Globalization And Trade Liberalisation Economics Essay

The current period in the world economy is regarded as period of globalization and trade liberalisation. In this period, one of the crucial issues in Development and International Economics is to know whether trade openness indeed promotes growth. With globalization, two major trends are noticeable: first is the emergence of multinational firms with strong presence in different, strategically located markets; and secondly, convergence of consumer tastes for the most competitive products, irrespective of where they are made. In this context of the world as a “global village”, regional integration constitutes an effective means of not only improving the level of participation of countries in the sub-region in world trade, but also their integration into the borderless and interlinked global economy.(NEEDS, 2005)

Since 1950, the world economy has experienced a massive liberalisation of world trade, initially under the auspices of the General Agreement on Tariffs and Trade (GATT), established in 1947, and currently under the auspices of the World Trade Organisation (WTO) which replaced the GATT in 1993. Tariff levels in both developed and developing countries have reduced drastically, averaging approximately 4% and 20% respectively, even though the latter is relatively high. Also, non-tariff barriers to trade, such as quotas, licenses and technical specifications, are also being gradually dismantled, but at a slower rate when compared with tariffs.

The liberalisation of trade has led to a massive expansion in the growth of world trade relative to world output. While world output (or GDP) has expanded fivefold, the volume of world trade has grown 16 times at an average compound rate of just over 7% per annum. In fact, It is difficult, if not impossible, to understand the growth and development process of countries without reference to their trading performance. (Thirlwall, 2000).

Likewise, Fontagné and Mimouni (2000) asserted that since the end of the European recovery after World War II, tariff rates have been divided by 10 at the world level, international trade has been multiplied by 17, world income has quadrupled, and income per capita has doubled. Incidentally, it is well known that periods of openness have generally been associated with prosperity, whereas protectionism has been the companion of recessions. In addition, the trade performance of individual countries tends to be a good indicator of economic performance since well performing countries tend to record higher rates of GDP growth. In total, there is a common perception that even if imperfect competition and second best situations offer the possibility of welfare improving trade policies, on average free trade is better than no trade.

From the ongoing discussion, it is evident that trade is very important in promoting and sustaining the growth and development of an economy. No country can isolate herself from trading with the rest of the world because trade acts as a catalyst of growth. Thus Nigeria, being part of the world, is no exemption. For this reason, there is a need to thoroughly examine the nature of relationship between trade openness and output growth in Nigeria.

Trade Openness And Output Growth: Historical Experience Of The Nigerian economy

Today, Nigeria is regarded to have the largest economy in sub-Saharan Africa, excluding South Africa. In the last three decades, there has been little or no progress made in alleviating poverty despite the massive effort made and the many programmes established for that purpose. Indeed, as in many other sub-Saharan Africa countries, both the number of poor and the proportion of poor have been increasing in Nigeria. In particular, the 1998 United Nations Human Development Report declares that 48% of Nigeria’s population lives below the poverty line. According to the Report (UNDP, 1998), the bitter reality of the Nigerian situation is not just that the poverty level is getting worse by the day but more than four in ten Nigerians live in conditions of extreme poverty of less than N320 per capita per month, which barely provides for a quarter of the nutritional requirements of healthy living. This is approximately US$8.2 per month or US27 cents per day.

Doug Addison (undated) further explained that the Nigerian economy is not merely volatile; it is one of the most volatile economies in the world. There is evidence that this volatility is adversely affecting the real growth rate of Nigeria’s gross domestic product (GDP) by inhibiting investment and reducing the productivity of investment, both public and private (see figure 1 below). Economic theory and empirical evidence suggest that sustained high future growth and poverty reduction are unlikely without a significant reduction in volatility. Oil price fluctuations drive only part of Nigeria’s volatility; policy choices have also contributed to the problem. Yet policy choices are available that can help accelerate growth and thus help reduce the percentage of people living in poverty, despite the severity of Nigeria’s problems.

Figure

During the period 1960-1997, Nigeria’s growth rate of per capita GDP of 1.45% compares unfavourably with that reported by other countries, especially those posted by China and the Asian Tigers such as Hong Kong, Singapore, Taiwan, and South Korea. Viewed in this comparative perspective, Nigeria’s per capita income growth has been woefully low and needs to be improved upon. (Iyoha and Oriakhi, 2002). In like manner, Ogujiuba, Oji and Adenuga (2004) wrote that the Nigerian economy has severally been described as a difficult environment for business. With a population growth of about 3%, it has been acknowledged that the current average output growth rate of less than 4% will see the country being poorer in the next decade.

