The Impact of Trade Liberalization on Developing Countries' Trade Balances with Industrial and Developing Countries: An Econometric Study

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ABSTRACT

This paper examines the impact of trade liberalization on the merchandise trade balance for a sample of developing countries that have adopted trade liberalization policies. The impact is differentiated according to the destinations and origins of the exports and imports, whether they are developing or industrial countries. This is important as one of the arguments for protection is based on the assumption of asymmetry in the elasticities of products traded between developing and industrial countries, and this asymmetry leads to disparity in economic growth. The paper shows that the impact on the merchandise trade balance differs between the two groups of trading partners; there is weak evidence that the trade balance worsens (increase in deficit) for trade with developing countries, but the trade balance improves (increase in surplus) for trade with industrial countries.

Keywords: Trade Liberalization, Trade Balance

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I. INTRODUCTION

The objective of the paper is to empirically examine the impact of trade liberalization on developing countries' trade balance with industrial and developing countries. Many developing countries have liberalized their trading regime with the hope of gaining static and dynamic gains from trade, and that the liberalization will increase both the growth of exports and imports, and, consequently, improve welfare. However, trade barriers are still relatively high in many developing countries. This is because a more liberal trade regime may invite the possibility of worsening trade balance, as the impact of liberalization depends on the relative increase in the growth of imports and exports and the prices of the product traded (Santos-Paulino and Thirlwall, 2004).

In spite of claims of the irrelevancy of current account deficits;1 for instance, Corden (1994) argued that an increase in the current account deficit should not be a matter of concern. But Khan and Zahler (1985) have shown that payment deficits due to liberalization are unsustainable and changes in the real exchange rate are too slow to rectify the problem. Furthermore, Edwards (2002) shows that current account reversal due to prolonged current account deficits may lower economic growth; it may even lead to economic crisis. Milessi-Ferretti and Razin (2000) emphasized the dangers of large current account deficits that must be compressed when external financing dries up.2,3 Hence, even though trade liberalization may promote growth from the supply side-for example, by encouraging competition and more efficient use of resources- if the current account worsens due to greater increase in import than export growth, economic growth may be thwarted from the demand side (McCombie and Thirlwall, 1994). Thus, knowing the impact of trade liberalization on trade balance is important, as it will affect economic growth.

Another important consideration with respect to the impact of trade liberalization on the trade balance and economic growth is that the income elasticity of products traded between developing and industrial countries are different. The Prebisch-Singer (PS) hypothesis, which leads to the push for the import substitution policy, assumes that the income elasticity of products traded by developing and industrial countries is different. Developing countries are exporting low-income elasticity products, while importing high-income elasticity products; industrial countries are importing low-income elasticity products while exporting high-income elasticity products. If the trade liberalization process further strengthens the differences in the income elasticity, it may further increase the income and growth disparity. If the PS hypothesis presumption holds true, developing countries which liberalized their trading regime will have a much faster growth of imports from industrial countries than their exports to industrial countries; consequently, the liberalization process will increase developing countries' trade deficit with industrial countries. …