Six
Export Liberalization

Juergen B. Donges and Ulrich Hiemenz

1
Introduction

There is a voluminous theoretical and empirical literature about the implications of alternative trade regimes for economic development. On balance it points out that export-oriented strategies, along with an efficient use of available resources, including indigenous labor, provide the most appropriate framework of economic incentives conducive to sustained and rapid growth (see, for instance, the surveys by Balassa 1980a; Donges 1983; and Krueger 1984a). Accordingly, an increasing number of developing countries have, in varying degrees, linked their economies to world production on the basis of comparative advantage and by doing so have been transformed into the now "newly industrializing countries" (NICs). South Korea is one of the outstanding cases in point. It committed itself to the notion of international specialization, adhering to it even when the world economic environment sharply deteriorated during the 1970s.

Yet, many governments of developing countries (and some influential academic economists as well) have remained skeptical about the implementation of outward-oriented trade regimes. The standard argument is that, after a long-lasting period of economic development based on policies of import substitution for industrialization, trade liberalization would cause excessively high adjustment costs, while the potential benefits from such a liberalization would only be small (if not negligible) in an unfavorable international economic environment such as the

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present one. The fact that some South American countries that embarked upon liberalization experiments during the 1970s fell into deep economic recessions, often accompanied by social and political upheavals, provides convenient support to such anxieties, despite pervasive evidence to the contrary in Asian countries. There are also instances, again mainly in Latin America, in which governments, faced with pressing foreign-exchange needs to service foreign debt, undid prior shifts to relatively outward-oriented trade regimes and readopted import-substitution strategies.

The purpose of this chapter is to reassess the case for outward-oriented trade regimes in the process of economic development. The nature of outward-orientation is briefly explained in the next section. As developing countries usually start their industrialization through import-substitution strategies, the shift from an inward- to an outward-oriented trade regime raises questions concerning the set of economic policies to be reshaped, the timing of the policy reform, and the feasibility of such changes, all of which are discussed in the third section. The fourth section provides evidence on both successful and unsuccessful liberalization attempts in the seventies and inquires into the causes for success or failure by relating the countries' experiences to the policy framework for export liberalization outlined in the previous section. In the fifth section, the revival of export pessimism is evaluated.

2
Essence of an Outward-Looking Strategy

Discussions of appropriate development strategies should start by recognizing that there are two dimensions of government policy that are analytically distinct, though sometimes mixed together. One is whether the government is intrusive in the process of economic development or is more "laissez-faire," and the other is whether government policies distort relative prices and markets or not. A government can be relatively "laissez-faire" and rely on market signals for the allocation of resources and economic growth (as in Hong Kong) or it can take a strong hand in steering the process of development without distorting markets (as in Singapore, South Korea, and Taiwan). It can distort prices but not try to plan the economy very much (as in Israel) or it can be both intrusive and distorting (as was the case in India and Mexico). Governments that do not want to rely heavily on market forces for development may resort to import substitution, but they could also apply an outward-looking strategy; in either case, the outcome of the chosen strategy will crucially

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depend on whether or not relative prices are in line with relative scarcities (of goods, services, and production factors). Though it is conceivable that an inward-looking government would pursue market-oriented economic policies, in reality such policies are more "normal" in countries integrated into the system of international division of labor, as shown below.

Export promotion and outward-oriented trade regimes have frequently been misinterpreted as policies that deliberately promote exports over other economic activities and beyond the level attainable under free-trade conditions (see, for instance, Streeten 1982). The crucial point to remember, however, is that government incentives for industrialization should be compatible with an optimal allocation of resources, to the largest extent possible (as elaborated in the rejoinders to Streeten by Henderson [1982] and Balassa [1983]). Disregarding externalities, an optimal allocation of resources requires that the domestic rate of transformation equal the international rate of transformation. Taking international prices as given (small country assumption), the ratio of relative domestic prices of importables and exportables over the respective world market prices must be unity (Krueger 1978). Then the system of incentives is neutral with respect to sales in domestic or in world markets. It is in this sense, and only this, that the export-promotion strategy is differentiated from the import-substitution strategy. Export-promotion strategies provide incentives to exports sufficient to compensate for the discrimination against export production inherent in import protection; they provide a uniform incentive to both import substitution and exports, and thus to saving and earning foreign exchange per unit of domestic resources used they do not aim at boosting exports beyond free-trade levels. The emphasis is on specialization based on comparative advantage, not on export expansion, per se.

An outward-oriented trade regime does not provide sectoral preferences either; agriculture, industry, and services can expand in accordance to the natural-resource endowments of the countries concerned. Hence the pattern of production and the composition of exports will vary substantially among developing countries. Small resource-poor countries with an abundant supply of semiskilled labor are likely to specialize in the production and export of labor-intensive manufactures, while resource-rich countries by definition have a comparative advantage as producers and exporters of primary commodities. Even in the case of the latter group of countries, it is important, for at least two reasons, that industrialization not be impeded by policy-induced obstacles.

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First, nonrenewable resources, by definition, are bound to run into depletion, and economic development sooner or later will have to be based on other activities; industrial production that promises high productivity gains and the creation of remunerative new jobs should be the prime candidate. Second, the sooner resource-rich countries diversify their export structures by including manufactures, the better the chances are that export earnings will be stabilized and the vulnerability to international commodity price fluctuations be reduced. A stable foreseeable framework is important if investors are to allocate their funds efficiently.

Judged in terms of the ideal of completely neutral policies, development strategies as actually applied can obviously err on both sides: too restrictive of imports or too promotive of exports. Both would probably raise marginal capital-output ratios and hinder economic growth. When the trade regime is biased toward import substitution based on a variety of trade barriers, ranging from high tariffs and restrictive quotas to outright import bans, too many resources are attracted by the protected industries. Moreover, as the process of import substitution goes on, encompassing the production of intermediate and investment goods, the incremental capital-output ratio will rise. This is likely to adversely affect the rate of economic growth, thereby leading to a vicious circle of generally lower saving and investment paths and weakening productivity and development trends. In the absence of corrective measures, exports will be discriminated against. On the one hand. exporters will have to pay higher prices than they otherwise would for protected locally produced or imported inputs (which they cannot pass on to potential customers on the world market unless they have a monopoly power, which is unlikely for most developing countries). On the other, the exchange rate tends to be overvalued owing to protection, a self-inflicted export obstacle par excellence.

