Chapter

V Phasing Exchange and Trade Liberalization

Author(s):
R. Johnston, and Mark Swinburne
Published Date:
September 1999
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One of the purposes of the IMF is “to assist in the establishment of a multilateral system of payments in respect of current transactions between members and in the elimination of foreign exchange restrictions which hamper the growth of world trade” (Articles of Agreement, Article I (iv)). The IMF also seeks to assist members “to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity” (Articles of Agreement, Article I (v)). Exchange and trade restrictions are important factors inhibiting the growth of world trade and are destructive of national and international prosperity.

This section describes the main linkages between the liberalization of exchange controls (specifically, controls on current international payments and transfers) and trade barriers, and examines the phasing of exchange and trade reforms in five countries—China, India, Korea, Mexico, and Russia—to 1997. It focuses on phasing of exchange reform relative to trade reform rather than the optimal sequencing of exchange and trade reforms per se.22 The case studies suggest that exchange liberalization tends to precede or accompany trade reforms and is often implemented at a relatively faster speed than trade liberalization. Exchange liberalization can provide an impetus to, and complement the reform of, the trade system, and can reinforce efficiency gains from, and the sustainability of, trade reform. Thus, coordination of exchange and trade reforms can help create a policy framework for an orderly development of a liberal external regime.

The liberalization of both controls on payments and transfers for current international transactions and controls on capital movements may be important for the phasing of trade liberalization. Liberalization of exchange controls for current international transactions has usually preceded the liberalization of controls on capital movements; this section focuses primarily on the historical relationship between such liberalization and trade reforms. The research in the appendix to the section shows, however, that in view of the extent of liberalization of exchange controls on current international payments and transfers, controls on capital movements are now more significant nontariff barriers for trade to the developing countries than exchange controls on current international payments and transfers, and that the liberalization of capital controls could significantly increase trade.

Relationship Between Exchange and Trade Measures

Exchange controls affect foreign exchange transactions with nonresidents and encompass regulations pertaining to the acquisition, holding, or use of foreign exchange, or to the use of domestic or foreign currency in international payments or transfers.23 Forms of exchange control are omnifarious, including foreign exchange budgets, advance import deposit schemes, currency repatriation and surrender requirements, limitations and prohibitions on payments and transfers, payments arrears, approval procedures, and multiple currency practices.24

Trade measures can be broadly categorized into tariff and nontariff barriers. The former include import tariffs and export taxes, and the latter encompass quotas, voluntary export restraints, and administrative barriers (such as licensing, government procurement, sanitary and phytosanitary standards; quality, safety, health, and environmental standards; trade-related intellectual property rights, local content requirements, and countervailing duties). Arguments for protection range from the promotion of domestic production and employment and the collection of tax revenue to the support of “infant” and increasing-returns-to-scale industries, the improvement of terms of trade, and national security. Trade policy, however, is typically not the first-best instrument to achieve the above objectives. Although theoretical cases exist under which trade protection could improve welfare, governments are unlikely to have sufficient information to design such welfare-enhancing trade policies. Trade protection also often encourages wasteful rent seeking.

Besides serving as independent policy instruments, exchange and trade measures can complement or substitute each other. Governments may resort to exchange controls to support trade policy instruments; for instance, the administrative allocation of foreign exchange through foreign exchange budgets tends to accompany import monopolies. Trade measures can be effected through the exchange system, for example, through multiple exchange rates and exchange-based taxes and subsidies. In turn, trade restrictions and licensing can be used to facilitate the management of exchange controls and the administrative allocation of foreign exchange. As policy substitutes, exchange controls are more often used for macroeconomic purposes, such as to protect the level of foreign exchange reserves, while trade measures have more often the objective of protecting or promoting individual industries. As regards fiscal purposes, exchange controls may affect government revenue indirectly depending on whether they help preserve the domestic tax base; in contrast, trade taxes are used directly as a taxation instrument.

Exchange and trade liberalization can both enhance welfare and promote economic growth by reducing distortionary intervention and thus improving the efficiency of the inter and intratemporal allocation of resources.25 A policy challenge lies in sequencing and coordinating various phases of exchange and trade reforms so as to maximize net welfare gains from these interrelated reforms.

Exchange liberalization contributes to the success of trade reform in the following ways. First, the removal of binding exchange controls reduces distortions in the exchange and trade systems, leading to a more efficient allocation of resources. Without exchange reform, the welfare gains from trade reform are likely to be limited. Exchange controls tend to raise the domestic relative price of imports, thereby reducing imports and distorting consumption, production and investment.26 Trade reform needs to be accompanied by the dismantling of binding exchange controls to promote production and trade in accordance with comparative advantage.27 In particular, the unification of the exchange rates for current account transactions prior to the liberalization of commodity trade could help ensure that exporters and importers face the same effective price of foreign exchange.28

Second, exchange liberalization fosters the development of liquid, continuous and efficient foreign exchange markets, thereby lowering transaction costs and uncertainty associated with international transactions. The settlement of trade payments becomes easier because exchange reform stimulates the development of modern payment instruments with lower processing time and higher reliability of payments (for instance, checks, debit and credit cards, and automated clearinghouse transfers, and large-value transfer systems). Last but not least, the cost and flexibility of business operations improve as exchange liberalization reduces incentives for the evasion of controls and rent seeking.

Third, exchange liberalization can help establish the preconditions to reform the trade system. Disequilibria in the foreign exchange market and the system of administrative allocation of foreign exchange may be key factors that gave rise to quantitative import restrictions. The removal of these restrictions hinged on exchange reforms, which helped to eliminate disequilibria in the foreign exchange market.29 However, in some countries with serious balance of payments problems, exchange liberalization might slow down trade reform where in the aftermath of exchange liberalization the country increased reliance on trade measures, for example, quantitative restrictions or countervailing duties, for balance of payments reasons.30 On the other hand, where depreciation or devaluation accompanies exchange liberalization, it is likely to stimulate exports and thus support trade reform.31

Exchange liberalization can also make trade reform more credible by enhancing its political feasibility and signaling precommitment to market opening. Exchange liberalization is often more feasible politically than trade reform.32 Unlike most trade measures, exchange controls are not specific to individual products, firms, or sectors, and therefore, dismantling exchange barriers does not require overriding powerful lobbies in protected sectors as much as trade reform does, and exchange reform can thus be implemented faster than trade reform. Issues concerning exchange controls have lower political visibility than those concerning trade barriers. Furthermore, export expansion stimulated by exchange liberalization often strengthens political coalitions supporting trade reforms, thereby increasing the sustainability of trade reform. Finally, in this context, the fundamental mobility and fungibility of money makes it difficult to control payments and transfers. As exchange controls become less effective over time, their liberalization becomes more feasible politically.

Both exchange and trade reforms may need to be coordinated with fiscal reform to avoid excessive reliance on trade and exchange taxes for fiscal purposes while achieving budget objectives. The impact of exchange liberalization on government revenues and expenditure is generally ambiguous. Exchange liberalization may involve the direct elimination of certain taxes or subsidies from the budget (e.g., multiple currency practices that apply a preferential rate to official transactions). This might encourage greater reliance on trade taxes to compensate for the lost tax revenue and thus might inhibit progress in trade liberalization.33 On the other hand, exchange liberalization can help reduce capital flight and thus the erosion of the tax base.

Exchange and capital controls tend to act as a barrier to trade, and thus increasing trade requires liberalizing both trade barriers and exchange and capital controls. This conclusion emerges from an empirical model, in which bilateral exports depend on the wealth and size of countries, the distance between them, tariff barriers, and exchange and capital controls.34 In a cross-sectional sample of 40 industrial, developing and transition countries for 1996, exchange and capital controls are found to reduce bilateral exports. The negative coefficient on the index of exchange and capital controls is significant at the 95 percent level for the entire sample and the subsample of developing and transition countries, but not for the subsample of industrial countries. The latter have relatively few exchange and capital controls, which affect trade negligibly. In contrast, in developing and transition countries exchange and capital controls are more widespread and tend to reduce bilateral exports significantly. The results suggest that the liberalization of exchange and capital controls can complement trade liberalization, leading to a noticeable expansion of trade.

In sum, exchange liberalization preceding or at least accompanying trade liberalization can enhance efficiency gains from and the sustainability of trade liberalization. By reducing distortions and entry barriers, exchange liberalization promotes competition. It also improves allocative and productive efficiency by helping foster a more market-based exchange system and the development of modern payments instruments. Furthermore, by allowing the exchange rate to move closer to its market equilibrium level, exchange liberalization stimulates exports and thus increases the sustainability of trade reform. However, to maximize the net gains from liberalization, trade and exchange system reforms must be part of a comprehensive package of economic reforms, including appropriate monetary, fiscal, and exchange rate policy.35

Selected Countries’ Experience with Exchange and Trade Liberalization

This section analyzes the phasing of exchange and trade liberalization in five countries—China, India, Korea, Mexico, and Russia—to 1997. The countries are selected to reflect various experiences with exchange and trade liberalization in terms of sequencing and results. The progress in reforms is illustrated by an array of measures. For trade liberalization, these measures include the mean tariff rate, the dispersion of tariffs, and the coverage of tariff lines by nontariff barriers. For exchange liberalization, the measures focus on the presence of individual exchange controls, such as multiple currency practices, special payments arrangements, foreign exchange budgets, and repatriation or surrender requirements.

