My subject is trade policy in Latin America, and the potential gains from greater openness of Latin America. It is of vital importance for maintaining and accelerating growth and poverty reduction.
Experience shows that open trade regimes are essential for sustainable rapid growth. While a liberalized trade regime is not a sufficient condition for rapid growth, there is no instance of sustained rapid growth in its absence.
This is an unusually auspicious moment to address this topic. The global outlook is favorable – notwithstanding the downside risks of which we are all aware. Policy measures to accelerate trade liberalization have a much more immediate payoff and smaller transition costs when the world economy is buoyant.
I want first to explore the role that trade policy plays in achieving higher rates of growth. I will next examine the extent to which earlier experience with trade policy in Latin America contributed to the region’s disappointing performance.
And I will assess the policy choices confronting governments in the region, including the debate between regional and multilateral liberalization and the timing of policy shifts.
Trade and Growth
Over the past several decades, there has been increasing acceptance worldwide that rapid growth over a prolonged period is essential for poverty reduction. Income or wealth redistribution cannot reduce poverty over a sustained period. Nor is there any systematic evidence that growth skews income distribution against the poor.
Evidence shows that the income of the poor tends to grow proportionately with mean per capita growth; although, to be sure, improving access to education and health need to be critical components of any poverty reduction strategy.
So rapid growth is vital. But it has to be sustained if the reduction in poverty is also to be sustained. Many developing countries have succeeded in boosting growth rates for a short period. But only those that have achieved higher growth rates over a long period have seen a lasting reduction in poverty.
And, as I noted, only those countries that have pursued strategies of trade liberalization and economic openness have succeeded in maintaining high growth rates over time.
The benefits of free trade have long been clear to economists. We know what happened to both national economies and the global economy in the 1930s when governments raised protectionist barriers.
The founders of the postwar international economic order understood the lessons of the 1930s, and they were determined that a period marked by the failure of international economic co-operation should not be repeated.
They recognized that the establishment of the Bretton Woods organizations in 1944, with their responsibilities for financial stability and economic development, had to be complemented by measures to foster trade growth.
Hence the creation of a multilateral trade framework, first under the auspices of the General Agreement on Tariffs and Trade (GATT) and then its successor, the WTO. This framework envisaged progressive multilateral trade liberalization.
Among industrial countries, tariff and non-tariff barriers in manufactures were lowered in successive trade rounds; the most favored nation principle was a central feature of the liberalization process.
The postwar international economic order delivered results that were far more impressive than its creators could have imagined. Global economic performance after 1945 contrasted sharply with that in the interwar years.
And the rapid rise in world GDP was largely driven by the even more rapid expansion of world trade. In 1950, merchandise exports accounted for about 8% of world GDP; by 2002 that figures had risen to 19%.
Trade expansion continues to underpin global growth. According to the latest World Economic Outlook published by the IMF only last week, trade volume grew by 9.9% last year, while world output grew by 5.1%.
Korea and Chile are among the more striking examples of countries that pursued strategies of trade liberalization – accompanied by the appropriate macroeconomic policies – and experienced dramatically accelerated growth in consequence.
For much of the immediate postwar period, however, many developing countries were not active participants in the rapidly evolving global trading system.
Many – including most countries in Latin America – preferred to rely on import-substitution policies as a means to achieve development. They resisted opening up their economies to the outside world, although they benefited from the rapid expansion of global trade.
Yet a key element of both the GATT and its successor, the WTO, was, and still is, the extent to which exporters have a clear incentive to provide a political counterweight to the protectionist pressures of import-competing interests.
The more open the trade regime, the more evenly aligned are domestic prices with those internationally. For most developing countries, this leads to rapid export growth as an engine of growth, and creates a virtuous economic circle of growth and development. Three sets of factors contribute to this.
First are what we might call technological-economic factors. These include the minimum efficient size of plant, especially in economies with small domestic markets; indivisibilities in the production process; and the necessity for competition.
If production is oriented to the domestic market, it is not possible for producers to exploit these factors to the maximum extent, and so growth is lower than it might otherwise be.
Second are issues relating to the application of import substitution polices themselves, and to the way domestic industries were protected from competition.
Quantitative restrictions, the bureaucratic procedures associated with production licenses, and excessively detailed controls on a wide range of economic activity all contributed to higher production costs than would have resulted from greater competition or a greater focus on minimizing the costs of production.
