I The Salient Features of the Present Situation

Naheed Kirmani, Shailendra Anjaria, and Arne Petersen
Published Date:
July 1985
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Continued Drift Poses Threat

The continued drift toward protectionism poses a threat to the balanced expansion of world trade in the medium term and to the prospects for suśtaining economic recovery. In the past several years, most industrial countries have become more protectionist than before, despite the continued tariff cuts of the Tokyo Round and limited instances of liberalization of nontariff barriers. Trade restrictions or trade-distorting measures were intensified or imposed not only in the traditionally protected sectors, such as steel, textiles and clothing, and agriculture, but were also extended to new sectors, such as automobiles and electronics. A notable exception is Japan, which in recent years has undertaken a series of important liberalization measures; exporters, however, have continued to express concern with the openness of the Japanese market.

Consumption in product groups subject to nontariff restrictions in 1983 accounted for some 30 percent of total consumption of manufactures in the major countries of the Organization for Economic Cooperation and Development (OECD), compared with 20 percent in 1980.1 A recent study2 estimated the share of imports restricted by nontariff measures in total imports of manufactures in 1980 at 6, 11, and 7 percent, respectively, for the United States, the European Community, and Japan; restrictions introduced during 1981–83, in terms of 1980 dollar values of imports, were 6½ percent and 4 percent, respectively, for the United States and the European Community. Many of the new restrictions applied to Japan and some of the major developing country exporters of manufactures. The OECD estimated that 15 percent of the combined exports of manufactures of five Asian exporters to the OECD countries were subject to trade restrictions in 1980; this proportion rose to 30 percent in 1983.3 Trade in temperate and competing zone agricultural products (accounting for almost one half of world agricultural trade) largely took place under restrictive and protectionist trade policies.

International trade flows are particularly responsive to cyclical factors. In addition, trade expansion induced by an open trading system feeds back on the growth of output. Although it is difficult to establish clearly the relative influence of cyclical factors and the stance of trade policies on the growth of international trade, it is evident that the recent economic recovery has had a strong positive effect on world trade expansion. According to General Agreement on Tariffs and Trade (GATT) statistics, growth in world trade averaged 8½ percent annually in 1963–73; the growth of world output averaged 6 percent. In 1973–83, world trade grew by 3 percent annually, and output by 2 percent. In contrast, the rise in world trade in 1984 (9 percent) outstripped the expansion of output (5 percent). Expecting a slowdown in economic growth rates in industrial countries, Fund staff projections indicate that the growth of world trade may decelerate to 5½ percent in 1985. Economic growth in industrial countries until 1990 is expected to remain well below the averages reached in the late 1960s and the early 1970s. While the strength of demand, rather than the stance of trade policy, has been the dominant influence, there is little doubt that the effects of protection on efficient resource allocation have implications for the pace and pattern of world growth of output and trade. These effects may well become more pronounced in a context of modest medium-term growth prospects.

Another aspect of the relationship between trade and growth at present is the unevenness of the economic recovery concentrated in North America. Reflecting strong demand and an appreciating dollar, U.S. imports (in terms of value) grew by 26 percent in 1984, with all country groups showing significant increases. In particular, U.S. imports from Japan and the group of major exporters of manufactures grew very rapidly—by 39 and 36 percent, respectively. Major exporters of manufactures, led by Brazil, Korea, and Singapore, expanded their market share from 10.4 percent to 11.2 percent of U.S. imports. Contrary to earlier expectations, however, the strong recovery in the United States was not accompanied by reduced protectionist pressures, either in the United States itself or to any notable degree among its trading partners, whose exports increased sharply as a result of the upsurge in U.S. import demand. Indeed, the persistence of high unemployment in many industrial countries made it more difficult to resist protectionist pressures and weakened the impulse for trade liberalization, especially in employment-sensitive sectors.

