Factors Determining the Severity of Challenges from Lost Competitiveness
Question
Discuss the factors that determine the severity of the potential challenges that might arise when a country loses its competitiveness. [15]
Answer
A country may lose trade competitiveness — its ability to sell goods abroad — or investment competitiveness — its ability to attract FDI. Both generate the same broad challenges, but their severity varies. My thesis is that the openness of the economy is the predominant factor, with the effectiveness of mitigating policy, the state of the economy, the root cause, the multiplier and the type of exports all conditioning the outcome.
How competitiveness is lost, and the challenges that follow. Trade competitiveness can fall through a loss of comparative advantage — depletion of resources, low-cost competitors, or relative inflation as wages outrun productivity. Investment competitiveness can fall through rising unit labour costs, poor infrastructure, uncompetitive taxes or weak macroeconomic performance, deterring FDI. The challenges are familiar: a worsening balance of trade lowers aggregate demand, and the reverse multiplier cuts real national income, raising demand-deficient unemployment; displaced workers face structural unemployment; net export and FDI outflows worsen the balance of payments; and falling investment plus a brain drain lower productive capacity. The factors below determine how severe these become.
Openness of the economy. A larger domestic market cushions the blow: large economies can prop up aggregate demand through demand-management because , and are large relative to trade. Small open economies cannot — domestic consumption and investment are too small to offset a fall in exports and FDI — so they suffer more severely.
Effectiveness of mitigating policy. If a government can implement supply-side policy — R&D and retraining — to restore competitiveness and reduce structural unemployment, the impact is alleviated. But effectiveness varies: outcomes are uncertain (Malaysia’s support for an ailing car industry against Singapore’s successful pivot to high-end manufacturing), and a government facing high debt has less room for tax cuts or capacity spending than one with consistent surpluses.
State of the economy. If the economy is near full capacity, a fall in AD mainly relieves inflationary pressure with a small fall in output; if it has much slack, the same fall produces a larger drop in output and a larger rise in unemployment.
Root cause. If competitiveness falls because of an appreciation or demand-pull inflation, the challenge is milder — it reflects strong fundamentals. If it falls through a lost comparative advantage (persistent wage rises above productivity, resource depletion, being leapfrogged on price and quality), the resulting structural unemployment compounds the short-run challenges.
Size of the multiplier and type of exports. A small multiplier — as in import-dependent, high-saving Singapore — means a fall in autonomous demand brings fewer rounds of induced contraction, so a smaller fall in income than in a self-sufficient economy like the US. And countries exporting price-elastic goods (high-end electronics) see a larger fall in export quantity for a given price rise than those exporting price-inelastic goods, worsening the fall in AD.
Judgement. Openness is the predominant factor. It is precisely their large domestic markets that let economies like China reduce dependence on trade and FDI, boost domestic consumption and investment, and deploy demand-management as a stopgap — options unavailable to small open economies. The other factors — policy effectiveness, the state and the root cause of the loss, the multiplier and export elasticity — modulate the severity, but it is the size and openness of the economy that most fundamentally determines whether a loss of competitiveness is a manageable shock or a structural crisis.