Efficiency Effects of Trade Liberalization: Theoretical Insights and Empirical Evidencefrom Argentina 1987-1995 9783964567017

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Axel Pols Efficiency Effects of Trade Liberalization

Göttinger Studien zur Entwicklungsökonomik de Desarrollo Económico in Development Economics Edited by Hermann Sautter

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Göttinger Studien zur Entwicklungsökonomik

Efficiency Effects of Trade Liberalization Theoretical Insights and Empirical Evidence from Argentina 1987-1995

Axel Pols

Vervuert • Iberoamericana • 1999

Die Deutsche Bibliothek - CIP-Einheitsaufnahme

Pols, Axel: Efficiency effects of trade liberalization : theoretical insights and emprical evidence from Argentina 1987 - 1995 / Axel Pols. - Madrid : Iberoamericana ; Frankfurt am Main : Vervuert, 1999 (Göttinger Studien zur Entwicklungsökonomik, de desarollo económico, in development economics ; 7) Zugl.: Göttingen, Univ., Diss., 1998 ISBN 84-95107-46-5 (Iberoamericana) ISBN 3-89354-177-2 (Vervuert)

© Iberoamericana, Madrid 1999 © Vervuert Verlag, Frankfurt a m Main 1999 All rights reserved Printed on acid free paper Printed in Germany

To my parents Anneliese and Albert Pols

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Acknowledgements

It is a pleasure to acknowledge the support of a considerable number of people who have in some way or other contributed to the successful completion of this piece of work. First of all, I wish to thank my supervisor Prof. Dr. Hermann Sautter. His patient support and steady encouragement have been essential for the accomplishment of this study. The Ibero-America Institute and its staff members have also been a constant source of support. In particular, I am grateful to Dr. Felicitas NowakLehmann D. who provided useful comments upon reading the entire manuscript and who was always prepared to discuss my 'work in progress'. I am also indebted to Matthias Blum for many fruitful discussions and associated 'knowledge spillovers'. Dr. Rolf Schinke was helpful in preparation of my research visit to Argentina. In this context I am thankful to Prof. Dr. Gerardo della Paolera for inviting me to the Universidad Torcuato Di Telia and to Dr. Adolfo Canitrot for extending this invitation to the Instituto Torcuato Di Telia. Apart from providing generous logistic support the Instituto/Universidad proved to be a stimulating research environment. I benefited a lot from discussions with, among others, Profs. Juan Carlos Torre, Julio Berlinski and Andrés Regalski. Of the various people who helped me gather the data and information necessary to carry on with this research project I am particularly indebted to Jorge Robbio (IDI), Osvaldo Kacef (IDI), Bernardo Kosacoff (CEPAL), and Federico Dorín (MEOSP). Mabel Villegas and Stella de Gregorio of the Di Telia library were also extremely helpful and understanding. More generally, I thank all those people who allowed me to include them in the series of interviews that I conducted during my stay in Buenos Aires. I would also like to mention Patricia Mascarenhas and her son Tomás, who provided me with a wonderful home in Argentina and greatly enriched my stay and knowledge of their country. In addition, I wish to thank the German Academic Exchange Service (DAAD) for its financial support of my research in Argentina. Furthermore, I thank Prof. Dr. Wolfgang König who acted as co-examiner and Prof. Dr. Walter Zucchini who kindly answered my questions with regard to some of the

8 econometric concepts involved. I am also grateful to the participants of the research seminar at the Ibero-America Institute who have regularly commented on my work. The helpful suggestions I received from Moritz Kraemer are greatly appreciated too. Special thanks go to Christoph Semes and Uwe Mummert, who were always ready to share their views and ideas with regard to my dissertation project and, in addition, provided moral support during the ups and downs in the last couple of years. Most of all, however, I wish to express my gratitude to my parents, Anneliese and Albert Pols, whose backing gave be the necessary confidence and persistence to accomplish this study. Axel Pols

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Foreword Since the mid-1980s Argentina, like some other Latin American countries, performed a dramatic change in its trade policy. Non-tariff as well as tariff barriers to trade have been reduced in a substantial way. Increasingly, the country moved from its former protectionist trade regime towards free trade. From a theoretical point of view this liberalization process will re-allocate resources to productive uses, stimulate competition and increase factor productivity; in short: it makes the economy more efficient. The question is, whether this effect can be proved empirically. Pols gives an answer to this question: liberalizing foreign trade has indeed positive effects on economic efficiency. Pols starts out his analysis by describing the different episodes of Argentine trade reform since 1987 and the accompanying policies: the exchange rate management during 1987 to 1990 and the "convertibility law" of 1991, the privatisation of public enterprises and the deregulation of the domestic economy. Moreover, he examines the factors that have motivated and influenced the reform process. He comes to the conclusion that the impetus to trade policy reform came from within the government (partly in response to pressure exerted by IMF/World Bank) rather than from the intervention of organized domestic interests. Yet, vested interests have had some influence on the actual implementation of trade policy reform, especially during the early phase of reform (1987-1988) when they succeeded in watering down the adopted measures. This influence apparently declined during the period from 1989 to 1992, when the duely elected government decided to intensify the reform process. After discussing on a theoretical level the various efficiency gains of trade liberalization (allocative efficiency, scale efficiency, technical efficiency, x-efficiency), Pols presents his empirical analysis. He focuses on the impact of trade liberalization on labour productivity and price-cost margins in the Argentine industry during the period from 1990 to 1995 and 1984 to 1993, respectively. Based on his careful economic analysis, Pols comes to the following conclusion: trade liberalization has made a relatively small but statistically significant contribution to both reduction of price-cost

10 margins and increases in productivity. Thus, what was to be expected from a theoretical point of view is validated by empirical analysis. The evidence suggests, that industry rationalization (via share-reallocation from less efficient to more efficient firms) and technological change have been the relevant mechanisms through which trade liberalization led to productivity gains. These results demonstrate the economic advantages of trade policy reforms implemented in Argentina since the mid-1980s. But liberalizing trade may not be sufficient in order to increase labour productivity in a substantial way; following Pols other facts were more important (especially output growth - a result reached by paying due attention to methodological and econometric problems). This merely indicates that trade liberalization should be supplemented by political measures that strengthen economic growth (especially human capital accumulation and technical as well as organizational progress). With his excellent empirical work, Pols substantiates this conclusion. He presents a well written study which improves our knowledge of the empirical effects of trade policy reforms. Gflttingen, April 1999 Hermann Sautter

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Contents

List of tables

14

List of figures

15

List of abbreviations

17

1 Introduction

19

2 Trade liberalization in Argentina since 1987 and accompanying policies

23

2.1 Trade liberalization since 1987: Motives and measures

23

2.1.1 Definition of trade policy and trade liberalization

24

2.1.2 Background: Argentine trade policies before the recent policy reforms .27 2.1.2.1 The period of import substitution industrialization

27

2.1.2.2 Episodes of trade liberalization in the 1960s and 1970s

28

2.1.2.3 The re-closure of the economy in the early 1980s

29

2.1.3 Gradual trade liberalization 1987-1988

31

2.1.3.1 Motives for the initiation of trade liberalization

32

2.1.3.2 Implementation of trade liberalization 1987-1988

35

2.1.4 Intensification of trade liberalization 1989-1991

38

2.1.4.1 Motives for intensifying trade liberalization

39

2.1.4.2 Implementation of trade liberalization 1989-1991

42

2.1.5 Consolidation of trade policy reform since 1991 and some new protectionist measures 2.2 Accompanying policies 2.2.1 Exchange rate policy during trade liberalization

45 49 49

2.2.1.1 Exchange rate management during 1987 to 1990

50

2.2.1.2 Exchange rate policy since April 1991: The Convertibility Law

52

2.2.2 Privatization

55

2.2.3 Deregulation of the domestic economy

57

2.2.3.1 Deregulation of the domestic market for goods and services

57

2.2.3.2 Labour market reform

58

2.3 Short summary

59

12 3 Does trade liberalization bring greater efficiency? Theoretical insights and empirical evidence 3.1 Efficiency gains of trade liberalization under perfect competition

61 63

3.1.1 The gains of free trade for a small economy

63

3.1.2 The cost of tariff protection

68

3.1.3 The cost of non-tariff protection: The quota case

70

3.1.4 Cost of protection due to rent-seeking

72

3.2 Efficiency effects of trade liberalization under imperfect competition

74

3.2.1 Introduction

74

3.2.2 Trade liberalization and domestic market power

76

3.2.2.1 Domestic monopoly

78

3.2.2.2 Domestic oligopoly

82

3.2.3 Trade liberalization and economies of scale

86

3.2.3.1 Market expansion via participation in world markets

87

3.2.3.2 Demand shifts, reduced market power, and output expansion

88

3.2.3.3 Industry rationalization 3.2.4 Trade liberalization and x-efficiency 3.2.5 Trade liberalization and technological change

90 104 108

3.2.5.1 Trade policy, domestic market structure, and innovation

108

3.2.5.2 Trade and endogenous growth

112

3.3 Disaggregating the possible gains of trade liberalization: A graphical analysis

121

3.4 The efficiency effects of trade liberalization: A summary of the empirical evidence

125

3.4.1 The impact of trade liberalization on domestic market power

125

3.4.2 The impact of trade liberalization on productivity

126

4 The efficiency effects of trade liberalization: A case study of Argentine industry in the 1990s

131

4.1 Industrial sector developments in the wake of trade liberalization: Structural change, trade, competition, and productivity

132

4.1.1 The evolution of industrial production, employment, and productivity. 132 4.1.1.1 Measurement of productivity

132

4.1.1.2 Overall development of industry and intersectoral change

134

13

4.1.1.3 Intrasectoral changes

138

4.1.2 The evolution of price-cost margins in industry

142

4.1.3 The evolution of import competition and openness

145

4.1.4 Evidence of industry rationalization and technological change

154

4.1.4.1 Industry rationalization

155

4.1.4.2 Technological change

161

4.2 The impact of trade liberalization on efficiency in Argentine industry: A statistical analysis 4.2.1 Outline of the adopted procedure and the regression model 4.2.2 Hypotheses and variables

168 169 170

4.2.2.1 Introductory comments

170

4.2.2.2 Dependent variables - efficiency indicators

172

4.2.2.3 Independent variables and hypotheses 4.2.3 Methodological issues

173 186

4.2.3.1 Assumptions of the OLS regression model

186

4.2.3.2 Applicability of the OLS regression model

192

4.2.4 Results of the regression analysis

195

4.2.4.1 The impact of trade liberalization on domestic market power (PCM)

195

4.2.4.2 The impact of trade liberalization on productivity in the industrial sector

199

5 Conclusion

209

5.1 Summary of major findings

209

5.2 Is there a trade-off between short-run and long-run gains of trade liberalization ?

212

Appendix 1: International Standard Industrial Classification of All Economic Activities, at the three-digit level

215

Appendix 2: Definition, measurement, calculation, and data sources of the variables used in the regression analysis

216

Appendix 3: Interviews

219

References

221

14

List of tables

Table 2.1-1: Evolution of trade policy indicators. Table 4.1-1: Employment, production, and productivity, 1947-1995 (average annual rates of growth in per cent) Table 4.1 -2: Argentina - GDP by sectoral origin, 1980-1995 (percentage of GDP at market prices; 1986 prices). Table 4.1 -3: Argentina - GDP 1986-1996 (annual growth rates, at constant 1986 prices) Table 4.1 -4: Growth rates and standard deviation of industrial sector production, employment, and productivity, 1990-1995 Table 4.1-5

Import competition in manufacturing, 1984-1995.

Table 4.1-6

Sectoral import competition in 1990 and 1994

Table 4.1-7

Sectoral openness in 1990, 1994, and 1995

Table 4.1-8

Distribution of establishments according to size, 1985 and 1993

Table 4.1-9: Employment, value added, and relative productivity according to size of establishments, 1984 and 1993.. Table 4.1-10: Gross fixed investment (thousands of pesos at 1986 prices), 1980-1995 Table 4.1-11 : Imports by economic use (in thousands of US dollar), 1980-1996 Table 4.1-12: Imports of capital goods by economic sector (in U S dollar), 1985-1996 Table 4.2-1

Expected signs for explanatory variables

Table 4.2-2

Determinants of PCM change: Regression results..

Table 4.2-3

Determinants of productivity change during 1990-1995: Regression results

15

List of figures

Figure 2.2-1: The real exchange rate, 1980-1990 (1990=100)

51

Figure 2.2-2. The real exchange rate, 1990-1995 (1990=100)

53

Figure 2.2-3: The real exchange rate, 1990-1995 (4th quarter 1990=100)

54

Figure 3.1 -1: Equilibrium with free trade

65

Figure 3.1 -2: Gains from trade (small economy)

67

Figure 3.1-3: Effects of tariff protection in partial equilibrium

68

Figure 3.1 -4: Effects of a binding import quota

70

Figure 3.2-1: Trade liberalization under imperfect competition: Possible gains and associated channels

75

Figure 3.2-2: Effects of protection on monopoly power

79

Figure 3.2-3: Tariff protection versus quota protection and monopoly power

81

Figure 3.2-4: Effects of protection on market power in oligopoly

84

Figure 3.2-5: Trade liberalization, demand shifts, and output in oligopoly

89

Figure 3.2-6: Protection and inefficient entry

92

Figure 3.2-7: Product differentiation and equilibrium in autarky (prohibitive protection)

97

Figure 3.2-8: Short-run adjustment

99

Figure 3.2-9: Long-run equilibrium

101

Figure 3.3-1: Possible gains from trade liberalization

122

Figure 4.1-1: Variation of (change output and productivity in manufacturing, 1990-1994 in per cent) Figure 4.1-2: Variation of output and productivity in manufacturing,

139

1990-1995 (change in per cent)

140

Figure 4.1-3: Capacity utilization in manufacturing, 1987-1996 (in per cent)

141

Figure 4.1-4: PCMs in manufacturing in 1984 and 1993 (in per cent)

143

16 Figure 4.1-5: Productivity index of tradables and non-tradables in industry, 1990-1995(1990=100)

153

Figure 4.1-6: Insolvencies and bankruptcies in industry, 1984-1995 (numbers per year)

159

Figure 4.1-7: Gross fixed investment (annual rates of change in per cent), 1986-1995

163

Figure 4.1-8: Imports by economic use (in per cent), 1980-1996

165

17

List of abbreviations

CENIT

Centro de Investigaciones para la Transformación

CEP

Centro de Estudios para la Producción

CEPAL

Comisión Económica para América Latina y el Caribe

CESS

Centro de Estudios Socioeconómicos y Sindicales

CGE

Computable general equilibrium

CIEDLA

Centro Interdisciplinario de Estudios sobre el Desarrollo Latinoamericano

CIF

Cost, insurance, freight

CPI

Consumer price index

ENTel

Empresa Nacional de Telecomunicaciones

EIU

The Economist Intelligence Unit

EXIM

The Export-Import Bank of Japan

FDI

Foreign direct investment

FIEL

Fundación de Investigaciones Económicas Latinoamericanas

GATT

General Agreement on Tariffs and Trade

GDP

Gross domestic product

IDB

Inter-American Development Bank

IDI

Instituto para el Desarrollo Industrial

IMF

International Monetary Fund

INCASUR

Instituto Internacional de Estudio y Capacitación Social del Sur

INDEC

Instituto Nacional de Estatística y Censos

ISIC

International Standard Industrial Classification

MEOSP

Ministerio de Economía y Obras y Servicios Públicos

Mercosur

Mercado Común del Cono Sur

MIT

Massachusetts Institute of Technology

NBER

National Bureau for Economic Research

NTB

Non-tariff barrier

OECD

Organization for Economic Cooperation and Development

OLS

Ordinary least squares

PCM

Price-cost margin

18 PE

Public enterprise

PYMES

Pequeñas y medianas empresas

RER

Real exchange rate

RESET

Regression specification error test

R&D

Research and development

SICE

Secretaría de Industria y Comercio Exterior

TFP

Total factor productivity

TPL

Trade policy loan

UCR

Unión Cívica Radical

UIA

Unión Industrial Argentina

UNCTAD

United Nations Conference on Trade and Development

UNIDO

United Nations Industrial Development Organization

USITC

United States International Trade Commission

US$

United States dollar

WIDER

World Institute for Development Economics Research

WPI

Wholesale price index

YPF

Yacimientos Petrolíferos Fiscales

19

1 Introduction

During the last 10-15 years, many countries in the developing world have turned their back on previously maintained protectionist trade regimes and instead embarked on significant trade policy reform, moving into the direction of free trade. Some of the most notable shifts in trade policy occurred in Latin American countries including for example Bolivia, Mexico, and Argentina. This change of course in trade policy has typically been accompanied by a number of further policy reforms, aiming generally at a reduced role of the state in the economy. In short, "public enterprise, industrial promotion, and trade protection were out; privatization, industrial de-regulation, and free trade were in."1 Indeed, the adoption of market-oriented policy reforms in general, and trade liberalization in particular, have since long been advocated by the broad mainstream of economic analysis on the grounds of presumed efficiency gains and improved growth prospects. Western donor countries have resorted to the idea of conditional lending - put into practice by international organizations, foremost the International Monetary Fund (IMF) and the World Bank - to promote market-oriented reforms. Trade liberalization has been a crucial element to qualify for support from those organizations.

1

Rodrik (1995, 2927). See also Sautter (1993) for an account of this kind of reorientation in Latin American countries.

20

From an economic perspective, key issues are the economic consequences of the mentioned reforms. In particular, a logical question to ask is whether the adopted reform measures have actually borne out the promise of improved economic performance that has been an important motive for their introduction. Indeed, an impressive amount of studies that address this question have meanwhile accumulated. Nevertheless, a recent survey of this literature finds that "there is still a need for systematic empirical studies on the consequences of the recent round of reforms".2 The major objective of this study is to analyse the consequences of trade policy reform in Argentina, focusing on the impact of trade liberalization on efficiency or productivity performance. Did trade liberalization lead to greater efficiency? This question is not only of considerable academic interest but it is also relevant to the long-standing debate on the appropriate trade policy orientation in order to foster growth and processes of technological 'catch-up'. In recent years, this debate has experienced a marked revival. On the one hand, the new literature on endogenous growth in the open economy has clearly contributed to this revival. On the other, the critical re-evaluation of past development experiences, including both Latin American and East-Asian economies, has induced renewed interest in the relationship between trade policy and economic performance.3 For two reasons, the process and effects of trade reform in Argentina are particularly interesting to analyse. First, trade liberalization in Argentina went further than in most other countries. Within a relatively short period of time the country shifted from being one of the most protected economies in Latin America to being one of the least. Therefore, the country is well suited to examine the impact of trade reform. Second, the impact on efficiency of the recent trade reforms in Argentina has not yet been systematically analysed. In addition, it is interesting to note that the necessity to increase productivity has been identified as a key issue in contemporary Argentina. In particular, it has been

2

Rodrik (1995, 2927).

21

recognized that productivity increases are of utmost importance both for continued stabilization and sustained growth/ This view has been induced by two factors. First, the volatility of international capital flows (as experienced for example in the context of the Mexican crisis in late 1994 and more recently in connection with the Asian crisis) has furthered the insight that foreign capital inflows can not be a substitute for increasing the efficiency of domestic resource use. Second, the fixing of the nominal exchange rate to the US dollar, instituted by the so-called Convertibility Law in 1991, has foreclosed resorting to nominal devaluation as a short-term remedy to improve the competitiveness of the domestic economy - again pointing to the importance of productivity increases to achieve viable growth.5 Consequently, the issue of whether trade liberalization may lead to increased productivity is of considerable relevance - not least for the future design of trade policies, both in Argentina and elsewhere.6 In order to analyse whether trade policy reform has induced efficiency gains in Argentina during the first half of the 1990s, the study is organized as follows. Chapter 2 documents the process of trade reform in Argentina. The purpose of this chapter is twofold: first, to clarify what has actually been achieved in terms of trade policy reform and second, to examine the factors that have motivated and influenced the reform process. Considering that Argentina has been a long-term adherent of protectionist trade policies, investigation of these factors is clearly warranted. The basic economic rationale for trade policy reform is discussed in chapter 3. In particular, the theoretical underpinnings of the argument that trade liberalization leads to improvements of static and dynamic efficiency is critically analysed. In this context special attention is given to the recent theoretical literature that incorporates

3

See e.g. Page (1997), Pack (1997), and World Bank (1993c).

4

For instance, Fanelli et al. (1994) state: "En la Argentina actual, el crecimiento de la productividad y la competitividad global de la economía son fundamentales, antes que para el crecimiento, para asegurar la estabilidad y la viabilidad financiera extemas dentro del marco de la política económica establecido por la convertibilidad."

5

Cf. e.g. Canavese/Gerchunoff (1996), Bour (1996), Rozenwurcel (1996), and Pack (1997).

6

The Economist (1998, 94), for example, maintains: "As the evidence on the long-term benefits of freer trade becomes even stronger, it is surely time the IMF did more to promote it."

22 insights of both industrial organization theories and modern theories of international trade. A characteristic feature of this literature is that it gives up the assumption of perfect competition, thus modelling trade in the presence of imperfectly competitive markets. As a result, it is possible to identify various mechanisms through which trade liberalization may enhance efficiency, apart from the traditional gains from trade in terms of improved static resource allocation. The major objective here is to provide a systematic up-to-date discussion of these mechanisms, as they provide the theoretical basis for the empirical analysis of the Argentine experience. The chapter is completed by a review of the empirical evidence on the relationship between trade liberalization and efficiency gains, as measured by productivity increases or reduced price-cost margins. Thus, the stage is set to turn to the empirical analysis of the efficiency effects of trade reform in the case of Argentina (chapter 4). The focus is on the impact of trade liberalization on efficiency (productivity, price-cost margins) in manufacturing. The analysis is carried out in two steps. First, the chapter provides a descriptive account of the major industrial sector developments in the wake of trade liberalization. Within this context a key issue is to seek evidence on the actual relevance of the various mechanisms, as identified in chapter 3, linking trade and efficiency. In a second stage, the relationship between trade reform and efficiency is investigated by means of regression analysis, i.e. efficiency indicators are regressed on different sets of explanatory variables, including alternative indicators of trade policy reform. Due attention is paid to relevant methodological and econometric issues that are often neglected in similar empirical studies. The final chapter (chapter 5) summarizes the major findings and relates them to the ongoing debate on trade liberalization and productivity growth.

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2 Trade liberalization in Argentina since 1987 and accompanying policies

This chapter provides an overview of the key policy reforms that were carried out in Argentina since the late 1980s. The focus is on trade policy reforms (2.1). In addition, some of the major policy reforms that have accompanied the process of trade liberalization are outlined (2.2), since they have clearly affected the outcome of trade liberalization in general, and the performance of the industrial sector in particular. Thus, this chapter concentrates on delineating what has been achieved in terms of (trade) policy reform. Moreover, when looking into the evolution of trade policy reform since 1987, the factors that have motivated trade liberalization will also be scrutinized. In other words, the issue of how to account for what has been

achieved

will be considered as well.

2.1 Trade liberalization since 1987: Motives and measures After presenting the adopted definitions of trade policy and trade liberalization (2.1.1), this section will provide an overview of the development of Argentine trade policies before the initiation of trade policy reform in the late 1980s (2.1.2); this includes an outline of the extent and main measures of protection that were employed before those policy reforms. The remaining three sections look at the evolution of trade policies since 1987, thus distinguishing three phases of reform

24

according to differences in scope and intensity. In short, the first phase of the reform process has been marked by a gradual beginning of liberalization in 1987 and some deepening in 1988 (2.1.3). The liberalization was significantly intensified in the following years and the commercial liberalization appeared to come close to completion in April 1991 (2.1.4). Since then tariffs have been modified several times and some trade restricting measures have been introduced (2.1.5).

2.1.1 Definition of trade policy and trade liberalization Since the notions of trade policy and trade liberalization are not always defined in the same way in the literature, it is useful to clarify what definitions are adopted in this study. With regard to the notion of trade policy it is necessary to distinguish between a narrow definition that comprises commercial policy or trade policy proper on the one hand, and a broad definition of trade policy that includes exchange rate policy, on the other hand. This study aims to draw conclusions as to the effects of trade policy proper, therefore, the narrow definition of trade policy is adopted. This kind of definition may appear self-evident, however, the implied conceptual separation of trade policy and exchange rate policy is often missed in general discussions of trade policy as, for example, in the context of the debate about the appropriate trade strategy.1 The suggested clear analytical distinction between trade policy (narrowly defined) and exchange rate policy is primarily motivated by the fact that both of these policies have typically different economic implications and objectives, even though their joint effects may sometimes be difficult to disentangle empirically. Trade

1

In particular, this debate has long been stated in terms of 'inward oriented' versus 'outward oriented' trade strategies (cf. e.g. Salvatore/Hatcher [1991] and Dollar [1991]; moreover, Liang [1992] provides a useful discussion of the shortcomings of existing definitions of 'trade strategies'). These notions usually incorporate both trade and exchange rate policies. In contrast, the case for property distinguishing between those policies is, for instance, forcefully argued by Helleiner (1995,1516) and Rodrik (1992b). Helleiner (1995, 15) emphasizes that "the interaction between trade (or commercial) policies and macroeconomic policies is considerable, complex and subject to misunderstanding. Assessments of the nature and efficacy of a country's economic policies should avoid confusing the issues of trade policy with those of macroeconomic (including exchange rate) policy."

25

policy directly affects the domestic prices of exportables and importables, thus having an impact on an economy's openness2 Typical trade policy measures include import tariffs and export taxes as well as quantitative restrictions, licensing, and prohibitions. Exchange rate policy, on the other hand, directly affects the relative price between all tradables (including importables and exportables) and non-tradables.3 In fact, the real exchange rate is often defined as the ratio of the prices of tradables to non-tradables. Consequently, exchange rate policy typically has an impact on the trade balance. To avoid any misunderstanding it should be emphasized that the suggested clear analytical distinction to be made between trade policy and exchange rate policy, is not meant to ignore the important role of exchange rate policy for the outcome of trade policy. This role is recognized. However, this does not affect the case for conceptual separation of both these policies. As to the notion of trade liberalization, two alternative meanings can be identified.4 In accordance with Edwards (1989; 1993) the difference between these meanings is mainly one of degree or intensity. More concretely, in one case the associated bench-mark of trade liberalization is incentive neutrality; thus, a liberal trade regime is defined as a regime that grants equal incentives to both exportables and importables.5 Consequently, trade liberalization is equivalent to any policy that reduces an existing bias between the incentives faced by producers of importables and exportables. With regard to the other definition of trade liberalization the associated bench-

2

More concretely, changes in the relative price of importables to exportables (pm/pj are associated inversely with changes in the openness of an economy: the higher this relative price, the smaller is (ceteris paribus) the share of imports and exports in national income and the greater is the level of import-substituting production. Cf. Rodrik (1994, 72).

3

It should be added, though, that exchange rate policy may have relative price effects that are equivalent to trade policy measures. In particular, application of multiple exchange rates as well as devaluation in the presence of foreign currency rationing affect the relative price of importables and exportables. Cf. Rodrik (1994, 73-76).

4

The following discussion draws primarily on the good exposition of the relevant issues in Edwards (1989, 179-182; 1993,1364-1365).

5

Formally, incentive neutrality is commonly measured in terms of the ratio of the effective exchange paid by importers (EERM) to the exchange rate effectively paid by exporters (EERx). EERm is typically calculated as the nominal exchange rated applied to imports, corrected by (effective) import tariffs, other import surcharges, and the premium associated with the existence of quantitative restrictions. Similariy, EERX is calculated as the nominal exchange rate for exports, corrected by export subsidies (or comparable measures) and export taxes (cf. Edwards [1993, 1364]). If the ratio is greater than one, this is interpreted as indicating a bias against exports.

26

mark is free trade rather than mere incentive neutrality. This implies that trade liberalization should aim to eliminate all trade distortions. In this context Edwards (1989, 180) has emphasized that "..recently trade liberalization has, in many ways, become synonymous with free-market policies involving minimum or no government intervention at any level". Thus, the two concepts of trade liberalization may conflict when classifying particular trade regimes, which, in turn, is often associated with discussions of some optimal degree of government intervention into foreign trade.8 However, when looking at trade liberalization as a process, there is less disagreement about whether a particular policy measure represents a movement in the direction of a more liberal trade regime: in general, reductions of trade restrictions represent trade liberalization in terms of both definitions.7 As a matter of fact, this study refers to trade liberalization as a process (rather than the benchmark of trade policy reforms) and, hence, a sharp distinction between the two definitions of trade liberalization appears less relevant.8 More specifically, referring to the common trade policy measures that have been mentioned above, trade liberalization amounts to a reduction of taxes on imports or exports, loosening of quantitative restrictions and elimination of outright prohibitions of particular imports or exports.8 Moreover, given the particularly distortive nature of quantitative restrictions (licensing) their conversion into tariffs is also regarded as trade liberalization. Similarly, if the dispersion of the structure of tariff protection is reduced, it is also considered as trade liberalization - even if the average tariff remains unchanged.

