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

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130(o¶

The Effects
of Protectionism

on a Small Country
The Case of Urutguay

BY
EDITED

AND


JAIMEDEMELO


The Effects
of Protectonism
on a Small Country
ne Case of Uruguay

WORLDBANK

REGIONALAND

SECTORALSTUDIES


The Effects
of Protectionism
on a Small Country
The Case of Uruguay

EDllEDBY
MICHAEL
CONNOLLY
AND
JAIMEDEMELO

The Vorld Bank
Was4ingAm,D.C.


@ 1994 The Enternational Bank for Reconstruction
and Development J The World Bank
*X- - 1818 H Street N.W., Washington, D.C. 20433
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Manufactured in the United States of America
First printing May 1994
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Bank, 66, avenue d'IWna, 75116 Paris, France.
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.
an(World 3ank regional and sectoral studies)
p.
Includes bibliographical references.
-ISBN 0-213-2788-7
1. Protectionism-Uruguay.
2. Uruguay-Commercial
policy.
II De
.
L Cormolly, Michael B. (Michael Bahaamonde), 1941IL Series.
Melo, Jaime.
1994
HF2016.E36
94-7420
382t'3'09895-dc2O
CIP


Contents

Preface

vii

Acknowledgments
Contributors

ix
x

1. The political economLyof protectionism in Uruguay
Michae B. Connolly andjfaime dieMelo

Protectionism and stagnation: an inter

:14

Midhael B. Connoliy and faine dieMelo

3. Adminiteed protection: reference prices and
minimum export prices
45
FMaimo Ckangnna quitand PatTinkA. Merssalin

4. Domestic content restrictons and compensatory export
requirments in the automobile sector
64
Wendy Takacs

5. Gains and losses from bilateral trading arneet
81
with Argentina and Brazil
Jai=e de,melo,CJudio mantene4 gro, and Wendy Takacr

6. T~helabor market and trade reforun in mianufacturing
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
and growth
150
Jorge F Roklds

iM

108


: Preface
Why have we put together this volume of essays on protectionism in Uruguay
when there are alreadyvexcellent comprehensive stUdies of the broad2aSpects
ofprotection in th-at country (Anichini, Caumont,and Sjaastad 1978; Favaro
-and Spiller 1990; and Favaro and Sapelli 1990)? We see at least four reasons
for further analysis.
Firt, pr-evious work has concentrated mostly on describing the protective measures rather than an-alyzing their- consequences and trying to quan-tify their effects on resource allocation, growth, antd welfare. The essays in
this volume go into more detail on the various regulatory mechanisms,
modeling the protective instruments and quantfifjng their effects. For example, the modeling and analysisof so-called antidumping mechanisms such
as refernce prices (chapterS3) is novel, detailing not only the magnification
effects of protection but also its. undesirable side effects on the quality of
dom estically produced manufactured goods. Since proposals for simil-ar
mech anisms are often put forth in developing countries, such in-deptdexploration can guide the analysis of their effectswherever such measures might.
appear. Similarly, the modeling -and welfare analysis of the automobile assembly industry (chap ter 4) provide a unify~ingfr-amework for analyzing the
welfare costs of such 'screwdriver" assembly operations anywhere.
-Second, economists should be interested in the essays in this -volume
because the policies analyzed have been adopted in many other countries.
Each chapter develops and uses an analytical -approach to examine the p:articular measure under study, followed by empirical measuremen't.
Third, tiinre is an interest for the policymaker. The essays go beyond
quanrilying thfeeffects of trade interventions to show the interactions between
various forms of intervention (between labor markers and protcecdion in
chapter 6, between protection and rent seeking in chapter 2, or between
market intervention and resource allocation in chapter 7). Thus, the essays
show the harmful effects of protectionism and of excessive intervention gen-


viii

Eflncr oFPWYrCoNLSM
ONA SMALCOUNmr THECAS OF URUCUAY

erally on a small economy, providing vivid examples of policies to avoid assiduously-notably those associated with antidumping, the promotion of
infimt industries, and non-price protective measures in general.
Finally, Uruguay offers an excellent laboratory for studying both comparahivelyandindividually the consequences of highlyrestrictive regulations
for a small economy, bringing out elements of relevance to many current
economic problems in the world today. A case in point is that of the socialist
econonies in transition and of the small states of the former Soviet Union,
such as Georgia and Armenia, which share many of the characteristics of
Uruguay. This volume is therefore a useful compendium for students, analysts, and policymakers in small economies that stand to reap considerable
benefits

from a more open tading

pattern.


