Increasing Trade & Investment rade & Investment 1

Policies, Instit , Institutions, and Development Assistance

Increasing Trade & In rade & In rade & Investment

United States Agency for Inter United States Agency for Inter national Development national Development

Summary Summary

Globalization offers an unprecedented opportunity for developing countries to achieve

faster economic growth through trade and

investment. But these resource flows remain

concentrated among relatively few, largely middleincome developing countries. Can low-income developing countries benefit from the global economy? This

paper argues that through greater openness and sound

governance—reforms that raise the level of economic

freedom—low-income developing countries can gain

access to global product and capital markets, and many

have already done so. The same measures encourage

local investment and enterprise as well. Elements of

successful reform programs include achieving macroeconomic stability, liberalizing the trade regime,

strengthening the role of the private sector in the

economy, and establishing the rule of law. The key is to

sustain the pace of reforms, and this is where development assistance can play a major role: nurturing support for reform, building market infrastructure to

support private transactions, and assisting vulnerable

segments of society through the transition.
2 Policy Brief Series, No. 1

Introduction

The global economy offers an unprecedented opportunity to direct resources toward development. Over the

past 10 years, developing countries’ total trade—exports and imports—has grown from less than $1.9 trillion to nearly $4.6 trillion. Growth in private capital

flows has been even more dramatic: net foreign direct

investment, or FDI, to developing countries rose from

$24 billion in 1990 to $184 billion in 1999. Countries

that have experienced growth in trade and investment

have achieved correspondingly faster economic growth.

The key to unlocking the power of trade and

investment is expanding the circle of countries actively

participating in the global economy. Recent work at the

World Bank shows that growth in trade volume has

been closely related to subsequent GDP growth in a

large sample of developing countries. For a select group

of countries that are rapidly integrating into the global

economy, trade growth has played a critical role in

supporting rapid growth in incomes and making

progress in reducing poverty.1

 These findings add

weight to previous research showing that developing

countries that adopted more open economic policies

have achieved substantially faster income growth than

have countries that kept their economies closed.2

Yet why is it that some countries get this bounty

and others do not? Some have argued that trade and

investment are only available to a select few countries,

such as those on the borders of the developed world or

those with natural resources. In fact, trade and investment have the potential to reach every corner of the

globe. While several factors influence the ability of

developing countries to attract trade and investment,

growth in these flows largely depends on the internal

process of opening up economies—both internationally

through lower trade barriers and domestically through

strong private markets, macroeconomic stability, and

the rule of law.

Foreign Dir eign Direct Investment and Economic ect Investment and Economic

Freedom

FDI is among the most important capital flows an open

economy can attract. FDI has drawn increased attention in recent years as a valuable form of capital, because transfer of production, marketing, and

organizational technology may accompany such funds.

Just as important, FDI has proved less vulnerable to

investor runs and cross-border contagion than either

portfolio capital or bank lending, thus providing a

valuable source of financial stability.

FDI has also been a harbinger of globalization.

Direct foreign investment inflows to developing countries were essentially flat from 1970 to 1986, fluctuating

around $11 billion in 2000 dollars. These figures were

small relative to development assistance and other

official flows. Then, from 1986 to the late 1990s, the

trend shifted sharply upward: net FDI to developing

countries rose more than sevenfold in the 1990s.

Middle-income developing countries receive the

vast majority of all FDI flowing to the developing world.

Since 1997, middle-income developing countries (those

with per capita incomes above $750) have garnered

some 93 percent of all such FDI. Even within middleincome countries, FDI flows are concentrated—the top

1

David Dollar and Aart Kraay, “Trade, Growth, and Poverty,” Development Research Group, (Washington, DC: World Bank,

2001). These results are examined in broader context in Paul Collier, David Dollar, et al., Globalization, Growth, and Poverty:

Building an Inclusive World Economy (Washington, DC: World Bank, 2001). 2

Jeffrey D. Sachs and Andrew Warner, “Economic Reform and the Process of Global Integration,” Brookings Papers on

Economic Activity (1: 1995: 1–118).

