EC702 TRADE AND DEVELOPMENT

TERM PAPER

TOPIC: Free Trade and Poverty Reduction

in developing countries: Empirical
evidence in context to India

Aastha Mohd Ashfaq Manasvi Nagpal Nikhila Mathew Tapolina Poria

Muskan Jain

Abstract

This paper aims to do a quantitative study to understand the relationship between free trade and
reduction in poverty. Various theories now and then have emphasised the importance of free trade
in reducing poverty. Our work successfully shows the positive impact of free trade in poverty
reduction. We have done an empirical study for India, since, India has gone through the phase of
restricted trade to free trade.

Introduction

It is well known that eradication of poverty, especially of extreme poverty, has been identified by The
United Nations as its number one Millennium Development Goal (MDG). Within this, it has been
further emphasised that global partnership, including through international trade (MDG 8), can play
a crucial role in contributing to promote development and hence eradicate poverty. Since the past
few decades, there has been a continuous debate amongst policymakers concerning the impact of
international trade on poverty. On the one hand, we have scholars and international organisations
who are of the view that international trade provides opportunities to developing and least
developed countries by expanding their markets, infusing new technologies and improving
productivity, thereby leading to their overall growth. On the other hand, complexities involved in the
mechanism through which international trade may alleviate poverty have been pointed out too.
Given the fact that India is a developing country and home to one-third of the world’s poor
population, it is a suitable country to work with for finding the answers to some of the very relevant
questions amidst the ambiguities surrounding the trade theories regarding the impact liberalisation
has on poverty alleviation.
We can divide the history of India’s external sector policies since independence into three broad
phases: 1950-75, when the trend was towards tighter controls, thus resulting in virtual autarky by
the end of the period; 1976-91, the period during which some liberalisation took place; and from
1992 onwards, when deeper and more systematic liberalisation was undertaken, which was largely
externally imposed in response to the severe Balance of Payments (BOP) crisis that affected our
country. Important things that were done was abandonment of extremely restrictive policies, the
duties on goods were revised and brought down by more than half as they were earlier because of
which the propensity to import rises, specifically for the goods which are importable without licence
or quantitative restrictions. The Lesser average tariffs, along with amendment in the tariff structure
across industries, led to adequate variations to find out the causal effects of trade policy enacted on
the income distribution.
Though reforms may have increased or lowered the poverty, this paper tried to explain that these
effects were unequal throughout the country, and certain regions and certain segments of the
society suffered more from trade reforms instead of being benefitted. It has been observed through
many studies that liberalisation of trade promotes the welfare of the low-income class in a number

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of ways. Firstly, it allows poor consumers access to import goods at cheaper rates, which actually
costs higher in domestic markets and also allows poor producers (getting comparatively lower prices
in the domestic markets) to export their products at higher prices. Moreover, it allows consumers to
access new products that are not available in domestic markets. Also, trade influences the relative
prices of the factors i.e., skilled and unskilled labour and capital that are used in the production of
traded goods, and hence in this way it influences the income and employment of the poor. It also
increases the government's ability to finance the poverty alleviation programs, by increasing
governments revenue collection from tariffs and duties. It incentivises investment and innovation
which further promote economic growth. But unfortunately, it sometimes makes the economy more
vulnerable by exposing it to the negative external shocks, which may affect the poor people more
adversely and can deteriorate their conditions. So, the channels influencing trade are interdependent
and hence get influenced by many types of policy interventions and economic events. The
above-mentioned changes brought about through trade may be observed immediately or it may take
some time to show its impact. In a nutshell, all this makes the link between trade and poverty more
complex, as a result of which, drawing any immediate conclusion about the impacts without detailed
study of the whole scenario might be misplaced.

This paper aims to investigate the impact of trade liberalisation on poverty reduction by checking the
significance of the coefficient of impact of trade on poverty reduction over the tenure of 50 years in
context to India.

