The effects of protectionism on a small country the case of uruguay (world bank regional and sectoral studies)

A volunlt export restriction is a quota on foreign exporters that confers on them thescarcity value of their exports to the domestic market The restriction may bevoluntary in name only s

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At the time of writin& Michael Connolly was professor of economics at the University of Miami H4e is currently visiting professor at Columbia University Jaime de Melo was clief of the Trade Policy Division in the World Bank's Policy Research Department He is currently a professor at the University of Geneva.

Cover design by Sam Ferro.

Library of Congress Cataloging-in-Publication Data

The effects of protecdonism on a small country the case of Uruguay

I edited by Michael Connolly and Jaime de Melo.

p an- (World 3ank regional and sectoral studies) Includes bibliographical references.

-ISBN 0-213-2788-7

1 Protectionism-Uruguay 2 Uruguay-Commercial policy.

L Cormolly, Michael B (Michael Bahaamonde), 1941- II De

Melo, Jaime IL Series.

HF2016.E36 1994

CIP

1 The political economLy of protectionism in Uruguay

Michae B Connolly andjfaime die Melo

Midhael B Connoliy and faine die Melo

3 Adminiteed protection: reference prices and

minimum export prices 45

FMaimo Ckangnna quit and PatTink A Merssalin

4 Domestic content restrictons and compensatory export

requirments in the automobile sector 64

Wendy Takacs

5 Gains and losses from bilateral trading arneet

with Argentina and Brazil 81

Jai=e de,melo, CJudio mantene 4 gro, and Wendy Takacr

6 T~he labor market and trade reforun in mianufacturing 108

Martin Parna

7 Economywide costs of protection and labor

market rigidities 124

Jaime de Mdo and David Roland-Hois

8 A long-rum perspective on trade policy, instability1

Jorge F Roklds

iM

: Preface

Why have we put together this volume of essays on protectionism in Uruguaywhen there are alreadyvexcellent comprehensive stUdies of the broad2aSpectsofprotection in th-at country (Anichini, Caumont,and Sjaastad 1978; Favaro-and Spiller 1 990; and Favaro and Sapelli 1990)? We see at least four reasonsfor further analysis

Firt, pr-evious work has concentrated mostly on describing the tive measures rather than an-alyzing their- consequences and trying to quan tify their effects on resource allocation, growth, antd welfare The essays inthis volume go into more detail on the various regulatory mechanisms,modeling the protective instruments and quantfifjng their effects For ex-ample, the modeling and analysisof so-called antidumping mechanisms such

protec-as refernce prices (chapterS3) is novel, detailing not only the magnificationeffects of protection but also its undesirable side effects on the quality ofdom estically produced manufactured goods Since proposals for simil-armech anisms are often put forth in developing countries, such in-dept dex-ploration can guide the analysis of their effects wherever such measures might.appear Similarly, the modeling -and welfare analysis of the automobile as-sembly industry (chap ter 4) provide a unify~ing fr-amework for analyzing the

welfare costs of such 'screwdriver" assembly operations anywhere.

-Second, economists should be interested in the essays in this -volumebecause the policies analyzed have been adopted in many other countries.Each chapter develops and uses an analytical -approach to examine the p:ar-ticular measure under study, followed by empirical measuremen't

Third, tiinre is an interest for the policymaker The essays go beyondquanrilying thfe effects of trade interventions to show the interactions betweenvarious forms of intervention (between labor markers and protcecdion inchapter 6, between protection and rent seeking in chapter 2, or betweenmarket intervention and resource allocation in chapter 7) Thus, the essaysshow the harmful effects of protectionism and of excessive intervention gen-

viii Eflncr oFPWYrCoNLSM ON A SMAL COUNmr THE CAS OF URUCUAY

erally on a small economy, providing vivid examples of policies to avoid siduously-notably those associated with antidumping, the promotion ofinfimt industries, and non-price protective measures in general

as-Finally, Uruguay offers an excellent laboratory for studying both parahivelyandindividually the consequences of highlyrestrictive regulationsfor a small economy, bringing out elements of relevance to many currenteconomic problems in the world today A case in point is that of the socialistecononies in transition and of the small states of the former Soviet Union,such as Georgia and Armenia, which share many of the characteristics ofUruguay This volume is therefore a useful compendium for students, ana-lysts, and policymakers in small economies that stand to reap considerable

com-benefits from a more open tading pattern.

In December 1989 we visted Uruguayunder the auspices of thejoint United

Nations Development Program (UNDP)-World BankTrade Expansion gram (TIEP) and subsequently delivered a report in june 1990 to the Uru-guayan governmen t, Untguay: Trade Reform andEconomicEffidaucp Often, inpolicy work, analysis and advice have to be produced on short notice This,mission was no exception However, for most of us, unanswered questionsremained& We wanted to probe deeper into the complex Uruguayan trderegime This volume is the outcome of the follow-up work

Pro-Throughout we benefited from support and advice from friends andcolleagues in Uruguay- rrmon Diaz and Elbio Nattino at the Central Bankwere most generous with their time So were Luis Macadar and Martin Ramia

at the CGentro de Investigadiones Econ6mnicas-Uruguay and Jorge Roldos,Glaudio S-apeui, -and Luis Vian-a at the Centro de Estudios de la ReaHidadEcon6micay Social, who provideduswith helpful suggestions along the'way-Carls Rodriguez of GEMA in Argentina also aided the mission

At the World Bank, we were fortunate to have the un6iling support ofEric Abalahin, MariaAmeal,jeff Hayden, and Rebecca Sugui We also thankMen de Coquereauraont who edited the volume

Two people deserve specia thanks Tom Cox, the manager of the TEP,was!a constant source of support -and encouragement -at every stage of our.work- In Montevideo, we were fortunate to be able to counxton Alberto Sojit,the Resident UNDP Representative until the time of his ftragic death duringour mission This volume owes much to his encouragement, and we hopethat lie would have found it a useful contribution to the study of protrection-ism in Un:guay

.: R : s-~~~~~~~~~~i

Trade Policy Division, World Bank, and Department of Economics, Ucniver

skty of Marland, Bfaltimore County

The political economyof protectionism in Uruguay

M.ichael B Connolly andJaime de Melo

Under the presidencies of Batile y Ordoiiez in 1903-07 and 1911-15 guay created progressive democratic institutions and awellhire state thatmade

Uru-it the most advanced, yet regulated, country in Latin America by the middle

of this century With ahomogeneous population and awell-functioning cratic system, this small country of less than 3 million people was know inthe early post-World War II period as the "Switzerland of the South.' Fourdecades later the country had undergone a precipitous decline that put it

demo-an xing the least prosperous middle-income counties

Afew comparative figures tell the stozy In 1950 Uruguay's GDP per capita

was $3,784 (in 1985 prices and adjusted to have the same purchasing power

as in the United States), dose to that in comparable small and wealthy pean countrieslike Belgium ($4,151) or Demnark ($4,512) In the RepublicofKorea, a country hailed today as a major development success, CDP percapita inl1953- was $822 In 1960 school enrollment ratios inUruguay reached11l percent at the primary level and 37 percent at the secondarylevel Thecorresponding figures for the European countries are 109 percent and 69percent foriBelgium and 1 03 percent and 65 percent for Denmark; and forKorea, they are 94 percent and 27 percent)

Euro-Uruguaywas definitely amaongr the mostdeveloped countries in the worldin1950 Measured in purely economic ters Uruguay's GDP per capita wasamong the highest in a group of thirty-five countries with a GDP per capitanear $3,800 in 1950 (in 1985 prices) But Uruguay's relative position dete-rirated so sharply chat by 1988 it was among the last in that grup (figure1.1) This economic dedine was accompanied by social unrest and politicalcrisis What happened?

