TRADE LIBERALIZATION, ECONOMIC GROWTH AND POVERTY REDUCTION
RECENT EVIDENCE FROM PAKISTAN
ISHRAT HUSAIN
THEORETICAL CONSIDERATIONS.
Standard economic theory starting from Ricardo to the neoclassical model is quite clear
about the benefits of trade between nations based on comparative advantage and relative factor
endowments (Hecksher-Ohlin). The main conclusions of the free trade model are that all
countries gain from trade and world output is increased; that the countries will tend to
specialize in products that use their resources abundantly; and given identical technologies and
production throughout the world, factor prices will equalize across trading countries. By
enabling countries to move beyond their production possibility frontiers trade is assumed to
stimulate growth by securing capital as well as consumption goods from other parts of the
world. Trade thus stimulates economic growth, promotes and rewards those activities in which
the country has relative abundance of factors of production. As developing countries posses
labor in abundant supply their wages will rise and the majority of the population will be better
off compared to no trade scenario.
The criticism against international trade theory arises from the validity of some of the
assumptions made by the proponents of the theory. For example, it is not obvious that all
productive resources have identical quality or are perfectly mobile within and across the
trading countries. Neither is the technology of production similar nor the markets are always
competitive seeking cost minimization and profit maximization. Under these circumstances the
realized benefits from trade may diverge from the intended benefits.
Moreover, even if trade is found to stimulate growth it is not obvious if growth can
automatically translate into poverty reduction. Growth is necessary but not sufficient condition
for poverty reduction. It should also be recognized that Poverty and Income inequalities are in
themselves two different concepts and outcomes. Anti-globalization and anti-growth thinking
that dominates among non-economists today stems largely from the considerations of income
inequalities and disparities. The distributional effects of trade have not been necessarily
positive or benign.
Keynote address at National Level Seminar on “Trade and Economic Growth Linkages” organized by
Quaid-e-Azam University at Islamabad on June 27, 2007
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Development Economics literature on trade got embroiled in the controversy between
Import Substitution and Export promotion. Prebisch-Singer theorem based on export
pessimism, the Big Push theory and other similar thinking argued forcibly that the developing
countries should embark on a strategy of substituting imports by domestic production of those
goods. Inward orientation and protection of domestic industry were therefore advocated in the
1950s and 1960s as tools of economic development. The weakness of this strategy became
apparent when several Development economists started systematic examination of the import
substitution strategy in the 1970s and 1980s and found it flawed as well as inhibiting to
growth. They concluded that the countries pursuing Export Promotion and Outward Oriented
strategies were more successful in achieving rapid economic growth. The collapse of the
Soviet economic model and the advent of globalization gave further impetus to this particular
line of thinking. What have been the results of this new way of thinking?
As the trade theory predicted, world trade has consistently expanded more rapidly than
World output. During the last fifty years, the volume of world exports has risen twenty fold
while output growth only seven fold. In 2006, for example, world economic output grew by 5.4
percent while world trade volume expanded by 9.2 percent. Of the $ 43 trillion global
economy, the US, Europe, and Japan still account for the bulk of the purchasing power. Access
to these advanced markets provided opportunities to developing countries for earning higher
incomes by selling goods and services at scales that were not available locally. The foreign
exchange earned by these exports relaxed the constraint of physical and financial capital
availability and net exports increased output levels in the economy. The poor and small
countries with limited market size and inadequate resources realized that they could not aspire
to achieve even modest growth unless they were linked to international trading and financial
system. The least developed countries with a host of natural and man-made problems could not
afford to remain isolated as they had to secure goods and resources from outside their borders
for their survival.
In light of this growing importance of trade and growth the elimination of barriers to
access to developed economies which enjoy relatively higher incomes and consequently higher
demand for goods and services assumes a critical role. The World trading environment has
improved considerably over time and lowering tariffs has been helpful to developing countries.
