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147 5. Liberalization of Trade: Why So Much Controversy? H. Tang and Ann Harrison Economists have long recognized the gains from international trade; the study of these gains is where modern economics began. Over the centuries, gains from international trade have been a powerful integrating force that brought together remote parts of the world and different civilizations, helped disseminate knowledge and ideas, and shaped the course of regions or nations. With rapid reductions in transport and communication costs, this trend accelerated in the 19 th century. At the beginning of the 20 th century it reached unprecedented high levels, from which it declined, however, following the two World Wars, the 1929 Crisis, and a world-wide increase in protectionism. A reversal in protectionism started after World War II among industrialized countries, and in the 1970s among developing countries. In the 1990s, trade reforms expanded or were consolidated in South Asia, East Asia, Latin America, Eastern Europe and, to a lesser extent, in Africa and the Middle East. Despite positive results and high expectations, controversies about the economic and social effects of trade liberalization have persisted. Why have some trade liberalizations ended up in reversals, and why have others brought about prosperity, opportunities, and economic diversification? Why has global integration been so vocally opposed by some? Is there still a role for protection of infant industries in growth strategies? Does trade liberalization cause growth, or is it growth that increases the openness of an economy? Does trade liberalization increase vulnerability and poverty? Or does it help reduce poverty instead? Has import substitution helped accelerate growth? Or has it reduced it? These issues will no doubt take time to be settled. However, from the experience and academic research of the 1990s this chapter finds sufficient evidence to draw five lessons: First, openness to trade has been a central element of successful growth strategies—all countries that sustained growth over time have also reduced trade barriers. This empirical regularity is confirmed both by the long term historical record and by the experience of the 1990s. Similar to country experiences with macroeconomic stability (Chapter 4), the experience of the 1980s put in sharp contrast the performance of countries that responded to shocks by increasing outward orientation (East Asian countries) and those that did not (Latin America in the 1970s, Africa, and most countries of the Middle East and North Africa). Influenced by this diversity in results, during the 1980s and 1990s, most developing countries significantly reduced tariffs on imports and dismantled other forms of impediments to trade: quantity restrictions, trade monopolies, and marketing boards. As in the case of macroeconomic reforms, however, the results varied and, in general, fell short of expectations—whereas a reduction in barriers to trade helped efficiency and growth in many cases (East and South Asian countries, Botswana, Chile, Mauritius, Tunisia), it failed to do so in many others—simply because reducing barriers to trade are only one of the measures needed for countries to expand their participation in international trade. One explanation for the diversity in outcomes, and this is the second lesson to draw from the 1990s, is that trade is an opportunity, not a guarantee. Trade reform in some countries brought about few gains in terms of export expansion or increased economic growth, while it

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5. Liberalization of Trade: Why So Much Controversy? H. Tang and Ann Harrison Economists have long recognized the gains from international trade; the study of these gains is where modern economics began. Over the centuries, gains from international trade have been a powerful integrating force that brought together remote parts of the world and different civilizations, helped disseminate knowledge and ideas, and shaped the course of regions or nations. With rapid reductions in transport and communication costs, this trend accelerated in the 19th century. At the beginning of the 20th century it reached unprecedented high levels, from which it declined, however, following the two World Wars, the 1929 Crisis, and a world-wide increase in protectionism. A reversal in protectionism started after World War II among industrialized countries, and in the 1970s among developing countries. In the 1990s, trade reforms expanded or were consolidated in South Asia, East Asia, Latin America, Eastern Europe and, to a lesser extent, in Africa and the Middle East. Despite positive results and high expectations, controversies about the economic and social effects of trade liberalization have persisted. Why have some trade liberalizations ended up in reversals, and why have others brought about prosperity, opportunities, and economic diversification? Why has global integration been so vocally opposed by some? Is there still a role for protection of infant industries in growth strategies? Does trade liberalization cause growth, or is it growth that increases the openness of an economy? Does trade liberalization increase vulnerability and poverty? Or does it help reduce poverty instead? Has import substitution helped accelerate growth? Or has it reduced it? These issues will no doubt take time to be settled. However, from the experience and academic research of the 1990s this chapter finds sufficient evidence to draw five lessons: First, openness to trade has been a central element of successful growth strategies—all countries that sustained growth over time have also reduced trade barriers. This empirical regularity is confirmed both by the long term historical record and by the experience of the 1990s. Similar to country experiences with macroeconomic stability (Chapter 4), the experience of the 1980s put in sharp contrast the performance of countries that responded to shocks by increasing outward orientation (East Asian countries) and those that did not (Latin America in the 1970s, Africa, and most countries of the Middle East and North Africa). Influenced by this diversity in results, during the 1980s and 1990s, most developing countries significantly reduced tariffs on imports and dismantled other forms of impediments to trade: quantity restrictions, trade monopolies, and marketing boards. As in the case of macroeconomic reforms, however, the results varied and, in general, fell short of expectations—whereas a reduction in barriers to trade helped efficiency and growth in many cases (East and South Asian countries, Botswana, Chile, Mauritius, Tunisia), it failed to do so in many others—simply because reducing barriers to trade are only one of the measures needed for countries to expand their participation in international trade. One explanation for the diversity in outcomes, and this is the second lesson to draw from the 1990s, is that trade is an opportunity, not a guarantee. Trade reform in some countries brought about few gains in terms of export expansion or increased economic growth, while it

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created social and economic adjustment costs. These country experiences do not imply that less trade reform would have been desirable, but that trade reform must be done sensibly, as part of an effective growth strategy. Liberalization of trade in Argentina in the 1980s and 1990s, and in Chile in the early 1980s, for example, was accompanied by an appreciation of the real exchange rate that reduced the competitiveness of domestic industries, and incentives to exports—with adverse consequences for the balance of payments and real economy. In many countries of Eastern Europe in the 1990s, trade was liberalized while property rights were not well defined, and the institutional base for a market economy was not well developed. These, and other institutional issues preventing the free movement of resources, often meant that trade reforms did not expand economic opportunities—restricting them instead (Freund 2004). In short, while trade integration can strengthen an effective growth strategy, it cannot ensure its effectiveness. Other elements are needed, such as sound macroeconomic management, building trade-related infrastructure, and trade-related institutions, economy-wide investments in human capital and infrastructure, or building strong institutions. Because these reforms are often difficult to implement, there has been excessive emphasis on trade policy alone, rather than as a component of an overall growth strategy. In addition to freeing markets and ensuring the institutional foundation of a market economy, there may also be a need for governments to address market failures that impede a supply response. Identifying which industries warrant special treatment is a highly risk- laden challenge, however, and the experience of the last few decades is riddled with examples of attempts at correcting market failures which became more costly than the failures themselves. At the same time, there has been learning in how to structure interventions in a manner that can reduce the risks of capture and failure. In part because successful trade reforms are introduced in conjunction with complementary policies and initiatives, it is difficult empirically to identify the growth effect of trade policy alone, compared with the growth impact of other policy initiatives, and to disentangle whether trade causes growth or growth causes trade. As an economy accumulates physical and human capital, shifts its comparative advantage towards more capital- intensive activities, and becomes internationally competitive on a wider range of goods and services, it will inevitably trade more. But is higher trade the result or the cause of its growth? Most likely both processes are at work. Third, there are many possible paths to open an economy. The challenge for policymakers is to identify which is the path best suited to their political economy, institutional constraints, and initial conditions. As these vary from country to country, it is not surprising that countries that have succeeded in promoting growth through trade liberalization have followed a variety of policy approaches. The heterogeneity in country experiences regarding the timing and pace of reforms is striking. Different countries have opened up different sectors at different speeds (for example Bangladesh and India); others have achieved partial liberalization through the establishment of export processing zones (for example China and Mauritius); and yet others have combined unilateral trade reforms (Estonia) with participation in regional trade agreements (for example Mexico and countries in Central and Eastern Europe that have now joined the European Union).

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Fourth, the distributive effects of trade liberalization are diverse—and not always pro-poor. Trade reforms were expected to be pro-poor because in most societies the relatively wealthy and urban classes have been more successful at using protection for their own benefit. The expectation was that trade reform would increase the incomes of the unskilled. Yet evidence from the 1990s on the relationship between trade reforms and poverty is to date mostly indirect. Even in instances where trade policy has reduced poverty, there are still distributive issues, and one important policy lesson is that countries need to help those affected move out of contracting (import-competing) sectors into expanding (exporting) sectors. This is an issue relevant to both developing and industrialized countries. Fifth, the preservation and expansion of the world trade system hinges on its ability to strike a better balance between the interests of industrialized and developing nations. It has long been recognized that the world trade system, while more supportive of development than at the beginning of the 1990s, still remains biased against the poor. The 1991 WDR had already documented the differential treatment of industrialized countries’ imports. Notwithstanding a decade of significant expansion of international trade, global markets are most hostile to the products the world's poor produce—agriculture, textiles, and labor-intensive manufactures—and problems of escalating tariffs, tariff peaks, and quota arrangements systematically deny the poor market access and skew incentives against adding value in poor countries. These problems are embedded in the remaining structure of protection in both industrial countries and developing countries (the latter both due to their own anti-export biases and to higher barriers to trade in developing country markets), and they can be addressed through collective actions. Those actions should best be done through the Doha Round and the WTO. Although there is a role for non-reciprocal preferences and for reciprocal regional approaches, this comes at a cost to excluded countries, is arbitrary and political, and thus not first best in terms of generating the right incentives for investment. Evidence for the first of the lessons above will be presented in Country Note 2 and is not repeated here. After a brief historical overview, this chapter discusses the evidence for the four lessons above. 1. From import substitution to export orientation to trade liberalization Protection of domestic industries has a long history. In the 12th century, for example, to maintain the competitive edge of their textile industries, Flanders and England restricted the movement of experienced weavers. In the 13th century, England enacted laws restricting types and origin of fabrics certain individuals could wear. Some of these laws aimed at identifying individuals’ social origins through their clothes, but the rationale for others was the protection of domestic industries. In the 17th century, a new law prohibited wearing imported silk and calicoes, which provided impetus to England’s calico-printing, silk, and cotton- linen industries, and hence restricted then-flourishing imports from France, India, China, and Persia. In 16th and 17th century France, the state promoted selected industries, through import protection, direct ownership, or subsidies, as did Japan later during the Meiji period. While protection of domestic industries took various forms—such as subsidized capital, monopoly or monopsony rights—protection from imports was the most widely used

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and became particularly important after the start of the industrial revolution. During the 1800s and first half of the 1900s, tariffs on imports in industrial countries were as high as 30-50 percent (Table 5.1).

Table 5.1: Tariff rates in industrial countries, 1820-1987

Kind of goods and country or region

1820 1875 1913 1925 1930 1950 1987

Manufactures Austria 15-20 18 16 24 18 9 Belgium 7 9-10 9 15 14 11 7 Denmark 30 15-20 14 10 3 France 12-15 20 21 30 18 7 Germany 10 4-6 13 20 21 26 7 Italy 8-10 18 22 46 25 7 Netherlands 7 3-5 4 6 11 7 Spain 15-20 41 41 63 Sweden 3-5 20 16 21 9 5 Switzerland 10 4-6 9 14 19 3 United Kingdom

50 0 5 23 7

United States 40 40-50 25 37 48 14 7 Average 22 11-14 17 19 32 16 7 All goods Australia 16 18 14 17 Canada 14 17 14 13 9 6 Japan 4 20 13 19 4 8 United States 45 41 40 38 45 13 6 Average 6 23 21 23 11 7 Source: World Development Report 1991. The infant industry argument was one among several used in the 1950s and 1960s to justify growth strategies that were based on industrialization-cum-import substitution. Three others were at least as influential. The first was the view that the income elasticity for goods produced by developing countries was low, implying that as incomes in industrialized countries rose, expansion of developing countries’ exports of agricultural products and raw materials faced declining relative prices. Second, many policymakers in the 1950s and 1960s were skeptical of free markets. Influenced by the depression of the 1930s, the positive role of governments in the recovery of the US and reconstruction of Europe, and the apparent successful development of the former USSR, these individuals believed that government forces were needed to help allocate resources for long-term economic development. Import protection was one of the tools towards that goal. Third, as discussed in Chapter 2, in the 1950s and 1960s capital accumulation, which could be encouraged through import protection, was seen as central for growth. Many developing countries pursued import substitution industrialization strategies in the three decades that followed World War II. Yet three developments raised doubts on the long-run effectiveness of growth strategies based on import protection. The first was that, starting in the 1960s, Korea and Taiwan, China, adopted export-oriented growth strategies that not only yielded superior results in terms of economic performance, but also helped these two economies much better withstand the severe interest rate and oil price shocks of the 1970s.

