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1 CHAPTER ONE Introduction 1.1Background Liberalization of the world economy has brought in seamless adjustments throughout the countries in the world The global trade dynamics has affected all the countries both developed and developing reshaping their economic restructuring The very process of globalization and trade liberalization has also created interdependency of nations to a significant extent This economic dependence creates economic interrelation among the countries in the world As a result the role of strong external sector becomes a topical issue for the development of countries and economic growth International trade consists of export and import of goods and services Countries experienced different trade strategies and policies external trade environment and domestic policies have a great impact on the trade and economic growth In order to obtain a favorable trade of balance like export orientation or import substitution strategies Liberalization of Ethiopia along with structural adjustments and slow process of privatization has shown mixed results for the economy The doctrine of import substitution industrialization trade policies that was pursued by many African countries during the period from the 1960s to the1980s began to shift to marketoriented reforms starting from the early 1980s.The major reasons for the shift towards more market-oriented reforms were in response to the economic crises in Africa in late 1970s and early 1980s which were advocated by international financial institutions The market-oriented policy packages, usually referred to as “Structural Adjustment Program (SAP)”, which contain trade liberalization as an integral part had taken different measures to liberalize import and to remove the most export-distorting interventions (Gidisa, 2010) The structural adjustment programs (SAPs), which most African countries pursued in the 1980 and 1990s, have been supported by increased level of grants and credits which, in turn, increased the level of merchandise into these countries The resultant combination of increased volume of import and possible decrease in the rate of import taxation has helped to sustain or even increase custom revenue (Teshome, 2003) In recent year it has become widely acknowledge that many developing countries desiring to accelerate their economic growth are unable to achieve this goal because of constraint imposed by trade balance Thus relationship between trade liberalization and trade balance become an important area of study in recent year especially in developing countries like Ethiopia They began to advocate the promotion of export can be made through import liberalization by amending the underlying structure of the economy (Shafeddin, 2008) The strategy of trade liberalization have been launched by many of the countries of the world which classified into three parts (waczicrg 2008) the first groups were Asian countries using their export oriented reform of dynamic trade and industry reforms in 1960’s The second one is consisting of African countries that adopted trade liberalization reform in late 1970’s and early 1980’s The third groups are composing of Latin American countries which adopted in 1980’s as a result of the press are of international financial institutions (shafeedin 2008) The market oriented policy packages, usually referred to as “Structural Adjustment Program (SAP)”, which contain trade liberalization as an integral part had taken different measures to liberalize import and to remove the most export-distorting interventions While about 60 percent of African countries were undergoing and had undergone through a Structural Adjustment Program by the second half of the 1980s (World Bank, 1994), most had undertaken the program by the mid-1990s (UNCTAD, 2008) Ethiopia has tried to implement different trade strategies in the post During imperial period the major policies of external sector were import substitution and protection of infant industry It tries to promote the growth of endogenous industry through protection of living import tariff quota different mechanism to protect the competition of imported good items After 1974 the military government era was a heavily state managed trading system were occurred There was an intervention in the transaction of trade activity most industries were nationalized currently the country experience a market oriented liberalized strategy which supported by the international financial institution (yebltal, 2011) Ethiopia mainly adopts the trade liberalization in 1996 In general as long as trade is the major component of economic variable trade liberalization is a key in the development favorable trade balance and positive terms of trade However this is going to be achieved if there is successful implementation of macroeconomic policy When we see the current condition of most African countries they fail to implement effective macroeconomic policy which makes them inefficient use of the trade liberalization 1.2 statement of the problem Most of least developing countries are characterized by weak performance of export and high price of import commodity In 1980 Africa’s share of the world’s export was only 2.5 percent and of the imports 2.3 percent In 1984 its share of the world’s export and imports were down to 1.6 to1.9 percent respectively In 1989 there was further drop in the relative shares with the export share down to 1.1 percent and imports 1.0 percent of the respective world totals Furthermore Africa’s export trade fell at the rates of 0.2 and 1.8 percent