Import substitution policies focused on nurturing new domestic industries at all costs: this simply introduced further distortions into the system, as other producers could only get high-cost, low-quality domestic inputs.
The third group of factors contributing to the virtuous circle relates to the political economy of trade policy. An export-oriented trade strategy places constraints on policymakers that directly lead to improved economic performance; both in terms of what policymakers can attempt to do, and because policymakers are more aware of the costs of policy mistakes.
If exporters are encouraged to compete in international markets, the scope for protection against intermediate or capital goods imports is immediately reduced, since exporters need access to these goods at the lowest possible cost. Tariffs or quantitative barriers prevent such access. Export success therefore requires a relatively liberal trade regime.
Openness increases pressure on governments to undertake other economic reforms. And it can spur innovation.
After 1945, the advanced economies were committed to the progressive liberalization of trade. Successive rounds of trade negotiations resulted in progressively lower tariff barriers and quantitative restrictions were greatly reduced.
From the 1960s onwards, a number of developing countries also began to recognize the economic benefits that trade openness would bring. East Asian economies, in particular, grew rapidly as they abandoned import substitution and adopted “outer-oriented” trade and development strategies.
Korea’s ambitious economic reform program is the most striking example of what opening up the economy can achieve. For four decades, Korea experienced remarkably high rates of growth; other countries such as Thailand, Singapore, and Malaysia also achieved rapid growth over a prolonged period.
To be sure, other reforms need to accompany trade opening, and the success stories would have been far more muted without them. But trade liberalization was central to the successful development strategy.
Elsewhere, countries like Turkey also experienced some of the benefits that trade liberalization could bring: after 1980 GDP growth initially accelerated as import substitution was abandoned, though a failure to persevere with economic reforms meant that some of the potential benefits were undermined.
And in the Pacific, Australia and New Zealand reaped considerable gains from the adoption of more liberal trading regimes.
In Latin America, though, growth performance was more volatile and less successful. There were successes, of course. Brazil was one of the most rapidly growing economies in the world between 1948 and 1964.
It experienced another growth spurt from 1968 to 1974, based largely on shifting to a more outward orientation, after it was recognized that growth potential under import substitution was largely exhausted.
The Brazilian economy grew by 9.8% a year on average between 1970 and 1974. Mexico also grew rapidly – averaging 6.5% between 1960 and 1979 (and more than 5% between 1995 and 2000).
But periods of rapid growth tended to be followed by sharp slowdowns. For much of the 1980s, for example, Brazil grew by less than 1% a year. Mexico’s growth rate also dropped sharply after 1980.
Both countries had reintroduced trade restrictions at about the time their growth performance deteriorated. And for decades, inflation rates in most countries in Latin America were, as we know, even more volatile than growth performance.
Such uneven economic performance had its roots in policies that have since been discredited. High tariffs and import substitution policies – along with heavily regulated labor markets, credit rationing, and other measures – helped stunt the development of countries rich in potential.
By the late 1980s and early 1990s, most Latin American countries had embarked on large-scale reforms intended to reverse the decades of disappointing performance. The exact nature of the stabilization and liberalization programs varied from country to country, as did the enthusiasm with which they were implemented. But they did share the common aim of delivering growth and stability through more market-oriented policies.
Ultimately, the high expectations were disappointed. The region only experienced growth of over 2% a year between 1991 and 1997, a significant improvement compared with the GDP contraction of 0.1% in the 1980s.
But as John Williamson pointed out [in After the Washington Consensus] Latin America in the 1990s did not achieve the average per capita growth rate of 2.9% seen between 1950 and 1980. After 1997, things got worse as GDP per capita fell by an average of 0.25% a year between 1998 and 2002.
Recent performance in many countries has shown a marked improvement, however, and the current outlook for Latin America is, like most other parts of the world, favorable. The challenge is to use this benign global environment to lock in reforms that will deliver lasting improvements in growth performance.
Trade liberalization should be an important element of these reforms: on average, countries in Latin America remain much less open than those in many other regions of the world.
One country stands out, of course: Chile, where reforms were first introduced in the mid 1970s. Since the late 1980s, Chile has experienced strong, crisis-free growth. It weathered the downturn of 2001-2002 more successfully than many of its neighbors, as a result of the strong fiscal and other reforms it had implemented.
Trade liberalization was an integral part of these reforms. Tariffs in Chile have been progressively lowered over the years, to the current level of 6% uniform across all commodities. (The actual figure is lower, because of Free Trade Agreements that Chile has with several countries.)
