Poor hurt by deregulation of trade and capital flows, says new study

Disproving a number of oft-cited studies which tout the benefits of economic openness, a new paper by two researchers at a Washington-based think-tank has found that global deregulation of trade and capital markets, far from successfully reducing poverty and inequality, actually harms the poor instead.

GENEVA: A careful study of evidence shows that policies of global deregulation of the current and capital accounts to promote trade and capital flows, often touted by the World Bank and others as successful means to reduce poverty and inequality, hurt the poor instead, according to a new study.

The study, “The Long and Short of It: Global Liberalization, Poverty and Inequality,” is by Christian E. Weller and Adam Hersh at the Economic Policy Institute, a Washington DC-based think-tank. It examines and critiques the available literature, including the major ones oft-cited by the World Bank as conclusive: the Sachs-Warner study (1995) about open economies doing better in terms of growth and incomes, two studies (both 2001) by Dollar and Kraay about trade, growth and poverty, and the Dollar and Collier (2001) survey of research on globalization, growth and poverty which purports to show that globalization promotes growth and reduces poverty.

Using data from the Bank, the IMF and the UN, and testing the impact of increased deregulation on the incomes of the poor, Weller and Hersh find that “global deregulation of trade and capital markets does hurt the poor.”

Looking at the short-term and long-run effects of global liberalization on the poor in developing economies, Weller and Hersh say that their results indicate that “more current and capital account liberalization hurt the poor, not because trade is directly harmful for the poor, but because of the institutional design under which trade is conducted.”

“In particular,” say the two researchers in their conclusion, “trade in a more deregulated environment lowers the income share of the poor, whereas trade in a more regulated environment raises the share of the poor. The short-term effects on the income share of the poor [are] not offset by faster income growth in the long run. Our results indicate that global deregulation has no measurable, robust impact on growth rates. Thus, there does not appear to be a trade-off between adverse effects in the short run and long-run benefits for the poor.”

In a regulated atmosphere, trade and possibly capital flows “may have a beneficial effect on growth in the long run, and no systematic adverse effect on the income share of the poor,” according to the authors of the study.

“Hence, greater trade and capital mobility in a regulated environment - as was the case for the majority of countries for most of the sample period (1980-1999) - appears to be a preferable development choice. More research, though, is needed to identify exactly which types of regulations are specifically well-suited to reap the benefits from trade and capital flows, while letting the poor share in the gains in the short term and in the long run.”

The study notes that a number of policymakers have recently been touting the potential of globalization and global economic integration to combat poverty and inequity. World Bank researchers (D. Dollar and P. Collier, 2001) have claimed that globalization “reduces poverty because integrated economies tend to grow faster and this growth is usually widely diffused.”

Other studies however cast doubt on this “benign view of global liberalization.” In particular, the evidence indicates that successful reductions in poverty and income inequality remain elusive in most parts of the world at the same time that trade and capital flows have become more integrated due to current- and capital-account deregulation. Also, the evidence of trends in global poverty and inequality tends not to support the stance taken by proponents of the global liberalization agenda. Gains in poverty reduction over the previous two decades, if any, were relatively small and geographically isolated, Weller and Hersh find.

The number of poor people, they note, rose from 1987 to 1998, and the proportion of poor people increased in many countries; in 1998 close to half of the population were considered poor in many parts of the world. Moreover, the numbers show that income inequality between and within countries increased along with deregulation of trade and capital markets. In 1980, median income in the richest 10% of countries was 77 times greater than in the poorest 10%; by 1999, that gap had grown to 122 times. Inequality has also increased within a vast majority of countries.

Differences in interpreting evidence

A closer look at the relationship between economic openness, growth and poverty reduction reveals that one of the main differences in the interpretation of the evidence lies in the time frame of reference. In particular, those in favour of liberalized trade and capital flows focus on the long run, often ignoring short-term fluctuations that are especially harmful to the poor.

Moreover, some of the previous studies used data only through the early 1990s, when the last round of trade and capital liberalization, through the entry into force of the World Trade Organization (WTO), had not taken place.