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The contrasting experiences of Korea and Brazil provide a clear example. Korea responded to the 1970s rising real interest rates and oil prices by further opening its economy and encouraging exports through a more competitive real exchange rate and improved access to imported inputs for exporters. Brazil responded by further closing its economy with a view to embarking on the “second phase of import substitution” focused on substitution of capital goods, expansion of public investment, and further rises in tariffs. The result, inter alia, was appreciation of the exchange rate. All these were policies that proved detrimental to exports, proved unsustainable in the long run, and had to be reversed in the following two decades. By contrast, Korea’s policies established the basis for three decades of rapid and sustained growth, and the country has joined the ranks of industrialized nations. In retrospect, it is clear that import substitution strategies overlooked the fact that the size of domestic markets set limits to the expansion of domestic industries, that manufacturing exports could be part of a viable growth strategy, and that substitution of imports could only be a phase, possibly short, of an industrialization process. Second, support from special interests led to levels of protection in developing countries during the 1970s and 1980s that were unprecedented in industrial countries, even after accounting for the natural protection afforded by higher transport costs in the 19th century and the beginning of the 1900s. In India, for example, maximum tariffs were as high as 350 percent in 1991 and similarly high tariff levels were common in other developing countries. In many cases, tariffs were not the main constraint on imports. Until the early 1990s, for example in India, Turkey, and Brazil, laws prevented imports of goods that could be produced domestically, regardless of the cost of domestic production, implying a de facto infinite level of protection. This protection was reinforced by numerous non-tariff barriers to imports, and administrative allocation of foreign exchange. High tariffs, administrative restrictions, rationing of foreign exchange and of import licenses created high returns to rent seeking, a complex web of vested interests, and an environment that stimulated corruption and weakened national institutions. Vested interests benefiting from such levels, and type, of protection, proved a formidable force against reduction of protection, and its maintenance well beyond the time it could be beneficial. The vulnerability of the state to capture by vested interests, and to the misuse of its discretion, discredited import substitution strategies even among those economists who believed in the strategic importance of protection in the initial phases of industrialization. Third, implementation of growth strategies based on import substitution proved to be much more difficult in practice than in theory, and the practical and political aspects of implementation often negated most of the expected gains (Balassa 1971; Little, Scitovsky, and Scott 1970). Essentially, the level of distortions became inconsistent with the goals of these strategies: central planning allocation of external resources, and high nominal tariffs often provided negative protection to emerging activities, protection to activities with negative value added, and contributed to misallocation and underutilization of capital in capital scarce economies. Overvaluation of the exchange rate resulting from import restrictions discouraged exports and penalized agriculture—further reducing the size of the market for import-competing industries.

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As a result, during the 1980s and 1990s virtually all developing countries followed the examples set by Singapore, Hong Kong, Korea, and Taiwan: encouraging exports and reducing levels of protection. Industrialization based on import protection was gradually discredited and, starting in the mid-1980s, most developing countries sought to reduce levels of import protection and liberalize trade. Chile and Sri Lanka were among the first liberalizers, starting already in the 1970s. Argentina and Uruguay followed shortly thereafter. Trade liberalization resumed and expanded in the 1990s, leading to increased integration of developing economies in world trade. At the beginning of the 1990s, many developing countries had already embarked on or were starting ambitious economic reforms. While some of these reforms were unilateral, others were accomplished in the context of multilateral trade agreements such as the Uruguay Round. Important components of those reforms included large tariff reductions and elimination of quotas, as well as the relaxation of restrictions on foreign investment. As discussed in Chapter 3, this was at the origin of a strong expansion in international trade. Export revenues for developing countries doubled between 1990 and 2000, rising from 12.5 to almost 25 percent of GDP. Using export shares in GDP as a measure of globalization, developing countries are now more integrated with the world economy than high income countries (Figure 5.1). Merchandise export growth for developing countries quadrupled in the 1990s, rising to an annual rate of 8.5 percent from growth rates of less than 2 percent in 1980s.

Figure 5.1: Export shares of GDP

(percent)

The decade of the 1990s saw a tremendous increase in the global integration in goods, services and investment flows (Table 5.2). The largest increase was in investment flows, with foreign direct investment (FDI) as a share of GDP rising by more than four times between

10.0

12.5

15.0

17.5

20.0

22.5

25.0

1980 82 84 86 88 1990 92 94 96 98 2000 2 Source: GEP 2003, World Bank data.

Developing countries

High income countries

-

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1990 and 2000. Developed countries experienced a much larger increase in FDI flows, which rose more than five times as a share of their GDP, while developing countries experienced a more modest but still sizeable increase of such flows.

Table 5.2: Global integration, 1980-2000

Exports and Imports of Goods and

Services as a share of GDP (in current US$)

FDI flows as a share of GDP (in percent)

1980-85 avg

1990 2000 1980

1990 2000

Developing countries 41.0 39.2 55.3 0.3 0.8 2.6 Developed countries 40.7 39.1 46.4 0.6 1.0 5.1 Note: A nominal measure is used here because of the difficulty in obtaining price deflators for services trade. Regardless of whether a real or a nominal measure is used, there was still a large increase in trade integration on the “goods” side in the 1990s. The analysis in the rest of the chapter regarding goods trade uses “real” measures, with nominal values deflated by the relevant price indices. Source: Trade and foreign direct investment flow figures from IMF Balance of Payments Statistics; GDP from World Bank World Development Indicators. In terms of absolute magnitudes (as measured by the share of GDP), the big story of the 1990s is trade integration, especially for developing countries. By 2000, exports and imports of goods and services had reached more than half (55 percent) of developing countries’ GDP in the aggregate, surpassing the developed country aggregate share of 46 percent. The increase in trade integration was also much greater for developing countries, as both groups had started the 1990s with nearly identical trade shares of 39 percent. And, despite the increasing importance of services trade (it rose from 8.1 to 9.6 percent of GDP in developed countries, and 7.6 to 9.4 percent of GDP in developing countries between 1990 and 2000), goods trade integration dominated the globalization scene in the 1990s (Table 5.3). Table 5.3: Exports and imports of goods and services as shares of GDP

(in current US$) Export and Import Shares of GDP

Developed countries Developing countries

1980 1990 2000 1980 1990 2000 Goods 34.2 31.0 36.8 37.1 31.6 45.9 Services 7.7 8.1 9.6 7.9 7.6 9.4 Goods and services 41.8 39.2 46.4 45.1 39.2 55.3 Source: Trade figures from IMF Balance of Payments Statistics; GDP from World Bank World Development Indicators. Equally remarkable was the shift in the composition of developing country exports. As a group, developing countries moved beyond their traditional specialization in agricultural and resource exports into manufactures trade. Exports of manufactures grew at nearly twice the rate of agriculture, and now constitut e nearly 80 percent of exports from all developing countries. Countries that were low-income in 1980 managed to raise their exports of manufactures from roughly 20 percent of their total exports to more than 80 percent (Figure

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5.2). As a result, many grew quickly and entered the ranks of today’s middle- income countries. The middle- income group of 1980 also increased their manufactured share, but somewhat less rapidly, to reach nearly 70 percent.1 Figure 5.2: Developing countries: important exporters of manufactures

1 These changes were not just due to declines in the prices of agricultural and resource commodities re lative to manufactures—the strong shift in the composition of exports shows up even when price changes are removed. Further, it was not just due to a few, large high-growth exporters such as China and India. Excluding China and India, the share of manufactures in developing country exports grew from one-tenth in 1980 to almost two-thirds in 2001. It increased sharply, but not equally, in all regions. The laggards included Sub-Saharan Africa and the Middle East and North Africa, which have yet to reach 30 percent. Many countries, particularly the poorest, remain dependent on exports of agricultural and resource commodities.

In middle income countries, manufactures make up 70 percent of exports…

0 10 20 30 40 50 60 70 80

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Manufacturing exports (%)

Resources exports (%)

Agricultural exports (%)

Middle - income countries ’ share of world exports, 1981

- 2001 (percent)

155

Source: World Bank, Global Economic Prospects (2004. The rising tide of exports did not lift all boats. Forty-three countries had no increase on average in their merchandise exports between 1980 and 2000.2 They were plagued by civil conflict, and engaged in politically motivated trade embargoes—factors that were often complicated by inept governance. Possibly as a result of these factors, or for independent reasons, many of these countries also relied excessively on one or two primary commodities. The poor performance of these countries can be traced to a number of explanations, of which trade policy is only one factor—consistent with the themes emerging from this chapter. Services trade was particularly important for some developing countries in the 1990s in accelerating either their trade integration, or income growth, or both. India and Mauritius are notable examples of countries that experienced much faster growth in services than goods trade, on both the import and export fronts. Between 1990 and 2000, services exports (in current dollars) from Mauritius grew at more than 8 percent per annum, compared with 2 percent per annum for goods exports; the same figures for India were 15 and 9 percent, respectively. In India, software exports constituted 40 percent of services exports in 2000-013 (around 10 percent of exports of all goods and services), which was by far the largest service export component. In Mauritius, communications and computer services experienced the fastest growth during the 1990s, tripling in dollar terms over the decade, and were the only category of service exports to increase its share of services exports (from 17 to 23 percent). Industrial countries imposed important restrictions on labor movements. In addition to goods and services, the global integration of labor has been emerging as an important issue in the globalization agenda during the 1990s. In 2001, remittances from permanent as well as

2 World Bank (2003b), p. 63. 3 Software exports were $6.2 billion in 2000/2001 according to the Trade Policy Review of India, 2002, by the World Trade Organization.

… and in low income, manufactures make up 80 percent of exports Low-income countries’ share of world exports, 1981-20001 (percent)

0 10 20 30 40 50 60 70 80 90

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Manufacturing exports (%)

Agricultural exports (%)

Resources exports (%)

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temporary migrants provided some US$ 71 billion to developing countries, nearly 40 percent more than all official development assistance and significantly more than net debt flows to developing countries’ income.4 However, such remittances were concentrated in a few developing countries; their importance for developing countries as a group has actually been declining over the decade, falling from slightly above 4 percent of all foreign exchange receipts to slightly below. 5 Yet the decline in remittances is difficult to identify since so much is unofficial. To many parts of the world, unofficial remittances far outweigh official ones—the 4 percent figure should hence be seen as a crude approximation. Regardless of the exact amount, existing payments systems make remittances difficult and costly, especially in and to Africa and Central America. The small share of remittances in foreign exchange receipts for developing countries, however, is more indicative of industrial country restrictions on labor movements than anything else. Allowing temporary labor movements could play an important role as a poverty reduction instrument: if the temporary movement of labor up to 3 percent of the total labor force in rich countries were permitted, developing countries would stand to gain as much as $160 billion in additional income.6 However, virtually all GATS commitments have focused on the first three “modes” of international service delivery rather than mode 4, which is labor. Mode 4, which involves the temporary movement of labor to provide services, accounts for only 1.4 percent of services trade (Figure 5.3). To date, little has been done to loosen conditions governing the temporary movement of natural persons supplying services. The lack of liberalization in labor services has been particularly costly to developing countries, whose comparative advantage lies in the export of medium and low-skilled, labor-intensive services.

4 World Bank (2003b), p.xxiii. 5 From 1990 to 2000, income from migrant workers overseas (including workers’ remittances and employees’ compensation) as a share of foreign exchange receipts (measured as exports of goods, services and workers’ income) fell from 4.3 to 3.8 percent for all developing countries. Conceptually it makes sense to compare income from migrant workers with receipts from exports of goods and services since labor could be viewed as one form of a country’s service exports. Almost all of the drop could be attributed to the decline in migrant workers’ income in Egypt5, which in 1990 had enjoyed the largest amount of this income in nominal terms in the developing world. The decline in migrant workers’ income in Egypt during the 1990s was Gulf War-related. Excluding Egypt, the ratio fell from 3.7 to 3.6 percent over the decade. The countries where incomes from migrant workers have become quite important—ranging between 20 to 46 percent of total foreign exchange receipts in 2000—and where such income had increased significantly over the 1990s (increases ranging from 10 to 46 percent) include Albania, Ecuador, Jamaica, Jordan, Nicaragua, Sudan and Uganda. At the same time, however, there are also countries that experienced large declines in such incomes ranging from 10 to 30 percent; these include Benin, Cape Verde, Egypt, Lesotho, and Pakistan. 6 Walmsley and Winters (2003).

