Many developing countries have substantially liberalized their trade regime over the past three decades, either unilaterally or as part of multilateral initiatives. Nevertheless, trade barriers remain high in many developing countries. One of the concerns that attributes to the reluctance of many of these countries to liberalize their trade regime is the possible worsening of the trade balance.1 This is the question we want to investigate in this study: did past liberalization episodes in developing countries lead to a deterioration of their trade balance?
On the theoretical ground, Ostry and Rose (1992) offer an extensive survey of the macroeconomic effects of trade tariffs based on different theoretical frameworks, including the income-expenditure approach, the monetary approach, and the intertemporal approach. The authors conclude that there is no clear conclusion about the effect of a tariff change on the trade balance. The effect depends on the behavior of real wages and exchanges rates, on the values of a variety of elasticities, the degree of capital mobility, and whether the tariff shock is perceived as temporary or permanent.
Using a simple two-period intertemporal trade model, we analyze the effect of trade liberalization on the import, the export, and the trade balance in a small country. The effects rely on the interactions among the real income effect, the intratemporal substitution effect between importing goods and exporting goods, and the intertemporal substitution effect across time periods. The intertemporal substitution effect is negligible, as the tariff reductions are permanent, and the small country takes the world prices and the interest rate as exogenous. Tariff reductions increase the real income and decrease the price of the import good. Thus, both the real income effect and the intratemporal substitution effect increase imports. The intratemporal substitution effect decreases the domestic consumption of the exportable good, whereas the real income effect increases it. Assuming the former effect dominates, trade liberalization will increase exports. As trade liberalization increases both exports and imports, the difference of these two, the trade balance, may increase or decrease due to tariff reductions. The impact of trade liberalization on the trade balance, therefore, needs to be investigated empirically.
One stream of the related empirical literature attempts to find out how trade liberalization affects a country’s imports, and generally finds a positive impact (Melo and Vogt, 1984; Bertola and Faini, 1991; and Santos-Paulino, 2002a). There are also empirical researches focusing on the effects of trade liberalization on exports, where the findings are more mixed. Some of them show that countries which embarked on liberalization programs have improved their export performance (Thomas, Nash, and Edwards, 1991; Ahmed, 2000; and Santos-Paulino, 2002b), whereas others have found little evidence of such a relationship (Greenaway and Sapsford, 1994; Jenkins 1996).
For policymakers, the impact of trade liberalization on the overall balance would be the more important question. There have been, however, surprisingly few cross-country empirical studies on the subject. Ostry and Rose (1992) studied the impact of tariff changes on the trade balance using five different data sets, mostly data from the Organization for Economic Cooperation and Development countries, and found no statistically significant effect. UNCTAD (1999) studied the effect of trade liberalization on the trade balance for 15 developing countries over the period of 1970–1995, and found a significant negative relationship. In a more recent paper, Santos-Paulino and Thirlwall (2004) studied the effect of trade liberalization on imports, exports, and on the overall trade balance using a sample of 22 developing countries for the period of 1972–97. They found that liberalization stimulated export growth but raised import growth by more, leading to a worsening of the overall trade balance.
One constraint researchers on the subject often face is the lack of systematic data measuring the dates of trade liberalization. Indeed, due to data limitation, most of the empirical studies on the subject are constrained to country case studies. In this paper, we use two recently compiled data sets establishing trade liberalization dates that cover a large sample of developing countries for a long period of time. In particular, our two samples cover 39 and 77 developing countries for the period of 1970–2004, and 1970–2001, respectively. Our study focuses on the impact of trade liberalization for developing countries, for which the policy relevance of this question remains especially high. We find strong evidence that trade liberalization leads to faster import and export growth. The evidence on the overall trade balance, however, is mixed. Using our first measure of trade liberalization dates, we find little evidence that trade liberalization worsens the trade balance. There is some evidence that liberalization leads to a deterioration of the trade balance when we use our second measure of liberalization dates, although the finding is not robust to alternative estimation specifications.
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