The Hindu Business Line : Reforms and importance of trade liberalisation

Higher growth and welfare on a sustained basis demands a lot more than just correcting a bad trade regime. Since the enabling environment includes establishing the climate for foreign capital inflow, hard work and foreign capital can bring gains in the first phase of economic growth. Subsequently, innovation will have to drive the growth process, says Bhanoji Rao.

IN THE wake of the Budget slashing the peak import duty to 15 per cent on non-agricultural products, it is useful to recapitulate and review what two trade and growth pundits said in 1992, the year reforms were started in right earnest.

An early 1992 issue of the Journal of Economic Perspectives (JEP), a relatively more reader-friendly journal of the American Economic Association, carried two articles on trade policy reform in the developing countries. One was by Rudiger Dornbusch from the Economics department at MIT, who passed away in 2002. Students of economics know him by his popular text on macro, which he co-authored with Stanley Fischer. In the JEP, Dornbusch wrote on The case for trade liberalisation in developing countries (JEP, 6-1, 1992).

The other article was by Harvard professor Dani Rodrik, a well-known economist, with an excellent understanding of the growth processes and theories. He wrote on The limits of trade policy reform in developing countries (JEP, 6-1, 1992).

Dornbusch, in his article, recounted the then on-going processes that favoured free trade such as poor economic performance of inward-looking nations and gives evidence of the success of outward-looking strategies.

He then discusses the benefits of trade liberalisation to developing countries. He mentions improved resource allocation, more choices for consumers and producers, emergence of relatively more rational market structures, transfer of technology and various other dynamic benefits.

The article referred to three cases — Turkey, Korea and Mexico. While Turkey experienced strong growth in the 1960s and the 1970s, its dependence on borrowing led to a debt crisis, leaving it with no option in the early 1980s but to go in for economic reforms that included liberalisation of the trade and exchange rate regimes.

Korean reforms occurred steadily in the 1970s. It used a selective liberalisation strategy, which helped it to develop its manufacturing sector. Mexico had a protectionist regime until 1985, but then it opened up and joined Nafta in 1994. In all the three countries, according to Dornbusch, trade liberalisation was part of a wider strategy of achieving stability and efficient resource allocation.

"Just as developing countries embraced protectionist policies in the 1950s and 1960s as a holistic solution to the problems of development, there is now a danger that free trade will be seen as the answer to the economic crisis of the 1980s," observed Dani Rodrik in his The Limits of Trade Policy Reform in Developing Countries.

He acknowledges, however, that the disappointment in import substitution and the interest in trade reform appear genuine.

Since the 1980s, trade liberalisation has taken three important dimensions: Simplification of import procedures, reduction or elimination of quotas, and rationalisation of the tariff structure.

Rodrik addresses three important issues — sustainability of trade reform, compatibility and conflict between trade reform and macroeconomic instability, and trade reform and imperfectly competitive market environments.

Sustainability is a problem if the reforms lack credibility.

That is, if they are launched at such times when the nation is facing trade deterioration, dwindling foreign capital inflows, capital flight, high inflation, zero or negative economic growth, low reserves and last but not least, the need to abide by conditions of the International Monetary Fund and the World Bank.

India has been somewhat lucky. It has had no major anti-reform backlash.

It is widely believed that there was general consensus on the need for reform, though not so on its pace and expected outcomes.

To some extent, our policy of `one step forward and two backward' has served us well except that no one seems to care about the outcome; instead, the left is happy simply to oppose rather than doing the homework on outcomes and the necessary corrections.

As for compatibility of trade reform and macroeconomic stability, while a flexible exchange rate and the removal of tariff and non-tariff barriers will favour imports and exports, that is, the trade volume, they do not guarantee a favourable or neutral trade balance, which is what counts for macro stability in the short run.

Finally, there are problems with trade reform under imperfect market conditions.

If domestic imperfections (erstwhile protected monopolies, for instance) were to ensure relatively high prices compared to imports, there will be a surge in imports in the sector concerned.

The very same imperfections could stand in the way of realisation of scale economies and technical efficiency.

The conclusion from Rodrik's analysis is that trade policy helps in undoing past follies; yet, it does not guarantee future success.

This asymmetry is because while a bad trade regime could drive a country to economic ruin, a good trade policy cannot make a poor country rich.

At this point it is worth looking at the performance record of the Dornbusch countries — Korea, Mexico and Turkey. For these economies, the Table shows growth rates of the Gross Domestic Product (GDP) for four decades.

The evidence supports the view that growth picks up in the decade of reforms or the one following, but there is no guarantee that the tempo will continue. As Rodrik hints in his article, trade policy provides an enabling environment for high growth; the choices in India today and the consumerism unleashed by reforms stands testimony to what has been gained. Yet, enabling environment need not mean getting higher growth and welfare on a sustained basis.

It requires a lot more than just correcting a bad trade regime. Since the enabling environment includes establishing the climate for foreign capital inflow, hard work and foreign capital can bring gains in the first phase of economic growth.

Going by the example of China, that phase could last a lot longer than a decade or even two, that is, as long as the regime can inspire its people to continue working hard.

Subsequently, however, innovation will have to drive the growth process. While both phases require extraordinary investments in human capital, let it not be said that substitutes can be found for hard work.

It is important to keep reminding people that there is no substitute for hard work, if all the economic reforms are to bear fruit.

Speeches and proclamations will not give that dream growth rate of 8 per cent on a sustained basis. It is also not that we need revolutionary labour reforms.

What we need is to create an environment that encourages and rewards hard work. It also calls for punishing the free rider with no rewards and no free lunches.

(The author, formerly with the National University of Singapore and the World Bank, is professor emeritus, GITAM Institute of Foreign Trade, Visakhapatnam. Feedback may be sent to e-mail to bhanoji@vsnl.net)

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