Acknowledgments
In December 1989 we visted Uruguayunder the auspices of thejoint United
Nations Development Program (UNDP)-World BankTrade Expansion Program (TIEP)and subsequently delivered a report in june 1990to the Uruguayan governmen t, Untguay: Trade Reform andEconomicEffidaucp. Often, in
policy work, analysis and advice have to be produced on short notice. This
,missionwas no exception. However, for most of us, unanswered questions
remained& We wanted to probe deeper into the complex Uruguayan trde
regime. This volume is the outcome of the follow-up work.
from support and advice from friends and
Throughout we .:benefited
R : s-~~~~~~~~~~i
colleagues in Uruguay-. rrmon Diaz and Elbio Nattino at the Central Bank
were most generous with their time. So were Luis Macadar and Martin Ramia
at the CGentrode Investigadiones Econ6mnicas-Uruguay and Jorge Roldos,
Glaudio S-apeui, -and Luis Vian-a at the Centro de Estudios de la ReaHidad
Econ6micay Social, who provideduswith helpful suggestions along the'wayCarls Rodriguez of GEMA.in Argentina also aided the mission.
At the World Bank, we were fortunate to have the un6iling support of
Eric Abalahin, MariaAmeal,jeff Hayden, and Rebecca Sugui. We also thank
Men 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 ftragicdeath during
our mission. This volume owes much to his encouragement, and we hope
that lie would have found it a useful contribution to the study of protrectionism in Un:guay.


Coyntributors
Federico Chnmganaquf
Trade Policy Division, World Ba-nk
Mfichael Connofly
Departmnent of Economics, University of Miami
jaimnede Melo
Trade-Policy Division, Worldl Bank, -and University oFC-eneva, Switzerland
Patrick Messetlin
IntemnationalTrade Division, World Bank
Claudio Monteneo
Trade Policy Division, World Bank
M4ardin
Ran
Trade Policy Division, World Bank, and Centro de Investigaciones Econ6micas,-Uruguay (CIVE)
David Rolnd;Hoist
QEGD Development Centre and DepartraLent of Economics, Mills College
Jorge Roldos
International Monetary Fund and Centro de Estudios de la Realidad Econ6-_
micay Social (CERES)
Wendy Takacs
Trade Policy Division, World Bank, and Department of Economics, Ucniver
sktyof Marland, Bfaltimore County


The political economyof
protectionism in Uruguay
M.ichael B. Connolly andJaime de Melo

I~~pa

Under the presidencies of Batile y Ordoiiez in 1903-07 and 1911-15 Uruguay created progressive democratic institutions and awellhire state thatmade
it the most advanced, yet regulated, country in Latin America by the middle
of this century. With ahomogeneous population and awell-functioning democratic system, this small country of less than 3 million people was know in
the early post-World War II period as the "Switzerland of the South.' Four
decades later the country had undergone a precipitous decline that put it
an xing the least prosperous middle-income counties.
Afew comparative figures tell the stozy.In 1950Uruguay's GDPper 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 European countrieslike Belgium ($4,151) or Demnark ($4,512). In the Republic
ofKorea, a country hailed today as a major development success, CDP per
capita inl1953-was $822. In 1960 school enrollment ratios inUruguay reached
11l percent at the primary level and 37 percent at the secondarylevel. The
corresponding figures for the European countries are 109 percent and 69
percent foriBelgium and 103 percent and 65 percent for Denmark; and for
Korea, they are 94 percent and 27 percent)
Uruguaywas definitely amaongrthe mostdeveloped countries in the world
in1950. Measured in purely economic ters Uruguay's GDP per capita was
among the highest in a group of thirty-fivecountries with a GDPper capita
position detenear $3,800
in 1950 (in 1985 prices). But
relative ndeRpbi
remrUruguay's|452
onrelleBlim411
rirated so sharply chat by 1988 it was among the last in that grup (figure
1.1). This economic dedine was accompanied by social unrest and political
crisis. What happened?
The essaysin thisivolumenareaboutthe cononeiczaspectsof this decline,
primarily the economic polides that accompaied it They examine the
mechanisms bywhicli these polices particuarlyprotectionism in allitsforms,


EmCTSOFPtOTECrONISM
ONA SMALL
CouNTRY:
THECAsEOFURUGUAY

.2

Figure1.1 Uruguay'sGDP per capitarankingamongthirty-five
economies,1950-88
* semi-industrial
RCnk