It has been argued that in cases in which the private costs of export production are higher than the social costs, and this positive externality is higher than the corresponding externalities associated with import substitution, a bias of the incentive system in favor of exports could be justified on economic grounds (Mayer 1984). The general problem with this version of the "infant industry" argument is, however, that it may turn out to be very difficult in practice to accurately demonstrate the existence of significant externalities and, if this were possible, to discontinue the extra subsidies to exporting (or the protection of import substitutes) later on when the assisted activities have become mature. For these reasons, policy-induced export expansion runs the risk of fa-

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voring a composition of exports that is not in line with the comparative advantage of the exporting country and may ultimately slow down economic development in very much the same way an import-substitution strategy does.

However, economic reasoning suggests a greater danger of policymakers slipping into excessive import substitution than into excessive export promotion. A successful export-promotion strategy requires a framework of incentives to free producers of exportables from cost disadvantages vis-à-vis foreign producers. As long as import protection is granted on the grounds of nonpecuniary dynamic externalities, exporters have to be compensated by some form of subsidies and/or duty-free import allowances, as discussed below. Since subsidies constitute drains on government budgets, they provide a stimulus to policymakers to refrain from excessive export promotion, to maintain realistic exchange rates as an alternative to public subsidies, and to keep import protection at moderate levels.

By contrast, import-substitution strategies have revealed built-in tendencies toward reinforcing the inward bias of the incentive system (Bhagwati 1978; Donges 1983, 280 82; Krueger 1983, 32 33). Tariffs, if not prohibitive, create government revenues and thus lead to their implementation being abused, often for purposes totally unrelated to the chosen industrialization strategy. Furthermore, import-substituting industries replace fewer imports than are actually required as intermediate inputs or for investment purposes, thus aggravating existing, or giving rise to new, balance-of-payments problems. Growing current account deficits, as well as the exhaustion of narrow domestic markets by the newly established industries, put pressure on governments to implement additional trade restrictions and to intervene in foreign-exchange, capital, and labor markets thereby further penalizing export activities.

3
The Framework of Export Liberalization

3.1
Economic Objectives

The outward-oriented trade regime aims at promoting sustained economic development and a rapid process of industrialization by exposing the domestic economy to international competition. The objectives are to improve the allocative efficiency of the economy as a whole by bringing the structure of production into line with the country's comparative advantage at each instant and to reap irreversible external benefits from the exploitation of economies of scale through exports, the stabilization

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of export earnings through export diversification into manufactured goods, the increase of savings for investment through raising real incomes, and the acceleration of technological innovation and human-capital formation through competition from, and contacts with, other countries. Such gains are forgone in an inward-oriented trade regime since import protection and the whole system of market regulations not only discriminate against exports and distort the structure of production and make it rigid, but also cause losses in efficiency through cartelization, rent-seeking behavior, the formation of a labor aristocracy, and the expansion of bureaucracy.

Export liberalization entails substituting price signals for administrative controls and adjusting domestic relative prices to international relative prices, either by gradual measures or shock treatment. Liberalization does not necessarily mean the implementation of free trade and nonintervention in all other markets; it rather means a reform of economic policies so that the price mechanism can work more effectively and competition is less distorted. Government measures to remove market failures are perfectly justified, provided that such market imperfections are real (nonpecuniary externalities, public interest in goods or services produced or consumed by the society, natural monopolies, and the like) and not the result of excessive encroachment of public authorities on the market process (as so often happens; see Krueger 1983; chap. 7).

A liberalization reform requires that ad hoc measures be replaced by a stable and foreseeable policy framework, uniform rather than selective interventions, and a return to price flexibility that allows for a proper response to market changes. What does this mean in detail? The answer will differ between countries, depending much on the nature of the inward-oriented trade regime previously in force. The common characteristics of an inward-oriented trade regime may therefore provide an appropriate starting point for a discussion of essential elements of a reform package.

3.2
The Inadequacies of Inward-oriented Policy Regimes

Once a country embarks on an import-substitution strategy, there seems to be a logic to the evolution of direct government controls on prices and quantities over time (Bhagwati 1978). Initial tariff protection for "infant industries" soon proves to be insufficient. Unprotected domestic sectors and discriminated-against export industries vehemently complain about unfair treatment, and protection creates an incentive to evade controls

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via smuggling, over- and underinvoicing, or black market transactions. The public authorities, yielding to political pressures of (often disparate) sectional interest groups, tend to react by moving from tariff protection to quantitative controls and import-licensing procedures, effected with ever-increasing product coverage and ever-finer selectivity. When easy import substitution possibilities have been exhausted, but the inward-looking policy approach is maintained, a complex control network is likely to evolve, encompassing direct import allocation by category of commodity, by type of domestic use, and by source of foreign exchange.

Despite proliferating import controls, import-substitution regimes will generally not come to grips with the balance-of-payments difficulties that typically afflict developing countries. As industrialization proceeds, the demand for imported intermediate and capital goods, which are complementary to domestic production, continues to grow at high rates, while the policy-induced overvaluation of the national currency retards or impedes export expansion. Rising trade deficits and subsequent shortages of foreign exchange make intervention in foreign-exchange markets inevitable and resort to external credits a pressing need. Hence, import controls are supplemented by a direct allocation of foreign exchange to domestic uses and also complemented by administrative credit rationing.

