Trade and Industrial Policy Reform

The 1980s was a period when the developing world was submerged in a debt and macroeconomic crisis. On the other hand, this was also a time when privatization, industrial de-regulation and free trade were introduced as the anti-export and anti-private enterprise bias of the prevailing policy regimes was shunned. This paper reviews the impact of such policy reforms using both theory and evidence.

Policy reform, structural adjustment and the World Bank

Structural adjustment became the major form of policy reform in the 1980s. Almost all occurrences of policy reform in developing countries were supported by the Structural Adjustment Loans (SALs) from the World Bank. Wherever reforms were attempted, the words "structural adjustment" became the code used to describe and legitimize them and liberalization and outward orientation the main strategies employed.

The World Bank focused on developing export capacity. When they started, they realized that existing country strategies were distorted. These countries had to first shift from flawed price incentives and investment frameworks to more stable ones.

The goals set for SALs addressed the need to macroeconomic stabilization and microeconomic reforms through managed reductions in expenditures and structural adjustment. The latter is about changing relative prices and institutions to make the economy more efficient, more flexible, and better able to use resources and so to engineer sustainable long-term growth. This paper focuses on structural adjustment policies, policies aimed at improving an economy's efficiency and its long-term growth.

What is to be reformed?

There are countless policies that came under attack by reformers. In trade policy, the reforms centered on quantitative restrictions like licensing, high tariff rates, export taxes, and heavy bureaucratic requirements and paperwork. On the other hand, industrial policy emphasized inefficient and loss-making public enterprises, entry and exit restrictions on private enterprise, price controls, discretionary tax and subsidy policies, and soft-budget constraints.

Why reform? The rationales for policy reform

There are four basic arguments in favor of market-oriented policy reform:

1.      Economic liberalization reduces static inefficiencies arising from resource misallocation and waste. Import-substitution policies, covering high levels of trade protection and industrial regulation had encouraged the development of high-cost industries that did little to increase productivity. The resulting pattern of specialization shifted away from comparative advantage. It yielded anti-export, anti-agriculture, anti-labor, and anti-newcomers effects for resource allocation.

2.      Economic liberalization enhances learning, technological change, and economic growth. Domestic and foreign competition provides incentives to keep up with modern technology to improve operations and market position. This view provides an explanation for the East Asian success and a prospective argument for the removal of distortions in other developing countries.

3.      Outward-oriented economies are better able to cope with adverse external shocks. Balassa (1981) analyzed the comparative experiences of countries during the first oil shock and found that export-promoting countries were able to increase their world market shares, which in turn affected their economic growth positively. He later confirmed these findings with a larger sample of developing countries. Sach (1985) gave a similar conclusion using East Asian and Latin American experiences. Their works do not suggest that outward oriented countries are immune to shocks. Rather, they propose that such countries have an easier time getting out of crisis.

4.      Market-based economic systems are less prone to wasteful rent-seeking activities. The institutional setting under which import-substitution policies have typically operated has given rise to a wide variety of incentive distortions and resource misallocations. In contrast, Bhagwati and Srinivasan (1980) have noted that tariff revenue can be sought by rent-seekers as the anonymity of revenues that accrue to the general budget shields them from the rent-seeking. Similarly, a uniform tax system may be more resistant to lobbying than one with a highly differentiated structure.

Heterodoxy I: Reinterpreting the East Asian experience

The success of East Asian countries like Japan, South Korea, Taiwan, Singapore and Hong Kong is usually attributed to price distortion minimization, market freedom, and export emphasis. Analysts credited the East Asian success to the government. According to them, these miracles happened because the government actively nurtured and protected infant industries, not because they got out of the way of private entrepreneurs. East Asian countries liberalized trade restrictions gradually, slower than what Latin American countries have done.

Amsden (1989) showed that the Korean government policy was successful not because it got prices right, but because it got them purposefully wrong. A key element of the strategy was that in exchange for government subsidies and trade protection, the government also set strict performance standards. Firms were penalized when they performed poorly and were rewarded when they fulfilled government objectives. Such discipline kept the system free of rent-seeking.

Wade (1990), on the other hand, examined the Taiwanese strategy and found that Taiwan is characterized by high levels of investment. Incentives and controls on private firms were pervasive as evidenced by import restrictions, entry requirements, domestic content requirements, fiscal investment incentives, and concessional credit. He argues that the emphasis on exports helped reveal policy mistakes and made reversal possible when some ventures got too costly.

Latin America, Africa, and the rest of Asia used the same policy instruments of East Asia. However, in contrast to the East Asian success, these countries failed miserably. The policies in question are import quotas and licenses, credit subsidies, tax exemptions, public ownership, and so on. One possible explanation stems from the differences in the way that the government interacts with the private sector.

In sum, the East Asian experience can be described by the following:

·         There has been a lot of government intervention and an active trade and industrial policy.

·         Intervention took place in the context of stable macroeconomic policies, with small budget deficits and realistic exchange-rate management.

