Although others are clearly important and they are obviously inter-related, I am only talking about trade liberalisation.

Trade and Poverty Different kinds of liberalisation There are many different kinds of liberalisation _ trade _ capital account _ foreign exchange _ credit _ domestic competition Although others are clearly important and they are obviously inter-related, I am only talking about trade liberalisation. What are the theoretical linkages between trade liberalisation and poverty? The standard bit of trade theory which is often used to analyse the impact of trade liberalisation is the Heckscher-Ohlin model. The Heckscher-Ohlin model looks at 2 countries, 2 goods, and 2 factors (along with a number of other assumptions including identical technology and preferences). It shows that each country will export the good which intensively uses its most abundant factor (and import the other one). The welfare of both countries is maximised by them adopting this strategy. Putting this together with the assumption that developing countries tend to be abundant in labour whereas richer countries are abundant in capital yields the typical policy recommendations which are espoused by the international institutions on free trade. Free trade, it is argued, removes distortions to international trade thereby enabling countries to export according to their comparative advantage. Since the comparative advantage of developing countries lies in their abundant labour, the principal beneficiaries of such export-led growth will be labour. And since the owners of labour in most developing countries tend to be far poorer than the owners of capital, liberalisation should benefit the poor more than the rich. Furthermore, if the labour intensive good has a high income elasticity of demand (i.e. people buy a lot more of it as they get richer), then its price is likely to be increasing. In this situation another piece of trade theory the Stolper-Samuelson theorem become relevant. The Stolper-Samuelson theorem states that an increase in the prices of the labour-intensive good raises real labour incomes and reduces real returns to capital. Hence the frequent policy advice to developing countries to expand labour intensive non-traditional exports. What are the pathways through which trade liberalisation influences poverty? 1 We look at three pathways through which trade liberalisation affects poverty: price transmission through the distribution system employment and wages government expenditure and revenue Distribution Consider the transmission of price shocks in pure accounting terms. For an import, the world price of a good, the tariff it faces and the exchange rate combine to define the post-tariff border price, p b. Once inside the country, the good faces domestic taxes, distribution from the port to major distribution centres, various regulations which may add costs or control its price and the possibility of compulsory procurement by the authorities. The resulting price we term the wholesale price, p w. From the distribution centre the good is sent out to more local distribution points, and potentially faces more taxes and regulations. In addition at this point, co-ops or other labour-managed enterprises may be involved. We distinguish these because their behaviour in the face of shocks could be significantly

different from that of commercial firms. We term the resulting price the retail price, p r, although of course market institutions may well not resemble retail outlets in the industrial economy sense. Finally, from the retail point, goods are distributed to households and individuals. Again co-operatives may be involved, plus, of course, inputs from the household itself. More significantly, the translation of price signals into economic welfare depends on the household's endowments of time, skills, land etc, and technology and random shocks such as weather. Anything that increases yields, for example, would permit a household greater welfare at any given price vector. In determining the effects of world price or trade policy shocks on poor households it is vital to have a clear picture of these transmission channels and the behaviour of the agents and institutions comprising them. For example, monopsonistic buyers of export crops will respond differently to price shocks than will producers marketing cooperatives. Regulations that fix market prices by fiat or by compensatory stock-piling can completely block the transmission of shocks to the household level. ii Even more important, all these various links must actually exist. If a trade liberalisation itself - or, more likely, the changes in domestic marketing arrangements that accompany it - lead to the disappearance of market institutions, households can become completely isolated from the market and suffer substantial income losses. This is most obvious in the case of markets on which to sell cash crops, but can also afflict purchased inputs and credit. If official marketing boards provided credit for inputs and against future outputs, whereas post-liberalisation private agents do not, no increase in output prices will benefit farmers unless alternative borrowing arrangements can be made. Employment and Wages The links in the enterprise sector consist of three elements demand, enterprises and factor markets. On the outer margins, demand for the output of home enterprises is determined by export, import and domestic prices. The demand for the domestic good must be matched by supply, which stems from the second element enterprises. These divide their output between home and export markets according to relative prices. They also determine total output according to the price of that output relative to costs. Costs, in turn, depend on factor prices and factor input-output coefficients, the latter of which depend on technology and again on factor prices. Factors and their returns need to be disaggregated by type, including caste, gender and home-working. Given total output and the technology, total factor demand is given, and this is confronted with total factor supply in the factor markets. They are equilibrated by movements in factor prices, with the result that employment and wages the two variables of most relevance to poverty - are determined. Government Revenue and Expenditure Trade liberalisation can reduce tariff rates so far that government revenue falls. The government, finding its revenue constrained, may curtail expenditure on social and other poverty alleviating policies and/or levy new taxes on staple and other goods consumed heavily by the poor. Given the association between stabilisation, liberalisation and poverty over the 1980s, these worries have some historical basis, but it would be mistaken to assume that the association is immutable. It is clear, however, that care and political focus are required to ensure that this indirect route does not lead to adverse effects on poverty. What is the empirical evidence? There is remarkably little concrete evidence specifically on the effect of trade liberalisation. Trade and Growth Growth reduces poverty (notwithstanding its impact upon inequality) (Bruno, Ravallion and Squire 1996; Roemer and Gugerty 1997; Dollar and Kraay 2000) Openness to trade IS good for growth There is a great deal of controversy over this. Several cross-country studies showing a positive 2

