A quarterly magazine of the IMF

September 2002, Volume 39, Number 3

Although there is a near-consensus among economists that trade liberalization strongly promotes growth and poverty reduction, concern about its ill effects has not abated. Hence, it is important to assess the quality of the evidence regarding the links between openness, growth, and poverty reduction. This article provides a critical survey of recent studies.

One of the most common criticisms of trade liberalization and globalization, particularly in developed countries, is that it drives down wages and exports jobs to low-wage economies. Critics see the creation of a global "sweatshop economy" in which corporations pit workers around the world against each other in a race to the bottom to see who will accept the lowest wages and benefits. In contrast, developing countries worry about a brain drain to the North of their most skilled workers and fear that greater openness and economic liberalization will bankrupt domestic industries overwhelmed by foreign competition. What is the basis for believing that reducing trade barriers and opening economies up to competition can increase wealth and help reduce poverty?

We focus on the links between trade and growth, for the simple reason that changes in average per capita income are the main determinant of changes in poverty. Over the past 20 years, the share of extremely poor people in the world (those living on less than two 1985 dollars a day) has fallen sharply, from 38 percent in 1978 to 19 percent in 1998. This decline is almost entirely attributable to growth itself, not to changes in income distribution. The irrelevance of changes in income distribution in explaining changes in overall poverty over the past 20 years is not a coincidence. In general, income distributions move around much less over time than does average per capita income. Thus, most variation in the income of the poor is a result of changes in average income, not changes in income distribution.

But how important is the contribution of trade openness to higher incomes, and how does trade openness affect poverty and inequality? We attempt in this article to cut through the mass of material on this topic by focusing on a number of key issues and by keeping in mind a few important methodological concerns. One such concern is the measurement of openness. The openness of an economy is the degree to which foreigners and nationals can transact without government-imposed costs (including delays and uncertainty) that are not levied on a transaction between two domestic citizens. Tariffs and other charges, nontariff barriers, domestic content requirements, and health and safety requirements (or inspection delays) above and beyond those imposed on domestic products raise the cost of buying from abroad.

As should be clear from this definition, it is extremely difficult to compare degrees of openness over time or, especially, across countries. In our survey of empirical work, we necessarily take an eclectic approach. We consider case studies and microeconomic studies, which often allow for the most detailed and careful measurement of trade barriers. We also consider many analyses that use policy-based measures, particularly the work of Jeffrey Sachs and Andrew Warner. Finally, we look at studies using outcome-based measures of openness, such as the share of exports and imports in GDP. In a foreshadowing of our own conclusion, it turns out that measurement error is not strong enough to bury the positive effect of trade on growth.

A second methodological concern is that we pay close attention to the difference between opening and openness. Considerable trade restrictions remain in many economies that have opened substantially, for example, and trade opening may increase growth for a time even in an economy that remains quite closed (and poor). Thus, we might look for a relationship between trade opening and growth, or between trade openness and the level of incomes, but it would, in general, be a mistake to expect one between, say, growth and the level of trade openness.

Openness and average incomes

We look in our paper at various pieces of evidence on the relationship between trade and growth—cross-country regressions, case studies, and firm- and industry-level analyses. The story that emerges is overwhelmingly that openness contributes greatly to higher productivity and income per capita and, similarly, that opening to trade contributes to growth. Empirical work from the past 15 years has concentrated on cross-country and panel regression analyses. Many papers have concluded that openness to trade is a significant explanatory variable for the level or the growth rate of real GDP per capita. Rather than review the many papers in this area, we concentrate on two complementary strands.

The first looks at the relationship between levels of income and trade openness across countries. Research by Robert Hall, Charles Jones, Andrew Rose, Jeffrey Frankel, and others has shown that the huge differences across countries in the level of output per capita are systematically and importantly related to openness.

This result holds up across various measures of openness, when the possible feedback from income to openness is controlled for and when a variety of other variables that may explain income are included. It also turns out, though, that institutional quality—defined broadly as the rule of law, the effectiveness of the government, and so on—is also an important determinant of cross-country variation in the level of productivity and income per capita. Moreover, institutional quality is closely correlated with openness. It is thus difficult to separate the effects of openness and institutional quality in a satisfactory way in this context.

In an effort to unravel the overlap between openness and institutional quality, we turn to a second strand of analysis that examines the relationship between changes in openness and changes in per capita GDP over time within countries. This approach avoids the difficulty associated with distinguishing the roles of slowly changing geographic, institutional, and cultural factors from trade openness by looking only at these differences over time.

The basic result is that changes in trade volumes are important determinants of changes in growth, after controlling for possible reverse causality from growth to trade. David Dollar and Aart Kraay estimate that an increase in the trade share of GDP from 20 percent to 40 percent over a decade would raise real GDP per capita by 10 percent. For example, if a country with a trade share of 20 percent of GDP and 1 percent annual growth in real per capita GDP were to raise its trade share to 40 percent, real per capita GDP growth would increase to 2 percent a year. This result turns out to hold even when other control variables are included.

Case studies have also shown the benefits of trade liberalization. Perhaps the central finding of the large multicountry studies of trade liberalization in the 1970s and 1980s was how distortionary the import-substituting regimes were before liberalization. In more recent years, a variety of studies have followed this approach, attempting to define liberalization episodes in a sample of cases and examine the effects. They also find that strong and sustained liberalization episodes result in rapid growth of exports and real GDP.

