The global financial crisis has stimulated a broad reassessment of economic integration policies in developed and developing countries alike. Despite the fact that an outward-oriented strategy can make the economies more volatile, as greater openness to trade typically increases vulnerability to product-specific and country-specific shocks from overseas, the trade agenda moving forward does not center on stepping back from integration into the world economy. By contrast, integration remains a key dimension of any development strategy.
A remarkable feature of the policy responses to the crisis was the limited recourse to overt protectionism to shelter domestic firms. The last time the world economy went through a global downturn, following the second oil price shock and the winding down of inflation at the end of the 1970s, there was a widespread resort to “voluntary” export restraints and quantitative restrictions for products such as cars, textiles, and steel. Nontariff barriers came to apply to over one-third of all developing country exports in the early 1980s, on top of average tariffs that were significantly higher than they are today. So far, this response has largely been avoided in the current downturn. The fact that countries are part of global production chains gives them less incentive to raise the costs of the imports that they process for re-exporting.
Having a well-established multilateral system with clear international disciplines proved effective. The rules embodied in the World Trade Organization (WTO) and enforcement mechanism that comes with it helped keep protectionism low during the crisis. Regional trade arrangements also played a role.
But the nature of global integration is changing, entailing new challenges for policymaking.
Focus more on South-South Trade
The recent growth in South-South trade was driven by growth of emerging economies and reduction of trade policy barriers. This trend was reinforced in the aftermath of the global crisis as developed economies stalled. Rapid growth of gross domestic product (GDP) is behind a significant proportion of growth in import demand in low- and middle-income countries (LMICs), and particularly in the BRIC countries. During the crisis, effective stimulus packages in major Southern economies including China supported demand for imports from other developing countries.
Reductions in the average level and the dispersion of border protection have also been a significant force behind South-South trade. The average tariffs imposed by BRIC countries decreased 44 percent during 1996-2008. Tariffs in LMICs dropped 31 percent during the same period. Although a variety of measures were imposed during the crisis to restrict trade, in the aggregate, these have not been significant.
Over the medium term, the development of “export-led growth v2.0,” in which South-South trade plays a more important role, will be essential. High debt and fiscal deficit levels in many Organisation for Economic Co-operation and Development (OECD) countries will continue to be drags on growth, and thus imports, for a substantial length of time. Thus, developing countries may not be able to rely on developed countries to fuel their export-led growth, as rapidly industrializing countries, such as China in the 1990s and the Asian Tigers before it, were able to do. South-South trade will reduce exposure to possible prolonged slow-growth markets in Europe, Japan, and the United States. For example, strengthening trade ties with East Asia, the world’s faster growing region, can be an important source for diversification and growth for the countries of Eastern Europe and Central Asia. To date, trade with neighboring East Asian countries is less than one fourth of the trade with Western Europe.
Yet, increased trade among developing countries should not be a substitute for trade with developed countries. Developed countries remain a significant source of import demand with high purchasing power. Moreover, Southern countries still export substantially fewer product varieties than high-income or even middle-income countries. Trade complementarity therefore continues to be important.
Reducing Volatility from Openness
Globalization and openness increase cross-border economic interdependence and may lead to convergence of business cycle fluctuations. The crisis generated a debate on international business cycle co-movements. Economic cycles in developing countries remain closely correlated with those in developed countries. While there has been no decoupling in the cyclical component of developing country growth, a decoupling in underlying trend rates of growth may have occurred after the 2000s. The trend growth in developing countries has become substantially higher than in the advanced world.
Although the decoupling of LMICs from HICs protects the South against demand shocks in the North, an outward-oriented strategy can still make the economies of developing countries more volatile. Greater openness to trade typically increases vulnerability to product-specific and country-specific shocks from overseas. Transmission of terms-of-trade volatility to output and growth rises as export earnings become a more important source of national income. However, a second mechanism works in the opposite direction. As a country’s export sector starts to operate more closely in tune with overseas market conditions, it necessarily becomes less strongly correlated with home market conditions. Because demand shocks at home and overseas are only imperfectly correlated, this force tends to reduce overall volatility of output.
