V. Trade Policy and Reform

Jeffrey Davis
Published Date:
January 1992
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Robert Franco

1. Introduction

Trade policy has received increased attention in recent years in Fund–supported adjustment programs. This attention reflects the growing concern with structural policies and the importance attached to developing programs aimed at stimulating aggregate supply, as well as re–establishing financial equilibria. Over 90 percent of Fund–supported adjustment programs in operation on June 30, 1990, called for the adoption of measures that would fall in the general category of trade policies. Furthermore, all of the Extended Fund Facility, Structural Adjustment Facility and Enhanced Structural Adjustment Facility arrangements included some form of trade policies, as did 10 of 14 stand–by arrangements.

This chapter assesses arguments for protectionism, reviews some alternative trade strategies and discusses the types of trade policy measures included in recent Fund–supported adjustment programs.

2. Protectionism versus open trade

Open trade promotes competition in domestic markets, increases pressure on enterprises to innovate, provides consumers with wider selection of goods, and allows firms to fully exploit comparative advantage and economies of scale. Thus, open trade raises the standard of living of nations. Furthermore, it unleashes dynamic forces tending to raise the growth rate of the economy in the long run by encouraging adaptation and innovation, while protectionism inhibits those forces increasingly as time passes.

Despite these advantages protectionism has many advocates, particularly among producers left behind in the process of development and structural change. Such protectionist pressures have a long history. For example in the 19th century, following the birth of the industrial revolution, Great Britain began securing new markets abroad, while France was drawing into a protectionist shell, as witnessed by the following plea by French wine growers in 1816 for a tax on tea:

This drink ‘tea’ destroys national character for it develops in those who use it frequently the cold nature of northerners, while wine expands the soul with a gaiety and hilarity which helps to give Frenchmen that friendly and witty character that distinguishes them from the citizens of all other nations.

Advocates of protectionism have put forward a number of economic arguments; many of these are fallacious, amounting to little more than weak rationalization for protectionism. Others have some substance, but require careful qualification.

a. Common fallacies

(1) Purchase of domestic goods keeps money at home

This argument is sometimes explained as follows:

A Frenchman buys a radio from Korea, the Frenchman gets the radio and Korea gets the French Francs (FF), but if the Frenchman buys a French–made radio, he has the radio and France retains the FF.

The fallacy is that Koreans do not work hard to produce radios for export to permanently hold FF. Rather, they earn FF to acquire commodities and other resources from France, or from third countries which will eventually use them for this purpose. Thus, while the French buy radios with money in the first instance, ultimately they are purchased with other domestic goods, services or assets. More generally, purchase of goods abroad may allow domestic productive capacity to be used for alternative, and potentially more valuable purposes.

(2) Labor productivity differentials limit competition

Although labor may be more productive in industrial countries (for example, Germany) than in developing countries, wages are also higher. When both influences are taken into account, it does not necessarily follow that costs are lower in Germany, and that developing countries cannot compete in certain areas. Developing countries may not be able to compete with Germany in areas in which it has a comparative advantage; there are, however, activities where lower productivity is more than offset by wage differentials. A variant of this argument is that industrialized countries cannot compete with cheaper labor from developing countries. However, the reasons wages are higher in Germany than in developing countries is that its labor is more productive. When both influences are taken into account, it does not necessarily follow that the German costs are higher.

(3) Tariffs should be tailored to equalize costs

This recommendation may sound plausible, but it misses the whole point of international trade; i.e., gains from trade are based on cost differences between countries. It is to the advantage of, say, Sweden to import bananas, oil or radios precisely because they can be produced more cheaply abroad. Thus, success in the difficult task of tailoring tariffs to make costs precisely equal domestically and abroad would eliminate incentives for trade, and the potential gains from trade would be lost. All that tailored tariffs accomplish is to strangle trade and raise the domestic resource cost of producing commodities (see Box V.I).

