3 the final draft edited

Thus relationship between trade liberalization and trade balance become an important area of study in recent year especially in developing countries like Ethiopia.. In general as long as

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 market-oriented 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 do 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 sub-Saharan 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

2 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

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)

Law of absolute cost advantage

In 1776, Adam Smith questioned the leading mercantile theory of the time in The Wealth

of Nations Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (London: W Strahan and T Cadell, 1776) Recent versions have been edited by scholars and economists Smith offered a new trade theory called absolute advantage, which focused on the ability of a country to produce a good more efficiently than another nation Smith reasoned that trade between countries shouldn’t be regulated or restricted by government policy or intervention He stated that trade should flow naturally according to market forces In a hypothetical two-country world, if Country A could produce a good cheaper or faster (or both) than Country B, then Country A had the advantage and could focus on specializing on producing that good Similarly, if Country B was better at producing another good, it could focus on specialization as well By specialization, countries would generate efficiencies, because their labor force would become more skilled by doing the same tasks Production would also become more efficient, because there would be an incentive to create faster and better production methods to increase the specialization (Schmitz, 2012)

Smith’s theory reasoned that with increased efficiencies, people in both countries would benefit and trade should be encouraged His theory stated that a nation’s wealth shouldn’t be judged by how much gold and silver it had but rather by the living standards of its people

Doctrine of comparative cost; Ricardo

The challenge to the absolute advantage theory was that some countries may be better at producing both goods and, therefore, have an advantage in many areas In contrast, another country may not have any useful absolute advantages To answer this challenge, David Ricardo,

an English economist, introduced the theory of comparative advantage in 1817 Ricardo reasoned that even if Country A had the absolute advantage in the production of products, specialization and trade could still occur between two countries

Comparative advantage occurs when a country cannot produce a product more efficiently than the other country; however, it can produce that product better and more efficiently than it does other goods The difference between these two theories is subtle Comparative advantage focuses

on the relative productivity differences, whereas absolute advantage looks at the absolute productivity (Schmitz, 2012)

Let’s look at a simplified hypothetical example to illustrate the subtle difference between these principles Miranda is a Wall Street lawyer who charges $500 per hour for her legal services It turns out that Miranda can also type faster than the administrative assistants in her office, who are paid $40 per hour Even though Miranda clearly has the absolute advantage in both skill sets, should she do both jobs? No For every hour Miranda decides to type instead of

do legal work, she would be giving up $460 in income Her productivity and income will be highest if she specializes in the higher-paid legal services and hires the most qualified administrative assistant, who can type fast, although a little slower than Miranda By having both Miranda and her assistant concentrate on their respective tasks, their overall productivity as a team is higher This is comparative advantage A person or a country will specialize in doing what they do relatively better In reality, the world economy is more complex and consists of more than two countries and products Barriers to trade may exist, and goods must be transported, stored, and distributed However, this simplistic example demonstrates the basis of the comparative advantage theory Krugman (2006)

Neo-Classical Trade Theories (Hecksher-Ohlin Theory) and Modern Trade Theory

The factor proportions model was originally developed by two Swedish economists, Eli Heckscher and his student Bertil Ohlin in the 1920s Many elaborations of the model were provided by Paul Samuelson after the 1930s and thus sometimes the model is referred to as the Heckscher-Ohlin-Samuelson (or HOS) model

The H-O model incorporates a number of realistic characteristics of production that are left out of the simple Ricardian model Recall that in the simple Ricardian model only one factor

of production, labor, is needed to produce goods and services The productivity of labor is assumed to vary across countries, which implies a difference in technology between nations It was the difference in technology that motivated advantageous international trade in the model

In a model in which each country produces two goods, an assumption must be made as to which industry has the larger capital-labor ratio Thus, if the two goods that a country can

produce are steel and clothing, and if steel production uses more capital per unit of labor than is

used in clothing production, then we would say the steel production is capital-intensive relative

to clothing production Also, if steel production is capital intensive, then it implies that clothing production must be labor-intensive relative to steel.(Steven,

