International Economics I

CHAPTER FOUR
INTERNATIONAL TRADE AND ECONOMIC DEVELOPMENT
4.1. Trade Theory and Economic Development

According to G. Haberler (1963), there are at least four major beneficial effects that international
trade can have on economic development, particularly in the context of developing countries.
First, trade can lead to the full utilization of domestic resources. In other words, through trade,
a developing nation can move from an inefficient production point inside its production frontier
to a point on its production frontier. For such a nation, trade would represent a vent for surplus,
or an outlet for the potential surplus of agricultural commodities and raw materials. For example,
Southeast Asia and West Africa have benefited from this phenomenon. Secondly, by expanding
the size of the market, trade makes possible division of labor and economies of scale. This has
taken place in the production of light manufactures in small economies such as Taiwan, Hong
Kong, and Singapore. Thirdly, international trade may act as a vehicle for the transmission of
new ideas, new technology, and new managerial and other skills. Finally, trade can stimulate
and facilitate the international flow of capital from developed to developing countries. In
the case of foreign direct investment, where the foreign firm retains managerial control over its
investment, the foreign capital is likely to be accompanied by foreign skilled personnel.

Generally, the gains (importance) of trade are reflected in the following manner.
Acquisition of Capital Goods Industries: The under-developed countries (UDCs) are enabled
by foreign trade to obtain in exchange for their goods capital equipment and heavy engineering
machines to foster their countries’ economic development. For example, India exports spices,
cotton and cotton textiles, marine products, germs and jewellery and in exchange import heavy
machinery, defense equipment, and other capital equipment from the developed countries.

Market Extension The foreign trade can extend the scope of the business to the international
market. The domestic market is limited; the foreign trade sector opens new vistas, new marketing
channels and new markets. When the markets are extended, the economies of scale are reaped;
the efficiency and productivity will increase. Accordingly, the forces of development will set
themselves in motion.

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Inflow of Foreign Direct Investment: The foreign trade is also helpful in attracting foreign
investment. The foreign investors are attracted towards active trading countries and invest in the
form of capital goods and technical expertise. In this way, the assembling plants, the
manufacturing plants and the latest technology will come into the country. Foreign Direct
Investments and off shoring will stimulate the economic climate of a nation.
National Income: When there is imports and exports of goods and services, the government can
earn the revenue in form of tariffs, custom duty, import license fees, etc.
Employment Opportunities: Moreover, the external sector also opens the employment
opportunities for the country-men in the foreign countries. For example, hundreds of thousands
of Indians are working abroad. Hence, India is earning billions of dollars through foreign
exchange remittances and stands in the second position just behind China. Therefore, such
remittances are proved to be a major source of foreign exchange earnings.

4.2. Alternative Trade Strategies

Economic growth is fundamental to economic development. Without generating greater output

and income, a country cannot make a substantial attack on poverty, unemployment, and other
economic and social problems. The basic question in this regard is which trade strategies have
enabled countries to attain high growth and to develop their industrial potential? This question
can be answered in two ways. First, by examining the thinking that lies behind different
strategies, the circumstances under which governments have adopted them, and the economic
performance of countries that have pursued them. Secondly, by examining the economic costs
and benefits of alternative trade strategies and suggesting some reasons why economic
performance has varied so widely under the different strategies.

For analytical convenience, trade strategies can be broadly divided into two groups, outward
oriented and inward oriented. An outward – oriented strategy is one in which trade and industrial
policies do not discriminate between production for the domestic market and production for
exports. Alternatively, the strategy does not discriminate between purchases of domestic goods
and purchases of foreign goods. In other words, trade is neutral. Neutrality in trade means that
the aggregate effect of all trade and industrial policies is to offer equal incentives to the
production of all tradable. Relatively few developing countries have pursued this strategy though

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the most spectacularly successful rates of progress have been achieved by countries which
followed this path. Hong Kong, Taiwan, and Singapore are examples. An outward – oriented
strategy involves the taking of more initial risks if success is to be attained. The success of this
strategy depends on the availability of several factors to enable production and distribution to
take place at comparatively low costs. Thus, the provision of an efficient infrastructure such as a
transport and communications network, and educated manpower is necessary. This requires the
expenditure of possibly large amounts of government funds. The countries that successfully
pursued this strategy have also ensured that foodstuffs and raw materials are always made
available as cheaply as possible.