China

Prior to 1979, China’s exchange and trade regimes were subject to administrative control and central planning.36Trade rights were limited to a modest number of specialized foreign trading companies (FTCs). The trade plan set import targets to cover domestic shortages in raw materials and capital goods, and the corresponding export targets to obtain foreign exchange to pay for imports. Foreign exchange was allocated administratively according to the foreign exchange plan. In 1979, China started a gradual economic transformation aimed at the decentralization of economic decision making, and the introduction of market incentives in the economy. Exchange and trade liberalization were the cornerstone of China’s reforms.

1979–84

Exchange liberalization was a prelude for trade reform, alleviating the severest foreign exchange constraints of enterprises (Tables 15 and 16). As early as 1979, the system of foreign exchange retention quotas and the associated trading mechanisms were introduced. Domestic enterprises were granted access to foreign exchange in an amount equal to the share of their foreign exchange earnings at the official exchange rate. Foreign-funded enterprises (FFEs) had an option of retaining their foreign exchange earnings directly in foreign exchange accounts. In selected localities an experimental trading system for foreign exchange was initiated, allowing enterprises to swap excess foreign exchange obtained through their retention quotas. Transactions were executed through the Bank of China at multiple internal settlement rates fluctuating within a tight band around the official rate. The rates were subsequently unified into a single internal settlement rate that was more depreciated than the official exchange rate. However, the remaining restrictions on the trading and use of accumulated retention quotas continued to inhibit the growth of swap trading.

Table 15.Phases of Exchange and Trade Reforms in China, 1979–97
Main Phases of Exchange LiberalizationMain Phases of Trade Liberalization
1979–84
  • A system of foreign exchange retention quotas was introduced (1979).

  • Foreign exchange swaps were allowed (1980).

  • Multiple internal settlement rates for transactions between foreign trading companies and enterprises were unified (1981).

  • Import tariff rates were revised.

  • Export duties were abolished (1980) and then reintroduced (1982).

  • The scope of export licensing was expanded (1984).

1985–93
  • Experimental swap centers were established (1985).

  • All enterprises were granted access to swap centers (1988).

  • Retention quotas were relaxed (1985–88) and unified (1991).

  • The internal settlement rate was abolished (1985).

  • Foreign trade reform aimed at decentralizing trade began (1985).

  • An import regulatory tax was imposed (1985).

  • Import tariffs were reduced (1992). Import quotas and licensing were scaled back. A new tariff schedule in accordance with the Harmonized System was introduced (1992).

  • The scope of export licensing was expanded (1990). Export subsidies were eliminated (1991). Mandatory planning for exports was abolished (1991).

1994–97
  • The retention quota system was abolished (1994).

  • Exchange rates were unified at the prevailing swap rate.

  • Foreign exchange certificates were discontinued.

  • Foreign exchange accounts were allowed.

  • Purchase of foreign exchange no longer required approval.

  • The China Foreign Exchange Trading System was established.

  • Regulations on current payments and transfers were eased (1995–96).

  • Article VIII was accepted (1996).

  • Surrender requirements were eased (1997).

  • The mandatory import plan was abolished (1994).

  • Import tariffs lowered.

  • Import quotas and licensing were reduced.

  • Transparency of trade regulations improved owing to the reduction of the number of internal documents.

  • The tendering system for exports of 24 items that were subject to restrictions by destination countries was introduced.

Sources: Chinese authorities; and IMF, Annual Report on Exchange Arrangements and Exchange Restrictions (various years).
Table 16.Individual Indicators of the Extent of Liberalization for China
PeriodExchange RateForeign Exchange BudgetSurrender RequirementAverage Unweighted Import TariffsStandard Deviation of TariffsShare of Imports Covered by Nontariff BarriersExport Taxes, Quotas, and Licensing
Prior to 1979MultipleYesYesNot availableNot availableNot availableYes
1979–84DualYesYesNot availableNot availableNot availableYes
1985–93DualYesYes38% (1986)27.4% (1992)50% (1989)1Yes
43% (1992)25% (1992)167% (1987)
51.4% (1992)250% (1989)
33% (1992)315% (1992)4
1994–96UnitaryNoYes23% (1996)16.7% (1996)32.5% (1996)5Yes
17.6% (1997)613.0% (1997)18% (1996)37
Sources: Chinese authorities; IMF, Annual Report on Exchange Arrangements and Exchange Restrictions (various years); and Dean, Desai, and Riedel (1995).

1985–93

The introduction and proliferation of foreign exchange centers led to the emergence of a segmented foreign exchange market. In 1985–86, independent swap centers—foreign exchange adjustment centers (FEACs)—were established as an experiment for trading retention quotas and retained foreign exchange earnings, primarily by foreign-funded enterprises. The incipient foreign exchange market was nurtured through the progressive expansion of entry rights and the relaxation and eventual unification of retention quotas. In 1988, all enterprises with retention quotas were granted access to the centers, and concurrently the swap exchange rate was decontrolled. In addition, all domestic residents were permitted to sell foreign exchange at the swap rate at designated bank branches. Purchases remained subject to approval by the State Administration of Exchange Control (SAEC) according to a priority list, which covered key imports and foreign debt-service payments.

The fostering of a market-based exchange system was accompanied by a decentralization of trade and a cutback of mandatory planning. In 1985, provincial branches of national FTCs became independent financial entities and each province was permitted to establish its own, causing a proliferation of them. In addition, FTCs were granted greater autonomy to trade on own account. The range of products they were allowed to trade expanded as mandatory planning was scaled back. In 1991, enterprises and local authorities were rendered more independent in setting trade targets. Mandatory trade planning was abolished in 1991 for exports and in 1994 for imports.

The retrenchment of administrative regulation resulted in a perplexing system of trade controls, involving tariffs, quantitative restrictions, licensing and other nontariff barriers on exports and imports. Direct trade controls were frequently overlapping; import licensing was used to allocate quotas and to influence imports in accordance with domestic and balance of payments objectives; import controls in the form of obligatory approval were adopted to protect domestic producers in selected sectors, inter alia, electronics and machinery; export licenses and quotas were applied to fulfill agreements with trading partners; import tariff rates were high and dispersed; and export taxes were widespread. A system of duty exemptions was in place, mainly for imports related to export production, imports by foreign-funded enterprises, and border trade.

1994–97

Exchange liberalization was largely completed during 1994–96. In 1994, exchange rates were unified at the prevailing swap rate and the retention quota system was abolished. The wholesale foreign exchange market was unified and integrated with the establishment of China’s Foreign Exchange Trading System (CFETS)—a national electronic trading system, which connected regional swap centers with the interbank market.37 Domestic enterprises remained subject to surrender requirement for foreign exchange receipts. Nonetheless, they were permitted to open foreign exchange accounts for selected transactions, such as foreign borrowing, stock issues, and approved debtservice payments. Approval requirements for access to the foreign exchange market for most trade and trade-related transactions was abolished, and purchases of foreign exchange could be made at designated financial institutions upon presentation of appropriate documents. SAEC approval was still needed for non-trade-related current payments by Chinese nationals, such as travel expenses, and for FFEs that wished to access the swap market. The use of foreign exchange certificates for foreign nationals was discontinued, and the multiple currency practice arising from the conversion of unused foreign certificates at the old official rate was eliminated. The remaining controls on access to foreign exchange for FFEs and limits on the availability of foreign exchange for certain non-trade-related current international transactions were abolished. Following these measures, in December 1996, China accepted the obligations of Article VIII, Sections 2, 3, and 4 of the Fund’s Articles of Agreement.

In parallel with the abolition of exchange controls on current international payments and transfers, trade liberalization accelerated. The Trade Package of April 1, 1996 stipulated the selective reduction of tariff and nontariff barriers. In 1997, import tariffs were lowered further. As a result, the average import tariff rate fell from about 40 percent at the end of 1992 to 17.6 percent at the end of 1997. In addition, tariff dispersion fell and duty exemptions were scaled back. The scope of export licensing and export taxes was also lowered. Also, the share of imports subject to nontariff barriers declined from more than one-half in 1992 to about one-third in 1996. Producers received larger access to trading rights as the share of imports subject to “canalization” declined from about one-third in 1992 to 18 percent in 1996. Furthermore, joint-venture foreign trading companies were permitted on an experimental basis in selected localities. Notwithstanding the recent progress, as of 1997, China’s trade regime continued to be characterized by numerous nontariff barriers, restricted trading rights, and high and dispersed tariffs.

India

India initially maintained highly restrictive exchange and trade regimes.38 To protect agriculture and to encourage industrial development, most imports were banned, except for goods not produced domestically (mainly raw materials and certain machinery items). Although import restrictions on certain intermediate and capital goods and inputs for export industries were eased in the late 1970s, the external regime remained extremely distorted with stringent exchange controls, high and dispersed tariff rates, widespread quantitative and licensing restrictions, and an intricate system of export controls and incentives. For example, imports of many goods were chaneled through parastatal monopolies, commodities for import were classified into 26 lists and subject to ten different types of import licenses, and imports of most consumer goods were prohibited. Some of these trade restrictions were maintained for balance of payments reasons under the General Agreement on Tariffs and Trade.