100

300

500

700

900

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Index: 1990=100

X + M

FDI

Figure 1. Developing Countries: Gr e 1. Developing Countries: Growth in Total

Trade and Net FDI Inflows

Note: X = exports; M = imports. e:
Increasing Trade & Investment rade & Investment 3

10 recipients of FDI consistently account for over 70

percent of the developing world’s total. FDI is focused

on a few countries that are large, relatively advanced, or

both. These include China, Mexico, Brazil, Korea,

Thailand, Malaysia, Indonesia, Poland, Hungary,

Colombia, the Czech Republic, Peru, India, Chile,

Argentina, and Hungary.

However, these figures obscure a more important

fact. While most FDI does flow to middle-income

countries, the ratio of FDI to GNP has been relatively

high in a number of poor countries, including Bolivia,

Cambodia, Ghana, Mozambique, Tanzania, and Vietnam. The amount of FDI going to poor countries may

be low relative to total FDI, but it can be high relative to

the size of these economies. Furthermore, this phenomenon is not simply a function of investment associated

with natural resources such as oil or diamonds.

FDI to the poorest countries can increase very

rapidly even if initial levels are low. The ratio of FDI

inflows to GDP among low-income countries rose from

0.5 percent in 1991 to 1.8 percent in 1997, before falling

back to 1.1 percent in 2000. FDI inflows for Bangladesh

increased from $14 million in 1996 to $180 million in

1999. In Mozambique, Tanzania, and Uganda, annual

net FDI inflows increased roughly sixfold between the

early 1990s and the late 1990s, from around $30 million

to around $160 million in each country.

A wealth of recent research supports the conclusion

that poorer countries can succeed in attracting FDI if

they introduce liberal trade and investment policies,

support free markets internally, and strengthen the rule

of law. For example, Saskia Wilhelms finds that liberalizing trade and investment policies has a strong impact

on FDI inflows after controlling for structural variables

such as market size; she finds that high rates of taxation

discourage FDI.3

 Margaret McMillan, Selina Pandolfi,

and Lynn Salinger endorse Wilhelms’ conclusions,

while also pointing to corruption as a universally

acknowledged barrier to FDI. McMillan, et al. also

emphasize the importance of good infrastructure and a

workforce with appropriate skills.4

 Finally, using the

Sachs-Warner “openness” classification to measure the

relevant policy environment and the rule of law measure reported by Political Risk Services, Inc. to gauge

the quality of the institutional environment, Alberto

Alesina and David Dollar find that each factor has a

strong and significant impact on FDI inflows. 5

Additional analysis based on a modification to the

Alesina-Dollar model indicates that policies that

enhance economic freedom are the principal means for

poor countries to attract foreign investment. Replacing

the openness and rule of law variables used by Alesina

and Dollar with the “Index of Economic Freedom”

reported by the Fraser Institute and Cato Institute

produces coefficients with similar or better levels of

statistical significance.6

 As shown in Table 1, estimates

of the impact of economic freedom on subsequent net

inflows of FDI remain quite stable in the face of changes

in other variables included in the estimates, including

measures of infrastructure development, educational

participation, and the role of fuels and minerals in

export earnings. This pattern suggests a significant

contribution of economic freedom to countries’ access

to FDI inflows.

The developing world offers many corroborating

examples of countries that have succeeded in attracting

increased FDI by implementing policies and strengthening institutions that enhance economic freedom.

Recent examples include Uganda, Tanzania, and

Bangladesh—all least-developed countries and ranked

in 1990 as among the poorest of the low-income developing countries.7

 None of the three enjoys any special

advantage in terms of natural resources or geography.

In Uganda, a landlocked country wracked by crisis ,

during the 1970s and early 1980s, the government

launched a broad economic reform program in 1992.

