The Effects of Protectionism on a Small Country: The Case of Uruguay (World Bank Regional and Sectoral Studies)

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130(o¶

The Effects of Protectionism

on a Small Country The Case of Urutguay

BY EDITED

AND

JAIMEDEMELO

The Effects of Protectonism on a Small Country ne Case of Uruguay

WORLDBANK

REGIONALAND

SECTORALSTUDIES

The Effects of Protectionism on a Small Country The Case of Uruguay

EDllEDBY MICHAEL CONNOLLY AND JAIMEDEMELO

The Vorld Bank Was4ingAm,D.C.

@ 1994 The Enternational Bank for Reconstruction and Development J The World Bank *X- - 1818 H Street N.W., Washington, D.C. 20433 All rights reserved Manufactured in the United States of America First printing May 1994 The World Bank Regional and Sectoral Studies series provides an outlet for work that is relatively limited in its subject matter or geographical coverage but that contributes to the intellectual foundations of development operations and policy formulation. Some sources cited in this paper may be informal documents that are not readily available. The findings, interpretations, and conclusions expressed in this publication are those of the authors and should not be attrbuted in any manner to the World Bank, to its affiliated organizations, or to the members of its Board of Executive Directors or the countries they represenL The material in this publication is copyrighted. Requests for permission to reproduce portions of it should be sent to the Office of the Publisher at the address shown in the copyright notice above. The World Bank encourages dissemination of its work and will normally give permission promptly and, when the reproduction is for noncommercial purposes, without asking a fee. Permission to copy portions for classroom use is granted through the Copyright aearance Center, Suite 910,222 Rosewood Dr., Danvers, Massachusetts 01923, US.A. The boundaries, colors, denominations, and other information shown on any map in this volume do not imply on the part of the World Bank Group any judgment on the legal status of any territory or the endorsement or acceptance of such boundaries. The complete backlist of publications from the World Bank is shown in the annual Index of Publications, which contains an alphabetical title list and indexes of subjects, authors, and countries and regions. The latest edition is available free of charge from Distribution Unit, Office of the Publisher, The World Bank, 1818 H Street, N.W., Washington, D.C 20433, U.S.A, or from Publications, The World Bank, 66, avenue d'IWna, 75116 Paris, France. At the time of writin& Michael Connolly was professor of economics at the University of Miami H4e is currently visiting professor at Columbia University. Jaime de Melo was clief of the Trade Policy Division in the World Bank's Policy Research Department He is currently a professor at the University of Geneva. Cover design by Sam Ferro. Library of Congress Cataloging-in-Publication

Data

The effects of protecdonism on a small country . the case of Uruguay I edited by Michael Connolly and Jaime de Melo. an(World 3ank regional and sectoral studies) p. Includes bibliographical references. -ISBN 0-213-2788-7 1. Protectionism-Uruguay. 2. Uruguay-Commercial policy. II De . L Cormolly, Michael B. (Michael Bahaamonde), 1941IL Series. Melo, Jaime. 1994 HF2016.E36 94-7420 382t'3'09895-dc2O CIP

Contents

Preface

vii

Acknowledgments Contributors

ix x

1. The political economLyof protectionism in Uruguay Michae B. Connolly andjfaime dieMelo

Protectionism and stagnation: an inter

:14

Midhael B. Connoliy and faine dieMelo

3. Adminiteed protection: reference prices and minimum export prices 45 FMaimo Ckangnna quitand PatTinkA. Merssalin

4. Domestic content restrictons and compensatory export requirments in the automobile sector 64 Wendy Takacs

5. Gains and losses from bilateral trading arneet 81 with Argentina and Brazil Jai=e de,melo,CJudio mantene4 gro, and Wendy Takacr

6. T~helabor market and trade reforun in mianufacturing Martin Parna

7. Economywide costs of protection and labor market rigidities 124 Jaime de Mdo and David Roland-Hois 8. A long-rum perspective on trade policy, instability1 and growth 150 Jorge F Roklds

iM

108

: Preface Why have we put together this volume of essays on protectionism in Uruguay when there are alreadyvexcellent comprehensive stUdies of the broad2aSpects ofprotection in th-at country (Anichini, Caumont,and Sjaastad 1978; Favaro -and Spiller 1990; and Favaro and Sapelli 1990)? We see at least four reasons for further analysis. Firt, pr-evious work has concentrated mostly on describing the protective measures rather than an-alyzing their- consequences and trying to quan-tify their effects on resource allocation, growth, antd welfare. The essays in this volume go into more detail on the various regulatory mechanisms, modeling the protective instruments and quantfifjng their effects. For example, the modeling and analysisof so-called antidumping mechanisms such as refernce prices (chapterS3) is novel, detailing not only the magnification effects of protection but also its. undesirable side effects on the quality of dom estically produced manufactured goods. Since proposals for simil-ar mech anisms are often put forth in developing countries, such in-deptdexploration can guide the analysis of their effectswherever such measures might. appear. Similarly, the modeling -and welfare analysis of the automobile assembly industry (chap ter 4) provide a unify~ingfr-amework for analyzing the welfare costs of such 'screwdriver" assembly operations anywhere. -Second, economists should be interested in the essays in this -volume because the policies analyzed have been adopted in many other countries. Each chapter develops and uses an analytical -approach to examine the p:articular measure under study, followed by empirical measuremen't. Third, tiinre is an interest for the policymaker. The essays go beyond quanrilying thfeeffects of trade interventions to show the interactions between various forms of intervention (between labor markers and protcecdion in chapter 6, between protection and rent seeking in chapter 2, or between market intervention and resource allocation in chapter 7). Thus, the essays show the harmful effects of protectionism and of excessive intervention gen-

viii

Eflncr oFPWYrCoNLSM ONA SMALCOUNmr THECAS OF URUCUAY

erally on a small economy, providing vivid examples of policies to avoid assiduously-notably those associated with antidumping, the promotion of infimt industries, and non-price protective measures in general. Finally, Uruguay offers an excellent laboratory for studying both comparahivelyandindividually the consequences of highlyrestrictive regulations for a small economy, bringing out elements of relevance to many current economic problems in the world today. A case in point is that of the socialist econonies in transition and of the small states of the former Soviet Union, such as Georgia and Armenia, which share many of the characteristics of Uruguay. This volume is therefore a useful compendium for students, analysts, and policymakers in small economies that stand to reap considerable benefits

from a more open tading

pattern.

Acknowledgments In December 1989 we visted Uruguayunder the auspices of thejoint United Nations Development Program (UNDP)-World BankTrade Expansion Program (TIEP)and subsequently delivered a report in june 1990to the Uruguayan governmen t, Untguay: Trade Reform andEconomicEffidaucp. Often, in policy work, analysis and advice have to be produced on short notice. This ,missionwas no exception. However, for most of us, unanswered questions remained& We wanted to probe deeper into the complex Uruguayan trde regime. This volume is the outcome of the follow-up work. from support and advice from friends and Throughout we .:benefited R : s-~~~~~~~~~~i colleagues in Uruguay-. rrmon Diaz and Elbio Nattino at the Central Bank were most generous with their time. So were Luis Macadar and Martin Ramia at the CGentrode Investigadiones Econ6mnicas-Uruguay and Jorge Roldos, Glaudio S-apeui, -and Luis Vian-a at the Centro de Estudios de la ReaHidad Econ6micay Social, who provideduswith helpful suggestions along the'wayCarls Rodriguez of GEMA.in Argentina also aided the mission. At the World Bank, we were fortunate to have the un6iling support of Eric Abalahin, MariaAmeal,jeff Hayden, and Rebecca Sugui. We also thank Men de Coquereauraont who edited the volume. Two people deserve specia thanks. Tom Cox, the manager of the TEP, was!a constant source of support -and encouragement -at every stage of our. work- In Montevideo, we were fortunate to be able to counxton Alberto Sojit, the Resident UNDP Representative until the time of his ftragicdeath during our mission. This volume owes much to his encouragement, and we hope that lie would have found it a useful contribution to the study of protrectionism in Un:guay.

Coyntributors Federico Chnmganaquf Trade Policy Division, World Ba-nk Mfichael Connofly Departmnent of Economics, University of Miami jaimnede Melo Trade-Policy Division, Worldl Bank, -and University oFC-eneva, Switzerland Patrick Messetlin IntemnationalTrade Division, World Bank Claudio Monteneo Trade Policy Division, World Bank M4ardin Ran Trade Policy Division, World Bank, and Centro de Investigaciones Econ6micas,-Uruguay (CIVE) David Rolnd;Hoist QEGD Development Centre and DepartraLent of Economics, Mills College Jorge Roldos International Monetary Fund and Centro de Estudios de la Realidad Econ6-_ micay Social (CERES) Wendy Takacs Trade Policy Division, World Bank, and Department of Economics, Ucniver sktyof Marland, Bfaltimore County

The political economyof protectionism in Uruguay M.ichael B. Connolly andJaime de Melo

I~~pa

Under the presidencies of Batile y Ordoiiez in 1903-07 and 1911-15 Uruguay created progressive democratic institutions and awellhire state thatmade it the most advanced, yet regulated, country in Latin America by the middle of this century. With ahomogeneous population and awell-functioning democratic system, this small country of less than 3 million people was know in the early post-World War II period as the "Switzerland of the South.' Four decades later the country had undergone a precipitous decline that put it an xing the least prosperous middle-income counties. Afew comparative figures tell the stozy.In 1950Uruguay's GDPper capita was $3,784 (in 1985 prices and adjusted to have the same purchasing power as in the United States), dose to that in comparable small and wealthy European countrieslike Belgium ($4,151) or Demnark ($4,512). In the Republic ofKorea, a country hailed today as a major development success, CDP per capita inl1953-was $822. In 1960 school enrollment ratios inUruguay reached 11l percent at the primary level and 37 percent at the secondarylevel. The corresponding figures for the European countries are 109 percent and 69 percent foriBelgium and 103 percent and 65 percent for Denmark; and for Korea, they are 94 percent and 27 percent) Uruguaywas definitely amaongrthe mostdeveloped countries in the world in1950. Measured in purely economic ters Uruguay's GDP per capita was among the highest in a group of thirty-fivecountries with a GDPper capita position detenear $3,800 in 1950 (in 1985 prices). But relative ndeRpbi remrUruguay's|452 onrelleBlim411 rirated so sharply chat by 1988 it was among the last in that grup (figure 1.1). This economic dedine was accompanied by social unrest and political crisis. What happened? The essaysin thisivolumenareaboutthe cononeiczaspectsof this decline, primarily the economic polides that accompaied it They examine the mechanisms bywhicli these polices particuarlyprotectionism in allitsforms,

EmCTSOFPtOTECrONISM ONA SMALL CouNTRY: THECAsEOFURUGUAY

.2

Figure1.1 Uruguay'sGDP per capitarankingamongthirty-five economies,1950-88 * semi-industrial RCnk

5 I0 AL 20 25 30 35. 1950

1955

1960

1965

1970

1975

1980

1985

Ausbala, Austia,Barbados, Belium, areincludedinthesample; Argentina, Now ThefoAowing economies Canada, Chile,Cyprus, Denmudk, Finand,Rance, Germnan GreatBritain, Greece, HongKong, Iceland. Norway. PRrWgal, Sngapore, theNetherlands, NewZealand, Irelnd, srael, lb1 Japan,lxembour Mexico, States, Unrguay, andenezuela. Swiezaland, Taiwan (China), theUnLted SouthAfiia Spain, Sweden,

contributed to Uruguay's economic deterioration. Policies applied to the manufctuning sectorand their economywide consequences receive the closest attention, even though much intervention and regulation also took place in agriculture. While the essays focus on the Uruguayan economy, the regulations and distortions examined are pervasive in a large number of countries. In many respects, Uruguay is a vivid example of how excessive regulation can bring about economic sclerosis. Because of its small size, Uruguay should have been pursuing outwardoriented policies to ensure its greatest possible integration into the world economy. The economy would have benefited from larger markets and the gains from specialization according to comparative advantage, aswell as from access to worldwide best-practice technologies and the incentives for adopting them. Uruguay chose instead to protect industry and to tax agriculture, the sector inwhich ithad a comparative advantage. Thus, Uruguay is a good example of-asmall country that, despite the obvious advantages offreer trade, has pursued industralization through import substitution behind a wal of protection andreguladon. The cost of the strategyhas been astunting of the export sector, notably agriculture, and a loss of general well-being, due to the high inefficiency costs of protection. Ultimately, these inward-looking policies and the rent-seeldng actiities and income redistribudon that surrounded them bred stagnadon and a low

Thepoliticleconomy ofproteaionirm ti

Uneguay

7

standard of living. That result would be anticipated for any small country that attempts to industrialize behind a barier of tariffs, quotas, and adminone like Uruguay, whose obvious long-run istered protection-especially comparative advantage lies in agricultural goods. In Uruguay these policies achieved a redistribution of income and production from the country to the city and promoted considerable rent-seeking acdvity around a small industrial base in Montevideo. This resource reallocation promoted an inefficient industrialization. -

.

Mechanisms of protectionism At various times in its history Uruguay has relied on a broad array of instruments ofprotecdon. MoststiR existin the earlyl99Os, though some are being reformed. They have proved to be a strong force fornearly two hundred years. Tariffs and referenceprices The most widespread and certainly the best known restrictions on trade are tariffs. There are two types of tariffs: an advalorem tariff, which is calculated as a percentage of the c.i.f. import price of a product, and a specific tariff, which is a specified amount levied on each unitimported. Both kinds of tariffs raise the domestic price of the importgood in the marketplace. The two forms are equivalent in the sense that, appropriately defined, they have the same effects. Tariffs have the familiar protective effect on production and a tax effect on consunption. 2 In Uruguay official tariffs are often applied to a reference price rather than to the declared ci.f. import price (see below and chapter 3), which is likely to magnify the protective effect of the official tariff. QzotsQ!uotas specify arnaximum physical quantity of a good that can be imported. The quotais bindingwhen the maximum amount specifiedis less than would otherwise be imported inafree market, givenworldpices, the domestic tariff, and ansportation costs. Under perfect competition quotas and s have a similar effect on the domestic price of an import good, so a quota also has a protective effect on domestic producdon. Its distributional effect is different, however, because the revenue does not go to the treasury. A volunlt export restriction is a quota on foreign exporters that confers on them the scarcity value of their exports to the domestic market The restriction may be voluntary in name only since there can be an implied threat to impose duties * or quotas ifagreement is not reached on the voluntary levels.

. -

i

4 -

FXmcas0oFPtoTECnONISl ONA SMALL CoUNmRx.THE CASEor URUGUAY

Licenses Alicense transfers an official right to import undera quota or other restricton arrangement to a single individual or a few individuals. The license may be given away, sold at a negotiated price, or auctioned off competitively. When the import license is given away, the holder of the license captures the scarcity value amounting to what otherwise wouid be tariff revenue. Under a fiullycompetitive auction, by contrast, the government captures the implict revenue or rent represented by the auction price of the license. Licenses can be used in conjunction with a quota or tariff or they can be issued for unlimited amounts of imports. For instance, the cuposdiscussed in chapter 5 are export licenses for goods that enter Argentina duty free under bilateral agreements. Domestic content requirements and compensatoryexports A less well known form of protection to domestic industry and suppliers is the domestic contentrequirement,which stipulates thatproduction processes use a mninimumpercentage of domestic materials and inputs as part of value added. Domestic contentrequirementspermitdomesticsuppliers to sellparts at higher than world prices and provide a nominal rate of protection equal to the percentage difference between the domestic and the world price. In Uruguay this scheme offered protection to the automobile parts industry, which was further protected by the requirement that automobile assembly firms export products in order to rompensatefor their imported parts. The assembly industry, in turn, was protected by a tariff of 40 percent for fSlly assembled automobiles in 1990 and compensatory export requirements for imports of finished vehicles (see chapter 4). Ad hoc antidumpingprocedures While antidumping legislation is commonplace, its effects are seldom analyzed.Antidumping measures can be used to effectivelyraiseprotectionrates on a goodjustas when customs imposes a duty based on a higher reference price instead of the declared ci.f. price of a good. Because reference prices have a stronger effect than an official duty-a reference price twice the declared cif. price has an effective duty twice the official duty-domestic producers are likely to lobby for higher reference prices. A stricter form of reference price known as the minimun export price collects, in addition, a moving surcharge on imports equal to the difference between the reference price and the dedared ci.f price, leaving the importer litde incentive to

Thepoiicaltavonmy oftprteaion

in Unrguay

5

declare a price less than the reference price. These procedures do not conform to GATT antidunmping or counterailing duy provisions. (The reference pnce system is analyzed in detail in chapter 3.) Prior deposit reqtirements Requiring advance depo:its for the inportation of goods is equivalent to imposinga tax on these funds equal to the opportunity costofholdingmoney since the deposits typically do notearn interest. Where the nominalinterest rate is established freely in the market, the implicit tax rate on prior deposits equals the nominial interest rate. With interest rate ceilings the implicit tax equals the real rate of return in the economy pius the inflation rate. Naturally, zero nominal interest on prior deposits combined with a high rate of inflation mayresultin an extraordinarilyhigh tax rate on prior deposits and, consequently, on importing. Unti 1975 importers were required to make advance deposits for imports which, at a time of high inflation rates, inplied high taritf equivalent rates (see chapter 2). Government procurement practices

Government procurement regulations or practices may give partial or complete preference to nationallyproduced goods over imports. This policymay be formallyincorporated in a 'buynational"law orinf-ormaly implemented through preferential purchasing practices. The poiicy has an obvious protective effect on domestic production since it allows domestic producers to charge more than world prices. Industrial countries often usify national preference in procurement on strategic or national defense grounds. In Uruguay, govremment preference to national goods in procurement occurs more by custom and practice than for explicitly stated goals. (Government procurement practices are not discussed in this volume.) Export banrs

Export bans are usually set to protect a downstream processing industry. An export ban on a specific good has a protective effect because itlowers its domestc pnce, which provides asubsidy to producion processes Usingte input since they pay less than the world price. Export bans tend to induce smuggling, however. Uruguay previously had export bans on hides and cattle on the hoot; which protected the meat pacling and leather industries. The ban was easy to evade by walking cattle over unattended borders. (Export bans are not analyzed in this volume.)

ONA SMALL CouNTRv THE CASEOFUwRUuAY ;-6 -;EFFECIS or PRDTECIIOMS

Mudipe exchngw -rat Charging different exchange rates for different types of foreign exchange transactions, whedter on the import or the export side, amounts to having a different tariff or subsidy rate on each good according to the exchange rate used.When an importer of a luxury good mustpay apremium of dpercent greater than the official foreign exchange rate as well as a tariff of t percent, the effective tariffisraised by dpercent compared to imports enteringat the officialrate. Similarly, a foreign exchange bonus of spercent paid to exporters for repatriating foreign exchange amounts to an export subsidy ofspercent relative to the official rate. Until the 1970s Uruguay had a widespread system offoreign exchange nintegrosor exportbounties. These are discussed briefly in chapter 2. Administered and hidden potection Trade and transport costs thatmust be paid on imports and exports provide extra, often hidden protection to import-competing actvities. Studies have found such costs to be significant in industrial countries. They are likely to presentan even greater baflier to trade in developing countres. In Uruguay portalhclities are veiyineffidentby intemtionalstandards, anda stronglabor movement adds to the impediments to trade through strikes, delays, and featherbedding (see chapters 6 and 7). Another distortion arises from the been obtained bywage premiums tatmightnothave ineffiiencygenrated 3 by labor unions had protection not existed. Sources of inefficiencies in highly regulated economies Whatare the mechanisms throughwhich such instruments of protection get translated into economicinefficiency? Trade polices are anatural firstplace to look for the cause of failure in Uruguay because small countries need an open trade regime to overcome the limits imposedbysmall domesticmarkets. Considerwhat happens when there is excessive regulation. Manufacturing firms become less efficient as their choice of optimum output level and input mix is restricted. Regulations affecting input markets all have an effect. Fims are impeded by labor legislation from adjusting theirworkforce. Managementofinventoriesis complicatedbyuncertaintyaboutwhetherand when firms wi be -ableto import spare parts and raw materials. Enterprises are unsure abouthow much capital theywil have access to-and atwhat cost. In heavily regulated economies finns aIso operate in restricted product markets. There are barriers to the entry offoreign companies. New domestic firms may be barred by a lack of access to capital-the limited pool of capital

The poEand wono7y of prmeaio

in Uruguay

7

may be parceled out according to long-sanding des between exsting producers and their creditors. Barrers to entry, of course, benefitexisting firms bygiving them more leeway in their pricing polides. Thus, finns sufferfrom some of the restrictions and benefit from others. Made-to-measure protectionis commonin highlyregulated economies, a situation that guarantees the coexistence within a sector of firmswith large differences in efficiency. Indeed, in such economies most firms are ineffident The level ofprotection is often chosen to make the least efficientfirms profitable, so many fins can operate at a profit with dated machinery and equipment (technical ineffiiency) or too many employees. Too many ofthem operate at too small a scale (scale inefficiency), fail to equate marginal productswith factorcosts (allocative inefficiency), and price theirproducts above themarginal costofproduction (priceinefficiency). Because consumershave nowhere else to turn, leading firms can charge higher than normal markups, and other finns wi follow. Firms with a wide range of technical efficiency thus coexist, leading to high rates of idle capacity and unproductive work forces. In addition, the incentive system is distorted because protection has been tailored for individual products to ensure the survival of firms already in operation. The made-to-measure protection usually indudes quantitative restrictions that give rise to enormous rents and induce economic agents to expendmuch oftheir effort-appropriatingrents rather than engagingin more socally productive activities. Resources are badly allocated and underused, and the resulting market structures are not compeatirve. The efficiency of investmentis low, growth is slow, and the economy stagnates. This is the story of Uruguay, but the messages are clear for other developing and trnsition economies. Political economy of trade liberalization Many readers will view Uruguay's reluctance to liberalize trde as baffling, considering the complexity and obvious inefficiency of measures restricting trade. What lies behind this reluctance to liberalize is the uncertainty and the redistribution of income that typically accompany trade liberalization. A great amount of income redistribution-whose exact outcome is unknown in advance-must take place to achieve a small amount of efficiency gains from expandedtrade. Unless the economyisin dire circumstanceswithhigh inflation and impending economic collapse, the gains from trade lhberaliation will not be enough to compensate for the income redistribution in the political calculus of voters and the government This argument, put forth by Rodrik (1992), can be demonstrated by a simple graph illustting the gains and the redistibution of income associ-

8

Etncrs oF PROTEaCONISM ONASMALLCOuNTRY: THE CASEOFURUGUAY

ated with. elminating an import quota. In figure 1.2 the distance SOrepresents a quota that has the effect of raising the domestic price to p, which is above the world price p*. Import license holders can purchase the quota amountat the world price for p*(SD)and sell it at the domestic market price forp(S), realizing rents equivalent to area rcDomestic producers are able to expand their production to the quantity S thanks to the higher domestic price. Consequently, they receive an increase in revenues equal to (p -p *)S but incur increased costs above world levels equal to area b.The producer's surplus, or rent, increases by area a thanks to the quota. Consumers, on the other hand, lose the consumer surplus equal to the sum of areas a, b, c, and d. They lose from the higher cost of a + b + c over the quantity D and from the decline in consumption at the higherprice associatedwith the quota and equal to area dRemoving the quota on inports has the following distributional effects: import-competing producers lose a, import license holders lose c,and the rest of the economy gains a + b + c +4 for a net gain of b + dThe point of Rodrik's analysis is to illustrate thatincome redistribution is large relative to the net gains to the economy. He proposes ameasure that computes the total redistribution of income divided by the net gains minus one, or the political cost-benefit ratio (PCBR) of trade liberalization: (LI<)

PCBRR= (a + b + c + d)-(b b+ d

+

d)

a + c b + d

jist

Figure 1.2 Distributional effects of quota removal Pice

a

b

c

d

Demnand 5

~D

Quantity

The politicaleconoy of protectionismin Uruguay

9

where p. is the share of imports in domestic consumption, Eis the absolute value of the elasticity of import demand, and t is the tariff equivalent of the quota. Rodrik shows that PCBR is likely to be small for most trade liberalizations taken alone. Take the case of the 1974-82 trade liberalization in Uruguay as an example- The share of imports of goods and services in domestic consumption private and govenmment, (p.)was 0.184in 1974, and the initial tariffand tariff equivalentwas about 100 percent ( = 1). Assuming an import elastcity (e) of 2 then yields a PCBR of 2.7, which implies that the political costs of redistributon are substantially greater than the benefits of trade liberalization. Combining trade liberalizationwith economic stabilization that benefits all individuals in the economy lowers the PCBR markedly, silice it is now measured by: (1.2)

PCBR =

where ris the percentage bywhich everyone is made better off (presentvalue of income), w is the reduction in the domestic pnce of importables relative to exportables due to the reform (internal terms of trade), and 0 is the share ofimportables in GNP (Rodrik 1992). Thus, coOrepresents the improvement in the terms of trade weighted by the share of importables in GNP. This revised fornula suggests that the costs of trade liberalization fall dramadcally relative to the benefits when stabilization measures undertaken during dire economic circunstances result in a return to prosperity. Now consider the PCBR for Uruguay in 1974 when stabilization and recovery are taken into accounL Assume an annual increase in the growth rate of 3 percent for 10 years-an approximation of the increase ir. growth during 1974-82 (see chapter 2)-and a discountfactorof5percent. Individuals' wealth (y) would increase by 19 percent. If importables fall 70 percent (co) in tenns of exporcables because of the trade reform, and the share ofimportables in GNP (8) is 17 percent, the PCBR now falls to 0.5. In other words, the PCBR index declines from nearly 3 to less than 1 as a result of the additional benefits of stabilization. Or consider the case ofjust one industry in Uruguay, the automobile assembly industry. The elaborate system of protection of the industry results in large efficency losses and tansfers to local assemblers and parts suppliers. Wendy Takacs estimates that the bulk of efficiency losses and transfers comes from the assembly industry rather than from the components industry (see chapter 4, table 4.1) . She estimates annual effidency losses from the system of incentives benefiting the assembly industry at $26.9 million and annual transfers of$39.8 million. The redistributions thatwould occurwidh reform are thus-nearly one and one-half times the efficiency gains.

:10

EFFECS OF PROTEoNISM ONA SMALLCouNTRY.THE CAsE OFURUGUAY

These estimates are also useful n elucidatingwhy the automobile industry is so heavily protected in the flrstplace. Uruguay has ten assembly fins, with the two leading firms each accounting for a third of the market Apm proximately 12,000 vehicles are sold a year, on which the average additional cost of protection to the consumer is $6,834 per vehicle. Takacs calculates that the total efficiencyloss (including the componentindustry) pervehicle is $2,427. The annual benefits of protection in the automobile industry are estimated at $14.3 million for each of the two largest firms. It is no wonder that there is strong incentive to lobby for protection on the parts industry andinsuffidentincentive to lobbyagainstprotection on the partofcorisumers. The combination of a small number of big winners and a large number of small losers (here, producers relative to consumers) iswhat Olson (1965) argues is a situation conducive to intense lobbying. Plan of the book In chapter 2 Michael Connolly andJaime de Melo give a brief history of protectionism and stgnaton in Uruguay. Tariffschedules in 1815 provided fora general tariffof25 percentwith some exemptions and amaximum tariff of 45 percent. By 1829 the general tariff rate had been cut to 15 percent and the maxinum was 25 percent-the first know.n instance of trade liberalization in Uruguay. The authors stress the political poWer of the city of Montevideo in distributing income away from the country and toward the ctybyimposinghigh taxeson agricultural exports. Theyalso report evidence of pervasive rent seeking, including a time senres on regulations from 1928 to 1983 that impeded trade, and of resource waste and lower savings and investment rates. In chapter S Federico Changanaqui and Patrick Messerlin focus on cisguised protectonism in Uruguay through administered reference prices that are used as the base for tarifflevies. Their theoretical analysis shows that this disguised form of protectionism, by providing more protection for goods whose price falls below the reference price, induces Uruguayan producers to specialize in low-price, low-quality products, contrary to the county's comparative advantage in products requiringhigher skilled labor. High-price, high-quality import goods with prices above the reference pnrce escape administered protection, which fvors their consumption. Thus, an unintended effect of the reference price system is to encourage production of low-quality goods and the consumption of high-quality goods. Changanaqui and Messerlin analyze the protective effects ofadministeredpricesapplied to 500 products and find that protection is strongly "magnified " In chapter 4 Wendy Takacs models the complex system of pro tection in the automobile sector that was instituted in 1971 to encourage leaning by

The polticaleconomy of prokc6ionim in Uruguay

11

doing through automobile assembly. The chapter offers a useful lesson on how not to provide for growth and technical change. The combination of high tariffis (40 percent in 1990) on assembled automobiles, low tariffs (10 percent) on automobile assembly kits, domestic content requirements, and compensatory export requirements encourages the local production of automobiles by finns thatassemble the imported kits. The cost to the consumer per car assembled in 1990 of this high effective protection is estimated at more than $6,000-more than half ofittransferred as arent to the automobile assembler. A net efficiency loss of over $2,000 per vehicle represents a

waste of Uruguayan resources in this "screwd[river"activity. Takacs provides a novel formal framework for analyzing the welfare benefits and costs of domestic content and compensatory export requirements, mechanisns all too often used to promote industrialization. Ihe industries that grow prosperous tmder this type of protective regime will lobby for contnued protection and fail to introduce innovative technologies or to compete with other producers in the world market Chapter 5 byJaime de Melo, Claudio Montenegro, and Wendy Takacs deals with tdie gains and losses from bilateral trade agreements with Argentina (Conveno Argentino-Uruguayo de Cooperacion Econ6micaor CAUCE) and Brazil (Protocolo de Expansion Comercal Uruguay-Brazil orPEC) - The authors deve!op a theoretical model of the effidency and rent transfers impliedby the arrangements. They thenapplyagravitymodel to intaregional trade to estimate the increase in the volume of trade with the region resulting from these preferential arrangements. The accord widt Argentina seems to have allowed uncompetitive manufacturing exports to that country, while th-atwith Brazil concentrates on Uruguay's exports in agricultural and natural resource-based products, more along the lnes of Uruguay's pattem of comparative advantage. Under the agreement with Argentina Uruguayanexports enter duty free but are subject to a cupoor export coupon that rations the rights to export to Argentina as a share of the Argentine market. Under the agreementwith Brazil the cupos are negotiated quantitiesrather than shares of Brazil's market Both systems could result in rents that allow inefficientfirms to continue to export, though econometric analysis of price data does nor reveal any significant rents. In chapter 6 Martin Ramaanalyzes the labor marketand trade reform in manufacturing and asks whetherunionizaion blocks the effects of trade liberalization. The Uruguayan case provides experimental conditions For answering this question since some of the trff reforms took place under the penod of authoriarian rule, when unions were forbidden. Barriers to trade give rise to rents to domestic firms, thus providing an incentive for labor to uionize and attempt to negotiate wage increases to capture some of these rents. Ramafinds that sectoral union membership rates in industrial sectors

12

ONA SMALLCouNTr1y EFmCS OF PROTECTIONISM

THECAsEOPURUGUAY

are correlated with indicators of market power of domestic finns, including an mdustry concentration index and the effective rate of protection. Analyais of forty manufacturing sectors over six years shows that the employment elasticity to changes in nominal protection rates was significantly lower in' the period with active trade unions, and the real wage elasticity was higher. In Chapter 7Jaime de Melo and DavidRoland-Hoistuse ageneral equilibrium model to quantify the economywide welfare losses due to the combinedinfluence of trade-and factormarketdistortions. Buildingon theanalysis in chapter 6, the model incorporates the effects of labor union activity, settingupan interaction between trade policyand the determination ofwages at the sectoral level. The simulations suggest that the system of administered Jimport prices distorts the Uruguayan economy more than the tariffs themselves.The costs of administered protection-removing administered prices couldadd4percentto GDP-farexceedthose due to tariffs.Addingresources. squandered in rent-seeking activities could raise the total cost of administered protection to 8 percent of GDP. The simulations also suggest that as a consequence of removing administered protection, nearly 4 percent of the labor force (or 50,000 workers) would have to relocate, explaining some of labor's resistance to trade reform in Uruguay. Resources would flow from formerly protected sectors to agriculture, casing an expansion of up to 15 percent, and light manufactures. The immense difference in trade margins between imports, at 35 percent, and domestic goods, at 9 percent (see chapter 3), would also shrink, although the notorious ineffidency of the Port of Montevideo probably contributes substantially to this marked difference. Chapter 8 byJorge Roldos provides a long-run perspective on the relationship between trade policy and ec -omic growth. Based on endogenous growth theory, Roldos tests for increasing returns to scale in Uruguay using neoclassical production functions. While the sum of the capital and labor exponents is greater than unity, it is not possible to reject the null hypothesis of constant returns to scale, so specialization according to comparative advantage does not appear to lead to significant economies of scale, at least at the economywide level. Calculations of the Solow residuals show total factor productivity to be correlated with export growth, suggesting that export externalities help explain the residuals. Roldos finds cross-sectional support for the hypothesis that trade openness isassociatedwith a high rate of growth in GDP per capita and that Uruguay's growth was lower than the cross-section model predicted. Notes 1. All cross-country comparisons are from the Sumrners and Heston (1991) data. We should note, however, the authors assign a C- grade to the reliability of the correc-

ThepoEtliticaecmnmy ofprotectionismin Unrguay

13

Lionsfor purchasing power for Uruguay. The comparisons of levels of GDP per capita across countries are therefore subject to a wide margin of error. Growth rates comparisons arc unaffected. 2. Total costs of the import good in the market are increased because of the tariff surchargs An ad valorem duty boosts the cif. pricc to the importer by the percentagc amount of the tariff. A specific duty boosts price to the importer by the amount I perunitso that the total importprice including the duty isPF+ t Itcan easily be shown thatdomestic taxeson consumption combinedwith subsidiestoproduction atthesame ratc replicate the effect of a tariff. 3. Imports offoodstuffs, pharnaceuticals, and other products are sometimes restricted or prohibited for health, sanitary, or environmental purposes. Since such restrictions and prohibitionsmay have astrong protective effect, domestic producers may lobby to enact them. This ype of restraint is not used in Uruguay.

References Anichini,JuanJose,Jorge Caumont, and Larry Sjaastad. 1978. La Poittica Comercialyaz -+otecci6nen dUruguay. Montevideo: Banco Central de la Repfublica Oriental del Uruguay. Favaro, Edgardo, and Clauidio Sape1li. 1990. Etp oPrtvnotion andEconomic Growth.San Francisco, Calif.: Institute for Contemporary Studies. Favaro1 Edgardo, and Pablo Spiller. 1990. 'Uruguay. In A. Choksi, M. Michaely, and D.Papageorgiou, eds., The 7imingand Seuencing ojTradeLibera za iom London: Basil Blackwell. Olson, Mancur. 1965. The Logic of ColctdiveACtion:Public Goodsand the Thwny of Goods.Camnbridge, Mass: Harvard University Press. Rodrik, Dani. 1992. 'Me Rush to Free Trade in the Developirng World: WhySo Late? Why Now? Will It last?" NBER Working Paper 3947. National Bureau of Economic Research, Cambridge, Mass. Summers, R., andA. Heston. 1991. 'he Penn World Tables (Mark V):An Expanded Set of International Comparisons, 1950-8." QuarterlyJoumnal of Econodcs. Mar. 327-68.

Protectionism and stagnation: an interpretative history Michael B. Connolly and faime dieMelo

Uruguay has such a long history of pro tection thatwe could have called this chapter 'Two hundred years ofprotectionismY' High levels of protection of manufacturing were maintained by taxing agriculture, the main activity in which Uruguay has astrong comparative advantage. Whatwere the causes of the early protectionism, and what have been its consequences? This book prvdes some answers by analyzng several f-acets of protectionism in Uruguay's recent history. Most of the chapters deal with the welfaLrecosts of the inefficiendies introduced by the various forms ofprotectionismn-tariffs, administered prices, bilateral trading arrangements, and local content requirements. Chapter 8 takes a longer-run perspective on the relationship between the trade regimne and growth since the 1950s. This chapter complements the more specific analyses that follow by providing -an overview of protection against which to judge the rel-ative imnportance of the various instruments of protectionism in Uruguay. Italso pl-aces Uruguay's overall performance in a comparative context, -and for the reader unfamili-ar with Uruguay's economic policies, the chapter sketches some of .the milestones in the country's long history of protectiomism. * What is striking in this description of protectionism before World War II is that a large nulmber of the protective instruments :adopted in the nineteenth century are stil around today. The p-anoply off measures that emerged during the deepening of protection from the 1950s.up to.the 1974-82 liberaHization episode is typical of the measures implemented by countries following a development strategy based on industrialization through import substitution. Under the militar rule of 1974-82 and later * after the retum to democracy in 1985, wide-ranging reforms were canTied out A fascmnating aspect of the 1974-82 period is the apparent break in the downward trend in postwar economic performance (see figure 1.1 in chapte-r 1). It is tempting to concdude that this resumption of growth resuflted from the reforms, whic inlddtaeadfnnillberalization as well '74

.

.dProtnism

and sttiaonW

an interprelaive his"

15

:as an overhaul of the fiscal system and a concurrent effort at stabilizing the economy. To any student of the influence of economic policies on performance, the causes of Uruguay's stagnation are as fascinating as those of the Asian economic ½miracle." In exploring the contribution of various factors to this stagnaadon, we start with a comparative analysis of Uruguay's growth performance, noting an improvement in its relative position following the 1974 refonns. We fit a simple cross-country growth model to a sample of thirty-five comparable developing countriesand find thatneitherinvestmentlevels nor initial conditions (GDP per capitaandeducationlevels) satisfactorilyaccount for Uruguay's poor performance. Uruguay's perfonnance is worse than predicted by this simple growth model. So we look for other causes. Drawing on recently collected data by Rama (1993), we note the high incidence ofrcnt-seeldng activities in Uruguay and relate them to the pervasive regulation of the economy. And we consider whether there really was a break in performance after the 1974 reforms, looking at evidence of changes in investment and savings behavior and at the role of external shocks. We conclude that there was probably a slight inprovement in performance attributable to the reforms carried outin 1974, but as the more detailed analyses in the remaining chapters in this voluxme suggest, Uruguaywas stillahighly distorted economy by the end of the 1980s. It is difficult not to conclude that the system of regulations and protection in Uruguay has been made-to-measure. In the end, protection was adopted more in response to lobbying acdvity than as a part of a rational design to promote industrial activities. Ramna(1993), in a detailed examination offoreign trade legislation between 1925 and 1983, counted 1,849 pieces oflegislation that explicidy identified their promoter. Rana translates one of them, dernvingfrom an application in 1937 concerning Sacman-type cIay tiles: "Mr. Horacio Acosta y Lara, proprietor of a nadonal firm manufacturconsiders that the low price on which customs tariff is -ig this product... based damages his own interests and puts him at a disadvantage relative to foreign industry.' -What accounted for this made-to-measure trade regime? Industrial concentration must have piayed an important role. The manufacturing sector. in Uruguay is concentrted in a few hands: as late as 1978 there were only 310 establishments that employed more than 100 workers (up from 210 in 1960). It is therefore not srisig that lobbying activity by manufacturers has been intense. According to Olson (1965) the smaller the number offinis

that benefit from a specific action, the larger the benefit share to each firm from that action, and hence the more intense the lobbying activity. Considering this strong lobbying for protection, it is natural to ask how much the reforms of tie 1970s and 1980s actually reduced effective protec-

- 16&

COUNTRY: THECAsEOFURUrUAY ONA SMALL EMCIS OFPROrEcmToMNsM

tion.Analysis suggests that, atleastuntil the mid-1980s, the reforms progressively eliminated primarily redunadantprotection, with tariff reductions having little effect on the spread between domestic and international prices (Macadar 1988). These estimates, based on compaisons of domestic and foreign comparable products, are approximate -at best. But it is clear that Uruguayhas alow trade share in GDP forits size, despite a noticeable increase in the share of exports in GDP following the reforms begun in 1974 (figure 2.1). These reformnswentalongway toward removing the most egregous trade restrictions, such as the prohibitioni of' capital goods imports, but Uruguay's foreign trade regime remained heavily controlled throughout the 1980s. Birth of protectionism: 1815-1939 High and vaniable rates of protection are not new to Uruguay--they were already in place in 1815 (table 2.1). Protectionwas common atthe tme (Great Britain's repeal of the corn laws in 1848 wasan exception), holding swayuntil 1850, when a bilateral trade accord betweenFrance and Great Britain ushered in an era of free trade in Europe. Uruguay, npervious to Britsh influenceand to commercial interests, continued to pass stiff amrifflawsthat discriminated increasingly against consumer goods. Poor harvests, diminished livestock outputand accumulated fiscaland merchandise deficits led to the agricultural and finanial crises of 1874, and then to the first attempt to simultaneously protect Uruguay's nascent indusFigure 2.1 GDP and exports (three-year movingaverages), 1935-92 (billionsof 1978pesos) Expans 12

Output 5040

oigaeae)

Fgure and 2.1 fflc~~~~ports GDP

959

4treya 8

Otu

30

6 20

2

10 0 1935

0 1945

1955

1965

SO&CeAuthors!calculations,basedon CentbalBankof Unrguaydata.

1975

1985

Protectionismand stagnation:an interfrstaidvehtstoty

17

Table 2.1 Tariff schedules,1815-1930 (percent) Year

;etneral

1815 1829 1831 1833 1837 1850 1856 1861

25 15 18 15 15 20 15 15

1875 1886 1888 1912

1927

15 30.5 31.0 None None

Machinery Maximum Minimum GConswpUn IntermedIate anddrLgs

45 25 25 25 31.5 30 35 22

0 0 0 0 0 0 0 0

0-45 5-25 5-25 5-25 0-31.5 15-30 15-35 0-22

90 5t SI 51

0 0 0 0

0-42 6-51 6-51 5-51

0-90 043 0-43 0-31

51

0

5-51

0-31

0-25 0-15 0-18 0-15 0-15 0-15 0-15 0-15

0-25 0-15 0-18 0-15 0-15 0-15 0-15 0-IS 0-35

-30.5 0-31 0-25

0-25

SourceAdaptedfro Favaro andSapelli(I 989,table2.12).

try andraise revenues. Duties of 10 to 20percentwere imposed on mostimported goods, but rates reached as high as 90 percent for lithographs and published works.1 In October 1875 duties were lifted on primary materials, industrial and agricultural equipment, and most inputs. The motivation for this pattem of duties was protection and development of the import-substitution industry in Uruguay. InJanuary 1888 a 31 percent basic dutywas set on merchandise imports, while imported parts for assembly (in this case, of steamboats), industrial equipment, and fenacng material were exempt or had low duties. Duties on consumption goods such as cheese, butter, brushes, shoes, clothing, hats, matches, and pu:ses were high, ranging from 44 percent to 51 percent. According to published report of the Treasury Commission of the House of Representatives, the high duties on consumption goods and low duties on inputs were intended to promote Uruguayan indusy and to raise revenues. The effect on imports of consumer goods in 1890-1900 was devastating. Despite high rates of population growth and immigration the value of imports fell 44 percent, from 17 million pesos during 1872-74 to 9.5 million pesos during 1890-1900. As earlyas 1859 there was concern that the high rates of protectionwould lead to smuggling (Favaro andSapelli 1989,42)t Despite talkoflowering tariff rates to discourage smuggling, protection continued to rise. A natural question to ask is: Why was protection so high in Uruguay while the rest of the world was pursuing free trade policies? There are no obvious polidcal economy reasons for the rise in protection in the nineteenth century. The agroexporters were in power, and they clearly benefited from free trade. The persistence and consolidation of pro-

:718

OFURUcUAY CouNwTr:THECASE IEECTS OFPROTECnONISMONA SMALL

tectionism in the early parts of this century during the presidencies of Batie y Ordofiez (1903-07 and 1911-15) can be at least partly explained by the shift of political powecrto Montevideo and by the influence of anarchist immigrants. Batlle y Ordoiiez promoted social legislation and active economic policies. The next watershed was the temporary admission law of 1911 and the raw material and intermediate input law of 1912. The duty drawback and temporary admission law of 1911 allowed the duty-free import of all primary materials and internediate goods used for production, provided that the finished good was exported within a specfied period. The tariff law of 1912 forinally established special duty treatment for imports of primary materials lused in the production of goods sold in the domestic market as well. The legislation of exceptions had begun, introducing new incentives for rentseeking activities. Once again the motivation was to promote domestic industry-and to createjobs. The log of the House of Representatives (October 4,1912) states that "every nation which protects its industries to create employment and icrease its population thanks to the greater employment, opens its doors to primary materials not available or in short supply at home in order to carry outmanufacturing inits national enterprisesandfactories" (cited inAnichini, Caumont, and Sjaastad 1978,19-20). The policy of high effective rates of protection for manufacturing has endured to this day. Tariff schedules still favor the import of raw materials and equipment (with the exception of automobile parts). The basic drawback-law remains in existence as well. Supply difficulties during World War I reduced imports and thus tariff revenues. With less competition from abroad, domestic manufacturing grew: the numberofmanufacturingestablishments rose from 1,000 in 1919 to 7,400 by 1930. When the war ended, exports fell and imports rose, prompting legislators in the 1920s to establish higher reference prices for calculating duties on some goods, particularly consumer items facing greater foreign competiton. Duties were levied on either the dedared c.if. value or the reference price, whichever was higher. This mechanism of protection is still in place today in Uruguay, albeit somewhat reforned. Its effects are analyzed in chapter 3. The stock market crashes of 1929 and the subsequent finandal panics inducedanewboutofprotectionism onaworldwide scale.The Smoot-Hawley Tariff in the United States in 1930 was followedwithin twoyears by increased tariffs in sixty other countries (Ethier 1983). Beggar-thy-neighbor policies in the industrial countries sought to protect domestic manufacturing and employment, but instead the contraction in trade led to a reversal of the substantial economic gains that had arisen from rade. On August 6,1931,

Protectionism and stqgndon: an intapretative hist

19

Uruguay passed a law authorizing the executive branch to raise duties to as high as 48 percent (up from 31 percent) on goods forwhich therewas "similarnationalproduction.' OnAugust20 the presidentwasalso given the right to suspend imports for up to a month on awide range of goods thatwere also produced nationally. On the export side multiple exchange rates were established in 1933 through a compensating system of preferential exchange rates with up to a 50 percent premium for exports. In an attempt to promote domestic industries, subsidies were given through tax exemptions (franquicias) for industries that moved to Uruguay or expanded their local productive capaciy. The antiprotective effect of a revaluation of the peso in December 1937 was undone by the reimposition of import licensing. What is remarkable in this period of Uruguay's economic history is that the economy grew fairly rapidly despite the relatively high protection. Uruguay benefited from the boom caused by the meat shortage during World War ILand the "natural" protection afforded by the depression was largely inevitable. But the relatively high rates of protection seemed to have had no perceptible effecton growth. Anichini, Caumont, and Sjaastad (1978) characterize theperiodas one of growth through importsubstitution,which ended in the 1950s, when the growth opportunities made possible by protection were exhausted. These authors, however, measuredgrowrh at domestic prices, which overvalues the increase in domestic output due to protection. Measured at constantworld prices, growth up to 1950 is lower. Consolidation of protection: 1941-74 The Korean war provided another, and the Last,positive external shock. On the whole, Uruguay's economic history after World War II is one of increasing protectionism and market interventions up to 1974. There were, however, several attempts at liberalization after 1959, including efforts to rationalize the trade regime and attempts to reduce the antiexport bias of the protective regime by extending various subsidies to nontraditional exports.