1991–92

A balance of payments crisis in 1990–91 spurred trade liberalization, and major trade liberalization measures were taken during 1991–92 (Tables 17 and 18). The level and dispersion of import tariff rates were substantially reduced in a succession of tariff cuts. The tariff structure was streamlined by reducing the number of tariff bands and eliminating special tariff exemptions. Import licensing requirements were eased, and quantitative restrictions on imports of most capital and intermediate goods were removed. The number of restricted items subject to “canalization” (i.e., those that can be imported only by the public sector) was also reduced. Goodsand sector-specific schemes with more general incentive schemes accessible to all exporters were streamlined, and many export taxes and direct export subsidies were abolished. Also, a system of EXIM scripts—special tradable import licenses—was introduced, allowing imports of production inputs up to a value equivalent to 30 percent of exporters’ foreign exchange earnings. The remaining goods (mostly agricultural and consumer items) were transferred to a unified negative list and subject to either import licensing or “canalization,” except for a few prohibited items. Items were gradually moved to a positive list or were issued open general licenses. In 1992, special import licenses (SIL) were introduced in preparation for relaxing restrictions on consumer goods imports. These tradable licenses were issued to exporters up to 15 percent of their export or foreign exchange earnings and could be used to import a few consumer goods, which had previously been on the negative list.

Table 17.Phases of Exchange and Trade Reforms in India, 1991–97
Main Phases of Exchange LiberalizationMain Phases of Trade Liberalization
1991–92
  • A dual exchange rate system was introduced to facilitate transition to a more market-based exchange rate (1992).

  • Authorized dealers were permitted to offer forward cover for all transactions permitted under the exchange control regulations (1992).

  • Payments for some invisible transactions were liberalized (1992).

  • The EXIM Script scheme was introduced, under which exporters received tradable import entitlement equivalent to 30 percent of the Value of their exports (1991). The EXIM Script scheme was subsequently replaced by a dual exchange rate structure (1992).

  • Import tariffs were substantially lowered. Quantitative restrictions on imports of most capital and intermediate goods were removed. A single negative list was introduced. A number of nontariff barriers were abolished, including actual user policy, phased manufacturing program, and government purchase preferences. On a limited scale, import of consumer goods was allowed through open general license, special import license scheme, and as luggage.

  • Direct export subsidies were eliminated. Sector specific subsidies were replaced by duty exemption schemes, including advance licensing, duty drawback and other schemes, and tax exemptions.

  • The coverage of export taxes substantially narrowed and remained only on a few selected items—for example, tea.

  • The scope of import and export “canalization” was narrowed.

1993–94
  • Exchange rates were unified (1993).

  • Limits on payments for many invisibles were liberalized (1994).

  • The scope of an exchange guarantee scheme for interest payments on nonresident foreign currency deposits, which resulted in a multiple currency practice, was narrowed to cover only deposits with a maturity of three years (1994).

  • Article VIII was accepted (1994); however, a number of exchange restrictions remained in place.

  • The level and dispersion of import tariffs were substantially reduced.

  • The scope of import and export “canalization” was narrowed.

  • Export controls were substantially relaxed.

1995–97
  • Payments for and remittances of proceeds from some invisibles were liberalized (1995).

  • Restrictions on the repatriation of current investment income were eliminated (1997).

  • The multiple currency practice associated with existing exchange rate guarantees on nonresident deposits was phased out (1997).

  • Ceilings were liberalized on a range of current account transactions and authorized dealers were permitted to conduct transactions—without seeking prior approval—on a bonafide basis (1997).

  • Import tariff rates were substantially lowered.

  • Import quantitative restrictions were eased through the expansion of the negative list.

Sources: Indian authorities; and IMF, Annual Report on Exchange Arrangements and Exchange Restrictions (various years).
Table 18.Individual Indicators of the Extent of Liberalization for India
PeriodExchange RateForeign Exchange BudgetSurrender RequirementAverage Unweighted Import TariffStandard Deviation of Import TariffsShare of GDP Covered by Nontariff BarriersExport Taxes, Quotas, and Licensing
Prior to 1991UnitaryNoYes128% (1990)41% (1990)93% (1990, in terms of tradable value added)Yes (export controls on 439 items)
1991–92DualNoYes128% (1991)

94% (1992)
41% (1991)

34% (1992)
75% (1992, same as above)Yes (export controls on 296 items)
1993–94UnitaryNoYes71% (1993)

55% (1994)
30% (1993)

25% (1994)
Not availableYes
1995–97UnitaryNoYes41% (1995)

39% (1996)

34% (1997)
19% (1995–96)

17% (1997)
66% (1995, same as above)Yes (export controls on 152 items)
Sources: Indian authorities; and IMF, Annual Report on Exchange Arrangements and Exchange Restrictions (various years).

At the onset of trade liberalization in 1991, the exchange rate was devalued by about 20 percent, and a free market exchange rate was introduced for many permitted transactions in 1992.39 Under the dual exchange rate system, the official rate applied only to imports by government, crude oil, fertilizers, and lifesaving drugs; all other permissible transactions were executed at a free market rate. Exporters were allowed to sell 60 percent of their earnings at a free market rate. Along with the changes in the exchange arrangement, payments for some invisible transactions were liberalized.

1993–94

During 1993–94, India made important steps toward current account convertibility. In March 1993, the exchange rates were unified, and most restrictions on payments and transfers for current international transactions were eliminated. Additionally, rules for repatriation of income and investment earnings were liberalized, and foreign exchange dealers were allowed to enter into forward transactions. Following these changes, in August 1994, India accepted the obligations of Article VIII, Sections 2, 3, and 4 of the Fund’s Articles of Agreement. However, some exchange restrictions remained in place, including those on nonresident deposits, income transfers by nonresident Indians, bilateral payment and debt agreements, and a dividend-balancing requirement.

Along with the unification of exchange rates, the trade regime was substantially liberalized. Tariff and nontariff barriers were lowered further. Notably, auxiliary duties involving differential rates that were applied on top of the basic tariff schedule were simplified and eventually discontinued. Quantitative import restrictions on capital goods and intermediate inputs were abolished, and maximum tariff rates dramatically reduced. In addition, licensing requirements for many export goods were eliminated.

1995–97

During 1995–97, exchange and trade liberalization continued, albeit at a slower pace. Restrictions on repatriating current investment income were eliminated, starting with income earned during the 1996–97 tax year. The multiple currency practice associated with the existing exchange rate guarantees on nonresident deposits was phased out as deposits under the scheme matured. In 1997, authorized dealers were permitted to conduct a broader range of current account transactions without seeking prior approval on a bona fide basis. In addition, the authorities began to prepare new legislation to streamline foreign exchange regulations. At the same time, import tariff rates were reduced, and import restrictions on consumer goods were partially liberalized. Although duty exemption schemes remained in place, they were streamlined in 1997 by discontinuing value-based advance license schemes.

Notwithstanding the progress in trade liberalization, as of 1997, India’s trade regime remained restrictive. The tariff structure was complex with 11 tariff bands and a 34 percent average tariff rate. Quantitative import restrictions and licensing continued to cover most consumer goods. Export controls, including quotas, prohibitions, and minimum prices, were extensive enough to keep domestic prices below the world level (particularly for agricultural exports, such as cotton, wheat, and rice). Furthermore, state enterprises retained monopoly control over trade in key goods, including some petroleum products, medicines, and cereals.

Republic of Korea

From 1953 to 1960, Korea’s economic development was based on an import substitution strategy, resulting in highly protectionist exchange and trade regimes.40 Multiple exchange rates and taxes on sales of foreign exchange for imports were in place. Exporters and others with foreign exchange earnings were given transferable rights to use their foreign currency proceeds for importing under an import-export linking system. Foreign exchange to finance imports that were not paid for with foreign exchange earned from exports was allocated by auctions. Residents were required to surrender foreign exchange in full to the Bank of Korea at the official banking rate. Upon surrender, residents received nontransferable exchange certificates, which could be used to repurchase foreign exchange within three months from the time of surrender.

Like the exchange system, the trade regime was severely distorted. Import tariff rates were high and dispersed. In 1960, for example, the unweighted average tariff rate was about 30 percent; and allowing for the foreign exchange tax, tariff equivalents, and exemptions, the actual tariff rate reached about 46 percent.41 Import commodities were differentiated into two categories: those paid for with Korean foreign exchange (so-called KFX imports) and those paid for with U.S. aid funds. KFX imports were classified into those subject to automatic approval, semirestricted, restricted (i.e., subject to quotas), unspecified, or prohibited items. While imports were extensively controlled, exports were promoted through multiple exchange rates and export subsidies.

1961–83

Exchange liberalization played a central role in the transition from import substitution to an export-oriented development strategy (Tables 19 and 20). Foreign exchange taxes were abolished in 1961, and multiple exchange rates were unified in 1964. By eliminating the severest disincentives for exports, these measures stimulated export growth. Between 1965 and 1980, exports as a share of GNP increased from 5.8 percent to 23.9 percent.42 Trade liberalization started in 1964 with the easing of some quantitative import restrictions and licensing. Export subsidies were revised several times and eventually abolished in 1965. The gradual reduction of tariffs began in 1973.

