The financial turmoil and the recessionary winds that it has fanned have claimed many victims, from arrogant investment banks on Wall Street to small toy companies in the export hubs through China’s Pearl River data. Much has been written and said about all the damage that we see around us.

One crack in the global economic system has not got the attention it deserves, especially in India. World trade is expected to shrink in 2009, the first time this is to happen in 27 years. That is what World Bank president Robert Zoellick said at the recent meeting of G-20 finance ministers and central bank governors in Brazil.

Part of the reason is obviously the slowdown in growth around the world. But there is another reason as well. The disruption in the credit markets has denied shippers access to short-term credit, insurance and bank guarantees.

The World Trade Organization (WTO) says on its website that 90% of global trade transactions involve some form of credit and estimates that the current liquidity gap in trade finance is $25 billion. WTO director general Pascal Lamy told a meeting of banks, international financial institutions and export credit agencies that “the market for trade finance has severely deteriorated over the last six months, and particularly since September. Two key causes of that were identified. One is a shortage of liquidity to finance trade credits. The second is a general reassessment of risks caused as much by the financial crisis as by the slowing down of the world economy, and it is there that those two cycles interact with one another. These problems are being felt most acutely by traders and banks in the emerging market economies" (italics added).

Global trade has grown at a faster rate than the overall economy since the end of World War II. Recent decades have seen the rise of truly multinational supply chains, with widgets being shipped from one country to another before the final product is assembled in a third country. This delicate arrangement can get ripped if world trade comes under threat. The immediate problem of the lack of trade finance can be solved easily. The $25 billion that Lamy estimates is needed is small change these days, when central banks and governments are pouring hundreds of billions of dollars into weakening economies without batting an eyelid.

Serious economists of every ideological hue agree that trade enhances welfare. There is also enough empirical evidence to show that open economies with few trade barriers are more efficient and grow faster than those that prefer to hide behind protectionist walls. There is also the resounding proof of how trade barriers erected in the 1930s sent the world economy spinning into even deeper trouble.

That doesn’t mean we can take the open trading system for granted. Shrinking trade volumes could raise protectionist tempers in several nations, not least the US. That would be unfortunate.

US President-elect Barack Obama’s commitment to free trade is suspect, especially if we are to go by the statements he made during his campaign about protecting American jobs and renegotiating the North American Free Trade Agreement (Nafta). China has recently done something that will test global trading rules. Faced with an unexpectedly large slowdown in exports, it has decided to include tax rebates to exporters as part of the big $586 billion spending package announced this month.

An economist I met last weekend told me that there is now a fear in many Indian industries that the Chinese will start dumping their products here in a bid to keep their export engine humming. So do not be surprised if domestic business lobbies start demanding similar tax rebates as well as the imposition of special import tariffs against goods that are dumped in India at a loss.

Some of these fears are premature, if not outright overblown. The depreciation of the rupee, compared with the stability of the Chinese yuan, has raised the effective rate of protection for Indian industry. China is a WTO member now and that forum is the best forum to settle dumping issues. Asian countries will have to agree at some stage not to get into protectionist wars amid slowing economies and shrinking trade.

South Korean economist Ha-Joon Chang, who now teaches at Cambridge, wrote in a recent article in The Financial Times that there could be a case for what he calls forward-looking protectionism: “Industries that can be revived through re-tooling of its factories and re-training of its workers should be given protection, but only if they fulfil certain conditions regarding investment and training. Industries that have no future should be given strictly temporary protection to ease phasing out through orderly liquidation and redundancy."

The challenge will be to prove that the government is capable of deciding which industries are in temporary distress and need protection against cheap imports and which industries are essentially high-cost and uncompetitive. That’s a tough one and is more likely than not to open a Pandora’s box of lobbying by special interests.

Broad-based open trade is a much better bet.

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