The G-20 Summit and Global Trade: Restore Credit and Resist Protectionism

March 14, 2009

The Group of Twenty (G-20) major nations accounting for 90% of the world’s gross domestic product, 80% of its trade and two-thirds of its population will meet in London beginning April 2, 2009. They plan to discuss the cooperative steps necessary to bring the current economic crisis to a speedy end. If history is any guide, measures to roll back creeping protection and move the process of trade liberalization forward ought to be high on their agenda.

The Smoot-Hawley Tariffs Act of June 1930, which quadrupled the then-effective tax rate on several thousand imported items to 60% and brought swift retaliatory response from the major U.S. trading partners, accelerated the spiraling down of trade flows worldwide.

According to the State Department, between 1929 and 1932, the U.S. exports to, and imports from, Europe fell 67% and 71%, respectively. This rapid decline contributed to the deepening of the economic depression.

The lessons of the Smoot-Hawley tariffs have not been lost on the policymakers around the world in the midst of the current crisis. They recognize that international trade today accounts for a much larger proportion of the GDP than at the beginning of the Great Depression in virtually all nations. The likely damage to their economies from a trade war aimed at securing domestic markets exclusively for domestic producers is many times what it would have been in the 1930s. Unsurprisingly, despite shrinking demand across the board, no trade war has broken out and few observers suggest that it is likely to break out in the future.

Nevertheless, international trade has been rapidly shrinking in the wake of the U.S. financial crisis and protectionist measures are creeping into the national economies. Both developments pose a threat to faster recovery and long-term growth prospects. The G-20 must address them head on when they meet in London.

There is no doubt that a key factor behind declining trade is the declining demand around the world. Therefore, a part of the solution to the revival of trade lies in the revival of the economies themselves. But trade has been impacted disproportionately more than the GDP.

For instance, the U.S., which declined 6.2% in GDP terms during October-December 2008, saw its exports and imports plunge 23.6% and 16%, respectively, during the same period. The decline in trade has been much sharper in many emerging market economies. India and China, which managed to register GDP growth rates of 5.3% and 2%, respectively, saw their trade flows shrink at double-digit rates during October-December 2008. Other Asian countries, including Japan, South Korea, Thailand, Taiwan and Singapore, have suffered much worse fates.

A key factor behind the spectacular decline in trade flows has been the breakdown of trade credit. Once a firm has an export order, it needs credit to finance the production and sale until it receives payment from the buyer. The bank that offers such credit may require the firm to obtain insurance cover for the loan in case of nonpayment. The importer faces the risk of nondelivery.

In all likelihood, the general breakdown of credit markets has asymmetrically impacted international trade transactions. With the exporter and importer located in two different countries, information asymmetries and the resulting distrust are deeper. The complex organization of production activity whereby components and raw materials for any product are imported from a number of different countries has made matters worse: A breakdown of credit markets at any link in the chain can adversely impact the entire chain. The G-20 must assign a high priority to restoring the provision of trade credit.

The major nations meeting in London must also take steps to arrest the creeping protectionism. Though the WTO rules have provided considerable restraint on the deployment of protectionist measures to shore up domestic market for one’s own producers, protection has risen through two channels.

First, stimulus packages have had an element of subsidy to domestic firms that violates the WTO rules and serves as a protectionist measure. For example, the subsidy element in the credit to the U.S. auto industry helps GM and Chrysler at the expense of auto imports and violates the WTO rules in goods trade. Likewise, the vast bailout packages to the U.S. and European banks are on shaky grounds under the WTO rules on trade in services.

Second, countries have resorted to protectionist measures using the flexibility available to them within the WTO rules. A prime example of this is the “Buy American” provision of the U.S. stimulus package. True, the Government Procurement Agreement is confined largely to industrial countries and allows the U.S. to discriminate against nonsignatory countries like India and Brazil. But this only encourages these latter countries to retaliate by raising their own tariffs on the goods the U.S. exports to them.

As long as the applied levels of these tariffs are below the bound levels to which they have committed at the WTO, the countries are legally permitted to raise them. In addition, the countries also have recourse to anti-dumping and related measures to retaliate. In London, G-20 must strive to avoid the use of both WTO legal and WTO illegal measures that try to divert demand toward domestic producers. Such diversion, when pursued by all, will yield no net gain in demand to any single nation. Instead, reduced trade will slow down recovery and also result in the loss of the gains associated with international trade.

Finally, the obvious must be stated. At least some concrete steps to move the Doha negotiations forward rather than just an expression of commitment to its eventual completion must be taken. By appearing ambivalent to the Doha Round, the Obama administration strengthens the existing impression that its commitment to worldwide free trade is at best weak. This in turn emboldens countries to resort to demand-diverting protectionist measures with greater callousness and contributes to the delay in recovery.