This is an essay I wrote during my development-economics master based on work I had been doing for years at EABER. I recognise that it is lame AF to post university essays, but this constantly comes up in discussions and I want something to reference without having to re-write it.
Whether openness to
trade will always lead to positive development outcomes is an extremely broad
question. I will focus on one specific issue that is related—openness to trade
in the context of contemporary value chain networks in East Asia. Within this
context I will argue that openness to trade in those industries where value
chain trade is prevalent will always lead to positive development outcomes.
My arguments will take
the following course. First, I will discuss what ‘trade openness’ and ‘positive
development outcomes’ are, and establish working definitions for use in this
paper. Second, I will elaborate on the nature of value chain networks in East
Asia and explain their effect on trade-related development in the region. This
section will begin with a theoretical analysis. I will explain how joining
existing chains allows for rapid specialisation in line with comparative
advantage, leading to profits. These profits can be reinvested to move
incrementally up the value chain to higher levels of development. Joining value
chains also results in positive spillovers, including technology transfer and
foreign investment, which can provide important development funding. A case
study of the Thai hard disk drive industry will provide an example of how this
development pathway works in practice. The third section of the paper analyses data
from East Asia to show that the region is indeed highly fragmented, and that
the policies outlined above are therefore suitable. The final section will
discuss fragmentation in the context of the wider debate on trade for
development policies. This section will show why traditional development
approaches to trade policy, particularly strong infant industry protection, are
not effective in the context of fragmentation. A comparative study of the
Malaysian and Thai automotive industries will illustrate this new state of
affairs.
Dowrick & Golley
(2004) differentiate between ‘revealed’ openness to trade and ‘policy’ openness
to trade. Policy openness refers to endogenous factors like tariff levels and
incidence and deliberate price distortions. Revealed openness refers to the
ratio of total foreign trade to GDP. Both measures have shortcomings. Pritchett
(1996) points out that revealed openness does not explain why a particular
country trades as much as it does—it does not consider issues like the
proximity of foreign markets or the size of the domestic market, for example.
Squalli and Wilson (2006) note that by the revealed openness measure the
USA—the world’s largest trader—is a closed economy! Policy openness is very
difficult to quantify. To date, the most influential measure of policy openness
is Sachs and Warner (1995), who use criteria including tariff levels, the
existence of black markets and the extent of state involvement in trading
industries. But this definition too has come under criticism (Rodriguez and
Rodrik 2001).
Fortunately, this paper
does not require an extremely robust measure for trade openness. An intuitive
measure combining revealed and policy openness will suffice. An economy open to
trade is defined as one that utilises trade as a significant source of GDP, and
maintains low tariff and other barriers to trade. It is generally accepted that
the emerging economies of Asia conform to this definition (Kohli et al 2011,
pp. 74–76). The ASEAN region is considered the most trade-liberalised region in
the world (Ponciano et al 2012).
The most influential
definition of development is that of Amartya Sen—development as freedom (Sen
1999). His use of freedom combines agency and liberty: the freedom to do what
you want and the power to actually do it. This definition however, is not very
suitable to our task as it is extremely broad and this essay is focussed on
trade, a distinctly economic matter. As such, this essay defines ‘positive
development outcomes’ to include economic growth, capital accumulation and
increased productivity. These outcomes are captured in the Swann-Solow model of
economic development (Swan 1956, Solow 1956). An additional positive outcome is
technological development, which features heavily in new growth theory (Romer
1994).
It is the contention of
this paper that openness to trade can bring about these positive development
outcomes in regions with significant fragmentation of value chains. In order to
substantiate this claim we must now
analyse what fragmentation is and what impact it has on trade related
development.
Trade fragmentation is
discussed under many different names including vertical specialisation, slicing
up the value chain, outsourcing, trade in tasks, offshoring, disintegration of
production, multi-stage production and intra-product specialisation (Hummels et
al. 2001; Athukorala 2009). All of these labels refer to the same
phenomenon—the breaking up of the production process into small parts and the
placement of these parts in different locations, usually across borders (Damuri
2012; Arendt & Kierzkowski 2003). These different stages are connected in a
production network or value chain. A production ‘network’ is where production
is coordinated across a large number of geographically dispersed operations.
Value chain refers to the fact that at each stage in a good’s production only a
small piece of value is added. This is why this approach to production is often
referred to as vertical specialisation: different firms involved in the
production process specialise in different levels depending on their
comparative advantage. Higher levels typically require higher skilled labour
and more advanced capital, and correspond to a higher amount of value added
than lower stages. When fully integrated, these firms form a production network
that outputs finished goods.
Production
fragmentation goes hand in hand with modern advances in coordination and
information technology including the internet, remote video conferencing,
complete knock down kits and computers (Baldwin 2011). These technologies allow
production to be managed across several geographically dispersed factories.
