International_Economics_Tenth_Edition (1)

OPEC as a Cartel

OPEC has generally disavowed the term cartel. However, its organization is composed of a secretariat, a conference of ministers, a board of governors, and an economic commission. OPEC has repeatedly attempted to formulate plans for systematic production control among its members as a way of firming up oil prices. However, OPEC hardly controls prices. The group currently controls less than 40 percent of world supply, insufficient to establish an effective cartel. Moreover, OPEC's production agreements have not always lived up to expectations because too many member nations have violated the agreements by producing more than their assigned quotas. Since 1983, when production quotas were first assigned to members, OPEC's actual production levels have almost always been greater than its target levels, meaning that countries have been selling more oil

than they're supposed to-in other words, they've been cheating, as shown in Figure 7.6. Simply put, OPEC does not have any club with which to enforce its edicts.

The exception is Saudi Arabia, owner of the world's largest reserves and lowest production costs. The Saudis spend immense capital to maintain more production capacity than they use, allowing them to influence, or threaten to influence, prices over the short run.

In the future, it is likely that OPEC will struggle to achieve higher prices amid growing supply competition. The recovery of Iraq's exports, following two wars with the United States and its allies, may strain OPEC's efforts to support higher prices. By 2007, significant new supplies from West Africa, the Caspian, Russia, deepwater areas of the Atlantic basin, and elsewhere are expected to come on stream and, coupled with rising capacity within

240 Trade Policies for the Developing Nations

OPEC, exert downward pressure on prices. In addition, the United States might initiate policies to increase the supply and/or decrease demand. However, achieving these measures involves difficult choices for Americans, such as:

•Raising the fuel economy standards mandated by the federal government. Analysts estimated that if the gas mileage of new cars had increased by only one mile per gallon each year

since 1987, and the mileage of light trucks by a half-mile per gallon, the United States would be saving 1.3 million barrels of oil each day. However, increasing fuel economy standards would meet resistance from auto producers, who would see their production costs increasing because of this policy.

•Increasing the federal excise tax on gasoline.

Although the resulting hike in the price of gasoline would provide an incentive for consumers to conserve, this would conflict with the preference of Americans for low-priced gasoline. Moreover, rising gasoline prices would especially harm low-income consumers with the least ability to pay.

•Allowing oil companies to drill on federal land designated as wilderness in Alaska, where there is a good chance they might find oil. Perhaps, but what happens when the wilderness is destroyed, never to return? Who pays for that?

•Diversifying imports. Although it could be expensive, the United States might forge closer ties with oil producers outside the Middle East to diminish dependence on the unstable region. However, this would require the United States to work even more closely with unsavory regimes in countries like Angola, Indonesia, and Vietnam. Also, OPEC oil is very cheap to get out of the ground. While it costs deepwater drillers like ExxonMobil or Conoco $6 to $8 to produce a barrel in the Gulf of Mexico or the North Sea, the Saudis and Kuwaitis spend a fraction of that-$l a barrel or less. This cost advantage enhances OPEC's market power.

Economic Growth Strategies:

Import Substitution Versus

Export -Led Growth

Besides seeking economic assistance from advanced countries, developing countries have pursued two competing strategies for industrialization: (1) an inward-looking strategy (import substitution), in which industries are established largely to supply the domestic market, and foreign trade is assigned negligible importance; (2) an outward-looking strategy (export-led growth) of encouraging the development of industries in which the country enjoys comparative advantage, with heavy reliance on foreign nations as purchasers of the increased production of exportable goods.

Import Substitution

During the 1950s and 1960s, the industrialization strategy of import substitution became popular in developing nations such as Argentina, Brazil, and Mexico; some countries still use it today. Import substitution involves extensive use of trade barriers to protect domestic industries from import competition. The strategy is inward-oriented in that trade and industrial incentives favor production for the domestic market over the export market. For example, if fertilizer imports occur, import substitution calls for establishment of a domestic fertilizer industry to produce replacements for fertilizer imports. In the extreme, import-substitution policies could lead to complete self-sufficiency.

