Chapter 19

Chapter 19

Trade andDevelopment

Norton Media Library

Dwight H. PerkinsSteven Radelet

David L. Lindauer

Learning Objectives• The premises, objectives, and policy instruments defining import substitution as a strategy

for industrialization. The main features of an outward-looking export-led strategy of industrialization.

• The outcomes generated from pursuit of the two alternative trade strategies. • The economic effects of tariffs and import quotas, including the distinction between nominal

and effective protection. • How various forms of subsidies are applied to support a country’s chosen industrialization

strategy. • How exchange-rate policy can be managed to influence the pattern of industrialization.

• How protectionist policies encourage rent-seeking practices in lieu of efforts to improve efficiency.

• How Asia’s newly industrializing countries balanced market interventions with competitive pressures, thereby reconciling import substitution and export promotion strategies.

• How multilateral agreements have been adopted to move the world economy toward freer international trade (multilateralism).

• How trade interacts with growth and its effect on poverty. In general terms, what has worked and what has not, with respect to trade and associated policies for industrialization, and why.

Chapter 19: Outline • Trade Trend and Patterns • Import Substitution • Protective Tariffs

– Import Quotas – Production Subsidies – Exchange-Rate Management – Outcomes of Import Substitution

• Outward Orientation and Export Promotion – Policies Supporting Outward Orientation – The Benefits of Outward Orientation

• Trade and Growth: The Empirical Evidence – Trade Volumes, Trade Policy, and Growth – Trade and Poverty Reduction

• Key Issues on the Global Trade Agenda – Increased Global Competition and the Rise of China and India – Does Outward Orientation Create Sweatshops? – Expanding Market Access – Multilateral Trade Negotiation and the WTO

Trade and Development

• Trade creates gainers and losers• The net benefit of trade is positive, i.e. benefits are greater

than costs • But, why are demonstrations against World Trade

Organization (WTO)• For example The head of the South Korean Federation of

Farmers, and Fishermen stabbed in Lee Kyang himself during protest!

• Lee opposed Trade liberalization arguing it would destroy South Korean Farmers

• The evidence is that on balance free trade has benefited developing countries

Trade Trend and Patterns

• Globally trade almost doubled from 13% of world out put in 1970 to 24% in 2003

• See figure 19.1 for export growth as share of GDP

• Globalization is broader than trade since it includes rapid financial lows, migration of people, and information flows through Internet and satellite phones, etc..

Table 19.1: Regional Participation in

Trade and Capital Flows

Global and Regional Trade

• There are significant regional differences in trade trends

• Global grew from 7% in 1970 to 38% in 2002

• Africa depends on trade that accounts about 20% GDP.

• But, Africa’s exports of 3.6% in 1970 by declined to 1.4% in 2002

Trends and Patters of Trade

• See 19.1.Regional Participation in International Trade and capital flows

• Shifts in the composition of exports , 1970-2003

• Trade shifts in the composition of exports (see table 19-2, from 1970-2003

Protective Tariffs

• Protective tariff is aimed at raising the domestic price of the imported good above the world price

• Figure 19.3 the Pw is the world price with free trade. If import tax or tariff is placed the Pd will include tariff or tax of (Pd-Pw) reducing imports form M2 to M1 as shown in the figure:

• Pd= Pw (1+tr)• We can identify the effect of tariff on the following:

tariff revenue, consumer & produce surplus, deadweight loss, etc

• Nominal Tariff rate= Real rate + inflation rate

Effective Rate of Protection

• Effective rate of protection (ERP) measures the effect on tariffs on input and output.

• It measures the impact of trade policies on value added

• ERP= (value added (domestic Prices)/ Value added (World Prcies)-1

ERP= (Pd-Cd)/(Pw-Cw)-1ERP=( Pwto-Cwti)/ (Pw-Cw) see box 19.1

Import Quotas & Subsidies

• These involve the quantitative restrictions on imports by import licensing.

