Trade leads to improved industry performance and innovation, and a reduction in inefficiencies in developing countries

Compared to 40 years ago, the developing world is much more open to international trade and integrated in the global trading system. The import substitution industrialisation pursued by several Latin American economies was abandoned in favour of large scale, unilateral trade liberalisations that accompanied these countries’ entry into the GATT or the WTO. India and China, once effectively closed to foreign competition through a combination of high tariffs, complex non-tariff barriers, and domestic regulations that discriminated against imports, slashed their tariffs and reduced non-tariff barriers substantially. In return, these countries saw the lifting of trade restrictions on their exports. In many instances, regional trade blocs (such as NAFTA or Mercosur) liberalised trade among their members, while maintaining trade barriers vis-a-vis non-member countries. Many restrictions to foreign direct investment were also eliminated. The reduction in transportation and communication costs made possible by recent technological advances has reinforced and accelerated the effects of trade liberalisation, and as a result, imports from and exports to the rest of the world have reached unprecedentedly high levels (Goldberg and Pavcnik 2007, Hanson 2012).

The liberalisation debate: Boon or bane?

What has this liberalisation wave done for developing countries? Has their integration in the international trade system delivered on the promises of higher growth, lower poverty, and enhanced efficiency that free trade advocates (either implicitly or explicitly) made? Are developing countries better off today than they were 40 years ago?

Two factions dominate the debate about whether or not openness is associated with faster development and growth. On one side are those who believe that industries and countries at an early stage of development need to be sheltered from more competitive rivals. This ‘infant industry’ protection type of argument was behind the import substituting polices of the 1950s and 1960s, as well as the export promotion strategies of the East Asian Tigers in the 1960s and the industrial policy of China more recently. On the other side are those who believe that low trade barriers and exposure to international markets and competition contribute to higher efficiency and growth. In principle it seems that one should be able to settle this argument with empirical evidence. Yet the relationship between openness and growth is one that, despite richer data, has remained empirically elusive. The main challenge is identification. Countries that are more open to trade may boast higher growth rates, but they vary in characteristics (geography, culture, history, and other domestic policies) that are plausibly correlated with growth. And prosperous countries may be more willing to reduce trade barriers. Given these identification challenges, the debate has often been based on first principles or theoretical arguments.

The recent waves of trade liberalisation in developing countries present an unprecedented opportunity to study this question using rich micro data and plausibly exogenous quasi-experiments. Because the key trade policy instrument in most developing countries was tariffs, trade liberalisation in these countries was first and foremost tariff liberalisation. In contrast to non-tariff barriers, tariffs are well measured, so their reductions provided researches with solid measures of the extent of liberalisation. Further, as we have argued in prior work (Goldberg and Pavcnik 2007, 2016), in each liberalising country, the tariff reductions differed across sectors for reasons that were, in many cases, unrelated to industry characteristics or lobbying. This cross-industry variation can be exploited in conjunction with micro data (firm, labour, or consumer surveys) to identify the causal effects of trade liberalisation. Making a direct causal connection between tariff reductions and aggregate outcomes such as growth or poverty rates is not possible as there is only one data point for aggregate growth or poverty per year. However, one can shed light on this relationship indirectly, by focusing on outcomes that are correlated with, and conducive to growth, such as productivity, innovation, R&D expenditures, and introduction of new products. These outcomes vary across firms and industries that have differential exposure to trade; by linking their changes to the differential tariff reductions experienced by different firms or industries, one can identify the causal effects of the liberalisation. So what does the evidence show?

The impact of liberalisation

Industry productivity

One of the most robust empirical findings is that trade liberalisation increases industry productivity, where productivity is measured as revenue productivity—that is, average revenue in the industry net of input expenditures. There are two mechanisms that contribute to this increase.

  • First, there is reallocation of market share towards the more profitable firms; less profitable firms go out of business or reduce their sales, while more profitable firms expand.
  • Second, the profitability of individual firms may increase, either because firms shift resources towards more profitable products or because firms reduce inefficiencies and adopt better managerial practices.

The relative importance of these two mechanisms for increasing profitability varies across studies. Further, it is not clear whether the extra profitability derives from increased efficiency or higher mark-ups. In either case, the evidence suggests that trade liberalisation boosts average industry performance (Goldberg and Pavcnik 2016).

Innovation

A further robust finding that seems specific to and particularly important for developing countries is that tariff reductions on intermediates (i.e., products that are used as inputs in the production of other, domestically produced products) have substantially larger effects on firm and industry performance than tariff reductions on final products (Amiti and Konings 2007, De Loecker et al. 2016, Goldberg and Pavcnik 2016, Khandelwal and Topalova 2009). The former encourage the import of cheaper and higher quality inputs that may have been unaffordable prior to the liberalisation. In India, a standard complaint of industry representatives prior to liberalisation was that the lack of adequate intermediates made it impossible to produce even for the domestic market, not to mention exports. The Indian trade liberalisation substantially reduced the cost of importing such intermediates and gave Indian firms access to previously unavailable inputs. Consistent with the industry complaints, the evidence shows that following the Indian trade liberalisation, domestic firms introduced many new products, and the new product introductions were more pronounced in sectors that had experienced large tariff reductions on their imported intermediates (Goldberg et al. 2010). Of course, access to appropriate inputs is important in every country; but the issue seems truly first-order in developing countries that, in contrast to more advance economies, may not have the capability to produce such inputs on their own. Hence, it is not surprising that the massive reduction of tariffs on intermediates in India boosted product innovation. While somewhat more scant, there is also evidence that trade liberalisation provided firms with incentives to invest in new technologies and R&D that enhanced productivity (Bustos 2011).