These developments are cause for continuing concern, particularly because the rise in protection is concentrated in sectors where comparative advantage is shifting and has taken the form of quantitative restrictions, which directly limit trade expansion on the basis of comparative cost. By impairing the functioning of the international price mechanism, the rise in protection creates uncertainties among investors, particularly with regard to expansion of export capacities. In a dynamic context, the longer-term adverse effects of protectionism on investment, efficiency, and growth are thus likely to be more severe than the immediate effects on exports of certain countries or groups of countries. The growth of public subsidies to enterprises in industrial countries has also continued and is of concern, both because of the need to redress fiscal imbalances and because of the trade distortions that subsidies create.

Recourse to Bilateral, Sector-Specific Trade Measures

Of particular concern about the drift toward protectionism is the frequent recourse to bilateral, sector-specific trade measures that harm the multilateral trading system based on the GATT and are counter to the principle of comparative advantage, which forms the basis for efficient trade expansion. As documented in Part Two of this paper, the vast majority of measures applied in response to difficulties in specific sectors have a strong bilateral element designed to restrict import competition from countries with a comparative cost advantage. Restraints, administrative guidance, and floor price systems apply to 40 percent of Japan’s exports to the United States and the Community and to about 20 percent of its total exports. The Multifiber Arrangement (MFA), which derogates from GATT principles by authorizing discriminatory restrictions, has been made progressively more restrictive against developing country exporters, particularly the largest suppliers. Notwithstanding the developing countries’ increased share in world exports of textiles and clothing in the aggregate, the existence of the MFA has prevented them from exploiting totally their comparative advantage potential. For example, the OECD estimated the compression of imports of textiles and clothing from non-OECD sources in 1982 and 1983 at 10 percent in volume terms.4

As the more advanced developing countries acquire the skills and investments to diversify exports toward more sophisticated manufactured products, restrictions against them tend to multiply. These not only impede the export prospects of the developing countries directly affected, but also slow specialization and diversification, thus severely affecting the “smaller” developing country exporters. Bilateral, sector-specific restrictions impede competition, not only between producers in industrial countries and lower-cost suppliers in developing countries, but also among the developing countries themselves. Investment opportunities may not be fully exploited in developing countries lacking assured access to markets abroad for future expansion of exports.

Virtually all major industrial countries protect their domestic agricultural sectors to a considerable extent. Recent experience in the agricultural sector illustrates that it may not be possible to contain the effects of bilateral measures to the intended countries. Agricultural trade frictions have revolved around the operation of the Community’s Common Agricultural Policy (CAP) and have been aggravated by subsidized sales under U.S. “blended” credit arrangements, which are partly designed to maintain the traditional U.S. market share for the products concerned vis-à-vis the Community. Although such competition for sales in third markets may have been designed to encourage reform of the Common Agricultural Policy, it has also, inevitably, put pressures on other efficient producers to match the more beneficial credit terms.

Reasons for Protectionist Drift

An underlying reason for the continued drift toward protectionism is a lack of full appreciation of the costs of protection and the economic arguments for liberal trade. But the reasons given for the failure to reverse the drift toward protectionism vary. They include exchange rate relationships; trade or current account deficits; “unfair” foreign trade practices; weak economic recovery; structural rigidities; high rates of unemployment; the perception that departures from liberal trade policies have been insignificant; developing countries’ need for infant industry protection; the need for protection in “new” industries such as high technology; and the special characteristics of a sector such as agriculture. These arguments explain some of the factors underlying the strength of protectionist pressures but do not take account of the costs of protection, particularly where measures are not “temporary,” as originally intended. In the final analysis, insufficient political will to resist protectionist and bilateral measures is the major explanation for the continued resort to protection.

