EC336 Economic Development in a Global Perspective

1. EC336Economic Development in a Global Perspective Abhishek chakravarty 2013-14 Lecture 4

2. Export Promotion versus Import Substitution • Import substitution: looking inward but still paying outward • First-stage IS involves substituting domestic production for imported simple consumer goods using the protection of tariff barriers and import quotas. This aids development of “infant industry” via economies of scale and learning-by-doing. • Second-stage IS involves diversifying domestic production into more complex manufacturing goods using the same tariff and quota protection against imports. • The benefits of this strategy involve greater industrial diversification and the potential to compete in international markets as domestic prices get closer to world prices with declining costs of production.

3. Import Substitution and the Theory of Protection Top diagram: Before international trade equilibrium price and quantity are P1 and Q1. With international trade, there is an infinite international supply at P2 and the country is a price taker. Domestic production is Q2 at this price, and Q2Q3 is imported to meet the remaining domestic demand. Hence there is loss of domestic production and employment due to international competition. Bottom diagram: If the government imposes a tariff of t0, the price rises to Pt = P2(1 + t0). Domestic demand falls to Q5, and domestic production rises to Q4. The amount imported falls to Q4Q5 due to reduced demand and higher domestic production, and the government earns cdfe in tariff revenue.

4. Export Promotion versus Import Substitution • The import substitution (IS) industrialization strategy and results • Protected industries get inefficient and costly due to lack of competition. • Foreign firms often benefit more by locating behind tariff barriers. • Subsidization of imports of capital goods tilts pattern of industrialization towards capital-intensive production, and contributes to balance of payments (BOP) problems. • Overvalued exchange rates hurt exports • Does not stimulate self-reliant integrated industrialization, due to reliance on imported capital goods rather than backward linkages in domestic industry.

5. Export Promotion versus Import Substitution There can be a very large difference between the nominal tariff rate, which measures the increase in price due to the tariff as a percent of the free trade price, and the effective tariff rate, which measures how much value is added to the product domestically due to the tariff as a percent of the value added under free trade. The nominal tariff rate, t, is: Where p′ is the tariff-inclusive price and pis the free trade price The effective tariff rate, g, is: Where v′ is the value added per unit of output, inclusive of the tariff, and v is the value added per unit of output under free trade

6. Export Promotion versus Import Substitution • E.g. A country produces and sells cars at the world price of $10,000 without tariffs. The value added of labour is $2000, with remaining inputs adding value of $8000, with the price of non-labour inputs being equal to world prices (so they are freely importable). • If a nominal tariff rate of 10% is imposed, the price of the car goes up to $11,000 leaving the price of inputs and labour unchanged. So an extra $1000 of labour can be applied to production on top of the $2000 worth that is applied already. • Hence the effective rate of protection for the local assembly process is 50%, as an additional 50% of the previously needed local labour can be applied as a result of the 10% nominal tariff.

7. Export Promotion versus Import Substitution • Summarising the four basic arguments for tariff protection: • Source of revenue from tariffs for government. • Response to chronic BOP problems from too many imports. • Help foster industrial self-reliance and growth. • Greater control over economic growth and development process. • Several countries adopted an IS strategy in the 1950s and 60s: Chile, Peru, India, Argentina, Nigeria, Ethiopia, Ghana, Zambia, etc. • The infant industry protection strategy has not really worked for the majority of countries that have tried it. The East Asian countries are exceptions to this, having used it effectively to build up local industries and then combining IS with export-oriented policy effectively.