The rationale for import substitution arises from the developing countries' perspective on trade. Many developing countries feel that they cannot export manufactured goods because they cannot compete with established firms of the industrial countries, especially in view of the high trade barriers maintained by industrial countries. Given the need for economic growth and development, developing countries have no choice but to manufacture for themselves some of the goods they now import. The use of tariffs and quotas restricts imports, and the domestic market is reserved for domestic manufacturers. This rationale is often

combined with the infant-industry argument: Protecting start-up industries will allow them to grow to a size where they can compete with the industries of the developed countries.

In one respect, import substitution appears logical: If a good is demanded and imported, why not produce it domestically? The economist's answer is that it may be more costly to produce it domestically and cheaper to import it; comparative advantage should decide which goods are imported and which are exported.

Encouraging economic development via import substitution has several advantages:

•The risks of establishing a home industry to replace imports are low because the home market for the manufactured good already exists.

•It is easier for a developing nation to protect its manufacturers against foreign competitors than to force industrial nations to reduce their trade restrictions on products exported by the developing nations.

•To avoid the import tariff walls of the developing country, foreigners have an incentive to locate manufacturing plants in the country, thus providing jobs for local workers.

In contrast to these advantages are several disadvantages:

•Because trade restrictions shelter domestic industries from international competition, they have no incentive to increase their efficiency.

•Given the small size of the domestic market in many developing countries, manufacturers cannot take advantage of economies of scale and thus have high unit costs.

•Because the resources employed in the protected industry would otherwise have been employed elsewhere, protection of importcompeting industries automatically discriminates against all other industries, including potential exporting ones.

•Once investment is sunk in activities that were profitable only because of tariffs and quotas, any attempt to remove those restrictions is generally strongly resisted.

•Import substitution also breeds corruption. The more protected the economy, the greater

the gains to be had from illicit activity such as smuggling.

Import-Substitution Laws

Backfire on Brazil

Although import-substitution laws have often been used by developing nations in their industrialization efforts, they sometimes backfire. Let us consider the example of Brazil.

In 1991, Enrico Misasi was the president of the Brazilian unit of Italian computer-maker Olivetti Inc., but he did not have an Olivetti computer. The computer behind his desk was instead manufactured by two Brazilian firms; it cost three times more than an Olivetti, and its quality was inferior. Rather than manufacturing computers in Brazil, Olivetti Inc. was permitted to manufacture only typewriters and calculators.

This anomaly was the result of import-substitu- tion policies practiced by Brazil until 1991. From the 1970s until 1991, importing a foreign personal computer-or a microchip, a fax machine, or dozens of other electronic goods-was prohibited. Not only were electronic imports prohibited, but foreign firms willing to invest in Brazilian manufacturing plants were also banned. Joint ventures were deterred by a law that kept foreign partners from owning more than 30 percent of a local business. These restrictions were intended to foster a homegrown electronics industry. Instead, even the law's proponents came to admit that the Brazilian electronics industry was uncompetitive and technologically outdated.

The costs of the import ban were clearly apparent by the early 1990s. Almost no Brazilian automobiles were equipped with electronic fuel injection or antiskid brake systems, both widespread throughout the world. Products such as Apple Computer's Macintosh computer were not permitted to be sold in Brazil. Brazil chose to allow Texas Instruments to shut down its Brazilian semiconductor plant, resulting in a loss of 250 jobs, rather than permit Texas Instruments to invest $133 million to modernize its product line. By adhering to its import-substitution policy, Brazil wound up a largely computer-unfriendly nation: By 1991, only

242 Trade Policies for the Developing Nations

12 percent of smalland medium-sized Brazilian companies were at least partially computerized, and only 0.5 percent of Brazil's classrooms were equipped with computers. Many Brazilian companies postponed modernization because computers available overseas were not manufactured in Brazil and could not be imported. Some Brazilian companies resorted to smuggling in computers and other electrical equipment; those companies that adhered to the rules wound up with outdated and overpriced equipment.