Literature Review

Before we proceed with the econometric analysis of the research question that we are trying to
answer, we would like to elucidate the manner in which poverty and trade are linked. In the paper by
Nazneen Kanji and Stephanie Barrientos titled Trade liberalisation, poverty and livelihoods:
understanding the linkages (2002), the authors emphasise the fact that poverty takes various shapes
and forms, based on the gender, ethnicity, race etc. of the population. The authors talk about how
liberalisation impacts poverty at the micro household level through three channels which are (a)
Enterprise, (b) Market, (c) Government. Through these channels we are able to see how trade affects
socio-economic factors. Trade liberalisation leads to increased specialisation in the production of
those goods in which countries have ’comparative advantage’ which in turn leads to a surge in the
output and incomes benefiting almost all the consumers within the country. Hence it won’t be wrong
to push the trade as the poverty alleviation tool agenda.

However data and rigorous empirical analysis tell a different story. We have found that even though
trade liberalisation improves the overall welfare or well-being the gains are small and unequally
distributed in different countries within different groups. Trade affects the terms of trade and hence
here the welfare effects are measured on the basis of price changes over time. Specifically we look at
how these price changes affect the demand for domestic factors of production. Production in highly
poor regions have been found to be more constrained which leads to lower development and growth
in these areas, which is aggravated by an unfavourable terms of trade situation due to liberalisation.

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Under this article titled United Nations Conference on Trade and Development, July 2012 we found
that structure of trade protection policies before liberalisation affects overall welfare effect on the
poor e.g., Tariff structure: - whether it is pro-poor (anti-poor) – is crucial in studying the trade and
poverty relationship. It would be naive to conclude that once a country has been opened to trade,
we can expect it to be a panacea, a solution to the problem of poverty. Since, how trade affects
people’s welfare depends a lot on the inherent policy structure and economic condition of the
country.

So, we have seen that a long debate has been going on to see the effects of global trade integration
on various important socio-economic factors, and poverty is one of them. We will be analysing the
Impact of trade liberalisation on household welfare and poverty in India. Exports have generated
extra employment and incomes in the economy, but these gains don't transfer to the poor directly.
For the poor to benefit from international trade, it is important to boost their participation in the
sectors that are expanding as a result of trade. The government plays a very important role in
deciding contemporary policies and promoting the pro-poor agenda of liberalisation. For a country
like India where the majority of the workforce is employed in the unorganised sector, the impact of
trade through increased employment and higher wages is conspicuous since it is reflected more in
the organised sector. Overall we can claim that trade liberalisation is one of the factors that helps to
lower the poverty line in developing countries like India.

Irrespective of the type of comparative regression analysis in consideration – Intra- country or

cross-country, there is strong evidence to support that international trade contributes to economic
growth and hence poverty reduction. In a paper titled “Trade liberalisation and poverty reduction”,
the author Devashish Mitra, emphasised on the need for appropriate complementary domestic
policies and Institutions to realise the poverty-reduction benefits of trade liberalisation. The author
based his arguments on the world's two largest countries – India and China. The trend data
(1980-2010) on poverty and trade showed that both the countries experienced high growth rates
and fall in poverty following drops in tariff rates. In India’s context specifically, trade liberalisation has
been less effective in reducing poverty in economically lagging states i.e. relatively higher
transmission of tariff reductions into prices has been observed in urban areas. The study
recommends that domestic policies like financial development, greater road density, sensible labor
regulations, etc are the must-haves for any Country to realize pro-poor effects of the trade reforms

During the period of economic reforms and trade liberalisation in the 1990s, India experienced a
sharp fall in urban poverty (poverty gap ratio) whereas income inequality (Gini Coefficient) showed
an increasing trend. In the paper titled “Trade Liberalisation, Poverty, and Income Inequality in
India” the author Rajat Acharyya aims to examine how far these trends can be explained by the
liberal trade reforms. He postulates that trade enhances growth of output which in turn increases
opportunities for upward income mobility for the lower-income groups. However, with the recent
shift in demand for high-technological goods, and the gradual change in India’s export composition
towards skill-intensive sectors at the cost of relatively unskilled sections of the workforce, this may
lead to increased wage inequality. The paper sheds light on a few measures that can make trade
work for the poor.