Box V.IKey Concepts

Nominal protection

The concept of nominal protection relates to the effects of protective measures on the price received for a product by domestic producers. When a tariff is levied on an imported commodity, the domestic price can rise by the full amount of the tariff if the world supply is perfectly elastic, or by less that the full amount if the elasticity is less than infinite. This assumes that the tariff is not so prohibitive that it precludes imports altogether. The tariff rate is often used as an acceptable indication of the nominal rate of protection. If the imports are subject to quantitative restrictions, the nominal rate of protection can in principle be estimated as the percentage difference between the domestic producer price and the c.i.f. import price of equivalent products, using shadow exchange rates. Thus, the nominal rate of protection may be defined as (Pd – Pw)PW, where Pd is the domestic protected price, and Pw the world or free trade price.

Effective protection

Since the possibility exists that inputs as well as outputs may be protected, economists have developed the concept of effective protection, which measures the combined impact of output and input protection. The effective rate of protection for a product is defined as the percentage difference between the value added in domestic prices Vd, obtainable as a result of the application of protective measures, and the value added in world market or free trade prices Vw. The former is derived by taking the output and its inputs in domestic prices and the latter by valuing outputs and inputs in world market prices, expressed in domestic currency at shadow exchange rates. Thus, the effective rate of protection may be defined as (Vd – Vw)Vw.

Domestic resource cost

A closely related measure to effective protection is that of the domestic resource cost, DRC, which measures the opportunity cost of earning or saving a unit of foreign exchange. The DRC of saving a unit of foreign exchange by import substitution is the total value of the domestic factors of production used in increasing domestic output of a good that was previously imported, divided by the net value of foreign exchange saved. Similarly, the DRC of earning a unit of foreign exchange through exports is the value of domestic factors of production utilized, divided by the net earnings of foreign exchange. In all cases, shadow exchange rates are used to convert foreign prices into domestic prices.

Trade regime biases

The notion of trade regime bias concerns the direction and the degree to which, on average, domestic incentives diverge from those that would prevail under free trade. Under this system, resources would be allocated among the production of tradable commodities, in such a way that at the margin resources devoted to saving a unit of foreign exchange should be the same as to earn a unit of foreign exchange, i.e., all DRCs would be equalized. If this is not the case, the extent of the bias can be defined as the degree to which domestic prices of importables to exportables diverge from their international price ratio. In a two commodity world, the trade regime bias B is defined as B = (DM/WM)/(DX/WX), where the Ds represent domestic prices, and the W8 free trade or international prices, while M and X denote the import–competing and exportable goods, respectively. Shadow exchange rates are used to convert world prices into domestic prices. If the world and domestic prices of exportables coincide and the domestic price of import–competing goods is above the world price, then B>1, and the trade regime is biased toward import substitution. Conversely, if B<1 the bias is toward exports. The greater is the divergence of B from unity in either direction, the more biased is the regime.

b. Arguments with some substance

(1) Domestic purchases preserve employment

This argument is sometimes explained as follows:

If Americans buy cars from Detroit, employment will rise in Detroit rather than in Japan.

This statement may contain elements of truth, particularly if there is mass unemployment in Detroit and significant rigidities in the labor market. However, the employment advantage is based on the questionable assumption that if the United States restricts imports, Japan will not reduce its imports from the United States. This is often called a beggar–my–neighbor policy, because the United States would be trying to solve its unemployment problem by shifting it onto the Japanese. In this case, the United States cannot prevent the Japanese from retaliating by restricting imports of United States’ goods, and thus, shifting the unemployment problem back to the United States. In periods of world–wide recession, all countries are tempted to initiate a beggar–my–neighbor policy with increased protection. However, if all countries attempt to solve unemployment this way, the results would be a general disruption of trade, possibly leading to an increase rather than a decrease in unemployment. If there is large–scale unemployment, the cure should be sought in domestic monetary and fiscal policies, and measures to improve the efficiency of labor markets, but not in mutually destructive trade restrictions.

(2) Restricting trade will diversify a nation’s economy

Just as trade encourages specialization, restrictions lead to diversification. However, countries can gain from specialization and trade even though there are risks involved. As discussed below, countries may be advised to take a cautious approach to encouraging diversification, and should avoid policies that adversely affect areas of existing comparative advantage. For advanced industrialized countries, policies to diversify the economy are unnecessary. No matter how freely they may trade and specialize, their activities are likely to remain highly diversified.