per annum during the periods 1973-1980 and 1980-1987 respectively During the same periods the corresponding export volume growth for the low income group of countries was estimated at 3.5 and4.2 percent per annum Africa’s distance from the low income group’s average continued to widen for the period up to 1990 (Teshome, 1990) The terms of trade too have been unfavorable to Africa’s export commodities The terms of trade for the low and middle income group countries during the period 1980-1987 were estimated at -3.7 as against -5.7 for sub-Saharan Africa Export volume increases to the desired extent were also not possible due to recurring unfavorable climate and related production constraint Even if it were possible to expand exports Africa’s earning would not have increased because of offsetting price inelasticities of demand for Africa’s products (Teshome, 1990) Ethiopian economy is one of the least developed countries of the world In the past period there was high trade restriction on the external sector Several protection of import made by levied tariff on the imported item Goods; there was also high government intervention in the trade transaction However even if governments this mechanism there was high import than the country export, this makes the country to experience unfavorable terms of trade Proponents of globalization believe that trade liberalization is the key to fight poverty in developing countries (World Bank 2002; WTO 2000; McCulloch, Winters & Cirera 2000) Most of the experts define trade liberalization as the total or part elimination of trade barriers such as quotas and tariffs imposed by governments on imported and exported goods (Marchant & Snell 1997) It is believed that the relaxation of trade barriers will facilitate trades and attract foreign direct investment (FDI) which in turn will boost economic growth and ultimately lead to poverty alleviation (WTO 2002) In spite of this, reports from the UNCTAD (2001) indicate that poverty in developing countries continue to exist The number of people living on less than one dollar a day has been increasing by almost 50 per cent in the last few years and the gap between rich and poor people in developing countries is widening UNCTAD (2001) points out that the poorest 49 countries make up 10 per cent of the world population, but accounts for only 0.4 per cent of world trade and this disparity is continuing to grow at an alarming rate In the year 2000 alone, sub-Saharan Africa lost nearly US$45 dollars per person thanks to trade liberalization Most trade liberalization in Africa has been part of the conditions attached to foreign aid, loans and debt relief This looks like a bad deal: in 2000, aid per person in subSaharan Africa was less than half the loss from liberalization only US$20 Africa is losing much more than it gains if aid comes with policy strings attached The staggering truth is that the US$272 billion liberalization has cost sub-Saharan Africa would have wiped clean the debt of every country in the region (estimated at US$204 billion) and still left more than enough money to pay for every child to be vaccinated and go to school (Africa Focus Bulletin July 5, 2005) In theory, trade liberalization is expected to have a positive influence on the long-term growth of the economy through a more efficient use of resources; increased competitiveness; flow of knowledge and investment; capital accumulation and technical progress; and export diversification However the impact of trade liberalization on the trade balance and the current account of the balance of payments of countries are ambiguous regardless of the framework of balance of payments adjustment theory used Therefore, the final effect doesn’t depend on the theory and, hence, it is an empirical matter (Santos-Paulino, 2004) Trade liberalization can stimulate economic growth of African economies ( Sahn, Dorosh and Younger,1996) while others maintained that trade liberalization may not provide positive contributions to long run growth of African economies (Stewart,De maio, and Hoeven ,1999) Still ,others argue that economic reform may cause African economies to recover from adverse effects of misguided policies of the previous decades(Bediane ,1999).The opposing argument is also gone as follows According to the Global economic prospects (2002), in developing countries, trade liberalization policies are hard to formulate and implement because the magnitude and distributional impacts tend to be very large Ethiopia implemented several foreign trade reforms with the objective of encouraging of export and liberalizing import trade reform as an integral part of structural adjustment program has been implemented program has been implemented with the objective of encouraging export foreign exchange auctioning removal of taxes and duties on export devaluation of currency and price decontrol But the above liberalization will not bring some desired result to maintain trade balance there are internal and external factor due to lack of exporting opportunity high cost of transportation , poor quality of production and uncomfortable condition for investment and saving (Zerihun, 2007) Although there are some studies identified the determination of trade liberalization studios are immense and limited This paper mainly tries to show how the recent trade liberalization policies mainly try to show how the recent trade liberalization policies affect the trade balance of the country 1.3 Objective of the study The major objective of the study is to find the impact of trade liberalization on the Trade balance of Ethiopian