Looking at the short-term impacts on the poor from greater liberalization of trade and capital flows through the end of the 1990s and also analyzing whether any short-term costs are offset by long-term gains, Weller and Hersh say that the results indicate that global deregulation of trade and capital markets does hurt the poor. They find that the income share of the poor is generally lower in deregulated and in macroeconomically less stable environments, which are more prone to occur after capital account liberalization. The evidence also suggests that trade flows in more regulated environments may be good for growth and, by extension, for the poor in the long run.

They find that the empirical results often used in the existing literature to support increased global liberalization may not necessarily be robust, and that the definitions of global liberalization, the selection of countries and the time frames employed in previous analyses have to be scrutinized.

A key problem, Weller and Hersh say, lies in the difficulty of gauging economic openness. While research has focussed on defining openness in terms of statutory measures as well as on the actual flows of trade and capital across national borders, these approaches suffer from a host of problems, as brought out in two studies (Rodriguez and Rodrik, 1999, NBER working paper; Eichengreen, 2001).

The World Bank research (by Dollar and Kraay) looks at the effects of increasing international integration of production, consumption and investment on developing countries, measured in the level of international trade and capital flows relative to GDP. This research makes a two-step argument to support the view that globalization tends to benefit the poor: first showing that an increasing level of trade is good for economic growth, and second that the benefits of this growth tend to be distributed equally throughout different income levels over long periods of time.

This approach implicitly assumes that changes in trade volumes are attributable to changes in trade policy. However, to leap from the notion that integration is good to the notion that openness is good because it will lead to integration is problematic. Trade volume alone indicates “only a policy outcome, not a policy choice for development.” The trade-volume approach tends to ignore possible causes of increasing trade other than changes in trade policy, such as reduced transportation costs and growing world demand.

As Rodriguez and Rodrik (1999) note, while purporting to answer the question “Do countries with lower policy-induced barriers to trade grow faster?”, the volume measures actually answer a qualitatively different question, “Does growth of trade raise economic growth rates?” This last offers little insight into the policy choices facing developing countries.

The second step of the two-step argument in the Dollar and Kraay paper examines the distribution of income to the poor relative to the rest of society, and finds that in the long run, there is a one-to-one relationship between the share of income accruing to the bottom quintile relative to the top quintiles. It should be no surprise that in the long run the shares of growth are distributed equally across all income levels.

[The UN’s Economic Commission for Europe, in its Economic Survey of Europe 2000 No. 1, found convergence of real per capita GDP between western Europe and the US in the post-war period up to 1973, a process that weakened thereafter. The two periods were marked by state intervention and active role in the economy, and greater reliance on markets respectively.]

In the Sachs-Warner (SW) study and index of 1995 (an oft-cited benchmark study by promoters of liberalization on growth effects of economic openness), an economy was judged to be open when none of the following characteristics held true: non-tariff barriers covering more than 40% of trade; average tariff rates of 40% or more; black market premiums of 20% or more for the 1970s or 1980s; a socialist economic system; or a state monopoly on major exports. Using these, Sachs and Warner found “open economies tended to grow faster.”

However, the study suffers from a number of problems. First, as SW themselves note, it is difficult to disencumber the effects of trade and capital market deregulation from other economic reforms such as price liberalization, budget restructuring, privatization and deregulation that inevitably comprise a comprehensive programme of reform.

In testing for which particular components of the SW study explained the association of openness with growth, Rodriguez and Rodrik (1999) found that black market premiums, implying foreign exchange restraints acting as a trade barrier, and the existence of state monopolies over exports, reducing the level of trade, explain the association of openness with growth. They found that tariff rates and non-tariff barriers have insignificant effects on growth. They also found that the state-export-board variable used posed a selection bias, since it was highly correlated with the regional variable for Africa, while the black-market-premiums variable was a bad indicator of trade policy since it was more closely related with macroeconomic imbalances attributable to other failed policies, political conflict and external shocks.

And Eichengreen (2001) found that just because an economy is open does not mean that it will integrate with the rest of the world. He cautioned against a presumption that capital will flow into a country for uses where its marginal product exceeds its opportunity cost, if a country is open to capital. Similarly, just because a country reduces trade barriers does not mean it will export more.

