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Masarykova univerzitaEkonomicko-správní fakulta
Studijní obor: Hospodářská politika a mezinárodní vztahy
DOPAD LIBERALIZACE MEZINÁRODNÍHO OBCHODU NA ROZVOJ ROZVOJOVÝCH ZEMÍ – PŘÍPADOVÁ
STUDIE BRAZÍLIE A INDONÉSIE
Impact of Liberalization of International Trade on Development of Developing Countries – Case study of Brazil and Indonesia
Diplomová práce
Vedoucí práce: Autor:Mgr. et Mgr. Oldřich KRPEC, Ph.D. Mgr. Michal ŽIŽLAVSKÝ, M.Sc.
PRAHA, 2014
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Jméno a př í jmení autora : Mgr. Michal Žižlavský, M.Sc.
Název diplomové práce: Dopad liberalizace mezinárodního obchodu na rozvoj rozvojových zemí – případová studie Brazílie a Indonésie
Název práce v angl ičt ině: Impact of Liberalization of International Trade on Development of Developing Countries – Case study of Brazil and Indonesia
Katedra : Ekonomie
Vedoucí diplomové práce: Mgr. et Mgr. Oldřich Krpec, Ph.D.
Rok obhajoby: 2014
AnotacePředmětem diplomové práce „Dopad liberalizace mezinárodního obchodu na rozvoj rozvojových zemí – případová studie Brazílie a Indonésie“ je rozbor dopadů liberalizace mezinárodního obchodu v Brazílii a Indonésii na jejich následný ekonomický rozvoj. První část práce je zaměřena na představení základních konceptů teorie mezinárodního obchodu včetně jejich demonstrace na vybraných ekonomických a politicko-ekonomických modelech. Druhá část se soustředí na proces liberalizace obchodu v Brazílii a Indonésii. Třetí část představuje použitou metodologii, včetně ekonometrického ARDL modelu. Čtvrtá část poté analyzuje dopad liberalizačních reforem na následný rozvoj obou zemí.
AnnotationThe aim of the submitted thesis “Impact of Liberalization of International Trade on Development of Developing Countries – Case study of Brazil and Indonesia” is analyzing the impact of international trade liberalization in Brazil and Indonesia on their subsequent economic development. The first part of the thesis introduces the fundamental concepts of the international trade theory and demonstrates them on selected economic and political-economic models. The second part focuses on the process of trade liberalization in Brazil and Indonesia. The third part introduces the selected methodology, including the econometric ARDL model. The fourth part analyses the impact of the trade liberalization reforms on the following development of both countries.
Klíčová slovaBrazílie, Indonésie, mezinárodní obchod, liberalizace, ekonomický rozvoj, rozvojové země, ARDL model
KeywordsBrazil, Indonesia, international trade, liberalization, economic development, developing countries, ARDL model
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Prohlášení
Prohlašuji, že jsem diplomovou práci Dopad liberalizace mezinárodního obchodu na rozvoj rozvojových zemí – případová studie Brazílie a Indonésie vypracoval samostatně pod vedením Mgr. et Mgr. Oldřicha Krpce, Ph.D. a uvedl v ní všechny použité literární a jiné odborné zdroje v souladu s právními předpisy, vnitřními předpisy Masarykovy univerzity a vnitřními akty řízení Masarykovy univerzity a Ekonomicko-správní fakulty MU.
Michal Žižlavský
V Praze dne 16. května 2014
Poděkování2
Předkládaná práce vznikala zhruba mezi listopadem 2011 a květnem 2014, tedy v horizontu nějakých 3 let. Během této doby se objevila řada událostí, faktorů a především osob, které měly na její výslednou podobu zásadní vliv. Chtěl bych proto vyjádřit své poděkování aspoň některým z nich.
Ze všeho nejdříve bych chtěl poděkovat doktoru Oldřichu Krpcovi za jeho odborné vedení a trpělivost a doktoru Danielu Němcovi za jeho nedocenitelné konzultace ekonometrické části práce.
Dále chci poděkovat svojí rodině, přátelům a blízkým za jejich morální i materiální podporu. Speciálně pak mojí mamince a stařence, Tomášovi, Orovi, Floor, Raphaelovi, Raluce, Lence, Fotini, Adile a Haně za udržování mě při psychické způsobilosti k tomu, abych práci dokončil.
Zvláštní dík potom směřuje k Samantě, za všechny hodiny, které proseděla po mém boku, když tato práce vznikala a za všechnu motivaci, kterou mi dala k tomu, abych šel v životě za tím, na čem mi opravdu záleží.
V neposlední řadě pak chci poděkovat samotné této práci za to, že mi umožnila se seznámit s Vaniou a proniknout tak hlouběji do realit a krás Indonésie.
Michal Žižlavský
V Praze 15. května 2014, 05:19 hodin
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CONTENT
Introduction............................................................................................................................................6
1. Theory of international trade and economic development.............................................................9
1.1. Basic theory of international trade...............................................................................................91.1.1. Classical political economy and the theory of comparative advantage..................................91.1.2. The Heckscher-Ohlin model.................................................................................................131.1.3. Sources of comparative advantage.......................................................................................151.1.4. Gains from trade liberalization.............................................................................................171.1.5. Loses from trade liberalization.............................................................................................201.1.6. The Immiserizing growth and the Singer-Prebisch thesis....................................................221.1.7. The Strategic Trade Theory - from comparative to competitive advantage.........................26
1.2. Protectionism..............................................................................................................................281.2.1. Instruments of protectionist trade policy..............................................................................28
1.2.1.1. Tariffs............................................................................................................................281.2.1.2. Quotas............................................................................................................................291.2.1.3. Voluntary export restraint..............................................................................................311.2.1.4. Export subsidies.............................................................................................................311.2.1.5. Other trade policy instruments......................................................................................32
1.2.2. Arguments for protectionist policies....................................................................................321.2.2.1. Protection of employment.............................................................................................331.2.2.2. Terms of trade and the optimum tariff...........................................................................341.2.2.3. Infant and senile industries............................................................................................351.2.2.4. Government revenues and income redistribution..........................................................37
1.3. International trade liberalization................................................................................................381.3.1. The determinants of trade liberalization...............................................................................38
1.3.1.1. Circumstances and crises...............................................................................................391.3.1.2. Interests..........................................................................................................................391.3.1.3. Ideas...............................................................................................................................401.3.1.4. Institutions.....................................................................................................................401.3.1.5. Factor endowments........................................................................................................41
1.3.2. Types of trade liberalization.................................................................................................411.3.2.1. Unilateral liberalization.................................................................................................421.3.2.2. Multilateral liberalization..............................................................................................431.3.2.3. Bilateral and Regional Liberalization............................................................................44
1.4. Political economic models of protection and liberalization.......................................................441.4.1. The Grossman–Helpman Political Contributions Model.....................................................451.4.2. The Xu’s Infant-industry Model...........................................................................................481.4.3. The Xu’s Trade Protection and Trade Talks Model.............................................................53
1.5. Developing countries, economic growth and development.........................................................571.5.1. Developing countries............................................................................................................571.5.2. Economic growth and economic development.....................................................................58
2. Trade liberalization in Brazil and Indonesia.................................................................................60
2.1. Trade liberalization in Brazil......................................................................................................602.2.2. Simple profile of Brazil........................................................................................................60
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2.2.2. Brazil before the trade liberalization....................................................................................602.1.2. Trade liberalization in Brazil and the post-liberalization years............................................61
2.2. Trade liberalization in Indonesia................................................................................................632.2.1. Simple profile of Indonesia..................................................................................................632.2.2. Indonesia before the trade liberalization..............................................................................632.2.3. Trade liberalization in Indonesia and the post-liberalization years......................................64
2.3. Comparison of Brazil’s and Indonesia’s degree of trade openness............................................65
3. The impact of trade liberalization – Selection of methodology....................................................68
3.1. The research method...................................................................................................................68
3.2. Variables.....................................................................................................................................693.2.1. The openness to trade variable.............................................................................................69
3.2.1.1. Trade ratios....................................................................................................................703.2.1.2. Adjusted trade flows......................................................................................................713.2.1.3. Price-based measures.....................................................................................................713.2.1.4. Tariff measures..............................................................................................................723.2.1.5. Non-tariff barrier measures...........................................................................................723.2.1.6. Composite indices..........................................................................................................73
3.2.2. The economic development variables..................................................................................73
3.3. Data.............................................................................................................................................75
3.4. The final method and hypotheses................................................................................................75
4. The impact of trade liberalization in Brazil and Indonesia on their economic development – Analytical assessment...........................................................................................................................79
4.1. The impact of trade liberalization on Brazil...............................................................................794.1.1. Impact on the standard of living in Brazil............................................................................794.1.2. Impact on the character of production capacities in Brazil..................................................804.1.3. Impact on the structure of Brazil’s exports..........................................................................814.1.4. Impact on the structure of Brazil’s export destinations........................................................86
4.2. The impact of trade liberalization on Indonesia.........................................................................894.2.1. Impact on the standard of living in Indonesia......................................................................894.2.2. Impact on the character of production capacities in Indonesia............................................904.2.3. Impact on the structure of Indonesia’s exports.....................................................................924.2.4. Impact on the structure of Indonesia’s export destinations..................................................96
Conclusion.............................................................................................................................................99
References............................................................................................................................................103
List of figures......................................................................................................................................108
List of tables........................................................................................................................................108
List of abbreviations...........................................................................................................................109
List of attachments.............................................................................................................................110
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INTRODUCTION “We are subjected to the intolerable competition of a foreign rival whose superior facilities
for producing light enable him to flood the French market at so low a price as to take away
all our customers the moment he appears, suddenly reducing an important branch of French
industry to stagnation. The rival is the sun. We request a law to shut up all windows, dormers,
skylights, openings, holes, chinks, and fissures through which the sun penetrates... Signed:
The Candlemakers”
Frederic Bastiat, 1854
“The causes which, determines the economic progress of nations belong to the studies of
international trade.”
Alfred Marshall, 1890
“The benefit of foreign commerce – a more efficient employment of the productive forces of
the world.”
John Stuart Mill, 1848
Over two last decades, the world has become a much smaller place and the volume of
international trade has grown twice as fast as the worldwide income during this period.
However, the benefits from trade do not seem to be distributed equally. While some countries,
as the countries of the ”West”, or the so called “newly industrial economies”, managed to
successfully build their wealth on plugging themselves into the world trade, for others, as for
example the countries of the African continent, free trade and its embodiment – the set of
liberal trade policies widely known as the “Washington consensus”, became the hated symbol
of misery and unfulfilled hopes. What is the real impact of opening itself to free trade for a
country? Should it trust to the magical principle of comparative advantage or rather pursue a
strategically chosen set of industrial and trade policies? After hundreds of economic studies, it
seems that economists were still not able to find a clear answer.
The main ambition of this thesis is contributing to the already rich bulk of studies
seeking to find the connection between free trade and growth by extending the analyses of the
trade liberalization impact beyond the traditional growth indicators to much wider concept of
economic development. We reflect the often neglected fact that development does not simply
equal the marginal growth in the gross domestic product per capita indicator, but it is
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accompanied by deeper changes in economic and social structure and the overall output
distribution.
The aim of the thesis is thus examining the impact of trade liberalization on
development of developing countries. In order to reach this goal, we chose the example of
Brazil and Indonesia throughout the period of 1970-2010. The case countries were selected as
representatives of South America and South East Asia – the two most dynamically developing
regions of nowadays, however well known for their different historical paths towards
development. Moreover, both countries dispose of very similar size and population, being the
5th, respectively the 4th largest and most populated countries in the world. Last but not least,
both countries are expected to be rising global economic and political superpowers in the
horizon of upcoming decades. This status is already being recognized by general public, as
they are both being mentioned as the part of the so called BRIICS, which is an acronym
standing for Brazil, Russia, India, Indonesia and South Africa aka the rapidly developing new
economic leaders, soon challenging the global economic and political positions of the old
superpowers gathered in G7. The time horizon was then chosen to provide sufficient time
period for comparing the development of the countries prior and post the trade liberalization.
Therefore, the main research question of the thesis is:
“What was the impact of trade liberalization on economic development in
Brazil/Indonesia?”
As we have previously defined economic development as wider concept than just
simple economic growth, we will further focus on the impact of trade liberalization of 4
particular aspects of economic development. These will be 1) the standard of living, 2) the
character of domestic production capacities, 3) the structure of the country’s exports and 4)
the structure of the country’s exports destinations.
The first choice method of the thesis is statistical regression analyses. However, as we
do not dispose with reliable long enough time series for all the indicators of our interest, we
will combine the regression method with simple visual observations of data after projecting
them on graphics. When it comes to the regression analyses itself, we do not use a fully
specified model of growth with all the major variables affecting development, but we rather
follow Serkar (2007) and estimate the gross relationship between trade share and other
development variables by relating their present values with their past values and the present
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and past values of trade shares under the Autoregressive Distributed Lag (ARDL) approach to
cointegration. The chosen ARDL approach frees our study of the long-term relationship
between trade openness and development from the clutches of pre-testing the stationarity
property of the variables.
The rest of the thesis is structured as follows: Chapter 1 offers brief introduction into
the theory of international trade. Its aim is not providing an exhaustive list of all relevant
theoretical schools, but rather introducing the most important relevant concepts influencing
the actual consequences of plugging in into international trade towards developing countries.
In order to better explain the mechanics and logic of these concepts, we use a variety of
economic and political economic models. Chapter 2 introduces the case countries and briefly
maps the process of trade liberalization in their unique economic setting. Chapter 3 serves to
select the proper methodology. It specifies 8 hypotheses rooted in the theoretical part of the
thesis and the methods which are later used to examine them. Chapter 4 contains analysis of
the countries data using the selected methods. Conclusion sums up the previous chapters and
concludes.
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1. THEORY OF INTERNATIONAL TRADE AND ECONOMIC DEVELOPMENT
1.1. Basic theory of international trade Since 1950, we have witnessed a massive expansion in the growth of the world trade
relative to the world output. At the same time, when the world output, as recorded by Gross
Domestic Product (GDP), expanded fivefold, the volume of the world trade has grown even
16 times at an average yearly growth rate of 7 percent (in some countries even 10 percent).
Trade performance has notably increased especially in countries with liberal trade regimes
and these countries have also experienced the fastest growth of GDP (Thirlwall 2000, 5). But
what are the reasons for this historically unusual upsurge of international trade exchange,
what economic factors motivate members of different nations to trade between each other in
the first place, and why and how is the international trade beneficial for us? In this
introductory chapter, we are going to present a quick overview of some basic theoretical
concepts that should provide us answers to these questions and enable us to better understand
the logic of today’s system of international trade, later in the analytical part of the thesis.
1.1.1. Classical political economy and the theory of comparative advantage
Although it has been already more than 230 years since the father of economics Adam
Smith introduced his famous book An Inquiry into the Nature and Causes of the Wealth of
Nations (1776), his and his successor’s David Ricardo’s thoughts still remain the fundaments
of the international trade theory. The main contribution of Smith’s doctrine was his frontal
attack on then principal mercantilist approach to international trade exchange, which
presented international trade solely as a zero sum game. Smith, with his concepts of natural
liberty, international specialization, labour division and widening markets (Holman 2001, 44-
61) systematically deconstructed this approach and turned international trade once for all into
one of the principal tools to enhance growth and improve the welfare of society as a whole.
Labour, according to Smith, is a source of welfare. The main source of welfare
growth, however, is the social division of labour – the division of labour between individual
producers specialized in production of some specific kind of goods and interconnected by
exchange of these goods on a market. The production efficiency of each of us is different in
each activity. If producers specialize only in the kind of goods in whose production they are
the most efficient, they are able to produce the goods in greater amounts and better quality in 9
comparison to others. If these producers latter exchange these goods between each other
through market mechanism, the welfare of all of them rises. The limits of labour division are
thus given only by the size of the market. Large markets enable deepening of the labour
division, because they encourage the producers to improve their productive powers, as they
assure them that their investment will return through expanded demand. This is the reason,
according to Smith, why those nations, who eliminated various regional trade barriers and
succeeded to create integrated large national markets, experienced notable increase in their
national welfare (Holman 2001, 49-50).
From this point, we are only one step to the international trade. Elimination of trade
barriers among different states will create one large world market and therefore conditions for
international division of labour and welfare growth of all nations that decide to integrate into
such market (Holman 2001, 49-50). Creation of a common world market allows the domestic
producers to carry the surplus part of their production, for which there is no demand on the
domestic market, to foreign markets, and bring back in return something else for what there is
a demand (Thirlwall 2000, 5). By realizing these arguments, we arrive to sufficient
justification for existence of international trade by turning it from “the zero sum” to “the non-
zero sum” game.
However, while talking about integration into common world market, Adam Smith
still considered only the concept of the absolute advantage, which means that certain country
is able to produce a good more efficiently that it is possible anywhere else in the world
(Husted, Melvin 2004, 58). It was only his successor David Ricardo, who, 41 years later,
proved with his concept of the comparative advantage that international trade can be
beneficial for literally everyone, even if he does not dispose of absolute advantage in
production of any good.
To demonstrate how this concept works, let’s assume a model situation with two
countries - A and B. What if A has absolute advantage against B in all goods it produces and
B in none against A? Ricardo’s answer to this question would be the following – countries
should specialize where they have their greatest absolute advantage (if they have absolute
advantage in all goods) or in their least absolute disadvantage (if they do not have absolute
advantage in any of the goods) (Husted, Melvin 2004, 60).
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Following the described logic, if we take the model situation with countries A and B,
exchange of goods among these countries will gradually lead to their specialization in
producing such good, in whose production they possess a comparative advantage related to
the other country. Let’s assume that there are only two kinds of goods - bicycles and
computers, and only one factor of production – units of labour measured per hour. The
numbers in the table 1 indicate the number of labour time required to produce one unit of
either bicycles or computers in a particular country. As we can notice, country A has the
absolute advantages in production of both goods. However, the strength of these absolute
advantages is not identical for the two industries. In particular, country A is 4 times more
efficient in production of bicycles (compare 6 to 24) relative to country B, but only 1.5 times
more efficient in production of computers (compare 12 to 18). Because A’s greatest absolute
advantage is in the production of bicycles, we can say that it has a comparative advantage in
bicycles. Similarly, because B’s least absolute disadvantage is in the production of computers,
we can say that it has comparative advantage in computers (Husted, Melvin 2004, 56-62). In
other words, we can also say that country A is relatively more efficient in production of
bicycles and country B is relatively more efficient in production of computers.
Table 1: Comparative advantage
Country A Country B
Bicycles 6 24
Computers 12 18
Source: Husted, Melvin 2004, 61
According to the logic of the comparative advantage, once countries open up to trade
between each other, they start to specialize in the production of their comparative advantage
good. That will directly result in a situation, when the productive factor(s), in this case labour,
start to move from the sector which is less efficient to the one which is more efficient, and the
more efficient comparative advantage sector will expand its output on expense of the less
efficient one. Let’s consider country A and suppose that output of computers in this country
falls by 1 unit. That frees up 12 hours of labour time and this labour can be employed in the
bicycle industry. The result of such transfer will be expansion in production of bicycles by 2
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units. If output of bicycles falls by 1 unit in country B, it will free up 24 hours of labour,
which, if employed in the computer industry, will increase the output of computers in the
country by 1.5 units. As demonstrated in the table 2, the result is remarkable. Even though
there are no new resources in the world and country A has absolute advantage in both goods,
the output of both of them rises by following the principle of comparative advantage (Husted,
Melvin 2004, 61).
Table 2: Per unit gains from specialization according to comparative advantage
Production of bicycles Production of computers
Country A + 2 - 1
Country B - 1 + 1.5
World as whole + 1 + 0.5
Source: Husted, Melvin 2004, 61
Let’s now assume that both countries A and B are endowed by 36 000 work hours per
year. In such conditions, what would be the maximum amount of bicycles or computers that
could be produced in these countries? The answer is 6 000 bicycles (36 000/6) and 3 000
computers (36 000/12) for country A and 1 500 bicycles (36 000/24) and 2 000 computers
(36 000/18). These numbers, when projected to a chart, give us production possibility
frontiers of both countries. Slope of the production possibility frontier, also called the
marginal rate of substitution, shows us, how much of one good we would have to give up, in
order to obtain one additional unit the other good.1 The price of one good expressed in terms
of the other one is its relative price (Husted, Melvin 2004, 61).
1 This could be also expressed through the concept of opportunity costs. Opportunity cost is the cost of production of one good expressed in terms of other good, which could have been produced by the same producer with the same resources (Krugman, Obsfeld 2003: 11-12).
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Figure 1: Production possibility frontiers and the comparative advantage
Source: Husted, Melvin 2004, 61
Building on what we have established so far, we can say that autarky relative price of
computers is ½ (3000/6000), and the autarky relative price of computers in county B is 4/3
(2000/1500). To get the autarky relative prices for bicycles, we just need to exchange the
numbers in the fractions. It is evident that the autarky price of computers is lower in country
A than in B and autarky price of bicycles is lower in B than in A.
But because there are more than just two countries in the world, the classical Ricardo’s
model assumes that international trade is going to be beneficial for all countries, if they
specialize in production of the good of their comparative advantage, and they will import the
rest, produced with comparative advantage by someone else.
1.1.2. The Heckscher-Ohlin model Despite the attractive arguments of the classical theory of comparative advantage, the
model is still far from reflecting adequately the real-world trade patterns. First of all, it has to
face the fact that labour is not the only factor of production. The Neoclassic economy’s
response to this problem was the Heckscher-Ohlin model developed by Eli Heckscher and
Bertil Ohlin. Its most important contribution was the inclusion of country’s resources (the
relative abundance of factors of production) and the technology of production (having
influence on the relative intensity with which different factors of production are used in the
13
production of different goods) into the process of determining what is the country going to
produce (Krugman, Obsfeld 2003, 67).