• Quota rent is substantial so importers expend great effort in rent seeking activities including bribes.

• The impact of subsidy is shown on Figure 19.4 next.• Producers are equally happy with a subsidy or equivalent

tariff.• The dead weight with subsidies is reduced to area b.

Economists generally prefer subsidies over tariffs but government officials prefer tariffs and quotas

Exchange Rate Management

• Figure 19.5 Shows the market for foreign exchange where exporters supply and importers demand foreign currencies

• Government can fix exchange rates with two outcomes:

• 1. Overvalued Exchange rate: official exchange rate below equilibrium rate

• 2. Undervalued Exchange: Official exchange rate above equilibrium rate

Exchange Rate Management, cont.

• The effect of overvaluing & undervaluing exchange rate:

• China’s exchange rate policy: A case of undervalued exchange rate

• China’s exchange rate of RMB8.28=$1 is kept above market clearing rate. This led china to attract net capital inflows and led to balance of payment surplus and accumulation of foreign exchange reserves reaching 769 Billion in 2005 or 13 months of import s (See box 19.2). China became the larges purchaser of US Treasury Bills

Overvalued and Undervalued Exchange Rate

• Undervalued exchange rate is where the government fixes exchange rate above market clearing rate which will lead to will make imports more expensive and exports profitable by increasing their price in domestic currency decrease consumption and increase savings, which will help country build foreign exchange reserves (see figure 19.5)

• Example is China’s exchange rate policy (read box 9.2)

Import Substitution Policy and its outcomes

• Countries that introduce import substitution may experience initial spurt in growth. But once the domestic demand is saturated, growth declines and they eventually run into BOP problems from growing trade deficits

• Protection or IS policy also unleashes incentives for rent seeking, corruption, lobbying and reduced competitiveness.

Export Promotion Policies

• This opening to world trade promotes internal competitiveness and efficiency

• It works for those countries that can use labor intensive products effectively.

• These products include textiles , clothing, shoes, vegetables. Flowers, and services such as data entry. Example India, China

• Kenya and Ethiopia have such potential …

Policies Supporting Outward Orientation

• Establishing export processing Zones (EPZs): read Box 19.3 for Export Processing and stories.

• Incentives such as export subsidies, undervalued exchange rates, special credit facilities, etc.

The Benefits of Outward Orientation

• Comparative advantage shows the clear benefit from global trade

• There is a learning process toward success such as in the “flying geese” model

• Asian tigers (Honk Kong, Korea, and Taiwan and later China) followed the successful earlier model of technology adoption and export success from Japan

Policies toward Export PromotionSee Figure 16.1 for Tariff Rates by Regions

Basic step toward economic liberalization such as:• Remove tariffs and quotas and other forms of

protection, allow currency to float with market determined rate & maintain macroeconomic stability

• Reduce unnecessary regulatory burdens and business costs

• Keep markets flexible for labor and credit with market determined wages and interest rates

• Enable mobility of labor and capital internally

Trade and Growth: Empirical Evidence

• There is strong positive relationship between manufactured exports and growth

• Measuring the link between specific trade policies and growth is complex.

• Studies that found combination of trade policies found strong relationship between openness and growth (Sachs & Warner)

• The political economy of trade is such as losers even small in number are very vocal and oppose free trade.

Trade and Poverty Reduction

• Greater openness and faster growth in labor intensive manufacturing reduces poverty

• In China the living below poverty line decreased from 28% to 16% between 1987-2001, Indonesia from 18 to 8%,

• Global move toward free trade is estimated to move 300 million out of poverty in the next 10-20 years

Key Issues on the Global Trade Agenda

• Increased Global Competition and rise of India and China

• Does Outward Orientation create Sweatshops?

