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Trade openness as a key to economic development

Recent decades have witnessed an acceleration of economic globalisation, in particular international trade. Is trade openness the key strategy to achieve economic development?

What lessons could you draw for policymaking?

Introduction

We have witnessed the unprecedented economic development of the four Asian countries who have become known as the Asian tigers. They have prospered in the past few decades, with GDP growth rates that the Western world can only dream of and mostly importantly, have lifted standards of living dramatically. With this proven success we can gain much knowledge and insight as to whether this was due to a country’s liberal stance towards trade or not. If so, how big a role did it play in contributing the success which can be used to form the basis for future trade policies in pursuit of greater economic development.

In this paper we will look at both sides of the arguments, for and against trade openness, thus, derive ideas for optimising policymaking with the goal of greater economic development.

False accusations

In the forever going debate of the importance of trade openness for economic development economists including Nobel price winner, Joseph Stiglitz have made various criticisms of free trade.

Criticism 1:

Countries which liberalised trade policies and fall short of its growth rate goal stemmed its failure from the element of free trade and should therefore have adopted import substitute policies

Flaw 1:

Trade liberalisation is a necessity for development but certainly not sufficient in itself to ensure it. Other essential ingredients include economic stability and policy stability

Criticism 2:

A number of countries who succeeded were not due to trade liberalisation but government induced investment

Flaw 2:

The initial growth was kick-started by investment incentives but their sustained growth was brought about by exactly an open trade link with others.

Criticism 3:

Countries such as China have adopted trade protection and have succeeded

Flaw 3:

Just as flaw 2, the problem is the sustainability of growth. These countries can afford to do so due to their enormous domestic market, not to mention China is now the 2nd biggest exporter in the world which, in fact, supports export oriented strategy rather than import substitution. Moreover, the case for sustained growth using import substitution is not feasible as proven by South Korea from the ‘50s to ‘70s who switched from a trade protectionist to a heavy exporter.

Larry Westphal and Kwang Suk Kim (1982), advocates for free trade stated the numerous benefits of free trade and in the case of South Korea its export growth was directly responsible for over one fourth of manufacture growth not to mention the employment created. There are also other supporting figures such as the fact that the manufacturing industry accounts for 40% of the growth in both employment and GNP. They then went onto saying that the actual positive impact of this is greater than stated as factors are omitted such as the backward linkages to domestically

produced intermediate inputs, multiplier effect and the efficiency in producing in line with one’s comparative advantage.

South Korea’s and India’s miraculous success serves as a platform for our analysis as to whether import substitution (IS) or export oriented strategy (EOS) is the driver for growth. Both India and South Korea experienced unprecedented growth with India boosting its GDP growth from <1% in the first half of the twentieth century to 3 to 4% in the ‘50s – ‘80s. However, this is where the similarities end. India was not a match of Korea mainly because instead of moving from IS to an EOS, India chose to continue and intensify with IS as virtually all imports were subject to strict licensing in the early ‘70s. The important fact worth mentioning here is that both countries started off with IS. In contrast, South Korea, in pursuit of efficiency from the notion of comparative advantage, opted to liberalise trade. The results speak for themselves, per head GDP growth of 1.1% for India versus 6.3% for South Korea from 1961-80.

Having said that, South Korea’s success was not solely free trade, it did, as a matter of fact, incorporate a heavy dose of government intervention. During the first phase of the three, namely 1953-60, they substituted the imports of non-durable goods and their intermediate inputs with domestic production with the help of tariffs on the imports of these goods.

With the second phase S Korea underwent 2 devaluations with the goal of encouraging exports in conjunction with exemptions on tariff and domestic tax on inputs for exports and lower tax rate on exports income, just to name a few.

The final (and the second) phase marks the strong contrast compared to the approach of India’s and ultimately resulted in the different levels of success. S Korea loosened up quotas and tariffs which brought back the incentives that a protected market lacked, as was evident in India.

More evidence in favour of trade openness is that instead of allowing exporters to produce entirely using domestic inputs with regards to technology and materials, S Korea allowed imports of both to be used as intermediate inputs for the export goods. This did not limit S Korea’s exporters to inferior inputs, giving them competitiveness. In addition, both the rupee and the won were overvalued to start with, thus, devaluating would mean a step towards freer trade. Although both S Korea and India did so, the latter offset this by hiking the tariffs rate to 30-50%

Miracles and Debacles (by Arvind Panagariya)

An exercise done by Arvind Panagariya serves to be a well suited analysis for this paper. He used data of growth rates for roughly 200 countries over a period of 38 years stretching from 1961 to 99 then divided them into two nineteen year periods, 1961-80 and 1980-99. Countries with a per capita growth rate of 3% or over are categorised as ‘Miracles’, and ‘Debacles’ for those that experienced a relapse. More to the point of this paper, we will then examine both the export and import growth for these miracles and debacles.

