The aim of this essay is to consider and analyse the policies that a country can pursue in order to restrict or modify its pattern of international trade. One may ask why a country wishes to alter its pattern of international trade rather than leaving market forces and comparative advantage to determine trade patterns. There are, however, several justifiable reasons why a country may wish to pursue such policies.
For example the country may wish to develop a new industry or it may wish to break free from the production of primary goods whose inelastic price elasticity of demand is seen to hinder the country’s potential rate of growth and development. Three main topics shall be covered in the essay, these being import substitution, export promotion and trade liberalisation illustrating the theoretical benefits and weaknesses as well as empirical evidence. An import substitution policy involves “erecting various barriers to the importation of foreign goods and substituting for these goods by producing them domestically”1.
There are many forms of import substitution from complete bans on the importation of certain products to discriminatory treatment for domestic producers of certain products. A combination of tariffs and quotas often plays the major role in a policy of domestic protection. A tariff is simply a percentage fee that is charged by the government on imports (in general or on specific items), hence raising the observed price of these goods to domestic consumers, whilst also raising revenue for the government. A quota on the other hand is a maximum quantity of a particular good that is permitted to be imported.
It is often the case that a tariff and quota may be combined with a tariff being charged on imports until some given quantity after which all further imports of that good are banned. As well as tariffs and quotas import substitution can be promoted in a number of other ways. For example the imports of capital and intermediate goods which are used in production may be allowed in free of duty, inputs to protected industries may be subsidised and the government may even decide to impose domestic content requirements on particular goods.
The adoption of protectionist policies is most commonly justified by the infant industry argument, which runs as follows. New industries would face too high costs to compete if they faced the international price line, but if it is believed that they may be able to become strong enough to compete after a temporary period of protection then a tariff and quotas policy is acceptable. For this infant industry argument to hold, therefore, three conditions must hold.
The industry in question must currently be uneconomic, but if developed would see a substantial fall in costs to such an extent that the gains exceed the costs of the initial protection. It is also necessary that the protection of the infant industry consists of positive externalities in that there are unintended benefits inferred upon other aspects of the industry / economy and that these externalities cannot be internalised themselves, as this would mean that a private enterprise would be possible.
It is also necessary that the protection is temporary and that this threat is credible and believed otherwise the industry will suffer from inefficiencies such as managerial slack. Export promotion is “the use of trade and industrial policy to provide a set of incentives which are neutral as between the export and domestic market, or which actually results in a bias towards producing for the export market”. 2 Export promotion is, therefore, essentially the opposite to import substitution and instead of tariffs and quotas exports are subsidised.
An export promotion policy is usually targeted towards the manufacturing / industrial sector, partly because it is usually the case that developing countries already possess a comparative advantage in the production of agricultural products. This is also, however, because it wishes to alter the pattern of trade and sees a dependence on primary exports as detrimental to potential development for reasons briefly mentioned earlier.
One way in which the government can alter the incentive structure to the economy in order to promote production for the export markets is by reducing import duties or quotas for imports that are required for the production of goods that are to be exported. Another common way in which exports are encouraged is by the government directing banks to extend preferential credit arrangements to firms that produce for the export market, i. e. at lower rates of interest / larger loans. Having introduced and explained the concepts of import substitution and export promotion it is now possible to analyse their policy implications.
It is first necessary to note that both a policy of import substitution and export promotion will both have the same effect on the exchange rate of the economy. Both policies will cause the exchange rate to become overvalued with the exchange rate of the country carrying out such policies appreciating. It is also necessary to note, however, that while both policies lead to an appreciation in the exchange rate, this is more of a problem for countries pursuing export promotion as opposed to import substitution.
The appreciation of the exchange rate obviously harms exports and hence the act of promoting exports itself hinders its own objective through its effect on the exchange rate. In order to return to the statement “Successful import-substitution always requires simultaneous export promotion” it is now necessary to define two further terms, these being inward orientation and outward orientation. “While under outward orientation similar incentives are provided to exports and to import substitution, inward orientation involves biasing the system of incentives in favour of import substitution and against exports”. In order to assess the above statement, therefore, it is necessary to see how countries operating under the different ‘orientations’ have faired empirically. Greenaway and Nam have conducted the best empirical evidence with regard to this. They took a sample of 41 countries and divided them into four categories: strongly outward orientated, moderately outward orientated, moderately inward orientated and strongly inward orientated.