5
I0
AL
20
25
30
35.
1950

1955

1960

1965

1970

1975

1980

1985

Ausbala,
Austia,Barbados,
Belium,
areincludedinthesample;
Argentina,
Now ThefoAowing
economies
Canada,
Chile,Cyprus,
Denmudk,
Finand,Rance,
Germnan
GreatBritain,
Greece,
HongKong,
Iceland.
Norway.
PRrWgal,
Sngapore,
theNetherlands,
NewZealand,
Irelnd, srael,
lb1 Japan,lxembour Mexico,
States,
Unrguay,
andenezuela.
Swiezaland,
Taiwan
(China),
theUnLted
SouthAfiia Spain,
Sweden,

contributed to Uruguay's economic deterioration. Policies applied to the
manufctuning sectorand their economywide consequences receive the closest attention, even though much intervention and regulation also took place
in agriculture. While the essays focus on the Uruguayan economy, the regulations and distortions examined are pervasive in a large number of countries. In many respects, Uruguay is a vivid example of how excessive regulation can bring about economic sclerosis.
Because of its small size, Uruguay should have been pursuing outwardoriented policies to ensure its greatest possible integration into the world
economy. The economy would have benefited from larger markets and the
gains from specialization according to comparative advantage, aswell as from
access to worldwide best-practice technologies and the incentives for adopting them. Uruguay chose instead to protect industry and to tax agriculture,
the sector inwhich ithad a comparative advantage. Thus, Uruguay is a good
example of-asmall country that, despite the obvious advantages offreer trade,
has pursued industralization through import substitution behind a wal of
protection andreguladon. The cost of the strategyhas been astunting of the
export sector, notably agriculture, and a loss of general well-being, due to
the high inefficiency costs of protection.
Ultimately, these inward-looking policies and the rent-seeldng actiities
and 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 country
that attempts to industrialize behind a barier of tariffs, quotas, and adminone like Uruguay, whose obvious long-run
istered protection-especially
comparative 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 industrial base in Montevideo. This resource reallocation promoted an inefficient
industrialization.
-

.

Mechanisms of protectionism
At various times in its history Uruguay has relied on a broad array of instruments ofprotecdon. MoststiR existin the earlyl99Os, though some are being
reformed. They have proved to be a strong force fornearly two hundred years.
Tariffs and referenceprices
The most widespread and certainly the best known restrictions on trade are
tariffs. 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 tariffs
raise the domestic price of the importgood in the marketplace. The two forms
are equivalent in the sense that, appropriately defined, they have the same
effects. Tariffs have the familiar protective effect on production and a tax
effect on consunption. 2 In Uruguay official tariffs are often applied to a reference price rather than to the declared ci.f. import price (see below and
chapter 3), which is likely to magnify the protective effect of the official tariff.
QzotsQ!uotas specify arnaximum physical quantity of a good that can be imported.
The quotais bindingwhen the maximum amount specifiedis less than would
otherwise 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 different, however, because the revenue does not go to the treasury. A volunlt
export restriction is a quota on foreign exporters that confers on them the
scarcity value of their exports to the domestic market The restriction may be
voluntary in name only since there can be an implied threat to impose duties
* or quotas ifagreement is not reached on the voluntary levels.

. -

i


4 -

FXmcas0oFPtoTECnONISl ONA SMALL
CoUNmRx.THE CASEor URUGUAY

Licenses
Alicense transfers an official right to import undera quota or other restricton arrangement to a single individual or a few individuals. The license may
be given away, sold at a negotiated price, or auctioned off competitively.
When the import license is given away, the holder of the license captures
the scarcity value amounting to what otherwise wouid be tariff revenue.
Under a fiullycompetitive auction, by contrast, the government captures the
implict revenue or rent represented by the auction price of the license. Licenses can be used in conjunction with a quota or tariff or they can be issued for unlimited amounts of imports. For instance, the cuposdiscussed in
chapter 5 are export licenses for goods that enter Argentina duty free under bilateral agreements.
Domestic content requirements and compensatoryexports
A less well known form of protection to domestic industry and suppliers is
the domestic contentrequirement,which stipulates thatproduction processes
use a mninimumpercentage of domestic materials and inputs as part of value
added. 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. In
Uruguay 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 rompensatefor their imported parts. The
assembly industry, in turn, was protected by a tariff of 40 percent for fSlly
assembled automobiles in 1990 and compensatory export requirements for
imports of finished vehicles (see chapter 4).
Ad hoc antidumpingprocedures
While antidumping legislation is commonplace, its effects are seldom analyzed.Antidumping measures can be used to effectivelyraiseprotectionrates
on a goodjustas when customs imposes a duty based on a higher reference
price instead of the declared ci.f. price of a good. Because reference prices
have a stronger effect than an official duty-a reference price twice the declared cif. price has an effective duty twice the official duty-domestic producers are likely to lobby for higher reference prices. A stricter form of reference price known as the minimun export price collects, in addition, a
moving surcharge on imports equal to the difference between the reference
price and the dedared ci.f price, leaving the importer litde incentive to


