Chapter Five

International Trade and Economic Development:

The Trade Policy Debate and Industrialization
5.1Role of Foreign Trade in Development
 Introduction
• Globalization- many interpretations
• Core economic meaning- the increased openness of
economies to international trade, financial flows, and
foreign direct investment.
• Concerns with globalization center around the unevenness
of the process, and risks.
5.1Role of Foreign Trade in…continued
 Some Key Issues: international trade
• Many developing countries rely heavily on exports of
primary products with attendant risks and uncertainty.
• Many developing countries also rely heavily on imports
(typically of machinery, capital goods, intermediate
producer goods, and consumer products).
• Many developing countries have chronic deficits on current
and capital accounts which depletes their reserves, causes
currency instability, and may slow economic growth.
• Recently many developing countries sought to promote
exports and accumulate large foreign exchange reserves
to mitigate against crises - urging new policy debates
5.1Role of Foreign Trade in…continued
 Some Key Issues: international trade(cont’d)
 Five Basic Questions about Trade and Development
– How does international trade affect economic growth?
– How does trade alter the distribution of income?
– How can trade promote development?
– Can developing countries determine how much they
trade?
– Is an outward-looking or an inward-looking trade
policy best?
5.1Role of Foreign Trade in…continued
 Some Key Issues: international trade(cont’d)
 The Importance of Exports to Different Developing
Nations
– Exports of developing countries are generally less
diversified than those of developed countries
– Merchandise exports as a share of GDP are often higher
for developing countries(see Table 5.1)
– Developing countries are typically more dependent on
trade than developed countries are.
Table 5.1 Merchandise Exports in Perspective:
Selected Countries, 2008
5.1Role of Foreign Trade in…continued
 Some Key Issues: international trade(cont’d)
 Demand Elasticities and Export Earning Instability
– Often low price elasticity of demand for agricultural
commodities
– Often low price elasticity of supply for basic
commodities
– Also, low income elasticity of demand for primary
products
• Result can be export earnings instability; risks to income
5.1Role of Foreign Trade in…continued
 Some Key Issues: international trade(cont’d)
 The Terms of Trade and the Prebisch-Singer Hypothesis
– Total export earnings(TR) depend upon:
• Total volume of exports sold(Quantity); and,
• Price paid for exports(price)
• TR= PQ
– Prebisch and Singer argued commodity export prices fall over
time, so developing countries lose revenue unless they can
continually increase export volumes
– They concluded that developing countries need to avoid
dependence on primary exports
5.1Role of Foreign Trade in…continued
 Theories of role of trade in economic development
 The Traditional Theory of International Trade
– Comparative advantage
• Specialization in production and export of
commodities with lowest relative cost (minimum
comparative disadvantage)
• DCs(Manufacturing goods) & LDCs(primary goods)
5.1Role of Foreign Trade in…continued