Realizing that the import-substitution policy had backfired on its computer industry, in 1991 the Brazilian government scrapped a cornerstone of its nationalistic approach by lifting the electronics import ban-though continuing to protect domestic industry with high import duties. The government also permitted foreign joint-venture partners to raise their ownership shares from 30 percent to 49 percent and to transfer technology into the Brazilian economy.

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Export-Led Growth -/ &'rmrcqlJ1 Vl~W

Another development strategy is export-led growth, or export-oriented policy. The strategy is outward-oriented because it links the domestic economy to the world economy. Instead of pursuing growth through the protection of domestic industries suffering comparative disadvantage, the strategy involves promoting growth through the export of manufactured goods. Trade controls are either nonexistent or very low, in the sense that any disincentives to export resulting from import barriers are counterbalanced by export subsidies. Industrialization is viewed as a natural outcome of development instead of being an objective pursued at the expense of the economy's efficiency. By the 1970s, many developing countries were abandoning their import-substitution strategies and shifting emphasis to export-led growth.

Export-oriented policies have a number of advantages: (l) They encourage industries in which developing countries are likely to have a comparative advantage, such as labor-intensive manufactured goods; (2) By providing a larger market in which to sell, they allow domestic manufacturers greater scope for exploiting economies of scale;

(3) By maintaining low restrictions on imported goods, they impose a competitive discipline on domestic firms that forces them to increaseefficiency.

Figure 7.7 illustrates the relationship between openness to international trade and economic growth for developing countries. A sample of 72 countries was split into "globalizers" and "nonglobalizers." The globalizers were defined as the 24 countries that achieved the largest increases in their ratio of trade to gross domestic product from 1975 to 1995. During the 1960s and 1970s, the nonglobalizers experienced somewhat faster growth of real income per capita on average than the globalizers. During the 1980s, however, globalizers experienced much higher growth rates; real income per capita grew an average of 3.5 percent a year in these countries, compared with 0.8 percent for the nonglobalizers. The divergence was even greater during the 1990s, with 5.0 percent annual growth for the globalizers versus 1.4 percent for the rest. To put these differences into perspective, had the average globalizer and the average nonglobalizer each begun with an income per capita of $1,000 in 1980, by 2000 the globalizer's income per capita would have growth to $2,300, and the nonglobalizer's only to $1,240.

This supports the notion that the economic performance of nations implementing export-led growth policies has been superior to that of nations using import-substitution policies. Export-led growth policies introduce international competition to domestic markets, which encourages efficient firms and discourages inefficientones. By creating a more competitive environment, they also promote higher productivity and hence faster economic growth. Conversely, import-substitution policies relying on trade protection switch demand to products produced domestically. Exporting is then discouraged by both the increased cost of imported inputs and the increased cost of domestic inputs relative to the price received by exporters.

Is Economic Growth

Good for the Poor?

Although the evidence strongly suggests that trade is good for growth, is growth good for poor workers in developing countries? Critics argue

that growth tends to be bad for the poor if the growth in question has been promoted by trade or foreign investment. Investment inflows, they say, make economies less stable, exposing workers to the risk of financial crisis and to the attentions of industrial-country banks. Moreover, they contend that growth driven by trade provides Western multinational corporations a dominant role in third-world development. That is bad, because Western multinationals are not interested in development at all, only in making larger profits by ensuring that the poor stay poor. The proof of this, say critics, lies in the evidence that economic inequality increases even as developing countries, and industrial countries, increase their national income, and in the multinationals' use of sweatshops when producing goods. So if workers' welfare is your primary concern, the fact that trade promotes growth, even if true, misses the point.

However, there is strong evidence that growth aids the poor. Developing countries that have

achieved continuing growth, as in East Asia, have made significant progress in decreasing poverty. The countries where widespread poverty persists, or is worsening,

are those where growth is weakest, notably in Africa. Although economic policy can affect the extent of poverty, in the long run growth is much more important.

