Throughout the 1980s, many developing countries that depend heavily on the exports of a primary commodity or a natural resource, such as petroleum, have been forced to restructure as a result of fluctuations in the world price of their exportable good. Indeed, many of these countries adapted to their newfound wealth after discovery of a natural resource only to face the need for adjustment after the boom had subsided. The general consequences of resource booms, known as Dutch disease, have usually included “deindustrialization,” real exchange rate appreciation, and a loss of competitiveness (see Corden and Neary (1982) and Corden (1984) for relevant surveys). As the boom proceeds, the booming sector expands and draws resources away from other sectors of the economy, usually other traded, import-competing sectors and some nontraded sectors, as these sectors must contract to free inputs to the booming sector; thus, deindustrialization results. The newfound wealth translates into increased spending on all goods, and this spending effect will increase the prices of nontraded goods, introducing an appreciation of the real exchange rate and a loss of competitiveness as the prices of traded goods (exogenous for a small country) fall relative to the prices of nontraded goods.
Against this background, many small, primary commodity exporting countries have had to adjust to the consequences of Dutch disease. A typical response to the restructuring inherent in a boom has been to resort to a policy of protection, as in the case of Trinidad and Tobago. In the late 1970s and early 1980s, the economy experienced a major expansion in the petroleum sector as the international price of petroleum rose sharply. In the wake of this boom, the economy maintained its protectionist environment of high tariffs and expanded the number of imported goods contained on the “negative list” in an effort to shield domestic import-competing industries from the effects of the real appreciation induced by the rise in the international price of oil. The expansion of import protection, designed to sustain output and employment in the import-competing sectors, further exacerbated the loss of competitiveness because protection causes an appreciation of the real exchange rate. Only recently has the economy begun to liberalize its trading regime in the hope of restoring competitiveness and promoting exports.
Trade liberalization has had important beneficial effects on the economy of Trinidad and Tobago, most notably, a restoration of competitiveness through real exchange rate depreciation. The effects of trade liberalization on the overall position of the public sector are less clear, however, and this aspect of trade liberalization is important because the central government’s recourse to additional financing is clearly limited. The effect of trade liberalization on the fiscal position of the government has become an important issue, but according to Blejer and Cheasty (1988), Tanzi (1989), and Feltenstein (1992), no definite conclusions can be reached a priori concerning the direction of the change in the fiscal position from trade liberalization. According to Tanzi, there is a presumption that trade liberalization will improve the fiscal position of the government, but the papers by Blejer and Cheasty and by Feltenstein are less definite on this point, especially Feltenstein, who finds that trade liberalization would worsen the fiscal position of Mexico.
Given this uncertainty, an empirical investigation of trade liberalization is appropriate. While trade liberalization may help restore competitiveness, if it worsens the budget deficit, it may also impede the economic adjustment necessary to promote growth in the economy. Trade liberalization will usually result in lower tariff revenue, but there are also indirect, sometimes positive, effects on revenue from other types of taxes, such as value-added taxes and export taxes. For example, in economies that derive revenue from the taxation of exports, liberalization of trade will increase revenue from that source because the real exchange rate depreciation that results from trade liberalization will increase exports. This effect may offset, to some degree, any loss in tariff revenue. In addition, if the consumption of imports is also subject to a consumption tax, such as a value-added tax, a reduction in tariff rates will increase import volume and so will generate additional revenue. However, the existence of a complex tax regime means that the effect of trade liberalization on the fiscal position is complicated, so it is necessary to examine this issue using a fully specified, applied general equilibrium model.
The purpose of this paper is to determine the effects of two types of external shocks—trade liberalization and changes in the terms of trade—on the real exchange rate, trade flows, and the fiscal position of the economy of Trinidad and Tobago using a computable general equilibrium model. The model is sufficiently general to be applied to other small, open economies, and is applied to Trinidad and Tobago to demonstrate the methodology and usefulness of the technique. The technique adopted in this paper—applied general equilibrium modeling-—is especially appropriate for analyzing the effects of changes in commercial policy and terms-of-trade shocks because of its ability to capture directly the important relative-price effects of various shocks; both types of shocks undertaken here involve changes in relative prices.1
In this paper, the model is used to perform three broad tasks: quantify the effects of trade liberalization on the performance of the fiscal and external sectors under different assumptions concerning the flexibility of the price of nontraded goods; quantify the effects of an adverse shift in the terms of trade and evaluate the effects of alternative policy responses to this shock; and rank the effects on efficiency of alternative tax policies designed to prevent an increase in the budget deficit following both types of external shocks. It should be emphasized that the analysis in this paper is static and does not consider how the various external shocks affect the economy over time.