6

In particular, this discussion has been fuelled by contrary interpretations of the reasons behind the spectacular export-led growth of the East Asian economies (including e.g. South Korea, Singapore, Taiwan, Hong Kong). See e.g. Rodrik (1996,12-21), Page (1997), and World Bank (1993c).

7

Possible conflicts arise mainly in the context of the application of export subsidies. For example, increase of an import tariff that is compensated by equivalent export subsidies represents trade liberalization in terms of one definition (incentive neutrality) while implying the opposite from the perspective of the other definition.

9

Of course, the underlying reason is that the pre-liberalization trade regime in Argentina has been highly illiberal in terms of both definitions. Moreover, no attempt will be made in this study to answer the question of whether the trade policy reforms have resulted in an optimal level/structure of trade-related government intervention.

9

Furthermore, the relative price effects of unification of multiple exchange rates and devaluation in the presence of foreign exchange rationing are equivalent to the relative price effects of trade liberalization. Cf. footnote 3.

27

2.1.2 Background: Argentine trade policies before the recent policy reforms To put the recent trade policy reforms into perspective, this section briefly reviews the early period of import substitution, the episodes of trade liberalization during the 1960s and 1970s, and, finally, the re-closure of the economy in the early 1980s.10

2.1.2.1 The period of import substitution industrialization Prior to the Great Depression Argentina's trade was characterized by export-led growth, based on the exploitation of abundant natural resources. However, in the late 1920s, facing declining terms of trade, Argentina started to move into the direction of a new strategy of development, based on import substitution production. This trend was reinforced during the Second World War and afterwards when the government turned to increasingly protectionist trade policies, designed to shelter and thus nurture domestic infant industries. Exports were discouraged and as domestic industries remained highly dependent on imported capital goods, the economy could not avoid foreign exchange shortages. During the Perôn administration (1946-1955) protection reached unprecedented levels. High tariffs were accompanied by quantitative import restrictions and import prohibitions. Exchange rates were overvalued, and a system of multiple exchange rates discriminated against traditional agricultural and non-traditional manufactured goods. It has been estimated that the average effective rate of protection in manufacturing stood at about 295 per cent during 1947-1952.11 Recurrent balance-of-payments problems and political instability have characterized the Argentine development since then. The military government that took power in 1955 pursued some trade liberalization. The constitutional government of Frondizi (1958-1962) started to implement a plan for the development of basic industries and high technology manufacturing, including for example, paper, chemicals, oil refining and automobiles. The selected industries were allowed to import capital goods at low rates of duty owing to exemptions and special regimes. During the early 1960s industrial exports were stimulated through

10

This review draws especially on information contained in Cavallo/Cottani (1991) and G A T T (1992).

1

S e e Cavallo/Cottani ( 1 9 9 1 . 1 8 ) .

'

28

the introduction of compensatory tax incentives. Yet, tariffs remained high and in addition, official customs prices and advance import deposits were applied.

2.1.2.2 Episodes of trade liberalization in the 1960s and 1970s Before the recent rush to free trade there have only been two other rather short-lived liberalization episodes since 1945. The first one occurred in 1967 when the average tariff was reduced from 119 per cent to 61 per cent and most prohibitions to import as well as export subsidies were eliminated.12 However, quantitative restrictions and import deposit requirements were only partly reduced and the episode terminated with the introduction of multiple exchange rates and further trade restrictions in 1971. In the following years quantitative restrictions were used extensively and many items were subject to import deposit requirements equivalent to 40 per cent of the cost, insurance, and freight (CIF) value of the imports. Under conditions of rising inflation, this meant a considerable increase in import costs. Several studies have reported a significant anti-export bias resulting from these commercial and exchange rate policies.13 The second and more significant liberalization programme was initiated in 1976. As with the previous reform in 1967 it followed a military coup. During the first two years of the Martinez de Hoz period (1976-1981),14 reforms were mostly limited to some export liberalization: export taxes were reduced or eliminated, and exchange-rates were re-unified. In general, import duties remained high and it has been argued that the tariff reductions that were mainly adopted during the years 1978-1979 merely reduced the 'water in the tariff.15 A study by Wogart/Marques (1984) concludes that existing tariff redundancies were primarily reduced due to the exchange rate policy

12

Average tariff figures are from Cavallo/Cottani (1991, 20, footnote 1).

13

For more detail see Cavallo/Cottani (1991, chapter 2) and the studies quoted therein.

14

Martinez de Hoz was the Minister of Economy who was in charge of the stabilization-cumliberalization programme.

15

Cf. GATT (1992, 86).

29

and that reductions in external tariffs were of secondary importance in this context. 16 Another important feature of the commercial liberalization was its uneven application, leaving a number of branches and firms highly protected by tariffs and licenses. 17 In particular, the military took great care that the military-industrial complex and those sectors that were considered important for reasons of national security did not have to compete with foreign producers. Finally, the liberalization attempt was reversed with the onset of the economic and political crisis in the years 1S81-1982, i.e. before the candidate of the Unión Cívica Radical (UCR), Raúl Alfonsín, was elected President. 18

2.1.2.3 The re-closure of the economy in the early 1980s Following the balance-of-payments crisis that triggered the reversal of trade liberalization in 1981 and in view of the external debt overhang, trade policy was dominated by short term exigencies in 1982-1984. In order to rapidly generate large trade surpluses necessary to provide the debt service, the government resorted to the widespread use of quantitative import restrictions.19 Moreover, import duties and taxes on traditional exports were raised to generate fiscal income. The Alfonsín administration (1983-1989) tried to tighten its control on import demand through the introduction of a new licensing system in 1984. Three categories of goods were distinguished: 20 goods prohibited to import, import goods that required prior approval of the so-called Declaración Jurada de Necesidad de Importación (Sworn Declara-

10

Moreover, Sjaastad (1989, 269) notes that "the final plan for reduction of those [import, A.P.] duties, announced in July 1980, was only partially implemented before being abandoned altogether."

17

Cf. Wogart (1983, 462) and Cavallo/Cottani (1991, 64-72).

18

Noteworthy analyses of the economic policies pursued during 1976-1981 include Canitrot (1980), who focuses on the political dimensions of the stabilization-cum-liberalization programme, and Mann/Sánchez (1984), who look into the socio-economic consequences of that programme. In addition, there is a considerable literature that has sought to dissect normative policy lessons from the comparative study of the policy reforms introduced in several Latin American countries (especially Chile, Uruguay, Argentina) during the 1970s. Representative studies include Cortx>/de Melo (1985; 1987).

19

According to Canitrot/Junco (1992, 26-27) the closure of the economy reflected the joint interest of external creditors and the Argentine government to sustain and amplify trade surpluses in spite of declining prices for traditional exports.

30 tion of the Need to Import), and other import goods for which licenses were readily available. The prohibited list comprised of most consumer goods as well as many domestically produced industrial goods. Prior approval was needed for most capital goods and some industrial imports. Indeed, it needs to be emphasized that the licensing system constituted the cornerstone of import protection during the 1980s. The central role of the licensing system in protecting domestic producers was also clearly visible in the licensing procedure: as mentioned above, for those items subject to licensing importers had to hand in a Sworn Declaration of the Need to Import to the Secretaria de Industria y Comercio Exterior (SICE).21 In the case of imports competing with domestic production, the import request was referred to producer associations which would generally advise against issuing the import permit. The SICE in turn rarely overruled the producer associations.22 Similarly, imports by the public sector (including public enterprises) has been constrained by the 'Compre Argentino' law, which laid down that import requests are to be denied when domestic substitutes are available at 'reasonable prices'. In short, the extent of import protection before the initiation of trade policy reform in the late 1980s may be shown roughly by the following figures: in 1986 more than 7000 tariff items (out of some 11500 tariff lines) were subject to import licensing and more than half of domestic production was protected by quantitative restrictions. Average tariff rates were 43 per cent; in addition, a 15 per cent across-the-board import surcharge had been introduced together with the Austral Plan in 1985. There were a number of additional import taxes. However, it should also be pointed out that many of the import charges were never collected, mainly because of numerous exemptions and special regimes (industrial promotion). As a consequence, the ratio

20

See GATT (1992, 86-87).

21

Being created in 1985 the SICE enjoyed the same status as a ministry. However, since the Argentine constitution does restrict the number of ministries (there must be no more than 8 ministries), the SICE could not officially figure as a ministry. Essentially, the creation of the SICE was an institutional reform that aimed to strengthen the role of trade and industrial policy. The SICE was constituted by three Secretarias (namely, the Secretarías de Comercio Exterior, Comercio Interior, and Industria) that had previously been operating under the authority of the Ministry of Economy (personal interview with Roberto Lavagna, head of the SICE 1985-87).

22

Cf. GATT (1992, 103-104).

31

of import taxes to tax revenues has been relatively low when compared to other Latin American countries.23 As to the main measures that were directly affecting exports, a variety of instruments that discouraged exports (especially export taxes) as well as instruments that sought to promote exports (export subsidies, duty and tax concessions) were used. Broadly speaking, the former applied to traditional export goods (i.e. mostly agricultural products), whereas the latter were used in order to promote non-traditional exports (including a variety of manufactures). In 1987, the average export tax rate for agricultural products was 18.2 per cent and 9.5 per cent for manufactures.24 In 1986 total tax rebates for exports amounted to US$ 160 million compared to export tax revenues of US$ 785 million.25 As a result of commercial policies, there existed a considerable anti-export bias: according to estimates by FIEL, the ratio of the effective exchange paid by importers (EERM) to the exchange rate effectively paid by exporters (EERX) was 1.47 (1.29) in December 1985 (1986).28

2.1.3 Gradual trade liberalization 1987-1988 This section reviews the crucial features of trade policy reform during 1987 to early 1989, i.e. as implemented by the Alfonsin government. The motives for the introduc-

23

According to a study by Dean et al. (1994, 71), the ratio of import taxes to overall tax revenue amounted to 5 per cent for Argentina in 1984. The comparable percentage figures for other Latin American countries are 22% (Peru), 13% (Columbia), 13% (Costa Rica), 11% (Chile), 5% (Venezuela), 3% (Mexico), and 2% (Brazil).

24

See GATT (1992, 117). To appreciate the significance of export taxes it is useful to consider the following figures: first, the realized share of export taxes in total export receipts reached roughly 15 per cent in 1965. Second, the ratio of export tax receipts to national tax revenue amounted to some 6 percent in 1986 (cf. GATT [1992, 118-120]).

25

GATT (1992, 118). For more detail see GATT (1992, 116-127).

26

FIEL (1991, 190). As noted before, a ratio of 1 is equivalent to incentive neutrality, whereas EERM/EERX > 1 indicates a bias against exports. The estimates of the EER M /EER X ratio by FIEL do not take account of quantitative restrictions, i.e. they are bound to underestimate the true degree of anti-export bias.

32

tion of trade liberalization will be discussed (2.1.3.1) before turning to the implementation of trade policy reform (2.1.3.2). 27

2.1.3.1 Motives for the initiation of trade liberalization Given the traditional reluctance of Latin American countries (including Argentina) to seriously alter the protectionist stance of their trade policies, it seems worthwhile to look into the factors that have motivated the government's decision to embark on trade policy reform at the start of 1987. As a matter of fact, this question is of particular interest in view of the large body of literature on the political economy of trade policy, which emphasizes the inherent dominance of protectionist interests over free trade interests, thus suggesting that trade liberalization will either not be attempted (due to lack of political will) or founder because of political resistance. 28 Here, no attempt will be made to probe the scope and limits of formal political economy models to account for trade liberalization. 29 Instead, drawing on some related work of other authors as well as information gained from a series of interviews that were conducted in Buenos Aires during September 1996 until February 1997, the intention is to point to the factors that have apparently been behind the initiation of trade liberalization in 1987.30 Without any doubt there is a variety of factors that needs to be mentioned. In fact, it should be emphasized that the following discussion does not claim to cover all the

27

In this context it may be useful to note that, in practice, trade policy making in Argentina is strongly dominated by the Executive via Presidential decrees and ministerial resolutions. The ministry in charge of most trade-related matters is the Ministry of Economy. Thus, the government maintains a high degree of discretion in deciding on trade policy. The abundant literature on the political economy of trade policy is nicely summarized in Rodrik (1995a). Basically, this literature has analysed the determinants of protection (a) across different industries, (b) among countries, and (c) over time. With regard to (c), the focus has been on longterm changes in trade policy (e.g. as a consequence of changing factor endowments; cf. also Baldwin/Baldwin [1996]), whereas short-term shifts between protection and trade liberalization have not been satisfactorily explained (Cf. Rodrik 1995a, 1485-1487).

39

The difficulty to account for trade liberalization from the perspective of standard political economy models is well evaluated in Corden (1987) and Nabli (1990). See also Krueger (1993a; 1993b). For a broader discussion of the arguable limitation of the public choice or new political economy literature to explain market-oriented policy reform, see the contributions in Meier (1991a), especially Grindle (1991), Bates et al. (1991), and Meier (1991b, 309-316).

30

A list of those persons interviewed as part of this research is included in appendix 3.

33

relevant issues. Moreover, it is generally difficult to attach specific weights as to their relative importance. The aim is to highlight those motives that appear to have been most relevant.31 • Intellectual influence and learning: The recognition that the original development strategy of industrialization via import substitution had run its course can be traced back to the 1970s. However, the bad experience associated with the ill-managed stabilization with liberalization attempt under the military government in the late 1970s, had the effect to temporarily discredit any similar policy package including trade liberalization. In other words, due to both guilt-by-association32 and the fact that the programme had been introduced by a military regime, trade liberalization had again become non palatable in Argentina in the early 1980s: 'Volver de hablar de la apertura era dificil."33 The following statement by the then Minister of Economy, Juan Sourouille, reflects indeed a profound scepticism towards the merits of opening up the economy: 'Trade liberalization has already been tried. It has not worked. It is dangerous. It is useless."34 Yet, during the 1980s a two-fold process that contributed to the adoption of trade liberalization in 1987 was set in motion: first, based on the re-evaluation of the achievements of the import substitution strategy, there emerged a growing consensus among policymakers and academics that this strategy had fallen short of producing the intended results; hence producing a general awareness that some change of direction was called for.35 Second, the stronger performance of

3

'

Interestingly, none of the key motives that have been identified here, is being considered in the standard political economy models, which are exclusively focusing on the distributive consequences of trade policy. Hence, this fact may provide a clue to the attested weakness of traditional political economy models to explain trade liberalization.

32

This notion captures the commonly observed phenomenon that trade policy is held responsible for overall macroeconomic performance (namely economic crisis, unemployment), although the latter typically calls for macroeconomic explanations (monetary, fiscal, exchange-rate policies). In principle, the argument works in both directions: for example, Corden (1987, 13) notes that "...the coincidence of macroeconomic crisis with an increase in protectionism can lead people to attribute the macroeconomic difficulties to protection, and so develop a bias against protection."

33

Bernardo Kosacoff, personal interview.

34

Quoted in Rajapatirana et al. (1997, 324).

35

This point is, for example, emphasized by Oscar Muñoz (1994, 73): "What ultimately prompted trade reform in Latin America was political acceptance that the rigid import-substitution model of industrialization had reached a dead end." Similarly, Krugman (1995, 28) claims that "...probably the most important factor in the new look of developing countries was a sea change in the intellectual Zeitgeist...". See also Whalley (1989) and Nairn (1995).

34 the East Asian economies which had followed an outward-oriented development strategy clearly influenced the debate on the appropriate trade policies. More importantly, the example of the neighbouring country Chile, which was outperforming Argentina during the 1980s played a catalytic role in the re-evaluation of the potential merits of economic liberalization.38 • Liberalization to achieve stabilization: The view that trade liberalization could actually contribute to achieve stabilization emerged during 1985-87. Within this context two issues are noteworthy. First, in view of ongoing difficulties to reduce the budget deficit and thus stabilize the economy, increasing attention was put on the fiscal cost of existing trade and industrial policies.37 Second, since the faltering of the Austral plan, Sourrouille and his economic team started to discuss the opening of the economy as a stabilization measure. The argument was based on the perception that the Austral Plan was threatened and finally it failed because it was dependent on the favourable price setting behaviour of major companies: agreed price discipline was not sustained as those companies reversed their original support of the Austral Plan. Therefore, the idea was to discipline the industrial sector by opening the domestic economy to foreign competition and hence introduce a price-cap to the domestic market. • External pressure (conditional lending): Another important motive for the adoption of trade policy reform has been the acute need of external finance on the one hand, and the availability of external finance in the form of conditional lending by international organizations (most notably IMF and World Bank) on the other. In fact, several country missions by the IMF and the World Bank had made it clear what was needed to be done from their perspective in order to qualify for financial support. Reflecting the high priority attached to trade policy reform by IMF/World Bank, those organizations emphasized that additional loans (apart from trade policy loans) would 36

However, it should be added that the attraction of Chile's market-oriented economic policy had long been limited because it was implemented under a military regime. It was only after Chile's return to democracy in 1989/90 that the Chilean economic model was stopped being questioned because of the political regime in charge of putting it in place.

35

only be available when reaching an agreement on the issue of trade policy reform. The architect of the 1987/88 trade policy reforms, Adolfo Canitrot, bluntly stated: "We introduced trade liberalization because we just needed money."38 Moreover, additional pressure to adopt a number of policy reforms (including trade liberalization) was exerted by the Baker Plan which established a linkage between the indebted countries' willingness to implement those reforms and negotiation on debt rescheduling.39

2.1.3.2 Implementation of trade liberalization 1987-1988 The implementation of trade policy reform during 1987-1988 broadly followed the targets that were agreed upon in the context of the trade policy loans granted by the World Bank. The reform programme showed three characteristic elements that can be interpreted as a reflection of previous experiences with explicit export promotion and import liberalization policies:40 (1) a strong emphasis on achieving free trade status for exporters early in the reform process, coupled with a phase-out of various specific export promotion measures; (2) a negotiated sector-by-sector approach to import liberalization; and (3) an attempt to maintain a competitive exchange rate for trade transactions.

37

According to estimates by the World Bank (1990, xxxi) the revenues forgone through industrial promotion incentives and overcharging on public sector procurement resulting from the previously mentioned 'Compre Argentino' law, have added up to 5 per cent of GDP to the deficit.

38

Personal communication. On behalf of the Argentine government, Canitrot started negotiations with the World Bank in order to reach agreement on a trade policy loan (TPL). In May 1987, formal agreement was reached and the World Bank granted a first trade policy and export diversification loan worth US$ 500 million in support of trade policy reforms. A second trade policy loan worth US$ 300 million was granted in October 1988.

39

Although trade policy reform was no explicit condition for entering negotiations on debt rescheduling, it signalled the political will to go ahead with structural reforms and thus facilitated talks with major creditors. In April 1987 Argentina reached an agreement with the bank steering committee of major creditors to reschedule US$ 32 billion out of the total foreign debt of almost US$ 52 billion. Moreover, in May 1987 an agreement was reached with the Paris Club creditors on a refinancing of US$ 2 billion of official debt on favourable terms (See e.g. EIU [1987, 35-36]).

40

Cf. World Bank (1990, 155).

36

As far as import liberalization is concerned, the more important policy changes during the early reform phase (1987-88) have included the following.41 - The prior intervention of honorary commissions required for the approval of import licences was abolished for all but 2033 tariff items. As a result, the production coverage of quantitative restrictions was reduced from 62 per cent to 18 per cent for manufactures and from 29 per cent to 2 per cent for agricultural commodities. - The import authorization process was made fully automatic for the majority of goods that were no longer subject to the prior intervention of honorary commissions. The authorization process was transferred from the SICE to the commercial banks. - The government implemented the GATT code on import valuation, thus abolishing official reference prices and instead basing the valuation of import duties on the invoice. - In October 1988 the range of tariffs for most imports was narrowed from 15-53 per cent to 0-40 per cent. As a consequence, the average (production-weighted) tariff dropped from 43 to 28 per cent for manufactures and from 29 to 20 per cent for agricultural goods. However, the government weakened the trade reform by a number of measures that were introduced only shortly after the adoption of the policy changes listed above. In particular, specific duties were imposed on 322 positions of the import-tariff nomenclature with a production coverage of 2 per cent. These specific tariffs were set at import prohibiting levels, therefore having the same effect as quantitative restrictions. Basically, there have been two interrelated reasons behind this weakening of the liberalization process. First, industrialists put increasing pressure on the government to grant exceptions to the overall import liberalization. Second, the government was struggling to gather political support for the implementation of another stabilization 41

See World Bank (1988, 23-33), World Bank (1990, 159-161), and FIEL (1991, 182-184) for more

37

plan (Spring Plan) in August 1988. Finally, the government bowed to industrialists' pressure, thus extending specific tariffs to further tariff items and later even allowing the Unión Industrial Argentina (UIA) to name the new Secretary of Industry and Foreign Trade from their ranks. As a consequence, the credibility of the trade policy reform was severely damaged and the World Bank suspended disbursement in March 1989 after no more than US$ 150 - i.e. the first tranche of the second TPL - of a total US$ 1.25 billion loan package had been disbursed.42 As to export policy, the main intention of the government was to reduce the negative impact on exports of the existing regulations. The policy changes enacted until early 1989, included the following:43 - The export licensing process was simplified for exports being shipped through Buenos Aires. However, the production coverage of license requirements (amounting to 54.5 per cent for agricultural commodities and 17.7 per cent for manufactures) was not altered. - The production share of positions of the export nomenclature which are subject to export taxation was reduced from 85.9 per cent to 34.5 per cent in agriculture and from 43.5 per cent to 6.3 per cent in manufacturing. The average (productionweighted) export tax rate was reduced for agricultural goods from 18.2 per cent to 4.1 per cent and for manufacturing goods from 9.5 to 0.6 per cent. However, after August 1988 the direct export tax reductions were more than compensated by the tax equivalent of the multiple exchange rate system. - The duty free admission of imported goods for use in export production, the temporary admission regime (TAR), was extended to nearly all primary inputs and intermediates. The new TAR complemented the existing drawback scheme under

detail. 42

Adolfo Canitrot, personal interview, and Torre (1989) who provides a fascinating account of the dynamics of negotiation and implementation of trade liberalization during 1987-1988.

43

See World Bank (1988, 23-33), World Bank (1990. 156-158), and FIEL (1991, 182-184) for more detail.

38 which exporters could apply for the reimbursement of duty payments after exports had been shipped. - The reimbursement of indirect domestic taxes was extended to the export of most industrial manufacturing, but not to agricultural and mineral commodities and to agro-based manufacturing. The average (export-weighted) rate of reimbursement for industrial manufactures increased from 6 per cent to 13 per cent. However, when Argentina drifted towards hyperinflation in early 1989, the government resorted to a number of short term measures that counteracted some of the previous achievements. Thus, the government raised export taxes and temporarily suspended the reimbursement scheme and the export financing facility of the Central Bank. To summarize, until 1989 the exposure of the domestic market to external competition continued to be rather low in spite of the trade policy reforms undertaken.44 In fact, when the proposed import liberalization started to seriously threaten the position of protected industries, the government partly bowed to protectionist interests and renounced more ambitious liberalization measures. Nevertheless, even the World Bank conceded to have started the reform of the highly distortionary trade policies may be considered a major achievement; especially when taking into account the resistance of vested interests and the harsh experience with the previous liberalization attempt.45

2.1.4 Intensification of trade liberalization 1989-1991 The particular feature of this phase of reform has been that the process of liberalization continued in an economic environment, characterized by a high degree of macroeconomic instability culminating in two outbreaks of hyperinflation in mid-1989 and early 1990. The discussion will again focus on both the factors that have moti44

This fact has been emphasized by most interviewees. Cf. also Chudnovsky (1991, 57) and Nogues/Gulati (1994).

39

vated adopted policy decisions (section 2.1.4.1) and the actual implementation of those decisions (2.1.4.2).

2.1.4.1 Motives for intensifying trade liberalization The process of trade liberalization was markedly intensified under the administration of the newly elected President Carlos Menem. 48 Generally speaking, the factors that have motivated the initiation of trade liberalization under the Alfonsfn administration also have some relevance when explaining the new government's decision to continue and intensify trade liberalization during 1989-1991. In particular, the conviction that import liberalization could make a contribution to induce domestic price discipline, remained an influential factor. Moreover, the noted sea change in predominant ideas was meanwhile reinforced by the fall of communism and the associated general discrediting of statist policies. In addition, Fernández (1992) suggested that populist policymakers have learnt from the experience of hyperinflation, thus recognizing the necessity of comprehensive structural reforms. In contrast, the impact of conditionally on trade policy reform was declining since 1990 (i.e. after the government had complied with the conditionally of the second TPL in order to obtain the previously suspended disbursement of the second tranche), as the government

decided to accelerate

loan/conditionality.

the

reform

process

independent

of

any

47

However, at least two further interrelated issues need to be mentioned in order to account for the intensification of trade liberalization: first, the government's intention to gain reputation and credibility as a decisive reform-minded actor, and second, the belief in the optimality of free trade on part of the economic team coupled with the

45

Cf. World Bank (1990,155).

46

In fact, considering the pace and intensity of the new trade policy initiatives as well as the ways in which trade policies were linked with macroeconomic policies, Damili/Keifman (1993, 261-262) maintain that "...the changes made in 1990-91 were so sweeping that it is more accurate to talk about a change in course, rather than the continuation of an existing programme."

"

This fact has e.g. been pointed out by Tussie (1993, 127-128): "..import liberalization continued throughout 1990 and 1991, no longer linked to conditionality but as part of the government's own initiative to pursue deregulation in all spheres of economic activity."

40

perception that rapid liberalization was preferable on the basis of political feasibility considerations. The relevance of these factors will be discussed in turn. • Reputation building / credibility via signalling: In accordance with Pablo Gerchunoff and Juan Carlos Torre, one of the key problems that the Menem administration was facing upon taking office was a credibility problem.48 Essentially, this problem was caused by two factors. Firstly, due to the fact that Argentina had already gone through a history of aborted reform efforts, any new reform initiative would be greeted with a lot of scepticism by economic agents and the public at large. Secondly, this kind of common credibility problem was aggravated by the fact that Menem's announcement to lance a programme of free market policy reforms, stood in direct contradiction to both his electoral campaign and the historic ideology of his party.49 Hence, the intensification of trade liberalization can be interpreted as an attempt by the Menem administration to signal the sincerity of its reform orientation.50 Considering that the closed economy import substitution industrialization model used to be associated with traditional peronism, rapid trade liberalization provided a particularly appropriate measure in order to build up a reputation for being serious

48

Personal interviews with P. Gerchunoff and J. C. Torre. See also Gerchunoff/Torre (1996). In this context a broad definition of credibility is adopted: following Funke (1993, 343), "a policy lacks credibility if private expectations about future policies deviate from the government's explicit or implicit announcement." The importance of credibility for the success of economic reforms has recently received increasing critical attention. See e.g. Rodrik (1989a) for a discussion of credibility and trade reform, and Dombusch (1991a) for an analysis of credibility and stabilization.

49

In this context, several analysts have convincingly argued that this radical change of course in Menem's political agenda was to a large extent a reflection of acute economic constraints (hyperinflation, fiscal crisis). Gerchunoff/Torre (1996, 735) put it like this: "Ante el potencial de aniquilamiento politico que exhibía la crisis, el nuevo presidente peronista, sorprendiendo a amigos y adversarios por igual, dejó de lado su programa electoral populista y adoptó la estrategia de cambio de cuño neoliberal en un esfuerzo por resolver el desafío prioritario de la hora: ganar la aquiescencia de los principales agentes económicos, internos y extemos, que disponían de un decisivo poder de veto sobre los mercados y la sustentabilidad de su gobierno." Similarly, de Pablo (1990, 128) argues that "through necessity more than through a unilateral change of mind, Argentina finds itself engaged in policy reform." See also Dombusch (1991b, 14).

50

The rationality of radical action in order to signal the political commitment of policymakers to reform has been examined by Rodrik (1989b). A key insight of this work is that, under certain conditions, it may be necessary for a government to resort to 'policy overshooting' in order to increase the credibility of the reform process. As noted by Rodrik (1989b, 758): "achieving credibility will always require a larger policy reform than would have been dictated in the absence of the credibility problem" (italics in original).