Table 19.Phases of Exchange and Trade Reforms in Korea, 1961–97
Main Phases of Exchange LiberalizationMain Phases of Trade Liberalization
1961–83
  • Foreign exchange taxes were abolished (1961).

  • The issuance of exchange certificates against the surrender of foreign exchange was discontinued.

  • The foreign exchange for all authorized purposes was to be sold without requesting the surrender of certificates (1961).

  • The retention quota system for export proceeds was abolished (1961).

  • Qualified banks and dealers were permitted to conduct exchange operations, except in respect of foreign aid (1962).

  • A major exchange reform was announced that substantially liberalized the exchange system.

  • Exchange rate was unified (1964).

  • Restrictions on payments for invisibles were relaxed. Licenses for payments for invisibles connected with foreign trade were granted automatically (1965).

  • Restrictions pertaining to resident and nonresident accounts were liberalized (1964, 1980).

  • Foreign exchange certificates were abolished (1980).

  • The system of export subsidies was revised (1961–64) and was abolished (1965).

  • The import-export linking system was expanded (1963). Some quantitative restrictions were relaxed or converted into tariffs, or both (1964).

  • Most goods previously requiring an individual import license were brought under the automatic approval procedure (1964).

  • Import restrictions were relaxed. The number of items authorized for import was increased from 694 to 1,431.

  • Import procedures were simplified (1965).

1984–97
  • Restrictions on payments for and proceeds from invisibles and current transfers were liberalized (1985, 1987).

  • The use of the Foreign Exchange Supply and Demand Plan was discontinued (1988).

  • Article VIII of the IMF’s Articles of Agreement was accepted (1988).

  • The requirement of advance import deposits was eliminated (1990).

  • Documentation requirements for foreign exchange transactions and foreign currency deposits were liberalized (1991, 1995).

  • The prohibition on sales of foreign currencies from accounts for making domestic payments was abolished (1991).

  • The regulations on forward exchange transactions were liberalized (1992–93).

  • The regulations on resident foreign exchange accounts were liberalized (1992).

  • The limit on the amount of Korean banknotes allowed to be exported was increased (1995).

  • Documentation requirements for payments and transfers abroad were simplified (1995).

  • Residents were allowed to hold foreign exchange without registering with banks (1995).

  • The prescription of currency requirements was abolished (1996).

  • Import controls were liberalized, as the number of automatically approved import items increased. Higher elastic tariffs were introduced for some of the newly liberalized import items (1985). The number of items of the elastic tariff list, including adjustment and emergency tariffs, was reduced (1984, 1985). The number of items on the import surveillance list was reduced (1987–88). Import tariff rates were reduced (1988).

  • A new Foreign Trade Act entered into effect, which, inter alia, liberalized a system of safeguards against import surcharges, by creating a special Trade Commission authorized to judge whether imports harmed domestic industries and reducing the reliance on import surveillance lists and adjustment tariffs (1987).

  • Export restrictions were eased (1984).

  • The import surveillance list, which required approval of the Korean Foreign Traders’ Association before an import license could be granted, was abolished (1989).

  • The system of emergency tariffs was abolished (1989).

  • Import tariff rates were reduced (1989–92).

  • Imports controls on 93 items, mostly agricultural products, were liberalized (1991).

  • Tariff quotas were introduced to replace import quotas in agriculture (1995). Tariff quotas also applied to crude oil.

  • A number of trade-related subsidies, for example, reserves for export losses, were abolished (1997).

Sources: Korean authorities; and IMF, Annual Report on Exchange Arrangements and Exchange Restrictions (various years).
Table 20.Individual Indicators of the Extent of Liberalization for Korea
PeriodExchange RateForeign Exchange BudgetSurrender RequirementAverage Weighted Import TariffsStandard Deviation of Import TariffsNumber of Items Covered by Nontariff Barriers1Export Taxes, Quotas, Licenses
Prior to 1961MultipleNoYes30% (1960)2Not availableNot availableYes
1961–83Unitary (since 1964)NoYes23.7% (1982)Not availableNot availableYes
1984–97UnitaryNoNo (since 1995)21.9% (1984)

18.1% (1988)

10.1% (1992)

7.9% (1996)3
6% (1992)15.2% (1984)

4.6% (1988)

2.3% (1992)

0.7% (1996)
Yes
Sources: Korean authorities; and IMF, Annual Report on Exchange Arrangements and Exchange Restrictions (various years).

1984–97

Since 1984, broad trade reform has been implemented in Korea, proceeding at a faster pace in manufacturing than in agriculture. By the end of 1991, most quantitative and licensing controls on manufactured imports were removed. Import tariff reductions were accelerated and by 1996, the unweighted average rate was less than 8 percent, and 93.4 percent of tariff rates were below 10 percent. The average tariff rate on nonagricultural imports was lowered to that of industrial trading partners. Import licensing became automatic, except for a narrow list of products with potentially adverse health or security effects. In response to bilateral trade frictions, Korea introduced an import diversification program aimed at alleviating significant bilateral trade imbalances. As a result, foreign producers gained access to service sectors, and some nontariff barriers, particularly for agricultural imports and automobiles, were removed.43 Exports were free of restrictions and were promoted through preferential credits and duty-drawback schemes.44

Exchange liberalization proceeded more rapidly than trade reform. During 1985–87, exchange restrictions on current payments and transfers were removed. In 1988, Korea formally accepted the obligations of Article VIII, Sections 2, 3, and 4 of the IMF’s Articles of Agreement. Subsequently, foreign exchange controls were eased further, notably those relating to documentation requirements, the foreign exchange position of banks, and capital controls. Exchange regulations were modified to improve the efficiency of spot and forward foreign exchange markets. Steps were taken to facilitate the settlement of external transactions by reducing documentation requirements and streamlining processing. Surrender requirements were maintained until 1995, and repatriation requirements still remained in place, as of 1997.

Mexico

After World War II, Mexico followed import substitution policies, and, as a result, its trade regime was characterized by a substantial anti-export bias.45 Import tariff rates were high, particularly on agricultural and consumer goods, and dispersed, and import licensing and quantitative restrictions were widespread. Traditionally, export restrictions were less pervasive than import ones. Export taxes, licensing, quotas, and prohibitions applied to a narrow range of items, mostly petroleum and agricultural products. In the aftermath of the balance of payments crisis of 1982, trade restrictions were tightened further, and by late 1982 import licensing requirements covered almost all imports. At the same time, the damaging consequences of extensive protection became evident as balance of payments problems mounted.

In contrast to the trade regime, Mexico’s exchange regime was relatively liberal, following the adoption of the obligations of Article VIII, Sections 2, 3, and 4 of the IMF’s Articles of Agreement in 1946. Foreign exchange accounts were permitted, and payments for invisible transactions were virtually free of restrictions. However, the foreign exchange market was segmented into controlled and free markets. Proceeds from exports of goods and services were subject to repatriation and surrender requirements. Special payments arrangements were in place, mostly with respect to other Latin American countries.

1983–85

During 1983–85, trade restrictions were selectively removed (Tables 21 and 22). The coverage of import licensing requirements was somewhat narrowed. The import permit requirement was abolished on intermediate and capital goods that were not manufactured domestically. The tariff schedule was rationalized, and, as a result, trade dispersion decreased. The coverage of official import reference prices was also narrowed. Nevertheless, these measures were limited, and trade restrictions continued to cover about three-fourths of imports and most goods that could be produced domestically.

Table 21.Phases of Exchange and Trade Reforms in Mexico, 1983–97
Main Phases of Exchange LiberalizationMain Phases of Trade Liberalization
1983-mid-1985
  • All imports subject to import duty became eligible for access to foreign exchange at the controlled market rate.

  • Foreign exchange financing of royalty payments for technology transfer was shifted from the free to the controlled market (1984).

  • Surrender requirements were eased (1984).

  • The prior import permit requirement was relaxed

  • Tariffs were raised, and the tariff structure was rationalized.

  • The coverage of official import reference prices was narrowed.

Mid-1985–91
  • Surrender requirements were eased further (1985–86, 1991) and were eliminated (1991).

  • The controlled exchange rate market was eliminated (1991).

  • Import licensing requirements were liberalized and were replaced with tariffs (1985, 1986). Temporary import licensing requirements were imposed on selected items (1990). The requirement of import permits was eased (1985).

  • A new tariff structure was introduced (1985). Import tariffs were reduced (1986, 1990) and were increased on selected items (1989).

  • Export subsidies were expanded (1985, 1991).

  • Export licensing was reduced (1990–91). Export duties were lowered (1990). Registration requirements for exporters and importers were introduced (1989).

1992–97
  • An over-the-counter market in forward and options in foreign exchange was introduced (1995).

  • Import duties were lowered (1993). Import tariffs on selected items were raised (1994–95). Import licensing requirements were liberalized (1992–93).

  • Export licensing requirements were further liberalized (1992, 1994).

  • The North American Free Trade Agreement was signed (1992) and came into force (1994).

