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Industrialization and foreign :an overview

This Report examines the role of foreign trade in This Report stresses efficient industrialization be- industrialization. The pace and character of indus- cause there is evidence of inefficiencies in indus- trial development are not simply the result of trade tries in both industrial and developing countries. policies. Many other factors matter. A country's These industries may not show financial losses be- size, its natural resources, the skifis of its people, cause protection allows domestic firms to sell the stability of its government and institutions and above international prices. Overvalued exchange their ability to promote change, the fiscal, mone- rates may allow them to buy machinery and inter- tary, and policies that the govern- mediate from abroad at prices below their ment pursuesall these and still more factors in- true cost to the economy. Such overvaluation of fluence a country's ability to industrialize outputs and undervaluation of inputs will exagger- The role of foreign trade in industrialization is an ate both the industries' profits and the contribu- important issue for several reasons. First, although tion that their output makes to the national prod- the relationship between trade policy and indus- uct. At the same time, undervaluation of trial development has concerned policymakers and and agricultural products will disguise their poten- economists for a long time, empirical studies over tial contribution to growth. The net effect is to the past thirty years now make it possible for use- magnify industry's part in domestic output and ful lessons to be drawn concerning the advantages growth. Simple statistics on the share of industry and disadvantages of different trade policies. Sec- or manufacturing in (GDP) ond, many fear that slow growth and rising are suspect in many countries. protection in industrial countries may cloud the The term "efficient" begs many questions. It has prospects for developing countries' exports. Third, meaning only in relation to specific objectives: effi- continuing debt problems increase the developing ciency is measured by the costs of attaining these countries' need to raise their net earnings of for- objectives. Industrialization contributes to eco- eign exchange to debt and maintain ade- nomic development. So the question is, What are quate growth. the ultimate objectives of economic development? This does not mean that other factors can be ig- Different governments may have different objec- nored. If, for example, a country reduces its trade tives in mind and will certainly disagree about the barriers but fails to make appropriate changes in its weight to be attached to them. Generally, how- fiscal, monetary, and exchange rate policies, the ever, they will include faster growth of national benefits it hoped for may not materialize Domes- income, alleviation of poverty, and reduction of tic inflation and an overvalued exchange rate could income inequalities. How is industrialization ex- discourage the investment flows needed to re- pected to contribute to these goals? spond to the new price incentives. Analysts look- Much of the early literature treated industrializa- ing at the past and governments setting policies for tion as the key element in economic development. the future have to bear in mind the complexity of The experience of the industrial economies the relationships among policies. showed a close association between development

1 Box 1.1 The World 's support for industrialization "Excessive emphasis on industry for industry's sake, contributing to economic development, has helped above all heavy industry, may leave an undeveloped build skills, , communications, and power country with the symbol of development rather than all vital inputs to modern industry. the substance. There are of course a number of in- More recently, however, the Bank's support for in- stances where heavy industry may be justified . But, dustrial development has added a new dimension to its in general, should be applied where it brings emphasis on projects. It now includes support for im- the greatest return" (World Bank memorandum to the proved policies and strengthened institutions. This United Nations Economic and Employment Commis- was in response to the structural adjustment problems sion, May 14, 1949). This 1949 quote is as relevant to- faced by developing countries following the interna- day as it was then. The Bank has always viewed indus- tional recession and to a growing awareness of the in- trialization not as an end in itself, but as a means to fluence of policies and institutions on industrial devel- raise productivity and incomes. And it is this view that opment. The Bank, jointly with its member countries, has shaped and guided the Bank's support for industri- devises a lending program that supports policy reforms alization in its member countries. and structural change across the whole economy, as The Bank has supported the efforts of its member well as at the level of the individual enterprise or insti- countries in building new industrial capacity, improv- tution. In recent years the Bank has made several struc- ing the efficiency of existing capacity, and providing tural adjustment and sector adjustment loans to devel- training and technical assistance to accelerate the ac- oping countries in support of changes in their macroec- quisition and mastery of new skills and new technol- onomic, trade, and industrial policies. ogy. Until the late 1970s, it did this by financing indus- The Bank's lending to industry will continue to trial subsector studies, project feasibility studies, evolve in response to the needs of its borrowers. Sup- project design and engineering, technical assistance, for industrialization will continue to emphasize and industrial investments. It also financed industry policies at both the economy and the project level. The indirectly by lending to industrial development ; Bank will need to meet the challenge of providing an these loans served the additional purpose of deepening integrated package of lending, technical assistance, financial markets in developing countries. To comple- economic analysis, and policy advice that addresses ment these efforts, the International Finance Corpora- the needs of individual countries and matches their tion (IFC), an affiliate of the World Bank, supports the capacity for reform. At the same time, recognizing the projects of private investors through loans as well as importance of skill and infrastructural development to equity participation. Last, but not least, the Bank's industry, the Bank will continue with project lending in lending for education and physical infrastructure, in certain areas.