– Relative factor endowments and international

specialization: the Neoclassical model
• Ricardo and Mill (static model)
• Heckscher and Ohlin (factor endowment theory)
– Different products require productive factors in different
ratios.
– Countries have different endowments of factors of
production.
– Specialization in production and export of commodities
which utilizes abundant resources.
– =>Dcs in Manufacturing goods & LDCs in primary goods
5.1Role of Foreign Trade in…continued
 Theories of role of trade in economic development
 Main conclusion of the neoclassical model is that all
countries gain from trade
– World output increases with trade(See fig 5.1)
– Countries will tend to specialize in products that use their
abundant resources intensively
– International wage rates and capital costs will gradually
tend toward equalization
– Returns to owners of abundant resources will rise
relatively
– Trade will stimulate economic growth
Figure 5.1 Trade with Variable Factor Proportions
and Different Factor Endowments
Figure 5.1 Trade with Variable Factor Proportions
and Different Factor Endowments (continued)
5.1 Role of Foreign Trade in…continued
 Answer to the five questions according to traditional trade
theory:
– Trade stimulates economic growth
– Trade promotes international and domestic equality
– Trade promotes and rewards sectors of comparative advantage
– International prices and costs of production determine trading
volumes
– Outward-looking international policy is superior to isolation
5.1 Role of Foreign Trade in…continued
 The Critique of Traditional Free-Trade Theory in the Context of
Developing-Country Experience
• Fixed Resources, Full Employment, and the International Immobility
of Capital and Skilled Labor
– Challenged by North-South Unequal trade
models: Trade and Resource Growth
• Rapid change particularly resources most crucial for
growth.
– physical capital, entrepreneurial abilities, scientific capacities,
the ability to carry out technological research and
development, and the upgrading of technical skills in the labor
force.
5.1 Role of Foreign Trade in…continued
– Challenged by Porter’s “Competitive
Advantage” theory:
– Traditional trade theory applies only to basic factors
(unskilled labor, physical resources)
– But creation of advanced factors (knowledge resources,
specialized infrastructure) is the first priority
- Central task to “escape from the straightjacket of factor-
driven national advantage”
– Alternative Theories
• Standard trade theories fail to recognize reality of
unemployment, underutilized resources in LDCs
• Vent for Surplus Theory(see figure 5.2)
– In short run, the beneficiaries of this process are colonial and
expatriate entrepreneurs rather than LDCs nationals.
– In long run, the structural orientation of the LDCs economy
toward primary-product exports in many cases inhibits
needed structural transformation in the direction of a more
diversified economy.
Figure 5.2 The Vent-for-Surplus Theory of
Trade
5.1 Role of Foreign Trade in…continued
 The Critique of …
• Fixed, Freely Available Technology and
Consumer Sovereignty
– Challenged by the Product Cycle theory
• Limited abilities of LDCs inhibit to capitalize on DCs R&D
– Development of synthetic substitutes for
developing country exports
– consumer preferences and tastes are often
created and reinforced by the advertising
campaigns that dominate local markets.
5.1 Role of Foreign Trade in…continued
• International Factor Mobility, Perfect Competition,
and Uncertainty: Increasing Returns, Imperfect
Competition, and Issues in Specialization
– Structural realities in developing countries
• LDCs production structure=> rigid and factor movement restrictions.
– Increasing returns and exercise of monopolistic
control over world markets
– Risk and uncertainty inherent in international trading
arrangements
– Ambiguous understanding of pattern of specialization
5.1 Role of Foreign Trade in…continued
 The Critique of …
• The Absence of National Governments in Trading
Relations
– Definite role for State
– Industrial policy is crafted by governments
– Commercial policies instruments (tariffs, quotas) are state
constructs
– International policies can result in uneven distribution of gains
from trade
• Balanced Trade and International Price Adjustments
– Unrealistic (example: impact of oil price hikes of the 1970s)
• LDCs are being challenged by deficits
5.1 Role of Foreign Trade in…continued
 The Critique of …
• Trade gains accruing to nationals
– Enclave economies are promoted by trade
– Difference between GDP and GNI becomes important
5.1 Role of Foreign Trade in…continued
 Some Conclusions on Trade Theory and Economic
Development Strategy
– Trade can lead to rapid economic growth under some
circumstances
– Trade seems to reinforce existing income inequalities
– Trade can benefit developing countries if they can extract trade
concessions(agreements) from developed countries
– Developing countries generally must trade
– Regional cooperation may help developing countries
5.2 The Trade Policy Debate: EP vs IS
 Export promotion vs Import substitution
 Export promotion: looking outward and seeing trade
barriers
– Primary-commodity export expansion, limited demand
• Low income elasticity
• Low population growth rates in developed economies
• Decline in prices implies low revenue (some periods of price
spikes, including recent years, but very long-run trend has been
downward)
• Lack of success with international commodity agreements
• Development of synthetic substitutes
• Agricultural subsidies
– Primary-commodity export expansion, supply rigidities
– Expanding Exports of manufactured goods: Greater successes,
particularly China; unevenly distributed across the developing
world
5.2 The Trade Policy Debate…continued

 Import substitution: looking inward but still

paying outward
– Tariffs, infant industries, and the theory of protection
Figure 5.3 Import
Substitution and the
Theory of Protection
5.2 The Trade Policy Debate…continued
 The import substitution (IS) industrialization strategy
and results
– Protected industries get inefficient and costly
– Foreign firms often benefit more
– Subsidization of imports of capital goods tilts pattern of
industrialization and contributes to balance of payments (BOP)
problems
• Remit profit, capital good import from parent and sister co.; lower
employment effect.
– Overvalued exchange rates hurt exports
• To make cheap import
– Does not stimulate self-reliant integrated industrialization
• State owned enterprises did not grow
• Domestic forward and backward linkage failed
5.2 The Trade Policy Debate…continued
 Argument for tariff protection
– Sources of revenue
– Response to chronic BOP problems
• By restricting import
– Help foster industrial self-reliance (general IS)
• Tariffs ; economies of scale; positive externalities
– Greater control over economic destinies
– Must be applied selectively and wisely
– Infant industry protection argument
– Many examples of perceived failures, but some success in East
Asia
5.2 The trade policy debate:

 Trade Optimists and Trade Pessimists: Summarizing

the Traditional Debate

 Trade pessimist arguments

– Limited growth of world demand for primary exports
– Secular deterioration in terms of trade
– Specializing in comparative advantage inhibits industrialization,
skills accumulation, and entrepreneurship
– Rise of “new protectionism”; WTO benefits limited in practice
5.2 The Trade Policy Debate…continued

 Trade optimist arguments - trade liberalization:

– Promotes competition and efficiency

– Generates pressure for product improvement

– Accelerates overall growth

– Attracts foreign capital and expertise, which are in scarce supply in most
developing countries
– Generates foreign exchange to use for food imports if agricultural sector lags
behind or suffers natural catastrophes
– Eliminates distortions caused by government interventions including corruption
and rent-seeking activities
– Promotes equal access to scarce resources,
5.2 The Trade Policy Debate…continued
 Trade Policies of Developed Countries: The Need for
Reform and Resistance to New Protectionist Pressures
• Rich-nation economic and commercial policies matter for
developing countries foreign exchange earnings
– Tariff and non-tariff barriers to developing country exports
– Adjustment assistance for displaced workers
• Because of freer access to labour intensive low cost developing country’s
exports
– General impact of economic policy
5.3 Balance of Payments and Macroeconomic
Stabilization
• The Balance of Payments Account
• General considerations:
– Balance of Payments (BOP)
– Surplus and Deficit
– Current Account
– Capital Account
– Cash Account or International Reserve Account
• Three forms balancing BOP:
– Hard currency(dollar, pound…)
– Gold
– Deposits with IMF
Table 5.2 A Schematic Balance of Payments
Account(revised)
Table 5.3 Credits and Debits in the Balance of
Payments Account
 5.3 Balance of Payments …continued

• The Issue of Payment Deficits

• Trends in the Balance of Payments
– Discouraging balances (see Table 5.4 & 5.5)
– Until 2000 negative CA balance
• Fall in commodity prices
• Global recessions(1980-82;1991-93)
• Increasing protection( in developed)
• Overvalued exchange( LDCs)
» Leads BOP problems and external debts
Table 5.4 Before and After the 1980s Debt Crisis: Current
Account Balances and Capital Account Net financial Transfers of
Developing Countries, 1978-1990 (billions of dollars)
Table 5.5 Developing Country Payments Balances
on Current Account, 1980–2009 (billions of dollars)
5.3 Balance of Payments …continued
• Some policy issues
• How a nation finances its debt?
– International reserves
• drawing down its central bank holdings of official monetary reserves:
gold, hard currencies, and special drawing rights at the IMF
• Export promotion/import limitation
• Devaluation
– Restrictive fiscal and monetary policies:
• Structural adjustment(WB)
– remove excessive governmental controls, make factor and product prices
reflect scarcity values, and promote market competition.
• Stabilization policies(IMF)
– Both limit domestic demand
» Lower imports, reduce inflationary pressure
 5.3 Balance of Payments …continued

• Accumulation of Debt and Emergence of

the Debt Crisis
• Background and analysis
– External debt
• Total private and public foreign debt owed by a country.
– Debt service
• payment of amortization and accumulated interest
– Basic transfer(BT)
• Net foreign exchange inflow or outflow related to its
international borrowings
• BT= dD-rD=(d-r)D
• If d>r=> gain foreign exchange
• d=% increase in debt(D)
• r interest rate of borrowing
 5.3 Balance of Payments …continued
• Attempts at Alleviation: Macroeconomic Instability,
Classic IMF Stabilization Policies
• The IMF stabilization program
– Four basic components of IMF stabilization program:
• Liberalization of foreign exchange and imports control
• Devaluation of the official exchange rate
• Stringent domestic anti-inflation program
• Opening up of the economy to international commerce