Trade Openness and Growth Evidence from Developing Countries

Trade Openness and Growth Evidence from Developing Countries - Transcript

Trade Openness and Growth Evidence from Developing Countries
Policy Project
Haris Usman Roll no 1181 B A h Economics IIIrd Year

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Definition
What is openness
The openness of an economy is the degree to which foreigners and nationals can transact without government imposed costs including delays and uncertainty that are not levied on a transaction between two domestic citizens Tariffs and other charges nontariff barriers domestic content requirements and health and safety requirements or inspection delays above and beyond those imposed on domestic products raise the cost of buying from abroad The Sachs and Warner Criteria SW constructed a dummy variable for openness based on five individual dummies for specific trade related policies A country was classified as closed if it displayed at least one of the following characteristics 1 Average tariff rates of 40 of more TAR 2 Nontariff barriers covering 40 or more of trade NTB 3 A black market exchange rate that is depreciated by 20 or more relative to the official exchange rate on average during the 1970s or 1980s BMP 4 A state monopoly on major exports XMB 5 A socialist economic system as defined by Kornai 1992 SOC

Traditional arguments in favour of trade










Freeing trade frequently benefits the poor especially Developing countries can illafford the large implicit subsidies often channeled to narrow privileged interests that trade protection provides Moreover the increased growth that results from freer trade itself tends to increase the incomes of the poor in roughly the same proportion as those of the population as a whole New jobs are created for unskilled workers raising them into the middle class Overall inequality among countries has been on the decline since 1990 reflecting more rapid economic growth in developing countries in part the result of trade liberalization Trade is an important stimulator of economic growth It enlarges a country s consumption capacities increases world output and provides access to scarce resources and worldwide market for products without which poor countries would be unable to grow Trade helps countries achieve development by promoting and rewarding the sectors where individual countries possess a comparative advantage whether in terms of labour efficiency or factor endowments It also lets them take advantage of scale economies Trade tends to promote greater international and domestic equality by equalizing factor prices raising real incomes of trading countries and making efficient use of each nations and the world s endowments To promote growth and development an outward looking international policy is required In all cases self reliance based on partial or complete isolation is asserted to be economically inferior to participation in a world of unlimited free trade

Is openness needed
LDCs have the most to gain from engaging in the global economy First they gain access to much larger markets both for imports and exports On the import side consumers gain access to a dramatically larger range of goods and services raising their real standard of living Domestic producers gain access to a wider range and better quality of intermediate inputs at lower prices On the export side domestic industries can enjoy a quantum leap in economies of scale by serving global markets rather than only a confined and underdeveloped domestic market Secondly LDCs that open themselves up to international trade and investment gain access to a much higher level of technology This confers on LDCs a latecomer s advantage rather than bearing the cost of expensive up front research and development poor countries can import the technology off the shelf They can incorporate new technology by importing capital equipment that embodies the latest advances and computers with the latest software Subsidiaries of multinational companies also bring with them new production techniques and employee training that bolster the host nation s stock of human capital Engagement in the global economy provides capital to fuel future growth Most LDCs are people rich and capital poor In a few countries in Asia the level of domestic savings has been high enough to finance domestic investment but typically the domestic pool of savings in an LDC is inadequate Global capital markets can fill the gap allowing poor nations to accelerate their pace of growth In 1998 166 billion in foreign direct investment flowed from the advanced economies to the less developed

Empirical Evidence
In 1960 15 6 of the countries in the world representing 19 of its population had open trade policies in the sense defined by Sachs and Warner 1995 In 2000 a total of 73 of the countries in the world representing 47 of the world population were open to international trade Dollar and Kraay 2001a examine the growth experience of countries differentiated by their openness to trade over the past 20 years after controlling for correlation across growth enhancing variables and addressing difficulties in determining causation Three groups are identified rich countries globalizers and nonglobalizers Globalizers are those developing countries that experienced a particularly large proportionate increase in trade as a share of GDP doubling for the group from 16 percent of GDP to 33 percent in 20 years The rich countries showed a 70 percent increase over the same period from 29 percent to 50 percent The nonglobalizers which make up two thirds of all developing countries experienced a decline in trade as a share of GDP The globalizers also experienced an increase in their growth rates from 2 9 percent per year in the 1970s to 3 5 percent in the 1980s to 5 percent in the 1990s while the nonglobalizers saw annual growth decline from 3 3 percent to 0 8 over the first two decades before recovering to 1 4 percent in the 1990s The results provide robust evidence about the effect of openness on growth