A study conducted by Iyoha and Oriakhi (2002) on Nigeria’s per capita GNP from 1964 to 1997 shows that it rose steadily from US$120 to US$780 in 1981. Thereafter, it fell almost steadily to US$280 in 1997. Thus, between 1964 and 1981, income per capita increased by 550% or at an annual average rate of 32.3% while between 1981 and 1997, it fell by 64.1% or at an annual average rate of 4%. It is worth noting that if income per capita had continued to increase beyond 1981 as it did before then, Nigeria’s GNP per capita would have equaled US$1,279 in 1997. The difference between US$280 and US$1,279, i.e., approximately US$1,000.00, is a rough measure of the cost to the average Nigerian of domestic macroeconomic policy mistakes and adverse international economic shocks. Likewise, in 1960 agricultural exports accounted for 70.8% of total exports while petroleum accounted for only 2.6%. Exports of other commodities like tin and processed goods amounted to 26.6% of total exports. By 1970 agricultural exports only accounted for 33% of total exports while petroleum exports had started to establish dominance by exceeding 58% of total exports. By the time the oil boom began in earnest in 1974, petroleum exports accounted for approximately 93% of all exports. The relative share of agricultural exports in total exports had shrunk to 5.4% while other products accounted for the remaining 1.9%. Since 1974, with the exception of 1978 when the relative share of petroleum in total exports amounted to 89.1%, petroleum’s share in exports has consistently exceeded 90%. Indeed, since 1990, the relative share of petroleum in total exports has exceeded 96%. Agriculture’s contribution has fluctuated between 0.5% and 2.3% while the share of other products has fluctuated between 0.5% and 1.7%. Thus, petroleum exportation has totally dominated the economy and indeed government finances since the mid-1970s.

Meanwhile, a puzzling and disturbing aspect of Nigeria’s export boom is that the growth it generated did not seem to be lasting or to have had a significant effect in changing the structure of the economy. For instance, in the 1970s, there was a major increase in measured GDP but the structure of the economy remained basically unchanged (see figure 2 below). This led Professor Yesufu (1995) to describe the Nigerian economy as one that had experienced “growth without development”.

Figure

During the period of 1970-1985, import substitution industrialization (ISI) strategy was a dominant feature of trade policy in Nigeria. The trade policy was generally inward oriented. Under this ISI strategy, “infant” manufacturing industries were protected using high tariffs, import quotas, and other trade restrictions like import licensing. Non-tariff barriers to trade such as import prohibitions were also utilized. During this period, trade policy was also adjusted in response to the exigencies of the balance of payments. Also, Nigeria was operating a fixed exchange rate regime under which the value of the naira was essentially tied to the U.S. dollar and gold. It is worth noting that the trade policy pursued during this period resulted in a rapid increase in manufacturing production and employment, particularly during the era of the oil boom (1975-1980) and that led to a rise in the share of manufacturing in Gross Domestic Product (GDP) from 5.6% in 1962/63 to 8.7% in 1986. (Iyoha and Oriakhi, 2002).

In 1986, Nigeria adopted the Structural Adjustment Programme (SAP) of the IMF/World Bank in 1986. With the adoption of SAP in 1986, there was a radical shift from inward-oriented trade policies to outward-oriented trade policies in Nigeria. These are policies and measures that emphasize production and trade along the lines dictated by a country’s comparative advantage such as export promotion and export diversification, reduction or elimination of import tariffs, and the adoption of market-determined exchange rates. Some of the aims of the Structural Adjustment Programme adopted in 1986 were diversification of the structure of exports, diversification of the structure of production, reduction in the over-dependence on imports, and reduction in the overdependence on petroleum exports. The main SAP measures were:

deregulation of the exchange rate

trade liberalization

deregulation of the financial sector

adoption of appropriate pricing policies especially for petroleum products

rationalization and privatisation of public sector enterprises and

abolition of commodity Marketing Boards.

However, as a result of trade liberalization gospel of the SAP, the Nigerian external sector has really grown in leaps and bound. For instance, the total domestic exports of Nigeria in 2006 amounted to â‚¦7555141.32 million as against â‚¦6621303.64 million in 2005 showing an increase of 14.10%. Domestic exports recorded negative growth rates in 1993(7.70%), 1994(45.5%), 1997(2.03%), 1998(38.48%), and 2001(27.06%). The largest increase in domestic exports was witnessed in 1995(448.42%). Total imports (c.i.f) stood at â‚¦2922248.46 as against â‚¦1779601.57 million in 2005 recording an increase of 64.20%. Total imports also recorded negative growth rates in 1994(45.72%), 1998(9.41%) and 2004(18.07%). The value of total merchandise trade amounted to â‚¦10477389.78 million in 2006 as against â‚¦45272.24 recorded in 1987. External trade was dominated by domestic exports between 1987 and 2006 averaging 67.17% while imports (c.i.f) averaged 32.82% (see figure 3 below). Consequently, the trade balance was positive between 1987 and 2006. Oil exports remains the dominant component of export trade in Nigeria between 1987 and 2006 accounting for about 93.33% of total domestic exports. On the other hand, non-oil exports accounted for a small value of 6.67% over the same period. (NBS report, 2008).