Chile is one of the most open economies in the region and has one of the most diversified export structures. Mexico, too, has benefited from major tariff reductions and, of course, NAFTA.
But most Latin American economies are classified as relatively closed to trade. There remains plenty of scope for further liberalization. It is true that tariffs rates have moved downwards across the continent: from an average of 49% in the mid 1980s, to around 11% in the late 1990s.
But there are still tariff peaks, high effective protection for some goods, and non-tariff barriers (NTBs) still restrict trade. These have also been scaled back, from covering close to 40% of imports in the late 1980s to 6% in the 1990s but are still a significant barrier in some industries. (1)
And there remains much to be done in the areas of trade in services such as communications, transport and finance. These are important inputs into production and trade and estimates suggest that liberalization would significantly reduce the cost of production and exports.
Pushing Ahead With Trade Liberalization
The experience of many countries – among them, Korea, Chile, Hong Kong and Singapore – has shown that unilateral trade liberalization brings significant gains. The rewards of pressing ahead without waiting for others to liberalize are clear.
Countries that press ahead with unilateral liberalization will enjoy enormous benefits and they will not be penalized by further multilateral liberalization – quite the opposite. Countries that open up unilaterally help themselves.
But the benefits of liberalization are greater if others liberalize as well, and this was the aim of those who established the postwar economic order. As I noted, it has served us well.
The progressive reduction of tariff and non-tariff barriers has benefited individuals, firms and national economies. Those benefits are greater for the economies that are more open: but there are benefits for all.
The success of the multilateral framework thus far is why completing the Doha round is now so important. It is striking that several Latin American countries are now major players in the WTO process, and in the Doha negotiations.
But there has also been much interest in promoting regional trade integration in Latin America. NAFTA was established in 1994. Negotiations have been under way for some time to create a Central American Free Trade Area and a free trade area covering the whole of the Americas.
There have been moves to revive and strengthen Mercosur. And several countries have signed bilateral free trade agreements – Chile has more than ten, and Mexico has an FTA with the EU, for example, in addition to NAFTA.
Regional integration can bring important economic benefits provided that it results in trade creation, rather than trade diversion; and provided that it lowers, rather than raises, barriers to multilateral liberalization.
This is essential. Multilateral trade liberalization remains the best way to achieve a more open world economy where trade can flourish and expand and help fuel global economic growth. If regional trading arrangements erode support for the multilateral framework, it would be counterproductive.
There is a danger that the emergence of regional trading blocs would be accompanied by increasing trade frictions and even rising trade barriers between competing blocs, or that countries’ production is mostly destined for regional partners at high cost relative to world prices.
Regional trading arrangements can serve protectionist purposes, not least because of rules of origin (ROOs). ROOs can lead to trade diversion if they oblige partners to buy higher priced intermediate goods from a partner rather than on the lower-priced world markets.
They can even export protection from one partner to another. And all FTAs provide special interest groups with another opportunity to lobby against competition from imports.
To the extent that RTAs are inward-looking, and give lower priority to trade and economic engagement with the rest of the world, global trade will increase real incomes by less than it otherwise might.
So the context in which regional trading arrangements are established and evolve is important. Take what is now the European Union, known as the European Economic Community when it was founded in the 1950s.
The original members of the EEC as it then was experienced rapid growth over a long period and experienced a considerable degree of economic integration. They did so in large part because the EEC was established at a time, and in the context, of rapid multilateral liberalization.
Intra-European trade barriers fell rapidly to zero from in excess of 40%; but the EEC’s external tariff was also reduced from the same 40% plus level to a weighted average of just over 3% now (excluding estimated ad valorem equivalents of specific tariffs).[6.5% if AVEs are included.]
Quantitative restrictions were also eliminated. The EEC liberalized its trade with the rest of the world significantly; and at the regional level it went just a bit further.
The economic success of the EU over a long period of time was the result both of the removal of internal trade barriers and the growth of intra-European trade; and of trade liberalization with the rest of the world. And the EU’s trade framework, by locking in the principle of tariff reduction, acted as a disincentive to protectionist lobbying.
In the appropriate circumstances, then, regional integration can be helpful. The late Richard Snape, an Australian economist who contributed greatly to our understanding of preferential trading arrangements, argued that it was possible to design preferential trading arrangements so that they were, in effect, an intermediate step, a sort of halfway house towards the infinitely more desirable goal of multilateral trade liberalization.