1941-59 Congress approved abill on export and import control in 1941 that consolidated the measures that had been implemented in piecemeal fashion during the depression. The law also authorized the president to create a comptroller of exports and imports with authority to prohibit imports that competed with national production. Foreign e-xchange was allocated by the central bank (Banco Reptiblica Oriental del Uruguay) by country and byitem, with pniority going to raw materials, "criticalr consuimer goods, intermediate

20

EFECTSOFPRoTECIoNIsMONA SMAL.LCouNTR THECAsE OF URuGUAY

and capital goods for the agricultural sector, and raw materials and machinery for the manufacturing sectoi. Multiple exchaange rates were introduced for broad categories of goods: necessities, intermediates, and luxuries. While this system made some sense during war years, itmade little sense later on, when it stifled foreign trade. Favaro and Spiller (1990) give a flravor of the discriminatory nature of the bill, describing how the law established norms for the distribution of foreign currency according to the "need each firm showed, the number of employees and their salaries, the volume of activity, and the time that the firm had been established in the market" (p. 347). During a period when world trade was booming, Uruguay was adopting a trading system based on bilateralism, mnuch along the lines pursued in Eastem Europe. Uruguay registered respectable gro*th during this period of rising protectionisrn.Justas it had benefited from not being involvedin World War IIL it now benefited from the Korean War, which led to another export boom. Real GDP growth averaged 3.9 percent a year and real industrial product growth grew 5.8 percent from 1942 to 1958. And once more, manufacting was fueled by import substitution.

1960-73 The period 1960-73 was markedbystalledgrowth and economic stagnation. Some reforms had been introduced in December 1959, induding temporary unification of exchange rates for commercial transactions. The tariff reforms of l959, however, ended up reinforcing the multiple exchange rates for imports, while the free market rate applied to exports and most imports of raw materials and capital goods. The executive branch was authorized to impose surcharges of up to 300 percent, to require prior deposits forimports, and to prohibit 3inports for up to 180 days. Moreover, the new tariffs were levied on administered prices rather than on ci.L prices. Despite lobbying by the Chamber

of Commerce

for a 150 percent

surcharge,

the executive

branch set the surcharges in September 1960 at 45 percent, 75 percent, and 150 percent (for luxury" goods.) Naturally, with such high surchargesadded to the triffs, demand for the affected goods nearly disappeared, and customs collections declined. lJruguayjoined the Latin American Free Trade Area (LAFTA) in 1960, which was established to provide preferential treatment for regional products. Implementationwas patchy, however, and tlhe preferences seem to have resulted in trade diversion rather than trade creation (see chapter 5 and Nogues and QuintaniUla 1993). Protection led to even more intervention in 1964, in an effort to compensate exporters through subsidies of up to 20 percent of the f.o.b. value

nPrtectionism and slagnation an intypretativehistor

21

and by relievng them of import duties on imported inputs used in export production. Discimination againstagriculture intensified, -istaxes were levied on exports of traditional products like wooL beef, and hides. The objective was to promote industrial exports. The result was to superimpose additional layers of taxesand subsidieson the existing structure of tariffschedules, prior-deposit requirements, and multiple exchange rates. D Despite the high levels of protection and the export subsidy schemes, industrial production increased by only 1.1 percentayearin real tenms from 1959 to 19 7 3-slower than the rate of population growth. Quotas imposed on imported materials because of balance of payments problems also contributed to the stgnation of manufacturing. Growth possibilities based on import substitution had been exhausted. How high was protection during th}isperiod? To estimate protection Favaro and Spiller (1990) use a measure-based on the ratio of import to export prices lor a sample of goods-that includes the effects of administered prices. Average nominal protection, according to this measure, is very high until after the reform of 1974-79: Year

Rate

1961 1964 1968 1971 1974 1979 1980 1982

384.4 684.1 578.1 534.5 452.4 69.5 62.3 52.7

While the magnitude of these estimates may be questioned (for a discussion see Favaro and Spiller 1990, 351-2), other evidence supports the claim of a verystrongprotective effectfrom the numerousinterventions, includingother estimates of protection (see Mezzera and de Melo 1985, for example) and measures of the restrictiveness of the trade regime (the share of final goods to total imports fell from 60 percent in 1951 to 31 percent in 1974). In any event, whatever the precise magnitude of protection provided by the system ofinterventions, itis dear thatprotectionwas on the rise until thewide-ranging reforms that began in 1974. Economic reforms of 1974 Following an external crisis caused by falling terms of trade and a ban on beef exports to the European Community, Uruguay began a sweeping.rever-

22-

Enas1

OFPROTECTIONSM ONA SMALLCouNwra THECASEOFURUGUAY

sal of its proteetionist polides in 1974. Controls on domestic prices and in-

terest rates were relaxed, and a floating exchange rate was adopted hIn1975 qantitative restrictions were eliminated, and in 1979 a program of tariff reductions was adopted. (See appendix for detils on reforrn measures.) Even after these reforms, however,.he range of instruments used to control trade and influence resource allocadon remained large. Import deposit requirementsand quotas Some of the trade reforms begun in 1974 have been loosely referred to as the elimination of quotas on imports. Technically, the system in place up to 1975 was not a formal quota system in that there were no set limits on the quantity orvalue of imports overa specified time period. Rather, for imports above specified amounts a set of prior import deposit requirements came into play. In prctice, however, the system operated like a set of value-denominated quotas once the import deposit requirements and inflation became so high that the cost of the deposits for over-uota imports was almost prohibitive. UntilJune 1975, imports subject to prepayments had to be registeredwith the central bankbefore orderswere placed abroad, and importers had to deposit, in Uruguayan pesos, a given percentage (over 100 percent) of the cif. value of imports. These deposits were refimdable after six months, upon application, but they accrued no interest Imports by public agences or financed by loans from international agencies or foreign governmentswere exemptfrom the depositrequirement. Other exemptionsfor particuar types ofproductswere occasionallyintroduced. Importers not only had to forgo interest earings on the deposits, but in an inflationary environment, they also suffered a loss of real purchasing power. The depositrequirements orprepayments applied only to importsabove a stated percentage of base period imports. Both the percentages and base periods were changed frequently, usually two to five times a year? The deposit share also varied, by productand over time. To illustrate: in 1968 there were three import deposit-rates: 150 percent, 300 percent, and 400 percent The 150 percentrate applied to goods exemptfrom the taziffsurcharge, goods subject to a 10 percent surcharge, and some goods subject to a 60 percent surcharge. The 300 percent rate applied to other goods subject to a 60 percent surcharge and to goods subject to a 90 percent surcharge. The 400 percent deposit applied to goods subject to surcharges higher than 90 percent. In November 1971 the deposit requirements were tripled to 450 percent, 900 percent, and 1,200 percent respectively) Deposits held by monetary authorities rose after the increase in deposit requirements in 1971 and fell after the 1975 liberalization. The decline in the realvalue ofthe*fmds on depositcanbeused to estimate the tariffequiva-

Protcktionism and stagnaton:

an intepretaive

histoy

23

lentin real tenns of the inport deposit requirements. If prices increase by a factor of rwhile the deposits are being held, this is equivalent to a tax of r/(1 + r) percent of the funds held. Thus, a price increase of 100 percent (which implies r= 1) cuts the purchasing power of deposited funds in half, an increase of 50 percent cuts it by one-third, and so on. Given that the deposit requirements are multiples of the value of imports, the impact is also multiplied. The real tariffequivalent of the import depositrequirement, T, can be calculated as: (2.1)

.T=

(1+ r)

where D is the percentage of the value of imports that must be deposited. A I100percent deposit requirement implies D = 1. A 400 percentrequirement (D=4) togetherwith a price increase of 100 percent (r= l) during the depositperiodimplies that the importergivesup purchasingpower equivalent to 200 percent of the value of the imports requiring deposits. Similarly, a 1,200 percent deposit requrement implies that the importer gives up purchasing power equivalent to 600 percent of the value of imports. This approach can be used to calculate the ex post tariff equivalentsthatis, once the inflation rate for the period is known-of the lowest and the highestapplicable import deposit requirements for fnds. From 1968 to the dird quarter of 1971 the lowest and highest deposit requirements were 150 and 400 percent; from the last quarter of 2971 to the second quarter of 1978 theywere 400 percent and 1,200 percent. Estimated tariff equivalents of the import deposit requirements range from a low of about 8 percent for the lowest deposit requiremenit during the period of lowest inflation to ahigh of more than 430 percent for the highest dep osit requirement during the most inflationarypenod. T ese high estimated tariffequivalents are consistentwith contemporary observatons that the cost of the import deposits to importers was so large that itwas virtually prohibitive.5 There are two reasons to suspect that these estimates of tariffequivalents may overstate the restrictiveness of the import deposit scheme. First, if dLe higher depositrequirements were actuallyprohibitive, there would have been at least some amnount of 'waterin the tariff equivalent' for these categories. But since at least some deposits were being held at all dimes during the period 1968-75, the lowest depositrequirementwas neverprohibitive and can be interpreted as a rough lower-bound estmate of the restrictiveness of the system. Second, firms thatargued that they couldnotmainrain their actvity levels withoutan increase in theirlicense allocations were granted increases. There is also at least one reason to suspect that these estimated tariffs may underestimate the real cost to importers. For commodities for which reference pnces were established, prior deposits were calculated on the basis of

24

Ercrs

CouNRY: THE CASEOFURUGUAY OFPROnEcroNlsM ONA SMALL

reference prices when they were&higher than the ci.f values. An artificially higher valuation basis would result in larger deposits and a higher ad valorem tariff equivalent. A somewhat lower measure of the restrictveness of the import deposit requirements is implied by the outcome of a central bank auction in October 1974 ofUS$625,000 in deposit-exemptforeign exchange forhigeduty luxury imports. Importers paid up to UrS1,500 per U.S. dollar allocated plus the Ur$1,392 costof foreignexchange atthe time ofthe auction. Thatmeans that importers were willing to pay an extra 108 percent rather than pay the prior deposit Thisbidis roughly the same as the estimated triff equivlentfor the lower deposit requirement (96 percent for fimds deposited during the firt quarter ofl974) but is considerably lower than the estimated tariffequivalenLt for the highest deposit requirement of the time, which was over 200 percent. The prepaynent system was liberalized as part of the sweeping reforms of 1974-77. In April 1975 the govermnuent announced that the system of *deposits and quotas would be eliminated as ofJuly 1, 1975. To avoid a large increase in liquidity as import deposits were released, an advance deposit requirement ofS35 percent of the ci.f value, to be held for 150 days, was imposed on all private sector imports as of April 14, 1975. The 35 percent deposit was maintained until December 1975, when it was replaced by a 7 percent surcharge on all imports except some investment and capital goods. The elimination of import deposits and the associated quota-like system lowered costs for-importers who were importing over quota and, more important, allowed substantial changes in the composition of imports and in their allocation among firms. Import quotas below the prior-deposit threshold were granted to firms according to the value of their imports in the reS evant base period. The system was inherendy discriminatory, and it severely impeded shifts in the allocation of imports toward more efficent firms or new finms. Maintaining the prior-deposit scheme would have made it difficult for firms to respond to the trade reforms by importing the capital goods, raw materials, or intermediate goods needed to expand export actities or to startup new businesses. Favaro and Spiller (1990) report that eliminating the prior-depositrequirementallowed import-competing sectors to become more effident, so that output increased during the first phase ofliberalization despite the rise in competing imports. The industrial sector grew at an annual rate of more than 4 percent a year for the three years following the liberalization measures. Tariff reform program of 1 980-89 While the system of prior deposits and quotas was being reformed, the tariff system remained highly protective. In 1976 five different duties were being

Pm:ecionism and sagapion: an intetrpraaive history

25

levied on imports: the tariff (applied to the higher of the cif. price or the reference price), aconsularfee of4percent of the fo.b. value, an 18 percent duty (on the higher of the c.i.f. price or the reference price), an exchange rate duty (ranging from 0 percent to 200 percent OFlae c.if. ralue), and a 7 percent consignment tax forsome inputs andcapital goods. The sum of these duties varied; itwas 3 percent for tractors, 47 percent for electric motors for industrial use, and 197 percent for electric vacuum cleaners. In 1979 Uruguayjoined the General Agreement of Tariffs andTrade (GAIT), signaling an end to its longstanding practice of providing subsidies to nontraditional exports.

The second phase of trade liberalization began in earnest inJanuary 1980 and involved six equal tariffreductions to be taken at the beginning of each year. From twenty-eightlevels of duties averaging 45 percent, with apeak rate of 116 percent, tariffswere reduced to eightrates, with asimple average of 36 percent and a maximum rate of 75 percent The crawling peg exchange rate policyintroduced in 1978 was replaced by a floating rate in 1982. The real apprecation that had occurred turned out to be unsustainable. Capital had flowed into the country following the opening of the economy and difficuldtiesin Argentina, iinancing an investment boom that led. to real growth in GDP averagig mure than 4 percent from 1973 to 1981.Realized real rates ofinterest, however, became unsustainably high in 1980 as agents anticipated the collapse of the pre-announced exchange rate (known as the tabita) by reducing capital inflows.As interational rates rose higher in 1981 and commodity prices other than oil fell, Uruguaysufferedadebtcrisis and economic collapse of severeproportionsreal GDP fell abruptly by 9 percent Tariff reductions were abandoned, replaced injanuary 1983 by a new tariffstructure with five levels and a 15 percent export tax on traditional exports (table 2.2). Tariffrates continued tofall, butmore graduallythanplanned.The only reversalwas asmall temporaryincrease inJune 1985. Tariffswere reduced 5 percentage pointsin 1989, andinAugust 1990 the highesttariffwas reduced to 30 percent. The reforms also narrowed the range of taff rates, bringing Table 2.2 Chronolog of tariff rates, 1979-87 Efectied te

Primryrmazids

Decenber1979 January1982 January1983 June 1985 August1986

August 1987

Oto18 10and 15 10 Is 10 .10

£OurcMamdar (I1988).

intermenxategoods

Findgoods

22to94 25 3545 55 65 254050 203545 203545

76to116 75 55 60 50

203040

45

26

ONA SMALL CoUNTRY TmECASEOFURUGUAY E}FEC1s OFPROTECrEOnISM

Uruguay closer to a uniform tariff. However, effectve protection remained muchhigher-andmore dispersed than these tarifffiguressuggestbecause of the operation of the reference price system (see chapter 3) and the special tariff regime for automobiles (chapter 4). Referenceand minimum exportprics, 1982-92 The old reference price system was replaced in 1982 by the current, more formalized and fully specified system of administered prices, the change prompted by the difficultyof implementing the antid umpiag and antisubsidy law ofJune 1981. Fifty-four types of products have referenea prices-textiles and apparel alone are covered by 177 separate reference prices. The mechanism is simple: when the dedared c.i.f. import price is less than the reference price, the official duty isapplied to the reftrence pri_e. Thus, the world price of synthetic tufted carpets maybe US$3.22ayard, butitsreferenceprice is US$750 a yard. As a percentage of the world price a 40 percent duty rate represents an effective duty of 93 percent A new minimum export price was added to the system of administered prices in 1983. The name is something of a misnomer since itapplies not to Uruguayan exports butto Uruguayanimports-other countries' exports. Be system covered seventy-fivetypes of goods in 1990 (thirty-fiveof them transferred from the reference price system). The minimum export price system is more protective than the reference price system since it adds a moving surcharge equal to the difference between the declared importprice and the mnimum export price. Consider automobile tires, with a world price of US$3.80 a pound and a minimum export price of US$4.30 a pound. Importers declaring an import price of US$3.80 would pay not only the official duty of4Opercent on the $4.30 price, but also the US$0.50 difference between the declared world price and the minimum export prices for a total effective duty of58 percenL Nantrally, there isa strong incentive for importers to avoid the surcharge by declaring an importvalue equal to the minimum export price. The system ofadministeredprices has been reformedinrecentyears by reducing the ratesand the numberofgoodscovered, but the systemremains in place. By boosting the true tariffs above the apparent tariFf, this system undermines the country's trade liberalization efforts. The special regime for automobiles, 1970-92 Another form of import deterrence is achieved by the elaborate system of domestic content and compensatory export requirements established in October 1970 in the automotive industry. In 1990importers offully assembled automobiles paid a 40 percent tariffandhad to have 'compensating" exports

Potectionim

and 5stgnation: an interptalive

his"

27

of automobile parts equal to 70 percent of the £ob. value of the fully assembled automobile. Importers of automobile kits had to pay a tariff of 10 percent, have a minimum Uruguayan value-added content of2Opercent, and have compensatory exports ranging from a minimum of 20 percent for a domestic content of 40 percent or more to a maximum of 60 percent for a domestic content of 20 to 25 percent The compensatory export scheme was less restrictive than it appeared, however, since export receipts could be purchased on the secondary market for 8 to 35 percent and used to satisfy the compensatory export requiremenL Export taxes and subsidies In addition to controls on imports Uruguay has a long tradition of taxing its traditional exports of beef, wool, and tanned hides. Furthermore, exports of key raw materials such as cattle on the hoofand untanned leather vere prohibited in order to provide cheap inputs to the meat packing and tanning industries. To compensate for this bias against tradable acdvities, export subsidies were introduced for nontaditional exports in 1964,and expanded in 1967and 1970.Nontrditionalexportsalso received exchangeraterebates, while traditional exports were penalized by an unfavorable exchange rate. Clearly this complex structure of import protection and promotion was a strong incentive for lobbying and rent-seeking activties. Bilatercr trade afrnngmntg-

-

Bilateral trade arrangements with Argentina (CAUCE,negotiated in 1974) and Brazil (PEG,1975) were an integral part of the reform package launched in 1974. The bilateral arrangements were intended to reduce Uruguay's chronic trade deficit with its neighbors and to secure access to these markets. The anrangements, which are descibed in detail in chapter 5, provide forfree access into Argentina and Brazilfor a selected number of lUruguay manufactures. However, free access was limited by quota ceilings for each product Thepreferenceswere regulated through coupons, which controlled access to the Argentine and Brazilian markets. Cross-country evidence on trade, growth, and stagnation What happened to growth ratesas Uruguay's economy became progressively more regulated andpro tected before 1974,when refonns gradually opened the economy to foreign trade? Four patterns stand out in the long-term relation between GDP and exports (see figure 2.1): stagnation of exports between 1953 and 1973;6two

28

CouNTRY: THECAsEOFURucuAY *EFcEsC OFPNorEcnoNisM ONASMALL

growth periods, fom the late 1930s to the mid-1950s and after 1973; an association between exports and GDP after 1974; and an explosion in exports after 1974. The question then is whether the changes can be attributed to policies or to external events. The first place to look for an external explanation for the rise in exports and tie acceleration in economic growth after 1974 is an improvement in Uruguay's commodity terms of trade. Far from improving, the terms of tde fell from 226 in 1973 to 122 in 1974 and stayed at or below 100 (with 1978 = 100) until 1987. Despite this worsening in the tenns of trade, real GDP expanded rapidly from 1974 to 1981 (figure 2.2). During a similar worsening in terms of trade from 1950 to 1972, income stagnated. The detenoration in the terms of trade may have contributed to.the slowdown in growth in this earlier p eriod, but not in the later period, an observation confirmed by Rama (1991) using causality tests that reject Granger causality from the terms of trade to outputgrowth. Anotier external factor thatprobably did play a role was the macroeconomic situation in neighboring countries, especially Argentina Uruguay's boom during 1979-80 and the ensuing deep recession in 1982-83, when real GDP fell by 14.7 percent, were strongly influenced by the similar boom-bust cycle in Argentina27 Cross-section analysis using average growth rates for a sample of thirtyfive countrieswith GDPpercapitaabove $3,800in 1973 (Surmmersand Heston 1991) shows Uruguay, alongvwithArgentina and Chile, its tvo Southerm Cone neighbors,with the lowvestaverageGDP growth for the tvo periods combined, 1950-74and 1974-88 (figure 2.3). Uruguay's relative position in the sample Figure2.2 Termsof trade and GDP growth, 194249

ReoGCDP (billions of 1978 pesos)

Termoftrde (I978=I 00)

40

150

30

100

0~~~~~~~~~~~~~~~~~~~5 1970 1980 oftrade: Central Bank ofUruguay. Sowgce GDR.IM Anemcnirnd 9nanckt Stndstkssterirs 1940

1950

1960

1990

JWotectionismand neag7adon:an iniepretative his"oi

29

improved during the second period, however, because while performance deteriorated for most of the sample following a series of price shocks beginning in 1973, UJruguaym-anaged to at least stand still. To explore some of the underlying determinants ofgrowth, we fit asimple growth model to the sample countries, using investmnent,initial income levels, and education levels as key explanatory variables.8 Since the model ignores other factors, such as trade policies, that could also affect growvth,the results are merely suggestive.But they do broadly confirm those of recent. cross.-courntrygrowth exercises, such a-sBarro (1991) and Levine and Ren elt. (I 992). (For this sample of relatively advainced developing countries, however, catch-up from low income levels is significant only in the first period and the influenceof education variables--proxies for human capita-is only marginal; table 2.3.)Jorge Roldos takes acloser look in chapter 8at the same sample in an extended model thatattempts to control for the effects of trde policies on growth. More interesting here is the difference between actual and predicted growth rates for Uruguay during each subperiod, after the effects of investment and education are taken into account. During 1960-73 actual goth was 2.5 percen thelowthe value predicted by the regression-byfar the largest negative residual in the sample. For the later period, 1974-88, actual Figure2.3 GDP growth for thirty-fivecountrieswith GDP per capita above$3,800 in 1973 F&irent1974-886 8

7 6

ISL

f:

C

0

:

e

l

-PNe

~~~~~AUT

O' M

:

NZLo

~~~~~~ARGO

-i

-2: -2 -I

0

I

2

3

4

S

6

7.

PercenL195r-74 Source:rnmers andHreston (1991), wih amounts adjustedtohave thesne purchangpoweras inthe United Stints.

6

CouNTRY:THECASEOFURUCUAY ON A SMALL EiFns OFPROTE=TIONISM

'30 -=

Table2.3 Regresionresultsfor cross-country growthdetenminants gowth) (dependent vcrtabe.oerageGDPper@1itO -PhlmaryschdooSecondrscol enrallbt ratio enralfient rtio (EDS) (EDPJ'

Constant Period

term

196D-72

27.2 (4.0)

-23.5 -(9.2)

1973-88

0.014 (0.015)

0.02 (0.01)

0.08 (0.04)

-0.02 (0.01)

Red GDP per capita (InGDPCQ

Investment GDP (AIW)

-3.4

F

0.11 172 (0.03)

(0.51) 1.5 (08)

0.19 (0.03)

9.1

in parernheses are standarderrors,basedon aftiryfive countriesshown i jfgure23. Nunbems Note: Sample matrix. coimrmnce Whies (1981)heteroskedasticity-cnsiswnt a. Bgining of periodvalues. and zon (1991). Sowcc.Authors'dcubtions basedon datafrom World Bank(variousyears)andSumnmers

growth was still some 0.3 percent below its predic:ted value, but the difference was not significanL

the regression

Thus

analysis confirms

a relative

im-

provement in the period af-,er the initiation of the reforns. Rent

seeking,

One

obvious

formance

reforms, place

investment

to look for reasons

for Uruguay's

which

translate

directly

into

for other

the policy

main

between

and

and

domestic

savings

and investment

trade

policies

savings.

servants,

do not

affect

8 looks

such as how

There

by influ-

is evidence

of

between

the

of income

and trade

manufacturers,

is also evidehce upward

for fur-

it does not

growth

there

In particulars

in 1974 led to a significant during

that follow,

and growth,

activities

growth.

of such

policy and growth,

between

and of its effect on investmentand initiated

effe cts of trade effects

chapter

over the distribution

social groups-civil

that the reforms

And while

distnbutional

in Uruguay

stuge

a broader

on growth.

linkages

possible

environment

investment

encing

effects

in some of the chapters

on the relation

ther evidence account

are explored

per-

economic

The microeconomic

and othermarketinterventions.

distortions,

dismal

until 1974, is the distortionary

since 1950, especially

poicies

three

and

unionssuggesting

shift in private

1974-82.

Rent seeking and investment As the discussion clear,

discrctionary

tion. From gressively subsidies

polices

were

control

to foreign

opened

trade.

to foreign

were used to promote activity

would

instruments

widely used

the 1930s to the 1960s restrictive

the economy

seeldng

of the array of trade

regulations

the mid-1970s,

trade,

discretionary

be expected

alloca-

were used

to close

as the economywas measures

trade. A considerable

in such an environment.

makes

resource

to influence

From foreign

in Uruguay

such amount

pro-

as export ofrent-

Protectionism and stagntion: an intuvpretative hisutoy

31

Adetailed examination offoreign trade legislation from 1925 to 1983 by Rama (1993) yielded 1,849pieces oflegislation thatexplicidtlyidentified their promoter-or 3973 if those that concerned only a small number of producers are induded as well. A sense of the importance of these rent-seeking activitiesin relation to the overall sizeof the economy can be derived byscaling rentseeking (measured as the number of trade-related statuLesbenefiting a - - fi orindustry) by thelevel of economicactivity over the period 1925single 83 (figure 2.4). The scaling shows two peaks, one-during the 1940sand one during the 1970s.The most intense penrod of rent seeking occurred during the import-subsdtution regime of the 1940s. The second peak is almost entirely accounted for by rent-seeking acdvities associated with exporting. Using dummy variables to capture changes in policies and institutions, Ramnafinds that rent-seeking activities intensified during militar dictatorships and during periods ofintense imporisubstitution (1931-69) or export promotion (1974-79). The estimated coefficients also suggest that import substitution had a stronger effect on rent-seeking activity than did export promrotdon. Particularly interesting is the relationship Rama finds between rent-seekingactivityandl.ong-run growth. He regresses the residuals (or 'innovations") from univariate models of the growth of outputand exports on indicators of rent-seeking intensity (following the approach of Blanchard and Fischer 1989), with time lags of up to twenty years to capture long-run effects. For both output growth and exports the results reveal a positive correlation in the earlyyears, followed bya negative one (figure 2.5). The change could be Figure 2.4. Rent-seeldng intensity, 1925-83 (regulations scaled byeconomic activity) (average= 100) Scdee 300

----..--------..

'---.---

.

_.,,

-.----

aled

'.-.-....-

i-

*..-............

---.--.-

50-

-..--..-

by exports

200 --.

lO

.

....

-....--.-

-_--.

-....-

.....

.---.

_--.--.

---- .

---..---.

.-.-..-.- -..

.-.....

-

~-

-..--

Scaled by output 1925

1935

S&rreaRarna(I993).

1945

1955

1965

1975

198

EncTs

32

ON* SMALLCouNmY:THE CASEOF UGRUUAY OFPRoTnenONISM

Figure 2.5 Rent seeking and export growth Carefatoncoeffident 0.15 0.10 0.05 0 -0.05 -0.15

-0.20 -0.25 -0.30 -0.35

I

2

3

4

5

6

7

8

9 10 11 12 13 14 15 16 17 18 19 20

AUregucdonsIagedt years Cnrrelaon coefficient

0.4 0.3

0.2~U -0.1

.1 E 44~

-0.2___ -0.3

-0.4 1 2 3 4 5 6 7

8 9 10 11 12 13 14 15 16 17 18 19 20 on exports,bggedt yeats Regulations

SoureRama(1993).

explained by an intense bout of lobbying following the trade liberalization of 1974-82 by those eager to preserve their rents. The correlations between the intensity of rent seeking and the growth rate of exports are positive at first but tum negative after three to four years, suggesting that capturing the rent requires investing in the favored sector. By stifling creativity and innovation, rent seeking lowers growth. Considering the lagged effects of the correlations, Uruguay's current economic malaise couldbeviewed as the after effects of the 1970s rent-seeking peak.

Protectionismand stagnation: an ineerpretadue history Impact of refms

33

on savings and investment

In addition to regulations and interventions in the foreign trade sector Uruguay had pervasive regulations affecting product and Factor markets. Before the reform program of 1974 price controls affected more than 90 percent of the consumer basket, the financial system was highly regulated and credit was rationecd, and a systemnof indirect taxation heavily penalized the agricultural sector. The reform package launched in 1974 eliminated most of these regulations, simplified th-e tax system, and reduced taxation on the agricultural sector (for a chronology of the main reforms see the apperdix). If the financial sector deregulation and other liberalization measures significantly changed savings and investmnent behavior, that niight explain some of the apparent relative improvement in perfonnance during 1974-84 (figure 2.3). De Melo and Tybout (1986) examined the pattem of savings and investment during 1962-83, finding several patterns that tend to confirm a change of 'regime" after the 1974 reforms. For one, incremental capital-output ratios (ICORs) fell by nearly 40 percent during 1975-S1 relatve to 1967-74. Short-term swings in capacity utilization can, of course, also affect ICOR values, but these averageswere computed over a relatively long period, and there is no other evidence of significant changes in capacity utilization between the two periods. Also, average pnvate sector investment rose markedly after 1974 from a very low base in the preceding period, funded mosdy by foreign savings.

Second, estimation of private savings and investmentfunctions reveals a clear shift around 1974.1The intercept term of the private investment equadon shifted upward significantly after the 1974 reforms and investment responded more significantly to real interest rates, as one would expect after the changes in the regulatory environment. During the 1960s private savings appeared to respond mainly to polices associated with financial repression and to (mostly) exogenous foreign capital inflows, whereas during the 1970s, when there were no restrictions on foreign borrowing, savings were negatively correlated with the real exchange rate. The private savings function also exhibited a significant upward shift after the 1974 reforms when other factors were controlled for. A sttistically significant upward shift in the private investment and savings functions around 1974 tends to suggest a change of regime. However, withi the benefit of hindsight (and in view of the evidence in chapter 8) it does not suggest a permanent acceleration in the rate of growth after the 1974reforms. during source

Itis more likelythat the relative

1974-82 reflected allocaton.

the one-shot

imnprovementin

perfornance

effects of a static improvement

in re-

.

34

EFmCS OFPROTECTONISM ON, SmALLCouNnTv:THE CASE OFURUGUAY

Distributional

acivities,

investment,

and growth

Though it is difficult at the microeconomic level to directly trace the effects of resource misallocation on growth, the evidence points toward a negative effect of distortions on growth. The discussion so far suggests that Uruguay continued to show respectable growth until the mid-1950s despite all the market interventions because it had notyet exhausted the opportunities for import substitution. But the interventions were pervasive and the domestic marketwas small, so the scope for domestic-ledgrowthwas small. Thus, otier factors influencing the turning point in the 1950s deserve attention. One of them is the progressive weakening of the Uruguayan state until the military coup of 1973. The loss of autonomy for policy decisions had a strong impact in an economy whose growth had been built largely on the development of a variety of public utilities. Civil servants were a large and influential group in Uruguayan politics-they rose from less than 3 percent of the population to more than 8.5 percent in 1969.'0 Rama (1991) argues thatduringthisperiodofweakening, the pressures exerted by the three dominantsocial groups-civil servants, manufacturers, andwage earners-intensified. He developsasimpleportfolio model inwhich manuflacturers

choose betreen

owning a finn and investing abroad on the

basis of expected profitability, with profitability negatively related to wages and the terms oftrade. He finds that during the period of economic stagnation from the mid-i950s and to the early 1970s realwages in all but two years were above the hypothetical real wage that would have resulted in an accumulation of capital suffcient to generate zero GDP per capita growth. Profitability and investment were restored frllowing the suppression of wage

councils and tacde union activities under the military rule. This finding supports other evidence, discussed above, pointing toward a shift in pnrvate investment and savings behavior at the time of the 1974 refonns. During the period when the government was weakening, the three social partners seem to have been strong enough to have an effect on economic equilibrium, but not broad-based enough to bear the costs of their activities. The manufacturers group was small, and the earnings of civil servants and unionized members amounted to less than a third of GDP. Thus, the organiations representing each group struggled for larger slices of the same pie rather than striving to enlarge the pie, as they mighthave done had they represented a larger share of the population. That a weakening of the state encouraged further exDloitation of the rent-seeking opportunides created by excessive state intervdntion in the first place in no way provides evidence that a strong state will bring economic efficiency. It is probable, however, that the process of economic stagnation

ProtctienLmand stagnation: an intsprnoav

hiscAry

35

and decline was accelerated by the state's loss of autonomy in decision-making after the early 1950s and that the arrival of stagnation was delayed by a stronger and more independent state in earlier years. Conclusion Uruguay's history of protectionisrn resulted in economic distortions and an inflexible economy that stagnated over a long period. Rent-seeking activities were rampant, and the labor union movement grew strong behind the high protective walls, since an organization having a monopoly on the labor supply could capture some of the rents conferred by protection through higher wages. A substandal opening of the economy followed the liberalization that started in 1973, but the reforms were suspended in 1982 with the onset of the international debt crisis. Occasional, small reductions in tariff rates were made in later years, but these were temporarily suspended under IMP programs in 1985 and 1990, which raised duties 5 percent for revenue purposes. Significant liberalization of foreign trade is the obvious way of diluting the power of interest groups and of diminishing rent-seeking activities, but ithas proved difficult to achieve in a societywhere the leading political groups benefited from protectiorism. With its decision to enter the MERCOSUR customs union with Argentina, Brazil, and Paraguay, Uruguay has committed itself to firther trade liberalzation, particularly in the automobile sector. (For a discussion of the merits of this regional approach to trade liberalization, see chapter 5.) The levels of protection will be jointly decided by the member countres, and Argentinaand Brazil, as the two largest, are certain to have the greatest influence on the outcome. During negotiations-in April 1993, Brazil appeared to be proposing high duties to protect some of its manufacturing industres, while Argentina and the smaller members were proposing lower, more even duties to promote freer trade within the region. For a country like Uruguay, with a long history ofrent-seeking interests, participation in MERCOSUR is likely to improve the credibility of its refonns. At the very least, a commitment to an across-the-board reduction in tariffs according to a timetable agreed on by the four countries should dilute the influence of domestic lobbies in policy decisions. Appendix.

Chronology of reforms, 1949-89

The firstsection provides a chronology of major reforms during 194949; the second section dassifies reforms during 1974-89 by their key area ofimporL

3

. EFncrs or PRoTcEcIoNIsXON A SMALLCOuNrY: THECASE OF URUGUAY

C-rono-og y, 194949

January 1941

Congress approves export and import control bilL Executive branch appoints a comptroller of imports and exports, with authority toprohibitimports thatcompete with national production.

December 1959

Multiple exchange rates for imports are eliminated (the price of foreign exchange is to be determined in the market) and replaced by explicit tariffs. The executive branch is authorized to impose surcharges up to 300 percentofci.f prices, require prior deposits foriimports, and prohibit imports for up to 180 days.

1960

Uruguay joins Latin American Free Trade Area, with status of 'lesser relatively developed" country.

-

September 1960

Presidential decree sets importsurcharges of45 percent, 75 percent, and 150 percent for "luxury" goods.

July 1964

Export subsidies available for up to 20 percent of the f.o.b. value, and imported inputs incorporated into exports are exempt from duties.

1965

Currency is devalued (twice).

1967

Currency is devalued.

June 1968

As part of a stabilization program, all prices including salaries are fixed; any price increase has to be approved by the price control agency; currency is devalued.

1969

Position of comptroller of imports and exports is abolished.

May 1971

Capital goods imports become subject to priorapproval, effectively prohibiting imports.

March 1972

New government takes office. Beginning of transition period leading to reforms. Recognition that system of price controls established in 1968 must be relaxed. Hundred percent devaluation.

Protedtionism andstagnation. aninterpretative

history 37

1972

untilNovemPassive crawlingpegintroduced-pursued ber 1978; creates double foreign exchange market

1973

Militarytakeover. Dissolution of Parliamentandsuspension ofpolidcal actvities.Approvalof developmentplan.

September 1974

Capital-market is opened, and Uruguayans are permitted to hold foreign exchange for the first time. The exchange rate is determined freely for capital transactions, and byacrawlingpegfor trnsactions in thegoods marketL

1974-75

Exportsubsidies are permitted on armassivescale, upon request

October 1978

Commercial and capital markets for foreign exchange are formally unified. The exchange rate is announced 90 days in advance.

December 1978

Tariff reforms are instituted, with a uniform tariff of35 percent and a uniform export subsidy of 5 percent to be achieved by 1985 through a linear tariff reduction.

1979

Uruguay signs the GATT subsidy code.

November 1982

Export subsidies cease, and indirect tax rebates are instituted.

Areas of imp4

1974-89

FNAcIAILMARKZr September 1974

Uruguayan residents can buy or sell assets denominated in extemal currencies withoutrestrictions, leading to de factoconverdbilityof the peso. Ceilings on peso-denominated deposits are raised from 15 percent to 30 percent

May 1975

Foreign investors are allowed to repatriate earnings and capital. Rules on credit-allocation are established.

March-September 1976

Domestic interest rates are effectively freed, with the ceiling raised to 62 percent Rediscount faclities for

38

Emcrs OFPROTErONISMONA SMALLCouNrRY:TnE CAsEOF URIucuAY commercial banks are eliminated. Currency trde is permitted outside commercial banks. The central bank begins to pay interest on legal reserve requirements.

Mid-1977

The 1965 banking law controlling the number of nonbank financial intermediaries is relaxed. (The number - - ofsurh institutions rises from one in 1976 to tventy-three in 1981.) They still cannot offer checking account service and are chiefly engaged in intermediating foreign currency funds obtained abroad (from nonresidents).

November 1977

The dualforeign exchange marketis unified. Commercial banks are allowed to pay interest on cash accounts.

October 1978

Three-month treasury bills, redeemable in dollars, are sold. In effect the central bank is preannouncing the exchange rate (official unification of dual foreign exchange market)-

Early 1979

Finanicial interest subsidies for exports are removed.

May 1979

Subsidized credits from the centralbank to "Frigorificos" are eliminated. The legal reserve requirement is eliminated. Commercial bank reserve requirements deposits in domestic and foreign currency are abolished. The banking tax is abolished (6 percent lender tax and 2.4 percent tax on loans to commercial banks).

FebruarySeptember 1981

To narrow the persistent cross-currency gap in lending rates, thecentra bank offersimplidt exchange guarantees.

COMMODnryAND LABORMARS

October 1970

Legislation establishing domestic content requirements and compensatory exports for the automobile industry is established for the purpose of "learning by doing."

June 1973

All trade union activities are banished by the new military governenL

July 1974

Personal income and inheri tance taxes are removed. A uniform 25 percent tax on corporate net profits is es-

Poetdionism and stagnation: an interpretativehistoy

39

tablished, with exports exempted for up to 50 percent of profits reinvested. Export taxes on beef and wool are removed to compensate for the dedine in world prices. July 1974

Internal prices of nonessential goods begin to be liberalized. At this time 94 percent of the consumption basket (for calculating the CPI) is still controlled, as is 65 percent of agriculture. Some barriers to imports are removed. Compulsory extemal financing for 180 days and prior permission to import capital goods are abolished.

October 1974

To encourgeforeigndirectinvestments, anewlawguarantees the repatriation of profits and capital.

Jauary

Remaining quantitative restrictions are removed.

1975

July-December 1975

Thirteeni percent of items in the CPI consumption basket are deregulated.

February 1976

Prices not part of the consumption basket are liberalized, except those produced under monopoly. Later in the year. another 25 percent of prices in the CPI consumption basket are deregulated.

July 1978

Anew agency (DINACOPRIN) takes overprice settang role,with the objective ofincreasingfiexibilityin setting prices and promoding comppetitionin the economy.

1978

Temporary admissionregime instituted, provding dutyfree access to imports of inputs used in export producton.

August 1978

Another 13 percent of CPI consumption basket prices are decontrolled, as is the meat market.

December 1978

The maximum surcharge (on c.i£ prices) is gradually reduced to 90 percent

February 1979

Tariff reductions are accelerated to prevent 'exaggerated" price increases. There is a return to some price controls (dothing, private schooling).

: - 40

EFFECTrsOF

CouNT.inTHECASEOF URUGUAY PROUCflONaISOrNA SMALL

March 1979

List of goods and services with prices fixed admiinistrat-ivelyis reduced.

September 1979

To fightinflation, tariffs are further reduced and prices liberalized.

November 1979

Tax reforms are put in place, including a uniform 18 commodities, reduction *percentVATfornonessential of social security charges, elimination of 8.4 percent banking tax, and elimination of subsidized credits and tax exemptions for exporters.

June 1980

Car prices are fixed because of the absence of foreign competition. ByJune 1980, 29 percent of prices in the CPI consumption basket are still controlled (16.1 percent excluding price of public utilities). Controlled agricultural prices dropped from 65 percentin December 1973 to 14 percent in December 1979.

1982

The reference price system is established, with tarifrates based on reference prices rather than c.if. importprices when these are lower than the reference pnce.

June 1982

A 10 percent surcharge tax is imposed on all imports.

November 1982

Thepreannounced exchange rate experimentcollapses, and a floating exchange rate is adopted. All export subsidies and the 10 percent surcharges on imports are dropped, with the subsidies replaced by indirect -tax rebates. A temporary tax of 15 percent is imposed on traditional exports. A five-level tariff system is created, with rates ranging from 10 percent for low materials to 55 percent for final goods.

1983

The minimum export price system is established, providing for a moving surcharge equal to the difference between the declared c.if. import price and the minimum exportprice. LEaddition, the tariffrate is applied to the minimum export pnce.

1984

The passive crawling peg is reinstituted, based on a basket of currendes but with no government commnitment

.Protctionism and stagnation: an nterpretativehistory

41

to a preannounced exchange rate. Taxes on traditional exports are reduced to 5 percent March 1985

Re turn to democracy. Unions are allowed. Wage bargaining mechanisms are set up at the sectoral level, and unions begin to play a significant role in manufacturing-

June 1985

Additional 5 percent tariff surcharge is reinposed for all tariff levels for fiscal purposes. (Removed in August 1986.)

Augus t 1987

Tariffs are cut 5 percent for the-two highest levels. Maximum tariff is set at 45 percent

1991

New tariff reform, with a uniform tariff of 15 percent to be achieved by 1999 through a stepwise tariffreduction.

1991

The minimum export price and reference price systems are reformed.

1992

The compensatory export requirements and domestic content requirements are abolished and the duty on assembled cars is reduced to 25 percent The highest tariff is now 24 percent

TRADEAGREEMENTS BmIATERAL

May 1975

Under the bilateral agreement with Argentina (CAUCE), no tariffs or quantitadve restrictions apply for Uruguayan exports to Argentina, except for agricultural and "sensitive" products. For each product covered, there is a ceiling of 5 percent of the previous year's Argentine production. Uruguay allows duty-free imports from Argentina of as much as 60 percent of the previous year's increase in Uruguayan exports to Argentina under CAUCE.

January 1976

Trade begins under the bilateral agreement with Brazil (PEC), signed in 1975. No taiffs on a negotiated list of products, with a ceiling for each product of 5 percent of the previous year's production.

42

EFFECrSOFPROTECTIONISM ONA SMALL CouNTRY:THE CASEOF URUCUAY

May 1985

C? (JCEis enlarged to cover all products up to the 5 percent ceiling. Nontariffbarriers on the Argentine side are removed. The ceiling is set at 2.5 percent of Argentine production for sensitive products and is negotiated on a case-by-case basis for critical"products.

August l986

PEC product coverage is significandy increased. Nontariff barriers on the Brazilian side are removed. An automatic device to adjust the ceilings is set up to allow up to a 30 percentyearlyincrease in some cases, although the 5 percent ceiling remains in force.

March 1991

Argentina, Brazil, Paraguay, and Uruguay sign the Treaty of Asuncion creating the MERCOSUR customs union. All tariffs must be removed by December 31, 1994, following a stepwise reduction scheme. Each country has an allowed list of "sensitive" products for which the external tariffregime remains in force (initially 960 pro ducts in the case of Uruguay). The number of products on the list has to be reduced by a fifth each year. There is no agreement yet on the extemal common tariff.

Notes l. Themajor studies on protection in Uruguay areAnichini, Caumont, andSjaastad (1978) and Favaro and Spiller (1990). For a description of the early stages of protecdion, also see Favaro and-Sapelli (1990). For a broad desciption of Uruguayan economic history, see Finch (1981). 2.Formore detailed accounts of the liberalization measures starring in 1974, see Favaro and Spiller (1990). On the sequencing of liberalization measures, they reach the same conclusions as Hanson and de Melo (1 985), that therc was no evidence that opening the capital account before the current account was a source of Uruguay's difficulties. 3. For example, for the period April 1 to September 30, 1968, the prepayments applied to an importer's imports in excess of 30 percent of the value of his imports in the periodJuly 1, 1966 to Oc tober 31, 1967; for the period October 1 to December 31, 1969, the surcharge applied to imports over 100 percent of imports exempted from pr-epayments in the period October 1 to December 31,1968; and forJanuary 1 to September 30, 1972, to imports over 174 percent of imports exempt from prepayIents during the second half of 1971. 4. Lowerdeposit requiremcnts applied to imports from LAFlAcountries, and from time to time exemptions from the deposit requirementswere announced. Forexample, beginningin February 1969, importsof certain capital goodsand transportequipment for export industries, industries producing goods for mass consumption, labor-intensive industries, and import substitution industries with low levels of protection were exempted from import deposit requirements.

hist Protectionismand tagnaion: an interpretative

43.

5. Observers of the import deposit system often incorrectly referred to it as "prohibitive," but te syster was never entirclyprohibitive, as indicated by a relatively large stock of deposits even when the real cost to importers was highest. It seems likely that the system was prohibitive only forover-quota imports in the categorieswith the highestdeposit requirements. Somc over-quotaimports continued in categorieswith lower deposit requirements. If so, the system operated like a tariff-quota for categories of products with lower requirements and likc a quota for categoneswith higher requirements. 6. The turning points in figure 2.1 are similar to those in de Melo and Tybout Rama (1991, figure 5.1) who identifies twogrowth (1986,figure 1), butdifferentfrom periods, 1935-56 and 1968-81, with stagflation during 1957-67. His break points are the outcome of a maximization of the coefficient of determination of a regression of real GDP per capita on an cxponential time-trend equation. 7. De Melo (1987) gives a short-term macro model in which the level ofeconomic of dcactivity depends on aggregate demand of Argentine tourists and cxpectations valuation account for the capital flight of 1982-83. 8. Data on education levels before 1960 are not available for a large number of countries, so the regression data stat with 1960. 9. The shiftwas detected econometricalyby the technique of recursivc residuals, which has the advantage of endogenous detection of functional shifts. 10. The constitutional amendment of 1951 set a rule for sharing public admninistrationjobs between the two leading parties (three for the wirmer, two for the loser) and prohibited the dismissal of civil servants. Many of the institutional arrangements adopted under this sharing rule greatly reduced public sector efficiency.

