Dual Gap Analysis and Foreign Exchange | Economics

Dual gap analysis which is also called two gap analysis was made in the context of foreign aid or foreign borrowing of capital by developing countries required for achieving rapid economic development. The question raised was what constrains acceleration of investment which is required to achieve a certain target growth rate of economic development in the developing countries.

The first important factor mentioned in this connection is the domestic saving rate in the country on which investment depends. Therefore, Harrod-Domar model which was generally used for development planning laid stress on the saving rate (and therefore investment) and capital-output ratio, as the two factors that determine economic development. Thus, according to Harrod-Domar model –

g = s/k

Where, g is the growth rate of GDP, s the saving rate of the economy (i.e., ratio of saving to national income) and k is the capital-output ratio. Capital-output ratio (which is the reciprocal of output-capital ratio) in this model is taken as given and rate of investment and therefore rate of economic growth depends on the domestic saving rate of the economy.

However, Harrod-Domar model was a closed economy model and foreign trade was not incorporated in it. However, every developing country even if it followed import-substitution development strategy needed imports of certain capital goods and raw materials which they could not manufacture themselves and required them for their industrialisation.

Therefore, in Harrod-Domar model foreign trade was to be introduced so as to explain the role of foreign exchange required to import capital and intermediate goods and raw materials needed for industrial growth. Accordingly, the extension of Harrod-Domar model was made by adding the term for foreign trade balance (namely, imports minus exports) as per cent of national income.

The extended Harrod-Domar model was written as –

The significance of this extended version of Harrod-Domar model was that the growth of exports of developing countries was limited, imports could exceed exports only if foreign aid (both grants and concessional loans) or private foreign investment was available to enable the developing countries to get the required foreign exchange for importing capital goods and industrial raw materials so that more investment than domestic saving can occur to achieve target growth rate.

However, even if domestic saving could be raised to achieve the required investment for attaining target growth rate, the foreign exchange needed to import essential capital goods and raw materials would not be there as the domestic savings and foreign exchange (provided by foreign aid and foreign investment) are not perfect substitutes of one another. Thus, the higher domestic saving would not make up the deficiency of foreign exchange to import the required Capital goods and industrial raw materials more than value of exports.

For example, for imports of capital goods and industrial raw materials we require dollars and not rupees. And the dollars can be obtained by either increasing exports or through foreign aid or foreign investment. This implies foreign exchange gap or bottleneck as distinct from saving gap to achieve the desired growth rate.

Since it was not possible for the developing countries in the initial stages of development to achieve sufficient growth in exports (except the oil producing Arab countries), foreign exchange gap was faced by them. It was therefore pointed out that to meet the foreign exchange gap, foreign aid or foreign investment was needed to help them achieve the desired rate of economic development in the fifties and sixties of the 20th century.

Now, it is important to note that in view of lack of substitutability between domestic saving and foreign exchange resources economic development could be constrained by whatever factor, domestic saving or foreign exchange reserves, is the most binding factor. Foreign capital (both in the form of foreign aid or borrowed funds) can play an important role in supplementing domestic resources in order to relieve both domestic saving constraint and foreign exchange constraint. Therefore, this was called dual gap analysis of foreign assistance by Chenery and Strout.

It was argued by them that the most developing countries either face lack of domestic saving to finance the required investment to achieve the desired rate of economic growth or shortage of foreign exchange required to import necessary capital goods and raw materials for industrialisation.

Besides, it was generally assumed by the exponents of two-gap analysis that the two gaps were unequal in size and were independent of each other, that is, there did not exists any substitutability between domestic saving and foreign exchange.

We explain below these two gaps in some detail:

1. Saving Gap or Saving Constraint:

The implication of the dual gap analysis that either of the two gaps will be binding for any developing country at any particular point of time. The saving gap is said to be binding or dominant when domestic savings are inadequate to support the desired rate of economic growth though it has adequate foreign exchange earnings for importing the necessary capital goods and raw materials.

Given the assumption of full employment or capacity output, the shortage of saving can be viewed as lack of productive resources such as manpower or other productive resources in the economy for being used for increasing investment to achieve higher growth rate, though the adequate foreign exchange resources are available and are not being used fully. In such a situation saving-gap constraint implies that the excess foreign exchange might be used for importing luxury consumer goods rather than capital goods and industrial raw materials for bringing about higher industrial growth rate.

Todaro and Smith therefore rightly say, If, for example, the savings gap is dominant, this would indicate that the economy is operating at foil employment and not using all of its foreign exchange earnings. It may have enough foreign exchange to purchase additional capital goods from abroad but there is not enough excess domestic about or other productive resources to carry out additional investment projects.

As a result, ‘excess’ foreign exchange, including foreign aid, might be spent on the importation of luxury consumption goods. Such a country is said to have a shortage of productive resources which from a different viewpoint can be regarded as a shortage in saving. Thus, in such a case a developing economy is said to be incapable of absorbing foreign exchange for purposes of economic growth.

It is worth mentioning that such a saving gap was faced by oil-exporting countries of Middle East in the 1970s when they suddenly had a flush of petro-dollars due to rise in oil prices by OPEC. These petro-dollars were spent by these countries for importing luxury consumer goods rather than using them for additional domestic investment.

However, in later years they realised the importance of their petro-dollars which they started using for buying capital goods and hiring manpower from abroad. In this way they were able to overcome their domestic saving gap by using their foreign exchange earnings. This means saving gap countries do not need foreign aid to increase their investment for attaining higher growth rate.

2. Foreign Exchange Gap:

On the contrary the saving-gap countries, the countries facing foreign exchange gap cannot overcome it by using their excess domestic saving. Therefore, for them foreign exchange gap is binding for achieving a desired rate of economic growth. In their case foreign exchange resources are inadequate for supporting higher rate of economic growth that is permitted by their domestic saving rate.