Diversification can operate as insurance against volatility. A higher level of diversification, mainly product diversification but also market diversification, weakens the link between openness and growth volatility. Outward orientation means that a country is more likely to export more products to more markets. Diversification offers a way of buying the benefits of openness while managing the downside of risk. It can take the form of breaking into new products or new markets. Geographic diversification also plays a role in reducing volatility. Countries whose main export markets are volatile are more likely to import volatility from their trading partners and be exposed to external fluctuations. If there is low correlation between the fluctuations in different partner countries, geographic diversification reduces the exposure of countries to external shocks.
With export product and market diversification acting as effective stabilizers, developing-country policy makers should emphasize measures that help broaden their country’s economic base and expand the range of exportable products. A comprehensive array of policies can help a country’s exporters achieve this goal. The main idea is to shift the attention from interventions that distort prices to interventions that deal directly with other problems that keep trade low. This array spans several broad areas: facilitating the costly search process for exporters by alleviating information externalities; getting the incentive structure right to reduce or eliminate policy-induced bias against exports in relative prices; lowering the costs of trade-related services, including telecommunications, ports, transport, and customs administration; and instituting proactive interventions by governments, including notably export promotion and standards.
In addition, a greater variety and sophistication of a country’s endowments, ranging from natural, physical and human capital to institutions, will also make the diversification of products and partners easier. Countries such as the Australia, Brazil and Canada have been able to leverage their natural resources and develop diverse sets of institutions, skills and ideas. This helped them to become richer and will help them stay to rich even when the natural resources are depleted.
Deepening International Cooperation
Deepening international cooperation is crucial to foster integration. Many policies play an important role in helping exporters to integrate into the world economy, including elaborating and implementing trade agreements that enhance access to markets, programs that signal the existence of potential partners and help to screen associates that can be trusted from a quality and credit perspective, investment in infrastructure and trade corridors, trade support and investment promotion institutions, financial support and tax incentives to promote quality upgrading, and so forth.
Trade agreements can be an important tool to support better access to markets, especially other developing country markets, given that barriers to trade are still substantially higher in the South than in OECD countries. For example, Russia’s WTO accession helps to reform the economy in three ways. It improves the quality and lower prices in business services through higher FDI; lowers the prices of intermediate inputs and final goods of consumers through tariff reductions; and improves market access for Russian exporters. Trade agreements can also be an important instrument to help governments manage proactive policies that aim to offset market and government failures that create a bias against investment in tradable activities. Joint surveillance of the effects of policies, their incidence, and effectiveness can be a source of valuable information and accountability. Agreements can be structured to increase the credibility of exit strategies--helping to ensure that support does not become a source of rents and to keep in place activities that are not viable. Finally, and most important, trade agreements offer a mechanism through which the potential negative externalities that are created by national policies can be addressed in a cooperative manner.
The crisis has not in any way weakened the case for international integration to be a core component of development strategies. A globalized world economy can generate very severe volatility. This stresses the importance of having countercyclical policy instruments available, as well as well-designed social protection polices, but does not imply that countries should in the future devote less effort to integrate further into the world economy and seek to expand the tradable sector--both goods and services. Diversification across markets and products can help reduce output volatility, especially volatility that is due to idiosyncratic shocks that are specific to a sector or source of demand.
An important consequence of the crisis is that the differential growth performance between high-income and emerging-market economies that was already evident will be strengthened. One result is that South-South trade will continue to expand, in the process helping to diversify patterns. From a policy perspective, a multipolar world calls for efforts by developing countries to reduce the barriers to trade they impose on each other. Initiatives that can make a difference include the extension of duty-free and quota-free access for least-developed country exporters by all G-20 members; further reductions of tariff and nontariff barriers on a nondiscriminatory basis on product in which poorer developing countries have a comparative advantage; and a concerted effort to cooperate on a regional basis to lower real trade costs created by poor trade and transport-related infrastructure, inefficient logistics services, and border management.