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28%

14% 57%

1%

Mode 1 (cross - border supply)

Mode 2 (consumption abroad)

Mode 3 (commercial presence)

Mode 4 (movement of natural persons)

Source : IMF Balance of Payments Yearbook

Figure 5.3: Temporary labor mobility, underused mode of trade in services (Value of world trade in services by mode (percent)

Source: World Bank, Global Economic Prospects 2004. 2. Trade: one element in successful growth strategies Developing countries shifted to more liberal trade policies in the 1990s. By the early years of the decade, the superiority of outward orientation over import substitution as a development strategy was generally accepted by researchers and policymakers alike.7 The fall of communism in central and Eastern Europe, together with the collapse of the former Soviet Union, gave further credence to the superiority of outward orientation over inward orientation as an economic strategy. Many countries had already started liberalizing their trade regimes before the 1990s, while others followed suit or escalated their efforts during the decade, including hitherto very highly protected and inward- looking economies like India. Trade liberalization was also adopted widely by countries in sub-Saharan Africa (SSA) as a key instrument to reverse the hitherto dismal growth performance in many of them. As in the case of macroeconomic reforms, however, the results varied and, in general, fell short of expectations—whereas openness has he lped efficiency and growth in many cases (East and South Asian countries, Botswana, Chile, Mauritius, Tunisia), it failed to do so in many others. One important determinant of the success of different trade reforms was the presence of complementary policie s. 7 See Krueger (1997) and Baldwin (2003) for expositions on the evolution of economic thinking over this issue during the second half of the twentieth century.

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The need for complementary policies as part of a successful growth strategy The rapid growth in trade integration and the fundamental changes in trade patterns that occurred during the 1990s were achieved through unilateral and multilateral trade reforms, in conjunction with a number of complementary reforms and investments. World Bank estimates indicate that tariff cuts in industrial countries accounted for about one-third of the improvement in market access and tariff cuts in the developing countries themselves accounted for two-thirds of the improvement in market access for the developing countries.8 While trade reforms both at home and abroad were one critical factor in explaining the increase in global integration, this section highlights other developments and policies that played important complementary roles, in particular, macroeconomic policies and trade-related infrastructure and institutions. Although this chapter focuses on only two sets of complementary policies, many other factors contributed to the rise in trade integration in the 1990s. Average educational levels and capital stock per worker rose sharply throughout the developing world. Improvements in transport and communications, in conjunction with developing-country reforms, allowed the production chain to be broken up into components, with developing countries playing a key role in global production sharing. Increases in foreign direct investment also played a role (Box 5.1). Foreign investment grew dramatically during the 1990s, bringing capital to developing countries, augmenting the total supply of capital per worker, and bringing connections with other elements in the network of global production sharing. The need for macroeconomic stability The presence of macroeconomic stability was an important component of successful outcomes from trade reforms (Thomas and Nash 1992; Nash and Takacs 1998). Macroeconomic stability entails low levels of inflation and a stable and competitive exchange rate. Exchange rate volatility creates a risky business environment in which there are uncertainties about future profits and payments. These risks are especially exacerbated in the many developing countries that have not developed financial instruments for hedging against foreign exchange risk. Some of the most severe cases of exchange rate mismanagement and attendant highly volatile real exchange rates in the 1990s were found in Ghana, Kazakhstan, Malawi, Nigeria, Zambia, Russia, and a few other CIS countries in Central Asia. Proper exchange rate management requires, inter alia, appropriate sequencing of trade reforms and capital account liberalization. In particular, sequencing of trade reforms prior to capital account liberalization is important, since the large inflows of capital that generally accompany the latter could lead to a large appreciation of the real exchange rate, with the negative consequence of large import surges that destabilizes domestic industries and the balance of payments.

8 World Bank (2003b), p. 76.

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Box 5.1: The impact of foreign direct investment on growth

Countries welcome FDI for many reasons. Capital-scarce countries benefit from the infusion of a less volatile source of capital. Greater investment financed by incoming FDI should also translate into higher growth. Foreign investors are expected to provide employment opportunities, better wages and working conditions, and more training. In many countries, foreign firms and joint ventures are given special treatment in the expectation that these firms will transfer new technology and knowledge to domestic workers and firms. What does the evidence suggest? There are two approaches to studying the impact of FDI on host countries: cross-country studies, which examine the relationship between FDI and growth, and micro studies which focus primarily on the impact of foreign firms on host country wages and test for the possibility of technology transfer. Cross-country exercises capture the direct effect of FDI (higher productivity levels/growth rates exhibited by foreign affiliates) and the contribution of FDI to capital accumulation, as well as possible technology spillovers. The cross country evidence is mixed, in part because incoming FDI as a share of GDP is typically quite small. A recent cross-country study using data for 72 countries for 1960-95 (Levine and Carkovic 2003) finds no evidence that FDI exerts a positive impact on economic growth independent of other growth determinants (openness, black market premium, financial development, initial income, years of schooling). However, Bosworth and Collins (1999) find that FDI, by raising total factor productivity, raises a country’s rate of output growth. Borenzstein et al. (1998) find that FDI both added to capital accumulation as well as raised the efficiency of investment, but only when the host country has a minimum threshold of human capital, an indicator of absorptive capacity. The Borenzstein study is consistent with more recent evidence that suggests that FDI can promote growth if the country has complementary institutions such as developed financial markets (Alfaro et al. 2003) or is open to trade (Balasubramanyam et al. (1996)). There are also a number of studies using micro-data that analyze the role of FDI in promoting technology transfer and raising host country wages. The evidence on firm-level analyses of intra-industry spillovers is mixed. In explaining differing micro-level evidence on the impact of FDI on growth, a recent World Bank Report showed that absorptive capacity can explain differences in ability to absorb technology from foreign firms (GDF 2000). Accordingly, Malaysia and Taiwan (China) have high absorptive capacity, and FDI was found to have a positive relationship to productivity, while Morocco, Uruguay, and Venezuela have low absorptive capacity, and FDI was not found to have a positive impact on productivity. However, the issue is not just the absorptive capacity. These findings could reflect an immediate (and short-run) shock from foreign entry resulting in local firms losing market shares versus the delayed (but possibly long-term) effect of knowledge spillovers. The loss in market share is one explanation for the lack of spillovers within the same sectors identified by Aitken and Harrison (1999), Haddad and Harrison (1993), Djankov and Hoekman (2000), Konings (2001), and Damijan et al. (2003). However, what all these firm level studies agree on is that foreign affiliates are more productive than indigenous firms. While part of these results could reflect the fact that foreign firms acquire more efficient domestic enterprises, anecdotal evidence also suggests that local firms acquired by foreign investors undergo restructuring and improve their performance as a result of the takeover. This direct effect should not be ignored as its magnitude may be significant. Other evidence also suggests that foreign enterprises pay higher wages (Aitken et al. (1997), Harrison and Scorse (2003)). In sum, while quite a lot of evidence points to FDI’s positive contribution to growth, there is no consensus on the issue, and in particular no consensus on causality. Regardless of whether FDI independently contributes to growth, it is clear that policies and institutions that are important for

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growth would also be the ones that would attract FDI as well as enhance the impact of FDI on growth. Therefore, countries should focus on such policies and institutions rather than narrowly on how to attract FDI. India provides a good example of proper sequencing of its trade reforms as well as maintenance of an appropriate macroeconomic framework, both of which contributed to its impressive export and growth performance in the 1990s.9 A significant real depreciation of the real exchange rate had preceded the first liberalization measures in the early 1990s. This served to increase export incentives and cushioned the impact of lower import barriers on the domestic industry. Also, trade liberalization had preceded opening of the capital account. And, since 1992, India’s real effective exchange rate has remained at more or less the same level, which has facilitated trade reforms. Zambia, on the other hand, provides a good illustration of how macroeconomic instability can undermine potentially positive effects of structural reforms. Despite undertaking substantial trade and other structural reforms in the early 1990s which had resulted in one of the most liberal trade regimes in Africa, Zambia’s export performance has been lackluster. One of the reasons for this outcome is an unstable macroeconomic environment, with high inflation and high real interest rates, as well as a highly volatile real exchange rate resulting from external shocks (large declines in 1995 and 1997 in the prices of copper, Zambia’s main export) and poor management of these shocks.10 Malawi provides another example where macroeconomic instability undermined export and growth performance. The country had not experienced a sustained period of macroeconomic stability during the 1990s. Inflation was generally high and on top of that, volatile, with rates ranging from 9 percent to more than 80 percent, and averaging 31 percent for the entire period. This had resulted in an overvalued and highly volatile real exchange rate, both of which had seriously undermined domestic production, investment, and exports. The manufacturing sector experienced a major contraction, falling by 9 percent during 1995 and 1996. These developments hindered the export diversification efforts of Malawi, which has continued to be highly concentrated in tobacco.11 The need for trade-related infrastructure and institutions Successful trade integration requires supporting trade-related infrastructure and institutions. This is the so-called “behind-the-border” agenda, which in principle could include virtually all aspects of the development agenda, as they are undoubtedly all important for engendering a supply side response.12 The importance of institutions is illustrated by the comparison below of Jamaica and Mauritius (Box 5.2). Two additional elements that have emerged as

9 World Bank (1994). 10 World Bank (2003g). 11 World Bank (2003d). 12 From Tsikata (2003), which summarized the findings of Diagnostic Trade Integration Studies undertaken during 2001-03 for twelve least developed countries (Burundi, Cambodia, Ethiopia, Guinea, Lesotho, Madagascar, Malawi, Mali, Mauritania, Nepal, Senegal, and Yemen).

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important constraints are transport infrastructure and institutional capacity for meeting products standards.

Box 5.2: Jamaica and Mauritius – a tale of two islands

Starting at nearly the same per capita GDP in 1984, the income levels of Jamaica and Mauritius began to diverge significantly such that by 2000, per capita GDP in Mauritius had more than doubled from its 1984 level in real terms (rising from $1,951 to $4,160 in 1995 US dollar terms), while that in Jamaica had more or less stagnated (rising from $1,925 to only $2,150 in 1995 US dollar terms). Over the period 1984-2000, per capita GDP grew at around 0.7 percent per annum in real terms in Jamaica, compared with 4.8 percent in Mauritius. This is a dramatic difference in growth performances, especially given the many similarities between the two countries. To start with, the two countries enjoyed similarities in natural endowments and historical legacies. Both are island economies, have tropical climates, are subject to shocks of nature (hurricanes in Jamaica and cyclones in Mauritius), and are former British colonies with English as the official language. Their economic structures are similar: around 6 percent of GDP is from agriculture; around one-third from industry; and the remaining 60 percent or so from services. Sugar cane is widely grown in both countries. Both countries enjoy trade preferences, in particular the Lome Convention that granted them access to the EU sugar market and the US sugar program that granted them access to the US sugar market. They both established export-processing zones (EPZs) where the apparel sector is well-represented, with the primary impetus being provided in both cases by East Asian investors which were bound by the quota limitations under the Multi-Fiber Agreement. The disparate growth performances between the two countries cannot be attributable to differences in trade performance. Between 1985 and 2000, Mauritian exports grew 3.9 percent per annum in real terms, while Jamaican exports grew 3.6 percent per annum in real terms. In terms of trade shares of GDP, in fact, Jamaica did much better than Mauritius, particularly in terms of goods trade (see table below). This reflects the much better growth performance in Mauritius, as well as the fact that much of this growth cannot be attributed to trade. Real goods and services trade integration, Jamaica and Mauritius, 1980-2000 (percent) Goods Services 1980 1990 2000 1980 1990 2000 Jamaica 65 57 79 39 36 55 Mauritius 98 109 71 26 38 37 The analysis of several factors that are generally accepted as either fundamental or important to growth rejected the following as possible reasons behind the growth divergence. First, initial per capita incomes, which were practically the same in the mid-1980s. Second, education, as Jamaica surpasses Mauritius in a host of education enrollment indicators for the two countries in 1990 and 2000. Third, FDI, as all through the 1990s Jamaica enjoyed higher FDI as a share of GDP than Mauritius. Fourth, geography, as Jamaica is much closer to the US and the EU than Mauritius is to either, with the EU and the US being the two main markets that have granted preferential access to the two countries. In fact, with the exception of the first factor, the performance of the two countries in all the other factors would indicate that Jamaica should surpass Mauritius in growth. The two key factors that are left that could explain the difference in growth performances are institutional quality and macroeconomic stability. An in-depth case study of the Mauritian growth