Heckscher and Ohlin’s model is based on the assumption that countries are endowed
with uneven amount of factors of production (for example labour and capital) suitable to be
employed in production of various goods. The goods then differ from each other according to
the proportion of these factors required to produce them. Each good demands unique ratio of
labour to capital. Given these features, a country is able to produce at lower costs (and
therefore have comparative advantage) such goods whose production requires relatively big
amounts of the factor/s of production with which the country is relatively well endowed
(Husted, Melvin 2004, 88).
To better explain the logics of the Heckscher-Ohlin model, we are now going to
demonstrate its mechanics on a simple model situation. Let’s assume two countries A and B,
which can both produce only two kinds of goods - shoes and computers, and which are
endowed by two factors of production - labour and capital. Country A has a higher ratio of
labour to capital endowment2, so it can be called labour-abundant, country B has a higher
ratio in capital and can be thus called capital-abundant (Krugman, Obsfeld 2003, 76).
Producers from both countries have access to the same choices of productions techniques and
production of shoes always requires more labour per machine than the production of
computers and vice versa. Production of shoes is therefore more labour intensive and
equivalently production of computers more capital intensive. The returns of scale are staying
constant (Husted, Melvin 2004, 87-88).
Since shoes are the labour intensive good, the labour-abundant country A tends to
produce a higher ratio of shoes to computers. As capital is a relatively scarce in country A, its
relative price is going to be higher and consequently the price of computers is going to be
higher in A that in country B. When A and B start to trade with each other, their relative
price levels will converge. The relative price of shoes in A rises and declines in B and equally
the price of computers declines in A and rises in B. The new world prices are established
somewhere in between the country ones. The increase in relative price of shoes in A leads to
increase in their production and decline in their relative consumption, so A becomes the
2 The abundance is defined in terms of a ratio and not in absolute quantities. Abundance is always defined in relative terms by comparing the ratio of labor and capital in the two countries, so no country can be abundant in both (Krugman, Obsfeld 2003, 76).
14
exporter of shoes and importer of computers. Conversely, the decline in the relative price of
shoes in B leads it to become an importer of shoes and exporter of computers. To sum it up,
the model suggest that a country will have comparative advantage and will therefore export
the good, whose production is intensive in factors that the country is relatively well endowed
with (Krugman, Obsfeld 2003, 76).
The Heckscher-Ohlin model shows clearly how powerful the effect of international
trade on distribution of income is. In terms of our model situation, changes in relative prices
have strong impact on relative earnings of labour and capital. In country A, where the relative
price of shoes rises, the labour owners gain from trade, but the capital owners are made worse
off. The opposite happens in country B. The general conclusion of the model therefore is:
“The owners of a country’s abundant factors gain from trade, while the owners of a county’s
scarce factor lose” (Krugman, Obsfeld 2003, 77).
1.1.3. Sources of comparative advantage Using the words of Raj (1998, 630-631), “a country has a comparative advantage in
the production of a particular commodity if it can domestically ‘transform’ other commodities
into this commodity more easily than others can.” However, how does a country get a
comparative advantage? This problem is one of the key problems of international trade and
thus this chapter will now offer a brief overview of the commonly assumed reasons.
First of all, as the Heckscher-Ohlin model suggests, one of the most important
determinants of comparative advantage is the country’s endowment with factors of
production. Argentina, for example, is one of the most important exporters of beef not
because of some technological advantage, but because of the appropriate factors of production
(vast lands, grass of certain quality etc.) that are abundant in the country. Another example
can be Saudi Arabia as one of the world’s greatest exporters of oil (Raj1998, 631).
Secondly, a country may draw its comparative advantage from its relative
technological advantage in production of some good, which it has in comparison with others.
Technological advantage is usually a result of a sophisticated research and development and
as such it demands costly initial investment. However, new technologies can be very easily
stolen or imitated and to prevent such undesirable practices, system of internationally applied
intellectual property law has been erected. Nevertheless, intellectual property rights in
15
developing countries such as China or India do not enjoy high levels of support from neither
the government nor the private sector.
Varying preferences are assumed to be another source and explanation of comparative
advantage. Even if we have two countries with exactly the same factor endowment and
technological level, varying conditions (as for example culinary habits, state of war or adverse
climate) may cause one of them to demand higher levels of certain good than the other one. In
such case, countries that do not have such high levels of consumption of this good may
possess a comparative advantage in its production. According to the logic of this
argumentation, for example rich country with lower level of consumption of food than a poor
country do not have to employ all of its domestic food production at the domestic market and
can therefore use this surplus for trade with countries with higher demand for imported food.
Moreover, as countries grow richer, there is also a greater demand for varieties of goods.
Large quantities of one kind of good may be therefore sold in a country producing in a large
scale the same or similar kind of good (for example Spanish vine in Portugal and Portuguese
vine in Spain) (Raj 1998, 636-638).
Lastly, the presence of increasing returns of scale may be the main reason of
comparative advantage, even if all countries have the same factor endowment, technology and
preferences. The term “returns of scale” expresses a state when the average costs of
production decline with an expansion in production scale (Raj 1998, 639-641). Trade
liberalization plays much important role in this process. When autarky countries open up
themselves to international trade, they open up the way to certain industries to maximize their
production scales through expanding markets and thus gradually reduce their production
costs. Such lower costs consequently lead to comparative advantage for those industries or
companies profiting from the economy of scale compared to others who have to produce for
the original autarky costs. There is an obvious effect connected to this situation which is
known as the advantage of the early start. Those, who entered the market and had the
possibility of profiting from the increasing production scale earlier than others, have apparent
advantage compared to the newcomers. This situation has been a permanent object of
criticism towards the liberalized trade regimes since as early as the half of the 19th century and
Friedrich List (Brown, Nardin, Reggner 2002, 524-525). Raj (1998, 641-642) further remarks
that it is important to differentiate between returns to scale internal to the firm and the returns
to scale external to the firm, but internal to the industry. The first case usually indicates
imperfect competition on the markets and few dominant companies competing between each
16
other. The second case on the other hand implies perfect competition and reduced industry-
wise costs via the external economies.
1.1.4. Gains from trade liberalization The previous pages gave us a short introduction to the theoretical reasoning of
international trade exchange and the simple mechanics on which it is based. However, the
actual gains for the country from opening itself to international trade go far beyond the
comparative advantage argument.
Traditional theory recognizes tree types of channels through which opening to trade
positively improves economic growth and development. The first channel is gains from
exchange - both consumers and producers benefit from reducing the trade barriers and
increasing exchange with foreign markets. Consumers by gaining access to imports that are
cheaper than domestically produced goods, producers by gaining access to cheaper primary
goods and intermediate outputs. The second channel are gains from specialization - reducing
trade barriers motivates domestic companies to re-direct resources from previously protected
uncompetitive sectors to more competitive ones with higher value added. The third channel is
the gains from economies of scale. Uncompetitive companies will be forced out of the market,
allowing the surviving companies to increase their output while at the same time decreasing
their average total costs, leading to bigger efficiency in using resources (Lane 2007, 3-4).
If we look at the gains from trade liberalization inter-temporally, we can, in
accordance with Thirlwall (2000), recognize two main types of gains - “the static” and “the
dynamic” ones.
The static gains are the gains based on the concepts of the comparative advantage and
opportunity costs and can be expressed as the extra resources that are gained by importing
cheaper goods from abroad instead of producing them domestically (Thirlwall 2000, 7-8).
When the domestic production is protected against international competition, sectors that are
not internationally competitive are encouraged and kept alive by artificial enforcing of higher
prices on customers. Removal of these price distortions caused by the protectionist measures
leads to more efficient allocation of resources (Lane 2007: 4). In other words, these gains can
be measured by the „excess cost of import substitution“ (Thirlwall 2000, 7-8). They are called
static, because they result in a one-off increase in welfare due to price changes, but they do
not automatically change the growth path of the economy (Stone – Shepherd 2011, 8).17
The dynamic gains can be expressed by the increase in availability of resources used
in production through improving the productivity of resources and augmenting their quantity.
One of the most important benefits of international trade is widening the total market for
country’s producers, especially if their production is experiencing increasing returns. In such
case, export lead growth can become a stable source of the growth in work productivity
(Stone – Shepherd 2011, 8). The newly increased market competition also reduces the
monopoly powers that would exist prior to liberalization. This is a significant step for many
developing countries, as state-run monopolies are very frequent in their most important
industrial sectors. Increase in openness can also lead to higher investment from both foreign
and domestic sources. This is again crucial for developing countries, as their saving rates are
often insufficient to develop a viable capital market to support the economic growth and
foreign direct investment (FDI) is thus necessary (Lane 2007, 4). These gains are called
dynamic as they are ascribed to changes in economy’s development in time (Stone –
Shepherd 2011, 8). Stone and Shepherd (2011, 7) account these gains to various channels
such as supply chain internationalization, increased rates of investment, improvement in
macroeconomic policies, transfers of technologies or technology spillovers from international
trade.
Recent endogenous growth models recognize two types of dynamic gains streaming
from technological knowledge accumulation and learning, which arrive with international
trade liberalization of an economy.
First type of models stresses that exposing the local producers to international
competitors leads to changes in the patterns of specialization of a country. Learning based on
such specialization is the faster the higher is the sophistication and the learning potential of
the product in which the country specializes. Such approach can be found in works of Young
(1991) and Lucas (1993) (Žižlavský 2013, 10-11).
The second type points out the fact that opening the country’s economy to
international trade opens its access to new sources of technological knowledge. Learning thus
no longer relies only on the domestic research and production because new technological
knowledge is effectively transferred and spilled-over to the country also across borders from
the trading partners, which had been simultaneously creating and accumulating their own
stock of knowledge. A country open to international trade can thus benefit from the
accumulated technological knowledge stock of the whole world. This approach can be
identified in work of Rivera-Batiz and Romer (1991) and Grossman and Helpman (1993). The
18
later bring in an assumption that developed countries with high amounts of accumulated
physical and human capital will conduct more R&D and thus grow faster than developing
economies. However, if less developed countries engage in trade with more developed
countries, they obtain access to larger variety of advanced intermediate inputs, which will
allow them to grow faster (Peluffo 2010, 4).
Technology transfers and technology spillovers are both aspects of technology
diffusion, differing from each other in the fact that technology spillovers occur without
counter payments and are very hard to regulate (Jacob 2006, 56). Technology spillovers can
take two distinctive forms - the knowledge spillovers and the rent spillovers.
Knowledge spillovers embody the characteristics of pure externalities and public
goods. If companies (in the same or different countries) demonstrate sufficient technological
closeness, they can profit from each other’s R&D efforts even without the necessity of
engaging in direct economic transactions. Knowledge spillovers can arise through codified
knowledge which can be found in scientific journals, patents or blueprints or through
economic activities as importing or exporting. If the technological knowledge gained via such
channels is later used in the firms’ own R&D or production process, we say that the
knowledge spillovers arouse (Žižlavský 2013, 15-16).
On the other hand, rent spillovers represent the fact that the price of a purchased
technology does not fully cover the one-time gain in productivity which arose due to such a
purchase. Because of the competitive market environment, the improvement in productivity
thanks to a purchase of highly innovative technology products is much higher than the price
that would have to be otherwise paid for such increase in productivity if this was to be
reached by other means. This „extra“ gain in productivity above the price of the purchased
product is thus a form of rent obtained by the buyer (Žižlavský 2013, 16). Using a slightly
different logic, Keller (2004, p. 755) views the purchaser as profiting from a rent spillover if
the cost of purchasing the intermediate good is lower than his opportunity costs to create the
technological knowledge built-in in the product with his own R&D.
Looking closer on the character of given trade relations, we recognize two types of
technology learning steaming from international trade – “learning by importing” and
“learning by exporting”. Learning by importing can be aligned with the second type of
19
models, as it implies that employing imported inputs from the world’s forefront of
technological knowledge allows local firms in less developed countries exploit the benefits of
global specialization. Moreover, they can concentrate their resources into activities in which
they exhibit their own comparative advantage, instead of spending them on expensive
development of inputs that are anyway being produced elsewhere and often even with higher
quality (Andersson and Lööf 2008, 2).
Learning by exporting on the other hand relates more to the second type of models.
Exporters learn to catch up and keep the standards of foreign customers and markets and
further improve the quality and the variety of their products, both directly through the seller-
buyer relationship and indirectly due to competing with foreign producers (De Loecker 2012,
2).
1.1.5. Loses from trade liberalization The whole discussion so far viewed international trade, benefiting from the principle
of comparative advantage, as something implicitly positive. It appeared that trade is not
actually harmful to anyone, as it permits all that was possible before and adds more to it.
However, things are not that simple. The potential gains from trade do not automatically equal
the actual gains and neither these are spread out equally to all concerned groups.
First of all, the Heckscher-Ohlin model, similarly to most economic models, assumes
smooth, immediate and costless transfers of factors of productions from the declining to
expanding industries and perfect applicability of all factors in all industries. However, Van
Den Berg (2012, 622) explains that the reality is much more complicated and specialization of
an economy brings significant adjustment costs. Relocating resources takes time, money and
effort. Workers might need to go through temporary unemployment, as they look for another
job, need to learn new production techniques and procedures, might need to move for their job
and may also lose a part of their previously accumulated human capital. Transferring capital
equipment than appears to be even more difficult. Machines and tools from one industry
might not have any use in other industries and most likely, the greater part of the old
equipment or buildings might not find any new use at all due to depreciation.
Figure 2 suggests more realistic path of economy adjustment than previously
mentioned models. Point A, lying on the Production Possibilities Frontier PPF, is the autarky
production equilibrium of a country producing goods X and Y and not participating in
20
international trade. Consumption in such country is given by the indifference curve I1.
Opening up the country to trade would expect progressive specialization in production of
good Y, in which the country possesses comparative advantage, and thus the shift along the
PPL to point P, lying on the world consumption possibility line WCPL. The WCPL suggests
that by gaining access to the world market, the country can exchange its own products for
products produced outside its borders. Shift to point P should thus allow the country
consumption on point C, lying on the higher indifference curve I3. Nevertheless, the trade
liberalization is connected with adjustment costs as temporary unemployment of both work
force and capital equipment causing loss of output. Production thus does not immediately
shift along the PPF to point P, but most likely moves first within the PPF through point P’.
The part of the path between A and P’ reflects the rapid fall in production of X, compensated
only partial by meagre growth of production of Y. Not all workers and equipment are able to
move immediately from one industry to another and despite reallocating their incomes in the
most efficient way, the income losses of the population caused by the temporary
unemployment allows the consumers to consume only on point B, lying on a lower
indifference curve I2 and lower world consumption possibility line WCPL’ (Van Den Berg
2012, 623-624).
Figure 2: Adjusting to free trade
21
Source: Van Den Berg 2012, 623
Despite having access to the world market, the consumptions is temporarily even
lower than in the case of autarky, as the economy is not capable of generating a sufficient
income. It thus takes some time for the economy to reach production point P, which allows
access to the desired consumption point C. Nevertheless, as Van Den Berg (2012, 625-626)
demonstrates on the case of Mexico after joining the North American Free Trade Agreement
(NAFTA) between the U.S., Mexico and Canada, this path might be very lengthy and painful.
Prior to the accession to NAFTA, Mexico was a major producer of grains and other
kind of agricultural products, which had been grown by local farmers on small-sized farms.
The accession to NAFTA allowed imports of the same products from the U.S., where there
were produced by large-sized producers, who were already exhibiting economies of scale
given by their access to the overseas markets and who were also profiting from the country’s
natural comparative advantage given by the vast and fertile Great Plains region and generous
agricultural subsidies from the U.S. government. When preparing NAFTA, economists used
the Heckscher-Ohlin model to argue that the losses caused by agricultural imports from the
U.S. would be offset by Mexican exports of competitive industrial products the opposite
direction and by improvement of production efficiency in agriculture due to technology
transfers. Nevertheless, the cheap imports caused an immediate drop of prices of agricultural
products, which imiserized Mexican farmers and aggravated the already poor living
conditions on the Mexican countryside. The small farmers didn’t have the resources to buy
new advanced technologies to improve their efficiency and instead they had no other option
left than leaving the land and start looking for other jobs in Mexican cities, where the
unemployment was already immense. The U.S. offered a new market for Mexican industrial
products, however they had to compete with cheap products from China and the amount of
new jobs created was by far not as significant as originally expected (Van Den Berg 2012,
625-626).
1.1.6. The Immiserizing growth and the Singer-Prebisch thesis Is necessary to say that the adjustment costs are not the only loses connected with
international trade. Bhagwati (1958) pointed out that under certain circumstances even
economic growth streaming from expansion of international trade might be immiserizing for
the country. As the economic expansion leads to increase in output, this increase can be
accompanied by deterioration of terms of trade. This, if significant enough, might offset the 22
benefits of the expansion and cause even a decrease of the real country’s income (Bhagwati
1958, 201).
We can demonstrate such situation on a simple model of a country producing food and
exchanging it for clothing, as demonstrated by figure 3 (Van Den Berg 2012, 626-627). Its
production capacity is represented by its production possibility frontier PPF1. The terms of
trade between these two goods are expressed by the terms of trade line ToT1. During the
initial situation, the country produces at point P1 and consumes at point A, lying on an
indifference curve I4. As the economy grows, the production possibility frontier moves to
point P2 lying on PPF2, which suggests that the increase in country’s production capacity
was concentrated mostly in the food producing industry. Van Den Berg (2012, 626)
emphasizes that this is often the case of developing countries, where the export sector is the
only sector with ready access to financing its development. Moreover, if the country belongs
to one of the mayor exporters of food, such increase in production will lead to decrease in the
overall world’s prices. This is demonstrated by shifting terms of trades from ToT1 to ToT2 in
our model, which more than offsets the previous positive welfare increase caused by the
expansion in production, as we can see by the new consumption point B, lying on a lower
indifference curve I3. In the case the country would not open up itself to international trade,
we could see an increase of welfare from consumption point D on the indifference curve I1 to
point C on I2. However, we can notice that both these points lie on indifference curves that
are lower than the indifference curves achieved in the case of opening the country to
international trade.
23
Figure 3: Immiserizing Growth
Source: Van Den Berg 2012, 627
The model thus suggests that a closed economy would not suffer the immiserizing
growth, but neither would it reach the levels of welfare achieved by an open economy (Van
Den Berg 2012, 627). Chacholiades (1990) summarized the conditions leading to
immiserizing growth into 6 points: 1) the growth in country’s production capacity
concentrates into exporting sectors, 2) the price of the exporting products is inelastic, 3)
exports contribute largely to the country’s overall GDP, 4) there is only minimal
technological change, 5) country belongs to one of the major world’s exporters of the given
good and 6) the country does not apply trade restrictions. These conditions however do not
need to be all met for immiserizing growth to occur (Van Den Berg 2012, 627).
24
Using the optics of political economy, the case of immiserizing growth, as a problem
of differences in demand elasticities and deteriorating terms of trade, uses logic analogical to
the widely known argument called the “Singer-Prebisch thesis” (named after its authors Hans
Singer and Raúl Prebisch). The thesis from the 1950’s was based on the observations of long-
term deterioration of terms of trade of the countries belonging to the “global South”, caused
by their exports dependence on primary products.
The word “primary” originates in the fact that these products satisfy our primary needs
and the first expenditures from our income are spent on them. However, such products are
being affected by the so called “Engel’s law”, which is a well-documented human behaviour
related to food items, but according to Raj (1998, 651), it likely affects the other primary
products as well. According to Engel’s law, as people get richer, the fraction of their income
that is allocated to primary goods has tendency to fall. The reason is that as people’s income
grows, so do the expenses for primary goods, but not necessarily at the same rate. The
enlarged budged allows people to move away to consumption of wider range of products
targeting on other than primary needs and thus reduces the budget share dedicated to primary
goods (Raj 1998, 651).
Prebisch and Singer drew upon this argumentation, but broadened it with political-
economic background of developing countries. They have criticized the contemporary system
of international trade, in which the developing countries are condemned to exercise their
comparative advantages in primary goods and developed countries profit from specializing in
more sophisticated manufactured products, and called for its reconstruction.
They argued that as the effects of the Engel’s law make the demand for primary
products inelastic with respect to income, the progressively increasing production of primary
goods leads to a decline in their prices rather to increase in consumption, which ends in
deteriorating terms of trade for the developing countries dependant on their production. This
negative shift in terms of trade is further aggravated by political-economic conditions.
Because of the highly organized trade unions and oligopoly structures on markets in
developed economies, increased productivity in developed countries of the global North are
absorbed by higher wages and company profits and do not lead into fall of the price of
manufactured goods. On the other hand, the absence of such highly organized structures in the
countries of the global South, plus increasing competition on the world market with primary
goods presses down the prices and keeps the wages and profits in these countries on the same
level. Finally, the structural decline in terms of trade of primary goods is being further
25
deepened by new inventions and increasing production of synthetic materials and substitutes
and by North’s protectionist policies (Spero, Hart 2010, 259-260).
However, the empirical evidence on the developing countries declining terms of trade
of is not entirely conclusive. According to Soubbotina (2004, 89), prices of primary goods
compared to prices of manufactured goods and consequently the terms of trade of most of the
developing countries have really deteriorated in the 1980’s and 1990’s. Between 1980 and
2000, real prices of for example wheat and rice shrink about twofold, cocoa more than
threefold and sugar about fivefold. Nevertheless, the last decade has seen a completely
opposite experience. According to the UNCTAD’s Trade and Development Report 2008 (28),
since 2002, there has been an upward trend in prices of all commodity groups with exception
of tropical beverages, which goes mostly on account of increasing demand from fast growing
developing countries as China and India.