Recent studies at the firm and industry levels have delineated some of the ways that trade liberalization and the resulting increase in import competition work to increase productivity and, hence, growth. Trade helps spread knowledge that contributes to productivity, partly through access to imported inputs. It lowers margins and increases turnover and innovation. Exit of firms is only the most visible part of the story—entry of new firms is also higher in sectors that liberalize imports.

Clearly, import competition helps. So does an emphasis on exports. While many studies have shown that exporting firms are more productive, the reasons are harder to establish. Recent evidence from several African countries and China, however, reveals unusual increases in productivity after firms begin to export. Moreover, recent evidence from East Asia suggests that firms aim at export markets, so that even pre-entry productivity increases are, at least in part, due to the promise of the export market. Finally, exporting firms are highly productive, and exporting allows them to grow faster. Thus, over time, resource shifts into these higher-productivity plants increase economy-wide average productivity.

In sum, the weight of the evidence is overwhelming on the positive effect of openness on growth. Now we turn to the question of whether the usual strong association between growth and poverty reduction is somehow modified by openness.

Openness and the poor

There are strong reasons to suppose that trade liberalization will benefit the poor at least as much as it benefits the average person. Trade liberalization tends to reduce monopoly rents and the value of connections to bureaucratic and political power. In developing countries, it may be expected to increase the relative wage of low-skilled workers, who are likely to be scarcer in the more developed world economy than at home. Liberalization of agriculture may increase (relatively low) rural incomes. If, nonetheless, trade liberalization worsens the income distribution enough, then it is possible that it is not, after all, good for poverty reduction, despite its positive overall effect on growth.

After examining the cross-country evidence and reviewing some of the vast microeconomic literature on the effects of trade liberalization on income distribution, we find that there is no systematic relationship between openness and the income of the poorest, beyond the positive effect of openness on overall growth. The aggregate evidence shows that the income of the poorest tends to grow one-for-one with average income. Of course, in some countries, the poor sometimes do better than average, and sometimes they do worse. But, as Dollar and Kraay have shown, openness does not help explain which of these outcomes occurs. On the question of whether the poor benefit more or less than others, no clear pattern emerges from the numerous studies of individual liberalization episodes. This is not surprising, as any particular liberalization will change relative prices and incentives throughout the economy in idiosyncratic ways.

Positive spillovers

Much of the evidence in favor of openness spurring growth and reducing poverty is vulnerable to the criticism that the effect of openness has not been isolated from that of many other reforms that were often implemented at the same time. In our view, the fact that trade openness tends to happen at the same time as other beneficial reforms and, indeed, is associated with strong institutional environments is an econometric problem but also a policy opportunity. First, insofar as the evidence gives us a lead, it suggests that openness is a particularly important component of reform. Second, there is little evidence that other reforms must precede effective trade reform, though there are many reforms that are complementary. Finally, trade openness has positive spillovers on other aspects of reform so that, on the whole, the correlation of trade with other proreform policies speaks to the advantages of making openness a primary part of the reform package.

In our view, there are few true preconditions—that is, conditions in the absence of which trade openness is a poor idea. Openness seems to promote growth in the poorest countries at least as well as in others. For example, in closed economies, low initial income reduces potential benefits from economies of scale, suppressing growth. But trade openness, by allowing access to broader markets, helps overcome this impediment. To this extent, the poorest economies, with the smallest home markets, may benefit the most. More broadly, there is little evidence of a "growth trap" in the sense of a situation in which countries become too poor to take off. The growth miracles of the twentieth century occurred in countries starting far behind the richest.

Many factors can make trade reform more successful, or less so. For example, a more egalitarian initial income distribution implies that a given amount of average growth has a larger impact on the poverty rate, all else held equal. Certain factors, such as higher rates of education, may permit the poor to benefit more fully from growth. Of course, these are arguments not against trade reform but rather in favor of pursuing these complementary reforms as well.

The most important set of relationships, in our view, has to do with positive spillovers from trade reform. In many cases and in many ways, trade liberalization is itself a precondition or a complement to other sorts of reforms and thus facilitates their success. Openness provides powerful channels for feedback on the effect of various policies on productivity and growth. For example, competition with foreign firms can expose inefficient industrial policies. Trade raises the marginal product of other reforms, in that better infrastructure, telephones, roads, and ports translate into better performance of the export sector. Moreover, though less visibly, productivity for domestic goods rises as well. Trade liberalization may change the political reform dynamic by creating constituencies for further reform.

It is sometimes argued that an absence of adequate prior institutional reform may limit the gains from openness. In our view, strong institutions are likely to be a powerful complement to trade liberalization, but there is little or no evidence to suggest that waiting for institutional reform is a good idea. On the contrary, there is strong evidence that openness may encourage institutional reform and, in particular, reduce corruption. Corruption is higher in countries where domestic firms are sheltered from foreign competition, and the estimated size of this effect is large.

Conclusion

Openness is not a "magic bullet"; much else matters for growth and poverty reduction. But this conclusion should not distract us from the importance of trade liberalization in developing countries. Trade is only one aspect of the development process. However, the breadth of evidence on openness, growth, and poverty reduction, and the strength of the association between openness and other important determinants of high per capita income, such as the quality of institutions, should give long pause to anyone contemplating the adoption of a novel (or tested and failed) development strategy that does not center on openness to trade.

This article is based largely on a paper titled "Trade, Growth, and Poverty: A Selective Survey" presented at the Annual Bank Conference on Development Economics in April 2002.

Reference:
David Dollar and Aart Kraay, 2001, "Trade, Growth, and Poverty" (unpublished; Washington: World Bank).