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The Challenges of Trade Liberalisation for Late Industrialisers

Written by Siyaduma Biniza 1

The issue of the impact of trade to economic growth and development is highly contested. Although there is some agreement that under very specific conditions, trade liberalisation can lead to growth there is little consensus regarding those conditions and the empirical evidence is inconclusive. Therefore the relation is still an empirical issue and some argue that the inconclusiveness of empirical evidence results from ineffective liberalisation or the methodological and theoretical problems of the comparative advantage theory that underpins trade liberalisation. However, besides the concerns about the viability of growth from free trade, I am concerned with the impact of trade liberalisation on the industrialisation of late industrialising countries. Here the main debates are whether trade liberalisation on itself will lead to industrial growth; or the extent to which trade liberalisation leads to competitiveness pressures that result in increased industrial productivity and growth; or whether trade liberalisation and specialisation would allow for industrialisation. In this essay, I argue that the global movement towards trade liberalisation can make it more difficult for late industrialising countries to develop their industrial sector because there are export-commodity-specific and structural socioeconomic constraints that undermine their industrialisation and that these constraints are overlooked by the global movement towards trade liberalisation; and because trade policy is insufficient as industrial policy, as illustrated through a case study of South Africa, late industrialising countries need a strong industrial policy that is coherently supported by trade policy. Lastly, and most importantly the question of trade liberalisation should be approached as a question of the degree of liberalisation and within which sectors, instead of the blind pursuit of free trade.

Siyaduma Biniza is currently an M.Com. in Development Theory and Policy student at the University of the Witwatersrand, holding a B.Com (Hon.) in Development Theory and Policy with Cum Laude and B.Soc.Sci in Politics, Philosophy and Economics from the University of Cape Town.

Firstly I consider the theoretical justifications for the global movement towards trade liberalisation. Then I consider the empirical evidence in relation to the theory before discussing the export-commodity-specific and structural socioeconomic challenges to the theoretical mechanisms. Lastly I conclude the analysis with a case study of South Africa before making final remarks regarding the question about the impact of trade liberalisation on industrialisation. Theoretical Justifications The view that free trade is the most efficient way for international trade to proceed is justified by the theory of comparative advantage. In my analysis of theoretical justification for trade liberalisation I use comparative advantage theory interchangeably with factor endowment theory even though these are distinct theories. This is because, despite their unique theoretical content, both the classical and new comparative advantage theories use the same logical mechanisms and arrive at the same conclusion which is to promote trade liberalisation. Both theories assert that all countries stand to gain from free trade if they specialise according to their comparative advantage because all countries have comparative advantage due to the opportunity costs and unique relative factor-intensity of producing various commodities traded amongst countries (Leamer, 1995; Schumacher, 2013; Deardorff, 1998). The comparative advantage principle and mechanisms of the gains from specialisation and free trade are illustrated in the example below. For simplicity, assume that the relevant factors to producing cars and maize are capital and labour, and that South Africa and a foreign country have the following endowments of these factors:
Table 1: Factor Endowments

South Africa Foreign Country Capital Labour Capital / Labour 10 4 3/4 10 25 2/5

South Africa has a higher ratio of capital relative to labour than the foreign. This means that South Africa has a comparative advantage in the production of commodities that are more capital-intensive because it has a higher capital-labour ratio. Therefore the principle is that countries have a comparative advantage in the production of commodities that use their relatively more abundant factor (Leamer, 1995). The comparative advantage in capital-intensive production implies that South Africa should import commodities that are labour-intensive. Practically, assuming that car production is more capital-intensive than maize production, South Africa should specialise in producing car and import maize from the foreign country. Conversely the foreign county should specialise in maize production and import cars from South Africa. Furthermore, this analysis means that even if a country is at an absolute disadvantage in its endowments it can have a comparative advantage due to the unique relative factor-intensity and the opportunity costs of producing cars and maize. For instance, if we continue with the example of trading in cars and maize, South Africa would have a comparative advantage over a foreign country even if South Africa has an absolute cost disadvantage in producing either of these commodities. This is because the countries have different opportunity cost of producing these commodities which allows for comparative advantage (Schumacher, 2013). For example, assume South African and the foreign countrys costs of producing cars and maize are given by:
Table 2: Cost of Production