Most of the developing countries are assumed to fall in this category as they face a situation where the foreign exchange gap is binding. These countries have enough domestic saving or productive resources such as labour and other inputs but lack adequate foreign exchange resources to import capital and intermediate goods, such as machines, oil, certain industrial raw materials which they cannot produce themselves. In such a situation due to lack of complementary foreign exchange resources, a certain part of domestic savings may remain unutilised.

The availability of domestic savings or resources would permit them to undertake new investment projects if they receive foreign capital inflows through foreign aid or through FDI and FIIs so that they can import new capital and intermediate goods (including oil and petroleum products). In the two years 2011-12 and 2012-13 India faced such a situation of foreign exchange because there was a large deficit on current account of balance of payments of more than 4% of GDP. If we had got adequate foreign capital inflows, it would have been possible to fill in the foreign exchange gap. As the surplus on foreign capital account was inadequate we used foreign exchange reserves held by RBI to finance the foreign exchange gap.

It is important to mention here a confusion which usually arises because in national income accounting of an open economy such as ours saving-investment gap is said to be equal to import- export gap (i.e., current account balance). If this were so, then question arises where does the problem lie? We state below the national income account identity of an open economy-

Y = C + I + X – M….. (1)

Where, Y stands for national income, C for consumption, I for investment, X for exports and M for imports. (Note that both exports and imports include both goods and services) –

Y – C = I + X – M

Since Y – C = national saving(S)

Therefore, S = I + X – M

or I – S = M – X …(2)

Thus the above equation (2) shows that saving-investment gap equals import-export gap. How does it happen? As a matter of fact, the above national income identity is only in accounting or ex – post sense and not in ex-ante or intended sense. Despite the trade deficit (or current account deficit) this identity will hold good. This is because import-export gap is somehow financed either by for­eign capital inflows which may occur either through commercial borrowing or foreign assistance or private capital inflows through FDI and FIIs or ultimately by withdrawal from accumulated foreign exchange reserves of the past years held by the Central Bank of a country.

Thus, the real problem remains how to relieve foreign exchange gap to undertake necessary additional investment which requires import of capital goods and raw materials. In fact, it was in this context that dual gap theory was used to show the crucial importance of foreign aid and other forms of capital flows to finance a deficit in the current account balance of payments (that is, the excess of imports of goods and services over their exports).

A Critical Appraisal of Dual Gap Theory:

Two-gap theory was put forward to bring out the crucial role of foreign assistance to relieve foreign exchange gap faced by developing countries. Of course foreign aid has been helpful for accelerating economic growth in developing countries but it has been often tied to development projects in which donor countries were interested.

It has been rightly asserted by Bruton that even developing countries which pursued import-substitution development strategy such as India needed foreign exchange to import capital goods, intermediate goods and industrial raw materials for the development of their basic heavy industries as all of them could not produce them at home and in view of the limited possibilities of increasing exports needed foreign assistance not only to supplement their domestic saving but also to fill up their foreign exchange gap.

However, in our view dual gap analysis overemphasized the lack of substitutability between saving and foreign exchange. As the oil-rich Arab countries used their own foreign exchange resources to buy both manpower and capital goods from abroad to relieve their shortage of domestic savings. Further, if you can cut down consumption of some goods which have export potential (and therefore save more) the foreign exchange earnings from exports so made can be used to import capital goods and raw materials for their development.

The dual gap model underplayed the export potential of developing countries. Therefore, after the mid-seventies of the last century, the emphasis was shifted from “aid” to “foreign trade,” Many countries such as Japan, South Korea, Taiwan and Singapore by adopting export-led growth strategies succeeded in achieving higher economic growth without much foreign aid.

In India too after 1991 when economic reforms have been made stress has been laid on export- orientation of our development strategy rather than import-substitution and we have succeeded a lot as our exports have registered quite a satisfactory growth rate in the post-reforms period.

As a result, our current account deficit has been quite small (1 to 2.5 per cent of GDP), except for a few years which was easily met by private capital inflows through foreign direct investment (FDI) and foreign institutional investors (FIIs). Our recent problem of large current account deficit (CAD) for the years 2011–12 and 2012–13 arose because of our dependence on imported oil and petroleum products whose prices sharply rose and our exports in these years have not been growing adequately due to sluggish growth in the US and recession in European countries.

Besides, our excessive demand for gold has led to the increase in its imports adding to our current account deficit, but once the US economy recovers and European crisis is over, our exports will rise resulting in reduction in of our current account deficit to a comfortable level. This shows that foreign trade (i.e., higher export growth rate) and not foreign aid can help relieve foreign exchange constraint on our economic growth. In fact in the last two decades the role of foreign assistance in financing India’s development has been only marginal.

Further, the two-gap model laid stress on foreign aid i.e. grants and loans at concessional rates of interest from developed countries. In the last over two decades (1991-2015) instead of foreign aid, the foreign capital inflows in the form of direct private investment (FDI) and FIIs have become more important as a source of foreign exchange.

Despite the financial instability caused by them, the private capital inflows can play an important role in promoting economic growth. India is a favourable destination for private capital inflows. Moreover, these private capital inflows are not-debt creating and therefore do not lead to the increase in external debt burden.

However, if a country finances its development programme through borrowing from abroad (even foreign assistance at concessional rates of interest), it leads to the problem of indebtedness. The problem of indebtedness had been actually faced by developing countries and recently by Eurozone countries. This leads to the problem of paying back the foreign debt and also servicing it. While describing foreign exchange gap and the need for foreign aid, dual gap models overlooked the problem raised by indebtedness caused by foreign aid.