Capital-market interventions usually arise from two sources. First, unchecked import-substitution policies favor production of relatively capital-intensive products (as typically the industrial structure gets diversified in the vertical direction), the application of capital-intensive technologies (because of relatively low barriers to imports of capital goods), and an inefficient use of capital (owing to the lack of competition in domestic markets). High incremental capital-output ratios will soon slow down industrialization and economic growth unless access to financial capital at reasonable rates of interest can be maintained. To sustain the momentum of import substitution, intrusive governments will, therefore, impose interest-rate ceilings on both deposits and loans and & 217 or provide preferential treatment for selected economic activities as has actually occurred time and again. As these interventions usually are administered in a discretionary way, they create uncertainty among investors; as they tend to be guided by public preferences rather than by comparative advantages, investment patterns are likely to be distorted. In addition, interest rate and other subsidies to capital formation become an increasing burden to the public budget.

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Second, interest-rate ceilings on bank deposits discourage domestic private savings and encourage capital flight, as well as an overvalued exchange rate both of which augment demand for external funds. Reflecting donor rules or preferences for securing external financing by government guaranties, loans from abroad may largely be channeled through public institutions, reinforcing the heavy hand of the government in the allocation of credit. Foreign borrowing is not, however, an unlimited source for financing public budget deficits. Governments that are not able (or not willing) to reduce the deficits may be tempted to turn the screw of the inflation tax by accelerating the rate of growth of the money supply. To collect the inflation tax, the banking sector has to be exposed to tighter supervision of the central bank. High non-interest-bearing reserve requirements on bank deposits, forced lending to public-sector enterprises and, ultimately, nationalization of private banks, are tools to make sure that the inflation tax accrues to the government, but these tools further weaken the functioning of the capital market. The experience of Argentina until the implementation of the "Austral Plan" in mid 1985 is a case in point (Fischer, Hiemenz, and Trapp 1985, chap. 3).

Import protection and the availability of credit at subsidized interest rates promote expansion of capital-intensive lines of production and thereby boost labor productivity at the expense of creating sufficient employment opportunities to absorb a rapidly growing labor force. The distorted structure of production paves the way to nominal wage levels in excess of equilibrium wages in the formal sector of the economy, with the well-known consequences of labor migration and informal labor markets.

The situation worsens if governments pursuing inward-oriented development strategies do keep wages above their equilibrium levels by minimum-wage legislation and if they artificially increase labor costs to employers further by excessively rigid labor codes and generous social policies. Such interventions have, in fact, occurred in many developing countries (Squire 1981; Berry and Sabot 1984). They were meant to secure the political support of the (in most cases well-organized) urban labor force for the development strategy applied by the government. For this reason, governments also sought to shelter the urban labor force from the costs derived from high inflation through price controls for essential consumer goods, publicly decreed wage increases, and/or formal indexation of wages. Thus, labor markets become subject to a significant degree of government regulation and control as inward-oriented eco-

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nomic development proceeds over time, and the benefits of comparative advantage based on a relatively elastic supply of labor are not exploited.

It is against such a background (an economic environment characterized by manifold interrelated and distorting government interventions in the economy) that export liberalization has to be contemplated. Attempts to liberalize the economy have to take into account the nature of controls and regulations as well as the interactions between them. Welfare theory suggests that in a case of multiple distortions, removal of one distortion may make things even worse. Export liberalization will, therefore, require a reform package that includes some degree of policy change vis-à-vis all major markets.

3.3
What Policy Reform Package?

From a theoretical point of view, export liberalization is best achieved by an instantaneous removal of all controls and regulations that distort the allocation of resources and contribute to an underutilization of available capacity. This best solution is, however, not likely to be feasible in the context of a highly regulated economy, since adjustment costs may become excessively high and even disrupt the political system as such. A more cautious approach to liberalization, which may therefore be chosen, raises a number of questions. Which are the key markets to be liberalized? What degree of deregulation is both necessary and feasible? What timing and sequencing of policy changes should be envisaged?

Under a fixed exchange-rate system, import liberalization can reduce the import-substitution bias of trade policies and may have a beneficial effect on inflation rates. It may, though, fail to achieve the desired export expansion if capital and labor markets remain under tight control. Export prices do not change because of the fixed exchange rate. Although intermediate input costs decline as a result of import liberalization, labor costs remain high, and artificially low capital costs, owing to interest-rate ceilings, provide little incentive to redirect investment flows toward export activities which usually yield a higher capital productivity than does import substitution.

A devaluation of the currency might appear to be more promising than import liberalization with respect to export expansion, since, even with quantitative import controls persisting, the relative domestic price of exportables would increase. This result depends very much, however, on how the necessary exchange-rate adjustment is effected. In the presence of high rates of inflation, the authorities may underestimate the

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difference between domestic and international inflation and thus cause a real appreciation of the exchange rate rather than a depreciation.

Even a freely floating exchange rate and a liberalization of the foreign-exchange market can have its drawbacks unless domestic financial markets are simultaneously liberalized. For, in the presence of controlled (and usually negative) interest rates, full liberalization of the exchange regime for both current and capital accounts, when coupled with a floating exchange rate, would surely result in capital outflows and rapid depreciation of the currency in excess of the rate of inflation. In countries with high and persistent inflation, a complete deregulation of financial markets will, however, hardly be feasible (at least not in the short run) since the tightly controlled banking sector will have lost the ability to collect and allocate financial resources efficiently.

Obviously, there are no recipes for initiating the transition from an inward- to an outward-oriented trade regime. Level of development, size of country, resource endowment, and relative importance of controls in individual markets will all have to be taken into account when designing an effective and feasible reform package. However, empirical evidence strongly suggests that trade interventions have been a major, if not the biggest, single source of distortion (Krueger 1984b, 417).

For this reason, it is a safe proposition that any policy reform will have to focus on the removal of obstacles to an expansion of exports in the first place. Depending on the nature and degree of protection, a combination of the following three elements of an import-liberalization strategy will have to be applied to accomplish this task: a transformation of quantitative trade interventions into tariffs, harmonization of tariff protection across sectors, and a reduction of the average level of protection.

