EC336 Economic Development in a Global Perspective

ABHISHEK CHAKRAVARTY2015-16

LECTURE 4

EC336 Economic Development in a Global

Perspective

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.

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.

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.

Export Promotion versus Import Substitution

pppt

The nominal tariff rate, is:

Where p′ is the tariff-inclusive price and p is the free trade price

There can be a very large difference between:

• nominal tariff rate the increase in price due to the tariff as a percent of free trade price

• effective tariff rate how much value is added to the product domestically due to the tariff as a percent of the value added under free trade.

The effective tariff rate, is:v

vv

Where v′ is the value added per unit of output, inclusive of tariff, and v is the value added per unit of output under free trade

Export Promotion versus Import Substitution

• 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.

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 most countries that have tried it. The East Asian tigers are exceptions to this, having used it to build up local industries and then combining it with export-oriented policy effectively.

Export Promotion versus Import Substitution

Trade Optimists and 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

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

Export Promotion versus Import Substitution

Export-led industrialisation as government policy: There are market failures in transfer of innovations, because 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

East Asian Miracle

Ranis (1995) focuses on the experience of Taiwan and the Republic of Korea and argues that their success has to do with favourable initial conditions, the early stage of ISI, flexible labour markets, human capital policies, early macroeconomic stabilisation, and adequate government intervention.

Both Taiwan and Korea were part of the Japanese colonial network. They were relatively small countries with labour surpluses and poor natural resources in the 1950s.

However they had high literacy rates, and engaged in substantial redistribution of lands.

East Asian Miracle

Import substitution (1953-63): ISI in Taiwan and Korea were not discriminatory of the agricultural sector which in the 1950s was the leading sector in Taiwan. It provided savings, foreign exchange, labour, and other benefits.

In Taiwan, agricultural surpluses financed the development of non-agricultural activities and the formation of small and medium scale enterprises in rural areas, strengthening the links (backward and forward) between agricultural and non agricultural output.

In Korea, the increase in non-agricultural activities was mostly financed by a combination of industrial reinvestment and foreign capital.

East Asian Miracle

The Labour-Intensive Export Substitution (1963-73): In Taiwan, the rapid growth supported initially by agriculture, fuelled labour intensive industrial expansion and resulted in increasing employment and a favourable income distribution.

Both manufacturing output and employment increased substantially. Most reallocation of labour consisted of people not actually leaving rural households because of the expansion of rural industry and services.

The export sector in EACs earned foreign currency but and generated investment funds for diversifying the industrial sector. In Korea, the proceeds from this stage financed the stage of heavy industrialisation (1972-79) and the deepening of the export oriented drive.

East Asian Miracle

Export orientation from mid 1970s: In Taiwan and Korea, this stage has been characterised by: non reliance on agriculture which instead, has been subsidised.

The increasing shortage of labour has shifted the industrial output and export mix (from textiles and other light industries to electronics, science and technology intensive).

The government has been paying increased attention to infrastructure related to science and technology and promoting R&D.

The government accommodated the shifts in the output mix by guiding investment, regulating the banking sector, enhancing human capital, by considering institutional investment in science and technology as a priority public good; and providing directed credit to export-oriented industries.

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.

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.

Trade Policies of Developed Countries

Rich-nation 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

Effective Tariff Faced by Income Groups, 1997-1998

DOHA Round of WTO Talks

The declaration for the DOHA “Development” round stated explicitly that the agenda is 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%.

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 included tiered cuts in tariffs to account for these differences, rejecting a formula proposed by the EU and United States that would have made average cuts but maintained relatively high peak rates.

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

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.

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.

Negotiations have seen several collapses since 2001, highlighting the difficulties in coordinating policy between difference countries.

Paris, 2005: The US, Australia, the EU, Brazil and India - who managed to get the talks back on track in July 2004 after they had foundered, failed to agree chicken, beef and rice tariffs.

Hong Kong, 2005: Trade ministers representing most of the world's governments reached a deal that sets a deadline for eliminating subsidies of agricultural exports by 2013.

DOHA Round of WTO Talks

Geneva, 2006: The in Geneva failed to reach an agreement about reducing farming subsidies and lowering import taxes, and negotiations took months to resume.

Potsdam, 2007: Major disagreement between India, the US, the EU, and Brazil over reducing rich nation farm subsidies and opening of agricultural and industrial markets.

Geneva, 2008: U.S. Trade Representative announced that the U.S. would cap its farm subsidies at $15 billion a year from $18.2 billion in 2006. However, there were disagreements special protection for Chinese and Indian farmers and African and Caribbean banana imports to the EU.

DOHA Round of WTO Talks

At the 2011 annual conference of the World Economic Forum in Davos, David Cameron called for the Doha talks to conclude by the end of the year: "We've been at this Doha round for far too long. It's frankly ridiculous that it has taken 10 years to do this deal.“

In December 2013, negotiations finally yielded an agreement called the Bali Package at the Ninth Ministerial Conference held in Nusa Dua, Bali, Indonesia.

The trade facilitation measures agreed in Bali could cut the global cost of shipping goods around the world by an estimated 10%, raising global output by over $400 billion a year, with benefits flowing disproportionately to poorer countries. – The Economist, Dec 2013