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performance (Subramanian and Roy 2001) has already pointed out that the Mauritius growth miracle cannot be explained by its trade performance, that Mauritius is a “super-grower but not a super trader.” According to that study, domestic export subsidization policies (through duty-free access to imported inputs, tax incentives and much greater labor market flexibility in the export processing zones) and preferential trade access (for sugar and textiles) together only manage to neutralize the anti-export bias arising from high import protection to the economy, with the latter being the bigger contributor. The outcome of such neutralization of the anti-export bias is a trading performance that is average, but not exceptional (like the East Asian tigers’ performance). The study then attributes the exceptional growth performance of Mauritius to other factors including superior institutions (democracy and strong participatory institutions), and ethnic diversity which provided it with important linkages with the rest of the world (68 percent of the population is Indian) and which forced the need for economic balance to preserve the cash cow (that is, sugar), and the need for participatory political institutions that were important for maintaining stability, law and order, rule of law, and mediating conflict. It appears that institutions could explain the difference in growth performances between Jamaica and Mauritius. According to the six indicators on institutional quality compiled by Kaufmann et al. (2002), Mauritius outperforms Jamaica in all but one: it does better in government effectiveness, political stability, rule of law, control of corruption, and voice. Regulatory quality is the only institutional measure in which Jamaica is superior to Mauritius. Recent World Bank analysis (World Bank, 2003c) indicates that the rule of law is particularly a problem in Jamaica, with crime and violence costing at least 4 percent of its GDP (excluding dynamic costs). The other major problem is the lack of a social/political compact in Jamaica (unlike that in Mauritius), although there appears to be progress on this front recently with the labor unions agreeing with the Government on limit their wage increases in response to the grave economic situation. Aside from institutions, another likely factor explaining the difference between the growth performances of Mauritius and Jamaica is their different macroeconomic performances. Mauritius outperformed Jamaica in macroeconomic stability for the two decades from 1980 to 2000, both in terms of the level of inflation, as well as the stability and competitiveness of the real exchange rate (see figures below). Inflation, in percent Real effective exchange rate, 1990=100

0

10

20

30

40

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1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

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Jamaica Mauritius The same recent World Bank analysis indicated that the poor management of adverse macroeconomic developments in the 1990s in Jamaica seemed to have more than offset the potentially positive effects of the substantial trade (and capital account) liberalization of the early 1990s. In particular, the crisis in the financial sector in the mid-1990s exacerbated an already deteriorating fiscal performance, which led to a huge increase in debt to GDP after 1996/97. This has negative affected private sector confidence, government investment, interest rates, and growth.

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For exporters in some developing countries, country- level evidence has revealed transport infrastructure as the single most important component of cost. The main issues related to transport are lack of competition and inadequate investments. Transport costs are further escalated by fees and checkpoints (formal and informal). Poor transport in particular affects agricultural producers (mainly smallholder farmers and herders) who have difficulty accessing markets, both domestic and external.13 Even in the absence of regulatory distortions, such localized markets may feature little competition and may fail to realize the economies of scale or scope. The result is typically a vicious cycle of low productivity and low profitability. Given the importance of agriculture in these poor countries (with shares of GDP ranging from 15 to 52 percent), such constraints severely limit their growth potential. And given that in most countries the majority of the poor reside in the rural areas, these constraints also have seriously negative effects on poverty. Malawi is a country where exceptionally high internal and external transport costs have weakened the competitiveness and profitability of firms and farmers. Transport costs are by far the single largest factor in the high costs paid by Malawian farmers. Although Malawi is an efficient producer of sugar, domestic transport costs account for 15 percent or more of local consumer prices, and for sugar exports, regional and international transport costs add nearly 50 percent to the ex-mill production costs.14 Part of the reason for high external transport costs is geographic: Malawi is landlocked, and its links to ports are long and uncertain. On the internal side, the lack of competition in the road transport sector (where restrictions are placed on foreign operators) and high transport taxes (for example, tires carry 30 percent duty and a 20 percent surtax) are some of the main factors contributing to high transport costs. In addition, Malawi is also one of the most costly countries in the world for air transport. A variety of landing fees, temporary service permits, fees to charge batteries and pump tires—as well as costs of aviation fuel—are generally higher in Malawi than elsewhere. There has been a proliferation of, and rising stringency in, products standards in international trade in recent years. While this is occurring in official channels, it is increasingly driven by consumer and commercial interests and magnified by advances in technology and, more recently, security concerns. Consumers and civil society organizations are demanding stricter food standards, the origin of which had to do with some highly publicized food scares (such as “mad cow disease” in the UK). Private sector players in the developed countries—major food retailers, food manufacturers and restaurant chains—have been adopting codes of practice, standards, and other forms of supply-chain governance as part of their commercial strategies of differentiation. Increasingly, middle- income and some low-income countries are also raising their product standards, in part through the investments undertaken by multinational supermarket or restaurant chains and competitive responses by local firms. Finally, new food safety standards in industrialized countries are serving to shape the expectations of developing country consumers, especially those with higher incomes and in urban areas.

13 The discussion in this paragraph is taken from Jaffee and Sutherland, who reviewed the same 12 studies mentioned in the previous footnote and summarized the agricultural sector analyses in these studies. 14 World Bank (2003e), p. 49.

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A recent World Bank study15 suggests that this trend is not going away and, furthermore, that the prospects are dim for applying “special and differential treatment” that would permit poorer countries to meet lower requirements. In this light, the study suggests that developing countries need to focus on developing and improving their food safety and agricultural health management systems in order to reposition themselves competitively and to enhance their export performances. Building such capacity is not beyond the reach of developing countries, and indeed some of them—including among the poorest ones—have managed to meet exacting international standards to access high-value markets in industrialized countries. Examples include Peruvian exports of asparagus to the US and the EU; and fish products in low-income African countries that meet the EU standards of hygiene with respect to processing, transport, and storage. Countries that do well in meeting strict standards are generally those where the private sector is well-organized and the public sector is well- focused and supports the efforts of exporters. Programs tailored to meet the institutional capacity of developing countries include outgrower programs for smallholder farmers, systems of training and oversight for small and medium-sized enterprises through associations and groups, or twinning and regional networking for small countries. Cross-country evidence The evidence from the 1990s suggests that a variety of factors—a stable investment climate, greater market access, complementary macroeconomic policies and unilateral or multilateral trade reforms—reinforced each other in developing countries that successfully integrated into the global economy. The fact that successful trade reforms were frequently pursued within a broader reform agenda provides one explanation for why there is no significant relationship between changes in import shares and tariff reductions shown in Figure 5.4. In principle, we would expect to see falling tariffs leading to rising import shares. However, without taking into account changes in physical and human capital investments, changes in market access and individual country macroeconomic policies, it is not surprising that tariff reductions alone show no significant association with changes in import shares.16

15 Jaffee and Henson (2004). 16 Only tariffs were used to analyze trade policy in this section because of the very limited availability of data on non-tariff barriers (NTBs) (both for countries as well as over time). However, this should not bias the analysis since changes in NTBs in countries have largely been in line with changes in tariffs. Changes in tariffs are defined as the percent change of (1+tariff), with tariffs being the simple average of statutory tariffs. In Figure 5.4, the correlation coefficient is -0.18 and not statistically significant. Note that these are simple correlations to illustrate the associations between the two variables only, without attribution to causality.

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Figure 5.4: Changes in import shares of GDP and changes in tariffs , 1990-2000

Note: Changes are for the ten-year period 1990-2000, not per annum. Table 5.4 also illustrates the large range of integration responses to the reduction in tariffs in the 1990s. There were large and positive trade integration responses in the countries that had begun the 1990s with very high tariffs and reduced them the most. The table shows a much wider range of responses for countries that began the decade with more moderate levels of tariffs and lowered them further. One explanation consistent with this evidence is that at more moderate levels of protection, other changes in the economy play an increasingly important role in explaining changing trade shares. These include macroeconomic policies, changes in “behind the border” barriers such as transport costs and health and safety regulations, and changes in the quality of institutions.

-1

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Percent change in relative price impact of tariffs

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/GD

P

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Table 5.4: Tariff reductions and changes in goods trade integration

Change in integration, 1990-2000 Reductions in tariffs, late 1980s - late 1990s

<1 times

1-1.5 times 1.5-2 times >2 times

40-70% India Bangladesh Sudan 20-30% Pakistan, Burkina

Faso Benin, Ecuador, Kenya, Peru, Thailand

China

10-20% Egypt, Iran, Mauritania, Mauritius, Zambia

Republic of Congo, Indonesia, Turkey, Uganda, Venezuela

Argentina, Colombia, Costa Rica, El Salvador, Guatemala, Nicaragua, Sri Lanka

Philippines

0-10% Tanzania, Paraguay, Senegal

Bolivia, Chile, Cote d'Ivoire, Jamaica, Malaysia, Nigeria, South Africa

Ghana, Nepal

0-2% increase Mozambique Madagascar, Trinidad and Tobago

Mexico

2-10% increase Tunisia Jordan, Morocco, Oman, Saudi Arabia

>10% increase Syrian Arab Republic

Note: Trade integration, defined as the share of export plus import shares of GDP, is measured in real terms and excludes services trade. Interestingly, Figure 5.5 shows that tariff reductions in the 1990s had a much greater impact on developing countries’ export shares than on their import shares.17 This is consistent with so-called “Lerner symmetry”, whereby taxing imports or exports has the same effect on international trade. A tariff on imports is equivalent to a tax on exports,18 and hence reducing tariffs promotes exports. Together, Figure 5.4 and Figure 5.5 suggest one important avenue through which trade reforms lead to growth: they reduce the anti-export bias in an economy, thereby promoting growth by encouraging exports.

17 In Figure 5.5, the correlation coefficient is –0.25 and statistically significant between the relative price impact of tariff changes and changes in real export shares. 18 Lerner’s symmetry in the two-good case can be illustrated as follows: Px/Pm(1+t) = [Px/(1+t)]/Pm, where Px=price of exports; Pm=price of imports; t=tariff.

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Figure 5.5: Changes in export shares of GDP and changes in tariffs, 1990-2000

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Note: Changes are for the ten-year period 1990-2000, not per annum. Some lessons Tariff reductions constitute only one element of a reform program for generating the expected gains from integration. Positive growth responses to trade reforms are most likely when trade reforms are part of a comprehensive strategy, with macroeconomic stability as one of the key other elements. Other important complements include trade-related infrastruc ture and institutions, investments in physical and human capital, greater access to developed and developing country markets, and a sound rule of law. Reaffirming lessons from earlier decades, trade reforms needed to be undertaken in the presence of macroeconomic stability. These risks are especially exacerbated in countries where financial instruments for hedging against foreign exchange risk are not developed, which is the case in many developing countries. Proper exchange rate management requires, inter alia, appropriate sequencing of trade reforms and capital account liberalization. In particular, sequencing of trade reforms prior to capital account liberalization is important, since the large inflows of capital that generally accompany the latter could lead to large appreciation of the real exchange rate, with the negative consequence of large import surges and destabilization of domestic industries and the balance of payments. The evidence discussed in the preceding section highlighted one important mechanism through which trade reforms affect growth: by reducing tariffs, trade reforms encourage exports. What in general are major determinants of export growth? Empirical analysis suggests that a number of factors mattered for export performance in the 1990s, including macroeconomic stability, relative price changes arising from changes in tariffs and

