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Free-trade sceptics: Wrong again

 Thanks to a handful of vocal free-trade sceptics among economists, pro-free-trade economists never have to fear being rendered redundant.

In a recent article in The Guardian (December 12, 2005), Larry Elliott writes that according to Harvard economist Dani Rodrik, the experiences of Vietnam and Mexico illustrate why liberal trade policies contribute precious little to economic prosperity.

"Take Mexico and Vietnam, he [Rodrik] says. One...has had a free-trade agreement with its neighbour across the Rio Grande. It receives oodles of inward investment and sends its workers across the border in droves. It is fully plugged into the global economy. The other was the subject of a US trade embargo until 1994 and suffered from trade restrictions for years after that. Unlike Mexico, Vietnam is not even a member of the WTO."

 "So which of the two has the better recent economic record? The question should be a no-brainer if all the free-trade theories are right - Mexico should be streets ahead of Vietnam. In fact, the opposite is true. Since Mexico signed the Nafta (North American Free Trade Agreement) deal with the US and Canada in 1992, its annual per capita growth rate has barely been above 1%. Vietnam has grown by around 5% a year for the past two decades. Poverty in Vietnam has come down dramatically: real wages in Mexico have fallen."

Like the other arguments against trade liberalisation by Rodrik, this one also appears plausible at first sight but collapses in the face of careful scrutiny. Thus, begin with a closer examination of Vietnam.

To be sure, Vietnam has been a huge success. Its GDP grew at 5.2% during the three-year period spanning 1989-91. In the following six years, 1992-97, the growth rate jumped to 8.8%. The Asian crisis saw the rate decline some but
the economy still managed to clock a rate of 5.8% during 1998-00. As one would expect, this rapid growth helped "pull-up" vast numbers out of poverty. The proportion of those living in absolute poverty fell from 78% to 37% between 1988 and 1998.

 f Vietnam had achieved this impressive growth in the absence of low or declining protection, it would indeed offer a serious indictment of pro-free-trade economists. But it did no such thing: Vietnam's exports of goods and services as a proportion of the GDP grew from 31% in 1991 to 55% in 2000. Because the rise took place during a period of very high GDP growth, the growth rate of exports of goods and services was truly impressive: 28% during 1991-01.

Sceptics would, no doubt, counter that this export growth proves nothing since the causation may have been running in the reverse: from GDP growth to export expansion. While there is no doubt that there is two-way causation between export and GDP growth, one has to be in Alice's Wonderland to argue that openness was not crucial to the expansion of Vietnam's trade. No amount of GDP growth can produce any export growth if a country effectively outlaws trade. In order for water to flow, the tap must be open. True, as water pressure grows, water would flow at a faster rate but you would take full advantage of the increased pressure only by opening the tap further.

To put the argument positively, trade policies in Vietnam underwent significant liberalisation along virtually all dimensions including external trade and investment during the period under consideration. Under the old regime, trade was primarily with the Soviet bloc countries. And it was regulated by shipment-by-shipment licences and import and export quotas using a multiple exchange rates system.

 Reforms resulted in all foreign transactions being done in convertible currencies by 1993. The multiple exchange rates were unified in 1989 and a series of devaluations helped eliminate the general bias against the traded goods. Import and export controls were relaxed and trade progressively moved from the licence-based to tariff-based regime. By 1995, export quotas had been removed on all products except rice and import quotas were limited to six items. Steps were taken to liberalise foreign investment throughout the 1990s.

What do we make of the lack of WTO membership and the US trade embargo? Traditionally, the large majority of the WTO members have granted their most-favoured nation (MFN) tariffs to non-members in the expectation that the latter would eventually become WTO members.

As a result, non-members have not been hugely disadvantaged as along as they themselves play by the WTO rules. The main exception for Vietnam was the United States, which subject it to a trade embargo until 1994. But such embargoes are almost never successful in preventing determined exporters unless they are applied by virtually all countries, as was done against South Africa under the apartheid. With the huge European and Asian markets open to them, Vietnamese exporters were not constrained on the demand side.

 While Vietnam, thus, bolsters rather than undermine the case of pro-free-trade economists, what about the poor performance of Mexico? Here  it bears reminding that careful pro-free-trade economists have always pointed to low or declining trade barriers as a necessary though not sufficient condition for rapid growth. Slow growth may result despite a liberal trade regime because of the absence of a variety of complementary factors such as macroeconomic stability, good governance, sound infrastructure and a competitive exchange rate.

The question we must ask is whether Mexico's performance would have been better, had it been closed to trade, foreign investment and outward flow of labour. Would Rodrik advise Mexico to close its borders to the flow of goods, foreign investment and labour flows? 

One final word: a country greatly enhances its chances of producing world-class cricketers such as Sachin Tendulkar if it opts to play test cricket. By limiting its team to state, district or college-level cricket, the country is likely to condemn its players to mediocrity. Entrepreneurship is no different.

Economic Times January 25, 2006