CHAPTER 5 – IMPROVE INPUTS AND CAPITAL GOODS
MARKET OPENNESS CAN REDUCE COSTS
It is generally accepted among economists that, subject to certain qualiﬁ cations, openness is the key to
economic growth, at least in the long term. This has been key in the policy prescriptions of international
ﬁ nancial institutions for many years. This is based on the notion that openness leads to cost-reducing
specialization, to improved allocation of scarce resources, to the improved functioning of the economy, and
hence to growth.
But there are situations that may warrant some form of intervention, based on long-standing ideas in welfare
economics and the so-called theory of the second-best, for example, to protect the environment.
There is no
guarantee that the process of moving towards greater openness will be achieved quickly and without costly
adjustment. This leads to the discussion in the next section as to how to reduce the costs of exporters while
the move to greater openness is being phased in.
While some industrial countries have pursued more openness to trade, others pursued a more cautious
approach. Many economies turned inwards in the wake of the depression of the 1930s, leaving high tariff
and non-tariff barriers (NTBs) that have taken many years to reduce. In developing countries, there was also
a period when the thinking in development economics was in favour of import-substitution industrialization.
This was based on the work of Raúl Prebisch
of the Economic Commission for Latin America and of
then at the United Nations Department of Economic Affairs. Singer warned of a long-term
deterioration in the terms of trade for developing countries, with their commodity export prices falling relative
to their manufacturing import prices.
Contrary to the views of many neo-classical economists at the time, the Prebisch-Singer thesis (as it came to
be called) foresaw that a continuing dependence on primary exports would lead most developing countries
down the path of increasing indebtedness and would widen global income inequalities. On these terms,
free trade could never be fair trade, and they called for import substitution, tariff controls and a drive for
Their work also became the basis for the Generalized System of Preferences (GSP), trying
to give developing country exports an edge in major markets.
However, from the mid-1980s, the Washington Consensus on trade led to the most important trade reforms
across the developing world and transition economies in recent history under International Monetary Fund
and World Bank structural reform programmes. These ‘autonomous’ reforms among developing countries
since the mid-1980s, carried out with varying degrees of enthusiasm, led to dramatic reductions in trade
intervention among developing countries and increased the openness of their economies towards foreign
Tariffs fell from some very high levels to moderate rates and there was substantial rationalization of tariff
structures, reducing the number of bands, in a few cases, to a single level. NTBs, such as quotas, were
largely eliminated. This process has continued in countries such as China and India so that their applied rates
are now below 10%. Moreover, under these reform programmes, the dispersion in rates across sectors has
been substantially reduced and tariff escalation is now more marked in developed than developing countries.
Apart from traditional trade theory, the reform process was justiﬁ ed by statistical evidence linking openness
And there were some notable successes, particularly in East Asia. However, not all the successes
could be attributed to the application of orthodox trade policies – there were also a number of failures,
1 British economist Arthur Cecil Pigou’s Wealth and Welfare, published in 1912, discusses this. Pigou was later heavily criticized,
although criticism of his role for the state looks weaker in the light of the ﬁ nancial crisis of 2008. British economist James Meade’s Trade
and Welfare, published in 1955, also discusses this issue. However, it often seems that policymakers prefer to focus on a naive, simplistic
version of theory that appeals to their vision.
2 Prebisch, R., ‘The Economic Development of Latin America and its Principal Problems’, New York, United Nations, 1950.
3 Singer, H., ‘The Distribution of Gains Between Investing and Borrowing Countries’, American Economic Review 40, No. 2, pp. 473-485,
4 Toye, J. and R. Toye, The UN and Global Political Economy: Trade, Finance, and Development; Chapter 5, Bloomington and
Indianapolis, Indiana University Press, 2004.