The SW study also examined the effect of openness on growth in the period 1970-1989. Yet most countries in their sample did not open their economies until the 1980s or 1990s. Twenty countries in their sample opened their economies between 1989 and 1994 and others only opened at the end of the period. It is widely held that economic integration and the transition to openness may take “a couple of decades or more.” Thus, with such a lag, it is unclear that the growth effects SW observe for those countries opening in the 1980s resulted from economic openness.

Since the publication of SW, deregulation of trade and capital markets has become nearly universal, with WTO membership now totalling 144 countries. With such a pervasive shift to liberalized economic policies, Weller and Hersh examine how well the SW findings hold for different time periods and for other countries. They address some of the shortcomings of earlier research, and in particular, control for both trade volumes and institutional design. They also extend the research to include the later part of the 1990s, and analyze both the short-term and long-term effects of openness and trade on the poor.

On the basis of existing literature, it is expected that global liberalization of capital and current accounts are harmful to the poor in the short run. But are there offsetting effects in the long run as a result of higher economic growth rates?

Burdens borne by poor

The Weller-Hersh study notes that over the past decades international capital mobility has grown as capital controls were reduced or eliminated virtually everywhere. Capital flows to developing countries grew rapidly from $1.9 billion in 1980 to $120.3 billion in 1997 (the last year before the global financial crisis), or by more than 6000 percent. Even in 1998, in the wake of the financial crisis, capital flows remained remarkably high at $56 billion. A substantial share of these capital flows, 36% in 1997, were short-term portfolio investments, according to the IMF.

Faster capital mobility in a more deregulated environment, the study says, can lead to rising inequality in the short and medium term, both within and between countries, and to less poverty reduction or even increasing poverty. A number of studies have found that the probability of financial crises in developing countries rises in direct relation to rises in unregulated short-term capital flows. More short-term capital inflows result in more speculative financing, thereby increasing financial instability. Several other studies have brought out that financial crises reduce the likelihood for the poor to escape poverty through economic growth because they are ill-equipped to weather the adverse shocks of macroeconomic crisis. Financial crises lower short-term growth rates, and it is estimated that for every percent decline in growth, poverty increases by 2 percent. Developing countries are prone to experience more severe economic crises with greater frequency than developed economies, leading to more inequality between countries.

The burdens of financial crisis, Weller and Hersh say, are disproportionately borne by a country’s poor. Since higher-income earners have better access to insurance mechanisms that protect them from the fallout of a crisis (including capital flight), macroeconomic crises lead to a more unequal income distribution within countries. Many studies that examine the impact of financial crises on the poor are likely to understate the true hardships suffered by low-income households during times of crisis. Many people are forced to reallocate household budgets away from spending on schooling and healthcare, to change their living arrangements, and to liquidate their assets in order to smooth consumption during a crisis.

At the same time that economic crises increase the need for well-functioning social safety nets, unfettered capital flows limit governments’ abilities to design policies to help the poor when they need it most in the middle of a crisis. The IMF often opposes increased government expenditures to assist the poor in the hardships of economic crisis, and investors withdraw their funds following increasing government expenditures. The poor are the first to lose under such fiscal contractions and the last to gain when crises subside and fiscal spending expands.

Trade liberalization, the complement to deregulated capital markets, also plays a significant role in raising inequality and limiting efforts at poverty reduction. By inducing rapid structural change and shifting employment within industrializing countries that liberalize, trade leads to falling real wages and declining working conditions and living standards. Critics of the view that trade liberalization has led to increasing inequality often contend that a more significant cause of inequality lies in skill-biased technological change. However, a study (Feenstra and Hanson, 2001) has shown that in fact skill-biased change can result from trade liberalization. Measuring the relative size of these effects, therefore, becomes an empirical rather than a theoretical issue.

Weller and Hersh also note that removal of trade barriers parlays into lower tariff revenues for developing countries; for example, tariffs generated roughly 40% of India’s tax revenues through much of the 1980s. Restructuring tax regimes to offset lost tariff revenues takes time and introduces administrative costs. Even if trade liberalization were growth-enhancing in the long run, in the short run revenue shortfalls may seriously constrain a government’s ability to maintain spending on social services that benefit low-income households.

