoretical issues that 
underlie the concept of competitiv eness are insufficiently discussed.16 
35. By contrast, the indicator that is most widely used in applied economic analysis is the real 
exchange rate based on relative price and/or cost  indices expressed in a common currency.  Real 
exchange-rate indices based on relative unit labour  costs may be the preferred measure of 
competitiveness, in particular for economies with a well-established industrial base and strong 
backward linkages.  This measure is defined as the ratio of employee compensation (including non-
wage labour costs) per employee and the volume of  output (value added at constant prices) per 
employee expressed in a common currency.  Thus, re lative unit labour costs depend on relative labour 
costs per worker, relative labour productivity and the exchange rate.  As such, a 10 per-cent slower 
rise in nominal labour costs, a 10 per-cent depreciati on in the exchange rate or a 10 per-cent faster 
increase in labour productivity all have an identical  impact on measured relative unit labour costs.  
Moreover, the real exchange rate based on rela tive unit labour costs allows the decomposing of 
changes in international competitiv eness into the relative impact of  changes that emanate from the 
domestic economy (i.e. productivity gains and nominal wa ge changes) and those that have their origin 
in international relations (nominal exchange rate changes).17 A drawback of this measure is that it 
tends to overestimate the impact of exchange-ra te changes on the competitiveness of domestic 
exporters to the extent that exports rely on impor ted intermediate inputs.  A relatively high import 
content of exports offsets, to a considerable  degree, the competitive edge provided by nominal 
currency depreciations.  Moreover, comprehensive data required to cal culate relative unit labour costs 
are not available.  This explains why empirical ass essments of changes in real exchange rates usually 
rely on changes in relative consumer prices.18 
VII. UNDERVALUATION AS A GENERAL SOLUTION? 
36. For policy makers in developing countries, the fact that exchange-rate changes can influence 
the overall competitiveness of a country and have th e potential to directly improve the overall trade 
performance of the majority of their firms and the ba lance of payments is a promising prospect.  On 
the other hand, the use of the exch ange rate as a powerful tool of economic policy is often strictly 
limited by the influence that the global capital mark et and the policy of other countries exert on that 
rate.  The exchange rate of any country is, by  definition, a multilateral phenomenon, and any rate 
change has multilateral repercussions. 
37. In the last three decades, developing and emer ging-market economies in all the major regions 
have had to struggle with financial crises or their contagion effects once they have tried to manage the 
exchange rate unilaterally or even opted for free floa ting.  Nevertheless, in the Bretton Woods era, as 
well as in the period of floating or managed floating thereafter, some patterns of successful adjustment to the vagaries of the international cap ital market emerged, which have been increasingly 
adopted by developing countries’ economic and fina ncial policies.  Since the Second World War, 
some experiences of successful catching up – su ch as by Western Europe, Japan and the newly 
industrialising economies (NIE) – suggest that , among other factors, long-lasting currency 
                                                     
 
16 However, Lall (2001) has significantly contributed to  a clarification of how these indices are actually 
constructed. 
17 Some analysts, such as Boltho (1996 ), have argued that using the real  exchange rate as an indicator 
for competitiveness reflects short-term macroeconomic management concerns.  However, when countries are 
subject to frequent external shocks, such as significant volatility in the nominal exchange rate or in commodity 
prices – that have an adverse effect on the country’s terms of trade – or lasting exchange rate misalignments, concerns about the level of the real exchange ra te also reflect long-term development objectives. 
18 However, Turner and Golub (1997) show that, for most countries for which comprehensive data are 
available, there is a substantial positive correlation betw een the two measures of real exchange rates, even 
though large differences between the two measures occur over the medium term, in particular for developed 
countries. WT/WGTDF/W/27 
Page 14  
 
