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Lecture 12
Trade Policy in Developing Countries
Introduction
 There is a great diversity among the developing countries in terms of their income
per capita. Why are some countries so much poorer than others?
Economic Growth and International Trade
 Using trade policy, how can a developing country achieve income per capita in
advanced countries?
How big are the costs of protection?
Net National Loss from protection as a percentage of GDP
= ½ x tariff rate t x percentage change in imports x import share of GDP
= ½ x t x %M x M/GDP
Let’s suppose t=10% will result in 20% reduction in M and that M/GDP =10%
Then NNL/GDP = 0.5 x 0.10x 0.2 x 0.10 = 0.1% of GDP! (not very large!)
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Free trade would increase GDP 10% at most.
Gains from Trade are not large and have a level effect (versus growth effects)
Need to industrialize. But how? By ISI strategy.
• The belief that the key to economic development is creation of a strong
manufacturing sector.
• This requires active public policy including that of protection from
international competition.
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Import-Substituting Industrialization
 ISI has been the most prominent strategy among developing countries
 Four arguments are made in favor of ISI
1- Infant industry argument
2- The developing country argument: taxing imports is the only way
government can raise revenues for any kind of economic development
program such as health education and so forth.
3- Cheap information argument: Replacing imports of manufacturing is a
way of using cheap and convenient market information.
4- Large country argument: A large organization of countries replacing
imports can bring better terms of trade effects than expansion of export
industries. Also large countries can manufacture in plants large enough to
take advantage of economies of scale.
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Why not encourage both import substitution and exports?
• A tariff that reduces imports also necessarily reduces exports (this is true
only if all goods are internationally tradable)
• Until the 1970s many developing countries were skeptical about the
possibility of exporting manufactured goods.
• In many cases, import-substituting industrialization policies dovetailed
naturally with existing political biases.
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Why ISI didn’t work the way it was supposed to?
• Import-substituting industrialization led to:
– High rates of effective protection
– Inefficient scale of production
– Higher income inequality and unemployment
• Example: In India, after 20 years of economic plans between the early
1950s and the early 1970s, its per capita income was only a few percent
higher than before.
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Change of trade policy orientation
• Until late 50s Taiwan used ISI but then switched to a policy that
encouraged exports and it subsequently achieved growth rates of above
10% per year.
• South Korea used ISI until policy reforms in the early 60s increase its
incentive for export and lowered its import barriers. Its growth rate
increased to about 10%
It seems those countries that have emphasized manufacturing exports have
experienced a higher growth rate.
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High performance Asian economies (HPAEs)
• A group of countries that achieved spectacular economic growth.
• In some cases, they achieved economic growth of more than 10% per year.
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The Facts of Asian Growth
• The World Bank’s definition of HPAEs contains three groups of countries,
whose “miracle” began at different times :
– Japan (after World War II)
– The four “tigers”: Hong Kong, Taiwan, South Korea, and Singapore (in
the 1960s)
– Malaysia, Thailand, Indonesia, and China (in the late 1970s and the
1980s)
• The HPAEs are very open to international trade
– Example: In 1999, exports as a share of gross domestic product in the
case of both Hong Kong and Singapore exceeded 100% of GDP (132
and 202 respectively).
Trade Policy in the HPAEs
• Some economists argue that the “East Asian miracle” is the payoff to the
relatively open trade regime.
– The data in Table 10-4 suggests that the HPAEs have been less
protectionist than other, less developing countries, but they have by no
means followed a policy of complete free trade.
– Low rates of protection in the HPAEs helped them to grow, but they are
only a partial explanation of the “miracle.”
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Does freer trade promote higher economic growth? no relationship in the data
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There is no proof that freer trade leads to economic growth
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Economic Growth and trade Policy
Do countries with lower policy-induced barriers to international trade grow
faster, once other relevant country characteristics are controlled for?
The answer is it depends.
• on whether the forces of comparative advantage push the economy's resources
in the direction of activities that generate long-run growth (via externalities in
research and development, expanding product variety, upgrading product
quality, and so on) or divert them from such activities.
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Grossman and Helpman (1991), Feenstra (1990), Matsuyama (1992), and
others have worked out examples where a country that is behind in
technological development can be driven by trade to specialize in traditional
goods and experience a reduction in its long-run rate of growth. Such models
are in fact formalizations of some very old arguments about infant industries
and about the need for temporary protection to catch up with more advanced
countries.
Identify and protect industries with positive externalities to achieve higher
economic growth rates
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Industrial Policy in the HPAEs
• Several of the highly successful economies have pursued industrial policies
(from tariffs to government support for research and development) that favor
particular industries over others.
• Most economists have been skeptical about the importance of such policies
because:
– HPAEs have followed a wide variety of policies, but achieved
similarly high growth rates.
 Ranging from detailed government direction of the economy in
Singapore to virtual laissez-faire in HK South Korea
deliberately promoted the formation of very large industrial
firms; Taiwan’s economy remains dominated by small, familyrun companies.
– The actual impact on industrial structure may not have been large.
 There is little evidence that countries with explicit industrial
policies have moved into the targeted industries any faster than
those which have not.
– There have been some notable failures of industrial policy.
 For example, from 1973 to 1979 South Korea followed a
policy of promoting “heavy and chemical” industries,
chemicals, steel, automobiles, and so on. This policy proved to
be very costly, and was eventually judged to be premature and
was abandoned.
 Beason and Weinstein (RE&S 1996) compare 13 different
industries in Japan and ask whether the industries that
benefited from government support performed better or not.
The study shows that the support primarily went to slowgrowth industries and those industries that grew quickly
typically did so with relatively little government help.
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It makes sense to support industries with positive externalities but in practice
it is difficult to identify them and to implement effective policies.