41

about reforms.51 In contrast, a mere continuation of the gradual opening up of the previous government would have been insufficient to produce such a 'signal': Moreover, in viev/ of the inherited economic crisis and the associated uncertainty and loss of confidence, the Menem administration was busy to emphasize that it was making a new start rather than continuing the arguably half-hearted reforms of the preceding government. • Political feasibility considerations: The preceding discussion stressed that drastic policy reform may have been necessary for the reform effort to be credible. Here the crucial argument is that the government's decision to intensify trade liberalization may have been also motivated by its presumption that rapid reform ('shock-therapy') was the best feasible reform strategy. As noted by a key member of Cavallo's economic team: "In theory I am in favour of a gradual strategy but not in the given context."52 In the theoretical literature it is possible to find both arguments in support of radical trade reform as well as arguments in favour of gradual liberalization - the optimal strategy typically depends on the underlying assumptions of economic and political constraints.53 For instance, several analysts have emphasized that speedy reform implementation may be a preferable option when a 'window of opportunity' for reform exists due to either an economic crisis and/or a newly elected government taking office.54 Taking into consideration the political/economic context prevailing in Argentina in 1989-1990, it does indeed seem plausible to suggest that the Menem government sought to apply the 'shock-therapy' in order to take advantage of the existing

51

This point has also been stressed by Palermo (1995, see especially 9 5 - 9 9 and 2 5 1 - 2 5 7 ) , who provides an intriguing analysis of the politics of structural reforms during the first years of the M e n e m administration.

52

Juan Llach, personal interview.

53

There is by now a vast literature dealing with the issues of speed and sequencing of structural reforms. These issues have been examined both from a purely economic perspective (e.g. Michaely [1986], Bacchetta/Dellas [1997]) as well as from a political economy perspective that considers the problem of political constraints in economic policy reform (e.g. Dewatripont/Roland [1992a; 1992b; 1995]). A good recent survey of the relevant literature is Bhattacharya (1997).

54

Cf. e.g. Williamson/Haggard (1994), Bates/Krueger(1993), and Little et al. (1993, chapter 12).

42 'window of opportunity' for reform.55 In this context, the case for rapid trade reform is commonly based on two arguments. First, it has been argued that a crucial advantage of rapid reform implementation is that "it does not allow time for opposition to build up and for interest groups to get together and increase their lobbying activities against the reforms".56 As well, there has been support for rapidly dismantling import protection on the grounds that the limited administrative capacities in many countries undertaking trade policy reform do not allow to opt for a more complex and/or gradual implementation.57

2.1.4.2 Implementation of trade liberalization 1989-1991 Trade policy changes have been implemented at various times during 1989-1991 (see also table 2.1-1). As a result, import liberalization appeared to come close to completion in April 1991, after Domingo Cavallo (until then Minister of Foreign Relations) had been put in charge of the Ministry of Economy; he initiated a comprehensive programme of stabilization and structural reforms, including further trade liberalization.58 Referring to import liberalization, the government achieved further progress with regard to the reduction of both quantitative restrictions and tariff levels: - The number of tariff lines subject to import licensing was dramatically reduced in October 1989 and March 1990, before being eliminated altogether in January 1991.59 The major exception to this rule is the special regime that applies to imports and exports of automobiles and parts. This regime includes quotas that

55

In this context it is interesting to note that Juan Llach pointed out that during 1 9 9 1 - 1 9 9 2 the President offered almost 100 per cent support for anything suggested by the economic t e a m (personal interview). S e e also Cavallo (1992). The role of technocratic reformers in the Argentine reform process has been analysed in more detail by Teichman (1997, 42-52) and Huneeus (1996).

56

Bhattarchaya (1997, 1047). S e e also Funke (1993) and Martinelll/Tommasi (1997).

57

Levy (1993) provides an excellent exposition of the relevant issues.

53

The major novelty of the Cavallo Plan was the introduction of a bimonetary currency board. This so-called Convertibility Plan will be discussed in some more detail In section 2.2.1.2.

59

The requirement for importers to prepare a "Sworn Declaration of the Need to Import" w a s abolished by Presidential Decree in July 1990. Cf. G A T T (1992, 93).

43

restrict the imports of automobiles. Consequently, with only a few exceptions, tariffs had become the relevant instrument of protection by 1991. - Several tariff changes instituted between October 1989 and October 1990 reduced both the average tariff rate as well as the dispersion of tariffs. Tariff surcharges were completely abolished. As of April 1991 a triple-tier tariff was introduced, with zero tariffs on raw materials, an 11 per cent tariff on intermediate inputs, and a 22 per cent tariff on finished goods. All items on which specific tariffs had been introduced in October 1988 became subject to the 22 per cent ad valorem rate. As a result of these changes the average tariff dropped from 22 per cent (October 1989) to 9.7 per cent. The weighted average of the effective protection rates has been estimated at 12.4 per cent, with a low standard deviation of 14.0 per cent.60 As to the measures directly affecting exports, the government's scope of action was clearly constrained by budgetary exigencies. In principle, the government continued along the lines of the policy changes that were carried out in 1988 under the Alfonsin administration: - Taxes on exports were relatively high between mid-1989 and late 1990 (additional taxes of between 20 and 30 per cent were adopted), but by April 1991 they were widely eliminated except for a statistical tax of 3 per cent.61 - The temporary admission scheme which had earlier been suspended was reestablished in 1992, though in a restricted version.62 - A new duty-drawback scheme was introduced in 1991. It allows for the reimbursement of tariffs already paid, provided that the product has been transformed to some extent.63

60 6

The relevant data were estimated by the World Bank and are contained in GATT (1992,147-148).

' A few raw materials (e.g. soybeans, hides) were exempted from the tax reduction, arguably in order to encourage producers to process them locally before shipping them abroad (see Damill/Keifman [1993, 281, footnote 12]).

62

See Berlinski (1994, 21) for more detail.

63

See GATT (1992, 122-123) and Berlinski (1994, 21).

44

-

Existing rates of reimbursement of domestic indirect taxes were maintained until March 1991 when they were lowered by 33 per cent. However, between March and June 1990, payments were completely suspended and it has been reported that - even after the introduction of the lower rates - the government did not meet its promise to pay the rebates in cash, arguably because of the tight fiscal situation.

Table 2.1-1: Evolution of trade policy indicators Average Tariff tariff dispersion Oct. 88 Oct. 89 Dec. 89 Jan. 90 Mar. 90 May 90 Oct. 90 Jan. 91 Apr. 91 May 91 Nov. 91 Nov. 92 Jan. 94 Apr. 94

28.9 22.3 17.4 14.8 13.9 17.0 17.3 18.2 9.7 9.7 11.7 10.2 9.4 9.1

13.9 12.9 10.6 8.3 8.9 5.2 5.4 8.4 9.5 9.5 7.7 5.1 4.8 5.7

Maximum tariff

Minimum tariff

40 40 30 24 24 24 24 22 22 35 35 20 20 20

0 0 0 0 0 5 5 0 0 0 0 0 0 0

Most Number of tariff lines subject to: frequent Specific Tariff sur- Non-tariff tariff duties charges barriers 40 37 30 24 24 24 24 22 0 0 0 15 15 15

119 129 327 327 325 329 324 279 0 0 0 0 294" 294"

845 807 801 802 800 759 0 0 0 0 0 0 t

7"

1056 122 118 118 27 27 25 0" 0 0 0 0 48° 48 c

a. Excluding statistical tax. b. Remaining NTBs were eliminated while simultaneously introducing a special regime applying to the automotive industry. c. Transitory measures. Figures refer to product lines affected by quotas during 1993-1994. d. Transitory measures. Figures refer to product lines affected during 1993-1994.

Sources: FIEL (1991) for data until May 1990; remaining data were supplied by FIEL.

In synthesis, the trade policy reforms implemented during 1989-1991 considerably reduced the degree of government intervention into international trade. Considering the virtual elimination of quantitative restrictions and the comparatively low level of tariff protection both of which were achieved during a short time span, the reform

45

effort went further than any other reform attempt since the departure from the outward-oriented development model and the shift to import substitution industrialization in the 1930s.64 Among the factors that help to account for the relative political ease with which this remarkable change of course could be implemented, are the following. First, the packaging of trade liberalization with other policy reforms (including stabilization) enabled the government to emphasize the large gains to the country as a whole (including the industrial sector) that the reform package was presumed to yield.65 Consequently, and especially in view of the general concern for macroeconomic stabilization, the beneficiaries of trade protection faced considerable difficulty to mount opposition against the reform programme. Second, the economic recovery that began in 1991 had the effect of dampening short-term adjustment cost - i.e. even the majority of those sectors that were now exposed to increasing import competition were able to participate in the demand-led economic boom. Third, there are some grounds for suggesting that the structural changes that have evolved within manufacturing during the last 10-15 years, have weakened the pro-protectionist interests and strengthened those industrial sectors (including e.g. transnational companies, basic industries managed by economic conglomerates) which are not against the opening up of the economy.66

2.1.5 Consolidation of trade policy reform since 1991 and some new protectionist measures The third phase of the liberalization process may be characterized by the fact that the appreciation of the real exchange rate (until 1994) created widespread concerns about the sustainability of the Convertibility Plan. Moreover, the government became aware of the fact that the high exchange rate in conjunction with import liberalization 64

In the words of Kosacoff (1993, 42), "La inexistencia de barreras no arancelarías y el bajo nivel y dispersión de las tarifas definen una apertura general inédita históricamente."

65

Cf. Rodrik (1994) for an elaboration of this argument.

66

This point has in particular been emphasized by Jorge Schvarzer and Bernardo Kosacoff (personal interviews). Cf. also Schvarzer (1994).

46

exerted extreme pressure on certain producers of import competing goods. Simultaneously, the industrial sector voiced demands for selective protection and additional incentives to exporters. First, the government reacted by rapidly going ahead with the privatization of public enterprises and the deregulation of the economy, in order to reduce the domestic cost of production (for more detail see section 2.2). However, in view of large deficits on the trade balance and mounting complaints by certain manufacturing sectors (textiles, footwear, paper), the government partly modified trade policies beginning in late 1992. The following modifications of import policies are particularly noteworthy: - Further tariff reforms, primarily enacted in November 1991 and November 1992, introduced a five-tier and later a nine-tier structure, with rates ranging from 0 per cent to 20 per cent.67 Until January 1992, tariff rates of 35 per cent were granted to products that had previously been subject to import quotas or reference prices, namely automobiles and electronics products. Reflecting the ongoing modifications of the tariff structure, the average nominal tariff (including the statistical tax) was estimated to be 12.2 per cent in November 1991, and 17.6 per cent as of October 1993.68 - A so-called statistical tax of 3 per cent on imports was introduced in late 1991 and increased to 10 per cent in 1992, arguably in order to reduce the growing trade deficit. In fact, the simultaneous adoption of export subsidies was meant to have an effect equivalent to an exchange rate devaluation.69 The statistical tax was eliminated by the end of 1994 in the context of Mercosur agreements. - The tariff structure was again altered in the beginning of 1995, with the launching of the Mercosur customs union. The common external tariff (CET) covers 85 per 67

Berlinski ( 1 9 9 4 , 1 5 ) reports that the relevant rates apply as follows: 0 per cent for capital goods not produced domestically; 2.5 per cent for primary inputs; rates of 5, 7.5, 10 per cent for the chain of the food industry; rates of 5, 7.5, 10, 12.5 per cent for the chain of basic industries; 15 per cent for competing capital goods and their spare parts, and for a range of final products (e.g. of paper, plastics, iron and steel, fabrics of the textile chain); 2 0 per cent for final consumer goods.

68

S e e Berlinski (1994, 26). The estimate is based on a sample of 201 tariff items.

69

Cf. Cline (1995, 40-41). Edwards (1995, 42-43) suggests that the magnitude of adjustment obtained via such a "pseudo" devaluation may be rather small.

47

cent of the harmonized tariff structure. The CET will be set fully into practice until 2006, thus allowing for some exceptions in the meantime. A comparison of the Argentine tariff structure (excluding the statistical tax) in late 1994 with the corresponding CET in 1995 revealed that the CET has resulted in a slight increase in average protection for most chapters of the tariff structure - overall, average protection has increased from 9.1 per cent to 11.2 per cent.70 - Apart from the temporary imposition the statistical tax, there have been a number of trade policy measures adopted contrary to the overall liberalization trend. As noted before, these policy changes have generally been related to concerns about the high increase in imports, particularly from Brazil. The respective policy measures include the introduction of import quotas (for certain types of paper products from Brazil), the use of minimum specific tariffs (on textile products and sports shoes) and the more vigorous use of antidumping measures.71 As suggested above, the government has undertaken some efforts to improve the deteriorating trade balance without resorting to a devaluation of the exchange rate. Those efforts have included the following measures as related to export policies: - In November '92 the existing reimbursement scheme was modified with the aim to establish parity in the incentives of production for the domestic market and the world market. Thus, the modified range of export rebates is equivalent to the nominal import tariff schedule, covering 8 levels between 2.5 per cent and 20 per cent.72 - In December '92 the government introduced a regime of industrial specialization. It implies that inputs may be imported at a preferential tariff of 2 per cent if the importing firm commits to incremental exports of the same amount as the respective imports. By mid-1994 the regime had attracted export commitments of

70

Information provided by FIEL.

71

Cf. table 2.1-1 and Berlinski (1994, 39-42).

72

Cf. Berlinski (1994, 20) and Cline (1995, 40-41). Cline considers the payments m a d e to exporters as "subsidies", while Bertinski refers to them as "rebates", as they have originally been designed to compensate exporters for domestic indirect taxes.

48 approximately US$ 700 million from about 200 firms.73 However, there has been some concern that the scheme is prone to misuse and administrative discretion, in particular as the mechanism depends on the prior approval of sectoral chambers, representing the interests of domestic competing industries. To sum up, the trade policy modifications introduced since late 1992 should be viewed as the fine-tuning of policies rather than as an attack on the overall policy stance. In fact, the government has been busy emphasizing that it remains strongly committed to the opening up of the Argentine economy and that the selective introduction of import quotas and specific tariffs were warranted due to the particular circumstances in the relevant industries.74 Nevertheless, some analysts have pointed out that, especially in the case of anti-dumping measures, big companies were partly successful in influencing policy making, whereas small and medium size companies (PYMES) did not have the political clout to do so effectively.75 Finally, the launching of the Mercosur customs union in 1995 implies that, in principle, changes in trade policy now have to be agreed upon by all member countries. As a result, the Mercosur serves as a restraint on the members' trade policy making, thus preventing unilateral actions towards renewed protectionism.

The specialization regime applies to four different periods, namely, 1993-96, 1997, 1998, 1999; the 2 per cent tariff rate is granted in the first period. In subsequent periods the relevant tariff rates will be calculated using the following formula: [0.02 + (A - 0.02)*B], with A = actual tariff, and B = 0.25, 0.5, 0.75 in the years 1 9 9 7 , 1 9 9 8 , 1 9 9 9 , respectively. Cf. Berlinski (1994, 38). u

Juan Llach, personal interview. See also the interview with Juan Llach in Pdgina/12, suplemento econ6mico, No. 168, 11.07.1993.

75

In particular, Daniel Chudnovsky, Claudio Lozano, and Jorge Schvartzer stressed this issue (personal interviews).

49

2.2 Accompanying policies It is evident that both the course and the results of trade liberalization efforts are critically dependent upon the macroeconomic environment in which the liberalization takes place. In this context exchange rate management and the behaviour of the real exchange rate are of special interest (section 2.2.1).76 Moreover, trade liberalization has been accompanied by other important structural reforms (most notably privatization and deregulation policies; sections 2.2.2 and 2.2.3) that have influenced economic performance in the 1990s. Consequently, it seems useful to review briefly those policy reforms in order to gain a broad understanding of the variety of factors that have affected economic performance in the wake of trade liberalization. Hence, this review will provide some useful background information with regard to the empirical analysis in chapter 4.

2.2.1 Exchange rate policy during trade liberalization Starting with a brief historic note, this section reviews the decisions of Argentine policymakers with regard to the exchange rate during the current liberalization effort and analyses the associated development of the real exchange rate. Argentina has a long history of currency instability which is also demonstrated by the fact that the currency has changed its name five times and seen thirteen zeros removed during the period 1969-1992. Policymakers have experimented with various exchange rate regimes, covering the whole range of possible regimes from a fixed peg to a freely floating rate (including, e.g. multiple exchange rates and a crawling peg system). Starting in the late 1970s, changes in the exchange regime were 76

With regard to exchange rate policy during liberalization, it has regularly been suggested that a depreciation of the real exchange rate is usually required for a successful trade policy reform. However, in high-inflation economies that have been trying to pursue trade liberalization at the same time as undertaking major stabilization efforts, the scope for currency devaluations has typically been restricted by the widespread use of the exchange rate as a nominal anchor. In other words, the dilemma that policy makers are facing in this context is that the exchange rate can not be used to maintain external competitiveness when using it as a nominal anchor to fight domestic inflation. Cf. e.g. Rodrik (1993) who analyses the sustainability of simultaneous processes of trade liberalization and exchange-rate-based stabilization programmes. See also Londero (1997) and

50

assigned a major role in stabilization programmes, aimed at disinflation and achieving a viable balance-of-payments. Above all, the Argentine experience with a preannounced crawl between June 1978 and February 1981 (the 'tablita' period), has triggered many discussions as to the merits and pitfalls of exchange rate based disinflation policies.

2.2.1.1 Exchange rate management during 1987 to 1990 A fixed exchange rate or a preannounced crawling peg were also a key component of the more recent stabilization programmes that were implemented after the initiation of trade liberalization in 1987: The last stabilization attempt of the Alfonsin administration, i.e. the so-called Spring Plan (August 1988 until February 1989), as well as the first stabilization plan of the Menem administration (July 1989 until December 1989) and the Convertibility Plan (since April 1991) fall into this category. The failure of exchange based stabilizations (with the exception of the Convertibility Plan) has typically resulted in the reintroduction of exchange restrictions and multiple exchange rates. Thus, exchange controls and/or multiple exchange rates prevailed throughout most of the periods between stabilization plans, i.e. from October 1987 to August 1988, and during parts of 1989. Hence, the decision of the Argentine authorities in December 1989 to allow unrestricted access to the exchange market, unify the various exchange rates, and adopt a freely floating exchange rate, has represented a marked shift from the exchange rate policies pursued during the previous decade.

A m a d e o (1996) for a discussion of some of the pros and cons of pursuing stabilization cum liberalization in the Latin American context.

51

Figure 2.2-1: The real exchange rate, 1980-1990 (1990=100)

- • - W P I deflated - e - W P I + C P I deflated

WB-index

Note: The WB-index is a trade weighted index, based on IMF and World Bank estimates. Cline (19S5) calculates the real exchange rate on a trade weighted basis against six major industrial countries (US, Germany, France, Italy, UK, Japan); one index is deflated by the wholesale price index (WPI), the other is deflated by a combination of WPI and consumer price index (CPI). A decrease denotes appreciation. Sources: World Bank (1996, table 3.2) for the WB-index; Cline (1995,101) for the other two indexes.

Figure 2.2-1 represents the development of the real exchange rate during the 1980s. A higher value of the index corresponds to a real depreciation of the Argentine peso. It is reassuring that the three alternative measures of the real exchange rate depicted in the figure do all provide a fairly similar picture: hence, the Argentine currency was extremely strong in 1980-81; in 1982 there was a very significant depreciation leading to a new plateau until 1988. Finally, there was another significant increase in the real exchange rate in 1989; however, this increase was already reversed by 1990 due to a considerable appreciation of the Argentine peso. As a consequence, the level of the real exchange rate in 1990 was almost the same as in 1982, i.e. after the major depreciation that followed the collapse of the previous stabilization cum liberalization attempt.

52

Hence, the trade policy reforms during 1987-1988 were carried out whilst the real exchange rate remained fairly constant at a level that was far more attractive for exports, (and providing greater disincentive to imports) than during the period of severe overvaluation that accompanied the previous liberalization effort before its collapse. The strong depreciation during 1989 invited a large increase of exports leading to a large surplus (5.4 billion US$) in the trade balance. Despite the significant appreciation of the Argentine currency during 1990, the trade balance showed a record surplus of over US$ 8 billion.

2.2.1.2 Exchange rate policy since April 1991: The Convertibility Law As an aftermath to the hyperinflations during 1989-1990, and the virtual collapse of the monetary system, on March 1991 the government announced a new monetary system, based on a fully convertible fixed exchange rate.77 To be specific, the Convertibility Law of April 1991 fixed the rate of the Austral at 10000:1 to the US dollar (on January 1992 the Austral was replaced by the peso at the fixed rate of 1:1 to the US dollar). The centerpiece of the Law was a legal commitment to maintain full backing of the monetary base by foreign exchange reserves.78 One analyst emphasized that, "locking the exchange rate into law and assuring that the domestic currency would have foreign reserve backing gave unique credibility to the exchange rate anchor, and provided a strong break to inflationary expectations."79 As a matter of fact, the Convertibility Plan proved quite successful in reducing inflation (from 1343 per cent in 1990 to 3.9 per cent in 1994, measured in consumer prices) and, more generally, in restoring confidence, both internal and external, as reflected in the significant reduction of the country's risk premium and the strong decline in interest rates. There have also been accelerated capital inflows, mainly in

77

Hence, Sjaastad was proven pretty wrong: in view of the failed stabilization with liberalization attempt 1 9 7 8 - 1 9 8 1 , he had made the following prediction: "The Argentine experiment with an exchange-rate stabilisation policy lasted a mere 25 months, but it will certainly be at least 25 years before such an experiment will be attempted anew in that country" (Sjaastad [1989, 267]).

78

Originally, the law permitted a m a x i m u m of 2 0 per cent of the monetary base to be backed by dollar denominated government bonds. This rate has later been raised to 33.3 per cent.

79

Cline (1995. 20).

53

terms of asset repatriation and in association with privatizations and direct foreign investment.80 In the given context, the development of the real exchange rate is of particular interest.81 Figure 2.2-2: The real exchange rate, 1990-1995 (1990=100)

—WB-lndex - e - R E R | Note: The WB-index is the same as indicated in figure 2.2-1. The RER index is calculated by Wohlmann (1998) as a trade weighted real exchange rate including both average tariffs and subsidies. A decrease denotes appreciation. Sources: World Bank (1996, table 3.2) for the WB-index; Wohlmann (1998) for the RER index.

Figure 2.2-2 shows that there has been a significant appreciation of the real exchange rate during the first 2 years after the introduction of the Convertibility Plan. The figure looks at the yearly development of the real exchange rate in order to allow direct comparisons with the 1980-1990 data (figure 2.2-1). Consequently, it can be seen that the level of the real exchange rate in 1993 did almost reach the historic low in 1980-1981. In addition, it is useful to inspect the quarterly fluctuations 60

Cf. World Bank (1996, 15-18) for more detail.

81

For a detailed analysis of the Argentine experience with the exchange rate anchor during 19911995 see Wohlmann (1998). Moreover, e.g. Cline (1995) and World Bank (1996) provide good expositions of the Convertibility Plan and its consequences.

54

of the real exchange rate (figure 2.2-3). This data reveals that the marked fall in the real exchange rate between 1990 and 1991 occurred primarily during the first 9 months of 1990, i.e. before the adoption of the Convertibility Law. Yet, the real exchange rate appreciated by some additional 20 per cent between the first quarter of 1991 and the first quarter of 1994.82 During 1994-1995 the appreciation trend was reversed. As a result, the level of the real exchange rate in 1995 was equivalent to its level in early 1991. Figure 2.2-3: The real exchange rate, 1990-1995 (4th quarter 1990=100)

90

91

92

93

94

95

— * — R E R -o-WB-index

Note: The WB-index is the same as indicated in figure 2.2-1. The RER index is calculated by Wohlmann (1998) as a trade weighted real exchange rate including both average tariffs and subsidies. Sources: World Bank (1996, table 3.2) for the WB-index; Wohlmann (1998) for the RER index.

82

In accordance with World Bank (1996, 16), "evidence suggests a strongly negative relationship between the real exchange rate and capital inflows, suggesting that capital inflows, coupled with inflexibility in the goods and factor markets, may be at the core of the real appreciation experienced early in the Convertibility Plan."

55

As previously mentioned, the sharp appreciation of the real exchange rate during 1990-1993 implied that producers of import competing goods were under increasing pressure to improve productivity in order to survive external competition. By the same token, the appreciation discouraged resource shifts towards export production, whilst making the production of non-tradables more attractive.83 As a consequence, the trade balance had a growing deficit during 1992-1994, reaching US$ 5.8 billion in 1994. The deficit turned into a trade surplus in 1995, when the Argentine economy suffered a recession that was triggered by the Mexican economic crisis. Finally, it seems useful to reiterate that the Convertibility Plan rested on at least three additional pillars apart from monetary reform. These pillars were structural reforms that had been started mainly during the first two years of the Menem administration, but which were only at that time integrated into a coherent framework: namely further trade reform, privatization, and deregulation.®4 Privatization and deregulation policies will be outlined in turn.

2.2.2 Privatization The bulk of public enterprises was established in the decade after the Second World War i.e. under the government of Juan Peron (1946-1955). There had been some discussion over privatization under the presidency of Arturo Frondizi (1958-1962) and again during the period of the military government in the late 1970s,85 but until recently there was no comprehensive effort at privatization. Instead, consecutive governments arguably made use of public enterprises in order to reward political supporters and constituencies, e.g. by over-staffing public enterprises or by subsidizing public tariffs.

83

At the same time it should also be emphasized, though, that the appreciation of the real exchange rate, by significantly reducing the cost of capital goods imports, also implied benefits to both tradable and non-tradable sectors.

84

Cf. Cavallo/Mondino (1996,11).

85

T h e World Bank (1993a, 1) reports that the military government privatized or liquidated 120 public enterprises. However, it should be added that those enterprises were all relatively small entities the core public enterprises were not touched. See also Lewis (1990, 470-471).

56 The first attempt to privatize major public firms occurred during the last two years of Alfonsin's administration. However, the government failed to receive the necessary legislative support when it proposed to partially privatize the Argentine telecommunications company (ENTel) and the national airline company (Aerolíneas Argentinas). Arguably, the objections to the privatization plan were partly due to ideological reasons and partly due to its bad design, particularly with regard to competition and regulation. Finally, the government simply ran out of time.86 The privatization programme that was carried out during the first four years of the Menem government has probably been the most sweeping privatization programme in Latin America. In no less than four years the government has virtually privatized all major state-owned enterprises.87 However, while the programme's distinguishing feature has been its speedy implementation, there is no doubt that this has also involved some shortcomings with regard to the design of the privatization process. In particular, it has been emphasized that the government gave undue priority to quickly achieving the desired fiscal effect while often neglecting the associated efficiency consequences.88 The first enterprises to be privatized were ENTel and Aerolíneas Argentinas in 1990. These privatizations were obviously badly managed and the sale of the national airline came close to failure. Among the various deficiencies that have been characteristic in this early phase of privatization, the following have been emphasized: lack of transparency of the overall process, change of terms of the bid during the bidding process, and lack of regulatory design.89 These limitations have also been acknowledged by the government which has made efforts to improve the procedure during the second wave of privatizations starting in late 1991. The major part of the privatization programme was completed in the end of 1993. During the four preceding

66

Cf. Hill/Abdala (1994,10-12) for more detail.

87

The privatization process in the provinces has been far more difficult to start and is still lacking far behind. In October 1991, i.e. after the first privatization wave, there were about 220 public enterprises with 26 per cent owned by the federal government, 65 per cent by the provincial governments and the remaining 9 per cent by the municipal authorities (World Bank 1993b, 117).

88

See e.g. Gerchunoff/Canovas (1995), Manzetti (1993, 436-449), and Petrecolla et al. (1993).

69

See e.g. Manzetti (1993, 446-447) and Hill/Abdala (1994, 18 and 33-34) for more detail.

57

years, the government sold 34 companies, and gave concessions for 19 services plus 86 areas for petroleum development.90 Employment in public enterprises decreased from 347000 in 1989 to 66700 in 1994 (in the remaining state firms). Total capital realized from the sale of state firms amounted to roughly 20 billion US$.91 Moreover, privatizations attracted massive foreign capital inflows (FDI). The main privatization method chosen was that of majority transfer to qualified bidders or what has been called the 'radical' approach to privatization, as it involves changing the management of the enterprise. In fact, a large share of the privatized enterprises have only been acquired by a relatively small number of Argentine and foreign companies, therefore concentrating the ownership in the hands of a few private groups. This has been a cause for concern to some critics who have noticed the increasing economic (and political) power of major Argentine conglomerates.92

2.2.3 Deregulation of the domestic economy Argentina's domestic markets for goods and services as well as the labour market have long been subjected to direct price or wage controls and other kinds of regulations. Deregulation of these markets has been an important objective pursued by the Menem government.

2.2.3.1 Deregulation of the domestic market for goods and services During the first two years of the Menem government, key macroeconomic variables including interest rates, wages and prices have been freed from direct state control. However, there was no systematic attempt to deregulate the domestic economy until

90

Cf. World Bank (1993a, 7).

9

Employment numbers are from Cline (1995, 60).

'

92

Cf. e.g. Manzetti (1994, especially 100-104) and Azpiazu/Basualdo (1995, 41-48). T h e concentration of privatized assets has likewise been noted by World Bank (1993a, 12). According to Cline (1995, 64), however, "it is unclear whether a close analysis would show that privatization substantially increased the share of ownership of Argentine industry owned by the leading private groups and families; nor that such an outcome would necessarily have been bad."