As to the first aspect, tariffs are preferable to quantitative restrictions not only because the latter tend to veil the actual degree of protection, but also because the competition for import licenses diverts productive resources from more efficient uses elsewhere in the economy, apart from encouraging corruption in the bureaucracy.^[1]

Second, reshaping the (new) tariff structure toward a uniform tariff system serves the purpose of eliminating, or at least reducing, the escalation and deescalation effects of selective nominal tariff protection on effective rates of protection. A more uniform effective rate of protection across sectors lowers artificial advantages for import-substituting activities through, for instance, duty-free imports of capital goods, and leaves

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the choice of efficient import-substitution possibilities to market forces rather than to bureaucrats. An intrusive government may be tempted to liberalize in a selective manner rather than across the board on the grounds that the benefits of comparative advantage will then be captured faster; this is dangerous, in that new sources of distortions emerge, to say nothing of the difficulty of accurately assessing comparative advantages in a dynamic setting.

Third, a more uniform tariff system in itself usually entails a lower overall degree of import protection for domestic industries, since sectors granted low protection in the past will now exert pressure on the government to treat other sectors equally. Obstacles to the expansion of exports are thus mitigated. However, additional efforts will be required if the general level of protection is to be lowered further.^[2]

As long as some degree of import protection prevails, export activities remain discriminated against both directly through higher prices for imported intermediate and capital goods, and indirectly through the effects of protection on the general level of product and factor prices. Direct cost disadvantages of export activities can be remedied by one or all of the following measures, which have been applied in a wide range of developing countries: duty-free importation of inputs for export production, drawback schemes for import tariffs, and the establishment of free export-processing zones. From the point of view of administrative ease, duty-free importation and export-processing zones are clearly superior to drawback schemes, and free zones, if appropriately established, may offer additional net benefits in terms of employment creation and strengthened linkages to the domestic economy.^[3]

A closer vertical integration of the economy is also promoted by measures compensating export activities for indirect cost disadvantages. Such measures include income and sales tax rebates, special depreciation allowances, preferential credits, and straightforward subsidies (for details, see Wulf 1978). These various kinds of subsidies of either output

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or factor use can be compared to a partial, export-related devaluation of the currency, which may be necessary to balance the incentive system with respect to sales in domestic and foreign markets. However, this approach bears some risks. To begin with, it is almost impossible to determine the subsidy rate required to compensate for disadvantages accruing from import protection, which may lead to an undesirable overshooting. Moreover, the subsidies, typically related to the amount of investment, lend to encourage the use of capital over labor, and may thus be detrimental to a satisfactory rate of employment growth. And last, but not least, export subsidies can provoke retaliation from industrialized countries, which tend to ignore the compensatory nature of these subsidies, regarding them as price dumping. For these reasons, the emphasis of trade policy reform should be on import liberalization rather than on the implementation of export subsidies.

With import liberalization, the compensation of indirect cost disadvantages can be achieved by a more rational exchange-rate policy that increases the prices of exportables without inflating import prices. In the medium and long term, exchange-rate policy has to neutralize differences between domestic and foreign rates of inflation to shelter domestic suppliers from inflation-induced cost disadvantages vis-à-vis foreign competitors. This goal cannot be achieved if the exchange rate is used as a policy instrument to influence other macroeconomic variables as well, such as the rate of inflation itself. If the exchange rate is used to break the inflation mentality, as was done for instance in Chile in 1979 81, this is at best a short-term policy, the success of which depends on the credibility of the government's effort to contain inflation and the ability of the export sector to cope with the temporary discrimination implied by the real appreciation of the currency.

The choices for an appropriate medium-term exchange-rate policy are ad hoc devaluations in an otherwise fixed exchange-rate system; a sliding peg, or preannounced, devaluation schedule: or a freely floating exchange rate. The first can be dismissed as impracticable both on theoretical and empirical grounds. In a fixed exchange-rate system, the external value of the currency is adjusted retrospectively to inflation differences. This in itself contributes to permanently fluctuating real exchange rates, which discourage export orientation on the part of domestic firms, is detrimental to long-range investment planning, and induces destabilizing speculation. These negative effects are aggravated if necessary devaluations are delayed on account of national prestige considerations, as frequently occurs, so that further uncertainly is caused.

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The choice between administered stepwise devaluations and freely floating exchange rates is a much more difficult one because the potential effect on resource allocation of either policy depends on monetary and credit policies pursued simultaneously. A controlled sliding peg has the advantage of leveling exchange-rate fluctuations and, hence, reducing exchange-rate risks for exporters and both local and foreign investors. Countries such as Brazil, Colombia, and South Korea successfully applied such a policy in the late 1960s and early 1970s (Donges and Müller-Ohlsen 1978, 112). Problems have been encountered with preannounced stepwise devaluations (tablitas ) in some Latin American countries, such as Argentina and Uruguay, however, with high increasing rates of inflation (for details, see Barletta, Blejer and Landau, eds., 1984). In these countries, throughout the second half of the 1970s and early 1980s, the tablita has repeatedly failed to bring about the desired devaluation of the currency in real terms, since governments have usually underestimated future rates of inflation. The result was a real appreciation of the currency, since nominal devaluation rates fell short of international inflation differences. The lesson is that a tablita policy will only help to restore foreign-exchange equilibrium if governments simultaneously pursue a strict anti-inflationary monetary policy, which usually implies incisive cuts of public deficits (Sjaastad 1983; Fischer, Hiemenz and Trapp 1985). In order to alleviate short-term adjustment costs as much as possible, anti-inflationary policies will have to be accompanied by financial policies designed to enhance the restructuring of the economy according to comparative advantage, a topic to which we shall return shortly.

The other alternative, transition from a fixed, overvalued exchange rate to a freely floating one, usually implies a large initial devaluation, with an equivalent rise in the price level, which is difficult to cushion by import-liberalization measures at least in the short run. Moreover, with low or negative real rates of interest in local capital markets, devaluation expectations are likely to give rise to an uncontrollable capital outflow, which will further reduce the ability of the economy to adjust to new relative prices. Yet a freely floating exchange rate may be the only feasible policy alternative as long as high inflation has not abated, since governments lack the foresight to predict future price increases correctly in an inflationary environment.

