Journal Issue

Trade and Exchange Policies for Economic Development

International Monetary Fund. External Relations Dept.
Published Date:
June 1967
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Margaret G. de Vries

THROUGHOUT the nineteenth century and about the first third of the twentieth, traditional economic theory had been the cornerstone of a strong case for free trade. Only two exceptions to free trade were recognized as having a sound economic base: tariff duties to protect “infant industries,” which were expected eventually to be able to compete in world markets without protection, and duties to raise revenue. International payments were governed by the “rules of the game” required by the gold standard—exchange rates which were fixed within narrow limits and the complete absence of any trade and exchange controls. Little, if any, distinction in the applicability of these policies was made between the highly industrialized countries and the rest of the world.

The Policy Dilemma of the Last Two Decades

After World War II the less developed countries were faced by a policy dilemma.

Many economists began to believe that as these countries placed primary emphasis on accelerating their economic growth, they would have to deviate from the orthodox policies. In their view, the less developed countries had not benefited as much from free trade as had the highly industrialized nations. Orthodox policies had oriented the economies of the developing countries excessively toward the production of agricultural commodities and raw materials, often with primitive techniques. Relatively low prices in world markets for these products—and sharp fluctuations in these prices—had condemned these countries to subsistence living standards. Foreign investment, while often improving methods of export production, had not given momentum to the domestic economy. For these reasons, several economists became convinced that the way to economic development lay through accelerated industrialization and the attainment of diversified economies and that these would necessitate considerable trade and exchange controls and higher tariffs for long periods of time. (For a detailed discussion of the views of different economists, see the author’s article, “Trade and Exchange Policy and Economic Development: Two Decades of Evolving Views,” Oxford Economic Papers, Vol. 18, No. 1, March 1966.)

In any event the policymakers in most developing countries were in the throes of several trade and balance of payments problems, together with institutional and administrative difficulties in choosing among alternative solutions, which had driven them to a variety of trade restrictions, exchange controls, multiple exchange rates, and rising tariffs. Since economic development would, of course, require decades, these problems and practices, however much they might deviate from traditional policies, could hardly be regarded as temporary.

Many economists, nonetheless, continued to believe in the orthodox policies. In their view, extensive use of controls interfered with the optimum allocation of resources, and they argued that the poorer countries especially could ill afford to neglect or lose the benefits of international trade. These countries should not, in a rush to industrialization, misallocate scarce resources into uneconomic industries.

Debates between protectionists and orthodox economists were not new; they had been going on for the last 200 years. These earlier differences, however, had been between economists and noneconomists; the postwar differences of view were among professional economists themselves, who were no longer agreed as to the benefits of liberal trade and payments policies for the primary producing countries.

In the last 20 years this issue has been a crucial one, not only for economists but also for government officials, who must formulate and implement policies on exchange rates, trade and exchange controls, and tariffs, as a matter of daily routine. The debate has been of direct concern to organizations dealing with international codes of behavior in these matters, such as the International Monetary Fund and the General Agreement on Tariffs and Trade (GATT). It was the purpose of the United Nations Conference on Trade and Development (UNCTAD), held in Geneva, in 1964, to seek new solutions to the trade and payments problems of developing countries.

The Balance of Payments Problems of Developing Countries

Although developing countries have used trade and exchange controls, including multiple rates and tariffs, for several reasons, the two principal trade and payments problems of developing countries have been, first, recurrent, or even continuous, balance of payments deficits and, second, the need to protect new industries. Balance of payments deficits have become virtually synonymous with development. Economic development usually involves the acceleration of investment. And any gap between the expanding level of investment and domestic savings results in a balance of payments deficit. Unless this gap is filled by foreign savings—that is, by private foreign investment or foreign aid—a deficit emerges that somehow has to be managed.

In practice this means that, as investment is increased, imports of capital goods are directly enhanced. Often there is also an even greater rise in imports of raw materials, fertilizer, fuel, and other commodities to keep an expanding domestic economy supplied. Moreover, as consumer demand increases and new domestic products for consumption are not yet sufficiently available, additional pressure is usually brought on consumer imports. These pressures may be considerably aggravated if development is financed by strongly inflationary methods (see Graeme S. Dorrance, “Rapid Inflation and International Payments,” Finance and Development, Vol. II, No. 2, June 1965).