Thepoiicaltavonmy oftprteaion

in Unrguay

5

declare a price less than the reference price. These procedures do not conform to GATT antidunmping or counterailing duy provisions. (The reference pnce system is analyzed in detail in chapter 3.)
Prior deposit reqtirements
Requiring advance depo:its for the inportation of goods is equivalent to
imposinga tax on these funds equal to the opportunity costofholdingmoney
since the deposits typically do notearn interest. Where the nominalinterest
rate is established freely in the market, the implicit tax rate on prior deposits
equals the nominial interest rate. With interest rate ceilings the implicit tax
equals the real rate of return in the economy pius the inflation rate. Naturally, zero nominal interest on prior deposits combined with a high rate of
inflation mayresultin an extraordinarilyhigh tax rate on prior deposits and,
consequently, on importing. Unti 1975 importers were required to make
advance deposits for imports which, at a time of high inflation rates, inplied
high taritf equivalent rates (see chapter 2).
Government procurement practices

Government procurement regulations or practices may give partial or complete preference to nationallyproduced goods over imports. This policymay
be formallyincorporated in a 'buynational"law orinf-ormaly implemented
through preferential purchasing practices. The poiicy has an obvious protective effect on domestic production since it allows domestic producers to
charge more than world prices. Industrial countries often usify national
preference in procurement on strategic or national defense grounds. In
Uruguay, govremment preference to national goods in procurement occurs
more by custom and practice than for explicitly stated goals. (Government
procurement practices are not discussed in this volume.)
Export banrs

Export bans are usually set to protect a downstream processing industry. An
export ban on a specific good has a protective effect because itlowers its domestc pnce, which provides asubsidy to producion processes Usingte input
since they pay less than the world price. Export bans tend to induce smuggling, however. Uruguay previously had export bans on hides and cattle on
the hoot; which protected the meat pacling and leather industries. The ban
was easy to evade by walking cattle over unattended borders. (Export bans
are not analyzed in this volume.)


ONA SMALL
CouNTRv THE CASEOFUwRUuAY
;-6 -;EFFECIS or PRDTECIIOMS

Mudipe exchngw -rat
Charging different exchange rates for different types of foreign exchange
transactions, whedter on the import or the export side, amounts to having a
different tariff or subsidy rate on each good according to the exchange rate
used.When an importer of a luxury good mustpay apremium of dpercent
greater than the official foreign exchange rate as well as a tariff of t percent,
the effective tariffisraised by dpercent compared to imports enteringat the
officialrate. Similarly, a foreign exchange bonus of spercent paid to exporters for repatriating foreign exchange amounts to an export subsidy ofspercent relative to the official rate. Until the 1970s Uruguay had a widespread
system offoreign exchange nintegrosor exportbounties. These are discussed
briefly in chapter 2.
Administered and hidden potection
Trade and transport costs thatmust be paid on imports and exports provide
extra, often hidden protection to import-competing actvities. Studies have
found such costs to be significant in industrial countries. They are likely to
presentan even greater baflier to trade in developing countres. In Uruguay
portalhclities are veiyineffidentby intemtionalstandards, anda stronglabor
movement adds to the impediments to trade through strikes, delays, and
featherbedding (see chapters 6 and 7). Another distortion arises from the
been obtained
bywage premiums tatmightnothave
ineffiiencygenrated
3
by labor unions had protection not existed.
Sources of inefficiencies in highly regulated economies
Whatare the mechanisms throughwhich such instruments of protection get
translated into economicinefficiency? Trade polices are anatural firstplace
to look for the cause of failure in Uruguay because small countries need an
open trade regime to overcome the limits imposedbysmall domesticmarkets.
Considerwhat happens when there is excessive regulation. Manufacturing firms become less efficient as their choice of optimum output level and
input mix is restricted. Regulations affecting input markets all have an effect. Fims are impeded by labor legislation from adjusting theirworkforce.
Managementofinventoriesis complicatedbyuncertaintyaboutwhetherand
when firms wi be -ableto import spare parts and raw materials. Enterprises
are unsure abouthow much capital theywil have access to-and atwhat cost.
In heavily regulated economies finns aIso operate in restricted product
markets. There are barriers to the entry offoreign companies. New domestic
firms 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 producers and their creditors. Barrers to entry, of course, benefitexisting firms
bygiving them more leeway in their pricing polides. Thus, finns sufferfrom
some of the restrictions and benefit from others.
Made-to-measure protectionis commonin highlyregulated economies,
a situation that guarantees the coexistence within a sector of firmswith large
differences in efficiency. Indeed, in such economies most firms are ineffident The level ofprotection is often chosen to make the least efficientfirms
profitable, so many fins can operate at a profit with dated machinery and
equipment (technical ineffiiency) or too many employees. Too many ofthem
operate at too small a scale (scale inefficiency), fail to equate marginal productswith factorcosts (allocative inefficiency), and price theirproducts above
themarginal costofproduction (priceinefficiency). Because consumershave
nowhere else to turn, leading firms can charge higher than normal markups, and other finns wi follow. Firms with a wide range of technical efficiency thus coexist, leading to high rates of idle capacity and unproductive
work forces.
In addition, the incentive system is distorted because protection has been
tailored for individual products to ensure the survival of firms already in
operation. The made-to-measure protection usually indudes quantitative
restrictions that give rise to enormous rents and induce economic agents to
expendmuch oftheir effort-appropriatingrents rather than engagingin more
socally productive activities. Resources are badly allocated and underused,
and the resulting market structures are not compeatirve. The efficiency of
investmentis low, growth is slow, and the economy stagnates. This is the story
of Uruguay, but the messages are clear for other developing and trnsition
economies.
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 restricting
trade. What lies behind this reluctance to liberalize is the uncertainty and
the redistribution of income that typically accompany trade liberalization. A
great amount of income redistribution-whose
exact outcome is unknown
in advance-must take place to achieve a small amount of efficiency gains
from expandedtrade. Unless the economyisin dire circumstanceswithhigh
inflation and impending economic collapse, the gains from trade lhberaliation will not be enough to compensate for the income redistribution in the
political calculus of voters and the government
This argument, put forth by Rodrik (1992), can be demonstrated by a
simple graph illustting the gains and the redistibution of income associ-


