Does trade liberalization lead to more development?
Mar 21, 2020
Introduction
Trade liberalization has been pursued through a variety of means: regional trade agreements, preferential trade arrangements, and multilateral institutions such as the World Trade Organization. However, it is not clear that trade liberalization is always better for development. This essay aims to explore under what conditions trade liberalization promotes economic development. I argue that free trade is beneficial when domestic industries are sufficiently efficient and advanced, macroeconomic stability is present, and countries have the requisite infrastucture and regulatory framework.
Central Arguments for Free Trade
There are a few important theoretical arguments for why trade liberalization is desirable for any unilateral actor. One such argument, put forth by Debraj Ray, focuses on the expansion of the production possibility set. There are two major determinants of the range and quantity of goods that can be obtained in a country. The first involves domestic inputs, which may be applied to the production of various kinds of goods. The second is influenced by trade. Goods of one type may be exchanged for goods of another type that cannot be domestically produced. Thus, by trade liberalization, the production possibility set is expanded; more commodities are available to countries that trade than to countries that do not. This benefit is independent of the trade policies of other countries[4].
However, it is not obvious that trade liberalization universally or uniformly benefits all citizens. As Ray (1998) shows using the Heckscher-Ohlin model, factor endowment distribution may determine the winners and losers of a trade liberalization measure. Consider two countries, N and S, that trade cars and textiles. N produces cars and imports textiles, and S does the inverse. When N is opened up for trade with S, a profitable international price in cars will induce N to expand car production and contract textile production. Because car production is more capital intensive than textile production, additional capital and labor will be absorbed by car producers at the expense of textile producers. For the same reason, textiles release a higher proportion of labor to capital than is demanded by car producers. Accordingly, this trade liberalization measure would cost owners of labor and benefits owners of capital[4]. This kind of worry is central to debates about the North American Free Trade Agreement, as Americans fear that the release of labor in Mexican industries will drive down wages. Note that this effect on wages would perhaps hurt Mexican laborers as well. To assess the desirability of a trade liberalization measure from a development standpoint, careful attention must be paid to the preexisting factor endowment distribution and how it might determine and impact the winners and losers of the policy. Although free trade might produce positive long-term effects such as technological advancement or robust export activity, if some citizens end up unemployed or extremely poor in the process, liberalization measures might be considered overall developmental failures. Such costs must be weighed and analyzed with respect to other short- and long-term gains.
Two additional arguments for trade liberalization focus on competition and market size. Competition forces firms in a local economy to adopt newer technologies so as to keep up with other international players. Absent this competitive pressure, local firms may remain inefficient. The size of the global market is also a potential boon for these firms, as they may have the opportunity to sell more than if the market were restricted to domestic buyers. By producing more, firms may also achieve economies of scale, which cuts costs and benefits home-economy buyers and employees as well as external buyers[1].
However, these arguments for free trade are a double-edged sword, as these same potentially beneficial market forces are capable of inhibiting development. When domestic industries are still in their infancy, being forced to compete with globally established producers may drown out up-and-comers before they have a chance to mature and implement efficient production technologies. In the same vein, a failure to nurture innovative sectors may leave a country with no option other than to continue exporting primary goods or unrefined natural resources, which may have limited growth potential[2]. Given these considerations, it may be wise for a developing country to protect domestic industries until they are sufficiently large-scale and efficient.
Domestic Conditions as a Determinant of Trade Policy
There are multiple factors that may render trade liberalization only contingently beneficial: exchange rate volatility, transportation infrastructure, and regulatory capacity are just a few key considerations.
Any successful trade liberalization efforts must be attuned to domestic macroeconomic conditions—exchange rate volatility in particular. When exchange rates are highly fickle, international investment becomes a risky proposition, as profits are uncertain. Other countries are deterred from investing because any requisite foreign exchanges risk substantial losses, and the value of future returns may be unpredictable. Moreover, domestic investors, too, may prefer to invest their money elsewhere, where the real exchange rate—and therefore the value of the return on investment—is more stable and predictable. When exchange rates are volatile, trade barriers might be the only thing deterring investors from putting their money in foreign businesses. The World Bank’s report on economic growth in the ‘90s offers a key example of how exchange rate volatility can doom development prospects in a liberalizing economy. Malawi during the ‘90s suffered high inflation, producing exchange rate volatility as well, and, as a result, domestic investment and exports dwindled, particularly in the manufacturing sector. For this reason, Malawi was unable to diversify exports beyond tobacco[8]. Perhaps if trade barriers remained in place during this inflationary period, a diversification strategy fueled by domestic investment could have been successfully undertaken. On the other hand, one might argue that such rampant inflation would have inevitably doomed investment prospects, regardless of Malawi’s trade policy. In any case, it is clear that trade liberalization has diminishing value from a development standpoint unless macroeconomic stability is present.