It is generally acknowledged that concentrated producer interests are able to lobby more strongly for protection than are the interests of comparatively less organized consumers and taxpayers who are more diffuse and spread throughout the economy. But it is technically and politically feasible to give greater weight to interests of consumers and trading partners, as was illustrated by the recent U.S. decision to reject import relief for copper producers—even though the proposed restrictions would have been consistent with domestic and international norms. For a better and more consistent balance between national producer and consumer interests to be effective, governments could make concerted efforts to publicize the costs of protection and to take them into account more systematically in trade policy making. For example, a recent study5 calculated the average subsidy paid by the consumer for each job protected in the United States as a result of tariff and nontariff restrictions applied on television receivers, footwear, and steel in the 1970s. It concluded that the annual cost of protection, in terms of the subsidy from the consumer, reached almost six times the cost of compensation per job in the television industry, more than nine times in foot-wear, and four and a half times in steel.

Need for Open Trade and Payments System

The smooth functioning of the international adjustment process requires an open trade and payments system. Trade protectionism distorts the exchange rate and hinders smooth balance of payments adjustment, whereas restrictive exchange systems impede the balanced expansion of world trade and the achievement of sustained economic growth. Although this shared complementarity of the monetary and trade systems has been recognized by the Fund and the GATT, large movements in exchange rates have, in recent years, given rise to concerns among some policymakers about the feasibility of maintaining liberal trading conditions. By creating greater market uncertainty, exchange rate volatility may give rise to protectionist pressures. However, a recent Fund staff study, while acknowledging the difficulties of assessing the impact of exchange rate volatility on world trade, found no statistically significant link to support the hypothesis that greater volatility since the early 1970s had impeded world trade.6

Across-the-board protectionist measures have been avoided in the industrial countries because it is widely acknowledged that trade restrictions and protectionism are inappropriate responses to exchange rate developments. In specific sectors, however, protectionist pressures have sometimes proved difficult to resist. Sectors where nontariff measures have been introduced are often structurally weak and probably would have pressed for protection even in the absence of exchange rate movements. Protectionist pressures have intensified considerably in the United States—which has experienced a sharp appreciation of the U.S. dollar against other major currencies and substantial trade deficits in the past two years. With a worldwide surplus capacity in several sectors, the fast U.S. recovery encouraged the sharp rise in U.S. imports, and protectionist pressures were felt most severely in traditional sectors where structural adjustment was weak or insufficient.

Exchange rate movements reflect financial flows as well as trade flows, and the importance of exchange rates that correspond to underlying economic fundamentals is unquestioned. Monetary and fiscal policies that influence savings and investment, in particular real interest rates, are important determinants of current account balances. Even though exchange rate movements can improve or undermine industrial competitiveness, the appropriateness of given exchange rate relationships cannot be assessed solely with reference to the size of trade imbalances. Exchange rate developments may explain some of the pressures for protection but they cannot justify either generalized or sectoral protection.

The Obstacle of Bilateral Protectionism

Bilateral protectionism is a serious obstacle to meaningful trade liberalization, because it lacks transparency and creates vested interests among exporters and importers for the preservation of the status quo. Many of the current trade restrictions are applied in the form of voluntary export restraints or informal understandings reached through bilateral bargaining between the importing and the exporting country by the governments or industries concerned. Such measures also create incentives for new bilateral measures to proliferate as producers in other sectors press for similar restrictions.

At the microeconomic level, bilateral market-sharing arrangements are perceived to have many attractive features. For the domestic producer of the import-competing product, a bilateral restriction shelters the producer’s market from the more efficient foreign producer and may help to maintain sales and profit margins. For the exporter, a voluntary export restraint arrangement—frequently specified in terms of quantity—provides an assured sales outlet and, depending on the relevant elasticities, may enable the exporter to capture the rents arising from the ability to raise the export price to the extent of the difference between the international price and the higher domestic price in the importing country. The allocation of export licenses on the basis of historical market shares may inhibit export sales by new firms. The exporter may resist converting a bilateral export restraint arrangement to a more transparent and economically more efficient tariff, as it could lead to a loss of rents; reverting to a free-trade situation is resisted because it could lead to a loss of market share as well. Exporters not initially restricted by a bilateral arrangement may in fact welcome the arrangement, as it provides at least a short-term opportunity to expand sales and increase market shares. If realized, however, further pressures inevitably develop to make bilateral arrangements more restrictive and expand them to cover more suppliers and close substitutes for the products initially restricted. Liberalization of such restrictions may be resisted both in exporting and importing countries because they can be rationalized as offering greater “security” in international trade flows than would an unrestricted trade regime. Cartelization of international trade may thus be encouraged.