5 Dollar, D. and A. Kraay, ‘Trade, Growth and Poverty’, Economic Journal, 114: 493, pp. 22-49, 2004. However, as Dollar emphasized
on a number of occasions, these were statistical results with a number of countries falling above and below the central ﬁ nding. See
also: Sachs, J. and W. Warner, ‘Globalization and economic reform in developing countries’, Brookings Papers on Economic Activity, 1,
Washington, D.C., Brookings Institution, 1995. In 2002, Turkish economist Dani Rodrik and Venezuelan economist Francisco Rodriguez
criticized the robustness of the statistical results.
CHAPTER 5 – IMPROVE INPUTS AND CAPITAL GOODS
especially in Africa, and there has recently been some serious rethinking in the Bretton Woods institutions
about trade policy prescriptions. Many of the reforms were carried out in the face of developments in trade
theory that challenged the new conventional wisdom.
A reappraisal of the impact of trade reforms intensiﬁ ed following the global economic slowdown in the wake
of the Asian, Russian and Brazilian crises of 1997-1998, some two years after the conclusion of the Uruguay
Round and the establishment of the World Trade Organization (WTO). The long overdue revisiting of the
orthodoxy represented by the Washington Consensus was signalled in a number of ways. First, there was
the intellectual challenge by American economist Joseph Stiglitz and Turkish economist Dani Rodrik, who
queried the emphasis placed on openness and the lack of attention to institutional and governance issues.
Second, problems in implementing WTO agreements led to the breakdown of attempts to launch a new trade
negotiating round in Seattle in 1999. Third, the 1990s saw a dramatic increase in the number of regional trade
agreements. Finally, growing evidence emerged of the failure of trade reforms, especially in Africa.
In 2008, the Commission on Growth and Development (hereafter the Growth Commission) noted that relying
on markets to allocate resources efﬁ ciently is clearly necessary but ‘that is not the same thing as letting some
combination of markets and a menu of reforms determine outcomes’. The Commission continues: ‘Wedded
to the goal of high growth, governments should be pragmatic in their pursuit of it. Orthodoxies apply only so
far … if there were just one valid growth doctrine, we are conﬁ dent we would have found it.’
noted that economists can say with some conﬁ dence how a mature market economy will respond to policy
prescriptions. However, mature markets rely on deep institutional underpinnings that deﬁ ne property rights,
enforce contracts, convey prices and bridge informational gaps between buyers and sellers, which are often
lacking in developing countries.
Noting that an important part of development is precisely the creation of these institutionalized capabilities,
the Growth Commission states:
‘We do not know in detail how these institutions can be engineered, and policymakers cannot always
know how a market will function without them. The impact of policy shifts and reforms is therefore harder
to predict accurately in a developing economy. At this stage, our models or predictive devices are, in
important respects, incomplete. As a result, it is prudent for governments to pursue an experimental
approach to the implementation of economic policy.’
In this respect, the Commission quotes Chinese leader and reformer Deng Xiaoping’s oft-quoted dictum to
‘cross the river by feeling for the stones’, and it argues that governments should sometimes move forward
step by step, avoiding sudden shifts in policy where the potential risks outweigh the beneﬁ ts. This will limit
the potential damage of any policy misstep, making it easier for the government and the economy to right
itself. It also notes that making policy is only part of the battle; policies must also be faithfully implemented
and tolerably administered.
While the Growth Commission remarkably says almost nothing about trade policy, it touches on a number
of closely related areas, including brieﬂ y on what it calls the ‘great symbolic importance’ of the Doha Round,
apparently accepting the downgrading by many economists of its economic signiﬁ cance. In the areas of export
promotion (including explicit or implicit subsidies, but not trade fairs, etc.) and industrial policy (in particular
targeting, rather than cluster group formation, etc.), the Growth Commission indicates the various sides of
the debate that were heard during its work. Orthodoxy suggests that neither export promotion nor industrial
policies work. However, the Commission, in a clear break with orthodoxy, suggests that, ‘If an economy is
6 Krugman, P., ‘Scale Economies, Product Differentiation, and the Pattern of Trade’, American Economic Review, 70, pp. 469-479, 1980.