58

October 1991 with President Menem's promulgation of the omnibus Deregulation Decree. This decree reduced state intervention in many areas of the domestic economy, thus affecting industry, insurance, transportation, ports, banking, capital markets and the professions, as well as the wholesale and retail trades. In all of these areas the decree dismantled state controls and regulations that had been established by previous governments by law or decree.93 Subsequently, the government used a number of more specific decrees to implement particular deregulatory measures. Moreover, the newly created Undersecretariat of Deregulation was put in charge of the implementation process. Major short-term goals of deregulation have included (1) the reduction in costs of nontradable goods and services, (2) increasing price competitiveness of exports, and (3) reducing government expenditures (by eliminating unnecessary bureaucratic entities).94 By and large, there is support for the thesis that deregulation contributed to the attainment of these goals. In particular, there is some evidence that the deregulation policy proved successful in improving the quality (and often reducing the cost) of various services (ports and navigation, transport, postal services), with both domestic producers and consumers as the major beneficiaries.95

2.2.3.2 Labour market reform Since 1991, labour market reform has been high on the agenda of the government, which has taken a few steps in order to increase labour flexibility. In general, governmental proposals have aimed to reduce labour costs (including for example, severance pay, labour accident compensation) and to remove institutional obstacles that limit the flexibility of individual firms to 'hire and fire'. However, reform of labour market regulations has been a cumbersome process, involving several setbacks not

93

There has been some debate whether the enactment of the decree was a legitimate action. Menem defended it on the grounds that "80 per cent of the norms that were modified or left without effect were sanctioned by de facto governments that, of course, are considered illegitimate" (quoted from Smith [1991, 73, footnote 21]).

94

Cf. Rojo/Hoberman (1994) for a detailed elaboration of the government's deregulation programme.

95

Cf. e.g. Rojo/Hoberman (1994) and Birle (1995, 315-317).

59

least because of the difficulty to muster the political support required for an effective reform.96 In 1991 Congress approved a new employment law involving more flexible mechanisms for contracting temporary work. However, the government did not manage to carry out some of its more fundamental reform proposals, which included for example the decentralization of collective wage bargaining. In accordance with Pessino (1997), downward wage flexibility continues to be severely restricted both by labour legislation and by collective bargaining agreements.97 Yet the government resorted to a number of decrees establishing that wage increases in the framework of collective bargaining agreements need to be matched by equivalent increases in productivity. Some analysts have found, however, that most of the new agreements use inappropriate measures of productivity increase and tend to adjust wages, on average, at the same rate as the consumer price index.98

2.3 Short summary Before turning to the next chapter, it seems useful to look back and briefly review some of the results of this chapter. In particular, it has been shown that Argentine policymakers carried out a significant overhaul of the country's trade regime during the late 1980s and early 1990s. High tariff as well as non-tariff barriers that were prevalent during most of Argentina's post-War history came down to a level that is low even when judged by international standard. Some gradual trade liberalization occurred during 1987-1988 and the liberalization process was markedly speeded up since 1989, i.e. after Carlos Menem had been elected President. As a result, quantitative restrictions which had affected more than 60 per cent of tariff lines in 1987

96

Etchemendy/Palermo (1998) provide a detailed account of the political process of labour market reform during 1989-1995. S e e Pessino (1997) for an elaboration of labour market developments during 1991-1995. In addition see also Montuschi (1996) and Beccaria (1993).

97

More generally, Pessino (1997, 188) finds that the "the introduction of the Convertibility Plan and economic reform (notably, trade liberalization) was accompanied by very timid, almost non-existent, labor market reform."

08

Cf. Pessino (1997, 192).

60

were virtually eliminated by 1991. During the same period of time the average tariff dropped from 43 per cent to roughly 10 per cent. Moreover, various administrative and procedural restrictions to international trade were abolished. Overall, Argentina's participation in the regional integration scheme (Mercosur) has helped to consolidate unilateral trade policy reform - even though there are some indications that vested interests partly succeeded in influencing the structure of the associated common external tariff. In addition to switching from a highly protectionist to a relatively liberal trade policy stance the Menem administration has instituted major policy reforms in a number of other realms of public policy. In particular, this chapter has highlighted the important changes that have been implemented with regard to exchange rate policy (namely the Convertibility Law in 1991) as well as privatization and deregulation policies. Viewed in perspective these policy reforms mark a seachange in Argentine economic policy. As noted before any systematic study on the consequences of these reforms requires both proper theoretical analysis as well as careful empirical investigation. Given the focus of this study on the impact of trade liberalization on efficiency, the next chapter will provide a theoretical perspective on the efficiency effects that may be expected as a result of the fundamental reorientation of trade policy that has been elaborated in this chapter.

61

3 Does trade liberalization bring greater efficiency? Theoretical insights and empirical evidence

What are the gains that may be reaped by opening up to international trade? What are the theoretical insights concerning the efficiency effects of trade liberalization? In particular, what are the benefits that may result from trade liberalization for efficiency in manufacturing? What are the underlying mechanisms? What about the empirical evidence that has been gathered so far? These are the major questions dealt with in this chapter. Obviously, only a small selection of the enormous amount of literature that has been written on the issues involved so far can reasonably be drawn upon. Thus, it is not the purpose here to provide a comprehensive survey of the theoretical and empirical literature that does appear to have something to say on the questions outlined above. Instead, the intention is to focus on those contributions that seem particularly relevant in the case of Argentina in general, and given the focus of the empirical analysis in the following chapter in particular. More concretely, this endeavour has the following important implications resulting from the particular structural and economic conditions that are deemed characteristic of the Argentine economy. (1) Given the predominance of oligopolistic market structures within Argentine manufacturing, theoretical insights that are derived from models that build on assumptions of perfectly competitive markets, will only be used as a first stage to review the traditional gains from trade (i.e. improved static allocative efficiency).

62 (2) Attention will be devoted primarily to more recent theoretical models that are incorporating insights of both industrial organization theories and modern theories of international trade that are explicitly modelling trade in the presence of imperfectly competitive markets. In particular, it will be shown that the potential for efficiency gains from trade liberalization largely increases when, for example, the assumption of perfect competition is modified in order to take account of economies of scale.1 (3) Finally, the focus is on the efficiency effects that may be expected when introducing trade liberalization in a highly protected economy. As noted in chapter 2, the form of protection in Argentina has been anything but selective and especially the degree of non-tariff protection has regularly gone beyond any that could reasonably be justified.2 Therefore, the issue of whether selective protection may, under particular conditions, be superior to a policy of free trade will not be considered here.3 As already mentioned, it seems useful to distinguish between the insights of traditional trade theory that is based on the assumption of perfectly competitive markets (section 3.1) and the more recent theories of trade that explicitly take account of trade under imperfect competition (3.2). Both will be discussed in turn. Section 3.3 provides a summary and a graphical interpretation of the potential gains from trade liberalization that have been identified in the previous sections. Finally, the remaining section (3.4) presents an overview of the empirical research in this field.

1

The notion of 'efficiency' is used in a broad sense in this study, including various sub-concepts (allocative efficiency, scale efficiency, technical efficiency, x-efficiency) that are distinguished in the theoretical analysis. Empirically, the various efficiency effects are difficult to disentangle. However, in accordance with the relevant literature (cf. Rodrik [1995, 2969-2971]), it may be aFgued that the overall efficiency consequences of trade liberalization may reasonably be analysed empirically by looking at the development of productivity and price-cost margins. For a critical discussion of alternative concepts of economic efficiency see Feldmann (1998).

2

In short, Argentina is likely to belong to the countries that Rodrik ( 1 9 8 8 , 1 3 2 ) was alluding to when emphasizing that "the levels of protection observed in the manufacturing sectors of most developing countries vastly exceed any that could be justified by the presence of imperfect competition."

3

This question is largely the topic of the literature on strategic trade policy that has flourished in the late 1980s but that seems to have lost some of its original attraction in the meantime. Representative of this literature are e.g. Brander/Spencer (1983, 1984, 1985), Krugman (1986), Dixit/Kyle (1985). Kierzkowski (1987) provides a useful survey. Stewart (1991) comments on the (limited) relevance of strategic trade policy for developing countries.

63

3.1 Efficiency gains of trade liberalization under perfect competition Analysing the effects of trade or trade policy while assuming perfect competition on all relevant markets has the advantage of being able to derive conclusions that are fairly clear-cut. In contrast to the theoretical models that are going to be discussed in the next section these models are straightforward in their predictions about the beneficial effects from trade liberalization (understood as elimination of tariffs or quota restrictions to trade). The arguments in favour of trade liberalization that follow from traditional trade theory are equivalent to the orthodox arguments for free trade. In this framework, impediments to trade simply prevent exploiting the full advantage of international trade. Consequently, it seems logical to discuss the gains from trade liberalization according to traditional trade theory by, first, looking at the gains from trade resulting from a switch from autarky to free trade, and, second, by looking at the cost of protection (and hence the possible gains entailed by removing it). In particular, the production and consumption effects of a tariff and a quota will be demonstrated and compared as they are the most prevalent form of protection.4

3.1.1 The gains of free trade for a small economy According to traditional trade theory (as represented by the contributions of David Ricardo, Eli Heckscher and Bertil Ohlin among others), gains from trade are equivalent to improvements in terms of allocative efficiency: international trade allows countries to re-allocate resources so as to make better use of their comparative advantage. The suggestion that countries will benefit from international trade as they will typically possess different comparative advantages is at the heart of traditional trade theory, going back to David Ricardo. The Ricardian concept of comparative advantage has actually become a pillar of traditional trade theory. However, extending the Ricardian framework, other models have come up with different propositions

4

The kind of analysis presented in this section (3.1) is covered in most standard textbooks on international economics. In particular, the section draws on Williamson/Millner (1991).

64 concerning the sources of comparative advantage. In particular, whereas the Ricardian model considers but one factor of production (namely labour) and thus views different levels of labour productivity as the source of comparative advantage, the model developed by Heckscher and Ohlin includes capital as a second factor of production. Their model has in fact become the orthodox explanation of the source of comparative advantage. The basic idea underlying the Heckscher-Ohlin model is that countries dispose of different factor endowments and will, therefore, face different relative costs producing particular goods. In short, a country with an abundant supply of labour will find it relatively cheap to produce goods whose production requires much labour relative to the other factors of production. This country will therefore be a potential exporter of labour-intensive goods. For convenience, the further presentation and analysis of the Heckscher-Ohlin model is conducted in terms of the familiar 2+2+2 framework; i.e. there are two factors of production, labour (L) and capital (K), two goods, say X and M, and two countries, namely a small country called A and a large country representing the rest of the world called W. As usual the small country assumption implies that A is a pricetaker in international markets. The terms of trade facing country A are determined by international market conditions and can not be affected by A. In general, this is a reasonable conjecture when A is to represent Argentina. In autarky, i.e. without any participation of A in international trade, the general equilibrium is determined by the interaction of domestic supply and demand. The basic change that occurs when introducing the possibility of trade is that domestic production and domestic consumption do not have to be represented by the same point on the transformation curve. In fact, assuming, for example, that the country in question is relatively rich in terms of labour, it will have a comparative advantage in producing labour-intensive goods and, therefore, have an incentive to produce more of those goods than in autarky. This outcome is illustrated in figure 3.1-1: assuming that the production of good X is relatively labour-intensive, the relative price of X will be higher in country W than in the (small) country A. In other words, the relative price line in the world (T) is steeper than in country A.

65 Figure 3.1-1: Equilibrium with free trade

M

Imports

Exports

As a consequence, producers in A will adjust their production, moving from E (equilibrium in autarky) to the new tangential point G. With international relative prices represented by the T line, country A will produce at G which enables the country to reach any point on the T line. Given the shape of the social indifference curves the country will choose to consume at C, exporting some of the production of X in order to finance imports of good M. As a result, consumers are on a higher indifference curve at C then they were without trade at E. This improvement is due to the fact that real income, measured at international prices has increased when comparing pretrade production at E with the new equilibrium at G. Before elaborating a bit more on the precise nature of the gains from trade outlined above, it is useful to recall the most important assumptions that are underlying the analysis so far. In accordance with Williamson/Millner5 three sets of assumptions may be distinguished. The first group comprises assumptions about the technology of production and can be summarized as follows:

5

See Williamson/Millner (1991, 40).

66 -The production function is homogeneous of the first degree, i.e. there are constant returns to scale in production. -There is continuous substitution between the factors K and L; i.e. the production is well-behaved with isoquants being smooth and convex to the origin. - There are no reversals of factor-intensities. - There is instantaneous adjustment, i.e. the economy is always in equilibrium. Second, there are assumptions that entail that after trade the price will be the same in country A as in the rest of the world: - There are no transport costs. - There is free trade. - All markets are perfectly competitive. Finally, in order to make the analysis more manageable it was assumed that: - Factors of production are fixed and always fully employed. - Consumer preferences can be represented by a set of social indifference curves that are convex to the origin. - There are two goods, two factors of production and two countries, one of which is small. Obviously, the relaxation of some of these assumptions has different implications for the robustness of the model. Modifying, for example, the assumption of no transport costs does not change the conclusion that consumer welfare will be maximized through free trade. However, things become rather more complicated when, for example, relaxing the assumption of perfectly competitive markets. The models discussed in section 3.2 will deal in particular with some of the implications involved when modifying the assumptions of perfect competition and those concerning the technology of production. To conclude this section, it is useful to be a bit more specific about the nature of the gains from trade in the Heckscher-Ohlin framework. Analytically, the gains from

67 trade involved in moving from the pre-trade equilibrium E to the post-trade consumption point at C can be separated into two distinct components. Figure 3.1-2 illustrates the argument. Figure 3.1-2: Gains from trade (small economy)

First, there are gains from exchange that accrue to the country because it benefits from the fact that international relative prices differ from the domestic price ratio in autarky. Thus, even if the country produced the same quantities of X and M before and after participating in international trade it could export some of good X and import some of good M in order to consume at point B, i.e. reaching an indifference curve (l't) which represents a higher level of utility than in autarky (I,). Second, there are gains from specialization as the country is producing a higher quantity of X, the good in whose production it has a comparative advantage compared to the large country W. Given the higher relative price of X in the rest of the world (W), the small country is, hence, able to further increase consumption of both X and M, realizing consumption at point C. In other words, the welfare gain due to the reallocation of resources is represented by the movement from B to C with the associated shift from I', to I,.

68 3.1.2 The cost of tariff protection One of the most common forms of protection is the levy of a tariff on imports. In Argentina as well, import tariffs have been a regular measure of protection. So, what are the effects of tariff protection according to the neoclassical framework outlined in the previous section? Or, put differently, what kind of gains are attainable when barriers to trade in terms of import tariffs are eliminated? In order to provide an answer it will again be helpful to illustrate the argument with some graphs. The principal effect of a tariff is that it drives a wedge between the world price of the importable good (p*m) and the domestic price of the imported good (pm). More specifically, assuming that imported and domestically produced goods are perfect substitutes, an ad valorem tariff levied on imports of good M will raise the domestic price of M by the amount of the tariff rate. Figure 3.1-3: Effects of tariff protection in partial equilibrium

Figure 3.1-3 provides an illustration of this point in terms of partial equilibrium analysis. When no tariff is levied on the importable good M the domestic price equals the world price p* Hence, domestic producers supply the amount q1 and the

69

volume of (q4-q1) is imported in order to satisfy domestic demand (q4). T h e imposition of a tariff on imports of good M raises its domestic price to p m =(1+t)p*, and, consequently, domestic supply increases to q2 while consumption declines to q3. Imports are being reduced from (q4-q1 ) to (q3-q2). T h e net cost of the imposition of the tariff t are equivalent to the sum of the two small triangles (b+d) in figure 3.1-3.® This result can be derived as follows: drawing on the concepts of consumer surplus and producer surplus, it is evident that area 'a' represents a pure redistribution from consumers to producers. 7 Moreover, a r e a 'c' is the amount of tariff revenue paid to the government by domestic consumers,

and,

therefore, stands for domestic redistribution. Of the remaining triangles, 'b' denotes the production cost due to the misallocation of resources, and 'd' captures the consumption loss. 8 Obviously, ceteris paribus, the more elastic is domestic supply of and demand for the protected good and the higher the tariff, the larger the size of those triangles will be. In addition, when considering that there are many goods with tariff protection, the greater the share of the protected goods in total consumption, the higher the associated efficiency cost will be. 9

6

These are the famous "Hartoerger triangles".

7

See, for example, the good exposition in Krugman/Obstfeld (1994, 201-206).

9

In this context it may be useful to point out that this static cost of protection may, under some conditions, also imply a (temporary) reduction of the rate of growth of real income, as argued by Corden (1971; 1974). Yet, as noted by Corden (1971, 126), "the growth gain results when parts of the static gain are invested. It thus represents a particular allocation of the static gain - an allocation which raises real income in the future rather than consumption now - and thus is not additional in a welfare sense" (italics added, A.P.). More generally, the relationship between trade and growth in the standard neoclassical growth model is characterized by the fact that trade liberalization does not affect the long-run rate of growth (see e.g. USITC [1997]; Maurer [1998, 16-31]). Therefore, it has long been difficult to relate international trade to dynamic efficiency gains or effects on the long-run rate of growth. As emphasized by Krueger (1980, 288) some 18 years ago, "trade theory provides little guidance as to the role of trade policy and trade strategy in promoting growth." Only with the recent emergence of the 'new' growth theories has the relationship between trade and growth become more accessible analytically. These theories do typically depart from the assumption of perfect competition and will consequently be dealt with in section 3.2 below.

9

Suffice it here to point out that export taxes are to some extent comparable to import tariffs. The precise effects of export taxes will therefore not be demonstrated in detail. In fact, adopting a general equilibrium perspective the Lerner symmetry theorem asserts that a uniform export tax is equivalent to a uniform import tariff. In other words, an export tax benefits import-competing producers whereas it hurts exporters. Consequently, the reduction of export taxes can also be regarded as a measure of trade liberalization.

70 3.1.3 The cost of non-tariff protection: The quota case Another important form of protection is quantitative restrictions on imports. In fact during the 1980s this way of providing protection to domestic producers of importables has been widely employed in Argentina. This section will analyse the effects of the typical quantitative restriction, namely a binding import quota. Under certain conditions the effects of quota restrictions are equivalent to the effects of an import tariff. Put differently, it is possible to determine the size of an import quota so that its effects on domestic prices, production and consumption are identical with the effects of levying a tariff on imports, as analysed above. Thus, using the same framework as in the previous section, the potential equivalence of both measures will be demonstrated before commenting on possible differences between quota and tariff protection. Figure 3.1-4: Effects of a binding import quota Pm

S

D q1

q2

q3

q4

CL

Figure 3.1-4 demonstrates that it is possible to define an import quota (Q') giving rise to the same effects on domestic welfare as those analysed in the context of tariff protection (Figure 3.1-3). The imposition of the quota Q' chokes off some imports of

71

good M. As a consequence, the new equilibrium is characterized by domestic production increasing from q1 to q2 and domestic consumption declining from q4 to q3 as the domestic price of good M rises to pm. Thus, if the distance between the new equilibrium price p m and the world price p* happens to be the same as the distance between domestic and world prices in the case of tariff protection (i.e. if the tariff t equals pm/p*-1), the welfare effects are clearly the same, the cost of protection amounting to the familiar two triangles (b+d). Nevertheless, there may be important differences between the implications of quantitative restrictions and tariff protection, respectively. 10 In this context, three major implications will be touched upon. First, tariff and quota restrictions commonly have different effects on government revenue. This results from the fact that there is usually no perfectly competitive market in order to allocate the quota among domestic producers. In fact, most governments including the Argentine government do not even resort to auctions that, in principle, provide the opportunity to sell the quota at the competitive price; more typically import licenses are distributed "for free" according to more or less transparent criteria. Hence, area c now stands for profits reaped by domestic importers (buying good M at the world price p* and selling it to domestic consumers at p m ) instead of government revenue from tariff collection. Second, another difference concerns the implications of shifts in demand or supply. In general, with a fixed import quota, demand or supply shifts entail price adjustments, whereas in the case of tariff protection adjustment occurs via quantities. For example, given a fixed quota Q' an outward shift in demand from D to D' raises the domestic price to p'm (see figure 3.1 -4). As a result the size of the two relevant triangles and hence the cost of protection increase. Considering the same situation with tariff protection, the price is constant (p m ) and imports expand, with the cost of protection remaining unchanged. Finally, it has also been argued that the problem of quota allocation is likely to give rise to further distortions as it motivates rent-seeking

10

T h o s e differences become especially relevant when modifying the assumption of perfect competition on all markets that is underlying the theoretical framework outlined above. In particular it can be shown that quota and tariff protection, respectively, give rise to distinct levels of monopoly power when the domestic market is imperfectly competitive. This issue will be discussed in some detail in section 3.2 below.

72 behaviour by domestic producers. This phenomenon will now be discussed in some more detail.

3.1.4 Cost of protection due to rent-seeking A seminal article by Anne Krueger (1974) argued that measures of trade protection are prone to entail efficiency costs that have not been captured in the traditional analysis of the costs of protection as outlined above. The costs that Krueger (1974) has in mind are associated with "rent-seeking" or "directly unproductive profit-seeking" activities (a notion coined by Bhagwati [1982]) that are presumed to be an offspring of rent-creating government policies including trade protection. Her basic argument can be summerized as follows: the imposition of a binding import quota typically creates rents on part of the import license holders. As a result, the quota entails rent-seeking activities by those who want to appropriate these rents; i.e. resources are devoted to competing for import licenses.11 In addition, the quota may also trigger lobbying in favour of its elimination by those who are hurt by the quota's introduction. Now, the resources that are spent in order to achieve the quota's abolition or to capture the associated rents are to be considered as deadweight costs that come on top of other costs of protection. The result is equivalent to an inward shift of the economy's production possibility frontier.12 Whereas Krueger (1974) focused on rent-seeking induced by quantitative restrictions other authors have shown that the argument holds as well in the case of tariff protection.13 In addition, it may also be argued that the introduction of barriers to trade will typically trigger a process of increasing protection both in terms of scope and degree; along these lines Krueger (1990a) has emphasized that "there will be a tendency for increasing proliferation of categories and of policy instruments, as various groups assert conflicting and

11

Lobbying is one possible form of rent-seeking. There are, of course, many other forms including illegal ones: bribery, corruption, smuggling, and black markets are mentioned by Krueger (1974, 2 9 1 ) as examples that fall into the second category. With regard to import licenses, Krueger (1974, 2 9 2 ) illustrates that the mechanism according to which licenses are distributed clearly has an impact on the form that rent-seeking takes.

12

Cf. Krueger (1974) for a formal derivation of this conclusion.

13

Cf. Bhagwati/Srinivasan (1980) and Bhagwati (1982).

73 competing claims, and this proliferation should also be counted as a cost of the original policy."14 Finally, a note on the empirical relevance of the costs of rent-seeking. Due to their very nature it is obviously difficult to derive precise judgements of the actual significance of the welfare costs of rent-seeking. Yet, one study that attempted to estimate the costs of rent-seeking associated with import quotas in Turkey found that these costs amounted to between 5 to 10 per cent of real GDP.15 Even if these figures should probably not be taken too serious they indicate that rent-seeking may indeed imply important costs.16 Clearly there is no guarantee that trade liberalization serves as a panacea for the elimination of rent-seeking. As noted by Rodrik (1995b, 2944), "as long as governments exist and they implement policy, individuals and groups will exercise political power to obtain particularistic benefits for themselves." Nevertheless, the argument that some forms of government intervention (e.g. quantitative restrictions) are more apt to induce rent-seeking than others (e.g. a uniform import tariff) is still fairly convincing. This does not exclude the possibility that the reduction or even elimination of highly distortive import barriers gives rise to new forms of protectionism (e.g. anti-dumping measures) that may again invite rent-seeking (or in fact be the result thereof).17

14

Krueger (1990a, 18).

15

Cf. Grais et al. (1986) and Lal/Rajapatirana (1987, 192). More generally, Krueger (1974) suggests that the actual value of rents indicates the volume of resources that are likely to be devoted to unproductive rent-seeking activities. In addition, she presents the results of a few empirical studies (on India and Turkey) that have estimated the value of rents from import licenses to lie in the range of 5 to 15 per cent of G D P .

16

Moreover, apart from the static cost of rent-seeking, Murphy et al. (1991) have formalized the idea that rent-seeking may have significant negative growth effects, because of its influence on the allocation of talents in a society.

17

More broadly, the determinants of rent-seeking also have to be sought in e.g. historical, ethic, and institutional characteristics of individual societies that all impinge on the behaviour of social and state actors. There is an emerging literature on 'governance' issues that deals with closely related topics. S e e e.g. Frischtak (1994) for an analysis of the relation between governance capacity and economic reform.

74

3.2 Efficiency effects of trade liberalization under imperfect competition 3.2.1 Introduction Giving up the assumption of perfect competition implies giving up the possibility to derive fairly general propositions from international trade theory. Under imperfect competition a huge variety of possible outcomes exists and it has often become a matter of empirical research to conclude on the relevance of the theoretical models. A recent survey of empirical research in this field emphasizes this fact noting that "...it is necessarily an empirical question whether or not an economy gains from trade liberalization in this case" (i.e. in the case of imperfect competition).18 Potentially, the gains from trade are much bigger than in a perfect competition framework. In fact, given the "discouragingly small size of the Harberger triangles"19, the possible gains from trade under imperfect competition have recently received increasing attention.20 A simple comparison may help to illustrate the argument: in the orthodox framework reviewed in the previous section any country is producing on its production possibility curve.21 Gains in terms of allocative efficiency have to do with improvements at the margin, as the country is moving along the transformation curve. In contrast, the models referred to in this section explicitly suggest that a country may be producing inside a given transformation curve. In other words, these models allow for technically inefficient firms, whereas traditional trade theory assumes that firms are always technically efficient. In addition, some models take account of possible links between international trade and outward shifts of the production possibility curve of a given country. In both cases (i.e. movement towards the production possibility curve and outward shift of the latter), efficiency gains concern the overall production of goods, not just marginal production; therefore, the cor-

18

Richardson (1988, 1).

19

Rodrik (1988,110).

20

A case in point is a major World Bank research project whose results have been published recently (cf. Roberts/Tybout [1996a]).

75 responding efficiency gains are potentially much larger than the marginal allocative efficiency gains mentioned above.22 The channels through which trade liberalization may lead to increases in productivity are, in short, the following: increased competition, exploitation of economies of scale, reduced producer heterogeneity (exit of inefficient producers), reduced x-inefficiency, faster technological change. Figure 3.2-1: Trade liberalization under imperfect competition: Possible gains and associated channels

2

' As hinted above, rent-seeking activities may result in a country producing inside its original transformation curve. However, this strand of theory should be viewed as an extension of traditional trade theory.

72

This argument has been illustrated by Conden (1974, 229-230) with the following example: "A tariff leads to a 10 per cent rise in output of the import-competing industry. The orthodox resource allocation effect focuses only on this 10 per cent. But the efficiency of producing the whole output may be affected; it bears thus on the original 100 per cent as well."

76

In addition, trade liberalization may yield further efficiency gains in protected markets that are dominated by a few domestic firms: i.e. trade liberalization may effectively restrict the market power of domestic monopolies or oligopolies that display distortionary pricing behaviour. The stylized graph represented in figure 3.2-1 intends to illustrate the channels through which trade liberalization may improve efficiency in terms of increased productivity and less distortionary pricing. The discussion of the theoretical underpinnings of those linkages is organized as follows: the next section (3.2.2) elaborates on the link between trade liberalization and the degree of distortionary pricing behaviour. The following three sections (3.2.3 - 3.2.5) all consider various channels through which trade liberalization may increase productivity in the economy. Finally, it may be useful to indicate that changes in pricing behaviour and productivity are also the efficiency indicators that are used in the empirical analysis in chapter 4.

3.2.2 Trade liberalization and domestic market power In a perfectly competitive market firms are price-takers. In contrast, the key feature of imperfect competition is that firms are not taking prices as given. In particular firms will realize that selling one more unit of output will typically alter the revenue they receive from selling all other units. Thus, firms will have some conjecture about the overall effect on their own revenue of changing their output and/or its price. As a result, price in imperfectly competitive markets normally exceeds marginal cost.23 Moreover, the ratio of price to marginal cost is commonly interpreted as an indicator of market power. With regard to trade policy the major presumption is, in short, that import competition places a substantial limit on domestic market power. According to Elhanan Helpman

23

Rodrik (1992b, 99), for example, notes: "the hallmark of imperfect competition is that prices exceed marginal costs of production (the latter including all relevant opportunity costs)."

