debt crisis, trade liberalization, structural adjustment, and growth: some policy considerations

DEBT CRISIS, TRADE LIBERALIZATION, STRUCTURAL ADJUSTMENT, AND GROWTH:

SOME POLICY CONSIDERATIONS SEBASTIAN EDWARDS*

This paper analyzes some dynamic aspects of trade liberalization reforms within the context of the debt crisis. In particular, the paper discusses issues concerning intensity of liberalization, speed of trade reform, and the interaction between liberalization and stabilization. It deals with analytical issues and draws from the empirical experiences of some highly indebted Latin American countries.

1. INTRODUCTION

The adjustment packages that the indebted countries have implemented since mid-1982 have averted what some considered an almost certain col- lapse of the world financial system. This has been achieved, however, at significant cost for the major debtors in terms of declines in employment, income, and standard of living. The key question now is how to move from the current situation toward what one could call phase 2 of the adjustment process-a phase characterized by adjustment with growth.

A number of authors, including supporters of the Baker Plan and the International Monetary Fund, have argued that a rapid trade liberalization coupled with devaluation, privatization, and financial reform is the most reasonable strategy to achieve these objectives. For example, Balassa et al. (1986, p. 88) have recommended that, among other things, the developing nations eliminate all quantitative restrictions (QRs) and, within five years, reduce import tariffs to a uniform 15 to 20 percent level. These tariff reforms should be coupled with significant devaluations so as not to “deprotect” the tradable good sectors. To some extent, these recommendations are similar to those that many economists have long advocated for the developing countries. However, these new proposals are more drastic in that they argue for a bolder movement toward free trade. The current proposals on significant trade liberalizations have not entered into a detailed discussion of the important issues related to strategy, such as the appropriate speed and sequencing of reform. Also, little consideration has been given to the possible

*Professor of Economics, University of California, Los Angeles. This is a revised version of a paper presented at the Western Economic Association International 63rd Annual Conference, Los Angeles, July 3, 1988, in a session organized by Robert L. Hetzel, Federal Reserve Bank, Richmond, Va. It is based on a longer paper prepared for the World Bank CECPT Division. The paper has benefited from comments by Vinod Thomas, Miguel Savastano, and two anonymous referees. However, the opinions expressed here are those of the author.

30 Contemporary Policy Issues Vol. VII, July 1989

EDWARDS: DEBT CRISIS 31

short-run trade-offs between these liberalization reforms, aimed at improving efficiency, and the overall programs’ other objectives, including disinflation.

Most of the traditional trade liberalization literature has assumed that these reforms occur in the absence of a foreign debt overhang problem. Moreover, many writers have assumed that during the trade reform process, countries can attract substantial voluntary lending. McKinnon (1973, 1982), for example, has warned forcefully of the dangers related to excessive capital inflows during a trade liberalization episode. At present, however, in the vast majority of less-developed countries (LDCs), very little danger exists that trade liberalization will attract excessive-or indeed, any-voluntary capital inflows. The problem today is quite the opposite: Countries must generate a positive resource transfer to the rest of the world.

The purpose of this paper is to discuss some specific issues related to trade reforms and structural adjustment. First I discuss the relation among outward orientation, trade liberalization, and export promotion. Then I ana- lyze issues related to the order and speed of reforms. In so doing, I focus on the relation between stabilization policies and trade reforms and on the unemployment effects of liberalization.

II. OUTWARD ORIENTATION, EXPORT PROMOTION, AND

By now, an impressive amount of empirical evidence suggests that countries adopting outward-oriented development policies have outperformed countries following inward-oriented strategies based on import substitution. Even CEPAL (Economics Commission for Latin America)-not exactly known for endorsing outward policies-recently has recognized that the excesses of import substitution have been too costly for Latin America. Some CEPAL senior staff members have recommended that export promotion should play a more central role in that region’s future development policies (Bianchi et al., 1987).