Elements included tighter management of fiscal and

monetary policies, more market-oriented approaches to

exchange rate management, and liberalized policies

toward coffee production and export. These and other

3

Saskia K.S. Wilhelms, “Foreign Direct Investment and its Determinants in Emerging Economies” (1998). 4

Margaret McMillan, Selina Pandolfi, and B. Lynn Salinger, “Promoting Foreign Direct Investment in Labor-Intensive,

Manufacturing Exports in Developing Countries” (1999). 5

Alberto Alesina and David Dollar, “Who Gives Foreign Aid and Why?” Journal of Economic Growth March 2000. 6

Measures of economic freedom represent a proxy for an array of underlying factors. The Fraser-Cato Index of Economic

Freedom covers seven areas of policies and institutions: the size of government, legal structure and security of property rights,

access to sound money, freedom to trade with foreigners, regulation of capital and financial markets, regulation of labor

markets, and freedom to operate and compete in business. The Index of Economic Freedom runs from zero to 10. 7

In a ranking of countries by per capita income in the 1990 World Development Report, Tanzania was fourth from the

bottom, Bangladesh was fifth from the bottom, and Uganda was sixteenth from the bottom. Uganda was ninth from the bottom

in 1985.
Table 1. Impact of Economic Fr able 1. Impact of Economic Fr eedom on

For eign Dir eign Dir ect Investment Inflows

reforms raised Uganda’s Index of Economic Freedom

from 2.7 in 1990 to 7.1 by 1999. The reform program

enabled Uganda to achieve rapid and sustained growth,

sharply reduced inflation, a reduced current account

deficit, and increased foreign exchange reserves. At the

beginning of the 1990s, net FDI to Uganda was essentially zero, but by the end of the decade it averaged

$221 million per year.8

Following a long, unsuccessful experiment with

socialism, Tanzania began taking tentative steps a

toward economic liberalization in 1986. The reform

process stalled in the early 1990s, then regained momentum in 1996 when a new government came to

power. By the end of the 1990s, Tanzania had taken

steps to improve macroeconomic management, liberalizing the exchange rate, reducing trade barriers,

8

Figures for the beginning and end of the 1990s refer to averages for 1989–90 and 1999–2000, respectively.

(1) (2) (2) (3) (4) (3) (4)

Notes: Pooled regression, with 91 countries and four periods. Dependent variable is (net FDI : 

inflow)/GDP, averaged over three five-year periods beginning 1981–85, and a final four-year period

1996–99. To minimize reverse causation, independent variables are initial values in the year before:

1980, 1985, etc. Missing values reduce included observations to between 244 and 307, depending

on the specification.

*, **, and *** indicate statistical significance at the 10-percent, 5-percent, and 1-percent levels,

respectively, based on White-corrected standard errors. t-statistics are shown in parentheses.

Data: Economic Freedom from Fraser Institute, : Economic Freedom of the World 2001. All other

data from World Bank, World Development Indicators 2001 (CD-ROM).

Constant -15.430** -12.982 -38.204*** -22.207**

(2.059) (1.540) (-4.227) (2.482)

Log of population -0.104* -0.057 -0.066 -0.076

(1.661) (0.783) (0.912) (1.040)

Log of PPP income per capita 3.994** 3.182 10.042*** 5.791**

(2.033) (1.420) (4.172) (2.463)

(Log of PPP income per capita) squared -0.240* -0.193 -0.650*** -0.376**

(1.893) (1.325) (4.114) (2.450)

Economic freedom 0.294*** — 0.279*** 0.349***

(3.366) (2.938) (3.618)

Economic freedom excluding rule of law — 0.290*** — —

(2.925)

Rule of Law — 0.070** — —

(1.978)

Telephones per 1,000 people — — 0.0077** 0.0062**

(2.472) (2.094)

Share of population (25 years+)

with “some” secondary schooling — — 0.0090

(1.230)

Fuel and mineral share in

merchandise exports — — — 0.0094**

(2.369)

Period dummy 1986–90 0.107 0.097 0.048 0.062

(0.065) (0.624) (0.241) (0.380)

Period dummy 1991–95 0.643*** 0.640*** 0.397 0.611***

(3.174) (3.176) (1.639) (2.760)

Period dummy 1996–99 1.743*** 1.688*** 1.565*** 1.558***

(6.385) (5.665) (4.561) (5.013)

Adjusted R2 0.270 0.262 0.318 0.315
instituting agricultural reforms, and improving tax and

revenue policies. The Index of Economic Freedom for

Tanzania increased from 3.6 in 1990 to 5.8 in 1999, and

FDI increased from around $3 million annually at the

beginning of the 1990s to over $188 million by the end

of the decade.