·         The governments' emphasis on exports helped minimize the resource costs and incentive problems that would have otherwise arisen from heavy intervention.

·         Intervention took place in an institutional setting characterized by a "hard" state and strong government discipline over the private sector.

Heterodoxy II: Recent models of imperfect competition

Wade (1990) suggested that under the right set of government policies, industries can be nurtured into competitiveness even if these industries are undistinguished with respect to potential comparative advantage. However, this conclusion are no longer clear amidst recent trade models with increasing returns to scale and imperfect competition because under such cases, the pattern of comparative advantage can be largely random. On the other hand, casual evidence would suggest that imperfect competition is very important in developing countries. However, imperfect competition is often the consequence of government policy itself.

Recent literature has provided new tools for analysis of some age-old questions. It has raised three types of policy questions: (i) strategic trade policy; (ii) policies to promote industries with scale economies; and (iii) policies to promote learning and growth.

Strategic trade policy

Modelling policy is greatly influenced by the work of Brander and Spencer (1985) on strategic trade policy. This model consists of two oligopolists based in different countries, competing in third markets and operating under constant costs. Each firm selects its output, taking the other firm's output as given, and the equilibrium is defined as the pair of outputs from which neither firm wishes to deviate. They showed that if one of the governments moved first and offered an export subsidy to the domestic firm, the policy would increase home welfare.

Home firm support might be a worthwhile objective in imperfectly-competitive markets because when there is limited entry, excess profits exist. However, Eaton and Grossman (1986) argue that the export-subsidy prescription is reversed when firms compete in prices rather than in quantities. When there is free entry into the industry, the rents from policy intervention are competed away and the home economy left worse off. If the government has insufficient information, they may set intervention at a wrong level. A prisoner’s dilemma might also result when foreign firms play the same game. Moreover, empirical studies show that only small gains from strategic policy.

Profit-shifting policy might be more useful in domestic markets in which home firms compete with local subsidiaries of multinational corporations or with direct sales from oligopolists abroad. In such markets, there is a case for discriminating against the foreign firms. This can be accomplished by import tariffs when foreign firms do not produce locally [Levy and Nolan (1992)], or by discriminatory performance requirements when they do [Rodrik (1987a)]. However, many of the limitations of the original profit-shifting argument carry over to this setting as well.

Levy and Nolan (1992) listed the lessons and implications of trade policy for developing countries. They proposed that: (1) Competition from foreign firms need not always be beneficial;

(2) Imports can be excessive under laissez-faire; (3) Foreign investment can be harmful, even under free trade; (4) Policies that discriminate in favor of domestically-owned firms can be beneficial; (5) Given the available empirical evidence, imperfect competition in the industrial sector of developing countries does not justify nominal tariff rates in excess of 15 percent; (6) Imperfect competition in the industrial sectors of developing countries is not an argument against trade liberalization measures of the type typically under consideration.

Policies to promote industries with scale economies

Murphy, Shleifer and Vishny (1989a, 1989b) proposed that coordination of investment across sectors is essential for industrialization as industrialization of one sector often affect the size of the market in other sectors in small domestic markets that are not enjoying free world trade. This result will be altered, however, when firms take advantage of world markets – when they are freed from dependence on demand spillovers from other sectors. This idea promotes free trade at the expense of government intervention. Furthermore, the argument for trade protection is weakened by the allowance for free entry as entry in the presence of scale economies crowd firms and duplicate fixed costs. Duplication is further aggravated when further entry is spurred by protection. Harris (1984) showed how the reversal of this process can create an industry rationalization effect, which can improve the welfare gains from trade liberalization. Moreover, it is important to note that the potential for excessive entry creates a role for entry restrictions, especially when entry has been artificially driven by trade restrictions.

Policies to promote learning and growth

Endogenous growth is obtained by allowing non-decreasing returns to reproducible assets, such as knowledge and human capital. Grossman and Helpman (1991) and Rivera-Batiz and Romer (1991) listed three main consequences of models of this type:

1.      Allocation effect. Static comparative advantage determines the instantaneous resource-pulls in an economy opening up to trade.

2.      Integration effect. International trade expands the size of the market which the R&D sector services; but it also increases the competition faced by the home R&D sector.

3.      Redundancy effect. In the absence of trade, some innovative activity is necessarily duplicated in different countries.

The more asymmetric trading countries are, the more likely that growth effects will be asymmetric also. This poses danger to developing countries as they might end up with the short end of the stick. For countries that are similar, this peril is less real.

In a closed economy, agricultural productivity is positively related to growth – the more productive is agriculture, the more resources can be allotted to manufacturing, and the faster the rate of learning and growth. In an open economy, however, specializing in agriculture withdraws resources form manufacturing. By analysing the effect of agricultural productivity on growth and by using Matsuyama’s (1992) results, one can argue that the optimal trade strategy for a developing country depends on the level of agricultural productivity. In contrast, Romer (1991) emphasized that openness to the outside world is at the center of the analysis.

