Thursday, April 29, 2010

Post-crisis trade recovering (but not fast enough)!

Merchandise trade volume grew in the Q4 2009 in the G7 countries, albeit at a slower pace than in Q3 2009. Though trade volumes and values have recovered since the plunge in Q3 2008 and Q1 2009, their level is still below the pre-crisis levels of mid-2008 (by almost 20 percent lower to pre-crisis level). Import and export volumes from G7 countries rose 3.1% and 3.9% respectively. The more rise in imports by G7 countries, the better is the chance of developing countries benefiting from the trade recovery, assuming that majority of imports by G7 countries come from the developing countries!
 Here is real GDP figures (see the plunge!)

Industrial policy is back: Rodrik

Rodrik argues industrial policy was never dead! Successful economies always used it.

British Prime Minister Gordon Brown promotes it as a vehicle for creating high-skill jobs. French President Nicolas Sarkozy talks about using it to keep industrial jobs in France. The World Bank’s chief economist, Justin Lin, openly supports it to speed up structural change in developing nations. McKinsey is advising governments on how to do it right.

Industrial policy is back.

In fact, industrial policy never went out of fashion. Economists enamored of the neo-liberal

Washington Consensus may have written it off, but successful economies have always relied on government policies that promote growth by accelerating structural transformation.

The shift toward embracing industrial policy is therefore a welcome acknowledgement of what sensible analysts of economic growth have always known: developing new industries often requires a nudge from government. The nudge can take the form of subsidies, loans, infrastructure, and other kinds of support. But scratch the surface of any new successful industry anywhere, and more likely than not you will find government assistance lurking beneath.

Tuesday, April 27, 2010

Ten bad ideas for economic growth

It comes from a recent report about post-crisis growth and developing countries by the Growth Commission. The set of bad ideas for growth are:

  1. Assuming the crisis is a “mean-reverting” event and the we will return to a pre-crisis pattern of growth, capital costs, trade and capital flows.
  2. Interpret the need for better regulation and government oversight of the financial sector as a reason for micromanagement of the financial sector.
  3. Abandon the outward-looking, market-driven growth strategy because of financial failures in the advanced countries.
  4. Allow medium-term worries about the public debt to inhibit a short-term fiscal response to the crisis.
  5. Adopt counter-cyclical fiscal policies without concern for the returns on public spending, and without a plan to restore the public finances to a sustainable path over time, once the crisis is past.
  6. Ignore the need for more equitable distribution of gains and losses in periods of prosperity as well as in crisis.
  7. Continue with energy subsidies on the assumption that commodity prices will not rebound after the crisis.
  8. Treat the financial industry like any other, ignoring its external effects on the rest of the economy.
  9. Focus monetary policy on “flow” variables like inflation, job creation and growth, ignoring potential sources of instability from the balance sheet (asset prices, leverage, derivates exposure).
  10. Buy assets whose risk characteristics are hard to understand. The high returns are likely to reflect higher risk even though the latter may be hidden from view. They will be overpriced and salable, if at all, in a crisis only at distressed prices. Things that seem too good to be true, probably are.

Monday, April 26, 2010

Growth in developing countries after the crisis

The Growth Commission has published a report (Post-Crisis Growth in Developing Countries) assessing the financial crisis and its fallout on economic growth in the developing countries. I was planning to read it last month but couldn’t do so. This report assesses if the previous recommendations in The Growth Report still holds true after the 2008 financial crisis.

global growth, WEO 2010

The conclusion is that the recommendations are still relevant but some restraint on capital controls and financial liberalization might be fruitful. The report emphasizes the crisis does not show the failure of market-based system but that of the financial sector. The outward-looking strategy is still relevant but it may not be as rewarding as it was before the crisis because of slower growth in trade, costlier capital, and a more inhibited American consumer.

Below are notes from the report. The figures are from WEO 2010:


Economies that had sustained growth of 7 percent or more for 25 years or longer had some common features:

  • Fully exploited the world economy; imported ideas, knowhow and technology; produced goods that met global demand, specialized and expanded rapidly without saturating the market.
  • Maintained macroeconomic stability; inflation under control and sustainable fiscal paths.
  • High rates of investment (25% of GDP), including public investment, financed by equally impressive rates of domestic savings.
  • Followed the market signals while allocating resources; used industrial policy to bent the law of comparative advantage, by favoring some industries over others; the favored industries had to pass a market test by successfully exporting their products to foreign customers who did not have to buy them; relatively mobile labor; stagnant industries were allowed to fail; protected laid-off workers from economic misfortune 
  • Strong, committed, credible and capable governments; their macroeconomic strategies and microeconomic regulations provided the setting in which market dynamics could work; provided a range of public goods such as schooling and infant nutrition that markets under-provide.

What did the crisis teach us? The crisis delegitimized an influential school of thought, which held that many financial markets could be left to their own devices, because self-interest of participant would limit the risks they took. At a huge cost, it taught an unforgettable lesson about how financial systems really work. But, the crisis is a failure of the financial system, not the market per se.

