The effect of trade openness on GDP

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Theory

In order to show the cause and effects of the Asian financial crisis and how it spread over Asia, the use of economic theory needs to be applied. Financial crisis is something which economic theorists have widely discussed and therefore there are many general theories on how and why a financial crisis occurs. The theory of trade openness explains the recovery and growth of each economy whilst the current account reversal theory is used to explain the magnitude of the drop in the GDP after the crisis.

The effect of trade openness on GDP

The theory of trade openness is a widely discussed subject and there are many theories on what effect it has on an economy. There are three categories of how open an economy can be, ranging from fully closed to partly open and then full openness. Thus it is hard to de-fine how open a country is that deals with trade but has restrictions.
Another aspect of openness of trade is that certain economists claim that larger countries can afford to be closed, whilst the smaller countries almost have to stay open in order to grow. The small countries face incentives to have an open trade policy in order to benefit from the larger market‟s spending power. Thus the smaller countries are expected to be more open to trade (Alesina & Wacziarg, 1997).
Empirical growth studies have also shown that outward-oriented economies have higher growth rates in comparison to inward-oriented economies. Certain theorists believe that a country can be open by having favourable policy to exports but barriers to imports, whilst others believe a country is open when it is unbiased in its import/export policies. Recently openness of trade has been widely referred to as being free trade. Thus it is quite clear that the theory behind openness is very broad and is not agreed upon by all (Yanikkaya, 2003).
The determination of a country‟s openness is thus in accordance of how one views the as-pect of trade openness. Certain theorists believe that enhanced free trade increases growth, whilst certain economists believe that protectionism will have a better effect. One of the main reasons for there not being a single theory or it being disputed is because one can not only use one single indicator to measure openness. This is due to there being many differ-ent aspects affecting trade (Edwards, 1998).
At the same time, the more open an economy is the larger is the possibility for it to be hit by an external shock, say a financial crisis. But at the same time these open countries have a benefit of their large export sectors, which will help them to reduce an external debt more easily than a closed economy. This is due to that the debt service absorbs a smaller part of the country‟s total export proceeds in comparison to a less open economy. With a reduced capital inflow, or it being interrupted, the country will have to alter the division of re-sources from the importing sector to exports, and this will generate the foreign exchange the country needs to cover for external debt. This in turn could have a negative effect on the domestic industries that rely on imported goods for their production, a so-called import compression. At the same time import compression could become even more costly to a relatively closed economy, due to the fact that certain essential inputs might be cut out (Milesi-Ferreti & Razin, 1996).
To conclude a more open economy allows a country to grow faster due to the use of if its trade sector. At the same time the more open economy is more vulnerable to an external shock than a closed economy. In accordance with this a more closed economy will not grow as fast but is not as vulnerable to an external shock as an open economy. At the same time if an external shock were to occur, the more open economy can handle this shock bet-ter due to the use of its trade sector.

Current account reversal

Edwards (2004) defines current account reversal as a decrease in the current account deficit by a minimum of 4% of GDP in a year. Such a reversal is often due to a so-called „sudden stop‟, which is referred to as an abrupt stop in the inflow of capital to a country, which in the end is highly disruptive since this is mainly foreign capital. On the other hand there are cases of sudden stops without a reversal effect after. The countries that have managed to avoid this have used their international reserves to make adjustments in their current ac-count. Moreover there is the opposite case, that there have been a reversals without a sud-den stop, but these countries were not first experiencing large inflows of capital (Edwards, 2004).
Many economists argue that a high amount of capital mobility is extremely troublesome. If a country were to restrict the use of capital it could help prevent the probability that a country will suffer from a sudden stop and current account reversal. Others claim that sud-den stops and current account reversals are inversely related to a country‟s size of openness (Edwards, 2004).
Edwards uses a „treatment effects‟ model to test what causes and to what degree, current account reversals as well as sudden stops. His findings indicate that a reversal is more likely to occur under a number of different circumstances such as a large current account deficits, low initial GDP and high occurrence of sudden stops in the region of that country. If a country has a high level of net international reserves then the probability of experiencing a reversal decreases. Furthermore Edwards finds that the effect of current account reversal on growth is highly dependent on trade openness of the economy (Edwards, 2004).
The level of trade openness will determine to what degree a country will be affected in terms of growth if a current reversal occurs. A current account reversal will always have a negative effect on a country‟s GDP but the negative effect is dependent on openness. The more open an economy is the smaller the negative effect on GDP will be. This is because, according to Calvo et al. (2003) openness, which is viewed as large supply of tradable goods, reduces the leverage over the current account deficit. In accordance with this the more closed an economy is, the larger the negative effect of a reversal will be on GDP. Thus a more closed economy will be more affected than an open economy by a current ac-count reversal. The reversal explains the magnitude of the drop after a reversal. Thus the larger the reversal is in magnitude of GDP the larger the negative effect on growth after (Edwards, 2004).