The assumptions behind the Engel’s law complemented by the varying nation
preferences argument, economies of scale and product differentiation, are most likely the
main reasons standing behind the recent phenomenon of intra-industry trade. Again, going
against the logic of the Heckscher-Ohlin model expecting trade to take place mostly between
countries with different factor endowments, the majority of world’s export is happening
between industrialized countries with similar factor endowments and with similar industrial
structures. The intra-industry trade expresses the fact that a large part of all trade is taking
place within the same sectors of the economy (as importing one kind of automobiles – for
example big ones – from the U.S., and exporting another kind of them – for example small
ones – from Europe). On the other hand, the inter-industry trade entails exchange among
different economic sectors (as importing raw materials and exporting hi-tech manufacturing
products). Intra-industry trade is thus characteristic for the so called “North-North” trade
relations, while inter-industry trade tends to be the feature of the “North-South” relations
(Gilpin 2001, 208-209).
1.1.7. The Strategic Trade Theory - from comparative to competitive advantage Despite the inconclusive evidence of the Singer-Prebisch thesis, its legacy has been
very important as it pointed out a serious problem – it seems that not all comparative
advantages offer the same level of benefits and attractiveness to a country (Subbotina 2004,
90). This argument is the fundamental cornerstone of the so called Strategic Trade Theory.
The theory assumes that comparative advantage in certain economic sectors is more beneficial 26
for the overall economy than in others and these sectors should be therefore supported by the
government. Sectors as manufacturing or high-tech industries are traditionally viewed as more
valuable, as they are usually characterized by higher rates of productivity growth, profits,
wages and value-added and last but not least - enjoy favourable price elasticities. The
importance of these industries lies in extensive research and development of new
technologies, which often generate knowledge, rent spillovers and positive externalities.
Thanks to that, these sectors cause direct and indirect benefits not only for the firms in the
same sector, but other sectors as well, and are therefore beneficial for the entire economy.
However, the crucial companies are often not able to realize the true value of their research
and development activities and will therefore under-invest in them. The strategic trade theory
hence argues for governmental assistance to such firms in the strategic industries in the form
of direct subsidies or import protection, in order to avoid such market failures (Giplin 2001,
216).
So now we have another important aspect brought into our discussion about
international trade – the growing concerns of countries about what they produce and about the
location of high-tech jobs and industries on their territory. According to Gilpin (2001) “it’s
unlikely that such crucial matters will be left solely to the interplay of market forces“ (130)
and „in the game of international economics, one vital national objective is to ensure
possession of important core regions and leading industries” (145). Gilpin (2001, 130)
underlines that national leaders repeatedly attempt to use their political influence and their
power in the international political system to determine the international division of economic
specialization. Economic growth, the geographic distribution of certain industries and
comparative advantages are thus often produced rather by arbitrary decisions and cumulative
processes than by market forces.
Contrary to the Hackscher-Ohlin theory, what we are witnessing nowadays is
international competitiveness and trade patterns originating not from substantial differences in
factor or resources endowment, but rather arbitrary specialization profiting from increasing
returns to scale. The growing importance of innovation, technologies and returns to scale has
become an important element in national and corporate economic and trade strategies and the
crucial role of competitive advantage has been replaced by emphasizing of so called
“competitive advantage” (Gilpin 2001, 210-211). Such advantage appears no longer as certain
fixed gift from the Nature, but much more as a result of deliberate corporate decisions and
27
governmental policies. Again, the case of an early start plays a crucial role in reaching the
economy of scale and strengthening the position on the market (Gilpin 2001, 213).
Such situation frequently leads to oligopolistic industries, when only few firms
profiting from scale economies are able to survive in the competition and benefit from super-
profits resulting from their monopolistic market position. These firms than also gain strong
political influence on governments and having such important national players able to
compete with international competition is often one of the strategic goals of governmental
economic policies, so they in many cases receive substantial governmental support3 (Gilpin
2001, 215). However, we shouldn’t forget that the case of competitive advantage is for
obvious reasons limited only to certain, mostly hi-tech industries and such strategic policies
can be applied only by certain national states, disposing with sufficient resources and human
capital allowing their implementation.
1.2. Protectionism After demonstrating the mechanics, the logic and the advantages and disadvantages of
free trade, we will now dedicate some space to explaining the mechanics, the logic and the
reasons of protectionist policies. Identifying these will also help us understand more in depth
the reasons for trade liberalization and the forms it can get.
1.2.1. Instruments of protectionist trade policy Trade policy disposes of various instruments that can be used to restrain free trade.
The basic classification divides them to tariff barriers and non-tariff barriers. The importance
of tariff barriers has declined in several past decades, as the governments began to prefer to
protect domestic industries by variety of nontariff barriers, as for example import quotas and
export restraints (Krugman, Obsfeld 2003, 186). The following chapters will briefly introduce
the fundamental trade policy instruments and their economic and political effects.
1.2.1.1. Tariffs Tariffs can be defined as a tax imposed by the government on imports or export.
Throughout the history, they have been widely used by basically every single country of the
world. They are commonly imposed on imports from other countries, however, some
3 As for example in the case of Japan and the large industrial conglomerates called zaibatsu.28
countries, usually the developing ones, apply tariffs on their own exports as well (Husted,
Melvin 2004, 151).
Tariffs have two principal important effects when imposed on imports. The first one is
the revenue effect, which expresses the fact that the taxation serves as revenue for the
governmental (Husted, Melvin 2004, 151). This revenue used to be a very important part of
the government’s budgets in the past; however, nowadays, its importance for most developed
countries is only very small. This, on the other hand, is not true for many developing
countries, for which the role of the revenue effect is still very important and the negative
weight of its loss might serve as an argument against trade liberalization. The other important
effect is the protective effect. Since the tariff is implied only on exported goods, the foreign
producers have to face an additional cost compared to their domestic competitors. Generally
both the revenue effect and the protective effect operate at the same time. However, special
cases, when only one of these effects is present, might occur. When tariff is imposed on
imports of a good which is not produced by any domestic producers, it would have only pure
revenue effect. On the other hand, when the tariff rate is so high that no goods are imported,
no revenue for the government is collected and the tariff has a pure protective effect (Husted,
Melvin 2004, 151-152).
What are the economic effects of import tariffs? According to Krugman and Obsfeld
(2003, 192), tariffs raise the price of a good in the importing (domestic) country and decrease
it in the exporting (foreign) one. As a result, consumers in the importing country lose and
those in the exporting one gain. This effect is the opposite for the producers. The domestic
ones gain and the foreign ones lose. Besides that, another gainer of this policy measure is the
domestic government, who, by imposing the tariff, benefits from additional revenue to the
state budget. Tariffs also mean notable terms of trade gain because they lower foreign export
prices.
1.2.1.2. Quotas We can define quotas as government-imposed limits on the quantity of goods traded
between countries. As quotas restrict the amount of foreign competition at the domestic
market, they tend to have similar effects to those of tariffs (Husted, Melvin 2004, 182-183).
The most common form of quotas is the import quota, which is a direct restriction on the
quantity of some imported good. The import quotas are often complemented by issuing
import licences to particular groups, individuals or companies (Krugman, Obsfeld 2003, 200).29
As mentioned earlier, quotas tend to have similar effects to those of tariffs, which
principally mean that imposing an import quota makes the domestic prices rise and quantity
of imports fall (Husted, Melvin 2004, 183). According to Krugman and Obsfeld (2003, 200),
when imports are limited, the immediate result is that with the initial price, the demand for a
good exceeds domestic supplies plus imports, which causes the price to bid up until the
market clears. This process happens every time, contrary to some politically motivated
misconceptions trying to claim the otherwise.
The biggest difference between quotas and tariffs is the distribution of gainers and
losers. First of all, import quotas do not bring any additional revenue to the government. The
sum of money that would have been gained as government revenue if a tariff was imposed is
collected by whoever receives the import licence. The licence holders then profit from the
high prices skyrocketed by artificial scarcity of the good on the market. Such abnormal profits
received by the licence holders are known as quota rents (Krugman, Obsfeld 2003, 200).
Furthermore, quota rents are connected to a problem called the rent seeking.4 The licence
holders are often willing to devote considerable resources for lobbying, bribery, lawyer’s
services, PR and other similar tools to maintain their favoured position. These expenses are
not true costs of production and they do not lead to any more output being produced - their
goal is just to determine who gets the money associated with the allotted quota (Varian 2005,
416). Competition among the rent seekers may lead to a situation, when they are willing to
bear the costs connected with the rent seeking activities up to the very value of the rent itself
(Schwarz 2001m 492). From the viewpoint of the society, this kind of expenses represents
pure deadweight loss (Varian 2005, 416). Husted and Melvin (2004, 186-187) then underline
the importance of the licenses distribution for domestic welfare. If the licenses are given to
domestic producers or importers, the income from quotas stays in the domestic country. If
they go to foreign suppliers, as showed later, the income flows from domestic residents to
foreign exporters.
To sum it up, the principal gainers from quotas are the domestic producers and the
selected foreign exporters, the principal losers are on the other hand the domestic customers,
the remaining foreign producers not endowed by the import licence, the domestic government
loosing potential revenues from tariffs and of course the society as a whole suffering from the
deadweight loss of rent seeking activities.
4 For further reading about rent seeking see Krueger 1974.30
Costs of a quota are therefore usually substantially higher than those of an equivalent
tariff and they are being viewed as more restrictive. As a result, quotas have been widely
replaced by tariffs or tariff rate quotas. Tariff rate quotas are policies, which allow a certain
quantity of a good into a country at a low or zero tariff, but then when the quota is reached,
apply often substantially higher tariffs on the exceeding quantities (Husted, Melvin 2004,
183).
1.2.1.3. Voluntary export restraint Voluntary export restrain is basically an import quota imposed from the exporting
country’s side instead of the importer’s one (Krugman, Obsfeld 2003, 202). They are
generally imposed on base of a voluntary restraint agreement negotiated with a foreign
supplier. Under such agreement, the foreign government restricts the exports of its industries
to the importing country. In return, these foreign industries are able to raise their prices and
earn the quota rents (Husted, Melvin 2004, 187). From the economic point of view, voluntary
export restrains have exactly the same effect as import quotas, where the licenses are assigned
to foreign governments and are therefore very costly for the importing country, as the quota
rent flows to foreigners (Krugman, Obsfeld 2003, 202).
1.2.1.4. Export subsidies Export subsidies can be defined as direct or indirect payments from a country’s
government to one or more of its export industries. Such payments enable exporters to charge
lower prices that would otherwise be charged based on the market price. With lower prices,
exporters are able to gain larger shares of the world market (Husted, Melvin 2004, 190) and
they will continue to export the good up to the point where the domestic price exceeds the
foreign policy price by the amount of the subsidy (Krugman, Obsfeld 2003, 197).
According to Krugman and Obsfeld (2003: 197), the effects of export subsidies are
exactly the opposite as those of tariffs. The price in the exporting (in this case domestic)
country rises, but because the price in the importing (in this case foreign) country falls, the
domestic price rise is less than the subsidy. In the domestic country, exporting producers gain
as they profit from the subsidized exported goods, government loses because it subsidies the
exports and domestic consumers lose as well, firstly by facing the increased prices of
exportable goods, and secondly on additional taxes that are required to finance the export
31
subsidies (Husted, Melvin 2004, 190). Another effect of export subsidies is production of
otherwise economically unprofitable goods and even keeping alive unviable industries. In
addition, in contrast to tariffs, by lowering the price of the export in the foreign market, the
export subsidies worsen the terms of trade. Krugman and Obsfeld (2003, 197) therefore
conclude that export subsidies unambiguously lead to costs that exceed their benefits.
1.2.1.5. Other trade policy instruments Beside the main four above mentioned tools of trade policy, there are many other non-
tariff policy measures whose importance is on a rise as a consequence of the progressive
elimination of classical tariff barriers from the last decades. In this subsection, we are going to
briefly review the most common of them.
Local content requirement – is a regulation determining that some specific part/s of a
final good has to be produced domestically. This might be stated either in specified physical
units, either in value terms, for example by demanding that some percentage of the price of a
good must represent domestic value added. This practice is very popular in developing
countries, targeting to shift their manufacturing base back from assembly to intermediate
goods (Krugman, Obsfeld 2003, 203-204).
Export credit subsidies – are specific variation of export subsidies, which take the
form of subsidized low-interest loans aiming to aid exporters (Krugman, Obsfeld 2003, 205).
National procurement – is a governmental policy based on purchases of goods and
services from domestic producers, even when these are more expensive and of a lower quality
than foreign imports (Krugman, Obsfeld 2003, 205).
Health and safety standards – it is common that governments regulate production and
distribution of products that pose a possible thread to health and safety of their citizens.
However, sometimes these standards are imposed in order to provide an additional protection
to domestic producers from their foreign competition (Husted, Melvin 2004, 192).
Human rights, environmental and labour standards – are very similar to the previous
group and serve mostly as a weapon to developed countries against the cheap production from
the developing ones, for whom lower standards mean not just a comparative advantage, but
also practical must be given by the actual level of their economic development (Gilpin 2001,
225-230).
32
1.2.2. Arguments for protectionist policies As showed in the introductory chapter, majority of world’s economists would almost
unanimously agree that free trade is superior to protectionism. However, in the real life, there
basically does not exist a single country that would allow free trade in its pure form and the
presence of some combination of the above mentioned trade policy tools is still viewed as the
standard situation in most parts of the world. Although the arguments for protectionism have
in many cases only little logical merit, they often enjoy wide support from both the politicians
and the general public. This is probably the main cause why various barriers to free trade
managed to survive until today. We must recognize also the important role of various interest
groups, for which the redistribution of national wealth caused be elimination of trade barriers
would mean a loss of their economic status. As a consequence, they are willing to sacrifice
substantial economic resources to keep the protectionist policies on, even though the welfare
of a nation as a whole is below its real potential. Such groups are of course supporting the
protectionist arguments and they are using them deliberately to excuse their actions.
In this section, we are going to introduce the most common arguments for the use of
protectionist policies and their economic validity.
1.2.2.1. Protection of employment Probably the most common argument used by politicians and lobbyist in favour of
protectionist policies is the protection of domestic employment. According to the logic of this
argument, protectionist policies create jobs by raising the price of imports and diverting
demand towards domestic production. As the demand for domestically produced goods
increases, it allows the producers to hire more employees and unemployment falls. This, of
course, happens on expense of output and employment loses abroad and it is thus a classical
example of the so called “beggar-thy-neighbour” policy, which became infamous in Europe
in the period after the World War I (Samuelson, Nordhaus 1998, 706).
Protection from imports certainly increases employment in protected industries;
nevertheless, the resources for this expansion come from other domestic industries, whose
output falls. And even if there are available unemployed resources for work in the protected
sector, the resulting decrease in imports should be expected to lead to a decline in those
industries, which are either dependant on imported inputs for their production or in those that
are export oriented. According to Husted and Melvin (2004, 197-198), the reason for the latter
33
is that in the international trade exchange, imports serve basically as receipts and exports as
payments and the nation cannot really help itself by diminishing its receipts.
To sum it up, due to protection from foreign imports, workers are often being
artificially kept in low productivity sectors losing their comparative advantage, instead of
moving to those sectors, where comparative advantage is currently present and productivity is
higher, but which somehow suffer from the protectionist policies. Increase of production in
the second caused by eliminating the protectionist policies would spontaneously lead to
increase of employment in these sectors, often notably higher than the employment caused by
protectionism. As Husted and Melvin (2004, 198) remark, protectionism thus contributes
much more likely to redistribution of jobs rather than to their creation.
1.2.2.2. Terms of trade and the optimum tariff Another argument for protectionist policies, in this case particularly for tariffs, is
based on cost-benefit analysis and it is valid principally for large countries that are able to
affect the prices of foreign exporters. As stated before, imposing a tariff increases the price of
imports and improves the terms of trade. The benefits resulting from such improvement must
be set against the costs of the tariff, arising from distortions in production and consumption
incentives caused by the imposed tariff. According to the logic of this argument, at small tariff
rates, a large country’s welfare is higher than with free trade. However, as demonstrated in
figure 4, as the tariff rate increases, the costs of the tariff begin to grow faster than the benefits
and the curve relating national welfare to the tariff rate turns down. The tariff rate tp, which
completely prohibits trade, leaves the country worse off than with free trade, and further
increases in the tariff rate below tp then have no effect and leave the curve flat. Point 1 on the
curve corresponds to tariff to, which is the tariff that maximizes welfare and it is called the
optimum tariff. It is the point where the marginal gain from the improved terms of trade just
equalizes the marginal efficiency loss from the production and consumption distortion
(Krugman, Obsfeld 2003, 223-224).
34
Figure 4: The Optimum Tariff
Source: Krugman, Obsfeld 2003, 224
However, as Samuelson and Nordhaus (1998, 705) point out, even the optimum tariff
is gain still just an example of the beggar-thy-neighbour policy and it is likely to cause a
similar protectionist reaction from the other states. When imposing tariffs (or other forms of
protection) by one country leads to increased protection in rest of the world, the country is
said to be in a trade (or tariff) war (Husted, Melvin 2004, 168). And when all countries start
imposing the optimum tariffs, it is highly probable that everyone’s economic welfare will
decline, as the barriers to trade become too restrictive (Samuelson, Nordhaus 1998, 705).
1.2.2.3. Infant and senile industries A very popular argument for protectionist policies is protection of certain industries,
which have special importance for the country and which are, for some specific reasons,
temporarily not able to survive on their own terms in face of aggressive foreign competition.
35
The most popular example, especially among developing countries, is the infant
industry argument. According to its logic, developing countries have a potential comparative
advantage in manufacturing, but new manufacturing industries in these countries are initially
not able to compete against well-established manufacturing in the developed ones. To allow
these infant industries getting through the vulnerable initial stage of their development, the
government should provide them temporary support until they have grown strong enough to
face the international competition. Of course, the best way how to do that is to use tariffs,
import quotas and other temporary measures to get the industrialization started (Krugman,
Obsfeld, 256). The infant industry argument is further supported by the appealing
argumentation of learning by doing. As mentioned earlier, the learning by doing argument
suggests that protection of an infant industry might encourage learning and assimilation of
new techniques of production, a process which might be only achieved by actual and ongoing
production on a significant scale. This presumes that domestic firms encouraged by the
security of protection will use the opportunity to train their employees in the use of new
technologies and methods. Subsequently, the process of production itself should generate a
virtuous circle of learning and higher efficiency in production (Raj 1998, 669).
If we look into the economic history, we can see that both the United States and the
United Kingdom, or later Germany and Japan, all began their industrialization behind trade
barriers. Realizing that, many developing countries tried to pursue the same strategy.
However, the protection given to infant industries must be used cautiously, as there are many
risks and pitfalls connected with such strategy. Firstly, it is not always good to try to begin
immediately with industries that are assumed to have comparative advantage in the future, but
the current society lacks the adequate technical and human capacities to produce them.5
Secondly, it is costly and time consuming to build a new industry (Krugman, Obsfeld, 256-
257) and such policies may also cause distortions that may persist and leave the sector
inefficient and vulnerable to competition. As consequence of that, infant industry tariffs tend
5 To demonstrate the danger of inappropriately chosen infant industry protection policies, we can turn to the example of Brazil. In 1984, Brazil banished most of foreign computers in the country in order to provide protection to development of their own computer industry. However, Brazilian-made computes were years behind the fast moving world market and their price was 2-3 times higher, so they were too expensive for ordinary Brazilians. Because of the high price, Brazilian computers were not able to compete on the world market, so the Brazilian computer companies could not take advantage of economy of scale by selling them to other countries. As a side effect of all that, the high price of domestically-made computers in combination with the ban on computers imported from abroad, hurt the competitiveness in the rest of the economy as well - it effectively blocked Brazilian industry from modernizing. In 1992, the ban on imported computers was abolished and Brazil finally experienced its computer revolution (Samuelson, Nordhaus 1998, 706).
36
to become permanent, no matter whether the industry can be still called infant or not and these
tendencies are amply supported by various interest groups profiting from the protection
(Rothband 1986, 5).
The senile industry argument has many common features with the infant industry
argument. Nevertheless, unlike it, it is used mainly by countries that are already developed
and now have to face the rising competition posed to them by the currently developing ones.
According to Rothband (1986, 5), older industries, which are notoriously inefficient, have
been complaining that they “need a breathing space” to retool and modernize in order to
become competitive with the foreign rivals and that this could be provided by several years of
protection by tariffs and import quotas. Rothband (1986, 5) warns that this argumentation is
even more dangerous than the infant industry approach, as it will be even more difficult to
figure out, at which point the senile industry finally reached its magical rejuvenation.
1.2.2.4. Government revenues and income redistribution Probably the most valid and unassailable arguments for protectionist policies are
government’s intentions regarding the usage of trade policies as a source of revenues for the
state budget or to redistribute incomes between different groups in the society.
All governments need tax revenues to function and tariffs represent one of the easiest
ways of collecting them. Firstly, they are politically favourable; as it is the foreigners rather
than domestic residents who pays the taxes and the domestic welfare rises. Secondly, they are
easy to collect. In most of the developed countries today, tariff revenues generate only a very
small fraction of the state budget. However, the situation in many developing countries is very
different and tariffs sometimes exceed even 50 % of all fiscal revenues. This is mostly due the
difficulties of these countries with establishing and collecting income or value-added taxes
from their own citizens (Husted, Melvin 2004, 199).
As for the income redistribution intentions of the government, as shown earlier, trade
policy can be effectively used to redistribute income from one part of the society to another.