and industrial expansion. But industry was also development the highest returns may come from thought to provide certain spilovers which would the of particular types of manufac- benefit other activities: enhancement of skills, tures, agricultural products, or services. How best training of managers, dispersion of , to use resources at any time depends on and so on. Moreover, pessimism about the pros- prospects and costs. So the interesting question is pects for exports of and raw materials made not how fast a country can be industrialized, but the substitution of domestic for imported manufac- how incentives and policies can be designed so hires seem the most promising route to develop- that new industries make the maximum contribu- ment. tion to the country's development (see Box 1.1). Subsequent experience showed most of these Foreign trade preceded industrialization by ideas to be too simple, or even misleading. Many thousands of years. Early industry relied largely countries have achieved high standards of living on trade within nations. Yet, as based mainly on the production and of noted, the development of industry is likely to be food and raw materials: Australia, , Côte severely handicapped if it is deprived of the ability d'Ivoire,Denmark, Kenya, Malaysia, New to trade widely. The division of labor is limited by Zealand, , and the oil-exporting countries, the size of the market, and the division of labor is to name but a few. Industrialization has certainly the key to increased productivity. been associated with growth, but it is not the only For small countriesand most developing coun- cause of growth. At certain stages in a country's tries are small in terms of their domestic market for

2 industrial goodsthis means that progress de- learning stages of development These arguments pends upon the ability to trade relatively freely depend largely on market failures of one sort or with the rest of the world. For large economies another or the existence of external benefits such domestic trade may provide scope for adequate as the spread of ideas and skills throughout the specialization, economies of scale, and enough economy. But history is also full of examples of to keep managers alert. But even large countries that have given their industries too much economies, if cut off from international trade, protection for too long. Many countries are now would lack stimuli for efficient industrial develop- struggling to reduce protection in order to improve ment. Competition from abroad forces firms to cut efficiency and switch resources to more profitable costs, improve quality, and seek new ways of pro- activities. ducing and selling their goods. Contacts through Much of the bias against trade in developing trade ease the flow of capital and speed the acquisi- countries has been unintended. Errors in macro- tion of new technology (see Box 1.2). economic policy or unexpected changes in the This is not to deny that throughout history many terms of trade have caused countries have developed industries behind pro- deficits and shortages of foreign exchange. Domes- tective barriers. There are respectable arguments tic inflation, combined with exchange controls, has to be made for assisting firms through the difficult led to overvalued exchange rates. These damaged

Box 1.2John Stuart Mill on the In his Principles of (1848), John Stuart fited; the dealer, in the end, is sure to get his profit, Mill discusses the gains that result from "foreign com- whether the buyer obtains much or little for his merce." Although more than a century has passed, his money" (p. 98). observations are as relevant today as they were in 1848. Mill also discusses the indirect gains from trade. He In referring to , one of the first to analyze states: "But there are, besides, indirect effects, which formally the benefits of trade, he notes: "From this must be counted as benefits of a high order. One is, the exposition we perceive in what consists the benefit of tendency of every extension of the market to improve international exchange, or in other words, foreign com- the processes of production. A country which pro- merce. Setting aside its enabling countries to obtain duces for a larger market than its own, can introduce a which they could not produce themselves more extended division of labor, can make greater use at all; its advantage consists in a more efficient employ- of machinery, and is more likely to make inventions ment of the productive forces of the world. If two coun- and improvements in the processes of production. tries which trade together attempted, as far as was Whatever causes a greater quantity of anything to be physically possible, to produce for themselves what produced in the same place tends to the general in- they now from one another, the labor and capi- crease of the productive powers of the world. There is tal of the two countries would not be so productive, the another consideration, principally applicable to an two together would not obtain from their industry so early stage of industrial advancement. A people may great a quantity of commodities, as when each employs be in the quiescent, indolent, uncultivated , with itself in producing, both for itself and for the other, the all their tastes either fully satisfied or entirely undevel- things in which its labor is relatively most efficient. The oped, and they may fail to put forth the whole of their addition thus made to the produce of the two com- productive energies for want of any sufficient object of bined, constitutes the advantage of trade" (p. 96). desire. The opening of a foreign trade, by making them Mill goes on to say: "There is much misconception in acquainted with new objects, or tempting them by the the common notion of what does for a coun- easier acquisition of things which they had not previ- try. When commerce is spoken of as a source of na- ously thought attainable, sometimes works a sort of tional wealth, the imagination fixes itself upon the industrial revolution in a country whose resources large fortunes acquired by merchants, rather than were previously undeveloped for want of energy and upon the saving of price to consumers. But the gains of ambition in the people: inducing those who were satis- merchants, when they enjoy no exclusive privilege, are fied with scanty comforts and little work to work no greater than the profits obtained by the employ- harder for the gratification of their new tastes, and