correlation between openness to trade and economic growth (Edwards, Harrison, Dollar). However, others suggest that this correlation does not suggest causation but is in fact caused by other things (Rodrik). However, there is virtually no evidence that openness to trade is bad for growth in the longrun. Trade and Inequality However, the distributional impact of trade liberalisation depends upon the liberalisation you can work it out in particular cases. In general in East Asia unskilled labour benefitted in the 1960 and 1970s; in Latin America in the 1980s it didn t. The difference may be due to: natural resources Latin America is not necessarily a labour abundant region China China s entry into the world market introduced both a huge new source of low cost labour new technology it is possible that increased flows of technology and information may increase demand for skilled workers rather than unskilled workers. Trade and FDI Higher rates of FDI for more open economies (Balasubramaniam et al 1996; OECD 1998) (but which way does the causality lie open implies more FDI or vice versa?) Foreign firms bring new technology, pay higher wages, buy local goods and services and pay taxes thus they add considerably more value to host economies than the profits they remit. Trade and Price Transmission Rich country liberalisation is likely to raise food prices (Anderson 1998) with obvious negative impact upon countries which are net food importers Ahmed and Rustagi say 75-90 percent of consumer price of food grains is paid to the farmer; in Africa the proportion is 35-60 percent (mostly because of inefficient marketing). Dorosh and Valdes (1990) say farm gate prices in Pakistan received by farmers increased as a result of trade reforms. Trade and Labour Demand/Wages Lots of work on the impact of trade policy upon the productivity and performance of manufacturing enterprises: Bonelli and Hay show strong productivity impact of trade liberalisation for Brazil, Wangwe, Lall, Teal et al show how openness has not brought about transformation of manufacturing in sub-saharan Africa. However, none of these look at how the impact upon these firms affects those working in them. i.e. the poverty impact. Trade and Government Revenue/Expenditure Trade liberalisation does not necessarily reduce revenue (Greenaway and Milner 1991) Often developing countries have considerable distortions within their tax systems. Therefore liberalisation can give revenue rises where taxes/regulations prevented trade; also liberalisation can be complemented by removal of exemptions and improvements in the efficiency of tax collection. So what is the impact of trade liberalisation upon the poor? The answer depends upon exactly the same variables as the non-poor i.e. they gain/lose through changes in prices, employment and public service provision. Clearly whether they actually gain or lose in any given context depends upon: the actual trade liberalisation implemented the price transmission effects the employment/wage effects and 3