It thus seems clear that appropriate trade policies have to be combined with fiscal and monetary policies designed to curb inflation, and with a deregulation of capital markets as well, if the shift to an

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outward-oriented trade regime is to succeed. The deregulation of capital markets gains particular significance once the adjustment process is considered. With greater reliance on market forces and increased competition from abroad, parts of the installed capacity will be rendered obsolete, while expansion into new profitable activities creates demand for credit to finance the necessary investment. The ease and the speed of the adjustment process will depend heavily on whether this demand for fresh funds can be met. Efforts have therefore to be made to mobilize domestic savings and attract capital from abroad.

In both respects it is imperative that interest rates reflect the true scarcity of financial capital so as to allow for a positive real rate of interest and to strengthen the ability of the banking sector to attract and allocate funds efficiently by removing excessive banking regulation.^[4] In some countries it may also be necessary to revamp investment legislation so that existing "red tape" is reduced and foreign investors are guaranteed their property rights, which is much more important than the provision of generous financial incentives by the host government, as all available evidence indicates (see, for example, the overview in OECD 1983).

Efficient capital-market policies are crucial, since the social acceptability of liberalization hinges on swift achievements in terms of output growth and employment creation. It need not be stressed that such achievements depend not only on consistency between trade, monetary, and credit policies, as pointed out earlier, but equally on the presumption that governments do not erode the potentially beneficial effects of the new incentive system by some countervailing policy action, such as controls on prices, profits, and dividends or interventions in labor markets.

The positive welfare effects of liberalization arise from a reallocation of resources following a shift in relative prices, including the wage rate. Any attempt to maintain the privileged income position of workers in a hitherto protected sector of the economy endangers the establishment and growth of internationally competitive activities and prevents the creation of additional productive jobs. Governments may find it difficult to resist the claim of organized labor to secure, if not increase, real wages, but this political pressure will relax only when the employment and income effects of liberalization materialize. This will happen sooner

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if real wages are allowed temporarily to decline until productivity gains accruing from better resource allocation again permit wage increases.

3.4
The Timing and Sequencing of Liberalization

Abrupt liberalization is the least painful way of proceeding provided (1) that with the new system of incentive firmly in place, adjustment proceeds rapidly without being hampered by resource misallocation during the transition; (2) that instantaneous adjustment prevents political opposition to the policy change from diluting it; and (3) that immediate transformation of the economic environment reduces uncertainty about the credibility of the policy initiative that could delay the response of economic agents to new incentives. If these considerations are overriding, the issues of timing and sequencing do not arise.

There is a widespread belief, however, that instantaneous liberalization of an economy hitherto subjected to exchange controls, import licensing, negative real interest rates, indexed real wages, and so on will completely disrupt economic activity and cause high adjustment costs in terms of declining output and increasing unemployment. Removing controls gradually so as to give economic agents time to prepare for adjustment (timing) and deregulating individual markets in a stepwise fashion, depending on the ease with which adjustment can be accomplished in these markets (sequencing), are therefore suggested.

Some of these problems have already been discussed above with respect to import liberalization and exchange-rate policy. Analytically, an optimal liberalization program depends on the degree of prevailing intervention, on the intensity of linkages between individual markets (the level of economic development), and on expectations that have been built up on the basis of past experience with economic policymaking (Lächler 1985). Although all of these factors do matter, very little is known about their precise relationships to the time schedule of a reform program. The basis for any proposal therefore remains largely judgmental. The advantages of graduation in import liberalization have been emphasized on the grounds that losses of capital and jobs, inevitable as they are in the process of moving toward a new production structure, will be minimized.^[5] Whether this can be achieved depends on the

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success of exchange-rate policy in shifting relative prices in favor of exportables without propelling domestic inflation.

Concerning the proper sequence of liberalization steps, Jakob Frenkel (1984) has argued that domestic distortions in the goods and asset markets should be removed before links with the rest of the world are liberalized. In addition, restrictions on capital flows should only be lifted after free trade has been introduced, because asset markets adjust more quickly to new policy regimes than do goods markets. The latter proposal also emerges from several studies of unsuccessful liberalization attempts in Chile, Uruguay, and Argentina (McKinnon 1982; Dornbusch 1984; Edwards 1984; Sjaastad 1984), which all conclude that liberalization of the capital account should be postponed because capital flows will either (under a freely floating exchange rate) push the value of the domestic currency to a level that impedes the structural transition of the real sector or (under a tablita or fixed exchange-rate regime) require extremely high real rates of interest in domestic capital markets to prevent large capital outflows and thus maintain the chosen parity.

Both effects are clearly undesirable, and there is little doubt that internal liberalization of capital markets alone could help improve the allocation of capital without risk of too much or too little (net) capital inflow or outflow. Yet, one could argue that the negative effects have actually resulted from an inconsistent mix of exchange rate and domestic economic policies rather than from the liberalization of the capital account as such. In particular, the attempt to use the exchange rate as an anti-inflationary device while distortions of domestic capital and goods markets remained in place has caused the severe economic recessions that each time marked the end of so-called economic liberalization in Latin America. Even if controls on capital flows had been maintained, the exchange-rate regime managed by the government would still have induced an appreciation of the real exchange rate. The resulting decline in the international competitiveness of the tradables sector, which was enforced by incompatible domestic policies such as wage indexation (Chile) or persistent monetary expansion (Argentina), would have been sufficient to prevent the necessary adjustment of the real sector of the economy and, thus, to provoke a new balance-of-payments crisis. Most

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likely, the risks associated with the choice of a "wrong" exchange rate are by no means smaller than those stemming from destabilizing capital flows.

Furthermore, there is evidence (Corbo, de Melo, and Tybout 1985, 17 27) that policy inconsistency rather than liberalization of the capital account has caused the substantial capital movements into, and out of, the countries in the Southern Cone. The persistent policy-induced distortions of factor and goods markets undermined the credibility of the tablita policy. Expectations were that the government could not sustain this policy; hence the perception of the exchange-rate risks hardly changed. For this reason, interest rates remained high when inflation rates began to decelerate, and attracted much capital from abroad. The resulting real appreciation of the exchange rate then increased expectations of the collapse of the exchange-rate regime, and capital flows were reversed until a new balance-of-payments crisis made a maxidevaluation inevitable.

