Trade Policy

There is a preponderance of cross-country evidence that trade liberalization and openness to trade increase the growth rate of income and output. In addition, numerous individual country studies over the past three decades suggest that "trade does seem to create, even sustain higher growth" (Bhagwati and Srinivasan 1999). A country’s trade policy is the key link in the transmission of price signals from the world market to the national economy. Undistorted price signals from world markets, in combination with the exchange rate, allow resource allocation consistent with comparative advantage, thereby increasing productivity. An open trade and investment regime encourages integration into the global trading environment and the import of diverse and modern technologies that are important for productivity improvements.

Trade, growth, and the poor. Growth in incomes of the poor is strongly related to overall growth in the economy—although the relationship differs substantially from country to country. The link of overall growth to poverty reduction has been demonstrated both in cross-country analyses (Dollar and Kraay 2000), and for individual countries. Trade liberalization can therefore be expected to help the poor overall, given the positive association between openness and growth. However, in the short run, liberalization may have a negative impact on some of the poor, depending on their sources of income and the impact of liberalization on the prices of goods and services the poor consume. There is therefore a need to examine the impact of trade liberalization in some detail to help to design policies that would protect those among the poor who may be adversely effected, especially in the short run.

Characteristics of the poor. Knowledge of how the poor obtain and how the poor spend their income is important in designing pro-poor policies (see Annex K). Food is by far the most important item of expenditure. In Bangladesh, for example, food represents about 73 percent of the total expenditures of the poor, with fuels, housing, and clothing combined accounting for just 21 percent. The sale of unskilled labor tends to be the most important source of income for the poor, complemented by the value of “own consumption”—that is, the imputed value of what the poor consume from their own production.

In general, the impact on the sources of income of the poor will be a more important determinant of the effect of liberalization than the effect on the prices of the things that they consume. The reason is that trade reform will affect many relative prices, some of which will move in offsetting directions. As the poor generally have limited assets, the most important of which is low-skilled labor, the impact on wages and employment therefore dominates.

Complementary policies and institutions. While a liberal trade policy is necessary for growth and poverty reduction, it is not sufficient in itself to promote trade growth. When trade reform has been implemented in an unstable macroeconomic environment or has been implemented without any effort being made to strengthen trade-related domestic institutions or without appropriate complementary policies, it has often either been reversed or has failed to stimulate growth. This chapter will discuss important "behind-the-border" reforms that should accompany trade liberalization to effectively allow a country to integrate into world markets. Such reforms should include development of a regime that encourages investment and competition, including openness to foreign direct investment (FDI), so that business services are supplied at competitive prices, and should include macroeconomic policies that encourage stable prices and a competitive real exchange rate. Although the poor are very diverse, they frequently work in the rural sector and in the urban informal sector. Thus, policies that affect agricultural and labor markets are important complements to trade reform for the poor.

Political economy of protection and the poor. Even when trade reform would benefit the poor and the economy broadly, it will often be resisted. The sectors that receive the greatest protection under the existing system will be aware of the benefits they gain from that protection, and will oppose reform. The expansion of exports that reform would support is likely to be economy-wide, often with new and sometimes unexpected industries emerging; the employment and income gains from reform are thus likely to be diffuse, and the same is true for the consumers who would gain from the reform through lower prices and greater choice. It is this diffuse nature of the gains to consumers and producers that explains why those who oppose liberalization—the beneficiaries under a protected trade system—often are dominant in political lobbying. The redistributive effects of trade reform can be a major factor impeding the launch of welfare-improving policy changes (Rodrik 1998).

Barriers to trade are typically put in place to protect domestic producers from international competition, and usually benefit powerful interest groups, not the poor. Nontariff barriers are especially pernicious in this regard as they effectively result in transfers from consumers, including the poor, to license holders. These so-called rents arise because the restriction on imports results in domestic prices that are above the world price. In the case of a tariff barrier, the government collects the revenue that is implied by the difference between the world price and the tariff-inclusive domestic price, but in the case of a nontariff barrier this implicit revenue is captured by those who hold the license to import. There is evidence that in developing countries such rents are a major cause of inefficiency, as companies and individuals seek to obtain import licenses and to influence policy in general (Krueger 1974). Import license holders are often among the wealthiest members of society. Thus, in addition to the inefficiency costs of trade protection, protection will often transfer income toward the rich and away from the poor. The negative effect of trade reform on the incomes of those who benefit from the existing trade structure, and the positive effect on the incomes of those who suffer under existing arrangements, can in percentage terms, be much larger than the (average) economy-wide income effects of liberalization. This is because trade policy is inherently a redistributive policy.

Structure of this chapter. Section 13.2 of this chapter describes briefly the experience with successful trade policy reform and discusses adjustment costs and the implications for the poor. Section 13.3 discusses and evaluates the principal trade policy instruments and institutions. Section 13.4 closely examines agriculture and business services, which are likely to be of particular importance for a poverty reduction strategy. Section 13.5 discusses and evaluates the most important complementary policies, as well as general and trade policy-specific safety nets. Section 13.6 briefly summarizes the principal points in a successful strategy for using trade for poverty reduction. A framework for analysis of the short-term and long-term impact on the poor of trade reform is provided in technical note K.1.

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