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Foreign trade regimes and economic development: Liberalization attempts and consequences
Journal of Development
Economics 6 (1979) 447-458. 0 North-Holland
Publishing Company
Jagdish N. Bhagwati, Foreign Trade Regimes and Economic Development: Anatomy and Consequences of Exchange Control Regiqes, National Bureau of Economic R zsearch (Ballinger Publishing Company, Cambridge, MA, 1978) pp. xix + 2.32. Anne 0. Krueger, Foreign Trade Regimes and Economic Development: Liberalization Attempts and Consequences, National Bureau of Economic Research (Ballinger Publishing Company, Cambridge, MA, 1978) pp. xxi :- 310. The two volumes by Professors Bhagwati and Krueger concf;rde the laige NBER research project on Foreign Trade Regimes and Economic Development. J:tgdish Bhagwati’s Anaromy and Consequences of Exchange ControI Regim FS and Anne Krueger’s Liberalization Attempts and Consequences reilect not only an overview of the nine country studks (Chile, Colombia, Egypt, Ghana, India, Israel, the Philippines, South Korea and Turkey) but alscs a synthesis of the theoretical and empirical lessons derived from the project as a whole. The two volumes are complementary. There is some overlap but there are basic differences in :style, emphasis and content. Bhagwati’s study is, in his cwn words, a ‘manual’. It provides a very convenient and comprehensive survey of hypotheses and techniques of analysis regarding interventionist trade regimes. The second ;~nd fourth chapters on the Anatomy of Exchange Control Regimes and Illegal Transactions also include a great deal of institutional de&i1 that is bound to leave many readers somewhat amazed at the multitude arid complexity of policy interventions and regulations that have characterizt:d exchange control regimes. The basic motel underlying Bhagwati’s analysis is the two tradable sectors model of trade theory, and the study is close in spirit to the theoretical literature cv trauie and domestic distortions associated with his name. After surveying iire static and dynamic effects of alternative trade strategies in Chapters 5 to 7, Bhagwati concludes in Chdpter 8 that the weight of evidence emerging from the country studies as well as thl theoretical insights gained by manipulating resource allocation models favor export promotion over import substituti,on as the more desirable trade strategy. Export promotion is c.ef’lned, however, somewhat paradoxically, as a neutral strategy that equal&es effective exchange rates for exports and imports. It is not really clear f -om the conclu..sion whether a unified effective exchange rate is recommended to the industrial sector or to the.economy as a whole. Assuming the
latter to be the case, Bhagwati’s conclusion i!- simply a recommendation of free trade. Neither dynamic considerations r or second-best considerations based on static domestic distortions come across as important enough to invalidate the neoclassical position. Bhagwati does, however, qualify his conclusion in the very last paragraph by referring to the possible growth of OECD protectionism and argues that relatively neutral across-the-board tariffs are a better policy than exchange rate overvaluation and quantity rationing to achieve ‘the import substitution that may be required by an unfavorable external environment’. This is a view held by many but it is not free from ambiguities. It is true that a shift in external demand caused by increased protectionism abroad will normally lead to a new equilibrium characterized by more prodIction of importables. But this will happen without the necessity of policy intervention through a shift in the terms of trade facing a smail country and through an exchange rate adjustment in a model tha,t distinguishes tradables from non-tradables. Thus, wiy.hout bringing in terms-of-trade considerations and/or \ arious rigidities and imperfect foresight, increased OECD protectionism does not constitute an argument for abandoning a neutral trade policy. If? on the other hand, terms-of-trade considerations and imperfect foresight are important, they probably are important independently of increased protectionism and a neutral trade policy may not ;X optimal after all. I suspect that part of the problem arises from the distinction that must be made between what is ,?ptimal for a single developing country and what is optimal for the developing countries as a whole. This distinction may be implicit in Bhagwati’s conclusion. The emphasis in Anne Krueger’s booh is on analyzing liberalization attempts and, in particular, devaluation. Krueger w6rks with the ‘Australian’ model where the real exchange rate is the relative price of tradables in terms of non-tradable home goods. But Krueger notes at the outset that a twosector (tradables, non-tradables) model does not suflice for an analysis of devaluation under exchange control. Contrary 10 traditional analysis, import substitutes and exportables will not be affected in a similar way if the predeva. Aation situation is characterized by massive import rationing. Where quantity rationing has led to substantial premia that must be paid by the users of imports over and above the c.i.f. + tariff price, 3 devaluation will raise export prices and c.i.f.