Figure

Therefore, it could be understood that SAP involved the deregulation and liberalization of the Nigerian economy. This policy thrust dovetailed nicely with the emerging international orthodoxy to the effect that deregulation and economic liberalization would yield the optimal allocation of scarce resources, reduce waste, and promote rapid economic growth in developing countries. Unfortunately, there has been no significant progress made in the achievement of these objectives. The economy is still excessively dependent on petroleum exports while the degree of openness of the economy has increased. The trade openness of the economy has significantly increased in the past three decades, with the trade-GDP ratio rising from 31.54% in 1970, to 46.91% in 1980, 57.23% in 1990, 88.16% in 1995, 85.26% in 2003 and 57.63% in 2007(see figure 4 below). Indeed, in the 1990s the ratio of trade to GDP has averaged 70%. This extreme openness of the economy could be disadvantageous in that it makes the country highly susceptible to internationally transmitted business cycles, and, in particular, internationally transmitted shocks (like commodity price collapse). A good example of this effect on the Nigerian economy is that of the global food crisis of 2007 and current global economic/financial crisis.

Figure

Statement of Research Problem

Nwafor Manson (undated) noted that the Nigeria’s trade policy over the years has been determined by one/more of the following:

Objective of the Study

The broad objective of this research work is to study, in its entirety, the relationship between trade openness and output growth in Nigeria. This broad objective can be subdivided into the following smaller objectives:

To examine the impact of trade openness on output growth in Nigeria.

To identify other internal and external macroeconomic shocks that determine output growth in Nigeria.

To determine the linear association (correlation) between trade openness and output growth in Nigeria.

To ascertain the possibility of long run relationship between trade openness and output growth in Nigeria.

To determine the possibility of structural changes (if any) in output growth between the pre-SAP and post-SAP period.

Statement of Research Hypothesis

In view of the foregoing study, with respect to trade openness and output growth in Nigeria, the following null hypotheses will be tested:

Ho: Trade openness does not have any significant impact on output growth in Nigeria.

Ho: There is no other macroeconomic variable (internal and external) that have significant impact on output growth in Nigeria.

Ho: There is no linear association (correlation) between trade openness and output growth in Nigeria.

Ho: There is no long run relationship between trade openness and output growth in Nigeria.

Ho: There is no significant structural change in output growth between the pre-SAP and post-SAP period.

Justification of the Study

Nigeria is currently undergoing a series of transformation in every sector of the economy, including the external sector of the economy. The country’s economic policy in the last two decades had one dominating theme which is an integral part of the Structural Adjustment Programme (SAP) — trade liberalization. This policy was espoused on the argument that it enhances the welfare of consumers and reduces poverty as it offers wider platform for choice from among wider variety of quality goods and cheaper imports. Today, there are many existing literature on the topical issue of trade openness and growth of which some support the axiom that openness is directly correlated to greater economic growth with the main operational implication being that governments should dismantle the barriers to trade. The focal point of this research work is to identify the short comings and benefits of this argument as well as check the validity of this ‘mainstream’ axiom in Nigeria in the presence of various internal and external shocks.

Significance of the Study

The role of international trade in the developmental journey of an economy can not be overemphasized, especially with the current trend of globalization. Nigeria, being part of the global village, is not left out of this world development. This research work is carried out to study how trade openness has influenced the performance of the Nigerian economy through output growth in the presence of other internal and external shocks. The findings of this research work transcend beyond mere academic brainstorming, but will be of immense benefit to federal agencies, policy makers, intellectual researchers and international trade think tanks that occasionally prescribe and suggest policy options to the government on trade related issues. It will also help the government to see the effectiveness of trade liberalization policy on the economic growth of the nation over the years. This research work will further serve as a guide and provide insight for future research on this topic and related field for students who are willing to improve on it. It will also educate the public on various government policies as related to trade issues.

Scope and Limitation of the Study

This research work span through the period of 1970-2007 (38 years), and is within the geographical zone of Nigeria. Thus, it is a country-specific research. This research exercise, like every other research work, is really a rigorous one that consumes much time and energy especially in the area of data sourcing, data computation and modeling. The work is relatively limited base on time and financial constraints, data availability, precision of data and data range, and methodology adopted which could further be verified by future research. Nevertheless, the researchers have properly organized the research so as to present dependable results which can aid effective policy making and implementation at least for the time being.

Chapter Summary and Prospect

In this chapter, we have introduced the concept of openness and output growth, the problems this study seeks to address, the targeted objective of the study and the hypotheses this study seeks to verify. We have also explained the justification for and the significance of this study as well as the scope and limitations of this study. In the next chapter, we shall review the related literature, both theoretical and empirical, as well as limitations of the previous studies.

