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Evidence That Trade Does Reduce Poverty, But Only If the Conditions Are Right

Raju Jan Singh's picture

Market negotiations. Source: Raju Jan Singh/World Bank.While most economists accept that, in the long run, open economies fare better in aggregate than do closed ones, many observers fear that trade harms the poor. African countries, for example, have experienced significant improvements in trade liberalization in recent decades. But Africa remains the poorest continent in the world. It seems that the large gains expected from opening up to international economic forces have been limited in Africa, especially for poor people.

So does trade reduce poverty? In a recent World Bank Policy Research Working Paper, my colleague Maëlan Le Goff and I examine this question, looking at the connection between poverty and trade liberalization in 30 African countries between 1981 and 2000. Our results suggest that trade does tend to reduce poverty, but only in specific settings: in countries where financial sectors are deep, education levels high, and governance strong.

This result corresponds to a certain logic. These three dimensions (finance, education, and governance) capture an economy’s ability to reallocate resources – to move them away from the less productive sectors to the more productive ones. This, in turn, allows countries to better take advantage of the opportunities offered by trade.

A more developed financial sector allows banks and investors to more quickly identify new and promising sectors and redirect credit to them. A more educated population is more able to acquire the new skills sought by growing sectors and adjust more rapidly to the changing conditions of the labor market. Finally, better governance allows contracts to be made and conflicts to be resolved more easily.

It’s easy to imagine how any of these factors could help pull people out of poverty. An easy-to-get business loan could help a new grocery store open and create new jobs, for example. A literate worker would be more able to transition from low-paying agricultural work to a job in a new factory. And foreign investors, observing that a country’s government enforces contracts, might be more willing to invest in a new plant, hiring local workers. If these conditions are not met, however, greater openness to trade could be associated with higher levels of poverty.

The good news is that our results suggest that many African countries meet these conditions and are well positioned to take advantage of the opportunities offered by trade. On average in Africa, however, while the financial sector (measured by the ratio of private credit to GDP) is deep enough and the level of education (measured by the share of the population over age 15 with completed primary education) is high enough to benefit from trade, institutions are generally too weak. A few countries, such as Liberia or Mali, do not meet any of the three conditions.

 

Countries above and below the thresholds (1981-2010)

Classification of countries with regard to the thresholds (1981-2010)

Source: Le Goff, Maëlan and Raju Jan Singh, "Does Trade Reduce Poverty? A view from Africa."

 

These countries will need to enact a wide range of policies designed to harness the power of trade for economic development. Inadequate policies and institutions, weak human capital, and limited financial development are not only bad for a country’s welfare. They also hold back the poor, denying low-income residents of developing countries the benefits of freer trade.

These results are consistent with the recent literature arguing that the benefits of trade are not automatic, but rather depend on good policies, too. Our findings suggest that these policies should encourage the financing of new investment, the effective resolution of conflicts, and the ability to adjust and learn new skills. This accompanying policy agenda should allow resources to be reallocated away from less productive activities to more promising ones. Trade liberalization should therefore not be seen in isolation.

Comments

I agree completely that open trade agreements with most SSA nations are highly beneficial, *especially* in specific cases where high barriers to trade exist and are replaced with aid programs: What is the next policy step? How can a poor/corrupt country increase "higher education/literacy levels, government policies that enforce contracts and create a functioning credit market" in order to benefit from trade agreements? The abstract mentions Liberia and Mali as failed cases (where is Sierra Leone in this study?). I'd add that it opens these weak states up to predatory trade policies that hurt the truly poor and benefit/reinforce existing power structures (i.e. keeping the poor destitute while giving contracts to the already wealthy whether in government or in business or a combination of both as if often the case). The way many contracts are written (and this may be specific to my knowledge in Sierra Leone in the extractive industry); "open trade" usually means that the benefits (revenue through taxation) are often not distributed to infrastructure in the country, education or any other distribution of wealth in the country to raise the general level of poverty in the country. Rather, it tends to fund those in power (whether that be government leaders or the business community). In addition, corruption/facilitation fees at a basic level (ports and other entry areas) can diminish investor confidence and also decrease the benefits of trade as the revenue is not distributed in country. I would like to re-iterate that I am ideologically for open and fair trade agreements with SSA countries; *particularly* in lieu of aid policies; however I find this article important as it reinforces what anyone who has lived in these countries understands immediately: if the state is weak, those in power have the ability to negotiate contracts that are beneficial either to only themselves or; especially in post-conflict countries, the expertise may not be "in country" in order to negotiate complex contracts to benefit the country long term versus short term. Example: extractive industry in Sierra Leone; where the tax structure with the mining companies is a great example of free trade not benefiting the general populous and are currently under review for re-negotiation. Hopefully future oil contracts will have built in longer-term benefits to the country and be distributed fairly. Additionally, what is the prescription for a country that has no functioning credit system? It can take years to set this up from scratch and in the interim grants, trade agreements and all incoming revenue may not have a functioning proper coffer to be placed in nor an accounting system to log it. As stated, on a micro level, a lack of a basic credit system eliminates the possibility for small businesses to grow, forcing many to be funded through outside sources (notably UK, Lebanon, USA), which restrict overall access to much needed capital to a certain few. Again, a problem of distribution. In the interim trade is very important for these countries, agreed. But what is the solution for countries that don't have the resources - either human or structural (literacy, credit system, contract reliability/recourse) - to enter into trade agreements in a way that benefits all?

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