Each of the categories had clearly defined specifications but in short these vary from high levels of protectionism under the strongly inward orientated to countries where trade controls were non existent for the strongly outward orientated. Greenaway and Nam analysed these different categories and their performance over a range of macroeconomic indicators for the period from 1963 – 1973 (the time of the first oil crisis) and from 1973 to 1985. Their empirical findings were that for both periods the strongly outward orientated countries significantly outstripped the strongly inward orientated countries.
Taking perhaps the most relevant of these macroeconomic indicators, income, the growth of GDP for the strongly outward orientated countries was twice that of the strongly inward orientated countries for the period 1963 – 1973 and three times as large for the period 1973 – 1985. Perhaps another relevant indicator, considering that the aim of trade policy is to alter the pattern of international trade, is that of manufacturing output. Once again the strongly outward orientated countries performed much better over both periods with the growth of output being four times as fast for the period 1973 – 1985.
The empirical evidence therefore, does seem to support the statement that “Successful import-substitution always requires simultaneous export promotion”. There are several objections to the findings of Greenaway and Nam. One objection is that there is much less of a difference between the two moderate groups than as is shown with the extreme groups. It is also necessary to note that the association between trade policy and economic growth does not imply causation and also if causation does exist there is no information to suggest which direction the causation runs and the reasons behind the causation.
It does seem fair, however, to draw certain conclusions from the Greenaway and Nam results, in that it appears that there are adverse effects associated with continued inward orientation. A parallel can be drawn here with import substitution as a result of the infant industry argument, in that again as discussed previously it is important that any protection is temporary. Another result that can be drawn is that outward orientation appears to lead to greater stability and better growth performances.
The most logical explanation as to why this is the case, regards the exchange rate. As previously discussed both import substitution and export promotion tends to appreciate the exchange rate and the maintenance of an overvalued exchange rate. The fact that the outward orientated countries faired better suggests that the combination of import substitution and export promotion led to a more realistic exchange rate, whereas the countries that were inward orientated seemed to be subjected more to the adverse economic swings.
During the oil crisis for example the outward orientated countries were able to adopt output increasing policies of export expansion and import substitution that fully offset the adverse Balance of Payments effects of the external shocks. It is now necessary to turn to the issue of trade liberalisation to try and analyse whether a policy to encourage this will help or hinder the industrialisation of less developed countries. One of the main features associated with the increasing trade liberalisation and free-trade arrangements that have been created is that of regionalism.
There are several lines of argument that can be taken to examine whether the effects of trade liberalisation are hence good for developing countries. The issue of regionalism involves the issue of partial trade liberalisation in that trade is opened to some partners but not to others. Partial trade liberalisation may be disadvantageous to overall welfare. The argument is that “freer trade between a subset of countries may cause consumers to shift from a more efficient supplier (who still faces a tariff barrier) to a less efficient one (who is a member of the free-trade group), thereby worsening the allocation of resources”4.
In essence although trade should expand among the partners but such liberalisation may also have the effect of diverting trade from other more efficient non-partners. It is also necessary to note that examples of successful free-trade agreements between countries at vastly dissimilar levels of economic development are not common, primarily due to the existence of lobbies to protect certain interest groups.
It can, therefore, be argued that free-trade agreements between developing countries may be harmful for industrialisation. The argument is based upon the Heckscher-Ohlin model of trade as product variety is low among developing countries with most producing primary / agricultural products. The problem with agreements between developing countries therefore, with regard to industrialisation is that although the agreements may increase the efficiency of locational choices etc. there is a high risk that regional inequality / imbalances may develop. Combined with cumulative causation this may create a successful core of countries and a less successful periphery of countries. This will obviously cause great strains on the ‘periphery’ governments both politically and economically. It is clear therefore, that although trade liberalisation could in theory help industrialisation, there are many potential problems of adopting such a policy that may hinder its aims.