Chapter 1

Trade, the Trading System and Development

TRADE AND DEVELOPMENT

Trade should not be an end in itself but a means to balanced, equitable and sustainable development.  The global trading system should thus be oriented towards the satisfaction of the material and non-material needs of the world's people.  Aspects of trade that can serve this goal should be encouraged and promoted.  Aspects that are inappropriate, at least at particular periods or in particular conditions facing a country, should be treated with caution. This can be contrasted with the current dominant approach, the main goal of which is the attainment of 'free trade' in all countries, and whose main operational principle is the removal of 'trade distortions' on the assumption that there is an automatic link between trade liberalization, on the one hand, and development, poverty eradication and improvement of people's welfare, on the other.

The rules and regulations that govern relationships between countries and constitute the multilateral trade regime should also provide an enabling framework that encourages and promotes greater balance in the world economy, taking into account the great imbalances in production and trade capacities between developed and developing countries. Countries with stronger capacities can better afford to operate on a free-trade basis, as their production units are more efficient and able to compete globally than are countries with weaker capacities. The latter should be given greater flexibility so that their domestic units of production can remain viable; indeed, these units should receive capacity-building support through both domestic state assistance and international cooperation so that they can participate in global trade and compete on better terms.  Differential treatment of countries with different capacities is, therefore, essential if there is to be fairness in the operations and outcome of the trading system.

The multilateral trade regime should also recognize and facilitate the implementation of national development strategies of developing countries. It should assist in satisfying their needs for domestic savings, productive investment, technology development and domestic capacity-building, including the strengthening of local enterprises, cooperatives and farms. It is on the foundation of stronger domestic productive capacity that weaker countries will be able to improve their export performance and benefit from the trading system.

Developing countries, depending on their particular situation over time, also need to strike a fine balance between the competing claims of production oriented to the domestic and external markets, as well as between obtaining inputs from domestic and external sources. It is important that they attain this balance within the context of an overall development strategy in which external trade, while viewed as an important and even crucial element, is nevertheless considered as only one element in generating conditions for the complex and dynamic processes of sustained growth and sustainable development.

At the national level, trade should contribute to employment growth, the eradication of poverty, the attainment of greater social equity, and the fulfillment of basic needs (in food, health, education, housing and information), within the context of environmental sustainability.  At the international level, the trading system should cater especially to the needs of the least developed and developing nations, which comprise the majority of the world's population.  Members of the trading system as a whole should identify the weaknesses of less developed members, and adopt operational principles, rules and practical measures to assist them in improving their terms of trade, their capacity to export effectively and beneficially, their ability to tailor their imports to the conditions of the domestic economy, and their ability to have a balance of trade and overall balance of payments that is healthy or at least sustainable.

In contrast to this ideal system, the actual operation of world trade exhibits many imbalances, owing partly to the differences in capacities between developed and developing countries and the inequalities in the terms of trade of their main exports (manufactures and commodities); and partly to the rules of the multilateral trading system. These imbalances combine with inappropriate trade policies and development policies to place developing countries in a position in which they are unable to surmount their weak productive and trading capacities.

TRADE LIBERALIZATION, DEVELOPMENT, AND THE NEED TO BALANCE IMPORTS AND EXPORTS

Trade liberalization, which has become an extremely fashionable policy prescription,  should not be seen as a panacea, as it is only one of several potential instruments for development. To realize its potential and enable liberalization to work in favour of development requires conditions tailored to the specific requirements of each country. The 'optimal' conditions for trade may differ from country to country, depending on such factors as the stage of development, resource endowment, and conditions relating to market access and prices of traded products.  Thus, a one-size-fits-all approach will not work and, if enforced, might cause more harm than good. Each country has to make decisions on what, for it, constitutes appropriate processes, degrees and sequencing of trade and trade liberalization. The role of trade (and what constitutes appropriate trade policy) may be different for countries with different conditions, including differences in levels and stages of development.  The multilateral trading system should, therefore, be sensitive to the differential needs of different countries.

The relationship between trade liberalization and development lies at the heart of trade and development policy.  There are two main aspects to trade: imports and exports.  It is necessary to attain a balance in the development of each and in the relationship between the two.  The factors determining imports and those that determine exports may differ. A developing country may be able to control how fast it liberalizes its imports, through policies relating to tariff and non-tariff barriers. However, it is much less able to influence the level and rate of growth of its exports, especially in the short term.

Trade liberalization has major implications in this context. Developing countries now face two major types of problems that hinder their effective and beneficial participation in international trade: pressures to liberalize their imports, affecting local production units in various sectors, including industry and agriculture; and the lack of adequate export earnings, export capacity or opportunities. Many developing countries have taken measures to rapidly liberalize their imports, and these have caused a surge in the inflow of imports.  However, the growth of export earnings has lagged, due to a combination of factors, including a decline in commodity prices, continuing barriers to industrial exports and supply constraints. As a result, there have been greater imbalances between imports and exports in many developing countries, adding to their trade deficits and external debt problem. The difficulties caused by import liberalization and the hurdles faced in attempts to expand exports are dealt with below, followed by the consequences of poorly planned trade liberalization.