There is intense debate over the extent to which the poor benefit from economic growth. Critics argue that the potential benefits of economic growth for the poor are undermined or even offset entirely by sharp increases in inequality that accompany growth. However, proponents contend that liberal economic policies such as open markets and monetary and fiscal stability raise incomes of the poor and everyone else in societyproportionately. Researchers at the World Bank have investigated this topic. As seen in Figure 7.8 on page 244, they confirm that, in a sample of 92 industrial and developing countries

across the world, the incomes of the poor have risen one for one with overall growth. This implies that growth generally does benefit the poor as much as everyone else, so that growth-enhancing policies should be at the center of successful poverty reduction strategies.

However, suppose it were true that income equality is increasing between the industrial and

developing countries. Would this be a terrible indictment of globalization? Perhaps not. It would be disturbing if inequality throughout the world were increasing because incomes of the poorest were decreasing in absolute terms, instead of in relative terms. However, this is rare. Even in Africa, which is behaving poorly in relative terms, incomes have been increasing and broader indicators of

Can All Developing Countries

Achieve Export-Led Growth?

Although exporting can promote growth for developing economies, it depends on the willingness and ability of industrial countries to go on absorbing large amounts of goods from developing countries. Pessimists argue that this process involves a fallacy of composition. If all developing countries tried to export simultaneously, the price of their exports would be driven down on world markets. Moreover, industrialized nations may become apprehensive of foreign competition, especiallyduring eras of high unemployment, and thus impose tariffs to reduce competition from imports. Will liberalizing trade will be self-defeating if too many developing countries try to export simultaneously?

Although developing countries as a group are enormous in terms of geography and population, in economic terms they are small. Taken together, the exports of all the world's poor and middleincome countries equal only 5 percent of world output. This is an amount approximately equivalent to the national output of the United Kingdom. Even if growth in the global demand for imports were somehow capped, a concerted export drive by those parts of the developing world not already engaged in the effort would put no great strain on the global trading system.

Pessimists also tend to underestimate the scope for intraindustry specialization in trade, which gives developing countries a further set of new trade opportunities. The same goes for new trade among developing countries, as opposed to trade with the industrial countries. Often, as developing countries grow, they move away from labor-intensive manufactures to more sophisticated kinds of production. This makes room in the markets they previously served for goods from countries that are not yet so advanced. For example, in the 1970s, Japan withdrew from laborintensive manufacturing, making way for exports from South Korea, Taiwan, and Singapore. In the 1980s and 1990s, South Korea, Taiwan, and Singapore did and same, as China began moving

I East Asian Economies

In spite of the sluggish economic performance of many developing countries, some have realized strong and sustained economic growth, as seen in Table 7.9. What accounts for this performance?

East Asia's Growth Strategy

The East Asian tigers are highly diverse in natural resources, populations, cultures, and economic policies. However, they have in common characteristics underlying their economic success:

rates of investment and (2) high and increasing endowments of human capital due to universal primary and secondary education.

To foster competitiveness, East Asian governments have invested in their people and provided a favorable competitive climate for private enterprise. They have also kept their economies open to international trade. The East Asian economies have actively sought foreign technology, such as licenses, capital-good imports, and foreign training.

The East Asian economies have generally discouraged the organization of trade unions-

East Asian Economies'Growth Rates,

1992-2002

hnp:/lwww.worldbank.org/data. Scroll to "Country at a Glance Tables." See also the World Bank, World Development Report, 2004.

246 Trade Policies for the Developing Nations

whether by deliberate suppression (South Korea and Taiwan), by government paternalism (Singapore), or by a laissez-faire policy (Hong Kong). The outcome has been the prevention of minimum-wage legislation and the maintenance of free and competitive labor markets.

In the post-World War II era, trade policies in the East Asian economies (except Hong Kong) began with a period of import substitution. To develop their consumer-good industries, these countries levied high tariffs and quantitative restrictions on imported goods. They also subsidized some manufacturing industries such as textiles. Although these policies initiallv led to increased domestic production, as time passed they inflicted costs on the East Asian economies. Because import-substitution policies encouraged the importing of capital and intermediate goods and discouraged the exporting of manufactured goods, they led to large trade deficits for the East Asian economies. To obtain the foreign exchange necessary to finance these deficits, the East Asian economies shifted to a strategy of outward orientation and export promotion.