The most common example is redistribution of income from consumers to producers – when,
due to protectionist policies, profits of domestic producers rise on expense of domestic
consumers, which have to face higher prices than foreigners. The desire of some policymakers
to steer profits to certain domestic industries, according to Husted and Melvin (2004, 200),
explains most protectionism patterns in industrialized countries and much of what we observe
in the developing ones. 37
1.3. International trade liberalization After discussing the mechanisms and characteristics of international trade and
protectionist policies as such, it is time to pay closer attention to trade liberalization, aka
removing the later in order to achieve the sooner.
Trade liberalization can be defined in several ways. The common understanding could
be similar to the definition of the businessdictionary.com: “The removal or reduction of trade
practices that thwart free flow of goods and services from one nation to another. It includes
dismantling of tariff (such as duties, surcharges, and export subsidies) as well as nontariff
barriers (such as licensing regulations, quotas, and arbitrary standards)”. Sally (2007, 15) then
talks for example about „moving to a state of ‘neutrality’ of government intervention as
between tradable and non-tradable sectors of the economy“ and “getting prices right by
aligning domestic prices with world prices of tradable goods”. Although, as already
mentioned earlier, the state of perfect free trade does not exist in any country of the world, in
last few decades we have witnessed a significant global movement towards trade
liberalization and higher trade openness.
1.3.1. The determinants of trade liberalization According to Sally (2007, 24), the real driver of trade policy reforms has always been
much more the distribution of wealth rather than generating wealth. Trade policy shifts, both
towards higher degrees of openness or protection, lead to redistribution of gains and losses
among various actors as regions (rural and urban areas), classes (owners of capital, skilled
workers, semi-skilled and low skilled workers), economic sectors (agriculture, industry,
services) or even ethnic groups. Especially in the short term, such disruptions might cause
serious problems, particularly in developing countries which are often suffering from political
instability, high levels of corruption, significant differences in wealth, fragile institutions,
minimal social security nets and ethnic divides.
38
When it comes to the principal determinants of trade reforms (especially towards
liberalization), Sally (2007, 24) identifies these five:
1) Circumstances, especially crises
2) Interests
3) Ideas
4) Institutions
5) Factor endowments
1.3.1.1. Circumstances and crises Historical evidence shows that major economic reforms were adopted as responses to
economic or political crises. Economic crises, characteristic for symptoms as extreme levels
of indebtedness, hyperinflation, grave payment imbalance, adverse term of trade or currency
devaluation, are the most common example. Such events lead to situations where “normal
politics” are set aside and periods of “extraordinary political measures” create windows of
opportunity for fundamental reforms, which would not be acceptable under usual conditions.
However, it is necessary to mention that trade reforms might lead both to greater levels of
openness and protection. Another issue is then the sustainability of such reforms, when there
is often no guarantee that the following reforms are going to be in accordance with the initial
ones (Sally 2007, 24-25).
1.3.1.2. Interests Influence of interests groups is widely agreed to be another major determinant of trade
policies, especially when it comes to protectionist measures. While the benefits of free trade
are spread out all across the country’s population, it is only a small group of producers who
bears the direct costs. The latter are thus highly incentivised to take organized collective
action. Such organized rent-seeking groups than seek protection from the politicians and
officials who supply it. During the period of 1930s’ and 1970s’, the so called “iron
quadrangles” of politicians, bureaucrats, trade unions and employers stood for the
protectionist measures in many developing countries. While the beneficiaries were usually
capital-intensive and unionised industries producing for the domestic market, the expenses
went on the account of agriculture and tradable sectors. However, organized interests do not
play only the role of the powers blocking the liberalizing trade reforms. Countervailing 39
coalitions supporting opening-up to foreign trade are formed, especially by exporters, users of
imported outputs, multinational companies with world spread production networks or cities
and regions aiming to become hubs for trade and foreign investment. Once the window of
opportunity occurs and the liberalizing reforms are undertaken, these are taking over as the
main supporting power from the previous weakened coalition and lobby intensively for
maintenance and further expansion of the free trade regime (Sally 2007, 25-26).
1.3.1.3. Ideas It is not easy to evaluate the influence of ideas, theories or doctrines on policymaking,
but again, historical evidence provides us with enough examples of policies that happened to
become an important embodiment of some them. When the prevailing climate of ideas meets
with favourable interests and events, it may become both the source and the reasoning for
actual policies. Like the combination of mercantilist state-building and structuralistic
interventionism became the fundament of the import substitution strategies, foreign aid and
state planning asserted in the 1970s by both developing countries and international
organisations. Similar situation than occurred around the 1980s, where this set of ideas was
replaced by a substantial change in ideology and a return to more classical and neo-classical
foundations of economical thinking known as the Washington Consensus, characteristic for
elements as aid scepticism, outward orientation or emphasizing government failure over
market failure. The current development of prevailing ideologies is not completely clear,
however it obviously swings the pendulum slightly away from the pure Washington
Consensus-like policies, as issues as protecting infant industries, government’s interventions
towards market failures, food security and importance of foreign aid are becoming again the
main agenda of trade policy thinking (Sally 2007, 27).
1.3.1.4. Institutions In the broad sense, according to Sally (2007, 28), institutions create “a steel frame of
the economy, its rules and constraints”. As such, they compose of two main components.
Firstly, the “formal institutions”, representing the legal framework of policymaking as
regulations governing financial markets, property rights, contracts, production, consumption,
but also the governmental structure. Secondly, the “informal institutions”, representing mostly
non-legal norms and traditions, which in certain manner influence the intersections of
government, business and law. Nevertheless, nowadays, the institutional framework 40
embracing trade policymaking is wider than ever and it spreads out to different actors (as
ministries, regulatory agencies, non-governmental actors or international organizations as the
World Trade Organisation) and levels (local, countrywide, bilateral, regional and
multilateral). It is again very difficult to evaluate the actual impact of the institutional setting
on particular policies that were adopted by the government; nevertheless, the set of
institutions is unique to every country and it thus makes the policy choice a unique experience
for every particular case (Sally 2007, 28-31).
1.3.1.5. Factor endowments The relative mix of factors (land and natural resources, labour and capital) the country
is endowed with is the last essential determinant of trade policies we are going to mention.
Again, this mix is unique for every country; however, a simple look at the 21 st century’s
division of the world allows us to aggregate countries into three main groups – capital-
abundant and technologically advanced countries of the West + Japan, labour-abundant
countries of South and East Asia and land- and resources-abundant countries of Latin
America, Eastern Europe, Russia and Africa. Compared to the labour-abundant countries
which were able to reduce poverty and improve their institutions after plugging-in into global
manufacturing and labour-intensive services markets, the land- and resources-abundant
countries seem to be on a structural disadvantage. Due to their relatively expensive labour
force, they seem to be crowded out from the global manufacturing markets by their labour-
abundant competition, especially from East Asia, and they are left dependant on volatile and
cyclical commodity markets. Moreover, the interest group constellations in resources-
abundant countries is usually set up in the way that the revenues from the resources end up in
the hands of a small group of rent-seeking businesses and corrupted political elites, instead of
being spread out to wider population or used to improve the economy and institutions. Of
course, such description appears very generalized and oversimplified, yet it points out some of
the most important problems a large group of developing countries has to face with regards to
their factor endowments today (Sally 2007, 31-34).
1.3.2. Types of trade liberalization There are several ways through which the trade liberalization of a country might
proceed. We basically recognize three main types – unilateral liberalization, preferential
liberalization (in the form of bilateral and regional trade agreements) and multilateral 41
liberalization. If we look at statistics, according to the World Bank estimates, during the
period of the big trade liberalization boom between 1983 and 2003, 65 % of all liberalization
in developing countries (cutting over 21 % in average weighted tariffs) was done unilaterally,
25 % multilaterally through the GATT Uruguay Round agreements and just about 10 % came
from preferential trade agreements (PTA’s). Figure H shows us these statistics in graphics
(Sally 2007, 36-37).
Figure 5: Share of total tariff reduction by type of liberalization during 1983-2003
42
Source: Sally 2007, 37
1.3.2.1. Unilateral liberalization Freeing up international trade, labor and capital flows unilaterally and not through
lengthy international negotiations is an approach favored by many political and economic
arguments. In the short run, independent liberalization is expected to bring immediate static
gains as cheaper and more advanced imports, replace costly and outdated domestic
production, restructure the domestic industries, relocate resources in a more efficient way and
also accelerate capital accumulation and allow economies of scale. In the longer-run, it is
supposed to initiate progressive dynamic gains as technology spillovers, inflow of FDI and
qualified labor from other countries. Arguably, these gains would be reached through other
forms of liberalization as well, nevertheless doing such steps unilaterally brings the above
mentioned gains more quickly and it allows the governments to be much more flexible and to
better-tailor the policies to local conditions, rather than if they would have to go through
politicized and bureaucratically burdened trade negotiations and follow one-size-fits-all
international blue prints (Sally 2007, 35).
Richardson (2001) draws attention to different motivations countries have for
unilateral liberalization according to their size. While in the neo-classical setting, small-sized
countries with little or none price-setting power having minimal ability to set up an optimal
tariff in order to improve their terms of trade are highly incentivized to liberalize trade
unilaterally, for large countries such actions mean sacrificing a significant part of their
“bargaining power”. However, in the past, we have seen many large countries undertaking
unilateral liberalization. Richardson explains such unilateral strategy as what he calls a “soft
reciprocity”. Although such steps are undertaken unilaterally, they are signalizing a
demonstrating effect to country’s trading partners and they are actually done with
expectations of non-obvious reciprocity from their side (Richardson 2001, 2-5).
Given the realities of today’s politics as mercantilist thinking, the perceptions that
trade liberalization is harmful to poor and vulnerable parts of the population and of course the
organized interest groups lobbying for protection, pursuing unilateral liberalization is not easy
to achieve in practice. It is then not surprising that such changes occur mostly during the
windows of opportunities given by economic crises and by significant shifts in the underlying
policy-setting mechanisms, such as movements in the political support groups or changes in
the political parties holding the governmental power (Richardson 2001, 4). 43
1.3.2.2. Multilateral liberalization Given the unease of achieving unilateral liberalization mentioned in the previous
paragraph, the rationale of multilateralized reciprocity endowed in multilateral trade
negotiations carried out on the basis of the General Agreement on Tariffs and Trade (GATT)
and later on the ground of the World Trade Organization (WTO), allowed the governments to
inhibit protectionist lobbies, mobilize exporting interests and provide them with arguments of
creating non-discriminatory and fair rules for everyone (Sally 2007, 39). Low (2004, 3)
argues that the largest merit of such multilateral process is its wide and encompassing
representation. However, she also points out that this obvious strength is also the biggest
weakness of multilateral institutions characteristic for their diverse and heterogeneous nature.
Sally (2007, 39) argues that multilateral liberalization was a successful tool during its GATT
era (1947-1995), when dealing only with relatively slim agenda and being dominated by only
a limited number of ideologically homogenous and structurally similar developed countries
(first of all by the US and by the EU). However, after transforming into the WTO in 1995, it
occurred to be extremely unsuccessful, as proven by the failure of the Doha round. According
to him, the reason for such a failure is first of all the technically more complicated, politically
more controversial and bureaucratically more burdensome agenda, less suitable for reciprocal
agreements, combined with the chaotic decision making in the assembly with nearly universal
membership leading to heterogeneous and often contradictory interests of the involved
countries. Reaching further progress in trade liberalization via the means of multilateral
negotiations at this point thus seems to be very difficult and less likely (Sally 2007, 39).
1.3.2.3. Bilateral and Regional Liberalization Given the current frozen state of the multilateral negotiations, the bilateral or regional
preferential trade agreements of like-minded partners seem to offer much better solution for
faster and wider deepening of trade liberalization than the WTO. Nevertheless, they often face
critique for undermining the authority of the WTO and creating “spaghetti bowls” (see
attachments 1, 2 and 3 for the spaghetti bowls schemes for East Asia, Africa and the
Americas), of discriminatory restrictions to trade and in general favoring strong players on the
expense of the weaker ones. The reality is in fact mixed and biased by complicated networks
of various PTA’s with different levels of integrations. While the highly developed PTA’s as
the EU, the NAFTA or the Australia-New Zealand Closer Economic Relationship exhibit high 44
levels of sector coverage, harmonized rules of origin or ambitious market-access and rules
commitments, the evolution in the other world’s regions is not that encouraging. Most of the
South-South and South-North PTA’s tent to suffer from vague foreign-policy objectives,
messy patchworks of weak free trade agreements without bringing seriously deeper
liberalization and from creating new complications to trade, especially through restricting
rules of origin. The biggest problem is than the fact that the PTA’s often contribute to erecting
new protectionist barriers poor developing countries use against their equally poor or even
poorer neighbors (Sally 2007, 4).
1.4. Political economic models of protection and liberalization In the previous chapters, we have discussed the most important economic and political
factors standing behind the trade protection and trade liberalization policies. In order to offer
the reader more in-depth insight into the way they interact with each other on determining the
actual policies, this chapter presents three political economy models designed to explain them.
The first model introduces setting up protectionist policies in a developed country, the second
one models the same situation, just in the realities of a developing country and the third one
simulates the process of trade negotiations between these two.
1.4.1. The Grossman–Helpman Political Contributions Model Although most of the arguments for the protectionist policies are based on the national
welfare fundaments, Krugman and Obsfeld (2003, 229) point out, that in fact, there is no
such thing as national welfare or national interest, only the desires of individuals, which get
more or less imperfectly reflected in the objectives and actions of the government. The final
trade policy output is thus most likely formed as a mixture of pressure by various lobby
groups, personal political interests and abstract national welfare intentions of the policy-
makers. The influence of these factors on protectionist policies of governments has been
reflected by numerous political economy models.6 Probably the most coherent and influential
theoretical model of endogenous trade policy formation was introduced by Gene M.
Grossman and Elhanan Helpman in 1994.
The fundamental structure of the model is based on the concept of Common Agency
Problem7, which is a situation that arises when several principals attempt to induce a single
agent to take an action that might be costly for him to perform. The government represents the
6 See Rodrik 1995, Gautier 2002 or Gawande, Krishna 2003 for review. 7 For further reading see Dixit, Grossman, Helpman 1997.
45
agent for various principals - conflicting lobbies - while bearing a cost for implementing an
inefficient policy that stems from its accountability to the general electorate (Grossman,
Helpman 1994, 836).
The initial set up of the model is a small open economy facing exogenously given
world prices. The government’s set of policy instruments is restricted to tariffs and subsidies,
while the optimal policy for the economy is free trade. Governmental policies determine the
difference between the world and the domestic prices. If the domestic prices exceed the world
prices, it implies an import tariff for a product that is imported and an export subsidy for one
that is exported. Vice versa if the domestic prices are below the world prices, it implies import
subsidies and export taxes.
The economy produces n various products using labour and input that is specific to the
particular sector. There is a high level of concentration in ownership of many of the n specific
inputs and the various owners of some of these inputs have banded together to form lobby
groups. These lobby groups may offer political contributions to the incumbent governmental
officials in order to determine the setting of the country’s trade policy. The incumbent
politicians may see a relationship between total collections (which can be used for political
campaigning) and their re-election prospects. However, at the same time, they may believe
that their chances of re-election depend also on the welfare level achieved by average voters.
The aggregate national welfare of voters is determined by the aggregate income of all sectors
plus trade tax revenues and the total consumer surplus given by the home prices. Based on
these considerations, the model assumes that the incumbent politician’s objective is to
maximize both the weighted sum of total political contributions and the aggregate social
welfare (Grossman, Helpman 1994: 835-838).
The lobbies and the government participate in a two-stage non-cooperative game. In
the first stage, the lobbies confront the government with their political contribution schedules
(Islam 2002, 4). Each lobby tailors its schedule to maximize the total welfare of its members,
from whom it collects donations used on the contributions (Grossman, Helpman 1994, 838).
The government sets its policy in the second round, knowing that contributions depend on
selected policies (Islam 2002, 4). It takes the contribution schedules as given and maximizes
the weighted sum of the total political contribution schedules and the aggregate welfare with
respect to prices p, according to the government welfare function
46
(1) G=∑i
Ci( p)+bW ( p ) ;b>0
where Ci(p) is the total contribution schedule of sector i and iCi(p) therefore the total
contribution to the incumbent from all sectors, W(p) is the function of aggregate welfare and
b is the government’s weight on aggregate welfare, where b > 0 (Gautier 2002, 9).
In order to better understand the logic of the model, we can re-write the equations as follows
(2) G=a1∑i
C i( p)+a2(W ( p)−∑i
C i( p)) ;a1>a2
with iCi(p) again representing the total contribution of the all sectors i, W(p) the function
of aggregate welfare, a1 the government’s weight on campaign contributions and a2 the
weight of net aggregate welfare. Maximizing G in equation (2) is the same as maximizing G
in equation (1), as b=a2/(a1-a2) for bsince. Equilibrium of the model consists of 1)
sum of political contributions Ci(p) by the lobby groups, maximizing the welfare of their
members, given the other lobby’s contribution schedule and the anticipated moves of the
government and 2) value of domestic prices maximizing the governments welfare function G (Gautier 2002, 9). The function induces the government to behave as though it was
maximizing the social welfare function that weights different members of society differently,
with those individuals represented by a lobby receiving greater weight. When all voters
belong to some interest groups and all sectors in the society are represented, then free trade
prevails (Islam 2002, 5).
The equilibrium tariffs or export subsidies t* than take their form according to
equation (3)
(3) t ¿=ti
1+t i=
I i−αL
b+αL( zi
ei)
where Ii is an exogenous indicator which takes the value of either 1 or 0, depending on
whether the sector i is represented by a lobby or not, zi is the equilibrium ratio of domestic
product to imports in sector i, ei stands for the import demand elasticity and L is the
47
exogenous share of total population that is represented by lobbies Gautier 2002, 9-10). This
further implies that the protection received by a sector is higher when it is organized, when its
output is high relative to competing imports and when the percentage change in import
demand is low (Rodrik 1995, 1469).
The model according to Islam (2002, 5), leads to three conclusions. 1) When there is
only a single lobby that faces no opposition from competing interest groups, it captures the
whole surplus from its political relationship with the government. 2) When all voters are
members of the lobby groups, the rivalry between the competing interests is intense and the
government uses this rivalry to capture the entire surplus. 3) With no political rivalry between
special interests, each industry group captures the entire surplus from its own political
relationship with the government.
1.4.2. The Xu’s Infant-industry Model The Grossman-Helpman model proved over time to have unusually high explanation
power on empirical data and became an important inspiration for numerous other trade policy
models building up on its structure8. As this thesis deals in the first place with developing
countries, we are going to use one such specific variation of the Grossman-Helpman model to
look closer on conditions especially related to them - concretely how heavily promoting infant
industries weights in determining protectionist trade policies in such countries.9 The Infant-
industry model was introduced in 2006 by Chinese economist Bin Xu and its relevance to our
topic can be best expressed by the words of the author himself: “...the question does not seem
to be the ‘existence’ of infant-industry consideration in the trade policy decisions of
developing countries’ governments (politicians), but rather how important the infant-industry
consideration is relative to other determinants in the political processes determining trade
policy“ (Xu 2006, 346).
The model assumes a small open economy which faces world prices under free trade.
All the individuals in the economy’s population are endowed with a unit of labour, but just a 8 See for example Golberg, Maggi 1999, Gawande, Krishna 2003 or Willman 2004. 9 For further reading on political economic models on trade policy in developing countries see for example Findlay 1990 or Cadot, de Melo, Olarreaga 2004.
48
fraction of them possess human capital h. Production factors can be employed in two ways.
The first one is in production of a low-tech good Y. The production of Y requires labour as the
only input. The second one is the production of a high-tech good X. The production of X requires employing two production factors - labour and various specialized skills, which are
learned in schools. The part of population which possess human capital chooses between
attending school and becoming a skilled worker and not attending school and becoming an
unskilled one. Producing specialized skills in schools requires investment of a certain amount
of human capital.
As specialized skills are used as input for the high-tech sector X and producing
specialized skills requires a certain amount of human capital, the high-tech sector is not viable
in the country unless the human capital stock has reached the threshold level HT. Moreover,
whether an individual invests his human capital into training or rather decides for employing
his labour directly is a matter of his free choice. Being a worker earns him wage w(t) = 1,
getting trained and obtaining specialized skills yields him and income which depends on a
rate of return to human capital r(t). The individual thus chooses the training only if r(t) ≥ 1 and
he human capital stock H is a function of r(t)h(t).
The key element of the model is the existence of dynamic external effect of training
and using specialized skills – human capital accumulates as a by-product of the training and
employing the skills in the production process of the high-tech sector. The higher the amount
of specialized skills which are produced through training and then employed in the high-tech
sector, the more knowledge will be learned by the participating individuals. The presence of
the learning sector then allows the high-tech sector to be qualified as an infant industry in the
developing country. However, given the fact that initially, at time t(0), H0 < HT, the high-tech
sector is not viable under free trade. Nevertheless, if the individuals with H0 were trained, the
high-tech sector was established at t(0) and the human capital stock in the developing country
was accumulated due to the dynamic external effect of employing the specialized skills in the
high-tech sector production process, the critical human capital level HT would be attained at
time tT. That implies that the developing country has the potential to develop a competitive
high-tech sector, but this potential can be only turned into reality if the high-tech sector is kept
viable during the infancy period (t(0) ≤ t < tT). As the high-tech sector would be beneficial to
49
the country in the future thanks to the dynamic learning effect, we are facing a case of a
classical infant industry argument.