How to reform? Issues in the strategy of reform

The theory of piecemeal reform

The theory of piecemeal reform questions which partial reforms can be undertaken to certain increased income aggregate real under the reality that policy distortions cannot be removed at once. Studies suggest that: i) an equal percentage reduction in all distortions increases aggregate income; and (ii) reducing the distortion on the most highly-taxed good increases aggregate income provided that good is a substitute to all others.

Is tax or tariff uniformity a good idea?

A uniform tariff is optimal only when the objective of policy is to decrease aggregate imports to a certain level. It is sometimes recommended on the basis of administrative simplicity and political economy, rather than economic efficiency.

Timing and sequencing of reform

Mussa (1986) shows that unless there is specific market distortions, the optimal policy consists of a jump to free trade. He showed that as long as individuals have rational expectations regarding the future path of factor rewards and there are no market distortions, they will adjust at a socially optimal rate when the reform is introduced all at once. Gradualism will be introduced when departures from these assumptions exist. For sequencing, Edwards (1984), Edwards and van Wijnbergen (1986), and Rodrik (1987b) have all suggested that trade liberalization should precede capital account liberalization.

Credibility in policy reform

According to Rodrik (1991), credibility problems can be self-fulfilling. The reversal of reform may come about for no other apparent reason than the belief that it will be aborted and credibility problems can arise because of inconsistencies in government policy. On the other hand, Matsuyama (1990) analyzed the extent to which a government can credibly threaten to liberalize so as to induce domestic firms to undertake appropriate investments and found that such threats are unlikely to be credible.

The fallacy of composition

The implementation of outward-oriented policies in countries that yield the same commodity exports has raised the worry of producing a fallacy of composition. With this note, empirical studies have shown that existing restrictions are much too high to justify on the basis of terms-of-trade arguments. Also, analysts like Bhagwati (1968) suggested that a country with market power in trade cannot experience growth as long as it has optimal export taxes – although Bandyopadhyay (1992) has shown that this logic need not hold when there is more than a single exporter of the same commodity, unless exporters select their export tax cooperatively.

Political economy issues

Governments are reluctant to undertake economic reform due to asymmetric information (Alesina and Drazen 1991). Fernandez and Rodrik (1991) suggested that individuals do not know exactly how they will perform under reform, even though the cumulative consequences may be well known.

Interaction with stabilization policy

The most significant trade and price reforms often have been in reality mere attachments to stabilization programs. Kaufmann (1991) found that the overall quality of macroeconomic management made a significant difference to the productivity of investment projects. Much of the debate on the wisdom of undertaking structural reform in the context of stabilization policies has focussed on whether the former can assist in the disinflation process. Liberalization in the midst of stabilization imposes conflicting pressures on exchange rate policy (Sachs, 1987). Usually, the conflict is resolved in favor of stabilization, leading to a prolonged overvaluation and large trade deficits. Also, trade liberalization, and the removal of quantitative restrictions may help disinflation by pushing convergence between domestic inflation in tradables prices and external inflation. Lastly, it increasing fiscal revenues is a primary goal of stabilization programs.

What has been achieved? Evidence on consequences of policy reform

The supply response and restructuring

The works of Faini et al. (1991) and Corbo and Rojas (1992) suggest that once external shocks are controlled, sector adjustment loans recipients tend to do better than comparator countries in exports and economic growth but worse in investment. Their findings are confirmed by Mosley et al. (1991). On the other hand, export evidence shows that a credible and lasting effort to increase the supply-price of exportables is rewarded by a large export response. Export performance may take a big push to get exports out, but once the transition is made, not much may be required to keep them going. Moreover, a healthy export response may be consistent with sluggish industrial restructuring if firms simply choose to substitute foreign markets for domestic markets.

Consequences for static and dynamic efficiency

Studies show that as trade theory has predicted, the relaxation of quantitative restrictions was effective. However, the findings indicate trade reform has not resulted in firms taking better advantage of scale economies through industry rationalization. On the other hand, available studies favor the hypothesis that trade reform is conducive to improvements in technical efficiency.

Conclusions: What we know and what we don’t

The benefits of price reform remain small in relation to developmental objectives. They are linked to economic growth through uncertain and unreliable channels. The East Asian success was driven in policy environments that have quantitative trade restrictions, selective subsidies, and discretionary incentives. But unlike other countries, these economies displayed discipline over private-sector groups.

Genuine reform will follow from a new set of interactions between the government and the private sector. This should provide an environment of policy stability and predictability, and must discourage rent-seeking activities, as well as improve on the governments' ability to discipline the private sector. Larger marginal social product can be attained by researching on issues of governance and institutional design.

Source:

Rodrik, Dani, “Trade and Industrial Policy Reform” Handbook of Development Economics, Volume III, (1995) pp. 2925- 2982.