-t tariff import prices. But unless it more than absorbs import premia, it will not raise the actual user price of imports. A devaluation, therefore, leads sot only to a change in the relative price of nontradable home goods but it also leads, even with fixer: international terms of trade, to changes in the relative domestic prices 0; tra-lables. I is important to realize that this implies that import substituting sectors may be adcevsel) affected by a devaluation. The resource pulls generated will favor exportables and will tend to lead to a contraction of non-tradables production. The effect
450
Book Reviews
of devaluation on import-substituting sectors that constitute the bulk of modern industry in most of the countries studied is ambiguous. The more stringent the predevaluation rationing and the more responsive foreign exchange earnings are to devaluation, the more likely it is that resource pulls will negatively affect import substituting industry. A point that does not receive sufficient attention in the Krueger study relates to the clistinctior between intermediate imports and final imports. The expansion of foreign exchange earnings that may follow a devaluation - an expansion in exports as well as foreign resource transfers - may, as stressed by Krueger, lead to al increase in imports and to a decline in the price of domestic import substitutes. In a multi-sector model this decline in gross prices may, however, l&l to either a decline or a rise in net prices (value-added ratios) ozgendiilg on whether or not the decline in input prices in any particular sector more than offsets the decline in output prices. All this establi,;hes beyond doubt that exchange rate changes can have major microeconomic allocation effects, a fact somewhat obscured by the recent “monetarist’ emphasis on the absorption approach and the exchange rate as a ‘monet:ary phenomenon’. Exchange rate adjustment is a purely macroeconomic tiair only in a small open economy model where all goods are tradable. Already in the ‘Australian’ model distinguishing tradables and non-tradables, an exchange rate adjustment implies a real relative-price adjustment. When there is import rationing, on.e must add real relative price changes within the tradable sector, In Chapter 7, Krueger turns to the macroeconomic aspects of devaluation and liberalization policies. Macroeconomic effects may prevent a nominal devaluation from translating itself into1 a real devaluation. If home good prices rise by an amount equal to the exchange rate adjustment, the real exchange rate will1nor change. Table 3-3 in Chapter 5 demonstrates that it is not ‘easy’ to devalu ate the real exchange rate. Krueger notes that out of the 22 devaluation experiences studied, there are ‘only three genuine exceptions to the notion that, at a fixed exchange rate, the real exchange rate ;b quickly eroded if devaluation is to a new, fixed parity’. On the other hand, Krueger stresses quite correctly that, other things being equal, a devaluation from a situation of excha.nge control particularly in a country where imports exceed exports, is itself deflationary. Premium absorption and the increase in net government revenlue due to increased tariff revenues will absorb purchasing power. Furthermore, it is likely that the trade deficit will irwreuse in domestic currency even thcugh it may decrease in foreign currency. Contrary to the cas’e of a country with balanced trade and no import rationing where devaluation can only be temporary a:ld induces inflationary pressure that socn restores the initial real exchange rate, there are no inherent macromonetary mechanisms that restore an exchange rate that never was an equilibrium rate to start with! But while there may be no automatic
Book Reviews
451