A brief look at the table above tells us that despite the time period, 60s and 70s, being the era of IS for LDCs most countries only qualified for this table (Miracles of 1961–80) by expanding both imports and exports. Brazil, for example, sustained a 4.6 per capita growth rate throughout this period with both imports and exports growing at an average of 8.1% and 7.6% respectively.

In response to those who claim a surge in imports (due to free trade) has a detrimental effect on incomes, we have table 2 below which contains the debacles.

Again, the figures for the import growth does not support this claim, if anything, it is against it only two countries saw a surge in imports. Moreover, the magnitude of growth in imports does not seem to have a link with the severity of the drop growth rate either. Ironically, Ghana actually experienced a fall in imports while still being one of the debacles.

The analysis of the later period 1980–99 is omitted due to the word limit of this paper. If interested, readers can find this on Panagariya A, 2004, Miracles and Debacles: In Defence of Trade Openness. The World Economy, 27( 8), pp. 1155-1161

Rodrik (1999)’s claims

Rodrik openly claimed IS was superior to EOS with the evidence backing this being: the period 1960-73 (period of IS)was the LDCs’ golden period of growth with 30 LDCs’ per head incomes growing at over 3% annually whereas growth plummeted in 1973-94 (with 1984-94 being the period of liberalisation).

Arvind Panagariya attacked this claim on the grounds that Rodrik derived his conclusion based on the number of countries, which were small with regards to both population and GDP. The Solow Growth Model provides the insight why small countries tend to grow quicker. A different story would emerge had he base his analysis on the size of the population instead.

Rodrik never defined IS either. This is important as countries such as S Korea actually pursued both ISI and EOS, thus, there is confusion between the two.

Nor did he examine the growth rates of exports and imports which are vital in the field of trade openness. To add to the crudeness of his analysis, trade policies of those periods were completely ignored.

Panagariya made a point that is true in not just economics. While a piece of evidence supports the hypothesis, it does not however, prove it. While IS does have its role in economic development, rapid growth derives more support from elements of EOS. From Westphal and Kim (1982) in Balassa (1982), per head GNP of Korea expanded at 0.7, 3.6, 8.8 and 7.5% annually in 1955-60, 1960-65, 1965–70 and 1970–75 respetively. While 1955-60 was the IS period, Korea’s case does not seem to support IS at all.

A brief look at Brazil will again, induces more scepticism of IS. Its exports and imports grew at 7.8 and 8.9% respectively in 1960-73. During this period, competitive imports dominated certain domestic production and the ratio of exports to GDP steadily increased, making Brazil not eligible for a successful candidate through IS.

If we look at different periods’ growth rates and the corresponding trade policies we will again find that Brazil’s success stemmed from trade openness not IS. 1961-68 (1.6% of GDP growth), 1968-75 (8.3%) and 1975-80 (3.5%). With the period 1965-73 being the export oriented period in which Brazil undertook numerous actions with the goal of liberalising. These actions include devaluations and reducing the average tariff of manufacturing from 99 to 57% and 53 to 34% on agricultural goods.

Stiglitz’s view

Nobel prize winner, Joseph Stiglitz states in the opening chapter of his book ‘Overselling of Globalisation’ he and others do not oppose to Globalisation itself but the relevant organisations (e.g. IMF) and policies imposed on LDCs. He claims that with globalisation brought increased poverty, degraded environment, westernisation (diminishing cultures) and undermined democracy.

The governance of globalisation has contributed to some of the problems cited above. Some of the East Asian Tigers succeeded as they did not follow the instructions laid out by the IMF. In stark contrast, those who did follow the instructions performed worse. The East Asian countries liberalised gradually rather than quickly (as proposed by the IMF), had government managed policies and emphasised on state enterprises.

Stiglitz believes statistical analysis in support of globalisation is flawed since different countries have different and unique circumstances, thus, is impossible to test how one country would fare with different sets of policies.

The World Bank studies, for instance, which witnessed a positive relationship between trade openness and growth does not prove causality. Stiglitz suggests that LDCs may trade little precisely because they do not have the resources to do so but not the reverse.

