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For Maximum Economic Growth from Trade Liberalization, Countries Should Consider Complementary Domestic Reforms

December 5, 2005Recent World Bank research suggests that countries should complement trade openness with greater flexibility of their investment climate and labor markets, and pay more attention to other key areas such as governance and infrastructure, among others.

As multilateral trade policies are debated during the Doha round of trade negotiations, it is clear that developing countries seeking to boost growth generated by trade liberalization should also build strategies for other domestic reforms.

Improve business climate before (or while) undertaking trade reform

Trade boosts growth in flexible economies, but its positive impact is much reduced—and in some cases, even reversed—in excessively regulated economies,” says Caroline Freund, Senior Economist in the World Bank’s Trade Research Team.

Trade stimulates growth by directing resources into their most productive uses both within and across industries. An excessive regulatory burden prevents this reallocation of resources from occurring, reducing the prospects for trade-generated growth.

Trade in most regulated economies - feature story 

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In fact, an analysis of over one hundred countries by Bolaky and Freund shows that in heavily regulated economies, increased openness is actually associated with a lower standard of living.

Governments clearly need to develop strategies to improve investment climate at the same time as—if not before—undertaking trade reform, their research suggests.

The good news is that some of the steps that heavily regulated economies need to take are easy and inexpensive. For example, it does not cost much to reduce excess procedures for registering a new business. New technologies can also facilitate deregulation, such as implementing an online registration system.

However, complications can arise because of interest groups that stand to lose in a more flexible environment. This is almost always the case with deregulation.

Where the cost of complementary reform is high, governments should be assisted by means of “aid for trade”, as has been recommended in the World Bank’s Global Monitoring Report 2005.

Trade in least regulated economies - feature story 

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Countries that have grown through trade that are not burdened by excessive regulations include Thailand, Malaysia and Chile.

On the other hand, Brazil, Argentina and Mozambique are examples of heavily regulated countries that appear not to have experienced much trade-related growth.

Analyze other aspects of the economy that may require reform

You can’t do aerobics wearing a suit of steel armor—or compete when burdened by inflexible conditions,” says Norman V. Loayza, Lead Economist in the Bank’s Growth & Investment Research Team. “The success of openness depends on whether firms can adjust quickly to the new conditions imposed by international competition.”

Chang, Kaltani, and Loayza recently analyzed six economic and institutional characteristics that influence this flexibility—educational investment, financial depth, public infrastructure, governance, labor market rigidity, and ease of firm entry.

Doing well in these areas clearly correlates with stronger trade-related growth, suggesting that countries may need to simultaneously undertake reform in several areas in order to benefit from trade openness.

This analysis can be applied to any country to help identify the areas requiring reform, allowing relevant characteristics to be studied in more detail. This helps design a policy package tailored for a particular country, as opposed to a “one-size-fits-all” approach.

For example, Loayza and co-authors found that Peru particularly needs to improve its port infrastructure, apart from general improvements in labor market and firm entry flexibility, to get the maximum trade-related growth.

The next step in this line of research is to analyze the reform process itself,” says Loayza. “Many countries do not implement even simple, low-cost, obvious reforms, and we need to understand the dynamics at play in the political economy.”

The Researchers

Caroline Freund
A one-time Peace Corps volunteer in Ghana, Caroline Freund is a senior economist in the International Trade Team, Development Research Group. She obtained a Ph.D. in economics from Columbia University. Before joining the World Bank, she was an economist in the International Finance Division of the Federal Reserve Board. She is currently doing research on regional integration, geography and trade, current account adjustment, and remittances. More...

Norman Loayza
Norman Loayza is a lead economist in the World Bank’s Development Research Group. He received a Ph.D. in economics from Harvard University in 1994. Since then, he has worked at the World Bank, with an interruption of two years (1999-2000) when he worked as senior economist at the Central Bank of Chile.  Norman has taught post-graduate courses and seminars at the University of the Pacific in Lima, the Catholic University of Chile, and the University of Sao Paulo. He has studied several areas related to economic and social development, including economic growth, private saving, financial depth, monetary policy, trade openness, poverty alleviation, and crime prevention.  He has edited five books and published more than thirty articles in professional journals. More...

References




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