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International division of labour
It was a time when the world had been divided into two groups which economists call ‘international division of labour’.
According to this division, one group produced manufactured products and supplied them to the rest of the world. This group comprised the rich world. The other group produced primary commodities – ranging from cereals to agricultural produce to minerals – and supplied them to the rest of the world. This latter group consisted of poor countries in the world. What was observed in the global markets was that while the prices of manufactured products continued to rise or remained stable, the prices of primary commodities had been depressed or had undergone frequent changes from increases to decreases showing a high degree of volatility.
Unfavourable terms of trade for poor countries
In terms of the international division of labour, the poor countries had to buy manufactured products by selling their primary products. But 
when the prices of manufactured products go up and prices of primary commodities decline, the poor countries face a freakish situation where they have to sell more and more of primary commodities in order to buy the required manufactured products. The price ratio of what one exports to what one imports is known as the Terms of Trade or TOT depicting how many units of exports which a country has to sacrifice in order to buy one unit of imports. If TOT is 100, then TOT is neutral for that country since one unit of exports can buy one unit of imports; if it is above 100, it is favourable since it can buy more than one unit of imports by selling one unit of exports but if it is below 100, it is the opposite.
Sri Lanka, victim of unfavourable TOT
Sri Lanka was a victim of this unfavourable market development all throughout its post-independence period. That was because three major crops – tea, rubber and coconuts – accounted for about 90% of its export earnings and it had to use those earnings to import all the manufactured products it had been using. Hence, TOT was particularly unfavourable to Sri Lanka. Just to measure the extent of loss, its Central Bank had been calculating the impact of TOT changes on the real national income of the country, thanks to the pioneering work done in early 1960s by one of the leading economists of the day – M.R.P. Salgado – under the direction of Gamani Corea who was the Director of Economic Research at that time.
What this calculation did was to measure the loss of the real purchasing power of Sri Lankans due to increases in import prices over the increases or decreases in export prices. For instance, if in a particular year, Sri Lanka’s import prices go up by 20% to 120 and export prices at a slower rate of 10% to 110, its TOT (110 divided by 120) deteriorates to 92 depicting that Sri Lanka now has to pay 9% more to buy its import goods. Thus, if Sri Lanka produces a GDP to a value of 100 rupees in that year, its actual purchasing power is approximately 91 rupees or it has to produce 9 rupees more to maintain the same real purchasing power. This was done long time before the world had gone for the Purchasing Power Parity as an alternative to measure the real welfare of nations.
Unfavourable TOT lowers real income below real GDP
For instance, in 1963, Sri Lanka had produced goods and services worth of Rs 6.9 billion in real terms but its real income level was Rs 6.7 billion or 96% of its GDP due to the unfavourable movement of TOT. This loss widened over the years and in 1972, a real GDP of Rs 10 billion had produced only a real income of Rs 9 billion or 90% of the original.
Gamani Corea was particularly alive to the loss of welfare of people in poor countries due to the unfavourable TOT at the time he became the Secretary General of UNCTAD. He wanted to alleviate their agonies by setting up an international mechanism to stabilise the prices of primary commodities.
Appraisal of Gamani Corea’s noble mission
This mechanism was presented in detail to an audience consisting of his fans and colleagues from his days at the Central Bank, Ministry of Planning and UNCTAD by Saman Kelegama, Executive Director of the Institute of Policy Studies or IPS last week. The event appraising Gamani Corea’s contribution to domestic and international economic policy had been jointly organised by Gamani Corea Foundation, Marga Institute and IPS under four major themes – his role in national planning, commodity price stabilisation, establishing a new international economic order and building institutions.
It was addressed by a selected group of local and international experts who had had close association with Gamani Corea in making those enterprises a success. Today’s My View exclusively focuses on his unremitting efforts at stabilising the international prices of primary commodities.
TOT issues running in the bloodstream
According to Kelegama, the deteriorating TOT and its impact on poor countries were in the bloodstream of Gamani Corea from his university days.
