Chapter 4

International ‘Trade and Economic Development

Introduction
Although the level and rate of economic development depend primarily on internal conditions in
developing nations, most economists today believe that international trade can contribute significantly
to the development process. In 1980s some economists believed that international trade and the
functioning of the present international economic system hindered rather than facilitated development
through secularly declining terms of trade and widely fluctuating export earnings for developing nations.
According to them the standard international trade theory based on comparative advantage was completely
irrelevant for developing nations and the development process. Therefore they advocated industrialization
through import substitution and generally placing less reliance on international trade by developing
nations and stressed on the reform of the present international economic system to make it more
responsive to the special needs of developing nations.

In this chapter, we will study all these topics. We examine the relationship between international trade and
economic development in general. We discuss the terms of trade and their effect on economic
development. We study the effect of terms of trade on export instability. We discuss the policy of
development through import substitution and export promotion.

Importance of trade and Economic Development

In this section we first analyze the claim that international trade theory is irrelevant for developing nations
and to the development process. Then we examine the ways in which international trade operated as an
engine of growth. We close this section on a positive note by examining all of the important ways in
which international trade can still contribute to the process of economic development today.

According to traditional trade theory, if each nation specializes in the production of the commodity of
its comparative advantage, world output will be greater and, through trade each nation will share in the
gain. With the present distribution of factor endowments and technology between developed and
developing nations, the theory of comparative advantage prescribes that developing nations should
continue to specialize primarily in the production of and export ofraw materials, fuels, minerals, and food
to developed nations inexchange for manufactured products.

While this may maximize welfare in the short-run, developing nations believe that this pattern of
specialization and trade will reduce them to a subordination position in relation to developed nations
and keeps them from reaping the dynamic benefits of industry and maximizing their welfare in the
long run. The dynamic benefits resulting from industrial production are a more
trained labor force, more innovations, higher and more stable prices for the nation’s exports, and higher
income for its people. With developing nations specializing in primary commodities and developed
nations specializing in manufacturing products, all or most dynamic benefits of industry and trade
accumulate to developed nations, leaving developing nations poor, undeveloped or dependent. This belief
is reinforced by the observation that all developed nations are primarily industrial, while most developing
nations are primarily agricultural or engaged in mineral extraction.

So, developing nations criticize international trade theory as static and irrelevant to the development
process. They view traditional trade theory as involving adjustment to existing conditions, while
development necessarily requires changing existing conditions. In short, traditional trade theory may
maximize welfare at one point in time but not in the long run. As a result, developing nations demand
changes in the pattern of trade and reform of the present international economic system to take into
consideration their special development needs.

A nation’s pattern of development is not determined once for all, but must be recomputed as
underlying, conditions change or are expected to change overtime. Therefore, developing nations are not
necessarily or always fixed by traditional trade theory to export mostly primary commodities and
import mostly manufacturing goods. For example, as a developing nation accumulates capital and
improves its technology, its comparative advantage shifts away from primary products to simple
manufactured goods first and then to more sophisticated ones (Brazil, Korea, Taiwan, Mexico & some
other developing nations).

The dynamic benefits from industry can theoretically be incorporated into the original calculations of
comparative advantage and into subsequent changes in comparative advantage overtime. This may indicate
that the expansion of industrial production does not always represent the best use of the developing nation’s
scarce resources — as some of these nations have now come to realize. So while the need for a truly
dynamic theory cannot be denied, comparative statics can carry us a long way toward incorporating
dynamic changes in the economy into traditional trade theory.

Haberler has pointed out the following important beneficial effects that international trade can have on
economic development:

(1) Trade can lead to the full utilization of otherwise underemployed domestic resources. That is, through
trade a developing nation can move from an inefficient production point inside its production frontier, with
unutilized resources because of insufficient internal demand, to a point on its production frontier with
trade. For such nation, trade would represent a vent for surplus, or an outlet for its potential surplus of
agricultural commodities and raw materials. This has indeed occurred in many developing nations,
particularly those in South East Asia and West Africa.

(2) By expanding the size of the market, trade makes possible division of labor and economies of scale.
This is especially important and has actually taken place in the production of light manufactures in small
economies such as Taiwan, Hong Kong and Singapore.