These import needs usually outrun the ability to export. World trade in primary commodities, for at least the last three decades, has lagged far behind world trade in manufactures. Switching to manufactured exports has been a slow and difficult process. The magnitude and persistence of payments deficits accompanying development varies from country to country and depends on many factors: the rate of investment, the composition of natural resources and especially of exports, the rate of growth of population, the rate of increase of consumption, the rapidity with which consumable products result from new investment, the degree of self-sufficiency of the economy in foodstuffs and fuels, and the extent to which new local industries can use domestic raw materials. Moreover, there is the all-important question of the particular financing policies pursued. In the longer run, a changed allocation of resources, which may be facilitated by long-term foreign investment or loans, for example through the World Bank, may alter the structure of the economy so as to reduce these problems.

In addition, the balance of payments positions of developing countries are very vulnerable to crop failures, declines in world market prices for their principal exports, changes in demand for particular products, and unexpected capital flight. Since the foreign exchange reserves of most developing countries are inadequate to cope with these deficits for more than a very short time, unless recourse can be had to secondary reserves—for example, through the International Monetary Fund—a choice among alternative policies must be made. Exchange rate devaluation is often rejected, or unduly postponed, because it is thought that it will not significantly increase the volume of exports and yet may worsen inflationary pressures and raise the prices of imports. The desire to reduce inflation makes it necessary to raise taxes—which runs into political opposition—or to cut back expenditures, which nearly always entails reductions in investment. The policymaker in a developing country is continuously grappling with the problem of how much stability to preserve, through credit restriction and budgetary balance, and how much expansion to permit in the interest of more rapid investment. When relatively free trade and payments policies are selected as a goal, the hands of the policymaker are more or less tied to monetary stability. Hence, controls on imports and outgoing payments seem to be the only way out, at least temporarily.

The Need for Protection

The other main trade problem of developing countries is that of the need for protection of new industries. The justification for such protection is the same as in traditional theory: during the early stages of production a new industry is not fully effective, as the level of output is below optimum, and costs are temporarily higher than they will be in the longer run.

Important differences of view arise on how much protection is desirable for developing economies and by what methods it should be applied. Some economists believe that all manufacturing industries in developing countries should be protected. These industries, it is argued, are at a disadvantage compared with agriculture: they must, for example, pay higher wages in order to attract rurally oriented workers. Hence, without some protection, manufacturing industries will be undersold by imports. Other economists argue for much more limited and selective protection, so as not to encourage inefficient industries.

Economists have usually preferred subsidization of domestic output to tariff protection on competing imports. Since subsidies lower the prices of domestic products while tariffs raise the prices of foreign imports, the former benefit both consumer and producer. Since subsidies have usually been politically difficult to accept, protective duties have usually been considered acceptable, as they, in contrast to quantitative restrictions, allow the price mechanism to operate. However, in the last two decades many developing countries have been implementing a great deal of protection through quantitative limitations on imports. Even outright import prohibitions on many items have not been uncommon. There are several reasons for this. Tariffs may not have been revised for many years and hence have become unrelated to current price levels. They have also been subject to international commitment. In many instances, tariffs have been considered ineffective as a means of keeping out competing imports. Moreover, where quantitative restrictions were required for balance of payments purposes, they served simultaneously to protect domestic industries.

Recent Shifts in Policy Approaches

In the last few years, although they are still a long way from complete agreement, the two groups—the protectionist school and the orthodox school—have gradually moved closer together. The majority of economists seem to have come to the belief that no universal trade and payments policy applies to all situations of development, and that trade and exchange policies need to be tailored to individual circumstances.

This lessening of the differences in viewpoint has come about both because of advances in economic thinking and because of additional experience with various policies in developing countries. Modern refinements in international trade theory have introduced many qualifications into the free trade approach: certain circumstances where protection can be defended, especially through tariffs, and for developing countries, are now widely recognized. Furthermore, most of the policy conclusions of modern balance of payments theory have become more qualified and complex than the conclusions of the gold standard era: there is need to “manage” the balance of payments with some admixture of exchange rate devaluation, internal monetary and fiscal policies, and commercial policy.

On the other hand, as a result of the practical experiences of countries, there has been a marked disenchantment with the results of import restrictions, trade and exchange controls, and multiple rates. Commercial and political pressures for changes in licensing policies or in multiple rates and frequent ineffectiveness of control have often grown into serious problems for exchange control authorities.

The many distorting effects on production and investment caused by excessive use of restrictions have become more evident. High-cost industries, as well as excessive assembly-type industries that are unduly dependent on imported parts, have often developed under an umbrella of protection. Quantitative controls on consumer imports have not, for the most part, been a successful means of obtaining additional capital goods for a protracted period of time: the economy tends to become starved for consumer goods or for the raw and intermediate materials and fuels with which to produce them domestically. Investment in export industries has often been neglected, thus further aggravating the payments deficits. As exchange rates become increasingly unrealistic, quantitative restrictions often tend no longer to restrain imports satisfactorily, or exports begin to need some special inducement: exchange taxes or some export promotion devices have to be introduced.