Transportation infrastructure is another important consideration heavily influencing the success of trade policy. Whatever deficiencies may exist may serve as effective trade barriers, even if nominal ones are removed. If it is very expensive to transport goods without or within a country, businesses are shielded from competition by means of this transport cost, and domestic industry, in effect, is protected. This protection is bidirectional. Domestic exporters face steep transportation costs when sending goods out of the country, which creates an incentive for firms to sell domestically instead. Moreover, the price of imports are also heightened by transport costs, which greatly advantages local suppliers. As a result, inefficient domestic businesses are shielded from competitive pressures, which would otherwise induce technological innovation and gains in efficiency[8]. One might say, therefore, that the benefit of competition is contingent upon the provision and maintenance of adequate transportation infrastructure. Two case studies confirm this proposition. First, Kiringai (2006) studies the effective protection rates in Kenya as a product of tariffs and transportation costs. She finds that despite Kenya’s substantial reductions in tariffs in the 1990s,—and, therefore, in effective protection rates—transportation costs rendered Kenyan manufacturers and agricultural businesses unable to compete with international players[2]. A second study about Uganda shows similar results but offers a more optimistic conclusion. Rudaheranwa (2006) shows that high transport costs and delays in the early 2000s prevented Uganda from diversifying its domestic industry into the realm of perishable agricultural products, as merchandise was likely to spoil along the way. These transportation deficiencies were observable with roads, rail, water transport, and various ports of entry[6]. However, Rudaheranwa also makes two other key arguments. First, he argues that steep transportation costs may motivate domestic producers to switch from bulky, unrefined goods to high value goods, as these would face lower transportation costs and are, therefore, more exportable[6]. Thus, one could conclude that trade liberalization paired with inefficient transportation infrastructure need not doom an economy to technological stagnation. Second, Rudaheranwa contends that the investment value of transportation infrastructure increases as trade liberalization measures are adopted because the potential for boosting exports is heightened[6]. Accordingly, trade liberalization may attract foreign investment in private transportation by air, rail, or inland waterways and, in the long term, facilitate substantial competitive gains. Note, however, that Rudaheranwa did not observe these developments during the studied period, but his suggestions indeed assuage concerns about transportation costs as an insurmountable challenge to trade liberalization.
Like transportation costs, regulatory deficiencies may also serve as an effective trade barrier, even in the absence of nominal ones. One example of this phenomenon can be seen in the Egyptian aquaculture sector. Many firms in China, Vietnam, and Denmark are global exporters of farmed fish. Egypt, too, is a prolific producer of farmed fish,—in fact, the seventh largest globally—but, unlike these other countries, for decades, Egyptian firms have been unable to meet the food safety standards of the US or European Union; Egypt, unlike other fish farming nations, does not regularly monitor and assess contaminants in fish tissues. Until Egypt improves its regulatory capacity and performance, Egyptian tilapia will remain confined to domestic markets[7]. While it may seem that food safety standards are a parochial concern related to trade liberalization, many developing countries are economically based on a few staple agricultural products. Furthermore, given the challenges posed by climate change, resource shortage, and population growth, food is an essential export whose regulatory demands must be addressed. Thus, regulatory inefficacies and the attendant export barriers represent serious obstacles to economic development.
Conclusion
From these various considerations, a few key conclusions can be drawn. First, before declaring trade liberalization a developmental boon, politicians must identify the winners and losers of any given policy given the prior factor endowment distribution. Whether or not a liberalization measure is advisable depends largely on the political consideration of which factions should be protected from losses—labor, landowners, etc.—and to what extent. Furthermore, trade liberalization must be concordant with a regime’s overall developmental vision for the country. If it is determined that it is in the country’s long-term interest to transition from primary goods to secondary, manufactured goods, then perhaps it is appropriate to protect an infant industry until it can sustainably compete. The process of liberalization can take place in stages so as to facilitate particular industrial, political, or economic transitions. Korea and Taiwan, for instance, opted to retain import restrictions in certain infant sectors while subsidizing domestic production in those industries. Eventually, when these businesses were sufficiently developed, Korea and Taiwan undertook further liberalization measures such that exports could blossom[8]. Evidently, institutions have an additional role to play in ensuring the success of trade liberalization; macroeconomic stability, the efficacy of transportation infrastructure, and regulatory capacity must be pursued. Otherwise, effective barriers to trade are still existent, and gains cannot be realized. Thus, conclusively, it appears the developmental benefit of trade liberalization is contingent upon a number of other conditions being met.
Bibliography
[1] CORE (2019), Core-Econ, Unit 18.
[2] Kiringai, J. (2006), “Trade Policy and Transport Costs in Kenya”, Centre for Research in Economic Development and International Trade, University of Nottingham.
[3] O’Rourke, K. (2000), “Tariffs and Growth in the Late 19th Century”, The Economic Journal, 110.
[4] Ray, D. (1998), Development Economics, Princeton UP.
[5] Rodriguez, F. & D. Rodrik (2000), “Trade Policy and Economic Growth: a Skeptic’s guide to the Cross-National Evidence”, NBER Macroeconomics Annual.
[6] Rudaheranwa, N. (2006), “Trade Policy and Transport Costs in Uganda”, Centre for Research in Economic Development and International Trade, University of Nottingham.
[7] Shaalan, M., El-Mahdy, M., Saleh, M. & M. El-Matbouli (2017), “Aquaculture in Egypt: Insights on the Current Trends and Future Perspectives for Sustainable Development”, Reviews in Fisheries Science & Aquaculture 26, no. 1, pp 99-110.
[8] World Bank (2005), “Trade Liberalization: Why so much controversy?”, Economic growth in the 1990s: learning from a decade of reform.