Brazil and China: Strategic Partners in the 21st Century?

By
Brazil
Brazil and China: Strategic Partners in the 21st Century? - Ilan B. Solot

Abstract

The objective of this paper is to discuss the implications of a possible improvement in the terms-of-trade for Brazil (a reversal of the controversial Prebisch-Singer Hypothesis) resulting from China's industrialization process. The paper will address, in particular, how this terms-of-trade improvement opens the possibility for a new model for Brazil's economic development, based on the export of commodities. It finds that the dual effect of lowering the prices of manufactures and raising those of commodities, brought about by China's industrial export-led growth model, will likely invalidate the declining terms-of-trade aspect of the Prebisch-Singer Hypothesis. Nevertheless, many of the implications derived from this hypothesis still deserve careful consideration.

"The 1990s already saw a return to a primary-exporting role for Latin America. All the signals are that the world economy will push Latin America even more strongly in this direction in the new century, especially in the fields of oil and mining. It behooves us to look very coldly at the political economy and social dimensions of such a model, with more than half an eye on the past. We need to be alert to what will need to change if primary ­resource-based growth is to be compatible with long-term economic and social development."1

-Rosemary Thorp, Oxford University

The Preface to a New Model

China has a population of 1.3 billion people. This means that if its per capita income were to increase by USD 100 there would be additional USD 130 billion demand to be absorbed by the global market.

Due to China's demographic outlook and stage of development, the recent rise in Chinese income has translated into an additional consumption of commodities. These commodities are likely to be food and the raw materials required for investments in infrastructure. As a net exporter of food and raw materials, a rare window of opportunity is opening for Brazil. While some of this increased demand will undoubtedly be met by expanding domestic production, imports of primary commodities are likely to continue to increase. For example, in spite of China's expanding production of minerals and metals, its exports have been falling for the last few years. Given both geological factors and signs of increasing scarcity of energy in China, future investments are unlikely to reverse this trend. As a result, China's mineral imports from developing countries outside Asia tripled from 1995 to 2002.10

The same applies to agricultural imports. The capability of China's arable land to feed its growing population (in numbers and income) has begun to come under strain. As a result, imports from developing countries outside Asia increased by a total of thirty percent from 1995 to 2002.11

In short, China's increasing demand is potentially the single most important determinant for Brazil's economic development in years to come. In 2003, China became the third largest importer of Brazilian products (behind the United States (US) and Argentina, respectively). In the same year, Brazil became China's tenth largest provider of imports. Moreover, China has become the fifth largest exporter to Brazil.

The pattern of trade between Brazil and China is clear: Brazil sells commodities to China and buys China's manufactures.

One of the main concerns about the Brazil-China trade pattern is that it emulates that of Brazil-US throughout most of the twentieth century (i.e., exporting commodities and importing high value-added goods). As we shall see, many of the arguments for a pro-manufacture "China Strategy" are based on the notion that this pattern of trade has to be broken if Brazil itself is to develop economically. These arguments, as many others, are based upon the intellectual foundation left by Prebisch and the Structuralist economists.

 

Objection to a Commodity Based Model

The first step for any economic model which favors primary commodities is to pass the "golden standard" set by the first generation of pro-industrialization advocates. This is especially important because much of the intellectual groundwork for contemporary pro-industrialization advocates draws from it.12

The first generation of pro-industrialization economists believed that promoting industrialization was the optimal strategy even if the industries turned out to be relatively less efficient than the agricultural sector.13 Many of the arguments that led to this conclusion can be revised to fit Brazil's current dilemma over a "China Strategy." Once revised, these arguments can serve as guidelines for the challenges a model based on commodity export is likely to face. Here are four examples, with their respective adaptations:

1. Agricultural activity is not capable of raising income or absorbing the growing labor force in Latin American countries. The recent growth in agricultural and mineral exports seemed to have little effect on the rural unemployment problem - in the case of Brazil, typified by the Landless Movement (Movimento sem Terra);

2. Primary product specialization will crystallize the North-South (or Center­ Periphery) dynamics in which only the North is able to retain the benefits of technical progress. Allowing this process to continue would perpetuate the income gap between the regions. Even if China moves towards the Center, so to speak, Latin American countries will continue to be at a disadvantage vis-a-vis the US and Europe. Moreover, the unfavorable pattern of trade between the US and Europe (which contributed to Brazil's underdevelopment), may very well extend to the Brazil-China trade relations;

3. Primary commodity exporting countries suffer from chronic external vulnerabilities resulting in structural balance-of-payment problems. Some have also argued that such vulnerabilities feed into inflation. '4 In any case, balance-of-­payment problems are thought to be related to the low income elasticity of commodities;

4. The dependence upon low value-added exports would not generate enough foreign exchange to import essential high value-added ones (e.g., machinery ) without incurring foreign debt. Given the available land and technological restrictions, there is no realistic terms-of-trade gain that would make the arithmetic work out favorably in order to raise the living standards of the population.