PRESSURES FOR RAPID IMPORT LIBERALIZATION AND NEED FOR A MORE REALISTIC APPROACH

Pressures on developing countries to rapidly open their economies to imports result from the world Trade Organization's (WTO) operational principles and rules as well as policy prescriptions of the International Monetary Fund (IMF), the World Bank, regional development banks and bilateral aid donors imposed as conditions of debt rescheduling, new loans and aid. According to orthodox theory, trade protection has negative effects, while trade liberalization brings benefits. While the negative effects of trade liberalization are sometimes recognized, they are seen as only temporary. According to the proponents of rapid liberalization, cheaper imports benefit the consumer, and generate greater efficiency in local firms that are forced to compete to survive.  Inefficient firms should close down, freeing resources to move to more efficient sectors, including for exports, and this is expected to generate new jobs and higher revenues.  Overall, the economy is expected to gain.

However, this theory has been challenged by empirical evidence that indicates that there is no straightforward correlation between trade liberalization and overall economic growth. For example, a 1994 UNCTAD study of 41 least developed countries (LDCs) over ten years found 'no clear and systematic association' between trade liberalization and devaluation, on the one hand, and the growth and diversification of output and export growth of LDCs, on the other. In fact, it found that in many LDCs, trade liberalization had been accompanied by de-industrialization, and where export opportunities expanded they were not always accompanied by the expansion of supply capacity (Shafaeddin 1994). Disturbing evidence of post-1980 liberalization episodes in the African and Latin American regions have also been described by Buffie (2001: 190-91) and are elaborated later in this paper.

Orthodox theory is also challenged by an emerging view that several other pre-conditions have to be present before trade openness can be of net benefit to developing countries.  These include an adequate level of competitiveness of local firms or farms, the capacity to overcome supply-side constraints in producing for exports, adequate levels of prices for the export products of developing countries, and the existence of export opportunities or adequate market access for their products. Other factors increasingly stressed by the international financial institutions include macroeconomic stability and good economic governance.  In the absence of some or all of these prerequisites, import liberalization may not result in the projected benefits and may instead produce adverse results.  It is thus critical to decide on the appropriate timing of liberalization in relation to the presence or absence of these prerequisites.  A more realistic approach would enable developing countries to first establish these conditions and integrate trade liberalization into their overall national development strategy when and where appropriate, rather than pressuring them to move towards an overly hasty liberalization of imports.  

DIFFICULTIES AND CONSTRAINTS ON DEVELOPING COUNTRIES' EFFORTS TO EXPAND EXPORTS

In many developing countries, rapid liberalization and increased imports were not matched by a corresponding expansion of export earnings. Most developing countries still depend on a few export commodities, the prices of and demand for which are usually beyond their control. There has been a continuous decline in the price of commodities in relation to prices of manufactures. This has been exacerbated by the emergence of substitutes. This combination of factors has adversely affected the export earnings and prospects of many developing countries in their traditional export sectors.

To realize its export potential, a country must have the physical infrastructure and the human and enterprise capacity to produce competitively for both the local and export markets. This is a long and difficult process, making it unrealistic to expect that a developing country can quickly shift its resources from uncompetitive domestic industries threatened by the fast pace of import liberalization to globally competitive export industries. Even in the theoretical and analytical literature, there is no consensus on how developing countries can build the necessary conditions to enable them to successfully participate in the world market as major non-commodity exporters.

It is rare for a developing country to be able to become a world-class exporter of modern industrial products based on its own locally owned enterprises. The Republic of Korea, following a path pioneered by Japan, is one of the few such examples. However, Japan and the Republic of Korea developed their industries in a pre-WTO environment. Today, with WTO rules that severely constrain the use of subsidies for local industries, prohibit investment measures favouring the use of local components, and make it difficult or costly for local industries to make use of technology that is subjected to intellectual property protection, it is far more difficult for developing countries to enable local companies to compete successfully in the world market for modern industrial products.

A few developing countries have succeeded in developing export industries based primarily on FDI.  Foreign companies based in these countries made use of their own technology and marketing channels (often buying inputs and selling the finished products to their own associate or parent companies) to export.    However, most of the industries are labour-intensive rather than high-technology, and the host countries have to work hard to remain competitive as the foreign companies can easily shift their operations to other countries that have lower costs. Moreover, it is erroneous to believe that developing countries in general can base their strategies for employment generation, export growth and GDP growth primarily on FDI. While it is true that FDI has significantly contributed to attaining these goals in a few countries, such as Singapore and Malaysia, it is because of the extraordinarily high concentration of FDI in these countries that it has been able to do so. If FDI were evenly spread over all developing countries, the amount per country would be too insignificant to enable it to be the main basis for job absorption or the growth of industrial exports, and most of these countries would not be able to rely on it to generate sufficient industrial exports to supply the basis for their development.

