3 Trade Liberalization

Zubair Iqbal, and Mohsin Khan
Published Date:
December 1998
  • ShareShare
Show Summary Details
Michael Mussa

The Road to Uruguay

Before Uruguay: Growing Liberalization

During the 1960s and the 1970s, industrial countries increasingly adopted trade liberalization. The General Agreement on Tariffs and Trade (GATT) provided them with a framework for a more coordinated multilateral liberalization of trade; successive GATT rounds of negotiations reduced tariffs and QRs among them. From the first round of multilateral talks to the close of the Tokyo Round in 1979, the average tariff on manufacturing in the major industrial countries was reduced from 40 percent to between 6 and 8 percent. In contrast, many developing countries, in their efforts to modernize, pursued inward-looking strategies, adopting “infant industry” support of nascent industries, and “import substitution” for the development of domestic industry. As part of this inward-looking strategy, tariffs, quota, and exchange and payments restrictions in many developing countries were increased.

Meanwhile, theoretical and empirical evidence mounted on the costs of protection to develop intellectual support for trade liberalization. The costs of import substitution as well as the benefits of outward-oriented development strategies, emphasizing development of competitive export sectors, was demonstrated by the success of the fast-growing countries of the Pacific Rim, which became increasingly visible by the early 1980s. Rapid growth in output and trade and efficient industrialization came to be associated with these outward-oriented policies. The gains from outward-looking strategies were clearly determined to outweigh the costs of protection. During the 1980s, the weight of this evidence began to be felt on policy in many other developing countries. The process of unilateral liberalization of trade regimes was begun in many of them in the context of comprehensive adjustment programs, often supported by the IMF and the World Bank.

World trade has expanded rapidly during the past three decades in response to this increasing acceptance of openness by countries, as well as decreasing transport and information costs; growth in world trade has far exceeded that in world production. The composition of trade has also changed substantially as developing countries have begun to exploit opportunities for technological improvement. The volume of intra-industry trade also expanded rapidly, allowing various stages of manufacturing to be located in different countries. This “slicing of the value-added chain” opened up many new opportunities for all countries as more flexible criteria for the location of industry were made possible by advancing technology.

There were, however, some developments that raised concerns about the forward momentum for further liberalization of the world trading system:

  • First, negotiations for the Uruguay Round (1986–93) were protracted, with their successful conclusions sometimes in doubt.

  • Second, regionalism, which had not been in vogue since the 1960s, reemerged. While frustration with the multilateral process was a factor, the political and economic imperatives of the regional partners were an additional motive. Fears of the emergence of warring trade blocs added to prevailing uncertainties, but no serious regional conflicts occurred.

  • Third, protectionist pressures and trade frictions escalated in some areas as growth slowed and unemployment increased in major trading nations. Delays in concluding the Uruguay Round, and new competitive challenges emanating from globalization and the dynamic trade performance of some developing and transition economies, increased the demand for protection and retaliatory trade measures. Resort to bilateral and unilateral approaches to trade disputes intensified at the same time as disputes brought to the GATT also increased. Notwithstanding increasing trade frictions and a number of specific actions, however, resort to nontariff measures did not increase on balance in industrial countries. Nonetheless, subsidies remained high, voluntary export restraints (VER) continued, and increasing attention was given to the efficacy of setting import targets (i.e., “voluntary import expansions” or VIEs). Increased use of trade remedy laws, especially antidumping ones, as an instrument of protection was also seen, and it spread to developing countries even while they liberalized their trade in other respects.

  • Fourth, as a more dynamic notion of comparative advantage emerged from growing and more flexible arrangements for trade, trade policy was interpreted more widely to include broader policy objectives—for example, competition policy and better environment and labor standards. These issues began to receive attention in national and international forums and were viewed as a possible backdoor means for protectionism.