Relatively less agreement seems to exist, however, on whether trade liberalization packages have played an important role in the performance of outward-oriented economies. For example, in a recent paper, Sachs (1987) questions the idea that trade liberalizations are indeed required for successful outward-oriented strategies. Sachs refers to the experiences of East Asian countries-Japan, Korea, Singapore, Taiwan, and Hong Kong-in arguing that these countries’ success was due largely to an active role of government in promoting exports in an environment where imports had not yet been fully liberalized and where macroeconomic-and especially fiscal-equilibrium was fostered. Whether one agrees with Sachs depends on how one defines outward orientation, export promotion, and trade liberalization, and on whether outward-oriented policies are possible without implementing a trade liberalization program. In fact, Sachs seemingly argues against adopting a

TRADE LIBERALIZATION

32 CONTEMPORARY POLICY ISSUES

laissez-faire regime rather than against trade liberalization measures as the traditional literature defines them.

The more traditional policy literature of the 1960s and 1970s defined trade liberalization very generally: Economists usually meant some relaxation of trade and exchange controls. In fact, in the classic National Bureau of Eco- nomic Research (NBER) study on trade regimes, directed by Bhagwati and Krueger, they defined a liberalization episode as a more extensive use of the price mechanism that would reduce the anti-export bias of the trade regime. In her 1986 review article on the problems of liberalization, Krueger insisted that even a (real) devaluation in the presence of QRs constituted a liberalization episode. These indeed are rather mild definitions of liberalization. In fact, few people today will even raise an eyebrow about them. More recently, however, trade liberalization has acquired a more drastic connotation. For many people, it means eliminating QRs and severely reducing import tariffs to a uniform level of around 10 percent. Moreover, trade liberalization has, in many ways, become synonymous with free market-oriented policies in- volving minimal or no government intervention at any level.

The difference between the old and the new definitions of trade liberalization is largely one of degree or intensity. A devaluation in the presence of QRs, or replacing QRs with (quasi-)equivalent tariffs, is a mild form of liberalization. But reducing tariffs-with no QRs-to a uniform 10 percent or, for that matter, completely eliminating tariffs is a rather drastic liberalization. To understand clearly the different issues involved in policy discussions, one must specify the intensity of liberalization to which one is referring. Unfortunately, this is not always done, and so the policy literature on the subject is plagued with imprecisions and ambiguities.

Little doubt exists that successful outward orientation and export promotion policies-the kind that Sachs favors-require some kind of trade liberalization. In fact, the historical evidence shows clearly that countries embarking successfully on that kind of strategy have had more liberal trade regimes than have countries following indiscriminatory import substitution. The successful outward-oriented countries generally have had lower cover- age of prior license systems, lower average tariffs, less dispersion in tariffs, and fewer episodes of real exchange rate overvaluation.

In the recent World Bank multicountry study directed by Michael Michaely, a clear relation was found between movements toward more liberal trade systems-though most countries still retained numerous controls-and a higher performance. In that regard, the case of Korea-possibly the most successful export-oriented country-is rather educating. In 1985, for example, 90 percent of Korean imports were subject to automatic approval-i.e., were subject to no form of QRs-and the average tariff rate was only 26 percent. Moreover, the tariff structure was characterized by higher tariffs concentrated on final goods, while capital equipment and intermediate inputs had relatively low degrees of protection. This extent of


import protection was significantly below that of most developing nations and also below that of Korea in 1965, before that country embraced the outward-oriented policy.

The Korean experience of export promotion coupled with trade liberalization contrasts sharply with the Chilean case. Between 1975 and 1979, Chile implemented a drastic trade liberalization eliminating all QRs and reducing tariffs to a uniform 10 percent in four years. In addition, as part of a massive move toward free market orientation, this period’s policies nearly eliminated the government’s role in defining external sector strategies. Be- cause the real exchange rate slipped by approximately 30 percent between 1979 and 1982, the Chilean experience of that period became one of ultra trade liberalization without export promotion-and with real exchange rate depreciation (Edwards and Cox Edwards, 1987).