Following the traditional infant industry policy logic, a tariff on imports of the high-
tech good can help establishing and keeping the infant industry viable during its infancy
period. Nevertheless, the tariff should be progressively declining over time, as H approaches
HT, and be abolished completely once HT is reached. The traditional infant industry argument
is based on an assumption that the developing country’s government maximizes the national
welfare. Nevertheless, if we set the conditions we are working with a little bit closer to the
real-life situation and we include organized interest groups into the model, we get the set up
well known from the previous Grossman-Helpman (1994) model.
The government in such a set up maximizes the sum of aggregated welfare of its
voters and the contributions from organized lobby groups. In this case, we assume that the
lobbies represent the owners of human capital, while the owners of labour are not organized.
The government then follows this welfare function
(4) G ≡∫0
t ¿
G (t ) dt ≡∫0
t¿
[ D (t )+aW (t )] dt
with [0,t*] representing the governments time horizon, D(t) the political contributions, W(t)
the total population’s welfare, dt the derivate of time and a (a≥0) the weight the government
gives to the welfare of the population (Xu 2006, 369).
W(t) in the previous equation is given as follows:
(5) W ( t)=(1−α )+α r(t )h(t)+( p (t )−1) M (t )+S(t )
with α representing the fraction of population endowed with human capital. Given this, the
first two terms (1 – α) and ar(t)h(t) represent the total income earned by owners of labour and
human capital. M(t) than represents tariff revenues, p domestic price level and S(t) is the term
for consumer surplus. Moreover, we define the “infant industry tariff” τI(t) which makes the
high-tech sector X viable during the initial period t ∈[0,tT]. Due to the dynamic learning
effect, τI(t) decreases over time until it becomes 0 at time t = tT , when H = HT. There are two
50
different values the government’s welfare function G can get – value G0, when there is no
infant industry tariff protecting of sector X, and value G1, when the sector is protected. The
government thus decides to adopt τI(t) if and only if G1 > G0. In the case there is no
protection, the country does not have any industry X and G0 is thus defined as
(6) G0=∫0
t¿
a(1+S( t )0 )dt
If the government adopts the infant-industry tariff, industry X becomes viable and G1
is defined as
(7) G1=∫0
t¿
¿¿d t ¿
Given that, G1 > G0 only if
(8) ∫0
t¿
[D (t )+a(α (r ( t )h( t )−1)+τ (t )I M (t )+S(t)
1 ¿−S(t)0 )]>0¿
There is the dynamic learning effect connected to production in sector X and if the
infant industry offers high enough benefit to the country, the dynamic effect in the long-term
exceeds the short-term loses caused by the tariff distortion. Thus, if the long-term national
welfare benefits from the high-tech industry truly are a priority for the government, it will
adopt the tariff rate that will be equal or will exceed the infant-industry tariff rate (Xu 2006,
370).
Nevertheless, the government also takes into account the political contributions D(t)
from the human capital owners. The final political tariff τP(t) satisfies both the government and
the lobbies. It is given as
(9) τ (t )P =p(t )−1=1−α
a+αX ( t)
−M ' ( p(t ))
51
where the politically-driven tariff rate τP(t) is thus the higher the less weight the government
gives to national welfare a, the more concentrated is the ownership of human capital α, the
larger is the high-tech sector X(t) and the less elastic is the import demand function –M’(p(t)). If
the high-tech sector X is viable, the tariff rate τ(t) set by the small economy will be τP(t) (Xu
2006, 371).
Figure 6 demonstrates the tariff rate of the country in equilibrium, which is jointly
determined by τI(t) and τP
(t). The downward sloping curve AA demonstrates the evolution of
τI(t) over time. The downward sloping is caused by the dynamic learning effect. The evolution
of τP(t) is then represented by curve PP. Taken that the demand elasticity stays relatively
stable, τP(t) has an upwards sloping curve, because the tariff rate increases in time t as human
capital accumulates, making the hi-tech sector X grow. The human capital owners invest more
into political support because their stakes get higher following the expansion of X (Xu 2006,
371).
Assuming that initially, τI(0) > τP
(0), the curves intersect at the point where t = tT.
During the t < tT period, pursuing the long-term national welfare considerations, the
government applies the infant-industry tariff τI(0). The human capital interest groups gladly
accept it, as τI(t) > τP
(t). When t changes to t < tT, the lobby groups intensify their activities, as
the industry X grows bigger and the human capital owners dispose with larger resources. The
infant industry tariff rate τI(t) stops being binding and the government replaces it with the
politically-driven tariff rate τP(t) > τI
(t). Following figure X, the politically driven government
of a developing country will adopt a V-shaped tariff schedule AEP (Xu 2006, 371-372).
Figure 6: The tariff rate evolution in a country pursuing infant industry protection policies
52
Source: Xu 2006, 372
During the initial period t < tT, sector X is relatively small and the stakes for the
human capital owners are neither high enough, neither they possess the sufficient resources to
keep τP(t) > τT
(t). If the government would not adopt the infant-industry tariff τI(t) in this
period, the hi-tech sector would not be viable. Later, when t ≥ tT, the influence of the interest
groups becomes the main driver of the governments infant-industry considerations and the
government thus adopts the politically-driven tariff rate τP(t), which exceeds the minimal
necessary protection needed to keep the hi-tech sector viable. Thus, even though the infant-
industry tariff is not binding anymore in the later stage, the organized interests would have not
been established if there was not for the infant industry tariff adopted in the initial period. One
of the main conclusions of the model thus is that the infant industry protection fosters
politically driven protection (Xu 2006, 372).
53
1.4.3. The Xu’s Trade Protection and Trade Talks Model The third model we are going to talk about draws upon the two previously introduced
models of setting up tariffs in a developed and in a developing country and adds an element of
international trade negotiations and their influence on the tariff selection. In the previous
models, countries decided upon their tariff rates non-cooperatively with respect to the
international environment. In this case, we will let them influence the tariff rates of each other
through their interaction.
We assume a world that composes of two large countries – a developing country
“South” and a developed country “North”. North produces a hi-tech good X*(t), which is then
exported to South. The learning effect on good X*10 had been already exhausted. The world
market of good X cleans when
(10) M ( p (t ) )+M ¿ ( p( t)¿ )=0
where M(p(t)) represents South’s import demand for X and (-M*(p*(t))) North’s export
supply of X. We set s*(t) the subsidy applied by the North and τ(t) as the tariff applied by
South. Good Y is taken as a numeraire and denoted as (t) and serves as the relative price for
X. Prices p and p* in equation (10) are then determined as
(11) p(t )=π ( t )(1+τ (t ))
(12) p(t )¿ =π ( t )(1+s(t )
¿ )
In contrast to small countries from the previous models, while setting up their trade policies,
large countries in this model take in account also the terms of trade motive. The political tariff
in South is given as
(13) τ (t )P =
p (t )−π(t )
π (t )=1−α
a+αX (t )
−M ' ( p( t ))π (t)
+ 1e(t)¿
10 Asterisk is used to denote the variables of the North.54
with a standing for the weight the government gives to national welfare, α for the fraction of
population endowed with human capital, X(t) for production of good X, –M’(p(t)) for the
import demand function and (t) for the relative price of good X. In addition, equation (13)
contains also the “optimal tariff” term 1/e*(t), with e*(t) representing the export supply
elasticity of the North.
The human capital owners in North organize themselves to lobby for the export
subsidy on good X, which is being exported to South. The height of the subsidy is given as
(14) s(t )¿ =
p(t )¿ −π(t)
π(t )= 1−α¿
a¿+α ¿
X (t )¿
−M ¿ ' ( p(t )¿ )π (t )
+ 1−e(t )
¿
where 1/-e*(t) represents the import demand elasticity of South (Xu 2006, 372-373).
The trade policies defined by equations (13) and (14) take in account both the
contributions and the terms of trade motives, however, they are still chosen non-
cooperatively. The big gain brought by trade negotiations is that they lead to national welfare
gains due to eliminating the inefficiencies from terms of trade. To demonstrate it on the
model, we consider a two-stage game. In the first stage, the lobbies set the schedules of their
contributions, in the second stage, the governments negotiate over trade policy schedules for
s*(t) and τ(t). The final outcome then emerges as efficient from the politicians own selfish
perspectives. The whole situations can be also imagined as if the lobby groups of both
countries were competing for influence on a single “world government”, which is maximizing
a sum of aG*(t) + a*G(t). Assuming this, we can see that the amount of South’s trade
protection relative to North’s trade promotion is given by the relative political strength of
their lobbies. Taking s*N(t) and τN
(t) as North’s and South’s trade policies which would arise as
a result of the trade negotiations, this can be expressed as
(15) τ (t )N−s(t )
¿ N=1−αa+α
X (t )
−M ' ( p(t ))π (t)
− 1−α¿
a¿+α¿
X (t )¿
−M ¿ ' (p(t )¿ ) π(t )
55
When considering their contribution schedules, the lobbies are thus aware that they tie their
contributions to trade policies of both countries. The trade policies have impact on domestic
true the world price (t). As an example, North’s subsidy on X reduces (t) and thus reduces
also the returns to human capital in South, which serves as a motivation for South’s lobby to
contribute to South’s government and thus “buy” the protection tariff from it (Xu 2006, 374).
We now add the South’s infant-industry considerations into the situation. At t = t(1),
South and North choose their policies non-cooperatively. When they engage in trade talks, the
strength of South’s lobby is weakened by North’s lobby. To demonstrate it at figure U, curve
PP shifts down to curve P´P´, implying that South is forced to reduce its tariff from τW to τB
if
it wants to reach an agreement with North. However, as figure U shows, tariff τB is lower than
the infant industry tariff τI at time t1. As the South’s government is aware of that, the trade
talks do not lead to an agreement, as South would lose its sector X in the case if it would
allow tariff τB (Xu 2006, 375).
Figure 7: The infant industry policies during trade talks
56
Source: Xu 2006, 372
The infant-industry tariff rate thus serves as a constraint on the tariff rates developing
countries would be pushed to accept in the international trade talks. Figure 7 suggests that
trade agreement between the South and the North will not be reached until time t2, when the
infant-industry tariff rate τI reaches equal value as the trade-talks tariff rate τB. Nevertheless,
despite the trade talks being unsuccessful until time t2, the fact that the government of South
participates in the trade talks undermines the power of South’s lobby, as it shifts curve PP to
position P’P’. As the time progresses and South produces larger scales of the hi-tech good X,
the dynamic learning effect leads to decline of the infant-industry tariff over time, heading to
eventually reaching tariff rate τB (Xu 2006, 375).
1.5. Developing countries, economic growth and development Before we finally move to the factual and the analytical part of the thesis, we dedicate
some space to clearing out and defining what do we actually understand by terms developing
country, economic growth and economic development.
1.5.1. Developing countries At the beginning of the 20th centuries, the difference between the “developed” or rich
countries and the “developing” or poor countries used to be very clear. The developed rich
world was represented by the colonial powers of Western Europe, Japan and the British ex-57
colonies as the United States, Canada, Australia and New Zealand, the poor developing world
then by countries from Asia, Latin America and Africa, often colonies of the former.
However, in the second part of the 20th century, after the World War II, massive
decolonization and rapid economic growth of countries like South Korea or Taiwan, and on
the other hand, the decline of countries like New Zealand, made the differentiation much
more blurry (Nafziger 2006, 21).
To make the definition clearer, there are various classifications used today, like the
one of the World Bank, which recognizes four groups of countries based on their Gross
National Product per capita. In 2011, the categories were $12,476 or more dollars for the High
income countries, $4,036 to $12,475 for the Upper middle income countries, $1,026 to $4,035
for the Lower middle income countries and $1,026 and less for the Low income countries.
(WB WDI). For convenience, the High income countries are usually referred as Developed
countries and the Middle- and Low- income countries as Developing countries or Less-
developed countries (Nafziger 2006, 21).
Similarly, the United Nation’s World Economic Situation and Prospects classifies all
countries in the Word into three categories - developed economies, economies in transition
and developing countries. These categories then contain subgroups based on geographical
locations or on ad-hoc criteria. Important ad-hoc criteria is for example whether the country
exports fuel or not (WESIP).
In 1971, a special “least developed country status” was designed by the United
Nations for 25 countries with the lowest income, manufacturing capacities and adult literacy
rates. The main objective was hoping to attract more economic assistance to these selected
countries. In the following years, further criteria of low levels of human development (such as
school enrolment rates or life expectancy indicators), natural handicaps (such as high climatic
risks or geographic isolation) and low economic diversification were added to the list
(Nafziger 2006, 24).
On the opposite side of the developing countries spectrum, there stand the so called
“newly industrialized countries” (Nafziger 2006, 24) or “emerging markets”
(http://www.investopedia.com/terms/e/emergingmarketeconomy.asp). Such countries do not
have yet the same level of market efficiency and overall structural development to be on par
with advanced economies, but they usually experienced a high level of economic growth in
last several years which brought them solid economic baseline that has been in some cases
58
accompanied by increasing political self-awareness. This is mainly the case of the so called
BRIC countries - group of rapidly developing new economic superpowers (Brazil, Russia,
India and China) who recently started challenging the economic and political positions of the
old superpowers gathered in G7, for the first time identified by this acronym by Goldman
Sachs Jim O’Neil (O’Neill 2001). These countries soon started to be aware of the sudden
upward shift in their political power streaming from their economic success. In 2006, they
initiated the first common political-economic negotiations under the above mentioned label,
which were, in 2008 in Yekaterinburg, Russia, transformed into official full diplomatic
cooperation aiming on increasing their global influence and importance compared to the old
economic powers. In December 2010, the group was officially enlarged by South Africa in
order to spread its influence to the African continent, transforming the acronym to BRICS.
Organizations like the OECD than commonly talk about the BRIICS, adding to the group
Indonesia, referring to its increasing importance and similar characteristics (Smith 2011).
For the case studies in the analytical part of the thesis, we thus chose Brazil and
Indonesia as the representatives of developing countries whose relatively dynamic economic
growth and unique size of the territory and population qualify them to be assumed the rising
world economic and political powers in the upcoming decades.
1.5.2. Economic growth and economic development Economic growth and economic development are often being used as synonyms.
However, these terms are not identical. In general, growth is a necessary, but not sufficient
condition for development.
Economic growth refers to increase in country’s total output of goods and services and
it is usually measured by gross domestic product (GDP), gross domestic income (GDI) or by
per capita versions of these indicators (Nafziger 2006, 15).
Economic development on the other hand refers to economic growth accompanied by
changes in economic and social structure and the overall output distribution. Such changes
may include improvement in welfare of the poor population, shifts in structural composition
of the GDP (usually decline in the share of agriculture and increase in the share of industry
and services) and diversification of production, increase in human capital of the labour force
due to improvement in education and fundamental technical advancement in the country.
Where growth focuses solely on quantitative measures, development pays attention to
changes is capacities (Nafziger 2006, 15).
59
For a long period of time, per capita GDP was the only widely used summary indicator
of economic well-being. The inadequacy of this measurement was however reflected by the
economist working under the United Nations Development Programme (UNDP) who, in
1990, developed the Human Development Index (HDI), reflecting the above mentioned
differentiation between growth and development. HDI an aggregated index is scaled from 0 to
1 and it is composed out of three components – life expectancy at birth (representing the
health standards of the country), years of schooling (representing the level of education) and
Gross National Income per capita (representing the standard of living in the country).
Compared to previous practice of using only income or product growth indicators, accepting
life expectancy and education as key elements to human capabilities enhancement helped to
understand development as a much wider concept, not generally dependent on private income
(MMF 2000 World Economic Outlook 162).
2. TRADE LIBERALIZATION IN BRAZIL AND INDONESIA In the second part of the thesis, we will have a closer look on the particular case of
trade liberalization in the two selected case study countries – Brazil and Indonesia. We will
review the economic development of the countries before and after the trade liberalization and
we will try to identify the main determinants of the liberalization, as well as classify its form,
in accordance with the theoretical part of the thesis.
60
2.1. Trade liberalization in Brazil
2.2.2. Simple profile of Brazil With its territory of almost 8 515 000 sqm and more than 200 million inhabitants,
Brazil is the largest and the most populated country in South America and also the 5th largest
and 5th most populated country in the world. Until 1988, it belonged to the lower middle
income countries according to the World Bank classification, than it became an upper middle
ncome country, however it returned back to the lower middle income class during the period
2002-2005. Since 2005, it remains in the upper middle group.
2.2.2. Brazil before the trade liberalization For more than 3 centuries, Brazil suffered from colonial dominance of Portugal and
neither winning its independence in 1822 brought the country to improvement in wealth,
despite relatively rich foreign investment and vast trade relations with countries from Europe.
The “golden period” of Brazilian economy then came paradoxically only in the third
decade of the 20th century, after being forced to devaluate its currency and drastically isolate
itself from international trade relations with other countries. The isolationist period drove the
country through substantial industrialization efforts and the success of such policies strongly
predetermined the country’s trade and industrial policy strategy in the following decades (Van
Den Berg 2012, 698-700). Wide trade restrictions were put in place and the industrial policies
became dominated by the import substitution industrial policies pursuing the infant-industry
aims (Van Den Berg 2012, 698-700).
This strategy dominated Brazilian politics in the 1960s and 1970s, bringing
comfortable average GDP growth of 6%, respectively 8.5%. Nevertheless, the second “oil
shock” in 1979 brought the end to the miraculous growth. At the beginning of the 1980s,
Brazil had to face severe decline in terms of trade caused by the falling prices of its exports
and increasing prices of capital goods imports, combined with unexpected rise in the
international interest rates and the following debt crisis spreading all over Latin America
throughout the decade (De Holanda Barbosa, 13).
Brazil was hit hard by the immediate consequences of the shock and its industrial
output dropped by 10 % in 1981, but it managed to get back on the growth path in 1984 and
stayed on it until 1987. Nevertheless, this temporary success was then replaced by a timely
recession lasting another 5 years. The period of the debt crisis and economic stagnation in
Latin America in the 1980’s is often called „the Lost Decade“(De Holanda Barbosa, 12). 61
During this five-years lasting period in Brazil, the country’s cumulative GDP drop accounted
for over 16 % and the inflation accelerated to immense 2574 % in 1990, when it reached its
peak and it than remained on similar digits until 1994 (Hay 1997, 1).
2.1.2. Trade liberalization in Brazil and the post-liberalization years To combat the crisis, the government of Brazil took several steps that fundamentally
changed its highly regulative and interventionist industrial and overburdened trade policies.
According to (Hay 1997, 3), prior to the liberalization, the combination of redundant tariffs
and various taxes were raising the regular costs of imports added on average by 28 %. Even
more restrictive were then the non-tariff barriers, best represented by the infamous “Lei do
Similar Nacional” (the law of the similar). The law imposed a complete ban on all imports of
particular goods, once the local Brazilian suppliers proved to be capable of producing a
“similar” product on their own (Van Den Berg 2012, 699).
The initial steps of the trade policy liberalization were taken in 1988, when the
government unilaterally decreased the level of redundant tariffs. The key reforms however
came only in 1990 with the interventions of the newly formed government. Vast majority of
the non-tariff barriers was completely abolished and a four-year plan of tariff reduction
decreasing tariffs from almost 50 % in 1989 to 14 % in 1994 was put in place (Schor 2004, 4).
The chosen direction was further affirmed in 1991 by signing the Treaty of Asunción that
introduced the fundaments of a custom union between Brazil, Paraguay, Uruguay and
Argentina, that was in January 1995 officially inaugurated as the Southern Common Market
(MERCOSUR) (Hay 1997, 6). On 1st January 1995, Brazil also officially became one of the
founding members of the World Trade Organization (WTO).
The trade reforms were followed by further economic and social reforms intended to
stabilize and reignite the economy by first of all cutting down the prevailing hyperinflation.
The main weapon against the inflation was adoption of fundamental monetary reform which
brought Brazil its current national currency national currency “Real” (Franco 1996, 9). Other
policy parallel policy measures included market deregulation and privatization of the
industrial sector. During years 1991 - 2000, the privatization process involved over 92 billion
USD and it concerned all important enterprises in public ownership (Baumann 2001, p. 155).
62
However, the liberalization policies and overvalued currency provoked the expectable
counter-attack from domestic protectionist lobbies, forcing the government to use the
MERCOSUR list of exceptions to reinitiate an increase in tariffs on selected manufacturing
products as consumer electronics and electricals, motor vehicles and textile – in some cases
up to 70% (Hay 1997, 6). Besides, to react on the impact of the Asian crisis and capital flight
in 1997, all members of MERCOSUR agreed on 3 points increase of their Common External
Tariffs (CET) and this measure haven’t been abolished until December 2003.
According to Valls Pereira (129), while Brazil liberalization process did not showed a
significant reversal, after the formation of MERCOSUR, its trade policy started to lack the
incentives for further unilateral liberalization. Except the negotiations within WTO, Brazil’s
tariff changes were strictly linked to MERCOSUR’s CET, but due to grave recession in
Argentina in 2000-2002, it became basically impossible to negotiate further commitments in
the negotiation process. Through the WTO Uruguay Round, Brazil also limited all its tariffs at
35 % for industrial and 55 % for agricultural products, bounding itself from any unilateral
reversal temptations Valls Pereira (130).
We can thus see that the main mean of trade liberalization in Brazil was unilateral
action, which was later replaced by regional liberalization within MERCOSUR and
secondarily complemented by accession to multilateral WTO. The main driver of the
liberalization was the economic crisis which hit Brazil during the 1980s in combination with
the ideas of the Washington Consensus, which has been the major trade ideology, widely
accepted in that period.