References Anichini,JuanJose,Jorge Caumont, and Larry Sjaastad. 1978. La Politica Comercialy la Proteccidn n el Uruguay.Montevideo: Banco Central de la Repuiblica Oriental del Uruguay. Barro, Robert. 1991. "Economic Growth in a Cross-Section of Counties." Quartery Joura

ofEconomicg

106 (2): 407-44.

Barro, Robert andJ. W. Lee. 1992. "Intemational Comparisons of Educational Attainment, 1960-85." Harvard University, Cambridge, Mass. Bl-anchard, Oliver, and Stanley Fischer. 1989. Lectures on Matroeconomics.Cambridge, Mass.: MIT Press. Corbo,Vittorio, andJaime de Melo. 1989. "ExternalShocks and PolicyReformsin the Southern Cone: AReassessment." In G. Calvo, and others, eds., Debt;Stabilation and Development Eays in Memory of Caros5DiazAlandro. London: Basil Blackwell. Ethier, Wilfred. 1993. Modern International Economics.New York- W. W. Norton & Co. Favaro, Edgardo, and Claudio Sapelli. 1990.Export Promotion and EconomicGnrwth.San Francisco, Calif.: Institute for Contemporary Studies. Favaro, Edgardo, and Pablo Spiller. 1990. "Uruguay." In A. Choksi, M. Michaely, and I. Papageorgiou, eds., The Timingand SequancngofT radeLiberzztion London: Basil Blackwell. Finch, H. 1981 -A PoliticalEconomy of Uruguay since 1870. London: Macmillan. Hanson,James, andJaime de Melo. 1985. "External Shocks, Financial Reforms and StabilizationAtternpts in Uruguay during 1974-83. " WorldDevelpmet 13(8): 917-39. IntemationalMonetaryFund (IMP). 1969-79.AnnualRepotonExchangeArrangemnts and Exchange R.stritions and IntanatioFinancial Statistis. Washington, D.C.

44

EFrEcn OFPROTECrIONISMON A SMALLCouNirx THE CASEOF URUGUAY

Macadar, Liis. 1985. "Protccci6n, VentajasComparativas yEficiencia Industrial." SUMA 3(5): 7-59. Melo,Jaime de. 1987. "Fimancial Rceforms, StabilizaLion and Growth under High Capital Mobility Uruguay 1973-83." In M. Connolly and C. Gonzialcz-Vega, cds., Economic Refom and Stabilization in Latin Amcnca New York: Praeger. on Mclo,Jaimc de, andjames Tybout 1986. 'The Effect of FinanciaI Libclization Savings and Investment in Uruguay." Economic Development and Cultural Change. 560-87. M&zzeraj., andJaime de Melo. 1985. "Adjus!imentby Industrial Finnsin Uruguay: 197482." In Vittorio Corbo andjaime de Malo, cds., Scramblingfor Surivmat How Firms Adjusted to the Recent Reform in theSouthen Cone. World Bank Staff Working Paper 764. Washington, D.C. Nogues,J., and R Quintanilla. 1993. "Latin America's Integration and the Multilateral Trading System." InJ. de Mclo and A. Panagariya, eds., New Dimensions in Regional :ntegration. Cambridge University Prcss. Rama,Martin. 1991. "Economic GrowthandStagnationinUruguay.'InM. Blomstrom and P. Maller, eds., Diverging Paths: GComaringa Cen"try of Scandinavian and Lati-n American DevelopmnentBaltimore, Md.:Johns Hopkins University Press. - 1993. "Rent-Seeking Trade Policy: A Time-Series Approach." Policy Research Working Paper 1142. World Bank, Trade Policy Dlivision,Washington, D.C. Summers; R., and A. Hcston. 1991. 'The Penn World Tables (MarkV): An Expanded Set of International Comparisons, 1950-88.' Qyartriyjouimrnalof Economics (May): 327-68. White, H. 1981. 'Consequences and Detection of Misspecified Nonlinear Regression Models."Jowrnal of theAmenican StatwisticaAssociation77:419-33. World Bank. Various years. WorldDevelopmentReport NewYork: Oxford University Press.

Administered protection: reference prices and mtntmum export prices FedericoChanganaqut and Patick A. Messerlin

Because of difficultieswith the formal procedures forimplementing the 1981 antidumpingandantisubsidylaws and the threat of retaliation byother countries, Uruguay sought otherprotectve instruments that would allow a quick response. The reference price system already in place to counter underinvoicing of imports began to be used to take the place ofantidumping and countervailing duty measures. In 1983 a new and more powerful instrument, the minimum export price, was introduced. The two have been applied to some 500 products and are now the major tools of administered protection in Uruguay. Uruguay is not alone in using reference pnces to protect domestic industries and to counter the underinvoicing often triggered by other protectionist measures. Peru and Cote d'Ivoire in the mid-1980s did the same. Reference prices have also been used to reduce the shocks associated with the opening of an economy, as Mexico did in 1985.1 The economic consequences of such administered pricing have generally been neglected in the literature. Our analysis of the effects of this form of administrative protection on the Uruguayan economy shows that the economic costs have two main components. First, reference prices magnify the tariff protection againstimports whose trnsaction prices are below the corresponding reference pnces, generadng distortions of the sort analyzed in traditional trade theory. Second, for each product covered, reference prices substandally reduce the price differentials between imports with prices lower and those with prices higher than the reference price. By increasing the domestic price of the cheaper variety relative to that of the more expensive variety, reference prices are likely to have an adverse effect on quality. Reference price procedures can induce foreign firms to shift their exports to the country toward expensive varieties of goods, induce domestic producers to shift production toward the cheap varieties, and induce domestic consumers to reallocate expenditures toward expensive goods, which have become 45

46

EFFECTS OFPROTECTIONISM ONA SMALLCoUNTrr THE CASEOFURUGUAY

relatively less expensive than before. Thus, this system of administered protection has negative distributional effects on the consumption side and promotes the production of low-quality domestic goods. Resource and welfare consequences of administered minimum prices This analysis of the resource and welfare consequences of reference prices begins with the simplifying-assumption that consumers are interested in dte goods themselves and not in the services they provide. This approach opens

the wayforan analysis of the impact ofadministered protection on the structure of exports and on domestic production. The nextstep is to assume that consumersare interested in the services provided by the goods, that the quality of the goods imported or produced domestically matters to them. This extension permits administered minimum prices to be compared with other instrumnents of protection in their impact on incentives to alter the product mix.

How admninisteredminimum prces work When the declared import price (c.i.f.) is less than the reference price (a floor price fixed by regulation), the official duty is applied to the reference prce. For transactions with a unit price higher than the official floor price, the published tariff rate is applied to the declared shipment price, so the apparent

(or published)

tariff and true (or paid) tariffs are the same. Thus,

the final domestic price (P) of an imported good equals the import price declared by the importer (p) plus the reference floor price established by the Uruguayan authorities

(F) times the nominal tariff rate (t): P-p p+ tF.

If F is less than p, ther p is used for calculating import duties.

An even more powerful protective measure is the minimum exportprice mechanism, which adds to the simple reference price mechanism a moving charge equal tf the difference between the minimum export price and the declared import price (F- p). Under the minimum export price system the domestic price in the importing county would be: (3.2)

P -p + tF (F-p)

-F(

+0.

One way to administer these reference prices is to fix them in nominal terms, without adjustment for foreign inflation, so that their ad valorem equivalent protection is eroded over time. Morocco uses this approach. A

pricesand minimnum carn prices Administeredprotetion:reference

47

second way is to build in a mechanism that allowssfrequent revisions in the reference prices. This is the approach taken in Uruguay and in several other developing countries. W4tfarecostsof the administeredsystem. We assume for now that goods are homogeneous, rather than differentiated by quality, so that the impact of protection on the quality of imports and on the domestic production mix can be ignored. The administered minimum price systems increase the cost of imports and generate the usual distortions expected from tariff protection: domestic production is diverted from exportables to importables, as shown in figure 3.1 for the reference price system. For the one-quality good foreign supply ispW domestic supply, pZS, and domestic demand, D. In afree trade situation, the marketwould clearat W,with aworld price ofp and quantity sold equal to 0L1 . An advalorem tariff (t) shifts the equilibrium to W', where the price isp(l + t) and the quantity sold is 0L1 (ON from domestic suppliers and NI4 from foreign suppliers). Domestic producers receive transfers equal to area a, govenment receives tariffrevenues equal to area c+ c', and consumers experience a netloss equal to areas b + d. Inposition of a reference price (fl on this systemgenerates an effective supply curve ofpZY.The market clears atE, where the price is p + tF,and the quandty sold is 04 (ON2from domestic suppliers and N2L4from foreign suppliers). Since the domestic price is determined by the reference price and Figure3.1 Referencepricesystem Pike

Z

p+tF

;eE

Y

p(l +t)

a

0

N,

N1

Lk

Li

Quandty

48

EFFECIS OFPROTECTONISM ONA SMLLCouNTRr.THECAsEOFURUcUAY

the duty, the system severely restricts competition in the domestic market There is an additional effciency loss equal to areas b' + c'+ d, and domestic producers gain extra transfers equal toarea a'. The governmentcollects extra tariff revenue equal to area c'' but loses tariff revenue equal to areas c'. The analysis for the minimum exportprice system is similar (figure 3.2). With the imposition ofa minimum exportprice, the market dears atL where the price is F(1 + C)and the quantity sold is OL (ONfrom domestic suppliers and hL from foreign suppliers). Domestic producers sell quantity ON,on which they capture rents equal to the sum of the two a areas. The government collects tariff revenue equal to area c + c', which includes the moving charge equal to area c. These revenues are offset by the welfare loss to con-

sumers equal to area pZEWp, which includes the higher prices paid for imports (areas c + c-), the higher cost of the domestic source of supply (the two

b areas), andthe efficiency loss m consumption (the two d areas). The net effect then is indicated by the sum of the band dareas. In addition, because the Uruguayan price remains unchanged when the world price fialls (curve pWshifts downward), the implicit tariff equivalent of the minimum export prnce increases as world suppliers become more efficienL Impact on quaity and domestic specialization

Nextwe assume that goods are differentiated by quality and that consumers buygoods for the services these goods provide. The actual quality ofle

goods

determines the features and longevity of the services provided. In this it is Figure3.2 Minimumexport pricesystem Price

p=F(I +t)

V

F p D .0

N

L

Quantihy

Adm.nisteredprotection:refrence pricesand minimumexpoprtdpcts

49

intuitivelyclear thatminimium pnce procedurescan influence qualityin three ways: they can induce foreign firms to shift exports to the country toward the more expensive, higher-quality varieties; they can induce domestic producers to shift production toward chQaper, lower-quality varieties; and because these procedures lower the relativeprice of the expensive varieties, they can induce domestic consumers to shift their spending toward expensive goods. Thus, this system of administered protection has negative distributional effects on the consumption side and promotes domestc production of lowquality goods. Administered protection may tius getin the wayof a country's achieving an optimalpattern ofspecialization. Itmayinduce local producers to produce goods of a quality range below their capacities (a situation that fits well the Rodriguez 1979 or Krishna 1987 models) as determined by the country's comparative advantage-or even at too high a quality niche. (See the appendix at the end of this chapter fora detailed analysis of the effect on quality.) Estimates of the extra protection provided by administered minimum prices Between 1981and 1989 Uruguayan administered protection covered roughly 500 products and tariff positions a year (table 3.1). As a rough measure of comparison, the United States and the European Community undertook some 200 antidumping actions during the same period. Even if such special protection as bilaterally negotiated quotas in textiles and steel in industrial countries is also taken into account, administered protection in Uruguay appears intensive by world-standards. While these are dearly rough indicators, precise companson that takes into account the size of the import flows involved and the degree of openness of the domestic economies would find Uruguay's adminiistered protection to be high. For nontextile products, the number ofgoods covered rose between 1981 and 1984, and then fell after 1985. At the same time, however, there was a marked shift of goods from the reference price to the minimum exportprice system. For texiles and apparel, coverage remained stable from 1981 to 1987, when it began to fall. Anotherway to look at the coverage of administered protection is through the percentage ofimports affected. Roughly 4 percent of Uruguayan imports, excluding oil, were covered by administered protection in 1987 and 5 percentin 1989. This low coverage is misleading, however, since the very granting of additional protecton to domestic goods under the administeredprice system introduces a systematic bias that leads to an underesdmation of the importance of these mechanisms. The apparent tarifffor the sample of goods under the administered protection examined in this study varied from 50

30

CouNTravTHECASEOFURUCUAY ONA SMALL EmaTs OFPROTECTlONISM

Table 3.1 Scope of administered protection

in Uruguay, 1981-89

(number orproducs cowered) Typecfprotection andproduct

1981 1982 1983 1984

Nolsnreiks ReferencepriCes Mininumexportprims Tranrsferred goods" Subtoal

8

1985

1986 1987 1988 1989

22 30

34 46 80

Yams FabriCs Othertextiles Subtotal

177 105 129 411

177 lO5 129 411

177 105 129 411

177 lOS 129 411

177 lOS 129 411

177 10$ 129 411

177 105 129 411

177 105 104 386

177 105 82 364

Al products

441

491

527

565

565

547

534

515

493

-

Textiksb

-

70 46 116

95 12 47 154

89 18 47 154

70 20 46 136

62 25 36 123

54 40 35 129

54 40 35 129

-

Not applicable.

a.Goodsinitiallyunderrefeencepnicsandprogressively tramslcrred to theminimum exportpie system. b. NumberofNADIitems underthe admninistrative pricngsystem.

S-rct: Nattino (I 989).

percent to 58 percent on average for 1986, and from 39 percent to 45 percent for 1989. The average apparent tariffimposed on all goods imported by Uruguay in 1986 was 29 percent; in April 1989, nominal tariffs ranged from Opercent to 45 percent. Thus, using the number of percentage imports affected by administered protection underestimates the impact of the reference price systems on Uruguayan trade. A betternotion of the impact comes, for exanple, from learning that the value of textiles and apparel products covered by reference prices equals one-third of Uruguay's total value added in manufictured

goods.

Effects of admninisteredprotection The costs of administered protection derive from three sources. Reference prices and minimum export prices magnify tariff protection for selected goods, erode the effects of trade liberalization measures implemented in recent years, and distort the relative prices of cheap and expensive imports of the same item (table 3.2). Theprolection-aug7nentation effect For import transactions at prices below the floorprice, administeredminimum prices are likely to substantiallyboost protection since administered prices affect goods that already Eacerelatively high nominal tariffs (50 to 58 percent in 1986, 45 percent in 1987, 44 to 45 percent in 1988, and 37 to 39 percent in 1989 for a sample of nontextile goods). The true tariffs fTacedby cheap imports are thus likely to be high.

Administered proteedon:referenacpices and minimum exportpics

51

To calculate the real tariff under the reference price mechanism, WFin equation 3.1 is divided and multiplied byp the c.i.f. price of imports: (BY'S)

P=p(1 +tp),

- where , =F/pandmeasures the protection-augmentation effectintroduced -bythe reference price mechanism. The augmentation coeffident ,Bis calculated by dividing the floor price for each item by the average price of transactions cleared at prices lower than the floor price for each item.2The computedaverage true tariffs-are higher than the average apparent tariffsby28.9 percentage points for 1986, 27.6 for 1987, 24.9 for 1988, and 18.1 for 1989. Real tariffs of more than 80 percent are not rare, and some goods have real -triffs of 150 percent or more.5 .For the minimum export price mechanism real tariffs are computed as F(1 + t)/p, where p is the average price (before protection) of transactions

cleared at prices lower than the floor price. Real tariffs arising from the mninimumn export price mechanism are lower than those from the reference price system,althoughsdll substantiaL 20.4points highertlhan apparenttariffs for 1986, 4.1 for 1987, 7.6 for 1988, and 7.5 for 1989. These results seem to show that the minimum exportprice system is less protectionist than the reference price system, but itis the differing coverage of the two systems that is responsible for this apparent contradiction. Byre-writingequation 3.2, itis easy to show that shiftingproducts from the reference price to the minimum export price system increases the level of protection:

(3.2'

P=p± F+ (F-p)

=p(l + tp + (F-p)/p).

All else being equal, real protection is higher for the minimum export protection system than for the reference price system by the difference between the floor price and the import price as a percentage of the import price, (F - p)/p. As a result, simply transferring a good from the reference pnce system to the minimum export price systm leads to an increase in protection if the import price is lower than the floor price, holding the apparent tariff, the transaction price, and the floor price constant. But transaction prices are not likely to remain constant, because the minimum export price system, far more than the reference price system, reduces the incentives for foreign exporters to keep their prices lower than thefloorprice. Underthereferenceprice system foreign exporters can compensate for the protection-augmentation effectwith lower prices. Under the minimum export price system, offering prices lower than the floor price provides no advantage to the foreign exporters because the sale prices in

Table3.2 Effects of administered protection onrealtariffsandprices,selected Items,198649 (percent) Pricecristottion effect (change in rmlatke unitvalue)'

Protection augmentation effect(tanscacdons betow flooprices)

7Tyeof protection andyear

Before After Giobol administered administered Apparent Real Apparent weighted Percentageunwe&ghted Percentage pricesystem pricesystem Percentage tarif'1 tariffc Difference tarifft t1ariff change d tariff change' d(rato) (ratio) changed .Global

Reference pricesystem 1986 48.9 77.8 28.9 1987 44.1 71)7 27.6 1988 42.1 67f0 24.9 1989 38.5 56.6 18,1 Minimumexeport pricesystem 1986 47.9 68.3 20A4 1987 45.0 49.1 4.1 1988 38.1 45.7 7.6 1989 36.4 43.9 7.5 Reference priceprotection fortextiles,$989 Yam 40.0 .47.1 7.1 Fabric Others All texties

Erosion ofJberalizadon effect

40.0 40.0 40.0

55.9 64.7 58.3

15.9 24.7 18.3

57.9 45.0 43.8 39.4

68.5 54.3 51.3 46.9

18.3 20.7 17.1 19.0

69.4 54.5 54.8 44.8

19.9 21.1 25.1 13.7

2.73 3.18 2.93 1.B4

1.65

39.6

1.80 2.03 1.44

43.4 30)7 21.7

50.0 45.0 45.0 36.7

63.2 47.4 47.3 38.5

26.4 5.3 5.1 4,9

61.6 47.1 47.6 40.1

23.2 4.7 5.8 9.3

2.31 1.77 2.65 2.02

1.98 .1.59 2.11 1.75

14.3 10.2 20.4 13.4

-

-

1.71

1A3

16.4

-

----

-

--

2.43 3.23

1.75 2.13

28.0 34.1

-

-

-

-

---...-

applicable. Notav-ailable. Note:Fordefinitions ofthepriceeffects, seetext. a.Ratio ofaverage prices of transactions Wthprices above theadministered minimum pricetotransactions withprices bel-ow tosneprices, computed forallgoods rorwhich transactions datawereavailable. b.Unweighted averages oftheapparent tafrifs imposed ontheselected products. c. Unweighted avenages oft.e realtariffs underadminiistered minihmum pricing, d. Percentage increase ofglobal taurifF overtheapparent tarff. e.Reducton oftherelative unitvalues duetotheRPorMEP systems. Source: Central Bank ofUruguay. -Not

Adminisered pwtetion: referencepricesand minimumweport prices

53

bedetermined byadministeredfloorpricesand apparent tariffs, : Uruguaywill two variables overwhich foreign exporters have no control. In these circumstances the lowest prices that foreign exporters will be induced to offer are close to the floor prices. Thus, they keep for themselves the price difference they would have been ready to offer in the form of a lower import price or to share (illegally)with the Uruguayan importeroruser who maybe a producer. The average augmentation coefficientof all items under reference prices (1.51) is 31 percent higher than the coefficient for all the items under minimum export prices (1.15). Moreover, until 1988 the augmentation coeflicients for items under the minimum export price system actually decreased while the floor prices increased, suggesting that foreign exporters learned quickly to raise their prices. Finally, the results suggest that the ausmentation effect isrelativelyevenly distributed among industries, with no obvious pattern of concentration. The iberaation

erosionefect.In l986 the Uruguayan authorities lowered

nominal tariffs, resuming the process of trde liberalation that had been suspended in 1982. These reductions, however, have probably been undermined by the application of administered protecton, as the following computations indicate (table 3.2). Average apparent tariffs and global real unweighted and weighted (by market share) triffs were computed for items with at least two consecutive years of imports. Global real tariffs are defined as the average of the apparent tariff for items on which transactions take place above the floor prices and of the real tariffs on goods whose transactions take place below the floor pnces. Trade liberalization is reflected in the fall in apparent tariffs, from 58 percent in 1986 to 38 percent in 1989 for goods under reference prices, and from 50 percent to 37 percent forgoods under minimum export prices. The global weighted real tariffs were considerably higher than the app'arent tariffs, however. That difference-19 percent for reference price goods and 5 percent for minimum export price goods in 1989-is a measure of the erosion of the effects of trade liberalization.4 Theprice-distort7ion effect.A rough estimate of the extent of the price-dis-

tortion effect can be derived by comparing annual average relative prices (unit values) of cheap and expensive varieties of import items before and after protection (both tariffs and administered prices). (Transactions in an item below the floor price imposed by the authorities are assumed to be sales of a homogeneous cheap variety of the product imported and transactions in an item above the floor price a homogeneous expensive variety of the product.) The changes (annual averages for all goods) in relative prices after protection provide an estimate of the price-distortion effect attributable

.54

ONA SMALLCouNTRY:THE CASEOFURUGUAY EFFEcrs OFPROnaCbONISM

to administered protection. That effect is substantial (table 3.2). For the reference period 1986-89, relativepricesfell 34percentforgoodsunderthe price system (27 percent for textiles), 15 percent for products under the minimum export price system. This distortion effect is probably underestmated in the case of the minimum export price mechanism, because it induces exporters to stick to the floor price in order to maxinize their rents. Effects on Uruguayan textile and apparelproducers Textiles and apparel under administered protection represent a substantial percentage (roughly 33 percentin 1983) of Uruguayan value added in manufactured goods. Textiles other than yarn are subject to a particularly complex form of administered

pncing. Reference prices for fabrics and apparel

are based on the reference prices imposed during previous stages ofproduction, resulting in multiplicative protection coefficients. This form of administered pricing has a more severe impact on textiles than on other manufactures. For 1989 the difference between apparent and real tariffs rises from 18.1 percentfor nontextiles to roughly 18.3 percentfor textiles under the reference price system and from 7.1 percent to 7.5 percentunder the minimum export price system And effective protection rises with the degree of processing (escalation of protection): the protection-augmentation effect averages 7 percent foryarns, 16 percent for fabrics, and 25 percent for other textile products considered..-That the apparent tariff is 40 percent for all textile goods studied means that the escalation of protection

is entirely the result of administered protection, which constitutes a substantial source of uncertainty and confusion for Uruguayan producers of fabric and other texdle products. The price-distortion effect is also more severe for textiles than for nontextile goods: 30.5 percenton average for textiles in 1989 comparedwwith 21.7 percentforallgoods under the reference price system and 13.4percent for goods under the minimum export price system (table 3.2). Escalation is also apparent: the price-distortion effect rises from 16 percent foryarns to 28 percent for fabrics and 34 percent for other textile goods. A more severe distortion effect for textiles than for nontextile goods is a finding of particular relevance for a. developing country, whose people spend a substantial proportion of personal income on textiles and apparel. Protection against macroeconomic in Argentina

disturbances

and Brazil

The reference price and minimum export price systems are often defended as a means of protecting Uruguay against the transfer of macroeconomic

Adminiterd prtecdion:referencepriea rtndminimum expwopticas

55

disturbances from Argentina and Brazil.The evidence does not support that argument, however, vhichwould require finding thatadministered pricing wasappliedprimarily toimports fromArgentdnaand Brazil. Evidenceshows, instead, thatadministeredprotecdon is applied as much againstimports fom the rest of the world (all trade partners of Uruguay except Argentina and Brazil) as itis against imports from Argentina and Brazil.5 F1k.the eighty-eight nontextile products under admiistered pricing, 'forty three have transactions below the floor price only for exports from Argentina and Brazil, thirteen for exports coming only from the rest of the world, and thirty-two for exports coming from both sources. Administered protection is triggered exclusivelyby exporLsfrom Argentina and Brazil for only 48.3 percent of products, a proportion that corresponcls roughly to the relative importance of trade flows from these two countries in 1986 (38.6 percent of total Uruguayan imports were from Argentina and Brazil). Also, the economic impact of administered pricing is similar for exports coming from Argentina and Brazil and for those from the rest of the world. The magnification of protecdion achieved by administered pricing is on average similar for exports from Argentina and Brazil and for exports from the rest of the world (tabIe 3.3). When all products with transactions under the floor prices are considered, irrespective of the country of origin, the augmentation effect on protection is slightly higher for goods from the rest of the world than for those from Argentina and Brazil, except for goods under the minimum export price system in 1986. But for goods in which only Table 3.3 Uruguay's useof administeredprices on selected imports from Argentina and Brazil compared with the rest of the world, 198649 (rnifjcation of protection) Typeofprotection andyear

AJlprodctsAl trade Agenbna Restof andBrazl thew¶rdb parteis

Common productsa Al)trde Argentina Restof andBrazil theweddb trtnse

Referfcepricesytem 1986

1.63

1.37

1.84

i.50

1.42

1987

1.62

1.53

1.57

1.75

1.61

1.57

1988 1989

1.51 1.46

1.38 1.34

1.68 1.40

1.37 1.39

1.36 1.32

1.60 1.44

Average

1.56

1.41

1.62

1.50

i.43

1.55

1.13 1.09 1.22 1.19

1.15 1.09 1.19 1.20

1.28 1.11 1.12 1.17

1.16

1.16

136

1.28

1.12 1.34 1.48 1.46 1.35 1i.49

1.21 1.09 1.15 1.19 1.16 1.29

1.22 1.47 1.42 1.49 1.40 1.48

1.60

Minimum exportpriceslstem 1986 t987 1988 1989 Average Gobalaverage

1.17 1.34

a. Productswithimportscorringrom bothArgentinaand Braziand the rest orthe world, b. Allnrade partnersof UruguayexcludingArgenrtina and Brazil. Sowre:CentralBankofUruguay.

56

THECASEOFURUGUAY CouNTnY: ONASMALL EFFECIS OFPROTECrIONISM

Argentina

and Brazil or only the rest of the world have transactions

below

the floor prices, the augmentation effect is systematically higher for the goods from the rest of the world than for the goods from Argentina or Brazil-unambiguously so in the case ofthe minimum export price system. The explanation may be that Argentine and Brazilian exporters are more familiar than other exporters wriththe loopholes of the Uruguayan minimum export price system and its capacity to generate price realignments and rents. Conclusion Byincreasing the costs of imports, administered minimum prices generate the usual distortions associatedwith triffprotection. Butadministered protection also creates other ncgative effects that a pure tariff system does not. Administered minimum prices distort the quality content of imports, domestic

production, and exports. Underperfect competition a taniffdoes notchange the optimal quality contentof imports, butan administered minimum price induces foreign firms to upgrade the quality of their exports to the affected market In a noncompetiidve setting the impact of niinimum prices on quality is ambiguous: a minimum price can induce a foreign monopolist to raise orlower quality content While more research is needed on the impact of minimum prices on the quality choices of domestic producers facing stronger competition from upgraded foreign goods, it seems likely that administered mnmimum prices impede a developing country's achievement of an optimal pattem of specalization based on compartive advantage. The reference and minimum

export pnce system affect goods that ac-

count for roughly one-third of Uruguayan value added in manufacturinga substantial share. These mechanisms undennine the effects of trade liberalization, boosting published tuiffrates by 7 percentfor the minimum export price systemn(probably an underestimate) and by 18 percent for the reference price system. These systems also create massive distortions (from 15 to 30 percent) between the relative domestic prices of goodsimported-atprices under and above the floor prices. Appendix. Impact of reference and minimum export prices on quality If goods are differentiated by quality and consumers buy goods for the services they provide, a crucial component of quality is the features and longevity of the servicesprovided. Intuidvely, then, minimum price procedures have three quality-related effects: they caninduce foreignfims to shiftexports to the country toward more expensive, higher-quality varieties; they can induce domestic producers to sbiftproduction toward cheaper, lower-qualityvariet-

pricesand minimumcp:n prices Admiisted pnfkctow reference

57

ies; and they can induce domestic consumers to reallocate expenditures toward expensive goods, whose rlative price is now less expensive. The results are negative distributional effects on the consumption side and the promotion of domestic production of low-quality goods. This appendix refines these intuitive results and extends the literature on-the quality effects of import quotas to cover the quality effects of minimum price procedures. Two questions are examined: What is the impact of the minimum price procedure on the quality of the goods imported, particularly compared with the impact of a tanrffor quota? What are the consequences of the reference pnce and minimum export price systems on the product mix of domestic producers competing with foreign producers of goods subject to these procedures? The competitivecase Foreign suppliers of most Uruguayan imports under reference price orminimum export price systems are likely to face competitive markets. A model suggestedbyRodriguez (1979) can be used to compare the impactofa triff and that of a quota on import quality, with the results extended to a minimum price system (see also Santoni and Van Cott 1980). The results showv thata tarff does not change the optimal quality content ofa physical unit of imports but that a quota and a minimum prce induce foreign firms to increase the quality content of their exports to the country. Under free trade foreign exporters determine the optimal quality content per physical unit they export by maximizing their profits pxq - xi4(q) with respect to quality content, where p is the price per unit of services, x is the numberofphysical unitsproduced, and hkq)is the constant average (and marginal) cost per unit of physical output The optimal quality content qp per physical unit under free trade is thus determined in the long run, where the price per unit of services equals the marginal cost of services:

(3A.1)

pp= k'(q).

Freedom of entry and exit in a competitive market structure implies that in long-run equilibrium firms will make zero economic profits, so that in the aggregate total revenue equals total cost:

(3A.2)

p(.S)S= A(q),

wherep(S) is the inverse of the demand function for imports of services,S =qX the total low of services provided by the goods, and X= l:(x). The long-run equilibrium situation is thus determined by:

59

THEsCAsEoF URcuGAY EFFECTS0F PRoTECTIONISMoN A SMALL.Couwgrny:

th-atis, the traditional equality between marginal and average costs Figure 3A.1 illustrates the model. Figure SA.1a shows the optimal quality contentq with a price per unit of services equial to P , and the total imports of services equal to 5,,. Figure SA.1b illustrates the equilibriumn situation F for the services market. Under an ad -valorem tariff (0', foreign firms maximnize their profits pl- tqxq - xls(q), which yields the optimal quality choice: :'(q). (SAX)

-

p(

=

Under the zero-profit condition the tariff solution yields: (SA.2') (3X3)

p(l

-

pA(q)

0 = h(q)/q, = (q)/q,

showing thatprofit-maximnizing foreign exporters under atariff face the same optimization condition as under free trde wihen they determine thie optimal quality content of theirproducts. They thus keep the sme optimal quality content 9,per physical unit of their exports as under free trade. Keeping q, impliesthatthe price per unit ofserviceu nder a tariff P,isesin proporion in the figure on the right In other words, -a 1= b (i) to the tariff up to tariff does not induce foreign finns to change the optmal quality content per physical unit, butitreduces the total amount of servicesimported from 5, ,(under free trade) toS8T.andthe toralv'olumeof imported goads fromX2,.to24.. By contrast, the introducdion of a quota creates an incentive for foreign exporters to increase the quality content per physical unit. The quota is as.a the tariff. sumed to lead to the same level of physical units imported, This constraint is illustrated by the curve P(qXw, which shows the domnestic price per unit of services as the quality content is changed, 4 being given and fixed. If foreign firmswere to maintain quality ue, they would be able to cost of (q)v (at the margin). At that level chiarge a price pFwhile bearing a sr the domestic price is P, with a rent equal to the difference i,n of imports [-lijdacaruing to quota holders. However, as long as each quota holder regards the domestic price for services as given, it ill pay to order imports Of higher quality content whenever the price is higher than the marginal cost. Foreign suppliers are thus induced to increase ateir revenues by choosing a pe(q) for qQ(at the margin), as shown -higher quality content, q such as p = in figure 3A.la. As a result, as shown by the equilibrium point Uin figure 3A.1b, total imports of services thus rise to Se, wvithSoO>8i.e ihe introducton of an administered minimum price leads to a similar

Administeredprotection:reference picas and minim'umn eA$ofpyiers

59

quality upgrading. The minimum export price mechanism is treated as a specific tariffr, thatis, afunction of the quality contentof the imported good: r= r(q).

(3A4)

For prices up to the floor price, the higher die quality (and therefore unit

price)the. smallerthedifference betweenthe arbitrrminimum export price and the declared impbirt price. tis assumed that dr/dlq<0, because the highier the quality, the lower the spedific tariff. In such a cas-e,-foreign.firms determine the optimal quality content by maximizing their profits [xqd- xh(q) That gives: -xr(q)]

p=

(3A.1

r(q)r

illustrated by the curve ((q) in igure 3A.1a. The zero-profit condition corresponding to free entry imposes: (SA.2-)

p(S)=Uh(q) + r(q)]/ q,

q As in the quota case a condition illustrated by the curve g(q) in flgur SA.la. q)) to pftincrease tq) rquality content. They will increase it - --foreign (3*1~) firms are induced Figure 3A I Determinationof optimal quality content o-seMces -.

P(q

(a)

a

_

-

nt

I

:

()(a

_

_

_

_

_

E

_

u~~~~~~

C q)

.

\

emand

a ~~~~~~~~~~~~~~~upy

D'=W

PF

-;