ment of capital in the country itself. . . Commerce is even to save and accumulate capital, for the still more virtually a mode of cheapening production and in all complete satisfaction of those tastes at a future time" such cases the consumer is the person ultimately bene- (p. 99).

3 exports and fueled a vicious circle of foreign cur- tractable, partly because a sluggish world economy rency shortages, controls, and overvalued ex- will also mean reduced net capital flows to the de- change rates. The resulting protection of domestic veloping countries. All this will make adjustment industries was quite inadvertent. And the levels of much more difficult. protection were often far in excess of any that even How should governments respond in the short the most fervent advocate of infant industry pro- term to avert these risks? The industrial market tection could support. economies need a reduction in the U.S. current For some countries the results of protection have account deficit and in the corresponding surpluses been industries whose contribution to national in- of the major trading partners of the . come was negligible or even negative. Supporting For that to happen there must be both a decline in them has burdened other sectors of the economy, the U.S. budget deficit and an increase in U.S. in particular the rural community, which contains exports. But this poses a risk of its own. Expansion most of the poorest citizens of the developing in the United States was instrumental in earlier countries. The same can be said for many of the periods of economic growth, and reducing de- industries of the centrally planned economies mand in the United States in order to cut its exter- (CPE5). Lack of exposure to competition from nal deficit will slow world growth unless the other abroad has fostered goods that are expensive and industrial countries take steps to offset the decline of low quality. The industrialization of the CPEs in global demand. So the policies of the industrial was impressively rapid, but less efficient than it nations need to be carefully coordinated. The task might have been. Recognizing this, many develop- goes beyond replacing the fiscal deficit of one ing countries and some CPEs are undertaking sig- country with a fiscal deficit elsewhere. It requires nificant reforms and are trying to reduce their the careful use of fiscal and monetary policy to trade barriers, switch more of their efforts into ex- smooth the process of adjustment. This adjust- , and compete more vigorously in world mar- ment should not be delayed. If the present im- kets. balances persist, they will threaten the stability of the world economy and encourage "beggar thy From recovery and adjustment neighbor" protection. to long-term growth (Chapter 2) In the longer term, the industrial market econo- Although countries ultimately rise by their own mies need to improve their economic flexibility by efforts, the world economy conditions their suc- lowering their trade barriers and tackling rigidities cess. The economic recovery that began in 1983 is in their markets for labor and goods. Such rigidi- weakening. For the industrial countries as a group, ties, in effect, resist the changes in comparative output growth reached 4.6 percent in 1984, but advantage, technology, and demography that then dropped to 2.8 percent in 1985 and to an esti- economies must heed if they are to grow and pros- mated 2.5 percent in 1986. Payments imbalances per. Reforms such as these may not be feasible among the major trading nations persist, as do the unless governments first address the pressing debt problems of many developing countries. Real problems of short-term economic adjustment. interest rates remain high compared with historical The fundamental goals of long-term structural levels, and low prices add to the diffi- adjustment in developing countries are to enhance culties of many developing countries. New funds efficiency, achieve equity, and expand the stock of to support the adjustment efforts of the develop- physical and human capital. The problems of the ing countries have been severely limited. highly indebted countries and Sub-Saharan Africa Against this background two positive features are particularly urgent, and their task would be stand out. First, inflation is low in most industrial easier if world growth were to revive. These and countries and declining in many developing coun- many other developing countries would benefit tries. Second, some industrial countries have from policy reforms in three areas, although the made steady progress in reducing their fiscal defi- precise form of appropriate measures will differ cits, which leaves more room to expand demand from case to case: and stimulate growth. Trade reform. Countries should move toward Despite these positive signs, there is the danger the adoption of an outward-oriented trade strat- that growth may slow further and that payments egy. Such a strategy means removing the bias imbalances will fail to subside. The threat of pro- against exports, replacing quantitative restrictions tectionism might then turn into actual protection with tariffs, and adopting more realistic exchange on a large scale. Debt difficulties could become in- rates.