But the current difficulties in the conclusion of Doha Development Round suggest that the
interests of the developing countries have also become highly differentiated and diverse. The
traditional dichotomy of developed vs developing countries in trade negotiations is no longer
applicable and a more nuanced approach that is also more complex underpins the negotiating
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position of different groups of developing countries. What may appear to be a concession by
developed countries to a least developed country (LDC) may in fact become a barrier for an
emerging economy. It is also paradoxical that while developing and emerging countries are
unilaterally liberalizing their trade regimes the protectionist sentiments are becoming stronger
in the US, Europe and Japan. Despite these difficulties, the empirical evidence on the
relationship between trade and growth is quite robust and therefore trade liberalization should
be pursued as part of continuing reform agenda by developing countries.
EMPIRICAL EVIDENCE
(a) Developing Countries.
The empirical evidence relating trade and growth is quite strong. Berg and Krueger
(2003) have shown that Trade openness has raised aggregate incomes and growth rates.
Sachs and Warner (1995) in an influential paper demonstrated that countries that were
more open grew faster than countries that were not open. Dollar and Kray (2002) provide
evidence that countries that trade more grow faster. Mamoon and Murshed (2006) conclude
that trade policies do matter and substantiate the earlier studies regarding the importance of
trade policy in determining economic growth. Greenaway et al (2002) analyzing the
relationship between trade liberalization and growth of 73 developing countries showed a
positive and significant impact of trade liberalization on growth with a lag. Yanikkaya
(2003) found a positive relationship between openness and economic growth. The link
from growth to poverty has been investigated through cross country studies. Studies by
Dollar and Kray (2002) and Ravallion (2001) support the hypothesis that mean incomes of
the poor rise and poverty rates decline with the rise in overall mean incomes. But reliance
on cross – country evidence to make inferences about specific instance is not helpful.
It appears that the outward-oriented strategy appears to have worked quite well for the
newly industrializing countries, followed by Asean countries and in more recent years by
China and India. The 21st century dubbed as the Asian country, in the eyes of many
observers, will be shaped by open markets, integrated financial systems, increased mobility
of labor and rapid diffusion of technology. The constant struggle for the smaller countries
in Asia and the developing world would be how to find niches for themselves while
competing with the enormous bargaining power of the large developing economies such as
China and India. Should they become integral part of the global supply chain of
manufacturing led by China and that of services led by India or remain insignificant and
marginal player operating on their own. Increased regional economic cooperation in Asia
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has raised the volume of intraregional trade and insulated to a large extent the participating
economies from the vagaries of the cycles in the developed world. The supply of
components and parts from the rest of Asia to final product assembly or fabrication in
China has been of mutual benefits to Asean Countries as well as China. This is the path
other countries may have to follow to derive benefits from trade.
b) Pakistan
Pakistan maintained a highly protective trade regime for over four decades until late
1980s. Tariff rates were excessively high and non tariff barriers kept competing imports
away from the domestic markets. It was only in the 1990s that trade liberalization policies
were initiated and then intensified during the last six to seven years. The share of Pakistani
exports in the world market has declined from 0.22% and has remained stagnant at 0.18%
of world exports while other Asian countries have made significant gains during the same
period. Had Pakistan simply maintained our historical share of 0.22 percent the exports last
year would have been $ 22 billion.
During the period of protection the manufacturing and tax revenues grew by less than 5
percent annually. Once the tariff reforms were intensified since 2002-03 manufacturing,
revenues and exports have all grown in double digits. This very crude correlation shows
that the fears that reduction in tariffs and other trade barriers will hurt domestic
manufacturing industry and adversely impact tax revenue collection have proved
unjustified. On the other hand, export growth had been quite buoyant until this year.
Khan et al (1995) provide evidence that exports promote economic growth in Pakistani
context. Iqbal and Zahid (1998) suggest that openness has a beneficial impact on economic
growth in Pakistan. Mohsin et al (2001) demonstrate that for the period 1963-64 to 1993-94
poverty declined in Pakistan with trade liberalization. Kemal et al (2002) found a positive
association between exports and economic growth in South Asian countries including
Pakistan. Din et al (2003) indicate that there is a significant long-run relationship between
economic growth and openness and vice-versa for Pakistan but not in the short term. Khan
and Qayyum (2007) examined the impact of trade and financial policies and real interest
rate on real GDP in Pakistan over the period 1961-2005. Their results reveal that trade
liberalization, financial development and real interest rate exerted positive impact on real
GDP. The study also found a positive impact of trade openness on growth both in the long
and in the short run.