This assessment suggests that appropriate liberalization policies for concrete cases can only be delineated after a careful economic analysis of the country concerned has been undertaken. With this qualification in mind, the history of successful liberalization in Asian countries and less successful liberalization attempts in Latin America's Southern Cone (to which we shall return in detail later) would at least suggest the following policy guidelines. Gradualism tends to be self-defeating with respect to stabilization and exchange-rate policies, while import and capital markets may be better candidates for a more cautious removal of controls. It has to be stressed, however, that at least a partial deregulation of the capital market is an urgent task, since capital markets have to play a key role in providing the funds needed for rapid and successful economic adjustment to a more outward-oriented trade regime. To facilitate financial flows, it may also be advisable in many countries not to postpone the liberalization of the capital account until the real sector of the economy has adjusted, even if there are some risks concerning an unwarranted appreciation of the currency. If the government abstains from interventions in the foreign-exchange market (and does not buy up the foreign-exchange inflow), a revaluation of the currency is unlikely. A steady course of the Central Bank with respect to monetary policy can prevent an inflationary increase of domestic money supply, while import liberalization will help to mitigate the revaluationary effect of capital inflows. The government should be prepared to accept a temporary deficit in the current account (J-curve effect) to accelerate productive

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investment based on imported capital goods and to limit the inflow of speculative capital. Once new investments go into operation and export growth is accelerating, the current account deficit will automatically be eliminated.

3.5
The Political Economy of Export Liberalization

Despite some open questions, the switch from an inward- to an outward-oriented trade regime has hardly been hampered by a lack of knowledge concerning the economic management of transition; it was rather impeded by a lack of political will to change the direction of economic development. The major problem with liberalization is that government officials, politicians, and the informed public can readily foresee those interests that are likely to be damaged in the short run by any liberalization effort. The damage accrues primarily to those benefiting most from controls and regulations, and it is in the logic of the system that the main beneficiaries of the regime, such as import-substituting industries, the labor aristocracy, and bureaucrats exerting power through controls, also tend to be well organized into political pressure groups. For them, it pays to invest in the continuity of an inward-oriented trade regime. Conversely, those who have to foot the bill for excessive regulations in terms of income and employment forgone, such as consumers, informal labor, export industries, and agriculture, often do not realize the price they are paying and, hence, have little incentive to organize themselves into special interest groups. They also usually find it difficult to perceive the medium- and long-term benefits that export liberalization holds out to them. For these reasons, there has always been a lot of opposition to, and little support for, a change of the trade regime.

Yet not just the so-called "Four Tigers" in Asia (Hong Kong, Singapore, South Korea, and Taiwan) but also quite a number of developing countries adopted export-promotion strategies in the 1960s and 1970s. This raises the question of which political conditions are conducive to liberalization. Bhagwati (1985, chap. 1) has hypothesized that authoritarian regimes can more easily choose appropriate policies than can democratic governments. His main argument is that the import-substitution strategy confers more political power than the export-promotion strategy, since it provides politicians with greater patronage. Hence, where politicians take power directly by authoritarian means, they have no need to use the economic system to generate and exercise power, freeing them to embrace economic liberalization. Though analytically appealing, Bhagwati's hypothesis does not carry very far in the

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light of empirical evidence. There are military dictatorships in some Latin American countries clinging to populist policies, while politicians in fairly democratic countries such as Malaysia and Thailand took the initiative to liberalize their economies in the 1970s.

So far we in fact know very little about the politicoeconomic background of economic decision making in developing countries and the constellation of power groups that provide governments with enough independence to implement appropriate policies for sustained economic development. Much more research is needed in this area. All that can be said at this stage is that the standard arguments against the political feasibility of export liberalization did not stand the test. The attempt to preserve national independence through a diversified domestic industrial sector, largely de-linked from the world economy, has increased dependence on imported intermediate and capital goods and has contributed to the currently intractable foreign indebtedness. Trade unions were not pacified by maintaining the course of import-substitution strategies the political pressure exerted by organized labor against the government was as strong under inward-oriented trade regimes as when liberalization was attempted. And, finally, persistent reliance on import-substitution strategies for fear of political and social upheavals in case of a policy change has not protected many countries in Africa and Latin America from plunging into economic crises and civil disorder, with subsequent changes of government. The new governments, often military, then had little choice but to implement some liberalization measures to remedy the economic crisis.

4
Evaluation of the Evidence

4.1
Export Performance

The proposition that an open trading environment promotes an efficient use of available resources has received impressive support from the experiences of an increasing number of old and new NICs, which gradually opened their markets during the 1960s and 1970s. Export liberalization has caused manufactured exports from the Third World to expand spectacularly, outpacing both world trade expansion and domestic industrial output growth. As table 6.1 shows, manufactured exports of developing countries grew on average at an annual rate of roughly 14 percent in real terms in the period 1965 82 about twice as fast as world trade. Export expansion was predominantly achieved by the nineteen countries listed in table 6. 1, which accounted for 79 percent of

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total Third World manufactured exports in 1982. With rapid domestic industrialization, the export portfolio of these countries significantly shifted toward manufactured goods, as shown by the shares of these goods in total exports, which increased from 7.2 percent in 1965 to 44.8 percent in 1982.

The nineteen countries in table 6.1 are quite diverse. Some (the firstgeneration NICs) had already established a substantial industrial base in 1965, whereas others (the second-generation NICs) were latecomers who began to promote industrialization and exports of manufactures only in the 1970s. Furthermore, a few first-generation NICs have pursued predominantly inward-oriented development policies, and for the reasons given in section 3 the consequences for their export performances were negative: either real growth of manufactured exports remained low throughout the whole period under observation (as in the case of India) or it slowed down considerably when the international economic environment deteriorated in the 1970s (as in the cases of Argentina and Mexico).