(3) Countries need to protect their infant industries

This argument can be illustrated as follows:

Kenya may not be able to compete with an industry with economies of scale until it is well established and operates at high volume and low cost. This can be a real problem if the industry is one in which Kenya has a comparative advantage, and where it would eventually be able to produce very cheaply. Thus, Kenya should use a tariff to protect such an industry from being wiped out by tough foreign competition during the delicate period of its infancy.

Although this line of reasoning is logically valid, it raises the important practical question of when the subsidy ceases to be needed. Experience of developing countries is replete with industries that are chronically dependent on tariffs. Such industries can become a real problem in terms of ongoing budgetary subsidies.

(4) Restricting imports may reduce prices

A single country, or cartel, may seek to use market power to reduce the price paid for imports, or increase that received for exports. For example, if France imposes a tariff or quota to restrict imports of Senegalese groundnuts, it may be able to lower the price it pays for that good. This is sometimes referred to as improving its terms of trade, that is reducing the number of units of exports it must give up in order to acquire a unit of imports. Similarly, the same type of argument can be made in terms of use of monopoly or oligopoly powers, such as for example OPEC, with oil in the mid–seventies and early eighties. The possibility of using market power to improve terms of trade is probably very limited in most cases. This is particularly so over time as alternative sources of supply and markets can be developed. Furthermore, attempts to develop and use such market power may lead to retaliatory measures and reduced trade volume.

3. Trade policies for adjustment and growth

The history of international commerce reveals a range of experience concerning the effects of trade policy on structural adjustment and growth. For many countries, trade appears to be an engine of growth, with gains from trade playing a crucial role in expanding their real incomes. Others, which have long been active exporters of primary products, have yet to see the gap between their real incomes and those of industrial countries narrow. Key trade policy issues include the emphasis that should be given to export diversification and the relative advantages of export promotion and import substitution strategies.

a. Export diversification for primary producers

Many developing countries earn almost all their foreign exchange from one or two exports, examples being Senegal (groundnuts), Côte d’Ivoire (cocoa and coffee), Sri Lanka (tea), and Iran (petroleum). Small reductions in the world price of an export may, depending on the commodity and country, limit their foreign exchange earnings substantially. This has given rise to two major concerns.

  • The tendency of demand for primary products to grow at a slower rate than real income, together with productivity advances in agriculture and the development of low–cost synthetic substitutes, can lead to over–supply and downward pressure on prices in the medium and long run.

  • Primary products are sold on commodity markets and their prices fluctuate from day to day, while many industrial goods are sold at administered prices. Moreover, because agricultural output is subject to crop failures due to changing climatic conditions and diseases, export earnings from rice, sugar, coffee, and the like are vulnerable to sudden and often drastic changes. The economic reasons for the price instability are the low price elasticities of demand and supply for primary products on world markets.

These concerns do not, however, necessarily indicate that countries should curtail their primary exports in favor of export diversification. While terms of trade of developing countries fluctuate, there is no clear evidence of secular decline. Furthermore, if countries have a proven comparative advantage in their export lines, and these must be curtailed for other kinds of production to be started, the opportunity cost of new enterprises may be too high. To the extent idle resources can be employed so that traditional exports can be continued and others added, there is much to be said for this type of development. As, however, discussed below, there are dangers in encouraging diversification through inefficient and internationally uncompetitive import substitution.

Diversification, when it requires the contraction of activities that can earn foreign exchange, may lose average real income over the years. The economic cost of diversification is, therefore, a sort of premium paid as insurance against price fluctuations. However, there may be less expensive ways to stabilize the incomes of export producers. Thus, government marketing boards can stabilize prices through purchase and sale of major commodities. A problem with stabilization schemes is that, by definition, they eliminate the regulatory effects of price changes; they also require a government wise enough to estimate developments in commodity markets, and strong enough to withstand producers’ influence on the marketing board and resist the temptation to turn the Boards into taxing agencies.