Within the Latin American context, the case of Colombia following 1967 provides another educating example of successful export promotion cum some trade liberalization. Until 1967, the Colombia external sector had been highly distorted and subject to deep and recurrent crises: Coffee exports provided most foreign exchange, and so the Colombian economy was subject to the vagaries of the world coffee market. In 1967, Colombia took three major measures. First, it abandoned any attempt to fix the nominal exchange rate and adopted a crawling peg system aimed at avoiding real exchange rate overvaluation. Second, it enacted an aggressive export promotion program: A subsidies scheme-the so-called CATS-and the government export promotion office, Proexpo, played important roles. Third, imports were liberalized greatly: In 1983, the average tariff in Colombia was only 29 percent, while the proportion of imports subject to QRs had declined greatly since 1967. Because of these policies, the Colombian non-coffee exports sector has performed efficiently and has helped Colombia sustain a vigorous growth rate during the past 20 years. Today, in fact, Colombia is the only Latin American country to have escaped the traumatic experience of the debt crisis while maintaining a reasonable growth rate (Thomas, 1986).

Although the evidence supporting the merits of outward orientation is abundant, no well-developed theoretical model-or empirical evidence-exists linking very low (or zero) import tariffs to higher growth. Nor does any evidence suggest that a complete “hands off’ policy by the government is the most desirable alternative. (See Edwards, 1989b, for a survey on the theory of growth and trade policies.) In fact, the East Asian countries’ success with export-led growth suggests that some selectively determined degree of intervention-specially aimed at supporting exports-played a key role. The difficult and critical question is determining the optimal degree of government intervention or the optimal level and structure of import tariffs. Indeed, this is one of the most difficult questions of economic policy. Even at the pure abstract and theoretical level, its answer depends on, among other things, whether other distortions exist, whether markets are complete, and


whether other policy tools are available. An important line of research relates to establishing an adequate framework for analyzing these issues. (On this, see Helpman, 1988.)

111. TRADE LIBERALIZATION, STABILIZATION, AND FISCAL REVENUES

An important policy question is whether a country should attempt the trade liberalization component of an outward-oriented strategy at the same time that such country is embarked on a severe stabilization and anti- inflationary program. Not surprisingly, the answer depends partly on the intensity of both the trade reform and the ongoing inflation.

Historically, a close link has existed between mild trade liberalizations and stabilization programs. Consider the following typical scenario leading to a stabilization program coupled with a mild-to-medium trade liberalization effort. At some point, a particular country’s authorities decide to pursue a fiscal policy inconsistent with the chosen nominal exchange rate regime- usually a pegged rate. Given the underdeveloped nature of the domestic capital market, the fiscal expansion is financed basically with domestic credit creation. As a result, a loss of international reserves will occur. Domestic inflation will exceed world inflation, and the real exchange rate will become increasingly overvalued. To stop the drainage of reserves, authorities usually will impose exchange controls and increase the degree of restrictiveness of existing trade impediments: They will hike tariffs and impose QRs. Naturally, so long as authorities fail to tackle the ultimate causes of the macroeconomic disequilibrium-the inconsistent credit and fiscal policies-all they will gain by imposing new trade restrictions is to delay the need for corrective macroeconomic measures. The real exchange rate will become more overvalued, international reserves will continue to decline, and a black market for foreign exchange will emerge. At some point, this disequilibrium situation will become unsustainable, and a stabilization program-usually under the aegis of the IMF-will be enacted. This program usually will consist of a significant nominal devaluation geared at correcting the overvaluation developed during the previous period, a contractionary macroeconomic policy, and a liberalization of trade restrictions aimed at dismantling controls imposed during the expansionary phase of the process. These types of liberalizations historically have been mild and seldom have consisted of completely eliminating QRs and greatly reducing tariffs to the extent now recommended for the indebted countries (Edwards, 1989~).

Perhaps Chile during 1975-1981 constitutes the most notable case of a major liberalization undertaken in conjunction with a major stabilization effort. Chile pursued a trade liberalization that eventually eliminated all QRs and reduced tariffs to a uniform 10 percent level at the same time that inflation was being reduced from 400 to 10 percent. The Chilean episode illus- trates quite vividly a critical trade-off that emerges whenever a country


undertakes a major liberalization at the same time it undertakes a major anti-inflation program. During the last phase of the Chilean stabilization effort, when inflation was reduced from 40 to 9 percent per annum, a significant real exchange rate appreciation occurred that reduced the degree of competitiveness of the tradables sector at a time when-due to the trade reform among other factors-the equilibrium real exchange rate had depre- ciated significantly. In the Chilean case, this real appreciation was due partly to the active use of exchange rate management to bring down inflation. In mid-1979, the nominal exchange rate was fixed relative to the dollar at a time when the dollar itself was appreciating relative to other currencies. This real appreciation played an important role in the disappointing outcome of the Chilean episode. It seriously deprotected the tradables sector and generated perverse expectations of devaluation. Ultimately, it conspired with the high real interest rates to provoke the worst financial debacle in Chilean history (Edwards and Cox Edwards, 1987; Corbo and de Melo, 1987).