Another realistic characteristic of the world is that countries have different quantities, or endowments, of capital and labor available for use in the production process Thus, some countries like the US are well endowed with physical capital relative to their labor force In contrast many less developed countries have very little physical capital but are well endowed with large labor forces We use the ratio of the aggregate endowment of capital to the aggregate endowment of labor to define relative factor abundance between countries Thus if, for example, the US has a larger ratio of aggregate capital per unit of labor than France's ratio, we would say that the US is capital-abundant relative to France By implication, France would have a larger

ratio of aggregate labor per unit of capital and thus France would be labor-abundant relative to

the US

The H-O model assumes that the only differences between countries are these variations

in the relative endowments of factors of production It is ultimately shown that trade will occur, trade will be nationally advantageous, and trade will have characterizable effects upon prices, wages and rents, when the nations differ in their relative factor endowments and when different industries use factors in different proportions

Based on the factor endowment a country will export goods that use its abundant factors intensively, and import goods that use its scarce factors intensively In the two-factor case, it states: "A capital-abundant country will export the capital-intensive good, while the labor-abundant country will export the labor-intensive good."

2.1.2Arguments of Liberalization

According to the World Bank (2001) trade liberalization is defined as 1) the removal or reduction in the practices that thwart a free flow of goods and services from one nation to another including avoidance of tariff as well as non-tariff barriers 2) It is the act of removing

government incentives and restriction from trade between nations by making the trade regime neutral

Countries try to implement several trade policies in order to shape their balance of current account The commercial policy to be followed by a country with regarded to its foreign trade has been the subject of heated controversy centering on whether a country should follow a policy

of free trade or protection In trade liberalization there are two alternative arguments

The first one is the neo-structuralist argument for trade liberalization which argues that developing countries must adopt policies that protect infant industries in a way that achieves comparative advantage (Adiam, 2011) Protection is the policy of encouraging home industries

by paying boundaries to domestic producers or more using by imposing customs duties on foreign products When the country resorts to production as a commercial policy can adopt many alternative devices or their combinations The important methods of protection are Tariff quotas exchange cont state trading Dumping subsidies commodity agreement international cartel It

is mainly based on import substitution industrialization (ISI) to expand industrial base Import substitution industrialization is a trade and economic policy based on the premise that a country should attempt to reduce its foreign dependency through the local production of industrialized product

It was theoretically organized in the works of Raul Prebish, Hans Singer, Celso Furtado and other structuralist thinker The principal justification of this argument was infant industries which allow governments to support temporarily until the industries are enough to compete internationally (Krugman, 2006) The government tries to protect infant industries through influencing the demand for import by policies such as tariff and non tariff barriers The imposition of these barriers will improve the domestic price of imported good; this will increase the competitiveness of the infant industry and lead to the fall in the volume of import which improves the trade balance

Generally the Neo-structuralist economist claim that trade liberalization policies must be with held until the strategic industries are strong enough to be forced to compete in the international market However it must also be kept in mind that developing internationally competitive industries may conflict with other forms of liberalization such as allowing

international capital or liberalizing the financial market This may cause government to intervene in the flow of capital and the financial market

The major advantage of import substitution was to increase domestic employment and resilience in the face of global economic shock However this strategy failed in promoting economic countries the industry that it creates are inefficient and obsolete

The second argument was the neoliberal argument for trade liberalization against structuralist Policy of non-interference by government in forging trade is referred to as free trade It implies absence of any artificial restriction on or obstacles to the freedom of trade of a county with other nations According to Adam smith the term free trade used to denote that system of commercial policy which draws no distinction between domestic and foreign commodities and there for, neither imposes additional burdens on the tatter nor grants any special favor to the former In other words, free trade implies complete freedom of international exchange Under such a policy there are no barriers to the movement of goods between countries and exchange can take its perfectly natural course