monetary or competitive market forces that counteract a devaluation in a setting of exchange control, there may be important social., political dnd market power forces that will attempt to restore disequilibriunl. The inability to achieve a real devaluation may be much more an inability to change the distribution of income linked to a particular structure of relal.ive prices than an automatic perverse response of the macroeconomic mechanism.’ While Krueger rightly stresses, perhaps at the cost of some repetition, that an analysis of devaluation under exchange control must differ from the fashionable monetarist reasoning, income distribution and political economy considerations may deserve more weight than she accords them. A discrete change in the exchange rate may be the sigr.al for monopolistic price and wage increases and added rounds of price and wage inflation I hat exacerbate the struggle for relative shares. It is not very helpful to insist t’hat this cannot happen with a fixed money supply and Krueger stays away from such truisms. The problem is precisely that the inflationary process cannot be controlled. Krueger’s nosition is that a country should not compound the difficulties by adding’ massive foreign exchange imbalance; to domestic inflation and advoca+:s a floating exchange rate that ‘can permit successful liberalization even iI_“ca.ses where inflation rates do not dir to the world rate’ (p. 121). I tend to agree. Nevertheless, the counter-argument that a floating rate will make inflation control more difficult cannot simply be dismissed. Much would seem to depend on the particular circumstances, the nature of the inflationary process, the role of expectations, the magnitude of the foreign exchange imbalance and the nature of the political process in the country concerned. A great deal of analysis and insight is contained in these two volumes. They also constitute extremely enjoyable reading. The basic dificulty t’aced by all who work on the applied and historical study of trade and development relates to the tensicin that exists between the elegant and ‘pure’ models of trade theory and the complexities, aggregation problems ar,d institut:lonal arrangements that characterize the reality of developing economies. The NBER project led by Professors Bhagwati and Krueger constitute!; an important milestone in the difftcult attempt to bridge this gap But with many questions ranging from long-run issues of scale economies, .u-efficiency and technical progress to short-run issues of transition policy and ‘[MF economics remaining qtiite open, particularly with regard to the quantitative significance of the various mechanisms recognized by theory, the field will rcaain a fertile ground for policy debate and applied economic analysis. Kemal Dervis
The World Bank and Princeton University ‘For arguments along the=< lines se:, fnr example, M. Diamond, 1978, “Toward a change in the economic paradigm through the experience of developing countries”. this journal, March.
Economics 6 (1979) 447-458. 0 North-Holland
Publishing Company
Jagdish N. Bhagwati, Foreign Trade Regimes and Economic Development: Anatomy and Consequences of Exchange Control Regiqes, National Bureau of Economic R zsearch (Ballinger Publishing Company, Cambridge, MA, 1978) pp. xix + 2.32. Anne 0. Krueger, Foreign Trade Regimes and Economic Development: Liberalization Attempts and Consequences, National Bureau of Economic Research (Ballinger Publishing Company, Cambridge, MA, 1978) pp. xxi :- 310. The two volumes by Professors Bhagwati and Krueger concf;rde the laige NBER research project on Foreign Trade Regimes and Economic Development. J:tgdish Bhagwati’s Anaromy and Consequences of Exchange ControI Regim FS and Anne Krueger’s Liberalization Attempts and Consequences reilect not only an overview of the nine country studks (Chile, Colombia, Egypt, Ghana, India, Israel, the Philippines, South Korea and Turkey) but alscs a synthesis of the theoretical and empirical lessons derived from the project as a whole. The two volumes are complementary. There is some overlap but there are basic differences in :style, emphasis and content. Bhagwati’s study is, in his cwn words, a ‘manual’. It provides a very convenient and comprehensive survey of hypotheses and techniques of analysis regarding interventionist trade regimes. The second ;~nd fourth chapters on the Anatomy of Exchange Control Regimes and Illegal Transactions also include a great deal of institutional de&i1 that is bound to leave many readers somewhat amazed at the multitude arid complexity of policy interventions and regulations that have characterizt:d exchange control regimes. The basic motel underlying Bhagwati’s analysis is the two tradable sectors model of trade theory, and the study is close in spirit to the theoretical literature cv trauie and domestic distortions associated with his name. After surveying iire static and dynamic effects of alternative trade strategies in Chapters 5 to 7, Bhagwati concludes in Chdpter 8 that the weight of evidence emerging from the country studies as well as thl theoretical insights gained by manipulating resource allocation models favor export promotion over import substituti,on as the more desirable trade strategy. Export promotion is c.ef’lned, however, somewhat paradoxically, as a neutral strategy that equal&es effective exchange rates for exports and imports. It is not really clear f -om the conclu..sion whether a unified effective exchange rate is recommended to the industrial sector or to the.economy as a whole. Assuming the