Cases of alleged “unfair” competition have been increasingly settled through market-sharing arrangements rather than through the imposition of antidumping or countervailing duties as permitted under the GATT. This has tended to further weaken international trade discipline, to the extent that exporters are encouraged to acquiesce in such bilateral arrangements rather than to eliminate the distortions arising from the dumping or subsidy practices themselves.

Renewed Interest in Bilateral Free-Trade Areas

The recent revival of interest in bilateral free-trade areas has raised questions about the prospects for strengthening the multilateral system. The possibility of establishing a free-trade agreement between the United States and Canada has been under discussion in academic and policy circles for several years, particularly on the Canadian side. Recent U.S. legislation authorizes the U.S. Government to negotiate bilateral free-trade agreements with Israel, Canada, and possibly other countries. In several other industrial and developing countries, concerns have been voiced about the possibility of trade diversion if bilateral trade liberalization between major trading nations is achieved at the expense of the most-favored-nation (MFN) principle.

GATT rules endorse the creation of customs unions and free-trade areas under certain conditions, and several have been in existence for many years. The recent concerns relate to the possible impact of new bilateral agreements involving one or more major trading nations on the prospects for global trade liberalization on a nondiscriminatory basis. As long as tariffs were the main instrument of protection, it was relatively simple to assess the costs and benefits of free-trade areas and to apply the compensation principle under the GATT to third countries adversely affected by such limited trade liberalization. In the present situation, however, free-trade areas based solely or primarily on zero duties on merchandise trade would be of limited importance, owing to the already low level of average MFN tariffs in the industrial countries. If, however, free-trade areas involved the negotiation between agreement countries of reciprocal lowering of nontariff barriers, questions would arise as to (1) whether such free-trade areas would, in practice, give rise to some form of increased nontariff restrictions against third countries; (2) whether the technical and political difficulty of lowering nontariff restrictions between free-trade partners is such as to make it feasible, with a relatively small additional effort, to extend the same treatment to all countries; and (3) whether new free-trade agreements at this juncture would divert the attention and interest of major trading nations from the multilateral trading system.

The Developing Countries

Restrictive Trade Regimes

Many developing countries generally maintain complex and restrictive trade regimes; their simplification and liberalization would promote greater efficiency of resource use and contribute to economic integration between developed and developing countries and also among developing countries. With some notable exceptions, developing countries have traditionally relied heavily on tariff and nontariff barriers to trade. Although, at an earlier stage, the adoption of a protectionist policy may have been considered necessary to stimulate economic development, experience suggests that protection often went considerably beyond what may have been justified on infant industry grounds. Balance of payments constraints have influenced the stance of trade policy to an important degree. Recourse to countertrade arrangements has also increased.7 Because developing countries often resort to both trade and payments restrictions, it is difficult to identify the incidence and effects of trade policies per se in these countries. A sample survey of 35 developing countries, based on information available in the Fund, showed that, between 1978 and 1983, little overall change occurred in the restrictiveness of their exchange and trade systems.8 In terms of their share in developing country trade, about one third of the sample increased reliance on restrictions, about two fifths liberalized restrictive systems, and in the remainder no significant change in restrictiveness occurred. This overall result must be seen in the context of the balance of payments difficulties of developing countries at this time. Only a few countries relied primarily on tariff protection; most used a combination of tariffs and nontariff trade restrictions.