The Uruguay Round

The successful conclusion of the Uruguay Round toward the end of 1993 helped to restore the credibility of the multilateral trading system, as well as significantly increase the scope and breadth of coverage of the issues by the multinational trade negotiations. Significant progress was made in three major areas:

  • Significant market liberalization was achieved, which according to preliminary estimates is expected to add approximately 1 percent to world real GDP and 12 percent to world trade upon full implementation of the agreement,

  • Rules and institutional structures were strengthened, particularly with the creation of the World Trade Organization (WTO), designed for better adjudication of disputes and more efficient surveillance over trade as well as unilateral and bilateral approaches outside the multilateral system,

  • New areas (e.g., agreements on services and trade-related intellectual property rights, or TRIPs, and the traditional “sensitive” sectors, agriculture, textiles, and clothing) were integrated into the multilateral trading system.

The last element may well be the most remarkable achievement, given the history of the Multifiber Arrangement (MFA), failure of past attempts to bring agriculture under multilateral disciplines, and the North-South differences over TRIPs and services.

As can be expected, there remain several areas of concern that will hopefully be ironed out in the course of implementation. For example, transition periods to liberalization of key sectors such as textiles may be too long; liberalization of agriculture may not be sufficient, or it may result in higher food prices; and the inclusion of TRIPs may make essentials like drugs more expensive for the poor countries. Implementation of the agreement may also involve transitional costs in specific areas for some countries and benefits for others. It is expected that the round will in general be beneficial for all countries and that, where adjustments are required, the implementation period will be fairly long to allow a gradual transition. Two important types of transition costs have been identified for some developing countries: those arising from the erosion of preference margins and from the possibility of higher costs of food imports. Preliminary analyses suggest that the erosion of preferences is likely to be small for most African and Caribbean countries but could be more significant for some North African countries. Moreover, as tariffs come down in successive rounds, and the world economy gets increasingly integrated, reliance on preferences as a basis for long-term export growth is not a viable strategy. Regarding food imports, the direct impact of possible higher prices is likely to be felt by those relying most heavily on commercial food imports and will depend on the extent of the rise in food prices. Conversely, the long-term trend for real food prices has been distinctly downward, and there is no reason to expect that this trend is about to end.

Beyond the Uruguay Round

The process of liberalization at the country level and for globalization at the international level will continue in the coming years. However, difficulties still lie ahead. While empirical as well as theoretical analyses show that openness is a strong determinant of economic success, the process of liberalization often leads to domestic opposition as the abolition of trade barriers imposes costs on those who benefited from protection. Given the political economy of trade liberalization in individual countries, it is easy to see that several themes and issues will dominate the debate in this area for some time to come.

Regional Trade Arrangements

Regional arrangements gained momentum as multilateral negotiations through the Uruguay Round became protracted. There are now at least 67 preferential regional trade agreements (RTAs). The most important RTAs are the EU, NAFTA, and the Asia Pacific Economic Cooperation forum (APEC).

All of us recognize that regional arrangements are second best and that multilateral liberalization is the preferred approach for the globalization of trade. Regionalism raises fears of trading blocs that potentially could eliminate access by outsiders. Moreover, gravitation toward large regional blocs may lead to an increased apprehension of retaliation and trade conflicts.

On balance, however, recent regionalization has not inhibited the growth of world trade or global integration. In general, there has been no increase in protectionism on the part of the major RTAs; the development of RTAs has proceeded alongside an expansion of trade with nonmembers.

Thus, regionalism is not inimical to global liberalization. Indeed, RTAs can often supplement the process of globalization. Neighboring countries may find that agreements between them are easier to achieve than those with all countries in the world, thus allowing a faster pace of liberalization in a regional context than in a global context. Regional groupings may also be more ambitious toward opening out than countries that rely only on a unilateral approach. However, we need to continuously monitor how regionalism develops, so that trade-creating aspects of RTAs are emphasized. At a minimum, we should expect that RTAs cover substantively all trade and not increase restrictions on third countries. We should also expect that RTAs have transparent and liberal rules of origin and accession provisions for potential new members.