More specifically it will address the following point  To investigate the effect of implementation of trade liberalization policies on the trade balance  To examine foreign trade policies and their effect on import export and trade balance and trade liberalization  To show how the economic integration affect the trade liberalization  To investigate the effect of exchange rate and terms of trade on trade balance 1.4 Data source and Methodology Data source The data were to be collected from all the possible secondary sources like books, periodicals, research articles of peer-reviewed Journals, News paper clipping, Government publications, Customs data, working papers, and occasional papers and publications, special issues by the international organizations and other country sources like UNCTAD, WTO, World Bank, IMF,Ministry of Finance and Economic Development (MOFED) and National Bank of Ethiopia (NBE) e.t.c Methodology The present research study is uses historical, comparative and analytical methods to interpret the relevant issues and concerns related to the topic by extensive use of secondary literature This is a descriptive study and the researcher would use both descriptive and econometric analysis Different statistical tests such as ADF, Unit root test and stationarity tests are conducted to check for stationary of variable statistical significance of model, co-integration test, long run and short run equilibrium test are going to be assessed to find out the empirical effect 1.5 Significance of the study By identifying the factor of trade liberalization which affects the trade balance This study help to policy makers to explore appropriate policy and measure to progress The term of trade of the country It also single out the impact of trade liberalization and make the necessary amendment to the countries trade policies In addition it examines whether trade liberalization help in balancing the trade deficit or worsen it 1.6 Scope of the study The scope of this study cover from the period of 1974 up to 2010.This period is chosen to compare the trade balance before the trade liberalization and after liberalization It is also important to estimate the time series data accurately since the time is more than 20 years 1.7 Organization of the study Following this section of the study, in the next section we see theory of liberalization and its relation with trade balance In addition empirical evidence that exist between the two factors is assessed In the third part there will be data presentation and methodology and the fourth part will be model specification in the analysis Finally the study will address conclusion and recommendation CHAPTER TWO Literature Review 2.1 Theory of trade and liberalization The term trade is commonly understood to mean exchange of goods, merchandise among people It comprehends every species of exchange or dealing in goods Trade may be internal or external By internal or domestic trade is meant transaction takes place within the geographic boundaries of a nation or region It is known as interregional or home trade External or international, on the other hand, is trade among different countries or trade across political frontier International trade thus refers to the exchange of goods and service between one county and regional and another is called international trade and trade within the territory of a nation internal trade The fundamental basis of international trade lies in the fact that all countries cannot produce all things equally well or cheaply due to the unequal distribution of natural resources among them and improportionality and imperfect substitutability of their available factors of production Moreover, for various socio-economic and political reasons, there is a lack of mobility of factors, especially labor as between one country and another Thus different kinds of production, which were most advantageous to them, were undertaken by different countries and when the exchange of these specialized goods which took place among them gave birth to international trade Thus international trade in so far as it is result of geographical specialization fundamentally the same as trade between two regions within the same country (i.e domestic trade) Each region within the country tends to specializes in the production of commodities for which it is best suited (Krugman, 2006) 2.1.1 International Trade theory The history development of trade theory is a convenient way of introducing the concepts and theory of international trade from the simple to the more complex and realistic The discussion begins with the economic doctrines known as mercantilism that prevailed during the seventh and eighteenth centuries and then go on to discuss the theory of absolute advantage developed by Adam smith It remained however for David Ricardo, writing some 40 years after Smith to truly explain the pattern of and the gain for trade with his low of comparative advantage theory The law of comparative advantage theory is one of the most important laws of economics with the application to nation as well as individual and useful for exposing many series fallacies in logical reasoning One difficulty remain Ricardo had based his explanation of the law of comparative advantage on the labor theory of value, which was subsequently rejected The Mercantilist Theory of International Trade The mercantilist theory of international trade is developed in the sixteenth century; mercantilism was one of the earliest efforts to develop an economic theory This theory stated that a country’s wealth was determined by the amount of