The limited comparable information available on tariff levels broadly indicates that developing countries maintain a high average statutory level of tariffs, and that, with some notable exceptions, this has not changed appreciably in recent years. Fiscal considerations are very important in determining tariff policy in many developing countries. Nontariff restrictions, and especially quantitative import restrictions, are widely used in developing countries, often in conjunction with industrial licensing and foreign investment policies. Statutory tariffs are prohibitive in some sectors, but import licenses are frequently granted with substantial exemption from the statutory tariff in accordance with established sectoral objectives. Such a system may exacerbate the dispersion of de facto tariffs and thus increase allocative distortions. In the dozen developing countries for which comparisons between 1983 statutory and actual average import duty rates were available, the scope of import duty exemptions was limited to 25 percent of imports or less in only one or two cases; in most countries of the sample, at least one half or more of imports benefited from duty exemptions.

It is questionable whether, in practice, high trade protection in developing countries is limited to infant industry considerations. In some sectors, a number of developing countries have a comparative advantage without the need to rely on protection. For example, a GATT survey of 21 developing countries found that the combined average tariff level for textiles and clothing ranged from less than 10 percent to over 50 percent and that only 4 had no nontariff measures.9 Moreover, in textiles and clothing a modest positive correlation existed between the level of tariffs and the number of nontariff measures.

The scope for further trade liberalization by developing countries therefore remains considerable, particularly if both import-competing and export-oriented domestic production are to benefit from more exposure to foreign competition and are to realize the longer-term gains from specialization and economies of scale. In some sectors in developing countries, some tariffs or nontariff restrictions may be redundant in an economic sense, and rationalization of protection may, in the first instance, involve the removal of these redundancies.

The perceived failure of major trading nations to resist the drift toward protectionism has weakened efforts to mobilize domestic support for a more open and rational trading system in developing countries. At the same time, the maintenance of visibly high trade restrictions in developing countries complicates the argument for trade liberalization in their favor in industrial countries. Thus, protectionism in industrial and developing countries tends to feed on itself and compounds the difficulties of forging an international consensus on mutually beneficial trade liberalization.

Moves Toward Liberalization

Several developing countries have recently taken important steps toward liberalizing their trade regimes in conjunction with the adoption of comprehensive adjustment programs; the success of these efforts will depend on comprehensive and sustained efforts to pursue appropriate domestic policies and on the openness of markets abroad. There has been growing recognition in recent years that economic growth in developing countries can be enhanced by pursuing more open trade policies. Thus, balance of payments adjustment efforts have been directed not only at bringing aggregate demand more in line with supply, but also at encouraging improved supply responses over the medium term throughout the economy, by greater reliance on the price mechanism. More export-oriented growth strategies involve reduced reliance on production at high resource cost for the home market and greater emphasis on price incentives for competitive production. This shift in policy emphasis is by no means generalized to all developing countries.

Steps taken by developing countries toward liberalization have varied, depending on prevailing balance of payments pressures, the extent of the distortions, and the scope of corrective domestic policies that the authorities were prepared to introduce. In several cases, trade liberalization was an important element in the adjustment efforts supported under Fund and World Bank programs. In a number of heavily indebted countries, external payments problems had developed to the point where sizable external payments arrears had emerged, and the first priority was to restore a degree of normalcy in the payments system through the reduction of arrears and the consolidation of external debt service payments. In other developing countries, the external imbalance, although serious, was not critical, and trade liberalization could be launched without delay. In a few instances, countries initiated more open trade policies before introducing adjustment programs, and the programs helped support and reinforce their liberalization efforts. In all cases, applying appropriate exchange rate policies was a critical element in the corrective policies pursued. Where complex and highly restrictive trade and payments systems had been introduced to avoid or delay the correction of an overvalued currency, the subsequent adjustment effort eased balance of payments pressures, thereby improving prospects for future liberalization.