While an in-depth analysis of these, and many other "neo-Structuralist" arguments, is beyond the scope of this paper, it is important to point out some of the main factors that could counteract the above challenges as well as open the window of opportunity to a primary product-based model.

Notes

Introduction

Should Brazil give up on manufacturing? Behind this seemingly rhetorical question lies what will perhaps be the next most important strategic decision for policymakers in Brazil, as well as in many other Latin American countries. While the Ricardian theory of comparative advantage seems to insinuate that the best trade strategy for Brazil is to specialize in exporting primary commodities, there is, on the other hand, plenty of reason for disagreement. After all, industrial activity has been - for the past two hundred years - the key to the development of virtually every advanced economy.

As a result of the recent Chinese industrial revolution, resource-rich countries like Brazil may finally get what classical economic theory had always promised them: a rise in the international value of commodities.2 In fact, this "promise" dates back to the English industrial revolution. Writing during the late 18th century, Robert Malthus prophesized that the "passion between the sexes" would cause the population to grow at an unsustainable rate, eventually leading to a dramatic condition of global food scarcity. Henceforth, many liberal political ­economists have contended that the gains from international trade would be distributed in such a manner that they would benefit developing countries, at least eventually. In the words of John Stuart Mill: "the exchange values of manufactured articles, compared with the products of agriculture and of mines, have, as population and industry advance, a certain and decided tendency to fall."3

But much has changed since the days of Malthus and Mill. In the late 1940s, two UN economists, Raul Prebisch4 and Sir Hans Singer, concluded that Malthus, Mill and the tradition of liberal political-economy were wrong with respect to rising commodity prices. Using cutting edge United Nations (UN) statistics from the time, Prebisch and Singer argued that prices of primary commodities were, in fact, falling vis-a-vis those of manufactures. This controversial observation, along with its controversial theoretical explanations, became known as the Prebisch-Singer Hypothesis (P-S).

In the years after the publication of his thesis, Prebisch became the most important advocate of an industrialization path for Latin America's economic development. He believed that any strategy in which economic activity was concentrated on the production of primary products would not succeed. Moreover, he argued that promoting industrialization was the optimal strategy even if the industries turned out to be relatively less efficient relative to agricultural production.5 Much of Prebisch's pro-industry conviction came from the belief that prices of primary products would continue their declining trend.

However, much has changed since the days of Prebisch and Singer. The rise of China (and soon India) as an industrial power, casts serious doubts on the continuing validity of the Prebisch's pro-industry postulate. China's increasingly important role in international trade is not only causing prices of commodities rise, but it is also causing prices of manufactures to fall. If this trend persists, it is clear that the P-S will no longer be valid.

This recent China-induced improvement in Brazil's terms-of-trade has paved the way for the re-emergence of the debate over a "commodity vs. manufacture economic development strategy." Much of the discussion over what is the optimal "China Strategy" resembles - both in substance and in rhetoric -the debate that took place in Prebisch's time.

A "China strategy" - or lack thereof - may prove to be the most important policy decision in determining Brazil's future role in the new international division of labor. There is increasing evidence that, without a decisive governmental strategy, Brazil may return to its historical condition of a commodity exporter and manufacture importer. Hence, as in Prebisch's days, the Brazilian government is called upon to support its national industry in spite of its Ricardian fate as an exporter of primary products. There is, however, one essential difference: this time around, commodity prices are expected to rise.

The P-S and its implications are the most resilient thread that links the debate from Prebisch's day with the present-day debate over a "China Strategy." A good example of how the P-S is re-contextualized can be seen from an interview with the current Brazilian Ambassador to China, Luiz Augusto de Castro Neves, conducted by the Falha de Sao Paulo on October 24, 2004. When asked if the government was worried about the export patterns of trade between Brazil (commodities) and China (manufactures), the Ambassador answered:

The expansion of primary commodities exports to China] has led us to reproduce, between Brazil-China, a north-south commercial relation, in which China would be north, while Brazil south. This dichotomy between agrarian versus industrial goods, in which higher value added and higher price potential is attributed to industrial goods, is changing little by little. What we have seen in Brazil during the last years is an enormous growth in the agribusiness, which is behind the recent economic performance. The agribusiness prevented a contraction of the Brazilian economy and is one of the inducers of growth.

It is clear that by "dichotomy," the Ambassador is either directly or indirectly referring to the fifty-year-old debate over the P-S. The importance of the P-S for the present day debate is unequivocal: if it holds in years to come, there will be no viable path to economic development through the export of commodities.