An inward – oriented strategy is one in which trade and industrial incentives are biased in favor
of production for domestic market over the export market. This approach is also referred to as
import substitution strategy. This strategy is one of the main development strategies chosen by
developing countries. In the early post – war years, it was thought by many economists and
governments of developing countries, that a policy of industrialization was the best strategy by
which to attain economic progress. The most obvious route was through import substitution. This
entailed the establishment of domestic industries behind tariff and quota barriers. Manufacturing
consumer goods industries were considered the most appropriate type with which to start this
process. Later, the manufacture of capital goods is envisaged. It was hoped that imports would be
replaced and internal growth fostered. Experience with this strategy has turned out to be
disappointing for most developing countries, mainly because of overvalued exchange rates which
discouraged exports.

Export Pessimism
In the 1950s, many economists and international organizations became “export pessimistic,” a
convenient label for the view that developing countries have only limited potential for achieving
economic growth through the expansion of exports. There are two variants of export pessimism,
one is associated with Prebisch (1950, 1959, and 1984) and Singer (1950), and the other is
associated with Nurkse (1962). The Prebisch – Singer version of export pessimism states that the
terms of trade of primary products had been declining over time and would continue to do so.
According to Prebisch and Singer, the causes for this phenomenon were exogenous to the
policies of developing countries themselves. On the other hand, the Nurkse’s version of export

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pessimism, which is often referred to as “elasticity pessimism,” states that there was low income
elasticity of demand for primary products. The arguments in both variants may be explained as
follows. In the early postwar years, most developing economies specialized in the production of
primary commodities, which they exported in exchange for manufactured products from
industrialized countries. The producers of primary goods faced a secular decline in their terms of
trade because the income elasticity of demand for primary products was low, synthetic
substitutes for natural resources were appearing, and technical innovations were cutting the
amount of raw materials needed for industrial production. All this suggested that the real prices
of primary goods would fall over time. By contrast, world demand for manufactures would
continue to grow. This provided a justification for encouraging industrial production.

4.3. Trade Strategy and Economic Performance

There are studies that were conducted to establish a link between trade strategy and
macroeconomic performance. For example, the World Bank’s World Development Report 1987
examined the experience of forty – one developing countries in an attempt to establish such a
link. The Bank classified these countries according to categories of trade strategy: outward –
oriented and inward – oriented. The study covered two periods, 1963 -1973 and 1973 – 1985.

Outward oriented: Trade controls are either nonexistent or very low in the sense that any
disincentives to export resulting from import barriers are more or less counterbalanced by export
incentives.

Inward Oriented: The overall incentive structure strongly favors production for the domestic
market. The average rate of effective protection for home markets is high and the range of
effective protection rates is relatively wide.

The evidence from the study suggested that the economic performance of the outward – oriented
economies has been broadly superior to that of the inward – oriented economies. Various criteria
of economic performance such as real GDP, real GNP per capita, gross domestic savings,
incremental capital – output ratio, rate of inflation, and manufactured exports were examined to
reach this conclusion.

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The World Bank’s findings have led to the recommendation that developing countries have to
adopt more outward – oriented policies. However, some economists and policymakers are
reluctant to embrace the strategy, arguing that some mix or sequence of the two strategies may
be appropriate in some cases. For example, South Korea engaged in import substitution before
embarking on its export – led growth path. In cases of infant industries, where protection is
justified, this may be a good strategy. In addition, some have suggested that economic
integration among developing countries may offer benefits because it is a combination of an
outward – looking strategy (through freer trade with other developing countries partners) and an
inward – looking strategy (because the integrated union is turning away from the rest of the
world economy). In any event, the precise extent to which a country should turn outward or
inward depends on the external and internal characteristics of that country. The policies to be
recommended can be decided only on a case – by – case basis.