Trade liberalization also gives teeth to employers’ threats to close plants or to relocate or outsource production abroad where labour regulations are less stringent and more difficult to enforce, and undermines worker attempts to organize and bargain for improved wages and working conditions. This trend fuels a race to the bottom in which national governments vie for needed investment by bidding down the cost to employers (and living standards) of working people.

The connection between rapid trade liberalization and inequality is widespread, indicating downward wage pressures and rising inequality following trade liberalization in industrializing and industrialized economies, according to a study by the US Trade Deficit Review Commission (2000). A report by the UN Conference on Trade and Development (1997) also found that trade liberalization in Latin America led to widening wage gaps, falling real wages of unskilled workers (often more than 90% of the labour force in developing countries) and rising unemployment.

Growing inequality

Weller and Hersh also look at the World Bank’s report on globalization and poverty (Dollar and Collier, 2001) lauding the profound impact of increasingly deregulated trade and capital markets in reducing global poverty and inequality. That report in fact shows that income inequality between and within countries increased along with deregulation of trade and capital markets. But the report raises two issues that supposedly mute the fact of rising intra-country inequality. It notes that the data for China dwarf observations for all other countries, and thereby suggests that rising inequality in globalizing countries does not exist outside of China. However, data for other countries show that growing inequality is indeed a widespread trend.

The World Bank has also claimed (World Development Indicators, 2001) that rising inequality is not a result of increasing poverty, and thus presumably less troubling. While this claim may hold true in China, say Weller and Hersh, it does not describe the trend in many other parts of the world.

The two authors point to the broad consensus that income inequality has risen in OECD countries since 1980. They cite several studies (including the Bank’s Dollar and Collier one) that show increasing inequality in the rich countries between the 1980s and 1990s, reversing earlier trends.

A number of other studies are also cited by Weller and Hersh showing that income inequality is also rising in industrializing countries, with an unambiguous rise in inequality in Latin America, as also the other areas of the developing world - East Asia, Eastern Europe, and Central Asia since 1981 - and growing polarization in South Asia. Only sub-Saharan Africa shows a trend towards more income equality since the 1980s.

While a widening gap between the rich and the poor within countries is not universal, it appears to have occurred at least in the majority of countries, and is affecting the income of the majority of people around the globe.

Gains in poverty reduction questioned

The study also finds that apart from the widespread increase in inequality, there are also signs that poverty reduction has not been particularly widespread. While Dollar and Collier claimed that the long-term trends of rising global inequality and rising numbers of people in absolute poverty have been halted and perhaps even reversed, the purported success is elusive: the number of poor people is on the rise, relative poverty shares remain high in many parts of the world, and poverty shares are rising in many regions, the Weller and Hersh study finds, citing in support some of the World Bank’s own studies as also a report of the IMF in 2000.

The World Bank’s assessment of poverty trends suffers from several problems, and when issues raised are studied, the Bank’s thesis about poverty reduction due to “more deregulated capital and trade flows does not stand up to scrutiny,” say Weller and Hersh.

Pointing to the problems of measurement of poverty, including the use of an international poverty line of $1.08 per day in 1993 dollars based on purchasing power parity (PPP), Weller and Hersh find that absolute poverty lines, such as this one, ignore regional or country-by-country differences.

By using the international poverty line, the share of people living in poverty is probably being understated. According to the World Bank itself (Global Poverty Monitoring database, 2001), when national poverty lines, instead of the international poverty line, are used, on average an additional 14% of the population is considered poor. According to the Bank’s Chen and Ravallion (2001) research, when a relative poverty line based on mean consumption or income levels in each country is used, on average an additional 8% of the population is to be considered poor.

Second, even the poverty reduction gains that the World Bank reports are small and geographically isolated. In 1998, the share of the population living in poverty in industrializing countries was 32% using the relative poverty line; though down from 36% in 1987, the actual number of people living in poverty increased from 1.5 to 1.6 billion. In 1998, the share of the population in poverty remained very high in some regions: 40% in South Asia, 50% in sub-Saharan Africa, and 51% in Latin America. Since 1987, the share of the poor stayed constant in sub-Saharan Africa, rose slowly in Latin America, and more than tripled in Eastern Europe and Central Asia.

