CHAPTER 17©E.Wayne Nafziger Development Economics 1 Chapter 17 International Trade.

CHAPTER 17 ©E.Wayne Nafziger Development Economics1

Chapter 17

International Trade


International Trade Does Trade Cause Growth? Arguments for Trade: Comparative

Advantage. Arguments for Tariffs. Path Dependence of Comparative

Advantage. Arguments about Income Distribution,

Child Labor, & the Environment.


International Trade (Cont)

Terms of Trade. Import Substitution & Export Expansion

in Industry. Global Production Sharing & Borderless

Economies. DC Import Policies. Expanding Primary Export Earnings.



Agriculture Protection. Trade in Services. The Mankiw Debate. Intellectual Property Rights. Foreign Exchange Rates. Domestic Currency Overvaluation. Domestic Currency Devaluation.



The Real Exchange Rate (RER). Dual Exchange Rates. The Impossible Trinity: Exchange Rate

Stability, Free Capital Movement, & Monetary Autonomy.

Currency Crises. Managed Float Plus.


International Trade (concluded)

Regional Integration. The Euro & U.S. Dollar as Reserve

Currencies. Promotion & Protection of Infant

Entrepreneurship. Black Market & Illegal Transactions.


Does Trade Cause Growth? Is the high correlation between trade &

GDP per capita a result of income causing trade?

Frankel & Romer (1999) find that trade causes growth.

Winters (2004): productivity growth attributed to increased import competition, technological improvements embodied in imports, export expansion, and learning through trade.


Caveats In short run, LDCs’ trade liberalization in 1980s

& 1990s associated with reduced growth. Uncertain whether poorest in LDCs benefit

from trade. Lundberg & Squire (1999) find openness

negatively correlated with income growth among poorest 40% of LDCs’ population, but positively correlated with growth among higher-income groups.

Dollar & Kraay (2004) say poor grow as much as others.


Caveats Trade liberalization increases resource

allocation efficiency but hurts trade balance (Parikh) & can perpetuate budget crisis (Mosley et al.).

Conclusion: liberal trade is beneficial in long run if not undertaken abruptly but sequenced as part of comprehensive program of economic reform.


Arguments for Trade: Comparative Advantage

Welfare is greatest when each country exports products whose comparative costs are lower at home than abroad (steel in Japan and textiles in Pakistan) and imports goods whose comparative costs are lower abroad than at home (textiles in Japan and steel in Pakistan) (Table 17-1).


Arguments for Trade: Comparative Advantage


Elaborations of comparative advantage

Factor proportions theory: Heckscher-Ohlin – nation gains from trade by exporting the good whose production requires the intensive use of the country’s relatively abundant (& cheap) factor of production & importing the good whose production requires the intensive use of the relatively scarce factor.


Elaborations of comparative advantage

Multinational corporations (MNCs) invest in LDCs to take advantage of cheap labor or natural resources.

Technological advantage: comparative advantage based on technological advantage – new product or production process that gives country (such as US or Japan) temporary monopoly in world market until other countries can imitate.


Product cycle model (Vernon) DCs have comparative advantage in

nonstandardized goods, while LDCs (with abundant unskilled labor) have comparative advantage in standardized goods.

Illustration: cotton textiles shift from England (mid-18th to mid-19 centuries) to Japan (late 19th to early 20th centuries) to South Korea, Taiwan, China, Hong Kong, Singapore (1960s) & subsequently joined by Thailand (1980s) & eventually displaced by other competitors.

Automobiles & call center outsourcing may follow same pattern.


Other costs of trade barriers

Romer: trade barriers thwart new goods & productive activities from abroad.

Winters: trade restrictions & price distortions reward rent seeking, corruption, & predatory behavior; undermine greater competition.


Benefits of free trade More efficient resource allocation

(comparative advantage). Introduces new goods & productive

activities. Widens markets. Improves division of labor. Utilizes surplus productive capacity. Stimulates greater managerial effort.