its gold and silver holdings In its simplest sense, mercantilists believed that a country should increase its holdings of gold and silver by promoting exports and discouraging imports In other words, if people in other countries buy more from you than they sell to you, then they have to pay you the difference in gold and silver The objective of each country was to have a trade surplus, or a situation where the value of exports are greater than the value of imports, and to avoid a trade deficit, or a situation where the value of imports is greater than the value of exports A closer look at world history from the 1500s to the late 1800s helps explain why mercantilism flourished The 1500s marked the rise of new nation-states, whose rulers wanted to strengthen their nations by building larger armies and national institutions By increasing exports and trade, these rulers were able to amass more gold and wealth for their countries One way that many of these new nations promoted exports was to impose restrictions on imports This strategy is called protectionism and is still used today (Schmitz, 2012) However, since all nations could not simultaneously have an export surplus and the amount of gold and silver was fixed at any particular point in time, one nation could gain only at the expense of others nations Thus the mercantilists preached economic nationalism, believing as they did that national interest were basically in conflate 10 Nations expanded their wealth by using their colonies around the world in an effort to control more trade and amass more riches The British colonial empire was one of the more successful examples; it sought to increase its wealth by using raw materials from places ranging from what are now the Americas and India France, the Netherlands, Portugal, and Spain were also successful in building large colonial empires that generated extensive wealth for their governing nations Krugman (2006) In any event mercantilists advocate strict government control of all economic activity and preached economic nationalism because they believed that a nation could gain in trade only at the expense of other nation The mercantilists were also attacked for their static view of the world economy To the mercantilists the world’s economic view was of constant size This meant that one nation gain from trade came at the expense of its trading partner, not all nations could simultaneously enjoy the benefit of national trade The Classical Theory of International Trade The classical theory of international trade is known as the theory of comparative cost Broadly speaking this theory is simply an application of the principle of division of labor to the production of goods by different countries The classical theory averred that international trade develops with geographical specialization in the production various goods which are reflected through the difference in their comparative cost of production between any two countries Adam smith the Scottish philosopher underline the principle of absolute advantage theory as the theory of international trade but the credit goes to Ricardo in formulating an explicit and precise theory in terms of the comparative costs doctrine with a lapse of time, the doctrine of comparative advantage costs has, however gone through many improvements and refinements at hands of eminent economists Krugman (2006) 43 The rate of growth grow rapidly after trade liberalization because of government took some measure on trade and related policies like avoidance of tariffs and incentives to export When we come to import, Ethiopia has to import those good that are not domestically produced or substitutable by other production which has failed to show any structural change after the EPRDF regime which advocate trade liberalization The import structure of a country also depends on its level of development and policies When we see the trend of import Ethiopia mainly bought semi finished well, fuel and capital good These good have a higher amount of value Table Growth rate of import period Before liberalization After liberalization Growth rate of Import 17.62% 23.18.% Source: - computed from Central Statistics Agency As we see from the above table the growth rate of the import grow rapidly after liberalization due to removal of the quantitative restriction The import growth by 23% rate which is more than the growth rate of export This will lead to aggravate the trade deficit When we see the general trend of the trade balance although the value of and growth rate of export grow after liberalization the trade balance deficit grow and grow because of alarming growth of import which is more than the growth rate of export In addition Ethiopia trade deficit was caused by after the coming of primary industrialization as a result of the continued effort to expand medium and large scale manufacturing goods and services the import has been growing steadily than earning of export which aggravate the amount of trade deficit This gap in trade balance become wider and wider especially after the trade deficit The amount of Imported item couldn’t be covered what we get from export The export coverage to import become lower and lower from time to time 44 Table Percentage Share of Total Import Commodity Before liberalization After liberalization Raw material 3.74 2.59 Semi-Finished product 16.95 15.75 Fuel 13.27 17.91 Capital Good 33.11 32.26 Consumer Durable 11.82 9.19 Non-Durable 20.3 19.35 Miscellaneous 0.78 2.94 Source:-Own calculation from Ethiopian custom authority From the above table we can consider that the most materials