SSA growth WEO 2010

Before the crisis (September 2008), developing countries faced very high commodity prices for eighteen months, peaking in the spring and summer of 2008. When the crisis erupted, there were declines in investment, employment and trade. The crisis spread to the developing countries through financial channel (credit tightened everywhere) and real economy channel (trade collapsed more than economic activity). China was less vulnerable to mobile investment funds because of its capital controls. China's response to this crisis was a repeat of its response to the Asian financial crisis in 1997-98, but on a much larger scale.

The government has to prevent a complete failure of the financial system and replace essential functions like credit provision until the normal channels reappear. It should also prop up economic activity and asset prices by filling the gap left by sidelined consumers and investors. Moreover, it has to act as a "circuit-breaker", interrupting the transmission of shocks from one part of the economy to the other. Fiscal stimulus reduces declines in the real economy, boosting employment, income and credit quality.

Post-crisis global economy

  • The US consumer will become the US saver in an effort to repair the damage to household balance sheets. The world will also face a set of additional challenges: energy, climate and demographic imbalances, among others.
  • Regulators and central banks cannot afford a narrow focus on consumer prices and employment, leaving asset prices and balance sheets to their own devices. They cannot hope to control inflation, manage growth, check overstretched balance sheets and ward off related sources of instability by manipulating short-term interest rates alone.
  • The government has a legitimate reason to intervene to ensure that taxpayers' interests are safeguarded. Vulnerabilities in the financial sector represent contingent liabilities for the government and rest of the economy.
  • Financial re-regulation should and will emphasize capital, reserve and margin requirements, seeking to limit the build up of systemic risk by constraining leverage.
  • The cost of capital will increase, debt will be more expensive and less ubiquitous, and risk spreads will not return to the compressed levels that prevailed before the crisis.
  • Joblessness in the advanced economies may not peak until late into 2010. Labor markets are still deteriorating.
  • Some of the fundamental determinants of growth are relatively crisis-proof: demography or human ingenuity.
  • The average rates of protectionism in the world economy, weighted by GDP, will increase as big emerging economies, which tend to have higher trade barriers on average than the industrial economies, grow in prominence.
  • No magic bullet for getting out of the crisis: The economy should gradually right itself, as financial markets stabilize and the real economy follows, pulling the sea anchor of extended deleveraging along with it. Policies likely to err on the side of running short run inflation risk, rather than the reserve.

Growth strategies

Successful economies have generally found a formula that includes a dynamic and innovative private sector supported by government investment in public goods, effective regulation, and redistribution to protect the most vulnerable. That balance varies across countries.

The crisis represents a major failure of the financial systems in the advanced countries. In particular, the lightly and incompletely regulated model that was influential in many Western economies is fundamentally flawed and in need of change. There is no evidence of a more broad based failure of the market and capitalist economies. The debate should focus on the financial sectors' stability and performance, rather than on a more sweeping condemnation of the whole market-based system.

The government should do more to protect people during times of extreme economic turbulence. Safety nets are indispensable to maintain public confidence and support for the market-led outcomes. Some countries (such as Brazil, Mexico and India) have shown that it is possible to devise more permanent programs that can serve the economy both in good times and bad, expanding during crises to meet sudden spikes in need. "Leaky" safety nets buys political support. Broader coverage may be the political price we have to pay for a well-supported safety net. Countries should prepare an inventory of well-designed projects that can be taken "off the shelf" when the need arises.

Quantitative easing, capital injections into the financial sector, bail-outs in a number of other industries, and fiscal stimulus programs have all added to the government's scope and influence. Budget deficits, if left unaddressed, will eventually raise long-term interest rates, making debts even harder to sustain.

The state's expansion needs to be reversed as the crisis subsides. Fiscal stimulus packages need to be replaced by medium-term programs to restore fiscal balance, based on realistic (and perhaps diminished) estimates of future growth. The expanded central bank balance sheets need to shrink through the sale of assets over time to the private sector.

Road ahead for developing countries

Consumption cuts and increase in savings by the American consumer could mean a $700 billion or more shortfall in global aggregate demand, relative to the world economy's productive potential. This shortfall should be filled by an increase in domestic demand in surplus countries.

To grow rapidly, countries must reallocate resources from traditional, low-productivity activities, such as agriculture, to new industries, which allow for rapid gains in productivity that often spill over to the wider economy. As countries make economic progress, their production of tradable goods tends to rise rapidly, leading to trade surpluses. There is no necessary connection between increasing the share of tradable goods in GDP and running a trade surplus. Rodrik has shown that trade surpluses do not have any independent, positive effect on growth, once you control for the share of industry in GDP. The share of "industry" captures the importance of non-traditional, high-productivity activities in a country's economy. Countries grow by promoting these activities, not by promoting trade surpluses per se.

Domestic demand is not a perfect substitute for global demand,where countries can specialize in a narrow range of products to serve specific customers. To cater to domestic demand, countries need to produce a broad range of products, so as not to saturate any particular local market niche. The limits to specialization are tighter and depend on the evolving composition of domestic demand.