77 and Paul Krugman this is in fact the oldest insight in the context of research on trade policy effects under imperfect competition.24 Thus, the degree to which domestic oligopolistic or monopolistic firms may mark up their prices over marginal costs is likely to be influenced by the extent of import competition that those firms are facing.25 There are actually myriad models that have been built in order to inquire into the possible links between trade policy and domestic market power. Those models may be distinguished according to the assumptions they make about market structure (oligopoly, monopoly), firm behaviour (non-cooperative, collusive) and technology (scale economies), to name the more important variables.26 Helpman/Krugman (1989) pull together the results of previous research in this field, analysing the effects of trade policy on domestic market power under a variety of assumptions concerning market structure and firm behaviour. They find that in all but one case protection of domestic producers increases their market power and, hence, their scope to prop up prices.27 Another important finding relates to the non-equivalence of tariff and quota protection with regard to their impact on domestic market power - an issue already hinted at in the context of trade policy under perfect competition (section 3.1). In this context it is useful to keep in mind that quantitative restrictions were in fact a characteristic feature of Argentine trade policy before embarking on trade policy reform. Therefore, continued attention will be paid to the comparative effects of quota and tariff restrictions.

24

Helpman/Krugman (1989, 27) put it like this: "The oldest insight in this area...is the idea that international trade increases competition and thus, conversely, that protection creates domestic monopoly."

25

CI. also Baumol/Lee (1991, 9) who emphasize the virtues of contestable markets (like e.g. absence of excessive prices or profits and the absence of inefficiency or waste) and point out that "...international trade can be a potent source of the sorts of pressures that impart contestability to a market."

26

According to Levinsohn (1993, 9) "..there are at least 30 cases one could consider...".

27

Helpman/Krugman (1989, 27-47) find one possible exception, namely the case of a quota when the protected industry is a collusive oligopoly whose actions are constrained by problems of enforceability.

78 The conclusions that can be drawn from an analysis of the impact of trade policy on domestic market power considering the case of an import-competing monopolist are extremely robust to changing formulations of market structure; therefore, it makes sense to illustrate the logic of the argument with reference to the straightforward case of a domestic monopolist.28 The more realistic situation of a domestic oligopoly will be discussed next.

3.2.2.1 Domestic monopoly In figure 3.2-2 the marginal cost curve of the domestic monopolist is represented by the upward-sloping line MC. Domestic demand for the firm's output is indicated by the demand curve D, with the associated marginal revenue curve MR. Moreover, a good (or a bundle of goods) which is assumed to be a perfect substitute to the domestic firm's output is available from the world market. The latter is assumed to be perfectly competitive and, hence, the import supply curve is a horizontal line at the world price p* Finally, the possibility to export is assumed away. Obviously, if there is free trade the monopolist can not afford to choose the profitmaximizing price-output combination (pM, qM) that arises from equating marginal revenue and marginal cost. To the contrary, the domestic monopolist is compelled to charge the competitive world price p*: if he charged any price above p* imports would be preferred by domestic consumers and the monopolist would have to cease production. Thus its profit maximizing output decision will be to produce up to the point q F where the marginal cost of production equals the world price p*. In short, the monopolist does not have any monopoly power under free trade!

28

The following exposition draws on Bhagwati (1965) and Helpman/Krugman (1989, 27-35) in particular.

79 Figure 3.2-2: Effects of protection on monopoly power

Pm

M C

M

P P

P

P D

qF

qM

QP

Qm

In order to analyse the effects of an import tariff on the price and output of the domestic firm it is useful to distinguish three situations. First, the tariff may be relatively small so that the world price plus tariff (p*+t) is somewhere between p* and the prohibitive price p p , i.e. the price at which any imports are choked off.29 Second, p*+t may be higher than p p but lower than the monopolistic price pM. Third, the tariff may be so large that p*+t > pM. In the first case, i.e. when p*+tpp there are no imports; however, the domestic monopolist is kept from charging pM as long as p*+tp M the firm will be able to charge p M the profit-maximizing monopoly price. It was already noted above that the potential equivalence of tariff and quota protection (in terms of their effects on domestic price and output) breaks down when introducing elements of imperfect competition into the analysis. In particular, it can be shown that "an import quota creates more domestic monopoly power than a tariff that restricts imports by the same amount, and it therefore leads both to lower domestic output and a higher domestic price." 30 Given the predominance of quantitative restrictions in Argentina during the 1980s it seems useful to elaborate this point in some more detail. The different impact on market power of tariff and equivalent quota protection 31 can perhaps best be seen when comparing a prohibitive tariff with a total ban on imports (i.e. a quota amounting to zero): even though imports are completely choked off when p*+t>p p , the mere threat of imports restricts market power in the tariff case as long as p*+t

q F ). However, this does not need to be the case. In particular it is also possible that domestic output declines as a result of protection as firms are induced to restrict output in order to increase their profits via the associated increase of prices. In this context, the crucial issue concerns the nature of the shift of the perceived marginal revenue curve - an issue that will be dealt with further below.

85 domestic firms calculate marginal revenue under a quota regime they will take account of the fact that domestic consumers are not able to substitute imports for domestic goods if they restrict their output. Therefore, the perceived demand curve in the case of quota protection is steeper (less elastic) than under the tariff that yields the same level of imports. Consequently, equilibrium price and associated markups under quota protection are higher, and output will be lower when compared to the "equivalent" tariff equilibrium. Thus, the conclusions drawn from the analysis of the case of an import-competing monopolist are broadly confirmed when considering an oligopolistic market structure.37 More generally, it is to be emphasized that, despite the large variety of existing models, the results concerning the impact of import protection on domestic market power are almost unanimous: hence there is significant theoretical support for the so called 'imports-as-market-discipline' hypothesis which is basically the inversion of the argument that protection creates domestic market power. According to this hypothesis an increase in import competition as a result of trade liberalization will reduce market power and associated markups in domestic industry.38 In addition this section has demonstrated that domestic markups are bound to be more significant in the context of quantitative restrictions - as they were excessively applied in the case of Argentina during the 1980s. Without going into too much detail it should nevertheless be emphasized that there remain various controversial issues that are related to conceptual and empirical questions; they concern, for example, appropriate definitions of market power and import competition. In this context no consensus has been reached.39

37

One exception has been noted in footnote 27 above.

38

See also Levinsohn (1993, 9) who points out that "with so many possible theoretical permutations, it is striking that a tariff or a quota will, in almost every case, increase price-marginal cost markups." Similarly, Havrylyshyn (1990, 14) points out that "the literature on industrial organization clearly shows that greater trade openness improves welfare by restricting oligopolistic market power through import competition and export opportunities." Cf. Caves (1985, 378-380).

86 3.2.3 Trade liberalization and economies of scale One of the key assumptions underlying orthodox trade theory is the assumption of constant returns to scale. However, the empirical relevance of scale economies in production can hardly be denied.'40 Introducing the possibility of increasing returns to scale has a number of important implications for economic analysis which in general gets more complicated. In this context it is possible to distinguish two types of scale economies: (1) external economies of scale that accrue at the level of an industry, i.e. outside a particular firm and (2) internal economies of scale which are relevant at the firm level. External scale economies are consistent with perfect competition, whereas internal scale economies are generally associated with a market structure characterized by imperfect competition. Consequently, this section refers to internal economies of scale. With regard to the effects of trade liberalization on economic performance (labour productivity), it can be argued that trade liberalization may improve scale efficiency in production and, hence, lead to an increase in productivity.41 In other words, this argument implies that domestic firms' output may actually increase as a result of trade liberalization. There are three channels through which this may occur, namely: (1) via market expansion, (2) demand shifts and the associated loss of market power, and (3) industry rationalization. The first argument is related to a broad general equilibrium perspective. The second and the third mechanism are particularly relevant as they suggest that - under imperfect competition - it is actually possible for liberalization to result in the expansion of import-competing firms, an outcome that would hardly be expected if perfect competition is assumed. The 'demand shift' and the 'rationalization' mechanism are closely interrelated, however, analytically they may be distinguished as the rationalization argument hinges on the assumption that firms enjoy relatively free entry and exit, whereas the other argu-

40

Berry (1992) provides a good introduction to the relevant issues and evidence.

41

Recent surveys of the empirical relevance of scale economies in developing countries are provided by Richardson (1988) and Tybout/Westbrook (1996). The latter article aims to identify the potential gains in scale efficiency that might be reaped through policy changes. Contrary to the conclusion of numerous simulation studies, Tybout/Westbrook (1996) point out that those gains may be rather modest. According to them "the reason is that large plants, which are close to minimum efficient scale, account for a disproportionate share of production" (p. 105).

87

ment operates even if the number of firms in the market is fixed. All arguments will be discussed in the following sections.

3.2.3.1 Market expansion via participation in world markets In this context it may be argued that trade protection entails a bias towards production for the (small) domestic market while discouraging exports. Correspondingly, opening up to trade or trade liberalization is associated with export expansion and production for the large world market: considering the case of a country whose domestic market is small relative to minimum efficient scale of production, opening up the economy may improve scale efficiency as domestic producers may expand their production by participating in world markets thus taking advantage of economies of scale in production.42 The argument is similar to the traditional gains-fromspecialization argument elaborated in section 3.1. In essence, it suggests that the gains from specialization may be further augmented because of increasing returns of scale. However, those additional gains can by no means be taken for granted. In particular, they can only be reaped if, on average, trade liberalization leads to the expansion of those sectors or firms which display economies to scale. Consequently, if those activities for which scale economies are especially relevant are predominantly located among import-competing sectors that have previously been shielded from foreign competitors, the overall impact of trade liberalization on scale efficiency may be negative.43 In other words, it is often expected that import-competing sectors are going to contract when import barriers are reduced.44 However, the following two sections point out that, in the presence of imperfect competition, trade liberalization may have the effect of leading to increased output per firm in import-competing sectors.

42

This point has e.g. been emphasized by Nishimizu/Robinson (1984, 179) and Nishimizu/Page (1991,253).

43

According to Rodrik (1988, 120-122) it is reasonable to expect a positive correlation between the degree of protection and the relevance of economies of scale in developing countries. He also provides some evidence of such a relation in the case of Turkey (ibid.).

44

It should be emphasized, though, that, notwithstanding scale effects, the reduction of domestic output in sectors where domestic marginal costs exceed the world price is still welfare enhancing. Cf. also the comment to Rodrik (1988) by Bowen (1988).

88 3.2.3.2 Demand shifts, reduced market power, and output expansion Whereas the preceding argument concerning the overall effect of market expansion is based on general equilibrium considerations, the argument that is being presented in this section and the following section is an outflow of partial equilibrium reasoning concentrating on the sectoral adjustment process in the wake of trade liberalization. As a matter of fact, the argument in this section can be viewed as another aspect of the discussion on trade liberalization and market power that was carried out above. More concretely, the preceding discussion concentrated on the linkage between trade policy and price-marginal cost markups in imperfectly competitive markets, whereas the key issue in this section relates to the impact that trade policy may exert on firm output via affecting firms' market power. The basic argument should be clear from the previous discussion: monopolistic market power may induce firms to reduce sales in order to push up domestic prices. Consequently, if those firms are facing increasing returns to scale over the relevant range, they will end up producing at an output level that does not minimize their average costs. Correspondingly, the reduction of barriers to trade may induce import-competing firms to expand output in order to reduce unit costs and, thus, be able to compete with imports.45 In other words, even if trade liberalization is associated with an inward shift of the domestic demand curve - as it is likely to be in the case of import-competing firms this shift may be more than offset by the change in the slope of the demand curve, leading to an expansion of those firms. There is, of course, no guarantee that this outcome will actually attain, but the possible relevance of this kind of effect should be evident. It shall suffice here to illustrate this argument in the context of domestic oligopoly, again making use of a graphical representation that modifies figure 3.2-4 which was introduced above; i.e. the underlying assumptions are the same as before (constant

45

The potential relevance of this kind of effect has, for example, be emphasized by simulation experiments carried out by Devarjan/Rodrik (1989; 1991). Devarjan/Rodrik (1991, 1161) find that "the pro-competitive effect...represents an important channel through which trade liberalization can become compatible with desirable expansion in the manufacturing sector in the absence of industry rationalization."

89

M C , identical firms, Cournot behaviour, imports and domestic goods are imperfect substitutes), except for the additional assumption that firms are producing under increasing returns to scale.

Figure 3.2-5: Trade liberalization, demand shifts, and output in oligopoly

Thus, figure 3 . 2 - 5 illustrates the argument that firm output may in fact be increasing when protection is reduced (q F >q p )

46

As mentioned above, the reason is the erosion

of market power due to trade liberalization: the mechanism at work is the increase in the perceived elasticity of demand faced by domestic oligopolists 47 , reflected by D * being flatter when compared to D

which

is

p 48

46

Note that q p and q F represent Industry output, i.e. qF>qp indicates that total production of the industry in question expands. Since firms are assumed to be identical this implies that output per firm expands as well - even if the number of firms remains constant before and after liberalization.

47

More specifically, it can be shown that with symmetric Cournot competition each firm's perceived demand elasticity (e) equals each firm's market share (1/n) multiplied by the elasticity of the overall market demand schedule (E); i.e. e = E/n.

48

Referring, in particular, to the liberalization of quantitative restrictions (like binding import quotas) with domestic producers being placed in large world markets where there is a great number of substitute products available, it is indeed reasonable to expect demand elasticity to rise. Cf. also the previous discussion of the effects on the slope of the perceived marginal revenue curve of quota restrictions and equivalent tariff protection, respectively.

90 Accordingly, the position of the demand curve under free trade (D*) can be derived by, first, pivoting the demand curve through the pre-liberalization equilibrium point and, second, shifting it inward thus taking account of the fact that imports are being substituted for domestic products when protection is reduced. Moreover, when marginal costs are assumed to be constant (as depicted in figure 3.2-5) economies of scale may accrue as a result of fixed costs that each firm has to pay. In other words, a s long as firms face declining average costs over the relevant range, any expansion of output will reduce unit costs and thus improve scale efficiency and productivity. T o conclude, it should again be emphasized that the expansionary effect of trade liberalization on firm output relies on the presumed elasticity effect of trade liberalization but not on firm entry/exit. 49 Additional considerations that are relevant when free entry/exit of firms is allowed for are discussed in the next section.

3.2.3.3 Industry rationalization T h e expectation of productivity increases due to industry rationalization can be viewed as another pillar of the argument that trade liberalization improves economic efficiency. Basically, the argument relies on relatively unhindered entry and exit of firms into relevant industries. In short, the idea is that trade liberalization may entail a process of industry rationalization where the profitability in highly

protected

markets has attracted excess entry of firms producing far below efficient scale. 5 0 Given the overall importance often assigned to the argument as well as its potential relevance in the Argentine context it seems useful to scrutinize the argument. Therefore, the argument will first be presented in its original version which presumed that protected domestic oligopolies are bound to agree on collusive behaviour.

49

Along these lines, Devarjan/Rodrik (1991, 1161) emphasize that "the pro-competitive effect... represents an important channel through which trade liberalization can become compatible with desirable expansion in the manufacturing sector in the absence of industry rationalization."

50

It is interesting to recall that, originally, during the high days of import-substituting industrialization strategies it was commonly argued that economies of scale actually provided an argument in

91

Secondly, the argument will be analysed in a different context characterized by the existence of differentiated products and the associated market structure of monopolistic competition. Finally, some reference will be made to recent research pointing to possible rationalization effects in the presence of producer heterogeneity.

a. Protection,

excess profits,

and inefficient

entry

The view that protection is likely to induce inefficient entry was first advanced by Eastman and Stykolt who were analysing the effects of protection on industry in Canada. Si Their work appears to have been quite influential although it does not provide an explicit model in support of their hypothesis. Basically, they suggest that, in a relatively small protected market, the number of firms permitted by economies of scale will typically be more than one but small enough to imply that firms agree on effective collusion. Thus, firms in the relevant industry will agree on some marketsharing arrangement and behave like a single producer: in particular, they will seek to raise the industry price to monopoly levels. Obviously, this behaviour will only be feasible if import competition is constrained by tariff or quota protection, both of which will initially lead to higher prices and profits. Hence, with the number of firms held constant in the short run, protection may allow incumbents to reap excess profits. In the long run, however, excess profits will induce additional firms to enter the protected market. If integer constraints are not binding this entry will eliminate any excess profits; otherwise, namely if discreteness problems are relevant, equilibrium is compatible with positive profits while any additional firm entry would lead to negative profits. Generally, firms have an incentive to enter as long as the domestic market price is higher than average costs. However, as the number of firms increases the output of each firm has to decline, thus producing at higher cost.

favour of protection: protection should raise the output of domestic firms, thus allowing them to travel down their average cost curves. 51

The following exposition is based on Eastman/Stykolt (1960) whose model has also found application in some empirical studies including the seminal work of Harris (1984) and Cox/Harris (1985). Cf. also Buffie/Spiller (1986) who build a general model of oligopolistic interactions in order to analyse the short- and long-run effects of partial quota liberalization given different oligopolistic conjectures. However, in contrast to the focus in this section Buffie and Spiller do not explicitly look into the impact of liberalization on firm output but concentrate on the adjustment of industry output.

92 Figure 3.2-6: Protection and inefficient entry

The essence of this argument can be illustrated with reference figure 3.2-6, i.e. considering first the simple case where, once imports cease, the domestic market is supplied by a single domestic producer. Production occurs under increasing returns to scale; fixed costs and constant marginal costs imply falling average costs of production: the AC schedule denotes the average cost curve of a representative producer. Assuming that imports and domestic goods are perfect substitutes and that competitively supplied imports are available at price p*, there would clearly be no domestic production under free trade. The minimum price (pp) at which a representative domestic producer would be able to operate profitably (i.e. without incurring any loss) is determined by the intersection of its average cost curve (AC) with the demand curve. Therefore, as drawn in figure 3.2-6, the tariff tp needs to be imposed to bring one firm into operation. Moreover, as this tariff displaces all imports, any tariff that increases the domestic price of imports above p p allows the domestic producer to reap excess profits (moving along the demand curve until the monopoly level is reached). As a result, other firms may be induced to enter the market in order to appropriate some of those profits. If the incumbent has no means

93 to prevent other firms to enter the market, firms may end up reaping only small or no monopoly profits at all, since these profits will be dissipated by higher costs owing to the smaller scale of production as firms have to share total market demand among each other. As drawn in figure 3.2-6, if due to tariff or quota protection the domestic price of imports is, for example, raised to pN the domestic market may support two producers that are each producing qN but without earning any excess profits (as p N equals each firm's average costs when producing the quantity qN). Now, if the tariff was further raised to say t „ both producers might agree to collude, setting the domestic price at the tariff inclusive price of imports (ps) and sharing market demand associated with p s ; hence, each firm may produce the quantity q s earning excess profits that are represented by the shaded area in figure 3.2-6. This situation corresponds to the short-run equilibrium in the case of a collusive oligopoly as described above. However, as argued above, in the long run these profits may be dissipated as new firms are induced to enter the market. Finally, it should be emphasized that the phenomenon of inefficient entry in the presence of protection may also be due to increasing demand (represented by an outward shift of the demand curve) which would allow more firms to enter the market - even if the tariff is held constant at the minimum level necessary to establish domestic production.52 To see this, one might imagine that, originally the demand curve may be represented by D 0 (implying that the minimum tariff rate to establish production is t„ with p*(1+t„)= pN); later on, demand expands and the demand curve shifts to the D schedule. Now, one possible outcome would be that the existing producer expands output, hence moving down his average cost curve and earning monopoly profits. However, an alternative outcome is that another producer enters the industry in question, thus keeping average costs at the previous level. Clearly, the rationalization effect of trade liberalization operates just like the reverse of the impact of protection: in short, the exposure to foreign competition puts downward pressure on the domestic price level and, correspondingly, average costs have

94 to decline. Therefore, some firms will exit; in equilibrium, again, price equals average cost but at a lower level than before. More generally, it should be emphasized that this outcome does not depend on any possible expansionary effect of trade liberalization (as discussed in the previous section); to the contrary, the outcome remains the same when the import-competing industry contracts in the aftermath of trade liberalization. In this case some firms are forced to exit and the remaining firms may produce at a larger scale and, hence, at lower unit cost. Finally, it should be pointed out that the potential effects of trade policy on output per firm and average costs (via firm entry/exit) are more ambiguous than it might appear from the previous discussion. In other words, while the elaboration of the EastmanStykolt hypothesis served to illustrate the excess entry argument that has often been put forward to highlight the counter-productive consequences of protectionist trade policies, it should be kept in mind that this kind of argument is not necessarily robust when exposed to variations in the underlying assumptions. Although it can be shown that the inefficient entry problem may also arise when assuming non-cooperative behaviour among domestic producers*3, there is no shortage of models that predict average costs to decline in the protected industry. More concretely, when relaxing the assumption that import supply is perfectly competitive, thus allowing for both domestic and foreign markets being dominated by oligopolistic industries, the effects of trade policy on firm output become highly dependent on a number of further assumptions; for example, with free entry/exit and imperfect competition both at home and abroad the effect of tariff protection on domestic output per firm has been shown to depend crucially on the specific assumptions concerning industry behaviour (e.g. Cournot versus Bertrand), international market structure (segmented versus integrated), and demand functions (e.g. linear versus convex), respectively. 54

M

Cf. Corden (1974, 212).

53

Cf. e.g. Dixit/Norman (1980, 267-273) and Helpman/Krugman (1985,100-104).

54

In this context, assuming segmented markets and Cournot competition, Venables (1985) shows that the imposition of a small tariff may actually increase output per firm in the domestic market; the major reason is that the domestic market becomes more competitive as new firms enter the market after the Imposition of the tariff. Thus, in this model protection has a (Indirect) positive

95 Thus, contrary to the inefficient entry argument, there may also be a positive relation between import protection and domestic output per firm.55 As argued further above, however, a detailed discussion of these issues is more relevant in the context of selective intervention and strategic trade policy than in the context of excessive protectionism (and recurrent trade liberalization) in a small country like Argentina.

b. Product through

differentiation, monopolistic trade liberalization

competition,

and

rationalization

In the previous section the discussion was primarily confined to the effects of trade policy changes in an environment characterized by monopoly (or collusive oligopoly) and the existence of homogeneous goods. In contrast, this section will concentrate on the possible link between trade policy and scale efficiency in a framework which explicitly takes account of product differentiation and the associated phenomenon of intra-industry trade.56 Given the assumption of relatively unhindered entry and exit, monopolistic competition is likely to be a relevant form of competition: first, product differentiation assures that each producer has a monopoly in his particular product within an industry and, therefore, will tend to ignore the impact of his own priceoutput decisions on other firms' price and output. Second, each producer is in reality facing competition from other firms within the same industry.57

effect on competition which dominates the (direct) effect of the tariff on domestic prices. Moreover, when markets are not segmented, the effect of an import tariff on domestic firm output can be shown to depend on the shape of the demand curve; in the case of linear demand curves, for example, output per firm remains unchanged since expansionary effects of protection on domestic output are accomplished entirely through firm entry. For concave demand curves, price and average cost in the relevant industry increase as a result of inefficient entry which, in turn, reduces output per firm. However, with constant elasticity demand curves Arm output may actually increase due to the tariff, while the case of convex demand allows no general conclusion. Cf. especially Horstman/Markusen (1986). See also Markusen/Venables (1988) for a comparative analysis. In addition see Eaton/Grossman (1986) who consider optimal trade policy under a variety of assumptions about market structure and conduct including Bertrand competition. 55

A case in point is Krugman's model of "import protection as export promotion" which is based on the idea that reaping scale economies in a protected domestic market allows firms to export to unprotected foreign markets. See Krugman (1984).

56

Many of the relevant issues are contained in Kierzkowski (1984).

57

Lancaster (1980, 152), for example, suggests that "...perfect monopolistic competition is the most relevant form of competition in the analysis of modem high-technology economies." A key advantage of a monopolistic competition model is that it helps to avoid many of the complexities that arise in the context of analysing oligopolistic interactions. Along these lines Krugman/Obstfeld

96 In fact the argument that a small closed economy may attract too many firms producing at sub-optimal scale receives additional support when taking account of consumer preferences for products with a variety of attributes.58 The basic reason is that in a small closed economy there exists necessarily a trade-off between reaping economies of scale and producing large varieties of products. As a consequence, given consumers' preference for product variety, excessive protection (exemplified by prohibitive tariffs or binding import quotas) may result in the establishment of too many firms and/or firms producing too many products at too high a cost. In contrast, opening up to trade holds the promise of twofold gains: first, the country may specialize in producing a narrower range of products thus reaping scale economies and, second, by importing other products it can at the same time increase the variety of goods available to domestic consumers and producers.59 In this context it is of particular interest to note that an enhanced variety of intermediate and capital goods available to domestic producers directly increases productivity and lowers resource costs.80 The adjustment mechanism at work is a combination of the elasticity effect (elaborated in section 3.2.3.2 above) and the rationalization effect (i.e. the possibility of firm exit or closure of product lines) both of which result from opening up to trade.81

(1994,124) state that "even though it may leave out some features of the real world, the monopolistic competition model is widely accepted as a way to provide at least a first cut at the role of economies of scale in international trade.* 58

There are two major arguments in this context: one suggests that consumers have a "love for variety", i.e. they prefer to choose among a number of products with similar attributes (textiles may be a case in point); the other approach emphasizes that different consumers may prefer products with distinct attributes, i.e. consumers have different "ideal products" (durable consumer goods may be an example).

59

Cf. Condon/de Melo (1991, 142-143) for a brief elaboration of this argument and some empirical evidence in support of it. See also Oombusch (1992, 74-75).

60

See e.g. Richardson (1988, 8-9).

61

Cf., for example, Lancaster (1980) and Krugman (1979) for a formal treatment of international trade under monopolistic competition.

97

To illustrate the argument it is useful to provide a graphical analysis, thus highlighting a few issues that are especially relevant when considering the production of nonhomogenous products in combination with internal returns to scale.62 Figure 3.2-7: Product differentiation and equilibrium in autarky (prohibitive protection)

P

MR

Q

As depicted in figure 3.2-7 there are two demand curves that need to be distinguished when firms produce differentiated products: first, the d p schedule represents the demand curve perceived by each producer. It indicates how demand for the product of the representative firm changes with respect to variations in its price given that all other firms do not adjust their price-output combination. Consequently, the slope of the dp curve is flatter than the slope of the second demand curve that needs to be considered, i.e. the D p schedule: the D p curve shows what happens to the output of a representative firm as all producers vary their prices by the same degree. Moreover, as firms are assumed to be identical with regard to production costs and perceived demand, they will all reach the same price-output combination

62

In particular, this analysis draws on Feuerstein (1993) and Helpman (1981).

98 in equilibrium. Therefore, the D p schedule can also be interpreted as denoting the share of a representative producer in total market demand (i.e. summing up individual D p curves yields the market demand curve). Consequently, a necessary condition for short-run equilibrium is that the profit-maximizing price-output combination of the representative firm (p p , q p ; given by the familiar (perceived) marginal revenue equals marginal cost condition) coincides with the intersection of the two demand curves (point E). In addition, long-run equilibrium requires that excess profits are eliminated and, therefore, the average cost curve of the representative firm will be tangential to the perceived demand curve. Thus, even in the long-run equilibrium firms produce at an output level where average costs are downward-sloping, i.e. they do not reach the cost-minimizing minimum efficient scale - this is clearly an outcome that would not be feasible under perfect competition. Next, the impact of free trade shall be analysed within the given framework. To show how the adjustment mechanism works it is again useful to consider both the shortrun impact of opening up as well as the new long equilibrium. First, opening up to trade (or, by analogous logic, liberalization of prohibitive import tariffs and elimination of binding quantitative restrictions) is likely to increase the elasticity of perceived demand of the representative firm: i.e. if the firm raises prices it will have to face a more significant reduction of its market share than under autarky. The reason is that the number of product varieties available to domestic consumers increases under free trade and, hence, consumers will be quicker to substitute another product variety for a specific product when its price is increased. 63

63

This is the 'elasticity effect' that was first introduced in section 3.2.3.2 above. In the context of differentiated products it is indeed plausible to presume that the price elasticity of demand increases as trade is liberalized. However, this effect depends, in particular, on the specification of consumers' utility function. More concretely, according to the Hotelling-Lancaster approach the elasticity of demand depends on the number of varieties that are available. As emphasized by Krugman (1989, 1183) this approach is in fact more realistic than the Dixit-Stiglitz formulation of consumers' utility function which implies that the elasticity of demand faced by the representative producer is independent of the number of product varieties available (see Dixit/Stiglitz [1977]). However, in the words of Krugman (1989, 1183) the advantage of the Dixit-Stiglitz approach is that it "lends itself quite easily to modelling."