A crucial objective of any stabilization program-including those that the major debtors undertake-is reducing the magnitude of the fiscal deficit. Many times, an important trade-off exists between a trade liberalization that reduces import tariffs and the achievement of this fiscal objective. Surpris- ingly, the policy and theoretical literature on trade liberalization policies usually have tended to ignore tariffs’ fiscal role in the developing nations. Most theoretical and policy discussions on trade liberalization assume, along the lines of traditional trade theory, that tariff proceeds are handed back to the public. In reality, however, this is not the case. Governments use tariff proceeds to finance their expenditures. This is particularly true in many poorer developing countries where, for various institutional reasons, taxes on international trade represent a high percentage of government revenue (Edwards, 19 8 9a).

So long as tariff rates are below the maximum revenue tariff, a trade-off will exist between trade liberalization and generation of the government surplus required to finance debt servicing. Reducing tariffs generally will reduce distortions but also will adversely affect government finances. Thus, what is needed is to replace trade restrictions with less distortive taxes that can generate the same-or a higher-amount of revenue. Of course, this would require major reforms of the tax systems in most countries. So long as this tax reform effort also focuses on efficiency aspects, it will tend to concentrate on imposing a value-added tax (VAT), among other taxes. This is not easy and takes time, as numerous efforts to implement sweeping tax reforms have shown recently. Tax reforms not only are politically difficult to get approved, but often are quite difficult to get going from an adminis- trative perspective. This is particularly true in poorer countries where the pre-existing tax systems often are rather rudimentary. Indeed, the recent In- donesian tax reform has shown clearly the difficulties involved in these types of efforts. (See Conrad and Gillis, 1984.) However, in middle-income coun-


tries where an operating tax system of some sophistication exists, a major tax reform can be implemented with reasonable speed. The Chilean tax reform of 1975 is, in that sense, a good example: In just over a year, a major tax overhaul introducing a VAT, full indexation, and unification of both corporate and non-corporate tax rates was implemented successfully (Corbo and de Melo, 1987).

Although in most cases implementing a major tax reform will take a substantial amount of time, some policies are conducive toward both im- proved efficiency and higher revenues in the short run. The most obvious is replacing QRs-licenses, prohibitions, etc.-with import tariffs. A well- known feature of QRs is that unless they are auctioned, the government misses the revenue associated with the trade restriction. By replacing the QRs with tariffs, the government can recapture this revenue.

Replacing QRs with tariffs has two other potentially desirable effects. First, a potential exists for a positive effect on income distribution. This is because in most cases large firms or large established merchants get the import licenses and thus the rents. By replacing the QRs with tariffs, the government gets these rents and can use them to reduce other taxes or even increase expenditures on social programs. Second, replacing tariffs with QRs generally will increase the effectiveness of devaluations. This is because the effects of devaluations are significantly different under quantity rationing- e.g., import quotas or licenses-than they are under import tariffs. In the latter case, a (real) devaluation will result in a higher price of both importables and exportables relative to non-tradables. Under QRs, the domestic price of exportables still will increase, but that of importables usually will not be affected. The devaluation merely will reduce the rents received by the party that got the license.

In many countries-particularly in the poorer ones with rudimentary tax systems-taxes on trade are an important source of government revenue. This introduces an important trade-off between trade liberalization reforms and the achievement of fiscal balance. In terms of the sequencing of reform, then, an important principle is making sure that tariff reduction reforms are not undertaken until the fiscal sector has been reformed and other revenue sources have been found. Replacing QRs with tariffs or devising a QR auc- tioning system are measures that can be implemented without producing fiscal costs while still improving efficiency. Also, solving the fiscal imbal- ance first reduces the possibility of real exchange rate overvaluation.

