The conventional wisdom that reforming economies should achieve macroeconomic stabilization before removing microeconomic distortions rests on three main arguments: the variability of relative prices may impede the realization of efficiency gains expected from price reform; trade liberalization reduces revenues from trade taxes which may be needed during stabilization; and liberalization may require a compensating devaluation, while successful stabilization requires a fixed exchange rate. In Discussion Paper No. 832, Research Fellow Dani Rodrik argues that low likelihood of efficiency gains under high inflation weakens but does not reverse the case for liberalization, which may even increase tax revenues if the positive effects of the ensuing import boom outweigh those of tariff reductions. The most serious problem arises because the exchange rate can only be used as either an instrument to achieve a real target or a nominal anchor for the domestic price level. Unless nominal wages are fully flexible, trade liberalization requires a devaluation to sustain the trade balance and employment. Otherwise an overvaluation will aggravate the real appreciation produced by the necessarily gradual convergence of domestic and world inflation rates.

Rodrik reviews evidence from Latin America's liberalizations since the late 1970s to show that liberalization has certainly increased overall trade, but the strongest gains were in cases where macroeconomic instability was substantially reduced first; whether exports grew as rapidly as imports also depended heavily on the exchange rate stance. In Mexico and Argentina, use of the exchange rate as a nominal anchor led to significant real appreciations, import booms and potentially unsustainable trade deficits. The theoretical basis of the policy dilemma in exchange rate management may also be overstated, since liberalization requires devaluation only when nominal wages are rigid, but this rigidity reflects policy-makers' lack of commitment. A credible commitment to a pegged exchange rate may therefore help to resolve rather than intensify the trade-off between liberalization and stability, although early liberalization may seriously jeopardize the credibility of disinflation.

Trade Liberalization in Disinflation
Dani Rodrik

Discussion Paper No. 832, August 1993 (IT)