4 Macroeconomic policy. Many governments need around the middle of the eighteenth century in to reduce their budget deficits and to provide in- Great Britain. New methods of spinning and centives for greater savings. Ensuring positive real weaving cotton, together with increasing speciali- interest rates, competitive exchange rates, and low zation, sharply increased productivity. These were inflation will not only increase the supply of do- followed by innovations in iron smelting and by mestic financial resources, but also help to support the invention of the steam engine. Continuing in- trade reforms. novations led to the production of steel and rail- Domestic competitive environment. In addition to ways, steamships, and other transport. These reforming trade and macroeconomic policies, gov- boosted trade and spread industrialization, first to ernments need to improve the supply response of the major European nations and then to the United the economy, especially by removing price con- States and . trols, rationalizing investment regulations, and re- A second industrial revolution began between forming labor market regulations. These policies 1870 and 1913. During this phase technological ad- will complement trade reforms and promote the vance came to depend on scientific progress. The adoption of cost-minimizing technology. demands of the new linked industrial But reforms alone will not restore growth in growth to supplies from Africa, Asia, and the Ca- most cases. Complementary increases in capital ribbean. After World War II a period of unprece- flows are needed. dented expansion in output and trade began. The All told, then, industrial and developing coun- postwar growth in manufacturing was fueled tries alike face formidable tasks of adjustment. by the widespread use of such prewar innovations Should their policy efforts succeed, the world as assembly line production, electricity, the auto- economy can return to a high-growth path. The mobile, and consumer durables. Entirely new alternative is stagnation, even greater instability, technologies also emerged: synthetic materials, increased protection, and a missed opportunity to petrochemicals, nuclear energy, jet aircraft, telé- raise the living standards of the world's poor. communications, microelectronics, and robotics. Chapter 2 of this Report tries to be a little more Many observers believe that the world is now on precise about the difference between success and the threshold of a third industrial revolution. failure. It presents two alternative growth paths. From the outset, then, industrialization has in- These are not projections but the ranges of out- volved the interaction of technology, specializa- comes possible under alternative assumptions of tion, and trade. This interaction provokes struc- policy change. Under the High case, it is assumed tural change within economies. For example, early that the industrial countries are successful in their industrialization is usually associated with an in- adjustment efforts. On this assumption, they grow crease in the share of industry in GDP (see Figure at a rate of just over 4 percent over the next dec- 1.1). Higher agricultural productivity is needed to ade. The prospects for developing countries would accommodate that shift. Of course, there are ex- also improve. Their growth could reach 6 percent a ceptions to the pattern. Some economies have re- year if their adjustment efforts are combined with mained agricultural and still achieved high per a favorable world environment. But if govern- capita incomeAustralia and New Zealand, for ex- ments in the industrial and developing countries ample. Others have become industrialized without do not take up the challenge of adjustment, the increases in agricultural productivity but through result will be slow growth, increasing protection, exports of labor-intensive manufacturesHong and greater instability in the world economy. So, Kong, the Republic of Korea, and , for in the Low case, the developing countries grow at example. around 4 percent, a rate too slow to enable them to Within these broad sectoral shifts, early industri- tackle their debt problems. Countries which at- alization moved through another seriesof tempted reforms would do better than those that changes. First it centered on textiles, then iron, did not, but in any event the Low case represents a steel, and engineering products based on steel. missed opportunity which would have drastic ef- Later the focus shifted to electronics and micro- fects on the vast majority of the world's poor. electronics. But today's developing countries need not follow the same sequence. Now that technol- Industrialization: trends and ogy is so portable, they can create an engineering transformations (Chapter 3) industry without producing iron and steel or leap Industrialization is a part of the open-ended to microelectronics without building large indus- process of economic development that began trial complexes.