2.2. Trade liberalization in Indonesia
2.2.1. Simple profile of Indonesia Indonesia is an archipelago located in South East Asia, with its almost 250 million
inhabitants being the 4th most populated country in the world. It is composed of more than
17 500 islands spread over a territory of a 1 904 500 sqm. Until 1993, it belonged to the lower
income countries according to the World Bank classification, than it became a low middle
income country, however as a consequence of the Asian financial crisis, it returned back to
the lower income group during the period 1998-2002. Since 2003, it remains in the low
middle group
63
2.2.2. Indonesia before the trade liberalization Similarly to Brazil, Indonesia had to withstand centuries lasting colonial dominance.
After early contacts with Portugal, the country had been colonized by the Netherlands as early
as from the beginning of the 17th century. Nevertheless, it had to wait for its independence for
much longer. During the WWII, from 1942 to 1945, it moved under the domination of the
fascist Japan. It declared its independence still in 1945, even before the Japanese withdrawal,
nevertheless it became fully independent only in 1949, after four years of bloody fights with
the Netherlands and grace to significant intervention of the UN into the situation (The CIA
World Factbook).
Historically, Indonesia’s economy had been weighted heavily towards agriculture and
its importance was even reinforced in the 1950s and 1960s through governmental policies
aiming at food self-sufficiency (Elias – Noone 2011, 34). However, the governmental goals
changed in the late 1960s and the First Five-Year Program from 1969 started gradual process
of industrialization through import substitution. Indonesia was not initially hostile to foreign
investment, which is proved by the enactment of the law on foreign investment in 1967, the
pressure of the local industrialists however lead the government to restricting import of goods
in selected sectors in 1970. The first oil shock in 1973 then boosted Indonesia’s governmental
income, as it belongs among the world’s major oil producers, which even reinforced the
isolationist voices in the country. Protectionist measures were tightened up through both tariff
and non-tariff barriers and the presence of foreign capital was further restricted (Ishida 2003,
14). The end of the protectionist policies came in the 1980s with the steep falls in oil prices in
years 1982 and 1986.
2.2.3. Trade liberalization in Indonesia and the post-liberalization years Substantial liberalization package was introduced in October 1986 and a series of
further liberalization measures followed in the next years. Import license requirement were
taken off from 544 various goods and restrictions on certain exports were abolished. The
proportion of goods burdened by non-tariff barriers in 1987 had dropped to 22 % compared to
32 % in 1976 (Simorangkir 2006, 11) and it further declined to 17 % by 1990 and 5 % by
1992 (Feridhanusetyawan, Pangestu 2003, 3). Major rationalization and reduction of tariffs all
across the board appeared during years 1985-90 and it lead to an average decline of
unweighted tariffs from 27% in 1986 to 20 % in 1992. Another significant move was
replacing the customs service notoriously known for a high level of corruption with a private
company form Switzerland - Société Générale de Surveillance (SGS). The exporters
64
duty drawback scheme went through significant improvement and also export oriented
investments were given much more liberal treatment when it comes to foreign ownership and
duties and VAT exemptions (Feridhanusetyawan, Pangestu 2003, 3).
The unilateral liberalizing efforts slowed down in 1991, when the reform had to face
strong resistance from local interests while trying to remove non-tariff barriers in politically
sensitive areas of the economy – especially in agriculture (in products such as sugar, soybean,
milk, wheat flour, garlic or dairy products) or uncompetitive manufacturing productions as
plastics or motor vehicles. The process was reanimated again in 1994 mostly due to the
country’s external commitments. The Asian-Pacific Economic Cooperation (APEC) meeting
hosted by Indonesia in 1994 motivated a substantial alleviation of restrictions on foreign
ownership. In May 1995, the government announced a complex program of tariff reductions
for the period of 1995 - 2003 that would touch upon 64 % of tariff lines. By 2003, all tariffs,
with exception of those on motor vehicle arts and products, would be set at maximally on 10
%, with most of them in the 0-5 % range (Feridhanusetyawan, Pangestu 2003, 3-4). On 1st
January 1995, Indonesia also officially became one of the founding members of the World
Trade Organization.
Nevertheless, the actual process of reaching the above mentioned goals happened to be
much faster than originally expected. Due to the ASEAN Free Trade Agreement schedule,
many intended above the 5% tariffs fell into the 0-5% target rate for intra ASEAN trade.
Another significant reform package then followed in 1996, decreasing average unweighted
tariffs to 12 % and non-tariff barriers only to about 3 % of all tariff lines. The pressure from
the International Monetary Fund intended to solve the Asian crisis in 1997 then spread the
liberalization to further sectors, including agriculture, and in June 1999, the government
decided to liberalize trade also in the most protected castor – motor vehicles. The tariffs in
the sector were reduced, licensing procedures fundamentally simplified and the local content
requirements completely removed. The main goal of the reform was to transform the
chronically unsustainable motor vehicles production into efficient and globally competitive
industry (Feridhanusetyawan, Pangestu 2003, 3-4).
We can thus see that similarly to Brazil, the main mean of trade liberalization in
Indonesia was unilateral action, which was later replaced by regional liberalization within
ASEAN and secondarily complemented by accession to multilateral WTO. The main driver of
the liberalization were the economic crises which hit Indonesia during the 1980s in and the
65
second half of the 1990s, in combination with the ideas of the Washington Consensus, which
had been the major trade ideology widely accepted in that period, and promoted by the
International Monetary Fund, which played important role in Indonesia’s liberalization during
the period of the Asian financial crisis.
2.3. Comparison of Brazil’s and Indonesia’s degree of trade openness Before we move forward to the analytical part of the thesis, we will dedicate a short
space to comparison of the degrees of openness of both our case countries. In order to be able
to compare them, we must be aware of different levels to which they are actually open to
trade. Not having reliable data on the NTBs, we will demonstrate the degree on two indicators
– the simple average tariff rates and the share of trade on GDP of the two countries.
Figure 8 shows us the simple unweighted average tariff rate for Brazil and Indonesia
between 1989 and 2010. We can see that during this period, Brazil exhibited much higher
tariff protection than Indonesia with its 42.91 % average tariff rate to Indonesia’s 18.74 % in
1989 and 13.44 % to 4.79 % in 2010.
Figure 8: Simple average applied tariff rate for all products in Brazil and Indonesia in the period 1989-2010
66
19891991
19931995
19971999
20012003
20052007
20090.005.00
10.0015.0020.0025.0030.0035.0040.0045.00
Brazil IndonesiaSource: WB WDI
Figure 9 than shows us the comparison of Brazil’s and Indonesia’s share of trade
(expressed as imports + exports) on GDP during the period of 1970-2010. When looking at
the graphics, we can clearly see that generally speaking, Brazil’s is much less open to trade
and economically dependent on trade than Indonesia. Whilst the lowest share of trade on
Brazil’s GDP was 14.39 % in 1989 and the highest 28.97 % in 2004, the lowest point for
Indonesia was 28.42 % in 1970 and the highest one 96.19 % in 1998. The difference between
the countries is thus very clear, as the lowest value reached by Indonesia during the research
period basically equals the highest value for Brazil.
Figure 9: Share of trade on GDP of Brazil and Indonesia in the period 1970-2010
67
19701973
19761979
19821985
19881991
19941997
20002003
20062009
0.0010.0020.0030.0040.0050.0060.0070.0080.0090.00
100.00
Brazil Indonesia
Source: WB WDI
3. THE IMPACT OF TRADE LIBERALIZATION – SELECTION OF METHODOLOGY
As the aim of the thesis is to present an impact analysis of the trade liberalization on
economic development of the case countries – Brazil and Indonesia, we first need to choose
the proper methodology to do so. As mentioned earlier, the ambition of the thesis is to go
68
beyond the usual evaluation of the impact solely on economic growth as expressed by the
GDP/GDP per capita growth rate indicators and study the assumed effects of the liberalization
on much more broader set of indicators reflecting deeper structural changes in the economy
and society as such. The conclusions of the analysis should allow us to answer the main
research question of the thesis:
“What was the impact of trade liberalization on economic development in Brazil/Indonesia?”
To be able to answer the research question, we will now define the research methods
and the variables which would sufficiently proxy for trade liberalization and for the economic
development of the chosen countries.
3.1. The research method The first choice method to be used in this case is the statistical regression analysis.
Nevertheless, as the subjects of our research are developing countries in the long term
horizon, we are facing a limitation given by the quality of the data available for our study.
Most importantly, obtaining long-enough reliable time series of relevant indicators shows to
be quite a challenge. Using long-term data series is crucial for our type of research, as we
want to compare Brazil’s and Indonesia’s performance in the chosen development indicators
before and after the liberalization. Only by using the pre-liberalization period as
counterfactual, we can claim with a sufficient level of certainty that the liberalization had the
expected effect on the chosen indicators.
In order to do so, we need to decide which exact period of time to take as the period of
the liberalization or its ending point, which might not be always easy. In some cases, it is not
completely clear which starting and ending points to choose for the reforms and this must then
be done arbitrarily by the researcher. We can find such approach for example in the work of
Jacob (2006). Based on the information from chapter 2, for the purpose of our analysis, we
choose years 1970-2010 as our research period of focus and we take 1994 for Brazil and 1990
for Indonesia as the years when the principal part of the liberalization reforms finished.
The particular econometric method we are going to use in the thesis is, following the
approach of Sarkar 2006, based on Pesaran and Shin 1999, the Autoregressive Distributed
Lag (ARDL) cointegration model. Using this model will help us avoid one of the most typical
complications connected with regression analyses. Standard regression analyses are built up 69
on an assumption that the examined series are “short term memory” series, which capture the
transitory deviation from the normal path of the series caused by an external temporary shock.
However, examining a long-run relationship between two time series variables demands a test
of unit root (the series integration test), in order to see how many times the series are to be
differenced to become stationary (the residuals of such regression are going to be stationary
so the standard t-tests can be applied), so we can imply that the observed temporary shocks
have permanent effects. The ARDL cointegration approach can be used for examining the
existence of long run relationships without requiring such pre-testing, as it does not require
the date to be stationary (Sarkar 2006, 15-16).
3.2. Variables After having chosen the principal research method, the next step is selecting the right
variables to be examined. Basically, we are looking for two kinds of variables to be selected –
the independent variable, representing the openness to trade of the country, and the dependent
variables, representing its economic development.
3.2.1. The openness to trade variable Trade openness is generally seen as one of the most important factors influencing
economic growth and there have been already a lot of both theoretical and empirical
economic studies examining this relation.
Endogenous theoretical models in works of Romer (1990), Grossman and Helpman
(1990) or Matsuyama (1992) are one of the fundamental studies examining the influence of
trade restrictions on the increase or decrease of growth in the world. The work of Grosman
and Helpman (1992) for example than shows that one of the relatively reliable ways leading
to sustainable growth is protection encouraging investment in sectors with high degrees of
research. Young (1991) and Rivera-Batiz and Xie (1993) on the other hand point out that
despite having different technologies and endowments, economic integration and trade
liberalization might actually become harmful for participating countries (Serkar 2007, 8).
Given the ambiguity of the results of the theoretical models, a multitude of empirical
studies were undertaken to examine the link between trade and growth on real life data.
However, choosing the right measure of openness showed to be a very challenging task and
different authors used different indicators in order to capture this variable. If we have a closer
70
look at the meaning of trade openness, besides the common idea of trade barriers and their
restrictiveness, there is no clear definition of openness that would be commonly agreed by the
academic community. Various studies have described openness in many different ways and
there have been many different approaches used to capture it. Lane (2007) reviewed an
extensive number of these studies and aggregated the various measures of openness that
appeared in them into 6 distinctive groups. These groups are (Lane 2007, 7-8):
1) Trade ratios
2) Adjusted trade flows
3) Price-based measures
4) Tariffs measures
5) Non-tariff barriers measures
6) Composite indicies
The first three groups include openness measures based on trade flows or price levels
while the other three on assessing directly the different kinds of trade restrictions. As Lane
(2007, 8) points out, the first three thus focus more the on outcomes whilst the other three on
particular trade policies.
We chose the first one - the trade ratios, calculates particularly as the share of foreign
trade on the country’s GDP expressed as (Exports + Imports)/GDP - as the measure of
openness used in this study. Nevertheless, in order to examine its advantages and
disadvantages, as well as the advantages and disadvantages of its alternatives, we will now go
through a short review of all these measures.
3.2.1.1. Trade ratios Trade ratios, also known as trade share or trade intensity, are the most commonly used
measure of trade openness. Most often, they are calculated in the simple form of (Exports +
Imports)/GDP, as used for example by Barro and Sala-i-Martin (2004). Alternative measure
are the import penetration ratios (Leamer, 1988), constructed by dividing imports of a given
commodity by the total domestic supply of that commodity. This measure is aiming to
provide the indication of competitiveness of domestic producer’s on international markets;
however, it is not widely used. Using trade ratios is criticized for being rather the measure of
country size and integration into international markets than openness as an outcome of trade
policies. The data for big countries is often being biased, as a much larger part of the domestic 71
production ends up on the domestic market than in the case of smaller countries, and the big
ones then appear as less open. The advantage of the measure is that as it is widely used, it
allows for comparisons among studies (Lane 2007, 9-10).
3.2.1.2. Adjusted trade flows The adjusted trade flows measures are based on using deviations of actual trade flows
from counterfactuals constructed as the predicted free-trade trade flows. The aim of the
counterfactuals is to represent what would be the outcome under different policy strategies –
e.g. the free trade. There are two types of methods being used to construct the counterfactuals.
The first one is using the Hecksher-Ohlin factor model in which the free-trade trade flows are
derived from the country’s endowment by resources as capital, labor, land or natural resources
(for example oil or gas). An example of such approach might be the work of Leamer (1988).
The second approach to construct the counterfactuals uses gravity models from Newton
physics. They are based on the assumption that trade flows between two countries are
positively influenced by the size of the country (represented by national incomes) and
negatively by the distance of the two countries (used as proxy for transport costs). We might
find usage of the gravity models for example in the work of Hiscox and Kastner (2002). The
main disadvantage of using the adjusted trade flow measures is that their outcomes are very
sensitive to the methods chosen to construct the counterfactuals (Lane 2007, 13-16).
3.2.1.3. Price-based measures The price-based measures aim to capture the openness of the country by searching for
price distortions in goods markets (by comparing the domestic prices with the international
ones) or with currencies (usually by using the black market premium). The most famous of
them is probably the Dollar’s (1992) “index of real exchange rates distortion”. When using
these measures, countries with higher prices are seen as the ones that are more protectionist.
The main advantages are that the price-based measures arguably capture the effect of both
tariff and non-tariff measures and they are more easily interpretable than for example flow-
based measures. However, the biggest pitfall of using them is that in order to be accurate,
three conditions need to hold at the same time, which is very unlikely. Firstly, countries do
not use subsidies or taxes on exports, secondly, all else equal, the prices of goods are the same
everywhere (the law of one price), and thirdly, geographic conditions and costs of transport
do not cause significant differences in prices between countries (Lane 2007, 16-18).72
3.2.1.4. Tariff measures Tariffs are the most direct and the most easily visible trade restrictions. Various tariff
measures are being used, from simple and trade-weighted tariff averages to effective rate of
protection. They are very popular among researchers, as it is relatively easy to obtain data;
however, this might not be the case every time. Countries do not always report their tariff
rates yearly, not even in the form of simple average tariffs. Besides that, there are several
significant problems related with usage of the tariff measures. We are going to mention two of
them. Firstly, as import elasticities vary across products and countries, a particular tariff might
have dissimilar effects for both differentiated product in an individual country of for the
identical product throughout different countries. Secondly, the unweighted average tariff
rates often overstate the average tariffs, as they comprise very high and limiting tariffs while
weighted average tariff rates are often downwards biased as the amounts of imports of items
with the highest tariffs tend to be usually low (Lane 2007, 18-20).
3.2.1.5. Non-tariff barrier measures As mentioned in chapter 1.2.1., Non-tariff barriers (NTB) take a variety of forms,
ranging from import quotas to voluntary export restraints etc. Moreover, not all NTBs are in
fact “barriers”. Some of them might rather be government’s instruments aimed at enforcing
domestic producers, as for example export subsidies, others might be created as a
consequence of the government’s increased involvement in particular industries, leading to
state monopolies or allowing collusions among companies. A special kind of NTBs are then
particular social, cultural and political institutions present in the country. Given the fact that
we should take in account the effects of all these, it is very difficult to assess the NTBs as
measures of openness. Creating a summary NTBs measure demands defining and identifying
instruments that are generally very opaque in both implementation and operation and it is also
very difficult to obtain any data on their actual impact and effects on the economy (Lane
2007, 20-21).
3.2.1.6. Composite indices Composite indices are measures using weighted or unweighted combinations of
indicators based on subjective selection of the researcher. Various institutional arrangements
73
and structural characteristics are combined into a single variable. Researchers that decide to
use the composite indices should, prior to applying them, familiarize themselves well with
both the components as well as with the particular data the components are based on. The way
the indicators are combined and weighted might be also based on certain theoretical
background. An example of a composite trade measure might be Sachs and Warner’s (1995)
zero-one dummy measure of openness used to research a relation between openness and
growth on a sample of 79 countries between years 1970 and 1989. The indicator gains value 0
= closed economy, in the case any or more than one of these conditions are met:
1) The average tariff rates of the country exceed 40 %.
2) The NTBs cover more than 40 % of all imports of the country.
3) The country has a socialist central planned economy.
4) There is a state monopoly for major exports in the country.
5) The black market premium in the country exceeded 20 % during the 1970s or 1980s.
However, as the choice of the indicators is arbitrary and depends first of all on the
individual intuition of the researcher, the inappropriate choice of the components or the
weights might cause a significant bias for example by results skewed towards some of the
components more than others. Secondly, using such indicators allows combining different
traits of trade policy with other different structural characteristics all together and their
compatibility can be in the end very questionable (Lane 2007, 20-21).
3.2.2. The economic development variables Our next step is selecting the set of variables which would adequately represent the
economic development of the case countries. As defined in chapter 1.5.2, we understand
economic development as the economic growth accompanied by changes in economic and
social structure and the overall output distribution. However, which are the best social
indicators to represent this definition?
If we once again have a look on how is economic development operationalized by the
UN in the Human Development Index (HDI), we can see that it consists of 3 different
components – life expectancy at birth (representing the health standards of the country), years
of schooling (representing the level of education) and Gross National Income per capita
(representing the standard of living in the country). Nevertheless, it is highly questionable to
what extent could trade liberalization actually influence the first two of these components, as 74
they are logically more significantly determined by other “more socially rooted”
determinants. We are thus left out with the GNP per capita indicator, which we can accept as
one of our dependant variables, just in the form of GDP per capita in its growth rate form, as
the GDP indicator is more common in the European research environment.
We will thus pay attention to the economic structure part of our understanding of
economic development. Particularly, besides the impact of the liberalization on the 1)
standard of living, we will focus our research around another three issues – 2) the character of
domestic production capacities, 3) the structure of the country’s exports and 4) the structure of
the country’s exports destinations.
When it comes to the character of domestic production capacities, we will examine the
impact of trade liberalization on the growth rate of domestic industry value added11, growth
rate of domestic services value added12 and the growth rate of domestic gross fixed capital
formation13.
When it comes to the structure of the country’s exports, we will try to capture the
impact of the trade liberalization on the actual simple product structure of the exports and on
the technology class structure of the exports14.
Last but not least, the impact of the trade liberalization on the structure of the
country’s export destinations will be examined on the actual simple country structure of the
export destinations and the structure of the export destinations according to the sophistication
of the market15.
11 Defined as the value added in mining, manufacturing, construction, electricity, water and gas. Value added is the net output of a sector after adding up all outputs and subtracting intermediate inputs. The origin of value added is determined by the International Standard Industrial Classification (ISIC), revision 3 (WB WDI).12 Defined as the value added in wholesale and retail trade (including hotels and restaurants), transport, and government, financial, professional, and personal services such as education, health care, and real estate services. Value added is the net output of a sector after adding up all outputs and subtracting intermediate inputs. The industrial origin of value added is determined by the International Standard Industrial Classification (ISIC), revision 3 (WB WDI).13 Gross fixed capital formation includes land improvements (fences, ditches, drains, and so on); plant, machinery, and equipment purchases; and the construction of roads, railways, and the like, including schools, offices, hospitals, private residential dwellings, and commercial and industrial buildings (WB WDI).14 Based on the OECD technology classification. 15 Based on the World Bank Analytical classification of countries based on their gross national income (GNI) per capita.
75
3.3. Data In order to obtain data series for constructing the variables selected in the previous
chapter, we are going to use three different sources. Nevertheless, these sources are limited in
extent, especially when it comes to the length of the data series we need for our analyses,
which we are going to have to reflect in the final selection of the research methods.
To construct the variables for trade openness, GDP per capita growth rate, industrial
value added growth rate, services value added growth rate and gross capital formation growth
rate, we are going to use the World Bank World Development Indicators (WB WDI)
database. Data from this source is available for the whole research period 1970-2010.
The data on the technological classes of Brazil’s and Indonesia’s exports will be drawn
from the OECD Bilateral Trade Database by industry and end-use (OECD BTDIxE). Data
from this source is available for the period of 1990 - 2010.
Last but not least, we will draw the data on Brazil’s and Indonesia’s exports and
export destinations from the Observatory of Economic Complexity (OEC) database. Data
from this source is available for the period of 1995-2010.
3.4. The final method and hypotheses Given the limited availability of sufficient data described in the previous chapter, if we
want to use all the selected variables, we are forced to relax our original condition for the
long-term character of the data series we decided to use. However, the insufficient length does
not allow us to apply the ARLD model for all the selected variables. We will thus have to use
two different methodologies. We will use econometric analysis for the variables available in
the extent of the whole research period and we will examine the remaining variables using
simple visual observation of the data when projected on graphics. In the second case, the
insufficient length of the time series will not allow us to compare the data to a counterfactual
in the form of the pre-liberalization values and neither we relate them to the measure of trade
openness, which both to a certain level decrease the weight of our results. However, using this
method can still provide us with valuable and relevant findings.