For all these reasons, many developing countries have, in the past six or seven years, been increasingly turning away from restrictive policies and reinstituting more liberal policies. Several have sharply devalued their currencies, eliminated long-standing multiple exchange rates, and reduced their quantitative restrictions (see “Twenty Years of Par Values, 194666,” by M. de Vries, Finance and Development, December 1966).

The Search for New Solutions

Plagued by lack of adequate solutions to the free trade versus restrictions dilemma, many economists in recent years have begun to seek new solutions to the trade and payments problems of development. Ways and means of accelerating foreign capital movements in order to finance development are continuously being explored. However, in the last few years increased attention has been given to the possibilities of expanding exports of primary producing countries. Not only are such exports a satisfactory way of financing development and of minimizing balance of payments deficits, but they are a preferred way. Several studies by the United Nations, the Economic Commission for Latin America (ECLA), the Economic Commission for Asia and the Far East (ECAFE), the World Bank, and others have shown noteworthy correlation between the growth of exports of a country and its over-all rate of growth: countries with the greatest expansion of exports have also experienced the most rapid rate of over-all growth: the examples of Mexico, Peru, Japan, Venezuela, Israel, the Philippines, and Thailand, among others, are often cited. Exports have been the key to successful development because they provide the most vital wherewithal to purchase the imports required for development. Moreover, export expansion seems to generate additional growth in other sectors of the economy.

The focus of the search in recent years, for new ways to assist developing countries, accordingly, has been on ways and means of expanding their exports. Much greater attention has been given to the extent and causes of the secular lag in world trade of primary products. The degree to which certain commodities have been affected more than others is also being examined. One factor which has been especially singled out for scrutiny is the problem of the trade barriers of the major importing countries. These barriers include the agricultural protective policies of several industrial nations, import quotas, internal excise taxes on agricultural goods or other commodities such as tropical beverages, as well as policies to protect their own industries from what is feared will be low-wage competition from the developing economies. Such barriers on imports by industrial nations have come under increasing attack.

Greater attention has been given to the extent to which European countries which belong to the Common Market may, as a consequence, divert their consumption away from the agricultural production of the developing countries in Latin America, Asia, and Africa to the products of other European countries with which they have special trade arrangements. Efforts have also been accelerated toward regional economic integration in Asia, Africa, and Latin America. An organization called LAFTA—Latin American Free Trade Association—involving Argentina, Brazil, Chile, Colombia, Ecuador, Mexico, Paraguay, Peru, and Uruguay—was established in 1961. A Central African Customs and Economic Union (UDEAC)—involving the Central African Republic, Chad, Congo (Brazzaville), Gabon, and Cameroon—came into being in January 1966. The possibilities of other customs unions, free trade associations, and special tariff concessions are continuously being investigated as ways for developing economies to expand their exports, particularly of new manufactured products, through increased trade with each other.

The shift of focus from imports to exports as the important trade factor in economic development has occasioned a parallel policy shift from measures applied by an individual country to international action. There is a new general awareness that the problems of expanding exports of developing countries, except for temporary and unusual circumstances, can be tackled only as a cooperative venture by a group of developing countries acting in unison, or on an international basis in conjunction with the individual countries as well.

Economic integration on a regional basis, for example, requires the working out of detailed arrangements among developing countries. A reduction in the trade barriers of the industrial nations can be achieved only with the cooperation of the United States, Canada, and the Western European countries concerned. The difficult problem of the fluctuations in raw material prices in world markets can be solved only through agreement between the major supplying and the major consuming countries.

In the last few years there has also been considerable discussion in international forums of these problems and of possible solutions. Various exceptions to the rules are gradually being worked out by the GATT. In the last few years, for example, it has been decided that in some circumstances developing countries may receive the benefits of tariff concessions by industrial nations without having to make similar concessions themselves. In 1963 the International Monetary Fund introduced a new facility known as “Compensatory Financing” to provide short-term financing assistance to countries suffering from fluctuations in exchange receipts of exports of primary products. In its 1966 Annual Report the Fund reported that it was re-examining this facility, giving weight to various subsequent suggestions. Following the UN Conference on Trade and Development in 1964, a new permanent body of UNCTAD has been set up to consider new proposals for dealing with the special trade problems of developing countries. The World Bank has also been considering some new supplementary financing arrangements.

It is not yet clear just which solutions are the most desirable or likely to be the most acceptable to all concerned. Nonetheless, it is apparent that there is increasing recognition of the need for internationally agreed workable policies. Hence, the prospect is for even greater discussion, in the future, of these problems and appropriate policies.

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