u

DXor

~~~~h(q)lq

0

(b)

qF

qq qR

Qualitycontent 0 ST SQSR ~~~~~~~~~~~~~(servcelurit)

SFS=qX

60

EFFECsOFPROTECTIONISM ONASMALL CouNTRY: THECASEOFURUGUAY

up to q,F which is higher than q and even q. The total flow of services increases up to SR,with SA>S> SrT.In sum, a minimum price intensifies the incentive to increase the quality content of foreign exports. TzhenoncornpetitiTe case -An altemative scenario is tat foreign exporters are monopolists, a case that may fit for some Uruguayan imports, although competitive markets are more likely in most cases. The results, derived using a model suggested by Krishna (1987), are quite different froomthose achieved under competition. A tariff induces a change in the optimal quality content for the foreign monopolist, and a quotamay lead to alower quality content (see also Das and Donnenfeld 1987). The two following optimization conditions apply to the foreign monopolist's choice between quantity Xand quality q for maximizing profits XP94q) -XC(q):

(3A.5)

XPV(X,q)+ P(X,q) - C(q) =0 7XPQ(Xq)-XC,(q)= 0.

and

The effect ofta quota on quality is obtained by differentiating totally the second first-order condition alone. This gives: (3A-6)

dq/dX=-P./(P

- Cs).

The sign of this expression depends on the sign ofP,x (since the denominator is a diagonaI element of the Hessian-that is, is negative in order to ensure the second-order conditions for a maximum). Nevertheless, Px1may be positive or negative. As shown by Spence, P is negative when 'the marginal value of quality falls as absolute willingness to pay falls, that is, when the average value attached to quality exceeds the marginal consumer's valuation" (1976, p. 419). As a result, a quota can induce a decrease-notan increasein the optimal qlualitycontentof thegoods exportedby the foreign monopolist. The minimum price case can be easily introduced to Krishna's model by restating the profit function as XP(Xq) - XC(q) - Xr(q). The new first-order conditions for maximizing profit are:

A-x,Xzq) +P(Xq)-C(q) (3A.5 )

XPq(Xq)

-

XC (q)

-

- r(q) =O x.rq) = 0.

and

The foreign monopolist can react by changing the optimal quality content, taking the quantity as constant; by changing the optimal quantityproduced, taking quality as constant; or by changing both the optimal quantity and

pricesand minimum exaot prices Administrd protection:reference

61

quality produced. For comparing the quality effects of the two trde measures, the bestapproach is to consider the same level of restrictions in termis of physical units. The corresponding comparative statics require differentiation of the second first-order condition and give:

(3A.62)

dq/dX--P

/ (P

-Cq

-r)

The sign of dq/dXis the same as in equation 3A.6. Nevertheless, the value of dq/dXin equation 3A.6' can be higher or lower than in equation 3A.6 since it depends upon the sign of r As a result, a minimum price can induce the foreign

monopolist

to amplify or reduce

respect to the changes undertaken

the changes

in quality contentwith

under a quota.

The welfareeffects The Rodriguez (competitive) and the Krishna (noncompetitive) modelsyield different results in terns of optimal quality content. But both models yield on theweltAre impactof the tariffor the quota. similar-and unusual-results In many cases (and in all cases in the Rodriguez model), a quota is shown to be unambiguouslysuperiorto a tariff, contrary to the findings of the traditional trade literature of the -welfare superiority of tariffs over quotas. We find, however, that the two types of models have limitations that diminish the robustness of this unusual result. The discussion here focuses on the competitive Rodriguez model because it seems a better fit for the Uruguayan economy (and because it leads to more striking results). The proof of the welfare superiority of a quota over a tariff goes as fol(q,> qT= q) and lows: a quotaincreases the optimal quaity contentperunit so allows for an overall quality level of imported services higher than that

allowed by a tarifffor thesameamount ofphysicalunits. The welfare gain is illustrated by the area TUBCin figure 3A.lb. Of this gain, TUEaccrues to domestic consumers and EUBCto import quota holders. This expansion in service quality comes at a higher unit cost of production (relative to those in the tariffcase); however, as illustrated by area CDPFC in figure 3SA.b. Rodriguez shows that the net welfare gain TUBC- CDPJFCis equal to the area tuf in figure 3A.1a and is thus positive. The same analysis can be applied to the minimum price case. A minimum price is said to be welfare improving (that is, less costly) relative to a ariffand a quotain thatit expands the services provided by the same amount of goods (as shown by TRB'C) -and welfare reducing in that it entails additional costs (as illustrated by CDPAC) How robust are these unusual results? They depend in both models on one crucial assumption; that there is no reaction by domestic firms." When -

.62

CouNmrv:Tim CA.s oF URuGuAY Em,FcTsOFPROTECTIONISMi ONA SMAULL

compa-ring the free trade and tariffcases in the Rodriguez model, forinstance,

this assumption iswithout consequence, because foreign firmnskeep the samne optimial quality content in both cases (this is not always true for the Krishn-a model). As a result, domiestic firms have no incentives to modifyrthe quality content of their own production sold in dom-estic markets. But the same -assumption creates a bias when comparing the free trade and tariff cases on the one hand with the quota and minimum price cases on the other. Domes? tic finns have incentives to modify their quality con tent if foreign firms have decided to change their quality content. That domestic firns will face stronger competition in the marke't niches with a high quality content implies adjustment costs for the domestic finns. These adjustnent costs. should be added to the welfiare costs of the quota or reference price, when comipairing these two cases with the free trade and ctariffcases. Notes I. At the beginning of the Mexican tradecliberalization in 1985, following theclim4nation of most quantitative restrictions, the perc-entage coverage of production of tradables under refe-rence prices increas-ed from 18 percent to 25 percentand remained at this level until the restrictions wverecompletely eliminated in 1987. 2. Theccomputations are based on data from- Uruguay's central bank, which permits separating transactions cleared above and below floor prices. The method of averag-ing prices for the two types of transactLions has the advantage of avoiding the risk of overestimaLing protection by focusing on the transactions with the lowest prices. Indeed, the price differentials between the twvotyes of transactions are a multiple of 2 and 3, a "normxal" figure by any standard. 3. Several reference prices were applied for television sets. The reported results are based on the lowestreference price. Thus, there is a possible underestimnation rather than a'i. overestimation of the augmentation effecL 4. Itis interesting to note that therecis nosign of catching up in the reference price system in the sense that the differentials between the apparent and global tariff-s are stable over time. That is not the case in the minimum export price system. As before, this result may be caused by the pricing behavior the system triggers among foreign suppliers. 5. This discussion deals only with non texti'le goodls.Textiles are subjeCt to 'indirect" imports when Uruguayans purchase these goods in Argentina and Brazil. That these indirect imports are generally considered to be significant (although there is no estimate) implies that the computations done in table 3.1 would be upward biased for textiles. 6. As Krishna mentions, another im portan t limitation of these models is that they consider one good, not a product line. For an analysis of a product line, see Krishna (1984). Reactions bydlomestic finns to foreign firms' decisions can be dealtwith through game theory. Das and Donnenfeld (1989) provide such an analysis within a duopolistic market structure, showing that a trade instrument's impact on the firms' decisions depends on the location of the firms in the quality spctr-um. In the c-ase-where foreign firxm.produce the high-quality variety, the domestic firm responds by upgrading qual-

Administered protection:ieferenceprices and minimum expoMprices

63

iy and expanding sales, but the total quantity sold to donmesticconsumers declines. The global impact on welfare is thus ambiguous, because the negative impact on tle thelose in tlehigh-qualityniche-iscompensated consumersurplus-dominatedby to somc degree by the increase in the profits of the domestic monopoly.

References Das, Satya P., and Shabtai Donnenfeld. 1987. 'Trade Policy and its Impact on Quality of Imports: A Welfare Analysis.fJourndl of lntrnaional Economics23: 77-95. . 1989. 'Oligopolisdc Competidon and Iternational Trade: Quantity and Quality Restrictions."Jourmna oflnternationalEconoamics27: 299-318. Krishna, Kala. 1984. Protectionand th ProductLine. NBER Wori*ingPraper 1535. Cambridge, Mass.: National Bureau for Economic Research. ional .1987. 'TariffsVersus Quotas With Endogenous Quality. "Joumnazoflnt Economics23: 97-122. Mecsserlin, Patrick A. 1990. "Antidumnping Regulations or Procartel Laws? The EC Chemical Cases." Policy Research Working Paper 397. International Trade Division, Iterntational Economics Department, World Bank, Washington, D.C. Nattino, Elbio. 1989. "Instrumentos Antidumping: Recomendaciones para Reducir la Protecci6n Diferencialy DiscrecionaL".Centro de Estudiosdela Realidad Econo6mica y Social (CERES), Infornzsy Propwstas l: 1-4. Rodriguez, Carlos A. 1979. 'The Quality of Imports and the Differential Welfare Effects of Tariffs, Quotas, and Quality Controls as Protective Devices." Canadian JournaTl of Econonics12(3):

439-49.

Santoni. GJ., and T.N.Van Cott. 1980. "mnportQuota.s TheQualityAdjustmentProbTem.' SoutenEconomicJournat46(4): 1206-11. Spence, AM. 1976. "Monopoly, Quality and Regulation." BellJournal ofEconomics (Autumn):

417-29.

Domestic content restrictionsand compensatory export requirements in the automobile sector WendyTakacs

Uruguay's complex system of protection and controls is perhaps best illustrated by the set ofpolicies that until recently regulated the automobile sector. These controls included tariffs on imported vehides and parts, domesdc content requirements, and compensatory export requirements. Domestic content requirements mandate a minimum percentage of domesticvalue added or domestic components for products soldwithin the country or provide strong incentives to substtute domestc for imported inputs. These measures are by no means unique to Uruguay. Many Latin American countries, Canada, and Australia have used such regulations as part of an industrialization strategy based on inport substitution to foster the development of domesticmotor vehide and pards industries (see Lloyd 1973; Baranson 1969;andMunk 1969). These protective regimes often resulted in the emergence of domestic assembly operations: firms would import kits or sets of components from abroad and combine them with domesdcally produced components to produce finished vehides. As the limits of import substitution were reached and interest shifted toward export promotion, many countries superimposed export promotion policies on the underlying domestic content requirements. Brazil (Mericle 1984) and for a time Argentina (Jenkins 1985) offered tax exemptions and waivers of inport deposit requirements if certain amounts of output were exported. At one dime Argentina even linked approval for expansion of domestic output to fulfllhent of quantitative export targets. In other countries, such as Mexico and Uruguay, exportpromotion took the form of more explicit compensatory exportrequirements. Finns importing kits or finished vehicles had to have exports equal to a specified percentage of the value of those imports (Bennet and Sharpe 1985; World Bank/UNDP 1990)In I990 Uruguay's protective regime for the motorvehicle industry consisted of all these elemens Fully assembled vehidles were subject to a tariff of 40 percent. Fmns importing assembled vehicles (completely built up or 64

Protedionthe

automobil sectr

65

CBU) were also obligated to exportautomnobile industry productsrith avalue added in Uruguay equal to 70 percent of the f.o.b. value of the imported vehicle. Firns assembling automobiles in Uruguay from imported kits (completely knocked down or CKD) were required to pay a tariff of 10 percent on the kits and comply with domestic content requirements and compensatory export provisions. For passengervehicles assembled from kits a minimum of 20 percent of the value of the product had to be of national origin. At the minimum domestic content of 20 percent, compensatory exports of 60 percent of the f.o.b. value of the kitwere required. Domestic content above the. 20 percentminimtum could be traded off for compensatory exports ata ratio of I to 2. For example, for a 5 percentage point boost in domestic content to 25 percent, compensatory exports could drop by 10 percentage points to 50 percent.' Amarket in the credits for compensatory exports developed, with vehicle assembly firms in need of compensatory exports paying parts exporters to credit their exports to the assemblers. Observers report that assemblers paid 5 to 15 percent of the value of the invoices for these export credits, with the average being about 8 percent, though payments reached as high as 30 percent in times of very high domestic demand for automobiles. A model of domestic content and compensatory

export requirements

A model was developed to investigate the distortions, costs, and transfers among groups resultingfrom the combination of domestic contentand compensatory exportrequirements in the automobile industryand to derive some rough estimates of the costs and transfers arising from this protection regime. The model simplifies byignoring differentiation among types ofcomponents and assembled vehicles, the trdeoffbetween domestic content and compensatory exports, regulations on levels ofminimum disassembly of components in kits, and prohibitions against importing certain components. It further assumes that domestic content and compensatory export requirements are binding (that is, that less domestic contentwould be used by assembly firms if there were no domestic content requirements and that exports of componentswould be lower in the absence ofcompensatory export requirements). The model also assumes that the country imposing the domestic contentand compensatory export requiirements is small, so that the world prices, or import prices, of assembled automobiles (PA*)and of auto components (Pe*) are both given..Aperfectly competitve domestic components industxy manufactures components, and a perfectly competitive domestic automobile industry assembles automobiles from imported and domestically produced components. The country produces a single type of finished or assembled automobile, madebyassemblingagiven number W"ofcomponents.

66

E.z-rs

OFPROTErCONISM ONA SMALLCouNrvR THECASEOFUzucuAy

Differences-among components are ignored3 Finished automobiles can be imported, subject to a tariff and compensatory export requirements. The domestic assembly industry is subject to domestic content requirements and compensatory export requirements for a package of imported components, called'a kit. Equilibrium prices and quantities in the markets for assembled automobiles and for components are determined jointly because they are tied together by normal input-output relationships and by the domestic content and compernsatory export requirements. Domestic marketfor assembled automobiles Importation of assembled automobiles requires compensatoiy exports of a certain proportion xA of the value of the imported automobiles. The value of compensatory exports required perautomobile would be xAPf= J%qC,where qc is the quantity of components that must be exported per imported finished automobile and Pc is the domestic price of componens If the components sell in the world market at PJ*, the cost to the firm of the required compensatory exports would be (P-PCS [ -PC )/PC]cxxAPA7.An ad valorem tariff rate of tA on automobiles increases the cost of the imported vehicle by the amount of the duty. Thus, the cost ofan imported automobile is PI*(' + Q + XAl(4 P? )/&&*. In the long run a perfectly competitive industry would be expected to make zero economic profits, so that in the long run the total cost of the imported assembled vehicle equals its price. Then: (4.1)

PA G

+ tA + XA [(PC

PP

)

AS

where PAis the domestic price of assembled vehicles and P. of components. Given the world prices of assembled automobiles and components and the domestic price of components, equation 4.1 deternines the domestic market price of assembled automobiles. The quanltity of automobiles sold (domestically assembled from kits and domestic components, QA'plus already assembled, MA) is then detennined by the domestc demand for finished automobiles: (4.2)

D(PA) = MA± QA

If there is an upward-sloping supply function ofvalue added in domestic assembly operations, the quantity of automobiles that firns are willing to assemble increases as the value added per unit (VA) increases: (4.3)

VA=V(Q)

V' positive

Protectionin the automobilesector

67

Thevalue ofan automobile assembly kitat world-.n'rketprices is ot(1 -8)Pc* where S is the proportion of total components that must be of domestic origin.3 The ralue of compensatory exports required to import the kitwould be x,cot(i - S)Pc* = PCqc, where xA is the value of the imported kit that must be compensated by exports of automobile industry products. The tariff on ki tsincreases the cost of'kits to the domestic assembly industry by the anount of the tariffpaid per kit, or a(l -. ) Pc*tK.The cost of domnesticcomponents would equal a8P . The assumption of a perfectly competitive assembly industry implies that unit cost equals price in the long run, so: (4.4) P = a.(l -5)P*[l

+ t,+ x,;(

P 0*)/PCI+ aSJ%+ V(Q4 ).

Equation 4.4 can be thought of as the long-run inverse supply curve of the assembly industry. Itis constructed byadding vertically the domestcvalue added required to induce fimns to assemble various quantities of vehicles, the cost per vehicle of domestic components used as intermediate inputs (OSP), and the effective cost of the imported kit, ac(1 - 5)PC*[1+ t,+ xJ(PC -P*)/RPC Equations 4.1 through 4.4 determine P, MA, QA,andDA,given Pc, A*, PC'JA' Ix' XA, X,, s, and &TIhe market for assembled automobiles is depicted graphically in figure 4.1. The price of automobiles to consumers is PA,which lies above the world price PA* by the amount of the extra costs imposed by the tariff tAPA* and the compensatory export requirements on assembled automobiles, X4 [ (PC -PC*)/AP4IPAAt this price consumers would demand D vehides. automobiles for assembled Figure4.1 Domesticmnarket s

Prce CC~~~(l4)Pcx K

A

PA

X

A*'=aCPC*+V(Q,,

S

P~/P~ P

as(P Pc*)+a(lAxr *)P O/P~X)jP(

QA ^

,

DA

^*

Qusnuy~'~A

C.

~~A~A

A_

DA---------tD

68

EFFCmS OFPRoTECrTONISM ONASMALL CoUNrRy:THECASEOFURUGUAY

Figure4.2 Domesticmarkeat for automobilecomponents Price 0

p

SC Fur 42Dmsi

act

fo auoobl

D.mDonents

PC

x.
-- QCM

|-6 QA(PC

qe

/PC -

^+

Quantiy

The supply curve of the domestic assembly operations is shown by curve wA, which is the vertical sum of the supply curve under free trade (SA*),the increasein assembly industry costs pervehicle due to the tariff [aC(l-S)-JP*t1, and the increase in costs attributable to the domestic content and compensatory export requirements [oc8(Pc - Pc*) + t(l - 8) xj(Pc - Pc*) Pc*tP9] At aprice of PAthe domestic industrywould produce Q 4 automobiles, with the difference between the quantity demanded and quantity supplied made up by imports M,. The various elements of the protective regime influence the market for assembled vehicles in potentially contradictory ways. The compensatory export requirements and the tariff on imports of assembled vehicles drive up importer costs and thus the price of the finished vehicle to the consumer. Higher prices on finished vehicles encourage greater output from domestic assembly operations. On the other hand the domestic content and compensatory export requirements for kits and the tariff on kits discourage domestic assembly operations by increasing input costs. This additional cost shows up as an upward shift in the supply curve for vehicles assembled in the country. Domestic market for components In a perfectly competitive domestic components curve for components

(4.5)

industry the inverse supply

is:.

p= S(Qc)

'po5iiive

Protedion in the automobile sector

69

where Qis the quantity of components supplier; by the domestic industry. Demand for domestic components arises from three sources: the demand for components to be combined with imported kits for domestic assembly (oSQ); the compensatory exportsrequired for the importation of kits (22); and compensatory exports required for the importation of assembledvehides (XA). Thus:

(4.6)

QC= XA

M +a8QA. +

Given compensatory export requirements P. XA = xP*M (1 - &)Pc*QA, equation 4.6 can also be expressed as:

(4.7)

and P, X'=

xA

QC=xAMA(PA*/PC) + X9(1 -8) QA(PC*/Pc) + aoQ.

Equation 4.7 can be thought of as the demand curve for domestic components. Equations 4.5 and 4.7 deternine PFand QC, iven Q(APS PlC XP, sA c, and S. Equilibrium in the market for components is depicted graphically in figure 4.2. The supply curve is shown by S.. The demand curve for components, D., is the horizontal sum of the demand for components by domestic assemblers,4 the demand for components for export to satisfy5compensatory export requirements for imported kits, and the demand for components to satisfI compensatory export requirements to import assembled vehicles. Equilibriumnoccurs at the price-quantity combination Pcand Qc.Under free trade domestc producers would be forced to match the world market price of components P1t and at thatprice components production would be Qc* The domestic contentand compensatory exportrequirements boost demand forcomponentsproduced within the country, driving up price andproduction. Because of the link between the markets for domestic components and assembled vehicles, equadons 4.1 through 4.5 and 4.7jointly determine the dependentvariables P, PC}DA,MA, Q., and Q,C given world market prices PA* and PC*and policy parameters t, tx, x xx,, ct, and 8. Equilibrium prices and quantities in both markets are determined simultaneously. Transfers and net cost of protection Under free trade and ignoring transportation costs, world market prices of assembled automobiles and components would prevail in domestic markets. In the components market quantity Q would be produced at the price Pc*7 Domes tc assembly op erationswould have access to components at this price, so their supply curve would be the vertical sum of the value added per unit

70

THE CASEOFURUGUAY COUNT.RY: ONASMALL OFPRoTwrioNIsM EFFECTS

This required for each output level and the cost of component inputs, czPI*% supply curve is shown by S* in figure 4.1. At the free trade price P,' the domestic industry would assemble. Q *units, consumers would purchase D units, and MA*assembled vehicles would be imported. The costs of the protective regime can be assessed using this free trade equilibrium as a benchmark. Domestic content and compensatory export requirements for imported kits increase input cc:ss to assemblers and push their supply curve up to SA.by an amounL equal to a8(c- Pc*) +ia(1 - S) x. (P%-Pc*)Pc*/Pc(distance ytin figure 4.1). The tariff on kits shifts tde supply curve up furtherbyan amount equal to a(l-8)Pc*L (distance by).Together, domestic contentrequirements, compensatory export requirements, and dic tariff shift the assembler's

supply curve from SA*to SA.

Thewelfare costs ofthe protective regime can be measured as the effects of distortions in the markets for assembled vehicles and components. The cost to consumers is shown by area adek, the reduction in consumer surplus as compared to free trade. Of this, area defis the deadweight loss in consumptdon due to higher prices for assembled automobiles. Area bdfiuresembles tariff-equivalent revenue, in that the height of the rectangle is the difference between domestic and importprices and the width is the number of vehicles imported fully assembled. But only area bdwxrepresents tariffrevenue collected on imported vehides. The remaining distance wfcan be thought of as the implicit tariffon assembledautomobiles imposed by the compensatory export requirements. Area xwrjhrepresents the tariffequivalent revenue associated -withthe increase in importers' costs because of the compensatory export requirements. Part of this increased cost is a transfer to domestic components manufacturers and part is a deadweight loss due to the increase in relatively high-cost production in the domestic components industry. The nature of the transfer and loss can be seen by noting that area xwtjh equals area pqrs in figure 4.2,5which represents the extra cost of producing pq units of componentswithin the country rather than imporuing them (the area under the components supply curve above the world market price Pc*) and the transfer to component manufacturers in the form of higher shortrun profits (equal to area pqv) for the extr outputpq (= ax^M). Area pqrs also can be thought of as the value of the subsidy to components exports generated by the compensatory export requirement on finished automobiles. The area represents the difference between domestic andworld marketprices of components (qr) times the quantity of compensatory exports needed to allow v'ehicle imports (pq). The subsidy is a transfer from domestic consumers to components exporters, using vehicle importers as intermediaries. Compensatorv export requirements for kits and domestic content requirements shift the assembler's supply curve up by the distance yl (from SA

-PJotecionin theautombile sector

71

to ),so thatat the resulting level of domestic assembly operations QA,area zybzrepresents the extra cost of components to assemblers attributable to these restrictions. Part of this increased cost is a transfer to domestic manufacturers of components and part is a deadweight efficency loss. Area zyin in figure 4.1 equals area opsuin figure 4.2.fAreavstrepresenLs the deadweightloss due to the excess of domestic production costs over the price at which the comnponents could have been purchased in the world market, and area Pnutu represents a transfer to domestic components manufacturers in the form of higher profits for the extra output op)produced because of the domestic contentand the compensatoly exportrequirements.Area qpsgcanbe thought ofas the value of the subsidy to componen ts exports due to the compensatory export requirements for kit imports. It is in essence a transfer from domestic consumnersto components exporters, using assemblers as intermediaries.? Area nlik represents an increase in profits to domestic assembly operations due to the net effect of the entire protective regime. Area ldirepresents aproduction deadweight loss, the exta cost ofassembling QA- QA*vehicles within the country rather than buying them in the world market at PJ,*. The net welfare effect of all of the restricdve measures is a loss to consumers equal to area adek broken out as follows: ' idk a transfer to domestic assemblers of automobiles. abyz,a transfer to the government in the fonn of tariffrevenue on kits. * zyin, a transfer to domesdc components manufacturers (equal to area opatu) plus a deadweight production loss (equal to area vst). 3 def a deadweight loss due to die distortion of consumption in the market for assembled automobiles. Chi,a deadweight production loss duie to high er-cost assembly of au to3 mobiles domestically. revenue on automobiles. * bdwx, twriff * xwft; fuss to consumers that is in part transferred to components mar afacturers (area pqv) and in part deadweight loss (area qrsv). IgnoinLg transfers, the net effect is a consumption loss of defand producdon deadweightlosses of 1hiin the assembly industry and qrtin the components iF4dustry. Tlhe transfers from consumers to the domestic assembly and the domestic components industries show that both industries can gain from the protective regime, though in some respects their interests are contradictory. For manufacturers of domestic components the more restrictve the domestic content and compensatory export requirements, the greater the gains. For dbmestic assemblers the more demanding the compensatory exportrequireholding 6 and xK ments forinports of assembled automobiles (the higher x,A, constant), the greater the gains, but the more restrictive the domestic content requirement and the compensatory export requirement for kits (the

72

COUNTRr. THE CAsK. 0F URuGuAY EwwrTs oFPROTEnONISM ONA SMALL.

higher Band xl., holding xconstant), the smaller the gains. Thus, assemblers need not gan on balance from the regime. Sufficiently high domestic content requirements and compensatory export requirements for kits (8 and xK)relative to compensatory export requirements for imports of assembled automobiles (xA) could result in a net loss for domestic assemblers, discouraging rather than encouraging domestic assembly of automobiles. It is not surprising, then, that domestic assemblers argued that the compensatory export requirements for assembled vehicles were low relative to those for kits (Sevel Uruguay, S.A. 1989). Calculation of transfers and costs The net welfare losses and transfers sketched out in-figures 4.1 and 4.2 can be calculated based on the actual values of the policy paraneters tA'ic and x4, the average values of x1 and B chosen by assemblers according to the tradeoff available, and the prices, quantities, and premiums paid for export invoices for compensatory exports. (The method of calculating these losses and transfers is explained in the appendix.) Uruguayan data and an assumed range of values for supply and demand elastidties were then used to calculate a range of estimates of the welfare effects of the protective regime (table 4£1). The market for motor vehides shows a loss to buyers of vehicles of $70 million to $80 million a year, depending on the assumed elastcties. The estimated transfer from buyers of Table 4.1 Gains and lossesfrom automobile industry protection, 1989 (milionsof U.S.dollars) -rs=.08 TIOA= 1

X=I =

Gainorloss Consumer loss (adek)

Transferto assemblyindustry(nilk) Efficiency loss (assembled automobiles) (def+lht) industry(oqtu) Transfertocomponents Efdiiencyloss(components)(qrt) Totaltransfertoproducers (nrd+oqw) Totalefficiencyloss (def+Ihi+qrr) Consumer cost per unitassembled(US$) loss per unitassembled(UW Efficiency -= Premium on do6mt

easfidty. - 1= Demand

X=0.08 710-=0.5

79.9 43.2 23.4 4.5 0.2 47.7 23.6 6,834 2,019

n =0.08 Ila,= I

e =2

70.5

79.9

43.2

31.8

14.0 4.5 0.2 47.7 14.2 6,028 1,214

28.0 4.3 0.4 43.0 28.4 6,834 2,427

rnpcmnents.

[or assembly. =Supplyelastsict foxrcomiponents. E;Supplyelasticity b Seeligtes 4.1 ar. 4.2 ;!fora,es corresponding to eas costelemenL istedat thetop of eachcDohr.ai ri catashownin parameters &ipufre: Autha'sawlcbtns basedon assumed 4A 1. -appendbtable

Protedion in tle automobik sector

73

vehicles to the domestic assembly industry ranges from $32 million to $43 million, and the effidencylosses in the assembledvehicles marketrange from $1 4million to$28 million. The components marketshows an estimated transfer to producers of about$4.5 million and estmated cfficiency losses of$0.2 million to $0.4 million. The estimates of transfers and losses in the components industry seemnsmall and are probably underestimated, for reasons explained below. These estimated costs and transfers are large both in absolute terms and as a proportion of total income and production in Uruguay. The welfare impact of the protective regime for automobiles can be put in perspective by noting tat the estimated cost to consumers of the protective regimnewvas equivalent to about 1 percentof Uruguayan GDPin 1989, or to about$6,000 to $6,800 per automobile assembled in Uruguay-some two to two and a half times per capita income in 1989. The estimates should be considered illustrative and tentative for a number of reasons. First, they are based on a range of assumed elasticties of demand for automobiles in Uruguay and assumed elasticities of supply of components and assembled vehicles by Uruguayan producers. The elasticities are reasonably close to those estimated for other markets and to those frequently assumed in the absence of actual estimates, but they are not estimated on the basis of Uruguayan data. Second, the percentage of the invoice.values paid to domestic components manufacturers for their export Lh c>ces is based on verbal estimates made by individuals familiar with the industry or involved in administering the system, rather than on observed data. Third, the model assumes homogeneous output ('assembled automobile") and homogeneous input ("components"). This obvious oversimplification biases estimates of the protection and transfers to the assembled vehicle sector upward and those to the components industry downrward. Overestimation of protection to assembled vehicles arises because fully assembledimportedautomobiles tend to be more luxuriousand expensive than the automobiles assembled in Uruguay, yet the loss to consumers is based on percentage price increases using the average import price as the base. Un.erestimadon of pro tection and oftransfers to the components industry arises because the industry will tend to export components that are the most competitve on the world market Thus, the premium on export invoices measures the relatively small deviation between domesdc and world prices for the most competitive components, and not the undoubtedly much larger deviation for the least competitive components. Fourth, the assumption of competiton in the automobile industry may be unrealstic for Uruguay. In 1989 there were about ten motor vehicle assembly firms, with two of them accounting for about a fourth each of the

74

ON A SMALLCouNrRvTHECASEOF URUCUAi EFFECrSOFPROTECTIONISM

domestic market. With this market structure firm behavior might not correspond to that predicted by the competitive model. Yet studies of the U.S. automobile industry indicate thatfinn behavior does not deviate significantly from competitive market behaavior (see Dixit 1988; Krishna, Hogan, and Swagel 1989). The model presented here is intended to clarify the protective effects of and interactions between the domestic content and compensatory exportrequirements and provide rough estimates of the order ofmagnitude of the potential costs of the protective regime. Amodel that captrred strtegic interactions among firms could provicle a richer analysisand possibly more accurate estimates of the true costs. Fifth, preferential trading arrangements with Argentina and Brazil create distortions that also cause underestimation of transfers to the domnesutc components industry and of the efficiency losses caused by the domestic content requirements. The impact of the protective regime on the components industry isvery sensitive to varationsin the deviations of domestic prices of components fromworld prices. These deviations are measured in the model by the premium paid by importers of assembled vehicles and kits for export invoices to credit toward their compensatory export requirements. The inclusion of exporw shipped to the protected markets ofArgentina and Brazil under preferential trading arrangements pushes the estimated average premium for export invoices below the premium thatwould be necessary to ship only to the world market This underestimation of the premium is not a problem in measuring tie cost imposed upon Uruguayan automobile buyars by the compensatory export requirements. In the absence of the preferental trading arLarLgerm.ents,however, de: costs could be much higher because compensatory exports would have to rece-.; an implicit subsidy high enough to make them competitive in the world market.8 Underestimation of the premium paid for export invoices will also result in underestimation of the effect of the domestic content requirements, because the rclevantprice differential is that between world market and domestic prices. Estimates of trnsfers to the components industry and efficiency losses from protected components production are very sensitive to this parameter, making it liklely that the method applied here underestimates the degree of protection to the componentis industry, perhaps significantly. Conclusion The model developed to analyze the impact of the protective regime for automobiles indicates that domestic content requirements, compensatory export requirements, and triffs on finished vehicles and kits kept vehicle prices high, maintained high-cost domesic production of both vehicles and components, and transferred large sums to special interest groups.

Protctiorn in the automobik sector

75

Domestic assembly operations were affected by the various elements of the protectiveregime in different, andpotentallycontradictory, ways.Higher prices on finished vehicles encourage greater output from domestic assembly operations, but tariffs and domestic content and compensatory export requirements for kit imporLsdiscourage domestic assembly activityby increasing input costs. The net effect could be either to discourage or to encourage domestic assembly operations. In Uruguay the protective regime appears to have encouraged domestic assembly,so part of the consumerloss from higher prices represented a transfer to the assembly industry and part represented an efficiency loss due to increased domestic assembly.ofvehides ata higher cost than the price of assembled vehicles in the world market. Domestic components producers were unambiguously helped by all elements of the protective regime, which increased the demand for components produced within the country and drove up both price and output in the marketfor domestic components. The triffon kits provided component producers with protection from imported components, the tariff on assembledvehides helped maintain domesticassembly operations anddemand for components, the domestic content requirements forced domestic assembly operations to use domestically produced components, and the compensatory export requirements for imports of both finished vehicles and kits increased demand for domestically produced components for export, acting as an export subsidy to the industry. The protective regime imposed substantial costson consumers and encouraged the allocation of resources in relatively high-cost activities. Compensatory export requirements and tariffs drove up the price of finished vehicles to consumers. The consumer loss was in part a transfer in the form of higher profits to the domestic producers in the assembly and components industries and in part effidency losses due to the distortion of consumer decisions and producdon leveLsand to the extra cost of producing components within the country hat could be obtained at lower costin the worldmarket. The protective regime imposed a loss on Uruguayan consumers of automobiles of from $70 mfllion to $80 million a year and transferred from $43 million to $48 million to domestic assembly operations and components manufacturers. The estimated net loss to the country ranges from about $14 million to $28 million a year- These estimates are tentative, however, because the model assumes a competitive industry, excludes some aspects of the protective regime, ignores the differentiation of automobiles and components, and does not adjust for trade distortions arising from preferential trade anrangements with Brazil and Argentina The govemment of Uruguay dismantled the protective regime for automobiles in 1992. Compensatory export requirements and domestic content requirements were abolished, and the tariff on assembled vehicles was reduced to 25 percent, 'with a further scheduled reduction to 20 percent in

76

£Fvsc'r oFtrPOecTIoNJsm oNA SMAL.LCOUNTRY.Tuz GAsRor URucuAV

January 11993. Temporary provisions through December 1992 allowed components producers to import assembled automobiles free of duty up to the -valueof their exports. This measure was designed to compensate components producers for their losses during the transition period once the protection regime was fuillydismantled; The industry had been protected for decades, and such transitional nieasures allow components producers a little tlime to adjust to the new regime. An alternative method would have been. to phase-in c-hangesby gradually reducing taiffs and domestic content and compensatory export requirements according to a preannounced schedule. Care nee&; to be taken with such an approach to avoid inadvertently increasing the degree of effective protection to the assembly industry by, for examnple,phasing out domestic content and cornpensatory export requirements on kits fiaster than those on finished -automobiles. Doing so -could temporarily increase the costs,of protection and provide false signals to domestic industry about the direction of adjustmnenL Appendix. Calculation of trAnsfers and costs of the protective regime for motor vehicles Te consumer loss is area adek in figure 4.1. Let2rt= CPc-Pc*)/IPcbe the premniumpaid for invoices to be credited as compensatory exports, and TlDAbe the elasticty of demand for assembled vehidles. Then, given that: (4A.1) (PA-?A*)i

PA*(,tA + xAlt)

and (DA*- DA)

PA*Q(,+xA70, =nDA,,(DA/IPA)

Area adek =(PA - PA*)D.A+0.5 (PA-PA*)(DA* - DA) = 'PAQA

(4A.2)

=P*D(i+

XAIE[D+

x'rrfl

O-5(D* -D0)

+ 0.SniDAlt+ xiifll

The deadweight loss in consumption, area deft would be: -DA) Area def= 0.5[PA*(4 4 + xATt)](DA* =0.5 [ PA*(tA + Xjt)]f2,qDA/PA (4A.3)

~~= 0.5PA*DAQA+

XA7t)kjfA4

In calculating the gain to the assembly industry (area nlik) and the deadweight loss to the economy from excess assembly operations (area lAO)it is useful to note that the height of each of these areas. equals the net impact of the restrictive regime, that is, the -amount, net of cost increases, by which revenue per unit exceeds free trade revenue. Let this distance (nk = hi) be designated N:

JProfedton in Meautomnobile sector

(4A.4) N PA* tA + AcA

x(

)tP*-a7P

C(

77

)xcCc

LetoC aPc*/PA*be the share of component production in the final cost of a finished vehicle. Then:

(4A.5)

N1=P¶*tA+ xA7cr aU -68)Q. xgr7)+ &c/ (I

-T).

Let t-heelasticity of the supply of vehicle asembly with respect to value

added be zsA, and note that (QA 4(tAG6)

QV)=s&JQ/ (PA*(I -ac)]N. Then,

Area lki =0. 5N 2 eMQ/(PA*(1

-Ca)].

The gain to the assembly'industry, area nlik, can be calcul-ated as area ni/dk less area 1h4 or:

(4A.7)

Area nlik=

N05Ne

QA/[A

(l-)]

Let the elasticity of supply of components be s., and 1{,=P.,Q be the value of domestic components production. The deadweightloss from excess production in the components industry is shown in figure 4.1 as area qvt

Are-aqrt = 0.59P%-P*) (Qc- Q2) (4A.8)

= 0.5 Vtcc r2

The tra-nsfer to the domestic components industry as a result of the protective regime is area oqu which equals area oqruless the deadweight loss: (4A.9) Area oqtu= (P

c)

c

. VcEx7r2 = Vcr -0.5 Vce.j 2 .

Application of the model to the Uruguayan protective regime requires data on quantities assembled, sales, import price of assembled vehicles, deviation of components prices from world prices, the ratio of components cost to the final price of a finished vehide, and the value of components production.

Tentative estimates of the magnitude of the welfare effects of the protective regime were calculated using the data presented in table 4A.], assumned combinations of elasticities of demand of -0.5 and -1.0 and elasticities. of supply of 1.0 and 2.0, and equations 4A.2, 4A.3, 4A.6, 4A.7, 4A8, and 4A.9. T'he results appear in table 4.] in the main text.

78

EFFECmS OFPROTECrIONISM ON A SMALLCoUwRmY. THE CASE OF URUGUAY

Table 4A. I Data used in calculations of impact of domestic content and compensatory export requirements VariabeVdue Mesue it

0.08 Percentage ofvalueof invoicepaidto exporterof components forinvoices to be caedited for purposes offulfilling compensatory exportrequirements. (Source: verbalestimates of individuals intenvewed.)

tA

0.561 Price-increasing effectofthe40 percenttariffon assenbled automobiles, taking intoaccountthatthetariff-indlusive priceiste baseforthe irternaltax(impuesto especifico interno)of 15percentandthetax-indusive priceisthebaseforthe22 percentvalue-added tax tA- .40(I.15)(1.22). 0. 165 Price-increasing effectofthe 10percenttariffon its, whichapplies onlyto approximately 14percent of importedkits(importsfromArgeninaandBrazilare exemptfromdutyunderbilateral tradingarrangements), takingintoaccount that kitsaresubject to anmntemal tax of 12percentanda22 percentvWalue-added tax: tK=

0.14(.1)(1.12)(1.22)+.12(1.22).'

-A x,,

0.70 Compensatory export requirementfor assembled vehicles.

xK

0.53 RNtioof compensatoyexportsto kit importschosenby firms(basedon data from two firmsrepresenting 27% of the market). 0.235 Averagedomesticcontentratio chosenby domesticassemblyfirms(basedon datafrom two firmsrepresenting2796 of the market).

-

v

$8,086 Unit valueof importedassembled vehides(1989),categoresA, C, D. E. andH (Source: Amarade Fabricantes de Automotores).

QA

11,690 Number of vehiclesassembledin Uruguay(1989),categoriesA, C, 0. E. andH (Source:Cimara de Fabriates de Autornotores).

-2-D 12,237 Number of vehiclessoddin Uruguay(I1989),calcuatedasQA plus529 assembled vehiclesimported. a

Vc

0.621 Shareof componentscostin finalcostof assembled vehicle(weightedaveragcof costsof domesticcomponentsand kitsasa shareof finalsalespricesfar four Uniguayanassemblyfirmsrepresenting 70 to 80 percentofthe industry,using unitsassembled in 1989asweights). Valueof component production,calculated withinthe programas:0.53(valueof kit imports)+ 0.7 (valueof finishedvehide imports)+ 0.235 (valueof assembled vehidessales= ,').

a.The internaltax on kitsis indudedinthecakulation of theprice-increasing efect ofthetarif on kitsbecause it directlyaffectscostsandthussupplyin theassemt4industry.In thismodelthedegreeof protectionto components manufacturers isrneasured by the prermiurn onexportiwokes,whichisassurmed to measure the percentage difference betveendomnestic andworld narketpricesfor components.

Notes 1. Data on the actual mix of conpensatory export and domestic content requirements are available for two firms representing approximately 27 percent ofthe market in terms of the number ofvehicles assembled in 1989. Compensatoryexports averaged 53 percent of kit imports and domestic content averaged 23.5 percenL

Protection in the automobik sector

79

2. This approach is similar to that of Grossman (1981) in that it assumes that doncstic and imported components are perfect substitutes. Mussa (1984) develops a model in which domestic and imported inputs arc less than perfectly substitutable. 3. Grossman (1981) shows that the effects of domestic content requirements will vary according to whether they are defincd in terms of physical quantities or valuc added. Uruguay's restriction is similar to a restriction in quantity terms because it uses servaluations, by weight, for the components. If P, is the set valuation byweight for the component ofwcightW, P' is the set valuation by weight for an assemblcd vehicle of weight WA,and &' is the required ratio of the valuc of domcstic components to the value of output, then the demand for components to be incorporated in domestically assemblcd vehicles (cquivalent to aSQA in the text) would be (PU WAIPC W4)S' Q4 4. Domestic content requirements arc calculated using the weightof the components and officiallyde tcrmnined prices for thc various types of componen ts. This method implies that highcr prices for domestic components will not affcct the quantity of domestic components demanded, so given Q,, t2laedemand curve for components to be combined with kits will be vertical. The use of administratively determined prices avoids the situation in which higherprices fordomestic components increase thcvalue added domestically and thus decrease the quantity of components necessary to fulfill the requirement. 5. Area xwfA = xA[ (PC - P*) /PCPI Ml = D,(P 0- Pf) = area pqr 6. Area zyln = [a8(P- Pc*)+ a(1-)xK(Pc - PC*)(Pc"/Pc)]Q = (PC-~PC) [a6Q+ V (1i- 8)X,QA(PCIPr)] =

(Op)

7. It is interesting to note that multinational firms at times explicitly recognized the subsidyelement to components exports. Bennettand Sharpe (1985,p. 186) report that Chrysler arranged for its Mexican assembly operations to transfer funds to its U.S. asscmbly operation to cover the extra cost of Mexican parts. S. Some of the costs of the Uruguayan automotive protective regime are also being paid by users of components ir. Brazil and Argentina, who are paying higher than world market prices for Ulruguayan components, and by the Brazilian and Argentine governments, in the form of forgone tariff revenue.

References Azzini, Juan Eduardo y Asociados. 1979. La Indusffa Autootriz en el LUguay. Cmanra Montevideo: Asociaci6n Nadonal deArmadoresdeVehiculosAutomotores. de la Industria Automotriz. Baranson, J. 1969. AutowtiveInustnis inDeudeping Cozunbis. World Bank Staff Occasional Papers 8. Washington, D.C. Bennett, Douglas C., and Kenneth E.Sharpe. 1985. TransnatWonalCorporatonsvesus the State: hePuiiiicaE&onmy oftheMxaicanAutomobileIndustry. Princeton, N.J.: Princeton University Press. Camara de Fabricantes de Automotores. 1989? 'La lndustriaAutomotriz en Uruguay: Un ENsfuezo sin Pausas.' Pamphlet Montevidco. del Uruguay). CENCI (Centro de Estadisticas Nacionales y Comercio Inteacional 1989. Manutal rdcticodeUImporlador.13th ed., voL 2. Montevideo.

S0

EFmES OFPROTECTIONISM ONA SMMU± CouNrrn THE CASEOF UrUGUAY

Corden, W. Max. 1971, The TheoryofProtection.Oxford: Clarendon Press. Dixit, A. 1988. 'Optimal Trade and Industrial Policies for the U.S.Automobile Industry." In R.C.Feenstra, ed.,Empi icacMethodsfoIlntmationaI Tradt Cambridgec,Mass.: MIT Press. Grossman, Gene M. 1981. "Te Theory of Domestic Content Protection and Content Prcfcrence." QuartrlyiJournalof Economics96(4): 583-603. Jenkins, Rhys. 1985. The Rise and Fall of the Argentine Motor Vchicle Industry.' In Rich Kronish and Renneth S. Mericlc, eds., ThePoliticalEconomy of de LatinAmerican MotorVehicleIndushy. Cambridge, Mass.:MIT Press. Krishna, K., K. Hogan, and P. Swagel. 1989. 'Thc Nonoptimality of Optimal Trade Policies: The U.S. Automobilc Industry Revisted, 1979-1985." Paper presented at thc National Burcau of Economic Research and Cen tcr for Economic PolicyResearch Conferencc on EmnpiricalStudies of Strategic Trade Policy, Cambridge, Mass., October 13. Lloyd, P.J. 1973. NontarifDistortios ofAustralianTradc Canberr: Australian National University Press. Mericle, Kenneth S. 1984. 'Te Political Economy of the Brazilian Motor Vchicle Induty." In Rich Kronish and Kenneth S. Mericle,eds., ThePoarticalEconmy of theLa in AmericanMotor VYe/ideIndustry.Cambridge, Mass.: MIT Press. Munk, Bernard. 1969. 'he Welfare Costs of Content Protection: The Automotive Industry in Latin America."Journal ofPolitiadEconomy77: 202-16. Mussa, Michael 1984. 'The Economics of Content Protection. NBERWorking Paper 1457. National Bureau of Economic Research, Cambridge, Mass. Sevel Uruguay, S.A. 1989. "La Industria Automotriz en Uruguay: Lineamientos Gencrales y Principales Indicadores de su Actividad." World Bank and INDP (United Nations Development Program). 1990. "Uruguay. Trade liberalization and Economic Efficiency."ULNDP-WorldBank Trade Expansion Program Country Report 5. World Bank, Trade Policy Division, Country Economics Dcpartment, Washington, D.C.

Gains and lossesfrom bilateral nts wt trading arrang Argentina and Brazil Jaime de M4elo,Claudio Montenegro, and Wendy Takacs

Uruguay is sandwiched between two giant neighbors, Argentina and Brazil. Compared to Uruguay, the two countries are economic giants, and they offer the prospect of virtually unlimited outlets for Uruguay's products. Uruguay's trade with them has oscillt,ted widely over the years, but in the last two decades accounted for about a third of exports and 40 percent of imports. Communications and transport with the two countries are also excellent, making Argentina and Brazil 'natural" trading partners for Uruguay. UJruguay's economic policy toward Argentina and Brazil reflects a strong desire to tap these large mark3etsand reap the benefits of trade with these neighbors. The case for economic integration with Argentina and Brazil extends beyondintegrationofgoods markets. Laborand capitalmove briskly betveen Uruguay and its neighbors as well. Conditions seem right for formnation of a currency area, except for one hitch: the macroeconomic instability plaguing the thiree countries, and the large swingsin real bilateral exchange rates. (The impact of regional instability on growth is explored in chapter 8.) UTruguay has tied to walk a fine line by pursuing dose long-term economic ties with Argentina and Brazil while also isolating its economy from the macroeconomic instability of its larger neighbors.' Preferential trade polices have been at the center ofmuch of Uruguay's regional developmentstrategy, beginningwith theLatnAmericaFree Trade Area (LAFTA) accord of 1960 and culminating in the treaty of Asuncion in 1991, an agreement to create a customs union amorigArgentina, Brazil, Paraguay, and-Uruguay (Tratado pan la Constituci6n de un Mercado Comuin, or MERCOSUR) . MERCOSUR is still under development and so may benefit from insights gained from an exarninatiorn of the most significant precedent to this evolvingarrangement the bilateralpreferendal trdeagreements withArgentina (ConvenioArgendno-Uruguayo de Cooperaci6n,Econ6mica,

81

82

*

Emecn oFzPRoTECrIONISM oN A,SmuALL Coumrav THiE CAsE. oF URuG:UAY

or GAUGCE)and Brazil (Protocolo de Expansi6n Gomercial Uruguay-Brazil, or PEG) negotiated in the mid-I 970s. Whether acounrtty should pursue a preferential approach to trade is hotly debated because the issue of gains and losses is difficult to setde. The choice between a bilateral and a mnultilater-alapproach to trade policy is especially imnportant today, with the resurgence of interest in regionalism, of which MERCOSUR is just one example. Looking at how GAUGE and PEG were designed and implemntendz and at whether they benefited the participants can therefore have aipplications beyond Uruguay. A small country entering into a customs unio(n w.ith large neighbors stands to gain significant market access, especially if the partners raise trade barriers against the rest of the world. If the analysis shows no g-ains in the case of GAUGE and PEG, that would provide fuirther evidence of potential problems in using regionalism as a development strategy, especially if the preferential agreements are limited to specific: prducts rather than made across the board. The analysis of bilateralism begins with a primer on the economics of preferential trading arrangements that defines the concepts of "trade creation" and "trade diversion." It moves on to the details of Uruguay's bilateral arrangements with Argentina and Brazil and the intraregional trade pattem that has resulted. A model is used to identify the.sources of static gains and losses under GAUGE and PEG, and data on unit values at the product-line level are used to establish wthether these arrange ments resulted in trade creation or trade diversion. For a. broader perspective, a gravity mnodel is used to explore whether. the gamut of regional -arrangements between Uruguay -and its neighbors resulted in a noticeable increase in intaregional trade. While the analysis is crude and does not lead to a direct identification of welf-are g-ainsand losses, it suggests th-at Uruguay gained little fr-om GAUGE and PEG. Under GAUGE Uruguay imported goods from a relatively high-cost supplier and exported goods in which it had, for the mnostpart, no comparative advantage. While the -analysisof unit values of export products under PEG showed no evidence of rents to Uruguay, despite the presumption in theory for such rents, Uruguay probably gained on balance from PEG because it permitted expansion of exports in which Uruguay had a comparative adv-antage. The basic economnics of preferential

trading arrangements

A regional approach to trade liberalization involves preferential treatment of some trading partners, unlike unilateral trade liberalization, which reduces tradebarriers across trading partners in -anondiscriminatory m-anner. GAUGE and PEG exempted only selected products from tariffs in what was in effect a partial free trade area. Each member maintained its own tariffs against

G0M4i1and lOSSes finn bik&lat tradng-a~rwagemenis uith ArgenAi#ddnd Brazl

83

nonmembers. By contrast the treatyoanMERCOSUR calls for fonrmationof a customsunion with a common external tariff. The -basic insight on free trade areas goes back to Viner .(1950), who introduced the concepts of urade creation and trade diversion. The simnplest model to Hiustrate these concepts is a three-country, two-good model. Consider three countries, A, B, C, potential partners in a free trade area. Let A stand for.Uruguay, B for Brazil, and C for the rest of the world. Figure 5.1I shows the general equilibrium inipoi-t-demand curve for countryA (MA) and the horizontal export-supply curves (PI,and P6 ) for the two parmner countries. Suppose that two goods are traded and that each,partner imports a different good (a strong but necessary assumption for a free trade area between A and B to have any effect). In the absence of trade intervention, the gain from trade (compared with the no-trade situation) for counta-yAis given by area ag~i.Now if A imposes a nondiscriminatory tridff, *, on all imports, country A wilI continue to import from' country C, the low-cost supplier. Reduced gains from trade are now equal to area abk If Aforms afree trade area with B, the cost to consurners wivllbe less for duty-free imports from B than for imports from C, which are subject to the duty,itoueth so imports ocpof will now come from the partner. There will be trade creeradecetoan rdcivso.Thsipls ation, equal to -area bd4 as the price paid by consumers fals by efand imports expand to point d. But there will also be trade diver-slbn,equal to areafek; as A's terms of trade worsen and tariff r'evenue falls. Area cbefrepresents a gain to consumers but a loss in tariff revenue, which cancel each other. Whether Figure 5.1 Trade creation and trade diversion triestw Supose good Ftareaadedand

hat ech

prmerimportsa

Rdativeprice a

(I +t)Ph

bn

As

nafter free traadeagreement

pb

Asskissafter free trade agreement

A MA

84

Emcrrs oF PRoTEcrloNIsMON A SMALL CouNrRy:THE CASEOPURUGUAY

the free trde areawillraisewelfare in A (and in the world asawhole) depends on which of the two effects-trade creation or trade diversion-dominates. Viner's analysis also points out the conditions under which a preferential approach to trade liberalization is more likely to raise welfare: * The larger the initial tariff in the sector. * The lower the tariff on nonpartners, an important factor in the creation of MERCOSUR - The smaller the difference in the cost of imports from the partner and the rest of the world. * The more elastic A's import demand curve. (On this last point: a large proportion of Uruguay's imports are concentrated in internediate and capitalgoods. forwhich the elasticityofunport demand islikelyto be low.2) The literature on customs unions shows that it is possible to design a welfare-augmenting free trade area and thata preferential trade agreement can be superior to a free trade area. But whether in practice preferential trading arrangements have increasedwelfare is an empirical issue. The consensus about integration schemes among developing countries is tat the agreements have generally been only partially implemented (usually on a product-by-product basis rather than across-the-board) and that designing and implementing

schemes that provide equitable compensation

for part-

ners has been difficult? (In the case of CAUCEand PEC, as is demonstated below, the welfare effects of preferential arrangements depend on which country gets the rents when the ceilings on preferences are reached.) With few exceptions the literature on customs unions also indicates that a unilateral approach to trade liberalization is superior to apreferential one. The one important exception is the theoretical case (first discussed by Wonnacott and Wonnacott 1981) of a world divided into a small number of trading blocs with free trade among members and high trade barriers against nonmembers. For a small country, the market access provided by bloc membership may be superior to the nondisciminatory route to trade liberalizadon. Whether this scenario is relevant for Uruguay is difficult to assesssince it depends on tade policies in Argentina and Brazil as well. All that can be said is that it is less relevant now than in the past, since both Argentina and Brazil have liberalized their tade regimes in recent years. Bilateral arrangements and the coupon quota system Uruguay has alonghistory of close economic tieswiti Argentina and Brazil.4 Notal

the anrangements have dealtwith trade preferences. Many recent ones

involve economic cooperation, mostly with Argendna, to establish common policies forportandtelecommunication acdvties (table 5.1) . Arrangements that establish common standards, regulatory frameworks, and practices re-

Gainsand lossesfrom bilateral radingairangementsuwi Argentina and Brazil

85

duce transaction costs, lead to the exploitadon of economies of scale and scope in transport, and reduce barriers to trade stemming from tansport costs and differences in regulatory frameworks. Clearly, such cooperation is welfare augmendng. Less cleariswhether thatis the case for Uruguay's trade policies extended on a preferential basis. Table 5.1 Bilateral agreementsof Uruguaywith LatinAmerican countries Mcaineld

Nrmeof theagreenent

Country

Dateandpbce

Tradepreferences

Tratadode Asunci6n: MerradoCornundelSur (MERCOSUR)

Argentia. Brazil, Paraguay

March26, 1991 Asuncid6n

Protocolode Exparisi6n ComerdalUruguay-Brazil (PEC)

Brazil

June1, 1975

CornerdoArgentina-Uruguay Argentina tdcnica deCooperaci6n (CAUCE) Economiccooperation (poicyind planning)

August12, 1974

Acuerdoparala Realizaci6n de Estudios Relativas a la Construcci6n del Puente BuenosAires-Colonia

Argentina

February 22, 1985 Buenos Aires

Acuerdossobre Poliica Comninen MatenaPorttnria; Arnpliaci6n de Telecomunicaciones

ArgehnTna

Febuary22. 1985 BuenosAres

Actade Coloniasobre Integraci6n Fsisa

Argentina

May19.1985 Colonia

Pcuerdossobre Sistema de ControlUnicode Fronteras; Poritica Cornmn en Materia Portuaria; Anpliaci6nde Telecomunicaciones.; Incremento de IaRedComun de Gasoductos, Estudios para la Construcd6n delPuente Aires-Colonia Buenos

Argentina

February 2, 1985 Buenos Ares

Mornorttdumsobreel Brazil Desarrolode la Cuencade IaLaguna Meony de Recursos Aprovechamniento HidricosdelRi)oYaguar6n

August13, 1986 Brsilia

Argentina Actade Coloniasobre lntegacid6n Fisica y Agropecuaria Complementaid6n

May19' 1985

Source: Peyes Chavez (I 988)andNcgues andQuntanilla (1993).

86

EFFEC=s OFPROTECrIONISM ON A SMALL CouNmTv: THECASE OFURUGUAY

MERCOSUR --Arger.tina and Brazil initiated the MERCOSUR arrangement in 1989; Uruguayand Paraguayjoined in late 1990. This new approach to integration will substitute automatic across-the-board elimination of tariffs and nontiff barriers for the previous sectoral approach to integration. MERCOSUR is a commitnent to trade goods and services free of trade barriers as well as to ensure factor mobility among member countries. The timetable for tariff reductions sauto-matic, srting '"i'x the stecpest tariff cLitsinjune 1991 (47 percent) and progressing with gradual reductions every six months, until all tariffs are removed

by December

1994.

While it is too early to venture an assessment, several elements of the agreement suggest a need for caution. First, though the across-the-board -approach to tariffreduction is preferable to the product-by-productapproach (see discussionbelow), exemptions from the-automatic tariffreductionswere permitted for many products (especially for Uruguay and Paraguay) to ease adjustment.) Second, there has been considerable disagreement among partners about the level of the common external tariff, which as ofApril 1993 had notyet been agreed on. Brazil, the largest partner with the most protective trade regime, seems to want a relatively high common external tariff. Third, the macroeconomic instability in the region has impeded implementation of the agreemenL In September 1992 Argentina adopted a temporary surcharge of 6 percent on all imports, ostensibly as a buffer against Brazil's recent strong real exchange rate depreciation against the Argentine peso.

CAUCEand PEG The oil crisis of 1973 and the dramatic slump in foreign demand for beef in 1974 as a result of European agricultural policy led to renewed interest in Uruguay in regional initiatves to encourage trade with its neighbors. The authorities believed that opening Uruguay to the world economy (see chapter 2) would not be sufficient to deal with the new adverse external environment. They looked to bilateral trading arrangements with Argentina and Brazil to help reduce Uruguay's chronic trade deficts with its neighbors by reorienting exports to the region and increasing capacity utilization. The CAUCE and PEC agreements of 1974 and 1975 were to become an integral part of Uruguay's shift to an outard-oriented development strategy and reduced antiexport bias. The bilateral agreements lasted throughout the 1980s, until they were superseded by the MERCOSUR agreement at the end of the decade. Under CAUCE (and its extension in the Act of Colonia in 1985), Argentina allowed duty-free entry of Uruguayan products of up to 5 percent of

Gainsandw sesfiom bilatl

tratdingarangementswitlsArgenina and Brazil

87

Argentine domestic production of each productin the previous year. Minerals, agricultural goods, and textiles were excluded. Uruguay was to enjoy unilateral tariff conce.ssions for five years. After 1979 these concessions were to be complemented by Uruguayan tariff reductions.7 The limitations of CAUCE are apparent from a closer inspection of the concessions themselves. Rules of origin under the Act of Colonia classified a goodasaUruguayan productonlyif less than .50percentofits contents came from third countries. Uruguay's concessions covered capital goods made or assembled in Argentina only if there was no similar production in Uruguay. OtherArgentine goods were exempted fron tariffs if theywere classified as industrial products and had a low duty in Uruguay's import tariff system. Argentine goods whose share had exceeded 30 percent of Uruguay's imports between 1982 and 1984 were not eligible for tariff exemptions. The bilateral agreement with Brazil under PEC involved far more reciprocity. Brazil offered trade concessions on 1,406 items, Uruguay on 1,009 items. Rules of origin also required domestic content of 50 percent of the final value of the item. In an effort to balance bilateral trade, corrective neasures were caled for if the bilateral trade balance for goods included in PEC showed a deficit of more than 10 percent of the total value of wade. PECwas revitalized in 1986 through the treaty of Brasilia (see table 5.1). Uruguayan export products eligible for preferential treatment were placed into seven groups. Five had quota limits in value terms of $0.3, $0.5, $2.5, and $5 million (1986 dollars). One group had limits specified in volume or value terms, and anothergroup was exempt from limitation altogether. Goods could be reclassified into-a higher group-including the no-limitation group-if exports reached 90 percent of the quota limits (see description below) for three consecutve years. Butimportant loopholes remained. Each partner could limit imports if they surpassed 5 percent of usimilar" domestic production in the previous year. The quota limits under CAUCE and PEC were enforced through a coupon (cupO) system. In Uruguay the Chamber of Industries administered the system by giving out coupons to meniberswhowantedpreferential treatment for their exports to Brazil orArgentina. The coupons were generally given to the more established and influential firms. Unused coupons were to be returned to the Chamber for redistribution, but, in practice, the-ywere traded in secondary markets. Trade patterns under CAUCEand PEC Though macroeconomic instability in the region led to considerable fluctuation in Uruguay's pattem of tradewithArgentina and Brazil, trade shifted progressively toward Brazil during the 1970s and 1980s (table 5.2). CAUCE.

88

FEmCaSOFPJOTECnoNIsM ON A, Svms COuRrRnTHECAsEoFURGUCJAY

and PEC did not eliminate Uruguay's chronic trde defidt with Argentina and Brazil. During the 1980s Uruguay had a cumuladve merchandise trade deficit of $34 million with Argentina and $204 million with BraziL There are some fimdamental differences in Uruguay's pattems of trade with Argentina and Brazil Almost three-quarters of Uruguay's exports to Brazil are agricultural and natural resource-based products, whereas more thant three-quarters of its exports to Argentina consist of manufactures. The pattern of Uruguay's exports to Brazil is much more in line with Uruguay's pattem of commodity exports to the rest of the world and so with its comparative advantage. That the composition of its exports to Argentina is quite different suggests that CAUCE allowed Uruguay to export prodtvcts to Argentina's protected mark-et thatwere not competitive on theworIdmarket. Data on the percentage of total exports by industry going to Argentina or Brazil provide further evidence of different patterns of exports to Brazil and Argentina Export concentration indices for 1987 based on trade classifications at the three-digit industry level show thatArgentina was the major outletfor motor cars (90 percent of total exports), paperproducts (70 percent), electrical machinery (48 percent), and "other chemicalproducts (37 percent). Brai was the major outlet for exports of barley (100 percent), fertilizer (89 percent), cerealpreparations (88percent),rubber (85percent), dyeing and tanning (83 percent), organic chemicals (80 percent), plastics (68 percent), and rice (46 percent). Table 5.2 Uruguay's exports under CAUCE and PEC, 1975-88 (mrrdiorsof U.S. do&ars) PEC xportpas

4UCEe*om as a Year

1975

1976 1977 1978

1979 1980 1981 1982 1983 1984 1985 1986 1987 1988

Totolexpos

CAUJCEEporrsto

toAgena

aoes

29.6

11.0

31.9 38.2

i3.5 15.4 21.7 51.9

26.8 97.1 1433 114.7 109.1 91.1 88.3 63.1 88.7 1132 100.2

88.8 77.1 66.0 53.0 68.9 45.5 743 97.9 873

Argentina

37.1

50.3

1 -fonm

gfpernae

Total Totale%aors PEC epors

to frail

elfS

to Braz

..

_

..

211.

..

..

..

..

48.4

.

56.8 53.5

..

62.4 67.3 63.5 58.2 78.0 72.1 83.8 86.4 87.1

8.4 63 6.5 6.1 7.4 6.3 6.9 8.2 6.2

..

145.8 1213 114.8 143.4 295.6 204.1 229.1

26.7 19.6 18.7 46.7 82.4

137.4 184.7

(

E4xorts Total eqors

..

..

17.7 162 16.3 32.6 27.9 67.3 80.6

_

2.6 1.9

-20 5.5 7.6 11.5 13.2

Notaaibble. S3re: Inoati('990, table5). CGaro de tddca Nacionales y ComnercIrternadonal delUruguay (CENCq. Bancode laRepCbica Orinal delUruguay (BROU), AsocibcinLatirrnerina deIntegrai6n(ALADI),andloint andpemranetolFice oftheCAJCE(for1975-81 ).

Gains and blssesfromlikztcn trading a7angwments with Agentina and Brwzl

89

CAUCE and PEC appear to have had little impact on Uruguay's import composition. The commodity composition of Uruguay's imports from Argentina and Brai remained quite similar to its overall import pattern for food, minerals, chemicals, andfinished consumergoods. Marked differences occurred only in fuel imports (extraregional concentration of imports), machinery (concentration on Brazil), and semifinished manufactures (concentration on Argentina). How important were CAUCE and PEC in Uruguay's trade with Argentina and Brazil Historical data show that over time the share of Uruguayan exports toArgentina and Brazil covered by the bilateral agreements increased sharply (table 5.2) - By 1988 more than 80 percent of Uruguay's exports to Argentina and Brazil came under the bilateral agreements. 8 These bilateral agreements can thus notbe brushed aside as oflittle importance in Uruguy's overall trade policies. But what about their welfare impact for Uruguay? The welfare inpact of bilateral preferences Apartial equilibrium modelis developed here to study thewelfare effects for Uruguay of CAUCEand PECGTo simplfy the analysis, all three countries are assumed to be small in theworld market for the productreceiving preferential treaunent and to supply exports to each other atincreaing marginal costs. Since Uruguay granted preferences onlyTforproducts notproduced lbcally, themodel assumes no import-competing domestic production in the import market. The discussion presents the case ofArgentina and Uruguay, but the analysis would be similar for the Brazilian arrangements, except as noted. Assume thatArgentina is a sufficently small importer of each good that the price in theworld marketis given (Pw;see figures 5.2 and 5.3). Argentina imposes a triff of tpercent (or maintains other trade restrictions thathave the same price-increasing effect). The supply curve of the domestic Argentine industry is SA,and Ss,u is the horizontal sum of the Argentine domestic supply curve and the Uruguayan export supply curve to Argentina in the absence of restrictions. With the coupon quota system limiting duty-free Uruguayan exports to Argentina to ppercent of Argentine output, the total supply curve for the Argentine market is shown by S4(1 +p) . The Argentine demand curve for the productisD. Consider first the case in which the quotabinds (figure 5.2). The pUice of the product in the Argentine market would be PA(1 + t ). Domestic pro-

duction would be Qt, domestic consumption Q., and total imports Q.- Q, (ac) ofwhich Q 2 -Q, (ab = X) are from Uruguay and Q,- Q2(c) are from the rest of the world. The bilateral agreement involves a cost to Argentina in lost tariff revenue on imports that enter free of duty from Uruguay under the arrangements (area abhg).Areafehgis adeadweightloss from inefficient

90

EFFECs OFPROTEnONISMON A SMALLCOUNIRY:THE CASEOF URUGUAY

resource allocation because of the higherproduction costs in Uruguay than in the rest of the world. For Uruguay area defrepresents a gain to Uruguayan producers- Area abedrepresents quotarents Uruguayan producersare willing to supply quantity XJ atprice P,., but the product will sell in the protected Argentine marketat Pw(1 + t). The distrbution of the quota rents depends on the market theexportindustryin Uruguayand structures ofimportinginArgentinaand on the method of administering the coupons. If importing is relatively competitive, administraton ofthe quotas on the exporting side by the Uruguayan Chamber of Industries would probably mean that the rents would go to the exporters in Uruguay, especially if they-are sufficiently concentrated to control the market The BraziJian import markets would be analyzed in the same way, except that under PEC the quotas are specific quantities or values rather than percentages of domestic production. With a quantityt-denominated quota, the line in figure 5.2 showing the total supply available from Brazilian and Urnguayan supplierswould be parallel to the Brazilian industry supply curve but displaced to its right by the -amount of the quota. Since Uruguay's exports to Brazil are doser to Uruguay's general export patter than are its ex-ports to Argentina, Uruguay's export supply curve is probably not too fr above the world price, implying larger quota rents relative to deadweight losses. Now consider the case in wshichthe quota does not bind (figure 5.3). Again, the equilibrium, price would be PA(1 + tA),imports would be Q - QI (km), ofwhich Q2- Q, (kl = Xu) would be fiom Uruguay. The lost ariff revFigure 5.2 Argentine import market: binding quotas Pice

SA SA

a i

\ ~~~~~~~~SA( I +P)

PwI +tl4

c,~r~Ip

SA+ u d

e

f

PW

g

\I

h

DA

Q;

Q2.

Q,