(3) International trade is the vehicle for the transmission of new ideas, new technology, and new
managerial and other skills.
 (4) Trade also stimulates and facilitates the international flow of capital from developed to developing
nations. In case of foreign direct investments, where the foreign firm retains managerial control over its
investment, the foreign capital is likely to be accompanied by foreign skilled personnel to operate it.

(5) In several large developing nations, such as Brazil and India, the importation of new manufactured
products has stimulated domestic demand until efficient domestic production of these goods become
feasible.

(6) International trade is an excellent antimonopoly weapon because it stimulates greater efficiency by
domestic producers to meet foreign competition. This is particularly important to keep low the cost and
price of intermediate or semi-finished products used as inputs in the domestic production of other
commodities.

Recent developments in endogenous growth theory starting with Romer (1986) & Lucas (1988) provide
a more convincing and rigorous theoretical basis for the positive relationship between international trade
and long-run economic growth and development. Specifically, the new theory of endogenous economic
growth postulates that lowering trade barriers will speed up the rate of economic growth and development
in the long run by

(1) Allowing developing nations to absorb the technology developed in advanced nations at a faster rate
than with a lower degree of openness,
(2) Increasing the benefits that flow from research and development,
(3) Promoting larger economies of scale in production,
(4) Reducing price distortions and leading to a more efficient use of domestic resources across sectors,
(5) Encouraging greater specialization and more efficiency in the production of intermediate inputs, and
(6) Leading to the more rapid introduction of new products and services.

In particular, endogenous growth theory seeks to explain how endogenous technological change creates
externalities that offset any propensity to diminishing returns to capital accumulation

The Terms of Trade and Economic Development

In this section first we define the various terms of trade. We then analyze the reasons for expecting the
commodity terms of trade of developing nations to deteriorate.

The
various.
Terms of. Trade.

There are several other types of terms of trade, notably, the income terms of trade, the single factoral
terms of trade, and the double factoral terms of trade. We will define each of these terms of trade, give an
example of each, and explain their significance.

0) Commodity, or Net barter, terms of trade (N): Is the ratio of the price index of the nation’s
exports (Px) to the price index of its imports (Pm) multiplied by 100 (to express in
percentage). That is:
N = (Px/Pm) 100
 For example, if we take 1980 as the base year (N = 100), and we find that by the end of 2000 the nation’s
PX fell by 5% (to 95%), while its PM rose by 10% (to 110), then the nation’s terms of trade
declined to
N = (95/110) 100 = 86.36.
This means that between 1980 and 2000 the nation’s export prices fell by 14% in relation to its import
prices.

(ii) Income Terms of Trade (I): A nation’s income terms of trade is given by

I = (Px/Py) Ox
Where QX is an index of volume of exports. So I measures the nation’s export based capacity to import.
If QX increased from 100 in 1980 to 120 in 2000, then the nation’s terms of trade increases to I =
(95/100)120 = (0.08636) (120) = 103.63

This means that from 1980 to 2000 the nation’s capacity to import increased by 3.63% even though
Px/Pm declined. The change in the income terms of trade is very important for developing nations, since
they rely to a large extent on imported capital goods for their development.

(iii) | Single Factoral Terms of Trade (S): It is given by

S = (Px/Py) Zx
Where ZX is productivity index in the nation’s export sector. So, S measures the amount of imports the
nation gets per unit of domestic factors of production embodied in its exports. For example, if
productivity in the nation’s export sector increases from 100 in 1980 to 130 in 2000, the nation’s single
factoral terms of trade increases to

S = (95/110) (130) = (0.8636)(130) = 112.27

This means that in 2000 the nation received 12.27% more imports per unit of domestic factors embodied
in its exports than it did in 1980. Even though the nation shares part of its export sector with other nations,
the nation is better off in 2000 than it was in 1980.

(iv) Double Factoral Terms of Trade (D) : The concept of single factoral terms of trade can be
extended to measure the nation’s double factoral terms of trade (D).