He was aghast by the loss of welfare levels in poor countries as a result of the Great Depression in rich countries in 1930s. The concern was that poor countries were dependent on a few export commodities for growth and welfare and if these products faced problems, so did the countries concerned.
That was the reason for him to select this area for research for the DPhil Degree at the University of Oxford. His thesis titled ‘The Instability of an Export Economy: The Case of Sri Lanka’ was later published by the Marga Institute.
Disappointing experience validated by Raul Prebisch
It had analysed the adverse impact of TOT on the Sri Lankan economy and drawn attention to the limited policy scope that it had provided. He had already encountered this issue as the architect of the first six year plan in 1952, the second ten year plan in 1959 and as the Secretary to the Ministry of Planning during 1965 to 1970. He had been enamoured by a popular economic theory put forward by Argentine economist Raul Prebisch and German-British economist Hans Singer on the subject.
The theory known as the Prebisch-Singer Hypothesis had predicted that poor countries in time to come will be able to import a lesser amount of manufactured commodities out of the goods they export due to the deterioration of TOT. Hence, when he became the head of UNCTAD he had already been armed with the problem, its diagnosis and possible curative treatment.
Following the lead by OPEC
In early 1970s the world had seen the collective power of producers in affecting prices when the Organisation for Petroleum Exporting Countries or OPEC decided to cut the supply and increase the crude oil prices by several folds. Gamani Corea thought that it could be replicated in other commodities as well.
Accordingly, if producers can get together through an international commodity agreement or ICA, they could effectively cause the market prices to go up. Along with this, a set of ideas was developed under the auspices of UNCTAD for developing countries to have a greater voice in promoting their interests which came to be known as the New International Economic Order or NIEO.
NIEO was both militant and pleading
NIEO was considered new because the old order, developed under the system that created the International Monetary Fund and the World Bank by the agreement reached at Bretton Woods in USA, had favoured the rich world especially the US which had a bigger voice in it. Thus, NIEO was an attempt at correcting the imbalance and gaining more power for the poor world. However, the tone of NIEO was both militant and pleading. Militant because it declared the right of poor countries to control and regulate multinational corporations and nationalise foreign property in their countries on their terms and conditions. Pleading because it appealed to rich countries not to penalise them on that count.
Given Corea’s bad experience with old Ceylon’s nationalisation of oil companies in 1962, it is doubtful whether this was in line with his thinking. It thus appeared that his noble mission had been hijacked by some militant groups in the poor world whose ideology was known as ‘Thirdworldism or bringing the Third World back to its glory’ at that time. Surely, with that type of antagonistic action, the mission of UNCTAD was pre-destined to fail. That was because it was based on the wrong assumption that world economies could function independently ignoring the needed interdependence among them for sustenance and therefore it could not muster support from the rich world to make it a success.
Critics of NIEO: wrong diagnosis leading to wrong treatment
In this background, the critics of NIEO, mainly Herbert Grubel of Simon Fraser University in British Columbia in Canada, have pointed that the proponents of NIEO have overlooked several key factors relating to the global trading arrangements. Commodity trading takes place in huge auctions conducted through commodity exchanges rather than by bilateral or multilateral agreements; not a single party or a group of countries cannot influence their prices. In addition, prices of manufactured products go up because of quality improvements over time whereas there is no similar quality improvement taking place in primary commodities.
The price declines in some primary commodities have taken place due to the introduction of better substitutes: Satellite communication and optical fibre replacing copper cables, synthetic yarn taking the place of cotton yarn, synthetic rubber easing the demand for natural rubber and polythene displacing jute as a packing material are some of the examples.
Then, changes in consumer preferences too caused the depression of the prices of some of the primary commodities. Orthodox black tea suffered because of the movement of consumers to instant tea on the one hand and the youngsters preferring soft drinks to tea in Western countries on the other. Coconut faced the threat of vegetable oils which were perceived, for rightly or wrongly, as heart-friendly. Thus, the poor countries have wrongly diagnosed the ailment and sought to prescribe the wrong treatment through NIEO. Thus, the patient, instead of recovering, should naturally die.