South Africa Foreign Country Cost of Producing 3 Cars Cost of Producing 100 kg of Maize 5 10 3 1

From this we can see that it is absolutely more costly to produce either of the goods in South Africa, but the opportunity cost of producing 3 cars in South Africa

is 50 kg of maize since that is the amount of maize that could have been produced using the same resources otherwise. Similarly the opportunity cost of 3 cars is 300 kg of maize in the foreign country. Therefore South Africa has a comparative advantage in producing cars because it has lower opportunity costs related to specialising in the production of cars as opposed to maize; conversely the foreign country has a comparative advantage in producing maize because the opportunity cost of producing 100kg of maize is one car in the foreign country in comparison to 6 cars in South Africa. The lesson to be learned from this illustrative example is that even if countries are at an absolute disadvantage they can still gain from specialisation Consequently, and free trade because of theory their comparative that it advantage. would be comparative advantage asserts

advantageous for all countries to specialise according to their comparative advantage and trade freely (Schumacher, 2013). Therefore the relative factor intensity and opportunity costs of production leads gain if that occurs. If there is free trade between the countries in the example above, and each specialised according to their comparative advantage, the overall output would be higher than the in autarkic state. The autarkic state is when countries are isolated and do not trade with any other countries, i.e. the very opposite of free trade. In the example above, there can only be a total 200 kg of maize and 6 cars produced under autarky if each country produces both commodities. But if each country specialised according to its comparative advantage South Africa would produce cars and the foreign country would produce maize; and there would be a total of 9 cars and 400 kg of maize. In addition to higher output, free trade and specialisation would lead to higher consumption than the autarkic state because under autarky each country would have 100kg and 3 cars. However, with free trade and specialisation the countries would trade commodities and possible have a higher share of each commodity for its consumers. So each country would gain in that its consumer would have higher consumption and there would be a higher total output than under autarky. These are the two main gains from free trade according to the comparative advantage theory. to comparative advantage incentivising specialisation and trade liberalisation because all countries stands to

The analysis is that specialisation and free trade will lead to higher output and consumption. Free trade is asserted as the best end that countries trade policies should pursue. This is what justifies the global movement towards trade liberalisation. However the theory of comparative advantage is underpinned by the dubious assumption that there are constant returns to specialisation. The implicit assumption of constant returns to specialisation is dubious because the assumption of constant returns to scale is conflated with constant returns to free trade after specialisation. Comparative theory also implies that free trade is beneficial regardless of a countrys export commodities and the demand for the exports. Thus trade liberalisation is asserted as being beneficial to all countries regardless of their degree of industrialisation or development. This exposes some theoretical challenges, which I will briefly discuss; in addition these assumptions and implications I argue that the theory comparative advantage overlooks some key export-commodity-specific and structural socioeconomic factors that influence the possible gains from free trade. Theoretical Challenges The theoretical grounds for promoting trade liberalisation, or free trade, are not empirically sound. But first its important to differentiate between free trade, which is the ideal, and trade liberalisation which is the mechanism by which countries pursue free trade. Free trade is not empirically observed due to even miniscule transaction and transport costs related to international trade. Therefore in many studies that seek to explain the relationship between trade and growth there are various problems with testing the impact of free trade due to the challenge of operationalising variables to measure how free trade is in a country (Rodriguez & Rodrik, 2000). Despite this, trade liberalisation consists of various policy measures that promote the pre-eminence of market mechanisms such as price, demand and supply in determining trade; examples include the reduction in tariffs and quotas which are seen as distortionary to trade and inimical to marketmechanistic determined trade (Rodriguez & Rodrik, 2000). Therefore, although the empirical evidence cannot say anything about free trade per se since free trade is unobserved, the empirical evidence does not conclusively justify supporting trade liberalisation either. Because the evidence is in itself

