Import Liberalization

Import liberalization involving the reduction of tariffs and quantitative restrictions leads to a rise in imports, other things being equal. Concern over the effect on the balance of payments has inhibited import liberalization just as defending the balance of payments has so often been the rationale for imposing and intensifying import restrictions. Import liberalization, though, also has a positive effect on the balance of payments since it shifts incentives away from production for the home market and toward production for the export market. How much and how quickly imports and exports respond is the crucial issue from the point of view of the effect of import liberalization on the balance of payments.

The question is one of the demand elasticity for imports vis-a-vis the supply elasticity of exports, and for any given set of such price elasticities, the net effect on the balance of payments depends on the exchange rate policies adopted, or the real exchange rate as macroeconomists use the term. A depreciation of the exchange rate would shift domestic demand from tradables to nontradables and foreign demand from other countries’ products to those of the economy that has depreciated its currency. For such expenditure “switching” to bear the sole brunt of balance of payments equilibrium may require excessive depreciation, especially when there are no restraints on domestic demand. Whatever the relevant price elasticities, restoring or maintaining equilibrium in the current account of the balance of payments is best done when both the exchange rate and expenditure switching are combined with restraints on aggregate domestic demand or with the “absorption” of tradables. The lower is aggregate demand, the lower will be the increase in imports upon import liberalization and the greater will be the surplus available for exports.

In theory, import liberalization does not have to worsen the current account because any rise in imports will be offset by an increase in exports. A modest depreciation of the exchange rate may be enough to correct any balance of payments disequilibria, or mild restraint on aggregate demand may do the trick. In practice, though, a substantial liberalization of imports is likely to involve some combination of all three adjustment mechanisms, and the required correction in the exchange rate and aggregate demand may be quite considerable. This is partly because the short-run demand elasticity of imports tends to be fairly high while exports are likely to respond with a longer lag. Invariably, the supply elasticity of exports tends to be significantly higher in the long run than in the short run.

Foreign capital inflows can greatly reduce the potential short-term costs of import liberalization. To the extent that such capital is available, it facilitates the macroeconomic management that must accompany import liberalization. Foreign capital lessens the need for or risk of such an excessive depreciation of the exchange rate that it becomes substantially undervalued in the short run compared with its longerrun equilibrium, with the possible danger of setting off an inflationary spiral. Similarly, the stabilization measures do not need to restrain demand quite as much when additional foreign capital inflows are available during the adjustment period.

Moreover, the availability of additional foreign resources is likely to induce the government authorities to undertake more import liberalization than they otherwise would. The uncertainty about the shortrun balance of payments effects and about the possible social and economic costs often inhibits liberalization of imports. To the extent that foreign capital inflows lessen the need for growth-restricting policies, adjustment involving import liberalization will likely cause fewer short-term costs in terms of economic growth.

Two caveats to the positive role that foreign capital can play in supporting import liberalization should be mentioned. One is to guard against the danger that capital inflows will lead to an excessive appreciation of the exchange rate; a mistake that has not always been avoided. The other is the importance of avoiding external debt that is in excessive amounts or on inappropriate terms and of making sure to use the foreign capital to adjust adequately, not to squander it.

The lessons of experience suggest the following ingredients of successful and sustained import liberalization: an exchange rate policy that encourages exports and efficient import substitution; avoidance of macroeconomic imbalances, since both high inflation and expansionary demand-management policies hinder the needed structural shifts in production and the viability of the balance of payments; and additional inflows of foreign capital on appropriate terms, which can facilitate import liberalization by reducing its possible short-term costs and giving governments the confidence to undertake more rapid or more substantial liberalization than they might otherwise have considered. This is not to say that faster, greater import liberalization is always better. But timid reforms that fall short of a critical minimum are likely to lead nowhere and fail to provide clear, strong signals to economic agents.

Development Experiences

Since the publication of the seminal critique of import-substituting, or inward-oriented, industrialization in developing countries (Little, Scitovsky, and Scott, 1970), the subject and related issues have probably received more attention than any other set of issues involving the economies of developing countries.³ More recently, however, awareness of and a consensus on the benefits of export promotion, or outward orientation, has grown, as has acknowledgement of the costs of an excessive emphasis on import substitution. The limitations of government intervention are also much better appreciated, and it is recognized that market failure, in itself, is not a sufficient justification for government action. As such, the probability and costs of inappropriate or ineffective intervention must be taken into account. Thus, a broad consensus has emerged that the following measures should be avoided: extreme levels of protection and an overvaluation of exchange rates, at least for prolonged periods; liberalization of the capital account of the balance of payments before liberalization of the current account; and macroeconomic instability.