A global public good without a global government
What happens in national or international policymaking is that if a mistake is not corrected initially, it leads to a series of subsequent mistakes. This was exactly what happened in the case of UNCTAD too. When the wrong curative treatment of using monopoly power to increase the prices was adopted as a policy, it became necessary for UNCTAD to buy the excess and build buffer stocks in order to prevent any decline in prices when there is excess supply.
Building buffer stocks was like producing a global public good without a global government to supply the needed funds. This problem does not arise in the case of local public goods since the sovereign governments have powers to raise funds through taxation and finance the supply of public goods. In the absence of a global government, it was the poor countries themselves that had to supply funds for financing buffer stocks.
Unsuccessful attempt at taming the market
According to Saman Kelegama, the initial requirement of funds for a Commodity Fund or CF to build buffer stocks was $ 6 billion. According to the UNCTAD statistics, the total GDP of the poor countries in 1974 amounted to $ 649 billion and the cost of CF was some 9% of their total worth. Hence, from the beginning itself it was to be an unrealisable goal. As such, as Kelegama had reported, UNCTAD was able to mobilise only $ 280 million or 5% of the targeted amount.
The poor countries were not unanimous in supporting the noble cause. The rich countries kept their distance from CF because NIEO had threatened to exercise the right to nationalise foreign ventures in poor countries according to their terms and conditions. Thus, the noble mission of stabilising the commodity prices by building market monopolies and financing the same through buffer stocks became a flop.
In hindsight, in a later publication titled ‘Taming Commodity Markets’, Gamani Corea had attributed the failure to some technical reasons – perishability of many commodities, quality variations, availability of synthetic substitutes and disincentive to efficient producers – and political reasons – non-cooperation by rich countries.
Market punishes wrong interventions
This writer is of the view that if Gamani Corea is asked to go along with this noble exercise today, he would adopt a different approach. In 1970s and early 1980s, he did not have the benefit of the subsequent developments in the global economy. As expected, OPEC lost its monopoly power by mid 1980s due to a mixture of market reactions to its artificial monopoly building.
Several factors caused to slow down the growth in the demand for crude oil: curtailment of consumption due to increases in prices, development of energy substitutes and invention of fuel efficient vehicles and production processes. On the supply side, oil fields which were not economical at previous low prices soon became profitable, technology was developed to drill off-shore oil wells, mainly in the North Sea and the Gulf of Mexico, and new deposits were discovered in countries like China and Viet Nam. Accordingly, the market ruthlessly punished the monopoly builders by depriving them of their artificially acquired power.
Diversification of products and productivity improvement a must
Countries facing the commodity price declines have to respond to the problem not by monopoly but by adopting a multitude of structural changes in their economies. They could move into manufacturing as was done by East Asian countries and minimise the risk of depending on primary commodities. In the case of primary commodities, the continuous research and development will enable countries to improve productivity and push down the average costs so that they could withstand the vagaries in the market effectively.
On top of that, countries should accept the life cycle of any product – that every product has a birth, existence and eventual death – and prepare themselves to change into new economic activities which will keep them floating above water all the time. Sri Lanka, which successfully has reduced its dependence on primary commodities in earning foreign exchange by moving into manufactured products, does not face the traditional TOT problem in the same way it had faced it four decades ago. Thus, in some years, TOT is favourable to Sri Lanka and in some years it is unfavourable to Sri Lanka. Accordingly, in the recent past, its real income adjusted for changes in TOT has been higher than the real GDP.
The mission unfinished may be irrelevant now
Gamani Corea’s mission was noble by all accounts. But he left UNCTAD with a mission unfinished. However, when one considers the changes in the global economy since then, one may ponder whether his mission has relevance today. Gamani Corea, being the erudite and humble economist he is, may very well go by that proposition too.
(W.A. Wijewardena, a former Deputy Governor of the Central Bank, can be reached at [email protected].)
