Globalization and Development

Frank Flatters

www.frankflatters.com

22

Purpose

• Review policy options for responding to globalization

The Importance of Trade

44

Growth & initial income: all countries

55

Growth & initial income: open economies

66

Convergence and divergence in the 1990s

-1%

2%

5%

2%

4%

6%

Less globalized countries

Rich countries More globalized countries

GDP per capita growth rates, 1990s (ppp)

0

77

Importance of trade

• The previous figures show:

– Open economies grow faster

– Poor but open economies are catching up; closed ones are falling further behind

88

Gains from liberalization

• Recent World Bank estimates of gains from global trade liberalization:

– By 2015 global income would be $355 billion higher ($1997)– Developing countries would get $184 billion of this– $121 billion of the gains of poor countries would be from their

own liberalization– Taking account of dynamic effects, the gains to developing

countries could be more than $500 million– Liberalization and reform of services in developing countries

could increase their incomes by almost 10 percent, or $900 billion (70 percent of this due to cheaper trade and transport)

99

First conclusions

• Trade policy is central to national development strategy

• What matters most is what we do for ourselves, and not what we negotiate with others

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Complementary policies

• While trade policy is critical, so are other policies and institutions, such as

– Legal institutions for the protection of property rights and enforcement of contracts

– Stable fiscal institutions and macroeconomic policies

– Effective and non-burdensome regulatory regime

– Competitive markets

– Infrastructure and basic services (finance, utilities, telecoms, transport, etc.)

– Human capital: education and flexible labor markets

How Trade Works

1212

Prices and relative costs

• Comparative advantage

– Trade is a technology for getting goods and services that would be relatively expensive and maybe even unavailable domestically from elsewhere, in exchange for goods and services that are relatively less costly locally

– This process is mutually beneficial, at least in aggregate, for all parties—the well known gains from trade

– Small, poor countries generally gain more since they do not influence world prices when they trade

1313

Specialization & scale

• Trade permits specialization and economies of scale

– Reduces costs and raises quality

– Increases product variety and availability, for both consumers and industrial users

1414

Investment

• Openness to trade, in all its dimensions, is a great attraction to both foreign and domestic investors

– Foreign investment is important for transfer of production technologies, design and marketing expertise, and for export growth and development of service industries

1515

Competition

• Trade increases competition, especially in small markets

– Encourages adoption of improved technologies, lowers prices and costs; increases choice

1616

Technology

• Trade provides direct and indirect access to improved technologies

– New technologies are embodied in imported capital, intermediate and final goods

– Trade-induced competition encourages productivity growth

– One of the primary benefits of trade-related foreign direct investment is access to new technologies (not just in production, but also design, marketing, etc.)

1717

“Competitiveness”

• Competitiveness and comparative advantage

– Comparative advantage and competitiveness are related but distinct concepts

– Comparative advantage refers to inter-country differences in relative costs that occur for many reasons and that form the basis for trade and the gains from trade

– Competitiveness relates to the dynamic process of productivity growth that is main determinant of long term economic growth; trade and investment according to comparative advantage is a key way to improve competitiveness

Typical Trade Patterns

1919

Fragmented production

• Falling transport and transactions costs make it possible to spread production around the globe in increasingly complex ways

• Creates many opportunities, especially for poorer countries, in labor-intensive production

• Trade, investment and technology usually go together

• Importance of trade in intermediate inputs and of transport and trade facilitation—import-led growth

2020

Labor intensity

• Low income countries specialize initially in labor-intensive exports

• With increasing skills, improved technology and streamlined trade and investment institutions, local content of exports increases (local content rules are unnecessary; they raise costs and impede development)

• Comparative advantage shifts and incomes grow (“moving up the ladder”— examples from Africa and Asia)

2121

Resource-based exports

• Resource-based exports can be of great benefit (exports, rents), but can create problems, especially if mismanaged

– Large earnings (big export projects) can cause real exchange rate appreciation, decreasing the competitiveness of labor-intensive, non-traditional exports (“Dutch disease”)

– Governments might also be tempted to squander resource rents and export revenues through inappropriate policies to encourage local downstream processing

Trade and Poverty:Key Mechanisms

2323

Growth

• The most important link between trade and poverty reduction is through economic growth

– Trade is necessary for growth and growth is essential for long term poverty reduction

2424

Consumption

• Trade liberalization reduces the costs of basic goods for the poor

– But what if we export a basic good (oil palm in Indonesia)?