8. Export Promotion versus Import Substitution • Trade Optimists and Trade Pessimists: Summarizing the Traditional Debate • Trade pessimist arguments • Limited growth of world demand for primary exports • Secular deterioration in terms of trade for primary products • Specializing in comparative advantage inhibits industrialization, skills accumulation, and entrepreneurship • Rise of “new protectionism” in developed countries means WTO benefits are limited in practice for LDCs

9. Export Promotion versus Import Substitution • Trade optimist arguments - trade liberalization: • Promotes competition and efficiency • Generates pressure for product improvement • Accelerates overall growth • Attracts foreign capital and expertise, which are in scarce supply in most developing countries • Generates foreign exchange to use for food imports if agricultural sector lags behind or suffers natural catastrophes • Eliminates distortions caused by government interventions including corruption and rent-seeking activities • Promotes equal access to scarce resources, • Enables developing countries to take full advantage of reforms under the WTO

10. Export Promotion versus Import Substitution • Export-led industrialisation as government policy: • There are market failures in transfer of innovations, because individual firms import less than the social optimum of superior technologies if their competitors also benefit. This creates a role for government to promote such imports of technologies. • Coordination failures may make industrialisation problematic, so governments can design sector-wide policy to promote firm behaviour that benefits industrialisation. • There may be learning by doing (or “watching”) effects in manufacturing sectors that spill over into other sectors, as with foreign technologies learned from exporting. • Performance is rigorously tested when firms attempt to export and export targets more visible; so governments can focus on more manageable problems. • Hausmann, Hwang, and Rodrik: exporting a mix of goods more typical for higher-income countries predicts higher growth

11. South-South Trade and Economic Integration • Economic Integration: Theory and Practice • Integration encourages rational division of labor among a group of countries and increases market size by promoting free trade between participating members and protecting the integrated area from external competition. • It provides opportunities for a coordinated industrial strategy to exploit economies of scale by increasing the size of the market available to local producers beyond the domestic market. • Trade creation occurs as production shifts from high-cost to low-cost members, and trade barriers between them are lifted. • Trade diversion occurs as domestic industry is allowed to develop without competition from producers in non-member countries.

12. South-South Trade and Economic Integration • Regional trading blocs and the globalization of trade • NAFTA • MERCOSUR • SADC • ASEAN • It is still unclear whether trading blocs help or hinder economic growth. • Countries with a enough of a comparative advantage over their partners can benefit more from a trading bloc, leading to a divergence of incomes between member states. • Developing countries may not benefit as much as theorised from South-South cooperation: lack better technology to transfer to each other, means to pay higher prices, influence in global negotiations. Widening gaps between them also means diverging priorities and interests.

13. Trade Policies of Developed Countries • Rich-nation economic and commercial policies matter for developing countries • Tariff and non-tariff barriers to developing country exports • Adjustment assistance for displaced workers • General impact of economic policy • Despite 8 liberalization rounds over 50 years under GATT and then the WTO, trade barriers remain in place in agriculture; and, through various mechanisms, to a degree in other sectors • Doha Development Round of WTO talks begun in 2001 tilted the nominal focus to needs of developing world; but talks remained stalled through the end of 2010, a self-imposed deadline

14. Effective Tariff Faced by Income Groups, 1997-1998

15. DOHA Round of WTO Talks The declaration for the DOHA “Development” round stated explicitly that the agenda would be to achieve “substantial improvements in market access; reduction with a view of phasing out all forms of export subsidies; and substantial reductions in trade-distorting domestic support..” Developing countries were meant to be the main beneficiaries from this round, being promised “special and differential treatment” and “duty free, quota-free access” to foreign markets. Tariffs on agricultural products were addressed directly, as these products are seen as the main exports of developing countries. The average applied tariff on agricultural goods in the early 2000s was also twice that on industrial goods, at 17% versus 9%.

16. DOHA Round of WTO Talks • The tariff structure differs substantially between developed and developing countries, with developed countries having lower average tariffs but much higher peaks in individual rates. • The formula proposed in July 2004 proposed tiered cuts in tariffs to account for these differences in tariff structures, rejecting a formula proposed by the EU and United States that would have made average cuts but maintained relatively high peak rates on certain goods. • Subsidies to agriculture are the major bone of contention. These were classified into three different types in the 1995 Uruguay Round: • Clearly trade-distorting - Amber box • Potentially distorting, but intended to limit production – Blue box • Little or no distorting effects – Green box

17. DOHA Round of WTO Talks The July 2004 proposal advocates that all Amber and Blue box subsidies be reduced by 20% in the first year of implementation. It also calls for an end to all export subsidies, except those by least developed countries. Domestic subsidies to agriculture are to be reduced to a maximum capped level, with no current commitment to reducing green box subsidies. The impacts on developing countries of these agreements are varied. The tariff cuts will only affect a few countries like India and Pakistan, that have maintained high agricultural tariff rates. Least developed countries and most other developing countries will not have to change their tariffs.