Krugman, P., Strategic Trade Policy and the New International Economics, Cambridge, MIT Press, 1986.
In 1992, Krugman expressed disappointment that the ‘fairly radical change in the way that economists explain international trade has so
far at least had relatively little impact on their recommendations about trade policy.’ See: Krugman, P., ‘Does the New Trade Theory Require
a New Trade Policy?’ The World Economy, 15:4, 1992.
7 Stiglitz, J., Globalization and Its Discontents, New York, W.W. Norton, 2002.
Rodrik, D., Has Globalization Gone Too Far? Washington, D.C., Institute for International Economics, 1997.
8 The Growth Report – Strategies for Sustained Growth and Inclusive Development, Commission on Growth and Development,
International Bank for Reconstruction and Development/World Bank, 2008. Available at: www.growthcommission.org/index.
CHAPTER 5 – IMPROVE INPUTS AND CAPITAL GOODS
failing to diversify its exports and failing to generate productive jobs in new industries, governments do look
for ways to try to jump-start the process, and they should.’ However, the Commission hedges its bets by
arguing that these efforts should bow to certain disciplines:
First, they should be temporary, because the problems they are designed to overcome are not permanent.
Second, they should be evaluated critically and abandoned quickly if they are not producing the desired
results. Subsidies may be justiﬁ ed if an export industry cannot get started without them. But if it cannot
keep going without them, the original policy was a mistake and the subsidies should be abandoned.
Third, although such policies will discriminate in favour of exports, they should remain as neutral as
possible about which exports. As far as possible, they should be agnostic about particular industries,
leaving the remainder of the choice to private investors. Finally and importantly, export promotion is not a
good substitute for other key supportive ingredients: education, infrastructure, responsive regulation, etc.
Thus, among professional economists, science is pointing towards a more cautious approach to openness
to trade or at least to unfettered, rapid liberalization in the face of adjustment costs and the existence of
externalities. This poses the question as to how to reduce the burden of existing trade interventions in goods
and services on exporters in the short term.
ELIMINATING ANTI-EXPORT BIAS
Apart from the general argument on the beneﬁ ts of a more open economy – at least in the longer term – it
has also been long recognized that protecting domestic industries can create difﬁ culties for exporters by
raising the price of inputs.
In general, tariffs and other measures that protect domestic industries create
disincentives to export.
This can be explained in several ways.
First, tariffs directly raise the price of imported inputs: raw materials, and intermediate and capital goods.
They also increase the proﬁ tability of the protected import competing sector, which is then able to bid up the
price of other inputs, such as land, labour (wage rates) and services. This has a negative effect on exporters
who have to meet those prices or bids for their inputs.
Second, as an alternative way of thinking about the issue, tariffs will likely reduce imports, with a positive
impact on the balance of payments, and a consequential upward pressure on the local currency, leading
to an appreciation. This means that exports become more expensive for foreigners and they are negatively
Either way, protection or other forms of intervention for a preferred import-competing sector has a negative
impact on the export sector, producing an anti-export bias. This applies even when the imported inputs are
duty free to exporters, because they still have to compete for inputs that are not imported, but whose prices
are affected by the protected or supported sector that bids up the prices of those inputs.
However, openness in itself may not be sufﬁ cient. There may be an absence of competition in the domestic
market that also needs to be addressed. For example, when Argentina substantially reduced protection on
cars and other goods to reduce prices as part of its anti-inﬂ ationary drive following the adoption of the Law
of the Convertibility of the Austral in 1991 (a convertibility standard for the peso), it found that large domestic
ﬁ rms in the distribution trade did not need to reduce retail prices. This required adopting more aggressive
competition law. In Colombia, following the opening of the banking sector to foreign banks in the late 1990s,
the arrival of foreign banks led to an improvement in the quality of banking services, including by local banks,
but there appears to be no lowering of interest rates or any other sign of price competition as a result of
improved banking technologies, with foreign banks comfortably co-existing with local banks.