Table Simple Correlations with Growth
Variable OPEN MON SOC BMP NTB TAR



Correlation 0 556 0 423 0 148 0 368 0 083 0 048

TAR own import weighted ratio of tariff revenues to trade Source Barro and Lee 1994 NTB own import weighted non tariff frequency on capital goods and intermediates Source Barro and Lee 1994

Data






A study of 117 countries by Jeffrey Sachs and Andrew Warner found that open economies grew much faster than closed economies Specifically the authors found that the developing countries that maintained open economies throughout the 1970s and 80s grew at an average annual rate of 4 5 percent compared with an average growth rate of 0 7 percent for closed economies As a result the open developing economies tended to converge toward the slower growing rich economies while relatively closed economies did not converge A more recent study by Jeffrey Frankel and David Romer produced similar results The authors found that trade exerts a qualitatively large and robust E positive effect on income In their study of 150 countries they concluded that increasing the ratio of trade to gross domestic product by 1 percentage point raises income per person by between 0 5 and 2 percent 10 The Organization for Economic Cooperation and Development OECD concluded that nations relatively open to trade grew on average twice as fast as those relatively closed to trade The post liberalization surge in investment rates is particularly clear for Chile Colombia Hungary Indonesia Jordan Korea Poland and Taiwan The break in the openness series is particularly apparent for Chile Colombia Cyprus Ghana Hungary Jordan Korea Mauritius Poland and Taiwan a closer examination of post liberalization changes in growth investment and openness for a restricted sample of developing countries reveals a considerable amount of heterogeneity in these countries





In the 1950s global merchandise exports accounted for approximately 8 percent of GDP a proportion that had increased to almost 26 percent in 2004 Krueger 2004 In depth analyses by Srinivasan and Bhagwati 1999 of country experiences that trade continued to create and sustain higher growth during this period In the past two decades international trade has continued to drive economic growth and has grown twice as fast as worldwide income Dollar and Kraay 2001 Recent evidence suggests a statistically significant and economically meaningful effect of trade on growth an increase in trade as a share of GDP of 20 percentage points increases growth by between 0 5 and 1 percentage point a year Dollar and during the 1960s and 1970s showed Kraay 2001

East Asia




The spectacular growth of many economies in East Asia over the past 30 years has amazed the economics profession and has evoked a torrent of books and articles attempting to explain the phenomenon Articles on why the most successful economies of the region Hong Kong Korea Singapore and Taiwan Province of China have grown to say the least robustly invariably refer to the phenomenon as miraculous Since 1960 Asia the largest and most populous of the continents has become richer faster than any other region of the world Of course this growth has not occurred at the same pace all over the continent The western part of Asia grew during this period at about the same rate as the rest of the world but as a whole the eastern half ten countries China Hong Kong Indonesia Japan Korea Malaysia the Philippines Singapore Taiwan Province of China and Thailand turned in a superior performance although variations in achievement can be observed here too The worst performer was the Philippines which grew at about 2 percent a year in per capita terms about equal to the average of non Asian countries China Indonesia Japan Malaysia and Thailand did better achieving growth rates of 3 5 percent This impressive achievement is however still modest compared with the phenomenal growth of Hong Kong Korea Singapore and Taiwan Province of China known as the Four Tigers because of their powerful and intimidating economic performance The Tigers have had annual growth rates of output per person well in excess of 6 percent These growth rates sustained over a 30 year period are simply amazing While the average resident of a non Asian country in 1990 was 72 percent richer than his parents were in 1960 the corresponding figure for the average Korean is no less than 638 percent Between 1993 and 96 the number of people living in absolute poverty in East Asia what the World Bank defines as less than 1 per day declined in the region from 432 million to 267 million In China alone the number of poor people so defined fell by 150 million between 1990 and 97 13 The 1997 98 financial crisis that began in East Asia brought a temporary halt to this progress but poverty rates in the hardest hit countries Korea Thailand and Indonesia have begun to decline back toward their precrisis levels