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government effectiveness.19 Macroeconomic stability refers to the stability of the real effective exchange rate as measured by the standard deviation, and average inflation. Tariff reductions were found to be important for export growth in the 1990s, consistent with the larger impact of tariff changes on export rather than import shares of GDP discussed earlier. Government effectiveness reflects the combined perceptions of the quality of public service provision, the quality of the bureaucracy, the competence of civil servants, the independence of the civil service from political pressures and the credibility of the government’s commitment to policies.20 Estimation conducted for this chapter suggests that export growth was higher in the 1990s in countries with greater macroeconomic stability, countries that reduced tariffs more, and countries that had more effective government, as defined above. In addition to the cross-country evidence described above, a number of detailed case studies have generated some stylized facts on the determinants of export activity. A series of papers using detailed plant- level data have shown that the manufacturing firms that move into exporting are frequently the most productive in an economy. Consequently, policies that encourage investments in human and physical capital, and that support technological change, are likely to promote export growth. Evidence for Morocco suggests that many exporters are new enterprises, which suggests that policies that encourage new plant entry and at the same time facilitate exit for inefficient enterprises are likely to play an important role. Evidence from Mexican and Indonesian censuses suggests that exporters are likely to use skilled labor, which suggests that policies supporting the development of human capital are important. Plant- level studies and anecdotal evidence also point to the importance of foreign investors in helping developing country exporters to break into new markets. The latest studies also control for the possibility of reverse causality, taking into account the fact that foreign firms may create or take over most efficient firms (Aitken, Hanson, and Harrison 1997). Even if the importance of foreign investment is difficult to identify in cross-country studies (Box 5.1 and forthcoming Technical Note Number 2), plant- level studies provide ample evidence that foreign ownership has been associated with export activity. Studies on Indonesia, Mexico, and Morocco show that joint ventures and foreign owned plants are significantly more likely to export than other types of enterprises. Although the mechanism is not completely clear, foreign firms are likely to provide knowledge of foreign markets and customer preferences, as well as access to new technology and financing opportunities. Infant industry protection While import substitution policies have been largely discredited, the need to address market failures preventing the development of internationally competitive industries in developing countries has continued to be of concern to policymakers and academics. Suggestions have been made to grant temporary modest levels of import protection where there is a demonstrated need (Williamson 2004). Other suggestions have focused on the right form of protection, and the fact that inducements in the form of import protection could be

19 Technical Note Number 2, forthcoming as part of this volume, will provide a full discussion of the regressions and regression results. 20 The government effectiveness indicator is compiled by Kaufmann et al. (2003) based on 17 separate sources of subjective data on perceptions of governance constructed by 15 different organizations.

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counterproductive. It has been pointed out that incentives should be in the form of subsidies to the initial entrants rather than an import duty, as the duty (through the rent it provides) would encourage other firms to acquire the knowledge discovered by the initial firms faster, thus discouraging the initial firm’s investment in knowledge acquisition in the first place (Baldwin 2003). As discussed in Chapter 1, other suggestions have been to approach development as a process of “self discovery” (Hausmann and Rodrik 2002). Specifically, according to this approach, the key challenge that a country faces in its process of transforming into a modern economy is learning what it is good at producing. The initial entrepreneur who discovers what the country should specialize in can capture only a small part of the social value that this knowledge generates, as other entrepreneurs will quickly emulate such discoveries. In light of these externalities, this type of entrepreneurship will typically be undersupplied and economic transformation delayed. Hence, there is a role for government involvement both to provide incentives to induce such investments, as well as to exert discipline in pruning investments that have turned out to be high cost ex post. A key challenge in pursuing such strategy is to structure the right combination of incentives (inducements) and discipline (competitive pressures, resistance against special interests). Some of the world’s most successful economies during the last four decades (South Korea and Taiwan, China since the early 1960s, China since the late 1970s) prospered by pursuing policies that combined inducements for investment and risk taking while, at the same time, gradually expanding competitive pressures that ensured efficient allocation by investors. The contrast between the successful experiences of Asia with the generally failed experiences of Latin America provides a useful illustration. During the industrial drives of South Korea and Taiwan in the 1960s and the 1970s, export subsidies were provided contingent on export performance. This strategy allowed policymakers to distinguish firms and sectors that were highly productive from those that were not. The kind of subsidies provided included supplying inputs, providing working capital, imposing import restrictions, and—in the case of the Taiwanese textile industry in the 1950s—buying up the resulting production. Local production grew spectacularly as a result. But the government also pruned non-productive firms subsequently. By contrast, when Latin American countries followed import substitution strategies in the 1960s and the 1970s, governments provided incentives without sufficient discipline, with the result that too many low productivity firms operated alongside the high performers. When discipline came along in the 1990s through trade openness and domestic competition, however, there was too little promotion (Hausmann and Rodrik 2002). The absence of a right balance between promotion and discipline on the part of Latin American countries resulted in industrial performance that fell short of the East Asian countries during all these decades. Contrary to common perception that Chile pursued policies exclusively supporting market discipline, the reality is that inducements have been part of that country’s success in the last decades. Chile appears to be the exception among Latin American countries by striking the right balance of inducements and discipline in promoting a domestic industry (Box 5.3).

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Box 5.3: Behind Chile’s success – a less than orthodox approach

Chile, with its economic success, has often been touted as a miracle of free-market economics. In reality, public -private collaboration strategies have played a very important role in fostering structural change and stimulating non-tradit ional activities in the country. Indeed, the Chilean Government has had a hand in the early stages of development of all major non-traditional exports. Chile’s two largest export items after copper, fruits and salmon, have both benefited from private-public sector partnership. The foundations of the fruit industry were laid in the early 1960s through the efforts of the Corporacion de Fomento , University of Chile and the National Institute of Agricultural Research (INIA). The INIA, established in 1964 and staffed with highly-salaried skilled researchers, had initiated the fruit research program from the start. The public sector carried out much of the development of scientific personnel and knowledge to achieve technological transfer; identification and planting of new varieties suitable for foreign markets; improvements in orchard and post-harvest management; and the development of the infrastructure necessary to export fruit to foreign markets. Private investment and exports took off after the reforms of the mid-1970s once uncertainties regarding land reform, macroeconomic stability, and labor militancy were resolved. They were further boosted by the sharp real depreciation of the currency in the mid-1980s. The salmon industry, which generates $600 million in exports and provides jobs for more than 100,000 people in this country of 15 million, also benefited significantly form public interventions. It was created single -handedly by Fundacion Chile , a non-profit institution created by the Chilean Government in 1976. Fundacion Chile brought the technology of salmon farming to Chile, adapted it and made it commercially viable, formed private sector businesses to use it, and eventually sold its participation to Japanese investors at great profit. Sources: Rodrik and Hausmann (2003); Ocampo (2004); and Washington Post, January 21, 2004. Identifying the conditions that make it possible to assist new activities is not easy. Rodrik and Hausman (2003) emphasize the importance of creating an institutional architecture that resists the pull of special interests. While remaining agnostic on how this can be done, they emphasize the importance of political leadership from the top, either through the guidance of the country’s leaders and/or through a high coordination council. Whatever institutions are employed to support new activities, they must be transparent and accountable. Otherwise, selective support is likely to evolve into a new mechanism for supporting private interests in the name of public gain. Promotion of new activities should conform to a set of design principles, which include the following: (1) incentives should be provided only for new, “sunrise” activities, not sunset ones; (2) there should be clear benchmarks for success or failure; (3) there must be a predetermined end to support (a so-called sunset clause); (4) public support should target activities such as worker training or infrastructure investment, rather than specific sectors such as electronics; (5) subsidized activities should provide clear potential for externalities; (6) agencies involved in these activities should be autonomous enough to avoid capture by private interests, yet maintain links with the private sector to maximize economywide gains. This is not a prescription for creating new state enterprises, promoting existing activities, or giving governments authority to expand their bureaucratic reach. Clearly, the institutional and administrative requirements for success are formidable.

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0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5

Average annual per capita growth, 1980-99 -

Increasing export share in GDP Decreasing export

share in GDP

Evidence on trade reform and economic growth As discussed in Chapter 2, on average, developing countries expanded exports more and enjoyed higher per capita income growth than developed countries in the 1990s.21 Yet by the end of the 1990s, skepticism began to emerge on the necessity of trade openness for growth, in large part because of the mixed outcomes of trade liberalization on growth and poverty reduction. Many countries—as many as 43 were identified by the World Bank (GEP 2003)—were left behind in the process of globalization. Many of them were low-income countries. In SSA, countries such as Malawi and Zambia experienced poor trade and growth outcomes despite quite extensive liberalization. These different outcomes led many policymakers, academics, and human rights activists to repeatedly ask the question: what is the relationship between trade reform and economic growth? Academic researchers have been debating the merits of openness and its association with growth for at least several decades (Box 5.4). The difficulties associated with finding a robust statistical relationship between trade integration, trade policy, and growth can be illustrated with Figure 5.6 and Figure 5.7. The first figure shows that countries with positive export growth grew faster than other countries in the 1980s and 1990s. Although there is no question that rising export shares are correlated with higher GDP growth, disentangling the direction of causation is difficult. For example, fast growing countries that are becoming more productive as a result of investments in human and physical capital—investments that possibly result from institutional reforms not associated with trade liberalization—are also likely to have rising export shares.

Figure 5.6: Integration with global markets and growth

21 For developing countries as a group, the growth of real GDP per capita rose from 0.8 percent per annum during 1980-90 to 1.9 percent in the decade following, surpassing income growth in developed countries which actually dropped from 2.5 percent per annum in the 1980s to 1.7 percent in the 1990s.

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Source: World Bank, Global Economic Prospects 2003. Figure 5.7 shows a negative relationship between tariff reductions and growth in GDP per capita in the 1990s.

Figure 5.7: Reductions in tariffs and changes in per capita GDP growth, 1990s

Countries that reduced their tariffs most also grew more quickly. However, the relationship is not very strong nor statistically significant. This is not surprising given that other determinants of growth—those mentioned in the preceding section—have not been accounted for. Yet, even taking into account the impact of other policies, there is still a weak relationship between openness and growth. 22 Other new research that focuses on the relationship between trade reform and economic growth in the 1990s also finds that trade reforms are associated with higher growth, but the strength of the results varies across different studies (Box 5.4) For example, Dollar and Kraay (2002, 2004); Lee, Ricci, and Rigobon (2004); and Alcala and Ciccone (2004) all show a positive relationship between trade and growth, whereas Rigobon and Rodrik (2004) get mixed results. One frequently cited recent study is Wacziarg and Welch (2003), who find a positive relationship between a

22 Properly identifying the causal impact of changes in trade policies on growth needs to take into account other factors associated with GDP growth, and the fact that changes in trade policy are often driven by other changes —such as GDP growth. This means that trade policy should be “instrumented” or represented with measures which affect trade policy but are not correlated with GDP growth. Since most reforms are driven by initial protection levels, one way to get around the problem is to “instrument” the changes in tariffs in the 1990s with initial tariffs during the 1986 through 1990 period. The latter was found to explain 36 percent of the changes in tariffs during the decade—countries with high tariffs in the late 1980s and early 1990s reduced tariffs by a higher percentage, while countries with already low tariffs reduced them less. The results, reported in Background Note Number 1, also control for some other policies that affected growth in the 1990s, including exchange rate policies, government consumption, and inflation. Although the results suggest that reducing tariffs encourages growth, the results are not very robust.

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composite measure of economic reforms and economic growth, but that relationship is not significant for the 1990s. 23 Box 5.4: The trade and growth debate The debate among economists and policymakers over the relationship between trade and growth has risen to prominence during the last few years due on the one hand to the mixed growth outcomes of developing countries that have undergone extensive trade liberalization and, on the other hand, differences over data, econometric techniques and model specifications among professional economists. On the analytical side, the resurgence of interest in the 1990s among economists on the impact of trade on growth can be attributed to the significant improvements in endogenous growth theory as well as to the availability of more comprehensive data and new econometric techniques. According to the new growth theory, attributed to Paul Romer (1986), Robert Lucas (1988) and Gene Grossman and Elhanan Helpman (1991), whether import protection raises or lowers the growth rate depends on the pattern of imports and exports. As a matter of theory, therefore, the relationship between trade and growth is ambiguous, which is widely accepted by economists on both sides of the debate. The issue is hence an empirical one, and that has become the focus of the debate in the last few years. The launching of the debate can be attributed to Rodriguez and Rodrik (RR) and Harrison and Hanson (HH) who in two 1999 papers reviewed a number of empirical studies in the 1990s. While HH showed that the Sachs and Warner (1995) study reflected the gains from macrostability rather than trade reform, RR reviewed a number of studies, including Dollar (1992), Sachs and Warner (1995) and Edwards (1998). RR expressed skepticism “that there is a strong negative relationship in the data between trade barriers and economic growth, at least for levels of trade restrictions observed in practice,” viewing “the search for such a relationship futile.” A unique feature of the HH and RR analysis was their use of the various authors’ actual data sets in undertaking various tests of robustness of their results. HH and RR criticized the empirical studies reviewed on data grounds, on model-specification grounds, and on grounds of econometric techniques. Data problems included, among others, the use of poor measures of trade barriers (including the World Bank’s classification of trade regimes which they criticized as subjective as in Edwards’ paper), and the use of measures that are highly correlated with other sources of bad economic performance such that what is captured is policy failure that is not necessarily due only to trade policy (as in Dollar’s and Sachs and Warner’s papers). Separately, Rodrik also criticized one of the more recent papers on the topic, Dollar and Kraay (2001) on data and model-specification grounds. The data problem arises from the combination of policy measures (tariff averages) with outcome measures (imports as a share of GDP). The model specification problem arises from regressing income on trade shares when both are endogenous (outcome variables). Notwithstanding these criticisms, it would be safe to say that most authors agree on the following. First, that trade protection is not good for economic growth. Even RR themselves stated in their paper that they do not think and have seen no credible evidence supporting the notion that trade protection is good for economic growth, at least for the post-1945 period. Second, that trade openness by itself is not sufficient for growth, which is what RR was arguing in their paper: that researchers and policymakers have been overstating the systematic evidence in favor of trade openness, when what is really necessary is to further identify the connection between trade and economic growth. 23 Nor do they isolate the role of trade policy per se, but look at the composite measure including exchange rate reforms. Their work is done in a panel context, since they measure the impact of changes in trade policy on economic growth.