Export-push strategies were enacted in the East Asian economies by the late 1950s and 1960s. Singapore and Hong Kong set up trade regimes that were close to free trade. japan, South Korea, and Taiwan initiated policies to promote exports while protecting domestic producers from import competition. Indonesia, Malaysia, and Thailand adopted a variety of policies to encourage .ex.ports while gradually reducing import restncnons, These measures contributed to an increase in the East Asian economies' share of world exports, with manufactured exports accounting for most of this growth.

The stunning success of the East Asian economies has created problems, however. The industrialize-at-all-costs emphasis has left many of the East Asian economies with major pollution problems. Whopping trade surpluses have triggered a growing wave of protectionist sentiment overseas, especially in the United States, which sees the East Asian economies depending heavily on the U.S. market for future export growth.

Flying-Geese Pattern

of Growth

It is widely recognized that East Asian economies have followed a flying-geese pattern of economic growth in which countries gradually move up in technological development by following in the pattern of countries ahead of them in the development process. For example, Taiwan and Malaysia take over leadership in apparel and textiles from japan as japan moves into the higher-technology sectors of automotive, electronic, and other capital goods. A decade or so later, Taiwan and Malavsia are able to upgrade to automotive and electronics products, while the apparel and textile industries move to Thailand, Vietnam, and Indonesia.

To some degree, the flying-geese pattern is a result of market forces: Labor-abundant nations will become globally competitive in labor-intensive industries, such as footwear, and will graduate to more capitalor skill-intensive industries as savings and education deepen the availabiliry of capital and skilled workers. However, as the East Asian economies have demonstrated, more than just markets are necessary for flying-geese development. Even basic labor-intensive products, such as electronics assembly, are increasingly determined by multinational enterprises and technologies created in industrial nations.

For East Asian economies, a strong export platform has underlain their flying-geese pattern of development. East Asian governments have utilized several versions of an export platform, such as bonded warehouses, free-trade zones, joint ventures, and strategic alliances with multinational enterprises. Governments supported these mechanisms with economic policies that aided the incentives for labor-intensive exports.

IChina: Awakening Giant

In the early 1970s, the People's Republic of China was an insignificant participant in the world market for goods. The value of its exports and Imports was less than $15 billion, and it was only the 30th largest exporting country. China was

also a negligible participant in world financial markets. By 2001, China had growth to the world's second largest economy, with a national output over half that of the United States and 60 percent larger than Japan's. What caused this transformation?

Modern China began in 1949, when a revolutionary communist movement captured control of the nation. Soon after the communist takeover, China instituted a Soviet model of central planning with emphasis on rapid economic growth, particularly industrial growth. The state took over urban manufacturing industry, collectivized agriculture, eliminated household farming, and established compulsory production quotas.

In the late 1950s, China departed from the Soviet model and shifted from large-scale, capitalintensive industry to small-scale, labor-intensive industry scattered across the countryside. Little attention was paid to linking individual reward to individual effort. Instead, a commitment to the success of the collective plans was relied on as the motivation for workers. This system proved to be an economic failure. Although manufacturing output rose following the reforms, product quality was low and production costs were high. Because China's agricultural output was insufficient to feed its people, China became a large importer of grains, vegetable oils, and cotton. As a result of this economic deterioration, plant managers, scientists, engineers, and scholars, who favored material incentives and reform, were denounced and sent to work in the fields.

By the 1970s, China could see its once-poor neighbors-Japan, Singapore, Taiwan, and South Korea---enjoying extraordinary growth and prosperity. This led to China's "rnarketizing" its economy through small, step-by-step changes to minimize economic disruption and political opposition. In agriculture and industry, reforms were made to increase the role of the producing unit, to increase individual incentives, and to reduce the role of state planners. Most goods were sold for market- determined-not state-controlled-prices. Greater competition was allowed both between new firms and between new firms and state firms; by 2000, nonstate firms manufactured about 75 percent of

China's industrial output. Moreover, China opened its economy to foreign investment and joint ventures. The Chinese government's

monopoly over foreign trade was also disbanded; in its place, economic zones were established in which firms could keep foreign

exchange earnings and hire and fire workers.