Textbook vs. Reality

All the benefits associated with globalisation as implied by academics may not apply to the real world. Opening to trade creates winners and losers. Free trade and investment increase growth is based on the assumption that unregulated markets are competitive and well functioning. As we have learnt from typical market failures, the principle agent problem where the two agents’ incentives are not aligned can be problematic.

A worsening of Terms of Trade (price of exports relative to imports) has been prominent as a result of the CAP (Common Agricultural policy) in the EU and the similar scheme in the US.

The Uruguay Round has been lauded for its inclusion of the free trade of services. One may ask, ‘how does this assist LDCs in any way shape or form?’ It is a well known fact that LDCs have a comparative advantage in primary sector. In terms of services they only have an interest in maritime and construction services which are shut out.

The TRIPS (intellectual property aspect of GATT) that protects any innovations, grant pharmaceutical giants exclusive rights and a temporary monopoly power which in turn has slowed the pace of innovations as the know-how is kept out of reach. At the end, those who suffered are the poor in LDCs, especially aids battered Sub Saharan Africa. This raises the question of morality, ‘is it right to see the poor suffer from life threatening diseases while allowing the few giant pharmaceuticals lobby for ever more protection?’

Problems with capital & trade liberalisation

Conventional wisdom is that intervention is another word for inefficiency, thus, deregulating will improve everything. Sadly, the capital market is prone to all kinds of market failures if left entirely to laissez faire. The increased risk induced by, for example, short term speculation will have lenders demanding higher interest rates. There will come a point where rates are so high that funds are no longer allocated efficiently (or even firms resorting to self reliance) this will then translate to lower growth in the long run.

The pace of liberalisation need to be tailored to ensure employment as was illustrated by China and Korea who were aware of this importance and concentrated on industries that were labour intensive during early stage of development only this time it is to avoid unemployment from a hike in interest rates that arise from reasons mentioned above.

Effects on Politics

Politics also come into the picture as IMF advocated opening to short term speculative capital flows. This has granted wealthy foreigners the power over political elections. One example Stiglitz gave was that should foreign investors dislike a political candidate, they can withhold loans, causing a rise in interest rates, thus, creating a chance for a recession.

Effects on cultures (Westernisation)

The number of Starbucks found in, say, Beijing is frankly, unbelievable. Local businesses have been exposed to the competition of multinational giants. The bankruptcies that result have created hardship for some.

More importantly, the environments of certain tourist attractions have been adversely affected e.g. coral reeve diving. It can be said that some have become a victim of their own success where the level of tourism has become unsustainable and local and indigenous cultures are becoming increasingly diluted by those of the West.

Free market cannot be count on to preserve ethnic and cultural diversity. Darwinism prevailed a century ago with the concept that the fittest lives, thus, if Starbucks comes out on top, be it. However, in the modern Western world it is compassion that prevails. Stiglitz’s book ‘Globalisation and its Discontents’ outlines a manner in which globalisation should be paced to allow societies to adapt, after all it is the mixture of contrary cultures that instigates the tremendous events of human creativity and the pace ought to be tamed such that cultures do not fall victim to the process.

A weakened government

Globalisation, as it has been carried out has meant a loss of revenue for governments, thus a loss of both political and economic power. Under the WTO constant pressure has been exerted to decrease the level of tariffs. This may or may not be part of a bigger plan set by the industrialised countries, we will not pursue further in this paper.

With globalisation goes democracy?

The voting mechanism in the IMF is unjustified, it is not based on one-person-one-vote, nor one-country-one-vote. It was partly determined by the economy’s size 50 years ago. Therefore, China ought to have greater voting rights given its economic and political size. The USA, the founder of IMF remains the ‘boss’ and has a veto, in effect has the final rights in case of any disputes. Further evidence that the IMF is possibly the worst ambassador for democracy is that only finance ministers and central bank governors have a say.

The dispute settlement body of the WTO is a bad reflection of the US judicial system since the panel of experts place too much emphasis on trade only but not on health and safety or the environment which certainly have an effect on economics.

A loss of sovereignty can result from globalisation as new rules are set, often by the advanced economies, depriving LDCs with respect to the available economic tools to deal with a crisis Should a country request assistance from the international financial institutions there will be conditions, e.g. Structural Adjustment Programmes, imposed greatly restrict their economic freedom, not to mention the effectiveness of them (which has come under heavy criticism).