 undervaluation can be extremely helpful to fully r eap the benefits of open markets.  Today, as 
multilateral arrangements do not exist on a global scal e, a strategy to avoid overvaluation by any 
means has become the preferred tool of  many governments and central banks. 
38. This is in stark contrast to the experience of  the 1990s in Latin America.  During that decade 
many Latin American countries maintained hard or soft currency pegs with some overvaluation 
during the 1990s, and used the exchange rate as a nom inal anchor to achieve rapid disinflation.  This 
led to an impressive improvement in their monetary  stability (Fischer, 2001: 9; Mussa et al., 2000) but 
also to currency appreciations that impaired the competitiveness of exporters  in these countries.  
Today, with inflation rates being relatively low and stable due to favourable domestic conditions, 
adopting a strategy designed to avoid currency overv aluation has become feasible for a much larger 
number of developing countries.  Indeed, many developing countries (such as China, Brazil and South 
Africa) have recently sought to avoid a revaluati on of their currencies through direct central bank 
intervention, with the result that they have a ccumulated substantial amounts of foreign-exchange 
reserves. 
39. It is clear that for these countries, avoiding currency overvaluation is not only a means to 
preserve or improve macroeconomic competitiveness, but  also an insurance agai nst the risk of future 
financial crises.  The accumulation of current-acco unt deficits, and frequent financial crises, with 
overshooting currency depreciations, pr oved very costly in the past.  Surges in inflation, huge losses 
of real income, and rising debt burdens have been a common feature of all recent financial crises. 
40. However, as TDR 2004 shows, a strategy of avoi ding currency overvaluation cannot easily be 
implemented if the capital account is open.  If inflat ion rates in developing countries exceed those in 
the developed world, or if there are expectations  of an imminent currency appreciation, monetary 
policy will often face a dilemma in trying to keep th e exchange rate stable and yet at a level that 
preserves the international cost competitiveness of the country’s exporters.  Calculations by the 
UNCTAD secretariat show that even a slightly di verging inflation trend between two open economies 
is sufficient for highly volatile short-term interna tional capital flows to force the central bank of the 
country with high inflation to give  up its undervaluation strategy or to face the severe fiscal costs that 
can be associated with this strategy.
19  
41. The results of these calculations are straightforwar d.  Only if the nominal short-term interest 
rate in a financially open emerging-market econom y exceeds that in a developed country by more 
than the growth differential, the nominal exchange rate of the former should depreciate at a (annual) 
rate that equals the difference in (annual) interest rates.  If this is not the case, the situation is not 
sustainable, as either the high interest rate or the overvalued exchange rate hampers sustainable 
economic development in th e emerging market economy. 
42. Hence the political choice to combine floating of the currency with restrictive domestic 
monetary policy to bring down inflation will d estabilise the external account.  Speculation on 
uncovered interest rate parities will yield high returns to arbitraging international portfolio investors, 
as nominal and real interest rates in the developing economies are higher than in the leading 
industrialised economies.  The currencies of the high-inflation countries will tend to appreciate, 
thereby, temporarily, even increasing the incentive for foreign investors to buy domestic assets and 
the incentive of domestic borrowers to borrow abroad. 
                                                      
19 Diverging inflation trends in open economies are much more important for the viability of an 
exchange rate strategy than the usually discussed "asymmetric shock", first introduced by Mundell in his paper 
on optimum currency areas (Mundell, 1961).  With diverging inflation trends grounded in different labour market regimes, the arguments used to defend hard pegs or dollarisation (e.g. Calvo, 1999) no longer apply, as 
long-lasting remedies to preserve competitiveness are sought and not just one-off measures.  WT/WGTDF/W/27 
 Page 15 
 