the government revenue/expenditure effects Need to know various things if you are going to be able to predict the impact of a trade liberalisation 1. What reform is being done This is often contentious and unclear - yet it is impossible to measure its impact unless you know what it is 1. The price effects Which goods are likely to be subject to major price changes. What is the structure of the import/distribution/wholesale/retail chain for these goods? How are prices likely to be passed on (or not)? 1. The employment effects Which sectors and companies will be most affected? Where are they? How many people do they employ? What are their skill levels/opportunities for alternative employment? What are their linkages to other poor families? (rural urban remittance very importance for lost of countries, but not all e.g. Zambia) 1. The revenue effects What are the likely short-term effects upon revenue? What financial compensatory measures may be required? What other taxes might fill the gap (and what are their effects on prices and livelihoods)? Governments also need to know about aspects of poverty in their countries in order to be able to see the impact of specific trade policy reforms upon the poor in their countries: Where do the poor live? What are the agro-climatic conditions? What are the key sources of income? Are there industries likely to affected? What is level and quality of infrastructure provision? How do the poor obtain their income? (subsistence? cash crops? self-employment? remittances? wages? what is the imputed value of government services?) How do these variables vary for households with different geographical, demographic and educational compositions? What the poor consume? (what foods and non-food goods are essential? how do proportions vary across different groups?) How do the poor cushion shocks? (extended family? government programmes? access to credit? extent to which local asset markets function?) With this information governments can obtain an rough indication of the likely scale of winners and losers from any given trade reform. Two Examples: Country A: Consider a country in which the poor live predominantly in rural areas and obtain most of their income from subsistence farming complemented with moderate amounts of farm and non-farm wage labour. An urban elite are relatively well paid in formal sector (particularly government) employment. A trade reform is implemented which removes the high levels of protection currently afforded to inefficient manufacturing industries in urban areas. The impact of this reform may be a severe recession associated with the contraction in formal sector employment as inefficient manufacturing industries are exposed to international competition. This will almost certainly increase urban poverty. Further it may affect government social expenditure which will have a wider poverty impact, particularly if no measures have been taken to compensate for any revenue loss experienced. Also if households in rural areas rely upon remittances from family members working in urban areas, then they may also be adversely affected. But in the long run rural areas may benefit from such a change since the removal of the bias against agriculture may result in greater resources being invested in agricultural production in rural areas. Furthermore if the change is accompanied with a removal of a food subsidy from which mostly urban 4

consumers benefit, then, although the urban poor will lose, the majority of the poor in rural areas will gain if they are net producers of food. This may also have a positive knock on effect on opportunities for farm and non-farm employment in rural areas. Country B: Consider a country in which the poor live predominantly in peri-urban areas. They obtain most of their income from informal sector self-employment and occasional wage employment predominantly in the service sectors. A similar trade reform in which high levels of protection afforded to inefficient manufacturing industries are removed will have quite a different impact upon poverty. In this instance the poor are likely to be directly and immediately negatively affected by the change, since the demand for their services will contract sharply while competition in the informal sector will increase as unemployed formal sector workers join their ranks. Furthermore, the removal of the food subsidy will hurt them again as they are more likely to be net consumers of food. What are the implications for trade policy? The way in which countries manage a transition to a more open trading regime matters 1. Should trade liberalisation be done with or after economic stabilisation? Simultaneous trade liberalisation may affect a government s ability to respond effectively to the contractionary impact of stabilisation, particularly if the contractionary impact is greater precisely because the two policy reforms have been combined. However, simultaneous implementation allows a faster transition to the new equilibrium. Since it is often the poor, particularly those in rural areas and in agriculture, who bear the cost of the current distortions, delaying trade liberalisation may not be in the best interests of the poor. Simultaneous implementation may actually help some poor households (particularly the urban poor and the landless) by reducing price rises caused by devaluations in the stabilisation programme. Thus the introduction of a poverty perspective does not supply an unambiguous preference about the initial timing of trade reform but rather indicates the considerations which might lead to such a choice. A government in a strong position politically and which has a good administrative capability will probably wish to undertake reforms jointly. By contrast a government with weak administrative abilities and which is susceptible to political pressure from the owners of import-substituting industries (or from organised labour in such industries) may wish to postpone trade liberalisation under after successful stabilisation. 1. At what speed should liberalisation take place? Measures which protect social expenditure are important. This would suggest a preference for gradual reform to avoid the reductions in revenue and thus the expenditure cuts associated with rapid reform. Secondly, if urban poverty is a serious concern and labour markets are inflexible then the large increase in urban unemployment that may result from rapid reform could increase urban poverty. Zambia may be useful case in point here, where a combination of rapid trade liberalisation and macroeconomic stabilisation has caused a large increase in urban poverty during the 1990s (McCulloch and Baulch 1999). Large and sudden increases in poverty amongst relatively vocal urban groups can cause social and political instability leading to partial or complete reversal of reforms. However, the poor in principle have much to gain from reform. Landless rural households who rely upon employment for most of their income will benefit from the increased demand for rural employment which results from the removal of the bias against non-traditional agricultural production. They, along with the majority of smallholders who are net food consumers also stand to benefit if food prices are reduced due to liberalisation. Delaying reform will not help these groups. 5