Criticisms






Rodr guez and Rodrik 2000 have suggested that these findings are less robust than claimed due to difficulties in measuring openness statistically sensitive specifications the collinearity of protectionist policies with other bad policies and other econometric difficulties Because of the doubts that this study has created about the linkages between trade openness and growth further research on this important topic is certainly called for Cross sectional results confirm recent criticisms of the SW findings by showing that they were sensitive to the chosen openness classification in the 1970 1989 period and that they no longer hold for the 1990s In the 1990s a vast majority of the countries in other samples are classified as open and a simple dichotomous indicator of openness no longer discriminates between slow and fast growing countries findings suggest that researchers should exercise caution when using simple dichotomous policy indicators such as the SW dummy Countries that liberalize often do so following periods of economic turmoil Tornell 1998 showed that most 60 episodes of economic reform including trade reform occur in the aftermath of a domestic political or economic crisis In this case pre reform growth could be depressed due to other factors and we could wrongly associate postreform changes in growth rates to the reforms per se

Why trade might not work
The conclusions of international trade theory are derived from a number of explicit and implicit assumptions that in many ways are often contrary to the reality of contemporary international economic relations This theory therefore often leads to conclusions incompatible with both the historical and contemporary trade experience of many developing nations This is not to deny the potential benefits of a world of free trade but rather to recognize that the real world is beset by all sorts of national protection and international noncompetitive pricing policies Some of the major and crucial assumptions of the traditional factor endowment theory of trade and how are these assumptions violated in the real world What are the Implications for the trade and financial prospects of a developing nations when a more realistic assessment of the actual mechanism of international economic and political relations is made Six basic assumptions of the neoclassical trade model do not necessarily hold 1 All the productive resources are fixed in quantity and constant in quality across nations They are fully employed and there is no international mobility of productive factors 2 The technology of production is fixed classical model or similar and freely available to all nations factor endowment model moreover the spread of such technology works to the benefit of all Consumer tastes are also fixed and independent of the influence of producers international consumer sovereignty prevails 3 Within nations factors of production are perfectly mobile between different production activities and the economy as a whole is characterized by the existence of perfect competition There are no risks of uncertainties 4 The national government plays no role in international economic relation trade is carried out among many atomistic and anonymous producers seeking to minimize costs and maximize profits International prices are therefore set by the forces of supply and demand 5 Trade is balanced for each country at any point in time and all economies are readily able to adjust to changes in the international prices with a minimum of dislocation 6 The gains from trade that accrue to any country benefit the nationals of that country

Criticisms of openness indicators
A noteworthy feature of these regressions is that the 1990s data

features 78 open countries and 27 closed economies This is in sharp contrast with the 1970 89 openness classification which featured 31 open countries and 74 closed ones Clearly the updated openness indicator can no longer effectively partition fast growing from slow growing countries A potential argument is that what constitutes an open country differs in the 1990s compared to earlier periods For example in a context where most countries have already opened up to trade even moderate barriers can effectively isolate a country from the world economy In other words perhaps the SW criteria for openness are not stringent enough for the 1990s Also An important and often overlooked drawback of the SW openness dummy variable is that it was based on averages of black market premium BMP data over each of two decades 1970 79 and 1980 89 averages of nontariff barriers NTB and tariffs TAR over the last years of their sample period 19851988 and on end of period data for the exprt marketing board dummy XMB and the socialist dummy SOC Furthermore if these openness indicators are correlated among themselves introducing them separately in a regression may not yield reliable estimates due