CHAPTER TWO: LITERATURE REVIEW

2.1 Introduction

“Openness” refers to the degree of dependence of an economy on international trade and financial flows. Trade openness measures the international competitiveness of a country in the global market. Thus, we may talk of trade openness and financial openness. Trade openness is often measured by the ratio of import to GDP or alternatively, the ratio of trade to GDP. It is now generally accepted that increased openness with respect to both trade and capital flows will be beneficial to a country. Increased openness facilitates greater integration into global markets. Integration and globalisation are beneficial to developing countries although there are also some potential risks. (Iyoha and Oriakhi, 2002). Trade openness is interpreted to include import and export taxes, as well as explicit non-tariff distortions of trade or in varying degrees of broadness to cover such matters as exchange-rate policies, domestic taxes and subsidies, competition and other regulatory policies, education policies, the nature of the legal system, the form of government, and the general nature of institutions and culture (Baldwin, 2002).

2.2 Theoretical Literature

The issue of whether trade and increased openness would lead to higher rate of economic growth is an age-old question which has sustained debate between pro-traders and protectionists over the years from classicalists like Adam Smith, John Stuart Mill, to John Maynard Keynes, Raul Prebisch, Hans Singer, Paul Krugman and so on. Theorists from both theses have influenced policy in many countries and at various stage of development. There has also been a huge policy debate about what constitute “good” and “bad” policies for these countries, especially the developing countries including Nigeria. Should these countries completely open up to international trade? Or should they instead, at least temporarily, protect some or all of their industries from the world market forces? Formal arguments have been developed pro and con of both theses. These arguments were discussed extensively by Maskus (1998) thus:

Argument One: Economies will grow faster if they protect domestic industry from import competition.

This is a general statement of the “Infant-Industry Hypothesis,” which states that manufacturing sectors in underdeveloped economies must be sheltered from competition in order to have the incentive to invest capital, learn how to produce goods efficiently, take advantage of scale economies through large-scale production, and develop innovative or distinctive products that can be sold on world markets. The broadest application of the infant-industry argument for isolation from global markets emerged in the widespread use of import substitution policies in developing countries. A policy of import substitution for industrialization purposes (ISI) involves extensively controlling virtually all components of the economy in order to direct resources into manufacturing. It is an old idea, but its modern origins come from economists writing in the 1950s and 1960s (Arthur Lewis, Raul Prebish, Hans Singer, Gunnar Myrdal, others), who claimed that developing economies faced two fundamental problems. First, their status as primary-commodity exporters left them vulnerable to world swings in commodity prices (e.g., oil, sugar, tin, copper, etc.) and also that over the long run, commodity prices would decline relative to manufacturing prices and costs of new technologies. Second, because developing countries have high population growth rates and abundant labor supplies, it would be difficult to absorb workers into primary production. Rather than waiting for comparative advantage to push resources into labor-intensive manufacturing, it would be better to force industrialization through ISI policies. Such programs became common in the 1950s throughout Latin America, Africa, the Middle East, South Asia and Southeast Asia. They are still much in evidence in many countries.

Policies imposed in a thorough ISI program include the following.

Escalating tariffs, or tariff rates that rise with the stage of processing. Thus, low tariffs on primary goods, medium tariffs on industrial inputs and machinery, and high tariffs on final goods, particularly consumer goods such as food products, clothing, cosmetics, automobiles, and so on. Such tariff structures establish very high effective rates of protection for final goods, meaning that auto factories and so on were strongly protected.

Considerable taxes on production of primary commodities in order to push labor out of the countryside and into the cities for developing manufacturing. Such taxes include tariffs on imported fertilizers, price ceilings at very low rates for crops, export taxes on farm goods, and so on. For these reasons, ERPs in agriculture were often strongly negative, vastly reducing output and productivity in farming.

Fixing exchange rates at expensive levels (i.e., “overvaluing” the domestic currency), again in order to discourage primary exports and production and also to reduce the cost of imported inputs for manufacturing sectors. Such exchange rates tended to generate large trade deficits, forcing governments to borrow from abroad and build up debt. It also required setting and controlling multiple exchange rates, so that capital and input transactions could take place at cheaper rates than goods imports in order to protect domestic industry.

Extensive systems of quotas and licensing for imports and production.

Rigorous controls on FDI coming into the country, requiring foreign firms to meet certain performance requirements. Also controls on imported technologies, with governments placing restrictions on costs of technology and under what terms it would be transferred to local firms.

Extensive nationalization of industry to establish state-owned enterprises (SOEs) in key sectors, such as petroleum, steel, chemicals, construction, banking, and airlines. These “industry champions” received government subsidies and were favored in the process of capital allocation, typically being allowed to borrow at very low rates from state banks (usually at negative real interest rates).