The essays in thisivolumenare aboutthe cononeiczaspects of this decline,primarily the economic polides that accompaied it They examine themechanisms bywhicli these polices particuarlyprotectionism in allitsforms,

.2 EmCTS OF PtOTECrONISM ON A SMALL CouNTRY: THE CAsE OF URUGUAY

Figure 1.1 Uruguay's GDP per capita ranking among thirty-five

Now The foAowing economies are included in the sample; Argentina, Ausbala, Austia, Barbados, Belium,

Canada, Chile, Cyprus, Denmudk, Finand, Rance, Germnan Great Britain, Greece, Hong Kong, Iceland Irelnd, srael, lb1 Japan, lxembour Mexico, the Netherlands, New Zealand, Norway PRrWgal, Sngapore, South Afiia Spain, Sweden, Swiezaland, Taiwan (China), the UnLted States, Unrguay, and enezuela.

contributed to Uruguay's economic deterioration Policies applied to themanufctuning sectorand their economywide consequences receive the clos-est attention, even though much intervention and regulation also took place

in agriculture While the essays focus on the Uruguayan economy, the lations and distortions examined are pervasive in a large number of coun-tries In many respects, Uruguay is a vivid example of how excessive regula-tion can bring about economic sclerosis

regu-Because of its small size, Uruguay should have been pursuing oriented policies to ensure its greatest possible integration into the worldeconomy The economy would have benefited from larger markets and thegains from specialization according to comparative advantage, aswell as fromaccess to worldwide best-practice technologies and the incentives for adopt-ing them Uruguay chose instead to protect industry and to tax agriculture,the sector inwhich ithad a comparative advantage Thus, Uruguay is a goodexample of-a small country that, despite the obvious advantages offreer trade,has pursued industralization through import substitution behind a wal ofprotection andreguladon The cost of the strategyhas been astunting of theexport sector, notably agriculture, and a loss of general well-being, due tothe high inefficiency costs of protection

outward-Ultimately, these inward-looking policies and the rent-seeldng actiitiesand income redistribudon that surrounded them bred stagnadon and a low

Thepoliticleconomy ofproteaionirm ti Uneguay 7

standard of living That result would be anticipated for any small countrythat attempts to industrialize behind a barier of tariffs, quotas, and admin-istered protection-especially one like Uruguay, whose obvious long-runcomparative advantage lies in agricultural goods In Uruguay these policies

achieved a redistribution of income and production from the country to the

city and promoted considerable rent-seeking acdvity around a small trial base in Montevideo This resource reallocation promoted an inefficientindustrialization

indus- - Mechanisms of protectionism

At various times in its history Uruguay has relied on a broad array of ments ofprotecdon MoststiR existin the earlyl99Os, though some are beingreformed They have proved to be a strong force fornearly two hundred years

instru-Tariffs and reference prices

The most widespread and certainly the best known restrictions on trade aretariffs There are two types of tariffs: an advalorem tariff, which is calculated

as a percentage of the c.i.f import price of a product, and a specific tariff,which is a specified amount levied on each unitimported Both kinds of tariffsraise the domestic price of the importgood in the marketplace The two formsare equivalent in the sense that, appropriately defined, they have the sameeffects Tariffs have the familiar protective effect on production and a taxeffect on consunption 2 In Uruguay official tariffs are often applied to a ref-erence price rather than to the declared ci.f import price (see below andchapter 3), which is likely to magnify the protective effect of the official tariff

Qzots-Q!uotas specify arnaximum physical quantity of a good that can be imported.The quotais bindingwhen the maximum amount specifiedis less than wouldotherwise be imported inafree market, givenworldpices, the domestic tariff,and ansportation costs Under perfect competition quotas and s have

a similar effect on the domestic price of an import good, so a quota also has

a protective effect on domestic producdon Its distributional effect is

differ-ent, however, because the revenue does not go to the treasury A volunlt

export restriction is a quota on foreign exporters that confers on them thescarcity value of their exports to the domestic market The restriction may bevoluntary in name only since there can be an implied threat to impose duties

* or quotas ifagreement is not reached on the voluntary levels

4 - FXmcas 0oF PtoTECnONISl ON A SMALL CoUNmRx THE CASE or URUGUAY

Domestic content requirements and compensatory exports

A less well known form of protection to domestic industry and suppliers isthe domestic contentrequirement,which stipulates thatproduction processesuse a mninimum percentage of domestic materials and inputs as part of valueadded Domestic contentrequirementspermitdomesticsuppliers to sellparts

at higher than world prices and provide a nominal rate of protection equal

to the percentage difference between the domestic and the world price InUruguay this scheme offered protection to the automobile parts industry,which was further protected by the requirement that automobile assembly

firms export products in order to romp ensate for their imported parts The

assembly industry, in turn, was protected by a tariff of 40 percent for fSllyassembled automobiles in 1990 and compensatory export requirements forimports of finished vehicles (see chapter 4)

Thepoiicaltavonmy oftprteaion in Unrguay 5

declare a price less than the reference price These procedures do not form to GATT antidunmping or counterailing duy provisions (The refer-ence pnce system is analyzed in detail in chapter 3.)

con-Prior deposit reqtirements

Requiring advance depo:its for the inportation of goods is equivalent toimposinga tax on these funds equal to the opportunity costofholdingmoneysince the deposits typically do notearn interest Where the nominalinterestrate is established freely in the market, the implicit tax rate on prior depositsequals the nominial interest rate With interest rate ceilings the implicit taxequals the real rate of return in the economy pius the inflation rate Natu-rally, zero nominal interest on prior deposits combined with a high rate ofinflation mayresultin an extraordinarilyhigh tax rate on prior deposits and,consequently, on importing Unti 1975 importers were required to makeadvance deposits for imports which, at a time of high inflation rates, inpliedhigh taritf equivalent rates (see chapter 2)

Government procurement practices

Government procurement regulations or practices may give partial or plete preference to nationallyproduced goods over imports This policymay

com-be formallyincorporated in a 'buynational"law orinf-ormaly implementedthrough preferential purchasing practices The poiicy has an obvious pro-tective effect on domestic production since it allows domestic producers tocharge more than world prices Industrial countries often usify nationalpreference in procurement on strategic or national defense grounds InUruguay, govremment preference to national goods in procurement occursmore by custom and practice than for explicitly stated goals (Governmentprocurement practices are not discussed in this volume.)

Export banrs

Export bans are usually set to protect a downstream processing industry Anexport ban on a specific good has a protective effect because itlowers its do-mestc pnce, which provides asubsidy to producion processes Using te inputsince they pay less than the world price Export bans tend to induce smug-gling, however Uruguay previously had export bans on hides and cattle onthe hoot; which protected the meat pacling and leather industries The banwas easy to evade by walking cattle over unattended borders (Export bansare not analyzed in this volume.)

;-6 -;EFFECIS or PRDTECIIOMS ON A SMALL CouNTRv THE CASE OF UwRUuAY

Mudipe exchngw -rat

Charging different exchange rates for different types of foreign exchangetransactions, whedter on the import or the export side, amounts to having adifferent tariff or subsidy rate on each good according to the exchange rateused.When an importer of a luxury good mustpay apremium of dpercentgreater than the official foreign exchange rate as well as a tariff of t percent,the effective tariffisraised by dpercent compared to imports enteringat theofficialrate Similarly, a foreign exchange bonus of spercent paid to export-ers for repatriating foreign exchange amounts to an export subsidy ofsper-cent relative to the official rate Until the 1970s Uruguay had a widespreadsystem offoreign exchange nintegrosor exportbounties These are discussedbriefly in chapter 2

Administered and hidden potection

Trade and transport costs thatmust be paid on imports and exports provideextra, often hidden protection to import-competing actvities Studies havefound such costs to be significant in industrial countries They are likely topresentan even greater baflier to trade in developing countres In Uruguayportalhclities are veiyineffidentby intemtionalstandards, anda stronglabormovement adds to the impediments to trade through strikes, delays, and

featherbedding (see chapters 6 and 7) Another distortion arises from the

ineffiiencygenrated bywage premiums tatmightnothave been obtained

by labor unions had protection not existed.3

Sources of inefficiencies in highly regulated economies

Whatare the mechanisms throughwhich such instruments of protection gettranslated into economicinefficiency? Trade polices are anatural firstplace

to look for the cause of failure in Uruguay because small countries need anopen trade regime to overcome the limits imposedbysmall domesticmarkets.Considerwhat happens when there is excessive regulation Manufactur-ing firms become less efficient as their choice of optimum output level andinput mix is restricted Regulations affecting input markets all have an ef-fect Fims are impeded by labor legislation from adjusting theirworkforce.Managementofinventoriesis complicatedbyuncertaintyaboutwhetherandwhen firms wi be -able to import spare parts and raw materials Enterprisesare unsure abouthow much capital theywil have access to-and atwhat cost

In heavily regulated economies finns aIso operate in restricted productmarkets There are barriers to the entry offoreign companies New domesticfirms may be barred by a lack of access to capital-the limited pool of capital

