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6. The Impact of Trade on Development

 

July 27, 2011

Carlos Lipari, FreeBalance Washington

This is a blog series discussing factors that impact development in developing countries. As a For Profit Social Enterprise (FOPSE), improving country growth through good governance is the core company mandate at FreeBalance. As such, FreeBalance participates in governance, development, foreign aid, ICT for development and transparency discussions globally.

Upsides of an open trade economy

The more open an economy is the easier it becomes to have foreign investments bringing new technology. This might allow a country to move higher in its value chain of production but theoretically it should mostly allow countries to specialize themselves in what they do best.

Specialization is the main argument in favor of open economies and it is true that it might contribute to an increase of the local GDP but there are certain things that need to be kept constants in order for this to happen. One of these things is the terms of trade (the relative prices of goods in the international market). What reality has showed us over the last decades is that terms of trade often get negatively affected due to this world specialization process, therefore affecting countries in different ways.

There is, though, another important advantage of an open trade policy that has to do with the fact that it potentially allows developing countries to benefit from economies of scale. Korea, for instance, is competitive producing cars, like KIA, because it produces them to the entire world. The local market, alone, would not allow their auto industry to be competitive.

Finally, a trade policy that promotes free trade tends to make it easier for the local economy to access external financing. Evidence has been found that free trade can contribute to accelerate investment and by doing this, contribute for higher rates of economic growth to occur.

Downsides of an open trade economy

In order to develop themselves, countries need to have, at least, some industry. This industry, though, in its early stages, generates higher costs because it is still improving its efficiency levels by achieving higher levels of economies of experience and scale. If a country has little or no external trade barriers in those products it might become very difficult for new industries to survive. Industries might need, in their early stages, some help to gain the necessary size, consumer awareness and efficiency to survive the competition.

Another potential downside of low trade barriers has to do with the fact that in some cases, as countries open their economies and specialize domestic productions, terms of trade in the international markets (relative prices of goods in the World market) change. A country like Brazil could produce a sharp change in the price of coffee if it chooses to further specialize itself in this commodity or to reduce its local production. This happened back in the 80s, when Brazil reduced its coffee production and world prices suffered a sharp increase (The World Bank Economic Review 1990).. Specialization might not ensure higher income if increases in production result in sharp decreases in the value of what is being produced.

In addition to what was said, there are also security reasons that can justify some protectionism. A developed or developing country might not wish to become extremely dependent of the foreign market in some productions.  In the EU, Japan or the US, local authorities highly protect with tariffs and/or subsidies the production of a set of agriculture products because they do not wish, in the event of a war or some other extreme event happening, to be totally depended from the external markets. This political decision has an economic cost but it also reduces the risk that those countries have of not being able to access some essential goods. It’s a difficult trade-off that generates always a great deal of controversy, with the EU, for instance, being constantly accused of depressing the development of developing countries as a result of its Common Agriculture Policy.

Finally, one should stress that protectionism is used by rich countries not only as a way of reducing dependence in foreign productions but, often, as a way of depressing the prices of those type of goods in the international markets. By doing this, the cost of certain tariffs applied to imports can be indirectly transferred to developing countries, allowing developed countries to increase their wellbeing and autarky simultaneously.

 

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Doug Hadden

Doug Hadden

Executive Vice President, Innovation at FreeBalance
Doug is responsible for identifying new global markets, new technologies and trends, and new and enhanced internal processes. Doug leads a cross-functional international team that is responsible for developing product prototypes and innovative go-to-market strategies.

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