~~~~~~~~Quantity

Gains and tossrafinn bilateraltrading armngements with Aigendna and Brazl

91

enue would be kir, of which kln represents a gain to Uruguayan export industries and nlsr the deadwveightloss from higher production costs in Uruguay than in the world market Because the quota does not bind, no rents are generated. Under both GAUCE and PEC agreements Uruguay offers duty-free entry for specified products that are not produced in Uruguay. In view of the small size of the Uruguayan market, it is reasonable to assume that the world price of the imported product is given at Pw.Suppose that Uruguay imposes a triffat rate tt, (or other form of trde restrction that causes asimilar divergence of domestic and import prices). Consider first the case in which imports under the bilateral agreements do not take over the entire Uruguayan market (figure 5.4). Suppose that the bilateral arrangement under consideration is with Argentina and that the Argentine export supply curve is S... Then MA would be imported from Argentna and M, - M4, from the rest of the wvorld.There are no consumer gains (gains from trade creation), just a displacement of imports from the rest of the world by imports from Argentina. The loss of tariff revenue to Uruguay (the loss from trade diversion) is vwzy, of which vwxis a transfer to Argendine exporters and xaty is the deadweight loss due to Argentine production costs that exceed the world market price. Duty-free access allows Argentine exporters to gain, at the expense of the Uruguayan treasury, and generates efficiency losses. Now consider the case in which there are gains from trade creation, although the overall welfare impact is ambiguous (figure 5.5). Suppose the Figure5.3 Argentine import market: nonbindingquotas PRice

PWAI +t,

Pw

k'A0)

S

r

t Dy

Q2 22Q

Quandity

92

EFiECrsOFPROTECTIONISM ONA SMALLCOUNTRY:THE CASEOF URUGUAY

same '7orld market price (P.) and Uruguayan tariff (1.f) and an Argentine exportsupply curve SX If the same tariffwere charged on all importsfrom Argentinaas well as from the rest of the world-no importswould come from Argentina. The domestic price to Uruguayan consumers would be P. (1 + tu), and M, imports would come in from the rest of the world. If the taiff were

eliminated

on imports

drop to PA, reslting lateral arrangements. Figure 5.4 Uruguayan

from

Argentina,

in gains to Uruguayan In the case of perfect

the

equilibrium

price

would

consumers of abec from the bisubstitutability between Argen-

import market: diversified sources of imports

Pnice SXA

x PW Wy

z

MA --

mu \Qantiy

Figure 5.5 Uruguayan import market: partner country sole supplier Prce

a

b

_

_

_

_

_

_

_

_

Pnce 2i

u~~~~~~~~

Pw h_ e~1

11

M1 M2

on

"t,,Ll,b

!-

;

y

Gainsand loss fronmbilate bdingaungmentstwunthAWge7ninaandBrazl

93

tine products and products from third countries illustrated here, Argentine exports would take over the markeL However, tariff revenue of abh would be lost, leaving a net gain for Uruguay if area bedexceeds area oidor a net loss if itfalls short It seems liely that Uruguay's losses from trade with Argentina couln be large because Argentn does not generally export the capital goods and industrial products it exports to Uruguay, implying a relatively large differential benveen P,f and Pw.In the case of Brazil relatively greater gains from trade creationand relativelysmalUerlossesfromtrade diversionare likelysince if Brazilian products are competitive on world markets, then the Brazilian supply curve is not likely to be far above the world market price. Analysis of product prices under CAUCE and PEC The analysis presented above suggests that the preferential arrangements would lead to price differentials on the export and import sides. Uruguayan exports would fetch a higher price in the Argentine and Brazilian markets than inworldmarkets (figure 5.2),?while imports (excluding dutypaid) from Argentina orBrazilwould be higher priced than imports from the rest of the world (figure 5.4), particularly if the products were not normally exported to world markets or the exporters had some control over market prices. To see whether the bilateral trade agreements resultedin systematicprice differentials, unit values byproduct orin or destination (Argentina, Brazil, and the rest of the world) were collected and analyzed for a sample of products covered by CAUCE and PEC. The sample includes f.o.b. unit values for the twenty-nine mostimportantproducts exported by Uruguay to Argentina and Brai during 1986-89 and the c.i.£ values for the thirteen most importantproducts imported under CAUCEand PEC during 1986-90. (The products covered in the sample are listed in appendix table 5Al1.) Two methods of analysis were used. The firstwas to compare unitvalues

in eah commodity classification for Uruguayan trade with Argentina, Brazil, and the rest of the world. On the basis of the previous analysis of trade patterns under CAUCE or PEC, wewould expect the unitvalue ofexports or imports to be higher on trade with Argentina or Brazil than on trde with the rest of the world. On the export side, the results are consistent with this expectation: for the thirty export products in the data set for 1986-90 the unit values of Uruguay's exports to Argentina or Brazil exceeds those of exports to the rest of the world more frequendy than thereverse (table 5.3). On the import side, the results are contary to expectaadons:for the thirteen most important Uruguayan import products covered by CAUCE and PEC, the unitvalue of imports from Argentina and Brazilwas lower than the unit value of imports from the restof the worldmore frequendy than the reverse.

of unit valuesof Uruguay'sexportsto and importsfromArgentina,Brazil,andthe rest of world Table 5.3 Comparison ofoccurrences) (number

1990 1989 1988 1987 1986 from or to Higher oorfrom Higher toorfrom Higher toorfrom Higher toorfom Higher No of Rest No or Rest No of Rest No or Rost No or Rest poadson co Partner Wordd comparison Partner *vdd comparison Partner wrfd comparison Partner ½rvd vrld Partnercomparison Exports Argenbtna

5

7

18

5

10

15

8

7

Is

4

9

17

7

5

18

Brazil

7

a

15

5

12

is

7

11

12

5

13

12

6

13

11

Imporn Argentina Brazil

12 9

1 3

0

12 9

1 3

0

10 9

3 2

0 2

10 8

3 3

0 2

8 7

4 3

i 3

calcblations. Authoes Source.

1

1

withArtina Gains and lossesfAmbilatezmlWadingarmrngmernss

and Bazir

95

Unobserved product differentiation may account for this result, with price differentials perhaps reflecting lower-quality products from Argentina and Brazil than from Uruguay's other trading partners. Also, the analysis does nottakeintoaccountthe dergeofprice difference across origins ordestinations. The second approach was to pool the products and to test for systematic pnce differentials between trade-with Argentna or Brazil and trade with the rest of the world, using the following model

X tYa

=

(51)

+

4

DPi*DT,

JIPXDA*DP& +XDB*D&

A+D+Eje

where Pis the unitvalue for export ito countryjin year t DP. and DT are dummy variablesforproduct and time, DAandDBDare dummyvariables for Argentina and Brazfl, and Ev,is an error term. The first set of interactive variables is designed to capture the effects of differences in productand time period. The second and third sets of interactive variables show the effect of the bilateral agreements, by product. The indiiidual country dummy variables indicate the average effect of the bilateral agreements across products and time- A similar specification would apply for import unit values. This model lends itself to several tests. Omitting the second set of in teractive variables (those showing the effects of the bilateral agreem ents product byproduct) permits testing for the presence ofa significant difference in the mean value of the markup on sales to Argentina or Brazil. Omitting the country variables allows testing for significant differences in prices at the product leveL The overall fit is generally very poor for the import unitvalue equation (R2 of around 0.04), except for one specification discussed below, and very high for the export unitvalues (R2 above 0.92). This resultreflects the observation noted above that most imports into Uruguay covered under CAUCE and PEC are manufactured products that tend to be highly differentiated. Tests for differences in prices at the product level show no significance on the export side buta strong significance on the importside. The F-value for the joint significance of the inclusion of the second set of interactive variables for the effectofbilateralagreements byproductis 7.04 (criticalvalue at the 1 percent significance level is 1.64). This result again confims the presence of more producthe terogeneity on the import side. However, the F-value for a significant difference in the mean value of the markup on exports to Argentina and Brazilis only 0.92. So the data do notindicate a significantmarkup (positive or negative) for exportproducts sold to Argentina and Brazil. On the import side the coefficients of the duramy variables captring the presence of a mean markup are positive and highly significant for prod-

96

EFFECISOFPROTECrlONISONASMALLCoURY: THE CASEOFURUCUAY

ucts originatng in both Argentina and Brazil (tvalues above 6 and a computed F-value of 23.6). While this resultis along the lines expected from the previous discussion of trade patterns under CAUCE and PEC, it is at odds with the simple comparisons reported in table 5.3. It is difficult to establish with confidence from these tests that Uruguay paid a higher price for imports under CAUCE and PEG, especially in view of the strong heterogeneity of products across exporters to Uruguay and the inability to control for differences in product quality across suppliers. At the product level the coefficients are statistically significant (at the 5 percentlevel or better) on three of the tfirty products one positive and two negative for Argentina and two positive and one negative for Brazil. On the import side none of the thdrteen products imported from Brazil and Argentina has a statistically different mean value, after varations in exogenous factors are controlled for through the use of the time dummies. In sum, examination of price differentials across product origins and On the export side there were no signs destinations reveals no clearpatternL that rentswere accruing to Uruguay from export sales to Brazil,which suggests that the coupon quotas were not binding.' 0 On the import side the econometric evidence of ahighermean price forimports originatinginArgentina andBrazil suggests thatthe preferentialarrangements gave rise to inefficiency. Because differences in qualityacross suppliers are not capturedin the model, however, this result cannot be established with confidence. Have CAUCE and PEC affected the vohlme of trade with Argentina and Brazil?

So far the data have indicated that an increasing share of Uruguay's exports was covered by the bilateral arrangements (table 5.2) and that the resulting trade pattern could well have been inefficient.hThe inspection of price differentials was inconclusive, however, especially on the import side, so the welfare effects of the agreements remain ambiguous. Acomplementaryapproach is to considerwhether there is evidence that the bilateral trade agreements significantly expanded trade between Uruguayanditsneighbors. One approach is toinvestigatewhetherUruguay trades more orlesswith these countries thanwould be expected on the basis ofsize, income, location, and other characteristics thathave been successfully used in other cases to predict trade patterns across countries. The idea is to find out whether, controlling for other factors, Uruguay's trade with Argentina and Brazil is significantly different from that predicted by the model. A gravity modelwas developed to test for this possibility (see Bergstrand 1989 for the theory ofgravity equations) . The model is similar to models used to examine the effects of preferential trading areas (Aitken 1973) and tO

Cmn and bossesfimobnila

ading anrnngents udthArentirnaand Brzil

97

predict the geographic shift of East European trade from 'east' to "west" followingrecent economic and political changes (Havrylyshyn and Pritchett 1991).The results suggest that thebilateralarrangementshadlitde effecton Uruguay's pattern of trade. The value of trade, T, between two countries iandjis postulated to depend on the total trade potential, TP, of each country and on the trade attraction between them, TA: (5.2)

T

f(TP',

TPi, TA"Y)

Separate equadons are estimated for imports and exports of manufactures industry classification codes 5,6,7, and8). Trade potentialdepends on total outputand the trade intensity of output, which depend on economic factors such as level of development and geographic factors such as country size. Although the theoretical underpinnings of the gravity model are not clearly specified, they can be linked to tastes and factor endowments (see, for eaample, Bergstrand 1989). Two versions of the gravity model are used to test for the presence of bilateral effects. ModelI] regresses Uruguay's trade (imports and exports) with agroup of eighty-four trading parmers and includes separate duramyvariables for Argentina and Brazil. Because there is perfect correlation betwveenthe dummyvariables and the usualbordervariable used to measure geographic proximity, a second sample was constructed. Model 2 uses asample of twenty-three semi-industrialized countries selectedfor their comparability with Uruguay. This model, similar to that of Havrylyshyn and Pnitchett (1991), allows separate testing for the effects of the bilateral agreements with Argentina and Brazil. The equation for model 1 is: T" = P+P

1

(DSTANCE

+f3 5 (lSLAND j )+

(5.3)

)+ P2 (GDP) +pS(GDPPC )+p4 (AREA) (LlDERJ)

+ XmDL

+t 7 DA +P8DB

where Threfers to Uruguay's merchandise imports from or exports to a trading partner j, and DA and DB are dummy variables for Argentina and Brazil, designed to capture any influence of CAUCE and PEC on Uruguayg's pattem of imports and exports. The en-or term has been omitted. The other variables are proxies for size (AREA and ISLAAD), geographic proximity (DISTANCE), economic simiarity (L[DER: absolute difference in per capita GDP between Uruguay and country j at purchasing power parity), and cultural factors (DL). (Precise definitions and data sources are given in the appendix.)

98

EFrcr oF PROTECTnoNISM ON A SMALLCouNmv

THE CAE OF.URUGUAY

'rhe equation for model 2, which estimates trade flows of twenty-three countries (indexed over t) with their eighty-four trading partners (indexed overj), is: T"i = 0 + 1 (D1STANGE1 )+2(BORDER)

+ P.(GDP) +134 (cDPPC )

+f3 5 C(AR i)+ P 6 (ISLAND )+ P7 0Pi +J35(GDPPCj)+39(APEAj)

+ 1 j0 ({ISLANDi)+jj(LJFNDERO)+ XSWZDLY +8,DA+52DB (5.4) +

5 LAT

Model 2 is similar to model 1, but allows the bilateral arrangements to be isolated by including a separate BORDERvariableto control for geographic proximity. In an alternative formulation, DA and DB are replaced by the dummyvariable DABU,vhich controls for trade between Argentinaand Brazil as well as trade between Uruguay and its neighbors. Both models are esdmated ona cross-section basisusingyearly trade and icome data. The estimation is repeated for severalyears (1970-87 formodel 1, 1980-88 for model 2) because trade between Uruguay and its neighbors has fluctuated significantly from year to year. (Appendix table 5A.2 reports results for 1985; table 5A.3shows the stability of the results over time.) Since bilateral de flowshave a lower bound of zero, censoring bias renders ordinay leastsquares inconsistent (Greene 1981). Tobitmaximum likelihood estimates are therefore reported instead." The results for model 1 are quite good, as they are with other applications of the gravitymodel. All the usualvariables have the expected sign and strong sttistical significance. Uruguay's trade decreases with the distance and physical size of the trading partner and increases with the partner's economic size and income per capita, although the difference in per capita income (a proxy for similarity) is insignificant As in other applications, the island dummy is generally not significant The dummy variables for Argentina and Brazil are of particular interest, since they capture thejoint effects of a border dummy and of preferential arrangements Surprisingly, they are negative for imports and exports, and strongly significant for exports (though the significance is not stable over the years-see table 5A.3). The grvity model does not control for the effects of trade policy or of other important determinants of the pattern of trade, such as factor endowments. But insofar as the variables in the model are good proxies for the deterninants of Uruguay's trade, the results indicate that Uruguay is exporting significantly less to Argentina and Brazil than would be predicted by size, income, and geographic proximity, casting doubt on the effectiveness of the preferential agreements in increasing intraregional trade.

gairn and losssfrom bilateralbadingarrangments with Avgentina and Brazil

99

Thieseresults do not carr over to model 2, which expands the number of sample countries and includes dummy variables for BORDERand for Imembership in the Latin American Free Trade Area (LAFTA).Now the effectof the BORDERvariableis significantlypositive,as expected. The LAFTA dummy (Argentina,Brazil,andUruguayare LAFTApartners)isalsostrongly significant,suggestingthat the preferential arrangements had a positive ef-

fect on the volume ofimports and exports, and thatsignificance is stable over

*

time. After controlling for the influence of bordering countries on trade patterns, there is no additional effect from CAUGEand PEC. Replacing the dummyvariables for Argentina and Brazilwitha dummy variable that controls for all patterns of trade among Argentina, Brazil,and Uruguay (DABR)yields a statistically significant negative coefficient (table

5AS3).Because the valuesof all the other coefficientsare stableand close to those reported in table 5A.2, they are not reported for this alternative formulation. Within this sample of semi-industrialcountries, then, the three countries seem to have rather similarproduction structures ('competitive" cost structures) so that they trade mostly with the rest of the world rather than among themselves.If that is the case-and the same observation has been made frequently in evaluations of regional arrangements among de-

veloping countries (see de Melo,Montenegro, and Panagariya1992)-integration would have little effect since most trade would continue to be with the outsideworld. This seems to be the resultsuggested by the gravityrmodel,

which is not surprising given the incomplete coverage of GAUCEand PEC. Alternatively, the significantly negative coefficient on DABUcould be capturing the effect of some omitted variable that is an important deterninant for the pattern of trade for the three countries. How robust are these results, and are there any discemible trends during the 1980s? Despite relatively large changes from year to year in the estimatedvalues of the coefficients for the dummyvariables capturing the effects of the bilateral accords in model 1, there is a trend in the value and significance ofthe dummies on the importside toward less negative numbers (table 5A.3). That trend suggests that regional. policies were progressively increasing Uruguay's imports from Argentina and Brazil. For exports both dummy variables always have a negative sign though the significance is greater for CAUCE than for PEC. Significance falls only in the later part of the 1 980s, suggesting a progressive effect for GAUCEand PEG and torroboratng the previous observaton of an increasing share ofpreferential exports in the value of toml exports toArgentnaand Brazil (table 5.2). Formodel 2 thevalues of the LA4KJAand DABU dummy variables are quite stable, and so no trend emerges for changes in the values of the coefficents of the dummyvariables. To sum up, the gravity model suggests litde evidence of a changing pattern of imports and exports to Argentina and Brazil during the 1980s as a

100

EFFCISOFPROT

ONISM M ONA SMALL CouNwRY:THE CASEOFURUGUAY

result of the preferences granted through CAUGE and PEG. The gravity model, though it suffers from omitted variable bias and uncertain dteoretical foundations, corroborates the results of the analysis of Uruguay's trade patterns presented earlier to suggest that the bilateral arrangements had litde effect on Uruguay's pattern of manufactured goods trade. Conclusion GAUCE and PEC share many of the characteristics often found in regional arrangements among developing countries. Though the arrangements granted duty-free access to a large number of products, numerous

restnc-

tions limited overall effectiveness (ceilings on the volume of duty-free imports, rules of origin, corrective measures if bilateral trade became imbalanced). Analysis ofthe pattern of trade under CAUCE and PEC revealed that an increasing share of regional trade during the 1980s was covered by the arrangements. Estimates of bilateral trade flows from a gravity model suggest that the bilateral agreements had no significant effect on the overall pattem of Uruguay's trade during the 198Osbut that LAFTA did have a'significantly positive effect on Uruguay's manufactures imports and exports. If anything, Uruguay traded less with her neighbors than would be expected from the estimates of the gravity model. -Did Uruguay benefitfrom CAUCE and PEC? Afirm answeris difficult to reach, even in the narrow sense of static gains and losses. But it can be said that under CAUCE Uruguay was importing products from a reIatively highcost supplier and, to a greater extent than under PEC, exporting products (mostly manufactures) in which it has no comparative advantage. It is therfore likely that CAUCE resulted in netlosses for Uruguay. In the case of PEC, theory suggests that Uruguay would gain rents from its access to Brazil's protected agricultural market, but the analysis of export productunitvalues found no significant evidence of rents. Overall, however, Uruguay probably gained from PEC because the agreementallowed Uruguay to expand expors of products in which it is a low-cost producer. Whatabout MERCOSUR? It is too early to tell whether it is likely to have benefits for Uruguay. The across-the-board approach to tariffreductionand the absence of quota limitations should contribute to greater trade expansion than under CAUCE and PEC. But credibility problems arise because of the longlistofUruguayan products exempted from the tariffreduction schedle undl 1994 and Argentina's temporary import surcharge of 1992. Also, implementation

maybe difficult ifmacroeconomic

instability persists in the

region. Overall, MERCOSURwillprobablyincrease Uruguay'swelfare if the common extenal tariff is low. But if the adopted external tariff is high, the preferential approach to trde liberalzation mayreduce Uruguay's welfare.

Gains and losse¶flombi&atnil frding arrangmnts with Arentina and Brazil

10J

Appendic This appendix lists the products analyzed in the section on prices under CAUCE and PEC (table 5A.1) and describes the samples and variables used in the gravity model. Table SA.I Listof sampleof productscoveredunderCAUCEand PEC code Desaflption NAVE' Importside 27100919 29030000 29300200 32070199 39011901 39020210 47010520 48010101 51040100 51040100 73130300 76010200 87020112 EVr !sde 02010600 03014505 04020201 04030100 04040209 10030199 10060200 11070100 29030101 29150501 31030302 32090300 32090803 38110500 39020204 39020401 39030200 40050200 40110102 48010202 48070101

Otherlbdcatingoil of heavygrade Sulfonated, nitrted, or nitrosatedderivatives of hydroarbons Tduenedi-4socynate products,indudingthoseof mineralorigin, Othercolorig matter-either of inorganic or of clored-organicmaterial liquidpolyesters Polymerization andcopolymnerization in anyform material or chemicalmeansfrornanyfibrousvegetable Pulpderivedby mechanical cellulose wadding)in rolb or sheets-for newsprint (including Paperor paperboard indudingwvvenfabricsof monfil fibers(continuous), Wovenfabricsof synthetic Cotton, not cardedor conbed

or platesof ironor steel,hot rolledor coldrolled Sheets LUnwrought aluninum;aluminum wasteandscrap induding between100ccand 1600cc, Passenger automobileIts with cylinderengines here) partsusedin othermotorvehides(ergineandcabareclassified

Meatandedibleoffalsof cows,pigs,sheep,lambs,goatsandkids,andhorsemneat, fresh,cilled, or frozen Fish,freshliveor dead),chilledor frozen concentrated or sweetened Mik andcream,preserved, Butter Cheeseandcurd Barley but not parboiled Rice,huskedor unhusked Malt,roastedor nct of hydrocarbons Sulfonated, nitrated,or nitrosatedderivatives Octylphthalate fertilizers, phosphaic Mineralor chemical Vamishes andlacquers; distempers; prepared waterpigrments ofthe knd usedfor leather finishing no soens containing Uquidvamishes andherbicides fungicides, ratpoisons, insecticides, Disinfectants, Chloridepolyvinylin dfferentforms in dferent brmrs Polyester cellulose Regenerated naturalor synthetcrubber sheets,andstripsof unvulcanized Plates, automobiles andcommercial Tiresfor passenger Paperusedfor books Paperandpaperboard to whichsuperfiaal coatingor layersof othermaterials have beenappliedto the wholeor partof oneor bothsurfaces onnextpage) (ccrtinued

Counmur.THE CAsEOF URUGUAY Erncrs OF PROTECTIONISM ON A SMALL

102

Table SA .(cant.)

List ofsample of products covered under CAUCE and PEC

NADE' code Descaption 5 poitside(con) of paperandpaperboard 48160101 Boxes,bags,andotherpaddngcontainers not for*retail sale fibers(conrtnuous), Yarnof synthetic 51010302 fibers(continuous) 51040202 Wovenfabricsof synthetic hair orlarnbswool orof finea irmal 53110101 Wovenfbrics of sheep's 55098901 Otherwovenfabrico(cottDn forspinning not carded.combedor otherwiseprepared fibers(discontinous). 56010102 Synthetic 56070400 Wovenfabricsof synthetic fiber(discortnous or waste) 61010503

Cotton pants for men and boys

Ce en bs aranceles Ceta merconcias araL dassifiocion a. Unrguays tarilf dassiictiorn system aNomendatura aduanas).

The data set used for model 2 contains twenty-three reporter countries (subscripted by index t). These twenty-three coantries were chosen from among those classified as "middle-income economies" in the WorldDevelopment Report1991. They are:

Algeria, Argentina, Brazil, Chile, Colombia, Costa Rica, Ecuador, El Salvador, Greece,Jamaica,Jordan, Korea, Malaysia, Mexico, Paraguay, Peru, Portugal, Thailand, Trinidad and Tobago, Tunisia, Turkey, Uruguay, and Yugoslavia. Models 1 and 2 were estimated for eighty-four partner countries (subscripted by index ). The sample was restricted to partner countries whose imports totaled more than $300 million in 1980 and forwhich no data were missing. The selected partner countries are: Angola, Argentina, Australia, Austria, Bangladesh, Benelux, Benin,

Bolivia, Brazil,Burma, Cameroon, Canada, Chile, Colombia, Congo, Costa Rica, Cote d'Ivoire, Denmark, Dominican Republic, Ecuador, Egypt, El Salvador, Ethiopia, Finland, France, Gabon, Ghana, Guatemala, Hait, Honduras, Hong Kong, India, Indonesia, Iran, Ireland, Israel, Italy,Jamaica,Japan,Jordan, Kenya, Korea, Kuwait, Liberia, Madagascar, Malaysia, Mauritania, Mauritius, Mexico, Morocco, Netherlands, Nicaragu2, Nigeria, Norway, Oman, Pal;istan, Papua N. Guinea, Paraguay, Peru, Philippines, Portugal, Saudi Arabia, SenegaL Singapore, Somalia, Spain, Sri Lanka, Sudan, Sweden, Switzerland, Syria, Thailand, Tobago, Togo, Trinidad and Tunisia, Turkey, United Kingdom, United States, Venezuela, West Germany, Zaire, Zambia, Zimbabwe.

Gains and losssfrm

biterd

tradingarrangments mith AeTnlia

and Braud

103

Variables are defined as follows: T*.the dollarvalue of either inports or exports ofmanufacaured goods (the sum of SITC codes 5, 6, 7, and 8). Source: UNSO COMTRADE database. * D1STANC'E'i: logarithm of the straight-line distance between the economiccenterofgravityoftherespectvecountries. Source:Linneman (1966). - BORDER': dummy variable, with a value of 1 when the reporter and the parmer share a border, and 0 otherwise. * CDPPC':logarithm of the purchasing powerparity (PPP) income per capitaof the reporter countries Source: Summers and Heston (1991). * AREA4 logarithm of the area of the reporter country (measured in thousands of square kilometers). * ISLAAD ' dummy variable indicating whether the reporter country is an island value of (1) ornot (0). * ISLAADJ: dummy variable indicating whether the partner country is an island (1) or not (0). * COPi.:logaithm of the totl GDP of the reporter county (millions of dollars). Source: World Bank dart = CDi': logarithm of the total GDP of the partner country (millions of dollars). Source: World Bank data. * CDPPCf:logarithm of the PPP income per capita of the partner countries. Source: Summers and Heston (1991). * AREAJ:logarithm of the area of the partner countries (measured in thous-ands of square kilometers). * LAETA#:dummyvariable thattakesavalue of 1 when the reporter and the partner counEres both belong to the LAFTA, -and 0 otherwise. - DA: dumnmyvariable that takes a value of I if the trade is between Argentna and Urugluay, and 0 otherwise. * DR dummyvariable that akes avalue ofl if the trade is between Brazil and Uruguay, and 0 otherwise. * DL/: dummyvariable that takes avalue of l if the reporter countryand the partner country share English as a common language, and 0 otherwise. * DL 7:dunmyvariable that takes the value of i if the reporter county and the partner country share Spanish as a common language, and 0 otherwise. * DL.J dummy variable that takes the value of 1 if the reporter country and the partner countryshare Portuguese as a common language, and

Ootherwise. LTNDER: logarithm of the absolute value of the difference in per capita GDP between the reporter and the partnar'. Source: Summers and Heston (1991).

104

Emcrs

OFPROTECnONISM ONA SMALLCoUmN: THE CASEOFURUcUAY

Table SA.2 Gravitymodel estimates (1985)

Voaiable

ModelI

Constant

-Ncn-oi imports Model2

34.76(-3.22))

hI(DISTANCEU) 4.42(-3.33) BORDERJ (= 1)

-46.16(-15.38) -0.48(4.49) 3.89(6.49)*

Non-dleaports ModelI Model2 -5.22(-0.62)

67.14(-20.27)

-5.96(-5.48)

-0.67(-5.90)' 4.38(6.90)"

PRorter-k

In(GDP') In(GDPC') In(AREA') ISLAND'

138 (10.42) -0.31(-0.83) -0.55(-5.96) ' -0.40(-1.12)

In(GDPJ) In(GDPPC') In(AREA') in(POPJ) ISLAND (-j)

4.82(7.86) -1.06 (-3.29) 3.05 (6.07) 0.36 (031)

UNDER(= 1") Preeren-

-021 (0.52)

2.70(19.18)" 0.62(4.05)" -0.43 (-5.74) -0.03 (-0.10)

3.89(8.82) -0.52 (-2.0) 2.24 (5.93)" -0.15(-0.16)

0.72(7.82)

0.29(-0.87)

1.43(14.73)" 0.02 (). 10) -0.47(-5.86)H -0.66(-2.41)' 0.86(.65)"

IYI)

LAFTAI Language(=

e

2.70(19.18) 1.83(4.57)" .73 (-7.45)" -1.25(-3.25)

2.22 (4.07)

2.47(4.25)

-0.r I (-0.14)

0.65(0.78) 1.0143.47) *0.25(-0.80)

')

ENGLISH SPANISH PORTUGUESE Bikarel dumrries DA (1) D5 (=1) Sumrnmary swdstics N (Obs)

1332(4.85) -0.61 (-1.96) -339 (0.72) -2.46 (-0.59)

0.12(0.03) 035(0.09)

84

1932(23 x 84)

SignfiFrntat5% 'Signifcantat 1%. Nbt Numbersin parenthesesare t-sbtastics.

-9.34(-2.38) -7.94(-2.26) 84

1.63(039) 1.71(0.41) 1932

x23 84

Cans and lossesfinm bibl

tradinganMnge

unt ih Arntina

and Braid

105

Table SA.3 Stability of the bilateral dummy vraables

Model I hnpwts

Year

Expmr=

DA

DB

1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1986

- 11.68 (-2.56) -10.71 (-2.19) -7.45 (-1.69) -7.79 (-2.02) -9.41 (-1.80) -3.53 (-0.63) -4.73 (-0.85) -8.05 (-1.46) -6.10 (-1.1 1) -7.25 (-1.24) -5.05 (-0.90) -5.46 (-0.95) -2.33 (-0.46) -5.64 (-1.09) -4.17 (-090) -3.39 (-0.72) -0.48 (-0.12) -1.30 (-037)

1988

-3.71 (-1.10)

-5.62 (-1.47) -4.93 (-1.19) -4.93 (-1.34) -5.71 (-1.72) -6. (- 38) -2.93 (-0.60) -3.64 (-0.74) -5.96 (-1.4) -4.96 (-1.01) -5.29 (-1.01) -4.12 (-0.82) -3.54 (-0.69) -2.15 (-0.48) -3.95 (-0.86) -2.81 (-0.69) -2.46 (-0.59) -0.49 (-0.14) -1.49 (-0.48) -3.23 (-[.06)

-13.81 (-3.14) -14.31 (-3.22) -13.66 (-2.61) -11.41 (-2.31) -I [.46 (-2.58) -J 1.65 (-220) -1052 (-1.88) . -13.41 (-2.84) -8.40 (-1.76) -11.76 (-39) -1039 (-2.26) -8.62 (-2.12) -7.68 (-1.70) -735 (-1.73) -11.63 (-283) -934 (-2.38) -6.70 (-1.69) -8.38 (-2.09) -5.27 (-1.39)

-4.11 (-1.13) -4.19 (-1.17) -4.10 (-0.96) -5.29 (-132) -6.20 (-1.6S) -679 (-1.60) -6.16 (-1.26) -8.02 (-20) -5.73 - 135) -7.93 (-1.83) -8.21 (-1.97) -6.76 (-1.87) 6.84 (-1.69) -6.03 (-1.60) -8.31 (-2233) -7.94 (-2.26) -5.78 (-1.62) -6.89 (-1.92) -3.66 (-1.07)

Model 2 IMPo

Year

A

EDarts

DABU

LAFTA

DABU

1980

248 (4.42)

-4.99 (-337)

2.79 (4.78)

1981

1.84 (3.24)

-4.51 (-3.02)

239 (4.21)

-5.11(-3.40)

-3.06 (-2.04) -2.76 (-1.77) -2.56 (-1.71) -2.27 (-.5 -290 (-213) -2.51 (-1.99) -3.20 (-1.73)

2.13 (3.70) 2.80 (4.79) 2.62 (4.40) 2.76 (4.68) 3.04 (5.45) 2.75 (5.03) 3.86 (5.63)

-3.76 (-2.47) -3.61 (-2.31) -374 (-2.37) -3.37 (-2.14) -4.08 (-2.76) -3.87 (-2.72) -4.69 (-2.17)

1982 1983 1984 1985 1986 1987 1988

1.90(334) 246 (4.19) 248 (439) 2.40 (423) .248 (4.83) 267 (5.52) 3.64 (6.20)

-5A46 (-3.55)

A isthevalueofthe acocientfor thedumnyvriableforArena mn equation5.3. DBis thevalueofthe coeffident fordurnmyte variablefor Brazilin equation5.3. LARAis the%aueof thecoefrident for theLAFTA dummyinequabon5.4. 04BU isthevalueof thecoellidentfor thedummyvarvblefor tradebetweenUruguayarditsneighbors or betweenAsrgfnnaand Bazilinanalterativefbrmuhtitn of equabon 5.4. Abte Numrrbers in parentheses aret-stati;cs.

106

CoUNTRYTHECASEOFURUGuAY EFnErs oF PROTECTONISM ONA SMALL

Notes We thank Elbio Nattino for helpful conversations and for the product line data, and Lant Pritchett andJames Tybout for comments on an earlier drafL 1. Uruguay's small size, coupled with thecas of communication with its two neighbors, has made 5uch isolation difficult (see Hanson and dc Melo 1985 and de Melo 1987). Indeed, a major motivation for the reference price and minimum export price systems examined in chapter 3 was to protect Uruguayan producers from shocks due to the large and sudden exchange rate shifts with Argentina and BraziL 2. In the case of increasing costs for partner B, the greater the complementarity in import demands between A and B, the largcr the gains from a free trade area. 3. For an illuminating discussion of the compensation issue see Foroutan (1993), and for an assessment of implementation see de Melo, Montenegro, and Panagariya (1992). For general propositions about conditions under which the discriminatory approach to trade lbheralization is likly to be trade creating (or trade diverting), see de Melo, Panagariya, and Rodrik (190Z). 4. This section, and the next, draw on Inotai (1990) 5. Some 300 Umxguayan products have been exempted from the automatic timetable for tariff reductions, with the move to free trade for these products to take place in one shot in the last phase of tariff climination in December 1994. 6. MlERCOSUR was preceded by seventeen protocols signed between Argentina and Brazil during 1986-89. It calls for the complete elimination of tariffs on regional trade by 1995 and the creation of a common market by 1998. Tariff reductions are automatic, following a timetable that puts tb.e steepest tariff cuts at the beginng (see Nogues and Quintanilla 1993). 7. Very little reciprocityactually took place on the Uruguayan side. Between 1975 and 1 985 Argentina provided preferences on 1,042 products, Uruguay on 377 (Ferrere 1984). 2. Even though alarge proportion oftrade was under CAUCE and PEC, there has been little change in the pattern of intraindustry trade. Kaplan, Sarachaga, and Vera (1988) calculated indices of intraindustry specialization for Uruguay's trade with Argentina and Brazil and found no significant effect for CAUCE and PEC. 9. This is the market-access argument developed by Wonnacott and Wonnacott (1981) . TIhey show that access to a market that has high barriers with the rest of the world can be superior to unilateral trade hlberalization. 10. In a recent study Correa (1993) examined quota udlization rates for 1987-91 under CAUCE and PEC and conduded that about 60 percent of the quotas were less than half filled11. Heteroskedasticity-consistent standard errors are used for the maximum likelihood estimates (see White 1981).

References Aitken, N. D. 1973. 'The Effect of the EEC and EFEA on European Trade: A Temporal Cross-Section Analysis." AmernicanEnomric Riew 63(5): 881-92. Bergstrand,J. 1989. "rhe Generalized Gravity Equation, Monopolistic Competition, and the Factor Proportions Theory in International Trade." Review ofEconomicsand Statsti cs: 143-53.

Gains and hbsrsfiom bi&atealtrading anzngement idih Argentina and Bradl

107

Correra, Femando. 1993. "Los Cupos y Ias Perspectivas del Comercio Regional: La Experiencia del CAUCEy dcl PEC."SU/MA8(14): 39-64. Ferrcre, D. 1984. 'The Uruguayan-Argentinian Trade C operationAgreement."Jour7UZnof World Trade Law 18: 320-34. Forou tan, F. 1993. "Regional Integration in Sub-Saharan Africa: Past lExperience and Future Prospects." InJ. de Melo and A. Panagariya, eds., NewDimensions in RPgional Integration. Cambridge University Press. Greene,W. 1981. 'On thcAsynptotic Bias of the 015 Estimaborof theTobit Model.* Eeonometrica49(2): 505-13. Hanson, J., andJ. de Melo. 1985. "External Shocks, Financial Reforns and Stabilization Attempts in Uruguay: 1974-83." WorldDevekpmnt 13 (8): 917-39. Havzylyshyn, O., and L. PritchetL 1991. 'European Trade Patterns after the Transition. 'PolicyResearch WorkingPaper 748. World Bank, Trade Policy Division, Washington, D.C. Inotai,A. 1990. Unruguay's Bilateral Economic Relations with Argentina and Brazil.' World Bank, Trade Policy Division, Washington, D.C. Xaplan,M., D. Sarachaga, and T- Veia. 1988. ntegracion, politica comercialycomercio mtnindustrial evidcncia para la valoraci6n del comercio intraregional.' Reista de Ecnonzmza2(3): 89-118. inneman, H. 1966. An EconometricStudy of finmrnational Trade Amsterdam: NorthHolland. Mclo, J. dec 1987. 'Financial Reforms, Stabilization and Growth under High Capital Mobility: Uruguay 197-83.' In RPConnolly and C. Gonz5lez-Vega,eds., Economic Refom and Stabilzation in Latin America Praeger. Melo,J. de, A Panagariya, and D. Rodrik. 1993. 'he New Regionalism: A Countiy de Melo and A. Panagariya, eds, NewDirsioinRegionalI7tgraPerspectivcInj. don Cambridge University Fress. Melo, J. de, C Montenegro, and A. Panagariya. 1993. L'integration rigionalc hier et aujourd'huit"RPs dEconomic du dve%eoppmzenz 2: 748. Nogues,J., andR Quintanilla. 1993. LatinAmerica'sIntegration and the Multilateral Trading System." InJ. de Melo and A. Panagauiya, eds., NewDinmnnsionsin Rgional Integration. Cambridge UnJrivcrsityPress. Reyes Chavez, Mazio. 1988. La cooperaci6n econ6mica bilateral en America Latina y su relaci6n e influencia en la consecuci6n del proceso de integracion regional. Inzegradan LatimanaMeana-:136-37. Summers, R., andA. Heston. 1991. 'he Penn World Tables (MarkV):An Expanded Set of Real ProductPrices and Price Levels: Estimates for 130 Countries." Quarterly Journal ofEconomics (May): 327-68. Vimer, J. 1950. The Cusoms Union IAune New York: Camegie Endowment for Intemational Peace. White, H. 1981. Consequences and Detection of Misspecified Nonlinear Regression Modcls."JournaleftheAmerican StatistiLclAssodation76: 419-33. Wonnacott, R, and P. Wonnacot. 1981. Is Unilateral Tariff Reduction Preferable to - a Customs Union? The Curious Case of the Missing Foreign Tariffs." Ameican EcnomicReview 71: 704-14.

