1

Trade and Poverty Linkages: An Overview

D R Khanal

Former Member, NPC

2

1. What Trade Liberalization Means?

- greater external competition into protected domestic markets for removing all type of discretionary practices through -elimination of preferential treatment for a specific sector-reduction in tariff rates and effective protection including reduction in the dispersion of tariff and average tariff rates-elimination in non-tariff barriers

-reduction in cumbersome administrative procedures for imports and exports, and

-removal of distortions in the exchange rate and financial system

2. Routes and Channels

- multilateral (WTO routes) - unilateral move- regional and bilateral routes.

3. Gains of Trade Liberalization

- rapid industrial transformation, - fast changes in employment structure,- higher growth in output, and eventually - drastic reduction in poverty.

3

Occurring through;

- factor productivity gains via higher specialization and exploitation of areas having comparative advantages,

- scale of economies and expansion in markets for domestic firms leading to increase in total factor productivity,

- stronger interaction with foreign firms and markets and hence technological innovations and improved managerial practices,

- lessening of anti-competitive practices and rent-seeking activities leading to reallocation of resources away from protected unproductive firms/sectors to more efficient activities,

- tariff reduction decreasing imports prices and increasing purchasing power of consumers, and

- spill over effect on both factor and product markets and creation of income and employment opportunities leading to welfare gains and poverty reduction.

4

Trade and Poverty Links: an overview

Trad e P o lic y

In com e leve l an d g row th

P overty

In com e d is trib u tion F isca l is su es , R isk , V o la tility

11 22

4433

5

Poverty-growth-income distribution

10 15 20 25 30 35

Reduction due to Reduction due to Growth Growth

Reduction due to Reduction due to distribution change distribution change

ZZ

6

4. Theoretical and Empirical Bases

- international trade theory of comparative advantages arguing countries gaining due to differences in the relative cost of producing different goods and services.

- from developing country's perspectives Stolper-Samuelson and Heckscher-Ohlin trade theories considered to be somewhat relevant as they argue:

-Income effect key to S-S theory –comparative advantages in the good that intensively uses the relatively abundant factor and hence free trade

increases the relative price of that good leading to increased real return of relatively abundant factor by an even larger percentage. It also argues that trade would reduce the return to the relatively scarce factor, though to a small degree and hence changes in commodity prices due to trade liberalization would magnify the resulting changes in factor prices. This means that there would be rise in relative returns to the abundant factor i.e. unskilled labor in the context of developing countries. On the grounds of expansion in labor intensive economic activities including employment, international trade is thus considered to be contributing to reduce poverty in developing countries markedly.

7

5. Channels and Mechanism of Trade Liberalization Affecting Poverty

- Impact of trade liberalization is transmitted through the effect on;

a. prices and availability of goods (expenditure channel) - lowering prices of imports as well as prices of substitutes leading to increase

people's real incomes.

- removal of export taxes or prohibitions may also help poor if they are net producers of exports (as is often true in agriculture).

- but may not be that much straightforward and the effect depends on; creation or destroying of local market, affect of lower prices of imports on small producers or subsistence farmers (i.e. production and consumption), price responses particularly in agriculture, transmission mechanism of border prices to the domestic consumers and above all market condition (monopoly or carteling).

b. factor prices and employment (income channel) - two factors may directly affect the wages and employment of the poor first, the

flexibility of labor markets constrained by labor regulations affecting the changes in real wages and second minimum wage legislation prohibiting downward adjustments in wages

- in view of highly flexible labor market with high elasticity of labor (mostly unskilled), adjustment to trade shocks would take place through changes in both employment and relative wages. Under such conditions, the costs of trade reform for the poor could be very large.