5 Figure 1.1 Long-term trends in GDP and employment by sector, selected years, 1890-1984 (percent) GDP Japan United United StatesBrazil Kenya Republic Kingdom of Korea

100

80

60

40

20

0 Employment i France Germany Japan United United StatesBrazil Kenya Republic Kingdom of Korea

100

80

60

40

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0

S Industry 0 Services 0 Agriculture

Note: The years are approximate time periods only. Industry includes manufacturing, mining, and construction (the data for Kenya also include electricity, gas, and water). The services category includes all output and employment not counted as part of industry and agriculture. a. Data from 1950 onward refer to the Federal Republic of Germany. Source: Kuznets 1957, appendix tables 2 and 4; International Labour Organisation 1970, 1980, 1985; and OECD and World Bank data.

The lessons of history, therefore, need to be in- Policy seems to matter more. All countries have terpreted with care. There is no unique path to protected industry at one time or another, but the industrialization. That said, some common themes successful early industrializers benefited from pe- emerge from past experience and point the way for riods of , and their levels of protection countries that are embarking on industrialization were for the most part low compared with those today. For example, countries with large domestic found today in many developing countries. markets are in a better position to establish indus- Thus far, all of the countries that have industrial- trial plants and take advantage of economies of ized began the process with relatively skilled labor scale. A rich endowment of natural resources pro- forces. And all except Britain acquired technolo- vides financial means to support industrialization gies from abroad. The two factors are linked, be- efforts. But neither size nor natural resources guar- cause technical skills are necessary to make intelli- antee that a country can industrialize successfully. gent choices of technologies, and the gains are Indeed, they can lull cOuntries into complacency. much greater when those choices are efficiently

6 adapted to each country's special circumstances. Most governments provide economic informa- Governments have played a key role in thisand tion and regulation of standards (weights, mea- in the provision of physical infrastructure. Ad- sures, safety at work). But there is a limit to the vances in transport and communications ex- information they can make available in time to be panded markets, increased specialization, and useful, and regulations can often be ineffective or brought about an integrated industrial world. Ex- counterproductive. cept in the , most of the early Governments in the industrial economies pro- transport networks were publicly funded. Another mote scientific and technological research. For de- key role for government has been the provision of veloping countries, where it usually makes sense stable yet flexible social and economic institutions: to acquire foreign technology, the arguments for a this includes everything from microeconomic large government role in industrial research and "rules of the game" (property rights and so forth) development are less compelling. But public sup- to noninflationary macroeconomic policy. port may be justified in some cases. State-owned enterprises were established to The role of government (Chapter 4) carry out some of these tasks. Some have per- formed well, but many have disappointed. Efforts Markets and governments have complementary are under way to reform them. Such reforms are roles in industrialization. Markets are adept at high on the agenda for structural adjustment in dealing with the growing economic complexity developing countries. that comes with industrialization, but they are In addition to these forms of direct participation, rarely perfect. Government must sometimes inter- governments intervene somewhat less directly in vene to achieve an efficient outcome. the running of their economies. Trade policy, fiscal First, governments have to set the rules of the incentives, price controls, investment regulations, game, which define the use, ownership, and con- and financial and macroeconomic policies are their ditions of transfer of physical, financial, and intel- instruments. Capital market failures and external- lectualassets.Irrespectiveofthe type of ities are the most cited justifications for direct inter- economywhether it favors private enterprise or vention. Both concepts have been used, for exam- is a command economythese rules impinge on ple, to defend policies toward infant industries. economic activity. The more they are certain, well Suppose a potentially profitable young firm is defined, and well understood, the more smoothly unable to find the funds to tide it over the period the economy can work. In many developing coun- before it becomes financially viable and can recoup tries these rules are often unclear, interpreted in its costs. Without government support such firms unpredictable ways, and managed by a cumber- would not be able to start production. Or suppose some bureaucracy. This tends to raise the costs of that the firm could generate economic benefits to doing and therefore discourages the the rest of the economyfor example, in the form transactions that are essential for industrial spe- of trained workers who leave and take their skills cialization. elsewhere. Again some form of government sup- Governments must continue to be the main pro- port is warranted. Import protection is never the viders of certain services that have facilitated in- best form of intervention in principle, but some- dustrialization in the past: times there may be no practical alternative. All governments play a major role in educa- Different forms of intervention will have differ- tion, especially in providing the basic skills of liter- ent effects on the economy. Indeed, the important acy and numeracy that are vital in a modern indus- question often is not whether to intervene, but trial labor force. Lack of education, rather than how. Quantitative restrictions on may be physical assets, is the main bottleneck in industri- used to protect infant industries, for instance. But alization. they will raise social costs more than a will, Most governments provide the physical infra- because they encourage unproductive activities structure of industry: transport, communications, such as the efforts of producers to avoid or exploit and power . Although some parts of such the controls. Tariffs, however, raise prices to con- systems can be, and are, profitably operated in the sumers. Subsidies to the industry could give the private sector in many countries, government pro- same assistance without raising pricesalthough vision of large systems in most developing coun- not without raising public spending and, possibly, tries is usually the only feasible option. budget deficits.

