Like every Friday, from Raj Nallari and Breda Griffith's teaching notes.

Open trade is good for overall economic growth and by extension poverty reduction, but what effect does it have on inequality? Trade liberalization tends to reduce monopoly rents and the value of personal connections with bureaucrats and politicians, thereby reining in the rich. In developing countries, it may be expected to increase the relative wage of low-skilled workers, who are likely to be scarcer in the world economy than at home. Multilateral liberalization of agricultural trade may increase rural incomes but expose urban dwellers to higher food prices. And, in many countries, trade openness may have adjustment costs with which the poor are ill-equipped to cope. At first glance, therefore, the relationship between trade and inequality is unclear.

Trade reform in developing countries took off from the late 1970s. Until then, developing countries had pursued inward-looking policies by promoting import-substituting industrialization strategies. The aim was to encourage domestic production and restrict foreign investment by multinational firms in order to support the growth of domestic firms. But not only do inward-looking policies create many distortions, as discussed above, they also tend to benefit relatively rich and powerful groups at the expense of the poor (Dollar 2004).

Since the late 1970s, developing countries have become more integrated with the world economy through foreign trade, foreign investment, and immigration. Integration has been driven by technological advances in transport and communication and by deliberate policy changes. China’s ratio of trade to national income has more than doubled since it opened to the world in the early 1980s, and countries such as Bangladesh, India, Mexico, and Thailand have seen large increases as well.

While the popular press is almost uniform in its view that trade reform is bad for the poor, the economics literature paints a completely different picture. While the relationship between trade and inequality remains unclear, the relationship between trade and growth is strong and positive, meaning that trade is most definitely pro-poor. According to Dollar and Kraay (2001a), increased trade generally accompanies more rapid growth while showing no systematic change in household income distribution thus increased trade generally goes hand-in-hand with improvements in well-being of the poor.  This finding is also borne out by Berg and Krueger (2002), who point out that, while the vast literature on the effects of trade liberalization on income distribution reveals no systematic relationship between openness and the income of the poorest, the positive effect of openness on overall growth and, in turn, on poverty, is firmly supported by the evidence.

In support of this argument, Dollar (2004) identifies trends in trade liberalization starting from 1980 that support a positive relationship between trade reform and poverty reduction. These are:

• Poor country growth rates have accelerated (developing countries on average grew 3.5 percent per capita in the 1990s) and are higher than rich country growth rates for the first time in modern history.
• The number of poor people in the world has declined significantly (by 375 million since 1981), and the share of the developing world population living on $1 a day or less has declined by 50 percent since 1981.
• Global inequality has declined modestly, reversing a 200-year old trend toward higher inequality.
• There is no general trend toward higher inequality within countries. The share of the  bottom quintile does not vary with per capita national income, a relationship that has not changed over time. Some countries had increases in inequality—China and the United States, for example—while others had decreases.
• Wage inequality is rising worldwide (but wages are a small part of household income in developing countries).
• Trends toward faster growth and poverty reduction are strongest in developing countries that have embraced trade liberalization.

In contrast to this generally positive picture, there are reasons to expect that trade reform may not benefit the very poorest members of developing countries. The following paragraphs, based on Bannister and Thugge (2001) outlines possible impacts  of trade liberalization on the welfare of the poor.

Trade liberalization normally increases real income by reducing the prices of imports and substitutes for imported goods. In general this is seen to have a positive impact on the poor. Imported products such as basic foods, pharmaceuticals, other medical and used clothing are important for the poor. Moreover, the poor may benefit from the removal of export taxes to the extent that they are net producers of exports, which is often the case in agriculture, for example. An open trade regime improves access to new products and the importation of new technologies and processes that may have positive effects for the poor.

The effect of trade liberalization on wages and employment depends on the level of labor regulation in the country. In a highly regulated labor market, the adjustment to changes in the prices of outputs will translate into changes in real wages. If firms are constrained from reducing their workforces, then wages will decline. Where minimum wages prevail and labor mobility is high, the adjustment will take place through changes in employment. Generally, the poor live in the rural and informal urban sectors that are characterized by flexible labor markets—thus adjustment to trade shocks will take place through employment, and we would expect the poor to suffer disproportionately. Furthermore, if the impact of trade liberalization is to remove protective barriers from sectors in which the poor predominate, we would expect a lowering of relative wages for the poor. Examples from Latin America (Ravallion and Chen, 2004) suggest that trade liberalization has increased wage disparities, benefiting higher income groups more than the poor.

The expectation that trade reform, by lowering trade taxes, leads to lower government revenues in the short run is unsubstantiated. It is likely, in fact, that reform as actually practiced will raise government revenue by replacing nontariff barriers with tariffs and eliminating tariff exemptions. Moreover, removing tariffs that are high initially may reduce the incentives for smuggling and corruption and therefore increase the amount of goods recorded at customs. Finally, simplifying the tariff regime and thereby promoting transparency may boost fiscal revenue. In the long run, however, lower tariffs may lead to lower government revenues. Policies designed to increase revenue—tax reform or expenditure restraint—may be needed to minimize the adverse effect of revenue losses on the poor.