Arguments for tariffs Increasing returns to scale. External economies. Technological borrowing. Intraindustry trade. Changes in factor endowment. Revenue. Improved employment & balance of

payments. Other arguments.


Path dependence Historically remote events influence

subsequent specialization. QWERTYUIOP: to reduce jamming from

typing & provide salespersons easy access to typewriter’s brand name.

QWERTYUIOP dominates computer keyboards.

Other examples of path dependence: Silicon Valley & Bangalore, India.


Special arguments for interfering with free trade

Income distribution: does skill-biased technological progress or trade hurt unskilled labor in DCs?

Debate on what causes increased skill premium.

Most economists attribute increased skill premium to skill-biased technical progress.

Moreover, free trade increases national income which can be used to redistribute income. But will the state redistribute?


Child labor 100 million children: 10% of world’s

children are working full time. 1 of 5 of primary aged children not

enrolled in school. Child labor, however, largely reflects

poverty of the children’s households. Countries more open to trade have lower

incidence of child labor (Neumayer & de Soysa).


Child labor

More child labor when poor credit markets & transitory income shocks.

In Mexico, subsidized mothers of children benefited more from grants than children working. Increased school attendance.

Chaudhuri (2003): sanctions against child-labor countries produce perverse effects.


Trade & environment LDC pollution havens do not distort

comparative advantage. In fact, free trade is generally good for

the environment. Trade openness raises world incomes

which reduce pollution concentrations (Antweiler, Copeland, & Taylor 2001).


Shifts in terms of trade

High export primary commodity concentration ratios among some primary product producers of Africa & Central America.

Greater volatility in export prices & earnings.


Commodity terms of trade (CTT) Price index of exports/price index of imports. Example: if export prices increase 10% &

import prices 21%, CTT drops 9%. 1.10/1.21=0.91. Prebisch & Singer argue that CTT in primary

product exports (LDCs) decline in long run. Inferred from inverse of rising terms of trade,

1876-80 to 1938 of Britain, a manufactures exporter & primary product importer.


Why did Prebisch & Singer think LDC terms of trade fell?

Engel’s Law: as income increases, proportion spent on manufactured goods rises & proportion spent on primary products falls, resulting in excess supply of primary products & excess demand for manufactured goods, contributing to increasing relative prices in manufactured goods.


Empirical data

Figure 17-1 shows declining trend for price of nonoil commodities relative to exports of manufactures, 1948 to 2001.


Other terms of trade measures Spraos: if extend Britain’s primary prices

between 1939 & 1973, questionable whether Prebisch-Singer is correct.

Export purchasing power (CTT X quantity index of exports) may have increased when CTT fell.

Single factoral terms of trade = CTT X output per combined factor inputs in export production.

Relevant is change in terms of trade


LDCs’ terms of trade

Kindleberger (1956) argues that LDCs, not primary product producers, are vulnerable to declining terms of trade because they cannot easily shift resources in accord with shifting patterns of comparative advantage (Table 17-2).


Import substitution & export expansion in industry

NBER (1978, 1981): export promotion generally more effective than highly protected import substitution in expanding output & employment.

Substituting domestic output for imports emphasizes good more likely to use much more capital per unit of labor, less efficient.


Export promotion preferable

Export promotion includes advantages: (1) international competition, encouraging quality

control, new products & techniques, & good management;

(2) cost economies from increased market size; (3) information provided by DC users improves

quality; (4) cost to society more visible than protection; & (5) efficient firms not limited by domestic demand

growth. Export promotion relies on pricing incentives, such as market exchange rates.


Mexico v. South Korea (1980s)

Mexico provided incentives for import substitutes & discouraged export development.

South Korea virtually no incentives for import substitution while heavily encouraging exports through capital subsidies, depreciation allowances, & import duty exemptions.


Mexico v. Korea (1980-1992) Mexico’s real annual growth: 1.6% in

industry & -0.2% overall. Korea’s real annual growth: 11.6% in

industry & 8.5% overall. Korea spurred by scale economies,

international competition, price flexibility, & no agricultural & foreign exchange shortages.


