Trade reform in the short run: China's WTO accession

Abstract

Because trade liberalisation, taken alone, reduces the home prices of foreign goods, there is a substitution away from home-produced goods and a real depreciation. In fixed exchange rate regimes, this requires a domestic deflation, which can be contractionary in the short run. This paper reviews the short-term effects of trade reform and shows that they are expansionary if the reformed economy enjoys an immediate improvement in allocative efficiency and it attracts a sufficient increase in investment from abroad. These offsetting effects are analysed in the case of China using a global comparative static macro model. The results suggest that a short-term contraction could result if capital controls stifle the inflow of foreign investment. On the other hand, ignoring exchange rate retaliation elsewhere in Asia, the results suggest China's trade reforms would be robustly expansionary were it to adopt a floating exchange rate regime. Simulations are also presented which detail the short-term effects of trade reform with alternative fiscal policies. Because the reforms cause the most substantial reductions in protection to China's food-processing sector, they lead to contractions in agricultural output in both the short and long runs. They therefore require substantial structural change, including the relocation of employment from agriculture to manufacturing.