International Trade and Economic Development

INDIAN INSTITUTE OF TECHNOLOGY, KHARAGPUR International Trade and Economic Development Swapnil S. Bagmar 06HS2004 Development Economics term paper (Spring 2007-08) International trade International trade is the exchange of goods and services across international boundaries or territories. In most countries, it represents a significant share of GDP. While international trade has been present throughout much of history, its economic, social, and political importance has been on the rise in recent centuries.

In this paper we will not go into the theories governing international trade but the focus will be more on its implications on economic development. Consider the following data: Sources: World Development Report EconomiesTrade per capita (US$, 2004-2006)Trade to GDP ratio (2004-2006)Share in world total exportsShare in world total imports High income economy: United States1086425. 98. 5915. 46 Upper-middle-income economies: Mexico464362. 72. 072. 16 Lower-middle-income economies: China1207698. 026. 38 Low-income economies: India30741. 811. 41

As evident from the above data, the volume of trade directly reflects a country’s per capita income. Likewise the share of the developed economies in world exports and imports is high. The imports consist mainly of raw materials which are the exports of the developing countries. The reason China is still a lower middle-income economy is due to its large population. During the 1950s and 1960s, most developing nations, particularly the larger ones, strongly opted for a policy of import substitution industrialization (ISI). This was based on heavy protection and generally led to very inefficient industries.

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Since the early 1970s, an increasing number of developing countries deregulated their economies and liberalized trade, and this stimulated efficiency and growth. Some developing nations also tried strategic trade policies and to indigenize growth (as postulated by endogenous growth theory), but with only limited success. It seems impossible and inconsistent under the new international trade rules, however, for other developing countries to duplicate the East Asia “miracle,” which was based on strong government support for domestic industry while stimulating competition and efficiency among domestic firms.

The successful completion of the Uruguay Round is expected to greatly benefit developing countries through continued deregulation and increased access to developed-country markets Characteristics of the international trade sector of developing countries and high income countries: Low incomeMiddle incomeUpper middle incomeHigh income Average annual growth rate of exports, 1980-19905. 7%3. 5%3. 5%5. 0% Average annual growth rate of exports, 1990-19949. 17. 07. 85. Average annual growth rate of imports, 1980-19901. 61. 02. 26. 1 Primary product exports as percentage of total exports, 199238514818 Manufactured goods exports as percentage of total exports, 199262495382 Primary product imports as percentage of total exports, 199227272625 Manufactured goods exports as percentage of total imports, 199274737476 International reserves in months of coverage of imports of goods and services, 19945. 0 mo3. 1 mo3. 8 mo2. 6 mo Source: The World Bank, World Development Report, 1996

The above table portrays various elements of less developed country’s international trade sector. Some important observations can be made from this information: 1.. The rate of export for all groups of LDCs increased in the 1990-1994 period compared to 1980-1990. 2. For the 1980-1990 period, the low growth rates of imports of developing countries importantly reflect the fact that some countries were compressing imports in an attempt to deal with their debt problems. 3.

LDCs are generally characterised by a higher ratio of primary products to manufactured goods in their bundles than in their import bundles, which has relevance to potential problems of export instability and terms of trade behaviour that the LDCs face in the international trade. 4. The ratios of international reserves to imports of goods and services (expressed in terms of months of import coverage) seem low, but recently they have been larger than those for the developed countries. The role of trade in fostering economic development: The static effects of trade on Economic development

If there is a difference between internal relative prices and those that can be obtained internationally, then a country can improve its well being by specializing in and exporting the relatively less expensive domestic goods that are relatively more expensive. From a development standpoint, the change in economic structure and factoral distribution of income that is assumed to accompany this adjustment is of clear concern. Imports may also help relieve short run domestic bottlenecks and permit the economy to operate closer to its production possibilities frontier.

Further to the extent that the developing country is a large country in terms of export goods, expansion of export supply may well lead to undesired terms of trade effects that will significantly reduce the expected static gains from trade and lead to a distribution of the gains from trade that favours the more developed trading partner. Finally, expanding production of basic labor intensive products and relying on the industrialised countries for manufactures and capital goods not only can lead to a critical economic dependency but also inextricably links the economic health of the developing country to that of the industrialised country.

The dynamic effects of trade on Economic development As in economic integration, the biggest potential impact of trade on development likely rests with the dynamic effects. On the positive side, the expansion of output brought about by access to the larger international markets permits the LDCs to take advantage of economies of scale that would not be possible with the limited domestic market. Thus, industries those are not internationally competitive in an isolated market may well be competitive by way of international trade if there are potential economies of scale.