The poEand wono7y of prmeaio in Uruguay 7

may be parceled out according to long-sanding des between exsting ducers and their creditors Barrers to entry, of course, benefitexisting firmsbygiving them more leeway in their pricing polides Thus, finns sufferfromsome of the restrictions and benefit from others

pro-Made-to-measure protectionis commonin highlyregulated economies,

a situation that guarantees the coexistence within a sector of firmswith largedifferences in efficiency Indeed, in such economies most firms are ineffi-dent The level ofprotection is often chosen to make the least efficientfirmsprofitable, so many fins can operate at a profit with dated machinery andequipment (technical ineffiiency) or too many employees Too many ofthemoperate at too small a scale (scale inefficiency), fail to equate marginal prod-uctswith factorcosts (allocative inefficiency), and price theirproducts abovethemarginal costofproduction (priceinefficiency) Because consumershavenowhere else to turn, leading firms can charge higher than normal mark-ups, and other finns wi follow Firms with a wide range of technical effi-ciency thus coexist, leading to high rates of idle capacity and unproductivework forces

In addition, the incentive system is distorted because protection has beentailored for individual products to ensure the survival of firms already inoperation The made-to-measure protection usually indudes quantitativerestrictions that give rise to enormous rents and induce economic agents toexpendmuch oftheir effort-appropriatingrents rather than engagingin moresocally productive activities Resources are badly allocated and underused,and the resulting market structures are not compeatirve The efficiency ofinvestmentis low, growth is slow, and the economy stagnates This is the story

of Uruguay, but the messages are clear for other developing and trnsitioneconomies

Political economy of trade liberalization

Many readers will view Uruguay's reluctance to liberalize trde as baffling,considering the complexity and obvious inefficiency of measures restrictingtrade What lies behind this reluctance to liberalize is the uncertainty andthe redistribution of income that typically accompany trade liberalization Agreat amount of income redistribution-whose exact outcome is unknown

in advance-must take place to achieve a small amount of efficiency gainsfrom expandedtrade Unless the economyisin dire circumstanceswithhighinflation and impending economic collapse, the gains from trade lhberalia-tion will not be enough to compensate for the income redistribution in thepolitical calculus of voters and the government

This argument, put forth by Rodrik (1992), can be demonstrated by asimple graph illustting the gains and the redistibution of income associ-

8 Etncrs oF PROTEaCONISM ON A SMALL COuNTRY: THE CASE OF URUGUAY

ated with elminating an import quota In figure 1.2 the distance SO sents a quota that has the effect of raising the domestic price to p, which isabove the world price p* Import license holders can purchase the quotaamountat the world price for p*(SD) and sell it at the domestic market priceforp(S), realizing rents equivalent to area rc Domestic producers are able toexpand their production to the quantity S thanks to the higher domestic

repre-price Consequently, they receive an increase in revenues equal to (p -p * )S

but incur increased costs above world levels equal to area b The producer'ssurplus, or rent, increases by area a thanks to the quota Consumers, on the

other hand, lose the consumer surplus equal to the sum of areas a, b, c, and

d They lose from the higher cost of a + b + c over the quantity D and fromthe decline in consumption at the higherprice associatedwith the quota andequal to area d-

Removing the quota on inports has the following distributional effects:

import-competing producers lose a, import license holders lose c, and the rest of the economy gains a + b + c + 4 for a net gain of b + d-

The point of Rodrik's analysis is to illustrate thatincome redistribution

is large relative to the net gains to the economy He proposes ameasure thatcomputes the total redistribution of income divided by the net gains minusone, or the political cost-benefit ratio (PCBR) of trade liberalization:

The political econoy of protectionism in Uruguay 9

where p is the share of imports in domestic consumption, Eis the absolutevalue of the elasticity of import demand, and t is the tariff equivalent of thequota Rodrik shows that PCBR is likely to be small for most trade liberaliza-tions taken alone

Take the case of the 1974-82 trade liberalization in Uruguay as anexample- The share of imports of goods and services in domestic consump-

tion private and govenmment, (p.) was 0.184in 1974, and the initial tariffandtariff equivalentwas about 100 percent ( = 1) Assuming an import elastcity(e) of 2 then yields a PCBR of 2.7, which implies that the political costs ofredistributon are substantially greater than the benefits of trade liberalization.Combining trade liberalizationwith economic stabilization that benefitsall individuals in the economy lowers the PCBR markedly, silice it is nowmeasured by:

where ris the percentage bywhich everyone is made better off (presentvalue

of income), w is the reduction in the domestic pnce of importables relative

to exportables due to the reform (internal terms of trade), and 0 is the shareofimportables in GNP (Rodrik 1992) Thus, coO represents the improvement

in the terms of trade weighted by the share of importables in GNP This vised fornula suggests that the costs of trade liberalization fall dramadcallyrelative to the benefits when stabilization measures undertaken during direeconomic circunstances result in a return to prosperity Now consider thePCBR for Uruguay in 1974 when stabilization and recovery are taken intoaccounL Assume an annual increase in the growth rate of 3 percent for 10years-an approximation of the increase ir growth during 1974-82 (seechapter 2)-and a discountfactorof5percent Individuals' wealth (y) wouldincrease by 19 percent If importables fall 70 percent (co) in tenns ofexporcables because of the trade reform, and the share ofimportables in GNP(8) is 17 percent, the PCBR now falls to 0.5 In other words, the PCBR in-dex declines from nearly 3 to less than 1 as a result of the additional ben-efits of stabilization

re-Or consider the case ofjust one industry in Uruguay, the automobileassembly industry The elaborate system of protection of the industry results

in large efficency losses and tansfers to local assemblers and parts ers Wendy Takacs estimates that the bulk of efficiency losses and transferscomes from the assembly industry rather than from the components indus-try (see chapter 4, table 4.1) She estimates annual effidency losses from thesystem of incentives benefiting the assembly industry at $26.9 million andannual transfers of$39.8 million The redistributions thatwould occurwidhreform are thus-nearly one and one-half times the efficiency gains

suppli-: 10 EFFECS OF PROTEoNISM ON A SMALL CouNTRY THE CAsE OF URUGUAY

These estimates are also useful n elucidatingwhy the automobile try is so heavily protected in the flrstplace Uruguay has ten assembly fins,with the two leading firms each accounting for a third of the market Apmproximately 12,000 vehicles are sold a year, on which the average additionalcost of protection to the consumer is $6,834 per vehicle Takacs calculatesthat the total efficiencyloss (including the componentindustry) pervehicle

indus-is $2,427 The annual benefits of protection in the automobile industry areestimated at $14.3 million for each of the two largest firms It is no wonderthat there is strong incentive to lobby for protection on the parts industryandinsuffidentincentive to lobbyagainstprotection on the partofcorisum-ers The combination of a small number of big winners and a large number

of small losers (here, producers relative to consumers) iswhat Olson (1965)argues is a situation conducive to intense lobbying

Plan of the book

In chapter 2 Michael Connolly andJaime de Melo give a brief history ofprotectionism and stgnaton in Uruguay Tariffschedules in 1815 providedfora general tariffof25 percentwith some exemptions and amaximum tariff

of 45 percent By 1829 the general tariff rate had been cut to 15 percent andthe maxinum was 25 percent-the first know.n instance of trade liberaliza-tion in Uruguay The authors stress the political poWer of the city ofMontevideo in distributing income away from the country and toward thectybyimposinghigh taxeson agricultural exports Theyalso report evidence

of pervasive rent seeking, including a time senres on regulations from 1928

to 1983 that impeded trade, and of resource waste and lower savings andinvestment rates

In chapter S Federico Changanaqui and Patrick Messerlin focus on guised protectonism in Uruguay through administered reference prices thatare used as the base for tarifflevies Their theoretical analysis shows that thisdisguised form of protectionism, by providing more protection for goodswhose price falls below the reference price, induces Uruguayan producers

cis-to specialize in low-price, low-quality products, contrary cis-to the county'scomparative advantage in products requiringhigher skilled labor High-price,high-quality import goods with prices above the reference pnrce escape ad-ministered protection, which fvors their consumption Thus, an unintendedeffect of the reference price system is to encourage production of low-qual-ity goods and the consumption of high-quality goods Changanaqui andMesserlin analyze the protective effects ofadministeredpricesapplied to 500products and find that protection is strongly "magnified "

In chapter 4 Wendy Takacs models the complex system of pro tection inthe automobile sector that was instituted in 1971 to encourage leaning by

