Sunday, 27 January 2008

Trade Liberalization and Economic Growth: China's Example

I thought I would finally write an essay again. This one includes a bibliography because readers pointed out that I should include sources to back up what I say.

In light of the rapid development of economies in Asia, the relationship between trade liberalization and growth has received a great deal of attention. Studies have analyzed the effect of international trade on economic development; however, none have established a causal relationship between liberalization policies, trade and growth that is free of criticism. This essay seeks to discuss the benefits for economic growth from liberalization and international trade in the context of Chinese reform. First, it will first address the theoretical benefits of unrestricted trade, as presented by the neo-classical comparative advantage model. Second, it will discuss China’s liberalization policies and the effect of international trade on its economic growth. Finally, it will present what can be learned from the collective case of developing countries pursuing liberalization strategies during the 1980s and 1990s.


That openness to international trade can lead to increased economic growth is a popular belief in contemporary economic thought. The theoretical conceptualization of the benefits of unrestricted trade may be traced to David Ricardo’s 19th-century principle of comparative advantage. The principle states that each country should specialize in the production of those goods and services with the lowest opportunity costs. Countries should trade surpluses of these products in the international market for others that would be relatively more expensive to produce domestically. In doing so, trading economies benefit from being able to consume beyond what they could in the absence of imports. In the neo-classical conception, this leads to a system whereby societal welfare and global GNP are maximized through international trade.

This principle has some important theoretical implications for economic growth. First, increased trade volume can itself yield a positive impact on national income. Second, given relative opportunity costs, developing countries will concentrate on the production of labor-intensive goods, while importing capital-intensive products. The importing of advanced products leads to the diffusion of new technologies into the domestic market. This factor, harnessed through reverse engineering and the import of foreign equipment, can exert a significant positive effect on economic growth.

Independent of the comparative advantage principle, foreign trade, in theory, can yield other important benefits for economic growth. Lardy (1995) states that outwardly oriented economies are more likely to achieve higher rates of savings and investment, and greater efficiency in the use of investment resources in comparison to their inward-looking counterparts. That is, import substitution policies will result in an allocation of resources that is inherently inefficient. Second, international competition may stimulate technical development and efficiencies. In the case of the East Asian ‘tiger’ economies, the World Bank argues that the promotion of exports led to rapid productivity growth, driving high levels of national income growth.

China's as an example:

Since the commencement of economic reforms towards the end of the 1970s, China has enjoyed accelerated levels of trade and economic growth. Over these years, China has experienced an average annual GNP growth rate of over 9 per cent. In terms of purchasing power parity, the nation’s economy has become the second largest in the world. In particular, China’s open-door policy has facilitated a dramatic 128% average annual increase in total trade between 1978 and 1993 (Lardy 1995).

This rise in China’s foreign trade, and the benefits it has had for economic growth, are the results of successful reform policy implementation. The overall thrust of the strategy was a drive away from import substitution and toward export promotion. Prior to reform, two characteristics marked China’s international trade policy: trade restriction and exchange rate control. Reforms decentralizing foreign trade, rationalizing the foreign exchange system, and creating special economic zones were undertaken to address these issues.

In the decade between 1979 and 1990, the number of firms permitted to engage in foreign trade was raised from only a dozen to over 8,000 (Lu 1995). After the passing of the foreign investment law in 1979 and the establishment of special economic zones the following year, the number of foreign-invested firms engaging in export activities expanded dramatically. By 1990, over 174,000 foreign-invested enterprises enjoyed international trade rights.

Foreign exchange reforms, allowing exporting enterprises to retain an amount of their foreign currency earnings, were first debuted in 1979 under the retention scheme. In 1986, a swap, or secondary market for foreign exchange was introduced. By 1993, 80% of foreign exchange earnings were priced at the swap rate. Finally, in 1994, the official and swap exchange rate markets were unified and a managed float system was created. These reforms, among others, facilitated the free availability of foreign exchange for use in trading activities.

The effects of China’s reform policies had a great impact on the growth of the nation’s economy. Immediately after currency market integration in 1994, exports grew over 30% and in the first eight months of 1995, by 37% (Lu 1995). China realized a distinct comparative advantage in the production of labor-intensive manufactured goods. Imports primarily came from capital-intensive or relatively advanced service sectors. Kou and Lou (1999) state that advanced technology imports and management skill acquisition from developed countries have greatly improved productivity in agricultural and industrial sectors and China’s competitiveness in international markets. China’s export growth pattern is also very similar to those of the high-performing economies of East Asia identified by the World Bank. Though it is very methodologically difficult to isolate these effects, China is likely to be experiencing similar total factor productivity improvement.

Discussion and Extrapolation:

The theoretical benefits of international trade, coupled with China’s liberalization success together pose the question: does trade liberalization policy generally have a positive effect on economic growth?

Empirically, evidence points to a positive relationship between the pursuit of open-door policies, trade growth and economic growth. After 1980, developing countries that have pursued tariff cuts and other trade liberalizing measures have enjoyed trade growth and economic growth greater in magnitude than developed and non-liberalizing counterparts. Dollar and Kraay’s seminal 2004 study presents evidence that, over the 20 years leading up to 2004, trade among such economies doubled from 16% to 33% of GDP. Aggregate annual economic growth rates for the group grew from 3.5% in the 1980s to 5.0% in the 1990s. The growth rates of rich countries slowed over this period, while the annual growth rates of non-globalizing poor economies were lower in the 1990s than they were in the 1970s.

While the conclusion that trade liberalization can lead to increased trade and economic growth appears to be clear, it must be looked upon with caution. China and all the liberalizing economies of the 1980s and 1990s also pursued fiscal adjustment, stabilization policies, capital market reform, and the strengthening of property rights. Isolating the effect of trade liberalization and exchange rate reform, as was performed by China, is very methodologically difficult. Though studies such as Sachs and Warner (1995) state that trade policy openness exerts a positive effect on growth, Rodriguez and Rodrik (2000) criticize their econometric methodology. Therefore, we may conclude that trade liberalization can have positive effects on economic growth; however, it must occur in tandem with other reforms as well.

Works Cited

Dollar, D, and A Kraay. "Trade, Growth, and Poverty." The Economic Journal 114 (2004).
Frankel, J, and D Romer. "Does Trade Cause Growth?" The American Economic Review 89 (1999): 379-399.
Koo, W W., and J Lou. "Role of International Trade in Chinese Economic Development." Review of Development Economics 3 (1999): 98-106.
Koo, W W., and J Lou. "Role of International Trade in Chinese Economic Development." Review of Development Economics 3 (1999): 98-106.
Lardy, N. "The Role of Foreign Trade and Investment in China's Economic Transformation." The China Quarterly 144 (1995): 1065-1082.
Lu, W. Reform of China's Foreign Trade Policy. Department of the (Australian) Parliamentary Library. Parliamentary Research Service, 1995.
Rodriguez, F. and Rodrik, D. (2000). ‘Trade policy and economic growth: a skeptic’s guide to the cross-national evidence’, in (B. Bernanke and K. Rogoff, eds.), Macroeconomics Annual 2000, Cambridge
MA: MIT Press for NBER.
Sachs, J.D. and Warner, A. (1995). ‘Economic reform and the process of global integration’, Brookings Papers on Economic Activity, no. 1, pp. 1–118.
Winters, L A. "Trade Liberalization and Economic Performance: an Overview." The Economic Journal 114 (2004): f4-f21.