For many countries, export diversification may best be served by eliminating existing distortions that adversely affect incentives for new and efficient industries. Establishment of a realistic exchange rate and liberalization of the import regime may be particularly important in this context.

b. Import substitution versus export promotion

For a variety of reasons, including the increased ability of the authorities to affect decisions by producers when the economy is less open, measures to promote import substitution tend to consist of a mixture of pricing actions and of direct quantitative controls over various aspects of economic activity. Although, in principle, import–competing goods could be encouraged with subsidies, this is often ruled out by budgetary considerations. Consequently, domestic production is usually encouraged by either imposing tariffs or quantitative restrictions (in the extreme case prohibitions) on the import of the commodity. Thus, the hallmarks of an import substitution regime generally include:

  • high levels of protection to a number of industries with a very wide range of effective protection, i.e., protection against the value of added component of imports;

  • fairly detailed and complex quantitative controls and bureaucratic regulations; and

  • an overvalued exchange rate.

An important and unwanted result of protecting domestic industry may be the discouragement of exports. This may occur for the following reasons:

  • exporters using the often more expensive protected commodity in their production process are placed at a disadvantage;

  • resources employed in the import–competing sectors are drawn away from other, including export, industries;

  • establishment of a new domestic industry often requires imported capital goods, which tends to put pressure on foreign exchange resources; and

  • overvalued exchange rates discourage exports.

An export promotion strategy requires a production or an export subsidy, or a realistic exchange rate. Subsidies, however, are costly to government budgets and since they are clearly visible, tend to be politically unpalatable. Consequently, this strategy usually involves maintenance of a realistic exchange rate, which not only encourages exports, but also reduces the balance of payments motives for tariff protection. Export promotion requires that industries be permitted to purchase their needed intermediate goods and raw materials at world prices if they are to be competitive. This puts pressure on the authorities to reduce barriers to imports, which in turn may encourage other producers to enter the export market. Thus, a genuine export promotion policy must be accompanied by a fairly open trade regime with limited biases. Cross–country evidence strongly indicates that this more liberal, market–oriented regime has been substantially more successful than import substitution strategies.

4. Trade policy measures in adjustment programs

Experience with liberalization suggests that the attainment of completely free trade is not a practical option. More realistic goals should include the elimination of antitrade biases from the policies in place, and the maintenance of low, non–discriminating, and transparent protection levels. The Fund has encouraged countries in the context of Fund–supported adjustment programs to implement measures to liberalize trade policies and bring about conditions that will engender economic growth concomitant with a viable balance of payments over the medium term. In this context, importance has been attached to coordinating trade reforms with initiatives in other areas, including tax and exchange rate policies. Below are listed some of the trade policy issues addressed in recent Fund–supported adjustment programs.

a. Encouragement of exports

(1) Reduction of impediments to exports

The following impediments to exports are often addressed in adjustment programs.

  • Quantitative restrictions on exports. The number of prohibited, or restricted exports, should be sharply limited. Further, lists of such exports should be published by the authorities and subject to annual review.

  • Restrictions on imported inputs. Intermediary goods needed for the production of exports should either not require licenses, or be subject only to open general licenses. Allocations of the required foreign exchange should be automatic.

  • Export taxes. Although such taxes may be required for revenue purposes, they have the undesired effect of discouraging exports. Over time, export taxes should be reduced and replaced with alternative, less discriminatory, tax measures.

(2) Reduction of anti–export bias in the trade regime

As previously indicated, attempts to promote import substitution have often led to a substantial bias against exports. Elimination of this bias, and particularly the adoption of an appropriate exchange rate, often represents a crucial part of the adjustment program. Similarly, reductions in import restrictions will help promote exports. Reduction of these restrictions will need to be coordinated with the move to a realistic exchange rate.

Export subsidies may have been used to compensate for biases in the trade regime. Such subsidies are, however, discriminatory and inferior to measures aimed at eliminating the exchange rate and other measures underlying the bias.

b. Liberalization of imports

(1) Simplification of quantitative restrictions

Quantitative restrictions on imports should be eliminated over time. Movement towards such elimination may take place in several steps.

  • In cases of absolute prohibition, positive lists of goods that can be imported may be replaced by negative lists of restricted imports.

  • Negative lists could be gradually converted from absolute prohibitions to import quotas. The transfer of items from the negative to the quota list may represent a program goal.

  • At a later period, general licenses should replace the quota system.

Administration of the import system by state monopolies may exacerbate inefficiencies. Early introduction of competition into the import trade may be an important step in the reform process. For example, in the context of the Fund supported program, Guinea in 1984 started to dismantle a pervasive system of state import monopolies.