• Expanding Market Access (Textiles & Agriculture

• WTO and multilateral Negotiations

Increased Global Competition & rise of India and China

• India and China are emerging global giants• India’s democracy may make success more

sustainable than China’s still closed polity• Global production networks allow firms from

many different countries to contribute to the production of one finished good each firm specializing in a phase that it has comparative advantages

• Flowers from Kenya and Ethiopia are harvested one day and sold the next day in Holland.

Does Outward Orientation create Sweatshops?

• Some writers have argued that outward orientation and globalization creates global sweatshop economy and race to the bottom to those who will accept the lowest wages, benefits and environmental standards

• This is also true for firms producing local markets such as agricultural workers in USA especially emigrants

Does Outward Orientation create Sweatshops?

• There is a huge gap in pay not because a Kenyan worker is exploited by his employer of or because a Swedish worker 10 times more skilled or due to differences in productivity

• Market wages are based on productivity. • It may be necessary to have core standards such as

child labor, gender discrimination, ethnic discrimination and permitting freedom of association and mobility for workers, improving working and safety conditions

Expanding Market Access

• Can developing or African countries sell in European Union, North American, and Japanese Markets.

• These countries have greatest trade barriers on products for which Africa has comparative advantages such as textiles, and agricultural products .

• For example US charges a 32% tariff on sweaters from Bangladesh

Textiles and Apparel

• As a part of the Uruguay round of WTO negotiations arrangements governing trade in textile were gradually phased out and eliminated in 2005, helping the most efficient producers or gains concentrated to countries such as China.

• Average tariff on textiles in US, Europe and Japan is around 10% which is 2 to 3 times other products

Agricultural Exports &Imports

• US, Canada, EU, Japan provide significant protection to their agricultural products through direct barriers and subsidies

• The Magnitude is quite high ranging from 205 in the US to over 80% in Japan

• Crops protected include cotton, dairy products, Maize, peanuts, soybean, sugar, rice, wheat and others,

Protection of Agriculture by Industrial Countries: subsidies & Tariffs

• Subsidies depress world rice prices by 33-50% and for sugar and dairy products 20-40%, as a result farmers in LDC receive low price and reduced income

• Agricultural subsidies of EU and US are 67billion and $20 billion respectively most of which paid to large commercial farmers

WTO and Multilateral Trade Negotiations

• After WWII industrial countries began to reduce tariffs. Between 1947 & 1994 eight round of trade negotiations took place through GATT which became WTO in 1995.

• The Uruguay round of trade negotiations became in 1986 and ended in 1994 involving 123 countries that took part.

The Outcome of Negotiation of the Uruguay Round

• Global average tariff on manufactured goods were reduced by 1/3

• Agricultural protection excluded earlier, was now incorporated

• Agreement on Textiles and Clothing with restricted textile and clothing imports in ICs are eliminated in 2005

• ICs and US won stricter adherence for trade-related intellectual property rights or TRIPS and prevented the production of generic or copy cat without permission, including new rules on investment and trade in services

The Grand Bargain between ICs and LICs

• With some reluctance the ICs committed to the following

• 1. Significant reduction in tariffs• 2. The end of Multi-Fiber Agreement• 3. Reduction in agricultural subsidies • LDCs also committed to large reduction in their

tariffs, agreement in new rules of investment, services, and TRIPS, and support for the new WTO

Summary • I. Nearly all developing countries try to accelerate the pace and influence the pattern of industrialization.

Two main trade strategies have been pursued for this purpose: inward-looking import substitution and export-led, outward-looking industrialization. The core premise of import substitution is that infant industries need protection to survive, while the premise of outward-looking industrialization is that domestic producers must become internationally competitive.

• II. Import substitution was nearly universal in the 1960s and remained wide spread until quite recently. This strategy entails identifying large domestic markets served by imports, assessing the technical feasibility of domestic production, and then erecting protective barriers to shield ostensible infant industries from import competition. After an initial burst of growth, import substitution generally bogs down because domestic markets are limited in size and infant industries remain too uncompetitive to penetrate export mar kets. In contrast, the export-led strategy of East Asia’s “tigers” has been outstandingly successful. These countries have been interventionist and protectionist to varying degrees, but they shared four key characteristics: a disciplined focus on policies to promote rapid economic development, prudent management of macroeconomic policy and exchange-rate policy, flexible factor markets, and insulation of exports from domestic price distortions.