The objective of this paper is to discuss the implication of a possible improvement in the terms-of-trade for Brazil (a reversal of the P-S trend), resulting from China's industrialization. The paper will address, in particular, how this terms­-of-trade improvement opens the possibility for a new model for Brazil's economic development, based on the export of commodities. The arguments in favor of this hypothetical new model will be contrasted with the objections by pro-industry advocates, which are drawn from the legacy left by Raul Prebisch and the Structuralist economists from the Economic Commission for Latin America and the Caribbean (ECLAC).

The remainder of this paper will be organized as follows: 1) a brief discussion of the P-S; 2) a presentation of evidence that terms-of-trade are improving, and are likely to continue to improve, at least for Brazil; 3) a presentation of numeric evidence for a possible "commodity export-led growth model;" 4) a presentation of possible objections to this model (drawing from Prebisch's intellectual legacy); 5) a broader discussion of the "window of opportunity" opened by China's industrialization in light of the presented evidence; and 6) concluding remarks and a historical overview of the composition of Brazil's export portfolio.

Prebisch-Singer Hypothesis (P-S)

The P-S refers to the observation that there is a long-term tendency of decline in the terms-of-trade for countries who export primary products. Using the UN statistics available at the time, Prebisch, along with another UN economist, Singer, simultaneously - though independently - came to the same conclusion: since 1876, the international prices for industrialized commodities were steadily rising, while those for primary commodities were steadily falling.6 As a consequence, the developed (industrialized) countries were growing richer while the underdeveloped (agrarian) were becoming poorer. This observation, along with its theoretical explanations, became known as the P-S.

Although Prebisch and Singer arrived at the same conclusion, they offered different theoretical explanations for what they observed. While Prebisch offered a supply side theory based on asymmetries between industrial and developing countries and Keynesian nominal rigidities, Singer focused more on the demand side, considering mainly price and income elasticities.7

Prebisch believed that labor unions in industrialized countries caused wages in manufacturing to become permanently fixed at a higher level with each subsequent business cycle. This was because wages would rise during upswings, but were "sticky" during downturns. In developing countries, on the other hand, weak unions were unable to prevent wage cuts during downturns. According to Prebisch, the observed decline in the terms-of-trade resulted from prices of commodities rising by less than the price of manufactures during upswings and falling by more during downturns. Graphically, this can be understood as a rightward movement in the relative supply (RS) schedule of primary commodities in terms of industrialized ones (see Graph 1).

Singer, on the other hand, considered mainly price and income elasticities to be responsible for the shortfalls of a primary commodity-dependent economic model. He argued that monopoly power held by industrialized countries prevented the prices of industrialized products from falling, much like Prebisch's explanation. However, he also argued that demand for primary commodities was relatively less income elastic. In other words, after any given income growth, the demand for industrialized products would rise by more than the demand for primary products. This would cause a leftward shift in the relative demand (RD) curve (see Graph 2).

The semantic link between primary product specialization and the condition of underdevelopment has been, for nearly fifty years, reliant upon the expectation that prices of primary commodities would fall relative to those of industrialized ones (i.e., P-S).

However, what if the prices for primary products where expected to rise, as opposed to falling? In other words, what if the P-S where expected to reverse in years to come? Would there still be a basis to defend a pro-industrialization position? These two questions open the door for building a new development model for Latin American countries based on the export of commodities.

A Postscript to the Prebisch-Singer Theory

On August 27, 2004, the United Nations Conference on Trade and Development (UNCTAD), the same UN branch for which Prebisch served as Secretary General, published its report entitled World Commodity Trends and Prospective. According to the report:

Commodity prices increased considerably in 2003 and the first half of 2004, particularly for minerals, while prices of agricultural products rose more slowly. The general economic recovery and rapidly increasing demand in Asia, particularly China, were the main reasons for the price rises ... Developments differed between commodity groups. Industrial raw materials experienced good demand conditions and the UNCTAD price index for minerals, ores and metals rose by more than 28 per cent during 2003 ... The index for agricultural raw materials rose by 27 per cent in 2003 ... In conclusion, Chinese and Indian demand growth will provide a major dynamic stimulus to international commodity markets over the next several years and, since commodity markets are global, the additional demand arising from Asian growth will benefit a wide range of countries and not only affect the immediate neighborhood.8

While the P-S's statistical claim seemed unconvincing when published, it is even more unlikely to hold today.9 Although there is so far no evidence of a sustained trend in increasing terms-of-trade for countries who export primary commodities, the data published in reports such as the World Commodity Trends and Prospective provide enough evidence to expect that the terms-of-trade will not be decreasing in the near future. This is particularly the case for Brazil's export portfolio, since soy and iron are amongst its top five export commodities.

The most recent data on the Brazilian agricultural sector shows an unequivocal trend of rising prices. The chart below depicts some of the most important Brazilian agricultural indexes since 1999.