7 Trade poiicy and industrialization trial incentives are administered by an elaborate (Chapter 5) and expensive bureaucracy. This Report presents a study of forty-one econ- Economists and policymakers in developing coun- omies which shows that outward-oriented econo- tries broadly agree that governments need to pro- mies tend to perform better than inward-oriented vide infrastructure, promote market efficiency, and economies. Their overall output grew faster. They foster a stable macroeconomic environment. Trade industrialized more smoothly, even though their policy is a much more contentious issue. explicit interventions in support of that goal were Trade policies can be characterized as outward far fewer. For the economies that followed more oriented or inward oriented. An outward-oriented mixed strategies, however, differences in average strategy provides incentives which are neutral be- performance were small; since many factors apart tween production for the domestic market and ex- from trade policy influence economic success, this ports. Because international trade is not positively is scarcely surprising. The important lesson is that discouraged, this approach is often, although the strongly inward-oriented economies did badly. somewhat misleadingly, referred to as export pro- motion. In truth, the essence of an outward- Trade policy reform (Chapter 6) oriented strategy is neither discrimination in favor of exports nor bias against import substitution. By Like most policy changes, the shift toward out- contrast, in an inward-oriented strategy trade and ward orientation inevitably involves transitional industrial incentives are biased in favor of domes- costs. Major shifts in resources accompany trade tic production and against foreign trade. This , as some activities contract and oth- approach is often referred to as an import substitu- ers expand in response to the changes in prices tion strategy. In some countries the bias against that the reforms must entail. If the economy is trade has been extreme. highly distorted to begin with, larger changes are An inward-oriented strategy usually means more likely to be necessary. One visible cost is un- overt protection. What is less obvious is that shel- employment, although recent research on trade re- tering domestic industries puts exports at a great form shows that it has caused less disadvantage because it raises the costs of the for- than is generally supposed. eign inputs used in their production. Moreover, an More often than not, trade liberalization comes increase in the relative costs of domestic inputs in the wake of economic crises that are associated may also occur through inflationor because of an with budget and balance of payments deficits and appreciation of the exchange rateas the import inflation. Such crises may create the political will restrictions are introduced. for changean important ingredient in undertak- In practice, trade policy contains elements of ing trade liberalization. A government's long-term both approaches. Differences arise as much from commitment to reform needs to be credible if eco- the choice of instruments as from the absence or nomic agents are to respond to the incentives the presence of intervention. Outward-oriented poli- reform creates. Trade liberalization may therefore cies favor tariffs over quantitative restrictions. be more likely to succeed when the initial shifts in These tariffs are usually counterbalanced by other policy are substantial: this adds to the credibility of measures, including production subsidies and the reform. Moreover, a strong initial shift in policy provision of inputs at "free trade" prices. Govern- can quickly boost exports enough to create vested ments aim to keep the exchange rate at a level that interests in support of further liberalization. provides equal incentives to produce exports and Stable macroeconomic policiesaimed at reduc- import substitutes. Overall protection is lower un- ing inflation and preventing the from der an outward-oriented strategy than under in- appreciatingare also crucial for the success of ward orientation; equally important, the spread trade reforms. Many trade liberalization efforts between the highest and lowest rates of protection have foundered owing to poor macroeconomic is narrower. policies rather than poor trade policies. Once the Inward-oriented strategies typically prefer quan- reforms are undertaken, their fate often rests titative restrictions to tariffs, and they involve a mainly with the balance of paymentsand this is higher overall level of protection, together with the outcome of macroeconomic policy. greater variation across activities. Exchange rates Experience suggests that export performance is are generally overvalued because of high protec- closely related to the level and stability of the ex- tion and the use of quantitative restrictions. Indus- change rate. Conversely, using the exchange rate