To some degree these policies successfully pushed industrialization, but rarely of an efficient kind. Developing countries are full of large manufacturing operations that operate at inefficiently low scales because market sizes are small and product quality is not good enough to penetrate export markets, which is a costly activity. These operations are partly supported by government subsidies, generating vested interests in keeping them going and opposing liberalization. Relative prices of goods are heavily distorted by the various subsidies, trade restrictions, and licenses. Other unintended effects include massive shifts of workers into the cities and worsened sanitation and health problems.

However, the question is whether such policies have limited growth. Evidently many other factors are at work. What seems clear is that such countries have not performed well in terms of acquiring and improving technologies, have lagged significantly behind in product innovation and adaptation, have inefficient and distorted agricultural and manufacturing sectors, and have not performed well in building human capital, physical capital, and infrastructure. Some relevant figures are given later. Thus, these sources of growth have likely been limited in countries pursuing ISI programs.

Argument Two: Countries will grow faster if they are open to international competition

This is the basic hope underlying trade-reform programs that involve extensive liberalization of trade and investment barriers, reduction of controls on technology transfers, unification of tariff rates and domestic tax rates, removal of consumption and production subsidies, and deregulation of industry and privatization of state-owned enterprises. It is the essential philosophy behind World Bank loans to facilitate restructuring and IMF lending packages that require microeconomic structural reforms. It is also a very old idea (going back to Adam Smith and David Ricardo at least) but its modern translation into trade liberalization largely began with the reforms in Chile in the 1970s advocated by the “Chicago School” of economists (e.g. Milton Friedman, George Stigler).

A somewhat different version of this approach is (to contrast it with ISI) called export promotion, which is the policy followed largely by East Asian and Western countries. These approaches are not necessarily liberal in the sense of free competition. There are many examples of sheltered and subsidized domestic firms or industrial groupings; much of this protection was designed to encourage infant industries to mature and export. However, the key component of export promotion programs is not to discourage exports, as is done under ISI programs. The basic policies under export promotion include the following.

Properly valued exchange rates, meaning exchange rates that do not discriminate between imports and exports. This is accomplished either through flexible rates or pegged exchange rates that are allowed to move gradually to account for inflation differences between the country in question and major export markets. In this sense, the exchange rate did not impose any tax on exports.

Remove taxes on export production and, indeed, make the tax and tariff system as neutral as possible across sectors of production. Thus, while in most of these nations agricultural production was protected from import competition, in manufacturing there was relatively little discrimination across types of goods. It is for this reason that export-promotion policies are far closer to open trade policies than are ISI policies. There were certainly major exceptions to this rule in many export-promotion countries, however.

Rather than rely largely on import protection to promote infant industries, some active forms of export promotion in manufacturing and high-tech sectors were taken, including favorable allocation of loans and subsidies and rebates of import tariffs paid on imported industrial inputs.

Recognizing that exporting is harder than cutting off imports because exports require improving levels of quality and considerable foreign marketing costs, East Asian firms have emphasized quality control and access to foreign technologies on favorable terms. Governments have supported this by ensuring strong public educational efforts, investments in infrastructure for exports, and technology transfer policies that attempted to force inward technology flows at cheap prices.

Recent problems in some countries (especially Asian countries) indicate that while export-promotion strategies may have contributed to growth, they ultimately cause serious problems of overproduction (excess capacity) relative to the economy’s ability to consume commodities. (Maskus, 1998)

The World Bank favors lifting the protectionist measures that have locked low-income countries out of rich-country export markets. In fact, most international bodies (WTO, IMF, World Bank etc) strongly support the case for trade openness and financial liberalisation when setting up programs for developing countries or when multilateral meetings occur. Some of the arguments put forward in favour of increased openness to trade include the following:

Specialization: Gains from specialisation in the good in which the country has a comparative advantage such as productivity gains, lower costs of production etc.

Variety: Greater variety of goods available to consumers thus increasing the consumer surplus and satisfying the consumers’ “demand of difference”.

Increasing returns: Economies of scale justify any market enlargement. However, conclusions are quite ambiguous. For instance, the gain is by large dependent of the process of firms’ issue. A fixed market structure inhibits such gains in the many firms complete

specialisation scheme of monopolistic competition. In the same way, imposing

consumers to buy a greater quantity of domestic products can be optimal. Domestic firms

increase their output and achieve economies of scale, while the variety is not reduced.

Notwithstanding such arguments, economies of scale are generally referred to as a key

objective of integration policies.

Pro-competitive effect: When an economy is open, there will be more intense competition which obliges local firms to operate more efficiently than under protection. There will also be drive for innovation and efficiency in production in a smaller of goods. The country can thus compete internationally.

