Trade Policy and International Competitiveness

Paper for Conference on South Africa's International Economic Relations in the 1990s, April 27-30, 1993, Transvaal, South Africa.

             In simple terms, international competitiveness means producing better products for lower prices than other countries competing in the international market. However, there are many factors affecting the quality and price of goods and services produced at home, trade policy being only one of them. For example, wage rates relative to labor productivity, interest rates, taxes, charges for services-such as transportation, communication, insurance, and so on-are the major cost components and as such affect the price of export products. Even cultural factors such as traditional labor management relations, the work ethic, and the level of education can have an important bearing on the quality and prices of products in a given country

It should also be noted that better quality and lower price do not necessarily bid fair in the foreign market under the current international trade environment. For example, Japanese automobile plants, benefiting from superior automation and younger and better-trained workers, are known to be twice as efficient as European auto plants. But Japanese auto exports are being limited by various protectionist measures on the part of importing countries-such as higher import duties (10 percent in Europe and 2.5 percent in the United States), "anti-dumping" measures, "voluntary" restraints, and quota agreements. Thus many diverse factors lie outside the scope of trade policy as it is usually defined, implying that trade policy alone cannot go very far in increasing a country's international competitiveness and exports.

Foreign Exchange Rate Policy

At the domestic level, trade policy is mainly concerned with the foreign exchange rate, custom duties, and regulation of imports. To begin with the foreign exchange rate, it is often the case with developing countries that chronic inflation tends to prolong overvaluation of the domestic currency as the rapid domestic inflation is not fully offset by the depreciation of the domestic currency, with the result that exports are discouraged while imports are encouraged. Korea was no exception in the early days, particularly in the period of 1945-1960. The real exchange rate, adjusted to changes in wholesale prices at home and abroad, fell to half its 1945-1950 value by January 1960. The drastic devaluation of the foreign exchange rate in 1961 from 50 won per dollar to 130 won and the unification of multiple exchange rates marked the beginning of the all-out government effort for export promotion. At the same time, the Korean government relaxed import controls, and subsidies were provided to exports.

Since 1960, Korea's exchange rate has tended to depreciate over time, currently standing at the rate of 780 won per dollar as of February 1993. The rate was adjusted periodically by the government, but the adjustment tended to lag behind rising prices at home and abroad mainly for two reasons. First, policy makers feared the vicious cycle of domestic inflation and depreciation as devaluation leads to increases in import prices in won currency terms, which in turn aggravates domestic inflation. Second, policy makers were also worried about the effect of the increasing won value of the nation's foreign debt and its amortization cost that must be borne by business units and the government. Caught between the public outcry for price stability and the need for export promotion, policy makers were reluctant to take prompt action, often swayed by political expediency rather than by any economic rationale. For example, despite domestic inflation rates far in excess of world inflation rates at the time of oil crises in 1973 and in 1978, the exchange rate was held constant at 484 won to the dollar from 1975 until 1980. This partly explains why export growth rates declined after 1976, and the volume of exports fell in real terms in 1979. The needed devaluation of 20 percent was carried out only in 1980, after a new government leadership came to power.

In response to changing conditions at home and abroad, Korea a few years ago adopted a floating exchange rate system in which the rates were to move freely in response to changes of supply and demand in the money market. One of the problems arising from the adoption of the floating rate system was that the inflow of foreign short-term capital, induced by the much higher interest rate at home-more than 18 percent per annum-tended to slow the speed of depreciation of the won despite the slow growth of exports, and it contributed to a marked deterioration of the nation's current account since 1990. At present, the Korean government is trying to liberalize the nation's financial market with the expectation that such a policy will serve, inter alia, to enhance competition in the market, thereby lowering the interest rate and moving it closer to the international level. The continuing influx of short-term capital from abroad may itself help reduce domestic interest rates, but at the same time, the nation's net foreign debts may increase to an intolerable level, while the excessively slow depreciation due to the capital inflow may unduly retard export growth and improvement in the balance of payments.