99 Figure 3.2-8: Short-run adjustment

Correspondingly, the slope of the perceived demand curve under free trade (dF) is flatter when compared to the d p schedule (figure 3.2-8). As a consequence, the representative firm has an incentive to expand production, thus moving along the dF curve in order to reap excess profits (since p>AC). This intention will be frustrated, however, as competing firms are all facing the same situation and, therefore, are expanding production as well. The result is that the dF curve shifts downwards and, as all firms are changing their output by the same degree, the representative firm is actually moving downward on the D p curve. A new (short-run) equilibrium might be reached in a point like H, for example." This equilibrium is characterized by the fact that the representative producer incurs losses (note that the new equilibrium lies below the AC curve - but above the MC curve). Therefore, some firms will decide to exit - or if firms are operating multi-product plants they may, alternatively, rationalize product lines. The result is that remaining producers (product lines) can increase

64

T h e shifted d F line going through point H is not drawn in the figure to avoid overcrowding of the graph.

100 their market share, represented by an outward shift of the D p curve.65 In this context it is useful to point out that the effect is compatible with two scenarios: first, the noted increase of the representative firm's market share may be due to the fact that the (equilibrium) number of firms in the integrated economy increases less, proportionally, than the expansion of the relevant market. In general, this situation would be expected when countries move from autarky (prohibitive protection) to trade.66 Second, even if the relevant market for domestic producers contracts, the exit of rival firms may more than compensate for this contraction, with the remaining representative firm producing at larger scale than before. This kind of scenario seems more plausible when considering the impact of trade liberalization on import-competing producers.87 Long-run equilibrium is reached in point F as depicted in figure 3.2-9. In comparison to the long-run equilibrium in autarky (prohibitive protection) denoted by point E, the new long-run equilibrium is characterized by increased scale efficiency (i.e. lower average costs) and associated lower prices. At the same time consumers benefit from the fact that free trade allows them to choose from a greater variety of products. In other words, free (intra-industry) trade resolves the trade-off between scale efficiency in production and the preference of consumers (and producers, when considering intermediate or capital goods) for product variety.

65

Strictly speaking the D p curve is pivoted anti-clockwise through the intercept with the ordinate.

66

Considering, for example, two countries which are identical in any respect, opening up to trade will have the effect of doubling the market1 size (with each firm selling half of its output at home and the other half in the foreign market), whereas the equilibrium total number of firms under free trade (N*) is smaller than the number of firms under autarky (N); correspondingly, there are more product varieties available in each country under free trade (n*) than under autarky (n) but the total number of varieties produced under free trade is less than double the number produced in each country before opening up (i.e. 2n>n*>n).

67

The reason for this has been mentioned in section 3.2.3.1 above. In short, import-substituting firms are often likely to lose part of their domestic market share to imports while having difficulty compensating for this loss of market share by exporting to foreign markets.

101 Figure 3.2-9: Long-run equilibrium

Finally, it should be emphasized that the results of the previous analysis are primarily relevant when comparing the effects of moving from autarky (or highly restrictive protection) to trade rather than when looking at the effects of selective import tariffs. Thus, it has, for example, been shown by Lancaster (1984) that even a small country may increase both product variety and scale efficiency by imposing import tariffs on a differentiated good.68 In his model the tariff induces demand substitution towards domestic varieties and, as a result, domestic firms can increase their market shares. Average costs are reduced and even though profits attract new entrants, this entry may actually be accompanied by an increase of output per firm when compared to the pre-tariff output level. Although this result may at first seem paradoxical, it can be explained as follows. The entry of additional firms in the domestic market implies that goods are now closer to each other on the product spectrum, so that the elasticity of

68

In addition, Lancaster (1984) assumes that the small country does not export the differentiated product while the large country (rest of the world) sells products in the domestic market. Moreover, in his model, industries in both countries face the same marginal cost (but not necessarily the same fixed cost) and the foreign country's industry reacts passively to the imposition of a tariff in the domestic market.

102 demand rises (note that the varieties produced abroad are still available, though at a higher price). As a result, tangency between the average cost curve and the perceived demand curve is reached at a higher level of output per firm. In other words, even though domestic firms' products are 'closer together', each firm's market is wider than before, since foreign firms market shares are reduced due to the tariff.69 Thus, in this case, the tariff has the effect of pushing down the price of the domestic good: something which would clearly not be possible under perfect competition.

c. Producer heterogeneity, trade liberalization, and industry rationalization The models discussed so far have implicitly assumed that there exists a representative firm in each sector (i.e. firms are identical). However, recent research has highlighted the empirical evidence of producer heterogeneity and elaborated on its relevance to productivity growth in developing countries.70 In fact this research identifies another potentially important route from trade liberalization to improved (scale) efficiency. More concretely, if large firms face lower marginal costs than firms that are relatively small (e.g. as a result of differences in credit market access and capital stock), equilibrium under protection may be associated with some (big) firms reaping excess profits while the marginal (small-sale) producer just covers costs.71 In turn, trade liberalization puts downward pressure on domestic prices and, consequently, average costs have to go down. The least efficient firms will incur losses and, assuming free exit, some firms will quit the market in question. Sectoral productivity

69

Without going into too much detail it should nevertheless be pointed out that for this result to hold true some further assumptions need to be made with regard to the arrangement of goods on the product spectrum in the two countries under consideration. In particular, two arrangements can be distinguished (cf. Lancaster [1984, 143]): (1) the 'interleaved case1: in which products of the two countries alternate in specification as one moves along the spectrum (2) the 'split case': in which countries produce at different ends of the product spectrum. The model that is referred to in this context presumes that the 'interleaved case' applies. Otherwise the gains from protection that are being discussed could not materialize (as the kind of interactions described in the text would not be relevant in the 'split case'). For more detail cf. Lancaster (1984).

70

See especially Roberts/Tybout (1996a). Of course, the evidence of producer heterogeneity implies some compelling challenges to theoretical modelling. One important issue has to do with the explanation of the simultaneous existence of firms with distinct levels of efficiency. A formal treatment is provided by Jovanovic (1982).

103

may therefore improve to the extent that trade policy changes entail intra-sectoral reallocation of market share: i.e. trade liberalization may increase the market share of large (i.e. more efficient) plants at the expense of smaller plants that are not reaping significant economies of scale.72 Along these lines Dutz (1996) constructs a formal oligopoly model in which firms are not equally efficient. He shows that, within this framework, "loosening a quota on elastically supplied imports will typically cause smaller firms with high marginal costs to contract more than larger firms with low cost (and to have a higher probability of exit), leading to lower industry-wide average costs. This rationalization effect is an important component of the welfare impact of trade reform."73 Moreover, it should be emphasized that this effect is certainly more significant in a market environment characterized by free entry and exit but it is not dependent on the absence of barriers to entry/exit. Finally, in addition to what has been said before, it seems useful to point out that the existence of producer heterogeneity may also stem from other factors apart from distinct levels of scale efficiency. Clearly, the described mechanism linking trade liberalization and improved productivity does not depend on the source of producer heterogeneity. Consequently, if producer heterogeneity is caused by factors other than different scale efficiencies, the mechanism may still be relevant. For example, another possible reason for producer heterogeneity is that firms reach different levels of x-efficiency. In other words, firms may face distinct marginal costs because they differ in terms of x-efficiency.74 As argued before, trade liberalization will be

71

Robert/Tybout (1991) develop a simple model to show that profit maximization under Cournot competition yields this kind of outcome in an industry characterized by marginal cost heterogeneity.

72

See also Roberts/Tybout (1991) and Tybout (1996) who provides an assessment of the empirical evidence concerning the role of producer heterogeneity in productivity growth.

73

Dutz (1996, 154). Analysing survey data from Morocco he provides some empirical evidence along these lines.

7
50 category was not feasible, since the divisions of the >50 category adopted by INDEC in 1993 and 1985 are not identical. Consequently, potentially important changes in the distribution (of establishments, value added, employment) within the >50 category could not be detected.

158 category with 26-50 employees slightly increased their employment share in comparison to the remaining categories. Thus, on the face of it, there is no evidence of increasing production by large scale producers. Rather, considering that the share of value added accounted for by large scale firms has declined from 78 per cent in 1985 to 68 per cent in 1993, there appears to be some evidence pointing into the opposite direction, i.e. into the direction of increasing production by small scale producers and further informalization of the manufacturing sector. However, it should be emphasized that the data referred to above does not allow to make direct inferences about changes with regard to scale efficiency. The reason is that large scale firms may have increased production (and thus taken advantage of economies of scale) even though their output share has declined relatively to small scale producers. 39 In fact, considering that manufacturing output has increased by 24 per cent (according to the National Accounts) during the relevant period and taking into account that the number of large firms was reduced by roughly 23 per cent over the same period, it seems reasonable to presume that, on average, the output of large firms has grown despite the noted (relative) decline of their contribution to manufacturing value added. Additional support of this suggestion comes from various studies that have analysed the contemporary adjustment process in Argentine manufacturing. A common theme of these studies has been the particularly dynamic growth performance of a limited number of large scale firms or rather conglomerates ("grupos económicos"). 40 As a matter of fact, this development would be difficult to detect by solely referring to the above data, not least because of the mentioned problem to identify changes in the distribution of firms within the size category with more than 50 employees. The previously mentioned reduction in the share of value added of large firms (>50 employees) in comparison to smaller ones (

CD to O)

co o>

CO

o

at at

5> at y—

CN o> O) *-

CO o> o> T-

sat r—

If)

at at

• Insolvencies • Bankruptcies • Total Note: Insolvencies include companies that announced insolvency ("concursos preventivos abiertos"). Bankruptcies include companies that are declared bankrupt ("quiebras decretadas"). Source: CESS (1997).

41

See e.g. Bisang et al. (1996).

42

In this context it has e.g. be emphasized by Donato (1996) that high inflation and macro-instability during 1975-1990 have resulted in particularly high transaction cost, thus favouring vertical integration processes and reducing the scope for activities like outsourcing and associated patterns of 'flexible specialization'.

160 Referring to this data, three issues are particularly noteworthy: first, the absolute number of business failures during 1990-1993 is roughly the same as during 19861989, thus suggesting that industry rationalization (in terms of firm exit) has not only occurred after 1990 but also before, namely during the period of increasing macroinstability in 1987-1989. Second, the increasing number of business failures since 1990 supports the overall hypothesis that competitive pressure in the domestic market increased considerably as a result of policy reform. Third, the high level of business failures in 1995 appears to reflect the further augmentation of adjustment pressure that occurred in association with the Tequila crisis'. To conclude, the considerable reduction of the number of existing establishments and the decrease of productivity differences between producers in distinct scale categories, do suggest that there has been an overall process of industry rationalization - being of relevance for both relatively large as well as small scale producers.'43 In other words less efficient firms or firms that did not succeed to quickly improve productivity in the face of increasing competitive pressure were forced to exit the market.44 However, the available data does not allow to draw strong conclusions about the impact of trade liberalization on scale efficiency in manufacturing. In particular, the question to what extent observed changes have been caused by trade liberalization, can not be answered on the basis of the analysis in this section. In fact, there is as would be expected some evidence that changing macroeconomic conditions have also been a relevant factor in this context.

43

Supportive evidence along these lines comes from a recent study of Robbio (1997) who analyses changes in wage cost and productivity by size of firms over the 1984-1993 period. He concludes as follows: "...el mayor grado de competencia en un ambiente donde la información se transmite con mayor fluidez y conserva su validez durante más tiempo, puede haber presionado hacia una mayor homogeneización de las productividades monetarias y las rentabilidades relativas" (italics added, A.P.).

44

Moreover, Leipziger et al. (1997) note that there is some evidence of industry rationalization in Argentina being associated with an expansion of intra-industry trade. The increasing relevance of intra-industry trade is especially due to closer trading relations between Argentina and Brazil (see also Lucángeli 11994]). Cf. section 3.2.3.3 for an elaboration of the theoretical argument linking trade liberalization to industry rationalization (via intra-industry trade) when taking account of product differentiation.

161

4.1.4.2 Technological change As elaborated in chapter 3 trade liberalization may lead to productivity gains through positive effects on technological change. Basically, it has been argued that trade liberalization may increase both the demand for technological improvements (in view of increasing international competition) as well as the supply of technology and associated knowledge. It has also been pointed out, that there are some grounds to expect the resulting short-term impact on productivity growth to be positive, even though the corresponding long-term growth effects may be more ambiguous. In particular, expected productivity improvements have been related to (1) the availability of cheaper and/or better quality inputs as well as (2) the possibility to choose from an increasing variety of intermediate inputs (especially capital goods).45 Consequently, it is of some interest to analyse the relevance of these potential effects of trade liberalization in the case of Argentina. If firms were actually seeking to introduce technological change (e.g. by modernizing or replacing outdated machinery or plants) one would expect both fixed investment and technology-intensive imports to increase in the wake of trade liberalization. In what follows, the intention is, hence, to clarify whether available data provide evidence along these lines. In regard to fixed investment, table 4.1-10 allows to put the recent development in perspective. Although the data does not refer to industrial sector but to the total economy, they may serve to provide a glance of the overall pattern of which manufacturing formed part.

* 5 Note that, what has been referred to as intermediate goods in the context of the endogenous growth models broadly corresponds to specialized inputs and capital goods. Thus, it is important not to mix up this definition with the classification of industrial sectors adopted in the previous section (cf. tables 4.1-6 and 4.1-7).

162

Table 4.1-10: Gross fixed investment (thousands of pesos at 1986 prices), 1980-1995 Year

Total

Construction

Machinery and equipment Total

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995

2721.9 2314.1 1852.5 1860.0 1783.1 1531.7 1700.8 1920.7 1853.1 1452.9 1232.2 1620.9 2164.1 2510.5 3056.9 2559.9

1643.9 1442.8 1279.7 1264.1 1126.6 961.4 1144.5 1291.1 1250.2 950.8 800.7 1022.9 1198.1 1330.4 1527.3 1358.0

1078.0 871.3 572.8 595.9 656.5 570.3 556.3 629.6 602.9 502.1 431.5 598.0 966.0 1180.1 1529.6 1201.9

Locally produced

Imported

647.4 494.6 403.0 463.4 536.9 440.0 440.8 453.4 446.0 377.6 326.0 347.2 436.4 464.6 491.6 373.1

430.6 376.7 169.8 132.5 119.6 130.3 115.5 176.2 156.9 124.5 105.5 250.8 529.6 715.5 1038.0 828.8

Source: Data supplied by CEPAL.

In particular, table 4.1-10 shows that there has been a considerable increase in terms of fixed investment since 1992. Comparing the amount of investment with previous years the following distinction is noteable: investment in construction recovered during the early 1990s to reach a level that is quite similar to the early 1980s. In contrast, in the 1990s investment in machinery and equipment, which is more relevant in terms of technological change, significantly exceeded the level of corresponding investment during the 1980s. Another interesting feature is that it is exclusively the expansion of imported investment goods that accounts for this increase. This observation is in line with the results of other studies which suggest that the manufacturing firms that have sought to close the existing productivity gap with regard to international standards have mostly done so by importing improved technology and much less by increasing their own activities towards innovation

163

(including, in particular, R&D activities).46 While being based on the same data as the previous table, figure 4.1-7 refers to annual rates of change, thus illustrating the strong increase of imported machinery and equipment during the period from 1991 to 1994. Negative rates of growth for 1995 are an outflow of the recession that was triggered by the drastic devaluation of the Mexican peso ('Tequila-effect'). Figure 4.1-7: Gross fixed investment (annual rates of change in per cent), 1986-1995 140.0

120.0

100.0 80.0 60.0 40.0

20.0 0.0

-20.0 -40.0

• Total Investment p Construction | M & E (local production) a M & E (Imported) Note: M&E refers to machinery and equipment. Source: Based on data supplied by CEPAL.

A drawback of the data presented above is that it does not allow the identification of the economic sectors in which the relevant investment occurred. Due to the absence of more disaggregated data it is necessary to refer to some alternative indicator. In this context it is useful to consider the evolution and allocation of capital goods imports, not least because they are typically associated with investments that embody new technology. In 1993 imports of capital goods have been equivalent to about 15 per cent of gross domestic investment in 1993.47

46

See e.g. Bisang et al. (1996), especially pages 206-208, and Kosacoff (1996).

47

See World Bank (1996, 22).

164

Table 4.1-11: Imports by economic use (in thousands of US dollar), 1980-1996 Year

Total

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

10540.0 9430.0 5338.0 4505.0 4584.0 3816.0 4724.0 5818.0 5321.0 4205.0 4077.0 8276.0 14872.0 16786.0 21589.0 20121.7 23761.7

Consumer goods

2055.0 1661.0 443.0 244.0 282.0 238.0 346.0 347.0 272.0 221.0 330.0 1514.0 3205.0 3527.0 3906.5 3173.8 3583.0

Intermediate goods

3601.0 3027.0 2333.0 2270.0 2328.0 1698.0 2362.0 2532.0 2581.0 2158.0 2069.0 3419.0 4742.0 5066.0 6242.0 7220.0 8407.6

Capital goods

2323.0 2097.0 982.0 787.0 692.0 702.0 663.0 1041.0 904.0 745.0 636.0 1435.0 3095.0 4115.0 6010.6 4745.6 5606.9

Pieces and accessories for capital goods

Vehicles for passengers, fuels, and others

1255.0 1395.0 889.0 747.0 810.0 719.0 920.0 1217.0 1053.0 701.0 691.0 1237.0 2591.0 2809.0 3396.1 3373.2 4801.1

1306.0 1250.0 691.0 457.0 472.0 459.0 433.0 681.0 511.0 380.0 351.0 671.0 1239.0 1269.0 2033.8 1609.1 1363.1

Sources: Based on World Bank (1996) for 1980-1994; MEOSP (1997a) for 1995-1996.

As indicated by table 4.1-11 there has been a very significant increase in imports of capital goods during the period from 1991 to 1994. The growth rate in imports of capital goods has only been surpassed by the rate of growth on consumer goods imports which quadrupled in 1991 alone. However, in 1993 and 1994 capital goods imports increased more than imports in any other category. It is therefore reasonable to suggest that the increasing volume of imported pieces and accessories for capital goods also helped to improve the performance of the existing capital stock.

165

Figure 4.1-8: Imports by economic use (in per cent), 1980-1996

• • • • •

Sources:

Consumer goods Vehicles for passengers, fuels, and others Intermediate goods Pieces and accessories for capital goods Capital goods

Based on World Bank (1996) for 1980-1994; MEOSP (1997a) for 1995-1996.

Referring to the corresponding shares of imports by economic use, figure 4.1-8 illustrates the following developments: the share of capital goods stood at 22 per cent in 1980/81, however, it declined sharply thereafter reaching no more than 15-17 per cent during the period from 1983 to 1991. During 1992-1996 the share of capital goods recovered considerably, reaching 24 per cent on average. Furthermore, when adding up the imports of 'capital goods' and 'pieces and accessories for capital goods' the figure shows that these imports represent the largest import during the 1990s. This development is reflected in the decreasing share of intermediate goods in total imports.

166

Table 4.1-12: Imports of capital goods by economic sector (in US dollar), 1985-1996 Year

Total

Industry Volume

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

700962 663293 1040959 904294 744732 635453 1438022 3095207 3977041 5818908 4745649 5645781

299258 289381 508371 493502 371886 305312 642044 1230129 1552423 1991007 1838865 2160933

Share of total (%) 42.7 43.6 48.8 54.6 49.9 48.0 44.6 39.7 39.0 34.2 38.7 38.3

Transport

Communication

Other sectors'

Share of total (%)

Share of total (%)

Share of total (%)

10.2 4.9 5.0 2.9 6.9 7.0 5.6 13.2 15.3 20.3 14.5 16.5

8.2 8.1 11.0 7.7 6.9 6.6 12.7 14.9 16.6 15.9 14.5 13.3

38.9 43.4 35.2 34.8 36.3 38.4 37.1 32.2 29.1 29.6 32.3 31.9

a. "Other sectors" include agriculture, mining, energy and water, construction, commerce and banking, health, and research. Sources: World Bank (1996, table 3.8) and M E O S P (1997b, table 2.7).

Finally, it is important to have a closer look at the allocation of capital goods among economic sectors. Thus, it appears that the share of capital goods being imported for use in the manufacturing sector has declined relatively to the share of capital goods imported by the rest of the economy (see table 4.1-12). In particular, the transport and communication sectors have strongly increased their imports of capital goods. During the 1990s these sectors have evolved as the biggest importers of capital goods next to the industrial sector.48 Meanwhile these three sectors account for roughly 70 per cent of all capital goods imports. Among the remaining sectors agriculture is the only sector that has significantly expanded its share of capital goods imports (from 1.3% in 1985 to 4.6% in 1996). All other sectors (including mining, energy and water, construction, commerce and banking, health, and

48

To a large extent this development is to be associated with the privatization of state owned enterprises in transport and communication, which has also attracted considerable foreign direct investment. For more detail see, for example, Chudnovsky et al. (1994; 1995) and Fundación Invertir Argentina (1996).

167 research) experienced stagnating or slightly decreasing shares of capital goods imports. With regard to the decreasing share of capital goods imports by the industrial sector it should, however, be recalled that this relative reduction has been accompanied by a strong expansion of capital goods imports in absolute terms. In fact, the average volume of capital goods imported by industry during 1991-1996 has been more than four times as high as the corresponding imports during 1985-1990. This implies that, overall, the industrial sector has undertaken significant efforts to modernize existing production technologies. According to the theoretical arguments spelled out in section 3.2.5, this development may be linked to both the improved availability of modern technology (as incorporated in capital goods) and the increasing pressure to invest in technological improvements that result from the opening up of the economy. The govenment's decision not to levy any import tax on capital goods imports also facilitated the modernization of domestic industry. Consequently, there also appears to be some evidence that the mechanism leading from trade liberalization to enhanced productivity via technological change, may have been relevant in the Argentine case, at least as far as the short term impact is concerned. Even though, it should once again be highlighted that the descriptive analysis carried out in this section does not allow to conclude that trade liberalization caused technological improvements. As noted before in the context of industry rationalization, there is no doubt that macro-developments that are not directly related to trade policy reform, (e.g. stabilization, weakening of the balance of payments constraint) have also contributed to the observed changes in terms of investment and increasing imports of technology-intensive goods. Finally, in combination with the data on investment in machinery and equipment presented above, the empirical evidence shows that technological improvements have been mainly accomplished through the large imports of capital goods and much less through domestic efforts in order to develop new technologies. As a matter of fact, the overall short term impact of trade liberalization on domestic R&D activities appears to have been rather negative.49 Whether this trend is going to

49

See e.g. Bisang et al. (1996, 212-213) who observe "una tendencia creciente a la adopción de tecnologías externas de producto cercanas a las mejores prácticas internacionales, en desmedro

168

persist and to what extent the current development may hamper productivity growth in the (long-term) future are open issues - both in theory and with regard to empirical evidence.

4.2 The impact of trade liberalization on efficiency in Argentine industry: A statistical analysis Previous chapters have (1) elaborated on the process of recent trade liberalization in Argentina, (2) discussed the various theoretical arguments that have been put forward in support of a positive link between trade liberalization and economic efficiency, and (3) provided an overview of industrial sector developments in the wake of trade liberalization in Argentina. Against this background this section aims to test the hypothesis that trade liberalization has had a positive effect on efficiency in the industrial sector. In this context it is interesting to quote at some length the judgement of a detailed study of the Argentine industrial sector, carried out by the World Bank in 1987. After evaluating the impact on manufacturing performance of the trade and industrial policy regime during the 1970s and 1980s, the following conclusion was derived: 'The Argentine policy regime has had an adverse impact on technical, allocative and managerial (or X-)efficiency. First, technical efficiency has been affected by excessive fragmentation and insufficient specialization. These structural deficiencies have precluded firms from reaping economies of scale and accumulating significant technological capabilities. Second, policy barriers to mobility have slowed down structural change, with an adverse impact on allocative efficiency. Third, the quality of management has suffered in an environment characterized by protection and captive markets. Technical, allocative and X-inefficiencies are difficult to disentangle. Their joint effect may be observed in the decline of total factor productivity growth and high price structures, with the consequent loss of international competitiveness."50

de los esfuerzos adaptativos locales y, mucho más aun, respecto de la generación doméstica de nuevos productos o procesos". 50

World Bank (1988a, 67).

169

Thus, according to this devastating judgement of the impact of the Argentine "policy regime" before the introduction of major policy reforms since the late 1980s, there has been ample room for the latter to significantly improve industrial performance. Moreover, it is interesting to note that the World Bank statement (quoted above) emphasizes the detrimental effects of the previous trade policies on productivity and price structures, both of which are the focus of this study.

4.2.1 Outline of the adopted procedure and the regression model As mentioned above the aim is to test the hypothesis that trade liberalization has had a positive effect on efficiency in the industrial sector. In order to do so, the following approach was adopted.91 Firstly, two indicators of industrial efficiency, namely labour productivity and price-cost margins were estimated, covering the period before and after major trade liberalization was implemented. Secondly, a set of explanatory variables were identified, including various indicators of trade liberalization and a set of variables reflecting industrial structure and technology. Thirdly, ordinary-least-square (OLS) cross-sectional regression analysis was applied to establish the determinants of changes in the efficiency indicators. Thus, changes in efficiency indicators were regressed on different sets of explanatory variables. Consequently, the hypothesis can be considered to be demonstrated, if changes in any of the trade policy variables are significantly correlated with changes in the efficiency indicators, with the expected sign. Formally, the regression model can be expressed as follows: f (TL, STRUCT, TECH)

El where El

51

is a measure of change in an efficiency indicator

TL

is an indicator of change in trade policy

STRUCT

is an indicator reflecting industrial structure

TECH

is a variable reflecting technology of production

The methodology employed In this study is fairly similar to the methodology adopted by a number of comparable country studies (including e.g. Gelbard [1990); Mulaga/Weiss [1996]) and, in

170

For each of the three sets of explanatory variables, different alternatives are examined. More detailed descriptions as to the construction of the chosen variables and information relating to the relevant data sources, are given in the following section and in appendix 2.

4.2.2 Hypotheses and variables Before turning to a detailed description of the variables and an elaboration of the hypotheses that are going to be tested by regression analysis, this section begins with some general comments concerning the problem to empirically test the linkageeffects between trade liberalization and efficiency change.

4.2.2.1 Introductory comments The theoretical chapter sought to identify the mechanisms through which the "input" trade liberalization may lead to the "output" of improved economic efficiency. In accordance with the theoretical discussion, section 4.1 aimed to bring together empirical material that may give some indication as to the relevance of the theoretical arguments. Overall, it has been shown that available data does not preclude that some of the potential positive efficiency effects of trade liberalization have been at work in Argentina. However, strictly speaking this kind of broad evidence does not allow to derive any conclusion as to the actual contribution of trade policy reform, in bringing about the noted improvements in industrial performance. Consequently, one would ideally want to test empirically if, and to what extent the various channels have been at work in the case of Argentina. There are a number of obstacles, though, mostly having to do with methodological problems and lack of appropriate data, that prevents a straightforward statistical test of the various possible mechanisms linking trade liberalization and economic efficiency.52 In this context a few notes are in order.

particular, it parallels the approach adopted by Weiss (1992a) analysing the Mexican experience with trade liberalization. 52

In part these problems are not peculiar to the Argentine context but have commonly hampered empirical analyses of the mechanisms in question. As a consequence, a number of recent publi-

171

Given the widespread conviction that scale effects may constitute one of the major sources of productivity gains, as a result of trade liberalization (and given some recent empirical evidence to the contrary 53 ) it would have been particularly interesting to directly analyse the relevance of those effects in the Argentine context. However, the contribution to improved productivity of scale effects (as compared to e.g. x-efficiency effects) can not be identified in this study, because such an analysis is based on the estimation of total factor productivities. 54 Hence, as this study is limited to the calculation of labour productivity, the measurement of scale effects is necessarily foreclosed. Similarly, due to the lack of sufficiently disaggregated data that would allow to construct indicators of technological change at the industry level, it is not possible to directly evaluate its relevance as a source of productivity change. In other words, in this study the separate relevance of the possible transmission mechanisms identified in the theoretical chapter can not be tested directly. Instead, it is only possible to observe the net impact on industrial performance of a combination of various possible effects. 55 A few 'second-best' indicators have been calculated that may at least shed some light on the actual relevance of the mechanisms in question. These indicators as well as all other variables that have been considered in the regression analysis will be described in the following sections.

cations have pointed to the desirability to further investigate those mechanisms. See e.g. Jenkins (1995); Greenaway et al. (1997,1891); Tybout/Westbrook (1995, 77). 53

Cf. section 3.4 and, for example, Roberts/Tybout (1997,13-14).

54

Cf. Morrison (1993, especially chapter 4) for a detailed discussion of the relevant conceptual and empirical problems, and Tybout et al. (1991, 238-244) for a brief consideration of these issues in the context of an empirical study of the efficiency consequences of trade policy reform.

55

Note that the difficulty to isolate different transmission mechanisms has also been highlighted in the previously quoted judgement of the World Bank (1987, 67): "Technical, allocative and X-inefficiencies are difficult to disentangle. Their joint effect may be observed in the decline of total factor productivity growth and high price structures...". See also Tybout/Westbrook (1995, 56-57), Nishimizu/Page (1991, 252-254), and Nishimizu/Robinson (1984, 177-180) for an explicit acknowledgement of this difficulty.