Positive externality: The technology is spread over the boundaries through trade and open countries benefit a better access to a world-wide

basket of technology. Also, there will be Adoption of sound policies to make sure the country is attractive to investors: trade openness acts as a watchdog for politicians as bad economic performances are blamed on them. Good governance should thus be fostered.

On the other hand, some arguments were put forward by protectionists against trade openness. Apoteker and Crozet (2003) have put forward five reasons that can at least underline the potential risks in opened trade.

Fluidity: All products do not have the same fluidity, meaning that some may be easily relocated while some others are ‘stickier’ and cannot be as easily moved.

Multiple comparative advantages: As many countries with similar resources are opening up to trade, they bring at the same time their same comparative advantage on the market. This will create an excess supply of that product and its world price will decrease, thus harming all the providers.

Instability as regards financial volatility: Implementing financial liberalisation implies allowing financial flows to freely move in or out of a country. However, in a country which lacks political credibility or monetary strength and power, capital mobility and volatility can make economic policies useless, thus preventing a country from using fiscal or monetary tools to try to solve domestic economic problems. This means greater dependence on the international environment.

Investors’ size versus market size: If concentration on a small market is high, the issue of market efficiency becomes critical. Indeed if one of the large and few investors on a small market withdraw its funds, it can threaten the whole market equilibrium, and even create panic among other investors without any “fundamental” reasons behind it.

Timeframe: A country’s development process is a long-term one, while financial investors usually have a short-term approach. Thus there are potential conflicts of interest between public authorities and private investors/companies, which can be harmful for development goals.

The unanimous agreement on the beneficial effects on growth and development of trade liberalization goes back to the emergence of the Washington Consensus in the early 1980s. The Consensus emerged in response to the economic crisis affecting most developing countries at the time, triggered by the debt crisis. Nonetheless, Long-term economic growth is generally seen as being dependent on openness to trade. But, literature on trade theory and policy has since the time of Adam Smith debated whether openness and trade liberalization provide the necessary ingredients for economic growth (Miller and Upadhya, 2000). Thus, in order to effectively understand the relationship between trade openness and output growth we need to review and understudy the trade theory, the theory of customs unions and free trade areas, and models of export-led growth.

2.2.1 Theory of Trade

The doctrine that trade enhances welfare and growth has a long and distinguished ancestry dating back to Adam Smith (1723-90). In his famous book, An Inquiry into the Nature and Causes of the Wealth of Nations (1776), Smith stressed the importance of trade as a vent for surplus production and as a means of widening the market thereby improving the division of labour and the level of productivity. He asserted that “between whatever places foreign trade is carried on, they all of them derive two distinct benefits from it. It carries the surplus part of the produce of their land and labour for which there is no demand among them, and brings back in return something else for which there is a demand. It gives value to their superfluities, by exchanging them for something else, which may satisfy part of their wants and increase their enjoyments. By means of it, the narrowness of the home market does not hinder the division of labour in any particular branch of art or manufacture from being carried to the highest perfection. By opening a more extensive market for whatever part of the produce of their labour may exceed the home consumption, it encourages them to improve its productive powers and to augment its annual produce to the utmost, and thereby to increase the real revenue of wealth and society.”(Thirlwall, 2000). We may summarise the absolute advantage trade theory of Adam Smith thus; countries should specialise in and export those commodities in which they had an absolute advantage and should import those commodities in which the trading partner had an absolute advantage. That is to say, each country should export those commodities it produced more efficiently because the absolute labour required per unit was less than that of the prospective trading partner. (Appleyard and Field, 1998)

In the 19th century, the Smithian trade theory generated a lot of arguments. This led to David Ricardo (1772-1823) to develop the theory of comparative advantage and showed rigorously in his Principles of Political Economy and Taxation (1817) that on the assumptions of perfect competition and the full employment of resources, countries can reap welfare gains by specialising in the production of those goods with the lowest opportunity cost and trading the surplus of production over domestic demand, provided that the international rate of exchange between commodities lies between the domestic opportunity cost ratios. These are essentially static gains that arise from the reallocation of resources from one sector to another as increased specialisation, based on comparative advantage, takes place. These are the trade-creation gains that arise within Customs Unions or Free Trade Areas as the barriers to trade are removed between members, but the gains are once-for-all. Once the tariff barriers have been removed, and no further reallocation takes place, the static gains are exhausted. The static gains from trade stem from the basic fact that countries are differently endowed with resources and because of this the opportunity cost of producing products varies from country to country. Opportunity cost is measured by the marginal rate of transformation between one good and another, as given by the slope of the production possibility curve; that is, by how much one good has to be sacrificed in order to produce another. The law of comparative advantage states that countries will benefit if they specialise in the production of those goods for which the opportunity cost is low and exchange those goods for other goods, the opportunity cost of which is higher. That is to say, the static gains from trade are measured by the resource gains to be obtained by exporting to obtain imports more cheaply in terms of resources given up, compared to producing the goods oneself. In other words, the static gains from trade are measured by the excess cost of import substitution; by what is saved by not producing the imported good domestically. The resource gains can then be used in a variety of ways including increased domestic consumption of both goods. (Thirlwall, 2000).