8

Etncrs oF PROTEaCONISM
ONASMALLCOuNTRY:
THE CASEOFURUGUAY

ated with. elminating an import quota. In figure 1.2 the distance SOrepresents a quota that has the effect of raising the domestic price to p, which is
above the world price p*. Import license holders can purchase the quota
amountat the world price for p*(SD)and sell it at the domestic market price
forp(S), realizing rents equivalent to area rcDomestic producers are able to
expand their production to the quantity S thanks to the higher domestic
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's
surplus, 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 from
the decline in consumption at the higherprice associatedwith the quota and
equal to area dRemoving 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 + dThe point of Rodrik's analysis is to illustrate thatincome redistribution
is large relative to the net gains to the economy. He proposes ameasure that
computes the total redistribution of income divided by the net gains minus
one, or the political cost-benefit ratio (PCBR) of trade liberalization:
(LI<)

PCBRR= (a + b + c + d)-(b
b+ d

+

d)

a + c
b + d

jist

Figure 1.2 Distributional effects of quota removal
Pice

a

b

c

d

Demnand
5

~D

Quantity


The politicaleconoy of protectionismin Uruguay

9

where p. is the share of imports in domestic consumption, Eis the absolute
value of the elasticity of import demand, and t is the tariff equivalent of the
quota. Rodrik shows that PCBR is likely to be small for most trade liberalizations taken alone.
Take the case of the 1974-82 trade liberalization in Uruguay as an
example- The share of imports of goods and services in domestic consumption private and govenmment, (p.)was 0.184in 1974, and the initial tariffand
tariff 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 of
redistributon are substantially greater than the benefits of trade liberalization.
Combining trade liberalizationwith economic stabilization that benefits
all individuals in the economy lowers the PCBR markedly, silice it is now
measured by:
(1.2)

PCBR =

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 share
ofimportables in GNP (Rodrik 1992). Thus, coOrepresents the improvement
in the terms of trade weighted by the share of importables in GNP. This revised fornula suggests that the costs of trade liberalization fall dramadcally
relative to the benefits when stabilization measures undertaken during dire
economic circunstances result in a return to prosperity. Now consider the
PCBR for Uruguay in 1974 when stabilization and recovery are taken into
accounL Assume an annual increase in the growth rate of 3 percent for 10
years-an approximation of the increase ir. growth during 1974-82 (see
chapter 2)-and a discountfactorof5percent. Individuals' wealth (y) would
increase by 19 percent. If importables fall 70 percent (co) in tenns of
exporcables 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 index declines from nearly 3 to less than 1 as a result of the additional benefits of stabilization.
Or consider the case ofjust one industry in Uruguay, the automobile
assembly industry. The elaborate system of protection of the industry results
in large efficency losses and tansfers to local assemblers and parts suppliers. Wendy Takacs estimates that the bulk of efficiency losses and transfers
comes from the assembly industry rather than from the components industry (see chapter 4, table 4.1) . She estimates annual effidency losses from the
system of incentives benefiting the assembly industry at $26.9 million and
annual transfers of$39.8 million. The redistributions thatwould occurwidh
reform are thus-nearly one and one-half times the efficiency gains.