Bangladesh is not generally considered a reform h

success story over the 1990s, but it should get credit for

prudent macroeconomic policies, reforms in trade,

exchange rate management, liberalization of prices for

agricultural inputs and outputs, and relaxation of

restrictions on FDI. While the Index of Economic

Freedom did not rise as quickly as it had in Uganda or

Tanzania, it improved from 3.1 in 1990 to 4.8 in 1999.

Net FDI increased from around $1.6 million annually at

the beginning of the 1990s to $229 million annually by

decade’s end.

Trade and Economic Fr rade and Economic Freedom

Economic freedom not only helps poor countries

attract FDI, but also encourages international trade

(Table 2). Some, like Dani Rodrik, have argued there is a

limited relationship between trade liberalization and

subsequent trade and economic growth.9

 This analysis

indicates, however, that trade liberalization coupled

with structural economic reform has a strong, positive

correlation with growth, both in trade and in the

economy overall.

Igniting trade growth in developing countries, and

especially in low-income countries, requires companion

polices geared toward macroeconomic stability, a sound

investment climate, regulatory reform, and the rule of

law. Ataman Aksoy and Uri Dadush have pointed to

these factors, along with public education, social safety

nets, and especially institution building and effective

governance.10 Without such internal policies in place,

domestic producers will not achieve the competitiveness necessary to export effectively, financial markets

will fail to shift funds toward promising new industries,

and higher quality, lower cost imports may remain shut

out of domestic markets.

Given the interaction between international and

domestic markets, international trade can play a key

role in boosting overall economic growth, even when

trade is initially a small component of the total

economy. For instance, trade reform can reduce bottlenecks and rent-seeking behavior associated with

importing capital goods. One of the most compelling

mechanisms linking trade with growth in developing

countries is that imported capital goods are likely to be

significantly cheaper (and of higher quality) than those

manufactured at home.11 With successful companion

policies, trade reform can boost the long-term growth

rate of the economy, both through its incentive effects

on domestic investment and by spurring innovation.12

In addition, trade reform is often associated with

increased inflows of FDI, attendant spillovers of technology, new business practices, and rising productivity.

Table 2 highlights the strong correlations between

economic growth and growth in imports, exports, and

total trade. This is not at all surprising, since export

growth is positively related to GDP growth as a matter

of accounting; and income growth clearly influences

growth in overall demand, including demand for

imports. When per capita income growth is included,

the explanatory significance of initial levels of economic

freedom fades. Changes in economic freedom remain

significant in explaining growth in trade, but with

significantly reduced coefficients.

Further regressions shed light on these results. Both

levels and changes in economic freedom are important

in explaining growth in per capita income. Including

both per capita income growth and economic freedom

in an equation explaining trade growth introduces

multicollinearity among the independent variables,

which causes the statistical significance of the correlated variables to be underestimated. The impact of

increased economic freedom on trade can be seen as

working through two channels. The first channel is an

openness effect: at any given level of income, more

open policies will lead to increased trade. The second

channel is a growth effect: the improvements in policies

and institutions embodied in increased economic

freedom contribute to growing incomes, which—for

any given level of openness—will result in greater trade,

9

Dani Rodrik, “Globalization, Growth and Poverty: Is the World Bank Beginning to Get It?” (2001).