The polticaleconomy of prokc6ionim in Uruguay 11

doing through automobile assembly The chapter offers a useful lesson onhow not to provide for growth and technical change The combination ofhigh tariffis (40 percent in 1990) on assembled automobiles, low tariffs (10percent) on automobile assembly kits, domestic content requirements, andcompensatory export requirements encourages the local production of au-tomobiles by finns thatassemble the imported kits The cost to the consumerper car assembled in 1990 of this high effective protection is estimated atmore than $6,000-more than half ofittransferred as arent to the automo-

bile assembler A net efficiency loss of over $2,000 per vehicle represents a

waste of Uruguayan resources in this "screwd[river" activity Takacs provides

a novel formal framework for analyzing the welfare benefits and costs ofdomestic content and compensatory export requirements, mechanisns alltoo often used to promote industrialization Ihe industries that grow pros-perous tmder this type of protective regime will lobby for contnued protec-tion and fail to introduce innovative technologies or to compete with other

producers in the world market

Chapter 5 byJaime de Melo, Claudio Montenegro, and Wendy Takacsdeals with tdie gains and losses from bilateral trade agreements with Argen-tina (Conveno Argentino-Uruguayo de Cooperacion Econ6micaor CAUCE)and Brazil (Protocolo de Expansion Comercal Uruguay-Brazil orPEC) -Theauthors deve!op a theoretical model of the effidency and rent transfersimpliedby the arrangements They thenapplyagravitymodel to intaregionaltrade to estimate the increase in the volume of trade with the region result-ing from these preferential arrangements The accord widt Argentina seems

to have allowed uncompetitive manufacturing exports to that country, whileth-at with Brazil concentrates on Uruguay's exports in agricultural and natu-ral resource-based products, more along the lnes of Uruguay's pattem ofcomparative advantage Under the agreement with Argentina Uruguayan-

exports enter duty free but are subject to a cupo or export coupon that

ra-tions the rights to export to Argentina as a share of the Argentine market.Under the agreementwith Brazil the cupos are negotiated quantitiesratherthan shares of Brazil's market Both systems could result in rents that allowinefficientfirms to continue to export, though econometric analysis of pricedata does nor reveal any significant rents

In chapter 6 Martin Ramaanalyzes the labor marketand trade reform inmanufacturing and asks whetherunionizaion blocks the effects of trade lib-eralization The Uruguayan case provides experimental conditions For an-swering this question since some of the trff reforms took place under thepenod of authoriarian rule, when unions were forbidden Barriers to tradegive rise to rents to domestic firms, thus providing an incentive for labor touionize and attempt to negotiate wage increases to capture some of theserents Ramafinds that sectoral union membership rates in industrial sectors

12 EFmCS OF PROTECTIONISM ON A SMALL CouNTr1y THE CAsE OP URUGUAY

are correlated with indicators of market power of domestic finns, including

an mdustry concentration index and the effective rate of protection

Analy-ais of forty manufacturing sectors over six years shows that the employmentelasticity to changes in nominal protection rates was significantly lower in'the period with active trade unions, and the real wage elasticity was higher

In Chapter 7Jaime de Melo and DavidRoland-Hoistuse ageneral librium model to quantify the economywide welfare losses due to the com-binedinfluence of trade-and factormarketdistortions Buildingon theanaly-sis in chapter 6, the model incorporates the effects of labor union activity,settingupan interaction between trade policyand the determination ofwages

equi-at the sectoral level The simulequi-ations suggest thequi-at the system of administeredJimport prices distorts the Uruguayan economy more than the tariffs them-selves The costs of administered protection-removing administered pricescouldadd4percentto GDP-farexceedthose due to tariffs.Addingresources.squandered in rent-seeking activities could raise the total cost of adminis-tered protection to 8 percent of GDP The simulations also suggest that as aconsequence of removing administered protection, nearly 4 percent of thelabor force (or 50,000 workers) would have to relocate, explaining some oflabor's resistance to trade reform in Uruguay Resources would flow fromformerly protected sectors to agriculture, casing an expansion of up to 15percent, and light manufactures The immense difference in trade marginsbetween imports, at 35 percent, and domestic goods, at 9 percent (see chap-ter 3), would also shrink, although the notorious ineffidency of the Port ofMontevideo probably contributes substantially to this marked difference.Chapter 8 byJorge Roldos provides a long-run perspective on the rela-tionship between trade policy and ec -omic growth Based on endogenousgrowth theory, Roldos tests for increasing returns to scale in Uruguay usingneoclassical production functions While the sum of the capital and laborexponents is greater than unity, it is not possible to reject the null hypothesis

of constant returns to scale, so specialization according to comparative vantage does not appear to lead to significant economies of scale, at least atthe economywide level Calculations of the Solow residuals show total factorproductivity to be correlated with export growth, suggesting that exportexternalities help explain the residuals Roldos finds cross-sectional supportfor the hypothesis that trade openness is associatedwith a high rate of growth

ad-in GDP per capita and that Uruguay's growth was lower than the tion model predicted

cross-sec-Notes

1 All cross-country comparisons are from the Sumrners and Heston (1991) data.

We should note, however, the authors assign a C- grade to the reliability of the

correc-ThepoEtlitica ecmnmy ofprotectionism in Unrguay 13

Lions for purchasing power for Uruguay The comparisons of levels of GDP per capita across countries are therefore subject to a wide margin of error Growth rates compari- sons arc unaffected.

2 Total costs of the import good in the market are increased because of the tariff surchargs An ad valorem duty boosts the cif pricc to the importer by the percent- agc amount of the tariff A specific duty boosts price to the importer by the amount I perunitso that the total importprice including the duty isPF + t Itcan easily be shown thatdomestic taxeson consumption combinedwith subsidiestoproduction atthesame ratc replicate the effect of a tariff.

3 Imports offoodstuffs, pharnaceuticals, and other products are sometimes stricted or prohibited for health, sanitary, or environmental purposes Since such re- strictions and prohibitionsmay have astrong protective effect, domestic producers may lobby to enact them This ype of restraint is not used in Uruguay.

re-References

Anichini,JuanJose,Jorge Caumont, and Larry Sjaastad 1978 La Poittica Comercialy az -+otecci6n en dUruguay Montevideo: Banco Central de la Repfublica Oriental del Uru-

guay.

Favaro, Edgardo, and Clauidio Sape1li 1990 Etp oPrtvnotion andEconomic Growth San

Francisco, Calif.: Institute for Contemporary Studies.

Favaro1 Edgardo, and Pablo Spiller 1990 'Uruguay In A Choksi, M Michaely, and

D.Papageorgiou, eds., The 7imingand Seuencing ojTrade Libera za iom London: Basil

Summers, R., andA Heston 1991 'he Penn World Tables (Mark V):An Expanded

Set of International Comparisons, 1950-8." Quarterly Joumnal of Econodcs Mar.

327-68.

Protectionism and stagnation:

an interpretative history

Michael B Connolly and faime die Melo

Uruguay has such a long history of pro tection thatwe could have called thischapter 'Two hundred years ofprotectionismY' High levels of protection ofmanufacturing were maintained by taxing agriculture, the main activity inwhich Uruguay has astrong comparative advantage Whatwere the causes ofthe early protectionism, and what have been its consequences? This bookprvdes some answers by analyzng several f-acets of protectionism inUruguay's recent history Most of the chapters deal with the welfaLre costs ofthe inefficiendies introduced by the various forms ofprotectionismn-tariffs,administered prices, bilateral trading arrangements, and local content re-quirements Chapter 8 takes a longer-run perspective on the relationshipbetween the trade regimne and growth since the 1950s

This chapter complements the more specific analyses that follow by viding -an overview of protection against which to judge the rel-ative imnpor-tance of the various instruments of protectionism in Uruguay Italso pl-acesUruguay's overall performance in a comparative context, -and for the readerunfamili-ar with Uruguay's economic policies, the chapter sketches some of.the milestones in the country's long history of protectiomism

pro-* What is striking in this description of protectionism before World War

II is that a large nulmber of the protective instruments :adopted in thenineteenth century are stil around today The p-anoply off measures thatemerged during the deepening of protection from the 1950s.up to.the1974-82 liberaHization episode is typical of the measures implemented bycountries following a development strategy based on industrializationthrough import substitution Under the militar rule of 1974-82 and later

* after the retum to democracy in 1985, wide-ranging reforms were canTiedout A fascmnating aspect of the 1974-82 period is the apparent break in thedownward trend in postwar economic performance (see figure 1.1 in chap-te-r 1) It is tempting to concdude that this resumption of growth resufltedfrom the reforms, whic inlddtaeadfnnillberalization as well

'74

. .dProtnism and sttiaonW an interprelaive his" 15

:as an overhaul of the fiscal system and a concurrent effort at stabilizing theeconomy

To any student of the influence of economic policies on performance,the causes of Uruguay's stagnation are as fascinating as those of the Asianeconomic ½miracle." In exploring the contribution of various factors to thisstagnaadon, we start with a comparative analysis of Uruguay's growth perfor-mance, noting an improvement in its relative position following the 1974refonns We fit a simple cross-country growth model to a sample of thirty-fivecomparable developing countriesand find thatneitherinvestmentlevels norinitial conditions (GDP per capitaandeducationlevels) satisfactorilyaccountfor Uruguay's poor performance Uruguay's perfonnance is worse than pre-dicted by this simple growth model