– Consumption link is generally greater for urban poor than rural poor

2525

Livelihoods

• The comparative advantage of low income countries in labor-intensive products means that trade almost always benefits the poor as workers, providing the main avenue out of poverty for many families; opening up of non-farm opportunities is critical

– Beware of well-intended beneficiation policies that harm the rural poor (cashews…)

2626

Government revenue

• Trade is an important source of government revenue (but still less than 15 percent in Mozambique) that can be used to provide pro-poor services

– Trade liberalization does not necessarily reduce revenue (share of customs revenues has increased in recent years)

– And trade taxes are very costly; there are better alternatives (VAT, large projects)

Protection

2828

Instruments of protection

• There are many different tools of protection

– Import duties (ad valorem, specific, etc.)

– Import quotas and other quantitative restrictions (QRs)

– Non-tariff import barriers (NTBs — standards, licensing, (lack of) trade facilitation, etc.)

– Indirect tax discrimination between domestic and foreign goods

– Export taxes

– Non-tax export restrictions

– More complex measures: local content rules, rules of origin, other performance requirements

Protection of Final Goods

3030

Price

• The main effect is to artificially raise domestic prices and reduce choice and availability of importable goods; the price-raising effect, relative to world prices, is called the “nominal rate of protection” for any good or service

• Note a big difference between tariffs and NTBs

– With tariffs, the difference between domestic and world price is collected as government revenue on imported goods

– With quotas, this becomes a rent that is a pure profit to importers or exporters, and often results in economic waste through administrative costs and/or rent seeking behavior

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Effect on consumers/users

• Buyers curtail demand in response to artificially raised prices

• Users of the goods would be willing to pay more than the goods actually cost the economy, but protection means there is no incentive to fill the need; this foregone opportunity is a pure economic waste to the economy due to protection

3232

Effect on producers

• Domestic producers face less competition and increase production, even if their costs are greater than the (true) cost of buying the goods abroad

• Such increases in production induced by protection are economically wasteful since we produce goods at a higher cost than they could be obtained internationally

3333

Effect on government

• Unless a tariff is prohibitive (prevents all imports) it generates revenue—a transfer from consumers and other users of importable goods to the government

• In the case of non-tariff protection, the government gets no revenue, but might be (dangerously) involved in distribution of rents and in other rent-seeking behavior

3434

Effect on trade

• Imports reduced as a result of the increased price of importables; exports fall as the country trades less

3535

Overall effect

• Transfer from domestic users to domestic producers and to the government (tariff revenues) or recipients of rents from non-tariff restrictions; reduced trade and competition; economic waste from distorted price signals and rent seeking

3636

Export restrictions

• Just as tariffs and import restrictions artificially raise the domestic price of importables, export taxes and other restrictions artificially lower their domestic price

• The net effects are: transfer from domestic producers of the goods to domestic users and the government (tariff revenues) or recipients of rents from non-tariff restrictions; reduced exports; economic waste from distorted price signals and rent seeking

Protection of Intermediate Goods

3838

Main effects

• For the producer of a protected intermediate good:

– The effect of protection is the same as for producers of final goods—it raises the domestic price and reduces competition in the domestic market

• For the user of a protected intermediate good:

– Protection of the intermediate good raises production costs and reduces ability to compete, especially in export markets

3939

Effective rate of protection

• The effective rate of protection (ERP) is a measure of the net effect on a producer of protection of its output(s) and its inputs

– It measures the percentage increase in the processing margin (or value added = the difference between total factory cost and the cost of all purchased intermediate inputs) on an activity as a result of protection of inputs and outputs of that activity

4040

ERP: Simple example

• Consider a garment that can be manufactured in world markets at a cost of 100 and that uses inputs (cloth) that cost 75 in the world market

• Suppose that there are import tariffs in the local market of 30 percent on garments and 20 percent on cloth

• The tariff on garments helps the producer when selling domestically, but not when exporting; the tariff on cloth hurts; the net effect, or the effective rate of protection (ERP) depends on the market in which the domestic garment maker sells

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ERP in domestic market

• VA at world prices: 100 - 75 = 25

• Calculate VA in local market after tariffs:

– Sales price in local market: 100 + 30% = 130

– Cost of inputs: 75 + 20% = 90

– Thus VA in local market: 130 - 90 = 40

• ERP is the percentage change in VA (relative to world values) due to protection; in this case:

ERP = (40 - 25)/25 = 60%

4242

ERP if exporting

• VA at world prices: 100 - 75 = 25

• Calculate VA if exporting:

– Sales price in export market (tariff doesn’t help): 100

– Cost of inputs: 75 + 20% = 90

– Thus VA if exporting: 100 - 90 = 10

• For a domestic exporter:

ERP = (10 - 25)/25 = -60%

4343

ERP with uniform tariff (20%)

• VA at world prices: 100 - 75 = 25

• Calculate VA if selling locally:

– Sales price in local market: 100 + 20% = 120

– Cost of inputs: 75 + 20% = 90

– Thus VA in local market: 120 - 90 = 30

• Thus for domestic sales:

ERP = (30 - 25)/25 = 20%

4444

Other cost-raising effects

• Protection cannot help all producers and all sectors

• In addition to its direct effect on input prices, protection raise domestic costs and the real exchange rate, which is harmful to all domestic producers of importable and exportable goods

• In principle, we should look at ERPs net of these additional cost effects; but the main thing to note is that differences in ERPs across sectors and activities are more important than levels of ERPs

4545

Costs of ERP differences

• Goods with positive net ERPs can be profitably produced at a higher cost than imports; foreign exchange “saved” in this way costs more in domestic resources than the value of the foreign exchange saved

• Goods with negative net ERPs can be produced at lower cost than in world markets and yet will not be exported; the domestic cost of foreign exchange that could be earned through additional exports is less than the foreign exchange earned

• Reducing levels of and differences in ERPs would result in rationalized production and economic gains through increases in imports of previously protected goods and in exports of goods that had been penalized by protection

4646

Properties of ERPs

• The overall impact of protection in an economy depends on patterns of nominal and effective protection

– If nominal protection on outputs is greater than that on inputs (“cascading protection”) effective protection rates will be higher than nominal rates; they will also increase as we move from primary to final products

– Effective protection is increased by raising protection on outputs or decreasing protection on inputs

– If nominal rates on outputs are the same, the ERP will be the same as the nominal rate (not zero!)

4747

Protection and exports

• Protection creates an anti-export bias

– Output tariffs make domestic sales more profitable than exports

– Protection raises the cost of inputs, which cannot be offset by corresponding protection on outputs when exporting (note WTO rules on subsidies)

– It increases the real exchange rate, further decreasing the incentive to export

– Protection often makes rent seeking more profitable than measures to increase competitiveness, especially in difficult export markets

4848

Duty drawbacks & VAT

• Tariffs on inputs give exporters negative effective protection; so do non-refunded input taxes under a VAT regime

• The input tariff problem can be neutralized by an effective duty drawback or exemption system

• With effective duty drawbacks and VAT input tax credits, exporters face world prices on inputs and outputs

• However, they still suffer from exchange rate effects of the protection regime, providing negative net ERPs

4949

Export restrictions

• Taxes or other restrictions on exports lower domestic price and discourage production and export; they are a burden on exporters

• By lowering the domestic price they are also a subsidy to downstream users or processors of the restricted export; they artificially lower the price to less than its true economic value, causing waste in the use of the restricted export

– Compare a primary product export in which there are rents (logs in Indonesia) with one in which there are no rents (cashews in Mozambique)

Patterns and Impacts of Protection

5151

Effects on domestic economy

• Import protection raises costs for consumers and producers; helps high cost producers; reduces imports and exports; reduces competition and reduces real incomes and growth

• Export restrictions help selected users and/or consumers at the expense of export producers; reduce trade and real incomes through wasteful local use and discouraged exports

5252

Effects on other economies

• Domestic protection affects other countries only if it changes world prices of protected goods and services

• For small countries with little influence on world markets for goods they import or export, this is highly unlikely

• Therefore protection in small countries is of little economic consequence to other countries

5353

Global patterns and effects

• Some aspects of global protection hurt small, poor countries

– Agricultural protection and export subsidies (impact depends on whether they are net importers or exporters)

– Cascading tariff structures discourage domestic processing of some exported raw materials

– Tariff peaks and other protection of key labor intensive goods (textiles and clothing) hurt; quotas, preferences and associated rules of origin create serious conflict (ATC)

• Can or should a poor country retaliate? Should it emulate? How to respond?