Empirical Framework

This section clarifies the method that will be used for the analysis and also explains the re-sults that are expected during the Asian financial crisis.

Method and Hypothesis

The Asian financial crisis affected many countries in East Asia but in different magnitudes. The six countries listed previously and that were widely affected by the crisis were Thai-land, Malaysia, Indonesia, Philippines, South Korea and Hong Kong. The aim is to see how the degree of trade openness of each country has affected the growth of GDP when the crisis hit. In order to put the magnitude of the crisis into perspective we will analyse to what degree each country was affected in terms of GDP after the crisis and how well they recovered.
In order to put these figures into perspective they are compared in relation to two coun-tries that are in the Asian region but were not as widely hit by the crisis. The countries used in this case is one smaller economy and one of the world‟s largest economies: Singapore and Japan.
In order to measure the trade openness of each respective economy the following formula was used:
This shows the proportion of goods and services that are entering and leaving the country in terms of the gross domestic product. The theory and calculations of openness are widely discussed and there are many sides to it. This formula is the most used when it comes to showing the most clear and direct measurement of how open a country‟s trade policy is.
As for the aspect and measure of the current account the analyses are based on the level of the account prior to the crisis, using descriptive statistics on before and after to see if there are any special changes. The current account balance is usually defined simply as the de-mand for countries exports of goods and services minus their imports of goods and ser-vices. But the balance also includes net unilateral transfers of income. There are many fac-tors that affect the balance but the two main determinants are the exchange rate as well as the domestic disposable income. (Krugman & Obstfeld, 2006)
To determine the effects of the crisis the use of two ordinary least square cross-sectional regressions is made. The first regression model is:
where  represents the intercept of the trend line,  is the slope of the trend line, illus-trating how the change in log GDP is dependent on the level of openness, and  is the er-ror term. The second regression model is:
for this regression  represents the intercept of the trend line,  is the slope of the trend line after 1997, illustrating how the change in log GDP growth is dependent on the aver-age level of openness from 1998 to 2005, and is the error term.
For regression (1) it is conducted once with all the countries and once excluding Japan. As for the second regression (2) it will follow the same procedure but this time excluding both Japan and Hong Kong. The reason for this is explained in the empirical results where it is relevant.
The growth rate shows one aspect to recovery, at the same time the levels of unemploy-ment prior to and after is analysed to see if there are any apparent changes and if there is any pattern in the levels during the years. The use of descriptive statistics is used to analyse how the unemployment acts according to the crisis. Unemployment is bound to increase during a crisis and thus one can see if the numbers start to return to the initial level before 1997 and thus indicating a recovery.
The aim of the thesis is to see how the openness of an economy affects the economy through the gross domestic product growth rate after a financial crisis.
Certain theorists believe that the smaller the economy is the more open the economy will be in general. Smaller economies have to be open to benefit from trade to be able to grow faster and recover from an event of financial crisis. At the same time they will also be more vulnerable to an external shock in comparison to a relatively closed economy.

  • The hypothesis for regression (1) is that the more open an economy is the more vulnerable it is to an external shock.
  • The hypothesis for regression (2) is that the more open an economy is the faster it will recover after an external shock, than a more closed economy.

According to the theory on current accounts there is an expectation that there will be a cur-rent account reversal effect after a crisis. This is due to the private sector money drop caus-ing the capital account to drop and in order to balance this, the current account will have to balance out the negative impact. Which means that if a current account is experiencing negative numbers in one year and there is a reduction of the current account deficit by 4% of GDP then there is a current account reversal. During these circumstances the smaller the degree of openness of a country, the larger will be the current accounts reversal nega-tive effect on growth, causing a larger drop in the year of the crisis. If on the other hand the country is very open the negative effect will be smaller.
In accordance with the effect the crisis has on GDP there will be different levels of recov-ery required for each country. The countries that are most affected will be in larger need to recover faster than those who did not suffer by the same magnitude. At the same time the more open an economy is the faster they can recover due to the use of the more open trade sector, in comparison to the more closed economies.

1 Introduction
1.1 Purpose
1.2 Outline
2 Background
2.1 History
2.2 Previous research
3 Theory 
3.1 The effect of trade openness on GDP
3.2 Current account reversal
4 Empirical Framework
4.1 Method and Hypothesis
5 Empirical Results 
5.1 Unemployment
5.2 Gross Domestic Product
5.3 Current Account
5.4 The relation of the 1998 GDP drop to Openness
5.5 Openness of countries and growth
6 Conclusion 
References 
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The Impact of Trade Openness on Gross Domestic Product A study of the Asian Financial Crisis

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