Argument in favor of trade liberalization is the key to fight poverty and inequality in developing countries to gain access to international market and allow foreign direct investment which in turn boost economic growth (WTO, 2007) Although the reforms have been uneven, there is clear evidence that protection of import substitutes with tariffs and non tariff barriers in developing countries has declined

According to this argument there are compelling reasons why the belief that openness to trade is good for growth and development dominate economic thought The first one is exposure

to foreign competition forces domestic industry to become more competitive and efficient The greater competition leads to better utilization of result which result higher growth of productivity due to access to imported input Secondly Free trade is the natural outcome of the comparative cost advantage It permits an allocation of resources and manpower in accordance with the principle of comparative advantage, with is just an extension of the principle of division of labor This will make people to earn more, as they will be employed for better use, hence, wages, interest and rent will be higher under free trade than otherwise Thirdly trade liberalization allow the free movement of multinational companies to conduct business globally due to the reason of

cheap labor, low taxes and fewer regulation in the developing nation These factors encourage both foreign and national companies to conduct business in the developing world which consequently lead to job creation and fast growth of economy

Furthermore export would increase as a result of greater access to imported intermediate input after the liberalization of trade Importing appropriate intermediate goods can enable a country to easily labor intensive product such as assembly service to task with higher value In addition (Jenkins, 1997) argues that trade liberalization reduces the un productive rent-seeking activities that are associated with intervention of government and distribution of income by increasing labor incentive activities that would in turn increase employment

Theoretically trade liberalization is expected to lead efficient allocation of resource and catalyze a chain reaction that would ultimately increase welfare of the society is expected to shift resources towards tradable, especially exportable and away from import substitutes However the scope successful trade liberalizing policy depends on the failure of trade liberalization

Free trade policy runs smoothly if all the countries follow the same If some countries do not adopt it the system cannot work gainfully Free trade prove advantageous to developed and technologically advanced countries but less developed countries are certainly at disadvantage on account of unfavorable term of trade Competition induce under free trade is unfair and unhealthy Backward countries cannot compete with advanced countries Gains of trade are not equally distributed under free trade due to unequal state of development of different countries A country with favorable balance of payment finds it is difficult to overcome this situation under free trade policy Free trade may encourage interdependence and discourage self-sufficiency

In general when we see the two arguments we conclude that trade liberalization by developing countries poses risks as well as benefits while it is argued that trade liberalization brings economic benefits to countries It can also create poverty and inequality in many countries which clearly demonstrate the increments in the gap between rich and poor, the increasing in human right violation and the causing of environmental degradation

2.2 Trade Liberalization and Trade Balance

It is conceivable that trade liberalization may lead to faster growth of import than export The faster growth in import in relation to export s could have a serious implication for balance of trade and this in itself could constrain economic growth in some of the developing economies Trade liberalization may promote growth on the one hand from the supply side through a more efficient allocation resource while it may constraint growth from the demand side unless a balance export and imports can be maintained through trade policies such as real exchange rate depreciation deficit in the short run can be financed by capital inflows

Since the 1980s trade liberalization has become an increasingly common feature of economic policy in developing countries They have liberalized their trading regime with hope of gaining static and dynamic gains from trade, and that the liberalization will increase both the growth of export and imports, and consequently improve welfare (Santos-Paulino and Thirlwall, 2004) Some developing countries have unilaterally liberalized trade in an attempt to integrate into the global economy and promote economic growth In other cases, countries have had to liberalize trade in order to satisfy the requirements of international lending agencies At the global level, multilateral trade negotiations under the auspices of the World Trade Organization (WTO) are pushing for freer trade in response to the demands of globalization It has been strongly sup-ported by the multilateral institutions, both financially through their structural adjustment loans and intellectually through studies of the effects of trade liberalization An important plank in the advocacy of trade liberalization is the belief that a more liberal regime will lead to increased ex-ports which in turn will have a favorable effect on economic growth and employment generation (World Bank, 2001)