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The recommendations include – a) Remove domestic market regulations and imperfections that are
prohibiting full realisation of efficiency gains of trade liberalisation (b) Encourage firms to obtain
ISO-9000 series certificates to change poor perceptions of foreign buyers about the quality of India’s
exports. c) Change export composition towards high-technology goods to strengthen export-led
growth, and ensure that unskilled workers displaced from import-competing industries are absorbed
in the export sectors d) Minimise cost of ISO certificate to promote the share of high-technology
goods in manufacturing exports e) Encourage development of high-skilled final software packages
instead of low-value-addition outsourced projects f) Invest in quality-improving production
technology in unskilled labor-intensive products, which in turn helps generate employment for the
unskilled workforce g) Target to make low-end exports more competitive by promoting economies of
scale and minimising per unit cost of production at constant prices in dollars h) Formulate trade
reforms specific to agriculture sector keeping volatile nature of world agricultural prices in mind

The article “Trade Liberalization, Poverty and Inequality: Evidence from Indian Districts” by Petia
Topalova investigates the link between trade liberalisation and poverty in emerging and wealthy
countries. This research takes use of differences in the timing and degree of liberalisation across
industries, as well as differences in the location of industries in districts across India, to see if there is
a causal link between liberalisation and changes in poverty and inequality. This research uses a
regression methodology to see if district poverty and inequality are linked to district-specific trade
policy shocks. This experiment examines the relative impact of liberalisation on places more or less
exposed to liberalisation on poverty in India, rather than the level effect. While liberalisation may
have had an overall effect of increasing or decreasing the poverty rate and gap, this article shows
that these effects were not uniform across the country, and that various locations and groups of
society gained less from it. So far, the article has shown that, whatever the overall consequences of
trade liberalisation in India were, rural areas with high concentrations of industries that were
disproportionately affected by tariff reductions had slower poverty reduction. Topalova (2004b) also
examines whether differences in the institutional environment and microeconomic flexibility
influenced the impact of liberalisation: the most pronounced effects on poverty occurred in areas
with inflexible labour laws (those that saw no change in industrial structure as a result of trade
liberalisation), whereas inequality increased as a result of trade liberalisation in areas with flexible
labour laws.

In light of the current debate about the influence of international trade on poverty, the study of the
“United Nations Conference on Trade and Development (UNCTAD)” in “ How are the poor affected
by International Trade in India” takes a different perspective. Rather than assessing the net impact
of international trade on poverty, an attempt has been made to determine how international trade
affects the poor. The study's concept entails tracing the influence of international trade on four
aspects of human development: empowerment, productivity, equity, and sustainability in depth to
determine the influence of international trade in poor people's livelihoods.The study shows that,
although exports have increased employment and wages in the economy, these benefits have not
reached the poor. One conceivable strategy to directly link the poor to commerce is to identify items
produced by the poor or those in which a large number of poor people are involved, and then boost
their exports so that the benefits flow to the poor directly. The influence of trade on unorganised
sector earnings and employment can have far-reaching ramifications for how trade affects the poor.
In some important ways, this research is groundbreaking. The study creates a concordance matrix.

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The exports and imports of items have been matched to the corresponding industries using this
matrix, resulting in industry-level trade statistics, unlike in the previous research. Finally, the study
calculates the extent to which exports produced employment in 46 subsectors of the economy and
earnings for individuals living in abject poverty and those living below the poverty line from 2003-04
to 2006-07.

Methodology

We are using regression analysis to measure the impact of trade on poverty reduction. Our papers
have provided a theoretical framework and claimed that trade plays a crucial role in poverty
reduction. They seemed to have analysed the changes in trade and poverty reduction, without
controlling for other variables which can potentially affect trade. Hereby, while doing our regression
analysis, we have controlled for various variables, i.e. , Government in power(left or right),
Population, Gross National Product per capita(LCU constant), Unemployment. The Left Government
is expected to be more concerned towards poverty alleviation than the latter one, so, we have used a
dummy variable to capture the effect coming out of government in power. Left has been allotted 0
while right has been allotted 1.

Population is also expected to negatively correlated with poverty reduction with more development .
More population will put more stress on limited resources, hence will lead to more deprivation of
resources in the nation. We expect to see a positive relation between GNI per capita and poverty
reduction. Trickle Down theory drives this intuition.

The proponents of trickle-down economics argue that rising incomes at the top end of the spectrum
would lead to more jobs, more output, more income and less poverty as the growth and higher
incomes at the top end will move at the lower end and to the poor. Unemployment raises a variety of
problems, both economic problems and social problems, if viewed from an individual's point of view.
Reduced or even no income causes the unemployed to reduce their consumption expenditure. So in
general it can be concluded that unemployment has a positive effect on poverty levels.