On the other hand, the dynamic gains from trade continually shift outwards the whole production possibility frontier of countries if trade is associated with more investment and faster productivity growth based on scale economies, learning by doing and the acquisition of new knowledge from abroad, particularly through foreign direct investment. The essence of dynamic gains is that they shift outwards the whole production possibility frontier by augmenting the availability of resources for production through increasing the productivity of resources and increasing their quantity. One of the major dynamic benefits of trade is that export markets widen the total market for a country’s producers. If production is subject to increasing returns, export growth becomes a continual source of productivity growth. There is also a close connection between increasing returns and the accumulation of capital. For a small country with no trade there is very little scope for large scale investment in advanced capital equipment; specialisation is limited by the extent of the market. But if a poor small country can trade, there is some prospect of industrialisation and of dispensing with traditional methods of production. It is the dynamic gains from trade that are focused on in modern trade theory such as the Heckscher-Ohlin trade theory.

2.2.2 Theory of Customs Unions and Free Trade Areas

Since the end of the World War II, there had been several attempts to promote trade through the creation of international and regional trade agreements in the form of customs unions and free trade areas. Free trade area is a form of economic union in which all members of the group remove tariffs on each other’s products, while at the same time each member retain its independence in establishing trading policies with non-members. In other words, the members of a free trade area can maintain individual tariffs and other trade barriers on the outside world. That is to say, in a free trade area, barriers to trade are brought down within the area, but there is no common external tariff. Also, free trade areas create trade, but the extent of trade diversion is likely to be much less, with the presumption that on narrow economic grounds free trade areas are superior.

On the other hand, a customs union is a form of economic integration in which all tariffs are removed between members and the group adopts a common external commercial policy toward non-members. Furthermore, the group acts as one body in the negotiation of all trade agreements with non-members. The existence of the common external tariff takes away the possibility of transshipment by non-members. Customs Unions create trade, but also divert it from lower cost suppliers to higher cost suppliers within the Union. Thus, the question is whether the benefits of trade creation exceed the costs of trade diversion. Apart from trade creation and trade diversion, Customs Unions may also have other important effects associated with the enlargement of the market which are neglected by the static analysis. Firstly, the larger market may generate economies of scale. Secondly, integration is likely to promote increased competition which is likely to affect favourably prices and costs, and the growth of output. Thirdly, the widening of markets within a Customs Union is likely to attract international investment. Producers will prefer to produce within the Union rather than face a common external tariff from outside. Finally, if the world supply of output is not infinitely elastic, there are terms of trade effects to consider. Specifically, if there is trade diversion, the world price of the good will fall, moving the terms of trade in favour of the Customs Union. This term of trade effect represents a welfare gain which may partly offset the welfare loss of trade diversion.

The two forms of economic integration discussed above are likely to be inferior to a policy of unilateral tariff reductions, and therefore need to be justified on other economic or non-economic grounds. Thus, De Melo, Panagariya and Rodrik (1993) suggest three channels through which regional integration could alter economic outcomes for the better. Firstly, a regional trade agreement entails a larger political community which might lessen the scope for adverse discretionary actions by governments, and in particular restrict the power of growth-retarding political interest groups, unless politically powerful lobbies can form alliances across countries. Secondly, when a regional institution is set up ab initio, better choices may be made than at the nation-state level, where policy-makers have to contend with existing institutions that accommodate factional interests. Thirdly, when participating countries have different economic institutions, policy-making at the regional level will entail a compromise between those institutions and may lead to a superior outcome for at least some member countries. For example, if a Customs Union adopts as its common external tariff, the average tariff of the Union, at least some members must benefit. Nevertheless, the World Bank is generally hostile to regional trading blocs, despite the potential political-cum-economic benefits, because of their relatively inward-looking nature. (Thirlwall, 2000).

2.2.3 Models of Export-led Growth

The three main models of export-led growth that will be discussed are the neoclassical supply-side model, the balance of payments constrained model which is also known as the Hicks super-multiplier model, and the virtuous circle model.