Unevenly distributed gains

East Asia is undoubtedly the winner of globalisation. Whereas with others, the ratio of population growth rate to rate of growth of living standard has increased, are worse off in real term. The same could be said of the race in reducing poverty where China and India stood out whose policies greatly contrasted to those suggested by the Washington Consensus. Take Mexico, for example, majority of the gains accrued to the wealthiest 30% of the country. It ise a de ja vu with the CAP scheme in the EU where the winners are the wealthy, exactly the lot that least needs help.

Bad prescriptions

In the 80s the US rectified the saving and loan crisis with heavy financial regulations, but simultaneously recommended financial deregulation to the LDCs. It is the same story with a dual mandate or a single focused solely on inflation, the US opted for the former while pushing for the latter to LDCs through the IMF. Stiglitz, who was part of the Clinton Administration says it criticised the Bush Administration on the grounds of trickle down economics, it (the Clinton Administration) braced international financial institutions which adopted exactly trickle down economics.

East Asia defied the prescriptions from the West and prospered.. Korea’s triumph cannot be used to promote globalisation since it did so with emphasis on exports, not the removal of trade barriers relentlessly pursued by the WTO. It did not, deregulate the capital nor the financial market at the time or pace suggested by the Washington Consensus.

India is the other which has been used by free trade advocates to support their view given its steady high growth in the past decade. However, it is worth pointing out three points that actually go against their loyalty in ‘free marketism’. First of all, India does not accurately fit the criteria of free market because of its still regulated capital account which has taken the credit for its ability in surviving financial crises. Second, it has been on its growth track long before any form of liberalisation, leaving much to argue how much of its unprecedented growth is and has been the result of globalisation. Lastly, in my opinion the truest, the silicone valley in Bangalore benefitted mostly from the free movement of labour, which in fact, is the exact opposite to the West’s stance. This has become truer than ever with the UK which is in discussion of raising the bar for immigration from a Bachelor’s degree to a Master’s amidst the current crisis in fear of competition for jobs.

Chile is another strong candidate for the club of ‘Washington consensus, you are wrong’. Despite being the one country that succeeded with the Washington consensus policies its president did admit how their policies differed to those of the Washington consensus’ in that, like India they still possess control over capital inflows, liberalised at a pace of their own, moreover, have left a number of copper mines centralised which are brining in much needed foreign reserves.

Conclusion

Stiglitz’s attack on globalisation is actually not on globalisation itself at all but at the way it has been implemented. Other than the complications mentioned above many failed globalisation attempts have been based on simplistic concepts of the economy, the IMF’s over reliance on sky-high interest rates in stabilising economies in Asia which led to a policy backfire, its capital market liberalisation created unnecessary volatility and over emphasis on exchange rate stability and repayment of creditors have all contributed to the failures of globalisation, thus, globalisation has fallen victim.

I believe trade openness is important, though, not the key strategy to economic development. I largely agree with Stiglitz’s view that globalisation is not to blame but how it has been implemented. With these problems addressed globalisation should serve a feasible path to greater economic development.

Possible improvements include disclosing IMF’s model assumptions allowing economists to reassess with alterations to the original model, an independent agency to assess the model and overtime shortcomings of models can be rectified. Africa needs to be heard, by increasing their effective voting power within the IMF. Conditionality is one area that needs to be addressed as they have been largely political and serve little purposes in amending an economy’s malfunctioning. Moreover, this greatly limits a country’s choice of economic policies.

IMF’s reluctance on swift bankruptcy was a contribution to the East Asian Crisis, otherwise capital flows would have been recommenced. Bankruptcy as opposed to bailout not only is a reflection of being proactive but lenders will also be more cautious as a result.

The global money supply needs to undergo some form of regulations as LDCs set aside reserves to insure against unforeseen external demands or to simply to convince lenders for a loan in the first place. Some of these reserves are in the form of US treasury bills whose interest rate moves inversely with their demand (price). The matter is worse if the reserves are held as gold which pays out no interest at all.

US is said to be living beyond its means as it is the biggest debtor in the world and has done so because it plays the role ‘deficit country of last resort’. However, with most debts denominated in dollars a loss of confidence in the US (as was reflected by China considering another reserve currency) a gigantic crisis could occur.

Hence, a global reserve currency, able to be exchanged to current major currencies should be considered by policy makers. This, in effect raises money supply, allowing LDCs live beyond their means, just as the US does.



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