IV. TARIFF REFORM, UNEMPLOYMENT, AND THE SPEED

The Baker Plan, as well as the World Bank- and IMF-sponsored adjustment programs, contemplates major trade reforms in the highly indebted countries. Agreement exists that trade reforms are desirable in the medium

OF TRADE LIBERALIZATION


run, but little discussion has occurred on the short-run consequences of these types of policies. The effects of trade reform on employment are important to consider when evaluating the short-run effects of these policies. This is particularly true under the current conditions, whereas countries already are experiencing rather high unemployment levels. Moreover, from a political economy perspective, the unemployment effects of any policy are crucial. Democratic governments-and even those not so democratic, but in a weak- ened position-will try not to generate massive unemployment. The costs of unemployment are recognized in the short run whereas the benefits of the structural policies that provoked unemployment usually are reaped in the medium run-when a different government is in office.

According to the most simple textbook approach, in a small developing economy with capital-intensive imports, fully mobile factors of production, and flexible prices, reducing import tariffs will have no effect on total employment even in the short run. In this simple setup, the only labor market effects of trade liberalization will be a reallocation of labor out of importables and an increase in the real wage rate. In reality, however, several reasons exist as to why these textbook conditions don’t hold and why tariff reforms can result in an employment decline in the short run.

The factor-specific Ricard-Viner model with downward real wage in- flexibility, provides the most simple model for illustrating the possible short- run unemployment effects of a tariff reform. (Regarding the Ricard+Viner model, see Dixit and Norman, 1981.) In this model, capital is fixed to its sector of origin in the short run. Only slowly through time, and possibly through investment, can capital be reallocated. Contrary to the more traditional textbook case of full flexibility of both prices and resource movements, a tariff reduction in this more realistic model can reduce the equilibrium real wage rate required to maintain full employment. But if a downward inflex- ibility of real wages exists due to government-imposed minimum wages, indexation, staggered contracts, etc., then the required reduction in the wage rate will not occur and unemployment will result. This unemployment, however, will be only of a short-run nature. As capital moves out of the importables sector and into the exportables and non-tradable sectors, forces will be working for the equilibrium real wage to increase so that those workers previously laid off will be rehired. For real wages to increase and for unemployment to disappear in the longer run, capital must indeed be reallocated. However, if the reform lacks credibility, as has been the case so often with liberalization episodes, capital will not be reallocated and unemployment will persist.

These models suggest that contrary to the most simplistic textbook view, a tariff reduction reform may well result in unemployment so long as re- allocating capital from one sector to the other takes time and (real) wages are inflexible. A first-best solution to this problem is to (fully) eliminate the sources of real wage rigidity. With complete flexibility, wages will go


down in the short run until all the labor force is absorbed. However, if real wages cannot fall sufficiently due to political or other reasons, a second-best solution is to proceed slowly with the trade reform. Tariffs should be reduced gradually in a pre-announced fashion. In theory, capital owners then will have time to reallocate capital and thus avoid the unemployment effects of the trade reform. Once again, for this solution to work, capital allocation should respond to the announcement of reform-i.e., the reform should be credible.

The NBER multicountry study on trade regimes and employment, directed by Anne Krueger (1983), has provided ample evidence suggesting that countries following outward-oriented policies generally have had a better employment record-in terms of both employment creat ion and lower unemployment rates over the long run-than have nations adopting import substitution industrialization strategies. That study, however, refers to the long-run characteristics and performance of the labor markets and doesn’t say much about the aggregate employment effects during the transition im- mediately following a tariff reform.

The limited existing evidence on the short-run aggregate employment consequences of trade liberalization indicates that in the case of mild reforms, no significant aggregate unemployment effects have occurred. This seemingly would be one preliminary conclusion of the exhaustive cross-country study undertaken by the World Bank and directed by Michaely et al. (1986). It is, however, somewhat difficult to interpret the evidence from that massive investigation. The episodes analyzed often refer to exceedingly mild liberalizations. For example, the 1970 Turkish devaluation, included in the study, would barely qualify as even a timid liberalization. Also, from such studies, one cannot know precisely whether specific changes in aggregate employment respond to the trade reform or result from other policies. This is the case regarding the slight increases in aggregate unemployment observed after several trade reforms including the Turkish liberalization of 1980, the Korean reform of 1979-1980, the Philippines liberalization of 1981, and the Israeli reform of 1972-1977.