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Stephen Tokarick is an Economist in the Western Hemisphere Department. He received his Ph. D. in economics from the University of Pittsburgh. He would like to thank David Bevan, Peter Clark, R, Anthony Elson, José Fajgenbaum. Samuel Itam, Charles Kramer, and Branko Marić for useful discussions.
While other types of modeling techniques, such as macroeconomic modeling, could conceivably be used, these types of models do not usually capture resource constraints, material balance constraints such as market clearing, and other elements grounded in general equilibrium microeconomic theory. In this paper, the focus is on the relative-price and welfare effects of changes in policy, rather than on the effects of external shocks on aggregate spending, output, and inflation. Inclusion of a monetary sector, for example, would not help reveal the inefficiencies of trade barriers, the existence of which is a central message of the paper.
Exports of petroleum and related products such as petrochemicals accounted for slightly more than 77 percent of exports in 1991.
This type of production structure is appropriate for an analysis of oil production. The assumption of fixed capital stocks reflects the fact that capital cannot be shifted into other sectors of the economy. Allowing for the use of imported intermediate inputs is also appropriate since most of the capital goods needed are not produced domestically. The oil sector can, however, compete with other sectors of the economy for labor. Finally, the scope for substitution between inputs, especially between value added and intermediate inputs is quite limited: hence, the choice of a Leontief technology is appropriate.
The stock of government debt and the volume of transfers are fixed in real terms.
Equation (20), which defines income. Y, should not be confused with GNP. In equation (20), Y denotes the amount of “money” available for the consumer to spend before taxes and transfers. If the government runs a surplus, then the amount of money available for the consumer to spend rises, as the government is assumed to return the surplus to the representative consumer. Similarly, if there is a trade deficit, the rest of the world is willing to lend, as domestic consumption exceeds income. This inflow of foreign lending (a capital inflow) represents resources available to the representative consumer, so it is included in the definition of Y, This is the approach adopted in Dervis, de Melo, and Robinson (1982), de Melo and Tarr (1992), and Rousslang and Tokarick (1995).
Since the model is static, there is no investment (I = 0).
The data on production, employment, and value added were provided by the Central Statistical Office, Trinidad and Tobago, Data on the fiscal accounts were provided by the Western Hemisphere Department of the IMF. All remaining information was taken from the trade policy study by Maxwell Stamp (1992).
The Government of Trinidad and Tobago has begun to implement the proposed program of trade liberalization.
See Maxwell Stamp (1992), p. 324. The initial nominal rate of protection of 52.7 percent includes the effects of the Common External Tariff, quantitative restrictions, and stamp duties.
In 1980, output of petroleum and petrochemicals accounted for 39 percent of GDP, while in 1991 their share was 23 percent.
The real exchange rate calculations use the price of traded goods inclusive of tariffs, where the price of traded goods consists of an aggregation of the price of importables and exportables. Alternatively, two real exchange rates could be computed: the importables real exchange rate, defined as PM/PN and the exportables real exchange rate, defined as PX/PN Jones (1974), Edwards (1988), and Khan and Ostry (1991) show that protection will cause the importables real exchange rate to depreciate (a rise in PM/PN while the exportables real exchange rate appreciates PX/PN falls). Hence, protection introduces a bias against exports.
Certain institutional features of the economy of Trinidad and Tobago may make price flexibility unlikely. For example, the existence of administered prices is not consistent with the flexible price scenario. Furthermore, the two cases presented in the paper represent polar extremes and the actual degree of price flexibility may fall between the two.
Consumer welfare is measured by the equivalent variation, which is described in the result tables.
Alam and Rajapatirana (1993) stress that trade reform should be preceded or accompanied by a real depreciation—a reduction in the price of nontraded goods relative to traded goods.
A reduction in the tariff on imports causes exports to expand because it increases the relative price of exportables to importables, as noted by Lerner (1936). A tax on imports is symmetrical to a tax on exports, so import liberalization increases exports.
If the price of the nontraded good is inflexible, then trade liberalization is likely to result in unemployment as import-competing sectors contract.
A 5 percent deterioration is approximately the average deterioration over the period 1991-1993.