Political Economy: Special Interests and Jobs

Why does protectionism enjoy broad support even in those countries, such as the United States, that have championed the cause of liberalism? There are two answers to this difficult question. First, in the practical determination of trade policy through the political process, the special interests of highly organized groups that correctly perceive the benefits to themselves from protectionist measures often operate more effectively than the relatively diffuse general interests that are comprehended in the economist’s concept of social welfare. As I sometimes like to put it, “In Washington, the truth is just another special interest, and one that is not particularly well financed.” Without going into the political economy of trade, a subject that is the subject of intense and rigorous analysis, I would only like to point out that economists who are involved in the determination of trade policy—hopefully on the side of the angels—should prepare themselves to use valid and effective arguments to counter those of the special interests.

Second, from the broad support often seen for protectionist policies, it is clear that such support does not come only from those who have a vested interest in such policies. Rather, it is based on a widespread and deep-seated feeling that opportunities for employing domestic resources to meet domestic needs should somehow be protected from foreign competition. Simply put, the issue is “jobs, jobs, jobs.” The commonsense perception is that if foreigners are allowed to supplant domestic producers of some product, then the domestic resources used in such production will become unemployed; or, more succinctly, “jobs will be lost.” These special interests fail to perceive that openness of trade, through a reallocation of resources, will result in job displacement from specific sectors only. In the aggregate, jobs can be expected to increase as a result of more openness as the efficiency gains from the increased trade take root. Those who are displaced will be able to find opportunities elsewhere.

In actual fact, the fixed-number-of-jobs fallacy often results in the adoption of trade-restricting policies that likely constrain economic growth, and hence employment. The arguments are based on the natural sympathy that everyone has for those who might lose their jobs because of foreign competition—a sympathy that is reinforced by the reality of prolonged periods of unemployment as a result of some sectoral shifts following a withdrawal of protection. The practical question for economists and policymakers, then, is, “How do we minimize the transition costs that arise from moving toward free trade?” It should be recognized that these costs occur only in the short run and can be (and have been) dealt with through appropriately designed social safety nets.

Fair-Trade Versus Free-Trade: Level Playing Field

With globalization and improved technology, production centers move easily to exploit cost advantages. Producers have, therefore, become very sensitive to the possibility of “unfair” advantage by foreign competition and raised the “level playing field” argument or the “fair trade before free trade” argument to demand partial (or total) harmonization of domestic policies.

It is not surprising that attention is focused on newer issues affecting market access now that traditional trade barriers have come down. In some cases, even though tariff reductions have taken place and QRs have been eliminated, market access appears to be limited to foreign competition. This naturally raises questions, such as “Can domestic, as opposed to border measures, be used for impeding trade?” “Is competition policy being enforced properly?” or “Is it effectively favoring domestic industries over foreign production?” Domestic policies toward foreign investment also influence market access. Hence, trade-related investment policies and the need for new multilateral rules on investment (particularly FDI) are also issues for the new trade agenda.

However, competition policy issues and its instruments need better definition and analysis before multilateral approaches can be formulated to tackle emerging trade frictions in this area. There is also a danger of trade policy being overloaded with objectives. For example, trade restrictions are being suggested to counter “eco-” or “social” dumping. The links between trade policy and environmental and labor policies are likely to get further attention in the future. Environmental and labor objectives are undoubtedly important and should be advanced without reliance on trade sanctions as an enforcement mechanism. More generally, there is no presumption that harmonization of all domestic policies and business practices is necessary for trade to be mutually beneficial—if it were, should we also demand the harmonization of climate?

Liberalization: What Can We Learn?

While major progress in liberalizing exchange and trade regimes has been made in recent years, it is important to note that some countries, especially the low-income ones, remain more restrictive compared with other regions of the world. However, it is encouraging that this restrictive stance of the poor countries is being perceived by most stakeholders as a major impediment to accelerating growth. Indeed, recent initiatives for sub-Saharan Africa have identified trade liberalization as a key reform area.

The promotion of open trade regimes is also considered an important element in the IMF’s work, both in terms of surveillance and program design, because distorted trade regimes operate as impediments to both macroeconomic reform and structural adjustment. Trade reform can contribute importantly to improving the efficiency of resource allocation, reducing the anti-export bias of the economy, exposing it to competition, promoting realistic exchange rates and balance of payments adjustment, spurring investment (including FDI), and diversifying the economy.