Given the choice of our variables, we can now formulate 8 hypotheses, which will be
examined in the analytical part of the thesis. The hypotheses are based on the classical free
76
trade arguments discussed in the theoretical parts of this paper and we will thus challenge
their validity on the example of Brazil and Indonesia. Hypothesis number 5 is then based on
the Xu’s infant industry model, assuming that the trade liberalization is allowed to happen by
the country only once the infant industry becomes viable independently on trade protection.
Hypothesis 1: Trade liberalization in Brazil/Indonesia had positive impact on the GDP per
capita growth of the country.
Hypothesis 2: Trade liberalization in Brazil/Indonesia had positive impact on industry and
services value added growth of the country.
Hypothesis 3: Trade liberalization in Brazil/Indonesia had positive impact on capital
formation growth of the country.
Hypothesis 4: Trade liberalization in Brazil/Indonesia lead to specialization of the country in
products in which the country possess comparative advantage.
Hypothesis 5: Trade liberalization in Brazil/Indonesia allowed for emergence of an infant
industry in the country.
Hypothesis 6: Trade liberalization in Brazil/Indonesia lead to increase of technologically
advanced exports from the country.
Hypothesis 7: Trade liberalization in Brazil/Indonesia lead to higher dispersion of the
country’s exports among its trade partners.
Hypothesis 8: Trade liberalization in Brazil/Indonesia lead to increase of exports of the
country to more developed markets.
In order to examine the first 3 hypotheses, we will use the econometric ARLD
cointegration model. In particular, we will regress the trade ratios variable for Brazil and
Indonesia against the variables representing their GDP per capita growth, their industry value
added growth, their services value added growth and their gross fixed capital growth in the
77
chosen period of 1970 – 2010. Besides the whole period, we will examine the effects also
separately in the pre-liberalization and the post-liberalization periods.
The following equations are fitted
(16) Gt=α+ βt+∑i=1
p
β i Gt−i+∑j=0
q
γ j T t− j
(17) I t=α+βt +∑i=1
p
β i I t−i+∑j=0
q
γ jT t− j
(18) St=α +βt+∑i=1
p
β i S t−i+∑j=0
q
γ jT t− j
(19) C t=α+βt +∑i=1
p
β iC t−i+∑j=0
q
γ jT t− j
where G (respectively I, S and C) stands for the growth rate of GDP per capita
(respectively industry value added, services value added and gross capital formation), T for
the trade ratios and the subscripts t, t-i and t-j identify the different time periods and p and q are lags determined by chosen criterions.
To define the number or lags p and q of the ARDL model, we use three indicators -
the classical R-Bar Squared and two information criterions – the Akaike Information Criterion
(AIC) and the Schwarz Baynesian Criterion (BIC).
Following Serkar (2007), in the case of Indonesia, we fit an extra equation adding a
dummy variable K accounting for years 1998-2002 in order to capture the impact of the Asian
financial crisis. The equation has similar alternations also for I, S and T.
(20) G(t )¿ =α+βt +∑
i=1
p
β iGt−i+∑j=0
q
γ j T t− j+δK
78
In order to examine hypothesis 4, we assume the top 12 export articles of the country
as the products in which the country has comparative advantage. We than observe whether the
share of these product on the total volume of exports increases or decreases.
To verify hypothesis 5, we will observe the data throughout the research period and
search for technologically advanced industry/product that would register significant increase
in export volumes. If we find such, we will assume we are dealing with an industry showing
the treats of a grown up infant industry.
We will examine hypothesis 6 by observing the trends in export shares of
technologically advanced products on the overall export volume during the examined period.
In order to verify hypothesis 7, we will observe the increases or decreases of
individual shares of Brazil’s and Indonesia’s Top 20 export destinations on the overall export
volume.
Hypothesis 8 will be tested by observing the trends in participation of high income
countries (aka countries of “the North”) on the overall sum of Brazil’s Top 20 export
destinations.
79
4. THE IMPACT OF TRADE LIBERALIZATION IN BRAZIL AND INDONESIA ON THEIR ECONOMIC DEVELOPMENT – ANALYTICAL ASSESSMENT
4.1. The impact of trade liberalization on Brazil
4.1.1. Impact on the standard of living in Brazil Table 3 gives us the results of regressing trade openness on the GDP per capita growth
in Brazil, our variable representing the standard of living in the country. The table is
organized according to the examined periods and it offers us separate coefficient values for
each selection criterion for each period. The numbers in the parentheses stand for the number
of the applied time lags selected by the given criterion, the underlined values are the R-Bar
squared values expressing the explanatory power of the particular model.
Table 3: Regression of trade openness on the GDP per capita growth in Brazil
Country
-: Criteria (ARDL Model in Parentheses): -
The whole period Pre-liberalization Post-liberalization
R-Bar Sq AIC BIC R-Bar Sq AIC BIC R-Bar Sq AIC BIC
Brazil 0.23
(2,1)
0.14
0.23
(2,1)
0.14
0.30
(3,2)
0.12
0.08
(2,1)
0.17
0.08
(2,1)
0.17
-0.07
(3,2)
0.15
0.03
(2,1)
-0.16
0.03
(2,1)
-0.16
0.26
(3,2)
0.05
Source: WB WDI
The impact of openness to trade on the GDP per capita growth rate in Brazil shows
positive values basically for all the selection criterions in all the research periods. However,
none of them appears to be significant. Also the values of R-Bar squared are very low and
even negative in the case of the post-liberalization period. Based on our indicators, we can
conclude that neither the level of trade openness, neither the liberalization of trade, had any
significant influence on GDP per capita growth in Brazil.
80
4.1 .2. Impact on the character of production capacities in Brazil
Table 4: Regression of trade openness on the industry value added growth in Brazil
Country
-: Criteria (ARDL Model in Parentheses): -
The whole period Pre-liberalization Post-liberalization
R-Bar Sq AIC BIC R-Bar Sq AIC BIC R-Bar Sq AIC BIC
Brazil 0.522
(3,2)
0.15
0.34
(0,0)
0.12
0,53
(3,4
0.12
-0.01
(3,2)
0.29
-0.11
(0,0)
0.29
0.26
(3,4)
0.26
0.77
(3,2)
0.14
0.14
(0,0)
-0.10
1.70
(3,4)
0.40
Source: WB WDI
As in the previous case, the effect of openness to trade on Brazilian industry value
added growth rate shows positive values almost for all the selection criterions and time
periods, just with two exceptions in the pre-liberalization period. Nevertheless, also in this
case, none of the values on the coefficients proved to be significant. Also the values of R-Bar
squared are again very low, showing only meager explanation power of the regression
models. Based on our indicators, we can conclude that neither the level of trade openness,
neither the liberalization of trade, had significant effect on industrial value added growth in
Brazil.
Table 5: Regression of trade openness on the services value added growth in Brazil
Country
-: Criteria (ARDL Model in Parentheses): -
The whole period Pre-liberalization Post-liberalization
R-Bar Sq AIC BIC R-Bar Sq AIC BIC R-Bar Sq AIC BIC
Brazil 0.17
(1,0)
0.17
0.17
(1,0)
0.17
0,13
(4,3)
0.08
0,10
(1,0)
0.32
0,10
(1,0)
0.32
-0.4
(4,3)
0.15
0.02
(1,0)
0.20
0.02
(1,0)
0.20
0.19
(4,3)
0.43
Source: WB WDI
The effect of openness to trade on Brazilian services value added growth rate shows
basically the same case as with the industry value added. The effect is almost in all cases
positive, but very weak, insignificant and with low values or R-Bar squared. The only
interesting result is then the fact that the R-Bar squared values are in general slightly higher
than in the case of the industry value added.
81
Table 6: Regression of trade openness on gross capital formation in Brazil
Country
-: Criteria (ARDL Model in Parentheses): -
The whole period Pre-liberalization Post-liberalization
R-Bar Sq AIC BIC R-Bar Sq AIC BIC R-Bar Sq AIC BIC
Brazil 0.17
(1,0)
0.17
0.17
(1,0)
0.17
1.06
(4,4)
-0.08
0.1
(1,0)
0.32
0.1
(1,0)
0.32
1.35
(4,4)
-0.16
0.02
(1,0)
0.20
0.02
(1,0)
0.20
-0.36
(4,4)
-0.06
Source: WB WDI
Not even the impact of openness to trade on Brazilian gross capital formation showed
any significant results and also the R-Bar squared stayed relatively low and moreover very
volatile, ranging from negative to positive values. In conclusion, we can say that trade
openness and trade liberalization did not proved to have any significant impact on any of the
variables we chose to represent both the living standard and the character of production
capacities in Brazil.
4.1.3. Impact on the structure of Brazil’s exports In this section, we will review the impact of trade liberalization on the structural
development of Brazil’s exports. Firstly, we observe the structure of Brazil’s main export
articles.
Figure 10 shows us the structure of Brazil’s main exported products during the period
of 1995-2010. The figure includes all the main articles that managed to get into Top 12 of
exported products at least 8 times during the observed period. There have been 13 products,
which managed to fulfill our condition. The Top 3 exported articles in 1995 were Iron Ore
with 5.62 %, Soybean Meal with 4.45 % and Coffee with 4.33 % of all Brazil’s exports.
During the 15 years long research period, Iron Ore remained Brazil’s main export article and
in 2010 held 14.71 % of all Brazil’s exports. The exports of Soybean Meal and Coffee lost
some of its share with 2.38 % and 2.59 % respectively, however they managed to stay in the
Top 8 of all Brazil’s exported products. Throughout the research period, Brazil managed to
build strong position in exporting Crude Petroleum, Raw Sugar and Soybeans occupying 8.31
%, 6.29 % and 5.45 % of all its exports in 2010. We can also notice that Brazil managed to
build up two viable hi-tech industries – Cars and Planes, Helicopters and/or Spacecraft, which
in 1995 with 0.9 % and 0.45 % did not even managed to get into the Top 12. Nevertheless, in
82
2010, production of Cars participated in the overall exports volume with 2.27 % and
production of Planes, Helicopters and/or Spacecraft with 2.18%. However, both of these
sectors reached their peaks at the beginning of the 21st century, with the later even becoming
with 5.92% shares Brazil’s main export article in 2001. We could thus assume that these two
industries are likely to be the case of Brazil’s infant industries, which managed to “grow up”
to be viable on their own even after the trade protection was removed during the trade
liberalization. However, in order to be sure of such a conclusion, we would have to have more
detailed information about the country’s trade policies prior the liberalization which we do
not. The graphics also imply the increasing specialization of Brazil’s exports, with these Top
13 export articles accounting for 33.8 % of all exports in 1995 and already 52.84 % in 2010.
83
Figure 10: The structure of Brazil’s main export articles during 1995-2010
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 20100%
10%
20%
30%
40%
50%
Iron Ore Raw Sugar Soybean Meal Coffee Soybeans
Cars Vehicle Parts Planes, Helicopters, and/or Spacecraft Sulfate Chemical Woodpulp Poultry Meat
Leather Footwear Fruit Juice Crude Petroleum Others
Source: EOC
83
Secondly, we observe the development of the structure of Brazil’s exports based on
their technology class. We assume that trade liberalization would increase the number of hi-
tech and medium high tech products, as opening the country to trade would be connected with
significant technology transfers and improvements in efficiency.
Figure 11: The structure of Brazil’s exports in years 1990 – 2010 based on their technology class I.
19901992
19941996
19982000
20022004
20062008
20100%
10%20%30%40%50%60%70%80%90%
100%
Hi-tech Medium HighMedium Low Low-tech
Trad
e l
iber
aliz
ation
Source: OECD BTDIxE
Figure 11 shows the evolution in the structure of Brazilian exports based on their
technology class. The figure demonstrates a clear trend in the increase in exports of high
technology goods in the second half of 1990’s after the trade liberalization. This trend peaked
at the end of the 20th and the beginning of the 21st century, reaching 15% share of the overall
exports. However it was later replaced by a slow decline of the share stabilizing at figures just
above the shares from the beginning of the previous decade. The export of low technology
goods and medium high technology goods exhibited more or less stable shares, fluctuating
with temporary deviations about the same figures throughout the whole period after the trade
liberalization. The sectors which experienced the most significant losses in shares were the
84
sectors exporting medium low goods, especially during the turn of the century. Nevertheless,
the figures from the second half of the first decade of the 21st century were also very similar to
those from the beginning of the 1990’s. We can thus say that when it comes to the structure of
the Brazilian exports, there was a significant trend towards exports of high technology exports
just after the trade liberalization, which has been nevertheless reversed back towards to the
original numbers in the first decade of the 21st century.
Figure 12: The structure of Brazil’s exports in years 1990 – 2010 based on their technology class II.
19901992
19941996
19982000
20022004
20062008
20102030405060708090
100
High Tech Low Tech
Trad
e l
iber
aliz
ation
Source: OECD BTDIxE
We obtain even more eloquent results on the technology character of the exports if we
look at figure 12, merging exports of high technology and medium high technology goods
into one category called “High Tech” and medium low and low technology goods into another
one called “Low Tech”. It is clear that the trade liberalization had initial positive impact on
the export structure in favour of the High Tech goods. Even though the boom from the early
post-liberalization years weakened after the peak year 2000, Brazilian export managed to keep
higher shares of the High Tech goods than in the pre-liberalization period.
85
4.1.4. Impact on the structure of Brazil’s export destinations First of all, we will analyse the structure of Indonesia’s and Brazil’s export
destinations using the cumulative shares of its main export destinations. Our analysis of this
indicator is based on the simple assumption that once trade is liberalised, the country’s traded
sectors develop and try to enlarge the portfolio of their trade partners, penetrate new markets
and try to increase their sales on these new markets. Thus, the more developed the traded
sectors of the country are, the more fragmented is the composition of their export destinations
and the lower should be the shares of the largest destinations. The logic behind the
assumption is that as the economy gets more sophisticated and developed, the more foreign
markets are penetrated by its exporters and subsequently, the more equally spread out is the
export of its goods, instead of being concentrated in higher numbers into a smaller number of
the major destinations. Of course, while using this assumption, we cannot forget about the
geographical position of the country which might limit the accessibility of foreign markets.
Figure 13: Dispersion of Brazil’s exports among its 20 main export destination
19951997
19992001
20032005
20072009
0.00%
20.00%
40.00%
60.00%
80.00%
100.00%Structure of export destinations Brazil
Top 5Top 10Top 15Top 20All
Source: OEC
Figure 13 and table 7 show us the development in the structure of Brazil’s export
destinations in the post-liberalization years 1995-2010. In 1995, just after the trade
liberalization, Brazil’s Top 5 export destinations accounted for 44.41 % of all its exports, the
86
Top 10 for 59.69 %, the Top 15 for 69.93 % and the Top 20 for 75.73 %. The development of
the trend visible on figure 12 shows a long term inclination to higher fragmentation, this
direction nevertheless had to undergo several shifts. Brazil experienced its highest export
destination concentration in 2000, when the Top 5 destinations absorbed almost 50 % and the
Top 20 more than 80 % of all its exports. On the other hand, the fragmentation peaked not in
2010 but in 2009, when the Top 5 destinations absorbed only 40.37 % of all exports,
experiencing a -4.04 % drop compared to year 1995. In the same year, the Top 10 destinations
accounted for 52.48 % (drop of -7.21 %), the Top 15 for 62.03% (drop of -7.9 %), and the
Top 20 for 69.64% (drop of -6.09 %) of exports. The data thus shows significant drops in
concentrations, which went mostly on account of the middle sized export destinations. Year
2010 than brought a shift back to higher concentration of exports among Brazil’s Top 20
export destinations, on average by 2.38 %.
Table 7: Dispersion of Brazil’s exports among its 20 main export destination
Top 5 Top 10 Top 15 Top 201995 44.41% 59.69% 69.93% 75.73%1996 47.30% 61.36% 71.40% 77.41%1997 48.22% 61.22% 70.69% 77.62%1998 47.77% 62.88% 72.20% 78.55%1999 48.45% 64.04% 72.66% 78.95%2000 49.48% 65.70% 74.66% 80.19%2001 45.37% 61.05% 71.68% 77.68%2002 42.43% 58.73% 69.61% 75.62%2003 44.54% 59.85% 70.76% 76.81%2004 44.40% 59.42% 69.05% 75.25%2005 41.88% 56.35% 66.58% 73.44%2006 40.81% 55.09% 65.87% 72.87%2007 40.88% 54.65% 65.85% 72.73%2008 40.57% 53.53% 64.25% 71.49%2009 40.37% 52.48% 62.03% 69.64%2010 42.66% 54.91% 64.40% 72.07%
Source: OEC
Figure 14 shows Brazil’s structure of exports according to the income level of its Top
20 exports destinations (based on the World Bank Classification of countries based on
according to GNI per capita) in the period of 1995-2010. We base this analysis on the
87
assumption that after the specialization following the trade liberalization, trade should happen
mostly between the countries of the South and the North, as these should exhibit different
comparative advantages streaming from their differing factor endowments. For the purpose of
our analysis, countries with high income are labeled as the “North” and countries with upper
and lower middle income and low income are labeled all together as the “South”. There is a
clear progressive trend of directing exports towards countries of the “South” observable from
the graphics. Throughout the 15 years period of our research period, the ratio of exports
directing towards North related to South within the Top 20 export destinations dropped from
73%/27% to 52%/48%. Thus, using the terminology of the theoretical part of the thesis, we
are observing increasing South-South trade relations and instead of increasing its exports to
more developed markets, Brazil’s is directing them towards the less developed ones.
Figure 14: Structure of Brazil’s export destinations according to their income level
19951996
19971998
19992000
20012002
20032004
20052006
20072008
20092010
0%10%20%30%40%50%60%70%80%90%
100%
North SouthSource: EOC
88
4.2. The impact of trade liberalization on Indonesia
4.2.1. Impact on the standard of living in Indonesia Table 8 gives us the results of regressing trade openness on the GDP per capita growth
in Indonesia. In this case, as in the case of the other variables used within the ARDL model
analysis, we are going to use two variants of the model – without and with the dummy for the
Asian financial crisis. The regressions including the dummy are marked by asterisk.
Table 8: Regression of trade openness on the GDP per capita growth in Indonesia
Country
-: Criteria (ARDL Model in Parentheses): -
The whole period Pre-liberalization Post-liberalization
R-Bar Sq AIC BIC R-Bar Sq AIC BIC R-Bar Sq AIC BIC
Indonesia -0.19***
(2,1)
0.52
-0.19***
(2,1)
0.52
-0.19***
(2,1)
0.52
0.02
(2,1)
0.03
0.02
(2,1)
0.03
0.02
(2,1)
0.03)
-0.32***
(2,1)
0.83
-0.32***
(2,1)
0.83
-0.32***
(2,1)
0.83
Indonesia* -0.08**
(3,1)
0.57
-0.1***
(2,1)
0.57
-0.06*
(4,3)
0.57
0.04
(3,1)
-0.03
0.02
(2,1)
0.03
0.12
(4,3)
0.20
-0.26***
(3,1)
0.86
-0.18***
(2,1)
0.84
-0.48*
(4,3)
0.88
Source of data: WB WDI
The results of the regression show highly significant negative values of trade openness
on the GDP per capita growth in Indonesia. Also the explanatory power of the model as
expressed by the R-Bar squared seems shows very high values. Nevertheless, it seems that
this negative effect appeared only after the trade liberalization, as the pre-liberalization values
are both positive and insignificant. Including the dummy for the Asian crises slightly
increased the R-Bar squared of the model but it also weakened the negative effect of trade
openness. We can thus claim that trade liberalization and increased openness to international
trade influenced negatively the growth of standard of living in Indonesia.
89
4.2.2. Impact on the character of production capacities in Indonesia
Table 9: Regression of trade openness on the services value added growth in Indonesia
Country -: Criteria (ARDL Model in Parentheses): -
The whole period Pre-liberalization Post-liberalization
R-Bar Sq AIC BIC R-Bar Sq AIC BIC R-Bar Sq AIC BIC
Indonesia -0.42**
(2,1)
0.35
-0.42**
(2,1)
0.35
-0,55*
(4,3)
0.31
-0.48*
(2,1)
0.34
-0.48*
(2,1)
0.34
-0,98*
(4,3)
0.46
-0.5***
(2,1)
0.55
-0.5***
(2,1)
0.55
-1,16**
(4,3)
0.61
Indonesia* -0.4*
(2,1)
0.33
-0.4*
(2,1)
0.33
0.55
(4.3)
0.29
-0.48*
(2,1)
0.35
-0.48*
(2,1)
0.35
-0.98*
(4,3)
0.46
-0.55*
(2,1)
0.55
-0.55*
(2,1)
0.55
-0.88
(4,3)
0.65
Source: WB WDI
Results of the regression stated in table 9 show us significant and relatively high
negative impact of trade openness on the industry value added growth in Indonesia. Also the
R-Bar squared values stay pretty high, implying that trade openness is responsible for about
one third of variation in the industry value added growth in the pre-liberalization and more
than a half of the variation in the post-liberalization period. Adding the dummy for the Asian
crisis weakened the significance of the coefficients, however, their values stayed relatively
untouched and there also was not any visible improvement in R-Bar squared. That implies
that the Asian crisis had only minimal effect on the industry value added in Indonesia.