:10

EFFECS OF PROTEoNISM ONA SMALLCouNTRY.THE CAsE OFURUGUAY

These estimates are also useful n elucidatingwhy the automobile industry 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 Apm
proximately 12,000 vehicles are sold a year, on which the average additional
cost of protection to the consumer is $6,834 per vehicle. Takacs calculates
that the total efficiencyloss (including the componentindustry) pervehicle
is $2,427. The annual benefits of protection in the automobile industry are
estimated at $14.3 million for each of the two largest firms. It is no wonder
that there is strong incentive to lobby for protection on the parts industry
andinsuffidentincentive to lobbyagainstprotection on the partofcorisumers. 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 of
protectionism and stgnaton in Uruguay. Tariffschedules in 1815 provided
fora general tariffof25 percentwith some exemptions and amaximum tariff
of 45 percent. By 1829 the general tariff rate had been cut to 15 percent and
the maxinum was 25 percent-the first know.n instance of trade liberalization in Uruguay. The authors stress the political poWer of the city of
Montevideo in distributing income away from the country and toward the
ctybyimposinghigh 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 and
investment rates.
In chapter S Federico Changanaqui and Patrick Messerlin focus on cisguised protectonism in Uruguay through administered reference prices that
are used as the base for tarifflevies. Their theoretical analysis shows that this
disguised form of protectionism, by providing more protection for goods
whose price falls below the reference price, induces Uruguayan producers
to specialize in low-price, low-quality products, contrary to the county's
comparative advantage in products requiringhigher skilled labor. High-price,
high-quality import goods with prices above the reference pnrce escape administered protection, which fvors their consumption. Thus, an unintended
effect of the reference price system is to encourage production of low-quality goods and the consumption of high-quality goods. Changanaqui and
Messerlin analyze the protective effects ofadministeredpricesapplied to 500
products and find that protection is strongly "magnified "
In chapter 4 Wendy Takacs models the complex system of pro tection in
the 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 on
how not to provide for growth and technical change. The combination of
high tariffis (40 percent in 1990) on assembled automobiles, low tariffs (10
percent) on automobile assembly kits, domestic content requirements, and
compensatory export requirements encourages the local production of automobiles by finns thatassemble the imported kits. The cost to the consumer
per car assembled in 1990 of this high effective protection is estimated at
more than $6,000-more than half ofittransferred as arent to the automobile 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 of
domestic content and compensatory export requirements, mechanisns all
too often used to promote industrialization. Ihe industries that grow prosperous tmder this type of protective regime will lobby for contnued protection 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 Takacs
deals with tdie gains and losses from bilateral trade agreements with Argentina (Conveno Argentino-Uruguayo de Cooperacion Econ6micaor CAUCE)
and Brazil (Protocolo de Expansion Comercal Uruguay-Brazil orPEC) - The
authors deve!op a theoretical model of the effidency and rent transfers
impliedby the arrangements. They thenapplyagravitymodel to intaregional
trade to estimate the increase in the volume of trade with the region resulting from these preferential arrangements. The accord widt Argentina seems
to have allowed uncompetitive manufacturing exports to that country, while
th-atwith Brazil concentrates on Uruguay's exports in agricultural and natural resource-based products, more along the lnes of Uruguay's pattem of
comparative advantage. Under the agreement with Argentina Uruguayanexports enter duty free but are subject to a cupoor export coupon that rations the rights to export to Argentina as a share of the Argentine market.
Under the agreementwith Brazil the cupos are negotiated quantitiesrather
than shares of Brazil's market Both systems could result in rents that allow
inefficientfirms to continue to export, though econometric analysis of price
data does nor reveal any significant rents.
In chapter 6 Martin Ramaanalyzes the labor marketand trade reform in
manufacturing and asks whetherunionizaion blocks the effects of trade liberalization. The Uruguayan case provides experimental conditions For answering this question since some of the trff reforms took place under the
penod of authoriarian rule, when unions were forbidden. Barriers to trade
give rise to rents to domestic firms, thus providing an incentive for labor to
uionize and attempt to negotiate wage increases to capture some of these
rents. Ramafinds that sectoral union membership rates in industrial sectors