By 2000, China had made all of the easy economic adjustments in its transition toward capitalism: letting farmers sell their own produce and opening its doors to foreign investors and salespeople. Other reforms still needed addressing: (1) a massive restructuring of state-owned industries, which were losing money; (2) a cleanup of bankrupt state banks; (3) the creation of a social security system in a society that once guaranteed a job for life; and (4) establishment of a monetary system with a central bank free of Communist Party or government control. If China were to shut down money-losing enterprises, millions of workers would be laid off with no benefits; their addition to the 100 million-plus workers already adrift in China could be volatile. In addition, banks that lent the state companies cash would require cash infusions if bankruptcies increased in the state sector. Such loans could render a central bank monetary policy ineffective and could fuel inflation.

Although China has dismantled much of its centrally planned economy and has permitted free enterprise to replace it, political freedoms have not increased. Recall the Chinese government's use of military force to end a pro-democracy demonstration in Beijing's Tiananmen Square in 1989, which led to loss of life and demonstrated the Communist Party's determination to maintain its political power. China's evolution toward capitalism has thus consisted of expanded use of market forces under a communist political system. Today, China describes itself as a socialist market economy.

Concerning international trade, China has followed a pattern consistent with the principle of comparative advantage. On the export side, China has supplied a growing share of the world's demand for relatively inexpensive sporting goods, toys, footwear, garments, and textiles. These goods embody labor-intensive production methods and

248 Trade Policies for the Developing Nations

reflect China's abundance of labor. On the import side, China is a growing market for machinery, transportation equipment, and other capital goods that require higher levels of technologiesthan China can produce domestically. Most of China's economic expansion since 1978 has been driven by rapid growth in exports and investment spending. Table 7.10 illustrates China's direction of trade in 2002.

How will future trading patterns evolve for China? Among major developing nations, China is the most poorly endowed with land except for Singapore. Therefore, China's specialization in labor-intensive manufacturing relative to agriculture is expected to be the greatest. This will result in China's importing food and moving into manufacturing exports to feed and generate employment for an expanding population. Its high savings rate allows the buildup of capital necessary to make the transition. At the same time, China will likely lose market shares in primary products.

What manufactured goods China exports will also depend on the quality of the labor force. With more people educated up to the secondaryschool level than to the tertiary level, and with low capital per worker, China is more likely to emphasize low-skilled manufactures and light industry. With its weaker higher-education base,

Direction of China'sTrade in 2002

Source: International Monetary Fund, Direction of Trade Statistics Yearbook, Washington, DC December 2003.

China is unlikely to emerge as a major source of knowledge-based and complementary skilledlabor products.

China is a nation currently in transition from an agricultural economy to an industrial one. It surely will transition one day to a largely services economy and "outgrow" manufacturing, as did the United States in gaining its wealth, education, and human capital. But right now, China is following the footsteps of early twentieth-century America; that is, developing its industrial base.

China Enters the World

Trade Organization

After 15 years of negotiations, China formally entered the WTO in December 2001. China made its accession to the WTO a priority for several reasons. First, it would represent international recognition of China's growing economic power. Also, it would give China access to the disputeresolution process in the WTO, reducing the threat of unilaterally imposed restrictions on Chinese exports. Furthermore, it would make it easier for reformers in China to push for liberalization policies if they could argue that such steps are necessary to fulfill China's international obligations. Finally, Chinese leaders realized that WTO membership would induce the United States to grant China permanent normal trade relations, thus ending the annual trade status renewal process and subsequent congressional debate over U.S.-China relations.

U.S. trade officials insisted that China's entry into the WTO had to be based on meaningful terms that would require China to significantly reduce trade and investment barriers within a relatively short period of time. Many U.S. trade analysts viewed China's WTO accession process as an opportunity for gaining substantially greater access to China's market and to help reduce the large and increasing U.S.-China trade imbalance. Other analysts contended that it would advance the cause of human rights in China by enhancing the rule of law there for business activities, diminishing the central government's control over the economy and promoting the expansion of the private sector in China.