So we look for other causes Drawing on recently collected data by Rama(1993), we note the high incidence ofrcnt-seeldng activities in Uruguay andrelate them to the pervasive regulation of the economy And we considerwhether there really was a break in performance after the 1974 reforms,looking at evidence of changes in investment and savings behavior and atthe role of external shocks We conclude that there was probably a slightinprovement in performance attributable to the reforms carried outin 1974,but as the more detailed analyses in the remaining chapters in this voluxmesuggest, Uruguaywas stillahighly distorted economy by the end of the 1980s

It is difficult not to conclude that the system of regulations and tion in Uruguay has been made-to-measure In the end, protection wasadopted more in response to lobbying acdvity than as a part of a rationaldesign to promote industrial activities Ramna (1993), in a detailed examina-tion offoreign trade legislation between 1925 and 1983, counted 1,849 piecesoflegislation that explicidy identified their promoter Rana translates one

protec-of them, dernvingfrom an application in 1937 concerning Sacman-type cIaytiles: "Mr Horacio Acosta y Lara, proprietor of a nadonal firm manufactur ig this product considers that the low price on which customs tariff isbased damages his own interests and puts him at a disadvantage relative toforeign industry.'

-What accounted for this made-to-measure trade regime? Industrial centration must have piayed an important role The manufacturing sector

con-in Uruguay is concentrted in a few hands: as late as 1978 there were only

310 establishments that employed more than 100 workers (up from 210 in1960) It is therefore not srisig that lobbying activity by manufacturers

has been intense According to Olson (1965) the smaller the number offinis

that benefit from a specific action, the larger the benefit share to each firmfrom that action, and hence the more intense the lobbying activity

Considering this strong lobbying for protection, it is natural to ask howmuch the reforms of tie 1970s and 1980s actually reduced effective protec-

-16& EMCIS OF PROrEcmToMNsM ON A SMALL COUNTRY: THE CAsE OF URUrUAY

tion.Analysis suggests that, atleastuntil the mid-1980s, the reforms

progres-sively eliminated primarily redunadantprotection, with tariff reductions

hav-ing little effect on the spread between domestic and international prices(Macadar 1988) These estimates, based on compaisons of domestic andforeign comparable products, are approximate -at best But it is clear thatUruguay has alow trade share in GDP forits size, despite a noticeable increase

in the share of exports in GDP following the reforms begun in 1974 (figure2.1) These reformnswentalongway toward removing the most egregous traderestrictions, such as the prohibitioni of' capital goods imports, but Uruguay'sforeign trade regime remained heavily controlled throughout the 1980s

Birth of protectionism: 1815-1939

High and vaniable rates of protection are not new to Uruguay they were

already in place in 1815 (table 2.1) Protectionwas common atthe tme (Great

Britain's repeal of the corn laws in 1848 was an exception), holding sway until

1850, when a bilateral trade accord betweenFrance and Great Britain

ush-ered in an era of free trade in Europe Uruguay, npervious to Britsh

influ-enceand to commercial interests, continued to pass stiff amrifflaws that criminated increasingly against consumer goods

dis-Poor harvests, diminished livestock outputand accumulated fiscalandmerchandise deficits led to the agricultural and finanial crises of 1874, andthen to the first attempt to simultaneously protect Uruguay's nascent indus-

Figure 2.1 GDP and exports (three-year moving averages), 1935-92

Protectionism and stagnation: an interfrstaidve htstoty 17

Table 2.1 Tariff schedules, 181 5-1930

(percent)

Machinery Year ;etneral Maximum Minimum GConswpUn IntermedIate and drLgs

Source Adapted fro Favaro and Sapelli (I 989, table 2.12).

try andraise revenues Duties of 10 to 20percentwere imposed on ported goods, but rates reached as high as 90 percent for lithographs andpublished works.1 In October 1875 duties were lifted on primary materials,industrial and agricultural equipment, and most inputs The motivation forthis pattem of duties was protection and development of the import-substi-tution industry in Uruguay

mostim-InJanuary 1888 a 31 percent basic dutywas set on merchandise imports,while imported parts for assembly (in this case, of steamboats), industrialequipment, and fenacng material were exempt or had low duties Duties onconsumption goods such as cheese, butter, brushes, shoes, clothing, hats,matches, and pu:ses were high, ranging from 44 percent to 51 percent Ac-cording to published report of the Treasury Commission of the House ofRepresentatives, the high duties on consumption goods and low duties oninputs were intended to promote Uruguayan indusy and to raise revenues.The effect on imports of consumer goods in 1890-1900 was devastating.Despite high rates of population growth and immigration the value of im-ports fell 44 percent, from 17 million pesos during 1872-74 to 9.5 millionpesos during 1890-1900

As earlyas 1859 there was concern that the high rates of protectionwouldlead to smuggling (Favaro andSapelli 1989,42)t Despite talkoflowering tariffrates to discourage smuggling, protection continued to rise A natural ques-tion to ask is: Why was protection so high in Uruguay while the rest of theworld was pursuing free trade policies?

There are no obvious polidcal economy reasons for the rise in tion in the nineteenth century The agroexporters were in power, and theyclearly benefited from free trade The persistence and consolidation of pro-

protec-:

718 IEECTS OF PROTECnONISM ON A SMALL CouNwTr: THE CASE OF URUcUAY

tectionism in the early parts of this century during the presidencies of Batie

y Ordofiez (1903-07 and 1911-15) can be at least partly explained by theshift of political powecr to Montevideo and by the influence of anarchist im-migrants Batlle y Ordoiiez promoted social legislation and active economicpolicies

The next watershed was the temporary admission law of 1911 and theraw material and intermediate input law of 1912 The duty drawback andtemporary admission law of 1911 allowed the duty-free import of all primarymaterials and internediate goods used for production, provided that thefinished good was exported within a specfied period The tariff law of 1912forinally established special duty treatment for imports of primary materialslused in the production of goods sold in the domestic market as well Thelegislation of exceptions had begun, introducing new incentives for rent-seeking activities

Once again the motivation was to promote domestic industry-and tocreatejobs The log of the House of Representatives (October 4,1912) statesthat "every nation which protects its industries to create employment andicrease its population thanks to the greater employment, opens its doors toprimary materials not available or in short supply at home in order to carryoutmanufacturing inits national enterprisesandfactories" (cited inAnichini,Caumont, and Sjaastad 1978,19-20)

The policy of high effective rates of protection for manufacturing hasendured to this day Tariff schedules still favor the import of raw materialsand equipment (with the exception of automobile parts) The basic draw-back- law remains in existence as well

Supply difficulties during World War I reduced imports and thus tariffrevenues With less competition from abroad, domestic manufacturing grew:the numberofmanufacturingestablishments rose from 1,000 in 1919 to 7,400

by 1930 When the war ended, exports fell and imports rose, promptinglegislators in the 1920s to establish higher reference prices for calculatingduties on some goods, particularly consumer items facing greater foreigncompetiton Duties were levied on either the dedared c.if value or the ref-erence price, whichever was higher This mechanism of protection is still inplace today in Uruguay, albeit somewhat reforned Its effects are analyzed

in chapter 3

The stock market crashes of 1929 and the subsequent finandal panicsinducedanewboutofprotectionism onaworldwide scale.The Smoot-HawleyTariff in the United States in 1930 was followedwithin twoyears by increasedtariffs in sixty other countries (Ethier 1983) Beggar-thy-neighbor policies inthe industrial countries sought to protect domestic manufacturing andemployment, but instead the contraction in trade led to a reversal of thesubstantial economic gains that had arisen from rade On August 6,1931,

Protectionism and stqgndon: an intapretative hist 19

Uruguay passed a law authorizing the executive branch to raise duties to ashigh as 48 percent (up from 31 percent) on goods forwhich therewas "simi-larnationalproduction.' OnAugust20 the presidentwasalso given the right

to suspend imports for up to a month on awide range of goods thatwere alsoproduced nationally

On the export side multiple exchange rates were established in 1933through a compensating system of preferential exchange rates with up to a