With these technologies, it is also extremely profitable to disperse production
because by outsourcing certain tasks to other regions or countries, firms can
realise gains from cheaper or more specialised labour without much loss of efficiency.
For example, creating a car requires several high skilled tasks, such as design
and engineering, which are best executed by a developed country with high
education standards. But it also involves a myriad of tasks that require lower
levels of skill that a highly skilled and therefore expensive labourer would be wasted on. For
example, assembling a chassis on a production line is not as difficult as
assembling a transmission. These lower value tasks can now be off-shored to
different locations to be executed by precisely the right level of labour at
optimum cost. This allows firms to make efficiency gains and host countries to
profit from their comparative advantages.
Production
fragmentation offers many developmental opportunities. In contrast to pre-fragmentation
production systems, emerging economies can now join supply chains rather than
having to build them all in-house. When early developers like Japan began their
path to advanced economy status it was necessary for them to create entire
value chains (Sen 1983). Every aspect of a Toyota was produced in Japan, from
the tyres to the engine. This was a slow and expensive process. Due to the
‘lumpiness’ of this kind of industry (meaning a large critical mass is required
before economic gains can be realised) early developing economies needed to
provide infant industries with substantial stimulus, including cheap credit and
protection from international competitors, which involved limiting openness to
trade. This was costly in the short term, and created market distortions that
affected other sectors and were often difficult to manage, especially as they
tended to establish vested interests that inhibited reform in the long run
(Kharas & Kohli 2011).
In the new global
production system development is different. Instead of creating entire
production chains, countries can now plug into existing supply chains at the
value level that is most appropriate for them, specialising in one small aspect
of production based on their comparative advantage (Arndt & Kierzkowski
2003, pg. 7). This specialisation allows for economies of scale as nations can
invest all their resources into one area. Because this process involves
interaction with multinationals looking to offshore, there is also a degree of
technology transfer from developed to developing nations as international firms
train local workers to create the components they need for operations higher up
in the value chain (Baldwin 2013). Multinationals also bring with them foreign
capital, developing industry without direct cost to the host nation (OECD 2002).
Combined, these factors mean that countries can industrialise rapidly in the
new system if they are able to effectively join a supply chain. This
industrialisation drives capital accumulation, and profits accruing from new
industrial activities can be reinvested in education and infrastructure to move
incrementally up the value chain (Ando et al 2006, pg. 9).
An instructive example
of the positive developmental outcomes afforded by openness to trade in the context
of fragmented value chains can be found in the Thai hard disk drive (HDD)
industry. HDDs are a typical value chain
good. They average 17 components per finished product as well as being compact
and lightweight, which makes them cheaply transportable and ideal for
fragmented production processes (Kohpaiboon, 2011, pg. 162). The HDD industry in Thailand is totally open
to trade, with zero tariffs on related goods for the period 1995–2010 (op. cit.
pg. 159). The country first moved into the industry after Seagate technology,
an American firm, outsourced the most labour intensive segment of its HDD
production chain to Thailand from Singapore in 1983 (op. cit. pg. 163). Seagate
trained local labour in the tasks required for HDD production, which increased
the supply of skilled labour available (McKendrick et al 2000). This attracted
other firms to Thailand (including IBM and Fujitsu), with industrial clustering
observable from 1990 onwards (Kohpaiboon, op. cit. pg. 164). Over time,
Thailand’s HDD manufacturing workers acquired more advanced skills relating to
HDD production, and the country has steadily moved up the HDD production value
chain to less labour and more capital and knowledge intensive stages of
production, such as engineering and not just assembly (Kohpaiboon &
Poapongsakorn 2011). Consequently, the industry has experienced both rising
wages and continuous growth in productivity over time. Today, Thailand is the
world’s second largest HDD exporter behind China, and accounts for 17 per cent
of global market share (Kohpaiboon & Poapongsakorn, op. cit.).
At this point, we have
a working theoretical understanding of why openness to trade in a fragmented
region will lead to positive development outcomes. The next analytical step is
to show that East Asia is a fragmented region and should therefore pursue
liberal trade policies, and then to consider alternate viewpoints.
Several studies by
Athukorala show that East Asia is home to several highly developed and
extremely fragmented value chains in some industries, notably electronics (2009;
2011a; 2011b; Athukorala & Menon 2010; Athukorala & Nasir 2012).
Production network exports accounted for 66 per cent of total manufacturing
exports in ASEAN in 2006/07 (Athukorala 2011b, pg. 77). Components trade across
all sectors accounted for 44.2 per cent of all trade in ASEAN in 2006/07, up
from 22.7 per cent in 1992/3. This data suggests the proliferation of value
chains throughout East Asia, and indicates that they are a dominant feature of
many industrial sectors. This observation is backed up by network analysis from
Damuri (2012), which shows extensive trade relations between hub and spoke
economies in East Asia, with final assembly economies like China and Japan fed
by component suppliers in ASEAN, who also trade extensively with each other.