Sources: Mexican authorities; and IMF, Annual Report on Exchange Arrangements and Exchange Restrictions (various years).
Table 22.Individual Indicators of the Extent of Liberalization for Mexico
PeriodExchange RateForeign Exchange BudgetSurrender RequirementAverage Unweighted Import TariffsStandard Deviation of Import TariffsShare of Imports Covered by Nontariff BarriersExport Taxes, Quotas, and Licensing.
PrereformDualNoYesNot availableNot availableNot availableYes
1985–91DualNoYes23.5% (1985)24.4% (1989)60% (1981)3Yes
12.5% (1990)24.5% (1991)100% (1982)3
13.1%92.2% (1985)4
(1989–91)19.9% (1990)4
18.3% (1989)
8.9% (1991)
1992–97UnitaryNoNo13.1% (1992)4.5% (1992)10.5% (1992)Yes
13.0% (1993)4.7% (1993)21.8% (1993)
12.5% (1994)6.0% (1994)10.6% (1994)
13.5% (1995)7.4% (1995)7.2% (1995)
Sources: Mexican authorities; and IMF, Annual Report on Exchange Arrangements and Exchange Restrictions (various years).

1985–91

In 1985, along with a broader growth-oriented stabilization and adjustment program, Mexico started comprehensive trade reforms. The following year it joined the General Agreement on Tariffs and Trade and signed a number of bilateral free trade agreements. Trade regimes were substantially liberalized. Quantitative import restrictions were replaced with tariffs, which were lowered subsequently. The coverage of quantitative restrictions fell from 92.2 percent of domestic production in 1985 to 19.9 percent in 1990. Imports of intermediate and capital goods became virtually free of quantitative restrictions. The average production-weighted tariff rate was reduced from 23.5 percent in 1985 to 12.5 percent in 1990; however, tariff escalation remained. Official import prices were gradually phased out during 1985–87 (previously, about one-fourth of imports was subject to official import prices). In addition to import liberalization, many export controls were removed. The coverage of production by export licenses declined from 48.9 percent in 1985 to 17.6 percent in 1991; the remaining export licensing requirements applied mostly to agricultural and agro-industrial products. Export taxes were eliminated in 1989. Trade reform was supported by the phasing out of the controlled foreign exchange market and surrender requirements. Surrender requirements were eased and then eliminated in 1991. At the same time, the controlled exchange rate market was abolished.

1992–97

During 1992–97, the exchange regime did not change significantly, while trade liberalization proceeded further, albeit at a slower pace. The average import tariff rate remained stable at about 13 percent; however, tariff dispersion increased from 4.5 percent in 1992 to about 7.4 percent in 1995. The phasing-out of import licenses continued, and the coverage of licensing requirements declined from 10.5 percent of imports in 1992 to 7.2 percent in 1995. Export licensing requirements were also liberalized. Mexico continued to participate in regional trade liberalization; notably, the North American Free Trade Agreement among Mexico, the United States, and Canada entered into force in 1994.

Russia

The Soviet economic paradigm stood on the pillars of state property, central planning, administrative regulation, and import substitution.46 Imports mainly acquired foreign technology and goods not available domestically, while exports provided foreign exchange to pay for imports. The right to engage in foreign trade and foreign exchange transactions was largely monopolized by the state. Foreign exchange was allocated administratively, while payments and transfers for international transactions were severely restricted.

1987–91

During 1987–91, trading rights were decentralized (Tables 23 and 24). In 1987, state monopoly on foreign trade was dismantled. Four years later, in 1991, producers were allowed to engage in international trade without registration. Simultaneously, the first interbank foreign exchange market, Moscow Interbank Foreign Currency Exchange (MICEX), opened in the capital. Decentralization of foreign trade paved a way for comprehensive exchange and trade liberalization, which accelerated after the breakup of the Soviet Union in December 1991.

Table 23.Phases of Exchange and Trade Reforms in Russia, 1992–97
Main Phases of Exchange LiberalizationMain Phases of Trade Liberalization
1987–91
  • The first and largest of the interbank currency exchanges, Moscow Interbank Foreign Currency Exchange (MICEX), commenced daily trading of the U.S.dollar (1991).

  • The state monopoly on foreign trade was abolished (1987).

  • Enterprises and associations were allowed to engage in foreign trade without any special registration (1991).

1992–97
  • Exchange rates were unified (July 1992).

  • The new foreign exchange law introduced current account convertibility for residents (November 1992). Current account convertibility was extended to nonresidents (1992–93).

  • Surrender requirements were eased from 100 percent to 50 percent (1992). The requirement that exporters subject to the 50 percent surrender requirement must sell 30 percent of export proceeds to the Central Bank of Russia was abolished; the entire amount of the surrendered foreign exchange should be sold to the auction exchange market through authorized banks (1993).

  • Export earnings of joint ventures were made subject to the 50 percent surrender requirement (1993).

  • The direct interbank foreign currency market developed as the largest authorized banks began to open credit lines for authorized commercial banks and to carry out regular operations to trade foreign currencies on a contractual basis (1993).

  • Authorized banks holding general licenses were permitted to import and export foreign currency banknotes, treasury notes, coins in circulation, and securities without restrictions, provided that customs regulations were observed (1993).

  • Regulations on procedures for nonresidents to open and maintain Russian ruble accounts were issued (1993).

  • A new system of controlling repatriation of export proceeds based on domiciliation in authorized Russian banks came into effect (1994).

  • The use of foreign currency banknotes in the domestic retail trade was banned (1994).

  • Article VIII was accepted (1996).

  • A relatively uniform import tariff schedule was introduced (1992). Import tariff rates were reduced for foodstuffs, medicines, and medical equipment, etc., and increased for alcohol and delicatessens (1993). Import tariff rates were increased by 5 percent on average (1994).

  • Special import tax of 3 percent was introduced (1994). A value-added tax of 20 percent and excise taxes (ranging from 10 percent to 250 percent) were introduced for most imports (1993). Import tariff rates were increased mainly on foodstuffs and agricultural products. An excise tax of 10 percent was introduced on imported foodstuffs (1995). Import subsidies were discontinued (1994). The remaining import licensing requirements were mostly abolished (1992). Import licensing requirements were introduced for ethyl alcohol and vodka (1997). Safety, quality, and certification procedures were introduced for most imports (1993).

  • Export taxes were reduced (1994–95) and abolished (1996). Uniform procedures for licensing and export quotas were introduced (1993). Export quotas and licensing were abolished (1994–95). The institution of special exporters existed (1992–95). Preshipment contract registration and mandatory certification procedures were in place (1994–96). A “passport” system of exchange registration was introduced (1994).

  • Discretionary duty exemptions were eliminated (1994); however, some exemptions remained to promote foreign investment in certain sectors (e.g., autos).

Sources: Russian authorities; and IMF, Annual Report on Exchange Arrangements and Exchange Restrictions (various years).
Table 24.Individual Indicators of the Extent of Liberalization for Russia
PeriodExchange RateForeign Exchange BudgetSurrender RequestAverage Unweighted Import TariffsStandard Deviation of Import TariffsShare of Imports Covered by Nontariff BarriersExport Taxes, Quotas, and Licensing
Prior to 1987MultipleYesYesNot availableNot availableNot availableYes
1987–91MultipleYesYesMost imports were exempt from taxes but subject to quotas and licensing.Not availableNot availableYes
1992–97UnitaryYesYes15% (1992)

14% (1994)

15% (1995)

12.7% (1995)1

13.3% (1996)1
9.6% (1995)2

9.1% (1996)2
Less than 3% (health and security reasons)Taxes: Yes (until 1996) Quotas and licensing: No (since 1994–95)
Sources: Russian authorities; and IMF, Annual Report on Exchange Arrangements and Exchange Restrictions (various years).

1992–97

As a result of the sweeping exchange reform of 1992–96, Russia moved from an administrative exchange regime closer to current account convertibility. Following the unification of exchange rates in July 1992, a new foreign exchange law was adopted in November 1992, which introduced current account convertibility for residents. By 1993, current account controls pertaining to nonresidents were substantially liberalized, and the frequency of foreign exchange auctions was increased. Some exchange restrictions remained in place, including those in the form of delays in settling outstanding net debit balances under inoperative bilateral payments agreements with Bulgaria, Egypt, and the Syrian Arab Republic under the transitional arrangements of Article XIV, Section 2. Following their elimination, in 1996, Russia formally accepted the obligations of Article VIII, Sections 2, 3, and 4 of the IMF’s Articles of Agreement.

In parallel with the liberalization of restrictions on current payments and transfers, surrender requirements were eased, and other measures to prevent capital flight were introduced. In 1992, exporters were permitted to surrender foreign exchange at market rates rather than below as previously. After 1994, the authorities monitored repatriation of foreign exchange export proceeds through a “passport” system of exchange registration. Under this system, an exporter had to present a breakdown of all financial transactions related to export to customs prior to shipment, thereby allowing ex post verification that export proceeds had been repatriated. A similar scheme existed for the prepayment of imports.

Along with the development of a more marketbased exchange system, trade liberalization proceeded gradually. During 1992–93, a key objective of trade reform was achieved, as Russia shifted to relying on world market prices in trade with other countries, including the Baltic and other countries of the former Soviet Union. As a result, implicit price subsidies to the former members of the Council for Mutual Economic Assistance and to the Baltic and other countries of the former Soviet Union were eliminated. Prices of export goods, mainly energy and raw materials, started to rise gradually to the world market levels. Furthermore, Russia dismantled most bilateral payment arrangements with countries other than those of the former Soviet Union. Settlement began to take place in convertible currencies for most transactions, except barter and countertrade.