50 percent premium for exports In an attempt to promote domestic

indus-tries, subsidies were given through tax exemptions (franquicias) for tries that moved to Uruguay or expanded their local productive capaciy Theantiprotective effect of a revaluation of the peso in December 1937 was un-done by the reimposition of import licensing

indus-What is remarkable in this period of Uruguay's economic history is thatthe economy grew fairly rapidly despite the relatively high protection Uru-guay benefited from the boom caused by the meat shortage during WorldWar IL and the "natural" protection afforded by the depression was largelyinevitable But the relatively high rates of protection seemed to have had noperceptible effecton growth Anichini, Caumont, and Sjaastad (1978) char-acterize theperiodas one of growth through importsubstitution,which ended

in the 1950s, when the growth opportunities made possible by protectionwere exhausted These authors, however, measuredgrowrh at domestic prices,which overvalues the increase in domestic output due to protection Mea-sured at constantworld prices, growth up to 1950 is lower

Consolidation of protection: 1941-74

The Korean war provided another, and the Last, positive external shock Onthe whole, Uruguay's economic history after World War II is one of increas-ing protectionism and market interventions up to 1974 There were, how-ever, several attempts at liberalization after 1959, including efforts to ratio-nalize the trade regime and attempts to reduce the antiexport bias of theprotective regime by extending various subsidies to nontraditional exports

1941-59

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

consoli-20 EFECTS OF PRoTECIoNIsM ON A SMAL.L CouNTR THE CAsE OF URuGUAY

and capital goods for the agricultural sector, and raw materials and ery for the manufacturing sectoi Multiple exchaange rates were introducedfor broad categories of goods: necessities, intermediates, and luxuries.While this system made some sense during war years, itmade little senselater on, when it stifled foreign trade Favaro and Spiller (1990) give a flravor

machin-of the discriminatory nature machin-of the bill, describing how the law establishednorms for the distribution of foreign currency according to the "need eachfirm showed, the number of employees and their salaries, the volume ofactivity, and the time that the firm had been established in the market" (p.347) During a period when world trade was booming, Uruguay was adopt-ing a trading system based on bilateralism, mnuch along the lines pursued inEastem Europe

Uruguay registered respectable gro*th during this period of rising tectionisrn.Justas it had benefited from not being involvedin World War IIL

pro-it now benefpro-ited from the Korean War, which led to another export boom.Real GDP growth averaged 3.9 percent a year and real industrial productgrew 5.8 percent from 1942 to 1958 And once more, manufacting growthwas fueled by import substitution

1960-73

The period 1960-73 was markedbystalledgrowth and economic stagnation.Some reforms had been introduced in December 1959, induding tempo-rary unification of exchange rates for commercial transactions The tariffreforms of l959, however, ended up reinforcing the multiple exchange ratesfor imports, while the free market rate applied to exports and most imports

of raw materials and capital goods The executive branch was authorized toimpose surcharges of up to 300 percent, to require prior deposits forimports,and to prohibit 3inports for up to 180 days Moreover, the new tariffs werelevied on administered prices rather than on ci.L prices Despite lobbying

by the Chamber of Commerce for a 150 percent surcharge, the executive

branch set the surcharges in September 1960 at 45 percent, 75 percent, and

150 percent (for luxury" goods.) Naturally, with such high surchargesadded

to the triffs, demand for the affected goods nearly disappeared, and toms collections declined

cus-lJruguayjoined the Latin American Free Trade Area (LAFTA) in 1960,which was established to provide preferential treatment for regional prod-ucts Implementationwas patchy, however, and tlhe preferences seem to haveresulted in trade diversion rather than trade creation (see chapter 5 andNogues and QuintaniUla 1993)

Protection led to even more intervention in 1964, in an effort to pensate exporters through subsidies of up to 20 percent of the f.o.b value

com-nPrtectionism and slagnation an intypretative histor 21

and by relievng them of import duties on imported inputs used in export

production Discimination againstagriculture intensified, -is taxes were

lev-ied on exports of traditional products like wooL beef, and hides The tive was to promote industrial exports The result was to superimpose addi-tional layers of taxes and subsidies on the existing structure of tariffschedules,prior-deposit requirements, and multiple exchange rates

objec-D Despite the high levels of protection and the export subsidy schemes,industrial production increased by only 1.1 percentayearin real tenms from

1959 to 1973-slower than the rate of population growth Quotas imposed

on imported materials because of balance of payments problems also tributed to the stgnation of manufacturing Growth possibilities based onimport substitution had been exhausted

con-How high was protection during th}is period? To estimate protectionFavaro and Spiller (1990) use a measure-based on the ratio of import toexport prices lor a sample of goods-that includes the effects of adminis-tered prices Average nominal protection, according to this measure, is veryhigh until after the reform of 1974-79:

to total imports fell from 60 percent in 1951 to 31 percent in 1974) In anyevent, whatever the precise magnitude of protection provided by the systemofinterventions, itis dear thatprotectionwas on the rise until thewide-rang-ing reforms that began in 1974

Economic reforms of 1974

Following an external crisis caused by falling terms of trade and a ban onbeef exports to the European Community, Uruguay began a sweeping.rever-

22- Enas1 OF PROTECTIONSM ON A SMALL CouNwra THE CASE OF URUGUAY

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

in-terest rates were relaxed, and a floating exchange rate was adopted hIn 1975qantitative restrictions were eliminated, and in 1979 a program of tariffreductions was adopted (See appendix for detils on reforrn measures.) Evenafter these reforms, however,.he range of instruments used to control tradeand influence resource allocadon remained large

Import deposit requirements and quotas

Some of the trade reforms begun in 1974 have been loosely referred to asthe elimination of quotas on imports Technically, the system in place up to

1975 was not a formal quota system in that there were no set limits on thequantity orvalue of imports overa specified time period Rather, for importsabove specified amounts a set of prior import deposit requirements cameinto play In prctice, however, the system operated like a set of value-de-nominated quotas once the import deposit requirements and inflation be-came so high that the cost of the deposits for over-uota imports was almostprohibitive UntilJune 1975, imports subject to prepayments had to be reg-isteredwith the central bankbefore orderswere placed abroad, and import-ers had to deposit, in Uruguayan pesos, a given percentage (over 100 per-cent) of the cif value of imports These deposits were refimdable after sixmonths, upon application, but they accrued no interest Imports by publicagences or financed by loans from international agencies or foreign gov-ernmentswere exemptfrom the depositrequirement Other exemptionsforparticuar types ofproductswere occasionallyintroduced Importers not onlyhad to forgo interest earings on the deposits, but in an inflationary envi-ronment, they also suffered a loss of real purchasing power

The depositrequirements orprepayments applied only to importsabove

a stated percentage of base period imports Both the percentages and baseperiods were changed frequently, usually two to five times a year? The de-posit share also varied, by productand over time To illustrate: in 1968 therewere three import deposit-rates: 150 percent, 300 percent, and 400 percentThe 150 percentrate applied to goods exemptfrom the taziffsurcharge, goodssubject to a 10 percent surcharge, and some goods subject to a 60 percentsurcharge The 300 percent rate applied to other goods subject to a 60 per-cent surcharge and to goods subject to a 90 percent surcharge The 400percent deposit applied to goods subject to surcharges higher than 90 per-cent In November 1971 the deposit requirements were tripled to 450 per-cent, 900 percent, and 1,200 percent respectively)

Deposits held by monetary authorities rose after the increase in depositrequirements in 1971 and fell after the 1975 liberalization The decline inthe realvalue ofthe*fmds on depositcanbeused to estimate the tariffequiva-

Protcktionism and stagnaton: an intepretaive histoy 23

lentin real tenns of the inport deposit requirements If prices increase by afactor of rwhile the deposits are being held, this is equivalent to a tax ofr/(1 + r) percent of the funds held Thus, a price increase of 100 percent(which implies r= 1) cuts the purchasing power of deposited funds in half,

an increase of 50 percent cuts it by one-third, and so on Given that the posit requirements are multiples of the value of imports, the impact is alsomultiplied The real tariffequivalent of the import depositrequirement, T,can be calculated as:

(1+ r)

where D is the percentage of the value of imports that must be deposited AI100 percent deposit requirement implies D = 1 A 400 percentrequirement

(D =4) togetherwith a price increase of 100 percent (r= l) during the

de-positperiodimplies that the importergivesup purchasingpower equivalent

to 200 percent of the value of the imports requiring deposits Similarly, a1,200 percent deposit requrement implies that the importer gives up pur-chasing power equivalent to 600 percent of the value of imports