Incidentally, it should be noted that under the current international monetary system, exchange rate fluctuations of major currencies in recent years have hardly reflected their current account positions; they have rather reflected the movement of the speculative short-term capital among the major currencies. To cope with this situation, the major governments undertook to intervene and "manipulate" exchange rates on the basis of the "Plaza Accord" of September 1985 or the G7 agreement in later years. This, however, raises an important question: If the floating exchange rate system fails to help correct the current account imbalances among countries, what else could we expect as an alternative international adjustment mechanism? This is, I believe, a fundamental question facing the international monetary system today.

Discriminatory Policies for Export Promotion

Turning to the trade policies for exports and imports, in August 1964, the Korean government undertook far-reaching economic reforms with a view to promoting exports. Exporters were given the right to import their inputs duty free and without restriction. The principal device for assuring this privilege was a system of "domestic letters of credit" (DLCs), which enabled exporters to receive inputs duty free and obtained automatic access to subsidized trade credit. Moreover, some of these benefits could be passed on by the exporter to its domestic suppliers, because banks were authorized to open further DLCs on the basis of the "master" LC. Exporters were also provided generous wastage allowances for the importation of raw materials. These incentives were later extended to indirect exports-namely, the production of domestic inputs for exports. In addition, tariff exemptions were granted to importers of machinery and equipment used to produce direct and indirect exports, and accelerated depreciation allowances were introduced. Furthermore, inputs used in export production were free of indirect taxes and exporters received a tax credit amounting to 50 percent of their income. Yet another export promotion measure gave credit preference to exporters in terms of availability of funds as well as the interest rate charged. On the side of imports, in 1967 the "positive" list of admissible imports was replaced by a "negative" list of products whose importation required government approval. This meant, in practice, further reduction of the scope of import restriction. In sum, the export regime thus established after 1964 provided in effect a free trade status to exporters, with some additional incentives.

The system of discriminatory policies for export promotion, however, was not without its own demerits. For example, in order to prevent the abuse of the concessional treatment for no-export purposes, the government had to set up highly complex checking systems in the area of custom duties, taxes, and bank credit, so much so that the red tape itself became a serious barrier hindering export activities, while corruption inevitably crept into the checking process. The government, aware of this situation and spurred on by public opinion, then set out to dismantle regulations and reduce the extent and scope of favored treatment for exports-this time in the name of a freer market and less government intervention. Thus, as Professor Balasa has noted, there emerged an interesting phenomenon of a trade policy cycle in which periods of "restriction" alternated with periods of "liberalization."

Apart from monetary incentives, the government established the Korean Trade Promotion Corporation (KOTRA) in 1964 to promote exports and to conduct market research abroad. The government also authorized the Korea Foreign Trade Association (KFTA), a private-sector organization, to collect 1 percent of the value of specified imports for use as an export promotion fund. KFTA has been active in organizing trade missions to foreign countries, training employees of its member companies, disseminating trade related information at home and abroad, and organizing trade shows year-round in its exhibition center.

Under the trade regime outlined above, Korea achieved phenomenal export growth during the 1960s and 1970s. Between 1962 and 1976, the annual growth rate of Korea's exports averaged 43 percent as compared with a 15 percent growth rate of world exports in the same period. In the subsequent period of 1977-1990, the average annual growth rate of exports slowed to 17 percent, which was still substantially higher than the world average of 10 percent. To what extent the trade policy of the Korean government was responsible for such rapid export growth, particularly during the period of 1962-1976, is a difficult question to answer because many factors other than trade policy combined to produce such a result. No doubt one of the most important factors was the highly favorable world economic environment up until the middle of the 1970s. Under the postwar world order, overseas markets were generally wide open for Korean products, particularly in the United States and Europe, and to a lesser degree in Japan. Foreign capital for domestic investment was readily available from both public and private sources, and technology transfer from developed countries was relatively easy.

Since the mid-1980s, Korea's trade policy has undergone gradual changes in response to changing conditions at home and abroad. Internally, there was a growing awareness both in and out of the government that the economy had outgrown the highly interventionist role of the state and that liberalization of the economic activities of the private sector was called for. Externally, there had been growing pressure on Korea from the United States and the European Economic Community to open up its domestic market to imports of their goods and services. As of today, Korea has largely eliminated selective treatment for exports in the area of taxation and bank credits. Korea's average tariff rate stands at about 6 percent, comparable to that of developed countries. By the end of 1992, 98 percent of manufactured products and 87 percent of agricultural and fishery products are on the government's list for automatic import approval. Yet the market opening for rice, Korea's single most important staple grain, still remains as one of the most contentious issues at home as well as in the Uruguay Round negotiation. Korea is currently implementing a market opening program for the financial and service sectors based in part on commitments made in negotiations with the United States and the anticipated outcome of the Uruguay Round.