The Neoclassical Supply-Side Model: This model shows the relationship between exports and growth, and assumes that the export sector confers externalities on the nonexport sector, because of its exposure to foreign competition; and secondly that the export sector has a higher level of productivity than the nonexport sector. Thus, the share of exports in GDP, and the growth of exports, matters for overall growth performance. Feder (1983) was the first to provide a formal model of this type to explain the relation between export growth and output growth. The output of the export sector is assumed to be a function of labour and capital in the sector; the output of the non-export sector is assumed to be a function of labour, capital and the output of the export sector (so as to capture externalities), and the ratio of respective marginal factor productivities in the two sectors is assumed to deviate from unity by a factor d. Feder tests the model taking a cross section of 19 semi-industrialised countries and a larger sample of 31 countries over the period 1964-73. He finds that there are substantial differences in productivity between the export and non-export sector and also evidence of externalities. The externalities conferred are part of the dynamic gains from trade which are associated with the transmission and diffusion of new ideas from abroad relating to both production techniques and efficient management practices. The cross-section work on exports and growth assumes, however, that all countries in a sample conform to the same model, with the same intercept and coefficient parameters linking exports and growth. In practice, this is highly unlikely to be the case; and it transpires, in fact, that when time series studies are conducted for individual countries, the relation between exports and growth is much weaker.

Balance of Payments Constrained Growth Model: No country can grow faster than that rate consistent with balance of payments equilibrium on current account in the long run, unless it can finance ever-growing deficits which, in general, it cannot. Ratios of deficit to GDP of more than 2%-3% start to make the international financial markets nervous, and all borrowing eventually has to be repaid. A country’s balance of payments equilibrium growth rate can be modeled by stating the balance of payments equilibrium condition, specifying multiplicative (constant elasticity) import and export demand functions in which imports and exports are a function of domestic and foreign income, respectively, and of relative prices, and substituting these functions in the equilibrium condition. Since imports are a function of domestic income, the model can be easily solved for the growth of income consistent with balance of payments equilibrium. Nureldin-Hussain (1995) applied this model to Africa to contrast the experience of slow growing African countries with the faster growing countries of Asia over the period 1970-90. He uses an extended model which also includes terms of trade effects and the effects of capital flows. The major explanation of the difference in growth rates between Africa and Asia turns out to be the difference in the growth of exports. He finds that the average growth of the African countries, excluding oil exporters, was 3.4 percent per annum, and of the Asian countries 6.6 percent. The contribution of export growth in Africa was 1.99 percentage points and in Asia 5.91 percentage points. Differences in capital flows and terms of trade movements made only a minor contribution to growth rate differences. Thus, he concluded that exports are unique as a growth-inducing force from the demand side because it is the only component of demand that provides foreign exchange to pay for the import requirements for growth. In this sense, it allows all other components of demand to grow faster in a way that consumption-led growth or investment-led growth does not.

Virtuous Circle Models of Export-Led Growth: There is a need to recognise the fact that exports and growth may be interrelated in a cumulative process. This raises the question of causality; but more importantly, such models provide an explanation of why growth and development through trade tends to be concentrated in particular areas of the world, while other regions and countries have been left behind. These models provide a challenge to both orthodox growth theory and trade theory which predict the long run convergence of living standards across the world. A simple cumulative model, driven by exports as the major component of autonomous demand, is to assume that (i) output growth is a function of export growth; (ii) export growth is a function of price competitiveness and foreign income growth; (iii) price competitiveness is a function of wage growth and productivity growth, and (iv) productivity growth is a function of output growth (this is referred to as Verdoorn Law which works through static and dynamic returns to scale, including learning by doing). It is this induced productivity growth that makes the model ‘circular and cumulative’ since if fast output growth (caused by export growth) induces faster productivity growth, this makes goods more competitive and therefore induces faster export growth. The Verdoorn relation not only makes the model ‘circular and cumulative’; but also gives rise to the possibility that once an economy obtains a growth advantage it will tend to keep it. Suppose, for example, that an economy obtains an advantage in the production of goods with a high income elasticity of demand in world markets, such as high technology goods, which raises its growth rate above other countries. Through the Verdoorn effect, productivity growth will be higher and the economy will retain its competitive advantage in these goods, making it difficult, without protection or exceptional industrial enterprise, to establish the same commodities. In such a cumulative model, it is the difference between the income elasticity characteristics of exports (and imports, if balance of payments equilibrium is a requirement, as argued earlier) that is the essence of divergence between industrial and agricultural economies, or between ‘centre’ and ‘periphery. (Thirlwall, 2000).

From the ongoing, we can conclude that trade liberalisation does not necessarily imply faster export growth, but in practice the two appear to be highly correlated. The impact of trade liberalisation on economic growth probably works mainly through improving efficiency and stimulating exports which have powerful effects on both supply and demand within an economy. There are several different measures of trade liberalisation or trade orientation, and all studies seem to show a positive effect of liberalisation on economic performance. Likewise there are several different studies of the relation between exports and growth and the evidence seems overwhelming that the two are highly correlated in a causal sense, but the relative importance of the precise mechanisms by which export growth impacts on economic growth are not always easy to discern or quantify.

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