Ostry (1991) regarded the model of saving – Investment as the one that is mostly used by researchers to understand the relationship between changes in the level of tariff and the trade balance The argument behind the adoption of the saving – Investment model is that, the reaction

of the current account to the change in the level of tariffs depends on how the change affects the saving – investment differential given the fact that the saving- investment differential is equivalent to the current account This is where the importance of the intertemporal effect of

trade liberalization comes in Before the implementation of the policy, one must take into account how the changes in the level of tariff rates affect the current account

However, several studies have investigated the impact of trade liberalization on Trade Balance in developing countries, and have reached conflicting conclusions Paulino and Thirlwall (2004) argue that the final effect of trade liberalization is theoretically ambiguous regardless of the balance of payments theory adopted The elasticity approach to the balance of payments, which is based on a partial equilibrium framework, shows that the final effect of this policy depends on the extent to which import and export duties change and the price elasticities

of imports and exports Similarly, the absorption approach, which is based on a general equilibrium framework shows that the final result of trade liberalization depends on how real income is affected relative to real absorption In this case, the increment in real income may not improve the balance of payments if the propensity to absorb is greater than one The monetary approach to the balance of payments also shows that the final effect depends on certain conditions The final outcome of the trade liberalization policy depends on how it affects money demand relative to money supply The authors, therefore, conclude that the final outcome of a trade liberalization on the performance of the balance of payments is an empirical issue rather than theoretical

When we see the impact of trade liberalization on trade balance of Ethiopia, It have several impact based on the volatility of the Ethiopian economy According to the World Bank (2001), Ethiopia has implemented trade liberalization in the late 1990s It was theoretically designed to increase the efficiency of national industries through competition with the outside world The potential advantages of trade liberalization for Ethiopia are firmly rooted in the theory of economies of scale The small size of domestic markets to absorb most of its supply desires expanding markets and increasing participation in the global economy Therefore, a relaxation of trade restrictions within a given range could reduce internal transport costs, stimulate intra-regional trade, and ultimately increase the growth and productivity of the country Additionally, liberalization could encourage the country to adopt a more out-ward-oriented attitude towards trade instead of the protectionist, inward-oriented mentality which frequently exists Instead, such liberalization may lead to the inability of Ethiopian industries to compete at all, thereby further assuring the dominance of the agricultural sector Consequently, Ethiopia’s economy has experienced several dramatic events and changes after trade liberalization The

volatile nature of the evolution of the growth rates of Ethiopian economies has been accompanied by a variety of re-forms (external and internal real shocks faced), and different responses to them The theoretical and empirical tools to determine the factors behind the performance of the economy could be broadly categorized in domestic policies and domestic or external shocks (such as domestic supply shocks, terms of trade shocks, international crises, violation of human right environmental degradation etc.)

2.2.1 Trade and Economic Integration

Economic integration according to Balassa (1961) is defined as "the abolition of discrimination within an area" And according to Kahnert et al (1969) economic integration is

"the process of removing progressively those discriminations which occur at national borders"

Therefore, scientifically, measures which merely diminish discrimination between countries According to Allen (1963, p.450) economic integration may mean something different

to nearly everyone The necessary conditions for its fullest attainment include the freedom of movement of goods and factors of production and an absence of discrimination amongst members

The basic ingredient of any integration form is the elimination of barriers to trade among two or more countries Allen (1963, p.450) also stresses the point that although traditional international trade theory has dealt with the effects of reduction of trade barriers, a separate theoretical framework is needed to study issues of economic integration

In 1947, 23 Nation meet at Geneva to set of multilateral trade agreements aimed at the abolition of quotas and the reduction of tariff duties among the contracting nations which is called General Agreement on tariff and trade (GATT) GATT’s most important principle was that of trade without discrimination, in which each member nation opened its markets equally to every other As embodied in unconditional most-favored nation clauses, this meant that once a country and its largest trading partners had agreed to reduce a tariff, that tariff cut was automatically extended to every other GATT member