This is in clear contrast to the experience of the more outward-oriented first- as well as second-generation NICs. As to the latter, the interesting point to make is that they were able to launch export drives in spite of successive oil shocks, economic recession in industrialized countries, high interest rates, and new protectionism during the past decade. The unfavorable external environment did not prevent these countries from penetrating the markets of industrialized countries further and from intensifying trade within the Third World. The real rate of manufactured export growth of 10.1 percent for all countries taken together, which has to be compared to a rate of 4.5 percent for world trade in manufactures, indicates the continuity of export success in the period 1973 82. In this difficult period, the second-generation NICs were even more successful than their forerunners, as shown by rates of export expansion of 14.6 and 9.6 percent respectively.

Equally noteworthy is the fact that the early export drive of the old NICs has not clogged the markets of industrialized countries leaving no room for latecomers, as is often asserted. Most of the new NICs started industrialization based on relatively open trade regimes in the 1970s, and were able to compete successfully with old NICs and with suppliers from industrialized countries. All second-generation NICs except Colombia (which had abandoned outward orientation by then) have achieved rates of manufactured export expansion in excess of the group of old NICs (for further details, see Havrylyshyn and Alikhani 1982). An

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analysis of ASEAN countries (Indonesia, Malaysia, the Philippines, Thailand, and Singapore) (Hiemenz 1985) even suggest that the take-off to export-oriented industrialization may have been easier for the latecorners, since the experience of the old NICs served as an indication for choosing an appropriate product mix, tapping the right markets, and exploiting established trade links. Most important, however, the demonstrated superiority of choosing an outward-oriented development path in the old NICs created an expectation of success that all segments of society in the new NICs could focus on.

A great number of country studies show that exports, which expanded so rapidly under outward-oriented trade regimes, have been the major driving force of economic growth and employment creation, exceeding any performance observed in countries pursuing import-substitution strategies (Donges 1983, and the references given there; Ram 1985). The domestic saving rate increased rapidly and so did the proportion of investment in GDP, both behind remarkable rises in the export-to-GDP ratios (table 6.2). Again, predominantly inward-oriented old NICs did not fare as well as the other NICs. Increments to savings and investment remained modest; hence real rates of GDP growth trailed far behind those achieved by most outward-oriented NICs.

What appears as an "export-led type" of economic development in most NICs in fact meant a continuous strengthening of the supply potential of the economy and a steady increase in productivity. Relatively low real wages provided the inducement to build up manufacturing-production capacities using labor-intensive technologies to a large extent, which allowed the absorption of surplus labor. When later on labor became scarcer during the industrialization process, and consequently real wages increased more rapidly (particularly in the leading NICs), the economies had gained sufficient flexibility on the supply side to be able to shift the production structure toward more physical-capital and skill-intensive activities and to be internationally competitive in these new undertakings. Direct foreign investment has contributed to the success of export orientation and diversification, mainly by providing technical knowledge and marketing expertise and by upgrading skills of domestic workers. With the exception of Singapore, the significance of (totally or partly) foreign-owned firms, in terms of investment, production, export, or employment shares, was much more modest than commonly believed.

The empirical evidence also confirms that these encouraging results have been brought about by improvements in trade and trade-related

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policies along the lines discussed in section 3. A corrected and more sensible import-tariff and export-subsidy policy, combined with more realistically valued real exchange rates, more rational factor pricing, and less intervention in goods markets, have constituted the pillars of outward-oriented trade regimes. State intervention remained important in all NICs (with the exception of Hong Kong, which has always come very close to a laissez-faire economy), but the readiness of governments to consider comparative-cost criteria, to modify plans when circumstances changed, and to learn from past mistakes was much greater than elsewhere in the Third World. When export liberalization involved some kind of resource misallocation for instance, because the government promoted exports bearing high marginal domestic resource costs per unit of foreign-exchange earnings the country's industrialization process did not come up against a balance-of-payments constraint, as it almost inevitably would have under an inward-oriented regime; those exports at least provided foreign-exchange revenues.

It should also be noted that the transition from an inward-oriented to an outward-oriented trade regime nowhere caused traumatic dislocations in production and employment. On the contrary, the more or less gradual approach adopted by the governments in reforming policies greatly facilitated the needed adaptation. Even many of the inefficient producers, which lived so comfortably with the previous protectionist environment, demonstrated that they were actually quite able to reduce costs through process innovations and to develop new markets through product innovations once the increased competitive pressures made such efforts imperative for survival.

4.2
External Shocks and Foreign Indebtedness

One frequently raised objection to export liberalization concerns the dependence of outward-oriented economies on conditions in world markets. It is argued that open economies are vulnerable to external shocks, while less trade orientation provides a protective shield against disruptive external demand or price changes. The experience of the 1970s and 1980s, when all developing countries were suddenly confronted with the need to overcome increasing balance-of-payments pressures in order to preserve the momentum of their development process, reveals the opposite. Outward-oriented economies commanded enough flexibility at both the macro- and micro-levels to meet the challenge of deteriorating world market conditions without falling into the debt trap, while inward-oriented economies suffered from severe economic depression

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and, in many cases, mounting foreign indebtedness. India is the major exception to this rule, perhaps because this country had previously not borrowed much abroad and has benefited from an improved performance of its agricultural sector more recently. Balassa (1984) has shown that outward-oriented economies relied largely on output-increasing policies of export promotion and import substitution to offset the balance-of-payments effects of external shocks in the 1974 76 and 1979 81 periods and accepted a temporary decline in the rate of economic growth in order to limit their external indebtedness. Inward-oriented economies, however, failed to apply output-increasing policies of adjustment; they financed the balance-of-payments effects of external shocks by foreign borrowing in 1974 76 and had to take deflationary measures in 1979 81 as their increased indebtedness limited the possibility of further borrowing. The policies applied led to economic growth rates substantially higher in outward-oriented than in inward-oriented economies, with the differences in growth rates offsetting the differences in the size of external shocks several times.^[6]

4.3
Aborted Liberalization Attempts in Latin America

The liberalization attempts initiated in Uruguay, Chile, and Argentina in the mid 1970s (for details see the country papers in Barletta, Blejer, and Landau 1984) seem to run counter to the arguments presented in previous sections. True, all three economies experienced initial success in reducing inflation and accelerating the rate of economic growth, but the positive developments ended abruptly, as each country encountered a sudden economic downturn, large increases in external indebtedness, and internal financial crises.