D = (Px/Pm) (Zx/Zm) 100

Where ZX is an import productivity index. So, D measures how many units of domestic factors
embodied in the nation’s exports are exchanged per unit of foreign factors embodied in its imports. For
example, if ZM rises from 100 to 105 between 1980 and 2000, then D rises to D = (95/110) (130/105)
= (0.8636) (1.2381) (100) = 106.92

Of the four terms of trade defined, N, I, and S are the most important, D does not have much
significance for developing nations and rarely measured. However, since N is the easiest to measure,
most of economic literature is in terms of N. N is often referred as simply “the terms of trade”. As it
shown in the above examples, I and S can rise even when N declines.
This is generally regarded as favorable to developing nations. The most favorable situation is when N, I,
and S all increase.
The worst possible situation from the point of view of developing nations occurs when all three terms
of trade deteriorate and lead to immiserizing growth, where even if wealth effect tends to increase the
nation’s welfare, the terms of trade may deteriorate so much to lead to a net decline in the nation’s
welfare.

1) Productivity: All of the productivity increases that take place in developed nations are passed on
to their workers in the form of higher wages and income, while most of the productivity increases
that take place in developing nations are reflected in lower prices.
So, the developed nations have the best of both. They retain the benefits of their own productivity
increase in the form of higher wages and income for their workers, and at the same time they also reap
most of the benefits fromthe productivity increases taking place in developing nations through the lower
prices that they are able to pay for agricultural exports of developing nations.

The different responses to productivity increase in developed and developing nations is due to the widely
differing conditions in their internal labor markets. Scarce labor and strong labor unions in developed
nations are able to extract the benefit of increase in productivity in the form of rise in wages. This
increases costs and production and the prices of manufactured goods that developed nations export. On
the other hand, because of surplus labor, large unemployment and weak labor unions in most developing
nations, most of the increases in productivity taking place in these nations are reflected in lower
production costs and in lower prices fortheir agricultural exports.

2) Demand for manufactured imports: Another reason for expecting the terms of trade of developing
nations to deteriorate is that their demand for manufactured exports of developed nations tends to
grow much faster than the demand for the agricultural product and raw material exports of developing
nations. This is due to much higher income elasticity of demand for manufactured goods than for
agricultural commodities and raw materials.
Import Substitution versus Export Substitution

Industrialization via Import Substitution

In many LDCs—especially in Latin America and Asia—the production of consumer goods in
substitution for imports has had considerable appeal as the dominant strategy of industrialization. Given
an existing demand for imported consumer goods, it was simple to base the rationale for industrialization
on the home replacement of these finished goods. In most industries this is done by importing
components and engaging in the final assembling process, in the hope of proceeding to "industrialize
from the top downward" through the ultimate production of the intermediate products and capital goods.
Besides allowing the home replacement of an existing market, import substitution had considerable
appeal by virtue of the common belief that it would help meet the developing country's balance-of-
payments problem.

Although the widespread pursuit of import substitution has in practice been based mainly on the
objectives of industrialization, the policy has been rationalized by a number of protectionist arguments.
Support for import replacement comes partly from an appeal to the experience of industrialized
countries. Historical studies of some countries show not only that the share of industrial output rises with
development, but also that the growth of industries based on import substitution accounts for a large
proportion of the total rise in industry. It is also true that much of the recent economic history of some
rapidly developing underdeveloped countries can be written in terms of industrialization working its way
backward from the ‘final touches’ stage to domestic production of intermediate, and finally to that of
basic, industrial materials.

For the objective of eventually replacing imports with domestic production, it would thus be self-
defeating to restrict imports at too early a stage and thereby forgo the awakening and inducing effects
that imports have on industrialization.” An increase in imports—not their restriction—is the effective
way to prepare the ground for the eventual creation of an import-replacing industry. Only after the
domestic industry has been established can the country afford to dispense with the "creative" role played
by imports, and only then would there be a case for protection of the domestic industry.
Although in promoting the demand for import substitutes, restrictions on imports allow the country to
by-pass the difficulties of having to build up internal demand simultaneously with supply.’ such a
protective commercial policy is designed merely to replace imports; this in itself is no guarantee of
cumulative growth. Even though industrialization may be initiated through import substitution, there
remains the problem of sustaining the industrialization momentum beyond the point of import replace-
ment.

