Environmental Impact of India's Trade Liberalization

Abstract

Abstract: In the last decade, there has been increasing concern about the environmental consequences of trade liberalization. Trade liberalization may lead to higher pollution levels - if polluting industries relocate from countries with strict environmental policy to countries with less stringent environmental policy or as a result of increased production and exports from dirty industries. However, empirical evidence on the relationship between trade liberalization and the environment remains ambiguous. This paper contributes to the literature on the environmental consequences of trade liberalization episodes in developing countries by analyzing the composition (pollution intensive versus less pollution intensive) of manufacturing export, domestic production and foreign investment inflows around the period of India’s trade liberalization program of 1991. Faced with a severe balance of payments crisis in 1991, the Indian government embarked on an economic reform program that included industrial and trade policy, financial sector reforms and privatization. In this paper we focus on the environmental impact of India’s trade liberalization policies. India has weaker environmental enforcement regime relative to its main trading partners . Therefore there is concern that trade liberalization could potentially encourage the use of India as a production base for more pollution intensive production. We have assembled industry-level economic and environmental data aggregated at the all India level for the manufacturing sector from various Indian government agencies. Using this unique database, we examine test three hypotheses. First we examine the composition of domestic production at the all India level pre and post-liberalization. We ask whether India's domestic production is larger in the 'dirtier' industries within the manufacturing sector and whether production has shown a greater increase in the dirtier industries between the pre and post-liberalization periods. Second, we analyze the composition of manufacturing export to determine whether India is specializing in pollution intensive exports in the post-liberalization period compared to the pre-liberalization period. Finally, we examine whether foreign direct investment (FDI) has shown greater increase in the pollution intensive industries in the post-trade liberalization period relative to FDI into less polluting industries. This study extends the work of previous empirical research on the environmental impact of trade liberalization episodes in developing countries (such as Grossman and Krueger, 1993 and Gamper, 2001). Due to a lack of reliable data there are very few empirical studies that examine the environmental impact of trade liberalization episodes in developing countries. Using time-specific trade and FDI liberalization episode as a policy shock, we are able to identify the effect of the liberalization episode on the environment. We are therefore able to avoid the identification problem that plague other industry-level analysis that regress trade or FDI variables on environmental indicators, whereby the liberalization episode may influence the composition of dirty versus clean production and in turn, environmental policies may also influence trade policy. In the case of India's liberalization, political economy studies suggest that Indian regulators' choice of which industries to liberalize was driven by economic considerations, not by their environmental intensity. Indeed we do not find a strong correlation between the industries liberalized and their pollution intensity. Moreover, at the time of India's liberalization, no major environmental policy changes took place that could explain changes in pollution intensity of production and exports. Therefore, by examining the changes in pollution intensity of exports, production and FDI between the pre and post-liberalization periods, we are able measure possible environmental impact of India’s liberalization episode. While the environmental impact of liberalization episodes in developing countries will be dependent on their specific endowments and specific programs of liberalization, India, which shares the typical characteristics of developing countries of having weaker environmental policies and previous trade barriers that favored capital intensive individuals, provide an interesting case study. The results from this study show that there has been a moderate increase in air and water pollution intensive exports in the post liberalization period compared to the pre-liberalization period. The results also provide support for the hypothesis that there has been a marginal increase in FDI inflows into sectors with higher air and water pollution intensity, after we address the sample selection issue in the dataset. These results are robust to different empirical specifications. These findings suggest that while the liberalization policy has been pursued to promote economic growth, it has led to some potentially adverse environmental consequences. The findings suggest that there is trade-off between the economic gains from liberalizations and the environmental consequences from the liberalization episode that has not been accompanied by a strengthening of environmental policies. The government would therefore need to make an informed decision on how to balance the trade-off between economic gains from liberalization and the costs and benefits of stronger enforcement against polluters. The case study of India serves as a caution for strengthening environmental policies at the time when liberalization of trade and investment regimes is being contemplated.