Off the back of this
data we can safely say that East Asia is home to highly fragmented production
networks, and that countries seeking gains from trade should be open to these
trade networks. What would this involve? Key policies are to allow open trade
through the elimination of tariffs and behind the border barriers such as
excessive bureaucratic red-tape and hidden charges like registration fees
(Patunru & Basri 2012; Basri 2012; Soejachmoen 2012; Wignaraja 2013; Anas 2012). Yi (1999) shows that tariffs dramatically
inhibit vertical specialisation and their elimination should thus be the first
policy of economies seeking to profit from value chains. As Hiratsuka (2011)
shows, value chain trade involves unfinished goods crossing borders multiple
times with only small amounts of value added. Tariffs and other similar
instruments wipe out these small gains and thus make countries unattractive
destinations for outsourcing.
In addition to tariff
reduction, developing economies would do well to create an economic environment
attractive in general to offshoring activities. Basri & Patunru (2011)
point to three principle areas in this effort. First, infrastructure provision
is crucial. Ports, roads and electricity are all important to the profitability
of trade based ventures, and must be developed by governments seeking gains
from trade. Second, effective policies for macro-economic stability,
particularly with regards to exchange rate controls, are valuable. Finally,
good labour market management that balances equity with the smooth allocation
of labour to growing sectors is necessary.
It is worth elaborating
on the role of government in fostering gains from trade in the context of
fragmentation, as it is one of the most fundamental controversies in trade for
development theory. As noted earlier, many developmental success stories,
notably the Asian Tiger economies, made extensive use of infant industry
protection involving closed-to-trade policies as part of their development
models (Amsden & Kim 1989; Amsden 1992; Green 1992). This has led to a
large number of commentators arguing against openness to trade as a pathway to
development (for example: ActionAid International 2005; Pilger 2008; and
Yustika 2001; for a more nuanced view see Thirwall and Pacheco-Lopez 2009).
However, these approaches need to be re-thought in the context of supply chain
fragmentation, which makes infant industry protection difficult and not as
profitable in development terms as joining a value chain. Fragmentation allows
international firms to capture dramatic cost savings, which makes their
finished products (cars for example) much cheaper than those produced by single
country production chains. This is why Malaysia’s domestic auto industry, a
late comer to the automobile industry, was unable to ever produce an
internationally competitive car. By the time Malaysia’s automobile project bore
any fruit (the mid-late 80’s) Established Japanese and Korean auto producers
were already dispersing their production across East Asia, driving down costs
and squeezing newcomers out of the market (Baldwin 2011).
What is needed in East
Asia’s contemporary industrial environment is a more nuanced understanding of
trade and development policy characterised by a soft-touch approach to
industrial assistance. Few commentators deny the ongoing importance of
government intervention in some form to nurture industrialisation, but the
heavily state-led approaches of Kore and Japan are obsolete. Approaches
effective in the contemporary environment are characterised by gentle steering
policies like special economic zones to encourage clustering and agglomeration
effects that assist firms in moving up the value chain without compromising
their exposure to international competition and best practice (Lin &
Treichel 2014).
Thailand provides
another instructive case study, this time in the form of its auto industry. In
contrast to Malaysia, Thailand abandoned infant industry protection policies in
the early 1980’s and oriented itself towards emerging value chains instead.
Trade and ownership controls were relaxed, and local content requirements where
downgraded (Baldwin 2011). Japanese auto-makers consequently chose Thailand as
the target of their early offshoring activities, and the auto-industry took
off, with associated positive development benefits (Techakanont 2007). Content
restrictions and residual tariffs were eliminated completely by the late 90s.
Today, the Thai auto industry employs 180 000 workers compared to 40 000 in
Malaysia and has a large trade surplus in finished vehicles (mostly vans) and
parts, while Malaysia operates a wide and growing deficit in both (Fuangkajonsak
2006).
By the above analysis
we have shown that, ceteris paribus, openness to trade will always produce
positive development outcomes for contemporary East Asian economies, while
closed-to-trade policies will lead to stagnation. Fragmentation has fundamentally
changed the trade for development environment. Emerging economies must now
pursue industrialisation policies aimed at joining production networks and
working their way up the value chain. This approach leads to positive
development benefits: capital accumulation, foreign direct investment,
technology transfer and rising GDP. By contrast, closed-to-trade policies lead
to uncompetitive industries that drag on the wider economy. Both theoretical
models and case studies suggest that the heavy handed infant industry
protection development policies of the 60s and 70s are no longer appropriate.
Some industrial assistance policies may still be useful and appropriate,
including credit schemes, but by and large government should focus on assisting
emerging firms in ways independent of traditional trade restrictions. For
example, rather than tariffs, domestic operations would benefit more from the
provision of trade infrastructure like ports and roads, and industrial
infrastructure like quality electricity provision and urban planning, as well
as good macroeconomic management.
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