8

c. government revenue and spending (transfers, tariff revenues and other taxes)- reduction in tariffs would help raise revenue instantly but gradually may dampen

revenue with adverse effect on macroeconomic stability and more importantly on social expenditures hurting the poor -short run adjustment costs (volatility, risk),

d. other external shocks (global liberalization and terms of trade) - although trade liberalization would help diversify exports and reduce dependency on

domestic market so that domestic economic downturns could be offset by growth in the international trade, abrupt changes in the terms of trade would affect growth. Similarly, shocks directly affecting certain sectors, such as agriculture or informal production may have significant effects on the poor.

e. long term growth (investment/productivity gains)- Reduction in anti-export biases and more efficient allocation of resources leading to

higher investment and productivity gains would have positive effect on an economy's long-term growth.

- the relationship may not be straightforward and would depend up on the existence of other, complementary macroeconomic and structural policies and the appropriate institutions. One example could be overvaluation of exchange rate that may inhibit growth. More importantly, pattern of growth that disproportionately benefits the rich may lead to worsening of income distribution.

Important Key Factors for Positive Outcomes- existing initial conditions and structure of an economy,

- features, sequencing and their processes,

- state of market institutions and capacity to implement, and

- parallel policy measures including a mechanism to compensate potential losers.

9

6. What Developing Country Experiences Indicate?

Economic Growth and Poverty - if openness pushes countries into less dynamic sectors (e.g. primary extraction)

and hence hurts growth.

- despite uncertainty about the size of the effect, the best estimate is that trade restrictions are harmful to long-run growth.

- most of the empirical studies show a positive impact on poverty reduction. But emerging consensus is that trade liberalizations generally worsens inequality.

- a recent World Bank study ( 2005) on Latin America by reviewing the evidence on the effects of trade reform episodes on income inequality, wage inequality, skill premiums and demand for skills shows that in the late eighties and early nineties there were clear cut evidence of big increase in wage inequality and some moderate increase in the income inequality. Market failures (e.g., absence of access to credit or insurance), have increased both inequality and poverty indicating for the necessity of strengthening market institutions accompanied by effective redistributive policies.

- poverty effect of trade liberalization depends on the price changes impinging on poor households given their consumption and production bundles. Generally poor farmers could lose from higher prices or price variability. Border price shocks, market creation or destruction and household response determine the extent of positive and negative effect.

10

Wages and Employment

- Unlike traditional international trade theory labor supply in developing countries is perfectly elastic. In this case the wage will be fixed exogenously and moving workers into the formal sector will alleviate poverty only if the loss of labor in subsistence agriculture is so large that the workers remaining in that sector increase their ‘wage’. The employment effect of manufacturing is also found to be ambiguous.

- Although liberalization would generally raise the demand for relatively unskilled workers in many developing countries and so, on average, be poverty alleviating, there are bound to be exceptions e.g. possibly where natural resources dominate exports and where out-sourcing is important – as well as cases where segmented import-competing sectors suffer adverse shocks.

- Recent study show that despite skill intensity gains being apparent in developing countries, gains are generally outstripped by welfare loses owing to unskilled job losses and wage vulnerability.

Government Revenue and Spending

- Although reduction in tariffs may lead to an increase in trade tax revenues, subsequent move toward intensive trade liberalization may have losses in trade related tax revenues.

11

7. Conclusions and Policy Implications

- A thorough review of empirical studies does not help derive definite conclusions. But generally, increased demand for skills with possible employment or real wage losses to the unskilled. Moreover, the external and internal shocks emanating from absolute price rise or relative changes in prices may increase the vulnerability of the poor including marginal and small farmers. In many cases there has been market destroying effect with detrimental impact on small producers in both agriculture and non- agricultural sectors. All in all wage inequality, poverty traps and rising income inequality are some of the phenomenon observed in many countries.

- Under these circumstances, compensatory policies and programs would be essential to reverse the present unwarranted trend. The major steps to be taken are:

-Broad-based reforms for progressive transformation of society

-Consistency in Macroeconomic Polices through a Priory Ex-ante Impact Analysis.

-Complementary reforms:

- Infrastructure Development

- Development of Markets

- Suitable Labor Policy

- Social Safety Nets

- Asset Redistribution and Access to Social Capital

- Government Actions in Key Areas

12

THE END