Given the underlying political and economic interests, trade reform remains a complex process, with each attempt at liberalization being confronted by differing circumstances. Nevertheless, several common themes emerge from the experience of liberalization in the past two decades. From these, we can derive valuable lessons for the countries of Africa in the design of their own liberalization experiences.

Complementary reform: Trade liberalization cannot function as an engine of growth in the absence of complementary actions in other macroeconomic and structural areas. While trade reforms continue to be narrowly defined to cover (import and export) tariffs and nontariff barriers (NTBs), policies such as exchange restrictions and the exchange rate, price controls, and state trading monopolies are closely related to trade reform and have direct significant effects on trade flows. The effectiveness of trade reform is enhanced when it is accompanied or preceded by reforms in the exchange system, price controls, and the privatization of state trading. Experience suggests that the most successful trade reforms have been part of comprehensive adjustment packages.

Bold and comprehensive strategies: Trade liberalization programs that started boldly and were followed through with vigor proved more durable than ones that took a more hesitant approach. The main elements of such a program are sharp reductions in tariffs and elimination of QRs in the context of a broader structural reform and stabilization package. If such efforts are sustained for 6 or more years, the liberalization effort is likely to be sustained. For the credibility of the reform process, it has also been found to be useful to preannounce the phased medium-term reform to provide economic agents with the signals and the time to adjust to the new structure.

Prudent macroeconomic policies: Successful reformers have shown themselves to be more fiscally prudent than others. Reversals of liberalization were more commonly associated with poor macroeconomic policies than with any other factor, including the power of vested interests and increased short-run unemployment. The perceived potential, adverse short-term impact of liberalization on the external and fiscal positions can be minimized. The balance of payments effects can be kept manageable, as long as domestic demand policies are properly managed, and the trade liberalization is appropriately phased and accompanied, as necessary, by an exchange rate adjustment. In general, with the adoption of flexible exchange rate policies in many African countries, the balance of payments argument for postponing trade reform is no longer credible, except perhaps for very short periods in particular cases of precarious reserve levels.

Sequencing and design issues: Credible and comprehensive trade reform can be out pari passu with macroeconomic stabilization. There is no compelling reason to wait for the completion of macroeconomic stabilization to initiate major trade reforms. Indeed, such an approach risks undue delays in commencing trade liberalization. However, such a delay may not be inappropriate if the inflation and reserve situations are so severe as to require immediate and major contractions in domestic demand, and these measures are expected to stabilize the position in the near term (1 year). If the achievement of macroeconomic stabilization is expected to occur gradually (say, over 2 to 5 years), it is prudent to integrate concomitant trade liberalization into the overall adjustment package.

QRs should be eliminated as a matter of priority because they are less transparent and more restrictive than tariffs. (QRs include prohibitions, quotas, licensing, and so forth.) It is preferable to phase out QRs (excluding those for security and health reasons) during a 2- to 3-year period at the beginning of the trade reform. The QRs should be replaced by tariffs; if necessary, these could be temporarily higher than normal maximum tariffs but should not exceed their tariff equivalents; they should be phased down to the normal maximum tariff within 2 to 3 years.

Measures for transparency and for reducing anomalies in the tariff structure should be implemented early in a program. For example, many sub-Saharan African countries resort to statutory and discretionary exemptions and have multiple duties and charges on imports over and above the basic tariff. Exemptions should be strictly limited to normal obligations under international conventions (for example, embassies), and eliminated for the rest, including parastatals, state trading enterprises, donors, and nongovernmental organizations. Once this is accomplished, it is easier to design a meaningful tariff reform that can aim at simplifying the structure to a few rates (3 to 5, including 0), and then reduce the level and dispersion of tariffs by reducing maximum and average tariffs.

Maintaining competitive exchange rates: The experience of successful reformers suggests that major trade reforms are easier to initiate and sustain when accompanied by a real exchange depreciation and an improvement of the fiscal position. This is particularly true if the initial level of protection is high and widespread and the reform period is concentrated over a few years, because the high level of protection itself artificially raises the value of the currency (compared with the equilibrium level in the absence of the restrictions). However, in some cases when temporary upsurges in capital inflows generate an appreciation of the exchange rate, trade liberalization is difficult to sell domestically and may also face a balance of payments constraint, unless the external reserve position is strong. The experience with sequencing thus indicates that programs could face risks if capital-market liberalization preceded trade liberalization, especially if it resulted in a surge of imports.