This approach can be used to calculate the ex post tariff thatis, once the inflation rate for the period is known-of the lowest and thehighestapplicable import deposit requirements for fnds From 1968 to thedird quarter of 1971 the lowest and highest deposit requirements were 150and 400 percent; from the last quarter of 2971 to the second quarter of 1978theywere 400 percent and 1,200 percent Estimated tariff equivalents of theimport deposit requirements range from a low of about 8 percent for thelowest deposit requiremenit during the period of lowest inflation to ahigh ofmore than 430 percent for the highest dep osit requirement during the mostinflationarypenod T ese high estimated tariffequivalents are consistentwithcontemporary observatons that the cost of the import deposits to importerswas so large that itwas virtually prohibitive.5

equivalents-There are two reasons to suspect that these estimates of tariffequivalentsmay overstate the restrictiveness of the import deposit scheme First, if dLehigher depositrequirements were actuallyprohibitive, there would have been

at least some amnount of 'waterin the tariff equivalent' for these categories.But since at least some deposits were being held at all dimes during the pe-riod 1968-75, the lowest depositrequirementwas neverprohibitive and can

be interpreted as a rough lower-bound estmate of the restrictiveness of thesystem Second, firms thatargued that they couldnotmainrain their actvitylevels withoutan increase in theirlicense allocations were granted increases.There is also at least one reason to suspect that these estimated tariffs mayunderestimate the real cost to importers For commodities for which refer-ence pnces were established, prior deposits were calculated on the basis of

24 Ercrs OF PROnEcroNlsM ON A SMALL CouNRY: THE CASE OF URUGUAY

reference prices when they were&higher than the ci.f values An artificiallyhigher valuation basis would result in larger deposits and a higher ad valo-rem tariff equivalent

A somewhat lower measure of the restrictveness of the import depositrequirements is implied by the outcome of a central bank auction in October

1974 ofUS$625,000 in deposit-exemptforeign exchange forhigeduty luxuryimports Importers paid up to UrS1,500 per U.S dollar allocated plus theUr$1,392 costof foreignexchange atthe time ofthe auction Thatmeans thatimporters were willing to pay an extra 108 percent rather than pay the priordeposit Thisbidis roughly the same as the estimated triff equivlentfor thelower deposit requirement (96 percent for fimds deposited during the firtquarter ofl974) but is considerably lower than the estimated tariffequivalenLtfor the highest deposit requirement of the time, which was over 200 percent.The prepaynent system was liberalized as part of the sweeping reforms

of 1974-77 In April 1975 the govermnuent announced that the system of

*

deposits and quotas would be eliminated as ofJuly 1, 1975 To avoid a largeincrease in liquidity as import deposits were released, an advance depositrequirement ofS35 percent of the ci.f value, to be held for 150 days, wasimposed on all private sector imports as of April 14, 1975 The 35 percentdeposit was maintained until December 1975, when it was replaced by a 7percent surcharge on all imports except some investment and capital goods.The elimination of import deposits and the associated quota-like systemlowered costs for-importers who were importing over quota and, more im-portant, allowed substantial changes in the composition of imports and intheir allocation among firms Import quotas below the prior-deposit thresh-old were granted to firms according to the value of their imports in the reSevant base period The system was inherendy discriminatory, and it severelyimpeded shifts in the allocation of imports toward more efficent firms ornew finms Maintaining the prior-deposit scheme would have made it diffi-cult for firms to respond to the trade reforms by importing the capital goods,raw materials, or intermediate goods needed to expand export actities or

to startup new businesses Favaro and Spiller (1990) report that eliminatingthe prior-depositrequirementallowed import-competing sectors to becomemore effident, so that output increased during the first phase ofliberaliza-tion despite the rise in competing imports The industrial sector grew at anannual rate of more than 4 percent a year for the three years following theliberalization measures

Tariff reform program of 1 980-89

While the system of prior deposits and quotas was being reformed, the tariffsystem remained highly protective In 1976 five different duties were being

Pm :ecionism and sagapion: an intetrpraaive history 25

levied on imports: the tariff (applied to the higher of the cif price or thereference price), aconsularfee of4percent of the fo.b value, an 18 percentduty (on the higher of the c.i.f price or the reference price), an exchangerate duty (ranging from 0 percent to 200 percent OFl ae c.if ralue), and a 7percent consignment tax forsome inputs andcapital goods The sum of theseduties varied; itwas 3 percent for tractors, 47 percent for electric motors forindustrial use, and 197 percent for electric vacuum cleaners In 1979 Uru-guayjoined the General Agreement of Tariffs andTrade (GAIT), signaling

an end to its longstanding practice of providing subsidies to nontraditional

exports.

The second phase of trade liberalization began in earnest inJanuary

1980 and involved six equal tariffreductions to be taken at the beginning ofeach year From twenty-eigh tlevels of duties averaging 45 percent, with apeakrate of 116 percent, tariffs were reduced to eightrates, with asimple average

of 36 percent and a maximum rate of 75 percent

The crawling peg exchange rate policyintroduced in 1978 was replaced

by a floating rate in 1982 The real apprecation that had occurred turnedout to be unsustainable Capital had flowed into the country following theopening of the economy and difficuldties in Argentina, iinancing an invest-ment boom that led to real growth in GDP averagig mure than 4 percentfrom 1973 to 1981 Realized real rates ofinterest, however, became unsustain-ably high in 1980 as agents anticipated the collapse of the pre-announced

exchange rate (known as the tabita) by reducing capital inflows As

intera-tional rates rose higher in 1981 and commodity prices other than oil fell,Uruguaysufferedadebtcrisis and economic collapse of severeproportions-real GDP fell abruptly by 9 percent Tariff reductions were abandoned, re-placed injanuary 1983 by a new tariffstructure with five levels and a 15 per-

cent export tax on traditional exports (table 2.2).

Tariffrates continued tofall, butmore graduallythanplanned.The onlyreversalwas asmall temporaryincrease inJune 1985 Tariffswere reduced 5percentage pointsin 1989, andinAugust 1990 the highesttariffwas reduced

to 30 percent The reforms also narrowed the range of taff rates, bringing

Table 2.2 Chronolog of tariff rates, 1979-87

Efectied te Primryrmazids intermenxategoods Find goods

26 E}FEC1s OF PROTECrEOnISM ON A SMALL CoUNTRY TmE CASE OF URUGUAY

Uruguay closer to a uniform tariff However, effectve protection remainedmuchhigher-andmore dispersed than these tarifffiguressuggestbecause ofthe operation of the reference price system (see chapter 3) and the specialtariff regime for automobiles (chapter 4)

Reference and minimum exportprics, 1982-92

The old reference price system was replaced in 1982 by the current, moreformalized and fully specified system of administered prices, the changeprompted by the difficulty of implementing the antid umpiag and antisubsidylaw ofJune 1981 Fifty-four types of products have referenea prices-textilesand apparel alone are covered by 177 separate reference prices The mecha-nism is simple: when the dedared c.i.f import price is less than the refer-ence price, the official duty is applied to the reftrence pri_e Thus, the worldprice of synthetic tufted carpets maybe US$3.22 ayard, butitsreferenceprice

is US$750 a yard As a percentage of the world price a 40 percent duty raterepresents an effective duty of 93 percent

A new minimum export price was added to the system of administeredprices in 1983 The name is something of a misnomer since itapplies not toUruguayan exports butto Uruguayanimports-other countries' exports Besystem covered seventy-five types of goods in 1990 (thirty-five of them trans-ferred from the reference price system) The minimum export price system

is more protective than the reference price system since it adds a movingsurcharge equal to the difference between the declared importprice and themnimum export price Consider automobile tires, with a world price ofUS$3 80 a pound and a minimum export price of US$4.30 a pound Import-

ers declaring an import price of US$3.80 would pay not only the official dutyof4O percent on the $4.30 price, but also the US$0.50 difference between thedeclared world price and the minimum export prices for a total effective dutyof58 percenL Nantrally, there isa strong incentive for importers to avoid thesurcharge by declaring an importvalue equal to the minimum export price.The system ofadministeredprices has been reformedinrecentyears byreducing the ratesand the numberofgoodscovered, but the systemremains

in place By boosting the true tariffs above the apparent tariFf, this systemundermines the country's trade liberalization efforts

The special regime for automobiles, 1970-92

Another form of import deterrence is achieved by the elaborate system ofdomestic content and compensatory export requirements established inOctober 1970 in the automotive industry In 1990 importers offully assembledautomobiles paid a 40 percent tariffandhad to have 'compensating" exports