In the late 1960s and early 1970s disappointments with the post-colonial economy led to regionalism in part of third world and economic co-operation among developing countries After the collapse of the former Soviet Union and establishment of World Trade Organization (WTO),

there appear to be a revival of both multilateralism and regionalism (Teshome, 1998).the implication of this for development of domestic economic policy was also not supportive of trade liberalization and multilateralism generally Many countries adopted an import substitution industrialization strategy and opted for socialism The nation state sought to achieve by regionalism, bilateral trade, south-south co-operation After the collapse of the former soviet union there appear rival to be a revival both multilateralism and regionalism The European is again setting the example of engineering successful regional economic integration, closely followed by the North American Free Trade Agreement (NAFTA) Other initiatives include the

1994 US-led summit to establish for the adjoining two continents a free trade agreement for the Americas and the Asia –pacific economic co-operation council (APEC), which includes a diverse group of pacific –rim countries A motive for the us initiatives to level the playing field for the us exporters in the mid 1990’s, faced trade barriers more than three and half times higher than those of united states among the development paradigm popular today is that sustainable growth is driven by factors such as free trade, globalization and competitiveness There are also a number of other initiatives for integration outside the frame work of the United States and EU in Africa Asia and Latin America, which are driven by those same forces

Economic integration can take many forms According to Balasaa (1962) there are four different stages of economic integration The first is a Free Trade Area (FTA), then a Customs Union (CU), then a Common Market (CM), and finally an Economic Union

Free Trade Area (FTA): - a group of countries that have few or no price control the form of tariff or quotas between each others Free trade allows the agreeing nation to focus on their comparative advantage and to produce the good which make them competitive and efficient, thus increasing the profitability of each country (A.S Hosny May 2013)

To develop a free trade area participating nation must develop rules for how the new free trade area will operate The goal is to create a trade policy that all countries in the free trade area agree up on

Free trade areas allow the partners to give each other preferential market access Thus free trade area helps to foster and facilitate the flow of trade and investment between partner countries There are three basic pillars of traded liberalization which are going to be covered by free trade area These are trade in good, trade in service and investment Free trade area may cover protection of intellectual property right government procurement and dispute settlement

Free trade area benefit consumers who will have increased access to less expensive and high quality foreign good and who will see prices decrease as government reduce or eliminate tariffs, producer may struggle with increase competition but they may also acquire a greatly expanded market of potential customers workers in some countries and industries are likely to lose jobs as production shifts to become more efficient overall free trade area can also encourage economic development in countries as a whole benefiting everyone who reside there through increased living standards (http://www.springer.com)

In an FTA member countries remove barriers to trade in goods and services between them but maintain their own tariff policies vis-à-vis third countries Retention of national tariffs

is what distinguishes an FTA from a customs union in which members establish a common external tariff (CET) Thus, a customs union combines free intra-regional trade with a CET

Customs Union (CU):- is an FTA in which member countries apply a common external tariff on a good imported from outside agreeing countries This common external tariff can, of course, differ across goods but not across union partners

"For the purposes of this Agreement:

A customs union shall be understood to mean the substitution of a single customs territory for two or more customs territories, so that

(i) Duties and other restrictive regulations of commerce are eliminated with respect to

substantially all the trade between the constituent territories of the union or at least with respect

to substantially all the trade in products originating in such territories, and,

(ii) Subject to the provisions of paragraph, substantially the same duties and other regulations of commerce are applied by each of the members of the union to the trade of territories not included

in the union"

The other important part of the theoretical framework that created the foundation for regionalism in its early days was the Viners work on customs union theory Viner discovered that customs unions and the liberalizing of intra-regional trade produce two important effects First is the replacement of higher-cost domestic production by lower-cost imports from partner countries (trade creation), and the second is the replacement of lower-cost imports from third countries by higher-cost imports from partners (trade diversion) Viner saw trade creation as welfare increasing for the union and the whole world If trade between partners increases without