India v. East Asia India: import substitution

industrialization limited: “narrow domestic market, high costs & technological backwardness.”

East Asia: exports facilitated learning through economies of scale & increasing returns, while foreign markets source for knowledge acquisition (D’Costa 200).


Global Production Networks (GPNs) View of economists that LDCs exports primary

goods & importer manufactures outdated in last 2 decades (except for Africa & Central America).

Low-income countries’ (LICs’) manufacturing exports as percentage of total exports rose from about 20% in 1981 to almost 80% in 2001 & middle-income countries’ (MICs’) from 24% in 1981 to almost 70% in 2001.

Even without India & China, rise in manufactures substantial


Major explanations for LICs’ & MICs’ transformation

Reduced protection, especially in industries a part of global production networks (GPNs) (Table 17-3).

Many LDCs moved up value-added ladder.

LICs (low-income countries) expand exports of low technology exports.

MICs (middle-income countries) exports’ level of technology increased.


East & Southeast Asia, India (after 1991)

Rapid growth in international trade & FDI result of expanding GPNs.

Much from international trade & foreign investment shifting from production & exchange of final consumer goods to production & exchange of parts & components, making it difficult to identify nationality of many products.


Manufacturing value-added in large number of countries, including LDCs Figure 17-4 indicates proportion of countries’

value-added in producing a US automobile. Compare to Henry Ford’s Model T in 1921; or

1950 – all US autos produced within the country.

In 1998, US comprises only 37% of auto’s value-added.

Fig. 17-5 shows how cross-border networks capture increasing share of production & trade.


GPNs enable production to be broken into discrete stages

LDCs undertake activities requiring low skilled labor, low tech component of high-tech goods.

China & India have expanded range of products exported.

US comparative advantage in producing & exporting high-value added portion of production (innovative software, fully assembled product).

US companies reduce cost of information & communications technology (ICT) equipment by 10-30% by making equipment in factories around the world, increasing US growth by 0.3 percentage points yearly, 1995-2002.


Increased division of labor in GPNs

Japan sought export platforms abroad, sometimes not even majority ownership.

Malaysia & Thailand – advantage in labor intensive goods.

GPN participation is contributing to independent technological innovation in Asian LDCs, such as China, India, Malaysia, & Thailand.


DC import policies

World Trade Organization/General Agreements on Tariffs and Trade (WTO/GATT) administers rules of conduct in international trade.

WTO applies only to economies where market prices are the rule.

China joined in 2001. As of 2005, Russia was not a member.


DC import tariffs

DC manufacturing tariffs discourage the processing of natural-resource-based goods, especially hurting Africa.

The Uruguay Round (1986-94) tariff cuts reduced DC tariffs to an average of 5-6% of value, ranging from 15% in agriculture and 11% in textiles and clothing to 4% in industrial products.


Misleading rates: more protective than rates suggest

Tariff rates are higher on labor-intensive goods, in which LDCs have comparative advantage.

Effective rate of tariff usually higher than nominal rate for manufactured & processed goods.


Misleading rates Tokyo Round (1974-79) protection on LDC

goods according to processing state was: 3% on stage 1 (raw material, e.g., raw

cotton) 23% stage 2 (low-level processing, as

cotton yarn) 20% stage 3 (high-level processing, as

cotton fabrics) 15% stage 4 (finished product, e.g.,

clothing)


Misleading rates

54% of DC imports from LDCs are at stage 1; 29% at stage 2; 9% at stage 3; & 8% at stage 4.


Example Assume DC has no tariff on raw cotton imports

but a 5% tariff on cotton yarn imports. Assume raw cotton sells for $600 per ton and

cotton yarn for $700 a ton, with $100 value added by the cotton yarn industry.

5% nominal cotton yarn tariff ($35) is small fraction of total sales value but 35% effective tariff rate on $100 value added.

Overall post-Tokyo Round effective protection was 2% for raw materials, & 15-20% for processed & manufactured products.