172

4.2.2.2 Dependent variables - efficiency indicators As indicated before, two efficiency indicators are calculated, namely productivity of labour and price-cost margins.

a. Productivity of labour Single factor labour productivity (PL) is value added per worker at constant 1986 prices. It serves as an indicator of productive efficiency. The analysis focuses on two periods, covering the time span from 1990-1995 and, alternatively, from 1990-1994. In this context, the intention was to find out whether estimates would produce diverging results for the two periods, thus reflecting the impact of the hefty recession (and the associated depreciation of the real exchange rate) in 1995. Calculation of labour productivity was restricted to the ISIC 3-digit level. Estimates at a more disaggregated level were precluded because employment data was only available at the 3-digit level. An improvement in economic efficiency is represented by a rise in labour productivity.

b. Price-cost margins As mentioned in section 4.1, price-cost margins (PCMs) are approximated by the following formula: PCM = (GP - Ml - W) / GP where GP is the value of gross production, Ml is material inputs (including services, but excluding any capital charge), and W is wages. The empirical analysis is based on a comparison of two years: firstly, PCMs were calculated for 1985, thus representing the pre-reform period, and, secondly, PCMs were estimated for 1993, hence allowing to identify the short-term impact on profit margins after the implementation of major trade liberalization. The estimation of PCMs is based on census data and could, therefore, not be extended to other years.

173

P C M estimates were carried out at the ISIC 3-digit level and at the ISIC 4-digit level, thus covering, respectively, 27 and 81 disaggregated manufacturing sectors. With regard to the impact of trade liberalization, it is the change in PCMs that is of particular interest, with a fall in PCMs interpreted as an improvement in efficiency due to more competitive pricing.

4.2.2.3 Independent variables and hypotheses As mentioned above there are three sets of explanatory variables; trade policy variables, industrial structure indicators, and indicators of industrial technology, all of which are described below. A summary table that indicates the expected signs of the explanatory variables is provided at the end of this section.

a. Trade policy variables There is general agreement in the literature that no single variable exists that would allow to describe the trade policy stance of a particular country. However, there is far less agreement as to the variables that should be chosen as best representation of trade policy and its change over time. For example, Edwards (1992, 32) emphasizes that the most important limitation of empirical work in this realm stems from the fact that "it has been exceedingly difficult to construct satisfactory and convincing measurements of trade orientation that can be used in time series analyses and, especially, in cross-country comparisons".56 Yet, it is interesting to note that - carrying out a cross-country analysis of the impact of trade orientation on growth Edwards (1992) finds that the major results of his study are quite robust to the kind

56

To illustrate this argument Edwards (ibid., footnote 6) points out that "...in the classical and monumental NBER Krueger-Bhagwati project, researchers faced enormous difficulties in constructing time-series of the bias in each country trade policy." As another example he points to the major World Bank study by Papageorgiou et al. (1991) which had great difficulties in performing crosscountry comparisons. See also Pritchett (1991) for a useful discussion of the difficult task to compare outward orientation across countries. In fact, Pritchett (1991, 32) concludes that "...no reliable, robust estimate of the impact of general outward orientation on economic performance (i.e. economic growth or export perfomance) is likely from cross country data. More generally, Harrison (1996, 425) underlines that "...no independent measure of so-called 'openness' is free of methodological problems."

174

of trade policy measure that is chosen. More specifically, of the nine indicators of trade orientation that were used the only one that does not have the expected sign is the index of non-tariff barriers (NTBs). According to Edwards (1992, 53) "in a way, this is not too surprising since NTB is likely to be one of the poorest indicators of trade orientation." The suggested reason for this, is that NTBs may have a broad coverage without necessarily being very restrictive. In other words, information on the ease with which import licenses are granted may be more important than data that merely relate to the coverage of NTBs. Quite similar to Edwards (1992), Harrison (1996) measures the impact of seven indicators of openness on economic growth. The results critically depend on the choice of the time period and on whether the analysis is based on cross-country data or on panel data that allow to combine cross-country and time-series analysis. However, half of the openness measures exhibit a robust relationship with GDP growth.57 Neither of the studies that have been referred to in the previous paragraph come up with recommendations as to the measures of trade policy, that should preferably be used in empirical studies. However, the general conclusion that can be drawn from those studies and from similar studies that have experimented with a variety of trade policy measures is the following58: Different measures of trade policy may capture different facets of trade protection and trade liberalization and, consequently, it makes sense to use a number of distinct indicators. In general, it is possible to distinguish three categories of trade policy measures: there are direct trade policy indicators, ex-post indicators of market penetration, and indicators reflecting the incentive effects of trade policy changes.

Direct trade policy indicators directly reflect trade policy decisions by policymakers. Therefore they are commonly used to evaluate and monitor the progress of

57

Moreover, Harrison (1996, 443) finds that "...the results could be perceived as surprisingly robust: when openness is statistically significant in any of the specifications explored...we find that greater openness is associated with higher growth" (emphasis in original).

58

Cf. Tybout/Westbrook (1995, 72-73) who use various trade exposure measures to analyse the impact of trade liberalization on efficiency change in Mexican manufacturing industries. S e e also Weiss (1992a; 1992b).

175

trade liberalization programmes. Two indicators that belong to this type of trade policy measures have been available for Argentina: - Nominal average tariff rates (AT) • Coverage of quantitative restrictions (QR) Sectoral data on nominal average tariffs in 1985 and in 1987 have been available from World Bank (1987) and World Bank (1988b), respectively. As noted before, tariff protection was fairly moderate in Argentina even before the introduction of major trade liberalization. Besides, there was little dispersion of nominal tariff protection across sectors, independently of whether average tariffs are weighted by import or by sectoral production values. Consequently, there was no reason to expect that this indicator could make any significant contribution to explain differences in the performance of industrial sectors in the wake of trade liberalization. In fact, when the indicator was considered as an explanatory variable at the first stage of the regression analysis it was clearly insignificant. Therefore, this indicator was dropped in further analyses. Due to the importance of non-tariff protection in Argentina it was highly desirable to include an indicator that should reflect the relevance of NTBs for each industrial sector. Here, the coverage ratio of quantitative restrictions has been the best measure available. This ratio gives the proportion of sectoral production that has been subjected to quantitative restrictions. Based on World Bank data this ratio could be calculated for each 3-digit industrial sector for 1985 and 1987.59 The main limitation of this measure has already been noted, i.e. it does not contain information about the difficulty of obtaining import licenses. Nevertheless, apart from the fact that there are no better measures of the relevance of quantitative restrictions available, there is another reason why the coverage ratio may provide a fairly acceptable approximation of the true impact of quantitative restrictions in the case of Argentina. Due to the major influence of producer associations on the granting of import permits, there is no doubt that import licenses have been difficult to acquire in most

59

With the exception of a few industrial sectors quantitative restrictions have been higher in 1985 than in 1987. In the regression analysis a combination of the 1985/1987 data was used, thus applying the higher (i.e. more restrictive) value of both years. However, there was no marked difference between the results when using the 1985 data and the combined data, respectively.

176

cases.60 Moreover, data available for 1985 show that quantitative restrictions have typically been very restrictive. This can be seen when considering the impact of quantitative restrictions on imports. On average, half of quantitative restrictions are associated with zero imports at the industry level!61 The key ingredient to trade liberalization has been the elimination of quantitative restrictions (with the major exception of the automobile sector). Consequently, the pre-reform level of quantitative restrictions can be interpreted as an indicator of the increased exposure to foreign competition that evolves as a result of the elimination of these restrictions. Hence, with regard to the arguable link between trade liberalization and improved efficiency the following hypothesis can be formulated: There will be a significant positive relation between the pre-reform level of quantitative restrictions on the one hand, and changes in labour productivity on the other. For changes in PCMs the expected sign is reversed, since improved efficiency corresponds to falling PCMs.

Ex-post indicators of market penetration seek to reflect the actual impact of trade liberalization on the domestic market. In this context, the indicator that is most commonly used is the change in the share of imports in total internal demand. Thus defined, the change in import competition (dIC) is also considered as an explanatory variable in this study. As noted before, import competition is calculated according to the following formula: IC = M / (GP + M - X) where M is imports, GP is gross production, and X is exports. All variables are in current dollars.62 Change in import competition is calculated in terms of percentage change and, alternatively, in log-differences, generally covering the same period of time as the dependent variable. For example, if the dependent variable represents the change in labour productivity between 1990 and 1994 the change in import competition is calculated for the same time span.

60

As noted in chapter 2 (section 2.1.2.3), in the case of imports competing with domestic production, producer associations had a major say in the decision making process and would generally advise against issuing the import permit.

61

Cf. World Bank (1987, annex VII, table 2).

62

Further details are provided in appendix 2.

177

Finally, it should be mentioned that using the change in import competition as an indicator of trade liberalization may involve a few problems.63 One limitation of this indicator has to do with the fact that import competition can be potential as well as actual. However, the threat of the potential entry of imports into the domestic market may not necessarily be reflected in the actual share of imports in domestic demand.64 By the same token, it is quite possible that trade liberalization could improve productivity without being reflected by greater import competition. Second, the indicator does not allow to distinguish between any positive effect of import competition on productivity and the fact that imports may be drawn to those sectors that display low productivity growth. Third, apart from the expected positive effects of increased import competition on productivity there is the potentially negative (shortterm) effect that may arise due to the noted pro-cyclical nature of productivity growth (cf. section 4.1.1.3; Verdoorn's Law). Therefore, if greater import penetration results in a contraction of domestic production, there might be a negative relation between change in import competition and productivity growth.65 However, in view of the overall expansion of Argentine industry during 1990-1994 there is some reason to expect that this potentially negative effect should not have been the dominating factor. Consequently, the following hypothesis can be formulated: There will be a significant positive relation between the change in import competition on the one hand, and changes in labour productivity on the other. For changes in PCMs the expected sign is reversed, since improved efficiency corresponds to falling PCMs. Indicators reflecting incentive effects are typically derived from direct comparisons of domestic and world prices for particular goods. Thus, they should pick up the combined effect of trade controls and potential or actual competition on domestic producers. However, measures based on direct price comparisons have not been

63

Cf. especially Harrison (1994, 68; 1996, 424) and Weiss (1992b, 712).

64

For example, Weiss (1992b) notes that potential import competition may increase significantly as a result of trade policy reform without necessarily being reflected in greater import penetration, if as in Mexico during 1985-88 - exchange rate policy and fiscal policies are applied to keep down import demand.

65

Vet, as elaborated in section 3.2.3.3, it is also quite possible that sectoral output contraction is associated with improved productivity, if the former leads to industry rationalization.

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available for the relevant period. Instead, effective protection rates which are, in principle, a better indicator of the incentive effects of trade policy reform than nominal tariff rates, could be considered. Effective rates of protection take into account both input and output protection, thus providing a good measure of the protection afforded to distinct activities in the production process (protection per value added).66 Figures on effective protection have been available for 1980 and for 1991. The following indicator of trade liberalization could, hence, be included in the analysis: - Change of effective protection (dEP) The data for 1980 are a proxy of the structure of effective protection before embarking on trade policy reform, while the figures for 1991 reflect the structure of effective protection as a result of the major reforms that were carried out during that year. Clearly, the data on effective protection in 1980 is only an imperfect indicator of the structure of effective protection that was prevailing during the 1980s. Nevertheless, since tariff protection did not vary a lot during the 1980s and considering that the impact of quantitative restrictions is taken account of by a separate measure, it may still be useful to include the information pertaining to effective protection in 1980 into the analysis. For 1991 two kinds of measures were available: first, average effective rates of protection for tariffs only and, second, average effective rates that consider both tariffs and tariff type measures. Both indicators of effective protection are production weighted. Clearly, trade liberalization is reflected in a fall of effective protection. Thus, the following hypothesis is formulated: There will be a significant negative relation between the change in effective protection on the one hand, and changes in labour productivity on the other. For changes in PC Ms the expected sign is reversed, since improved efficiency corresponds to falling PCMs.

66

A useful and more detailed discussion of the effective protection concept is e.g. provided by Greenaway/Milner (1993, chapter 5).

179

b. Industrial structure variables The rationale behind the use of industrial structure variables is that they should pick up the influence on performance of particular structural features that vary among industrial sectors. The three structure variables that are used are the following: - Concentration, as represented by the Herfindahl index (HD) - Privatization (PRIV) - Promoted Investment (PROM) Data on industrial concentration are only available for 1984. They are an outflow of the economic census in 1985. Estimates of industrial concentration that could, principally, be derived from the data collected as part of the 1994 census have not yet been made available. Consequently, it was not possible to consider the change of industrial concentration as an (in)dependent variable in this study. However, the indicator of concentration in 1984 may also be quite useful. Under the reasonable assumption that concentration remained fairly constant between 1984 and the beginning of the liberalization process in the late 1980s, the 1984 Herfindahl index may be interpreted as an indicator of the degree of concentration that was prevailing when trade liberalization was carried out. Thus it is possible to derive hypotheses about the impact of concentration on efficiency change in the aftermath of liberalization. As elaborated in chapter 3, the relation between concentration (as a measure of market power) and efficiency is not definite, though. To repeat the main arguments in whole: the Schumpeter point of view suggests a positive relation, the opposite view argues that concentration, especially when accompanied by protection from international competition, will invite x-inefficiency and lack of innovation. As a matter of fact, considering that the domestic market has largely been sheltered from import competition during the 1980s, there is some reason to presume that the 'optimal blend' of competition and monopoly has not been realized. Rather, the overall evidence suggests that the domestic market has been characterized by a lack of competition, especially as far as the more concentrated branches are concerned.67

67

Cf. World Bank (1988a). Moreover, further supporting evidence stems from detailed case studies of the technological behaviour of particular Argentine firms (see especially Maxwell [1987) and

180

Therefore, the general expectation is that both the liberalization-induced pressure to improve efficiency as well as the potential to do so should be more pronounced in more concentrated branches.68 Moreover, there is some evidence that large enterprises were in a privileged position to gain access to the international capital market in the wake of the stabilization and liberalization of the Argentine economy, whereas the majority of small and medium size companies was incapable to do so.69 Consequently, those sectors that are dominated by large enterprises may have faced less difficulty to finance efficiency enhancing investments, than the remaining sectors. The following hypothesis is derived: There will be a significant positive relation between concentration on the one hand, and changes in labour productivity on the other. With regard to the impact of concentration on the price-cost margins the general expectation is that more concentrated sectors have more scope to prop up prices than sectors that are characterized by a low degree of concentration. By the same token, the impact of trade liberalization is likely to be felt more intensively in the concentrated sectors. As argued before, this fact is also accounted for, by the introduction of multiplicative variables.70 With regard to the impact of initial concentration per se on the change of PCMs after liberalization there is no clear-cut relation. On the one hand, it may be argued that high levels of concentration have enabled firms to prop up prices which must come down as a result of trade liberalization-cumstabilization. On the other hand, it is possible that concentrated sectors retain more Katz et al. [1987]). A common theme of these case studies is the lack of innovations introduced by the companies at times when they were neither facing any significant domestic nor foreign competition. 68

In this context, it seems also useful to introduce multiplicative variables that combine indicators of concentration and trade policy. These variables should be particularly well suited to pick up the effect of trade policy change on efficiency in highly concentrated branches. More specifically, if trade liberalization has a greater impact on concentrated sectors one should expect that the estimated coefficient of the multiplicative variable is greater (or more significant) than the coefficient of the respective trade policy variable (Cf. Weiss [1992a, 21, footnote 8]). Multiplicative variables involving trade policy indicators and concentration have also been in a similar context by Gelbard (1990), for example.

69

The privileged position of large enterprises (in contrast to small and medium firms) to gain access to the international capital market in the 1990s has been highlighted e.g. by Bisang et al. (1996, 193-195).

70

For a theoretical model that suggests the introduction of an interactive term including import competition and concentration as a determinant of PCM see Jacquemin et al. (1980). For empirical applications see e.g. de Melo/Urata (1996) and Katircioglu et al. (1995).

181

scope to raise prices even in the wake of trade liberalization. Thus, the first argument suggests a negative relation, while the second argument supports a positive relation. In the given context the overall expectation is that the first argument will be more relevant and, therefore, the following hypothesis is formulated: There will be a significant negative relation between concentration on the one hand, and changes in PCM on the other. As to the privatization variable, it aims to capture the extraordinary influence on productivity change that may be expected as a result of privatization of major public enterprises in the manufacturing sector. The overall privatization process has already been outlined in chapter 2. With regard to Argentine industry three sectors have especially been affected by the privatization of state owned enterprises, namely the iron and steel sector (ISIC 371) and the petrochemical sectors (ISIC 353/354). These activities have reacted to privatizations by a massive dismissal of labour: from 1990 through 1994 the iron and steel sector reduced labour by 40 per cent; the corresponding figures for the petrochemical industry are -66 per cent (ISIC 353) and -22 per cent (ISIC 354). In contrast, during the same period the average reduction of labour in the remaining industries has amounted to 11 per cent. Clearly, the productivity gains that resulted from the dismissal of labour in privatized companies should not be attributed to trade liberalization. The privatization variable is a dummy-variable that is zero with the exception of the two sectors mentioned above, where the dummy is one. Hence, the hypothesis is as follows: There will be a significant positive relation between the incidence of privatization on the one hand, and changes in labour productivity on the other. Referring to the relation between privatization and PCM change, it is crucial to consider the characteristics of state pricing policies in the respective sectors before privatization and possible price regulations associated with privatization. As to the impact on pricing behaviour of the state-owned companies, there is evidence that in both the petroleum sector and the iron and steel sector, prices were kept down by state influence.71 Moreover, in both cases the privatized companies appear to

71

See, for example, Gerchunoff/Canovas (1995) and Petrecolla et al. (1993).

182

possess significant domestic market power.72 Consequently, the related hypothesis is as follows: There will be a significant positive relation between the incidence of privatization on the one hand, and changes in PCM on the other. Finally, promoted investment is the third structure variable considered here. For each industrial sector, it gives the ratio of value added in 1984 to promoted investment during the period from 1974-1987. This variable was included into the analysis in order to find out whether the level of promoted investment before the initiation of trade policy reform had any influence on productivity change in the wake of trade liberalization. Given that Gelbard (1990) found a positive impact of investment promotion on productivity change in Argentine industry during 1974-1985, it is of some interest to check whether a similar relationship can be observed in the given context. In other words, what is really at issue is whether the investment subsidies granted during 1974-1987 have had a continued positive effect on productivity growth during the early 1990s. Thus, the related hypothesis is the following:73 There will be a significant negative relation between the promoted investment ratio on the one hand, and changes in labour productivity on the other.

c. Technology variables The technology variables that have been included into the analysis are the following. - Output growth (OG) - Capital-labour ratio (KL) - Scale index (SI) - Technology index (Tl) Except for output growth, which refers to the same period as productivity growth, all of these variables are calculated for 1984, drawing on data from the 1985 census. The most recent 1994 census does not provide information that would allow to estimate comparative technology variables.

12

Cf. Gerchunoff/Canovas (1995, especially pp. 502-504 and pp. 510-511).

75

Note that a low value for P R O M (VA 1984 / promoted investment 19 74-1987) indicates a nigh value of promoted investment relative to value added.

183

As noted in section 4.1.1.3, there is some ground to expect output growth and productivity growth to be positively correlated (Verdoorn Law). In particular, it has been emphasized that this relation may reflect both short-run capacity effects as well as endogenous technical change and economies of scale. In order to be able to differentiate between these effects it would clearly be preferable to calculate rates of change between two years that are characterized by comparable levels of activity {e.g. peak-to-peak or trough-to-trough). Given that the two periods under consideration here (i.e. the 1990-1994 period and, to a smaller degree, the 1990-1995 interval) represent periods of increasing economic activity, the capacity effect is indeed likely to be of some relevance. The overall hypothesis is as follows: There will be a significant positive relation between output growth on the one hand, and productivity change on the other. The capital-labour ratio is a measure of capital intensity. Due to the lack of genuine information on capital the latter is approximated by installed horse power. In fact, this proxy is often used when the lack of capital data is a problem.74 With regard to the relation between capital intensity and productivity growth a positive relation is expected, since capital intensity is related to technical progress and, consequently, manufacturing sectors where the capital-labour ratio is high may provide more scope for technical innovation and rationalization. Therefore, adjustment pressure due to liberalization should lead to larger productivity improvements in capital intensive sectors. Thus, the following hypothesis is formulated: There will be a significant positive relation between the level of capital intensity on the one hand, and productivity change after trade liberalization on the other. Turning to the impact of capital intensity on PCM change, the general expectation is based on the following arguments. First, high capital intensity can be an important barrier to entry and thus, hold back competitive pressure in industry. Consequently, the tendency to prop up prices (before liberalization) would have been greater in those sectors that were characterized by high capital-labour ratios in 1984. Second, by definition the share of capital charges in value added is comparatively high in capital intensive sectors. Therefore, changes in the cost of capital, ceteris paribus, 74

For example, Gelbard (1990, table 3) uses the same measure as a proxy of capital intensity.

184

have a stronger impact on PCMs in capital intensive sectors.75 Now, the greater availability of foreign finance as well as the reversal of capital flight in the wake of the general opening up of the economy have been associated with a reduction of capital charges, and the capital intensive sectors did, therefore, have additional scope to reduce PCMs. Hence, both the scope and the pressure to reduce PCMs as a reaction to trade liberalization is expected to be more marked in capital intensive activities.76 The associated hypothesis is as follows. There will be a significant negative relation between the level of capital intensity in 1984 on the one hand, and changes in PCM on the other. Finally, the scale and technology indexes are basically measures of producer heterogeneity. The variable called scale index attempts to capture the range of production scales that can be found within separate industrial sectors. It is defined as the ratio of average production scale and largest production scale in a particular sector. The measure is based on census data that distinguish different size categories within each sector.77 Thus, it was possible to, first, calculate average firm size for each industrial sector and, second, relate this figure to average firm size in the largest size category of the respective sector. The rationale behind the introduction of this variable has to do with the potential relevance of scale effects as a mechanism linking trade liberalization and improved productivity on the one hand, and the previously mentioned difficulty to directly identify the actual contribution of scale effects to productivity growth on the other. In this context it may be argued that the scope for improvements in terms of scale efficiency should be particularly great in those sectors that are characterized by a marked difference between average firm

75

Note that P C M s as measured here include capital charges. Moreover, the better access to foreign capital of large capital intensive producers (i.e. mostly producers of intermediates) has been highlighted e.g. by Bisang et al. ( 1 9 9 5 , 1 9 3 - 1 9 5 ) .

76

Note the difference between the impact of capital intensity on P C M change on the one hand and the impact of capital intensity on the level of P C M on the other hand. The relation between capital intensity and P C M levels is generally expected to be positive, since capital intensive activities require higher P C M s to pay off the factor capital.

77

Distinction of size categories is based on output per firm.

185 scale, and large scale producers - which is equivalent to a small value for the scale index.78 This argument lends support to the following hypothesis: There will be a significant negative relation between the level of the scale index in 1984 on the one hand, and productivity change after trade liberalization on the other. Similarly to the scale index, the technology index aims to capture the technological diversity within a particular industrial sector. The index compares average productivity in a sector with best-practice productivity in the same sector. The estimation of this index follows the same procedure as the calculation of the scale index: first, drawing on the same data as mentioned above, productivity is calculated for all size categories of a particular industrial sector. Thus, sectoral best-practice productivity (which has generally been achieved by producers in the largest size category) is identified. Second, average productivity per sector is divided by best-practice productivity in the respective sector. With regard to the impact of trade liberalization, the expectation is that there should be more scope for industry rationalization (via firm exit or technological catch-up) if there is a large gap between average productivity and best-practice productivity at the branch level. Consequently, the following hypothesis is formulated. There will be a significant negative relation between the level of the technology index in 1984 on the one hand, and productivity change after trade liberalization on the other79 To conclude this section, the following table provides an overview with regard to the theoretically expected association between the explanatory variables and the dependent variables.

78

Note that the chosen definition of the scale index (SI) implies that great scale diversity is reflected by small values of SI.

79

Note that great differences between average and best-practice productivity -and, hence a large extent of technological diversity- within a particular branch is reflected by small values of the technology index.

186

Table 4.2-1: Expected signs for explanatory variables Trade policy

Efficiency dPL dPCM

Technology

Industrial structure

Quanti- Change Change Herfin- Privati- Industrial Output Capital- Scale Techdahl zation promotion growth labour index nology tative re- import effective strictions competi- protection index (PRIV) (PROM) (OG) ratio (Sl)b index Bc a (HD) (QR) tion (dEP) (KL)b CTI)" (dIC) +

+

+

+

+

-

+

+

+

n.a.

n.a.

-

n.a.

n.a.

a. QR refers to quantitative restrictions before liberalization. b. The year of reference is 1984. c. Multiplicative variables including trade policy measures (QR, dIC, dEP) and concentration (HD) have also been constructed. As mentioned before, the rationale behind the introduction of these variables is to test whether trade reform had a greater impact on more concentrated sectors. Clearly, the expected signs for the multiplicative variables are the same as indicated for the respective trade policy measures.

4.2.3 Methodological issues This section aims to provide some background to the regression analysis that is carried out as part of the empirical analysis. In particular, two basic issues are considered: first, the section provides an outline of the major assumptions that are behind the use of the OLS regression technique, and, second, the section analyses the applicability of the OLS technique in the given case.

4.2.3.1 Assumptions of the OLS regression model In order to find out whether the OLS technique can be applied to carry out the suggested regression analysis, it is important to check if the assumptions that are underlying the OLS method, are satisfied in this case. Therefore, this section will briefly review the main assumptions that lie behind the use of the OLS regression model. 80 In particular, there are six principal assumptions; four of them

80

are

For a good exposition of these assumptions see, e.g. Maddala (1977, chapter 7) and Harnett and Murphy (1980, chapter 11).

187

concerned with the disturbance terms81, whereas the remaining two assumptions concern the relationship between the variables in the structural relationship: (1)

The expected value of the disturbance term (u) is zero: E(u,) = 0 for all /.

(2)

The disturbance terms have a constant variance. Var(u,) = o 2 u for all /.

(3)

The covariance of the disturbance terms is zero, i.e. u, and Uj are independent for all / and j (/' * j). Cov(u„ u,) = 0.

(4)

The disturbance terms (u,) are not correlated with the independent variables (XJI), i.e. Cov(u„ XF) = 0 for all j and /.

(5)

The dependent variable is a linear function of the k variables included in the model: Y, = b, + b2X2i + bsX* +... + bjXji.

(6)

There are no exact linear relationships between the independent variables XJI,j= 1, 2, 3, ... k, where X „ = 1 for all /' (i.e. the constant term).

Given these assumptions it can be shown that the OLS estimators of the structural parameters are best linear unbiased estimators (Gauss-Markov theorem).82 In other words, if the listed assumptions hold true, the OLS technique satisfies the standard criteria that one is looking for when choosing a regression technique. In short, unbiasedness means that an estimator does not show a systematic tendency for the estimates it yields, to differ from the value of the structural parameters in a particular direction - i.e. the estimated value in a particular case is not generally higher or generally lower than the parameter one is trying to estimate. Furthermore, in this context the best unbiased estimator is the one whose variance is lower than that of any other unbiased estimator. Moreover, the estimators are linear in that they can be shown to be linear functions of the dependent variables. Thus, it is worth noting that the mentioned properties do not depend on any assumptions about the distribution

81

On the face of it the focus of these assumptions (and, more generally, of much of econometrics) on the disturbance terms may seem surprising. The following statement by Gillespie (1992, 112) provides some explanation: "Econometricians sometimes seem to be obsessed with questions about the behaviour of unobservable disturbance terms. Such questions may seem to be about as relevant to the concerns of the practical applied economist as do questions about the number of angels that can dance on a pinhead. The reason why the disturbance terms are important can perhaps be seen by considering what they represent. They simply reflect the fact that the underlying economic relationship we are concerned with will not be exactly demonstrated in the data we observe. The latter will be affected by measurement errors, human unpredictability, random extraneous influences and so on. To say that we cannot observe the disturbances is simply to to say that we cannot observe the underlying economic relationship: we can only make an estimate of it."

82

For a more detailed treatment of the Gauss-Markov theorem see e.g. Greene (1993, especially 157-158).

