Is free trade good for innovation?

By David Ray

MELBOURNE, Australia (JP): The recently held APEC meeting of heads of state in the Philippines has injected a new momentum into the drive free trade in the Asia Pacific region.

There are no shortages of proponents of Asia Pacific Economic Cooperation or explanations as to why free trade is good for the region. Economic commentators and free trade economists typified by those at the World Bank have long argued that lower trade barriers will benefit all through improved market access and a more efficient allocation of resources (we all do what we do best thereby generating greater global output and income).

For developing countries, such as Indonesia, free trade has another important advantage in that it improves access to international flows of technology.

It is on this last point that I focus the attention of this article. This is because it is not always clear that an open trade and or foreign investment regime facilitates the transfer and development of new technologies.

Japan, Korea, and Taiwan, arguably the three most technologically successful countries in the Asia region, have pursued through the course of their post World War II development, and to varying degrees, a number of restrictive trade and or foreign investment policies.

More importantly, there is evidence to suggest that such restrictive policies may have promoted rather than impeded the use and production of ideas.

An important study on the National Innovation System of Japan by two Japanese economists Odagiri and Goto, for example, concludes that in regard to the development of indigenous R&D capability, the restrictions on imports and foreign investment was probably the most important policy until the early 1970s.

Restricting the growing Japanese market, already the second largest in the capitalist economy in the late 1960s, to Japanese firms who were competing intensively among themselves gave a strong incentive to invest in plants, equipment and R&D. Moreover there were a number of key industries such as automobiles, which had been assisted by military procurement prior to Japan's Peace Constitution but were in their relative infancy in the post-war period and might have been wiped out were the market made open to foreign competitors.

It is important to note that as late as 1979, manufactured imports constituted only 2,4 percent of Japanese GDP: the corresponding proportion in a number of European Economic Community countries was five to six time higher.

This was the result of high import controls in the 1950s, 1960s and 1970s particularly in the capital goods sector. Protection levels were however reduced in the 1970s only after it was evident that Japanese machinery became internationally competitive. Other sectors to have enjoyed high levels of protection in the 1960s and 1970s included the textiles, nonferrous metals, wood products and the iron and steel industries.

There is also substantial evidence that the Korean government actively promoted a number of selected sectors through a range of tariff and nontariff barriers. Most studies in the economies literature show high levels of protection -- particularly in the heavy and chemical industries (iron and steel, metal products, machinery, electronics and industrial chemicals) in the 1960s and early-mid 1970s but decreasing gradually over the mid 1970s to mid 1980s period reflecting the government's efforts to actively promote this sector.

In the case of foreign investment, a number joint ventures with U.S. and Japanese Trans National Corporations were established to help start up the country's electronics industry in the 1960s. Early policies encouraging foreign investment were, however replaced by a more restrictive regime in the 1970s and 1980s which deemphasised foreign investment and promoted the exploitation of foreign technology though a number of other channels such as original equipment manufacturing (assembling products under instruction from a foreign customer) licensing agreements and the temporary hiring of foreign technical assistance. Korea's cumulative foreign investment in the mid 1980s was much lower than in the other Asian New Industrializing Countries reflecting the country's explicit policy of promoting its independence from multinationals, particularly those from Japan.

Taiwan is another East Asian country which used various regulatory controls to foster the development of local industries. The textile and electronics industries, for example, were both beneficiaries of a widespread import substitution program practiced throughout the 1950s and 1960s. Whilst tariff barriers have since fallen, nontariff barriers continue to be used as indirect subsidies for domestic firms. Throughout 1980s and early 1990s there were still a number of informal practices and programs in place that supported local suppliers of equipment and intermediate inputs against foreign competition.

Like Korea, TNC's played and important role in the start up of Taiwan's electronic industry with many local firms supplying them with goods and services, leading to more advanced local activities associated with subcontracting, licensing and original equipment manufacturing arrangements.

Unlike Korea, foreign investment in Taiwan continued to play a key role in the electronic sector throughout the 1980s and into the 1990s. Despite this more open approach to foreign investment the government of Taiwan has exhibited a high degree of policy flexibility providing where and whenever necessary the appropriate restrictions to protect and develop local industry.

Foreign investment outside of an export-processing zone must still be approved by the government and are often subject to restrictions on sales in the domestic market and or the achievement of certain export targets and must meet local content requirements.

The experiences of Japan, Korea and to a lesser extent Taiwan contradicts the arguments that a policy of openness with few trade barriers represents the most effective means for the transfer and development of new technologies. This is not to suggest that openness can not represent an important means for technological development. Singapore, Hong Kong and Malaysia were able to derive significant technological benefits from relatively open trade and foreign investment regimes.

The key point that needs to be drawn from the above analysis is that there is as yet no conclusive evidence to suggest that openness to trade or investment flows is a necessary condition for the successful importation of foreign technologies.

Whilst the argument that trade and foreign investment restrictions promoted rather than impeded innovation in a number of East Asian countries may be faulted, it is no more or less appealing than the argument that free trade promotes innovative behavior. We can only conclude that the issue remains unresolved and that there is more work to do on this front.

David Ray is based at the Center for Strategic Economic Studies, VUT Melbourne.

Window A:

More importantly, there is evidence to suggest that such restrictive policies may have promoted rather than impeded the use and production of ideas.

Window B:

The experiences of Japan, Korea and to a lesser extent Taiwan contradicts the arguments that a policy of openness with few trade barriers represents the most effective means for the transfer and development of new technologies.