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CASE STUDY ON PAKISTAN
A case study on Pakistan carried out recently by the Social Policy Development Centre
(SPDC 2006) sheds further light on this important question. The study shows that since the late
1980s there has been a clear effort to reduce trade barriers and liberalize the economy through
a sharp reduction in import tariffs, dismantling most of the non-tariff barriers and eventual
elimination of most of the SROs. Overtime, the interaction of trade liberalization with a more
stable macroeconomic and policy environment as well as a more favorable external
environment has accelerated Pakistan’s trade. Nonetheless the study found that Pakistan is still
relatively a more restricted economy than many developing countries in Asia and also which
ranks as one of the highest among all the countries in the world in terms of a lack of access to
markets allowed by other countries. The extent of trade liberalization that has taken place since
the early 1990s may have led to an acceleration of trade but has not resulted in the spurt of
trade that is characteristic of many other developing countries in Asia.
The SPDC study using both partial equilibrium and the general equilibrium impact of
trade liberalization and the simulations for the future concludes that, contrary to popular
beliefs and perceptions, the process of trade liberalization in Pakistan does not appear to have
had a significant adverse impact on poverty and income inequality. The results of the study
indicate that trade liberalization has, if anything, reduced poverty and inequality although only
modestly so on balance. The main channels of transmission leading to this outcome are
growth, productivity, investment and price stability. Foreign direct investment that has come
into Pakistan does appear to increase income inequality as it is highly skill and capital
intensive and does not use much of the abundant factor of production i.e labour. Also some
industries do seem to have suffered from trade liberalization but such restructurings in the
transition period are a natural consequence of trade liberalization. An interesting and highly
unique insight gained from the study was that trade liberalization has had some adjustment
costs associated with it, in particular costs related to fiscal adjustments. Had the lower
government revenue collection arising from a reduction in import tariffs been fully neutralized
by other modes of direct and indirect taxation and development expenditures had not fallen the
impact of trade liberalization on poverty and income inequality would have been larger. Thus,
trade liberalization policies should only be pursued in conjunction with government revenue-
neutral policies.
It should also be realized that Pakistan’s competitors have continued on path of
liberalization while we seem to have stalled. According to WTO, simple average of applied
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tariff rates for Asean Countries ranges between 4 to 8 percent and these rates are being further
reduced. More than forty percent of tariff lines of Pakistan have tariff rates exceeding
15 percent. Further reforms in tariff reduction will have to be carried out if Pakistan’s exports
are to grow. There is ample evidence to show that reduction in tariffs boosts exports since the
tariffs act as an implicit tax on exports. Chile’s exports in 1999 were $ 15.6 billion. By freeing
up its imports from tariff duties (97% of its imports are now duty free) Chile’s exports have
jumped to $ 58 billion. Using the conclusions of the study by Stephen Tokanick it can be
inferred that Pakistan could achieve a 16% increase in exports by removing its import tariffs.
Pakistan’s industry is twice as much protected as Indonesia’s and one and a half times as much
as Sri Lanka. This high level of protection induces inefficiencies and makes Pakistani products
less competitive in world markets. The increasing tendency of entering into bilateral free trade
agreements and regional trading blocks would per force move towards zero or minimum tariff
rates.
CONCLUSION
To conclude it is evident from theoretical and empirical literature that the links between
trade liberalization, economic growth and poverty reduction are positive and can be harnessed
by appropriate policy interventions. The case study of Pakistan shows that the economy can
potentially gain from further trade liberalization but only if it is accompanied by other pro-poor
policies. Increase in development expenditures that are more pro-poor in their composition and
reduction in recurrent expenditures can magnify the gains of further tariff reduction and have
sizable impact on economic growth and poverty reduction. The potential growth-inducing
tendencies of both trade liberalization and development expenditures can interact to generate
positive synergies that can potentially gain from further trade liberalization.
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