questionable due to the operationalisation of variables and even when we accept the validity of evidence there is contradictory evidence that either supports or undermines the theoretical mechanisms described above (Rodriguez & Rodrik, 2000). Nevertheless, I argue that even if we accept the theory of comparative advantage there are still deficiencies in the global movement towards trade liberalisation because it cannot account for export-commodity-specific and structural socioeconomic factors that determine the gains from trade. So, contrary to what the theory implies, trade liberalisation and specialisation does not always just lead to high output and consumption that benefits all; and free trade can be inimical to growth and industrial development. Export-commodity-specific and Structural Socioeconomic Factors of Trade The global movement towards trade liberalisation overlooks export-commodityspecific and structural socioeconomic factors such as deteriorating terms of trade, which can be intuitively understood by comparing the price of cars and maize to reasonably justify the idea that one country needs to trade a lot of maize order to import cars; and the fact that when peoples incomes change they do not continue demanding goods the same way. Therefore cars and maize are very different commodities and they are demanded differently which is unaccounted for by the assumptions of constant returns to scale and specialisation. Structural theory and dependency theory approaches to development emphasise the importance of structural conditions and processes which undermine development of late industrialising countries and perpetuate unequal development (Ake, 1981; Hunt, 1989). Some of the structural conditions that lead to underdevelopment can be the deteriorating terms of trade for underdeveloped countries exports, preferential trade agreements or even characteristics of the domestic economy (Todaro, 1996). This is to say that there are export-commodityspecific and structural socioeconomic factors that are not accounted for by the global movement towards trade liberalisation, which impact on the prospects of industrialisation, growth and development from trade. From this perspective late industrialising countries who export predominantly low value-add primary commodities to industrialised countries; whilst industrialised countries produce higher value-add manufactured goods and export these to the

late industrialisers. This causes developmental problems for late industrialising countries because their exports are goods with deteriorating terms of trade, volatile prices and low income elasticity of demand which negatively affects their prospects at industrialisation (Ake, 1981). Deteriorating terms of trade is the situation where the price of late industrialisers exports is decreasing relative to the price of its imports which means that the late industrialisers need to increase the volume of exports in order to balance trade (Todaro, 1996). In addition late industrialising countries export commodities with volatile prices which means that a country could face uncertain foreign exchange earnings from its exports which can affect its balance of trade (Todaro, 1996). This could possibly also lead to sovereign debt or currency crisis if the country persistently cannot balance its trade and payments; or if a country has to repeatedly revalue its currency in order to realise its exports. Lastly, there is sufficient empirical evidence showing that there is a lower income elasticity of demand for primary commodities, which predominantly late industrialising countries have a comparative advantage in (Todaro, 1996). That is to say, as incomes rise in a foreign country, there is diminishingly increased demand for the export commodities from late industrialising countries which has the same negative impact as the other structural conditions due to diminishing export earnings. In other words, late industrialisers may experience diminishing returns to scale and specialisation if they export commodities with deteriorating terms of trade and lower income elasticity of demand; and they will realise diminishing returns to scale and specialisation. Given these key export-commodity-specific and structural socioeconomics factors, late industrialising countries would not experience constant returns to specialisation. Therefore, although specialised free trade can be mutually beneficial in terms of high output and consumption, it is neither equally beneficial nor is it maximally efficient if we consider export-commodity-specific and structural socioeconomic factors which determine the nature of gains from free trade. Thus free trade is not necessarily the best end for poor countries trade policies, as the theories imply.