Reduction in inefficiencies

Last but not least, the exposure of developing countries to foreign competition has led to the reduction of secondary distortions, inefficiencies, and misallocation due to size-dependent distortions. For example, the elimination of the Multi Fibre Agreement in 2005 resulted in a 21% increase of revenue productivity in China; two thirds of this improvement are due to the elimination of the distortions associated with the way the quotas were allocated among domestic firms (Khandelwal et al. 2013). The reduction of barriers to exporting in Vietnam in 2001 resulted in reallocation of workers from small, unproductive firms in the informal sector to larger, more efficient firms in the formal sector (McCaig and Pavcnik 2014). Taken together, this evidence strongly suggests that the integration of developing countries in the world market has contributed to better industry performance, adoption of new technologies, innovation, and elimination of distortions and inefficiencies in these countries.

Concluding remarks

Three qualifications are in order. First, the massive trade liberalisations were in many instances accompanied by domestic policies that directly or indirectly benefited exporters (industrial policies, subsidies, preferential credit). For example, we do not know for sure whether China is a success story because it opened up or because its government actively supported exports (McMillan and Rodrik 2011).

Second, one important lesson from international trade theory is that trade liberalisation generates winners and losers. And while it is in principle possible for the winners to compensate the losers in such a way that no one is worse off in the end, such compensation does not always happen in practice. At a minimum, compensating the losers requires knowledge of who the losers are and how much they lost. In the context of developing countries, much research has focused on the effects of liberalisation on the income distribution of these countries. We will leave discussion of these findings to a future column. At present, it is important to note that establishing that a policy (e.g., trade liberalisation) has beneficial effects in the aggregate, does not guarantee that this policy will be implemented or continued. If the policy has adverse distributional effects, it is likely that the losers will try to block it or reverse it. Hence, even if one believes that for developing countries the distributional consequences of free trade are second-order relative to the first-order issues of growth and poverty reduction, it is still critical to understand these distributional consequences if one wants free trade to survive.

Third and relatedly, empirical evidence suggests that competition from low-wage developing countries has contributed to the decline of manufacturing employment in the US, polarisation, and increase in inequality (whether or not this competition was the primary cause of these phenomena as opposed to a contributing factor remains an open question) (Autor et al. 2013, Pierce and Schott 2016). In a provocative book, Branko Milanovic (2016) argues that the reduction in global inequality across countries has been achieved at the cost of rising inequality within countries. Concerns about rising within-country inequality in the US and Europe have led to calls for protectionism, so that the gains from trade liberalisation can no longer be taken for granted. To avoid a return to the past, it is more important than ever for academics and policymakers alike to actively engage with the distributional consequences of globalisation.

References

Amiti, M and J Konings (2007), “Trade liberalization, intermediate inputs, and productivity: Evidence from Indonesia”, American Economic Review 97(5): 1611-38.

Autor, D, D Dorn and G Hanson (2013), "The China Syndrome: Local labor market effects of import competition in the United States", American Economic Review 103(6): 2121-68.

Bustos, P (2011), “Trade liberalization, exports, and technology upgrading: Evidence on the impact of MERCOSUR on Argentinian firms”, American Economic Review 101(1): 304-340.

De Loecker, J, P Goldberg, A Khandelwal and N Pavcnik (2016), “Prices, markups and trade reform”, Econometrica 84(2): 445-510.

Goldberg, P and N Pavcnik (2007), "Distributional effects of globalization in developing countries", Journal of Economic Literature 45(1): 39-82.

Goldberg, P and N Pavcnik (2016), "The effects of trade policy", Handbook of Commercial Policy, K Bagwell and R Staiger (eds), Volume 1A, Chapter 3.

Goldberg, P, A Khandelwal, N Pavcnik and P Topalova (2010) “Imported intermediate inputs and domestic product growth: Evidence from India”, Quarterly Journal of Economics 125(4): 1727-1767.

Hanson, G (2012).  “The rise of the middle kingdoms: Emerging Economies in Global Trade,” Journal of Economic Perspectives 26(2): 41-63.

Khandelwal, A, P Schott and S Wei (2013), "Trade liberalization and embedded institutional reform: Evidence from Chinese exporters", American Economic Review 103(6): 2169-95.

Khandelwal, A and P Topalova (2011), “Trade liberalization and firm productivity: The case of India”, Review of Economics and Statistics 93(3): 995-1009.

McCaig, B and N Pavcnik (2014), “Export markets and labor reallocation in a low-income country", NBER, Working Paper 20455.

McMillan, M S and D Rodrik (2011) “Globalization, structural change, and economic  growth”, NBER, Working Paper 17143.

Milanovic, B (2016), Global inequality: A new approach for the age of globalization, Harvard University Press.

Pierce, J and P Schott (2016) “The surprisingly swift decline of US manufacturing employment”, American Economic Review 106(7): 1632-62.

Globalisation Trade liberalisation Tariffs Imports Exports International trade Innovation