Further, since comparative advantages change over time and with economic development, international trade can foster the development of infant industries into internationally competitive ones by providing the market size and exposure to products and process that would not happen in its absence. This of course is one of the reasons cited for using trade policy instruments to restrict imports or promote exports, although there are problems with using the policies in practice.

Other dynamic influences of trade on economic development arise from the positive antitrust effects of trade, increased investment resulting from changes in the economic environment, the increased dissemination of technology into the developing country, exposure to new and different products, and changes in institutions that accompany the increased exposure to different countries, cultures and products. The impact of international trade on economic development can be very well studied by analyzing carefully the labour market distortions present in transition and developing economies.

We consider three kinds of economies: market, transition, and developing, with different institutional arrangements in the labour market. Trade can only improve social welfare in a market economy. In transition and developing economies social welfare may fall due to trade. In market economies, workers earn their marginal product. In transition economies, workers in indivisibles earn a common market clearing wage unrelated to their ability. This is meant to capture the idea that workers get a common wage, especially in state owned sectors which make indivisible consumer goods.

As a result, low productivity workers who cannot earn more in divisible are attracted to indivisibles. These workers are paid more than their marginal product in divisible which makes the cost of producing indivisibles higher than that in a market economy with the same technology. On the other hand, the higher incomes earned by less able workers increases the potential market size for indivisibles. Trade can reduce social welfare in such an economy when it involves importing the indivisible good.

Such trade has adverse effects as it lowers production of indivisibles, which reduces wages, and hence the ability to afford the indivisible good. 2 Loosely speaking, before opening up to trade, socialist economies had a relatively equal distribution of income, which, although not as high as in capitalist countries, allowed most citizens access to simple consumer durables like ranges and refrigerators, though maybe not cars. Opening up to trade resulted in such goods being imported rather than produced domestically. As a result, labour allocated to manufacturing fell, as did real wages there, so that few could afford such goods!

Liberalization and welfare reduction went hand in hand. In developing economies the dependence of the bulk of the population is on agriculture. This results in workers earning their average rather than marginal product in agriculture. In a developing economy workers in the divisible good sector, interpreted as agriculture, work in family farms and obtain the average product of labour in the farm. When workers have diminishing marginal product in agriculture, their average product exceeds their marginal product so that too many workers remain in agriculture.

In the development literature this distortion has been linked with the concept of “Disguised Unemployment” Sen (1960). However, when labour is of differential productivity, only lower quality labour remains in agriculture. As a result, the marginal worker produces more than the average product of labour in agriculture, so that too few workers remain in agriculture rather than too many. Low productivity workers who cannot earn more in indivisibles are attracted to divisibles. These workers are paid more than their marginal product in indivisibles hich makes the cost of producing indivisibles lower than that in a market economy with the same technology. Also, the higher incomes earned by less able workers increases the potential market size for indivisibles. Trade can reduce social welfare in such an economy when it involves importing the divisible good. Increased output of the indivisible good reduces the labour force and average quality of labour in agriculture, thereby reducing the earnings of those in agriculture, and hence their ability to afford the indivisible good.

The conclusion is that trade liberalization without structural reform can have serious adverse effects in transition and developing economies. Timing matters! Also another important factor determining the extent of advantage for a developing economy through international trade is the timing of opening up for external trade. For instance after the successful experience of the East Asian economies in the postwar period, trade liberalization in developing countries has been considered as a policy to achieve rapid development.

As reported in the World Bank (1993), trade liberalization in these economies was effective to reduce the degree of income inequality and enhance human capital accumulation. However, recent empirical studies on Latin American countries cast a serious doubt on this view. In contrast to the case of East Asia the degree of income inequality, measured by the wage differential between skilled and unskilled workers, increased after trade liberalization. Wood (1997) suggests that this apparent contradiction may be explained by differences in the timing of trade liberalization.

He argues that the observed difference in wage outcomes occurred because the world had changed between the 1960s and 1970s, when trade liberalization took place in the East Asia, and the late 1980s and 1990s, when the Latin American countries increased their openness to trade. When the East Asian economies liberalized their trade regime, the world markets consisted of only skill abundant developed countries, and therefore these East Asian economies had strong comparative advantage in producing less-skill intensive exports.

As a result, the wage differential between skilled and unskilled workers decreased after trade liberalization. However, when the Latin American countries moved to an open trade policy, they could not take advantage as skill-scarce countries because they were skill-abundant relative to the world average after the entry of the largest low-income countries, such as China and India into world markets in the 1980s. This different consequence of trade liberalization on income inequality may be, to some extent responsible for the different performances of these economies after trade liberalization.