Moreover, trade liberalisation ensures that the structural and industrial inequality in the global economy is maintained in favour of industrialised countries. Trade liberalisation ensures that late industrialising countries continue needing to increase the volume of their exports and face uncertain foreign exchange earnings whilst facing lower income elasticity of demand and depending on imports with higher income elasticity of demand. Besides, most industrialised economies actually followed a route to industrialisation that was followed by heavy protectionism and in fact some of the causes of great wars were the protection or monopolising of specific trade-related inputs (Chang, 2004). As a result it is very suspicious that most industrialised countries, which are often in control of multilateral financial institutions, which require policies that they themselves did not follow in their route to development. If history is laden with examples of what to do, and what to avoid, late industrialising countries ought not to embark of trade liberalisation with the end goal of free trade. Even if we can accept the theory due to its theoretical validity despite its empirical indeterminacy, the move towards trade liberalisation fails to take commodity-specific and structural contexts that undermine the sufficiency of trade policy as industrial policy. In addition, if we consider the unique factor endowments between countries, each country has a comparative advantage due to its relative factor endowments and the unique factor intensity of producing the traded commodities. That means that global inequalities in factor endowments are a source of comparative advantage which incentivises trade. This is the strongest thrust of the global movement towards trade liberalisation. The argument is that inequalities in factors of production can be compensated through international trade (Leamer, 1995). This is because free trade leads to factor price convergence through price and demand mechanisms according to the theory (Leamer, 1995). As demand for the abundant factor increases due to specialisation, the price of that factor increases and demand for the scarce drops which reduces its price allowing countries to overcome absolute disadvantages of their factor endowments. Therefore free trade will lead to mutual benefit for trading partners with unequal factor endowments because their comparative advantage will lead to high output and consumption under free trade; and there would be a global convergence in factor prices which allows for income convergence in the world (Leamer, 1995). But there

is significant global divergence and growing income inequality even though there is a strong political and ideological push towards trade liberalisation (Deraniyagala & Fine, 2001; Pritchett, 1997). Therefore beyond the theoretical and empirical problems above, trade liberalisation faces problems that undermine it even ideologically. The foregone objections point to the dubious separate treatment of trade and industrial policy in the trade liberalisation discourse (Deraniyagala & Fine, 2001). The discourse of trade and development are dominated by two paradigms, one which views trade policy as sufficient substitute for industrial policy, and another which views trade policy as an instrument of industrial policy. As already mentioned the global movement towards trade liberalisation consists of various policy measures that promote the pre-eminence of market mechanisms such as price, demand and supply in determining trade; examples of which include the reduction in tariffs and quotas which are seen as distortionary to trade and inimical to market-mechanistic determined trade. Often this paradigm is described as promoting export-led growth models by advocating free trade which is meant to expose domestic economies to foreign competition from substitutable imports that are seen as an impetus for domestic firms to improve efficiency and promote industrial growth and development (Rangasamy & Harmse, 2005). In this view trade policy is sufficient as industrial policy and proponents of this view would advocate for minimal state intervention excepting when the state promotes trade and economic liberalisation, i.e. the neoliberal or neoclassical economics type of propositions. However this paradigm is diametrically opposed to the view that trade policy is an instrument of industrial policy. Here trade policy is seen as important in aiding the promotion of certain economic sectors through various coherent tariff regimes that protect infant industries. This approach often advocates for coherence between trade and industrial policy to promote import-substitution industrialisation as a mean of structural economic transformation which is seen is a requirement for development and industrialisation in late industrialising countries (Hunt, 1989). Therefore in this paradigm trade policy on its own is not sufficient and the industrialisation of late industrialising countries requires industrial policy that is

aided by coherent trade policy. In light of this, South African case is a relevant example that shows the insufficiency of trade policy as industrial policy. The Case of South Africa South Africas liberalisation began in the 1970s but really culminated in the strong liberalisation direction in the 1990s. South Africas trade liberalisation w as based on the premise that increased competition from imports would be an impetus for improved efficiency which would result in higher exports from domestic producers of competing goods. Therefore the main thrust behind trade liberalisation was the pursuit of greater manufacturing competitiveness as a means of creating growth and employment (Rangasamy & Harmse, 2005). But this was not achieved.
Table 3: Manufacturing exports: 1990-2000 (% contributions)