• III. Governments have four basic policy instruments at their disposal to influ ence the industrialization process: tariffs on imports, quantitative restric tions on trade, various forms of subsidy, and exchange-rate policy. Protective tariffs involve significant efficiency losses, particularly when effective rates of protection are quite high. Import quotas have similar effects, with the added disadvantage of bestowing monopoly power and scarcity rents on favored firms. Subsidies and other market preferences can achieve similar ends, with less of a deadweight loss to the economy. These instruments can be applied to very specific products or firms. Exchange-rate policy, how ever, affects all producers of tradables in a more evenhanded fashion. An over valued real exchange rate renders exports less profitable and imports less expensive, while an undervalued real exchange rate has the opposite effects. Ironically, efforts to shield domestic producers from import competition discriminate, through exchange-rate effects, against exports as well as against imports.

•

Summary Cont• IV. Where these instruments have been geared to protect import-substitution industries they typically impose

heavy costs on consumers, discourage exports (limiting import capacity), induce excessively capital-intensive investments, discourage backward linkages, promote political rent-seeking activity in lieu of competitive market adjustments, and ultimately lead to arrested growth. Where the instruments have been used to encourage outward-looking industrialization, the result generally has been rapid growth in income and productivity, although the direction of cause-and-effect remains uncertain.

• V. To induce domestic entrepreneurs to commit capital to new industries, there may well be a need for some form of protection, but it should be used selectively to support infant industries that show clear promise of growing up and becoming competitive. Not all developing countries, of course, have the capacity to intervene so judiciously. In any case, once competitive production is within reach, no further protection is justified.

• VI. The spread of outward-looking trade strategies, together with multilateral agreements to reduce barriers to international trade, has sparked rapid growth of manufactured exports from developing countries after 1965. This trend benefits all trading countries. Yet, within each country, trade creates losers as well as gainers. Since the benefits of trade tend to be spread widely, while the costs are borne narrowly by particular sectors, shifts in comparative advantage have bred political pressures in many industrial economies to impose new nontariff barriers to trade. Such reactions are quite costly to the developed country itself, but even more so for developing countries that lose access to large export markets. One response to the threat of protectionism has been greater trade between developing countries and moves to establish regional trade arrangements, such as customs unions and free-trade areas. Another is to opt for multilateralism via the WTO process.

• VII. More sophisticated recent research indicates that open economies per form better than closed ones. Still, some notable skeptics remain. In general, trade helps poverty reduction as well. Even though some suggest that out ward orientation creates more sweatshops, evidence does not corroborate this suggestion. The text concludes with updated issues of the global trade agenda especially the Doha Round and the areas of market access, textiles and apparel, and agriculture.

Boxed Case Examples

• There are two boxed examples in Chapter 19.

• The first de scribes how Kenya’s import-substitution policies led to rapid initial industrial growth. By the end of the 1970s the bloom had faded from this strategy because the domestic market was too small to support sustained industrial growth that depended on protectionism. In response, Kenya slowly moved toward a more outward-looking industrialization strategy.

• The second case study ex plains the radical transformation of trade policies in Mexico during the late 1980s. To emerge from the depth of its debt crisis, the Mexican government switched from a heavily protective trade strategy to a bold program of encouraging trade.

• These reforms culminated in the North American Free Trade Agreement (NAFTA), which took effect at the beginning of 1994.

End Chapter 19

This concludes the Norton Media LibrarySlide Set for Chapter 19

W. W. Norton & CompanyIndependent and Employee-Owned

Economics ofDevelopment

SIXTH EDITION

ByDwight H. Perkins

Steven RadeletDavid L. Lindauer