latter to be the case, Bhagwati’s conclusion i!- simply a recommendation of free trade. Neither dynamic considerations r or second-best considerations based on static domestic distortions come across as important enough to invalidate the neoclassical position. Bhagwati does, however, qualify his conclusion in the very last paragraph by referring to the possible growth of OECD protectionism and argues that relatively neutral across-the-board tariffs are a better policy than exchange rate overvaluation and quantity rationing to achieve ‘the import substitution that may be required by an unfavorable external environment’. This is a view held by many but it is not free from ambiguities. It is true that a shift in external demand caused by increased protectionism abroad will normally lead to a new equilibrium characterized by more prodIction of importables. But this will happen without the necessity of policy intervention through a shift in the terms of trade facing a smail country and through an exchange rate adjustment in a model tha,t distinguishes tradables from non-tradables. Thus, wiy.hout bringing in terms-of-trade considerations and/or \ arious rigidities and imperfect foresight, increased OECD protectionism does not constitute an argument for abandoning a neutral trade policy. If? on the other hand, terms-of-trade considerations and imperfect foresight are important, they probably are important independently of increased protectionism and a neutral trade policy may not ;X optimal after all. I suspect that part of the problem arises from the distinction that must be made between what is ,?ptimal for a single developing country and what is optimal for the developing countries as a whole. This distinction may be implicit in Bhagwati’s conclusion. The emphasis in Anne Krueger’s booh is on analyzing liberalization attempts and, in particular, devaluation. Krueger w6rks with the ‘Australian’ model where the real exchange rate is the relative price of tradables in terms of non-tradable home goods. But Krueger notes at the outset that a twosector (tradables, non-tradables) model does not suflice for an analysis of devaluation under exchange control. Contrary 10 traditional analysis, import substitutes and exportables will not be affected in a similar way if the predeva. Aation situation is characterized by massive import rationing. Where quantity rationing has led to substantial premia that must be paid by the users of imports over and above the c.i.f. + tariff price, 3 devaluation will raise export prices and c.i.f.-t tariff import prices. But unless it more than absorbs import premia, it will not raise the actual user price of imports. A devaluation, therefore, leads sot only to a change in the relative price of nontradable home goods but it also leads, even with fixer: international terms of trade, to changes in the relative domestic prices 0; tra-lables. I is important to realize that this implies that import substituting sectors may be adcevsel) affected by a devaluation. The resource pulls generated will favor exportables and will tend to lead to a contraction of non-tradables production. The effect
450
Book Reviews
of devaluation on import-substituting sectors that constitute the bulk of modern industry in most of the countries studied is ambiguous. The more stringent the predevaluation rationing and the more responsive foreign exchange earnings are to devaluation, the more likely it is that resource pulls will negatively affect import substituting industry. A point that does not receive sufficient attention in the Krueger study relates to the clistinctior between intermediate imports and final imports. The expansion of foreign exchange earnings that may follow a devaluation - an expansion in exports as well as foreign resource transfers - may, as stressed by Krueger, lead to al increase in imports and to a decline in the price of domestic import substitutes. In a multi-sector model this decline in gross prices may, however, l&l to either a decline or a rise in net prices (value-added ratios) ozgendiilg on whether or not the decline in input prices in any particular sector more than offsets the decline in output prices. All this establi,;hes beyond doubt that exchange rate changes can have major microeconomic allocation effects, a fact somewhat obscured by the recent “monetarist’ emphasis on the absorption approach and the exchange rate as a ‘monet:ary phenomenon’. Exchange rate adjustment is a purely macroeconomic tiair only in a small open economy model where all