He proposed that rules of origin should be uniform across all goods and services at a specified percentage of value added, and that any other country wishing to join a PTA on the negotiated terms should be able to do so automatically. But he fully recognized that some PTAs, with varying rules of origin and content requirements, could be detrimental.
Multilateral trade liberalization should remain the ultimate goal.
Trade liberalization is not a panacea, however. It cannot be a substitute for broader economic reform. Rather it is a key element of any strategy aimed at achieving sustained rapid growth. Other policy reforms are needed to ensure sustained growth; and these reforms will, in turn, increase the returns from trade liberalization.
Sustained growth needs a sound macroeconomic framework: prudent fiscal policies, and monetary policy aimed at reducing inflation and delivering price stability.
Experience has taught us that flexible exchange rate regimes also have an important part to play in maintaining economic stability and thus paving the way for more rapid growth. [This last is particularly important if the potential benefits of trade liberalization are to be realized.]
Institutional reforms are also important if the proper incentives are to be in place for encouraging enterprise. Property rights, the rule of law, commercial codes are all vital ingredients of a well-functioning market economy. So are labor market reforms that lead to greater labor market flexibility.
Infrastructure improvements must accompany trade liberalization to realize potential benefits. Low-cost transport and communications are essential for productivity increases generally, and especially for trade.
Improvements in administrative services and functions can also make an important contribution to trade growth. Reductions of delays in ports, customs clearance, and red tape can contribute to overall economic growth as well as facilitating trade.
The cumulative impact of this reform agenda is to deliver the productivity increases that are essential for growth. But it also contributes to the level playing field for all economic actors that is necessary if trade liberalization is to fulfill its potential. A level playing field ensures that resources are allocated across activities efficiently, and provides incentives for expansion of those activities with the highest return.
Having the right economic incentives in place, in an open economy, is also the best way to attract international capital for financing investment needs.
I noted that the returns to trade liberalization can be significantly increased when trade reform is accompanied by other economic reforms. Each reform brings more benefit from those reforms already undertaken. And trade liberalization can, in turn, strengthen the impact of those other reforms.
It can also provide strong incentives to introduce such reforms. The more open an economy is, the more difficult it will be for policymakers to resist changes elsewhere in the economy. That is why trade liberalization makes sense for its own sake, and should not be delayed until other reforms can be introduced.
Of course, the development of, and the need for, economic reform is not confined to Latin America. And the relative importance and urgency of individual reforms depends on the circumstances of individual countries.
But Latin American countries have experienced a lesser degree of trade liberalization than countries in some other parts of the world. The potential benefits to be had are, therefore, correspondingly greater.
Let me sum up briefly.
There has been a growing recognition among policymakers that what economists have known for some time is true: an open trade regime is a vital ingredient for achieving rapid and sustained economic growth.
Latin America is unusually rich in resources, natural and human, but in recent decades has not lived up to its economic potential. Like any other part of the world, further trade liberalization could contribute a great deal to improved economic performance.
Indeed, because countries in Latin America tend to be less open than those in other regions of the world, the potential gains from trade liberalization are correspondingly greater.
Trade liberalization makes sense for its own sake, and should be pursued as rapidly as possible. The broader the accompanying economic reforms, the greater will be the benefits.
Trade liberalization is best carried out in a multilateral framework, which is why it is encouraging to see some Latin American countries playing an important part in the Doha Round.
A successful Doha outcome – one that delivers significant further multilateral liberalization – is important for all countries and Latin American countries should benefit at least as much as others.
Unilateral liberalization brings important short-term benefits pending agreement at the multilateral level anyway. But care is needed when pursuing trade integration at the regional level.
Regional trading arrangements cannot be a substitute for multilateral liberalization. They can, but should not be, a disguised form of protectionism which must be avoided.
Timing is crucial. Latin America, like most parts of the world, is currently experiencing more buoyant growth than it has seen for some time. This is the moment to press ahead with reforms on all fronts – not least trade liberalization.
And this is also the year when there is a real opportunity to make progress in the Doha negotiations. The potential benefits are enormous. It is an opportunity not to be missed.
(1) Lora, Eduardo, 2001. “Structural reforms in Latin America: what has been reformed and how to measure it,” Research Department Working Paper 466. Washington DC: Inter-American Development Bank.
The text above is a speech by Anne O. Krueger, the IMF’s first deputy managing director, at Notre Dame University, in Indiana.