Costs of adjustment may not be large: Regarding output effects, a World Bank multicountry study suggests that short-term costs were surprisingly small. In particular, reallocation of resources to more efficient patterns suggested that overall output and employment were not very adversely affected and that the reallocation of labor was achieved largely within sectors, causing less disruption than might have been feared. Indeed, the short-term effect of liberalization on overall national output in Latin American countries was strongly positive, and on employment it was, at worst, neutral.

Trade Reform in Africa

Trade liberalization is now widely accepted in sub-Saharan Africa. Many countries have eliminated QRs and reduced maximum tariffs from triple-digit levels to the range of 20–40 percent. How much further should they go, and during what period? Although theory suggests that a small economy cannot influence world prices, and that the optimal tariff is zero, practical and political considerations make this level impractical. We can, therefore, assume that tariff rates will be positive for purposes of domestic protection and to generate fiscal revenues. There is no magic formula to determine the appropriate level of tariffs pertinent to the implementation of a medium-term growth strategy in sub-Saharan Africa, and ultimately the particular circumstances of each country will determine the extent and pace of reform. As a general rule, countries could consider a two-stage approach to trade reform. The first stage would be implemented on an accelerated basis, and the second stage in the medium term. The first stage would aim to remove all QRs (except for security and health) and to bring down tariffs to a range of 0–30 percent, with an average tariff of not more than 15 percent, within a period of less than 2 years. Some sub-Saharan African countries have already reached this stage, and a number of others are close to it. These countries can proceed to the second stage, which would cover a 3-year period where tariffs are further reduced to a range of 0–15 percent, with an average tariff of 10 percent or less. Tariffs on some luxury imports for which domestic production is infeasible may be at a somewhat higher level for revenue purposes and for tax equity in the absence of a capacity to effectively enforce other progressive taxes. The above two-stage approach provides for a 5-year period to implement tax reforms that would substitute domestic revenue mobilization for trade taxes. This would constitute an ambitious but feasible reform program that would enable Africa to compete on equal or better terms (ceteris paribus) with the successful reformers in Latin America and Southeast Asia.

While liberal trade policies contribute to the improvement of efficiency, promote export growth, and enhance an economy’s adaptability, they have to be supported by an appropriate macroeconomic policy stance. Inappropriate fiscal, monetary, and exchange rate policies can constrain the ability of economic agents to compete abroad and also generate protectionist pressures. Exchange and trade restrictions restrain trade, and hence negate trade liberalization. Trade policy, in turn, can affect macroeconomic performance through its impact on fiscal balances (e.g., the revenue effects of tariff reforms), on the balance of payments (e.g., in the short term through incentives to export and import), and on the exchange rate (e.g., heavy reliance on trade restrictions can amount to overvalued—effective—exchange rates).

In African countries where the industrial base is narrow and highly dependent on protection, the contraction of output in the protected industries may not be as rapidly offset by the development of export industries. However, this is more a question of the length of the lags rather than the nature of the response. Also, there may well be instances where domestic industries with high effective protection on final products have negative value added for the economy. Output losses for such industries are immediately beneficial for the economy as a whole.

Supply responses in sub-Saharan Africa may be more sluggish than in other regions because of the existence of more bottlenecks in complementary areas, such as poor infrastructure, power and telecommunication facilities, and lack of marketing information. This, again, points to the need to integrate reforms into comprehensive structural adjustment packages that include measures to ease supply bottlenecks.

The experience with special protection for infant industries in Africa (and most other regions) has been generally poor. In the few cases where such a policy has been “successful,” it has entailed large costs and has been accompanied by circumstances that do not prevail or cannot be replicated in Africa (e.g., a very high rate of domestic savings, skilled administrative capacity, and macroeconomic stability). African governments should be discouraged from diverting scarce resources to dubious infant industry development, which often is a pretext for the support of particular vested interests.