Each of the actual examples of liberalization contains some of the elements described above. In Brazil and Mexico, immediate priorities were the correction of a severe currency overvaluation and the orderly settlement of external arrears. As the adjustment programs take hold, these countries are moving toward reducing reliance on nontariff trade barriers and are examining the modalities of removing excess protection of domestic industries and rationalizing the tariff structure. Reliance on quantitative restrictions was also reduced in India and Pakistan; in Korea, Turkey, and Thailand, trade liberalization included reduction of both tariff and nontariff barriers. In contrast, liberalization in Malaysia consisted mainly of lowered tariffs. Korea is of particular interest because trade liberalization will be phased in over a number of years, so that industries will be able to adapt progressively to increasing foreign competition. By the end of 1988, the scope of Korea’s discretionary import licensing and the height of the tariff are not expected to be substantially higher than in some OECD countries. Several developing countries have undertaken to reduce or freeze their export subsidies under the GATT code on subsidies.

Successful trade liberalization in developing countries encourages a shift of resources from import-substituting to export-oriented production. Two critical requirements must be met if this shift is to be more than transitory and is to be allowed to have the desired response on investment. First, trade liberalization must be accompanied by the sustained pursuit of sound domestic financial and economic policies. For example, trade liberalization may entail greater reliance on the price mechanism, including more market-related pricing, exchange rate, and interest rate policies. Second, the success of efforts to increase export orientation must not be frustrated by foreign trade barriers. The lack of assured open markets, as evidenced by the drift toward protectionism, impedes developing countries’ efforts to promote growth based on comparative advantage.

Foreign Direct Investment Flows

More open trade policies in industrial and developing countries would enhance the sectoral composition of and tend to encourage foreign direct investment flows to developing countries and thus improve the balance of payments adjustment process and efficiency in the allocation of world savings. Foreign direct investment flows to developing countries are influenced by a variety of factors and policies, including the host country’s economic policies.10 Of particular importance in determining the composition of foreign direct investment flows is the extent to which the host country’s policies favor import-substituting production, or whether they also encourage the expansion of exports. High levels of tariff and nontariff barriers, particularly in developing countries with large domestic markets, encourage direct investment inflows into manufacturing for the domestic market, while more open trade policies (e.g., in Singapore) encourage production for export markets. A corollary of the recent shift to more open trade policies in some developing countries has been a liberalization of policies to attract a greater inflow of foreign investment. To the extent that the additional investment flows are directed toward production for export markets, industrial countries’ willingness to absorb imports from developing countries in sectors where they have a comparative advantage will be critical, both in encouraging greater reliance by developing countries on private direct investment and in reinforcing the pursuit of more open trade policies by developing countries.

OECD (1985). The proportions were calculated using 1980 values.

The exporters concerned were Hong Kong, Korea, Japan, Singapore, and Taiwan (Taiwan Province of China). The 1983 proportion is calculated using 1980 trade weights.

The OECD study estimated import compression as the difference between actual imports and imports predicted by a model based on 1966–81 data. It noted that, subsequent to the implementation of the MFA in 1973, OECD imports of textiles and clothing became almost totally unresponsive to price signals. When based on 1966–72 data, the model estimated that 1982–83 import volumes from non-OECD sources would be at least twice as large as the observed magnitudes.

International Monetary Fund, Exchange Rate Volatility and World Trade, Occasional Paper No. 28 (Washington, July 1984). The study was prepared in response to a request by the GATT Contracting Parties. A subsequent study by the staff of the Federal Reserve Bank of New York concluded that exchange rate variability might have reduced the volume of international trade in manufactured goods in the United States and the Federal Republic of Germany. M.A. Akhtar and R. Spence Hilton, “Effects of Exchange Rate Uncertainty on German and U.S. Trade,” Federal Reserve Bank of New York, Quarterly Review (New York), Vol. 9 (Spring 1984), pp. 7–16.

Countertrade arrangements may account for as much as 5 percent of world trade; see Banks (1983).

See also Part Two, Section V.

International Monetary Fund, Foreign Private Investment in Developing Countries, Occasional Paper No. 33 (Washington, January 1985).

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