Trade reform resulted in a relatively liberal import regime by 1997. In 1992, a relatively uniform import tariff schedule was introduced for fiscal reasons with an average rate of about 15 percent. Despite repeated revisions, the average trade-weighted duty (excluding specific duties on alcohol) remained stable at around 13 percent, while the dispersion declined since mid1995. Tariff rates above 30 percent were lowered to at least 30 percent, except tariffs on alcoholic beverages. The import regime was almost free of quantitative and licensing restrictions, and only a few items remained subject to licensing controls, mostly for health and security reasons. Although the practice of discretionary duty exemptions was discontinued in 1995, some legal exemptions were preserved, albeit at a smaller scale since 1996 (for instance, humanitarian aid and contributions to the charter capital of joint ventures). Persisting protectionist pressures resulted in the introduction of an import licensing requirement for ethyl alcohol and vodka in 1997. Under the requirement, the prepayment of all customs duties was needed for an import license request to be satisfied.

In contrast to import liberalization, the removal of export controls, such as taxes, quotas, licensing, and other nontariff barriers, proceeded slowly and intermittently. Export restrictions centered on strategic commodities (including raw materials, energy, and precious metals) and were aimed mainly at halting domestic inflation, preventing illegal exports and capital outflows, and improving tax collection. During 1994–95, export taxes were gradually reduced, and, in 1996, the remaining export duties on strategic commodities were abolished. The fiscal impact of tariff reform in Russia could be illustrated briefly as follows. In 1993, trade taxes represented the third largest source of revenue for the federal government, accounting for about 23.0 percent of federal government total revenue. In 1996, trade taxes became the fifth largest source of revenue and covered about 10.3 percent of total revenue. Export licensing and quantitative restrictions were harmonized in 1993 and abolished during 1994–95. Nonetheless, other nontariff barriers remained in place. For example, during 1994–96, exports of strategic commodities were subject to the mandatory registration of preshipment contracts and the certification of quality, quantity, and price. Additionally, in 1993, about one-fourth of exports was recentralized to provide the government with access to foreign exchange to pay for centralized imports. Other centralized exports continued to include arms and defense-related equipment. In 1992, rights to export strategic commodities were given to approved intermediaries, also known as special exporters; following the abolition of this system in 1995, all enterprises became eligible to export. However, access to oil pipelines remained subject to government regulation.

Summary of Country Experiences and Conclusions on Phasing Exchange and Trade Liberalization

The review of countries’ experiences suggests that while there is no universal approach to phasing external liberalization, exchange system liberalization has often been a critical early element of such liberalization.

Summary of Country Experiences

The study examined the experience of five countries—China, India, Korea, Mexico, and Russia—in phasing exchange and trade liberalization. For each country, the relative timing of exchange and trade liberalization can be summarized in a reform sequence matrix. The matrix focuses on certain benchmarks or milestones in the reform process. For exchange liberalization, these benchmarks include the unification of exchange rates, the elimination of foreign exchange budgets, the abolition of surrender requirements, and the acceptance of obligations of Article VIII, Sections 2, 3, and 4 of the IMF’s Articles of Agreement. For trade liberalization, the focus is on the abolition of import quotas and licensing, the reduction of import tariffs to the 10 percent level of the average unweighted import tariff rate, and the joining of the WTO. Each element of the matrix represents the number of years by which the exchange liberalization benchmark in the respective row preceded the trade liberalization benchmark in the respective column. A positive number in the matrix means that the exchange liberalization measure was completed earlier than the respective trade liberalization measure. A negative number means that the exchange liberalization measure occurred after the trade liberalization measure. Zero indicates that the respective exchange and trade measures were implemented in the same year. The entry in the matrix is indeterminate if neither the exchange measure nor the respective trade measure have been liberalized yet. For instance, in China, abolishing import quotas and licensing was still ongoing, as of 1997, although it started in 1993. The earliest, in principle, when import quotas and licensing could be abolished was 1998. Hence, the unification of exchange rates, which occurred in 1994, would precede the abolition of import quotas and licensing by at least four years.

In China, exchange reform tended to lead and was completed earlier than trade liberalization (see Table 25). The transition to a market-based exchange system began with the introduction of exchange retention quotas and arrangements for their trading, which eventually developed into a nascent foreign exchange market. By the mid-1990s, exchange rates had been unified and the remaining restrictions on payments and transfers for current international transactions had been eliminated. Although trade reform accelerated in the late 1990s, many tasks remain: inter alia, lowering import tariffs and nontariff barriers, and expanding the rights to trade. Trade reform is proceeding gradually, instigated partly in the process of China’s accession to the WTO.

Table 25.Reform Sequence Matrix for China
Phases of LiberalizationAbolition of Import

Quotas and Licensing

(since 1993)
Reduction of

Import Tariffs

(since 1992)
Joining the World

Trade Organization

(no)
Unification of exchange rates (1994)At least +4At least +4At least +4
Elimination of foreign exchange budgets (1994)At least +4At least +4At least +4
Abolition of surrender requirements (no, as of 1997)
Acceptance of Article VIII (1996)At least +2At least +2At least +2
Sources: Chinese authorities; and IMF, Annual Report on Exchange Arrangements and Exchange Restrictions (various years).

India implemented exchange and trade reforms as part of broader efforts aimed at liberalizing the restrictive economic regime. During 1991–94, substantial trade reforms took place (especially when evaluated from the starting point of the regime). After 1994, trade reforms continued, albeit at a slower pace. Exchange liberalization proceeded concurrently, starting in 1991 with the devaluation of the exchange rate and a subsequent introduction of a free market exchange rate for many permitted transactions (see Table 26). Exchange rates were unified in 1993, and the obligations of Articles VIII, Sections 2, 3, and 4 of the IMF’s Articles of Agreement were accepted in 1994. Notwithstanding notable achievements, trade liberalization remained only partial.

Table 26.Reform Sequence Matrix for India
Phases of LiberalizationAbolition of Import

Quotas and Licensing

(since 1991)
Reduction of

Import Tariffs

(since 1980s)
Joining the World

Trade Organization

(1994)
Unification of exchange rates (1993)At least +5At least +5+1
Elimination of foreign exchange budgets (did not exist in 1990)Not applicableNot applicableNot applicable
Abolition of surrender requirements (no, as of 1997)At least -4
Acceptance of Article VIII (1994)At least +4At least +40
Sources: Indian authorities; and IMF, Annual Report on Exchange Arrangements and Exchange Restrictions (various years).

In Korea, exchange liberalization was a pivotal factor in the transition from import substitution to an export-oriented industrialization policy and in stimulating export growth. Exchange reform started in the early 1960s with the abolition of foreign exchange taxes and the unification of the exchange rates. Though some nontariff barriers were lowered during the 1960–70s, concerted trade reforms began only in 1984. Controls on current payments and transfers, including prescription of currencies, import and export payments, and payments for and proceeds from invisible trade, were liberalized gradually and tended to lead the liberalization of the trade system (Table 27).

Table 27.Reform Sequence Matrix for Korea
Phases of LiberalizationAbolition of Import

Quotas and Licensing

(since 1964)
Reduction of

Import Tariffs

(1973–92)
Joining the World

Trade Organization

(1994)
Unification of exchange rates (1964)At least +34+28+30
Elimination of foreign exchange budgets (1988)At least +10+4+6
Abolition of surrender requirements (1995)At least +3-3-1
Acceptance of Article VIII (1988)At least+ 10+4+6
Sources: Korean authorities; and IMF, Annual Report on Exchange Arrangements and Exchange Restrictions (various years).

Since the end of World War II, Mexico had a relatively liberal exchange regime (Table 28). Trade liberalization began in the early 1980s within a broader context of macroeconomic stabilization. In concert with comprehensive trade reforms, Mexico unified exchange rates by eliminating the controlled foreign exchange market. Surrender requirements were gradually eased and eventually abolished. As a result of reforms, Mexico’s exchange and trade regimes became virtually free of restrictions.

Table 28.Reform Sequence Matrix for Mexico
Phases of LiberalizationAbolition of Import

Quotas and Licensing

(since 1985)
Reduction of

Import Tariffs

(1985–91)
Joining the World

Trade Organization

(1994)
Unification of the exchange rate (1991)At least +7-1+3
Elimination of foreign exchange budgets (did not exist in 1946)Not applicableNot applicableNot applicable
Abolition of surrender requirements (1991)At least +7-1+3
Acceptance of Article VIII (1946)At least +52+44+48
Sources: Mexican authorities; and IMF, Annual Report on Exchange Arrangements and Exchange Restrictions (various years).

Russia, in contrast to the other countries surveyed, implemented a “big bang” rather than a gradualist approach to external liberalization. Exchange liberalization followed the abolition of the state monopoly on foreign trade and proceeded in tandem with trade reform (Table 29). After the interbank foreign exchange market was established, most restrictions on payments and transfers related to current account transactions were removed. Transition from an administrative exchange system to current account convertibility was largely completed during 1992–96. Likewise, Russia has made considerable progress in trade liberalization: tariff rates remained relatively low and uniform, most quantitative and licensing restrictions were eliminated, and export taxes were lowered. A number of trade-related barriers, however, remained in place, and discussions on Russia’s accession to the World Trade Organization currently focus on market access issues, protection of intellectual property rights, government procurement, preferential trade, and investment measures.