By reducing the anti-export bias of trade policy, trade liberalization brings about a more efficient allocation of resources that favors economic growth. Sustaining that growth, however, requires complementary macroeconomic and institutional reforms. For example, if the country’s exchange rate is overvalued, policy makers may choose to implement changes to improve competitiveness and avoid impeding the additional growth that would otherwise be possible as a result of trade liberalization.

Trade liberalization deepens economic integration. While there are many positive externalities to integration—such as less dependency on a single export market or product, and less dependency on the domestic market—adverse external shocks can significantly affect economic growth. Moreover, the shocks may affect the sectors in which the poor are employed—agriculture for example. As noted in the literature, it is important that other macroeconomic reforms should be pursued in line with trade reform so as to maximize and sustain the beneficial effect of trade reform on poverty.

Given the lack of assets and access to resources by the poor, they are more likely to suffer the adjustment costs that arise from trade liberalization. A transitory loss in income has a deeper impact on the poor than on other citizens and can reduce their chances of escaping poverty. Because the poor are disproportionately vulnerable, trade liberalization policies should include a social safety net.

The literature agrees that the adjustment costs of proposed reforms may be high in some countries and may affect the poor disproportionately. In other words, any reform plan will create some losers among the poor, especially in the short run, as well as many winners. For this reason, researchers agree on the importance of a social safety net. In the long run, most researchers agree that changes in investment and technology will lead to higher growth that will benefit the poor in the long run.  Ravallion and Chen (2004a) found that periods of greater trade liberalization in China did not coincide with periods of poverty reduction.  Moreover, tariff reductions in the lead-up to China joining the World Trade Organization (WTO) had minimal effects on poverty and inequality.  Yet Ravallion and Chen (2004a) note that overtime there will be both gainers and losers from trade reform and that long-run productivity gains will have a positive impact on growth and poverty reduction.   In the meantime, policy makers must be in a position to assess the impact of various policies through the use of diagnostic tools that measure the effect of trade-liberalization policies on the more vulnerable members of their society. Facts such as these can direct social protection policy in conjunction with trade reform.

Bannister and Thugge (2001) suggest how trade liberalization policies might be made more egalitarian. They argue for broad-based liberalization, so that the costs of adjustment are spread across a wide range of sectors. It may be necessary to sequence reform at different speeds for different sectors. Furthermore, exchange rate flexibility will facilitate a faster adjustment to trade reform policies and dissipate their shock throughout the economy. As already mentioned, trade reform policies will have a more positive impact if they are accompanied by other reforms. The authors identify three areas in particular—infrastructure development, development of markets, and labor mobility and training.

Rich countries can play a part in helping developing countries achieve and benefit from trade liberalization. The requirements for joining the World Trade Organization (WTO) and for settling disputes within the organization are onerous for poor countries. The advanced economies maintain extensive protection, especially in agriculture and labor-intensive products, that lowers the incentive for developing countries to pursue multilateral trade liberalization and reduces the benefit of unilateral reform.

Agricultural subsidies and protectionist policies distort trade. In the high-income countries, subsidies of various sorts account for nearly one-third of agriculture revenue. Most of these subsidies are provided through mechanisms that artificially boost production and undercut the market for farmers in developing countries. The group known as the West Africa 4 (Benin, Burkina Faso, Chad, and Mali) can produce high-quality cotton at the lowest cost in the world. In spite of their productive efficiency, the West Africa 4 lag far behind the world’s largest producer, the  United States, where cotton is heavily subsidized. This leads to paradoxical results. Because of cotton subsidies, which cost the  United States up to $4 billion each year, Mali alone loses $43 million in cotton earnings, each year, while receiving $37 Million in U.S. aid. As the production of cotton supports 10 million people in West Africa but just 25,000 farmers in the United States, protectionist policies seriously impair poverty reduction strategies by depriving farmers in developing countries of their livelihood. The subsidies depress world cotton prices, cutting the income of poor farmers around the world. EU sugar subsidies have the same effect. Aid from developed to developing countries totals about $75 billion per year, far less than the subsidies provided to developed-country farmers, which amount to about $350 billion per year.

Conclusion

Trade openness has been an unequivocally positive development for the poor in developing countries. Evidence on the relationship between trade development and inequality, on the other hand, is plentiful but inconclusive. Nevertheless, it is clear that trade is good for growth and that growth is good for the poor. In order to work best, policies opening a country to trade should be sequenced properly and accompanied by complementary reforms, so that the growth benefits of opening to trade can be maximized.

Advanced countries have a role to play in helping developing countries reap the benefits of trade. Trade subsidies provided to agricultural producers in advanced countries are distortionary and hurt poorer countries. Their harmful effects far outweigh the amount of aid typically provided by donor countries. As the same time, it is also fair to say that trade distortions within poorer countries themselves are also highly damaging. Further progress is also needed in this area if the full growth potential of international trade is to be realized.

Next week: Institutions and Growth