changing its trade with the rest of the world, then the world moves closer to free trade Trade diversion, by contrast, is welfare reducing from the point of view of world trade National protection is extended to the regional level which is a movement away from free trade Those who claim that regionalism is a positive force associate it with trade creation while those who think the opposite often relate it to trade diversion Trade diversion and trade creation are the static effects of trade liberalization The balance between trade creation and trade diversion determines whether economic integration is profitable or not Modifications of Viner's work, such as a distinction between production and consumption effects, shows that the static effects account for only a small part of the effects of economic integration The issue of regionalism has become more complex and regional arrangements cannot be considered in isolation as Viner assumed they could With blocs forming almost simultaneously throughout the world, the interaction effect as well as the strategic behavior of nations cannot be neglected

It is therefore more fruitful to study the dynamic effects of economic integration These are the consequences of free trade agreements on economies of scale, efficiency and competition, intra-industry specialization, investment growth rates and political decisions The theory of preconditions and barriers deals with these dynamic effects (J Edblad, 1996)

Common market (CM):-is achieved when the circulation of production factors is liberalized Capital, labor and entrepreneurship move freely among member countries It further allows free movement of labor and capital among member nations This is usually referred to as

"factor integration" At the beginning of 1993, the EU achieved the status of a custom market in which people have a right not only moving themselves and their capital to the member countries but also to be protected their natural and intellectual property right (J Edblad, 1996)

Economic union:-The most advanced type of economic integration is the Economic Union, where the monetary and fiscal policies of member states are harmonized and sometimes even completely unified This is usually referred to as "policy integration" The extreme case of

an Economic Union could be a Monetary Union (MU)

Table 1 Categories of Economic Integration

No Tariff

or Quota

Common

or External Tariff

Free Flow

of Factor of production

Harmonization

of Economic Policies

Unification of policies and political institution

Free Trade Area 

Source: Bela Balassa "The Theory of Economic Integration", 1962

2.2.2Economic Integration in African Countries

There are fifty African states politically independent and member of the organization of African unity, despite their political independence, the African countries were remaining even today colonial or neo-colonial This colonial or neo colonialist formation of the African economy makes for a weak economic system which is both under developed and dependent the African economy is more rural than urban, agricultural rather than industrial, stagnant and heavily dependent on the industrialized market economies both for funds and for the sale of produce The colonial structure of the African economy has failed to harmonize economic growth and development The production system is not aligned to either the requirements of the African countries or their resource endowment The development of economic and social infrastructure such as transportation and communication, banking and insurance, education, health e.t.c are at the rudimentary stage Africa’s economic crises are deeply rooted in the past in the 1960s when the most African states gained their independence , the under developed economies they inherited were already in the grip of international economic crises caused by declaration of economic growth and general drop in commodity price s in North America and the OECD countries African economies located in the fringe of the world economic system tended to

Receive these minor vibrations great economic shocks In the 1970s Africa was the hardest hit by the world economic recession triggered by the oil price hikes Economic declines in the 1970s were made acute by environmental deterioration and imbalances in the ecosystem The problem engulfing the entire continent into the food crisis situation by the early 1980s African economic crises reached the deep trough by 1984 when 24 countries were declared “food aid dependent” and a further three were added into the list by the end of that year This will make African countries to integrate each other in order to eradicate this economic problem

In addition there were several reasons to make a relationship between member countries The basic political and economic reason for the existence of organization for the state is that they produce good that the member country or the individual cannot or does not want to produce it Goods for all members enjoy are produced by the regional organization in area because joint production is some time profitable for all

Joint production can produce large cost saving which are high capital product long term products long term projects and product with decreasing marginal cost The regional organization may seek to liberalize internal trade, promote collective bargaining with members which encourage cooperation aimed at regional industrialization In order to create a harmonious trade relation certain condition should be fulfilled including the tariffs and national trade barriers If the trade barriers of member are initially lower there are opportunities for trade diversion it will also preferable that the amount of extra-regional trade is low priori to integration since there will be little to diverted, thus the regional integration schemes will strengthen natural trading pattern