If we accept the contentions that there is disparity in the income elasticity’s of demand for imports and
exports, that the industrial imports are essential and must be either imported or produced at home, and
that the country has no other means of increasing its capacity to import, then there is a case for industrial
protection to encourage import substitutes.
We should also allow for the fact that a developing country's capacity to import industrial products will
depend not only on its export earnings, but also on the inflow of foreign capital, changes in the terms of
trade, and the capacity to replace other imports (such as foodstuffs and raw materials) with domestic

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production. To the extent that these other factors may raise the capacity to import industrial products,
there is less need for industrial protection.

Another facet of the argument for replacing industrial imports with domestic production is related to the
objective of expanding employment outside of agriculture. It may be contended that industrialization is
necessary to provide employment opportunities for the presently underemployed, to absorb manpower
that would otherwise become redundant when agricultural productivity rises through the adoption of
more advanced techniques, and to take up the increase in the size of the labor force as population grows.

There are also two arguments that have more merit for import substitution. These are the infant industry
case, and the attraction of foreign investment argument.

Temporary tariff protection of an infant industry is generally accepted as a valid policy for establishing
an industry that would eventually be able to produce at lower costs and compete favorably with foreign
producers. Nonetheless, to justify government intervention, it is not sufficient to anticipate solely the
realization of internal economies of scale.

For if the future benefits were to accrue only to the firm, the investment might then still be made by a
private firm without protection, insofar as the firm can cover its earlier costs of growth out of its later
profits.

Protection should instead be based on the condition that the social rate of return exceeds the private rate
of return on the investment. The social benefit is likely to exceed the private benefit in an infant industry
for two special reasons that are particularly relevant for a newly developing country: the knowledge of
new industrial production techniques acquired in the protected industry may also be shared with other
producers, and the training of the labor force may also redound to the benefit of other employers. When
external economies are present, social benefits will exceed private benefits, and market forces would not
yield the social optimum output. To gain the additional benefits, government aid may then be advocated.

It should be realized, however, that protection causes society to hear not only the losses that would be
incurred by the industry during its period of infancy, but also the cost of consumption in the form of
higher priced import substitutes during this period. The ultimate saving in costs, therefore, ought lo be
sufficient lo compensate the community for the excess costs during the "growing up” period

We may simply note that in many instances, the protectionist policies have resulted in higher prices, a
domestic product of inferior quality, excess capacity in the import-competing industries, and a restrain of
agricultural output and exports. A number of country studies can now document the contention that
over-investment has occurred in import-replacing industry.
In some countries, the promotion of import substitutes through tariff rates that escalate with the degree
of processing (low on imported intermediate goods and high on final goods) has actually resulted in
negative value added. Although high protection of final goods makes production of the import substitute
privately profitable in local currency, the value of inputs at world prices exceeds the value of the final
product at world prices; the process of import substitution is socially inefficient.

The actual process of import substitution not only has been inefficient in resource use, but also has often
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intensified the foreign-exchange constraint. At the same time as policies have subsidized import
replacement, they have inhibited expansion of exports, but there has not been a net saving of imports
because the replacement of finished import commodities has required heavy imports of fuels, industrial
materials, and capital goods, as well as foodstuffs in cases where agricultural development has also suf-
fered.

After a period of import-substitution industrialization, the problems of mal distribution of income and
unemployment have also become more serious than they were in the first place. The use of subsidies,
overvalued exchange rates, the rationing of under priced import licenses, high levels of effective
protection, and loans at negative real interest rates have induced the production of import substitutes by
capital-intensive, labor-saving methods and have resulted in industrial profits in the sheltered sector and
high industrial wages for a labor elite, aggravating inequalities in income distribution. As noted
repeatedly, employment creation in the urban import-replacement industrial sector has not kept pace
with the rural-urban migration, and the unemployment problem has been aggravated by the transfer of
the rural underemployed into open unemployment and underemployment in the urban sector.
Generally, an import substitution industrialization (ISI) strategy has three main advantages.

