In particular, the vulnerability of countries to (some types of) external shocks should be reduced when these countries are better diversified in their exports. More specifically, the effect of trade openness on growth volatility – whether negative or positive on average – is likely to be exacerbated when the country in question exports either a relatively small set of products, or sells its goods to a small number of destination markets. The argument is that a higher degree of concentration in exports would imply that any idiosyncratic price shock experienced is more likely to have a substantial impact on the country's terms of trade, and this would then induce greater fluctuations in a country's growth process. Furthermore, a higher degree of diversification would likely imply that a country is involved in a larger number of both implicit and explicit international insurance schemes, which would similarly serve as a cushion against such fluctuations.
Fig: The level of export diversification determines the total effect of openness on growth volatility.
The plot is based on the share of the 5 most important products in total exports as a diversification measure. We can see that the impact of trade openness on volatility is significantly lower than zero, with 90% confidence, as long as a country scores lower than about 0.24 on the diversification variable. The effect gradually increases and changes sign (threshold) at about 0.48. In contrast, above a value of about 0.71, the impact of trade openness on growth volatility is significantly positive.
As expected, all high income economies, with the exception of Norway and Ireland, have attained levels of diversification that lie substantially below the threshold value we identified, implying that they are likely to enjoy the benefits of trade openness while being well shielded against global shocks via the participation in a large number of global value chains. Yet, we also see that the vast majority of countries above the diversification threshold are low income countries, although a large number of low income economies also fall below the threshold. Whereas countries such as Nigeria and Botswana are troubled by extremely high export concentration, China and Nicaragua have reached levels of diversification that fall clearly below the threshold.
The authors argue that diversification is indeed possible in developing countries. In fact, with appropriate policies, the developing countries can expedite diversification process.
This means that export-led growth that is founded on diversified export basket will work. Industrial policy works. And, what countries export matters.
More specifically, policymakers can encourage entrepreneurial export activity by instituting a broad- based system of tax relief and subsidies that support the discovery process, complemented by a liberal trading regime that combines export incentives while relaxing restrictions on the import of intermediates. One way to do this is to facilitate the costly search process for exporters by alleviating information externalities (export promotion agencies) or setting tax incentives for firms to engage in the costly trial and error process of exporting.
Not only should export incentive schemes aim at promoting exports of new products, policymakers should also encourage production diversification as such. This would entail setting incentives supporting the discovery of profitable choices of products, perhaps via tax incentives, subsidised public R&D, or laws and regulations that provide greater access to high risk insurance.