Closer examination of the experiences of these countries underlines the extreme importance of internal consistency in the policy package implemented to liberalize an economy. In particular, a fixed exchangerate system pegged against an appreciative currency (then the U.S. dollar) turned out to be incompatible with fiscal, monetary, and wage policies. In the Chilean economy, the momentum of economic development achieved by trade liberalization and anti-inflationary budget policies broke down when the exchange rate was fixed against the U.S. dollar in 1979. A sharply appreciating real exchange rate in 1980 81 combined with a considerable rise in real wages (owing to wage indexation to past,

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and higher, inflation rates) and persistently high interest rates (owing to bank regulations causing substantial arbitrage costs) could not but erode the international competitiveness of the tradables sector and provide strong incentives for speculative investment (mostly in construction activities).

A lack of consistency between exchange-rate policy and trade policies, as well as fiscal policies, also caused the failure of economic liberalization in Argentina, where a tablita was implemented, with a concomitant opening of the capital account, while protectionist trade interventions remained untouched and large fiscal deficits continued to fuel domestic inflation. This combination of contradictory policies put the trade sector under untenable pressure (as in the case of Chile) and gave rise to an unprecedented outflow of domestic capital. Both countries accumulated staggering levels of foreign debt within a relatively short period as a result of unresolved balance-of-payments problems.

These partial deregulation attempts can clearly not be used as examples against export liberalization based on a package of stabilization-cum-restructuring policies as suggested in section 2 and applied in most of the second-generation NICs. However, they do provide lessons with respect to the crucial link between exchange rate, interest rate, and wages, and with respect to the disastrous consequences of step-by-step approaches to liberalization. Sjaastad (1983, 19) makes the point unequivocally: "The fatal flaw is not to be found in the liberalisation programme per se, but rather in policy inconsistencies. Policy inconsistencies are of minor importance when markets are heavily regulated. Free markets, however, require a high degree of policy coherence."

5
World Market Conditions-Obstacle to Export Liberalization?

The above analysis has stressed that the main factors determining the success of outward-oriented economic development are to be found on the supply side of the economy. To be sure, world market conditions also matter, and when they are as favorable as they were in the 1950s and 1960s the chances for accomplishing a successful transition to an open trade regime are particularly good. But even a buoyant external demand can only be transformed into an impetus to economic development if there is adequate export potential. Nevertheless, persistent skepticism fuels new variants of export pessimism, resting on the as-

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sumption that the revival of protectionism will further restrict access to the markets of industrialized countries, that these markets cannot absorb expanding exports from a large number of developing countries, and that world demand will remain sluggish owing to the weak economic performance of the industrialized countries.

Though "new protectionism" in industrial countries has not completely eroded the gains from earlier rounds of trade liberalization (Hughes and Waelbroeck 1981, 131) and has not prevented exportoriented economies (in particular the East Asian NICs) from penetrating foreign markets, the danger is that it generates additional uncertainty among investors in developing countries concerning engagement in export-oriented activities. Investors may then turn to presumably "safe" investment opportunities geared toward production for local markets, and political forces favoring an import-substitution type of economic development may succeed in forestalling, or at least slowing down, any attempt to liberalize the system of economic incentives. In this sense, protectionists in the industrial countries play into the hands of protectionists in developing countries.

As to the proposition that it will be impossible for all developing countries to emulate success stories because the resulting surge of manufactured exports to Western markets would cause a glut on those markets and provoke further protectionist tendencies (Cline 1982; Spraos 1983, 140), it reflects a fallacy of composition. When moving in the direction of market liberalization, it takes a longer time for large, resourcerich countries, like those in Latin America, starting from a higher level of distortion, to arrive at the same manufactured export share in GDP than it does for small, labor-abundant countries like Korea. Taiwan, Singapore, and Hong Kong. In fact, it is likely that manufactured export shares in the former group will always fall behind those in the latter group, even at the same population and income levels. Nor, given differences in resource endowments and skills, will all developing countries export the same products. Even in the labor-intensive segment of the product range, there is a wide variety of manufactures that developing countries can specialize in, and market penetration is rather marginal in industrialized countries for most of these products.

Moreover, the implementation of an outward-oriented trade regime will provide for some degree of import liberalization. This offers the chance to expand South-South trade along with South-North trade, in particular with labor-intensive and standardized capital-intensive

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products. And, finally, should too many developing countries specialize in the same exports, their terms of trade will deteriorate (other things being equal), but this can be only a temporary effect, because it is unreasonable to assume that investors and exporters do not learn. Most likely, they will react to declining prices by changing the product mix.

As to export pessimism derived from slow economic growth in developed countries, it should be emphasized that for industrializing developing countries there is not a stringent and invariable link between the rate of expansion of world demand and that of exports (Riedel 1984). The composition of output changes and so does the structure of exports. In fact, the changing composition of exports has been the major reason behind rapid export expansion of developing countries over the past twenty-five years. Third World manufactured exports grew twice as fast as real GDP in industrialized countries in the 1960s, and more than four times faster after 1973, when industrialized countries experienced successive economic recessions.

6
Conclusions

This chapter has reviewed the arguments and the empirical evidence for the superiority of outward-oriented trade regimes in promoting industrialization and accelerating economic development. Trade policies that do not discriminate between local and foreign sales improve allocative efficiency and provide dynamic gains from economies of scale, enhanced transfers of technology, and better access to international financial markets. Beyond outward-oriented trade policies, internal liberalization of markets increases the flexibility of the economy, which is one necessary condition for successful economic development. These advantages accrue even in an international economic environment less buoyant than that of the 1960s and early 1970s. It is, however, of crucial importance that a high degree of coherence between trade liberalization and related economic policies be achieved, that the policies be credible, and that they be implemented rigorously.

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