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Chapter 19
Trade and
Development
Dwight H. Perkins
Steven Radelet
David L. Lindauer
Learning Objectives
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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.
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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.
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How protectionist policies encourage rent-seeking practices in lieu of efforts to
improve efficiency.
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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.
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Chapter 19: Outline
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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..
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 , 19702003
• 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)-1
ERP=( 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 Promotion
See 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 3350% and for sugar and dairy products 2040%, 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
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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: inwardlooking 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 widespread 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 markets. 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 influence the
industrialization process: tariffs on imports, quantitative restrictions 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, however, affects all producers of tradables in a more evenhanded
fashion. An overvalued 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
Summary Cont
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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
Boxed Case Examples
• There are two boxed examples in Chapter 19.
• The first describes 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 explains 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.
W. W. Norton & Company
Independent and Employee-Owned
This concludes the Norton Media Library
Slide Set for Chapter 19
Economics of
Development
SIXTH EDIT ION
By
Dwight H. Perkins
Steven Radelet
David L. Lindauer