Geographic proximity is a relevant pre condition for successful regional integration Integration between countries location far away from each other will be non effective and give rise to transportation as well as communication costs

Political leaders in Africa are traditionally in favor of regional integration and this has resulted led to a large number of integration projects Trends in the international economy create incentives for regional integration European integration has had a positive demonstration effect

on Africa This has encouraged the developing countries to adopt the regional integration

One of the most important multilateral trading system in which most African countries are active members is the World Trade Organization(WTO).The WTO has a total membership of

146 countries and an additional 30 observers Africans member and observers are respectively 41 and 7.The WTO agreements cover both benefits and obligation or commitments These commitments basically refer to the implementation of decisions in regard to trade in goods, services, intellectual properties investment environment, food security, public procurement etc and other ground rules of international commerce aimed at enhancing the growth of global trade and economy through equitable sharing of the benefits of free trade (Teshome, 2003)

The other multilateral trading system to which the most African countries belong is the ACP-EU partnership agreement, which is trade and economic cooperation agreement between African, Caribbean and pacific (ACP) and European Union (EU).although the African group of countries in the ACP have indicated recently, their need for compensatory financing from EU to cover expected tax revenue losses resulting from their obligation to offer most favored nations preferences to EU countries under WTO rules (Teshome, 2003)

African countries also maintain bilateral trade and cooperation agreement with other African and non African government, among this the most important bilateral agreement is perhaps the US’s African growth and opportunity Act (AGOA) the us has gone beyond offering

a temporary and non-reciprocal grant of preferences for African countries with this Act In addition to this program, the US provides security to investment and technical and economic assistance for development Since African countries are offered unreciprocated preferences, which permit their export to enter the US market untaxed no revenue loss is expected from transaction (Teshome, 2003)

The reason behind the failure of the integration is, the countries faced an economic stagnation and failing in living standards especially in 1980 Heavy debt burden, low level of investment, weak institution, high population growth, massive unemployment, higher bureaucracy and illegal action like bribery were the major hindrance factor to progress in the region Most African countries have been trying to adopt a free market strategy using structural adjustment program during the 1980 to avoid economic stagnation but the growth has been slow and success few due to the natural and manmade condition like drought ,flood and political unrest and civil wars Although the economic situation is very bad in Africa there are now some signs of recovery through conducting a relation among them There are attempts made to

increase other institutional measures aimed at promoting intra-African trade These include the harmonization of trade policies, reduction of tariffs and non-tariffs barriers

African countries are also actively engaged in intra-regional trade The focal points for regional integration in Africa are perceived in treaty establishing the Africa economic community as its building blocks One of the integration between African countries is COMESA (Common Market for Eastern and Southern Africa) The history of COMESA began in December 1994 when it was formed to replace the former Preferential Trade Area (PTA) which had existed from the earlier days of 1981 COMESA was established 'as an organization of free independent sovereign states which have agreed to co-operate in developing their natural and human resources for the good of all their people' and as such it has a wide-ranging series of objectives which necessarily include in its priorities the promotion of peace and security in the region

However, due to COMESA's economic history and background its main focus is on the formation of a large economic and trading unit that is capable of overcoming some of the barriers that are faced by individual states.(http://www.africa-union.org)

COMESA's ultimate objective is to create a fully integrated and internationally competitive and unified region in which goods, services, capital and persons move freely The principal route that has been chosen in order to realize this goal is development integration through development of trade and investment COMESA's current strategy can thus be summed

up in the phrase 'economic prosperity through regional integration' With its 21 member states, population of over 385 million and annual import bill of around US$32 billion COMESA forms

a major market place for both internal and external trading Its area is impressive on the map of the African Continent and its achievements to date have been significant (www.wikipidea.com)