188

of the error term u,; i.e. the given assumptions are sufficient to ensure that the OLS method yields best unbiased linear estimators. However, in addition to the six assumptions mentioned above, it is essential to introduce a seventh assumption if the intention is to construct confidence intervals for the estimates of the parameters and to test hypotheses about them. Consequently, the following assumption is commonly made: (7) The residuals u, are normally distributed: u, ~ N(0, o2u) Thus, the calculation of standard errors or f-ratios of the coefficients requires the residuals to be normally distributed. Infringements of one or the other of the given assumptions do not necessarily imply that the OLS technique is inappropriate and should, therefore, not be employed. Rather, if infringements are properly identified, there are a number of techniques available that allow to eliminate estimation problems that may arise due to those infringements. There are also a few specific problems, however, that may require the adoption of an alternative regression technique.83 Yet applying these techniques is regularly associated with other additional problems (e.g. identification of appropriate instrumental variables) and, as a consequence, the more straightforward OLS technique is preferable whenever it can be used. Violations of the listed assumptions do not all have the same consequences. In what follows, a brief description of the phenomena that are associated with those violations and their consequences as well as possibilities of their detection is given. In order to organize this section it will be useful to proceed in two steps: thus, referring to the assumptions that are related to the disturbance terms, first, and considering the remaining assumptions (i.e. [5] and [6]), in turn.

83

For instance, the O L S method will produce biased estimates if there exists a problem of endogeneity of explanatory variables. In this case the two-stages-least-square (TSLS) technique should be applied which implies that appropriate instrumental variables have to be defined. Moreover, as emphasized by Weiss (1992, 21, footnote 3) the O L S technique is inappropriate where the dependent variable is constrained to be positive (truncated data problem). This problem requires the use of a Tobit model. However, in the given context this problem does not arise, as the dependent variable is given by rates of change and can therefore be negative.

189

To start with, violation of assumption (1) leads to a bias in the estimate of the constant term in the regression equation. Infringement of assumption (2) is called heteroscedasticity. As a result, OLS estimates are unbiased but do not have minimum-variance (i.e. are no more 'best' estimators). Violation of assumption (3) is called serial correlation or autocorrelation. Consequences of violation are the same as those mentioned above: OLS estimates are unbiased but have high variances. Moreover, violation of assumption (4) implies that disturbances (u¡) are correlated with the independent variable. This can be caused by various phenomena including omitted variables, measurement errors in the explanatory variable, the use of endogenous variables, or the use of lagged endogenous variables in combination with serial correlation of disturbances. As a consequence, OLS estimates may be biased. Finally, the rationale behind assumption (7) has already been discussed above. The detection of violations of the relevant assumptions is not always straightforward. More concretely, violations of the assumptions (2) and (3) can be identified by formal tests, whereas there is not a generally applicable method of detecting violations of assumption (1) - OLS estimates, by definition, imply that E(u¡) equals zero. This is part of the reason why the problem of non-zero expected values for the disturbance terms is often given less attention than other problems discussed in this context. The other reason has already been stated above, i.e. the fact that the problem of nonzero expected values for the disturbance terms, does not affect the values of the coefficients applying to the independent variables - while the main interest is usually in those coefficients and not in the constant term. Nevertheless, it should also be pointed out that the value of the constant term gains importance when adopting a linear transformation of a non-linear relationship. In this case the constant term may play an important role in the non-linear relationship.84 Considering assumption (4), there is no way to test directly whether it is violated or not. Yet it is possible to

84

Consider e.g. an equation of the form V = ab*. This can be transformed to give: log(V) = log(a) + Xlog(b). Thus, the corresponding regression equation can be written: log(V) = d + cX. Now, if the expected value of the disturbance term is not zero, the estimate of rf [slog(a)] would be biased and hence the estimate of a [=antilog(d>] would be biased as well. This may be important since a affects not only the absolute value of V but also the way in which V is estimated to respond to changes in X.

190

analyse whether some of the problems that may cause violation of this assumption may be present. In particular, there are a few tests that seek to detect whether endogenous variables have been included on the right hand side of the equation or whether important variables have been omitted from the model. 85 Clearly, whether assumption (7) is violated or not can be derived by subjecting residuals to a formal test of normality. It is important to note that the likelihood that one, or the other assumption is actually violated is partly influenced by the kind of analysis being carried out. In particular, problems of serial correlation or autocorrelation of residuals (violation of assumption [3]) are typically encountered in time-series analysis but not in cross-sectional regression models. In contrast, problems of heteroscedasticity (violation of assumption [2)) is quite common in cross-sectional analysis. Finally, it is necessary to refer to the remaining assumptions (number [5] and [6]) which are concerned with the relationship between the variables in the structural relationship. Strictly speaking, the assumption that the dependent variable is a linear function of the specified set of independent variables (assumption [5]) is one of the most fundamental assumptions that is implied when formulating a regression model. The reason is, that it makes no sense to talk about the accuracy of estimates (e.g. in terms of degrees of significance) if one is estimating the 'wrong' thing. Infringements of this assumption are known as specification errors, and they are typically caused by one of the following three problems: (a)

the wrong set of independent variables has been chosen;

(b)

the parameters that are to be estimated may themselves not be stable - either because they change over time (time-series analysis) or because they differ between identifiable sub-samples of cross-section data (cross-section analysis);

(c)

the relationship may not be a linear one.

85

As to the problem of endogeneity, it may generally be detected by means of the Hausman-test (cf. EViews3 [1997, 360-362] for a description of the test procedure) which is based on Hausman (1978) or by a modified F-test (for a derivation and description of the modified F-test see Nowak [1989, 126-127] and Nowak-Lehmann D. [1997, 6-8]). Formal tests that aim to detect specification errors (of which omitted variables are a special case) will be mentioned below in the appropriate context.

191 As a consequence of specification errors, OLS estimators will be biased and inconsistent. In this context it is worth noting that some of the problems that have been discussed above, may actually arise as a result of specification errors. For example, non-zero expected values for the disturbance term may also be thought of as specification error. Similarly, correlation between the disturbance terms and the explanatory variables can be caused by the omission of an explanatory variable which should have been included in the regression model. On principle, specification errors need to be identified by economic reasoning as there is no generally applicable statistical test available that can properly identify whether the problem is present in a particular case. In fact this should not come as a surprise, since the notion 'specification error* covers a comparatively broad spectrum of underlying problems. Nevertheless, there are a few statistical tests that seek to detect particular specification errors. For example, Ramsey's regression specification error test (RESET) falls into this category and it will therefore be mentioned again in the following section when discussing the actual applicability of the OLS technique. Turning to assumption (6), the associated problem is called collinearity. It arises if a strong correlation between the independent variables exists. The extreme case is given when there is an exact linear relationship between the independent variables (perfect multicollinearity). The problem entailed by multicollinearity is that it becomes difficult to disentangle the separate effects of the independent variables on the dependent variable. Although OLS regression still provides the best linear unbiased estimates, the coefficients in the regression equation are not very reliable as estimates of the 'true' structural relationship. As a result, standard errors for these coefficients will be relatively high and the corresponding f-values will be low. There is no clear-cut rule as to the acceptable level of multicollinearity. However, as indicated before, high values for the correlation coefficients between independent variables suggest that the problem may be present.

192

4.2.3.2 Applicability of the OLS regression model The previous section has highlighted the major assumptions that need to be fulfilled when applying the OLS regression technique. In this context some reference has also been made to statistical tests that can be employed in order to find out whether a particular assumption has possibly been violated. This section outlines the general procedure that has been adopted to examine whether the OLS regression method could reasonably be applied to estimate the respective equations. As indicated above, for each of the three sets of explanatory variables different alternatives have been tried. In other words, a variety of model specifications are tested, both with regard to the determinants of productivity change and when looking into the determinants of PCM change. The following procedure was adopted to inquire whether any of the relevant assumptions discussed in the previous section were possibly violated.86 These issues will be discussed partly in more detail in the next section, i.e. when presenting the results of the regression analysis. • Multicollinearity: Correlation coefficients for the explanatory variables that were included in a particular equation were calculated in order to check whether their joint inclusion might give rise to problems of multicollinearity. Thus, variables that were highly correlated were not used together in the same equation. • Specification errors: All estimated regressions were subjected to Ramsey's RESET, which aims to detect specification errors that are caused by some or all of the following problems: omitted variables, incorrect functional form, and correlation between the explanatory variables and disturbances.87 Hence, the RESET is a potentially powerful test; but it certainly does not substitute for economic (or econometric) reasoning but may rather supplement the latter.

86

The computer programme "Econometric Views" was employed to carry out the regression analysis as well as most of the relevant formal statistical tests.

87

A brief outline of the test procedure is given in EViews (1995, 227-229). The test is described in some more detail in Ramsey (1969).

193

• Stability of parameters: Parameter instability can be interpreted as a special case of specification error.88 In the context of the analysis of the determinants of productivity change, economic considerations suggested that parameter instability might be a problem.89 Therefore, the estimated equations were subjected to the Chow breakpoint test. Thus, the Chow test was used to check whether the respective equations should be fitted separately for the identified sub-samples instead of including all observations in one sample. • Functional form: A priori there are no clear-cut economic reasons that would allow to determine the character of the underlying structural relationship, i.e. beforehand it is not clear, for example, whether the relationship that is in question may better be approximated by an additive or by a multiplicative formulation of the regression model. One reason that indicates that it may be recommendable to apply a logtransformation of variables, is the following: several variables display extreme oscillations; some of the variables that relate to rates of change range from values of 100 per cent to over 1000 per cent. Hence the transformation into logs allows to reduce the unwarranted influence of such extreme fluctuations without losing any information contained in the data. Moreover, the inspection of two-by-two scatter diagrams of the dependent variable (i.e. PCM change or productivity change) and one of the independent variables regularly showed, that the log-transformation better approximated a linear relationship between the relevant variables than the normal form specification. Consequently, all equations were estimated in natural logarithms. This has the additional advantage that coefficients may be interpreted as elasticities. In fact this is one of the major reasons for the popularity of the logarithmic specification in applied economic research.90

88

Formally, lack of parameter stability can be interpreted as a special case of the problem of omitted variables. See e.g. Mukherjee et al. (1998, 245).

69

This issue will also be treated in some more detail when discussing the regression results (section 4.2.4.2). Cf. also the previous discussion of the distinct performance of tradables and nontradables in section 4.1.3.

90

For further discussion of the versatility of the log-transformation see e.g. Mukherjee et al. (1998, 148-159).

194

• Endogeneity of explanatory variables: On the face of it, there are two explanatory variables that might perhaps be suspected of being partly endogenous, namely output growth and change in import competition. Yet it may plausibly be argued that both variables were rather exogenous in the given context. With regard to output growth, it is in fact more convincing to presume that output growth has been determined mainly by the growth of domestic demand (or 'demand boom') that resulted from the successful stabilization of the economy after hyperinflation. The alternative suggestion that exogenous sectoral productivity shocks should have determined output growth definitely appears less relevant here.91 As to import competition, the results of the regression analysis indicated that there was no need to be concerned about the endogeneity of this variable. The reason is that endogeneity would imply a negative relation between productivity growth and change in import competition (because imports would be drawn into sectors with low productivity growth), whereas the estimated coefficient on import competition has an (expected) positive sign regularly. Due to the difficulty in finding appropriate instrumental variables no formal test on endogeneity was carried out.92 • Distribution of residuals: After running a regression, residuals were subjected to the Jarque-Bera test in order to find out whether the hypothesis of normally distributed residuals could be maintained. As outlined above, it is essential that residuals are distributed normally (u, ~ N(0, a2)) since any hypothesis on the significance of the estimated equation and of the associated parameters is based on this assumption. • Heteroscedasticity: Due to the fact that the adopted approach is a cross-section analysis, particular attention has been given to detect problems of heteroscedasticity. Therefore, the estimated residuals were always subjected to the White-test of

91

This point of view is also put forward by Kacef (1994, 4). He argues that the distinct performance of tradables and non-tradables supports the view that demand growth was the source rather than the outcome of productivity growth.

92

Any formal test of endogeneity (like the Hausman-test or the modified F-test mentioned before) hinges on the availability of appropriate instrumental variables. Appropriate instrumental variables are characterized by a high correlation (preferably close to 1) with the replaced variable and no correlation (i.e. preferably close to 0) with the disturbance term.

195 heteroscedasticity.93 If the result of this test indicated that heteroscedasticity might be a problem, the regression was re-estimated applying White's correction procedure that yields a heteroscedasticity-consistent covariance matrix for calculating standard errors and f-statistics.94 As mentioned before there was no need to test for autocorrelation or serial correlation because this problem may only be relevant in the context of time-series analysis or pooled analysis.95

4.2.4 Results of the regression analysis The results of the statistical analysis of the determinants of PCM change and productivity change will be discussed in turn.

4.2.4.1 The impact of trade liberalization on domestic market power (PCM) As shown in section 4.1.2 there has been a considerable decline of PCMs in almost all manufacturing branches during the period from 1984 to 1993. Overall, the results of the regression analysis suggest that trade liberalization has in fact contributed to this reduction. Table 4.2.-2 provides an overview of the results of the estimated equations. In what follows, these results will be discussed and a few general caveats concerning their interpretation will be spelled out in addition.

93

As hinted before, this test was carried out as part of the computer programme "Econometric Views". A short description of this test is contained in EViews (1995, 223-224).

94

More specifically, if the associated test statistic indicated the rejection of H 0 (homoscedasticity) at the 10 per cent level (i.e. p = 10 per cent, where p gives the probability that H 0 is rejected although it is correct), it was assumed that heteroscedasticity might be a problem and the White procedure was adopted to yield heteroscedasticity consistent f-values. For more detailed information on this procedure see EViews (1995,196 and 223-224).

95

The characteristic feature of pooled regression analysis is that it combines both time-series and cross-sectional analysis.

196

Table 4.2-2: Determinants of PCM change: Regression results Explanatory variables and expected signs (1) -0.05

Constant dEP dEP*HD

Estimated equations (2) -0.15

(3) -0.04

(4) -0.09

(5) 0.40

(6) 0.68

(7) 0.79*

0.12***

0.13***

-0.14*

-0.16**

0.13***

(+) +

() -0.07

QR

(-)

QR*HD dIC

(-)

dlC*HD HD

(-) (-)

PRIV

(+)

0.29

0.27

0.19

KL

(-)

-0.26"*

-0.24*** -0.28***

-0.24***

-0.29***

-0.29***

-0.26***

R2

0.34

0.29

0.34

0.29

0.53

0.51

0.49

Adj. R2

0.22

0.23

0.25

0.23

0.43

0.42

RESET*

r

nr

r

nr

nr

nr

0.42 nr

(-)

-0.01

-0.02 -0.02

-0.03

-0.05 0.27

Note: Asterisks indicate level of significance of coefficients: significant at 10% level (*); significant at 5% level (**); significant at 1% level (***). a. This row reports the results of Ramsey's RESET, thus indicating whether H 0 (no specification error) was rejected (r) or whether it was not rejected (nr) at the 5 per cent level (i.e. p = 5 per cent, where p gives the probability that H 0 is rejected although it is correct). Source: Own calculations.

First of all, it is remarkable that the signs on all coefficients are consistent with the previously formulated theoretical hypotheses. However, not all of the coefficients are significantly different from zero. The level of significance is indicated by the number of asterisks that are attached to the estimated coefficients. More specifically, one asterisk denotes that the coefficient is significant at the 10 per cent level, two (three) asterisks indicate significance at the 5 per cent (1 per cent) level.96

96

In other words, one (two, three) asterisk(s) indicate(s) that the probability that H 0 (coefficient equals zero) is rejected although it is correct is 10 ( 5 , 1 ) per cent.

197

Turning to the trade policy indicators, some support for the price discipline hypothesis can be derived from equations (5) to (7), in particular: changes in effective protection are significantly and positively associated with changes in PCMs. The significance of the effective protection variable is high, at the 1 per cent level. Hence, the positive association of changes in effective protection and PCM change provides some support for the hypothesis that PCMs will be reduced in industrial sectors with declining protection, since the latter typically implies greater competition from imports. Both the level and significance of the multiplicative variable (dEP*HD) are not different from the simple dEP. Thus, the expectation that the reductions of effective protection might have a greater impact in more concentrated sectors, finds no empirical confirmation. In this context it is interesting to note, however, that the multiplicative variable including quantitative restrictions and concentration (QRxHD) performs better than the simple QR variable. This can be seen when comparing the results of equation (5) with the results of equations (6) and (7). Consequently, there is some support for the hypothesis that the impact of quantitative restrictions is more marked in more concentrated sectors.97 Referring to the ex-post indicator of trade policy change, i.e. change in import share in domestic demand (dIC), the estimated coefficients have the expected sign but they are not significant. The corresponding multiplicative variable (dlC*HD) is not significant either. The fact that the other trade policy indicators are significant while the ex-post indicator of trade liberalization is not significant may seem surprising, however, bearing in mind the methodological problems involved in the construction of trade policy indicators (cf. section 4.2.2.3), this outcome is not a big surprise. Basically, what is implied by this result, is that the sectors that experienced a strong reduction of effective protection have not necessarily been identical with the sectors that experienced a considerable increase in import penetration.98 As a matter of fact, this kind of lack of theoretically expected

97

As mentioned above, QR gives the sectoral production coverage ratio of quantitative restrictions in 1985. Since the transport sector (automobiles) has still been protected by a special regime (including quantitative restrictions) in 1993, equations (5) to (7) have also been estimated without inclusion of the transport sector. This adjustment did not entail any significant change of the results reported in table 4.2-2.

98

This can also be seen when calculating the simple correlation coefficient for dIC and dEP. This yields a value of 0.34, thus suggesting that both variables are weakly and positively correlated.

198 associations among different trade policy indicators, seems to be the rule rather than the exception in the empirical literature on trade liberalization." Of the industrial structure variables, concentration (HD) and privatization (FRIV) have been included in the analysis.100 Both variables have the expected sign but neither is significant. Moreover, dropping the privatization variable from equations (1) and (3) affects the result of the specification error test (RESET): considering equations (1) and (3), the associated test statistic implies that H0 (no specification error) should be rejected, thus suggesting that there may be a problem of specfication error. In contrast, no rejection of H0 is statistically recommended when the equations are estimated without the PRIV variable (equations [2] and [4]). However, there is no indication that the privatization dummy per se gives rise to specification problems, since its inclusion in equations (5) and (6) is not associated with a rejection of H0 when applying Ramsey's RESET. On the other hand, joint inspection of the values of R2 and adjusted RJ makes it clear that PRIV can be dropped without significantly thereby reducing the explanatory power of the equation. This can be seen by comparing equations (6) and (7): dropping PRIV from equation (6) reduces R2 but the adjusted R2 remains unchanged (0.42).101 Finally, of the technology variables, the indicator of capital intensity (KL) has been included as a regressor in all of the estimated equations. It is always highly significant with the expected negative sign. Moreover, the value of the coefficient on KL is fairly constant across the different estimated specifications of the regression model, Clearly, the positive association contradicts the theoretical expectation. A possible explanation is that both variables do not refer to the same period of time, i.e. dEP refers to 1980-1991, while d i e has been calculated for the same period as dPCM, namely 1984-1993. 99

Cf. e.g. Tybout/Westbrook (1995, especially pp. 72-73) and Weiss (1992b, 720).

100

Apart from the equations the results of which are reported in table 4.2-2, further regressions nave been run that have included HD as an explanatory variable. However, HD did regularly fail :o be significant.

101

As usual R 2 is the coefficient of determination which is defined as the ratio of the explained SLm of squares (i.e. the variation in the dependent variable that is explained by the variation in all repressors) to the total sums of squares (which includes the explained sum of squares and the 'unexplained' residual sum of squares). The difference between R 2 and adjusted R 2 is that the atter takes account of the number of variables included in the estimated equation. The reason is that the inclusion of further variables will almost always increase R 2 . Consequently, comparing adjusted R 2 values may be a better indicator of whether the inclusion of a particular variable significantly improves the goodness of fit of the relevant equation.

199

thus providing further evidence of the relevance of the estimated coefficient: hence, the more capital intensive sectors (as measured in 1984) have experienced a larger reduction of price-cost margins than the less capital intensive sectors. As noted before this kind of negative association can be mainly explained by two arguments: first, the capital intensive sectors (i.e. especially intermediates like petroleum, chemicals, paper, iron and steel) faced little domestic competition before the opening up of the economy (capital intensity as barrier to entry). Second, by definition the share of capital charges in value added is comparatively high in capital intensive sectors; consequently the capital intensive sectors benefited considerably from the reduction of capital charges (due to the increased availability of foreign finance and the reversal of capital flight) in the wake of the general opening up of the economy. Last but not least, a few general caveats (which have partly been noted before) shall be reiterated. First of all, a general drawback of the analysis is that it refers to industrial sectors at the ISIC 3-digit level which implies that important differences among more disaggregated branches are not captured. Second, there is some doubt as to the quality of the data. In particular, the fact that the PCMs calculated for 1984 are likely to overestimate actual PCMs (mainly because of the high inflation during the relevant period), introduces the possibility of biased estimates, especially if not all sectors are affected by the same degree (cf. section 4.1.2).

4.2.4.2 The impact of trade liberalization on productivity in the industrial sector The empirical analysis of the determinants of productivity growth has focused on two periods, covering the time span from 1990-1995 and, alternatively, from 1990-1994. Overall, the results of the regression analysis have been very similar for both periods. In particular, there has been no major change in the size or significance of the estimated coefficients. Therefore, there is no need to present the results for both periods.102 Instead the focus will be on a variety of specifications relating to the 1990-1995 interval. Given that the results are broadly the same for both periods, the

102

The results of the estimations for the 1990-1994 interval are available from the author upon request.

200

decision to concentrate on this period has been based on two arguments in particular: first, as noted before, it is preferable to calculate rates of change between two years that are characterized by comparable levels of activity. According to this criterion 1990 and 1995 are definitely more similar than 1990 and 1994.103 Second, considering that industrial adjustments to trade liberalization take time to evolve, there is some reason to extend the period of analysis, i.e. to include the figures available for 1995. The results of the regression analysis are presented in table 4.2-3. Before having a closer look at the estimated coefficients, a few more general comments are called for. First of all, it is useful to re-consider the issue of parameter instability that has been touched upon before. More concretely, previous sections have already pointed out that there is some reason to expect a significant difference in the sectoral impact of trade liberalization, depending on the tradability of the sectoral output (cf. section 4.1.3). To test for the relevance of this consideration, industrial sectors were put in order according to their openness, and the estimated equations were regularly subjected to the Chow breakpoint test. In other words, the Chow test was applied to test whether the estimated parameters differed significantly between the group of tradable sectors and the group of non-tradable sectors.104 The results of the Chow test are also reported in table 4.2-3. Second, it is useful to have a look at the results of Ramsey's RESET. Interestingly, in both cases where this test leads to the rejection of H0 (i.e. equations [1] and [2]), the Chow test indicates the presence of parameter instability. This concurrence suggests that the possible specification errors detected by Ramsey's RESET might 103

Note that both years 1990 and 1995 have been characterized by economic recession: manufacturing GDP decreased by 2.3 per cent in 1990 (after having declined by more than 7 per cent in 1989) while decreasing by 7 per cent in 1995. In contrast, manufacturing G D P expanded by roughly 6 per cent in 1994 (see also table 4.1-3).

104

More formally, the Chow test is based on a comparison of the unrestricted residual sum of squares (which is equivalent to summing the residual sums of squares for each of the sub-groups) and the restricted residual sum of squares (which is equivalent to the residual sum of squares when the equation is fitted to the complete sample) The output from the test is an F-statistic (as well as a

201

have been caused by the lack of parameter stability. Nevertheless it should also be noted that there are two other equations (i.e. equations [3] and [8]) where the RESET does not recommend rejection of H0 (no specification errors), whereas the Chow test points to parameter instability (although only at the 10 per cent level). Third, it is useful to mention that the inclusion of output growth as a regressor to explain productivity growth may give rise to spurious correlation."* The latter may be caused by the identity of the numerator of productivity growth and the explanatory variable OG, thus resulting in spuriously high R2 values ' 06 The empirical literature on the productivity consequences of trade liberalization has rarely taken account of this issue, although output growth is regularly included as a regressor in the respective regression models. However, the traditional specification of the Verdoorn Law has long been criticized for this shortcoming.107 As a matter of fact, the related literature has also pointed out that the problem may easily be obviated by re-specifying the Verdoorn Law.108 By the same token, the problem of spuriously high R2 values can also be avoided in the given context: more concretely, considering that dPL = OG - dE, where dE is the growth of employment, the estimated equations simply need to be rearranged so that dE (instead of dPL) is regressed on the explanatory variables. log-likelihood ratio) with associated probabilities. Cf. EViews (1995, 225-227). For more detail see also Greene (1993, 206 and 211-212) and Mukherjee et al. (1998, 231-234). 109

As argued above, the other potential problem (i.e. endogeneity of output growth) did not appear to be relevant here.

,os

Cf. Fingleton/McCombie (1998, 90) and McCombie/Thiflwall (1994, 168-171).

107

See e.g. McCombie/de Ridder (1984, 270). The traditional specification of the Verdoorn Law is as follows: dPL = a, + bfOG where dPL and OG are the growth rates of labour productivity and output, respectively. The socalled Verdoorn coefficient (b,) has often been estimated to be in the order of one-half, which implies that a 10 per cent increase in output growth is associated with a 5 per cent increase in productivity (cf. e.g. McCombie/Thirlwall [1994,167-180]).

108

Due to the fact that dPL is definitionaily equal to OG minus growth of employment (dE), the traditional specification of the Verdoorn Law (see previous footnote) can easily be rearranged to give: dE = a', + b',OG

with a'« = -a, and b', = (1 - b,).

Hence, both specifications can be used to estimate a, and b t (the standard errors of the estimated coefficients are identical as well) but the re-specified version of the Verdoorn Law avoids the element of spurious correlation found in the traditional specification. As a consequence, the R 2 of

202

For example, equation (1): dPL = a, + b,dEP + b2QR + b3PRIV + b4OG can easily be rearranged to give: dE = a', + b'idEP + b'2QR + b'3PRIV + b\,OG with a', = -ai, b'i = -bi, b'2 = -b2, b'3 = -b3l and b'< = (1 - b4). As emphasized before (see previous footnote), the results of this kind of re-specification are a perfect mirror of the results of the original specification, while yielding an R2 which is corrected for the element of spurious correlation present in the original specification. Therefore, table 4.2-3 does exclusively report the corrected R2, i.e. the coefficient of determination when dE is regressed on the explanatory variables.109 Overall, the results of the regression analysis provide some support for the basic hypothesis that a positive relation between trade liberalization and productivity change exists. In this context it is particularly noteworthy that the signs on all of the significant variables are consistent with the hypotheses elaborated before (cf. section 4.2.2.3). Referring to the trade policy indicators, the only variable that does not have the expected sign is the coverage ratio of quantitative restrictions (QR), neither in its simple form nor in the multiplicative formulation (QR*HD). However, as indicated before, these variables are not statistically significant. Support for the hypothesis of a positive efficiency impact of liberalization, can be derived from the remaining liberalization indicators. The effective protection variable (dEP) is significant when the equation is fitted separately for tradables. The negative sign on dEP implies that manufacturing sectors with decreasing effective protection experienced rising productivity growth.

the re-specified version is typically somewhat lower than the R 2 of the traditional specification. Cf. McCombie/Thirtwall (1994,168-172) for more detail. 109

The difference between the original R 2 and the corrected R 2 is roughly between 5 to 20 per cent, depending on the respective equations. For instance, in equation (1) the original R 2 (adj. R 2 ) is reduced from 0.66 (0.60) to 0.47 (0.37) when applying the re-specification. In the case of equation (4) the corresponding values are 0.87 (0.85) for the original R 2 and 0.80 (0.77) for the corrected R .

t-

All

All

All

All

All

(9)

All

-0.50 I

-0.74

!

(9a) Trad.

-0.31"

-0.26I

(8a) Trad.

!

(8)

•0.35-

-0.29I

(7a) Trad.

t

(7)

0.04

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-0.29

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0.01

I

(6a) Trad.

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I

(4a) Trad.

(4)

0.08

0.15*

s

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(3)

a „ « j î ' nr

070

0.80 0.76 0.86 0.82

0.004

0.78— 0.74— 0.78— 0.75— 0.78—

0.0002 0.75— 0.78—

0.73— 0.016 0.78— 0.75— 0.76— 0.72—

0.002

0.29— 0.31** 0.27— 0.320.29— 0.320.230.260.31 — 0.31—

0.80 0.77 0.87 0.83

0.06

0.89 0.85 0.10

0.82 0.78

0.04 0.04

0.86 0.82

0.80 0.76

0.86 0.83

0.80 0.76

0.86 0.83

0.80 0.77

0.65

0.34—

0.71

0.30—

0.53 0.47

0.78

nr

nr

nr

nr

nr

nr

nr

nr

nr

nr

nr

nr

nr

nr

nr

0.50 0.40 r

0.70—

0.73—

0.55— 0.73—

0.63—

0.46**

0.77 0.69

0.47 0.37 r

osa—

0.74***

0.59—

(•)

ole-

0.67***

Tl (-)

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r

nr

r1

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nr

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-0.02

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0.41**

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c

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Explanatory variables and expected signs

> S o

Trade policy

M

equations 1 Constant I1

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