10Ataman Aksoy and Uri Dadush, “Tackling the Trade Agenda in the Poorest Countries” (Washington, DC: The World

Bank, Draft Paper, 2001). 11Dani Rodrik, “The Global Governance of Trade As If Development Really Mattered” (Cambridge, MA: Harvard University, paper prepared for the UNDP, July 2001, revised). 12Compare with Paul Romer, “What Determines the Rate of Growth and Technical Change?” World Bank Policy, Planning

and Research Working Paper, WPS # 279 (Washington, DC: The World Bank, 1989). See also Tamim Bayoumi et al. “R&D

Spillovers and Global Growth” (IMF Working Paper WP/96/47, 1996).
6 Policy Brief Series, No. 1

Total Trade (X+M) rade (X+M) Imports Exports Growth in GDP (%) owth in GDP (%)

Table 2. Impact of Economic Fr able 2. Impact of Economic Freedom on Trade and GDP Gr rade and GDP Growth

particularly imports. When growth in per capita

income is included as an independent variable, the

growth effect is captured directly and separately, while

the measured impact of economic freedom reflects only

the openness effect.

These results confirm the importance of economic

freedom—trade liberalization, macroeconomic stability,

a strong private sector, and the rule of law—in promoting growth in income and output, trade, and investment, including direct foreign investment. The

proposition that market-friendly policies and institutions matter for growth in trade, investment, and the

economy overall is hardly controversial among economists, though some mistakenly question the applicability of these universal principles to much of the

developing world.

Development Assistance and Economic Development Assistance and Economic

Freedom

Given the evidence that increased economic freedom

and greater openness spur trade, investment, and

ultimately growth, why have more developing countries

not taken this path to development? The answer is that

for closed economies, opening presents political, social,

and managerial challenges that can test the most

courageous politicians. For instance, in Mali, freeing

agricultural prices while ultimately allowing the country to raise production to the point where it could

export food, initially resulted in drastic swings in

domestic grain prices. Furthermore, in many developing countries, fear of competition from cheaper, higher

quality imported goods and services causes protected

Notes: Pooled regression, with 78 countries and two periods. Dependent variable is average growth over 1980–89 and 1990–99. : 

“Initial” economic freedom, trade, and GDP refer to first year of each 10-year period.

*, **, and *** indicate statistical significance at the 10-percent, 5-percent, and 1-percent levels, respectively. t-statistics are shown

in parentheses.

Data: IMF,Direction of Trade Statistics Quarterly, 2001.

Initial trade 0.57** 0.18 -0.12 -0.16 -0.46 0.16 -0.11 — — 0.32**

(2.48) (0.66) (0.49) (0.49) (1.57) (0.61) (0.46) (2.41)

Initial economic freedom 1.18*** 1.13*** 0.49 1.22*** 0.53 0.87** 0.25 0.63*** 0.40** 0.44**

(3.37) (2.94) (1.42) (2.73) (1.29) (2.08) (0.66) (2.89) (2.08) (2.32)

Change in economic freedom 0.05*** 0.05*** 0.03** 0.05*** 0.03** 0.04*** 0.02 0.02*** 0.01** 0.01**

(3.93) (4.00) (2.28) (3.72) (2.09) (3.12) (1.46) (3.73) (2.02) (2.08)

Growth in GDP per capita — — 1.04*** 1.08*** — 1.04*** — — —

(6.62) (5.77) (5.99)

Initial GDP per capita — — — — — — — 0.15 0.00 -0.27

(0.68) (0.01) (1.21)

Growth in trade — — — — — — — — 0.25*** 0.25***

(6.59) (6.72)

Asia — 4.55** 0.90 4.35** 0.54 4.90** 1.23 3.74*** 2.33*** 1.91**

(2.47) (0.53) (2.03) (0.27) (2.46) (0.66) (3.73) (2.60) (2.13)

Latin America/Caribbean — 0.95 0.40 0.86 0.29 0.79 0.27 0.26 -0.05 0.16

(0.51) (0.25) (0.40) (0.15) (0.40) (0.15) (0.28) (0.06) (0.20)

Middle East/N. Africa — 1.26 -0.60 0.38 -1.54 2.94 1.04 1.85* 1.44* 1.30

(0.66) (0.35) (0.17) (0.76) (1.42) (0.56) (1.91) (1.71) (1.58)

Sub-Saharan Africa — 0.45 -0.22 -0.34 -1.02 0.76 0.12 0.29 0.02 0.24

(0.24) (0.14) (0.16) (0.53) (0.38) (0.07) (0.30) (0.02) (0.29)

Adjusted R2 0.25 0.32 0.49 0.32 0.46 0.20 0.37 0.40 0.55 0.57
Increasing Trade & Investment rade & Investment 7

industries and their workers to lobby against the

removal of barriers to imports, despite the costs those

trade barriers impose on the broader economy.