Other trade restrictions

MFA (Multifiber Arrangement), “voluntary” export restraints, mostly by China beyond the 2005 phase out.

Other nontariff barriers (NTBs): trigger price arrangements, antidumping duties, industrial subsidies, and so forth.


Generalized system of tariff preferences (GSP)

DCs grant of duty- & quota-free access to eligible products.

US provides more liberal preferences for Caribbean Trade Preference for 24 countries; Andean Trade Preference for Bolivia, Colombia, Ecuador, & Peru to reduce drug production & trafficking; & African Growth & Opportunity Act – duty-free access for virtually all products, including apparel made in Africa from U.S. yarn & fabrics (World Bank).



European Union GSP available to all LDCs, including China in certain categories of goods.

Preferences for LDCs have not been reliable, frequently have been removed, and have diverted exports from LDCs denied access.

LLDC (least-developed countries’) preferences mean that developing countries with ¾ of world’s $1/day poor do not benefit.



Top 9 beneficiaries of U.S. preferences are Thailand, Indonesia, India, Philippines, Venezuela, South Africa, Russia, Turkey, & Chile, mostly middle-income countries.

Cline (2004) calls for DCs to provide “immediate free entry for imports from ‘high risk’ low-income countries,” the best way to reduce LDC poverty.


Expanding primary export earnings

Staple theory of growth: Canada’s expansion of wheat production spurred growth in the 19th-century.


Expanding primary export earnings

Reduced agriculture protection: Burfisher et al. (2003) indicate that eliminating global agriculture policy distortions (tariffs & subsidies) would mean annual world static welfare gain of 0.2% of global GDP.

1999-2001: protection by U.S. 29.6%, EU 56.0%, & 152.9% for Japan.


Effect of OECD subsidies Increasing OECD support to sugar resulted in

world price below production costs of some of the most efficient LDC sugar subsidies (Figure 17-8a).

Small (2004): full liberalization would increase GDP per capita in seven West African cotton dependent countries by 14%.

However, African-Caribbean-Pacific low-income economies receiving EU preference would be hurt at expense of other LDCs (sugar & cotton).


Trade in services U.S. comparative advantage in services

& financial assets. During Uruguay (1986-94) & Doha

(2002-) Rounds, U.S. led in efforts to liberalize trade among services.

Trade in services is 25% ($1.2 trillion) of 1999 total world trade.


Trade in services By 2015, $6 trillion additional income in

LDCs from liberalization in services. Management consulting, legal,

accounting, engineering, advertising, insurance, health, educational, transport, trade, tourism services, & software.

Many LDCs fear dismantling of public services, although WTO members can determine which activities are open to foreign providers.


Trade in services

China, India, & the Philippines would benefit from increased trade.

As communication costs fall, U.S. & other DCs are increasingly outsourcing skilled services.


The Mankiw debate

In the 2004 Economic Report of the President, the Council of Economic Advisors, whose chair was Gregory Mankiw, wrote:

“One facet of increased services trade is the increased use of offshore outsourcing in which a company relocates labor-intensive service industry functions to another country . . . When a good or service is produced more cheaply abroad, it makes more sense to import it than to provide domestically.”


The controversy This is an application of the theory of

comparative advantage. However, amid the 2004 election, with

Democratic challengers focused on job insecurity and inadequate health insurance, this comment immediately sparked a public debate.

Politicians of both parties condemned Mankiw’s statement while most prominent economists supported Mankiw.


Intellectual property rights (IPR) The U.S., as leader in patents, trademarks, &

copyrights, forms of IPR, is vulnerable to losses from unprotected rights & piracy.

WTO provides 10-20 years of protection to many forms of IPR.

Bhagwati (2002) is critical of lengthy patent protection, blaming pharmeceutical companies & U.S. government for pressure on WTO & LDCs.

Bhagwati: WTO should concentrate on trade liberalization & not collecting royalties.