We will be running simple Linear regression to measure the quantitative effect of trade on poverty.
We are using data from the time period 1960 -2011 for our analysis. To measure poverty, we are
using the annual Head Count Ratio(HCR) calculated by NSSO in their annual survey. For data on
trade, unemployment, GNI per capita, population, we have used World Bank Data. For creating a
dummy for the government, we have manually checked which government was there for which year.
For missing values, we have used the average of immediate values. We start with presenting the
summary of our data for a holistic understanding of the reader. Then , we construct the correlation
matrix to check out the relation among the regressors. We have plotted some essential graphs to
give a visual view to the readers.

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SUMMARY

In summary of variables, talking about year, minimum year is 1960 and maximum is 2011. Mean of
the observations is 1986 while median is also 1986. We can do the similar interpretation of other
variables, i.e., Population, Trade, GNI per capita, Government, Unemployment.

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From the graphs, we can see that HCR is decreasing over time. Even the negative relationship of HCR
with trade, Population, Unemployment, GNI per Capita (constant LCU) is quite evident from the
graphs, though, it’s a weak relationship between unemployment and trade. Now, let’s plot the
correlation matrix.

CORRELATION MATRIX

It is quite evident that there is a strong correlation among so many regressors. Trade is highly
correlated with Population and GNI per capita. Population is also highly correlated with GNI per
capita. With that there is a mild correlation among all the other possible pairs. So, while running our
simple linear OLS regression, we might face the problem of multicollinearity.

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PRELIMINARY ANALYSIS with RESULTS

We first present the results of simple multiple linear regression without taking into account any
statistical problem into account in our model.

It is visible that though R-square is very high, we have few significant t values, which is a classic
symptom of multicollinearity, hence, we will use Principal Component Analysis statistical technique
to get away from the problem of multicollinearity and will run regression again to see the impact of
trade on poverty. We attach the results below:

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Our Scree plot tells us that components 1 and 2 whose variance is greater than 1 can be safely
considered, and rest can be ignored for further analysis.

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First component is strongly correlated with GNI per capita, Population and Trade. Second component
is correlated with GNI per capita, Government and unemployment. Component 1 explains 57% of the
variation while component 2 explains 24.5% of the total variation.

Now, let’s regress PC1 and PC2 calculated on HCR, results are attached below.

We can observe that PC1 is significant at even 1 % level of significance while PC2 is insignificant even
at 10 % level of significance. Trade which is 55.5% correlated with PC1 hence is significant. One unit
change in PC1 will lead to a 6.46% decline in HCR on average.

Conclusion

In order to find evidence in support of the pre-existing theories that suggest that international trade
has a positive impact on poverty reduction, we conduct an empirical study in the context of India for
the time period 1960-2011. To ensure that the model isn’t mis-specified or under-identified, we also
control for other variables that potentially impact poverty, although we find an insignificant impact
of trade on poverty, which may have been due to the presence of multicollinearity. We accounted for
this problem using principal component analysis and then carrying out the regression analysis once

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again. Post this, we found the coefficient on the ‘Trade’ variable to be statistically significant. Hence,
we conclude that effective policy on trade enhancement can achieve reduction in poverty.

References

[1] Devashish Mitra (2016), “Trade liberalisation and poverty reduction”, IZA World of Labour

[2] Rajat Acharyya (2006), “Trade Liberalisation, Poverty, and Income Inequality in India”, Asian
Development Bank, INRM Policy Brief No. 10

[3] Amelia U. Santos-Paulino (2012) Trade, Income Distribution and poverty in developing countries:
A Survey, United Nations Conference on Trade and Development (UNCTAD)

[4] Nazneen Kanji and Stephanie Barrientos (2002), “Trade liberalisation, poverty and livelihoods:
understanding the linkages”, IDS Working Paper 159

[5] Petia Topalova (2005), “Trade liberalisation poverty and inequality: evidence from Indian
districts”, University of Chicago Press

[6] “How are the poor affected by International Trade in India”, United Nations Conference on Trade
and Development (UNCTAD) (2013)

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