Table 29.Reform Sequence Matrix for Russia
Phases of LiberalizationAbolition of Import

Quotas and Licensing

(1992)
Reduction of

Import Tariffs

(1992)
Joining the World

Trade Organization

(no, as of 1997)
Unification of exchange rates (1992)00At least +6
Elimination of foreign exchange budgets (1992)00At least +6
Abolition of surrender requirements (no, as of 1997)1At least -6At least -6
Acceptance of Article VIII (1996)-44At least +2
Sources: Russian authorities; and IMF, Annual Report on Exchange Arrangements and Exchange Restrictions (various years).

Conclusions on the Phasing of Exchange and Trade Liberalization

There is no universal approach to the phasing of exchange and trade reforms, and the evolution of the national regulatory regime largely depends on country specific macroeconomic and institutional conditions. Nonetheless, the analysis of experience in the five countries suggests some general principles concerning initial conditions, phasing, speed, and outcome of exchange and trade liberalization.

Exchange liberalization generally started prior to or concurrently with trade reform and proceeded in tandem with it with the objective of fostering trade and economic growth by eliminating restrictive trade barriers, and controls on current payments and transfers. Most binding exchange controls tended to be abolished early in the reform process, while trade liberalization and institution-building measures were often implemented more gradually. Surrender and repatriation requirements were abolished at the later stages of reforms as part of a more gradual liberalization of the capital account. (See Section VI for a discussion of the sequencing of capital account liberalization.)

In Korea, the multiple currency practice and foreign exchange taxes were eliminated at the beginning of the reforms, and other controls on current payments and transfers were liberalized later. Gradual trade liberalization began after the first major exchange reform and continued after the introduction of current account convertibility. In India, the exchange rate devaluation and the dual exchange rate system were used as transitional steps in a successful movement to a unified exchange rate system and current account convertibility. In parallel, trade regime was liberalized step-by-step, with major trade reforms implemented at the outset. In Mexico, the main distortion in the exchange system was eliminated with the unification of exchange rates at the beginning of exchange and trade reforms. Current account convertibility was achieved prior to the successful completion of trade reform.

The phasing of exchange liberalization depended on the extent of initial government intervention. Transition economies faced a daunting challenge of transforming a command economic system into a market-based one, and therefore, their exchange liberalization was coordinated with the decentralization of trade and the creation of basic market institutions. In Russia, exchange reform followed the elimination of the state monopoly on foreign trade. The first step in exchange liberalization was the establishment of the interbank foreign exchange market, followed by the removal of the remaining restrictions on current payments and transfers for residents and then nonresidents. In parallel, quantitative and licensing restrictions on imports were converted into a relatively uniform tariff structure, quantitative and licensing restrictions on exports were abolished, and export taxes were reduced. In China, early establishment of the exchange retention quota system paved a way for the development of a rudimentary foreign exchange market and was followed by the unification of exchange rates, integration of foreign exchange markets, and elimination of the remaining restrictions on current payments and transfers. In parallel, the decentralization of trade and scaling back of mandatory planning proceeded gradually. Notwithstanding the significant progress in trade liberalization, the lowering of import tariffs and nontariff barriers and the expansion of trading rights remain on the reform agenda.

Exchange liberalization tended to proceed at a faster speed and to be completed earlier than trade reform. Trade liberalization often took longer to implement because it had to be closely coordinated with industrial and fiscal policies. In particular, the speed of tariff reductions sometimes reflected the availability of alternative sources of tax revenues for achieving fiscal objectives. Furthermore, most trade measures were specific to individual industries and even firms, and, as a result, political economy factors influenced the speed and extent of trade reform. Trade reform was often implemented gradually to give domestic industries time to adjust to more competitive economic conditions.

The duration of reforms varied across countries, reflecting, inter alia, the overall strategy of economic reform. China, for example, pursued a gradual approach to economic liberalization, including external sector reform. Current account convertibility was achieved after about 17 years of continual institutional transformation. In contrast, exchange and trade reforms in Russia proceeded at a much faster pace, partially because Russia followed the “big bang” approach to liberalization. The main steps of exchange liberalization were largely completed within two years.

The outcome of exchange liberalization was more similar across the countries than that of trade liberalization. As a result of exchange liberalization, all countries have achieved a high degree of current account convertibility and adopted the obligations of Article VIII, Sections 2, 3, and 4 of the IMF’s Articles of Agreement. India continued to maintain some exchange restrictions after adopting the obligations of Article VIII, Sections 2, 3, and 4. In contrast to exchange liberalization, outcomes of trade reform varied dramatically across countries. As of 1997, trade liberalization remained incomplete in China and India, which maintained relatively high and dispersed import tariffs and numerous nontariff barriers. Korea, Mexico, and Russia had largely completed major tasks in trade reforms and established relatively liberal trade regimes.

The foregoing analysis suggests that exchange liberalization can be an important catalyst and complement to trade liberalization. Exchange liberalization preceding or accompanying trade liberalization can contribute to the success of trade liberalization. The elimination of binding exchange controls and the development of a market-based exchange system tends to reinforce efficiency gains from, and the sustainability of, trade reform. Thus, exchange and trade reforms need to be coordinated to create a policy framework for an orderly development of an open, neutral, and transparent external sector regime.

As a final point, the empirical analysis discussed in the appendix to this section finds that in view of the extent to which exchange systems have been liberalized for payments and transfers for current international transactions, controls on capital movements are now the more significant nontariff barrier to trade, and that capital account liberalization could support trade liberalization. As discussed elsewhere in the volume, capital account liberalization should also be coordinated with financial sector reforms in view of the critical importance of using and allocating efficiently international financial resources.

Appendix. Exchange and Capital Controls as a Trade Barrier

This appendix briefly describes the methodology, data, and results of an empirical study that examined how important exchange and capital controls are as a barrier to international trade.47 The analysis is based on the gravity-equation framework, in which bilateral exports depend on the distance between countries, the countries’ size and wealth, tariff barriers, and exchange and capital controls. The extent of exchange and capital controls is measured by unique indices.48 Overall, exchange and capital controls are found to represent a noticeable barrier to trade. The specific impact of exchange and capital controls on trade, however, varies depending on the level of development of a country and the type of control. In view of the degree to which countries have liberalized their exchange systems, controls on current payments and transfers are found to be a minor impediment to trade. Capital controls are also found to be a minor impediment to trade for the industrial countries, while they significantly reduce exports into developing and transition economies. An implication of this study is that further liberalization of exchange and capital controls could discernibly foster trade for the developing and transition economies.

An Empirical Model of Trade with Exchange and Capital Controls

According to the gravity model, bilateral trade is determined by the wealth and size of countries, the distance between them, and other factors distorting trade. This parsimonious and flexible general equilibrium framework has been successfully and extensively used in empirical studies of international economics since the 1960s. Recently, the theoretical foundations of the model have been based on the theory of trade under imperfect competition and have been integrated recently with the factor-proportions and demand-based theories of international trade.49 The basic gravity equation is given by

where Xij are exports from country i to country j; (Qi/Ni) and (Qj/Nj) are per capita incomes of countries i and j; N; and Nj are populations of countries i and j; Dij is the geographical distance between countries i and j, which represents a proxy for transportation and other transaction costs; Aij denotes factors distorting/augmenting trade, and eij is a log normally distributed error term.

For the empirical analysis, the above equation is modified by taking natural logs and defining tariffs, and exchange and capital controls as trade distortions, that is,

where Tij is the import duty imposed by country j on imports from country i, and Ej denotes an aggregate measure of exchange and capital controls in country j. Given the computational difficulty of obtaining the data on bilateral import duties, an average measure of import duties in country j, Tj, is typically used as an approximation of Tji,; thus, for estimation purposes, Tji = Tj. The intercept accounts for the effect of unmeasured trade distortions on bilateral exports.

Data

The model is estimated using the ordinary-least-squares method for a sample of 40 industrial, developing, and transition economies for 1996. The sample includes 15 industrial countries (Australia, Canada, Denmark, France, Germany, Greece, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Spain, United Kingdom, and the United States), 19 developing countries (Argentina, Brazil, Chile, China, Egypt, India, Indonesia, Kenya, Republic of Korea, Mexico, Morocco, Pakistan, the Philippines, Saudi Arabia, South Africa, Thailand, Tunisia, Turkey, and Uruguay), and 6 transition economies (Czech Republic, Hungary, Kazakhstan, Latvia, Poland, and Russia). Thirty-eight of the 40 countries in the sample have accepted the obligations of Article VIII, Sections 2, 3, and 4 of the IMF’s Articles of Agreement. Brazil and Egypt maintained exchange restrictions under Article XIV. For comparison, as of the end of 1996, 138 out of 181 members have accepted obligations of Article VIII, Sections 2, 3, and 4 of the IMF’s Articles of Agreement. Summary statistics and correlations are presented in Tables 30 and 31, respectively. The extent of national exchange and capital controls is captured in three aggregate measures: the indices of controls on current payments and transfers (denoted by CCI), capital controls (KCI), and exchange and capital controls in their entirety (ECI). The indices summarize information on 142 individual types of national exchange and capital control from the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER) and primarily reflect the de jure incidence of controls (see Section III).