(1) The market for the industrial product already exists, as evidenced by imports of the
commodity, so that risks are reduced in setting up an industry to replace imports.
(2) It is easier for developing nations to protect their domestic market against foreign competition
than to force developed nations to lower trade barriers against their manufactured exports.
(3) Foreign firms are induced to establish so-called tariff factories to overcome the tariff wall of
developing nations.

Against these advantages are the following disadvantages:

(1) Domestic industries can grow accustomed to protection from foreign competition and have no
incentive to become more efficient.
(2) Import substitution can lead to inefficient industries because the smallness of the domestic market
in many developing nations does not allow them to take advantage of economies of scale.
(3) After the simpler manufactured imports are replaced by domestic production, import
substitution becomes more difficult and costly as more capital intensive and technologically
advanced imports have to be replaced by domestic production.
Industrialization via Export Substitution

In contrast with via import substitution there, is an increasing interest in the potentialities of an
industrialization strategy that emphasizes export substitution. "Export substitution is the export of
nontraditional products. This, in turn, will induce a substitution of capital for labor and reduce profit
margins, thereby causing savings to decline and the rate of capital formation to decrease. Industrial
employment will thereby be adversely affected.

The evidence from the past three decades does show that the range of labor-intensive manufactures
exported from LDCs has indeed widened, and the number of LDCs engaged in export substitution has
increased. In conformity with hypotheses about export-based development, the evidence indicates that
export growth rates explain a significant portion of the variance in income growth rates, which cannot be
explained by the growth in primary inputs; that generally the greatest increase in the GNP of various
LDCs is better correlated with exports than with any other variables; that the higher-income LDCs have
a higher ratio of export- to GDP and a faster rate of growth; and that the higher rate of growth is
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correlated with a more diversified export base.

Export-oriented industrialization has led to superior development performance in a number of countries,

of which the East Asian newly industrialized countries (NICs) are prime examples. By undertaking
policies that remove the bias against exports and make it as profitable to produce for export as for the
domestic market, these countries achieved dynamic gains from trade. They overcame the diseconomies
of being small countries and realized dynamic efficiency in their mobilization and allocation of
resources. Evidence of increasing dynamic efficiency appeared in the greater utilization of plant
capacity, the realization of economies of scale, a declining incremental capital-output ratio, the gains of
X-efficiency, higher saving ratios, the transfer of factors to activities with higher marginal productivities,
greater total factor productivity, and the overcoming of organizational dualism.

The basic attraction offered by developing countries to such export activities by transnational firms is
obviously due to the very low wages of unskilled labor in such countries given minimum productivity
rates.

The development of this type of international sourcing by transnational firms has important re-
percussions for developing countries Their comparative advantage in this case rests in specializing in
unskilled labor whose wages have to stay comparatively low while importing a package of inputs, (both
physical and intangibles) from abroad. Since skills and technology, capital, components and other goods
arc mobile internationally while unskilled labor is not (or is preferred not to be, due to the heavy social
costs involved), transnational firms will be induced to intensify such international sourcing, diversifying
their sources of unskilled labor among different developing countries to assure a continuous availability
of supply, or the products of that input.

The “shallowness” of such a development process is a result of the following reasons. The type of labor
utilized represents generally the weakest and less organized part of the labor class, thus limiting possibil-
ities for increasing labor returns unless a general shortage of labor takes place in the country, in which
case opportunity cost considerations arise for the host economy. If wages increase foreign investors will
tend to shift to other countries since their location interests stem from the existence of low wages given
some minimum productivity levels. The training necessary for local labor in such activities is generally
very small, limiting spill-over effects. Of critical importance is the absence of marketing know-how ef-
fects for the host country since the goods traded are within the captive markets of affiliates. Final
product promotion is handled abroad by the foreign centers of decision making.