1. Compensation can help politics and credibility is key Some reforms are likely to have short term costs. These costs may endanger the political viability of the reforms. If this is the case then uncertainty about the credibility of the reforms may undermine them. In this situation compensation for the most adversely affected groups can be important not only for poverty alleviation (the worst affected may not necessarily be the poorest), but to ensure the credibility of the programme. However, ultimately the best guarantor of credibility is consistency people expect policy reversals if policy is reversed. Ultimately the ability to be consistent to maintain and continue reforms depends upon the particular politics of each country. Politicians and policymakers have to make choices over the timing, sequencing, speed and transparency of reforms based upon their judgement of what will work there are few general answers. A Second-best world needs second-best solutions There are lots of existing trade agreements (NAFTA, MERCOSUR, SACU, SADC, ASEAN etc) just going for full liberalisation can actually cause problems for those who benefit from existing regimes. This suggests that the most sensible policy for any individual country will depend upon the existing distortions which it faces. Furthermore, size matters! Little countries tend to get good access because they are not a threat to the major markets. Equally, other than donors, there are few objections to them pursuing highly protectionist policies since they are not important markets for western goods. Big countries by contrast are pressed to open their markets, but are also in a position to use access as a bargaining chip to obtain better access to other markets. (Of course the economic logic of this is perverse it is driven by the political logic of trade negotiations. But since this is unlikely to change, strategic trade theory suggest that if you have an important market it is worth playing the game to get better access.) Balance between encouraging competition and creating opportunity Pro-poor growth occurs when people invest in productive activities the value-added of which accrues to poor households more than to non-poor households. Why do people invest? Typically because they expect a high return to their investment. Such high returns are often obtained when the investor is the first (or one of the first) to invest in the new area, since they can then obtain monopoly rents from the activity. However, the maintenance of such monopoly power discourages future innovation and investment. Policymakers therefore face a dilemma: appropriate forms of protection and assistance can encourage investment in activities which are likely to benefit poor groups; but in the longer run promoting effective competition ensures that the benefits of the activity are shared with consumers by forcing producers to be efficient. Also there is a balance between promoting competition internally and recognising the thinness of markets. Some situations are natural monopolies simply because the market is so small that it will only support a limited number of suppliers. Destroying existing mechanisms/institutions even monopolistic ones can result in nothing taking their place. There are two issues here ensuring contestability to keep the market efficient; and the speed with which agents can respond to market signals. From Trade to Growth If trade reform is to be successful in reducing poverty it must promote pro-poor growth. This means that it must encourage productive investment by domestic residents (including the poor) in the production of tradeables. Investment has four key pre-requisites: 6

knowledge & skill information credit opportunity for profit There are reasons why these may not be optimally provided privately in all cases: 7

people don t know what knowledge they need => public education and training provision people may be risk-averse about investing in obtaining information => public provision of information AND facilitation of a free media lenders may be worried about adverse selection => facilitating mechanisms to provide confidence to lenders BUT the one thing which shouldn t be provided is an artificial opportunity for profit, unless there are clear positive social externalities associated with the investment. The public sector can complement private trade-related investment through the provision of public goods, particularly where these facilitate private initiative e.g. transport infrastructure, information and coordination. They can also facilitate private coordination to reduce the cost and risk of investment in socially beneficial public goods. Furthermore, the government can help to create incentives for learning. Evidence suggests that the key to growth is continuous technological capacity building, innovation and upgrading. Government can encourage technological upgrading and productivity improvements through short-term investment incentives targeted at addressing market failures identified above. i This section is drawn from Winters, 2000. ii Lest this seem automatically a good thing, remember that many shocks are positive and that official bodies have a tendency to take a cut out of the price in return for providing the service of insulation. 8