In facing these difficulties, development assistance

can play a unique and important role, by helping

encourage, support, and sustain the self-help efforts

behind development progress. FDI and trade respond

to and reinforce development progress, creating a

virtuous cycle. Development assistance acts through

several channels: It can support governments in their

reform efforts, it can help develop the market infrastructure necessary for smooth private transactions, it

can cultivate the skills necessary to participate in the

global economy, and it can provide a cushion for

adverse exogenous shocks that might otherwise erode

support for reform.

To complement Mali’s agricultural sector reform, s 

USAID invested in critical market infrastructure aimed

at helping private markets work more efficiently. Prior

to that effort, farmers, traders, and consumers found it

difficult to obtain timely information on agricultural

prices prevailing in different parts of the country.

Market news moved at a camel’s pace, creating an

internal trade barrier between regions of surplus and

regions of shortage. The situation has been transformed

by the introduction of a twice-weekly radio show on

farm prices, supported by USAID and implemented by

Michigan State University. The show reports in local

languages on current prices for grains, crops, and

livestock at 64 markets around Mali. About 70 percent

of Mali’s population tunes in to the market report with

the loyalty of a soap opera audience. With this information in hand, the private sector now shifts supplies from

surplus to deficit areas. Mali’s trade capacity has been

enhanced through the deepening of market institutions.

The program has helped Mali solve its internal grain

distribution problems and has contributed to its ability

to export rice to nearby countries.

For Uganda, development assistance stiffened the a

resolve of the government to pursue reform. After

suffering 16 years of political instability, civil strife,

repression, and severe economic and government

mismanagement, the government ended its heavyhanded economic command approach and adopted a

market-oriented set of economic reforms. Successful

economic reforms beginning in the late 1980s generated remarkably strong economic performance

throughout the 1990s. USAID technical assistance and

conditionality concentrated on private-sector development, nontraditional exports, abolishing government

export monopolies, reducing other trade controls, and

streamlining the trade bureaucracy. Backed by support

from USAID, the World Bank, and the IMF, government spending was sharply curtailed, runaway inflation

stopped, the overvalued foreign exchange system

replaced with a free-market rate, and import and

foreign exchange controls eliminated. Government

marketing arrangements for coffee, tea, and cotton

were dismantled, and controls on foreign exchange and

investment were eliminated. Foreign investment, which

had been minimal before 1990, increased. New, nontraditional exports grew rapidly.

In Peru, development assistance helped stimulate a u

shift in the terms of the internal debate over economic

policies, leading in turn to the adoption of important

reforms. In the early 1980s, most intellectuals, academic economists, and government policymakers were

strongly opposed to economic reform and market

liberalization. They distrusted outsiders, but USAID

found an innovative way to reform the regulatory

framework by changing the intellectual climate. USAID

provided half of the funding of Hernando de Soto’s

Institute for Liberty and Democracy. The Institute,

employing 50 to 75 researchers, carried out field-based

research, held conferences to spread awareness of its

findings, and prepared legislative proposals. The

research analysis and presentations by a respected local

institution carried considerable weight in Peru. The

policy reform payoff came when Peru decided to

improve its regulatory treatment of low-income,

informal-sector entrepreneurs.

The Institute studied street vendors, squatters, taxi

owners, and small farmers, all of whose land and

operations were outside the law, as it was nearly impossible for informal businesses to register and become

legal. In 1990, the economic reform issues were debated

among presidential candidates, and as a result many of

the reforms were approved. By improving the performance and flexibility of the small-scale and informal

sector, these legal and regulatory reforms have complemented and facilitated the far-reaching reforms Peru

has undertaken since the early 1990s, including elimination of the fiscal deficit and liberalization of the

exchange rate, interest rates, and the trade and payments system.

