Development Economics

4.4. The role of International Trade

Problems with trade for developing countries Overspecialization: specialization has previously been mentioned as an advantage of free trade, related to the concept of comparative advantage and the efficient use of resources. However, if countries overspecialize in the production of a narrow range of goods then they may be increasing their vulnerability. This is because if the competitiveness of the product, in which the country has specialized in, deteriorates then the economy will suffer significantly. For instance, a natural factor, like unusually adverse weather conditions, war, a sudden increase in the prices of imported intermediate goods or a new entrant into the market could contribute to a fall in the demand of supply of the product concerned. Therefore, it does seem favorable to maintain a degree of diversification because it then reduces such risks. In addition, if a country specializes on exporting a certain goods then it will become overproduced and exploited, leading to a depletion in resources, assuming the absence of appropriate regulatory framework. Negative externalities would likely result as the environment may be adversely effected.  Price volatility of primary products: developing countries tend to be particularly dependent on the production of primary products, which include agricultural goods, raw materials and fuels. However, these are often very vulnerable to supply shocks, which may be caused factors such as war, droughts and hurricanes. If the international prices of commodities fall or supply shocks cause an increase in domestic prices, then this will have an adverse effect on the terms of trade - they will be unable to import as many goods and services. In addition, those involved in the extraction and exportation of the primary commodities will suffer in terms of revenue and income, which may be followed by a rise in unemployment.  Inability to access international markets: the economic growth and development in some countries is restricted as a result of economic sanctions and protectionist policies of other countries, which reduce their access to international markets. Economic sanctions are usually

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placed on a country as a form of punishment for political decisions made by their leaders. These sanctions may involve limiting imports and exports to and from the target country, restricting foreign investment to the country and prohibiting private financial transactions. Protectionist policies, such as tariffs, subsidies and quotas, benefit the country concerned, to the detriment of other countries as it becomes more difficult to compete. Both economic sanctions and the protectionist policies of other countries, can prevent developing countries from accessing international markets, which means that they may not be able to acquire economies of scale. Without EOS, the growth in their net exports is likely to be limited which adversely effects aggregate demand and growth. Economic sanctions are therefore often criticized for harming the citizens of the target country, rather than the leaders involved in the political decision-making.  In current times, the Internet has also become a significant factor when considering firms' access to international markets. This is because the Internet can allow individuals to establish their own businesses at minimal costs and interact with others around the world that may be interested in the goods and services that they offer. Similarly, mobile phone networks are extremely important for trade between countries. However, those without the Internet and mobile phones are at an immediate disadvantage as they are forced to rely on other methods to share information, which are often slower and less efficient.  Case Study: Russia With the economic sanctions following the annexation of Ukraine and the fall in oil prices, Russia is a very suitable country to analyze the effects of overspecialization on primary products and restricted access to international markets. Take a look at these diagrams from the Economist, The Wall Street Journal and Reuters to see the close relationship between Russia's economy, politics and oil prices.      

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Trade strategies for economic growth and development Import substitution This involves replacing foreign imported goods and services with goods and services produced domestically. Developing countries may follow this policy in the belief that it will help them become self-sufficient and less reliant on developed countries. Such a policy tends to focus on the government helping domestic infant industries to grow, through the use of tariffs, subsidies and import quotas. These domestic industries then have the opportunity to establish themselves and begin benefitting from economies of scale. Once the domestic firms are large enough, the government may choose to allow greater international competition. Import substitution ultimately protects domestic employment, local culture and economic growth in the short run.  However, such a policy may breed inefficiencies because there is a lack of competition for the domestic producers, which gives them little incentive to innovate and reduce consumer prices. Therefore, consumers may suffer as they lack choice. Although import substitution can aid some domestic producers, those that rely on import intermediate goods will suffer and they may be forced to use more expensive domestic alternatives. In addition, import substitution may increase tension between countries as foreign producers suffer a fall in demand and income. In turn, other countries may retaliate.  Export promotion Export promotion is where the government intervenes in order to expand its export industry and promote economic growth. Many developing economies have gradually moved from import substitution to export promotion over years. This may involve the state owning financial institutions to offer favorable borrowing rates to domestic firms, incentives for private research and development, government funded investment grants and subsidies for exporting firms. Such a policy cannot only aid economic growth, but development as well due to the increase in investment, like education and healthcare. In addition, employment opportunities would likely increase and the balance of payments improve.  

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Trade liberalization This involves the reduction or elimination of trade protectionist policies, including tariffs, import quotas, export subsidies and administrative barrier. This is essential for countries to develop comparative advantage, which is where they have the lowest opportunity cost in the production of the good or service considered. When countries specialize in products that they have comparative advantage over, resources are more efficiently used and economies of scale can be reached, which lower the average costs of production. Developing countries that focus on free trade policies often benefit from higher income growth and poverty reduction than those that do not. Reduced subsidies on imports means that government revenue can be better spent elsewhere, such as on health and education. Also lower tariffs help to reduce tensions between countries and promote mutually beneficial trade. The formation of such trade relations have father benefits as they encourage a faster transferal of ideas and innovations, which can lead to the adoption of new technologies needed for a dynamic economy.  Washington Consensus The English economist John Williamson coined the name ‘The Washington Consensus’. He noticed that Washington D.C. based financial institutions often suggested the following ten policies, including the International Monetary Fund (IMF), World Bank, and the US Treasury Department, to promote growth in developing countries.  