Intellectual property rights (IPR)

LDCs’ royalty, licensing, and administrative costs have increased.

Ghosh (1993) complains that LDCs need to increase their payments of patents for life-saving drugs.


Foreign exchange rates

The present system is a managed floating exchange rate system.

Hybrid of single floats of major currencies, independent float, pegged currencies, & crawling peg.


Domestic currency overvaluation Figure 7-9 shows Nigerian naira (N) price of

foreign (U.S. $) exchange, for example N150=$1.

In a free market, this exchange rate is determined by the intersection of demand & supply curves.

If the Central Bank of Nigeria uses exchange controls to limit its citizens’ purchase of U.S. dollars for equipment, materials, consumer goods, and travel, demand is repressed from D1 to D2, changing foreign exchange rate from N150=$1 to N75=$1.


Overvaluing N (naira) or other local currencies

Discourages import substitutes (making imports cheap) and exports (making exports less lucrative).

Most LDCs’ prices of foreign exchange are lower than market rates (N75=$1 is lower than N150=$1), meaning that they are biased against exports, a mistake that Meiji Japan (1868-1912) and South Korea (last half of 20th century) did not make.

Both countries had rapid growth during these periods.


Domestic currency devaluation

Usually preferable to surcharges, compensating duties, exchange controls, licenses, or quotas.

Devaluation rations imports through the market, encourages import substitution, & promotes exports.


The Impossible Trinity

Attaining goals of exchange rate stability, free capital movement, & monetary autonomy is impossible, according to Reisen (1991).

12 European Union members had to sacrifice monetary autonomy for a common currency (euro) and free capital movement.


Eurozone & CFA poor record In 2005, European Central Bank Vice-

President Papademost expressed concern about macroeconomic underperformance of eurozone members relative to non-euro OECD members.

Francophone West African countries (CFA) forewent growth by maintaining fixed currencies from 1948 to 1994 (UN 1994).


Currency crises

Before Asian 1997-98, Russia’s 1998, Mexican 1994, & Argentine 2001-02 crises, the countries had overvalued currencies.

Argentina’s currency board was too rigid to increase its competitiveness in the late 1990s, 2001-03.


Stiglitz (2002) faults the U.S. & IMF for the Argentine crisis

In the early 1990s, the IMF gave Argentina an “A” grade when it balanced the budget & kept inflation under control, despite high unemployment.

U.S. failed to provide trade credits to Argentina as it did to Mexico in 1995, or as Japan did to East Asian LDCs during their crises.


Regional Integration Some LDC leaders, reacting to DC

protectionism, few scale economies, & declining terms of trade, have advocated economic integration.

Economic integration: a grouping of nations that reduces or abolishes barriers to trade & resource movements among member countries.

Integration ranges along a continuum from its loosest form (preferential trade arrangement) to the most advanced integration (complete economic & monetary union, such as the United States in 1789).


Regional economic continuum

Preferential trade arrangement: lower tariff & other trade barriers among member countries than nonmembers. [1982-95: Preferential Trade Area for Eastern & Southern Africa States (PTA)].


Regional economic continuum Free trade area (FTA): North American

Free Trade Agreement (U.S., Mexico, & Canada, signed 1993).

Free trade of goods & most services & free capital movement in most sectors but not free labor migration.

FTAs need rules of origin to ensure that a majority of the value-added originates in member countries.


Customs union

Goes beyond free trade area to retain common trade barriers against the rest of the world.

Mercosur (Brazil, Uruguay, Argentina, & Paraguay) provides for progressive tariff reduction & free movement of people.


Common market

Goes beyond customs union to allowing free labor & capital movement among member states.

Despite the name, European Union has only attained this.


Economic union

Unifies members’ monetary & fiscal policies (EU has not achieved this yet).


Complete economic & monetary union

13 states of United States in 1789.


African Economic Community (AEC) AEC (in operation since 1991) seeks to create

African Common Market (ACM) in six stages, using the nine existing regional trade organizations (RTOs) as building blocs.