The labor market and trade reform in manufacturing Martin Rama

The labor market and trade reform are related in two ways. Sluggish adjustment of the labor market to changes in product market conditions could slow the movement of labor from import-competing activities to export sectors Also, the rents created as a result ofbarriers to foreign competition may provide an incentive forworkers to unionize and push up wages. That means that trade barriers are a potential source of labor market distortions and that these very distortions make it more difficult to dismantle trade barriers. The relationship between trade barriers and the labor market in Jruguay is an interesting case for many reasons. On the policy side, Uruguay represents one of the most extreme examples of an import-substitution strategy. Despite the small size of its domestic market (fewer than 3 million people), Uruguayapplied the whole gamut of protectionistpolices for more than 40 years. Concurrently, a strong labor movement had been developing since the middle of this century. Trade unions were severely repressed during 1973-84 by a harsh dictatorship. Following the recovery of democracy the labor movementreboundedstrongly in 1985-And concurrentlywith both these periods there has been a gradual dismantling of trade barriers, beginning in the mid-1970s. These dramatic changes in economic policies, polidical regime, and the treatment of labor unions provide good experimental conditions for studying the effects of trade reform on labor allocation under both competitive and noncompetitive labor market conditions. The analysis begins with an exploration of the main features of the Uruguayan labor market in the manufacturing sector, highlighting the prevailing institutional arrangements and wage setting procedures in force since democratic recovery. It also measures union strength through sectoral membership rates at two points in time. Examination of the rent-sharing issue shows that Uruguayarz unions played almost no role in the rent-seeking process leading to the establishment of trade barriers. Yet they are claimants to these rents, as suggested by the significant relationship found between I08

The lainrmar*etand frade refonntn manufactuing

109

union membership rates and variables reflecting market power at the sectoral level (the concentration index and the effective protection rate). Measurement of the effects on sectoral employment and real wages of the liberalization process carried out from 1978 to 1986 shows that sectoral real wages were not sensitive to changes in protection, whether under dictatorship or democracy. But sectoral employment adjusted significantly when there were no unions. Major features of the Uruguayan labor market Of the 1.3 million people in the Uruguayan labor force, about three-quarters work in the private sector, the rest in the public sector. Most public sector employees belong to the centrl administration or to local governments. Only a fourth of them work in one of the dozen smta-owned firms. Many of these firms are commercial banks; others are natural monopolies or have been granted legal monopolies. Although informal sector activities are less important in Uruguay than in other Latin American countries, they expanded greatly during the 1980s, accounting for 15 to 30 percent ofMontevideo's total employment (Diez de Medina and Gerstenfeld 1986; Aguirre and Mendez 1988, estimated from household surveydata). A large share of infonnal activitiesis related to smuggling of consumpton goods from Argentina and BraziL About two-thirds of urban jobs are in services. Since these are mainly nontradables, this large share ofservicesjobs reflects the low degree of openness oftheUruguayan economy. The manufacwring sector providesapproximatelyone-fifth ofurbanjobs, mostofthem associatedwith highly protected actiities (figure 6.1). For instance, in 1985 less than ahalfofindustrialjobs were in sectors with an effective protection rate below 40 percent (estimated according to Corden).1 And about 10 percent ofjobs were in sectors with an effective protection rate above 150 percent Patterns were even worse 4 years earlier, when only one-fifth of employment was in sectors with protection rates below 40 percent and almost half of industrial jobs benefited from protection rates above 150 percent. This change suggests that trade reform had significant effects on labor allocation, at least until 1985. Inst iutuionalftramework Almost two-thirds of private sector workers are wage earners, so institutional arrngements affecting wage setting play a crucial role. These arrangements changed dramatically over the last decades. In 1968, within the context of a stabilization program, wage increases for all workers were to be decided by the government. This policy was reinforced in 1973 by the military govern-

110

EFFECrS OFPRomaEcboNLsM ONA SMALL COUNTRY: THECASEOFURUGUAY

Figure6.1 Protecton and industrialemployment, 1981and 1985 Enployment in mantbcturing (percent) 100 90I 80 70 60 18 50 40 30 20 I0 -40

-20

0

20

40

60

80

100

120

140

Efectdve proeccion rote(percent) Sourr Basedon dalafromCentrode Investigaciones Econ6mzics (CINVE)andDireccidn Generalde Estadfstiay CensostDGEC),with efffectiveprotection ratesestimarted accordingtoCorden(1971).

ment's ban on trade unions. By the late 1970s, however, the government had

reduced its interference in wage setting to the establishment of minimum wages, and by 1985 the wage-bargaining mechanism in use from 1943 to 1968 (the heyday of the labor movement) was fully restored. Wage councils (cons4os de salarios)are the keystone of this mechanism. Delegatesfrom firms, trade unions, and the governmentsetminimumwages by sector and labor category. Until 19SJ wage levels were adjusted every 4 months. From then on, they were adjusted whenever cumulative inflation exceeded some preset threshold. Adjustments are allowed even if the wage councils do not meet, provided that expllcitagreementwas reached in former rounds on the algorithm to be used. Such long agreements 24 months.

usually last 16 to

In May 1985 forty-eight activity groups were created to negotiate wage agreements One of them has never met, and the others continued to split up into more and more groups. Today, there are more than two hundred wage councils, organized by sectors or by large firms. They cover from less than one hundred to many thousand workers. Government delegates to a wage council are not just referees in the bargaining process. Their consent is required to validate any agreement, thereby extending it to the whole sector covered by the wage council. Without it, the terms of the contrctare binding onlyfor the firms andtrade unions directly involved in the negotiation. In practice, validation has been conditional on wage increases in line with official inflation targets.2

The labormarket and traderefom in manufachuing

111

A furious outbreak of strikes in the private sector accompanied the revival ofwage bargaining: newspapers reported some one thousand strikes in 198586 (Filgueira 1990). The intensity of these conflicts is usually explained as a manifestation of the accumulated social demands that went unmet during the military regime. More likely, however, it reflected a learning process by trade unions concerning the true location of the labor-demand schedule. The wages of only about 350,000 workers are set by direct negotiation throughwage councils, so notall activitiesare covered.Wage bargainingapplies primarilyto manufacturing. For labor categorits not covered, such as rral workers orhousekeepers, and for cases in which no agreement isreached by dic wage council; the government-set minimum wag: or wage increase applies.' Labor contracts in the public sector have teatures that distinguish them from others in the economy. Once civiiservants have tenure (usually, after 6 months) they cannot be dismissed except for manifest incompetence or the commission of misdemeanors. Even then, the Senate must consent to the dismissal Workers in state-owned enterprises can be dismissed for other reasons aswell, and Senate authorization isnot required. In practice, however, dismissing aworker is almost as difficult as it is in the central administration. Trade unions

Trade unions or federations are not organized by labor categories or skills, bursimply by sector. Thus, blue-collar workers and foremen (and sometimes even managers) belong to the same guild. Union membership rates remained almost unchanged in the public sector from 1985-87,just after the democratic recovery, to 1990 atLanaverage level of 58 percent (table 6.1). Nor has there been much change in the number of public sector strikes (or their harshness) since the return of democracy (Filgucira 1990). In the private sector, however, membership rates fell, dropping from an average of 54 percent of wage and salary workers in 1985-87 to 47 percent in 1990 (from 39 percent to 34percentas ashare of all personnel). The decline mayreflect some initial overshooting of labor union affiTiarionsfollowing the return of democracy or even the weak auditing of declared membership before 1987. The 1990 figures probably provide a more reliable picture of the actual strength of the labor movement Wage setting in manufacturing -Higher union wages may result from the capturing of rents that arise when foreign competition is blunted by tradebarriers. Did unionswork to gettrade barriers erected or did they simply work to gain the rents after barriers were already up?

112

EFFwErsOF PROTECTIONIS4 ON A SMAU.CouNTRiY THE C4SE OF URUGUAY

Table 6.1 Union membership, 198547 and 1990 A ashore ofwge

kxdtwyckss4ctunIndustry I

31.11 3112 3113+3119 3114 3115 3115+3122 3117 3118 313 314 321 322 3231 3233+324 341 342 3522 351-+352-3522 355

362 381+382+383 4 5

6 7

8 9

Agriculture Meatproducts Dairyproducts Preservesandcandies Fish Edibleoils Grainmill products Bakeryproducts

andsaolry wvkws 1985-87 1990

5.9 60.3 71.0 35.3 47.5 75.7 108.4 14.7 81c Sugar Beverages* 787 manufacturers 70.0 Tobacco Texile products 51.9 Apparel 93.6 Leathertanning 473 Footwear.leatherproducts 60.4 Paperandalliedproducts 56.6 Printingandpublishing 38.5 Drugs 59.9 Otherchiemicals 423 Rubberproducts 74.9 Gass 108.9 73.4 Metalandmachinery 75.4 ULRdfes (public) Construction 32.7 12.4 Trade Transportand conmmunications (public) 70.1 Trasport and commnunications (private) 34.8 Fnanceandinsurance 43.8 Centralgovnmment 26.6 Localgovernment 59.9 Otherservices (private) 26.9

4.1 42.1 55.6 34.6 49.2 67.9 112.5 .. .

109.4 68.9 49.3 21.8 63.0 45.4 31.4 32.9 55.8 371 53.4 ..

Asa share c(

agpersonned J985-87 1990 3.4 38.0 66.7 26.7 40.7 57.0 61.8 7.4 69.9 57.1 41.2 31.9 45.7 46.4 35.1 54.9 21.8 49.1 34.8 70.4

2.3 26.5 52.1 28.7 42.4 50.8 64.9 79.3 40.2 30.3 10.7 61.8 26.7 30.5 18.6 45.8 303 49.4

106.4

633 78.8 232 8.1

41.0 75.4 22.2 -9.2

353 78.8 15.8 6.0

72.1

70.1

72.1

343 41.9 28.2 53.2 26.1

28.8 27.0 26.6 59.9 18.0

29.0 25.8 28.2 53.2 17.2

Notavmalable.

ftte: Because thepolit weightofa unicninthe abormovmentdepends on itsnumberof aRfliates, these membersipfiguresmaybeoveres6mated-as ratesover 100 percentstrongly suggesL a. IndLidesone or rnore tate-ownedfinns Source:Basedon datafrm kireci6n Generalde Esadkdcay Censos(DGEC Oina de Plrearieo

y

Presupueszo (OPP).andRienar Inotersindcal deTrabajadores-Convend6n Nacional deTrbaladores(Prr-CNT).

Rent seeking by organizedlabor The first question, then, is whether trade unions participated in the rentseeking process underlying protective measures. Uruguayan economic history suggests that the answer is no (Rama 1991). Inward orientation intensified in the l930s and early l940s. The general tariffrose from 31 to 48 percent

The labormarket and trade reform in manufaauning

113

in 1931, and multiple exchange rates were established in 1933-34 and importlicensesin 1938. In 1941 a central bureauwasgiven authority to allocate foreign exchange, approve import licenses, and ban imports that competed with domestic production. Organized labor was not a relevant social partner during that period. Its strength had been dramatically reduced by conflicts between Marxists and Anarchists at the beginning of the century and later by the Great Depression. The initiative to create the wage councils in 1943 did not come from trade unions but from a parliamentary committee charged with investigating the living conditions of the working class. More direct evidence of labor's lack of involvement is available from Rana's (1993) surveys of privately promoted foreign trade regulations in Uruguay from 1925 to 198N.Roughly half of the four thousand or so laws, decrees, and resolutions creaung or modifying trade barriers for the benefit of a few firms or sectors explicitly idendfyr their petitioners. Of these, only two include a trade union among their sponsors. In October 1947 a lumber firm and its corresponding trade union got a change in the import tariff on planks and in March 1949 the leather guild and the sectoral trade union got an export subsidy for tanned hides and footwear. In all other cases, rent seeking was carried out by firms only. Rnt shadng by organized labor Although Uruguayan trade unions did not play a direct role in petitioning for trade barriers, they could have claimed some of the rents created by such barriers. When firms face harsh competition, there is little scope for wage increase Trade unions are better placed in situations wbere firms enjoy significant market power. Unions are thus expected to be stronger in sectors in which competitors are few. One way to test the rent-sharing hypothesis is to check whether union membership rates are higher when there are barriers to competition in the corresponding product markets.4 (Table 6.2 reports 1990 rates only, since no significantregression results can be obtained from 1987figures, confirming their unreliability.) Monopoly power in the product market is capmured by the sectoral employment share of the four largest firms in each sector in 1987, measured at the four-digit industrial classification level (table 6.2) .That means that figures reported for aggregated sectors at the three-digit level (apparel, for instance) are in fact employment-weighted averages of the disaggregatedshares. In a small country, concentration isagood index ofmarket power only if there is little competition from abroad, and so the concentration index is usedjointly with the corresponding effective protection rate

114

OFURRUGUAY EFFEcrsOFPaOTCON SM ON A SMALLCouNTRr:THECASE

Table 6.2 Unionmembershipandthe rent-sharinghypothesis (percent)

Industry cassifiotvn

kidustry

Effecive Shore ofwvge and Share of fotr sakzywir.ers Abrgestfirms in protection oronized in unions ernpfowrmenr ratesb (1990) (1987) (1985)

3111 3112 3113+3119 3114 3115

Meatproducts Dairyproducts Preserves andcandies Fish Edible oils

42.1 55.6 34.6 49.2 67.9

295 753 49.4 48.9 57.9

-3.6 17.9 -1.4 1383

3117

Bakeryproducts

14.7c

7.2

3.5

3118 314 321 322 3231 3233+324 341 342 3522 351+352-3522

Sugar Tobaccomanufcrers Textileproducts Apparel Leathertanning leatherproducts Footwear, Paperandalliedproducts Printing andpublishing Drugs Otherchemicals

81.5c 68.9 49.3 21.8 63.0 45.4 31.4 32.9 55.8 37.2

100.0 55.2 295 10.1 46.5 30.4 60.8 20.1 17.5 51.8

355

Rubberproducts

53.4

72.8

53.7

381+382+383

Metalandmachinery

63.3

24.0

167.1

3103 4.5 25.1 0.3 -1.7 -30.9 27.8 513

N Notaaitable. percentare droppedfromtheanalysis. Note:Sectorswihmemrbership ratesthatexceedIWU reportd fres areempment-weightedaverages. a.Atthe fburdgt level.Foraggregteindustries, b. Cordenmethod(1971). c Last"baiblefgures arefor 1985-87. S'urceTable6.1anddta fromCentrodeInvestigaiones Econ6rnicas (CINVE) andDirecr6nGeneral de Estadisticay Cens (GEC).

(var-iablesare measured at different points in time because of uneven data availability) Regression results are reported for both linear and log-linear speciiications (table 6.3). The coefficient for the employment share of the four largest firms in -a sector is statistically significant in all cases, with an elasticity of union membership rates with respect to this share of approximately 0.4. Higher protection rate-salso lead to higher union membership rates, but elasticity rates are hard to assess because of the high variance of the estimates. Together, the two variables chosen as indicators of imperfect competition account for roughly half the variation in union membership rates. That does not mean that trade liberalization would immediately bring union membership rates down. For one thing, the market power of domestic firms would not vanish immediately.6 For another, once the costs of organizing unions and setting up bargaining procedures have been incurred, such. arrangements are likely to remain in force.

The labormarketand traderejon in manufacturing

115

results:explainingunionstrength Table 6.3 Regression Lag-&near model Linecrmodel SpeciricadonSpedficoaonSpecificationSpecificationSpecificationSpecifation I 2 3 1 2 3

Variable Constant

0.296 (4.217)

0.438 (8.867)

Concentration index, 0.426 (3.032) Elfecive protection rate R2

0.325

0.295 (3.545)

-0.368 (-2.733)

0.352 (2.020)

0,428 (3.915)

0.120 (2.520)

0.072 (1.469)

0.292

0.436

0.457

-0.910 (-6.421)

-0.414 (-2.500) 0.451 (3.728)

0.437 (1.712)

0.196 (1.038)

0.129

0.580

aretstaistics. Note.: Number.inparentheses Oirmns in a sector. share ofaourlargest a. Ermployment rate protection leastsquare estimates basedondataintable6.2.Thelogofoneplustheeffective Source: Ordnaay variable. waswedastheexogenous

Product markets and labor dermand If, as the preceding discussion suggests, workers share the rents created by protection and the level of protection has no effect on union membership in the short run, what are the likely effects of trade liberalization? A preliminary answer can be provided using a simple analytical model that leads to testable predictions on the relationship between protection and sectoral employment and sectoral real wages. There are n firms in an industry that compete with each other by producing differentiated goods. The firms or industries also compete with imports, whose price expressed in domestic currency is normalized to one. The tariff-inclusive price of the imported good is (1 + T). - From the standard monopolistic competition model, the demand schedule faced by a firm or industry i (with i = 1, ... , n) can be written as follows: (6.1)

q1= a, Y(J/V)

-

O < ai.< 1, cr> I

where q1is output of firm or industry i, P is price, Y is aggregate demand for the nt+ I goods in the model and is expected to be positively correlated to economic activity, and a is the price elasticity of demand (the lower a the greater the monopoly power of firm or industry i). The average price of the imported good and its corresponding domestic substitutes is given by V: (6.2)

V

Aaiu.+TiT)it=

[ i=l

+ -

1

~~~~~~~~~~i=1

116

EFrECrs OF PROTECTIONISMON A SMALL COUNTRY: THE CASE OF URUGUAY

where .Lincreases with individuals' preference for imported goods (a, is assumed to be small, so that dV/dP = 0). For simplicity, suppose that domestic goods are produced with labor only (L;), under constant returns to scale: (6.3) where [,Bis the labor coefficient in firm or industry i. The first-order condition for profit maximization implies: Pi =5U cf W

(6.4)

where W1is the nominal wage paid by the firm. The price of the good produced by firm i is thus set by applying a constant markun ratio over wage costs. The analytical expression of the labor demand schedule can be drawn from equations 6.1, 6.2, and 6.4: ~ j a (6.5)(6.5) Lj=A~Y(-7) w-Y, A 1 =acj317(--), S

,wj=W/P.

In this expression, P is the general price index for all goods, notjust the nt+ 1 goods in the model. Hence, w;is the relevant real wage for individuals' decisions. The V/P ratio is higher (other things being equal) the higher the tariff rate T. The demand for labor in firm or industry i increases with aggregate demand Yand with trade barriers T, and decreases with the real wage wi. The elasticity (a) with respect to the realwage is the price elasticity of demand in the product market. By assumption, this parameter does not depend on the tariff level. In the short run, then, trade liberalization in this sectorwould shift the labor demand schedule to the left, without modifying its shape (figure 6.2). The role of trade unions The effects of trade liberalization depend on whether the labor market is competitive. Assume that individuals have no risk aversion. The utility Uof an individual working in firm or industry i can be written as: (6.6) with parameter utility becomes:

U= rw,

r depending on preferences. If the individual is laid off,

The laharma,*et and trade reform in nanufSacing

(617)

U= r-r(Y, L,, T),

117

dr/dY > 0, dr/dL, > 0, dr-/dTc 0

where rf Y,L, 7) represents either the wage level in the competitive sectors of the economy or the real income level associatedwith domestic activities. This reservation wage is a positive functicri of aggregate demand Y. In addition, itincreaseswith employment in firm or industry ibecause of imperfect substitution between specific labor skills. Finally, it is a negative function of tariffs, under the asstumption that trade barriers reduce economic efficiency. In acompetitive labor market, firm orindustry ipays the reservation wage:

(6.8)

zu.= r.

When equation 6.8 holds, trade liberalization leads to a fall in employment, but its effect on the real wage level is ambiguous. A lower demand for labor in firm or industry i reduces the reservation wage for the corresponding skills, while gains from trade shift the r(Y, Lj, 7) schedule up. The marketequilibrium moves from point C4to 4 (figure 6.2). That labor demand is not infmitely elastic creates an incentive forworkers to raise wages. The simplest analydcal tool for dealing with this issue is the monopolyunion model, inwhich the trade union sets the wage level and the finm or industry the employment level (see Oswald 1985). This condidion corresponds to a Stackelberg equilibrium in which the union, as leader, takes into account the reaction function of the firm or industry, represented by its labor demand schedule. Such asymmetric power seems plausible in a country with as strong a labor movement as Uruguay's. Figure 6.2 Trade Uiberalization and the labor market Reetwvige

i

Unionwage

~~~C2

I

A I~

~~~RI == 5

Reservadonwage =

|

oo

~~~~~~~Labordemnd b

118

Emas

OFPROECIONIS ONA SmAr. CouNTrr THE CAsEOFURUGUAY

Assume that the trade union in finn or industry i has M. members and

thatM,does notdepend on trade barriers T in the shortrn. The trade union in firr or industry i sets the nominal wage level W (and thus the real wage level w,.)that maximizes the expected utility of its representative member: (6.9)

AX Li

rw, + (1-

)rr

sulbject to equations 6.5 and 6.7. This yields:

(6.10)

Li

where e represents the elasticity of the reservation wage r to employment L. Note that for e = 0, the wage level set by the trade union is a constant markup over r, with the markup ratio being the same as thatused by firm or industry i to set the price P. (see equation 6.4). But in the general case the markup ratio increases with L, and so does the wedge between the union wage and the reservation wage. Thus, in a unionized fiwmor industry trade liberalization shifts the labor market equilibrium from R, to R2 (figure 6.2). As in the competitive labor market case employment falls and the effect on real wages is ambiguous. But the percentage drop in employment is smaller, and the real wage falls moreor rises less-than in the case of competitive labor markets. Two caveats apply to this analysis. First, different assumptions about the wage-bargaining mechanism could have resulted in a different impact of trade reform. For instance, de Melo and Tarr (1990) consider a model in which bargaining involves both wages and employment, so that the outcome is no longer on the labor demand curve. Grossman (1984) assumes a seniority layoff rule, implying that senior workers have a disproportionate influence on union decisions and, therefore, that wages respond sluggishly to trade reform. Second, the results hold only in the short run. In the long run foreign competition in the product market should increase the price elasticity of the demand for goods (<sin the model) and, therefore, thewage elasticity of the demand for labor. The markups used by the firm to set prices and by the union to set wages would gradually vanish, thus removing the incentive to unionize. Eventually, both the product and the labor marketwould become competitive. Trade reform, employment, and real wages Since the mid-1970s tariffs have been falling in Uruguay. Protection rates fell along with tariffs until the early 1980s when the increased use of refer-

The labor mwnkdand tradernormin manufaduiung

119

ence prices in many sectors, a form of administered protection, caused a partial erosion of the effects of tariff reductions (see chapL!r 3). Estimates of nominal protection rates at the four-digit industial classificationlevel (CINVE 1987;Macadar 1988) can be used with the model above to assess the impact of trade liberalization on employment and real wages.' The labor market model presented earlier can be summarized in two log,linear equations: (6.11)

log L,,=l +$2 log (1 + T,,)+ 0,log Y,

(6.12)

log wit= 8f +82 log (1-i-) +

+ 9+ log Y.

According to the model, coefficient$2 ispositivewhether workers are unionized ornoL. Thesign of O2is ambiguous. CoefiTcients43and %., which control for changes in aggregate demand, are both positive. Note that equations 6.11 and 6.12 include sector-specific intercepcs 4,i and 9-,. Allowing for different constant tenns is a natural assumption for sectoral employment In terms of equation 6.5, coefficients 0 it reflect differences in parameters acand J3.As forreal wages,coefficients 8,4are intended to capture persistent interindusaywage differentials such as those associated with sectoral differences in workers' skills, nonwage characteristics ofjobs, and the like.3

In the estimation, L,,is measured by the number of wage earners (both blue-collar andwhite-collar workers) in finns with five or more personnel in each sector. In turn, w.is the average real wage of blue-collarworkers at 1978 prices. For T7,two different indicators are used: the nominal protection rate (the import tariff, adjusted for the gap between reference prices and border prices) and the implicit protection rate (the excess of domestic prices over border prices).9 Equations 6.11 and 6.12 are similar to those applied in studies of U.S. labormarkets by Freeman and Katz (1991) and Revenga (1992), except that these studies use import penetration ratios and import prices as indicators of foreign competition, instead of protection rates. Import penetration ratios depend on output decisions (and therefore, on employment decisions) by domestic firms, so they are endogenous. The same holds true for import prices, to the extent that the United States is not a small country in world markets. Protection rates, by conrast, are exogenous. Estimated elastidties The estimates for coefficients $2 and 02 suggest that over the six years covered trade liberalization had a negative effect on industrial employment but

120

CouNrTrrxTHECASEOFURUGUAY EFFwr OF NaoromoNtsM ONASMALL

Table 6.4 Responseof employment and real wages to changesin protection rates (elostkites) Rec wees(w,)

Empbyment (L,)

(6.13) (6.12) (6.14) (6-li) (6-13) (6.11) Varable Nonrinoprorctinrate(I 1T) -0.005 0.377 Wholesanple' (-0.083) (3.196)

(6.12) (6.14)

Years with competive

labormarket Changedue to unionization

0.236

0.048

(1.762)

(0.687)

-0.186

-0.021

(-1.032)

(.0.217)

Inmplcitproteton rate ( +T) WIhole sampIe'

-0.103 (-1.561)

0-514 (4.400)

Yearswith competitive labor market

0.441

-0.069

(3.758)

(-0.978)

-0.443 (-2.570)

-0.066 (-0.715)

Change due to unionization

R2

0.898

0.905

0.903

0.914

0.767 0.769

0.771

0.771

acity. Numbesin parentieses aret4atksia. contolingforeoonoric Nlar Covarance modelspecdraion. 1982. (atthefour-dt induwtriidassiictionIleI) overthesixyears1978.1980.1981. a.Thrty-ninesectors 1985.and 1986. Econ6rnicss (C lE). CentraldelUrguay(BCU),Cero deInvesfiaciones SourceBased on dataforn Banco andDrecd6nGenerC de EBdi;tiy Censos(DGEC

no significant effect on real wages. Indeed, cutting down the tariff-inclusive price of imports by 1 percent led to an employment drop of 0.377 percentage points when the nominal protection rate is used as an indicator or 0.514 percentage points when the implicit protection rate is used (table 6A4,columns 1 and 4). Real wages, in turn, rose slightly (0.005 or 0.103 percentage points), but the coefficients are not statistically significant. The analysis was repeated allowing for a one-yearlag between the changes in protection and the corresponding effects on employment and real wages, to accountfor rigidities thatprevent adjustmentwithin the same period. The results were roughly the same with the exception of a drop in the elasticity of employmentwith respect to the tariff-inclusive price of imports. Freeman and Katz (1991) and Revenga (1992) achieve similar results for the United States when considering annual changes in employment and wages. Revengafinds an elasticity to importpricesofO.351 percentage points for employment, and 0.085 percentage points forwages. Freeman and Katz find that a 1 percentage point increase in the import penetration ratio leads to a decline of 0.508 percentage points in employment and 0.059 percentage points in real wages.' 0

The la&r marnt and tradereformin manufacturing

121

Effects of unionization The sample includes fouryears under military dictatorship (1978,1980-82) and two years under a democratic government (1985 and 1986). Thus, the sample can be split in order to compare the effects of trade reform under competitive and noncompetitive labor market conditions. To measure the change in elasticities 2 and 02, equations 6.11 and 6.12 are replaced bT

(6.13) log L,=4,J +

@>4D,+ 2 log (1 + Tg) + 4.D, log (1 + 7) 4 log Y,

(6.14) log wi,=Oj +04D++ 0 log (1 + Tt) +O 5D, log (1 + T,) + 03 log Y, where D;is a dummy variable that takes a value of 1 in 1985 and 1986, and 0 otherwise. When workers are organized in unions, the elasticity of employment with respect to the tariff-inclusiveprice of imports is 02+ 45(instead of 4; in the competitive labor marker case); the corresponcdingelasti-ityforreal wages is 02 + 05 (instead of 0-). According to the model above, 45should be negative and 65positive. ' 8, and ishow that neither 6(0.048 or -0.069) nor Estmates for 4o 05 (-0.021or-0.066) isstatisticallydifferentfromzero,indicatingthattrade liberalization did not affrct real wages whether the labor market was competitive or not (table 6.4, columns 2,3, 5, and 6). The real wage levelwas not the same inboth cases, however. Coefficient64 is positive (notshown in table6.4) and significant at the 10 percent level when implicit protection rates are used. 1 Real wages are higher when workers are organized in unions. The elastidty of employment to the mriff-indusiveprice of imports is positivein the period with labor market competition (42 of 0.236 or 0.441),12but ]lUsafter workers unionize, as figure 6.2 suggests itwoulci Coefficient 65is alwaysnegative (4.186 or -0.443) and is significantlydifferent from zero when tariffs are measured by implict protection rates. That means that in 1985-86 -tradeliberalization became a less effectivetool for achieving labor relocation. Is this result due to unionization only, or are there other factors behind it aswell? There were no changes in legal dismissal procedures following the democratic recovery,so the negative sign of coefficient O,does not arise from higher fiing costs. Uncertainty in the first years of democracy was high, however, and firms may have been reluctant to adjust to changes in protection if they believed them to be temporaxy. Conclusion Trade barriers may strengthen the market power of domestic firns and create rents. Since wages can be raised by capturing rents, protection is an incentive to unionization. There is some evidence of a relationship between

122

EiFte

rsO PROTECTIONISM ONA SiuAL Couwrnt THECAsEoFUxuouay

union membership rates and variables measuring a firm's markCErpower, including a concentration index and the effective protection rate. These correlations are observed in cross-sectional data, however, and dynami'c effects may differ. Although trade liberalization should weaken labor unions in the long run, wage-bargaining procedures might remain in force for some time. If labor market imperfections outlast the product market imper-fections that gave rise to them, there may be problems during the transition if trade liberalization-proceeds too quickly. The short-run effects of trade refor-m should not be exaggerated, though. The scctoral elasticity of employment to protection rates is much lower when workers are organized in unions than when labor markets are competitive. This result suggests that labor market imperfections may reduce the short-mun effectiveness of trade policy as an instrument for improving labor allocation. Notes 1. The effectiveprotection rare measures the gap between value added at domestic prices and at international prices. The rate increases with trade barriers on output and decreases with tr-adebarriers on inputs. 2. In fhact,the threat of nonvalidation has operated as an incentive to continue to divide into activitygroups until e-achgroup includes homogeneous firms, in the sense that they can all afford the-same wage level. 3. Until 1990 all private sector wageswere adjusted at the same time. Since then the setting of minimum wages(or wage increases) by the govermecnt has not necessarilybeen synchronized with the adjustments decided by wage councils 4. The rent-sharing hypothesis is tested by Rose (1987) for the United States, by Stewart (1990) for the United Kingdom, and by Christofides and Oswald (1992) for and.The studies use wagesas the endogenous variable,taking unionizaton asgiven. 5. No statisticallysignificant coefficientswere obtained when using other indicators of sectoral openness, such as Krueger's ratio (the ratio betwe-enthe foreign-trde deficit of a specific sector and its correspontding domesticdemand), the share of exports over total sales, or the share of imports over domestic demand. 6. A CMNVE report (1987) cites the example of firms in Uruiguaythat became iniporters after trade liberalization and kept using the same trade network. 7. Estimates of nominal protection rates are available for thirty-nine sectors for 1978,1980,1981,1982,1985, and 1986.Ikwould have been better to use information on effectiveprotection rates, but estimatesare available at the four-digit.level for 1981 and 1985 only. Even for nominal protection rates, not all required information is available for all sectorsand years.Thus, sonicobservations have to be set aside in the analysis. 8..In econometric terms, allowing sector-specific intercepts corresponds to the covariance model specification, which is a simnplewayto deal with panel data (crosssection for sectors, time series for years).9. Both indicators differed in the first stages of tr-ade liberalization, when redundant protection was still high (Rama 1982). 10. The figure r-eported byIFreeman and Katz (1991) is actually 0.545in the case ofemploymcnL However,this estimate is obtained for a given real wage. Since employ-

Thelabormar*uand trade refom in manufactuing

123

ment decreases with real wages,and the latter decrease with import penetration, the reported figure overestimatesthe emnploymentimpact of foreign competition. 11. It is even signifiCantat the 5 percent level under the restriction 02 = 05= 0. Estimatesfor 04 are 0.062 or 0.050,depcnding on the chosen protection indiator. 12.This is in accordancewiththe significantlabor relocationdepictedin figure6.1. References

Aguirre, R., and E. MEndez 1988. "El trabajo informal urbano en Uruguayr una aproximaci6n a travEsdel analisisde lasencuestasde Hogares. SUMA3(4): 89-103. Christofides,L., and A. Oswald.1992.'Real WageDetermination and Rent-Sharingin CollectiveBargainingAgreements.' OwanerlyJounaiofEconmics(August):985-1002. CINVE (Centro de InvestigacionesEcon6micas). 1987. "La industria fiente a la competencia extranjera CINVE-Edicionesdc la Banda Oriental, Montevideo. Corden, M. 1971. The Thery ofProtection OxfordcClarendon Press. Diezde Medina,R.,and P. Gerstenfeld. 1986."Sectorinformal urbano: marco te6rico, cuantificad6n ypropuesta de medici6n para el caso Uruguayo. Direcci6nGeneral de Estadisticay Censos,Montevideo. Filgueira, C 1990. 'Organizaciones sindicales y cmpresariales ante las politicas de estabilizaci6n:Uruguay 1985-7." In Estabitacidny Respusta So&acInternational .LabourOrganisation, Santiago de Chile. Freeman, R., and L Katz 1991. Industrial Wageand Employment Determination in an Open Economy."InJ. Abowdand R. Freeman, eds., Immigration,Tradeand the LaborMaTietUniversityof ChicagoPress. Grossman,G. 1984."International Competitionand the Unionized Sector.' Canadian Journad of Econmics 17(3): 541-56.

Macadar,L. 1988."Protecci6n,ventajascomparadasycficiendaindustial."SL hA3(5): 7-59.

de Melo,J., and D.Tarr. 1990. 'Industrial Policyin the Presence of WageDistortions The Case of the U.S Auto and Steel Industries." Center for Economic PolicyResearch Working Paper 435. London. Oswald,A. 1985."he Economic Theory of Trade Unions: An Introductory Survey." Scandiumianfourrau ofEconomics87(2): 160-93.

Rana, M. 1982. "Protecci6nycrecimiento industrial.' ClNV-Ediciones de la Banda Oricntal, Montevideo. .1991. "EconomicGrowth and Stagnation in Uruguay."In ALBlomstromand P. Meller, eds.,DiveingPaths: CompainWgaCenu7ayof&Sandinavianand Latin American EonomicDevkopmenL Baltimore, Mdz:JohnsHopkins UniversityPress. 1993. "Rent-SeekingTrade Policy:A Time-SeriesApproach." PolicyResearch Working Paper 1142.World Bank, PolicyResearchDepartment, Washington, D.C. Revenga, A. 1992 'Exporting Jobs? The Impact of Import Competition on Employment and Wages in U.S. Manufacturing." QyarteriJournal of Economis 107(1): 255-8t

Rose, N. 1987. 'Labor Rent Sharing and Regulation: Evidencefrom the Trucking Industy."Journal ofPolitcalEconomy95(6): 1146-78. Stewart,M. 1990. "UnionWageDifferentials,ProductMarketInfluences and the Division of Rents." EconomicJournall0f(403): 1122-37.

costs ofprotection Economyzwide and labor market rgdities Jaime de Melo and David Roland-Holst

Preceding chapters have documented the extensive distortionsin Uruguay's goods and labor markets. Evidence was presented of rent-seeking activities and their associated costs in terms of lower growth rates in sectors that received disproportionately large amounts of discretionary protection (chapter 2).- Reference and minimum export pnce systems were shown to have boosted protection by some 7 to 18 percent (chapter 3). The high costs of protective measures in the automobile industrywere shown to generate substantial rents (chapter 4). And although no direct evidence of trade diversion was detected from the operation of the bilateral trading arrangements 'with Argentina and Brazil, the coupon quota system was suspected of leading to inefficient specialization patterns with Brazil and especially with Argentina (chapter 5) . Uruguay's labor market in manufacuingwas shown to be dominated by strong labor unions (chapter 6) Wie these manyinterventions in product and labormarkets are indicative of the distortions in resource allocaton, th%reare still others that have not been analyzed. The prohibition against exporting catde on the hoof providedprotection to the meat-processingand leatherindustriesin theform of lower prices. Interest rate ceilings led to extensive credit rationing. And even after the progressive decontrol of interest rates that accompanied the financial sectorreforms begun in 1974 (see the chronology ofreforms in the appendix to chapter 2), remaining con trols permitted preferential access to credit for selected activities, particularly for public sector enterprises. The complexity and pervasiveness of such interventions suggest that it is appropriate to investigate their economywide inplications in a general equilibrium setting by quantifying the likely welfare losses due to the combined influence of interventions in the labor market and in foreign trade. The estimates are derived from a static computabIe general equilibrium (CGE)

model, using input-output data for thirty sectors for 1983, the most recent year with reliable data. 124

Beanosquide castsofpprfecsionand laboriwn*igidizes

125

Not all the effects of trade and labor market interventions are incorporated in these estimates. Trying to account for all of them would be a Herculean task under any circumstances, especally for an interventionfiddled economylike Uruguay's. The decision aboutwhat effects to explore was therefore guided by both the availability of data and the desire to illustiate how an improved allocation of resources gets tanslated into higher welfare. Thatled to aconcentration on the effects oftarifis andadministered protection in foreign trade and on wage premiums in the labor markeL Also, because the estimates are forarelativelyfine disaggregation of the economy, they capture the effects of differences in price wedges across sectors. In this stepwise approach to estimating the costs of protection and labor marketrigidities, the first step is to estimate the likelycosts ofindividual trade interventions, assuming no distortions in the labor marketand perfect competition and constant returns to scale throughout the economy. The next step considers the implications of labor market distortions, taldng existing trade interventions as given. Finally, the welfare costs of protectioia and labor market rigidities are estimated, allowing for increasing returns to scale and noncompetitive behavior in manufacturing. The estimatesfind thatthe costs ofadministeredprotectionfaroutweigh the costs of tariffprotection. The costs of tariff protection are small because weighted arrage nominal protection is about 10 percent and the import share in GDP is 12 percent But administered pro tecti n exacts a high price: trade and transport margins are four times higherfor imports than fot 'similar" domestic goods. The general eqailibrium estiaates indicate that eliminatine this extraprice wedge wouldadd some tc 4percent to base GDPwhile removing tariff protection alone would add only 0.1 percent to base GDP. The costs of administered protection double if the value of the rents generated is dissipated in unproducive activities. The simulation analysis suggests thatthe resource allocation gainsfrom eliminating wage premiums would be relatively small (tiough twice as large as the gains from removing tariffpro tection alone) because for tradables the premiums are concentrated in sectors with low employment levels, while for nontradables the scope for labor relocation is quite limited. When economies of scale are introduced for selected manufacturing sectors, the gains from removing tariffs and administered protection are about 50 percent higher than under coastant returns, as resources move from sectors operating under constantretumrnsto those operatingunderincreasingreturns to scale. Modeling the effects of Uruguay's market interventions Three sources of foreign trade distortions are explored: the price wedge resulting from import tariffs and the operation of the reference price system

:126

ONA SMALLCouNTraTHECASEOF URUGUAY Ewzcrs OFPROTECTIONISM

(administeredprotection), thepossibilityofpricingabovedomesticaverage costs when trade barriers limit entuy, and rent-seeking behavior. Consider the wedge between imports and the donmesticallyproduced competing product The value of imported and domestic goodswas decomnosed into producer value, tax, and margin components (see following section).1 In line with the evidence provided by Changanaqui and Messerlin in chapter 3, differences in margins are interpreted as reflections of the effects of nontriffbarriers. These effectsare decomposedinto twoeffects: the higher tradeand transportmargin on imports and the resource costof rent-seeldng activity. The wedge resulting from the excess" trade and transport margin paid byimportsovercomparable domesticgoods (ew) forsectoriiscalculated as: (7.1)

twJ= frm.-ttrd

where tnnrand tnidare the margins on imports and domestically produced goods in sector i These margins appear as a source of final demand for tie r-adeand ransport sectors. A case can be made that the revenues accruing to the trade and transport sectors-notably those arising from the port activities in Montevideo-are rents. So the second effect of nontariffbanriers arises from the possibility of rent-seeling activities. Following the tradition of the literature on rent-seeking, we assume tat individuals will spend resources to obtain these rents and that this rent-seeking activity consttutes an additional cost to society. As an approximation of this resource waste we assume that the value of rents in sector iis given by: (7.2)

X(tm Df=

-ird)PMmM

where PM. is the domestic currency price of imports and M. is the volume of imports. Rents, collected on the tariff-inclusiveprice of imports, are equal to the value of resources committed to the trade and transport sectors to obtain the rents. As in the literature, it is assumed that rent seeking uses resources. This is a strong assumption for which there is litde direct evidence. Az exception (coincidentally) is Rama's (1991) examination for Uruguay (discussedin chapter 2), which providesjustification for exploring this pathway of the effects of protection. The formulation follows Grais, de Melo, and Urata (1986) and assumes that the efficiency gain fromremovingnontariffbanriers can be capturedby augmenting the efficiency parameter, A, by the value of rents in the total value of output, X: (7.3)

X-=,-(1+R;

/PDjXj)Fj(Kj,L,)

Eoanomywide cosafofp/tDecton and labor mari* iigidties

127

where PD, is the price of the domestically produced good and 15() is the production functionforsectori£Aserviceable ifsimplistic formulation, equation 7.3 imputes all costs of rent seeking to the trade and transport sectors and assumes that the 'technology' of rent seeking is similar to that of the regular producdton activityin the trade and tansport sectors. Before turning to labor market distortions, we briefly describe ourmodeling of oligopolistic behavior. Increasing returns to scale are modeled by assuming constantmarginal costs and positive fixed costs (figure 7.1). Asimplifying assumption in this modeling of oligopolistic behavior is that the response to a change in policy takes place through changes in the number of products rather than the number of firms.' The various forms of protection are assumed to result in sufficient baniers to entry that domestic producers collude to obtain an above-normal profit rate, 'fj, on domestic sales. The domestic pricing rule under protection is then: PDj= (1 + TW)AC,

(7.4)

where A4. is average cost in sector £ The resulting equilibriumwith protection is shown in figure 7.1. Output drops to X, and profits are equal to the shaded rectangular area It is assumed that the above-normal profit rate would not be possible without administered protection, so '. is set to zero when protection and labormarket interventions are relaxed. The costs to society are equal to areas 1 plus 2. The size of the costs depends on the extent of unexploited economies of Figure7.1 Increasingreturns to scale A*keL

_SiL

PDj(1++)

AC

o

xI

Output

.128:

Eacrs OFNoNTEcnoNIsm ONA SMALL COUNTRY: THECASE OFURUCUAY

scale. This fornulation does not allow for rationalization effects to occur through changes in scale due to firm entry or exit.4 Distortions and rigidities in the labor market result from labor union activity or other labor market regulations that allow different wages to be paid to the same type of labor in different sectors. Two cases are considered in the modeling: wage differentials due to exogenous distortions and those due to (endogenous)

labor union activity.5 The econometric estimates ofthe

sectoral wage differentials, 4, (based on household survey data; see below), control for education and seniority and so can be interpreted as premiums rather than payments for differences in worker characteristics. - Th.ewelfare cost ofan exogenously causedwage differentialis illustrated in figure 7.2 for the case of a two-sector price-tking economy. Awage differential in favor of sector R (manufacturing) results in too little employment in tha-.sector and too much in sector U (agriculture). If there are no other market Imperfections, the social costs of the rents accruing to labor in sector Rare equal to the private costs, that is, to area abc. But because the wage premiums are in manufacturing-the most protectedsectorinUmuguay-removingprotectionwill exacerbate the social costs of distortion ir. the urban labor market by shifting the social demand curve for labor in for manufacturingand out foragriculture. This second-bestsituation means that the outcome of removing trade distortions is ambiguous, so the effects of removing trde and labor market distortions are examined separately. - The second specification of wage differentials assumes them to be endogenous, following Rama's evidence in chapter 6 that wages in Uruguay Figure 7.2 Labor market distortionsfrom exogenousinterindustry wage differentials WFt

Wa=Wo

SP MPI

.~

~~

WU

LR

,_

<4

'

Lu

.-';-'

'

-

-

Ecenomywade costsof pmtcdon and laborma*elrigidities

129

are determinedlargelybylaborunions. Followingde Melo andTarr (1993), the labor union is assumed to have a generalized Stone-Geary linear expenditure system udlity function:U= f(W4L)

(7.5)

with the avenge wage W employment 4 and the wage premium x as arguments (sectoralsubscriptshave been omitted). The union eithersets the wage rate unilaterally or negotiates it with the finn, and the firm unilaterally deterxnines the level ofemployment. The outcome isshown in figure 7.3, where the firmnchooses the profit-maximizing level of employment Lk along its labor demand curve, L = L(WO4,where p is the endogenously determined wage premium chosen by the union to maximize its utility at WI.It can be shown that: L

-(7.6)

F1 O

*=F(a,8y):

where ais the elasticityof substitution between labor and capital, 6 and yare the weights atta&hed to employment and wages in the union's utility functon, and the F teons are the partial derivatives of the function determining the endogenous wage premium 4. Thus, the endogenous wage premium depends on the union's objective function and on the relative weights attached to wages and employment.6 In this formulation the labor union sets the wage, so the costs of labor market rigidity are endogenous. For example, a reduction in protection in Figure7.3 Wagedetenninationwith a labor union

w

; Wug \

U \1

LU

= .\

U-UI

U

z~~~~~~~~~ u=~~~~~~u=u

Lv= Labordemard L L

:

-

130

Em.ars OFPROTECnONISm ONA SMALLCOUNTRrY THE CASEOFURUGUAY

a sector will result in a lefward shift in the labor demand curve for that sector because of a shift away from the domestic substitute good, causing the

union to choose a lower wage premium. (Calibration of the initial value for the wage differential is cxplained in the following section.) The remaining features of the model are standard for a computable general equilibrium model, except for the inclusion of trade margins as a proxy for the distortionary effects of administered protection. 7 A representative consumer maximizes utility and a representative produlcer maximizes profits, with atomistic behavior throughout (except for one case that allows for an above-normal profit rate in manufacturing sectors under increasing returns to scale). The economy's terms of trade are fixed by the small-country assumption, and capital and labor are in fixed supply. Equilibrium is reached in the usual manner, with a vector of relative product and factor prices that eliminates excess demands in product and factor markets. Assumptions about functional forms are given in figure 7.4, and the resulting social accounting matrix for 1983 to which the model was calibrated is given in appendix table 7A.1. Estimates of price distortions and wage premi Estimates of price distortions in product and factor markets, based on detailed input-outputaccounts of 1983 (BCBJ1989), include the wedges introduced by tariffs, by trade and transportation margins, and by wage differendials (appendix table, 713.1).The average import-weighted tariff is 10 percent,' but the major wedge between the c.if. import price and the reta pnce is accounted for by landing costs and other import margins, which together avenge 35 percent of the markup on the c.i.f. import value. The 1983 input-output table forUruguay gives unusuallyspecifi.caccount-

ing information on the tax and margin components of prices for domestic goods and comparable

imports. Trade and transport margins are the usual

payments for distribution services on domestic goods. For imports they are likely to include in addition not only landing costs but also any price effects of nontariff barr,iers. If the data are sufflciendly disaggregated to distinguish comparable goods at the sectoral level, the effects of nontariff barriers-the reference and minimumr export price system-will showup as the differences in margins on imports and comparable domestic goods. The microeconomic evidence provided by Changanaqui and Messerlin (chapter 3) supports the use of differences in trade and transport margins (columns 2 and 3 of ap pendix table 7BJ1) as proxies for the tw1 variable defined in equation 7.1. While in principle the transport component of price margins should be similar for imports and comparable domestic goods, that isnot the case here.