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More recent efforts to identify the gains from trade continue to get mixed results(see Baldwin (2003) for a survey). Frankel and Romer (2000), for example, show a positive impact of trade on income, using a clever technique that takes into account the endogeneity of trade policy by allowing trade flows to depend on geographic proximity. However, their specification does not control for unobserved differences across countries and the results are not robust to the inclusion of region effects Other papers that find positive effects of trade on growth, using a variety of new econometric techniques and new instrumental variable approaches, include Frankel and Rose (2003); Dollar and Kraay (2002, 2004); Lee, Ricci and Rigobon (2004); and Alcala and Ciccone (2004). Other authors get mixed results, including Rigobon and Rodrik (2004) and Wacziarg and Welch (2003). Wacziarg and Welch use panel techniques that identify the impact of growth from following the same country over time. The advantage of using panel techniques is that these approaches control for differences across countries which are unobservable. Although Wacziarg and Welch (2003) find a generally positive relationship between opening up to trade and economic growth, they find that this relationship is not significant for the 1990s. In addition, Wacziarg and Welch use a composite measure of openness, which reflects the impact of many different policies, an approach which has been heavily critiqued by HH and RR. Source: Baldwin (2003). The fact that countries that have successfully integrated into the world economy have followed different approaches and adopted a range of complementary policies makes it difficult to pin down the exact statistical relationship between trade policy, trade integration, and growth. The academic debates on whether openness to trade causes higher growth are riddled with problems of measurement, reverse causation (faster growing countries tend to open their markets more quickly), and omitted variable bias (countries that successfully lower tariffs also adopt other complementary policies). Despite the difficulties in interpreting country experiences during the1990s, however, most economists agree that trade liberalization is important for growth over the long run. Yet trade liberalization by itself is not enough for growth. 24 Recent studies show that trade policy is most likely to be associated with positive outcomes when it is combined with a favorable economic environment.25 A recent World Bank study shows that lack of regulations can undermine growth effects of trade, but that in countries with effective regulation, the effects of trade reforms are positive for growth. 26 These academic studies reinforce the case study and cross-country evidence presented earlier that emphasizes the importance of complementary policies to maximize the gains from trade.

24 See, for instance, Rodrik (1997b). 25 Wacziarg and Welch (2003) say that “…preexisting institutional environment of countries, the extent of political turmoil, the scope and depth of economic reforms, and the characteristics of concurrent 26 See Bolaky and Freund (2004). The authors measure excessive regulation using a World Bank survey on labor regulations and business entry regulations. They find that the benefits of expanding trade (as measured by trade shares) are offset by excessive regulations in the most regulated economies in the 1990s.

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3. Trade liberalization, poverty, and income distribution Despite expected gains for the economy as a whole in the longer term, trade and investment reforms generate both winners and losers in the short run.27 The critical question is the following: do the short-run costs of trade reform fall disproportionately on the poor? Is globalization associated with changes in within- or across-country inequality? Economists in the 1990s expected trade and foreign investment reforms to help developing countries reduce poverty. Trade liberalization was expected to increase demand for goods produced by the poor or low-skilled workers in developing countries. Why? Developing countries were expected to have an abundance of unskilled labor, leading to a comparative advantage in producing and exporting goods that used unskilled labor. Trade reforms were also expected to increase the prices of the agricultural products produced by the poor and to reduce prices for goods consumed by the poor. Yet if increasing globalization is in fact associated with increasing demand for skilled labor in developing countries, then trade reforms could lead to higher poverty and greater inequality. The effects could be worse in the short run if trade reforms lead to unemployment and greater job instability. Opening up to trade could affect poverty through several different avenues. One avenue is direct: if opening up to trade is associated with higher growth, then economic growth may be associated with a decline in poverty. This argument rests on two assumptions: first, that opening up to trade leads to higher growth and second, that growth raises incomes of the poor as much as it raises the incomes of the rich. What actually occurred? There is widespread evidence that aggregate growth does reduce poverty. 28 In other words, GDP growth is generally neutral with respect to changes in income distribution, which means that all individuals gain. However, there is no clear evidence on whether GDP growth is “pro-poor”, which would mean that the poor gain proportionally more than the rich. To achieve GDP growth which is biased towards the poor, policies to promote low-income households would probably have to be explicitly followed. Trade, aggregate growth, and poverty reduction To the extent that trade liberalization is associated with growth in the long run, trade reforms should be associated with reductions in poverty. As discussed earlier in this chapter, while the direction of causality is statistically not clear, the cross-country evidence suggests a positive relationship between trade reform and long run growth. China and India are prominent examples of countries that have experienced tremendous increases in trade integration and growth, as well as large reductions in poverty. From 1980 to 2000, real per capita GDP grew at an annual average of 8.3 percent in China and 3.6 percent in India, while

27 See Winters et al. (2004) and Goldberg and Pavcnik (forthcoming) for comprehensive surveys. 28 See, for example, the survey papers by Berg and Krueger (2003) and Winters et al. (2004), as well as papers of Dollar and Kraay (2001). The general conclusion of these papers is that growth, including growth that is due to trade openness, has no impact on income distribution, and therefore that income growth has led directly to poverty reduction on average(that is, growth increases the incomes of the poor by just as much as it increases the incomes of everybody else on average).

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trade integration (of goods and services in real terms) doubled from 23 to 46 percent of GDP in the former, and grew by 60 percent from 19 to 30 percent in the latter. Over this period, both countries experienced massive reductions in the incidence of poverty—from 28 to 9 percent between 1978 and 1998 in China, and from 51 to 27 percent between 1977-78 and 1999-2000 in India.29 These large reductions in the incidence of poverty in the two countries have served to reduce or mitigate overall inequality in the world over the last 10 to 20 years—since a large share of the world’s poor live in these two countries—even though at the same time inequality has risen within both countries.30 Trade reforms can also affect poverty indirectly. Winters et al. (2004) identify a number of important channels : (1) trade reforms could affect employment opportunities and wages of the poor; (2) reforms also affect the prices that poor consumers pay for the goods that they buy; (3) trade reforms could reduce government revenues and in turn social expenditures that particularly affect the poor; and (4) liberalization could increase income instability as well as workers’ chances of becoming poor. Even if aggregate poverty falls or remains constant, many households may move into or out of poverty as a result of liberalization An emerging literature using household level data suggests that the effects of trade liberalization via changes in factor and goods prices can lead to poverty reduction. For instance, a recent study of trade liberalization in Argentina using household survey data31 found that Mercosur has benefited the average Argentine household across the spectrum of income distribution. Furthermore, the same study also finds that Mercosur has had a pro-poor bias: on average, poor households have gained more than middle- income households from Mercosur, while the impact on rich families is positive but not statistically significant. The reason behind these results is that Argentine trade policy has protected the rich over the poor prior to the reforms, and granted some protection to the poor after the reforms. While some studies have found short-run costs to employment from trade reforms, others have found that trade reforms increased employment over the long run, as expanding sectors created new employment opportunities. A study by two World Bank economists found that trade explains much of the decline of Singapore’s unemployment rate, from more than 9 percent in the 1960s to close to 2 percent in the late 1990s. A study of 18 countries in Latin America and the Caribbean for the period 1970-96 found that trade liberalization had a negative, though small, direct effect on employment.32 The negative effect was found to be compounded in countries where the real exchange rate appreciated as a result of capital inflows that had followed the economic reforms. Similar results were obtained in a study on Brazil for 1990-97.33 This found that although trade liberalization had a negative—though relatively small—short-term effect on employment, the more labor-intensive output mix that resulted over the long run increased employment. Appreciation of the real exchange rate during the period also contributed to this negative employment effect by encouraging imports and undermining exports.

29 Asian Development Bank (2000), cited by Bhagwati and Srinivasan (2002). 30 Bhalla (2001); Ravallion (2003); and Sala-i-Martin (?). 31 Porto (2003). 32 Marquez and Pages (1997). 33 Moreira and Najberg (2000).

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Much larger negative effects on output and employment have been found in some African countries. One study for Kenya, Tanzania, and Zimbabwe34 found that the majority of firms responded to import competition pressure by contracting rather than upgrading aggressively. Among the suggested reasons for such behavior are the firms’ lack of preparation for competition, absence of policies to promote technological improvement (especially among small and medium enterprises), and poor technological and human infrastructure. These mixed results were echoed in a recent report that reviewed the impact of trade reform in the 1990s on countries in Latin America and the Caribbean (De Ferranti et al. 2001). The authors found losses in employment in previously protected industries and gains in employment in others. Argentina lost much of its automobile industry while seeing an expansion in more sophisticated chemicals and capital- and labor- intensive manufactures. Brazil lost much of its cereals industry to Argentina under Mercosur, and its manufacturing industry suffered more generally. Costa Rica lost much of its labor- intensive manufacturing processes to Mexico after NAFTA, but also saw a substantial increase in manufactures of computer chips. In each case substantial numbers of workers lost their jobs, and some experienced either very long periods of unemployment, or large wage losses, or both. The report makes the point that such dislocations are transitional and do not imply a permanent increase in the unemployment rate, as shown in the experiences of Chile and Mexico. Chile experienced double-digit rates of unemployment for several years after liberalization, but from 1986-97 it had among the lowest such rates in the region. Mexico’s present rate of unemployment is roughly at its traditional level, despite that country’s dramatic economic integration with the US. Although most of these studies find that the unemployment effects of trade liberalization tend to be temporary, even short-term costs can be high in human terms. Such costs must be addressed through a variety of policy approaches, including stronger social safety nets, in order to ensure that trade reforms succeed. Finally, no direct evidence relates trade liberalization to social spending, another avenue through which liberalization could affect income distribution. The available evidence, relating mostly to the 1980s35, suggests that many trade reforms had no revenue costs. Some of the main reasons were that temporary tariff surcharges were introduced when quantitative restrictions were removed, and that changes in the import/export base arising from the trade reforms had enhanced revenues. For example, one study that examined the impact of Kenyan liberalization between 1989-99 (entailing halving the simple average import duty rate over the period and abolishing import licensing requirements and foreign exchange controls) found increases both in duty as a share of imports, and in import duty revenues as a share of GDP (Glenday 2000, cited in Winters et al. 2002). The study attributed this increase in revenues to the expansion of the revenue base, tighter exemption management, increased duty rates on certain products (oil and agricultural commodities), a shift in imports to the higher duty classes and possibly also improvements in customs administration and the introduction of a pre-shipment program.