Table 10: Regression of trade openness on the services value added growth in Indonesia
Country -: Criteria (ARDL Model in Parentheses): -
The whole period Pre-liberalization Post-liberalization
R-Bar Sq AIC BIC R-Bar Sq AIC BIC R-Bar Sq AIC BIC
Indonesia -0.28**
(0,0)
0.19
-0.28**
(0,0)
0.19
-0.12*
(4,3)
0.17
0.22
(0,0)
0.03
0.22
(0,0)
0.03
0.51
(4,3)
0.51
-0.45***
(0,0)
0.49
-0.45***
(0,0)
0.49
-0.82*
(4.3)
0.42
Indonesia* 0.19
(2.3)
0.34
0.09
(2,1)
0.32
0.25
(4,3)
0.31
0.59*
(2,3)
0.48
0.53**
(2,1)
0.42
0.50
(4,3)
0.51
-0.4**
(2.3)
0.49
-0.57
(2,1)
0.46
-0.64
(4,3)
0.47
Source: WB WDI
90
Regression results for the effect of trade openness on the services value added shows
again negative significant values, especially in the post-liberalization period. Including the
dummy for the Asian crises however erases this significance. However, the overall effect of
the dummy inclusion seems to make the results more biased than clearer. First of all, it takes
off the significance from the coefficients in the whole and the post liberalization period,
however not really improving the R-Bar squared values in the later. Moreover, it actually
brings significance to the pre-liberalization coefficient, which in fact does not make a lot of
sense, as there could not be affected by the crisis which happened years after this period. We
can thus claim that the results of the impact of trade openness and trade liberalization on
Indonesia’s services value added growth are rather inconclusive.
Table 10: Regression of trade openness on gross capital formation in Indonesia
Country -: Criteria (ARDL Model in Parentheses): -
The whole period Pre-liberalization Post-liberalization
R-Bar Sq AIC BIC R-Bar Sq AIC BIC R-Bar Sq AIC BIC
Indonesia -0.61***
(2,2)
0.49
-0.61***
(2,2)
0.49
-0.73**
(4,4)
0.44
-0.41
(2,2)
0.34
-0.41
(2,2)
0.34
-0.08
(4,4)
0.30
-1.02***
(2,2)
0.63
-1.02***
(2,2)
0.63
-1.34*
(4,4)
0.57
Indonesia* -0.31
(4,4)
0.52
-0.42*
(2,2)
0.49
-0.31
(4,4)
0.52
0.08
(4,4)
0.30
-0.41
(2,2)
0.34
0.08
(4,4)
0.30
-0.79
(4,4)
0.84
-0.26*
(2,2)
0.65
-0.79
(4,4)
0.84
Source of data: WB WDI
The results in table 10 show highly significant and strong negative effect of trade
openness on the gross capital formation in Indonesia, especially in the post-liberalization
period. Nevertheless, adding the Asian crisis dummy into the equation causes the significance
to drop completely in almost all the cases and such models also exhibit much higher values of
R-Bar squared. We can thus conclude that unlike the Asian financial crisis, the trade openness
and trade liberalization did not have any significant effect on gross capital formation in
Indonesia.
91
4.2.3. Impact on the structure of Indonesia’s exports Figure 15 shows us the structure of Indonesia’s main exported products during the
period of 1995-2010. The figure includes all the main articles that managed to get into Top 12
of exported products at least 6 times during the observed period. There have been 14
products, which managed to do so. The Top 3 exported articles in 1995 were Crude Petroleum
with 10.23 %, Petroleum Gas with 8.52 % and Plywood with 7.56 % of all Indonesia’s
exports. During the 15 years long research period, Crude Petroleum and Petroleum Gas
remained Indonesia’s major export articles and in 2010 held 5.77 % and 7.60 % of all its
exports. The exports of Plywood lost most of its shares and with 1.12 % ended up being only
13th Indonesia’s most exported product. On the other hand, throughout the research period,
Indonesia managed to build strong position in exporting Coal Briquettes and Palm Oil
occupying 10.16 % and 6.62 % of all its exports in 2010. We can also notice that Indonesia
managed to build up three relatively viable technologically advanced industries – Computers,
Video Recording Equipment and Office Machine Parts, which with 1.20 %, 1.45 % and 1.01
% did not even managed to get into the Top 12. These three industries went through their
period of success at the beginning of the 21st century, with Computers peaking at 3.35 %
shares in 2000, Video Recording Equipment at 2.27 % in 2002 and Office Machine Parts at
1.80 % also in 2002. However, the exports of these products later went through a turn down
an in 2010, none of them reached the Top 12, each participating on the overall exports volume
with less than 0.7 %. We could thus assume that these three industries are likely to be the case
of Indonesia’s infant industries, which managed to “grow up” to be viable on their own after
the trade liberalization, but unluckily did not managed to keep their viability in the long term
horizon. However, in order to be sure of such a conclusion, we would have to have more
detailed information about the country’s trade policies prior the liberalization which we do
not. The graphics does not unambiguously imply increasing specialization of Indonesia’s
exports. On one hand, we observe visible concentration of exports into largest 7 industries
(Coal Briquettes, Petroleum Gas, Palm Oil, Crude Petroleum, Rubber, Copper Ore and
Refined Petroleum), on the other hand, these Top 14 export articles accounted for 47.61 % of
all exports in 1995, which is a higher concentration than 46.38 % shares reached by the same
industries in 2010.92
93
Figure 15: The structure of Indonesia’s main export articles during 1995-2010
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 20100%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
Crude Petroleum Petroleum Gas Copper Ore Refined Petroleum Coal Briquettes Palm Oil Rubber Plywood
Leather Footwear Other Furniture Computers Video Recording Equipment Office Machine Parts Crustaceans Others
Source: EOC
93
Figure 16 shows the structure of Indonesia’s exports in the years after the trade
liberalization based on the technology class of the goods. As visible from the graphics, the
dominant share of the low technology goods (over 68 % of all exports in 1990, 72 % in 1994)
has been progressively decreased in the subsequent years in benefit of the remaining sectors.
The most visible growth is visible in the share of the medium high technology and hi-
technology goods sectors, while especially the later has been practically inexistent at the
beginning of the 1990’s, early after the trade liberalization, but managed to reach over 18.5%
share in 2000 (higher than in Brazil), settling down on slightly below 10% share at the end of
the first decade of the 21st century.
Figure 16: The structure of Brazil’s exports in years 1990 – 2010 based on their technology class I.
Source: OECD BTDIxE
94
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
0%
20%
40%
60%
80%
100%
Hi-tech Medium HighMedium Low Low tech
Trad
e l
iber
aliz
ation
Figure 17: The structure of Brazil’s exports in years 1990 – 2010 based on their technology class II.
19901992
19941996
19982000
20022004
20062008
20100
20406080
100
Indonesia‘s High Tech vs Low Tech Exports
High Tech Low TechSource: OECD BTDIxE
The increasing importance of high technology goods for Indonesia’s export is even
more visible if we again aggregate the high technology goods with middle high technology
goods and middle low with low technology goods into the superior categories High Tech and
Low Tech goods. There is a clear upwards trend in the shares of High Tech goods from the
early post-liberalization years throughout the 1990’s. This trend than stopped at the beginning
of the 21st century and the shares of High Tech goods stabilized itself around 30 % of the
overall Indonesian export.
95
4.2.4. Impact on the structure of Indonesia’s export destinations
Figure 18: Dispersion of Indonesia’s exports among its 20 main export destination
Source:
OEC
Figure 18 and the data in table 11 show us the development in the structure of
Indonesia’s export destinations in the post-liberalization years 1995-2010. We can see that in
1995, 5 years after the trade liberalization, the Top 5 export destinations accounted for more
than 58 % of all Indonesian exports, the Top 10 for 74 %, the Top 15 for 84 % and the Top 20
for 89 %. The long term trends then show visible inclination towards larger fragmentation,
even though it is necessary to say, this shift did not happen completely linearly. The data from
2010 display that the Top 5 destinations accounted for over 52 % of all exports, which
indicates a drop of -6.05 % compared to year 1995. The Top 10 destinations then accounted
for about 71 % (drop of -3.63 %), the Top 15 for over 80 % (drop of -3.7 %) and the Top 20
for 86 % (drop of – 3.24 %). We can thus conclude that Indonesia’s exports became more
fragmented in the post liberalization period and the share loses were mostly on expense of the
largest export destinations.
96
19951997
19992001
20032005
20072009
0.00%10.00%20.00%30.00%40.00%50.00%60.00%70.00%80.00%90.00%
100.00%
Top 5Top 10Top15Top 20All
Table 11: Dispersion of Indonesia’s exports among its 20 main export destination
Top 5 Top 10 Top 15 Top 201995 58.45% 74.59% 84.08% 89.55%1996 57.92% 73.06% 83.15% 89.22%1997 57.00% 72.42% 82.40% 89.13%1998 53.04% 69.03% 80.08% 87.59%1999 55.00% 69.92% 80.48% 87.82%2000 57.68% 72.47% 81.85% 88.48%2001 55.27% 70.42% 80.36% 87.17%2002 54.33% 69.23% 79.84% 86.83%2003 55.21% 70.45% 80.72% 87.56%2004 54.85% 70.88% 81.06% 87.54%2005 56.53% 71.57% 81.08% 87.08%2006 56.04% 71.64% 80.76% 86.52%2007 54.10% 70.28% 79.09% 85.20%2008 52.91% 70.42% 79.04% 85.07%2009 51.58% 69.56% 79.43% 85.80%2010 52.40% 70.96% 80.38% 86.31%
Source: OEC
Figure 19 shows Indonesia’s structure of exports according to the income level in the
period of 1995-2010. Again, countries with high income are labeled as the “North”, countries
with upper and lower middle income and low income are labeled all together as the “South”.
Similarly as in the case of Brazil, we are observing a progressive trend of increasing the
shares of exports towards the countries of the “South”. Indonesia’s inclination towards this
trend was already visible in the 1990s, however, the Asian financial crisis temporarily
reversed it, as Indonesia’s trading partners from the South are mostly other Asian countries.
During the research period, the ratio of Indonesia’s exports to the North to exports to the
South within the Top 20 destinations dropped from 83%/17% to 66%/34%.
97
Figure 19: Structure of Brazil’s export destinations according to their income level
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 20100%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
North South
Source: EOC
.
98
CONCLUSION The main ambition of this thesis was discovering the impact of trade liberalization on
development of developing countries. In order to reach this goal, we chose the example of
Brazil and Indonesia throughout the period of 1970-2010 and expressed our aim in the main
research question:
“What was the impact of trade liberalization on economic development in Brazil/Indonesia?”
Prior answering this question, we have explained the most important theoretical
concepts in nowadays theory of international trade and demonstrated their mechanisms on a
set of economic and political economic models. We have then shortly introduced both case
countries. We have showed the similarities of the process of their trade liberalization, when
both liberalizations started as unilateral and were later replaced by regional liberalizations,
complemented by multilateral negotiations on the WTO level. The main drivers of both trade
liberalizations were the economic crises that hit them during the 1980s, in the cases of
Indonesia also in the 1990s, reinforced by the ideological influence of the so called
Washington Consensus, which dominated the international trade thoughts in this era. On the
other hand, we have also demonstrated the different degrees of openness of both countries.
To be able to find the answer for the research question, we have specified two
methodologies that were used to analyze relevant data. The first method was the econometric
ARDL cointegration model, the second method than analyses of the date projected on
customized graphics. As we have defined economic development as a wider concept than just
simple economic growth, we decided to focus on 4 particular aspects of economic
development, on which we have examined the impact of trade liberalization. These were 1)
standard of living, 2) the character of domestic production capacities, 3) the structure of the
country’s exports and 4) the structure of the country’s exports destinations. The selected
research methods were then used to verify or falsify the following 8 hypotheses, covering the
mentioned aspects of development. The first 2 aspects were examined with the ARDL model,
the second 2 with visual observation and the conclusiveness of the results is thus much
weaker than in the case of the first 2.
99
1) The standard of living
“Hypothesis 1: Trade liberalization in Brazil/Indonesia had positive impact on the
GDP per capita growth of the country.” In neither of the countries, this shoved to be truth.
The results of the regressions given by the ARDL model proved to be insignificant in the case
of Brazil and significant but negative in the case of Indonesia. We can thus reject the
hypothesis for Indonesia and consider our results inconclusive for rejecting or falsifying it for
Brazil. We thus did not find any evidence that the trade liberalization would improve the
standard of living in the case countries.
2) The character of domestic production capacities
“Hypothesis 2: Trade liberalization in Brazil/Indonesia had positive impact on
industry and services value added growth of the country.” Again, in neither of our research
countries, this shoved to be truth. Also in this case, the results given by the ARDL model
proved to be insignificant for Brazil for both the industry and the services value added and
significant but negative for the industry and inconclusive for the services value added for
Indonesia. We can this reject the part of hypothesis concerning the industry value added for
Indonesia and consider our results inconclusive for rejecting or falsifying for the whole
hypothesis for Brazil and for the services value added part of the hypothesis for Indonesia.
“Hypothesis 3: Trade liberalization in Brazil/Indonesia had positive impact on
capital formation growth of the country.” In this case, the ARDL model did not show any
significant results for neither of the countries. We thus consider our results to be inconclusive
for rejecting or falsifying for the hypothesis.
Based on our inability to reject of confirm any of these hypotheses, we conclude that
we have not found any evidence that the trade liberalization would improve the character of
domestic production capacities.
3) The structure of Brazil’s and Indonesia’s exports
“Hypothesis 4: Trade liberalization in Brazil/Indonesia lead to specialization of the
country in products in which the country possess comparative advantage.” The exports of
Brazil showed clear inclination towards concentrating into the Top 13 traded industries (from
33.8 % of all exports in 1995 to 52.84 % in 2010) and we can thus assume specialization
100
according the comparative advantage after the trade liberalization. The results for Indonesia
seem to be a bit less conclusive; however this inconclusiveness is given by our ill-fitting
method. We see a high level of concentration, but only in the top 7 traded industries, but not
in the Top 12, respectively Top 14, as we have chosen as our evaluation criterion.
Nevertheless, the obvious conclusion is that Indonesia simply has its comparative advantage
in less industries and we than consider our hypothesis verified.
“Hypothesis 5: Trade liberalization in Brazil/Indonesia allowed for emergence of an
infant industry in the country.” While evaluating this hypothesis, we need to be aware that the
explanation power of our conclusion is undermined by the fact, that we base our results only
on our assumption and observation of data, but we lack the factual proves that the
governments of Brazil or Indonesia would actually support the particular industries as infant
industries. Nevertheless, after observing the data, we conclude that we have encountered 2
likely cases of grown up infant industries in Brazil (Cars and Planes, Helicopters and/or
Spacecraft with) and 3 for Indonesia (Computers, Video Recording Equipment and Office
Machine Parts).
“Hypothesis 6: Trade liberalization in Brazil/Indonesia lead to increase of
technologically advanced exports from the country.” The results of our research show that
trade liberalization lead to increase of technologically advance exports in both countries. In
Brazil, the trend reversed after few years, nevertheless, despite this reverse, the values stayed
still on higher values than before the increase. In the case of Indonesia, the trend stabilized
technologically advanced exports exhibit stable trade shares on higher values than before. We
can thus verify the hypothesis for both countries.
Based on the confirmation of all three hypotheses, we can conclude that trade
liberalization had positive impact on the structure of Brazil’s and Indonesia’s exports.
4) The structure of the country’s exports destinations
“Hypothesis 7: Trade liberalization in Brazil/Indonesia lead to higher dispersion of
the country’s exports among its trade partners.” The results of our research for both countries
confirm the assumption expressed in the hypothesis. The results for Indonesia and Brazils
shows higher levels of dispersion, with the difference that in the case of Brazil, the dispersion
happened mostly on expense of share losses of the largest export destinations, while in the
case of Indonesia, on expense of share losses of the smaller export destination. We thus verify
the hypothesis for both countries.
101
“Hypothesis 8: Trade liberalization in Brazil/Indonesia lead to increase of exports of
the country to more developed markets.” The results for both countries exhibit values that are
completely contradictory to the hypothesis. Instead of increasing export shares to the
developed markets of the North, we are witnessing increasing export shares to the less
developed markets of the South. In particular, the ratio of exports directing towards North
related to South within the Top 20 export destinations dropped from 73%/27% to 52%/48% in
Brazil and from 83%/17% to 66%/34%. There might be several explanations for this trend.
Firstly, this might be given by the high degree of saturation and competitiveness of the
developed markets, when it easier for the producers from developing countries to penetrate
new less developed markets rather than spending enormous efforts for competing for the
developed ones, while looking for demand for their supply. Secondly, this trend might be also
included by the fact, that even the less developed markets of the South are becoming more
developed and demanding and exporting to them does not necessarily mean exporting to
markets on a smaller level of development. Nevertheless, we must falsify the hypothesis for
both countries.
Thus, based on our hypotheses, we can answer our research question as follows: 1) In
the case of Brazil, trade liberalization lead to higher specialization of exports according to the
comparative advantage, increase in exports with advanced technologies, higher dispersion of
its exports among the export destinations, mostly on expense of trade shares of larger export
destinations, and increase of trading with countries of the South. It also likely allowed for
emergence of two infant industries. 2) In the case of Indonesia, trade liberalization caused
decrease in the standard of living and in industry value added. It furthermore lead to higher
specialization of exports according to the comparative advantage, increase in exports with
advanced technologies, higher dispersion of its exports among the export destinations, mostly
on expense of trade shares of smaller export destinations and increase of trading with
countries of the South. It also likely allowed for emergence of three infant industries, which
however did not proved to be successful in the long time horizon.
102
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LIST OF FIGURES
Figure 1: Production possibility frontiers and the comparative advantage...................................Figure 2: Adjusting to free trade....................................................................................................Figure 3: Immiserizing Growth.....................................................................................................Figure 4: The Optimum Tariff.......................................................................................................Figure 5: Share of total tariff reduction by type of liberalization during 1983-2003....................Figure 6: The tariff rate evolution in a country pursuing infant industry protection policies.......Figure 7: The infant industry policies during trade talks...............................................................Figure 8: Simple mean applied tariff rate for all products in Brazil and Indonesia in the period 1989-2010......................................................................................................................................Figure 9: Share of trade on GDP of Brazil and Indonesia in the period 1970-2010.....................Figure 10: The structure of Brazil’s main export articles during 1995-2010................................Figure 11: The structure of Brazil’s exports in years 1990 – 2010 based on their technology class...............................................................................................................................................Figure 12: The structure of Brazil’s exports in years 1990 – 2010 based on their technology class II............................................................................................................................................Figure 13: Dispersion of Brazil’s exports among its 20 main export destination.........................Figure 14: Structure of Brazil’s export destinations according to their income level...................Figure 15: The structure of Indonesia’s main export articles during 1995-2010..........................Figure 16: The structure of Brazil’s exports in years 1990 – 2010 based on their technology class...............................................................................................................................................Figure 17: The structure of Brazil’s exports in years 1990 – 2010 based on their technology class II............................................................................................................................................Figure 18: Dispersion of Indonesia’s exports among its 20 main export destination...................Figure 19: Structure of Brazil’s export destinations according to their income level...................
LIST OF TABLES Table 1: Comparative advantage...................................................................................................Table 2: Per unit gains from specialization according to comparative advantage........................Table 3: Regression of trade openness on the GDP per capita growth in Brazil...........................Table 4: Regression of trade openness on the industry value added growth in Brazil..................Table 5: Regression of trade openness on the services value added growth in Brazil..................Table 6: Regression of trade openness on gross capital formation in Brazil.................................Table 7: Dispersion of Brazil’s exports among its 20 main export destination............................Table 8: Regression of trade openness on the GDP per capita growth in Indonesia.....................Table 9: Regression of trade openness on the services value added growth in Indonesia............Table 10: Regression of trade openness on the services value added growth in Indonesia..........Table 10: Regression of trade openness on gross capital formation in Indonesia.........................Table 11: Dispersion of Indonesia’s exports among its 20 main export destination.....................
108
LIST OF ABBREVIATIONS AIC - Akaike Information CriterionAPEC - The Asian-Pacific Economic CooperationARDL - Autoregressive Distributed LagASEAN - The Association of Southeast Asian NationsBIC - Schwarz Baynesian CriterionBRIC – Brazil, Russia, India, ChinaBRICS – Brazil, Russia, India, China, South AfricaBRIICS - Brazil, Russia, India, Indonesia, China, South AfricaCET - Common External TariffEU – European UnionFDI – Foreign direct investmentG7 – Group of 7GATT - General Agreement on Tariffs and TradeGNI – Gross National IncomeGDP – Gross Domestic ProductGDI – Groos Domestic IncomeHDI – Human Development IndexISIC – International Standard Industrial Classification
MERCOSUR – Southern Common MarketNAFTA - The North American Free Trade AgreementNTB – Non-tariff barriers PTA – Preferential trade agreementOECD BTDIxE - Organization for Economic Co-operation and Development Bilateral Trade Database by Industry and End-use categoryOEC - Observatory of Economic ComplexityR&D – Research and DevelopmentSGS - Société Générale de SurveillanceUS/USA – United States of AmericaUN – United NationsUNCTAD - United Nations Conference on Trade and DevelopmentUNDP – United Nations Development ProgramVAT – Value added taxWESIP - United Nation’s World Economic Situation and Prospects WB WDI – World Bank World Development IndicatorsWTO – Word Trade Organization
109
LIST OF ATTACHMENTS
Attachment 1: PTA patterns in East Asia.
Attachment 2: PTA patterns in Africa
Attachment 3: PTA patterns in Americas
110
Attachment 1: PTA patterns in East Asia
Source: Sally 2007, 37
111
Attachment 2: PTA patterns in Africa
Source: Sally 2007, 37
Attachment 3: PTA patterns in Americas
Source: Sally 2007, 37
112
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