Ewrnwi&d cos fofedion and lkbor ma*vngidit s IS Figum 7

spedfication lasEisdky

of production (a)AJocadon Domesticwuply

Grossoutpt

Vai ade

I

I

CErSUP*l E~~~~~~~q~~Boft

'.

Idnterediate

Leontief

CES

I\

A~~~~~~ CL

cap es Labor

CES

'-ES

impoed Domestic internediate i

- -

-

Dorestic m t

(b) Comnsuerdemand Consumptio

LES

con

s p---: C1

--

(a) M2u e CES

CES Domestic 5x

Imported

3.1. nde MebadTarw(:992)taibe

Domestc

Impted

Imported ie

132

EFFECasOFPzOToCnONISMONA SMALLCOUNTRY: THE CASE OF URUGUAY

One reason for the differences is the inefficiency of the port of Montevideo, which harndles most imported commodities. The port is unusually inefficient by intemational standards. According to World Bank estimates the port's cargo handling performance is about 60 percent of the average for a group of 220 international ports, and its hourly productivity is about 62 percent that of a control group of ports in developing countries. The National Port Authority has an antiquated and overgrown administrative structure, and most activities are under the strong control of labor unions. Its financial situation has deteriorated steadily since 1980, with rising costs, shrinking traffic, and declining productivity. At the same time, portuser costs have risen, both nominally and in terms of waiting time, damage, and other losses. In the United States,. where wholesale margins are also found to be systematically higher on imports than on comparable domestic goods (Rousslang and To 1992), delivery lags and additional storage costs for imports account for a 9 to 11 percent price difference between domestic steel and physically identical imports (Jondrow, Chase, and Gamble 1982). But other factors may also account for differences in the value of margins on imports and domestic goods. Distibution channels may be quite differentsince imports tend to go towholesalerswhereas domestic manufacturers sell directly to retailers, performing the wholesale services themselves. In any event, whatever the other causes of the observed differences, they are unlikely to lead to differences as large as those found for Uruguay: on average imports pay over four times more in trade and transport costs than do domestic sectors (appendix table 7B.1). For reference, consider again the United States, the only country forwhich detailed comparisons are available. The added protection attributable to higher wholesale and freight costs for imports isabout 15 percent (RousslangandTo 1992, table 7.3)-farless than the fourfold difference observed in Uruguay. This large difference between the two countries suggests that the inefficiency of the port of Montevideo cannot alone explain the large margins between importand domestic goods inUruguay and that administrtive importdeterrence, such as the reference price system, must play a substantial role. . Concentration ratios for the thirty manufacturing sectors average 44 percent, indicating that the largest four firms in a sector generally account for nearly half the employment in their sector. Though the figure varies from a low of 17 percent (bakery) to a high of 100 percent (sugar), the concentration measures are fairly uniform and indicate that most sectors could be strongly influenced by the individual or collective decisions of a few fiwms, especially if there are barriers to entry for imports. These high concentration ratios provide indirect support for the assumption that protection may have allowed above-normal profits in manufacturing.

cats ofrpmtectionand labormarketrigidifies Economywide

133

Finally, the estimates of wage premiums, adapted from more disaggregated estimates by Bucheli (1992), were obtained econometrically from household surveydata (appendix table 7B.1). Following the methodology of Krueger and Summers (1987), the premium estimates control for education

and seniority, therebyjustifying the use of these premiums as a proxy for the extent of distortions in the labor marketL Costs of tariffs and administered protection To evaluate the welfare costs of trade restrictions and to get a rough idea of the relative costs of each form of protection, trade restrictions are decomposed into tariffs and administered protection. To help in intexpreting the results of the experiments, the trade and production structure in the base solution is described in appendix table 7B.2. Uruguay's pattern of trade is typical for an economy with a strong agricultural base-agriculture contributes 13 percent to GDP and is the second largest employer. Exports are concentrated in activities that use agricultural inputs and in light manufactures, with imports concentrated in capital and skill-intensive activities. The estimated pattern of effective protection from tariffs alone (appendix table 7B.2) is quite different from the pattem of norninal tariff protecdion (appendix table 71B.1)because of the effects of triffs on intermediate inputs in the determination of a sector's effective rate of protection. For exanple, dairyproductshave the second highestrate of effective protection, but only the fifth highest rate of nominal protection. Both dairy and bakery products sectors have a nominal protection rate of 19 percent, yet the effectve rate of protection for bakery products is less than half thatfor dairy products, a divergence due to the much highcr valuc-added ratio in bakery products. Of the two measures of protection, the pattern of effective rates of protection is the better indicator of the likely pattern of resource pulls that will resultfrom the elimination of tariffprotection since it measures the protection to the factors employed in each activity. The first set of experiments (all experiments are cumulative) compares the welfare costs of tariff protection with those of administered protection: * B-1: Set all tariffs to zero. Measures the standard costs of protection. * E-2: E-1plus equalize trade and transport margins-remove adminisdomestic and imported goods (let trm. tered protection-between = rd.). Adds the costs of administered protection due to higher trade and transport margins for importsm * E-3: E-2 plus assume that the value of rents imputed to administered protection is dissipated in rent-seeking activities (see equation 7.3).

Z34

THECASEOF URUGUAY ON A SMALLCouNmrxv EFrns OFPROTECEONISM

Assumes that the value of rents accruing to the trade and transport sectors is committed to rent seeking and results in resource waste. Given the modeling assumptions about the costs of the various forms of protection, experiment 1 represents a lower bound for the costs of protection and experiment 3 an upper bound. The aggregate effects on welfare are reported using the equivalentvariadionmeasure, which estimates the change in the representative consumer's income as a result of the policy changc (table 7.1).Y To simplify comparisons, results are evaluated against the calibrated base simulation (appendix table 7B.2), using the pattcrn oftarffsand administered protection described in appendix table 7B.1. Thus, the equivalent variation-welfre measure is expressed as a percentage of income in the calibrated base simulation. To give an idea of the likely resistance of workers to policy changes, an aggregate measure of labor relocation is also estimated, expressed as the percentage of the labor force that must relocate as a result of the policy change. The aggregate results for the welfare costs of tariff protection are very small (less than 0.1 percent of initial income). The cost is low because average (import-weighted) nominal protection is only about 10 percent and the share of trade in GDP is about 12 percent. The estimated costs of administered protection are much higher, at more than 4 percent of base income, bringing tie total costs of protection to 418 percent of initial income. As noted earlier, imports pay an average offour times as much for distribution as similar domestic products (appendix table 7B31). Taking into account the resources dissipated to obtain the rents in sectors engaged in trading and transport (in the model these are the wholesale trade, transport and communication, and other services sectors) boosts the potential costs of protection to 8.3 percent of GDP. This figure is a reasonable naximum considering that the costs of administeredprotection are difficult to evaluate and that the total value of rents is probably not dissipated in rent-seeking activities. Estimates of the share of the labor force that would have to relocate in the long run as a result of each policy change help explain whyworkers resist Table7.1 Aggregateeffectsof removingtariffsandadministered protection frmnbase incomeaid enplyrnent) aQeentage change Eweiment

E-I: Removetrifrprotecton protection tariff andadministered E-2: Remove protection tart andadminstered E-3: Remove acites andceaserent-seeking

Chaxneinwelbrme

Labor rebcae

0.08 4.18

1.6 3.8

8.27

5.1

asa perenageof baseGDPof 174.6billionpesos variation.Wefaregin isexpressed byequ?valent a. Measured and ofie eployentdiages inthousndsefwork-years ashlf thesumof theabsolutevale b. Cornputed is 1.159mDionworker-yean epressedasthepercentgeof workersthatmustrebate. Baseemployment based onBcu (1989)datL Sorce:Authcrs'calcladans.

Ec-nomywdde cost of proecxon and labormarket ngugdes

135

efforts to dismantle protection. Between 1.6 and 5.1 percent of total employment of 1.16 million workers would be affected, so removal of protection would result in as many as 50,000 workers having to relocate. The microeconomic results describe the sectoral resource shifts that would be induced by the removal of protection (appendix table 7B.3). The pattem of resource pullsatthe sectoral level is shown as the percentage change in output and employment from the calibrated base. Removing only ariffs causes the greatest contraction in sectors with the highest rate of protection. For example, footwearshrinks by 22.5 percent.' 0 There isalso asmall resource shift toward tradable sectors brought about by a real exchange rate deprecation of 3.9 percenL This shift toward tradables is more pronounced when thegap in distribution margins is eliminated byremovingadministeredprotection as well as tariffs, as the real exchange rate depreciates 13.5 percent The wholesale trade sector contracts by 11.8 percent and the transport and communications sector by8.7 percent. Agriculture expands 7.3 percent, more than twiceas much as when only tariffs are eliminated. Finally,ifit is assumed that administered protection was accompanied by rent seeking, the results are magnified because fewer resources need be used-in trade and transport activties. Agriculture expands by 15 percent, and the contraction in the wholesale trade and transport and communication sectors is less than half that resulting from the removal of tariffs and administered protection without rent seeking. Te pattern of effective protection rates calculated using the standard predictorof the pattern ofresource pardal equilibriumformulaisnotagood pulls in a model with differentiated products. One reason is the generAl equilibrium effects operating through interindustry linkages. For examplt, the leather sector contracts more than footwear even though footwear has one of the highest rates of effective protection and leather one of the lowest (appendix table 7B.2). The reason, of course, is that the fate of the leather sector is linked to that of the footwear sector, a link that can be properly captured only in a general equilibrium setting. Thus, the estimated sectoral pattem ofcontraction and expansion is llustrative of the likelyresource shifts thatwould occur if protection were rem oved, butnot too much significance can be attached to the magnitudes themselves since the structure of tariffs and administered protection is very roughly estimated. Another reason is that productediffeirentiation confers some amount of autonomy on the domestic price system since itmeans that there is no longer a one-to-one relation between a change in trade policy and the corresponding change in the domestic price. Hownmuch a 10 percent tariff reducton onimnported drugs will affect the price of domestically produced drugs depends on supply and demand elastiities and on the respective axport and import shares in the sector producing drugs."

136

EFFES OFPRoTECnroNISM oNASMALL CouTRYTHECASE OF URUcUAY

Effects of labormarket rigidities Labor market rigidities also affect the welfare costs of protection. To the extent that the protected manufactuning sectors pay wages that are higher than the opportunity cost of workers, not enough labor is employed in manufacturing. When such distortions exist (a second-best situation), removing protecton might lower welfbre. Whether it does in a particular case is an empirical matter since it is not clear beforehand whether wage preniums occur in the sectors with high rates of effective protection. And when labor unions are strong, wage premiums are likely to be endogenous, so the adjustment in wage premiums resulting fiom import liberalization is of interest in itself. To assess the -effects of labor market rigidities, the effects of tariff and administered protection are combined and the possibility of rent seeking is ignored. For the following four experiments changes are measured relative to asbase solution that incorporates the wage differentials estimated earlier (appendix table 7B.1, last column): e £4 Setall exogenouswage differentials equal to unity, keeping tariff and administered protection. Measures the cost of wage differentials under tie assumption that theyare policy imposed and can therefore be removed. * E-5: Remove tariffandadministeredprotection, with exogenous*age differentials at base values. Intended to detect any second-best effects due to the combination of trade and labor market distortions. * E-6: E4 plus E-5. Measures the combined effiectsof labor market distortions and protection. * E-7: Same as E-5 but with endogenous wage differentials (see equatdon 7.6). Recognizes thatwages are determined through wage bargaining, making wage premiums endogenous. - Eliminating wage distortions leads to an estimated welfare gain of 0.14 percent of base income (table 7.2), about twice as large a gain as from eliminating tariff protection (table 7.1). The gain is larger, as expected, because labor income is a larger share of GDP than are imports. Eliminating taifh and administered protection (E-5) shows a largergain than in experiment 2, suggesting thathighlyprotected sectors payalowerwagepremium than other sectors, on average 12 Eliminating protection and wage distortions together results in an estimated gain of 5.04 percent of initial income. For the more realistic case in whic h protection is eliminated but labor unions remain active; the estimatedgain drops to 4.85 percentbecause less labor isreallocated)13 All in all, the estimates suggest that labor market distortions add an additional 25 percent to the costs of tariffs and administered protection-

Econmyuidecostsof proion

and labormaAetrigidties

137

Table 7.2 Aggregateeffectsof protectionand labor market nrgidities baseinmGeandeoramert) (wpentgedwngeftorn &penmiet E4: Erirate wagediffertials E-5: Siminre protectn with wagedifferentals E-6: Bimmnitprotctin andwagedifferentials protectionwih endogenous E-7: Elimiriate wagedifferentials

Char inwelfare

Laborreiocotbt

0.14

4.6

4.85

4.3

5.04

9.3

4.84

:2.3

asa perentageofbaseGOPor 174.6blionpesos. by equivatvaridaon. Welfaregainisexpressed a. Measured thoandsowork-yewsarsd b. Computedashalthe surno(the absoutevalueoftheemploymentdwVhanesit worker-years. is 1.159mnilion eqssed asthepernage otworkersthatmustrebcatc Baseemployment datb. basedon BCUC1989) Satcre Authorscalcuiaior's

The detailed sectoral results for employment andwages show that elknnating exogenous wage differentials boosts demand for labor and raises the wage-rentl ratio by 1.6 percent (appendix table 7B.4). For sectors with no wage differentials (agriculture, for example) wages rise 10 percent For sectors in which wage differentkals are eliminated, wage changes reflect changes in the economywidewageandin each sector'swage differential. Employment shifts toward manufacturing and services as a result of the elimination of the wage differentials (appendix table 713.4,column 1). If tariffs and admiistered

protection

are eliminated while wage differ-

entials are kept unchanged (E-5), the wage-rental ratio increases by only 0.74 percent This increase implies that sectors benefitingfrom turiffs and administered protection are, as expected, capital intensive. The combined effect of eliminating wage differentials plus tariffs and administered protection (E-6) indicates a reversal of resource shifts in many cases since several sectors with high protection also pay high wage premiums. Probably the most realistic pattern ofexpected resource shifts from eliminating protection is shown for the case in which wages in sectors with wage premums are determined by labor union actiity in each sector, according to the mechanism described in equations 7.5 and 7.6. (In the results reported in appendix table 7B.4, column 8,/6 = 2 in the labor union's objective functdon, implying a strong preferencc for wages over employment, a not unrealistic assumption in the case of Uruguay.) Sectors that experience a large outward shift in their demand-for-abor schedule experience the highest increase in wages. Consider, for example, the grain mill products sector. Removing tariffs and administered protection (E-2) results in a strong resource shifttoward the sector (appendix table 7B.3), causingarightward shift in its labor demand schedule. If labor unions determine wages, this increase in demand for labor will be reflected in a large increase in wages (81.8 percent).

138

EFEEcrsOFPRorEIloNIsMONA SMALLCouNTR. THECASEOFURUGUAY

lIncreasaig returns and oligopolistic

market structures

The high values for sectoral concentration ratios (appendix table 71.1) and the barriers to entry created by administered protection in Uruguay are likely to have contributed to the establishment of oligopolistic markets in manufacturing. A comprehensive assessment of the importance of these oligopolistic structures would require identifying and measuring the excess price-cost margin made possible by the barriers to firm entry created by administered protection. This information is not available, but there is growingcross-country evidence supporting the import-disciplinehypothesis. (For early evidence on Chile, see de Melo and Urata 1986.) Neither are there reliable estimates of the returns to scale at the sectoral level. In place of this informaton the experiments here rely on rough estimates of economies of scale and excess profits that are assumed to be the same across all manufacwring sectors. The simulations are therefore merely suggestve of the likely effects of increasing reurns to scale and noncompetidve domestic market structures. To explore the influence of oligopolistic markets on the effects of protection, the elimination of tariffs and adniinistered protection is simulated under the following two sets of assumptions: - E-8: Same as E-2, butwith uniform increasing returns to scale inmanufacturing sectors (CDR, = 0.10). * E-9: Same as E-8 but with an above-normal profit rate of 10 percent (I' = 0.1) in manufacturing sectors that disappear when protection is eliminated.

-

Both experiments are comparable to the elimination of taiffs and administered protection carried outin experiment 2, except that the calibrated base solution now incorporates unexploited economies of scale in manufacturing and, for experiment 9, excess profits under protection. Whether the aggregate benefits of eliminating tariffs and administered protection rise or fall depends on whether unexploited economies of scale are more or less extensive in sectors that attract resources than in those that lose resources. Although tiis is an empirical issue that can be settled only with detailed econometric estimates of returns to scale at the sectoral level, lower gains could be expected because of the resource shift toward agricuture, which is assumed to operate under constant returns to scale. But comparing experiment 8 (table 7.3) with experiment 2 (table 7.1) indicates that the gains from eliminating arifftsand administered protecdon are almost 60 percent higher, even though unexploited economies of scale are assumed to be relatively smalL Eliminating protection reallocates resources from nontradable sectors that operate under constant returns to scale to tradable sectors that in many cases operate under increasing re-

Econoemywdecostsofptrotectionand laborma7t rigidities

139

Table 7.3 Welfare gain of removingtariffand administeredprotection with oligopolistic market structures (pecentacechrn fjbrnboseiromrne ande*p/oymenq &pement E-8: Sameasexperiment2cbut with uniform increasing returnsto scalein manufactring E-9: Sare asexperinent8 butwith above-norrnal profitrateof 10%in rnanufictng sectorsthat disappears with lossof protecon

Chagen riwrelre

LborrelocOab

7.61

3.14

9.62

4.42

a.Measured byequivalent varation. Welfare gainisexpesedasa perrentage ofbaseGDPcf 174.6 bEknpesos. b. Computed ashalfte sumof theabsolute valueofrte ewiplaymendcanges inthousndsof vart-yearsand eprssed asthepercentage orworkersthatmustreloatt Basecerplomntis !.159milionwonker-years. c.Seetable7.1. Sourc Authas calculatiosbasedon BCLJ(I 989)data.

scale, the main exceptions being agriculture and mining. Since expansion in agriculture is largely balanced by contraction ir. mLhing, there is a net resource shift toward sectors with increasing returns to scale. Under the assumpdon that adjustment occurs through changes in the number of products produced by a firm rather than through firm enty or exit, this shift in resources means that firms move down their average cost curves in response to the righcward shift in demand induced by the elimination of protection (see figure 7.1). Of coarse, underan alternative pricing rule such as monopolistic competition, adjustment woufldoccur through the entry of new firms and firms would move up their respective average cost curves.

4

Finally, suppose that the elimination of pro tection also removes barriers to entry so that firms are forced to price more competitively. There is evidence that trade liberalization results in lower price-cost margins," 5 which

supports the assumpton that above-normal profits (the shaded area in figure 7.1) disappear when tariff and administered protection is eliminated. This move toward more competitive pricing behavior by manufacturingfirms adds another 2 percentage points to GDP. Added together, then, the costs of administered protection would be about 10 percent of GDP, only a small fraction of it due to tariff protection. While the stylized numerical analysis cannot pretend to capture precisely the various components of the costs of protection, it is clear that the costs of nontariff protection in Uruguay are relatively high, especially if some resource waste accompanied rent-seeking activities and if protection allowed firms to engage in more ohgopolistic behavior. Conclusion The numerous and pervasive distortions in Uruguay's economy present a difficult modeling challenge. In the absence of more detailed information,

140

COUNw: THE CASEoF URUGUAY ONA SMALL EmasC OFPROTPZnONISM

the general equilibrium simulation' analysis was confined to modeling the effects of tariff protection, administered protection, and intersectoral wage differentdals not accounted for by education and other worker characteristics. Though using the wedge between imports and similar domestic products created by different trade and transport service costs as the mechanism through which administered protection affected resource allocation and welfare is only a rough approximation, it permitted exploration of some of the likely effects of administered protection. The simulation estimates of the likely magnitude of the welfare effects and the pattern of resource reallocation that would take place if selected protection measures were eliminated confirm the more detailed analysis in chapter 4: the costs of administered protection are far greater than those due to tariffs. According to the crude estimates from the simulation exercises, the statc costs of administered protection could total 4 percent of GDP-even double thatamount ifadmninistered protection gives rise to rents whose full value is dissipated inwasteful rent-seeking activities. The benefits of eliminating differences in sectoral wages not accounted for by education or other characteristics of workers are estimated to be twice those of eliminating

tariff protection.

These gains total only some 0315 per-

cent of GDP, however, because wage premiums are largest in sectors that employ a relatively small share of the labor force engaged in tradable actvities and because the extent of labor reallocation is more limited for nontradable activities, which have little scope for specalization. The disaggregated model used to estimate the effects of distortions also gives an approximation of the likely resource reallocation thatwould occur if protection were elmin-ated. The simulations indicate that the resources move released by the elimination oftarffs andadministeredprotectionwould toward agriculture and, within manufacturing, toward light manufactures. The patter of trade and labor market distortions does not give rise to second-best effects because the highestwage premiums are notusually found in sectors with the highest rates of effective protection. What can we say about the robustness of the estimates presented here, considering that not all the protective instruments affecting international trde have been incorporated and that sensitivity analysis of elastcity choice and model structure has not been conducted?) No doubt the least robust estimates are those for the resource allocation costs of administered protection, which were modeled indirectly. While the results are at best suggestire, it is nevertheless likely that the costs of administrative protection are substandal larger than the costs of tariff protection. Considering Uruguay's low ratio of trade to GDP for a small country, it is not unreasonable to imagine that the costs of administered protection are ten to twenty times those

Econon-wide costsofprotection and laborkza*et

gidWIies

141

of tariff protection. Regardless of assumptions about elasticities or model structure, the exercises here show dearly that the costs of nontariffbaniers are, under any plausible scenario, many times larger than the costs of tariff protection.

The general equilibrium estimates also suggest thatif administered protection is as pervasive asis modeledhere, removingprotectionwould involve a depreciation of the real exchange rate on the order of at least 10 to 20 percent. A move toward free trade would thus entail a substantial contraction of manufacturing and an expansion of the agricultural sector of perhaps 10 percent Such a shift is to be expected in a country that has taxed its agriculture heavily for so many years. Finally, the estimates on labor relocation give some notion of howmuch resistance is likely to greetattempts to substandall5ychange trade policy.While granting that the magnitude of the estimates is sensitive to assumed parameter values governing firms' demand for labor, it is nonetheless instructive to considerwhat the need to relocate some 50,000 workers would mean in a country like Uruguay, with a strong labor union movement Stiff labor resistance should certainly be anticipated. Appendix A.

The Uruguayan social accounting matrix

The social accounting matrix (SAM) underlying the computable general equilibrium model used for the analysiswas constructed with 1983 data from the input-output matrix, national accounts, and balance of payments accounts. All data were provided by the Central Bank of Uruguay. A SAM is a tableau form of single entry accounting for income and expenditure flows between institutions in the economy. It gives an exhaustive and disaggregated accounting of the composition of national income and product The SAM used here was constructed to give particular attention to production accounting, because of the study's focus on the effects of trade policy on resourcc allocation- The SAM indudes thirty domestic actity sectors, detailed by input-output linkages, value added, and final demand. An aggregate version of the SAM with ten producing sectors is presented in table 7A.1 for seventeen institutions. Rows of the matrix indicate income sources for each instimtion, and columns their expenditures. Row and column sums are equal for every agent by individual income-expenditure identities. The blocks of the matrix correspond to various accoundng categories. The largest block (first ten rows and columns) details interindustry flows or production accounts, faniliar from input-output analysis. These entres itemize the receipts for sectoral deliveries (rows) and the expenditure requirements (columns) of internediate production. The next block

142

THE CAsEoF URUCUAY EFFECrsoF PboTECTnoNsMON A SMALLCouNTRY:

Table 7Ak1 Socialaccountingmatrix for Uruguay, 1983 orcuntentnewpesos) (miXions

Agrictture Minhg Food I 2 3 4 5

Agimt,.ure Mining Food Apparel Other nondurables Durables

OthernonConstwcApprel durables DuroblesUwrity ton

0 20.470 1,634 2.127 11,777 1,116 0 4,580 956 166 5 236

3.625 295 1.796 5.090

287 379 350 77

[.296 1,549 509 167 6.093

1.27i 620 199 20 2,666

5,768 876 284 37 2,726

2.630 1.001 53 392 6.820

69 204 51 0 1,174

0 536 4 2

15 1,282 1 3

1,421 76 3.481 173 333 1,187 32 8 2,707 99

2,143 7,720 216 0 118

116 1,007 7 198

6 7 Utrity 8 Construion Dtibution 9 10 Cther 509 252 299 483 152 1,614 611 895 services 896 13,257 7,908 6,472 7.748 3.611 6,832 22,953 II Factors 0 0 0 0 0 0 0 0 12 Households 13 Importtaxes 0 0 462 1,675 804 255 3,01B 4,719 andmargns 14 Domesfictax 516 660 926 2.051 847 3,804 5.766 1,007 andsubsidies 0) 0 0 0 0 0 0 0 15 Govemrment 16 Capital 0 0 0 0 0 0 0 0 account 724 4.896 9,051 0 0 17 Restofworkd 1,978 10,809 1,288 Total 42,504 30,616 58,744 26,088 26,727 32.254 8,001 19,145 SDuwi: BCU (I989).

covers the factor accounts for labor and other productive factors. Row 11 details wage and rental payments by sector, and factors in turn remit their income to domestic institutions (column 11), including households (row 12) and government (row 15). Household and enterprise accounts receive income from factors in their rows. Households disburse their income in consumption across sectors and to private savings (column 16). Uruguay has no personal income tax, but there are payments to enterprise taxes, expatriated profits, and savings and to finance inventory changes. The last accounting block consists of "exogenous" accounts for government, capital and real accumulation accounts, and the restof theworld. The government collects revenue from a variety of direct and indirect fiscal instruments and disburses its revenue in the form of sectoral subsidies, public expenditure on goods and services, transfers, public savings, debt service, and foreign transfers (column 15). Capital accounts accumulate private and

Economywidecostsofproectionand laborma*Aetigdities

Distribu. Other don seMces

Import Domestic taxes taxes House- and and Coven- Capitol Rest of Factors holds marzuins subsidiies ment account wattd Total

247 3,917 3,405 55

21 590 72 290

0 0 0 0

7,616 5,057 29,199 5,427

0 0 0 0

206 694 754 1,904

680 1,576 786 377 2,208

2,366 1,868 522 1,521 911

0 0 0 0 0

5,557 0 4,183 0 3,033 0 146 0 12,509 5,265

26 7 0 0 1,007

3,619 4,464 0 36,446 27,551 50.446 0 0 0 0 134,806 0 0 3,632 0

0 3,529 0

143

0 1,083 11,786

0

810 0 0

0

479 1,150 435 93

2,239 5,548 42,504 -523 1,213 30,616 704 16,483 58,744 847 11,694 26.088

670 918 1,836 26,727 747 6,983 1,267 32,254 761 0 67 8,001 436 16,008 0 19,145 640 0 3.831 48,775

14 1,175 14,174 1,971 67,489 0 0 0 0 147,675 0 21,831 0 14,412 171,049 0

17.035 0 0 3,147 4,858 40,855

0 4.612 754

0 0 5,835

0

10,933

0 0

45,467 67,234

0 0 0 38,031 0 0 0 0 10,062 48,093 723 889 0 3,664 0 0 33,453 909 0 68,384 48.775 67,489 147,675 171,049 10,933 45,467 67,234 48,093 68,384

public savings (row 16) and finance sectoral investment demand and governmentborrowing (coluKnn16). The rest oftheworld receives incomefrom import sales (row 17), purchases exports, and engages in other remittances and capital account transfers. Appendix B. Sectoral tables (Tables begin on page 144.)

EFFECrSOF PROTEmONISM ON A SMALLCOUNTRrYTHE CASEOF URUGUAY

144

Table 76.1 Estimatesof pricedistortions,domesticconcentration,and wage premiums (pecent) onet goods

IMpot Indtuy

Tadif

Tradeand

Tradeand

Indusry onci.f

urnspar

Wage t mspon concentroaion

Ftr-firrn

price

mfagin

margin

ratio

preiniumn

I 2 3111 3112

8 10 2 19

54 7 28 91

1I 5 10 16

30 75

35.0

3113.3119 3114 3115

9 17 8

92 68 32

20 5 9

49 49 58

35.0 35.0 35.0

11 19 2

84 a1 60

7 10 7

-

9 10

3116,3122 3117 Bakeryproducts 3118 Sugar

35.0 35.0 35.0

11

Beverages

313

12

-

35.0

314 321 322 3231 3233.324

30 94

24

1 9 0 2 45

55 72 31 43

49 13 16 9 19

55 30 10 47 30

35.0 37.1 37.1 37.1 37.1

code

Agricuture Mining Meatproducts Dairyproducts Preserves. cardy Fish Edibleoils Grainmil

I 2 3 4 S 6 7 8

producaS

7 100

12 13 t4 t5 16

Tobacco Textiles Apparer Leather Footwee

17

Woodproducts

33

16

69

7

18 19 20 21

9 44 11

38 40 77

13 20 10

61 20 18

44.7 60.5 60.5

22

341 Paperproducts7 342 Printg, publications' 3522 Drugs Other chemicals 351.352.3522 355 Tiresandrubbee

14 16

34 41

II 9

52 73

60.5 60.5

23

Glass

20

109

22

-

24

Metal. rnachinery'

381.382,383

12

42

8

24

25

Utilkies

4

0

0

2

-

-

26 27

5

0

0

I

-

20.8

6

0

0

I

-

11.7

28

Construction Wholesale,retail trade Transport, comrnunicaton

7

0

0

5

-

16.9

29

Fnance,insurance

8

0

0

1

-

48.9

30

OtherseMices Weghted average'

9

10

35

35

9 9

-

10

-

362

Not applcable.

-

5.9

7.4

26.6

-

44

(seechapter4). protecdon forr ofadministered sonme * Indicates areimports andgrosoutputs. a. Weights raiosand forconceradton 6of tisvolume datachapter based onBU (1989) Avxrs calculirrns. Sovrce: Bucheri(I 992.tale I) fr wagepremiums.

145

Econonywide costsof protwciionand labormairet vidities

Table 7B.2 Trade and productionstructurein the calibrated basesolution (percent) V-lue- Emplor- Capital output ratio shore ratio

Grss added ment Industry -ouput

12.2 58.0 Pgriculture 4.9 5.6 Mining 21.9 products 6.1 Meat 1.3 17.0 Dairyproducts 1.3 25.7 Preserves. candy Fish 0.5 23.8 Edibleoils 0.3 18.4 21.1 Grainrmilproducs 2,1 1.6 32.4 Bakeryproducts 39.6 0.7 Sugar 2.1 -28.7 Beverages Tobacco 1.I 12.2 3.7 326 Textese 1.9 37.9 Apparel 17.6 1.4 Leather 0.7 35.6 Footweae' 39.3 0.8 Wood products 0.9 34.9 Paperproducts' 31.1 Printig, publications 0.7 Drugs 0.3 43.5 3.1 33.0 Otherchemicals Tiresandrubbee 1.1 39.2 1.5 45.1 Glas Metal,machinery 3.0 42.1 2.4 45.5 Utilities Cosructon 5.8 36.1 retail Wholesale, 9.9 53.1 trade 28 Trasport. 7.1 46.1 communication 29 Finance, insurance 13.6 82.6 30 Otherservices 7.0 61.3 100.0

Total

10.0 2.0 6.5 0.9 11.6 273 15 77.2 39.9 12.3 9.8 627 0.0 0.0

5.1 11.9 -1.7 152.8 99.8 38.7 65.5 64.7 -1.3 31.4 57.1 -2.1 27.7 -9.1 -11.4 146.0

5.9

1.1

4.3

-5.2

5.2 8.5 !.3

2.7 !.3 1.5

10.8 2.8 3.1

-6.1 -0.4 -7.6

4.3

9.5

13.4

7,3

4.4 2.4 2.6 1.5 2.4 2.0 1.8 2.0 3.1 3.9 44 6.8 3.1 2.2 1.7 2.9 3.4 35 23 4.5 3.3 3.8 4.3 3.7 6.3 .8

8.9 49.4 0.3 0.1 14.3 6.7 33.6 7.5 0.0 2.9 1.9

12.5 5.2 2.1 38.1

-2.0

61.6

40.0 160.0 31.0 39.7 625 66.0 334 -2.1 -44.1

100.0

45.5

Indicates soneformofadinistered provtedion. is calcdated as: a.The effective rateof prtection orsecors intable78 1. ERP,= (t,t,)/C(l- So,,) fromthe zariTrats Source:Aud'

Efetaive protectbn rate"

13.8 6.7 46.8 31.8 16.4 83.3 15.3 40.5 13 11.6 0.5 2.7 45.8 36.4 65.7 44.1 2.9 I 13 4.5 14.8 12.0 44 5.5 8.4 0.8 0.0

16.5 0.5 2.0 0.4 0.4 0.2 0.1 0.7 0.5 0.2 0.6 0.1 2.4 2.2 0.6 0.5 1A 03 0.7 0.0 0.8 0.6 0.7 2.6 1.5 5.5

I 2 3 4 5 6 7 8 9 I10 II 12 13 14 I5 16 7 18 19 20 21 22 23 24 25 26 27

Weightedaverage

E&orz Ipors demand output

olculatiors,basedon BCU(1989)data.

146

EFmCI OFPROTECnONISMON A SMALLCouNTRY:THE CASEOF URUGUAY

Table 7B.3 Resourceshiftsfrom removingprotection (perxntage dcrMge fromcalbruted basesolution) Itizsty

I 2 3 4 5 6 7 8 9 I0 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27

E&errnent I Output Eaports

Agriculture 3.5 Mining -11.1 Meatproducts 2.4 Dairyproducts -47.8 Preserves, cady 1.6 Fish 25.1 Edibleoils -32.2 Grainmillproducts 23.5 Bakeryproducts 3.2 Sugar 0.1 Beverages -0.5 Tobacco 0.0 Textilese 20.4 Apparel -6.7 Leather -49.6 Footweas -22.5 Wood products' -0.3 Paperpp!uct 1.8 Prinirng.publicatiOnS 2.1 Drugs -2.0 Otherchemicals 16.3 TreSand rubber 1.2 Glass 0.4 Metal,machinery 0.5 Utilities -0.6 Construcion 1.7 Wholesale,retail trade -0.8 28 Trnsport communication -8.6 29 Finance,insurance -0.5 30 Otherservices 0.8 Weightedaverae -0.3 -

ExperimienE2 Output Expots

ELperiment 3 Output Exports

9.5 -18.9 8.5 -70.5 85 27-7 -53.0 40.8 12.7 5.4 6.4 6.9 35.2 -7.5 -67.9 -30.8 10.9 7.8 8.8 5.4 51.2 15.1 7.7 11.6 5.5 0.0

7.3 59.0 20.9 -15.1 -9.5 -43-4 10.3 24.7 6.5 2.5 -L8 0.4 -10.9 -24.5 -64.1 -30.4 0.7 63.6 11.4 -4.1 43.8 2.7 2.7 -9.9 -1.1 S.I

20.9 233.0 37.5 -18,6 -10.0 -45.3 35.9 46.4 26.4 16.7 11.5 14.2 -8.6 -33.1 -85.0 -40.5 24.0 175.5 37.6 14.4 139.5 30.4 26.1 -2.5 10.9 0.0

15.0 -14.6 30.8 -20.6 48.5 -7.4 15.1 37.2 14.5 7.8 3.8 4.4 -25.8 -19.6 -56.5 -13.9 3.5 7.6 7.4 -11.4 9.3 3.7 4.1 20.7 1.2 7.0

32.7 -31.3 50.8 -29.1 126.5 -7.3 44.8 64.6 43.9 22.6 27.1 22.1 -33.4 -26.0 -77.4 -16.6 30.0 22.9 23.6 13.4 38.2 28.1 24.4 73.9 14-2 0.0

5.0

-1 1.8

-1.6

-5.8

20.6

-16.4 8.2 12.2 42

-8.7 -6.3 1.8 3.1

10.8 4.2 24.9 15.4

-2.6 I. I 3.7 3.5

29.6 24.4 26.9 14.8

Indicates someformoradrninisered protection.

Saurac rthors' aonrs, basedon BCU(I1989)data

Economwide costsof trotedion

and labormaret rigidities

147

Table 7BA Resourceshift from eliminating protecdon and labor market rigidities (rcentage chanEe rtmrn thecalibrated bosesolukcon)

hdustry

I 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

E*peermenc 4 Experment 5 bmpefrret6 Epenrment 7 Wage Wage Wage Wage Employmentrote Employment rmce&rpoyrmentrate Employmentrrate

-125 Agriculture Mining -16.9 Meatproducts -145 Dairyproducts 22.9 Preserves.candy 28.0 Fish 215 Ediblecils 26.7 Grainmil produces 24.6 Bakeryproducts 28.7 303 Sugar 15.9 Beverages Tobacco 17.4 Textile 29.7 Apparel 19.8 Leaher 21.0 22.6 Footvear Woodproducts -3.9 Paperproducte 20.9 Printng. Publicarors 16.3 Drugs 34.5 Otherchemical 31.3 Tireand rubber 24.9 Glass -1.7 Metal,rnachinery 10.9 -7.7 Ulics Construcion 9.8 Wholesale,retail trade -0.1 Trasport communicaton 3.8 Finance. insurance 42.3 Otherservices -5,3 Weightedaverage 0.0

11.5

10.0 253 -15.9 -17.9 -15.9 2.7 -15.9 -37.3 -15.9 12.5

4.0 4.0 4.0 4.0 4.0 4.0 4.0

-10.2 -30.5 -25.2 29.2 60.7 29.4 55.3

14.2 14.2 14.2 -37.7 -37.7 -37.7 -37.7

-5.1 -10.6 -3.1 -1.5 -8.2 -1.4

7.9 7.9 7.9 3.5 5.7 -3.6 5.8

-15.9 -15.9 -159 -15.9 -15.9 -17.0 -17.0 -17.0 -17.0 4.4 -20.9

76.0 11.8 -1.0 -3.1 -1.6 -43.0 -31.6 -17.8 142.6 -0.6 0.3

4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0

267.8 108.1 59.3 29.3 33.3 20.9 23.9 48.3 234.8 -6.9 41.7

-37.7 -37.7 -37.7 -37.7 -37.7 -40.0 -40.0 -40.0 -40.0 3.0 -47.6

41.4 11.8 -3.0 -2.0 -1.5 -2.2 -1.3 -1.5 0.0 - I.5 -2.2

81.8 25.9 3.6 2.2 3.5 4.7 6.1 57 7.9 53 1.1

-27.7 2.1 -27.7 -13.1 -27.7 18.6 -27.7 0.9 3.1 0.7 -11.0 0.5 10.0 -2.3 -7.2 4.0

4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0

44.4 84.3 62.1 58.6 -0.7 15.8 -16.4 25.9

-61.2 -51.2 -612 -61.2 0.4 -27.9 14.2 -20.3

-0.3

6.9

-0.5 -0.2 -0.8 -3.0 -4.4 0.6

6.1 7.2 5.8 0.1 7.9 8.8

4.0

-8.8

-6.8

-5.5

-1.4

4.0

-14.1

-14.8

-6.1

-2.5

4.0 4.0 4.0

76.4 -14.5 0.4

-51.5 14.2 -1.1

-2.9 -1.7 0.0

2.3 5.4 53

10.0

10.8

10.0

8.1

-0.5

-11.5

-4.4 -128 -22.8 iO.0 2.4

-5.7 0.5 0.0

Icircates somre formof administerdprotecion. Source: AuN' calculations, based on BCU(1989)data.

-7.5 -13.6

148

ON A SMALLCoUNTRr. THE CASEOFURUGUAY EFFECrSOFPROTECTIONISM

Notes 1. As discussed in the next section, margins are systematicallyhigher for imports than for 'comparable" domestic goods. Caveatsin our interpretation of differences in margins reflecting the effectsof nontariff barriers are also discussedin the nextsection. 2. 2This distortion-and associated rents-is likely to have a strong distributive effect (see followingsection), because the model onlyhas one representative consumer, it does not capture the likelydistributive implication of this wedge. 3. The alternative is to assume that the zero profit is achieved through firm enty and exit in a monopolistic compedtion framework. See, for example, Harris (1984), Devarajan and Rodrik (1992), and de Melo and Roland-Hoist (1991). 4. Fordetailson parametcrvalues, see the followingsection. Fora comparison of results derived from this pricing rulc with those for monopolistic pricing allowingfor entry and exit, sec de Melo and Tarr (1992, chapter 7). 5. The treatment of wagedifferentials isthe same as that specified in de Melo and Tan (1992, chapter 6), which contains a more detailed explanation of the specification. - & An alternative is to assume chat the union and the firmnjointlynegotiatewages and employment, as in McDonald and Solow(1981). 7. The model's structure closelyresembles that of de Melo and Tarr (1992,chapters 3, 6, and 7) except for the treatment of rent seeking,which isinspired by Grais,de Melo,and Urata (1986).Foran introductorypresenration to the structure of the model used here, see de Melo and Tar (1992, chapter 2). & There are also sectoral taxesand subsidies,but to simplifythe interpretation of results, they are not included in the model. 9. The equivalent variation measure uses final prices in the evaluation. An alternative measure, the compensating variation, uses base prices and gives very similar results. 10. Dairy products, a major export sector, also shrinks by 48 percent because of a high effective rate of protection. In this case, the effective rate of protection is probably not a good indicator of the sector's competitiveness. 11. For a formula indicating how the domestic price is related to a change in the import price, in terms of the parameters describing supplyand demand elasticitiesfor the functional forms selected in table 7.1, see de Melo and Tr (1992, section 2.5). 12. In the case of the U.S. auto and steel industries, estimates go in the other direction, withla slightlysmaller welfare gain from eliminating protection in the presence of exogenous wage distortions. 13. For a sensitivityanalysisof the results to changes in the weights on wagesand employment, see de Melo and Tarr (1992, table 6.8). 14. For a comparison of the two pricing rules and a formula decomposing the welfareeffects of a change in trade policyinto scaleand other efficiencyeffects,see de Melo and Roland-Holst (1991). 15. For example, de Melo and Uraa (1986) compared price-cost margins for Chilean manufacturing firms in 1967 and 1979. They found that price-cost margins fell drasticall followingthe trade reforms. They also found econometric support for the import discipline hypothesis,which is captured in an ad hoc wayin experiment 9.

Economyuwide costsof protedion and l

mborketgiWities.

149

References Anichini,J.J.,J. Caumont, and L. Sjaastad. 1978.'La politic comercial y laproteccion en cl Uruguay.' Banco Central del Uruguay, Montevidco. BCU (Banco Central del Uruguay). 1989. "Matrizde insumo-producto del Uruguay." Montevideo.

7(12)Bucheli, M. 1992. "Diferencias scaoriales de salarios en cl Uruguay." SUAMA 55-80. Devarajan, Shanta, and Dani Rodrik. 1991. 'Pro-competitive EffectsofTrade-Reform: Results from a CGE Model of Cainrcon."Eurpean EconomicReview35: 1157-84. Grais,WafikJaime de Melo, and Shujiro Urata. 1986. 'A General Equilibrium Estimation of the Effects of Reduction in Tariffsand Quantitative Restrictions in Turkey in 1978."In T. N. Srinivasan andJ. Whalley, eds., GeneralEquilibrium TrzdePoliy Modeling.Cambridge, Mass.:MIT Press. Harris, R. 1984. 'Applied General Equilibrium Analysis of Small Open Economies with Scale Economies and Imperfect Competition." AmericanEconomicRBview74: 1016-32. Jondrowj., D. Chase, and C. Gamble. 1982. 'The Differential between Domestic and Imported Steel."Journal ofBusiness 55: 383-99. Krueger, A., and L Sumners. 1988. "EfficiencyWages and the Inter-Industry Wage Structure." Economebica56: 259-93. Macadar, Luis. 1989. "Protecci6n,ventajas comparadas y eficiencia industial." SUM 3(5): 7-59. McDonald, r. M., and R M.Solow. 1981. 'Wage Bargaining and Employment." AmericanEconomicRview71:896-908.

MeloJ. de. 1987. "Financial Reforms, Stabilization,and Growth uider High Capital Mobility: Uruguay, 1974:83." In M. Connolly and C. Gonzilez-Vega, eds., Economic Reform and Stabilization in.Latin America New York: Praeger.

MeloJ. de, and ID.Roland-HoIsL 1991. T'rade Policy and Industrial Organization: Evidence from Korea. In R- Baldwin, ed., EmpiricatStudies of CommercialPolicy.Universityof Chicagc Press. MeloJ. de, and D. Tarr. 1992. A Gneral Equilbrium Analysis of U.S. Tr& Poliy. Can-

bridge, Mass.:MIT Press. . 1993. "Industial Policy in the Presence of Wage Distortions The Case of the U.S. Auto and Steel Industries." Inerwional EconomnicReview 34: 833-51. Melo,J. de, and S. Urata. 1986. The Influence of Increased Foreign Competition on Profitability."Inn4w.iona1Journaiof industrial Orcnization 4: 287-304. Rama, M. 1991. "Endogenous Trade Policy:A Time-Series Approach." World Bank, Policy Research Department, Trade Policy Division, Washington, D.C.

Roussiang,D. and T. To. 1992."DomesticTrade and Transportation Costsas Barriers to International Trade." CanadianJournal of Eonoamics26: 209-21.