34 Lall (1999). 35 See Winters et al. (2002) for studies cited.

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Even in cases where revenues were cut, available evidence suggests that reductions in public expenditures important to the poor need not occur. There are alternative sources of revenues (though caution needs to be exercised to ensure that replacement taxes do not hurt the poor) and, with political will, social spending and in particular that oriented towards the poor, may be shielded. Regarding the effect of trade liberalization on vulnerability and income volatility, a recent World Bank study36 reviewing the experience in three East Asian countries (Indonesia, Korea, and Thailand) finds that their opening up to trade in the late 1980s and early 1990s did not have strong negative effects on poverty and vulnerability. The study did indicate that it remains an open question whether openness made the 1997-98 financial crisis much more serious than the shocks that had hit the three countries in the 1980s, and suggested that this is an area that required more analysis. In sum, it is difficult to make any general statements about how trade reforms affect poverty. Trade liberalization and inequality The evidence on the relationship between trade liberalization and income distribution also produces a complex picture. Simple predictions based on general equilibrium trade models suggest that since developing countries have a comparative advantage in producing goods using unskilled labor, globalization should have led to more equity, as the wages of unskilled workers rose. Economists in the 1980s expected that trade reforms would lead developing countries to increase exports of goods that use unskilled labor (such as textiles), raising the returns to unskilled labor and reducing inequality. However, the emerging evidence suggests that inequality within both rich and poor countries has been increasing. Can this increase in inequality be attributed to globalization? The short answer is that there is still a lack of a comprehensive understanding of the forces behind the global increase in inequality. One popular hypothesis is that technological change—which may or may not be associated with opening up to trade—has led employers to demand more skilled labor. This phenomenon, referred to as skill-biased technical change, has occurred in both developed and developing countries. Some economists argue that the demand for more skilled workers is unrelated to trade liberalization, since this same trend has been documented in services that are not traded on world markets. Others, however, argue that skill-biased technical change is itself an outcome of globalization. One reason why trade reforms may be associated with increasing inequality is that many countries have traditionally protected the sectors that use unskilled labor. In Colombia, Mexico, Morocco, and Poland, for example, protection prior to trade reforms was higher in sectors that used more unskilled labor (such as textiles and apparel). Another explanation for why trade reform may be associated with increasing inequality is that exporters—who benefit from trade reforms—need to hire skilled workers in order to succeed in world markets. A number of studies have shown that exporters are more likely to use a high proportion of skilled workers. This means that as countries turn to exporting, the demand for skilled workers will rise, increasing their wages relative to unskilled workers. Foreign firms in 36 World Bank (2003a).

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developing countries also tend to hire more skilled workers relative to domestic firms. In Mexico, increasing inequality is most evident in the border region—the region most affected by increasing trade with the United States. Nevertheless, the evidence on trade liberalization and wage inequality remains inconclusive. In Argentina, Brazil, Costa Rica, the Dominican Republic, and Mexico, the industries that are most exposed to international competition pay the highest wages. It is difficult to separate the impact of globalization from technical change, since the adoption of new technologies could be stimulated by external competition via trade. As an example, in Mexico, the tripling of manufactured exports during the 1990s has been associated with increased rates of adoption of modern production technologies, an acceleration of productivity growth, a relative increase in the demand for skilled labor, and an increase in inequality. There is no evidence that liberalization permanently worsens income distribut ion. There is evidence that it has been associated with—at times significant and prolonged—adjustment costs in the form of employment losses. In several instances, however, such adjustment costs were exacerbated by other factors such as an appreciation of the real exchange rate that had accompanied or followed trade liberalization (as in some Latin American countries). In the case of Mexico, trade integration through NAFTA, while reducing poverty, has also increased income inequality between regions due to their different initial conditions—regions with lower per capita GDP and higher telephone density grew faster, while regions with high public employment grew more slowly (Perry 2003). To summarize, it is likely that trade reform in the 1990s was accompanied by falling poverty and rising inequality. There is no systematic evidence that social expenditures for the poor suffered as a result of revenue losses from trade reforms. Despite employment gains over the longer run, some individuals were hurt by trade reforms in the short run. Governments need to help the disadvantaged by strengthening social safety nets and by providing education and training for the unskilled. Yet the administrative and institutional capacity required to design and successful implement safety nets that are well-targeted and that avoid leakages is daunting. The latter eludes even industrialized countries (as attested by the continued protectionism in these countries), suggesting that more innovative approaches to trade reforms and trade reform assistance packages may be needed. 4. Different paths to trade reform There are different ways to pursue trade liberalization. Some countries, such as Hong Kong and Singapore, achieved spectacular success through unilateral trade reforms. In the 1990s, a number of successful reformers—including Bangladesh, China, and India—pursued an approach that focused first on obtaining an export supply response through limited trade liberalization. Another approach that has produced successful trade integration is to combine unilateral or multilateral trade reforms with participation in regional trade agreements, as in the case of Mexico joining the North America Free Trade Agreement (NAFTA), and the Central and Eastern European countries participating in the Europe Agreements with the European Union (EU) member countries.

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Conversely, there are countries such as Malawi and Zambia that pursued across-the-board rapid liberalization but, due to a combination of poor macroeconomic management and poor management of trade policies, experienced resounding failure. Other countries adopted yet another approach. Korea and Taiwan, for instance, established a complex set of administrative measures that produced highly export-oriented economies; China established special economic zones, while India pursued its own unique approach to liberalization. In this section, we document the great diversity of country experience in promoting growth through trade liberalization. One element is common to almost all of the success stories: though the approaches were diverse, they all either explicitly or implicitly promoted export growth. Exporters were provided with incentives to ensure that selling on international markets was as attractive as domestic sales. This required establishing a regime that offset the anti-export bias, and in turn required an effectively functioning bureaucracy to implement the offsetting regulation—like “indirect duty drawbacks” in Korea. Since the institutional capacity that is required to implement offsetting regulation is frequently absent, classic trade liberalization—through low, uniform tariffs and the elimination of quantitative restrictions—a is generally prescribed. At the end of this section, we discuss the unique country circumstances that made it possible to compensate exporters in countries that did adopt conventional trade reforms. China and India China provides an example of a model of partial trade liberalization, which it pursued through a dual-track approach. Special economic zones (SEZs)—one of the drivers in China’s export and growth success—were set up in the 1980s to provide the firms established within them access to duty-free imports of inputs. Firms outside the SEZs faced a much more protected trade regime with much higher tariffs on imports—the average tariffs they faced were 56 percent in 1982, going down only to 44 percent in 1991 and 16 percent by 2000 (Lardy 2002). China began with partial trade reform through the establishment of SEZs.37 China began with the establishment in 1980 of four SEZs in two coastal provinces (Guangdong and Fujian), which were selected for their geographic location. Their success led to the addition in 1984 of 14 coastal cities (including Shanghai) as “coastal open cities,” which were given authority similar to that of the SEZs. By 1992, most cities along the Yangtze River and the borders of China were also granted special privileges as coastal cities, with Shanghai being granted even more autonomy. These developments, in turn, spurred the establishment of numerous “development zones” in many inland cities that extended tax benefits and autonomy to foreign and domestic investment. In many cases, such zones were established without the approval of the central government.38 Within two years, 1991 to 1993, foreign direct 37 Information in this paragraph is from Qian (2000). 38 The autonomy given to local governments in China is a very important factor in this development. This autonomy is provided in the form of the “fiscal contracting system” introduced between 1980 and 1993, under which provincial governments are provided incentives to build up local economies and their own revenue bases. Specifically, the incentives arise from allowing the provinces to keep the lion’s share of the increases in revenues at the margin—data from the reform period of 1982-91 show that the correlation coefficient between the provincial budgetary revenue and expenditure is 0.75, compared to 0.17 in the pre -reform period of 1970-79

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investment into China rose nearly eight times, from US$ 4.4 billion to US$ 28 billion (from 1.2 to 6.4 percent of GDP). In 1993 China became the second largest destination for FDI, next to the US. The SEZs enjoy lower tax rates, and are granted greater authority in approving foreign investment projects than other regions. Within the SEZs, foreign firms are allowed to invest, and directly import and export. Duties on imported equipment and materials are low for exporting firms. The removal of these administrative barriers had nearly as great an effect in spurring trade as the tariff reductions, which did not really begin until the 1990s. Exports grew at an annual average of 15 percent in the decade of the 1980s, and 19 percent in the decade of the 1990s.39 India provides another model of partial liberalization. Unlike China, where liberalization was initiated only in the SEZs, India liberalized trade across the economy, although it liberalized one sector at a time. India launched a coherent trade reform program in 1991, after piece-meal efforts at liberalizing trade during the 1980s. This program has continued to date, with some faltering during 1997-2001.40 The reforms entailed concurrent reductions of what had been among the highest non-tariff barriers (NTBs) and tariffs in the world. A large reduction in NTBs and the streamlining of a very complex import licensing regime came early in the reform program, while tariffs were reduced in a phased manner, with reductions still continuing to date. Currently, the maximum customs tariff for non-agricultural goods is 30 percent and is scheduled to be reduced to 20 percent in 2004.41 Capital and intermediate goods imports were liberalized first, and consumer goods (which were effectively banned) not until several years later. It was not until 2001 that all consumer goods imports were liberalized.42 This sequencing of trade liberalization, which entailed earlier liberalization of capital and intermediate goods and much steeper reduction in tariffs for some of them, was intended to deter the deferment of investments that might occur if domestic producers expected further reduction in capital goods tariffs.43 It had the following results: the liberalization of capital and intermediate goods contributed to a rapid supply (export) response: exports grew 20 percent in dollar terms within three years of the start of the reform program. The strong export supply response provided impetus for a continued response, not least because the export receipts that were generated alleviated the pressures on the balance of payments.

(Qian 2002). Another study (Jin, Qian, and Weingast 2001) found that such incentives were indeed significant—both for the growth of employment of non-state enterprises as well as in the reform of state enterprises. 39 Qian (2002); Jin, Qian, and Weingast (2001). 40 A result of the increasing import competition from East and Southeast Asian countries that devalued their currencies in the aftermath of the Asian financial crisis. 41 These tariffs underestimate true import competition since there are also specific tariffs. 42Although imports of several agricultural goods, making up 40 percent of Indian agricultural GDP, continue to be controlled by state trading enterprises. 43 World Bank (1994).

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A role for regional agreements? Some countries have managed to achieve strong integration and growth outcomes by adopting unilateral or multilateral trade reforms combined with participation in regional trade agreements. In the 1990s, the central and eastern European countries signed Europe Agreements with the European Union, and Mexico joined the North America Free Trade Agreement (NAFTA). Signing on to RTAs provides these countries with access to the markets of their fellow members, and can also help improve the quality of domestic institutions. In the case of the central and eastern European countries, World Bank (2000a) shows that the institutional harmonization aspect of the Europe Agreements has been very important for the successful trade integration and growth outcomes of these countries. In particular, the “deeper integration” aspects of the agreements entailing harmonization of investment policies, regulatory rules and institutions with members of the EU has encouraged export-oriented foreign direct investment into these countries. In Mexico, a recent study44 shows that NAFTA has had positive effects on trade, FDI, technological transfer, and growth, and is also associated with improvements in manufacturing total factor productivity. However, the successful outcomes in the central and eastern European countries and Mexico are thus far the exceptions rather than the rule : evidence suggests that as many as half of regional trade agreements are substantially trade-diverting. There are also significant economic losses to the economies excluded from North-South trade agreements (which is the vast majority of the South), via trade and investment diversion. Evidence suggests that for developing countries, signing on to regional trade agreements with developed countries, particularly large developed countries, is most useful. It has certainly been beneficial for the central and eastern European countries and Mexico.45 But country case studies also suggest that signing on to RTAs (even with developed countries) will not generate positive export and growth responses unless the countries themselves also pursue other necessary economic, political, and social reforms. The experience of the EU accession countries in the 1990s shows that simply signing on to the Europe Agreements provided no guarantee that there would be benefits. Benefits only accrued to those countries that were also undertaking the necessary economic, political, and institutional reforms to transform their economies into market-based ones.46 This was amply demonstrated in the case of Bulgaria and Romania, both of which signed Europe Agreements in 1993, in advance of several other accession countries, but have lagged behind in the transition process and fared much worse in economic performance compared to some of the latecomers (in particular Estonia and Slovenia, which signed such agreements in 1995 and 1996, respectively). Further, a study on NAFTA47 found that although the agreement has contributed to institutional harmonization between Mexico and the US in the areas covered by the

44 Lessons of NAFTA , World Bank (2003). 45 World Bank (2000c). 46 Much of the benefits came in the form of export-oriented FDI from the EU member countries. World Bank (2000a). 47 Perry et al. (2003).