1 Fiscal policy discipline - criteria for limiting budget deficits2 Public expenditure priorities - redirection of public

spending from subsidies toward poverty reducing areas, like primary education, primary health care and infrastructure investment

3 Tax reform - broadening the tax base and reducing marginal tax rates. This means more people pay tax, but the amount an individual pays per additional dollar earned is less than previously. 

4 Market determined interest rates that are positive (but moderate) in real terms

5 Competitive exchange rates

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6 Trade liberalization - lower tariffs and minimal quantitative restrictions

7 Liberalization of inward foreign direct investment by reducing barriers

8 Privatization of state enterprises9 Deregulation, meaning the abolition of regulations that impede

market entry or restrict competition, except for those justified on safety, environmental and consumer protection grounds

10 Legal security for property rights These policies were partially in response to the uncontrollable inflation effecting countries in Latin America during the 1980s and early 1990s. However, it has been argued that the USA was primarily motivated by its own desire to have greater access to foreign markets and increase capital mobility. The International Monetary Fund offered bridge loans to countries that agreed to adopt free market principles with privatization and reduced restrictions on money. Recipient countries included Mexico, Canada, Argentina and Bolivia. Prior to the Washington Consensus, the majority of Latin American countries had import substitution policies to protect their domestic economies, where foreign imports were replaced with domestic products. As their economies moved towards freer markets, some of the countries greatly suffered. For instance, the World Bank and the International Development Bank made it a requirement for Bolivia to privatize its water supply if they wished to continue receiving state loans. In addition, mines were privatized and then closed. It is believed that such policies caused the significant increase in unemployment and poverty, whilst worsening income inequality within the country. Within these countries, governments were following tight monetary policies to reduce inflation, which added to the financial suffering for individuals. In Bolivia prices reached a more stable level, which encourage foreign direct investment, however, political unrest and the economic decline of the late 1990s led to a fall in foreign investment.  

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The role of the WTO The World Trade Organization focuses on promoting trade liberalization globally and regulating trade between countries. It was officially established in 1995 to replace the General Agreement on Tariffs and Trade. The headquarters are in Geneva, Switzerland and there are currently 161 member states (April 2015). It promotes non-discrimination between trading partners, the lowering of trade barriers and increased competition. In the past the organization has been criticized for overlooking developing nations and favoring rich multinational corporations, thus allowing issues such as child labour, poor working conditions, climate change, deforestation and the depletion of fish stocks to be neglected. More focus seems to now be given to provide for developing countries as well as environmental safeguarding. Some also criticize the WTO for the length of time it has taken to settle trade disputes. For instance, in 2000 the European Community requested consultations with the United States in regards to the US's continued application of countervailing duties on certain products, yet it was not until 2005 that the dispute was settled.  Bilateral and regional preferential trade agreements Bilateral preferential trade agreements: an exchange agreement between two countries to facilitate trade and investment between them by lowering or eliminating tariffs, import quotas and other forms of trade protectionism.  Regional preferential trade agreements: an exchange agreement between a number of countries within a particular region to facilitate trade and investment between them by lowering or eliminating tariffs, import quotas and other forms of trade protectionism.  An example of a regional preferential trade agreement is the North American Free Trade Agreement (NAFTA), which is between Mexico, the United States and Canada. This came into effect on 1st January 1994. Even with hindsight, such a trade agreement is very difficult to evaluate because of the infinite other variables that have shaped the economies concerned. It has been argued that the trade between the U.S. and Mexico would have continued to increase to the same degree regardless of NAFTA. Some economists attribute NAFTA as the cause

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of job losses in the U.S.'s manufacturing industry because production moved to Mexico. However, others indicate that this industry was already declining and NAFTA had little overall effect on unemployment in the U.S. Some have also claimed that the agreement led to greater poverty in Mexico as their producers had to compete with subsidized corn and wheat from the U.S., which then led to greater Mexicans migrating to the U.S.  Diversification Economic diversification is where countries produce a range of goods and services, as opposed to specialization.  Developing countries are often more vulnerable to economic shocks because they tend to be over reliant on producing primary goods which are very dependent on uncontrollable variables, like weather conditions. For example, many have cited Russia's high dependence on oil revenues to blame for the extent of its currency collapse in 2014.  Another country with an overreliance on oil revenues is Saudi Arabia. However, in recent years the country has been trying to diversify. They have met with difficulties in doing so as competition from other countries prevents them from easily establishing themselves in new markets. In addition, regulations and the country's strict social rules make it less appealing to foreign investors. 

Source: http://ibstudy.wix.com/ibeconomics#!44-the-role-of-international-trade/czcx, accessed Tuesday 10th November 2015

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Examination Questions

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