Uncertainty, Trade, and Capital Flows in Sub-Saharan Africa

In most African economies, both agricultural production and the terms- of-trade are highly uncertain. This paper re-examines the implications of such uncertainty for the optimal mix of production and trade under alternative assumptions about international capital flows. The ultimate objective is to explore the possible effects of increased financial integration on real economic activity in developing countries. In the presence of uncertainty and limited international capital flows, diversifying production -- and exports -- rather than specializing according to comparative advantage may be desirable depending on a country’s degree of risk aversion. Once international borrowing and lending becomes available, however, it may provide a more efficient mechanism for coping smoothing consumption in the face of income fluctuations than does diversifying production and exports. The ability to trade equity securities (which represent claims on uncertain future production) in world capital markets permits additional risk sharing possibilities. In some circumstances where equities trade is well- developed, production diversification completely unnecessary. That is, production and price uncertainty can be efficiently hedged through portfolio diversification instead of production diversification.