Why do we need Trade Policy Reforms Now

Why do we need Trade Policy Reforms Now? A Practical Guide Sarath Rajapatirana Ph. D. 1

Plan of the Presentation �The nature of our present trade regime �Impact of our trade regime on the economy. �Some wrong perceptions about trade regime reform. �What to do to reform the Trade Regime ? �How to reform the Trade Regime ? �What to expect from the reforms ? 2

Our Present Trade Regime � We have the most protective trade regime in our neighborhood which has our main competitors. � It has high average protection (both tariffs and non-tariff measures) compared to our competitors and our history of having the most open trade regime in South Asia in the late 1970 s to the late 1990 s and up to 2005. � Because our nominal rates of protection are high for final goods and are low for intermediate goods and raw materials we have high effective rates of protection (or protection accorded to value added) for import competing domestic production. Consequently they distort resource allocation and lead to inefficiency and lack of competition. � There are behind the border barriers such as clearances for exports from various agencies and ministries and much ambiguity in classifying intermediate good imports that leads to a chaotic incentive structure. � There are tariff- like restraints called para-tariffs that have very high rates. All imports, including inputs imported by export producing firms, are subject to paratariffs. Thus para-tariffs reduce the effectiveness of duty-free import concessions provided to export production, under the present trade policy regime. � Our protective structure has wide variance which has deleterious effects on resource use. 3

Impact of the Present Trade Regime � High effective protection to import-competing production creates a bias against exporters who have to buy labor and capital in the domestic market while high import protection gives producers of import substitutes a larger quantum of resources to bid away these factors from potential exporters. � The trade regime has high variance in protection which distorts incentives such that investments in the tradable sectors do not go to the highest return sectors but to those protected by the trade regime. � The present trade regime acts against the competitiveness of our economy both with respect to exports and the production of efficient import substitutes. Thus an important aspect of the present trade regime is that it acts against efficiency. � Our trade regime is non-transparent and unpredictable which runs contrary to our policy to increase efficiency of the economy. This is seen by the low total factor productivity of our economy which is between 1 -2 per cent in the last 30 years. Our aspiration to double per capita income in a decade is being compromised by low productivity. Trade reform would help to raise productivity and economic growth. 4

What to do to reform the Trade Regime ? � The average rate of tariffs (the rate of nominal protection) including tariffs and paratariffs on imports should be reduced to a uniform nominal rate of 15 per cent. This would mean that effective rates would also be 15 per cent across all industries. � The 15 per cent nominal rate could be achieved by reducing the high rates and raising the low rates. This could be done in two stages with announcement of stages. Moving towards a low uniform tariff structure has to potential to increase tariff revenues. This would also speed up customs clearance and reducing the potential for corruption as it reduces discretion of custom’s officials. � To compensate for the revenue losses from reduced tariffs get rid of tariff exemptions and keep a competitive exchange rate. � On the export side get rid of all cesses as they reduce the effective price received by exporters and thereby discourage exports. � Do not use trade measures to deal with BOP problems as they have adverse collateral effects. � Make the trade regime predictable by not using it to stabilize domestic prices. � Attempting export promotion mainly through the creation of institutions does not work without reducing barriers and aligning incentives. 5

Some Wrong Perceptions about the Trade Regime in Sri Lanka � Import restrictions (tariffs and non-tariff measures) cannot correct an imbalance in the current account deficit in the BOP. E. g. imposition of import controls does not reduce excess demand, -the main cause of a current account deficit. In addition, import restrictions can contribute to widening the trade deficit by discouraging exports (import restrictions are a tax on exports). � Increasing per “unit value” added (the percentage of value added on a give product) is not by itself a good policy when we aim to reach the gains for global economic integration. What is needed is increasing total value added (i. e. contribution to GDP) which is mostly determined by export volume. � Exchange rate policy is closely linked to the trade outcome. A good trade outcome cannot be expected from an out of line exchange rate. � Greater uncertainty with respect to trade measures ( tariffs and non-tariff measures ) inhibits production planning and aligning both export and import substituting activities. � Signing many free trade agreements (FTAs) can be counter productive. Administering such a system would be difficult and it also give discretion to customs and trade officials which can be abused. Most importantly, actual trade effects of a FTAs depends on the rules of origin (conditions required to become eligible for tariff concessions ) which are integral parts of any FTA. Empirical evidence shows of actual utilization rates of FTAs concessions are very low 5 -10 per cent because of the high administrative costs of meeting rules of origin. � Finally, there are many barriers to trade that are neither tariff nor non-tariff related but procedural and organizational but could have a high protective effect. These could be overcome better trade facilitation, streamlining procedures and prosecuting incidents of bribery and corruption at the ports. A 2010 ITCN survey of exporting firms by in Sri Lanka found that 70 % of them said domestic barriers were more important than barriers beyond the border. 6

How to do it : Timing and Sequencing � It is best to introduce trade reforms and exchange rate reforms along with other reforms such as fiscal reforms and labor market reforms. � Many countries have used economic crises to introduce trade reforms. During crisis those who have opposed reforms lose their resolve or are not able to command support from others. � Compensatory measures can be taken such as income transfers to the poor as during a fiscal crisis to undertake reforms. The main thrust is a adjustment in relative prices while income related measures are taken. � Sequencing can influence thrust and outcome of reforms by picking the low hanging fruit at first, e. g. replacing quantitative restrictions with tariffs which would also help to raise revenues. � Also, income transfers can cushion impact of an increase in tariffs and on essential commodities. Price adjustments can go through and the resulting decline in real income is moderated by these transfers. 7

What to Expect from the reforms ? �A trade reform is undertaken to alter relative prices. Response to reforms depends on the how quickly domestic supply of exports and import substitutes could adjust. We have to take international prices as given to a small country like ours. Demand for our exports is infinite as we cannot alter world prices. �The implication is that when a trade reform is taking place access to capital and labour must increase so that economic agents can respond to the changed incentives. At the same time, access to raw material and intermediate goods should also increase. �Other factors also determine supply response such as access to credit, overcome onerous labor laws and access to electricity. �Without proper macroeconomic policies that support the relative price changes, a trade reform cannot succeed. 8