Potectionim and 5stgnation: an interptalive his" 27

of automobile parts equal to 70 percent of the £ob value of the fully sembled automobile Importers of automobile kits had to pay a tariff of 10percent, have a minimum Uruguayan value-added content of2O percent, andhave compensatory exports ranging from a minimum of 20 percent for adomestic content of 40 percent or more to a maximum of 60 percent for adomestic content of 20 to 25 percent The compensatory export scheme wasless restrictive than it appeared, however, since export receipts could bepurchased on the secondary market for 8 to 35 percent and used to satisfythe compensatory export requiremenL

as-Export taxes and subsidies

In addition to controls on imports Uruguay has a long tradition of taxing its

traditional exports of beef, wool, and tanned hides Furthermore, exports of

key raw materials such as cattle on the hoofand untanned leather vere hibited in order to provide cheap inputs to the meat packing and tanningindustries To compensate for this bias against tradable acdvities, exportsubsidies were introduced for nontaditional exports in 1964, and expanded

pro-in 1967and 1970.Nontrditionalexportsalso received exchangeraterebates,while traditional exports were penalized by an unfavorable exchange rate.Clearly this complex structure of import protection and promotion was astrong incentive for lobbying and rent-seeking activties

-Bilateral trade arrangements with Argentina (CAUCE, negotiated in 1974)and Brazil (PEG, 1975) were an integral part of the reform package launched

in 1974 The bilateral arrangements were intended to reduce Uruguay'schronic trade deficit with its neighbors and to secure access to these mar-kets The anrangements, which are descibed in detail in chapter 5, provideforfree access into Argentina and Brazil for a selected number of lUruguaymanufactures However, free access was limited by quota ceilings for eachproduct Thepreferenceswere regulated through coupons, which controlledaccess to the Argentine and Brazilian markets

Cross-country evidence on trade, growth, and stagnation

What happened to growth ratesas Uruguay's economy became progressivelymore regulated andpro tected before 1974, when refonns gradually openedthe economy to foreign trade?

Four patterns stand out in the long-term relation between GDP andexports (see figure 2.1): stagnation of exports between 1953 and 1973;6 two

28 *EFcEsC OF PNorEcnoNisM ON A SMALL CouNTRY: THE CAsE OF URucuAY

growth periods, fom the late 1930s to the mid-1950s and after 1973; an sociation between exports and GDP after 1974; and an explosion in exportsafter 1974 The question then is whether the changes can be attributed topolicies or to external events

as-The first place to look for an external explanation for the rise in exports

and tie acceleration in economic growth after 1974 is an improvement in

Uruguay's commodity terms of trade Far from improving, the terms of tdefell from 226 in 1973 to 122 in 1974 and stayed at or below 100 (with 1978

= 100) until 1987 Despite this worsening in the tenns of trade, real GDP panded rapidly from 1974 to 1981 (figure 2.2) During a similar worsening

ex-in terms of trade from 1950 to 1972, ex-income stagnated The detenoration ex-inthe terms of trade may have contributed to.the slowdown in growth in thisearlier p eriod, but not in the later period, an observation confirmed by Rama

(1991) using causality tests that reject Granger causality from the terms of

trade to outputgrowth Anotier external factor thatprobably did play a rolewas the macroeconomic situation in neighboring countries, especially Ar-gentina Uruguay's boom during 1979-80 and the ensuing deep recession

in 1982-83, when real GDP fell by 14.7 percent, were strongly influenced bythe similar boom-bust cycle in Argentina27

Cross-section analysis using average growth rates for a sample of five countrieswith GDPpercapitaabove $3,800in 1973 (Surmmersand Heston1991) shows Uruguay, alongvwith Argentina and Chile, its tvo Southerm Coneneighbors,with the lowvestaverage GDP growth for the tvo periods combined,1950-74and 1974-88 (figure 2.3) Uruguay's relative position in the sample

thirty-Figure 2.2 Terms of trade and GDP growth, 194249

Reo GCDP (billions of 1978 pesos) Term of trde (I 978=I 00)

JWotectionism and neag7adon: an iniepretative his"oi 29

improved during the second period, however, because while performance

deteriorated for most of the sample following a series of price shocks

begin-ning in 1973, UJruguay m-anaged to at least stand still.

To explore some of the underlying determinants ofgrowth, we fit asimplegrowth model to the sample countries, using investmnent, initial income lev-els, and education levels as key explanatory variables.8 Since the model ig-

nores other factors, such as trade policies, that could also affect growvth, theresults are merely suggestive But they do broadly confirm those of recent.cross.-courntry growth exercises, such a-s Barro (1991) and Levine and Ren elt.(I 992) (For this sample of relatively advainced developing countries, how-ever, catch-up from low income levels is significant only in the first periodand the influenceof education variables proxies for human capita-is onlymarginal; table 2.3.)Jorge Roldos takes acloser look in chapter 8at the samesample in an extended model thatattempts to control for the effects of trdepolicies on growth

More interesting here is the difference between actual and predicted

growth rates for Uruguay during each subperiod, after the effects of ment and education are taken into account During 1960-73 actual gothwas 2.5 percen thelowthe value predicted by the regression-byfar the larg-est negative residual in the sample For the later period, 1974-88, actual

invest-Figure 2.3 GDP growth for thirty-five countries with GDP per capita

-=

'30 EiFns OF PROTE=TIONISM ON A SMALL CouNTRY: THE CASE OF URUCUAY

Table 2.3 Regresion results for cross-country growth detenminants

(dependent vcrtabe oerage GDP per @1itO gowth)

Constant enrallbt ratio enralfient rtio per capita GDP

Period term (EDPJ' (EDS) (InGDPCQ (AIW) F

(4.0) (0.015) (0.01) (0.51) (0.03)

-(9.2) (0.04) (0.01) (08) (0.03)

Note: Sam ple aftiryfive countries shown i jfgure 23 Nunbems in parernheses are standard errors, based on

Whies (1981) heteroskedasticity-cnsiswnt coimrmnce matrix.

a Bgining of period values.

growth was still some 0.3 percent below its predic:ted value, but the

differ-ence was not significanL Thus the regression analysis confirms a relative

im-provement in the period af-,er the initiation of the reforns

Rent seeking, reforms, and investment

One obvious place to look for reasons for Uruguay's dismal economic formance since 1950, especially until 1974, is the distortionary effe cts of trade poicies and othermarketinterventions The microeconomic effects of such distortions, which are explored in some of the chapters that follow, do not translate directly into effects on growth And while chapter 8 looks for fur- ther evidence on the relation between trade policies and growth, it does not account for other possible linkages between policy and growth, such as how the policy environment and distnbutional activities affect growth by influ-

per-encing investment and domestic savings In particulars there is evidence of

a broader stuge in Uruguay over the distribution of income between the three main social groups-civil servants, manufacturers, and trade unions- and of its effect on investmentand growth There is also evidehce suggesting that the reforms initiated in 1974 led to a significant upward shift in private savings and investment during 1974-82.

Rent seeking and investment

As the discussion of the array of trade control instruments in Uruguay makes clear, discrctionary polices were widely used to influence resource alloca- tion From the 1930s to the 1960s restrictive regulations were used to close the economy to foreign trade From the mid-1970s, as the economywas pro- gressively opened to foreign trade, discretionary measures such as export subsidies were used to promote foreign trade A considerable amount ofrent- seeldng activity would be expected in such an environment.

Protectionism and stagntion: an intuvpretative hisutoy 31

Adetailed examination offoreign trade legislation from 1925 to 1983 byRama (1993) yielded 1,849 pieces oflegislation thatexplicidtlyidentified theirpromoter-or 3973 if those that concerned only a small number of produc-ers are induded as well A sense of the importance of these rent-seekingactivitiesin relation to the overall size of the economy can be derived by scalingrentseeking (measured as the number of trade-related statuLes benefiting a

-single fi orindustry) by thelevel of economicactivity over the period

1925-83 (figure 2.4) The scaling shows two peaks, one-during the 1940s and oneduring the 1970s The most intense penrod of rent seeking occurred during

the import-subsdtution regime of the 1940s The second peak is almost

en-tirely accounted for by rent-seeking acdvities associated with exporting.

Using dummy variables to capture changes in policies and institutions,Ramna finds that rent-seeking activities intensified during militar dictator-ships and during periods ofintense imporisubstitution (1931-69) or exportpromotion (1974-79) The estimated coefficients also suggest that importsubstitution had a stronger effect on rent-seeking activity than did exportpromrotdon

Particularly interesting is the relationship Rama finds between ingactivityandl.ong-run growth He regresses the residuals (or 'innovations")from univariate models of the growth of outputand exports on indicators ofrent-seeking intensity (following the approach of Blanchard and Fischer1989), with time lags of up to twenty years to capture long-run effects Forboth output growth and exports the results reveal a positive correlation inthe earlyyears, followed bya negative one (figure 2.5) The change could beFigure 2.4 Rent-seeldng intensity, 1925-83

rent-seek-(regulations scaled by economic activity)