It is therefore, clear that the issues raised by a strategy of industrialization via export substitution are
controversial. They cannot be resolved in isolation. The efficacy of this industrialization strategy
depends or the performance of foreign investment, relations between multinational enterprises and host
countries, and the trade policies of the developed importing countries.
Generally, Export Oriented industrialization also has advantages and disadvantages. Advantages
include the following:

(1) It overcomes the smallness of the domestic market and allows a developing nation to take
advantage of economies of scale. This is particularly important for the many developing
countries that are both very poor and small.
(2) Production of manufactured goods for export requires and stimulates efficiency throughout the
economy. This is important when the output of an industry is used as an input of another
domestic industry.
(3) The expansion of manufactured exports is not limited by the growth of the domestic market.
Two serious disadvantages:

(1) It may be very difficult for developing nations to setup export industries because of the
competition from the more established and efficient industries in developed nations.

(2) Developed nations often provide a high level of effective protection for their industries
producing simple labor-intensive commodities in which developing nations already have or can
soon acquire a comparative advantage.

10
The Experience with Import-Substitution

The policy of industrialization through import substitution generally met with only limited success or
failure. Very high rates of effective protection, in the range of 100% or 200% or more, were common
during the 1950s, 1960s and 1970s, in countries like India, Pakistan, Argentina & Nigeria. These led to
very inefficient domestic industries and very high prices for domestic consumers. Sometimes the foreign
currency value of imported inputs was greater than the foreign currency value of the output produced
(negative value added).

Heavy protection and subsidies to industry led to excessive capital intensity and relatively little labor
absorption. For example, the capital intensity in the production of steel was almost as high in capital poor
nations such as India as it is in the capital rich United States. This quickly exhausted the meager
investment funds available to developing nations and created only few jobs.

The result was that most of the yearly increase in the labor force of most developing countries had to be
absorbed into agriculture and the traditional service sector, so aggravating their unemployment and
underemployment problem. In addition, the hope of finding high paying jobs in the modern urban
sector attracted many more people to the cities than could find employment, leading to an explosive
situation. The highest priority was given to the construction of new factories and the purchase of new
machinery, with the result of widespread idle capacity for lack of funds to purchase needed raw material
and fuel imports. One shift operation of plants also contributed to excessive capital intensity and low labor
absorption in developing nations.

The effort to industrialize through import substitution also led to the neglect of agriculture and other
primary sectors, with the result that many developing nations experienced a decline in their earnings from
traditional exports, and some were even forced to import some food products that they had previously
exported. Furthermore, the policy of import substitution often aggravated the balance of payments
problems of developing nations by requiring more imports of raw machinery, raw materials, fuels and
even food.

The overall result was that those developing nations such as India, Pakistan and Argentina that stressed
industrialization through import substitution fared much worse and grew at a much slower rate than
those developing economies such as Hong Kong, Korea and Singapore. It has been estimated that the
policy of import substitution resulted in the waste of up to 10% of the national income of developing
nations. It must be understood that a policy of import substitution may be some benefit in the early stages
of development, while an export orientation becomes an absolute necessity latter in the development
process. So rather than being alternatives, policies of import substitution and export orientation could
profitably be applied some extent sequentially, especially in the larger developing nations. This was in
fact what Korea did.

Starting in the 1980s, many developing nations that had earlier followed an import substitution
industrialization strategy began to liberalize trade and adopt an outward orientation. The reforms were
spurred by the debt crisis that began in 1982 and the evident success of the outward oriented countries.

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In general, the reforms involved a dramatic reduction and simplification in average tariff rates and
quantitative import restrictions. This resulted in a much higher degree of openness as measured by the sum
of exports plus imports as a ratio of GDP, a sharp increase in the ratio of manufactures in total exports
and higher rates of growth for the liberalizing economies. Trade reforms were most successful when
launched in a single bold move rather than with a number of small hesitant steps over time and when
accompanied by anti-inflationary measures.

The World Bank has greatly facilitated the planning and carrying out of trade liberalization programs
with technical assistance and loans. The World Bank began its lending for structural adjustment in
1980, and by 1995 it had lent more than $20 billion to more than 60 countries for the purpose of
implementing structural or sectoral reforms. The largest number of loans went to Sub- Saharan African
countries, but since these loans were generally small, a much larger amount went to other developing
countries.

The fact is that many of the liberalizing developing countries have joined the General Agreement on
Tariffs and Trade (GATT) and consolidated the reforms already undertaken and encouraged further
reforms. These are likely to increase productivity and growth in developing countries over the next
decade.

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I [4

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