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agreement—in particular intellectual property rights, investor protection, and environmental standards—it did not help narrow the institutional gaps outside of these areas that are important for income convergence between the two countries, especially in the areas of rule of law and corruption. Most importantly, regional trade agreements can divert attention away from the multilateral WTO process, and result in higher costs than benefits for the developing countries.48 Recent experience with the Free Trade Area of the Americas, the Central American Free Trade Agreement, and the US-Australia Free Trade Agreements suggests that regionalism is not likely to do much to address the key market access priorities for developing countries: trade-distorting agricultural support in the North, contingent protection, and liberalization of temporary movement of service suppliers. Furthermore, the high costs of negotiating such agreements also divert resources away from such larger multilateral issues. Political economy of trade reforms The success of trade reforms, whether via the complex administrative type of the East Asian tigers, or the special economic zone or export processing zone (EPZ) type adopted by China and Mauritius, or the approach adopted by Bangladesh and India, is not automatic, and there are certainly countries where such strategies have failed. The failure of EPZs, for instance, has been the norm rather than the exception, particularly in Sub-Saharan Africa but also elsewhere.49 A factor that was clearly important for the trade reforms adopted by China and India was the credibility of reforms, both in terms of their not being reversed and also in their being time-bound. Another factor was strong institutions. In the case of Mauritius, democracy and strong participatory institutions have been suggested as important reasons for success.50 Political economy considerations need to be taken into account when designing a trade reform program in order to ensure the sustainability of reforms. This is of great importance in stimulating private investment. If the expectation is that the reforms will be reversed, the private sector will not invest. There is also a vicious circle here, as a positive supply response would in turn garner social and political support to maintain, as well as to further, liberalization. The key elements on the political economy front are (1) to ensure that the costs of adjustment arising from reforms are eased; and (2) that reforms are credible. Easing the costs of adjustment Easing the costs of adjustment is clearly important to generate social and political support for reforms. Ensuring that safety nets are adequate to compensate losers is one way of easing 48 Discussion of this point is taken from World Bank (2004); see also Stiglitz (2004). 49 The pursuit of a strategy that relies on compensating exporters for import tariffs—depending on how it is implemented—could contravene WTO rules where export subsidies are involved. One suggestion by Williamson (2004) is for the WTO to allow temporary protection in developing countries for industries they wish to nurture so long as there is a pre-specified timetable for the removal of such protection, with the discipline taking the form of WTO sanctions when countries do not abide by the timetable 50 Subramanian and Roy (2001).

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adjustment costs. However, as discussed earlier, a more efficacious way is to design a reform program that minimizes adjustment costs. China and Mauritius provide good examples in this regard. China minimized political opposition to the reforms ex ante—not many vested interests opposed the SEZs because these were set up outside the scope of central planning and did not disrupt planned production and allocation. At the same time, the approach also maximized political support for maintaining the reforms ex post as the number of winners grew over time. In Mauritius, too, new profit opportunities were created at the margin while leaving old opportunities undisturbed. The upshot was that there were no identifiable losers. Mauritius partially liberalized trade by establishing export processing zones (EPZs) and segment ing the labor market (Subramanian and Roy 2001). Labor market rules were much less stringent in the EPZs than elsewhere in the economy. Until the mid- to late-1980s, employers had greater flexibility in discharging workers in the EPZ sector. This approach worked because allowances had to be paid before dismissing workers, and advance notification of retrenchment to a statutory body was not required, and the conditions of overtime work were more flexible. In the 1980s, EPZ wages were about 36-40 percent lower than wages in the rest of the economy, with the differentials narrowing to 7-20 percent in the 1990s. Aside from acting as a subsidy to exports, the segmentation of the labor market also prevented the expansion of the EPZs from driving up wages in the rest of the economy and disadvantaging the import-substituting industries. Ensuring credibility Reform credibility is an area that could benefit from much more understanding and analysis, not just for trade reforms but for reforms in general. The following discussion, based on country examples, highlights some ways in which credibility of trade reforms can be achieved. In the first instance—and at the very least—reforms should be publicly communicated so that economic agents are aware of them and respond accordingly. In a well-known example of a “failed” case of reforms, the lifting of export restrictions on cashew nuts in Mozambique, there was very little communication to those directly affected by the reforms—the cashew nut farmers—about the reforms (McMillan, Rodrik, and Welch 2002). Few farmers were aware that substantial reforms were going on, and this diminished the benefits they received from the reforms since much of the price increase that resulted from the reforms went to the traders. This also meant that the supply response was stymied. If the farmers had been made aware of the reforms, they could have strengthened their bargaining power vis-à-vis the traders, making it difficult for the latter to pay low prices. Finally, public communication of the reforms would also diminish the possibility of reform reversals, thereby boosting their credibility. Credibility could also be promoted by undertaking measures that are less easy to reverse than price changes. In the Mozambique nut case, the supply response was poor not just because farmers did not benefit from much of the price increase as mentioned, but also because entrepreneurs in the cashew nut processing industry did not make investments to improve

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efficiency (which themselves could also enhance the irreversibility of the reforms) despite the higher farm gate prices, probably because they expected the reforms to be reversed. Had the price reforms been accompanied by non-price reforms, the credibility of the overall reform program would have been strengthened. Non-price reforms that would have helped promote the supply response in the Mozambique case could have come as various forms of government interventions. Government investment in transport, for instance, would help make the marketing sector more competitive and cashew farming more profitable. The government could also intervene to provide traders and farmers with access to credit—in the case of the former to promote competition in cashew marketing and in the latter to encourage adoption of improved technologies for cashew growing. Finally, such non-price interventions by themselves would also signal to the public the government’s commitment to the reforms and hence strengthen the ir credibility. Yet other ways of promoting credibility include the establishment of institutions such as India’s Tariff Commission, which is charged with the design and implementation of the trade reform program and has a tenure that outlasts governments. Such long tenure helps enhance the credibility of reforms, as it diminishes private sector expectations that the reform program will be reversed by successive governments. Finally, credibility could also be achieved through signing on to regional trade arrangements that lock in reforms. 5. Issues of differential market access The 1990s saw the continuation of trade liberalization around the world that had begun a decade before. Average unweighted tariffs were cut by half in both developed and developing countries, from around 8 to 4 percent in the former, and from around 26 to 13 percent in the latter (Table 5.5). There was also a substantial reduction in non-tariff barriers and significant progress in moving toward market-based foreign exchange regimes. The tariff reductions in the 1990s left tariffs higher on agriculture than manufacturing goods in both developed and developing countries, and tariff escalation in both types of goods and both groups of countries (Table 5.6). The relatively low average tariffs of developed countries, however, mask the sometimes high protection in these countries in the form of tariff peaks, tariff escalation, specific duties, and production subsidies, with such protection being much more pronounced in agriculture than in manufacturing.51 The large numbers of the poor who live in rural areas and work in agricultural production in developing countries mean that such protectionism exacerbates poverty in the world. The issue of protectionism in agriculture, in particular in cotton, has risen in prominence in multilateral trade talks, to the extent that it was one of the main reasons for the failure of the most recent round of World Trade Organization (WTO) talks in Cancun in September 2003. Since then, Brazil has gone to the WTO with charges that the US subsidies on cotton52 are inconsistent with WTO obligations, and the WTO ruling on April 2004 affirmed Brazil’s charges.

51 World Bank (2003b). 52 US subsidies on cotton amounted to US$ 3.7 billion in 2002 (three times US aid to Africa).

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Table 5.5: Average unweighted tariffs , by country group, 1980-2000

(percent)

High

Income Developing South

Asia Africa Latin

America & Caribbean

E.Asia Middle East & North Africa

E.Europe & Central Asia

1980-85 8.0 33.0 65.0 30.0 31.0 29.0 28.0 15.0 1988-90 7.7 25.5 64.4 24.8 23.3 16.6 17.1 12.8 1993-95 6.8 19.0 36.1 21.6 13.2 14.4 18.2 8.9 1998-00 4.0 13.2 22.9 16.3 10.7 9.6 15.7 9.8 Note: These are statutory tariffs (most-favored-nation tariffs), which reflect countries’ trade policy stance. Actual tariffs are lower because of preferences and various exemptions. Source: WTO CD ROM 2000 and WTO Trade Policy Review, various issues, 1995-2001.

Table 5.6: Average unweighted tariffs , by product group

(percent)

Agricultural product Industrial product Average 1st

stage Semi-processed

Fully processed

Average 1st stage

Semi-processed

Fully processed

Developing countries

17.4 16.9 21.5 25.4 12.7 9.9 10.9 15.2

Developed countries

5.5 4.6 8.3 11.0 3.3 2.9 3.4 4.8

Note: The average agricultural tariffs for developed countries do not include the ad valorem equivalent of specific tariffs; if the latter were included, the figures would be much higher. Source: WTO CD ROM 2000 and WTO Trade Policy Review, various issues, 1995-2001. Today, trade in manufactures as well as in agriculture is still impeded. Although tariffs on manufacturing in rich countries are on average lower than in developing countries, the types of goods exported by poor countries face higher tariffs in the rich countries (Table 5.7). For example, exporters of manufactures from industrial countries face, on average, a tariff of 1 percent on their sales to other industrial countries, while exporters from developing countries pay anywhere from 2 percent if they are from Latin America (where the North America Free Trade Agreement weighs heavily) to 8 percent if they are from South Asia. In agriculture, the industrial countries impose an average 15 percent tariff on imports from other industrial countries, whereas the rates on imports from developing countries range from 20 percent (Latin America) to 35 percent (Europe and Central Asia). Overall, rich countries collect from developing countries about twice the tariff revenues per dollar of imports that they collect from other rich countries. Protection also takes forms other than tariffs—among them quotas, specific duties, and contingent protection measures such as antidumping duties. As with tariffs, these measures tend to be used more frequently against labor- intensive products from developing countries. The quota arrangements in the WTO Agreement on Textiles and Clothing still shackle the exports of many poor countries, and while these are scheduled to be removed [at the start of 2005], rich countries to date have freed up only 15 percent of trade, obliging them to implement major changes at the end of the

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phase- in period. Average antidumping duties are seven to ten times higher than tariffs in industrial countries, and around five times higher in developing countries. Today’s protection remains heavily concentrated in the most politically sensitive areas—textiles, clothing, other labor- intensive manufactures, and agriculture—in both rich and poor countries. Table 5.7: Rich countries levy higher tariffs on poor countries’ exports

(1997 protection rates facing exporters in each region, in percent) Importing Region

Exporting Region East. Asia

Europe and

Central Asia

Latin Americ

a

Middle East

South Asia

Sub-Saharan Africa

Industrial

Agriculture

Industrial East Asia Europe and Central Asia Latin America and Caribbean Middle East South Asia Sub-Saharan Africa

33.3 31.0 24.2 42.1 23.0 16.6 26.7

43.7 30.3 36.4 36.0 43.4 34.6 20.3

20.1 15.5 23.8 14.8 14.9 13.7 14.4

65.4 45.3 55.3 50.3 76.4 41.1 39.1

16.4 38.4 34.2 29.7 31.8 27.7 30.9

24.0 19.0 12.7 24.7 18.9 11.0 33.6

15.3 30.5 35.1 20.4 23.4 25.8 23.6

East. Asia

Europe and

Central Asia

Latin America

Middle East

South Asia

Sub-Saharan

Africa

Industrial

Nonagriculture

Industrial East Asia Europe and Central Asia Latin America and Caribbean Middle East South Asia Sub-Saharan Africa

7.4 8.2 6.4 4.3 5.4 7.1 4.4

9.6 13.8 6.4 6.7

11.5 11.0 6.1

8.5 15.1 11.4 15.4 8.8

13.6 11.7

10.4 12.2 8.6 8.9

11.4 10.2 6.1

25.2 28.1 25.8 19.4 33.6 19.0 27.6

12.2 14.5 12.8 11.9 11.7 17.4 20.6

1.0 5.1 5.9 2.1 6.0 8.1 4.2

Source: Weighted averages calculated using GTAP Version 5 Database (www.gtap.org). Most-favored-nation rate except for major free-trade blocs such as the European Union and the North America Free Trade Area. The differential protection by industrialized countries against developing country exports has been recognized for some time (WDR 1991). Even in after large, unilateral trade reforms by developing countries in the 1990s, differential treatment by industrialized countries still constrains the expansion of trade by developing countries, particularly the poorest. China has been able to successfully negotiate rapid export growth in a trading system that restricts free exchange of many agricultural and labor- intensive goods, but many other countries have not achieved the same success. And even high-export growth countries such as China as well as less spectacularly successful developing country exporters would benefit from further liberalization of developed country markets. To continue the momentum towards greater global integration, high- income countries must further open their markets to developing

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