Once again, the Chilean experience and its orthodox policies are educa- tional. As already mentioned, Chile underwent one of the most ambitious trade liberalizations of modem times between 1974 and 1979. Quantitative restrictions were fully eliminated, a multiple exchange rate system consisting of up to 15 different exchange rates was unified, and tariffs were slashed to a uniform 10 percent. During this same period, Chile had very high unemployment, reaching more than 20 percent in 1975 and never falling below 15 percent. A subject debated extensively in Chile’s popular media, as well as in the specialized media, is the extent to which the tariff reduction process “contributed” to the unemployment problem. Little doubt exists that as a result of the tariff reform, several contracting or even disappearing manufacturing firms laid off large numbers of workers. On the other hand, ex-


panding firms from the exporting sectors increased employment, and this partially offset the negative effect. The net result, however, was an increase in unemployment generated by the trade reform. This negative effect was particularly marked in manufacturing, wherein firms trimmed their payrolls and increased productivity so as to work their way out of the difficult situation that increased foreign competition created.

The tariff liberalization generated short-run unemployment in Chile in two main ways. First, a natural adjustment period occurred during which laid-off workers took time to start searching for work in a different expanding sector. Second, because in reality-contrary to the most simple textbook case- physical capital is fixed in its sector of origin, the expansion of production in some exporting sectors was somewhat sluggish at first. Only as additional investment occurred through time was it possible to fully increase production and employment in these expanding sectors. However, the existence of wage rigidity-and particularly of a minimum wage in real terms-made it much more difficult for the expanding industries to absorb labor. Edwards and Cox Edwards (1987) argue that a slower reform would have resulted in a reduced unemployment effect. However, the proportion of total unemployment that one can attribute to the tariff reform is relatively small when compared with the magnitude of the overall unemployment problem. Edwards and Cox Edwards (1987), for example, calculated that an upper bound for the unemployment effects of the trade reform was 3.5 percentage points of the labor force (129,000 people). The bulk of this unemployment was in the food, beverage, tobacco, textile, and leather products subsectors (57,000 people).

The above discussion has concentrated on the possible beneficial effects of a gradual trade reform on employment. However, still other channels exist-mainly via an intertemporal effect on expenditure-through which a gradual tariff reform can have positive effects on the economy. For example, a slow reduction of tariffs generally will have a positive impact on both the savings rate and the current account. To the extent that the gradual trade liberalization process is a credible proposition, it will have a non-trivial effect on reducing the consumption rate of interest. As the public expects tariffs- and thus the domestic price of importables-to be lower in the future, it will postpone current consumption. Consequently, savings will increase and the current account will improve.

In sum, gradually lowering tariffs offers several attractive features for economies such as the debt-ridden countries. First, this strategy will likely reduce the short-run unemployment consequences of the trade reform. Sec- ond, positive effects on savings likely will occur, and this will help growth prospects. Third, this strategy will tend to improve the current account. Fi- nally, a gradual reduction of tariffs will have positive effects on the government budget. On the negative side, a gradual trade reform may lack credibility and, if so, may induce perverse responses.


V. CONCLUSIONS

Trade liberalization is a key component of the type of structural adjustment packages that the Baker Plan, the IMF, and the World Bank support. However, most discussions on this issue have ignored important aspects including the desired intensity of trade reform, the speed of liberalization, and its relation with macroeconomic stabilization programs.

This paper has tackled these issues from the perspective of the developing countries. The paper has argued that some trade liberalization is needed so as to sustain a successful outward-oriented trade strategy based on export promotion. On the other hand, it has pointed out that no evidence exists to support a policy of complete laissez-faire. Regarding the relation between disinflation programs and trade reforms, the paper has argued that substantial steps toward liberalizing an economy should be taken only after the macroeconomic equilibrium has been re-established. It has pointed out, however, that some liberalization steps-such as replacing QRs with tariffs.-an be implemented at the same time that the disinflation program is under way. Finally, the paper has argued that because of unemployment and credibility considerations, a gradual trade reform generally is preferable to an abrupt one.

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debt crisis, trade liberalization, structural adjustment, and growth: some policy considerations

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