Cons From a broader perspective, countries that rely on exports of primary goods for export earnings may find that the international prices of these goods do not rise as rapidly as prices of the manufactured goods they import due to differences in their income elasticities. This deterioration in terms of trade lowers the gains from growth in short run and reduces the future growth by diminishing the ability to import needed capital goods. Many economists have agreed that the terms of trade of developing nations have declined over a long period of time much to their disadvantage.

Also another factor namely the price effect of technological change affects the development of the trading economies. Technological advances in developing nations are assumed to decrease in the prices of developing country products, whereas in industrialised country’s technological advances leads to increase payments to the factors of production. Protectionism or Free trade ? ” Free trade can be shown to be beneficial to the universe as a whole but has never been proved to be the best policy for a single country” Tibor De Scitovszky, 1944

The above statement has been a hot topic for debate in recent times. Inspite of the persuasive theoretical arguments pointing out the net welfare gains that result from unobstructed international trade, individuals and organisations continue to pressure government policy makers to restrict imports or artificially enhance the size of country’s exports. Because the expansion or contraction of international trade has implications for income distribution it is important to understand who the winners and losers are from trade differences in order to assess the economic and political desirability of alternative trade practices.

Since the impact of restrictions varies with the particular trade instrument employed the political economy of trade policy can be very complex. Effects of protectionism: The reduction of imports is likely to lead to a reduction in exportsof the tariff imposing country. This takes place as soon as domestic resources are withdrawn from export production and used in the production of import substitutes at the higher domestic prices of these goods. Further there is likely to be foreign country tariff and non tariff retaliation against tariff imposing country’s exports.

Protection thus not only lowers real income in the imposing country but also redistributes it from export industry to import competing industries. These shifts take place in the short run and reduces the incentive to invest in the affected export industries, contributing to reduced ability to export in future. The subsequent slowing down of technological change in the comparative advantage industries could be critical to efficiency and welfare in our increasingly interdependent world. The effect of protection in certain industries on total imports may be less than it appears if only the change in imports of the protected goods is examined.

This would be the case if the increase in the domestic production of the import–competing products required intermediate inputs that have to be imported. Then, while protection reduces imports of the targeted products, increased domestic production leads to increased importation of the required intermediate products. This is often ignored aspect of protection that turned out to be critical for number of developing countries that were pursuing an import substitution policy to reduce their total imports by producing the previously imported goods at home.

Ignoring the indirect import requirement of the expanding import competing sector contributed to serious mistakes in estimating the potential effectiveness of import –substitution strategies. Thus the increased levels of protection bring greater and greater net welfare losses to the trade restricting country. Trade Trends in Developing Countries During 1990–1997, the volume of world trade (export and import volumes) grew by 6. 5 percent per year, and the exports of developing countries grew by 8. 7 percent per year.

Although the East Asian crisis in 1997 led to a reduction in export growth in that region, the growth rate of exports from developing countries in the first seven years of the 1990s was substantial. World output grew at 2. 3 percent per year over the 1990–1997 period, and developing country output grew at 3. 1 percent per year (World Bank 1999). Developing economies also became more integrated into the world economy. The estimates of trade openness in developing countries (as indicated by their trade ratios) show an equally good performance (Drabek and Laird 1998).

World exports of commercial services grew by 8 percent per year during 1990–1997. Starting from a low base, the share from developing countries grew faster than the world rate of growth of commercial services (World Trade Organization 1998). In 1997, developing countries accounted for 30 percent of the world’s exports of commercial services. The “other commercial services” category, which includes financial services, construction, and computer services, was the fastest-growing category of services exports.

World services exports slowed in 1997, in part because of the economic crisis that began in East Asian countries, which were the main importers of commercial services in the developing world. Given the further liberalization of services trade following the Uruguay Round (1995) and the two ministerial meetings that took place prior to 1998, the opportunities for faster growth in world trade in services will be even greater. Once East Asia recovers from its crisis, developing countries will be able to make use of the opening-up of services trade.

The average volume in commodity and services trade during the 1990s masks many differences in the individual performances of countries and regions. The East Asian countries led the way in the growth of exports and permanently changed the patterns of trade between developed and developing countries. First, manufactured goods exports from the developing world, and from East Asian countries in particular, were the fastest-growing component of trade. They averaged increases of some 12–15 percent per year during the 1990s, thereby continuing a trend that started in the late 1960s when East Asian countries liberalized their trade regimes.