However, many important areas of controversy remain. A vigorous debate continues on various matters: the pace and sequencing of trade and payments reforms, including the relative merits of across-the-board liberalization versus selective liberalization; the validity of the infant-industry argument; and more generally, the ingredients of growth-oriented adjustment. In the light of developing country experiences and the economic literature, the following “lessons” can be discerned (also see Noman, 1991a).

• —While extremely high levels of protection should be avoided in the long run, they can help in the early stages of industrialization, at least in medium to large countries. The crucial features of good economic management are not to prolong this early phase but to initiate policies aimed at efficient resource allocation and resource use, thus leading to the fairly quick removal of the anti-export bias so that EERx ≥ EERm.

• —Adjustment need not be sudden and across the board. Although large variations in effective trade protection are not recommended, considerable variance within EERx and EERm (while on average EERx ≥ EERm) has been a feature of such East Asian miracles as Taiwan, Korea, Japan, and more recently, Thailand. The contrast between import substitution and export promotion has often been overdrawn—not just in the sense that importsubstituting industries can become export industries with rising levels of efficiency but also that it is possible to pursue both simultaneously.

• —Rapid export growth can precede import liberalization. In most cases, export growth should ideally precede an across-the-board liberalization of imports, especially when foreign capital flows cannot ease the balance of payments constraint that the consequent surge in imports can quickly face.

• —Undervalued exchange rates can be a powerful way of promoting exports and providing protection, as demonstrated by the experiences of Korea, Taiwan, Japan (in the 1950s and 1960s), and Chile (in the early 1980s). However, moving to an undervalued exchange rate can be a tricky business because of the inflationary implications of exchange rate depreciation. But a realistic exchange rate, in the sense of a nominal exchange rate that does not require enormous subsidies to exporters, is necessary for sustained export expansion.

• —Macroeconomic stability is essential to sustain liberalization and growth. But more controversial questions are what constitutes the right blend of demand- and supply-side measures for growth-oriented adjustment and whether stabilization should precede or accompany structural adjustment in cases of severe imbalances. Certainly, a poor supply response and an inadequate growth orientation have been major concerns.

• —Credibility, consistency, and coherence are important for the success of liberalization policies. This requirement is closely related to the question of governmental commitment to its reform program. Without strong commitment, indeed without “ownership” by the government, reform efforts are most unlikely to succeed.

• —The ability of governments to intervene successfully varies enormously. The differences are partly a matter of the quality and experience of the civil servants responsible for the design and implementation of policy and partly one of political economy. This factor along with the level of development and size of the country are among the most crucial contextual issues determining the appropriate set of reform policies.

Economic Development and Macroeconomic Policy: The Case of Pakistan

Pakistan’s experience during the 1950s and the 1960s has been widely hailed both as a model of successful development, especially of industrialization, and as one of the worst examples of import-substituting industrialization.⁴ An assessment of these contrasting views and the subsequent industrialization of Pakistan can be found in Noman (1991b). Interestingly, both views of Pakistan’s industrialization have considerable merit, though there is almost certainly more merit in the view that Pakistani industrialization was more a success than a disaster.

As for Pakistan’s industrialization after this initial stage, an economic setback in the 1970s, partly caused by the “shock” of nationalization and the break-up of the customs union of East and West Pakistan, was followed by a decade of fairly rapid growth. But it has been argued that this reflected developments which permitted fairly rapid, easy industrial growth without the need to undertake the policy reform needed to create a more competitive, technologically advanced, and dynamic industrial sector. Thus, in the late 1980s, when the favorable external shocks ended, the need for a major reform of trade and industrialization policies, particularly to boost exports, became fully apparent. To examine Pakistan’s experience in greater detail, these various periods of industrialization will be discussed individually.

The 1950s

The decision not to devalue along with the pound sterling and the Indian rupee in 1949 was immediately followed by a run-up in the prices of Pakistan’s exports (at that time, mainly raw jute and cotton). An overvalued exchange rate, quantitative restrictions on imports, and acute scarcities created by the disruption of trade with India meant high return on imports. Importers made quick fortunes.