Hernando de Soto’s analysis was published in his

book The Other Path, and highlighted in the World

Bank’s 1987 World Development Report. His approach

has been adopted by many other developing countries

and by bilateral donors and multilateral lenders.
8 Policy Brief Series, No. 1

This policy brief is the first in a series that USAID will pr This policy brief is the first in a series that USAID will pr oduce r oduce r egularly to explor egularly to explor e solutions

to the challenges of inter to the challenges of inter national development. Kenneth Borghese, Michael Cr national development. Kenneth Borghese, Michael Cr osswell, Brian

Frantz, Elaine Grigsby, Joseph Lieberson, Donald Sillers, and John Simon contributed to this

work.

Political Will Is Indispensable

Unfortunately, development assistance cannot substitute for political will. In the 1980s, most developing

countries had economic controls that deterred investment, trade, and economic growth. USAID, the World

Bank, and other donors worked with a number of

countries as they introduced major economic policy

reforms. One fundamental lesson learned from that

period is that pressure from aid donors alone cannot

generate reform. If a country has the political will and

mounts a strong self-help effort, success is possible, and

donor technical assistance and funding can improve the

pace of reform. If the country lacks commitment,

progress is not possible.

A study by Malcolm McPherson, funded by

USAID’s Africa Bureau, analyzes donor-supported

policy reform in Africa. Over the 1980s and 1990s,

most African countries launched macroeconomic,

trade, and exchange rate policy reforms. McPherson

finds that many countries failed to sustain reform

efforts when those efforts threatened to upset entrenched interests. The cases of Zambia and Ghana

illustrate this point.

Following its democratic reforms in 1991, Zambia

received large amounts of foreign assistance—more

than $7.9 billion between 1991 and 1998. Zambia

introduced several macroeconomic reforms in the early

1990s, but by 1996 had reached a crossroads. Largescale foreign investment was needed to rehabilitate and

expand the mining sector, requiring more serious

economic reforms, privatization of the copper mines,

and a clampdown on corruption. Zambia’s leaders

showed no interest in halting corruption or in selling

the mines. They stalled the reforms and tried to muddle

through, at the cost of forsaking some donor support.

As a result, by the late 1990s Zambia was again caught

in a spiral of rising debt, declining savings, stagnant

investment, increasing poverty, and declining per capita

GDP—down nearly 1.7 percent a year.

Ghana began a compre Ghana hensive reform program in

1983, backed by strong financial and technical support

from donors. The early reforms were straightforward,

though economically essential and politically challenging: devaluation, removal of price controls, interest rate

liberalization, and tax reform. The institutional reforms

that came later were more complicated: removal of

subsidies, financial sector reforms, investment promotion, privatization of state-owned enterprises, civil

service reform, and government capacity building.

After nearly a decade of progress, the reform process

came to a halt in 1992, when election-related wage

increases of over 80 percent, along with a broader loss

of fiscal discipline, generated macroeconomic instability and surging inflation. FDI peaked in 1994 at more

than $200 million and then began a steady decline to a

mere $17 million in 1999.

Despite these failures—or because of them—many

developing countries have learned the importance of

political will. After an election in 2000 brought a new

government to power, Ghana has again begun to

implement economic reforms, including fiscal stabilization and reduced intervention in foreign exchange

allocation, along with plans to divest public enterprises

to the private sector. FDI has increased dramatically, to

$100 million in 2000. In Zambia, privatization of the

mines began in 2000. The cases of Ghana and Zambia

demonstrate that aid cannot buy reform—it can only

reinforce the resolve of a forward-looking government

and its constituents.

Broadening Participation in the Global oadening Participation in the Global oadening Participation in the Global

Economy Economy

As the world focuses on development, the need to

encourage more countries to participate fully in the

global economy through domestic reforms—including

trade liberalization, macroeconomic stability, a strong

private sector, and the rule of law—has never been

greater. Such participation holds greater rewards than

ever, and the cost of failure is correspondingly higher.

As countries move to take advantage of these opportunities, the United States is prepared to support their

efforts, broadening the circle of participation in the

global economy, one country at a time.