Second, there was a decline of trade in mining products from developing countries after the decline in oil prices. The previous decade had begun with the oil shock of 1979–1980, when oil prices rose to unprecedented levels. Third, there was an increase in intraregional trade among developing countries, attributable to unilateral liberalizations and to the reduction in trade barriers against one another on a preferential basis—that is, the institution of lower tariffs and the granting of greater market access for fellow members of regional trading agreements (RTAs).

Latin America led the developing world in rejuvenating and creating RTAs. Africa had the slowest growth in trade in the 1990s, because of its slower liberalization and because its commodities were concentrated in primary products. World trade slowed in the three years preceding 1998, primarily because of trade contraction in East Asia but also because of the decline in commodity prices, which fell sharply in 1997–1998 and began to recover in early 1999. The price declines were so sharp that primary product prices fell to 50 percent of their peaks for the first time since World War II.

The declines were somewhat moderated in 1999 with the recovery of oil prices. In terms of regional groups, the most severely affected were the African and Middle Eastern economies, because of their concentrations in primary products. The prices of services exports fell to their lowest level in dollar value since 1983, and the prices of all the major commercial services, including transport and travel, declined. It is worth noting, however, that the price declines are a transitory phenomenon and that prices are sure to recover with the revival of the East Asian economies.

Indeed, evidence of a recovery in the region began to emerge in 1999. The trade policies of developing countries in the 1990s differed from those of the 1980s in terms of their dominant themes and the policy experiences of different groups of countries. Writing on the main features of the trade policies of the 1980s, Anne Krueger (1990) concluded that “it is by no means clear that the trade policies of developing countries are any more restrictive in 1987 than they were at the end of the 1970s! ” For most developing countries, trade regimes are more open in the late 1990s than at any time in the post–World War II period.

There is no better way to demonstrate the trade trends in developing countries than to contrast the themes of the 1980s (Krueger 1990) with the emerging themes of the 1990s. First, a comparison of the trade regimes of the 1980s with those of the period 1950–1980 shows increased differentiation in trade policies among the developing countries. Many East Asian countries took the lead in liberalizing their trade regimes, while nearly all other developing countries maintained restrictive regimes. In the 1990s, there is less differentiation, because nearly all of the developing countries have begun to liberalize their regimes.

Second, a long-term trend toward less-restrictive trade regimes was observed in the 1980s. In the 1990s, trade reform has become a unifying goal, varying only according to the speed of liberalization. The response to reform has differed among countries depending on the strength and credibility of their initial reforms and the different circumstances within individual countries. A third aspect of the reforms of the 1980s saw developing countries become more integrated with the world economy, in both trade and capital flows, than in the previous three decades.

This process of integration into the world economy continued in the 1990s. Measured by trade-intensity indexes (the ratio of the sum of exports and imports to GDP), developing countries are more closely integrated into world trade than ever before. They are also closely integrated into the world capital market. In fact, the amounts of both short- and long term capital flowing into developing countries in the 1990s are four times the levels of the 1980s, which was a period characterized by debt problems. It is beyond the scope of this essay to xplore the consequences of integration into the world capital market, but we can observe that manufactured exports from developing countries have become closely linked to private foreign direct investment in the export sectors. That became possible with the reduction of bias against exports through trade liberalization and the creation of a more hospitable environment for private foreign direct investment in most of the developing countries, thanks to the reform of their regulatory regimes in the 1990s.

Finally, in the 1980s, real oil prices reached a peak, and mining products were a large share of the total exports of developing countries. In the 1990s, many developing countries moved from being exporters of primary products (agricultural and mining products) to becoming exporters of manufactures on a wider scale than before. That was a consequence of the changed economic environment of the 1990s and the decline in the real price of oil, which fell to its lowest levels since the early 1970s and reduced oil exports as a component of total exports.

In the mid-to-late 1990s, the prices of agricultural exports also fell, thereby increasing the relative value of manufactures. The manufactured exports of developing countries significantly increased their share of the total exports of developing countries—from 17 percent in 1980 to 24 percent in the 1990s. Despite the East Asian crisis of 1997, the past decade has been less turbulent than the 1980s. Many of the countries that were in desperate straits in the 1980s have staged recoveries thanks to reforms and to the return of private foreign direct investment.

The irony is that some of the East Asian countries that were setting a strong pace for export growth, such as Malaysia, South Korea, and Thailand, fell victim to their own success in the late 1990s. The crisis was attributable to weaknesses in their financial systems, to inadequate vigilance in the conduct of macroeconomic policies (which led to the appreciation of real exchange rates), and to the recession in Japan, which reduced the demand for their exports. Regulation of international trade: Traditionally trade was regulated through bilateral treaties between two nations.