12

ONA SMALLCouNTr1y
EFmCS OF PROTECTIONISM

THECAsEOPURUGUAY

are correlated with indicators of market power of domestic finns, including
an mdustry concentration index and the effective rate of protection. Analyais of forty manufacturing sectors over six years shows that the employment
elasticity 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 equilibrium model to quantify the economywide welfare losses due to the combinedinfluence of trade-and factormarketdistortions. Buildingon theanalysis in chapter 6, the model incorporates the effects of labor union activity,
settingupan interaction between trade policyand the determination ofwages
at the sectoral level. The simulations suggest that the system of administered
Jimport prices distorts the Uruguayan economy more than the tariffs themselves.The costs of administered protection-removing administered prices
couldadd4percentto GDP-farexceedthose due to tariffs.Addingresources.
squandered in rent-seeking activities could raise the total cost of administered protection to 8 percent of GDP. The simulations also suggest that as a
consequence of removing administered protection, nearly 4 percent of the
labor force (or 50,000 workers) would have to relocate, explaining some of
labor's resistance to trade reform in Uruguay. Resources would flow from
formerly protected sectors to agriculture, casing an expansion of up to 15
percent, and light manufactures. The immense difference in trade margins
between imports, at 35 percent, and domestic goods, at 9 percent (see chapter 3), would also shrink, although the notorious ineffidency of the Port of
Montevideo probably contributes substantially to this marked difference.
Chapter 8 byJorge Roldos provides a long-run perspective on the relationship between trade policy and ec -omic growth. Based on endogenous
growth theory, Roldos tests for increasing returns to scale in Uruguay using
neoclassical production functions. While the sum of the capital and labor
exponents is greater than unity, it is not possible to reject the null hypothesis
of constant returns to scale, so specialization according to comparative advantage does not appear to lead to significant economies of scale, at least at
the economywide level. Calculations of the Solow residuals show total factor
productivity to be correlated with export growth, suggesting that export
externalities help explain the residuals. Roldos finds cross-sectional support
for the hypothesis that trade openness isassociatedwith a high rate of growth
in GDP per capita and that Uruguay's growth was lower than the cross-section model predicted.
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-


ThepoEtliticaecmnmy ofprotectionismin Unrguay

13

Lionsfor 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 comparisons 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 percentagc 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 restricted or prohibited for health, sanitary, or environmental purposes. Since such restrictions and prohibitionsmay have astrong protective effect, domestic producers may
lobby to enact them. This ype of restraint is not used in Uruguay.

References
Anichini,JuanJose,Jorge
Caumont, and Larry Sjaastad. 1978. La Poittica Comercialyaz
-+otecci6nen dUruguay. Montevideo: Banco Central de la Repfublica Oriental del Uruguay.
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 ojTradeLibera za iom London: Basil
Blackwell.
Olson, Mancur. 1965. The Logic of ColctdiveACtion:Public Goodsand the Thwny of
Goods.Camnbridge, Mass: Harvard University Press.
Rodrik, Dani. 1992. 'Me Rush to Free Trade in the Developirng World: WhySo Late?
Why Now? Will It last?" NBER Working Paper 3947. National Bureau of Economic
Research, Cambridge, Mass.
Summers, R., andA. Heston. 1991. 'he Penn World Tables (Mark V):An Expanded
Set of International Comparisons, 1950-8." QuarterlyJoumnal of Econodcs. Mar.
327-68.


Protectionism and stagnation:
an interpretative history
Michael B. Connolly and faime dieMelo