(2) Removal of quantitative restrictions on non–competitive imports

Quantitative restrictions on non–competitive imports are for balance of payments purposes and not for protection. Their removal needs to be accompanied by use of other instruments to prevent a flood of imports. An appropriate exchange rate can substitute for quantitative restrictions. Sufficiently restrictive monetary and fiscal policies complement the expenditure–reducing effect of devaluation. When no exchange rate adjustment is feasible for institutional reasons (e.g., in the CFA countries of Africa), the Fund has suggested that quantitative restrictions on noncompetitive imports could be replaced by indirect taxes, tariffs, and tight monetary policies.

(3) Lowering effective protection on import substitutes

The major long–term benefits from liberalization derive from opening up the tradable goods sector to foreign competition. This is especially true for developing countries, where domestic production is usually concentrated in monopolistic or oligopolistic structures. Consequently, Fund–supported programs have given special importance to this area. The speed of implementation may depend on the economic and political influence of the affected subsectors. Agriculture, for example, has succeeded in retaining protection long after most manufacturing was opened up to foreign competition in high income and newly industrialized countries. For most developing countries, trade liberalization has most relevance for the manufacturing sector. In most cases, it would be desirable to prepare preannounced time schedules, specifying the tariff ceiling, the items on which tariffs would be lowered and the new levels. A useful system is to initially lower higher tariffs. This has been done in many Fund–supported adjustment programs.


The potential gains from trade for developing countries are substantial. Both economic theory and the empirical evidence show that fuller participation by developing countries in world trade should increase their efficiency and growth. This suggests that developing countries ought to gain if they reduce their trade barriers and liberalize their own economies. They would, however, find such policies much easier in an environment of more liberal and expanding world trade. This gives developing countries a keen interest in the successful completion of the Uruguay Round (see Box V.2).

Box V.2The Uruguay Round

Since the end of World War II, countries have agreed on tariff reductions largely through multilateral negotiations under the aegis of the General Agreement on Tariffs and Trade (GATT). GATT has fostered large tariff cuts and helped settle serious disputes over commercial and trade policy. As a result of seven successive rounds of multilateral trade negotiations, average tariffs on manufactured products in industrialized countries declined to about 5 percent in 1988 from more than 40 percent in 1947.

Current multilateral trade negotiations are covered by the so–called Uruguay Round, initiated when 105 countries and the European Community (EC) met during September 15–20, 1986 in Punta del Este, Uruguay, and issued a common declaration. It is generally recognized that the Uruguay Round is the most ambitious of all the GATT negotiations that have taken place so far. This is evidenced by the many and greatly varied subjects that have been put on the agenda at the ministerial conference. No less than 14 different negotiating groups were created by the Group of Negotiations on Goods, which deals with such matters as tariffs, agriculture, dispute settlements, trade–related investment measures, safeguards, and the general functioning of the GATT system. In comparison, the Tokyo Round negotiations (1973–1979), which at the time were regarded as embracing all trade problems, were conducted in only six negotiating bodies. In addition, for the first time a Group of Negotiations in Services was created in the current Round.

The Uruguay Round was scheduled to be completed by the end of 1990 in Brussels. However, major issues remained unresolved, and the negotiations continued into 1992. The areas in which it proved most difficult to reach agreement included agriculture, trade–related aspects of intellectual property rights, safeguards (that is, Article XIX of the GATT, which allows temporary restrictions on imports when domestic producers are seriously affected), and textiles and clothing.

A group favoring fundamental reform—which is made up of agricultural exporters, including the United States—has pressed to remove the agricultural exceptions to GATT rules. It would phase out all voluntary export restraint agreements and other gray–area measures and would eventually prohibit domestic subsidies that distort trade. The Multifiber Agreement would be terminated under these proposals, and textiles would be covered by GATT rules.

A second group—including the European Community, Japan, the Nordic countries, and Switzerland—has argued for restraint. These countries contend that national policies protecting agriculture should be continued although limited. Disagreement between the EC and the United States regarding possible reductions in farm support programs accounted, in large part, for the extensions of the deadline for completing the negotiations.


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