Daniel Bach, ed., Regionalisation in Africa (1999): African RTOs (including ACM) exist only on paper.

Borders not costly impediments to movements of goods & resources in Africa, as there is a large volume of unrecorded trade, including drugs & mineral smuggling, even in failed states.


Many LDC attempts at economic integration not successful

East African Cooperation (EAC) broke up in 1996, as Uganda & Tanzania accused Nairobi & other cities in Kenya as receiving overwhelming amount of new industrial investment.

Market size of many unions is too small to attract industries that require substantial internal economies of scale.

Still we can expect increasing efforts at South-South integration & trade.


LDC efforts at regional economic integration with DCs

All 15 EU members before 2004 plus Slovenia were high income countries.

Poland, Czech Republic, Hungary, Slovakia, Estonia, Latvia, Lithuania, Malta, & Cyprus (EU’s 10 acceding countries) are middle-income countries.

10 acceding countries benefit from continuing structural reforms, specialization & scale economies from integration into world’s largest market (455 million in 2004), free movement of labor after 2011, & attraction of capital flows because of lower labor & other input costs.


WTO/GATT allows RTOs

Regional trade organizations (RTOs) can remove barriers among members (in no more than 10 years after formation) if they don’t raise trade barriers against nonmembers.


RTOs’ trade diversion & creation

Trade diversion – reduces world welfare: a member country displaces imports from a lowest-cost third country (NAFTA diverts U.S. sourcing from lower-cost Korea, Taiwan, & Asia to Mexico).

Trade creation – increases world welfare: beneficiary country’s firms displace inefficient domestic producers in a member country (NAFTA increases Mexico’s exports of electronic products & ladies’ dresses to the U.S.).


RTOs & world welfare Grossman & Helpman (1994) argue that political

pressure to form RTOs are greater when members’ firms gain more from trade diversion than they lose from trade creation, thus reducing world welfare.

Frankel (1997): RTOs more likely to spur net trade creations when number of RTOs in world is low; transport costs between world regions are high; transport costs within RTO are low; preference for RTO goods is low; & asymmetries among member states (in GDP & number of member nations) are low; & elasticity of substitution between domestic & foreign goods is high.


Economists’ opposition to FTAA

Free Trade Area of the Americas (FTAA) opposed.

Not so much because of net trade diversion.

Hufbauer & Schott (1994) oppose the United States negotiating NAFTA’s expansion country by country.


Economists’ opposition to FTAA

Movement of resources back & forth in FTAA as RTOs continually change composition of their membership.

When the U.S. & other countries pursue a “blight” of bilateral & multilateral agreements, the trading system resembles a “spaghetti bowl” (Bhagwati 2002) (Figure 17-11).


Euro & U.S. Dollar as LDC Reserve Currencies

Dollar-dominated world monetary system replaced by 2 ½ - polar system: dollar, euro, & yen.

By 2010: euro reserves are expected to be one-half of what dollar reserves are (Polack 1998).


Promotion & protection of infant entrepreneurship

Dynamic gains from learning management & technology by doing (from being open to international trade) are substantial.

Technological borrowing can proceed from imported product to a copy, with slow improvement, to finer grades & specialties.

Experience, improved endowment of human & physical capital, & shift in comparative advantage can promote infant entrepreneurship.

Meiji Japan; post-1970 Asian Tigers; & contemporary Chile.


Black markets & illegal transactions

Black markets for foreign exchange form in response to restrictions on trade & controls on currency transactions (Figure 17-9 above).

Mid-1983: black market premium 30% in Nigeria, 27% in Pakistan, 26% in Mexico.

Illegal & black-market transactions important components of international trade in 1990: 186% of legal export earnings in Columbia, 184% in Bolivia, 121% in Mexico, & 39% in Pakistan.

CHAPTER 17©E.Wayne Nafziger Development Economics 1 Chapter 17 International Trade.

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Transcript of CHAPTER 17©E.Wayne Nafziger Development Economics 1 Chapter 17 International Trade.