Industrial Policy

In the area of industrial policy, the heavy industry development program carried out in the first half of the 1970s has attracted much attention among scholars and policy makers abroad. The scope of this highly ambitious program included the automobile, shipbuilding, steel, machinery, metal refineries, and petrochemical industries. Unfortunately, in the course of implementation, the program fell victim to the oil crises of 1973 and 1978 and the ensuing worldwide recession and inflation-a calamity entirely unforeseen by the economic planners at the time of initiation of the grand investment projects. Naturally, the program was criticized at home and abroad as a glaring case of overinvestment and misuse of resources. Collins, for example, suggested that "the anti-export bias" in the program in this period was largely responsible for the decline in GDP of 4.8 percent in 1980.

Some qualification of this observation, however, seems to be in order. To be sure, the Korean economy suffered from overinvestment and overcapacity for a considerable period, with much higher costs involved than originally anticipated. Yet many Korean policy makers today ask themselves: Would Korea have ever had a better chance of building heavy industry if the nation had not embarked on such a program in those days despite so many difficulties? Many of them answer "No," pointing to the fact that since the time of the construction of Korea's heavy industry, there has been enormous escalation of resource costs in international markets, in addition to skyrocketing land prices and construction costs at home relative to the increase in product prices. The opportunity cost of the heavy industry program in a dynamic as well as static sense is difficult to assess, yet it remains true that exports of heavy industry products have been gaining importance in Korea's export composition in recent years. That is to say, exports of heavy industry products have been increasing at a much faster rate than traditional light industry products (textiles, footwear, electric appliances, etc.). This trend reflects Korea's weakening comparative advantage in labor-intensive products in relation to less developed countries in Southeast Asia and China, which was predicted by economic planners at the time of initiation of the heavy industry program in the early 1970s. The negative GDP growth in 1980 was not entirely a result of the problems of heavy industry, but was also the result of the then worldwide recession combined with the internal political disruption following the assassination of President Park Chung-Hee in October 1979. At any rate, it is true that Korea had to pay a relatively high price for building its heavy industry.

Lessons from the Korean Experience

What, then, are the major lessons to be drawn from the Korean experience with trade policy for other countries such as South Africa that are seeking the right path to export growth? Without much knowledge of the South African situation, I am not sure to what extent the Korean experience has relevance for South Africa. However, I may offer some comments in what follows.

(1) Let me once again stress that other factors than trade policy are equally or even more important in achieving a rapid growth of exports. In the Korean experience, besides the favorable international trade environment as previously noted, there were other positive factors that can be enumerated as follows: first, dynamism of entrepreneurship and business acumen; second, an exceptionally high ratio (78 percent) of total trade (export plus imports) to GDP, indicating a high degree of exposure to the global economy; third, free and swift labor mobility from the agriculture to the industrial sector; and fourth, stable labor-management relations enforced by an authoritarian government. It is worth noting that the last-mentioned factor could not have existed in more democratic countries, where government-enforced labor discipline would not be acceptable to such an extent. It is perhaps no surprise that Korea's export growth has slowed since 1990 in response to a worsening international trade environment and serious labor unrest following political democratization that began in 1989.

(2) The international as well as the Korean experiences seem to indicate that maintenance of a realistic exchange rate is a key condition for maintaining international competitiveness and continuing export growth. A prompt adjustment of the exchange rate should be made in such way that its effect on domestic prices is minimized by concurrent use of stabilizing monetary policy and wage guidelines subject to the understanding and cooperation of organized labor. The adjustment may be effected either by government decree or by the free play of market forces. A free foreign exchange market is desirable for many reasons, yet it may fail to reflect the change of the nation's current account position owing to the speculative movement of short-term capital among countries. In that case, government intervention may become inevitable for a country to defend its balance-of-payments position.