18. DOHA Round of WTO Talks • However the tariff cuts will give Latin American and Asian developing countries much greater access to developed country markets relative to least developed and African countries that already get preferential access. • But is developed country policy really the main culprit in foreign trade relations? Panagariya presents six fallacies about this point of view. • Fallacy 1: Agricultural border protection and subsidies are largely a developed country phenomenon. • Tariff levels are much smaller in Europe, United States, than in Cairns group of countries (Argentina, Mexico, Colombia etc.) • The proportion of items entering duty free into the United States and Europe is much larger than in nearly all developing countries. • Subsidies are hard to compare without better data, but developing countries do subsidise agriculture.

19. DOHA Round of WTO Talks • Fallacy 1: (cont’d) • Import quotas are interpreted as restrictive, when they actually ensure a minimum level of exports from developing countries enter developed country markets instead of being priced out via prohibitive tariffs. • Fallacy 2: Developed country agricultural subsidies and protection hurt the poorest countries the most. • The argument is that these subsidies reduce world prices and also limit market access for the poorest countries, reducing both the quantity and value of their agricultural exports. • But some of the poorest countries are importers of agricultural goods, and therefore benefit from lower world prices arising from subsidies to agriculture. As many as 48 of 63 low income countries are net importers of food. • Also, least developed countries get duty-free and quota-free access to EU markets under the Everything But Arms initiative. Therefore they enjoy effectively the same protection as EU agricultural producers,

20. DOHA Round of WTO Talks • Fallacy 2: (cont’d) • It is also unlikely that net food importers will benefit from removal of agricultural subsidies in developed countries by exporting more of their own produce at higher prices. This is because the removal of the subsidies would also likely be accompanied by the removal of accompanying tariffs. • This would bring down the internal price of agricultural goods in the EU, which is kept artificially high using tariffs to benefit EU producers. the poorest countries with preferential access to these markets would face the same declining internal prices. • The politics within developed countries after the Doha round is already leading to non-tariff barriers such as Sanitary and Phytosanitary (SPS) measures. • Fallacy 3: Developed country subsidies and protection hurt poor, rural households in the poorest countries. • Again this does not hold if the poorest people in the poorest countries that are net importers of food are consuming the imported products at low subsidised prices.

21. DOHA Round of WTO Talks • Fallacy 3: (cont’d) • If developed country subsidies were actually hurting the poorest within the population, the natural solution would be to impose countervailing duties on the imports so that domestic producers benefit from protection and the government earns tariff revenue to redistribute to the poor. • But calling for a worldwide reduction in subsidies and protection rules out the above option, as the focus is on reducing them in developed countries rather than considering how they would affect developing countries. • Fallacy 4: Developed country protection and subsidies are the principal barriers to the development of many poor countries • Internal policy is much more important for development than developed country policy. • Fallacy 5: Agricultural protection reflects the double standard and hypocrisy of developed countries. • Developing countries themselves opted out of multilateral trade negotiations in the 1960s and 1970s, opting for import substitution policy.

22. DOHA Round of WTO Talks • Fallacy 5: (cont’d) • Also the agricultural political lobbies were able to effectively achieve protection for their domestic markets in developed countries without external pressure from developing countries that were pursuing import substitution industrialisation. • Fallacy 6: What donor countries give with one hand, they take away with the other • The true loss in export revenues from each dollar of subsidy given in developed countries is not one-to-one and must be computed. It is likely to be much less than what is given in aid. Also we have seen many developing countries actually benefit from being able to import food at lower prices.