Fiscal Policy and Trade Liberalization

The relationship between tariff reforms and fiscal revenues is problematic. Sub-Saharan Africa depends on trade taxes for fiscal revenues to a greater extent than most other regions. Finding domestic sources of revenue to reduce reliance of trade taxes has been an important cause of delays in initiating, following through, or completing major trade reforms. Often the difficulties have been compounded by poor tax administration capacity. In some cases, the fiscal argument has been exaggerated or used as a pretext to delay trade reform. Indeed, a well-designed tariff reform may actually improve the import tax collection rate at the same time as statutory tariff levels come down, particularly if the original high tariffs have lead to widespread exemptions, smuggling, tax evasion, misclassification, and corruption. The incentive for these activities is reduced with the reduction in tariffs.

Nonetheless, the fiscal impact of trade liberalization may be negative, requiring a careful consideration of the manner and speed of implementing trade reforms. Alternative sources to domestic revenue, such as the value-added tax (VAT), need to be designed and implemented. Taxation of primary commodity exports may be an important source of revenue, while the collection of income taxation in rural areas and on small farmers scattered over a wide area may be difficult. Notwithstanding these difficulties, the design and implementation of tariff and fiscal reform should be well coordinated and synchronized to manage these difficulties over the medium term. The aim should be to broaden the effective tax base and, if the sources of revenue are limited, to emphasize better expenditure control. Waiting for the “right” time vis-à-vis the fiscal situation may inordinately delay the initiation of trade reform.

Regional Integration in Africa

Regional integration movements, which are being developed in Africa, should be encouraged to the extent that they are consistent with multilateral liberalization and carry economic benefits for the concerned country, its neighbors, and its trading partners. Trade reform in the regional context in sub-Saharan Africa should bear two considerations in mind. First, countries in a proposed regional grouping should incorporate specific trade liberalization measures to ensure, broadly, the same scope and timing of trade reforms. This has been missing, for example, in the programs for Cross-Border Initiative (CBI) participants, probably because the individual economic circumstances are different, even with the intention to harmonize tariffs on a given timetable. Second, while it is theoretically desirable to aim for a common or harmonized tariff for a given product at the level of the lowest tariff among the participants within a regional grouping, in practice this is difficult to implement. Indeed, in some cases, joining a regional arrangement may have the effect of raising tariffs to the regional standard, thereby reducing welfare in the country concerned. In such cases, the strategy should be to persuade the bigger economies in the regional arrangement to undertake an ambitious trade reform program, in the expectation that this route would carry the whole group forward more rapidly.

The Role of the IMF

IMF surveillance and programs have as their objectives the attainment of sustainable growth and the balanced expansion of trade. In this context, the linkages between macroeconomic and structural policies and trade policy developments have an important bearing on the IMF’s work. Maintaining open markets is especially important for the success of adjustment efforts of members undertaking IMF-supported programs. Further attention is likely to be given to strengthening the analysis of the effects of trade measures and of the links between trade policy and other macroeconomic and structural policies, including assessment of the impact of protection on domestic adjustment. Some of this analysis may also be conducted at the regional level if required. Similarly, problems of developing countries and economies in transition with access to markets will also receive attention. The recent increased emphasis on structural issues, the trade policy content of IMF-supported programs, has significantly increased. A review of design issues highlights the importance of integrating trade policy with other program policies—particularly fiscal and exchange rate—and adhering to a medium-term trade reform strategy with clearly established short- and medium-term goals.

The IMF’s work on trade reform complements that of the WTO. The major focus of the WTO is the implementation of multilateral rules and disciplines on trade in goods and services, the settlement of disputes, and the conduct of multilateral trade negotiations. The policy advice of the IMF and the World Bank is consistent with the general rules of the WTO and with the individual country’s specific commitments and legal obligations in the WTO. The IMF will need to monitor carefully members’ adjustment to the Uruguay Round agreement, including its impact on their balance of payments, and help countries manage an orderly transition. The IMF and the World Bank stand ready to use their existing facilities where appropriate to address external financing and policy adjustment needs arising from implementation of the Uruguay Round.

    Other Resources Citing This Publication