are capital good and semi finished product which take the major value in import sector Most of the good which were in pre trade liberalization are continued with similar percentage share after the trade liberalization The paper also tries to evaluate the growth rate trend of import in Ethiopia trade before the growth rate trend of import in Ethiopia trade before the trade liberalization and after the trade liberalization has been taken out Table Value of Export as a percentage of Import period Before liberalization After liberalization Value of Export as a % of Import 47.38% 27.45% Source: - computed from Central Statistics Agency When we see from the above table the value of export that cover the amount of Import is around 47% before the liberalization period, but this rate drop down to 27% after the trade liberalization is implemented As the coverage of export to import decline the trade deficit is going to increase This gap in trade balance become wider and wider especially after the trade liberalization has been taken The government couldn’t take the measure on the substitution of imported good when he tries to expand industrialization program 45 4.2 Economic Analysis Result and Discussion Multivariate time series models enable one to estimate the dynamic effects of the explanatory variables on the dependent variable To undertake estimation or testing procedures it is important to make sure that the variables are stationary From theoretical point of view a time series is a collection of random variables the order of such random variables is called stochastic process Stationar test are conducted before running regressing a time series variable on another variables obtains a very high R2 although there is no meaningful relationship between them which estimates and test statistics obtained would be misleading.(Gujarati, 1995) However, there is an exception to this problem where if non stationary series happen to have a linear relationship that is stationary they are destined to have a long run relationship to which there is an error correction mechanism that leads the variables to their long run equilibrium (Verbeek, 2004) The first thing to before running any of the regression is to check for the stationarity of the variables under study 4.2.1Test for Correlation Closely related to but conceptually very much different from regression analysis is correlation analysis, where the primary objective is to measure the strength or degree of linear association between two variables In other words postulates that the disturbances ui and uj are uncorrelated Technically, this is the assumption of no serial correlation, or no autocorrelation This means that, given Xi, the deviations of any two Y values from their mean value not exhibit patterns We see that the u’s are positively correlated, a positive u followed by a positive u or a negative u followed by a negative u the u’s are negatively correlated, a positive u followed by a negative u and vice versa 46 Table correlation Relation between the variables LOGBOP LOGREER LOGTB Pearson Correlation LOGTOT TLB -.364* 821** -.458** 704** 027 000 004 000 N 37 37 Pearson -.364* Correlation LOGRER Sig (2-tailed) 027 N 37 37 Pearson 821** -.495** Correlation LOGTB Sig (2-tailed) 000 002 N 37 37 Pearson -.458** 495** Correlation LOGTOT Sig (2-tailed) 004 002 N 37 37 Pearson 704** -.553** Correlation TLB Sig (2-tailed) 000 000 N 37 37 * Correlation is significant at the 0.05 level (2-tailed) ** Correlation is significant at the 0.01 level (2-tailed) 37 37 37 -.495** 495** -.553** 002 37 002 37 000 37 -.502** 830** 37 002 37 000 37 -.502** -.673** 002 37 37 000 37 830** -.673** 000 37 000 37 37 LOGBOP Sig (2-tailed) When we see the result with the correlation of dependent and explanatory variable we can consider that there is a high correlation among trade balance and balance of payment as well as trade balance and trade liberalization So it is expected to be the impact of those variables to be significant on the trade balance of Ethiopia 47 4.2.2Test for stationarity Estimation of parameters and hypothesis testing using time series data requires an investigation of the data generating process of the variable under consideration This investigation helps to avoid estimating a spurious correlation between variables in a regression, where what actually exist is correlated time trend rather than a meaningful economic relationship (Granger and Newbold 1974) A combination of variables that contain a time trend or are nonstationarity may lead to spurious correlation To avoid the problem of spurious correlation due to the presence of non-stationary variables in the regression model, the time series properties of the variables used in the model are investigated A series is said to be stationary if the time origin doesn’t affect its properties, i.e the joint probability distribution not affected by a shift along the time axis According to Gujarati (2004), if a time series is stationary its mean, variance and autocorrelation remain the same no matter at what point we measure them that is they are time variant So that it help as to study variables for time periods in addition to time under consideration and generalize it to other time period In order to test for unit result in the sample data, this study uses the Augmented-Dickey Fuller (ADF) test on both level and differences of the entire variable.ADF test is based on the null hypothesis that a unit root exist in variables against that the variables are stationary An autoregressive process such as Yt = α+β Yt-1 +ε t is said to be stationary if -1 < β