goods are tradable. Already in the ‘Australian’ model distinguishing tradables and non-tradables, an exchange rate adjustment implies a real relative-price adjustment. When there is import rationing, on.e must add real relative price changes within the tradable sector, In Chapter 7, Krueger turns to the macroeconomic aspects of devaluation and liberalization policies. Macroeconomic effects may prevent a nominal devaluation from translating itself into1 a real devaluation. If home good prices rise by an amount equal to the exchange rate adjustment, the real exchange rate will1nor change. Table 3-3 in Chapter 5 demonstrates that it is not ‘easy’ to devalu ate the real exchange rate. Krueger notes that out of the 22 devaluation experiences studied, there are ‘only three genuine exceptions to the notion that, at a fixed exchange rate, the real exchange rate ;b quickly eroded if devaluation is to a new, fixed parity’. On the other hand, Krueger stresses quite correctly that, other things being equal, a devaluation from a situation of excha.nge control particularly in a country where imports exceed exports, is itself deflationary. Premium absorption and the increase in net government revenlue due to increased tariff revenues will absorb purchasing power. Furthermore, it is likely that the trade deficit will irwreuse in domestic currency even thcugh it may decrease in foreign currency. Contrary to the cas’e of a country with balanced trade and no import rationing where devaluation can only be temporary a:ld induces inflationary pressure that socn restores the initial real exchange rate, there are no inherent macromonetary mechanisms that restore an exchange rate that never was an equilibrium rate to start with! But while there may be no automatic
Book Reviews
451
monetary or competitive market forces that counteract a devaluation in a setting of exchange control, there may be important social., political dnd market power forces that will attempt to restore disequilibriunl. The inability to achieve a real devaluation may be much more an inability to change the distribution of income linked to a particular structure of relal.ive prices than an automatic perverse response of the macroeconomic mechanism.’ While Krueger rightly stresses, perhaps at the cost of some repetition, that an analysis of devaluation under exchange control must differ from the fashionable monetarist reasoning, income distribution and political economy considerations may deserve more weight than she accords them. A discrete change in the exchange rate may be the sigr.al for monopolistic price and wage increases and added rounds of price and wage inflation I hat exacerbate the struggle for relative shares. It is not very helpful to insist t’hat this cannot happen with a fixed money supply and Krueger stays away from such truisms. The problem is precisely that the inflationary process cannot be controlled. Krueger’s nosition is that a country should not compound the difficulties by adding’ massive foreign exchange imbalance; to domestic inflation and advoca+:s a floating exchange rate that ‘can permit successful liberalization even iI_“ca.ses where inflation rates do not dir to the world rate’ (p. 121). I tend to agree. Nevertheless, the counter-argument that a floating rate will make inflation control more difficult cannot simply be dismissed. Much would seem to depend on the particular circumstances, the nature of the inflationary process, the role of expectations, the magnitude of the foreign exchange imbalance and the nature of the political process in the country concerned. A great deal of analysis and insight is contained in these two volumes. They also constitute extremely enjoyable reading. The basic dificulty t’aced by all who work on the applied and historical study of trade and development relates to the tensicin that exists between the elegant and ‘pure’ models of trade theory and the complexities, aggregation problems ar,d institut:lonal arrangements that characterize the reality of developing economies. The NBER project led by Professors Bhagwati and Krueger constitute!; an important milestone in the difftcult attempt to bridge this gap But with many questions ranging from long-run issues of scale economies, .u-efficiency and technical progress to short-run issues of transition policy and ‘[MF economics remaining qtiite open, particularly with regard to the quantitative significance of the various mechanisms recognized by theory, the field will rcaain a fertile ground for policy debate and applied economic analysis. Kemal Dervis
The World Bank and Princeton University ‘For arguments along the=< lines se:, fnr example, M. Diamond, 1978, “Toward a change in the economic paradigm through the experience of developing countries”. this journal, March.