A long-runperspective on trade policy, instability, and growth Jorge E. Roldos

The impact of trade policy on economic growth has attracted the attention ofboth growth theorists and development economists, and their insights are beginning to converge in thenewhendogenous growth theories.Though some of the forecasts derivedfrom these theoriesmake them observationally equivalent to the neoclassical growth model, the new theories have different implications for economic policy. Anumber ofwell-known comparative studieshave presented the empiriexportpromocal evidence suggesting thatdevelopmentstrategiesbasedon tion lead to better economic outcomes than import-substitution strategies. Some endogenous growth models now capture the intuition that export growthleads to higherproductivitygrowth through theexploitation of economies of scale, technology tansfer, or increasing competition (see Nishimizu and Robinson 1984)-whatBhagwati (1986) and others characterize as "grey area" dynamic effects. Within the endogenous growth framework, the staticor level-effects traditionally considered distortions can be reinforced or offset by dynamic or growth effects (Easterly and others 1990). This chapter draws on some of the insights from endogenous growth theory to examine the role of trade policy in the performance of the Uruguayan economy. After a period of rapid growth in the 1940s based on a strong import substitution policy, Uruguay went through a period of stagnation between 1955 and 1974 (see chapter 2). While Uruguay was stagnating other coun.trieswere growing fairly rapidly as world trade expanded in the postwar period. In response to its dismal performance, a sharp deterioration in the terms of trade, and a balance of payments crisis, Uruguay shifted away from its import-substitution strategy, and at least for the second half of the 1970s, its no-growth recordwas reversed. The debt crisis and the deepening of preferential trade agreements with neighboring Argentina and Brazil have conditioned Uruguay's more recent performance in terms of growth, trade, and m3croeconomic stability. This chapter explores these linkages. 150

A long-runpaspective on tradepoliey, instability, and growth

151

It first addresses the perennial question: 'Does growth drive trade or is there a reverse link from trade to growth?' (Helpmarn 1988, 6). A purely statistical look at the issue-using Granger causaIitytests-uncovers no evidence of temporal causality in either direction for annual or quarterly data, and no indication of cointegration of exports and GDP. Some evidence is found of a positive correlation of export growth and Solow growth residuals, suggesting that growth extemalites may have played a role in the relationship between exports and growth in real output. Economies of scale, which play a models, may be importantin Uruguay, large role in manyendogenousgrowth Some formal and informal evidence is also although the evidence is weak. presented on whether increasing returnsdie hallmark of the new growth tbeories-are importanL Finally, an exploration of the effects of preferential trade agreements on exports andgrowthfinds clearevidence thatexports to the region are more unstable than those to the rest of the world and that this instability is assodated with less GDP growth at the sectoral level. Exports and growth: causality tests Mostnormative arguments in favor of an export-promotion trade strategydefined as one tLat creates no biased incentives toward import substitution (see Bhagwati 1986)-are static. They stress an import-substitution regime's generation of distortions in p: oduction and consumption, the increase in directly unproductive or ldbbying activities, and the welfare-reducing, tariff-jumping invesunent it induces. Bhagwati (1986) adds a final group of arguments he calls "grey area" dynamic effect, which include the impact of the trade regime on savingsand innovation. These effects are becoming better understood with the development of new trade theories-based on increasing returns to scale and imperfect competition-and endogenous growth theonres. There is ample empirical evidence on the superior performance of economies under export-promotion regimes over those with import-substitation reginmes.Most studies involve some cross-section regression of changes in exports oni changes in GDP (see Michaely 1977 and Feder 1982). But as Helpm-an (1988) notes, the crucial question to be answered, in theory and empirically, is whether growth causes trade or trade causes growth. Early two-sector models of growth and trade-generally extensions of Solow'sneoclassicalmodel-explain the dynamics ofboth variablesin terms of capital accumulation and exogenous technological progress. When technological progress occurs in the exportable sector, exports grow faster than GDP-a pattern found for many fast-growing economies. The problem with predictions derived from those models (Helpman 1988) is that they suggest that causality goes from outputgrowth to exportgrowth, whereas many economists believe it goes the ocher way. The new endogenous growth theorists

152

CouNTr. THE CASEOF URUCJAY EFFtrs OFPROTEwOnSM ONA SMALL

have started to develop models in which export growth causes CDP growth. This section looks at this causality problem for Uruguayan data for 1935 to 1989 (see figure 8.1). Conventional augniented Dickey-Fuller tests show both variables to have a unitroot or a stochastic trend. Indeed, both are well characterized by integrated moving average ([MA) processes, IMA(1,1): AY = 0.02 + (1 + 0.285L)e,

(8.1)

(3.48) (8.2)

AA=

(2.06)

-(1-0.476L);r (3.39)

where Y,is the logarithm of GDP and X,is the logarithm of export volume. With these results in mind, causality tests were conducted on first differences of both variables (lower-case letters denote rates of growth). A traditional regression of GDP on export volume growth rates yields the following result, after a Cochrane-Orcutt zorrection: (8-3)

Y= 0.15 + 0. 0 7 4 X, + 0.095x, I (3.40) (2.08) (2.64) R2

0.25

DW = 1.60

F =5.32

Figure8.1 Exportsand GDP, 1935-89 Index(1961 100) 2.50 200-

100

so '

0 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 Source: Seeappendix.

A ongrun pedivect

on Ol

cde po6cy, instabily, and gowth

153

Theresultshowsapositive correlation between outputgrowth and exportgrowth, especially if a lagged export growth vaiable is induded, but this probably reflects a cyclicalcorrelation and not the kind of trend growdt of interest here. Granger (1969) causality tests and a test suggested by Geweke, Meese, and Dent (1983) were used to test for temporal causality. According to the Weiner-Granger definition of causality (Grangerand Newbold 1986) avariable xis said to cause another variable yif prediction of the currentvalue of y is improved (in a least-square sense) by the use of past values of x The practical tests are undertaken by running the regression: k

(8.4)

YJ =.o +YPjyf-j j=1

+AYjxt_} $* j=1

where jis the number of lagged periods, and testing for the null hypothesis that y = 0 (x, does not cause y) by means of the usual F-tests. The order k of the lags is often set at some arbitraily high number, keeping in mind that the power of causality tests is low for heavily parametrized models. Simulation results in Geweke, Meese, and Dent (I 983) suggest an alternative test After equation 8.4 is estimated using ordinar least squares and denoting by C2 the error-vaiance estimate, the following equation is estmated, also using ordinary least squares: -iE, Y, =Po +Y5Jc 1=' denoting by a the residual variance estimate of this regression. The test statistic is: 2 a 2) (8.6) *T = (y~~~2

(8.5)

which has an asymptotic chi-square distribution with k degrees of freedom under the null hypothesis tat x does not cause y. Under both tests the hypothesis that export growth does not cause GDP growth cannot be rejected (table 8.1). There is weak evidence of causality for the case of two lags, but it is not confirmed by the more powerful t-test. Strong evidence that output growth does not cause export growth rules out reverse causality. Splitting the sample and doing the same tests for the subperiod 1965-89-the series seems to exhibit a structural change in the early 1970s coinciding roughly with the change in trade policy-yields similar results: a lack of temporal causality in either direction. One problem with this kind of causality testing is temporal aggregation. If the true lag between cause and effect is one quarter but the stochastic process is observed annually, then causalitywill seem to occurinstantaneously and so will not be captured by these tests- Quarterly data-available for GDP

154

EFFECww OFPROTECrbONISM ONA SMALL CouNmY: THECASEOFURUGUAY

since 1975-were used to overcome this problem. The results again show no causality in either direction (table 8.1). Another problem with these causality tests is philosophical: Cooley and LeRoy (1985) among others have suggested that causation can be accepted only if the empirical evidence is associated with a complete and convincing theory about how the cause produces the effect A rather casual, Bayesian sort of answer to this concern is given by Granger and Newbold (1986,22223). A prior belief abouta particular theory could be expressed in probability terms, so that after the data have been gathered and proper testing has been done, the probability could be raised or lowered, according to.the results. For the case being considered here, this process would probably result in a downward adjustment of the probability since there is little evidence for Uruguay to support the hypothesis that exports cause growth. A final problem with these causality tests is their failure to allow for instantaneous causality. While estimation and testing of a structural model of the determination of exports and output is beyond the scope of this study, the possibility of cointegration of the two variables was examined. Since both variables have aunitroot, they couldbe cointegrated, that is, they could share a common stochastic trend (Engel and Granger 1987). If the variables are cointegrated, they can, following the Granger Representation Theorem, be represented as an error-correction model, in which long-run (permanent) components of exports and GDP obey some equilibrium constraints, and short-run (transitory) components of the variables have a flexible dynamic specification. No evidence was found, however, of cointegration between exports and GDP, even after dropping the early sample covering the period of fast growth in tie early stages of the import-substitution strategy. Table 8.1 Causality tests for export and GDP growth Eor

grwh cses

Output growh cLmu

Series

cutpLttgrowth F-tet T-test

exportgmwth F-test T-test

Annual(1935-89) 4 lags 3 lags 2 lags

1.33 2.04 3.17'

1.5 1 3.40 4.60

0.35 0.62 0.01

Annual (1965-89) 3 lags 2 lags

1.64 1.25

2.25 0.56

1.45 0.29

4.54

Qwrwml (1975-8) 6 lags 5 lags 4 lags

1.41 0.89 0.86

2.80 *

0.83 0.89 0.94

0.72

*'Theciflerential error-variance is negUi&ble *Sinifintatte IOpercentleveL Sorce See apperndc

*

*

S 0

A tong-un paenchiwe on tradepoicy, insfabilit4, and gr=k

155

Scale effects, trade policy, and growth If there is no statistical causality between exports and growth, is there evidence of other scale or trade policy effects? A brief review of traditional anudendogenous growth theories demonstrates why such effects could be important Traditional and endogenousgrowth theories Following the neoclassical growth model elaborated by Robert Solow in the 1950s, the growth accounting literature has attempted to quantify the contribution to growth of each physical input and technological progress. The model assumes constant returns to scale, diminishing returns for each factor, and exogenous technological progress. Even with adjustments for the quality of inputs (education, equipment vintage) these studies suggest that physical inputs account for only 50 to 70 percent of growth in output (see Middison 1987). In the simple Cobb-Douglas case, after taking logdifferentials, a large part of output growth (Y) is explained by the residual A, (where a caret indicates percentage change): A

(8.7)

1%

A

A

Y, = Al + aK, + (I - a)LI.

This residual is generally attributed to exogenous technoIogical progress, the onlyfactor that could generate the nondeclining rates of productivity growth found for industrial economies. Thus, dissatisfaction with the model mounted, intensified by its inability to explain other important aspects of economic development, such as why productivity levels and growth rates in developed and less developed countries were not converging. Building on the neoclassical growth model, new endogenous growth theories have begun to consider the implications of exteralities and increasing returns and to treat the choice of technology, human capital, and labor supply as endogenous. Especially intriguing is the insight that economic policy can affect not only the level of output, as in the neoclassical model, but also the rate of growth. Following Romer (1987) and Helpman (1988), the models can be classified into two broad groups: those in which economies of scale are extemal and those in which theyare internal. Among the furstgroup is Romer's model (1986) that makes technological change endogenous by assuming that private investment in physical capital increases the private stock of productive knowledge, which also becomes available to other firms. The externality associated with this technological spillover could overcome the diminishing returns to investment. It yields a production function of the forn:

156 (8.8)

EFFBisOFPRoTEcraoNIsM ONA SMALLCOUNTRY:THE CAsEo; URUCUAY

Y, =B,K!bKtLl-a =B, KabL-.

where B,is basic knowledge. that grows at an exponential rate and a + bis the output-capital elasticity, which differs from the share of capital. When a+ b is greater than or equal to 1, capital stockper capita can grow withoutbounds; with a fixed labor force the borderline case of a + b = 1 behaves like a model with a linear production function. Lucas (1988) presents a model in which private investment in human capital yields a similar externality and increasing returns to scale. The second group of models allowsfor fixed costs in the production of intermediate inputs (Romer 1987,1990), so that Rin equation 8.8 would be replaced by koX(i)Adi Productivity in the final goods sector depends on the range or number of middle products, which, together with the fixed costs of production, isakeyfactorin the appearance of increasing returns. Grossman and Helpman (1990,199laand b) explicitly model the introduction of new varietes of consumer goods as a result of calculations of the fixed costs of research-and development and future monopoly profits. Though the models appear to be more relevant for industrial countries than for developing counties, the same economic principles that guide innovation could be applied to the adoption or adaption of technology by developing countries. These models suggest that some policies can affect growth rates (Easterly and others 1990). For instance, policies thatweaken incentives to invest in physical or human capital or to innovate tend to reduce growth. Rebelo (1990) suggests that polcies that alter the return of factors that can be producedwithout the use offixed factors affect the growth rate,whereas policies that alter the return of fixed factors can affect only the output leveLSome of these models suggest the possibility of a tradeoff between the negative static effectofsome distortionarypoliciesand theirpositive growth effecLKrugman (1988), for instance, shows how the positive static effect of removing tariffs could be lost if it results in a country specializing in sectors with slow uptake of technology change. The Grossman and Helpman (1990, 1991a and b) models show that trade liberalizadon can accelerate technological progress by increasing the size of the market available to technology producers and can boost the growth rate of countries that imitate the new technology. If trade policy shifts resources toward product innovation, it can accelerate growth (though the welfare resultsmaybe ambiguous). Butitcouldalso divert talented people into rent-seeking endeavors and slow the pace of innovation and imitation. - Though some of these endogenous growth models havetnorinative inplications that may favor an active role for policy in stmulating growth, Helpman (1989, 183) stresses that 'identifying useful policies requires an understanding of market structure and conduct, entry constraints, inter-

A long-runp

epctive on tradepoliop irlabiitA, 4nd gMWt/a

157

sectoral links, and the ]ike.... Meanwhile, policy should be designed on a case-by-casebasis and-because good policies improvewelfare only slightlyno intervention (free trade) remains a good rule of thumb." Crass-sectionevidence These new growth theories have motivated a series of cross-section studies on the detenninants of growth. Forninety-eightcountries in the peiod 196085, Barro (1991) shows that the growth rate of GDP per capita is positively related to initial human capitl and political stability and negatively related totde inintal level of GDP, the share of govemment consumption in GDP, and the level of market distortions. Uruguay is an oudier in Barro's regression, with a negative residual of -0.0295, resulting from an actual growth rate of 0.23 percent and a predicted growth rate of 3.18 percent; Rerunning Barro's regression for the sample of thirty-five countries selected in chapter 2, using a tade openness measure (the share of exports plus imports in GDP) to check for the impact of trade policy, shows trade openness to be positively related to growth (figure 8.2). Uruguay is still an outlier, but its predicted growth rate has been reduced to about 2 percent because of the low share of trade in GDP. Similar results are obtained when amore sophisticated measure of openness is used, such asPritchett's'(1991) structure-adjusted trade-intensity ratio, demonstrating the robustness of this relationship.

FigureL2 Partial assodationbetween per capitagrowth and openness,I960-85 PercapitoCDPgrowthrare 0.04 .

OHKG

0.08

OscP

0.02

_ _ * wxCAN*

0.01

ECHE-A# ESP* sU

SE

LUE

NO

*ND

*

BEL

MEXO

0

-0.02

0

~ZAPs*0vEN

20

40

-FIN

OIRS

so

E

100 120 oftradein GDP Share

140

160

180

Notc Percapit growthisnetofthevahue predictedbyallexplanatoryvariables exceptopenness. Countries areaslied indcapter2 S&EJrJ Author'salcuktions, rerunningBwrm's (1991)regression.

158

EnwwrnOFPROTECToNISM ONA SMALLCouNTnY: THECASEOF URUGUAY

The cross-section evidence covers the entire period 1960-85. To see whether Uruguay's performance improved after 1974, as the results in chapter 2 suggest, the following section examines time-series evidence. This ap-

proach also has the advantage of allowing for better isolation of the role of policy. Evidence on scale and the role of policy The traditional growth models assume constant returns to scale and consider Uany kind of shift in the production function" (Solow 1957, 312) to be the result of technological change. Thus, in per capita terns (lower case letters are in per worker tenns): (8.9) FollowingRomer

y,= At + ak. (1987) and Baldwin (1989), the data are allowed to 'speak

for themselves" before the elasticir' of outputwith respect to capital or labor is forced to equal each factor's share in GDP. An Andex of employment was constructedfor Uruguay, using the mostsensible measures-available for each time period (see appendix). A capital stock series was also constructed, using the perpetual inventorymethod (see Harberger and Wisecarver 1978 and CXniara de Comercio 1986). When the index of GDP per worker is plotted against the index of the capital stock perworker, the capital stockindex seems

to follow the GDP perworker index much better than when the assumption of constant returns to scale is applied (represented by the lower plotted line in figure 8.3, where 0.46 is the share of capital in national inconme). A regression of equation 8.9 yields a coefficient of 0.80, which is larger than the 0.46 share but not as large as estimates for industrial countries reported in Romer (1987) and Baldwin (1989). A more direct way to test for constant or increasing returns to scale is to run a regression on an equation like 8.7 to see whether the sum of the coefficients equals one. Four regressionswere run (table 8.2): regressions RI and R2 use a measure of capital stock adjusted for utlization; regressions RS and R4use the unadjusted index. In the absence of a true measure of utilization, the raw capital stock figures were adjusted by the share of the labor force unemployed in each year (as in Solow 1957), which tends to account for cyclical movements. Except for this adjustment, data limitations precluded making any of the other adjustments usually made in growth accounting (as for education, age, and gender of the labor force, vintages of capital goods, structurl change; see Maddison 1987). For the two regressions with the adjusted index (RI and R2) the estimates of the elasticity of output to capital are dose to the average estimate of the share of capital in national income

pmpective on Irade poEfy, instability, and grww&

A long6n

159

Figure 8.3 Capital, labor, and productivity, 1955-89 Index(1955=100) ISO 170 GDPperworker

160 ISO 140 130

."tstv t

120

ll

100

90 1955

.1960

1965

1970

1975

1980

1985

Source: Seeappendix.

Table 8.2 Estimates of production aozY,=B1 ,gP

function

+ 21ogL, + 3TWME)

Di

B½

RI

R2

R3

R4

0.495 (2.81)

CA16 (2.22)

0.373

(2.01)

0.339 (1.73)

0.758 (2.33)

0.804 (2.56)

0.976 (2.88)

0.927 (2.79)

13

0.014 (4.04)

0.015 (432)

AR(I)

1.239 (6.82)

1.117 (6.46)

1316 (7.27)

1.157 (7.01)

AP(2)

-0.266 (-1.47)

-0.407 (-2.35)

-0.338 (-1.87)

-0.484 (-2-85)

0.97 1.84 322

0.97 1.84 284

0-96 :.75 288

R2 (adjusted) DW f-staistic Esrin'tes of scaleecanoies

C:entralestimTate 95%confidnceinterval

0.97 1.80 273

1.266 .349 1.21!0 - 1.253 (0.931,1.576) (0.961.1.479) (1.004, i.694) (0.988,1.544)

seeappend. Saurce: Author'scalcultions;

160

OrNA SMALLCouVNIY:THE CASEOFURUGUAY EFFECasOFPROTECnONISM

(0.46).' Estimates mith the other two regressions are smaller, than that share, but they are more in line with those for industrial countries (see Maddison 1987, table 9). The estimates of the elasiicity ofGDP to laborare much larger than the corresponding share of labor in national income. Time trendswere highly significant (R2 and R4), suggesting technological progress at an exponential rate of 1.4 to 1.5 percent a year. Tests of the null hypothesis of constant returns to scale-coefficients on capital (f1,)and labor ([2) inputs equal to one-tend to suggest the presence of increasing retums to scale (coefficients total 1.22 to 1.35; table 8.2). Nevertheless, the hypothesis of constantreturns to scale could not be rejected at the 95 percent confidence level, except for R3. A key theme in the new theories of trade and growth is that trade induces more specialization and so allows for the exploitation of economies of scale. These economies could be due to spillover effects across finns, industries, or countries. Backus, Kehoe, and Kehoe (1990) tiow thatwhen spillovers operate at the industry level with little spillover across industries, aggregate growth is a simple fimction of the product ofa specalization index and GDP. Thatvariable reflects the effect of economy size on growth and the intuition thatfor agiven size a higher level of spe-cializationleads to more learning by doing and so to more growth. Specialization indices were constructed for the Uruguayan manufcturing sector based on data from the 1968 and 1978 census and the 1987 Survey on Economic Activity, where the specialization index is defined as, (8.10)

S=

wher e the term in brackets is the shz e of each industrial sector in total value ad(.ed (at the three-digit industrial classification level). Uruguayan industry ha's increased its degree of diversification with the specalization index falling from 10.1023 in 1968 to 0.0817 in 1978 and 0.0786 in 1987. Since less specialization slowsdown leaing by doing, the result according to this dass of models, is reduced growth potential in the manufacturing sector. In sunmary, the evidence on increasing returns at the aggregate level is not clearcutL Nor are the implications clear of the new endogenous growth theory for trade policy. Nevertheless, several studies have shown that export growth leads to higher total productivity growth through the exploitation of economies of scale, technology transfer, and increasing competitiveness (see Feder 1983; Nishimizu and Robinson 1984; de Melo and Robinson 1992). In the case of Uruguay, calculation of the Solow residuals (A), or total factor productivity (see details in the appendix), shows dLat changes in productivity are correlated wit export growth but not with changes in capital per worker (see figure 8.4):

A lorog-nn perspecliueon trade policy, iistability, and grpvwth

161

At= 0.164k,,+ 0.073+ (0.97) (2.74) R120.13

DW=1.54

F=4.48

The statistical analysis suggests that export externalities help explain Solow residuals whereas increases in the capital stock-as suggested by the Romer (1986) model-have no explanatory power.2 Finally, it is interesting to see what role trade policy played in Uruguay's export growth. In 1974 Uruguay shifted from an import-substitution strat egy to export promotion. progressively lowering tariffs (the average nominal rate of protection was 453 percent in 1974; see Favaro and Spiller 1987) and providing first subsidies and then tax rebates for exports. These policy changes are captured in a trade policy index (TPI), defined as the ratio of subsidies to the average nominal tariff (see the appendix for details). An increase in the value of the index means an increase in the relative price of exportables to importables. Though a crude measure of trade policy (for example, it does not include the effect of reference prices), this measure captures the major changes after 1974. Though the share oftraditional exports (basically meat, wool, andhides) in total exports fell substantially, From more than 75 percent before 1970 to Figure 8.4 Exports and productivity, 1955-89 Exportvolume index(1981=100) Capitclperworkerindex(19SS=100)

Factorproduciviyindex (1957=100)

140

250

130

130

M~~~~~~ota facto?r t .

/

\>

2D0

~~~~~producik

120-

1) 110~~~~~~~~~~~~~~~~~~~5

~~~~~~~~~~~~

4, -

-

A. C0 100

90 1955

~~

1960

Sorre Seeappendix.

~

mevoum ~ ~

1965

%.~

1970

Export

1975

vlm

1980

1985

50

162

EFECIsa OFPROTECToNISMON A SMALLCouNwrm THE CASEOF URUGUAY

less than 50 percent after 1975, the share remained importantL Because traditidnal exports are especially subject to price fluctuations, the following regression attempts to measure the importance of changes in trade policy against changes in the terms of trade (TOT) in the evolution of the volume of exports: log XA= 5.72 - 0.267 log TOT+ 0.007 (7.61)(-1.76) (4.17) R2 Adj. = 0.90

DW = 1.60

J+0.084 PTAl + 0.21 PTA2, (0.82)

(2.72)

F = 63.7

where X is export volume and PTA1 and PTA2 are dummy variables for the preferential trade agreements with Argentina and Brazil, and for tleir expansion in 1985-86. The results indicate an important role for the trade poliqr variable and for the preferential trade agreements after their expansion, but not before. The terms of trade have an unexpected negative sign. The strong deterioration of the terms of trade in 1974 required an important adjustment in the level of exports, but it also seems to have had an impact on the rate of growth of exports (figure 8.5). These may be ansitory growth effects, however, rather than a permanent change in the steady-state rate of growt.h. Figure8.5 Trade policy and exports, 196049 Exprt volume index (1961= 100)

lrms of tradeindex(1978=100)

Tradepolicyindex 90

250

80

225 Termsof

70

TofedoIjc

200 2ndex

trade

60 175 50 ume

40

125

30 20 10 1960

4311*

l,

t

75 1965

1970

1975

1980

Note:Thetrde poliy index istheraio ofsubsidies to the average nomina Wiff. Sow'ce: Seeapperndkc.

1985

A long-runperpeaiveon tradeapoicy,instabity, and grwth

163

These results are consistentwith those ofFavaro and Spiller (1991),whose examination of the impact of trade liberalization at the sectoral level showed increases in producdvity and a sectoral relocation of factors, especially during 1974-78. These achievements were pardally reversed in 1979-82, however, because of a real appreciaton of the currency induced by increased capital inflows; the exchange rate-based stabilization program, and rising aggregate demand due to Argentine tourists. Viana (1990) decomposes the sources of growth from the demand side and finds that exports are an important determinant of growth between 1974 and 1978, but that internal demandis the tnain determinant of growth from 1979 to 1987.At the sectoral level he finds that between 1984 and 1987 the most dynamic sectors were those that had not previously produced for export but that were exporting to Argentina and Brazil foilowing extension of the preferential tade agreements. The increases in productvity induced in other sectors by the growth of intraregional exports are much smaller than those induced by exports to the rest of the world-which Favaro and Sapelli (1989) and Kaplin, SarAchaga, and Vera (1988) attribute to the preferential trade aWeements being merely an extension of the import-substitution strategy to "captive" markets in the neighbor countries. These findings cast doubt on the prospects for continued productivity growth through export growth. Export instability and growth The big export-promotion push ofthe second halfof the 1970s was discriminatoiy, granting higher subsidies to the more protected sectors (Favaro and Sapelli 1989,157). Ihis bias was reinforced by the preferential trade agreements. The resultwas a substantial increase in trade flowswithin the region. Driving this policy was a.desire to diversifyUruguayan exports. Critics of outward-oriented policies (see Yotopoulos and Nugent 1978) have suggested that small open economies would end up with exports concentrated geographically and by commodity, thereby increasing the risks of instability and secular decline in the terms of trade. Yet diversification of exports through increased regional exports has involved more instability in export income rather than less (Roldos 1989). Exports to the region are strongly correlated witi exports to the rest of the world, and so expanding regional exports increases the instability of aggregate export income. Because of wide fluctuations in the real exchange rate with neighboring countries, swings in export income from the region are more unpredictable and frequent than fluctuations in the prices of its natural-resource-based exports to the rest of the world. The negative effect of increased umcertaintyon capital accumulaton andgrowth wod thus have to be added to the static effects of the preferential trade agreements.

.164~ EFnCTsOFPNOTECTIONISM ONA SM~ALL CouNqTgv: THECAsEOFURUGUAY

Following Yotopoulos and Nugent (1978, 331), export instability indices were constructed for export sectors and destinations:

(cbogx, - ogkY) (8.11)

logX

n

where X, is the value of exports, X the mean value, and Xthe trend componenL The instability ofexportincome is much higher for the flows to Arn'entina and Brazil than for those to the rest of theworld, despite an annual growth rate of exports to the region double that to the rest of the world from 196265 to 1987-90 (table 8.3). Over the more recentpast, performance has deteriorated with Argentina and has improved substantially with Brazil, so that together, the rate of growth of exports to the region is similar to th2t to the restof dteworld. Considering the expansion of the preferential trade agreenents, greater growth ofregional exportswould be expected, suggesting that macroeconomic instabilityin the region might have reduced export growth. To analyze the impact of export instability on GDP growth, the stochastic trends of each sector's exports were estimated using quarterly data for a sample of the main industrial exports from 1975 to 1990. Adequate datawere available fornineteen sectors. To calculate the instabilityindexfor each sector, log X, was estimated as the permanent component of a Beveridge-Nelson (1981) decomposition. (The methodology aswell as the main properties of the series are reported in the appendix.) Annual growth rates of the output volume

index were also calculated

for each industry

between

1975-77

and

1987-89. Indices and rates were weighted by the share of each sector in industrial value added. A cross-section regression of the output growth rates on the respective export instability indices yields a negative but statistically insignificant coefficient. Sectors that export outside the region havealmnost double the growth rate of output of those thLatexport to the region and face half the export instability (table 8.4). Regardless of the crudeness of this measure, it does suggest a negative inpact of regional instability on output growth, the result ultimately of discriminatory export-promotion policies. Table 8.3 Instabilityand export growth Instabilityindex

Restof theworld

Argentina

Brazil

59.1

49.1

15.4

15.7 2.1

18.5 8.7

7.6 6.4

Expo,tgrMlh 1987-90/1962-65 1987-90/1977-80

Note:Instability indices dokted according to equation8.1 1,wth a detemiristictrendbetween1962and 1990; exportgrowiL'istheannualized growLhratebetweenavergeof samnple extremes. SowruAuthor'scalcubtions.

A long-n pmpective onitrae policy, instability, and gnh

165

Table 8.4 Exportinstabilityandoutput growthfor mainindustrialexports Industry code

Industry

outsidetheregon Exports 3111 Meatpacking 13114 Fishing 3211 Textiles 323[ Leather 3240 Footwear Average Exports to theregion 3112 Dairyproducts 3115 Oil 3116 Rice 3133 Breweries Paper 3411 3512 Chemicals 3513 Plastics. 3521 Paints 3551 Tires 3620 Glass 3710 BasicmetaJs norKlectric 3820 Machinery, electric 3830 Machinery, Automobiles andpins 3843 Average

Output gtowth'

Export irlobitityb

-1.08 1.74' 5.67 1.67 -1.18

3.97 1.35 131 3.12 202

2125

2-48

4.73 0.28 2.62 0.17 0.95 0.77 0.72' 3.27 -0.35 0.56 -130 5.73 136 0.18

7.56 4.46 5.33 2.50 5.97 5.44 4.63 9.52 4.33 10.53 19.98 5.43 1.92 4.92

1.21

5.57

(NIF)between theaverages for 1987-89 and1975-77 (or 1978,thebaseof a.Annuaked growthrates atoutput theindex, frthe sectors vwith an asterisk). b. Instabiltyindexdefinedin equation8.11,wIth log equalto the stochastictend in a Bevericigels-on deconposition. Source:Authar'scaulations; seeappendix.

Conclusion Tests for the effects of trade policies onrgrowth over the period 1960-85 using cross-sectional evidence for a sample of thirty-five countries confinn, as expected, thatopenness is positively correlatedwith growth. When per.capita GDP growth for this sample, net of the value predicted by all other explanatory variables, is plotted against openness, Uruguay is an outlier, with actual growth about 2 percentage points below predicted growth. These expected findings from the cross-sectional evidence did not carry over as clearly to the evidence based on time-series data for Uruguay. First, no evidence was found of temporal causality from exports to GDP (or vice versa), confirming the results of Jung and Marshall (1985) for a large sample of countries. These results cast some doubt on the direct effects of export-promotion polides on growth, though the results may be influenced by the period of strong but temporary growth due to import-substitution

166

Emen

OFPROTEmONISM ONA SMALL CouNTRY: THE CSE OFURUGuAY

policies and the long period of stagnation in 1955-74 and the recession of 1982-84. It is likely that the important positive correlation between contemporaneous exports and GDP growth was due to cyclical rather than to growth factors. Second, the evidence on scale economies was mixed. A key theme of the new growth theories is that trade induces greater specialization, which allows for the exploitation of economies of scale. Though the sum of the coefficients on a Cobb-Douglas production function totaled more than 1 (1.22 to 1.35), the hypothesis of constant returns to scale could not be rejected at a 5 percent level. Further, greater diversification rather than greater specialization -wasfound for the industrial sector, suggesting a reduction in growth potential since less specialization slows learning by doing. Solow technology residuals were found to be correlated with exports but not with capital per worker, confirming the simulation results of de Melo and Robinson (1992) on the potential for a neoclassical model with export externalities to account for the stylized.facts of trzde and growth in developing countries. Though the shift to export-promotion policies in 1974 had a big push effect on exports, it is not clear whether the growth in 1974-80 reflected a permanent change in the rate of growth or transitional dynamics of adjustment to substantial deterioration in terms of trade. The discriminatory bias ofrde subsidies to exports and the preferential trade agreements thatinduced thatbig push castdoubt on the alternative of apennanent change in growth rate. These policies generated substantial trade flowswithin the region, yet sectors exporting to the rest of the worldwere found to have higher growth rates and less export instability. Thus, Uruguay's export-promotion strategybetter described as a regional extension of the import-substitution strategyhad not only a static distortionary effect but also a negative effect on growth thiough increased instability. To expand exports widely and boost the longrun GDP growth rate, Uruguay would need Eo reduce the discriminatory bias-by sector and destination- of its export-promotion policies. Appendix.

Data sources and assumptions

The data on the capital stockwere constructed by Harberger and Wisecarver (1978), using the perpetual inventory methodology, and updated in Cimara de Comercio (1986). We extended the series to 1989. The share of capital in national income was also calculated based on those studies. It includes interest income, dividends, and rents from the national income accounts, with a deduction for the imputed income of owners, family members, and inde-

A kang'n pempectiveon tradepdiyq,instabily, and growth

167

pendent workers. It was not possible to construct extended series on those imputedincomesfor the agricultural sector, so the share has an upward bias estimated at 4.8 percent for 1978. The employment index was constructed from the best sources available. For 1965 to 1989, we used the number of workers in Montevideo (source: Insituto de Estadistica, Facultad de Ciencias Economicas y Administraidn, andDireccion General deEstadisticayCensos);we interpolated 1964, using data for 1965 and that from the 1963 census. We projected the series from 1962 to 1955 using the annual rte of growth of the sum ofemploymentin manufacturing (source: Ciman de Industrias, Departamento de Estudios Economicos) and in the public sector (source: constructed from data from the OficinaNacional de Servicio Civil). The data on unemployment, which were used as a proxyfor capital udlizadon (as in Solow 1957), were from the same sources for 1963 to 1989, with the avenge for 1962-68 used for the period 1955-61. Table 8A.1 presents the series on the share of capital, output and capital per worker, as well as the Solow residuals (Solow 1957, table 1). The tade policy index (TPI) was calculated as the ratio of one plus the subsidy rate diided by one plus the tariff rate times 100. The subsidy rate was calculated as the ratio of certificates issued over nontraditional exports. (Sources: C(mamade Comercio 1979;Departamento de Estadios Econ6micos, for 1961-77; GINVE 1983 for 1978-82; CINVE 1986 for 1983-85; for theperiod 1986-89, indirect taxes rebates from Direccion General hnpositiva.) The same could not be done with the tariff rate, because the implicit tariff on actual imports was very low due to prohibitive rates. We took estimates on a sample of products presented in Favaro and Sapelli (1989, cuadro 5.5), plus the ones in CINVE (1986) for 198586, and the average of the five rates of the structure for 1986-89, and interpolated linearly the missing years. Though a crude measure of trade policy (it disregards quotas, reference prices, and other nontariff barriers), it seems to capture the main shifts in policy. The instability indices for the sectoral exports were calculated according to the definition in equation 8.10. Whenever appropriate, a stochastic trend (instead of a deterministic one, see Stock and Watson 1988) was constructed from the currentvalue of exports. That stochastic trend is the permanentcomponentofa Beveridge-Nelson decomposition of the series. Miller (1988) shows how that permanent component can be generated from an autoregressive filter obtained from the first difference of the series, then applied to the levels of it. The ARMA processes used to generate that AR filter, and the stochastic trend, are presented in table 8A.2.

168

EmcnS

OF PROTEcrIONISMON A SMALLCOUNTRE THE CASE OF URUGUAY

Table BA.I Calculation of Solow residuals Year

KSHARE

1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972

0.469000 0.469000 0.475000 0.463000 0.515000 0.511000 0.434000 0.393000 0.401000 0.435000 0.420000 0.397000 - -0.419000 0.395000 0.383000 0.363000 0.396000

1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1.986 1987 1988

0.417000 0.434000 0.447000 0.455000 0.485000 0.490000 0.543000 0530000 0.516000 0.493000 0.547000 0.555000 0.506000 0.493000 0.493000 0.480000

0.395000

1989

..

YL

K2L

27.24155 27.37893 27.71300 27A2683 27.08654 28.43941 29.95666 28.88775 28.68639 29.28125 29.71676 30.61887 2971424 30.26591 32.10879 3359739 33.45327 33.73450

79.19048 80.68803 82.17400 82.43847 82.97582 .83.78407 84.80900

34.10098 35.40464 3738078 38.46B80 38.45769 40.48014 43.59496 46.45474 47.88527 46.09008 43.72235 42.54190 41.63513 44.22036 45.69784 46.14522

92.07607 93.32452 94.27297 90.94421 93.78143 99.15085 107.7780 114.7044 121.8709 126.3266 121.4180 121.7462 118.6048 120.1909 118.1523 119.5471 120.9489

47.19024

85.76386 85.97275 87.46797 89.13491 89.64286 91.12557 89.17521 89.358 I5 91.30727 91.30646 93.28669

DLA

A

1.000000

0.000000 -0.003687 0.003465 -0.011919 -0.015898 0.042641 0.045403 -0.041400 -0.007974 0.013460 0.006520 0.027083 -0.036904 0.027391 0.056586 0.036131 -0.004305 -6.94e-05

0.996000 1.000000 0.988000 0.972000 1.014000 1.060000 1.016000 1.003000 1.021000 1.028000 1.056000 1.017000 1.045000 1.104000 1.144000 1.139000 1.139000

0.016230 0.031016 0.048368 0.044937 -0.014962 0.023426 0.027984 0.029557 -0.000469 -0.056338 -0.032040 -0.029244 -0.008377 0.051956 0.040838 0.004095

1.157000 1.193000 1.251000 1.307000 1.288000 1.318000 1.355000 1.395000 1.394000 1.316000 1.273000 1.236000 1.226000 1.289000 1.342000 1.348000

Not availabit Mote: iHSARE iscapil asa shareci income.Y is outputper worker,K2Liscatal perworker.andDIA ard A areSolowreiduals. SDurc See appendix text

A lng-nrunppetdive

on iradepolcy, instability;andgswtk

169

Table 8A.2 ARMA models for sectoral exports Iduscycod

Qsws}c

Model

.

(I + 0.462L)Ax,

3114

10.3

(3.97) 3211 3240

3 ) Ax, (I + 0.447L+ 0.476L2+ 0.392L (3.53) (3.79) (3.12)

(I + 0.555L+ 0.252L2 + 0.12L3- 0.214L")Ax,= (4.18) (1.85) (0.91) (1.66) A=x = (1-0.692L) i; (5.41)

3112 3115 3133

;

(I + 0.343L+ 0.3 LI Ax=s; (2.53) (2.28) (I +0.506L+0.551L2 i+0.203L')Ax, = (4!56) (5.47) (1.84)

8.3 13.1 15.7 15.7 12.8

3411

Ax, = (i - 0.533L); (3.66)

16.0

3512

Ax,= (I-0.501L); (3.86)

7.6

3551

2 + 0.235L)Ax, (I + 0.282L+ 0.255L = Et (2.14) (1.91) (1.78)

9.1

3620

3)Ax,=; (I + 0.634L+ 0.522L2+ 0.222L (4.77) (3.71) (1.68)

23.9

3710 3820

Ax,

(I -0.314L-0.387L'); (2.37) -91) Ax,

(I -0.52L);

5.7 11.4

(4.03) 3830

(I+0395L)Ax,=; (3.24)

8.9

3843

Ax,= (I- 0465L) (3.52)

16.1

Note:Axstardsforefirstdifferncecf(ocg)exportsoftherespectivesector.Seors3111.3231.3116.3513. fan a nodiascone. adeterminisc trendvwSmoreappropriate and352( arenotricudedherebeouse SuDe:Seeappendix txL

170

ErFEcrs OF PROTCrIONISMON A SMALLCOUNTRY: THE CAsE OFURUGUAY

Notes I wishto thankLuisVianaforinterestingdiscussions,AdrianaCassoni,MichaelConnolly, Jaime de Melo,William Easterly,and MarcelVaillantfor their comments on a previous draft, and Dolores Benaventeand Carlo Grazianifor extending and updating the data. All errors remain my own responsibility. 1. This may overcstimate capital's share since we were unable to obtain estimates of income inputed to independent and family workers in the agricultural sector. We estimate this bias to be less than 5 percent of national income (see appendix), 2. Changes in import volumes-the import externality suggested by de Melo and Robinson (1992)-did not have any explanatory power when added as a regressor. 3.Thisisimportantbecause, asshown byStockandWatson (1988)and Cuddington and Urznua(1989), the removal ofa deterministic time trend can alter substantiallythe nature of the remaining cyclicalcomponent of the series. References Anichinij.J.,J. Caumont, and L. Sjaastad.1978. LaPolitica Comercial y la Protecci6n en el Uruguay." Banco Central del Uruguay. Montevideo. Backus, D., P. Kehoe, and T. Kehoe. 1990. "In Search of Scale Effectsin Trade and Growth. Journal of EconomicTheory58: 377-409. Baldwin,R. 1989. 'On the Growth Effects of 1992.7EconomicePolicy9: 247-81. Barro, R. 1991. "Economic Growth in aCrossSection of Countries." QuarlyjounIaof &conomics106(2): 407-44. Beveridge, S., and C. Nelson. 1981. 'A NewApproach to the Decomposition of EconoomicTime Series into Permanent and Transitory Components with Particular Attention to the Measurement of Business Cycles."Journal of MonetaryEconomics7: 15r1-74. Bhagwatij. 1986."ExportPromotingTradeStrategies:IssuesandEvidence."WoridBank Disussion Paper, Development PolicyIssues Series no. VPERS7.Washington, D.C. Cdxnara Nacional de Comercio, Departamento de Estudios Econ6niicos. 1979. "Comercio exterior del Uruguay, 1961-1978."Montevideo. . 1986. Publicaci6n no. 17. Montevideo.

CINVE(Centro de InvestigacionesEcon6micas). 1983. "Industria yprotecci6n en un contexto de apertura externa: Uruguay 1978-1982."Montevideo. 11986. "Estudio sobre la reestructura de la protecci6n arancelaria.' Montevideo. Cooley,T., and S. LeRoy.1985. "AtheoreticalMacroeconomics:A Critique.Journal of MonetaryEconomics16: 283-308.

Cuddington,J., and C, Urzua. 1989. 'Trends and Cyclesin the Net Baner Terms of Trade: A New Approach." Eonomcfourna199: 426-42.

Easterly, W., Ri King, R. Levine, and S. Rebelo. 1990. "Do National Policies Affect Long-RunGrowth?' WorldBank, PolicyResearch Department,Tra-nsitionand MacroAdjustment Division,Washington, D.C. Engel, R., and C W.J. Granger. 1987. "Co-integration and Error Correction: Representation, Estimation and Testing." Exonometzica 55(2): 251-76. Favaro, E., and P. T. Spiller. 1991. 'Thc Timing and Sequencing of aTrade Lberalization ELcperiment:Uruguay 1974-1982."In D.Papageorgiou, M Michacly,A Choksi, eds., LiberaizingForeignTrad, vol. 1. Washington, D.C.: World Bank.

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Favaro, E., and C. Sapelli. 1989. 'Promoci6n de e:cportacioncs y crecimiento econ6mico." Centro de Estudios de la Realidad Econ6mica y Social, Centro Internacional pam el Desarrollo Econ6mico. Montevideo. Feder, C. 1983. "On Exports and Economic Crowth. Journal of Dueelopmt Economics 12: 59-7.Gewcke,J. R, R. Mecse, and W. Dcnt. 1985. ComparingAltcrnative Tests of Causality in Temporal Systems."Journal ofEconometrics21: 161-94. Granger, C. W.J. 1969. "Investigating Causal Relations by Econometric Models and 37: 424-38. Cross-spectralMethods." Econometrica Granger, C. W.J., and P. Newbold. 1986.ForecstingEconomicTimeSeries.2nd. edition. San Diego, Calif;:Academic Press, Inc. Grossman, C. M., and &- Hclpman. 1990. 'Comparative Advantage and Long-Run Growth.' American EconomicRevitw 80: 796415. .1 991a. "Endogenous Product Cycics."EconomicJoumnal101: 1214-29. . 1991b. "Growth and Welfare in a Small Open Economy." In E. Helpman and A. Razin, eds. Inernational Trade and TradtPoliy. Cambridge, Mass.: MIT Press.

Harberger, A., and D. Wilsecarver.1978. 'Tasas de Retorno al Capital en los Ambitos Privado y Social en el Uruguay.' Banco Central del Uruguay. Montevideo. Helpman, E. 1988. "Growth, Technological Progress and Trade.' Austrian Economic Papers 1: 5-25. , 1989. The Noncompetitive Theoryof InternationalTrade andTrade Policy." Proceedingsof the World Bank Annual Conferenceon Delpament Economics, Washington, D.C.

Jung, W. S., and P.J. Marshall. 1985. "Eorts, Growth and Causality in Developing Economics18: 1-12. Countries."JoumnalofDevelopment Kaplin, M., D. Sarachaga, and T. Vera. 1988. "Integraci6n, Politica Comercial y Comercio

Intra-industrial:

Evidc. a4s pan

la Valoraci6n

dei

Comercio

Intrarregional." ReuistadeEconomiaS%3).Montevideo: Banco Central del Uruguay. Krugn-an, P. 1988. 'he Narrow Moving Band, the Dutch Disease, and the Competitive Consequences of Mrs. Thatcher Notes on Trade in the Presence of Dynamic Scale Economies Journal ofDevelopmew Econoomics 27: 41-55.

Lucas, R. E. 1988. "On the Mechanics of Economic Development"Journal ofMonetary Economics22: 3-42. Maddison, A. 1987. 'Growth and Slowdownin Advanced Capitalist Economies: Techniques and Quantitative Assessment."Journal ofEconomicLiterature25: 649-98. Melo,J. de, and S.Robinson. 1992. "ProductivityandExternalities:ModelsofExport-Led Growth."Journal oflntemnational Trade andDevelopment 1: 41-69.

Michaely, M. 1977. "Exports and Growth:An Empirical Investigation."Journal ofDevelopmentEconomics4(1): 49-53.

Miller, S. M. 1988. 'The Beveridge-Nelson Decornposition of Economic Time Series." 21: 141-42. Journal of Monetary Economics Nishimnizu,M., and S. Robinson. 1984. 'Trade Policy and Productiviy Change in Semi-Industrialized Countries."Journal ofDevelopmetEcmomics16. Pritchett, L. 1991. "Measuring Outward Orientation in Developing Countries: Can It Be Donc?" PolicyResearch Working Paper 566. World Bank, Trade PolicyDivision, Washington, D.C. Rebelo, S. 1990. 'Long Run PolicyAnalysisand Long Run Growth."Jornal ofPolitical Economy 99:500-21.

Romer, P. 1986. Increasing Returns and Long-Run Growth."JournalofPdliticacEconomy 94: 1002-37.

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. 1987. "Crazy Explanations for thc Productivity Slowdown." NBER MacroeconomicsAnnual 2: 163-202. 1990. "Endogenous Technical Change." Journal of Political Economy 98(5): S71-102. Roldos, J. 1989. "Export Instability and Growth." Centro dc Estudios de la Realidad Econ6mica y Social. Montevidco. Solow, R. 1957. 'Technical Change and the Aggregate Production Function."Reviewof ____,

Economics and Statistics 39: 312-20.

Stockj. H.. and M. W. Watson. 1988. "VariableTrends in Economic Time Series."JournaI offenrinic Pe-sFkaives.2:1 47-74. Viana, L. 1990. "Los Efectos dc los Cambios en el Nivel de Protecci6n sobrc las Exportaciones." Paper presented to thcjornadas de Economia, Banco Ccntral dcl Uruguay. Montevideo. Yotopoulos, P., andJ. Nugent. 1978. Economicsof Development:Empirical Investigations. New York: Harper and Row.

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