Therefore, what is much more important for developing countries as a whole is the development of their local industry, services and firms. They should rely on their own domestic capital and enterprises to generate jobs, livelihoods, growth and exports (if that country is to succeed as an exporter).  As a rule, they also need to go through the process of building their own enterprises and industries through the efficient mobilization and use of savings; investment in health, education and skills development; development of management and marketing skills; and accessing and upgrading technology. To break into the export market, companies must also establish regional and international marketing channels, brand development, or strategic alliances with bigger companies.  For a country to go through these processes successfully may not be an impossible task, but it is a very difficult one, requiring planning, discipline and hard work at every stage, with many risks and no guarantee of success.

Even then, successful export performance will also depend on market access, especially for developing countries, and the extent of this access will be largely beyond the control of any individual developing country. There are currently many tariff and non-tariff barriers in developed countries to several products of export interest to developing countries which will need to be removed if the export potential of developing countries is to be realized.  As UNCTAD has pointed out, developing countries have been striving hard, often at considerable cost, to integrate more closely into the world economy. But protectionism in developed countries has prevented them from fully exploiting their existing or potential comparative advantage. The missed opportunities for them due to trade barriers are estimated at an additional $700 billion in annual export earnings in low-technology industries alone. (UNCTAD 1999c: 143).

THE CONSEQUENCES OF POORLY PLANNED TRADE LIBERALIZATION

The above discussion has pointed out that there are different determinants of the behaviour and performance of the two main aspects of trade:  imports and exports. In order to maintain a sustainable trade policy which also assists in development, a developing country has to aim for balance between imports and exports. If there are persistent negative imbalances, there will likely be adverse consequences for growth and development. For example, if import liberalization proceeds while conditions for successful export growth are not yet in place, the resulting increased trade and balance of payments deficits may add to external debt and the debt-service burden, thereby reducing growth and increasing unemployment. 

In the short run, the trade deficit can be sustained by attracting enough foreign credit and capital to cover it.  However, if the deficit is long-term and structural, the inflow of capital will not necessarily help, as it increases vulnerability to a larger capital outflow later. Moreover, the large inflow of foreign direct investment (FDI) and credit or portfolio capital can add to future balance of payments problems even on the current account, due to large outflows of investment income.

As indicated, in the recent experience of many developing countries, trade liberalization can (and often does) cause imports to surge without a corresponding (or correspondingly large) increase in exports. UNCTAD's Trade and Development Report 1999 found that for developing countries (excluding China) the average trade deficit in the 1990s was higher than in the 1970s by 3 percentage points of GDP while the average growth rate was lower by 2 percentage points. Inappropriate trade liberalization in these countries contributed to this negative phenomenon. According to UNCTAD, it 'led to a sharp increase in their import propensity, but exports failed to keep pace, particularly where liberalization was a response to the failure to establish competitive industries behind high barriers' (ibid: vii).

It is thus imperative to reorient trade policy and the WTO operational principles away from the simplistic assumption that trade liberalization necessarily has a positive impact on developing countries. If the trading system is to meet the development needs and goals of developing countries, the criterion by which a policy should be judged should be whether it is development-consistent or development-distortive, rather than whether it is trade-consistent or trade-distortive.

THE RELATIONSHIP OF TRADE TO OTHER ECONOMIC POLICIES

Trade and other economic policies should be mutually consistent and supportive. This is particularly important in the case of finance. On the one hand, trade policies should not result in greater problems in the external finances of developing countries. Sustainable trade balances and sustainable balance of payments are necessary to enable developing countries to avoid falling into structural deficits and an external debt trap. On the other hand, the global financial system should also promote conditions that support healthy trade. The instability that characterizes the present global financial system has been harmful to trade as shown by the Asian financial crisis of 1997-98 and the negative trade impact of the recessions it caused. There is thus an urgent need for reform of the global  financial architecture in a manner that supports rather than undermines development enhancing trade.

STRUCTURE OF THE PAPER

Following this discussion of the role of trade and the world trading system in the context of development, a brief history of the evolution of the current trading system is provided in Chapter 2 of this Paper, while Chapter 3 analyzes that system as it is embodied in the WTO taking several WTO agreements as illustrations. Chapter 4 examines the impact of the WTO and some of its major agreements on development and developing countries since its establishment in 1995. Chapter 5 offers proposals for improving the multilateral trading system. Finally, Chapter 6 provides some longer-term proposals for institutional and structural reforms.