Source: (Rangasamy & Harmse, 2005)

Figure 1: Sectoral Growth (real GDP 1990=100)

Source: (Rangasamy & Harmse, 2005)

The table above shows that between the liberalised and moderately protected sectors there was stagnant contribution from technology-intensive production meanwhile technology-intensive production increased for protected sectors. The figure above also show that there has been growth in liberalised sectors (L) which exceeds growth in moderately liberalised (M) and protected (P) sectors. This shows that growth in manufacturing has been closely correlated to liberalisation (Rangasamy & Harmse, 2005). However, although there was higher output, trade liberalisation was unable to increase production of technology-intensive goods which suggests that technology transfer did not result as expected from trade liberalisation (Rangasamy & Harmse, 2005). In addition, although there was an increase in exports during the 1990s, there is no mechanism to prove that these exports were due to trade liberalisation. And although there wasnt significant de -industrialisation in manufacturing sector, output in this sector was specialised in technologically stagnant goods (Rangasamy & Harmse, 2005). Therefore, trade liberalisation did not deliver gains as expected. Therefore trade liberalisation was not a source of competitiveness and industrialisation. Furthermore, trade liberalisation had the impact of restructuring the composition of labour and production in the economy (Edwards & Behar, 2006). The South African governments commitment to trade liberalisation and global competitiveness pressures meant that many domestic firms had to restructure through right-sizing and downsizing which led to large -scale job losses (Satgar, 2012, p. 47). More importantly labour-intensive import-substitution industries suffered the most whilst export-led industries failed to create job due to a shift towards capital-intensity in order to retain competitiveness (Satgar, 2012). This has had dire impacts on South Africa in terms of its employment because the country has an abundance of unskilled labour which would mean its competitiveness is in labour-intensive production. However, trade liberalisation has had a negative impact since South Africa could not maintain its competitiveness in labour-intensive production and instead had to succumb to international pressure and shift towards capital-intensive production to retain competitiveness (Rangasamy & Harmse, 2005). The ability to resist international

competition and promote competitiveness of labour-intensive production requires industrial policy in order to promote the development of sectors involved in labour-intensive production. This case shows the clear insufficiency of trade policy as industrial policy which shows the gap that requires industrial policy and coherent trade policy. Therefore South Africa needed a clear industrial policy which ought to have support by trade policy that could promote labour-intensive production in order to grow its industry. Moreover, even if one does not accept the forgoing import-substitution line of argument, the South African case is a classic example that shows that the issue of trade liberalisation is more about the degree of trade liberalisation than complete free trade. Thus, the South African case like many other late industrialising countries, shows that regardless of the paradigm trade liberalisation should be a case of blind pursuit of free trade. This case shows that there are problems with trade liberalisation that treats trade and industrial policy as separate because in fact the two are intimately connected, and trade policy is insufficient as industrial policy. In conclusion, the global move towards trade liberalisation therefore makes it difficult for late industrialising countries because: firstly it is underpinned by shaky theoretical grounds, secondly the paradigm ignores the impact of commodityspecific and structural socioeconomic factors that are related to what a country exports which also determine the gains from trade, and lastly the movement towards trade liberalisation overlooks the importance of industrial policy in determining the impact of trade for growth and development. Therefore, having analysed the situation there are export-commodity-specific and socioeconomic factors that make it difficult for late industrialising countries to industrialise through trade liberalisation. Regardless of whether one advocates the export-orientated or import-substitution industrialisation approach to growth, countries need to be sensitive of the link between industrial and trade policy and understand that growth from trade liberalisation does not necessitate completely free trade; instead the question might be the degree of liberalisation or protection and within which sectors.

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