5454

Rent seeking

• The benefits of protection are often large and concentrated; their size and distribution depends on the instruments of protection used

• The costs are less well recognized and much more widely dispersed

• This makes it profitable to seek protection; it results in bad trade policy and wastes entrepreneurial resources in rent seeking activities (rather than doing business)

• Question: How to avoid rent seeking and “capture” by special interests?

Some Implications for Trade Policy

5656

Import policies

• Tariffs are better than quotas, NTBs and other requirements

• A good tariff structure has low, uniform rates and makes minimal use of exemptions and surcharges

• Import tariffs are an economically costly revenue raising device; a properly functioning VAT is much better since it does not discriminate between local and foreign goods

• Evaluation of pleas for protection should be transparent and should consider the impacts on all stakeholders, not just the requesting firms

5757

Export policies

• Do not impede exports with taxes or other restrictions

• Smoothly operating duty drawback or exemption facilities (including EPZs) are essential as long as tariffs have a significant effect on the cost of imported inputs; but they are only a partial stop-gap and the only long term solution is to reduce all protection

• Input credits for exporters under the VAT must be quickly and efficiently refunded; risk-based monitoring and audits will also be needed to avoid fraud, but must not impede legitimate business

5858

Trade facilitation

• High transport and trade facilitation costs are just like protection, but with no offsetting benefits such as tariff revenues;

– Regulatory- or corruption-induced high costs are pure economic waste

• In a world of integrated global production networks logistics are critical, and unnecessarily high trade facilitation costs are a huge barrier to investment and export development

– Importance of customs, port and transport services (e.g. Indonesian shipping, ports and customs reform in the 1980s)

5959

Investment environment

• For the full benefits of trade to be felt, trade reform needs to be allied with regulatory reform that provides a supportive investment environment

• This includes legal structures and institutions, enforcement of property rights and contracts, financial institutions including bankruptcy procedures, licensing regimes, basic “public” infrastructure and services

6060

Policy processes

• Good policy requires the ability to analyze the full economic impacts of current policies and proposed alternatives

• It also requires transparency and accountability

Some Implications for Trade Negotiations

6262

Negotiating tips

• The fallacy of “concessions”

– Use negotiations to improve and lock in good domestic trade policies—to do what you should do anyway, regardless of what the others do

– Do not use negotiations to postpone good policies

– Be very careful in claiming and using a right to “Special and Differential Treatment” (SDT) for poorer countries; it might just condemn your people to stay poor longer

• Most good trade policy can be conducted at home; no need to travel; no need to negotiate with other countries

Regional Trade Agreements

6464

Building blocks or ??

• Do regional and other preferential trade agreements (PTAs) promote global and unilateral liberalization, or do they impede it? Do they promote or impede domestic and regional competitiveness? Do they lead to open regions or fortresses?

– If they can be used to promote necessary and useful domestic reforms, and do not impose hidden economic costs, the answers might be favorable

– But there are serious dangers…

6565

Dangers of PTAs

• Economic dangers:

– Trade Diversion: Tariff preferences switch us to higher cost import sources, losing tariff revenues with little or no benefit to users of imports. (Solution: make all tariff reductions on an MFN basis.)

– Rules of Origin: These are necessary in PTAs (except customs unions); they become a costly new instrument of protection, an obstacle to trade and an target for rent seeking. (Solution: simple and non-burdensome rules of origin and reduced intra- and extra-PTA tariff rate gaps.)

– Policy Diversion: Limited policy capacity is diverted from more important domestic reforms and unilateral MFN liberalization; negotiating mercantilism is reinforced

6666

Examples for Mozambique

• SADC: backloading; rules of origin

• SACU: customs union and control of tariff structure; opportunity to improve domestic policies?

Investment Incentives

6868

Are incentives necessary?

• Most governments feel direct and/or indirect tax incentives are necessary to attract investment

• International experience suggests the opposite

– Indonesia

– The real concerns of investors are different

6969

The costs of tax incentives

• Foregone revenue (but this usually underestimated)

• Complex administration and compliance

• Wasteful rent seeking

• Perverse impacts: large, unintended, misunderstood and costly distortions of investment decisions — unrelated to any social goals

• Distract attention from big investment issues

7070

Why tax incentives continue

• Rent seeking

• Costs are hidden and not well understood

• They are easy

• Institutional imperatives, public and private

• Keeping up with the neighbors

7171

Some lessons

• Tax incentives not critical for most investors, but they are happy to receive them

• Understand the costs

• Maintain the integrity of the tax regime—stability, simplicity, low rates, minimal use of exemptions and other special deals

• Deal with the real problems

Arguments for Protection:Infant Industries

7373

The usual request

• The usual argument is that a new industry needs some start-up assistance in order to become competitive against global competition; it is sometimes supported by a further claim that the investment is of “strategic importance” to the country

• In view of this, “temporary” tariff or other import protection is required

7474

The issues

• If assistance is required and justified, is import protection the best way to give it?