 
 43. Overall, the dilemma for developing-country policy-makers of a situation in which 
international investors earn high rates of return in their countries, despite falling real income, 
domestic profits and employment, cannot be reso lved under conditions of free capital flows.  
Developing-country policy-makers ar e usually unable to reduce interest rates to stop the speculative 
capital inflow, because doing so would endanger the cred ibility of their monetary  policy domestically.  
The political will to achieve economic stability is refl ected in the decision to keep nominal interest 
rates high.  How long an external economic imbalance following an exchange rate peg or an appreciation can be sustained is an open question.   With growing visible external imbalances, the 
developing country’s exch ange-rate policy will begin to lose credibility in markets.  Once investors 
are convinced that the anchoring country will not be able to manage slowing down the growth of its 
external debt smoothly, confidence will deteriorate.  This will lead to renewe d crisis, a reduction of 
reserves and eventually a depreciation of the country’s exchange rate. 
44. In any case, exchange-rate changes are neces sary to compensate for the opening scissor 
blades of the price and cost developments between a high-inflation and a low-inflation country.  As 
long as developing countries are not able to converge perfectly in nominal terms with the developed 
countries, devaluations are unavoidable in order to  preserve the competitiveness of the high-inflation 
countries.  However, exchange rate changes, and in particular, real exchange-rate changes, that 
determine the competitiveness of the whole economy,  cannot be left to the market.  Given the 
arbitrage opportunities between high- and low-inflati on countries, a rule of competitive neutrality of 
the exchange rate, like the PPP rule, has to be enfo rced by governments and/or central banks.  Ideally, 
such a rule should be the result of multilateral ag reements, as exchange-rate changes always have 
multilateral repercussions.  But if the international community is not able to agree on rules to avoid 
competitive devaluations and huge destabilizing s hocks, countries will continue to manage the 
floating of their currencies unilaterally. 
45. Managed floating, however, faces an adding -up problem on the global scale.  Not all 
countries can simultaneously manage the movements of their exchange rate and achieve their targeted 
rates.  The exchange rate, by definition, is a multilateral phenomenon, and attempts by many countries 
to keep their currencies at an undervalued rate may end up in a race to the bottom – or in competitive 
devaluations – that would be as harmful for the world economy as in the 1930s.  Moreover, given the 
size of international short-term capital flows and the inherent vo latility of these flows, only those 
developing countries that are big and competitive en ough to withstand strong and sustained attempts 
of the international financial markets to move the exch ange rate in a certain direction, will be able to 
manage the floating successfully.  A small and ope n developing economy will hardly be able to 
continue fighting a strong tendency to ap preciate over many years or even decades. 
46. Multilateral or even global arrangements are clearl y the best solutions to this problem.  The 
idea of a cooperative global monetary system w ould be to assure, on a multilateral basis, the same 
rules of the game for all parties involved, more or less in the same way as multilateral trade rules 
apply to every party equally.  That is why the ma in idea behind the founding of the International 
Monetary Fund in the 1940s was to avoid comp etitive devaluations.  In a well-designed global 
monetary system, the need and the advantages of th e currency depreciation of one country have to be 
balanced against the disadvantages to the others.  As changes in the exchange rate, deviating from 
purchasing power parity, affect international trade in  exactly the same way as changes in tariffs and 
export duties do, such changes should be governed by multilateral regulations.  Such a multilateral 
regime would, among other things, require countries to  specify their reasons for real devaluations and 
the dimension of necessary changes.  If such rules were  strictly applied, the real exchange rate of all 
the parties involved would remain more or less c onstant, as strong arguments for creating competitive 
advantages at the national level would rarely be acceptable. 
47. In a world without a multilateral solution to the currency problem, the only way out for high-
inflation or high-growth countries that are not member s of a regional monetary union is to resort to WT/WGTDF/W/27 
Page 16  
 
 controls of short-term capital flows or to follow a strategy of undervaluation and unilateral fixing.  If 
developing countries are able to avoid destabilising in flows and outflows, either by taxing those flows 
or by limiting their impact through direct inte rvention in the market, the hardest choices and 
misallocations due to erratic excha nge-rate changes can be avoided; but the resort to controls or 
permanent intervention should not replace the search fo r an appropriate exchange  rate system at the 
regional or global level.  WT/WGTDF/W/27 
 Page 17 
 
 
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