4.4. Trade Strategy and Industrialization

The evidence by the World Bank’s Report suggested that rapid economic growth and efficient
industrialization are usually associated with outward – oriented policies on trade. Outward
orientation encourages efficient firms and discourages inefficient firms. Furthermore, by creating
a more competitive environment for both the private and public sectors, it also promotes higher
productivity and hence faster economic growth. The evidence in favor of outward – oriented
policies may be convincing, but there are other issues that have not been addressed. For example,
the new protectionism in some industrial countries raises an important question for developing
countries as to how an outward – oriented strategy can successfully be adopted under these
adverse circumstances. Another important question is the issue of how an economy may
successfully move from inward – orientation to outward – orientation. In this regard, the design
of policy reform becomes important. In other words, the policies should be selected, phased, and
sequenced to gain the benefits of reform as quickly as possible while minimizing transitional
costs and political resistance.

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4.5. Country Experiences and the Role of the State

Early explanations of the Asian “miracle” focused on the apparent openness of the most
successful Asian economies to external markets, by contrast with the import – substitution
approach pursued in some African and Latin American countries. The root of Asia’s success was
thought to lie in state neutrality towards economic sectors, allowing existing comparative
advantage to determine the composition of production and exports. State neutrality could take the
form of equal exchange rates for exports and imports and equality between domestic and world
market prices. Later, it was recognized that many Asian States were not at all neutral in their
promotion of individual sectors. According to Johnson (1962), these governments fostered
export competitiveness by using mechanisms such as the maintenance of export – friendly
effective exchange rates and the granting of large subsidies to exporters. Trade policies were
therefore part and parcel of broader national development strategies.

It should also be noted that today’s most advanced economies used a range of industrial and
trade policy tools during early stages of their development to support emerging industries. For
example, France, Germany, and Japan pursued industrial development in a highly controlled
context, and were able to take advantage of high levels of protection to achieve strong growth
rates.

4.6. Current Problems Facing Developing Countries

Currently, there are at least three most serious problems that face developing countries. These
are: 1) poverty, 2) foreign debt, and 3) trade protectionism of developed countries. Regarding the
first problem, there are empirical evidences that show that many developing are characterized by
low per capita income, high infant mortality rate, and low life expectancy. Secondly, developing
countries have accumulated a substantial foreign debt, which they subsequently found very
difficult to service (that is, repay the principal or even pay the interest). Finally, there is trade
protectionism of developed countries against developing countries’ exports. Developing
countries sought to overcome these problems by demanding a new International Economic Order
(NIEO). The NIEO refers to the demands made by developing countries as a group at the United
Nations (in June, 1974) for the removal of the alleged inequalities/injustices in the operation of

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the present international economic system and for the implementation of specific measures to
facilitate the development of these nations. Specifically, the demands of developing countries
include stabilization of their export earnings, preferential access to developed countries’ markets,
transfer of technology, and greater role in decision making. However, with the slowdown of the
world economy during the 1980s and early 1990s and with most industrial countries turning
inward to address their own internal problems of slow growth and unemployment, the NIEO
stopped being a hotly debated issue.

4.7. Summary

1. Developing countries are characterized by a relatively high concentration of exports in

primary products, whose prices fluctuate in the world market. This has led to long – run
forces that cause deterioration in their commodity terms of trade. However, there are
economists (for example, G. Haberler) who argue that there are still many ways in which
international trade can contribute to the development process.
2. Trade strategies can broadly be divided into two groups: outward – oriented and inward –
oriented strategies. Some empirical evidence (for example, the study by the World Bank)
suggests that outward – looking approach may enhance economic performance in
comparison with the inward – looking approach. However, the outward – looking approach is
not without difficulties. In general, economists think that the outward – looking approach
may help the developing countries to realize positive static and dynamic development effects
of trade.
3. It is recognized that today’s most advanced economies used a range of industrial and trade
policy tools during early stages of their development to support emerging industries. The new
thinking stresses the complementary roles played by the state and the market.
4. The East and South East Asian experience shows that trade policies cannot be pursued in
isolation from broader development strategies. Furthermore, trade policies should be
carefully selected, phased, and sequenced to gain the benefits of reform as quickly as
possible while minimizing transitional costs and political resistance.

5. The current most serious problems that confront developing countries are poverty,
unsustainable foreign debt, and trade protectionism of developed countries. To overcome

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these problems, developing countries demanded a NIEO. But, because of the changing
circumstances in the world economy, these demands could not be materialized.

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