Balance-of-Payments Constrained Growth — Growth Theory

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Writes Thirlwall on pages 369-371 of Growth and Development, 2006: 

In national income accounting an excess of investment over domestic saving is equivalent to a surplus of imports over exports. The national income equation can be written from the expenditure side as

Income = consumption + investment + exports - imports

Since saving is equal to income minus consumption, we have

Saving = investment + exports - imports

or

Investment - savings = imports - exports

A surplus of imports over exports financed by foreign borrowing allows a country to spend more than it produces or to invest more than it saves.

Note that in accounting terms the amount of foreign borrowing required to supplement domestic savings is the same whether the need is just for more resources for capital formation or for imports as well. The identity between the two gaps, the investment-savings (I-S) gap and the import-export (M-X) gap, follows from the nature of the accounting procedures.

It is a matter of arithmetic that if a country invests more than it saves this will show up in the accounts as a balance-of-payments deficit. Or to put it another way, an excess of imports over exports necessarily implies an excess of the resources used by an economy over the resources supplied by it, or an excess of investment over saving.

Before going into dual-gap analysis in more detail, a reminder of elementary growth theory is in order. 

Growth requires investment goods, which may either be provided domestically or be purchased from abroad. The domestic provision requires saving; the foreign provision requires foreign exchange. If it is assumed that some investment goods for growth can only be provided from abroad, a minimum amount of foreign exchange is always required to sustain the growth process. In the Harrod model of growth (see Chapter 4), it will be remembered, the relation between growth and saving is given by the incremental capital-output ratio (c), which is the reciprocal of the productivity of capital (p) that is, g = s/c or g = sp, where g is the growth rate and s is the saving ratio. Likewise the growth rate can be expressed as the product of the incremental output-import ratio (LlY/M = m') and the ratio of investment-good imports to income ([M/Y] = i), that is, g = im'.

If there is a lack of substitutability between domestic and foreign resources, growth will be constrained by whatever factor is the most limiting- domestic saving or foreign exchange.

Suppose, for example, that the growth rate permitted by domestic saving is less than the growth rate permitted by the availability of foreign exchange. In this case, growth will be savings-limited and if the constraint is not lifted a proportion of foreign exchange will go unused.

For example, suppose that the product of the savings ratio (s) and the productivity of capital (p) gives a permissible growth rate of 5 per cent, and the product of the import ratio (i) and the productivity of imports (m') gives a permissible growth rate of 6 per cent. Growth is constrained to 5 per cent, and for a given m' a proportion of the foreign exchange available cannot be absorbed (at least for the purposes of growth). 

Conversely, suppose that the growth rate permitted by domestic savings is higher than that permitted by the availability of foreign exchange. In this case the country will be foreign-exchange constrained and a proportion of domestic saving will go unused.

The policy implications are clear: there will be resource waste as long as one resource constraint is dominant. If foreign exchange is the dominant constraint, ways must be found of using unused domestic resources to earn more foreign exchange and/or raise the productivity of imports. If domestic saving is the dominant constraint, ways must be found of using foreign exchange to augment domestic saving and/or raise the productivity of domestic resources (by relaxing a skill constraint, for example).

Suppose now a country sets a target rate of growth, r. From our simple growth equations (identities), the required savings ratio (s*) to achieve the target is s* = rip, and the required import ratio (i*) is i* = r/m'. If domestic saving is calculated to be less than the level required to achieve the target rate of growth, there is said to exist an investment-savings gap equal at time t to 1, - s, = s*Y, - sY, = (rip) Y, - sY, (15.1)

Similarly, if minimum import requirements to achieve the growth target are calculated to be greater than the maximum level of export earnings available for investment purposes, there is said to exist an import-export gap, or foreign exchange gap, equal at time t to M,- X, i*Y, - iY, (rim') Y, - iY,, (15.2) where i is the ratio of imports to output that is permitted by export earnings. If the target growth rate is to be achieved, foreign capital flows must fill the largest of the two gaps. 

The two gaps are not additive. If the import-export gap is the larger, then foreign borrowing to fill it will also fill the investment-savings gap. If the investment-savings gap is the larger, foreign borrowing to fill it will obviously cover the smaller foreign exchange gap.

The distinctive contribution of dual-gap analysis to development theory is that if foreign exchange is the dominant constraint, it points to the dual role of foreign borrowing in supplementing not only deficient domestic saving but also foreign exchange. Dual-gap theory thus performs the valuable service of emphasising the role of imports and foreign exchange in the development process. It synthesises traditional and more modern views concerning aid, trade and development. On the one hand it embraces the traditional view of foreign assistance as merely a boost to domestic saving; on

the other hand it takes the more modern view that many of the goods necessary for growth cannot be produced by the developing countries themselves and must therefore be imported with the aid of foreign assistance. 

Indeed if foreign exchange is truly the dominant constraint, it can be argued that dual-gap analysis also presents a more relevant theory of trade for developing countries that justifies protection and import substitution. If growth is constrained by a lack of foreign exchange, free trade cannot guarantee simultaneous internal and external equilibrium, and the gains from trade may be offset by the underutilisation of domestic resources. 

(Emphasis added)