8 to stabilize domestic prices is inconsistent with common, attempt to influence the pattern of pri- trade reform. In the countries of the Southern vate investment in line with government priorities. Cone of Latin America, capital inflows led to the Investments by foreigners are often subject to appreciation of exchange rates, which offset the more stringent regulations than those of nationals. incentives for increasing the production of exports The result is a distorted pattern of prices and in- and import substitutes. Large capital inflows were centives. For example, investments in capital- in some cases the result of liberalization of the fi- intensive technology are in many cases the result nancial markets in which domestic interest rates of the low price of capital and overvalued ex- rose very sharply. This provoked heavy borrowing change rates. High domestic protection encour- from abroad. ages "tariff jumping" by foreign investors, which A review of the recent history of trade policy in turn leads to investments in activities with low reforms suggests that three elements seem to mat- or negative social returns. ter most in their design. The first is the move from Financial policies are another important influ- quantitative restrictions to tariffs. This links do- ence on the pattern of industrialization, through mestic prices to foreign prices. The second is the their effects on savings and the cost of capital. In- reduction of the variation in rates of protection terest rate controls are common in developing alongside reductions in its overall level. Other- countries. They encourage investment at low rates wise, protection accorded to value added in some of return and excessively capital-intensive technol- sectors may increase, because as a result of re- ogy. They also discourage financial savings. But duced tariffs and quotas the prices of inputs may dismantling these controls must be done carefully: fall faster than the prices of outputs. The third ele- macroeconomic stability, low public sector deficits, ment is the direct promotion of exports to offset and proper exchange rate may have the bias arising from import tariffs. Specific mea- to precede attempts to liberalize financial policies. sures to promote exports risk acquiring a perma- Because medium- and long-term finance is often nent status, however, and often lead to the post- found inadequate for industrial investments, gov- ponement of more fundamental changes relating ernments in developing countries have established to the exchange rate. They may also contravene medium- and long-term financial institutions such the General Agreement on Tariffs and Trade as development banks. They have also tried to pro- (GATT), create lobbies that will oppose their re- mote bond and equity markets. In many cases moval, and risk countervailing actions from these institutions have depended heavily on public importers. resources and have been unsuccessful in mobiliz- ing resources for themselves. Complementary policies for industrial Labor market policies involving highly regulated development (Chapter 7) wages, payroll , and rules governing job secu- rity are common in developing countries. Mini- Trade policy is only one of the many instruments mum wage regulations are particularly prevalent, used by governments to influence the pattern of but they carry certain risks. If minimum wages are industrialization. The others fall into four broad set too high, they deter employment by favoring categories: the use of capital over labor, they increase inequali- Price controls are used to achieve income distri- ties between the formal and informal sectors, and bution goals, to protect consumers from monop- they reduce returns to education and training by oly, to promote industry through their influence narrowing differentials between skilled and un- on input prices, and to control inflation. They are skilledlabor. The other popular forms of pervasive in many developing countries. Although interventionsuch as payroll taxes, wage policies they can have some short-run beneficial effects by for the public sector, and rules on job securityall lowering price expectations in periods of high in- risk, to some extent, distorting the labor market in flation, their usual long-run effects harm rather ways that reduce employment and overall living than promote efficiency. They restrict supply, en- standards. courage the emergence of dual markets, distort cost relationships, entail high administrative costs, The combined effect of trade and domestic policies and create vested interests in their permanence. Programs targeted to support the poor directly are Trade and domestic policies jointly influence prices a better way to attack poverty. of capital and labor. For example, exchange rate Regulations, of which licensing is the most overvaluation increases the demand for capital in