In the face of a balance of payments crisis at the end of the commodity boom in 1952, which had been related to the Korean War, the government intensified import restrictions. In addition to heavy protection, the manufacturing sector was provided with generous fiscal incentives and cheap credit. Profits were high and guaranteed, and inflation was modest. The traders who had earlier made overnight fortunes were now in a position to respond to these powerful incentives, and they did. As Little, Scitovsky, and Scott noted about their sample, only Pakistan, and to a lesser extent Taiwan and the Philippines, needed to create an entrepreneurial class. Within a decade, Pakistan had done so.

It should be noted that a large domestic market and the presence of raw materials that could be easily processed and marketed (jute and cotton) made the early stage of inward-oriented industrialization easier and longer. Nevertheless, the most extreme period of protection lasted only seven years, 1952-59.

The 1960s

In 1959, Pakistan began to reverse the anti-export bias of its trade regime. The second plan period, 1959/60-1964/65, witnessed a number of important departures, including:

• —the introduction of an export bonus scheme—in effect, a multiple exchange rate system favoring manufactured exports—and a host of other incentives for exports, including preferential access to foreign exchange;

• —a substantial increase in foreign capital inflows (on concessional terms);

• —a significant liberalization of imports that was accompanied by increases in import capacity, via rising exports and aid, and carefully managed to avoid a balance of payments crisis; and

• —the beginning of the “green revolution” in agriculture.

Economic growth accelerated sharply. Ahmad (1980) has observed that the rise in agricultural productivity and incomes occurred at a time when the limits placed on the domestic market for manufacturing by import substitution were being increasingly felt.

1970-77

This was a period of severe exogenous and endogenous shocks: war and civil strife, the break-up of the country, the nationalization of large parts of industry and finance, and the first oil shock. At the same time, the familiar complexities and distortions created by the multiple exchange rate system ended with unification and the devaluation of the exchange rate.⁵

Pakistan’s manufacturing industries that had learned to export in the 1960s were quite successful in diverting sales from the protected market of the former East Pakistan to the world market in the early 1970s. But the effects of the devaluation are impossible to distinguish from those of the “shocks” noted above.

After 1977

Following the upheaval of the early to mid-1970s, industrial growth recovered with the support of earlier “heavy” investment by the public sector and a rapid expansion in domestic demand. The latter reflected a rapid growth in workers’ remittances, a rise in foreign resource inflows and illicit exports related to the war in Afghanistan, and a growing fiscal deficit. This period can be characterized as one of relatively easy, soft-option growth fueled by booming domestic demand. Improvements in international competitiveness and exports were at best inadequate. By 1988, however, all these trends had been reversed. Remittances had stabilized at a level well below their peak; foreign resource inflows related to the Afghan war began to decline; and fiscal deficits began to be reduced.

Between about 1980 and 1990, there was gradual liberalization, and the exchange rate system was moved to a managed float in 1982; since that time, the rupee has gradually depreciated. In 1990, a major package of economic reforms was introduced. It focused on exchange and payments reform (including liberalization of the capital account), privatization, deregulation, attraction of foreign direct investment, fiscal reforms, and export promotion. While some generalized import liberalization was also planned, its pace has been slower than that of the other reforms noted above.

The new reforms include the following measures:

• —Restrictions have been removed on foreign currency bank accounts, on foreign exchange for travel, and on other payments for advertising abroad, education, publications, trade fairs, and so on. Certain other restrictions, such as the rules governing private sector foreign borrowing, have been greatly liberalized.

• —A number of restrictions on foreign direct investment have been abolished or greatly liberalized. Among the former category are rules pertaining to the approval of investments, limits on equity shares, and remittances of dividends and profits.

• —All commercial banks nationalized in 1974 are to be privatized; two of them already have been transferred to the private sector. A number of areas previously subject to public sector monopoly have been opened to the private sector (power generation, telecommunications, airlines, and shipping), with 115 industrial units to be privatized.

• —Measures to encourage exports have included improvements in the scheme for duty drawback, bonded duty-free imports, and export credit. Also, the scheme for export-processing units, the allocation of textile export quotas, and income tax rebates are among the export-promotion policies that have been revamped.

• —Import licensing has been largely eliminated, and the small list of exceptions is being reduced further. The maximum tariff has been reduced from 125 percent to 90 percent (except for motor vehicles).

• —Industrial investment has been largely deregulated and offered strong incentives.

Perhaps the most potent manifestation of these reforms has been the 23 percent increase in exports during 1990-91; GDP growth has also accelerated, to 6.5 percent a year. These improvements occurred despite the severe adverse impact of the Middle East crisis on Pakistan and the nonavailability of any official assistance to deal with it. There were also larger capital inflows in the form of a 25 percent increase in foreign currency deposits.