For centuries under the belief in Mercantilism most nations had high tariffs and many restrictions on international trade. In the 19th century, especially in Britain, a belief in free trade became paramount. This belief became the dominant thinking among western nations since then despite the acknowledgement that adoption of the policy coincided with the general decline of Great Britain. In the years since the Second World War, controversial multilateral treaties like the GATT and World Trade Organization have attempted to create a globally regulated trade structure.

These trade agreements have often resulted in protest and discontent with claims of unfair trade that is not mutually beneficial. Free trade is usually most strongly supported by the most economically powerful nations, though they often engage in selective protectionism for those industries which are strategically important such as the protective tariffs applied to agriculture by the United States and Europe. The Netherlands and the United Kingdom were both strong advocates of free trade when they were economically dominant, today the United States, the United Kingdom, Australia and Japan are its greatest proponents.

However, many other countries (such as India, China and Russia) are increasingly becoming advocates of free trade as they become more economically powerful themselves. As tariff levels fall there is also an increasing willingness to negotiate non tariff measures, including foreign direct investment, procurement and trade facilitation. The latter looks at the transaction cost associated with meeting trade and customs procedures. Traditionally agricultural interests are usually in favour of free trade while manufacturing sectors often support protectionism. This has changed somewhat in recent years, however.

In fact, agricultural lobbies, particularly in the United States, Europe and Japan, are chiefly responsible for particular rules in the major international trade treaties which allow for more protectionist measures in agriculture than for most other goods and services. During recessions there is often strong domestic pressure to increase tariffs to protect domestic industries. This occurred around the world during the Great Depression. Many economists have attempted to portray tariffs as the underlining reason behind the collapse in world trade that many believe seriously deepened the depression.

The regulation of international trade is done through the World Trade Organization at the global level, and through several other regional arrangements such as MERCOSUR in South America, NAFTA between the United States, Canada and Mexico, and the European Union between 27 independent states. The 2005 Buenos Aires talks on the planned establishment of the Free Trade Area of the Americas (FTAA) failed largely due to opposition from the populations of Latin American nations. Similar agreements such as the MAI (Multilateral Agreement on Investment) have also failed in recent years. Conclusions:

Trade regimes in developing countries were more liberal in the late 1990s than at any time since World War II. Yet theoretical and empirical work on trade in the 1990s reveals that the benefits would be greater still if developing countries maintained more-liberalized trade regimes than they now do. Developing countries would do well to reduce protection and its variance, to rely on tariffs, to avoid imitating the protectionist stance of developed countries in their use of antidumping and the continued protection of agriculture, and to embrace most-favored nation– based trade over regional arrangements.

Beginning a new round of multilateral trade negotiations sooner rather than later would best serve the agenda for reform. The negotiations would facilitate further liberalization and would allow developing countries to realize their objectives in many of the areas of interest to them. In the 1980s and 1990s, the macroeconomic crises that many countries experienced were the principal stimulus to reform, and both theoretical and empirical aspects of the political economy of reforms support a crisis-driven hypothesis.

But crises are not an efficient way to generate reforms; hence the need for an external impetus, such as multilateral trade negotiations. Country-to country or multilateral negotiations do not generate optimal outcomes, for they may be confined to limited sectors. Even multilateral trade negotiations limited to a few sectors would not be optimal, because they would advance the trade interests of only the more-powerful countries, which would take the opportunity to “cherry pick” from an agenda the items that might not be as beneficial to developing countries.

As soon as developed countries accomplished their goals through this process, they would be unwilling to negotiate measures to reduce barriers in areas of interest to developing countries. Of course, developing countries could liberalize their trade regimes unilaterally—and some have already done so. (Chile is the prime example. ) That strategy remains the best option for developing countries. But multilateral trade negotiations, such as the proposed Development Round or Millennium Round whatever the politicians choose to call it), would allow developing countries to make gains over and above those of unilateral trade liberalization, and would allow them greater latitude as well in addressing items of interest to them. Further, such negotiations would help to check domestic protectionist interests, which may resist further liberalization. Multilateral trade negotiations are a more efficient mechanism than crises to induce reforms, because the give-and-take of the negotiations, if properly conducted, allows all parties to benefit, and to a greater measure than any one of them could achieve unilaterally.

The failure at Seattle should be seen as only a temporary setback, and it should not be allowed to spoil the case for a new round Biblography: 1)International Economics: Trade theory and Practise by Appleyard Field. 2)International Economics: Theory and Policy by Paul Krugman & Maurice Obstfeld. 3)Journal of Development Economics, volume 84, September 2007. 4)World Development Indicators (04), The World Bank. 5)Trade policy of developing countries by Sarath Rajapatirana