• Almost all investments face negative cash flow in early years and this must be weighed against future profits in determining whether to proceed; why should private costs be publicly subsidized to generate future private profits? How to choose?

• Subsidizing private costs encourages wasteful investments (if they could not succeed otherwise) or makes unnecessary transfers (if they would have succeeded anyway)

7575

The facts

• Governments are poor at “picking winners”; and investors are skilled at extracting rents

• Infant industries often become perpetual children and impose long term costs on domestic consumers, downstream users and taxpayers; others fail, before or after the end of protection; and others make huge excess profits from unnecessary protection and domestic monopolies

• Examples: motor industry in SA; pasta in Namibia; steel and plastics in South Africa; domestic airlines, telecommunications and other “service” industries through the region

7676

What to do?

• If the problem is weak capital markets and inability to borrow against future profits, improve the capital markets (often themselves a result of infant industry protection and poor regulation); look for capital market solutions and not protection

• If the problem is a weak investment environment, begin to repair it; don’t make it worse by inviting rent seeking and engaging in costly and arbitrary protection

• If the problem is too much rent seeking, stop encouraging it

Arguments for Protection:Declining Industries

7878

The usual argument

• Industries, or at least some firms in them that are having difficulties with global competition, especially during or after trade liberalization, plead that they need temporary assistance to enable them to adjust, become competitive and save jobs

• They request “temporary” tariff or other import protection

7979

The issues

• The purpose of trade liberalization is to promote adjustment and create an environment where firms can compete; if firms could not become competitive after years of protection, why would they be able do so with additional “temporary” protection?

8080

The issues (cont’d)

• Protection to preserve non-competitive firms or industries is not in the interests of the workers or the poor

– The immediate employment implications are often exaggerated

– It impedes growth and hence poverty reduction

– It hurts consumers and prevents the development of more and better job opportunities elsewhere (e.g. protected vs unprotected firms in Indonesia; appliances in Mauritius and South Africa)

8181

What to do?

• Direct assistance to vulnerable workers (even generous lifetime pensions) is more effective and far less costly than continued protection; protection is a very costly form of adjustment assistance; use trade policy to promote growth and not to prevent it

– Examples: global textiles and garments; SA motor industry; costs per job elsewhere

Arguments for Protection:Dumping

8383

The usual argument

• The most commonly used argument for protection is that foreign sellers are “dumping” their products in the local market at unusually low prices, making it impossible for domestic producers to compete

8484

What the petitioners mean

• In a very large number of cases they mean simply that they cannot compete at prevailing world market prices—the foreigners’ prices are less than domestic costs

• In some cases the petitioners argue that foreigners are selling at a price less than their own costs

• In many cases they argue as well that the domestic producer(s) will be driven out of business, leaving the domestic market at the mercy of foreign monopolists, with no countervailing local competition

8585

The economics of dumping

• If foreign suppliers can sell at less than prevailing local prices, it is in the country’s interest to import from them; this is the basis for the gains from trade

• The only economic justification for interfering with this process is if there is “predatory dumping”, in which a foreign supplier is willing to incur short term losses in order to wipe out competition and enjoy subsequent monopoly profits, at the expense of local consumers and users

8686

The likelihood of predation

• For predatory dumping to occur the foreign supplier would have to believe that no future foreign or domestic competition would arise when they started to charge monopoly prices in the local market

• There are few, if any goods or markets in which this would be the case, unless the domestic authorities cooperated with them by protecting them from foreign and domestic competition

• The best defence against predatory dumping is an open trade and regulatory regime

8787

What to do about dumping?

• Keep markets open to competition

• In considering dumping claims, consider the interests of domestic users and consumers of “dumped” products (WTP rules do not require this)

Discussion:Implications for Mozambique?

Some related papers—www.frankflatters.com