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Joseph Stieglitz’s Infant Country Argument: Protect the Manufacturing
sector with a uniform tariff/subsidy rate.
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Spillovers of Knowledge: An empirical investigation
 Gains from trade are much more likely when knowledge flows across borders.
 Coe and Helpman (1995) test for the presence of such spillovers using data for the
OECD countries.
• Their hypothesis is that if international spillovers occur, then the growth rates of
countries should be correlated with both their own R&D expenditures and also the
R&D expenditures of their trading partners.
• They find that TFP (Total Factor Productivity) growth rates at the country level are
indeed correlated with own and partner-country R&D expenditures, lending support
to the idea that research and development carried out in one country “spills over” to
its trading partners.
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Funk (2001) finds that there is no significant relationship between TFP growth and
import-weighted R&D expenditures of partner countries.
However, he does find a significant relationship between TFP and export-weighted
R&D expenditures of partner countries, supporting the idea that exporters learn from
their customers.
Keller (2002) has extended the results of Coe and Helpman using sectoral rather than
aggregate country data. He finds out that the spillovers are quite highly localized.
For the two closest countries in his sample, Germany and the Netherlands, one dollar
of R&D expenditure in Germany has 31% of the impact on Dutch productivity as
does one dollar R&D expenditure in the Netherlands.
The effects of foreign R&D are lower for all other countries; for example, the relative
effect of American R&D on Canada is only 4% of the value of Canadian R&D on its
own productivity.
So Keller’s results provide evidence of R&D spillovers across borders that are
precisely estimated, but small.
Branstetter (2001, p. 75) finds that spillovers are primarily intra-national in scope.
There are some regressions where Japanese firms benefit from the weighted R&D
activity of American companies, but this effect does not remain significant when the
domestic spillovers are included in the regression.
Conversely, there is no evidence that American firms benefit from the R&D activities
of the Japanese.
This raises the idea that knowledge spillovers may be asymmetric, and presumably
flow from the most technologically advanced country outwards.
In other work, Branstetter (2000) has explored whether Japanese firms that have
foreign affiliates in the U.S. act as a “conduit” for knowledge flows, i.e. whether there
is a greater spillover between these foreign affiliates and other American firms.
It appears that this is indeed the case, so that foreign investment increases the flow of
knowledge spillovers both to and from the investing Japanese firms.
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Inward versus Outward orientation, laissez-faire or free trade
Tradables, Nontradables and PPF
export-promoting policy → RER↑→ QT↑& QNT↓
QNT
Non-tradables
RER= NER*PTW/PNT’
QNT
A
RER’=NER*PTW/PNT
QNT’
B
QT
QT’
QT
Tradables
RER (Real Exchange Rate) = PTW / PNT
Ratio of tradebales at world prices PTW (evaluated at domestic currency) to
domestic price of nontradable PNT
NER = Nominal Exchange Rate = # of domestic currency per unit of foreign currency.
Inward Orientation: a mover towards the non-traded goods
Can happen because of Trade Polices and/or Fiscal/Monetary or Exchange Rate
Policies that leads to RER Appreciation
i.e. If a country prints money to finance increased state expenditure, the higher level
of demand increases the price of non-tradables. With NER being fixed this leads to a
fall in the value of RER (this is called RER appreciation). This causes resources to
move out of tradables to nontradables resulting in a decrease in the production of
tradables and an increase in the production of nontradables.
Some useful terminology
In import-substituting policy ERPImportables > ERPExporables
This policy is also called inward-oriented policy
Here there is a bias against the tradable sector
In export-promoting policy ERPImportables = ERPExporables >0
This is also called outward-oriented policy
Here there is a bias against the production of non tradables.
But since there is no overall policy bias toward the production of any
particular production within the tradable sector this is considered a free
trade policy
In laissez-faire ERPImportables = ERPExporables = 0
There are no policy distortions within the entire economy.
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Is seems that HPAEs exercised an outward-oriented trade policy
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Other Factors in Growth
• Two factors can explain the rapid growth in East Asia:
– High saving rates
– Rapid improvement in public education
• The East Asian experience refutes that:
– Industrialization and development must be based on an inward-looking
strategy of import substitution.
– The world market is rigged against new entrants, preventing poor
countries from becoming rich.
• FDI, Multinationals and growth. Do multinational corporations promote of
hinder growth?
– Depends on how they are employed. They help transferring marketing,
production, and managerial know-how that otherwise the country did
not have access to. But this is not an automatic process. MNCs do not
want to share their know-how information if they do not have to. If the
receiving country does not actively seek the transfer of technology FDI
is not necessarily growth promoting.
Appendix
Effective rate of protection (Optional)
• One must consider both the effects of tariffs on the final price of a good, and the
effects of tariffs on the costs of inputs used in production.
• The actual protection provided by a tariff will not equal the tariff rate if imported
intermediate goods are used in the production of the protected good.
• Example: A European airplane that sells for $50 million has cost $60 million to
produce. Half of the purchase price of the aircraft represents the cost of components
purchased from other countries. A subsidy of $10 million from the European
government cuts the cost of the value added to purchasers of the airplane from $30 to
$20 million. Thus, the effective rate of protection is (30-20)/20 = 50%.
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ERP formula
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ERP = (VT – VW)/VW = tA + PC [(tA-tC)/(PA – PC)]
– VW = value added in the sector at world prices
– VT = value added in the presence of trade policies
– PA = the world price of an assembled automobile
– PC = the world price of components
– tA = the ad valorem tariff rate on imported autos
– tC = the ad valorem tariff rate on imported components
for tA = tC have ERP = tA
for tA < tC have ERP < tA
for tAPA < tCPC have ERP < 0