Uruguay has such a long history of pro tection thatwe could have called this
chapter 'Two hundred years ofprotectionismY' High levels of protection of
manufacturing were maintained by taxing agriculture, the main activity in
which Uruguay has astrong comparative advantage. Whatwere the causes of
the early protectionism, and what have been its consequences? This book
prvdes some answers by analyzng several f-acets of protectionism in
Uruguay's recent history. Most of the chapters deal with the welfaLrecosts of
the inefficiendies introduced by the various forms ofprotectionismn-tariffs,
administered prices, bilateral trading arrangements, and local content requirements. Chapter 8 takes a longer-run perspective on the relationship
between the trade regimne and growth since the 1950s.
This chapter complements the more specific analyses that follow by providing -an overview of protection against which to judge the rel-ative imnportance of the various instruments of protectionism in Uruguay. Italso pl-aces
Uruguay's overall performance in a comparative context, -and for the reader
unfamili-ar with Uruguay's economic policies, the chapter sketches some of
.the milestones in the country's long history of protectiomism.
*
What is striking in this description of protectionism before World War
II is that a large nulmber of the protective instruments :adopted in the
nineteenth century are stil around today. The p-anoply off measures that
emerged during the deepening of protection from the 1950s.up to.the
1974-82 liberaHization episode is typical of the measures implemented by
countries following a development strategy based on industrialization
through import substitution. Under the militar rule of 1974-82 and later
* after the retum to democracy in 1985, wide-ranging reforms were canTied
out A fascmnating aspect of the 1974-82 period is the apparent break in the
downward trend in postwar economic performance (see figure 1.1 in chapte-r 1). It is tempting to concdude that this resumption of growth resuflted
from 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 the
economy.
To any student of the influence of economic policies on performance,
the causes of Uruguay's stagnation are as fascinating as those of the Asian
economic ½miracle." In exploring the contribution of various factors to this
stagnaadon, we start with a comparative analysis of Uruguay's growth performance, noting an improvement in its relative position following the 1974
refonns. We fit a simple cross-country growth model to a sample of thirty-five
comparable developing countriesand find thatneitherinvestmentlevels nor
initial conditions (GDP per capitaandeducationlevels) satisfactorilyaccount
for Uruguay's poor performance. Uruguay's perfonnance is worse than predicted 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 and
relate them to the pervasive regulation of the economy. And we consider
whether there really was a break in performance after the 1974 reforms,
looking at evidence of changes in investment and savings behavior and at
the role of external shocks. We conclude that there was probably a slight
inprovement in performance attributable to the reforms carried outin 1974,
but as the more detailed analyses in the remaining chapters in this voluxme
suggest, Uruguaywas stillahighly distorted economy by the end of the 1980s.
It is difficult not to conclude that the system of regulations and protection in Uruguay has been made-to-measure. In the end, protection was
adopted more in response to lobbying acdvity than as a part of a rational
design to promote industrial activities. Ramna(1993), in a detailed examination offoreign trade legislation between 1925 and 1983, counted 1,849 pieces
oflegislation that explicidy identified their promoter. Rana translates one
of them, dernvingfrom an application in 1937 concerning Sacman-type cIay
tiles: "Mr. Horacio Acosta y Lara, proprietor of a nadonal firm manufacturconsiders that the low price on which customs tariff is
-ig this product...
based damages his own interests and puts him at a disadvantage relative to
foreign industry.'
-What accounted for this made-to-measure trade regime? Industrial concentration must have piayed an important role. The manufacturing sector.
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 in
1960). 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 firm
from that action, and hence the more intense the lobbying activity.
Considering this strong lobbying for protection, it is natural to ask how
much the reforms of tie 1970s and 1980s actually reduced effective protec-


- 16&

COUNTRY:
THECAsEOFURUrUAY
ONA SMALL
EMCIS OFPROrEcmToMNsM

tion.Analysis suggests that, atleastuntil the mid-1980s, the reforms progressively eliminated primarily redunadantprotection, with tariff reductions having little effect on the spread between domestic and international prices
(Macadar 1988). These estimates, based on compaisons of domestic and
foreign comparable products, are approximate -at best. But it is clear that
Uruguayhas alow trade share in GDP forits size, despite a noticeable increase
in the share of exports in GDP following the reforms begun in 1974 (figure
2.1). These reformnswentalongway toward removing the most egregous trade
restrictions, such as the prohibitioni of' capital goods imports, but Uruguay's
foreign 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 wasan exception), holding swayuntil
1850, when a bilateral trade accord betweenFrance and Great Britain ushered in an era of free trade in Europe. Uruguay, npervious to Britsh influenceand to commercial interests, continued to pass stiff amrifflawsthat discriminated increasingly against consumer goods.
Poor harvests, diminished livestock outputand accumulated fiscaland
merchandise deficits led to the agricultural and finanial crises of 1874, and
then to the first attempt to simultaneously protect Uruguay's nascent indusFigure 2.1 GDP and exports (three-year movingaverages), 1935-92
(billionsof 1978pesos)
Expans
12

Output
5040

oigaeae)

Fgure
and 2.1
fflc~~~~ports
GDP

959

4treya
8

Otu

30

6
20

2

10
0
1935

0
1945

1955

1965

SO&CeAuthors!calculations,basedon CentbalBankof Unrguaydata.

1975

1985


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