9 relation to the demand for labor. Import licensing goods, steel, and shipbuilding use standard tech- systems, which often give priority to capital im- nology and, in many instances, labor-intensive ports, reinforce this bias. Interest rate controls methods. This has made them vulnerable to com- work in the same direction. petition from the newly industrializing countries Another aspect of the interaction between trade (NICsdefined here as the economies of Brazil, and domestic policies is their influence on the com- , , the Republic of Korea, and petitive environment. On the one hand, barriers to Singapore) in recent years. As new entrants, the entry brought about by import restrictions can cre- NICs were able to absorb the existing technology ate monopolies. On the other hand, stringent laws and combine it with labor that was much cheaper to limit the size of firms make it harder to achieve and highly productive. Labor in the NICs not only economies of scale. Rigid job security regulations, was willing to operate at lower wages than in the laws against mergers and acquisitions, and the ab- industrial countries, and with fewer for sence of bankruptcy laws can make it difficult for and safety at work, but also was exempt firms to leave an industry. Exit barriers maintain from the overmanning, job demarcation, and re- inefficiency and inhibit structural change. And strictive working practices which were common in many studies indicate that trade, industrial, and the industrial countries. financial policies discriminate against small firms. Management and labor in the industrial coun- tries' traditional industries have a common interest Technological developnient and industrialization in gaining protectionmanagement to maintain profits, and workers to retain jobs and incomes. Technological development involves the acquisi- Labor unions have the additional motive of retain- tion and adaptation of technology. Prices strongly ing members who would be lost to the union if influence the process. Governments have at- they became unemployed or switched to other in- tempted to provide public support for technologi- dustries. Overvalued exchange rates (in some cal development in many waysfor example, cases) and world recession added to the pressures through systems of patents to protect proprietary and led to increased demands for protection. rights in technological advances and through sub- These spread beyond the parties directly involved sidized research Greater contact with producers to others who, in a climate of rapidly rising levels would increase the impact of the public research of unemployment, saw protection as a general so- institutes. There is little hard evidence on which lution. Yet protection has not, as a rule, saved jobs. approaches work best, but a combination of undis- An alternative response to changes in the struc- torted market signals with targeted public support ture of trade is to ease the movement of resources seems most promising. out of the industries which have lost competitive- ness, while providing compensation to workers The threat of (Chapter 8) who need to retrain, move to new forms of work, or opt for early retirement. Protection is justified Since World War II, tariffs in industrial countries only if it is necessary to slow the speed of adjust- on most manufactures have fallen so far that they ment, and then only if subsidies are not available are no longer significant barriers to trade. But re- for the purpose. Even so, the protection could be cent years have seen a resurgence of protection in damaging if it is not designed to be temporary and the form of nontariff barriers. The proportion of degressive. Otherwise it will not promote adjust- North American and European Community im- ment, but simply delay the shift of resources from ports affected by various nontariff restrictions has dying industries to more productive uses. risen by more than 20 percent from 1981 to 1986. Such restrictions cover large volumes of imports Toward a more open trading (Chapter 9) and affect developing countries' exports in particu- lar. Nontariff barriers in clothing and footwear A big danger is that industrial countries will act in have proved porous, so developing countries have a negative and defensive way toward increased been able to go on increasing their exports to the imports of manufactures from developing coun- industrial economies, but at a cost, and with in- tries. This would mean raising trade barriers of the creasing difficulty as leaks in the nontariff barriers more discriminatory typethat is, more nontariff are plugged. barriers more effectively administered. This would Nontariff protection is concentrated on a few in- further undermine the integrity of the GAIT sys- dustries. Textiles, clothing, footwear, leather tem and would restrict the growth of developing

10 countries' exports. Many developing countries are outward orientation, even though the benefits already heavily in debt, so a reduction in their ex- would be reduced in a more protectionist indus- port earnings would aggravate the problems of trial world. But politically it would then be very world debt. difficult for them to follow an outward-oriented Developing countrieswith limited foreign ex- strategy, even if it were objectively their best bet. change and facing unusually low commodity In other words, there is a serious risk that in- pricesmay soon face even higher barriers against creased protection by the industrial nations will set the manufactures which have traditionally been back economic development for many years and their first industrial exports. Should that happen, inflict unnecessary suffering on some of the poor- there could be widespread disillusion with the est people in the world. In any case, the industrial outward-oriented trade strategies which have nations themselves stand to gain from open trade. proved so successful for the NICs in recent years. The risks make it crucial that all countries strive If countries such as the United States or the United for a successful outcome from the Uruguay Round Kingdom increase their protection, it would hardly of multilateral trade negotiations (MTN). For some be surprising if many developing countries fol- developing countries that may mean offering to lowed suit. Unfortunately, increased protection reduce, or at least bind, some of their trade barriers will still mean poor economic performance in all in order to encourage the industrial nations to countries. open markets to them. Most of the ways to achieve If industrial countries become more protection- greater and more secure access are on the agenda ist, this would force developing countries to ex- for the MTN. Implementation of the "standstill plore a range of second-best options. These would and rollback" provision of the MTN would imme- include trying to expand trade with the centrally diately help developing countries. A reduction in planned economies, and with other developing tariff escalation would also aid their exports of countries, on a discriminatory basis. But the pros- manufactures. A more effective proce- pects of greatly improved trade in either of these dure in a reformed Article XIX would contribute to directions are not good. Neither could replace increased security of market access, as would a trade with the industrial market economies. more liberal Multifibre Arrangement and im- The best option for most developing countries is proved procedures for settling disputes.

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