The primary instrument for achieving trade development is trade liberalization and the freeing of market forces This market-focused approach will have a favorable effect on the allocation efficiency of the economies of the member States through the rationalization of their actual and emergent economic structures which will result in trade creation, expansion, and investment rationalization and production integration This will also give rise to expanded

domestic and foreign investment inflows into the integrated area as a result of investment creation The key mechanism for trade liberalization is the removal of tariff and non-tariff barriers to intra-COMESA trade In this regard, COMESA has adopted a program for the reduction and eventual elimination of tariff and non-tariff barriers to intra-COMESA trade The reduction program towards the eventual elimination of tariffs on intra-COMESA trade is as follows: 60% reduction by 31 October 1993; 70% reduction by 31 October 1994; 80% reduction

by 31 October 1996; 90% reduction by 31 October 1998; and 100% reduction by 31 October

2000, thus achieving a Free Trade Area (www.comesa.gov.et)

The tariff reduction is complemented by program aimed at removing the remaining tariff barriers The non-tariff barriers that segment the COMESA regional market consist of those that affect trade, production and investment The concurrent pursuit of trade liberalization, infrastructure development and investment promotion and co-ordination, with science and technology providing the driving force, is expected not only to deepen the integration process, but to also lead to higher and sustainable levels of economic growth (www.wikipidea.com)

non-The other economic integration between African countries is ECOWAS (Economic Community of West African States) which was formally established in 1975 ECOWAS encompass 200 million people in 16 countries

The ECOWAS main objective is to create a single market for the members The steps to

be used to achieve this were regional trade liberalization, free movement of factors of production and harmonization of monetary, fiscal and agriculture policies A Fund for Cooperation, Compensation and Development (FCCD) was established in order to mitigate the impact of integration and tariff reductions on the least developed members At the 1978 Conference of

Heads of State and Government a decision was taken to prohibit an increase in tariffs on goods from any member This was regarded as a first step towards a custom union Several decisions were taken during the 1980s to speed up tariff reductions but the time tables agreed upon have not been realistic (J.Edbald, 1996)

The structure of the economies is similar Twelve members of ECOWAS have agriculture sectors that account for at least 25% of their gross national production and in nine

countries the share is 30% In order for a successful intra-regional trade to develop specialization

is necessary According to 1970-figures, intra-regional trade it was less than 3% of the total exports of the grouping a figure suggests that comparative advantages have been found in trade with non-regional partners Import substitution and extensive government intervention also posed a challenge to the implementation of the liberalization policies called for in the ECOWAS treaty Only 6.4% of the total world exports went to Sub-Saharan Africa in 1990 That is a small increase (3.6%) from 1980 Another explanation for the low intraregional trade is that the currencies of the member countries are not completely convertible within ECOWAS (J.Edbald, 1996)

The other economic cooperation in eastern in eastern Intergovernmental Authority on Development (IGAD) in Eastern Africa was created in 1996 to supersede the Intergovernmental Authority on Drought and Development (IGADD) which was founded in 1986 The recurring and severe droughts and other natural disasters between 1974 and 1984 caused widespread famine, ecological degradation and economic hardship in the Eastern Africa region Although individual countries made substantial efforts to cope with the situation and received generous support from the international community, the magnitude and extent of the problem argued strongly for a regional approach to supplement national efforts

In 1983 and 1984, six countries in the Horn of Africa - Djibouti, Ethiopia, Kenya, Somalia, Sudan and Uganda - took action through the United Nations to establish an intergovernmental body for development and drought control in their region The Assembly of Heads of State and Government met in Djibouti in January 1986 to sign the Agreement which officially launched IGADD with Headquarters in Djibouti The State of Eritrea became the seventh member after attainingindependencein1993.In April 1995 in Addis Ababa, the Assembly

of Heads of State and Government made a Declaration to revitalize IGADD and expand cooperation among member states On 21 March 1996 in Nairobi the Assembly of Heads of State and Government establishing the revitalized IGAD with a new name “The Intergovernmental Authority on Development" Its main objectives are Promote joint development strategies and gradually harmonize macro-economic policies and programs in the social, technological and scientific fields, Harmonize policies with regard to trade, customs, transport, communications, agriculture, and natural resources, and promote free movement of goods, services, and people