Rodriguez further provides this conceptual problem










Think of a small economy that takes world prices of tradable goods as given What is the relationship between trade restrictions and real GDP in such an economy The modern theory of trade policy as it applies to such a country can be summarized in the following three propositions 1 In static models with no market imperfections and other pre existing distortions the effect of a trade restriction is to reduce the level of real GDP at world prices In the presence of market failures such as externalities trade restrictions may increase real GDP although they are hardly ever the first best means of doing so 2 In standard models with exogenous technological change and diminishing returns to reproducible factors of production e g the neo classical model of growth a trade restriction has no effect on the long run steady state rate of growth of output 7 This is true regardless of the existence of market imperfections However there may be growth effects during the transition to the steady state These transitional effects could be positive or negative depending on how the long run level of output is affected by the trade restriction 3 In models of endogenous growth generated by non diminishing returns to reproducible factors of production or by learning by doing and other forms of endogenous technological change the presumption is that lower trade restrictions boost output growth in the world economy as a whole But a subset of countries may experience diminished growth depending on their initial factor endowments and levels of technological development Taken together these points imply that there should be no theoretical presumption in favor of finding an unambiguous negative relationship between trade barriers and growth rates in the types of cross national data sets typically analyzed The main complications are twofold First in the presence of certain market failures such as positive production externalities in import competing sectors the long run levels of GDP measured at world prices can be higher with trade restrictions than without In such cases data sets covering relatively short time spans will reveal a positive partial association between trade restrictions and the growth of output along the path of convergence to the new steady state Second under conditions of endogenous growth trade restrictions may also be associated with higher growth rates of output whenever the restrictions promote technologically more dynamic sectors over others In dynamic models moreover an increase in the growth rate of output is neither a necessary nor a sufficient condition for an improvement in welfare

Since endogenous growth models are often thought to have provided the missing theoretical link between trade openness and long run growth it is useful to spend a moment on why such models in fact provide an ambiguous answer As emphasized by Grossman and Helpman 1991 the general answer to the question does trade promote innovation in a small open economy is it depends 9 In particular the answer varies depending 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 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

Conclusion
The methods and indicators used can clearly be questioned and









at best show a correlation between liberalization and growth especially if considered over a long run period A distinct possibility is that the classification of countries as open or closed is too crude to provide much explanatory information for growth in a simple cross section Also some of the assumptions of trade theory might not be applicable to actual Third world Experience These experiences have been heterogeneous and clearly show the significance of variables other than trade in determining whether it is beneficial The question it seems is not if to trade at all but what and on what terms to trade Though I would disagree with Kofi Annan who says It has been said that arguing against globalization is like arguing against the laws of gravity Policies need to be formulated carefully by LDC governments who should not blindly liberalize since clearly certain degrees of closed economy might be necessary to safeguard national interests Liberalization should be done in phases according to need and



Trade can be an important stimulus to rapid economic growth by promoting greater utilization of idle human and capital resources increasing foreign exchange earnings and expanding access to technological knowledge At the same time for a majority of developing countries the principal benefits of world trade have accrued disproportionately to foreign residents and wealthy nationals as well as to the developed countries This is the result not of trade as such but of the imbalanced structure of the world economy in which trade takes place with bargaining power concentrated in the hands of developed country private and public institutions Trade because of its biased distributional effects may often tend to reinforce existing inequalities rather than serve development objectives Some trade is essential and beyond that more is beneficial Some LDCs such as Taiwan South Korea and some OPEC countries have strongly benefited The issue is not whether to trade but which if any exports to try to promote in the current world economy Whether expanding trade especially doing so without public controls makes sense as a key development strategy depends on the nature of the export sector and its medium to long term potential for example terms of trade the distribution of its benefits its linkages with the rest of the economy and the LDC s ability to respond smoothly to changing international price signals In general balanced success will require access to developed countries markets for labor intensive manufactures extensive linkages between the export sector and other sectors of the economy and the ability to influence activities of foreign enterprise

Bibliography
Todaro and Smith 8th edition Freetrade org A SKEPTIC S GUIDE TO THE CROSS NATIONAL EVIDENCE

Francisco Rodr guez and Dani Rodrik www imf org World Development reports Cypher and Dietz Trade Liberalization and Growth New EvidenceWacziarg and Welch Worldbank org Developments org