Markets & Trade

Why Developing Countries Should Open Their Markets to Foreign Capital

A new study of 18 nations shows manufacturing wages and productivity skyrocket after an infusion of foreign capital.

October 01, 2008

| by Dave Murphy

When a developing country opens its stock market to foreign capital, the resulting economic effect usually helps more than just big business. A recent study of 18 nations found that typical manufacturing workers saw their real wages go up seven times faster than they would have otherwise during the first three years after the inflow of foreign capital.

At the same time, productivity grew even faster than real wages, said Peter Henry, the Konosuke Matsushita Professor of International Economics at Stanford GSB. “Unit labor costs fall, so firms are actually becoming more profitable even as workers experience an unprecedented increase in wages.”

In many developed countries, companies that gain productivity may cut back their workforces. Technology might help one worker do what two did before, but the already-large markets can’t expand enough to keep both of the workers. A cutback is one way to improve the bottom line. But, Henry said, those pains didn’t occur in the developing nations he studied because the more manufacturing efficiency often led to an increased demand for the items manufactured. “The productivity gains do not lead to a fall in the number of workers employed.”

The study examines emerging economies from all over the world that began opening their markets from 1986 to 1995. Henry and coauthor Diego Sasson, who recently earned his doctorate in economics from Stanford, found that the average worker’s real compensation increased by about $752 (US), more than a 25 percent rise compared with their pre-liberalization pay.

Henry said the first impact of opening financial markets operates through the capital markets rather than wages. Manufacturers often find it easier to get financing, and might have a wider range of potential buyers and investors. “Opening up the stock market reduces the cost of capital, so some things that were not profitable to invest in before liberalization are profitable now,” Henry said.

Companies that build more plants or expand their horizons need more workers. Henry said Colombia is a typical example. “They opened up their equity markets pretty substantially,” he said. In 1991, Colombia opened its stock market to foreign investors. The next year, real wages rose 5.9 percent. The year after that, they jumped 11.1 percent.

In their study, Henry and Sasson used a control group of countries not undergoing liberalization to ensure that the wages increases they observed were not driven by worldwide factors that had nothing to do with the liberalization in each country. They found that the wage gains of the liberalizing countries were not shared by the control group.

The average growth rate of labor productivity, for example, was 10.1 percentage points more during liberalization and the two years afterward than in non-liberalization years. But countries in the control group did not have a comparable productivity increase.

The changes carry with them a lasting impact on the workers’ standard of living. In 15 of the 18 countries studied, the median growth rate of real wages in the post-liberalization period is more than the pre-liberalization median.

One limit in the study, Henry said, is that it applies only to the manufacturing sector. “We don’t know what happens to the workers in agriculture or the service sector.”

Still, he said, it’s clear that the economic impact of liberalization goes well beyond the capital, having a marked impact for a significant fraction of a developing country’s workforce. “Even if wages are not going up in other sectors,” Henry said, “the average overall wage of workers is going up.”

Henry said some economists and politicians have argued that developing countries are making a mistake by opening their markets. “I think this is one more piece of evidence that suggests that the antiliberalization argument is probably not right,” he said.

The bottom line? “Policy matters,” Henry said. “A lot.”

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