Only a comprehensive opening of the economy in goods and services, supported by efforts to improve
competition in the domestic market, can eliminate the anti-export bias. The difﬁ culty is that eliminating the
9 This has its intellectual basis in: Lerner, A. P., ‘The Symmetry between Import and Export Taxes,’ Economica, (New Series), 3(11),
pp. 306-313, 1936.
10 Aron, J., B. Kahn and G. Kingdon, editors, South African Economic Policy under Democracy, New York, Oxford University Press, 2009.
CHAPTER 5 – IMPROVE INPUTS AND CAPITAL GOODS
measures that protect or support the import competing sector in goods or services may be difﬁ cult to reduce
or eliminate in the short term without causing severe structural adjustment problems, as discussed in the
How can a government act to reduce the costs of inputs into the export of goods and services without
engaging in potentially disruptive, comprehensive liberalization in the short term? The options available to
governments to assist exporters are to act directly on import, export or production costs, including through
some long-term measures that are not speciﬁ c to international trade. However, in pursuing some of these
speciﬁ c measures, governments must ﬁ nd means that will not run afoul of WTO rules, whose reach has
extended since the days of the earlier General Agreement on Tariffs and Trade (GATT). Some of the measures
used by successful exporters in the past, for example, in East Asia, are no longer legally available to newer
exporters. Moreover, the Doha Round could well lead to a further tightening of those rules.
REDUCING INPUT COSTS
There are a number of means that can be used to lower the costs of imported inputs for export industries, but
under WTO rules some care has to be taken to ensure that these are not uniquely for exporters or there is a
risk that the scheme would be considered as an export subsidy.
Some countries favour using specialized schemes because they are easier to administer than larger scale
national reforms. Such schemes include using duty drawback and special import licenses for exporters,
as well as specialized schemes, like bonded manufacturing and export processing zones. Developing
countries can beneﬁ t using more favourable rules regarding subsidies to support local industry, such as duty
drawback, special economic zones (SEZs), condoning or not collecting government revenues otherwise due,
and export credits.
Governments need to further consider the merits of liberalizing on a preferential liberalization or most favoured
nation (MFN) basis. Before looking in some detail at these various approaches, it is useful to brieﬂ y review
WTO rules on subsidies, which cover domestic supports as well as export subsidies.
WTO RULES ON SUBSIDIES
The WTO’s subsidy rules are highly complex, distinguishing between domestic supports (subsidies)
and export subsidies, and providing for differential treatment of agriculture and manufactured products.
Subsidies are deﬁ ned as ﬁ nancial commitments by a government. They may take the form of direct or indirect
ﬁ nancial transfers, government practices involving transfers, foregone revenues, provisions of goods and
services (other than infrastructure), or some form of price or income support. Some subsidies are prohibited,
while others are considered ‘actionable’, being subject to action at the multilateral level or to countervailing
All ‘speciﬁ c’ subsidies, which have to be notiﬁ ed to the WTO, are subsidies that are not generally available,
i.e. subsidies that are targeted to particular enterprises, industries or regions, as well as export subsidies
and import-substitution subsidies. The WTO Agreement on Subsidies and Countervailing Measures (the
SCM Agreement) classiﬁ ed speciﬁ c subsidies under three different categories: prohibited (red), actionable
(amber), and non-actionable (green) subsidies, known as the trafﬁ c lights approach. However, the non-
actionable class was eliminated on 31 December 1999. In addition, the WTO Agreement on Agriculture
prohibits the use of export subsidies, except in conjunction with product-speciﬁ c reduction commitments,
and deﬁ nes the conditions under which certain types of domestic subsidies (green box, blue box or special
and differential treatment (S&D) box)
are exempt from reduction commitments.
11 The agreement also originally contained a third category: non-actionable subsidies. This category existed for ﬁ ve years, ending on 31
December 1999, and was not extended. The agreement applies to agricultural goods as well as industrial products.
12 The S&D box offers special and differential treatment for developing countries.
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