Third, since the data do not extend beyond 1998, the full impact of the crises in Asia, Latin America and Russia is not included, which makes it likely that future revisions will show less progress in poverty reduction. Frequent macroeco- nomic crises have been found to be the single most important cause of rapid increases in poverty in Latin America. Consequently, future revisions to the poverty trends in the late 1990s could show smaller average reductions or larger increases in the crisis-stricken areas. Revisions to past data already show less success in poverty reduction than previously assumed, with Chen and Ravallion finding in 2001 that the reduction of people living below the poverty line between 1987 and 1993 was not 4 percentage points as estimated by them in 1997, but less than one percentage point.

Finally, the conclusion that the lot of the poor has improved with increasing trade and capital flow liberalization relies substantially on data from China and India. The facts in both of these countries undermine the case for a connection between greater deregulation and falling poverty and inequality.

In 1995, SW deemed China a closed economy and China only signed on to the WTO late in 2001. While in China the percentage who are poor has fallen, there has been a rapid rise in inequality. Most notably, inequality between rural and urban areas and provinces with urban centres and those without grew from 1985 to 1995. Claims to poverty reduction in China rely on rising per capita incomes spurred by rapid economic growth and stable population size. However, recently, some have questioned whether China’s data are exaggerated; and consequently, China’s successes in poverty reduction may be exaggerated.

Using India to illustrate the benefits of unregulated globalization is equally problematic since India’s progress was accomplished while remaining relatively closed off from the global economy. Total goods trade (exports plus imports) was about 20% of GDP in 1998, or 10 percentage points less than in China, and only about one-fifth that of such export-oriented countries as Korea; and the IMF is constantly recommending to India that it should liberalize more.

The World Bank’s assertion (Dollar and Collier) that “between countries, globalization is mostly reducing inequality” seems also to contrast directly the IMF’s assessment that “the relative gap between the richest and the poorest countries has continued to widen” in the 1990s.

The Weller and Hersh study (in tables) finds that the distribution of world income between countries grew unambiguously in the 1980s and 1990s. The median per capita income of the world’s richest 10% of countries was 77 times that of the poorest 10% of countries in 1980, 120 times in 1990, and 122 times in 1999. The ratio of the average per capita incomes shows a similar yet more dramatic increase. The improvement in equality in the 1990s was somewhat more pronounced when using the ratio of median incomes instead of average incomes. Even under the different measure, the distribution of incomes was remarkably more inequitable in 1999 than at the beginning of the 1980s.

The gains in the 1990s have come solely from rising incomes in China. If China is excluded, there is an unambiguous trend towards growing income inequality across the remaining world population in the 1980s and 1990s, Weller and Hersh find.

The study tests three hypotheses. First, more deregulated trade flows are likely to hamper income growth at the bottom, and hence help to perpetuate if not to increase poverty and inequality. Put differently, it is not trade per se but rather unregulated trade flows that are harmful to the poor. Second, greater capital account liberalization results in greater financial and macroeconomic volatility. And people at the bottom of the income scale are more likely to be adversely affected by increased macroeconomic instabilities since they do not have the same insurance mechanisms that higher-income people have. Consequently, capital account liberalization is harmful to the poor since it raises macroeconomic instability. Third, both current- and capital-account liberalization are more likely to be harmful to the poor in the short run than in the long run. In comparison, the poor may benefit from increased growth from more trade in a more regulated environment.

Using regression equations and measures (explained in the paper) to test these hypotheses, Weller and Hersh find that more current- and capital-account liberalization hurt the poor. This is not because trade is directly harmful for the poor, but because of the institutional design under which trade is conducted, they find. In particular, trade in a more deregulated environment lowers the income share of the poor, whereas trade in a more regulated environment raises the share of the poor. The short-term effects on the income share of the poor are not offset by faster income growth in the long run. The results of the Weller and Hersh study also indicate that global deregulation has no measurable, robust impact on growth rates, and there does not appear to be a trade-off between adverse effects in the short run and long-run benefits for the poor. (SUNS5150)  

The text of the study can be found at:

From Third World Economics No. 283 (16-30 June 2002).