(3) Dean Holden has noted that "the World Bank (1987) views Korea as one of the outstanding examples of an outward-oriented and liberalized economy, whereas for others it represents a convincing case for intervention." The truth of the matter, in my view, is that Korea created an "artificial" free trade regime for exporters, making it a haven from the protectionist regime for importers. Yet Korean policy was flexible enough to adjust import policies over time in response to changing conditions at home and abroad. The principal lesson to be learned from the Korean experience is that exports can grow rapidly only under a free trade regime, whether artificial or natural.

(4) The Korean experience seems to indicate that incentive measures for exports were useful and effective in marshaling and channeling energy and resources of business units to export industry in the early stage of development. But as time went on, policy makers became increasingly aware that such a system of selective measures had its own drawbacks: Apart from the problems of red tape and corruption attendant on selective control, the business units habitually sought government assistance and protection whenever they were in difficulty, reducing their incentive to undertake self-help efforts for managerial and technological innovation. And, it is true, Dean Holden states that it was far easier for the government to grant protection than it was to remove it. It took the Korean government not a few years before it was able to relax import restrictions, lower tariff barriers, and eliminate income tax benefits for exporters in the mid-1970s and finally reach the present stage in which most of the selective measures are gone. The lesson to be learned here is that incentive measures are useful only in the beginning stage of an ambitious export promotion program, when business units may need to be externally "motivated" to push exports. In introducing selective incentive measures, therefore, the government is well advised to announce at the same time a schedule for phasing out such measures to preclude overprotection.

(5) It is difficult to draw a clear line between an import substitution industry and an export industry. The textile industry in Korea, for example, was initially intended mainly for import substitution but grew into a major export industry in later years. What matters is the prospect for international competitiveness. Protection is almost inevitable in the early stage of new industry because no investment can be expected to yield a profit in the first one or two years of operation, while the financial capability of private business is generally very weak in a developing country. What is crucial is whether or not the protected project will be internationally competitive in the expected time horizon without further protection. Seen from this perspective, the argument for protection of industry appears to have practical wisdom in its favor.

(6) We have noted that the Korean government embarked on an ambitious heavy industrial development program in the early 1970s that can be viewed as a case of what is called "strategic trade policy"-a strategy to build new industries with the purpose, among others, to preempt entry into the domestic market by foreign producers. There are several lessons to be drawn from Korea's experience with heavy industry. First, the time phasing of individual projects is essential to avoid simultaneous initiation of massive projects at one time, which would overburden the financial capability of both investors and the banking system, leading to inflationary financing. It would also make it difficult for individual investors to tide over the period of the initial loss resulting from new investment. Second, the assessment of the long-term prospect of international competitiveness of large-scale investment should be based on the assumption that there will be no tariff protection, even if such protection exists at the time of assessment. The viability of large-scale investment projects should be determined on the basis of the comparative advantage in the cost of labor, technological advancement, and managerial efficiency. I stress this because I was once appalled by a businessman telling me that he was planning to build a petrochemical plant on the assumption that the protective tariff would be maintained indefinitely at a high level. This is why tariff barriers are prone to mislead businessmen and misallocate resources. Finally, the Korean experience seem to indicate that in the real world of uncertainty, long-term dynamic events can easily defy judgment based on a static short-term economic analysis. This has both negative and positive implications: A well-conceived policy from a short-term perspective may fail when confronted with the vagaries of time, while risk taking by energetic and dynamic businessmen and the government may have a better chance of success in the longer term than the more passive behavior of those who cling to conventional wisdom and the status quo. As the Korean proverb states, "A tiger cannot be caught unless one ventures into the tiger's lair."

(7) In any event, the tide in favor of open markets and fair trade is running high in the major industrial countries today, and protectionist measures in developing countries are likely to invite retaliation from their developed partners. Given the current international trade climate, the Korean pattern of trade policy in the past should not be considered ideal, nor is it likely to be copied by other developing countries today. They are better advised to put greater emphasis on the indirect support of export promotion by the government through dissemination of information, education and training of workers, promotion of research and development, providing adequate public facilities including ports, transportation, and communications, and above all, adopting a sound macroeconomic policy framework in a well-functioning market system.

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