Table 30.Summary Statistics
EXDISTPOPEXPOPIMGDPEXGDPIM1+TARCCIKCIECI
All countries
Mean1,897.734,88010710710,67410,7301,14.00.130.380.25
Standard deviation8,268.543,8732352357,4857,49113.50.100.300.19
Minimum0.01137221,3801,380100.00.010.010.03
Maximum16,4761.4079,6351,2221,22226,98026,980156.30.330.950.62
Count151915191,5191,5191,5191,5191,5191,5191,5191,519
Industrial countries
Mean3,806.804,795.851075310,41619,467105.30.050.120.09
Standard deviation12,689.604,478.18236677,41434913.50.040.120.07
Minimum0.01187241,38011,7101000.010.010.03
Maximum16,4761.4079,6351,22226726,98026,980110.50.160.540.35
Count580580580580580580580580580580
Developing and transition countries
Mean718.544,931.5810714110,8345,334119.30.170.540.35
Standard deviation2,757.083,448.212352907,5282,63514.60.100.260.17
Minimum0.011372213801,380100.00.030.100.10
Maximum56,760.8062,3331,2221,22226,98018,940156.30.330.950.62
Count939939939939939939939939939939
Table 31.Correlations
EXDISTPOPEXPOPIMGDPEXGDPIM1+TARCCIKCIECI
EX1.000
DIST-0.1131.000
POPEX0.0360.0091.000
POPIM0.0370.014-0.0281.000
GDPEX0.231-0.002-0.2380.0011.000
GDPIM0.2300.0090.001-0.239-0.0321.000
1+TAR-0.1360.0970.0280.554-0.057-0.6081.000
CCI-0.103-0.009-0.0060.4280.021-0.6310.6151.000
KCI-0.125-0.006-0.0050.3400.022-0.6610.5830.8291.000
ECI-0.124-0.007-0.0050.3740.023-0.6750.6110.9010.9901.000

Data on exports of goods and services (denoted by “EX”) are from the IMF’s Direction of Trade Statistics Yearbook. GDP per capita (“GDPIM” and “GDPEX” for importing and exporting countries, respectively) are adjusted according to the purchasing power parity and come from the World Bank’s World Debt Tables. Population data (“POPIM” and “POPEX” for importing and exporting countries, respectively) are for 1996 or the latest available year, as published in the IMF’s International Financial Statistics. The geographic distance (“DIST”) is measured as the direct-line distance between the capital cities of countries.50 Trade restrictions are represented by mean tariff rates (“TAR”) by country. The tariff data for 1995 or the latest available year come from the World Bank’s World Development Indicators Database and are adjusted to take into account free trade agreements, as reported in the Annual Report of the World Trade Organization.

Estimation Results

Equation (2) is estimated with three alternative measures of exchange and capital controls, CCI, KCI, and ECI, and the respective equations are denoted as 2a, 2b, and 2c in Table 32.51 Estimation results are summarized in the table. The estimated intercept is negative, implying that unmeasured trade distortions tend to reduce bilateral exports. Distance has a significant negative effect on bilateral exports, in part because trade costs (e.g., transportation and communication) tend to increase with distance. Tariff barriers in the importing countries have a negative, albeit insignificant, effect on exports into these countries. GDP per capita and population, on the other hand, have significant positive effects on bilateral exports. The insignificance of the coefficient on tariff barriers, although not uncommon in studies based on an aggregate gravity model, could be explained as follows. First, the measure of tariff barriers—the mean tariff rate adjusted for the free trade agreements—does not capture the full variation in tariff barriers across trading partners. Second, in developing countries, nontariff barriers are often more important than tariff barriers. The effect of nontariff barriers (other than exchange and capital controls) is reflected in the intercept, which is significant.

Table 32.Estimation Results
All CountriesIndustrial CountriesDeveloping and Transition Countries
Eq. (2a)Eq. (2b)Eq. (2c)Eq. (2a)Eq. (2b)Eq. (2c)Eq. (2a)Eq. (2b)Eq. (2c)
C-37.13*-37.34*-37.11*-33.56*-33.27*-33.73*-38.69*-38.03*-38.91*
In DIST-0.91*-0.91*-0.91*-0.59*-0.60*-0.58*-1.06*-1.04*-1.07*
In POPIM0.94*0.94*0.94*0.94*0.95*0.93*0.96*0.95*0.96*
In POPEX1.03*1.03*1.03*0.99*0.99*0.99*1.06*1.06*1.06*
In GDPIM1.37*1.39*1.37*0.97*0.93*0.99*1.48*1.40*1.51*
In GDPEX1.90*1.90*1.90*1.77*1.77*1.77*1.99*1.98*1.99*
ln (1+TAR)-0.73-0.83-0.73-7.14-6.69-7.30-0.21-0.64-0.10
ECI-0.66**-1.20-0.75**
CCI-0.89-2.21-0.65
KCI-0.42**-0.71-0.53**
Number of observations151915191519580580580939939939
R-squared0.760.760.760.800.800.800.720.720.72
F-statistic697.05*694.76*697.26*318.81*318.52*318.59*334.31*332.47*334.82*
Notes:

Exchange and capital controls are a barrier to exports to developing and transition economies but not to industrial countries. This finding can be attributed to capital controls, which noticeably reduce bilateral exports to developing and transition economies and have only a minor negative impact on bilateral exports to industrial countries. The reason is that industrial economies have relatively liberal regimes for international capital movements, while many developing and transition economies continue to maintain various capital controls. Controls on current payments and transfers represent only a minor barrier to bilateral exports to all countries, since these controls have been substantially liberalized worldwide.

Note: This section was prepared mainly by Natalia Tamirisa, an Economist in the IMF’s Policy Development and Review Department.

For the analysis of trade liberalization in the context of IMF programs, see IMF (1998).

The IMF’s jurisdiction under the Articles of Agreement extends to exchange control measures that restrict the making of payments and transfers for current international transactions or that give rise to discriminatory currency arrangements or multiple currency practices. To analyze the phasing of exchange and trade liberalization, this section focuses on exchange controls in general rather than exchange restrictions subject to IMF jurisdiction.

For more details on various types of exchange control, see IMF (1997a).

In a recent study, Sachs and Warner (1995) found that openness and economic growth are positively related in developing countries.

Greenwood and Kimbrough (1987) showed that the economic effects of exchange controls are similar to those of an import quota, and multiple exchange rates for imports and exports are equivalent to exchange controls. For an analysis of exchange controls in the presence of sophisticated financial markets, see Stockman and Hernandez (1988).

Trade restrictions are rarely an appropriate response to balance of payments difficulties, even in the short term.

On a related topic, see the comparative analysis of the political economy of capital account and trade liberalization in Helleiner (1994).

Although fiscal considerations are often cited as impediments to more rapid trade reform, a recent IMF study did not find a correlation between indicators of fiscal difficulty and citation of fiscal constraints on trade reform (see IMF (1998) for more details). To mitigate the fiscal impact of trade reform, revenue-enhancing or neutral elements of trade reform may be implemented first (such as issuing tariffs of quantitative trade restrictions or elimination of customs duty exemptions). It might also be possible to develop alternative tax instruments that do not distort international trade.

See the appendix to this section for more details on the empirical study and Section VII for the description of the indices of exchange and capital controls.

The liberalization of controls on current international payments and transfers opens more opportunities for the circumvention of capital controls and thus makes it harder to control the capital account. Thus, following exchange liberalization, monetary and fiscal discipline became particularly crucial for achieving balance of payments objectives.

The rules for participation in CFETS varied for domestic and foreign entities. Domestic enterprises only had access to the bank retail market, which was subject to different settlement arrangements than the wholesale market, while FFEs could trade directly, through their banks, in the wholesale market.

See Thomas, Nash, and associates (1991); Dean, Desai, and Riedel (1995) for a general discussion on India’s regime.

Previously, the exchange rate was set on the basis of a basket of exchange rates of India’s major trading partners.

See Thomas, Nash, and associates (1991); Dean, Desai, and Riedel (1995); and Kim (1994) for a general discussion of Korea’s regime.

Ibid.

Adjustment tariffs and special safeguard duties were levied on a small number of commodities (about 1 percent of total imports) and were within the bindings of the World Trade Organization (WTO). Korea’s developing country status under the WTO allows it 10 years to fulfill the WTO commitments.

In response to the currency and financial crisis of late 1997, the Korean authorities expressed their intention to implement additional trade liberalization measures, including, inter alia, the reform of trade-related subsidies, import licensing, and import diversification program. A detailed consideration of these recent developments lies beyond the scope of this study.

For a more detailed discussion of the empirical model, data, and estimation results, see Tamirisa (1998).

See Section VI for more details on the indices of exchange and capital controls.

For more details on the gravity model see Anderson (1979); Bergstrand, (1985), (1989), and (1990); and Helpman and Krugman (1985).

The adjusted R-squares are above 0.70, and F-statistics are significant at the 99 percent level. Since heteroskedasticity may be a problem owing to differences in country size, standard errors and covariances are calculated on the basis of the White heteroskedasticity-consistent matrix.

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