Developing countries should curb financial products they may be ill equipped to handle. Several countries, including Brazil, India and China make heavy use of reserve regulatory restrictions to dampen their banks' enthusiasm. China imposes different requirements depending on the kind of assets banks hold, thereby influencing the direction of credit as well as its quantity.

Developing countries should ensure that some banks remain domestically owned, even if they are not owned by the state. The government's focus is quite understandably on the domestic economy. But foreign entities will have divided loyalties at best.

Sunday, April 25, 2010

Economic crisis and sub-Saharan African exports

The African financial sector was pretty much isolated from the financial crisis that wreaked havoc in the developed countries’ financial sector. All good. But, if the African exporters are dependent on external trade finance, then the real cost of the global crisis on Africa may actually be high, argue Berman and Martin.

African exports has nosedived after the financial crisis. The interesting question is how does the financial crisis in one country affects exports of another country? To find this out, Bernam and Martin study past financial crises (1976-2002) and its impact on bilateral trade flows. The explore the deviation of exports from their ‘natural’ level generated by financial crises.

Two channels through which financial crisis affect exports: income effect (leading to drop in demand of exported items) and disruption effect (leading to fall in trade credit). They find that the largest disruption effect occurs when the financial crisis hits industrialized countries. The African countries are affected more by income effect than disruption effect. In addition to the income effect, they find that, for an average exporter, the disruption effect due to a financial crisis in the partner country is moderate (a deviation from the gravity predicted trade of around 2 to 8%) and long lasting (around 7 years). For African exports particularly, due to disruption effect, the fall in trade (relative to gravity) is at least 20% more than for other countries in the aftermath of the crisis.

Fig: Exports after financial crisis in partner country, Africa. It shows the deviation of sub-Saharan African exports after a financial crisis that takes place in year t = 0, with respect to the average disruption effect. A positive (negative) excess trade ratio means that the effect of a financial crisis in the partner country on African exports is more positive (negative) than the average effect on exports.

Conclusion: “The underdevelopment of financial systems in Africa is not a "blessing in disguise" in the current crisis. If the cost of such low development is that African exporters are very dependent on external trade finance, then the real cost of the financial crisis on Africa may actually be higher due to the underdevelopment of financial systems.”

Population growth and technology

Growth in incomes was accompanied by unprecedented increases in population and exponential increases in the rate of scientific discoveries. More here.

Saturday, April 24, 2010

Five reform agendas to kick-start Nepal’s growth

My latest piece is based on a simple set of crucial reforms that are needed to kick-start Nepal’s jammed growth engine. These reforms can be launched simultaneously or in any other form deemed appropriate and politically feasible.

Main point: “To achieve a 5 percent plus growth rate in an undeveloped but budding economy likes ours, it is necessary to start from something that will first lubricate the growth engine, then speed it up, then attain stability, and then ensure sustainability of growth rate.”


Five Reform Agendas

If someone asked you to enumerate five reform agendas that will kick-start Nepal's jammed growth engine and sustain five percent plus annual growth rate, what would be your response? Recently, I was asked this question. By considering the pattern of reforms in countries that have passed through the existing development state of our economy and the evolution of institutions, culture, reforms and constraints in Nepali economy, my non-exhaustive list of reform agendas were: (a) Infrastructure (electricity and roads); (b) contemporary industrial policy; (c) overhaul of education and healthcare sectors; (d) governance and regulations (financial and non-financial sectors); and (e) social safety nets.

Before explaining the rationale behind this hierarchy of policy reforms, let me be clear about two key assumptions. First, it postulates that political situation will eventually be stable. Second, as is the case with the emerging economies, an increase in economic growth rate will lead to poverty reduction.

When macroeconomic situation is in a mess, we need to first ensure that fundamental variables are promptly taken care of. We need to identify the most binding constraints on economic growth in order to tackle the most troubling aspect of the economy. Studies have shown that the most binding constraint right now is a lack of infrastructure, mainly roads and electricity. With the supply of electricity about five times less than the demand, it is not only difficult for entrepreneurs to start new business, but is equally hard for the existing firms to keep their machines running. Note that Nepal has the highest electricity tariff (dollar per KWh) and lowest electric power consumption (KWh per capita) in South Asia.

An inadequate transport infrastructure increases transportation and transaction costs, leading to loss of competitiveness. Nepal has the highest transportation costs and lowest road density in South Asia. Provision of good infrastructure facilities incentivizes domestic entrepreneurs, both agricultural and non-agricultural. It facilitates the rise of small and medium enterprises (SMEs), the main source of employment for people and revenue for entrepreneurs. It kick-starts the growth engine but won't guarantee speeding up of the engine fast enough.

For this to happen we need to prop up firms that can exploit economies of scale and expand markets abroad. A contemporary industrial policy (IP) that can 'lead the market' and 'follow the market' is required to speed up growth rate. South Korea adopted 'lead the market' principle, where it picked potential winners and promoted 'winning' industries. Meanwhile, Taiwan adopted 'follow the market' principle, where the state 'nudged' firms to upgrade their technologies through appropriate incentives, performance requirements and facilitation of transfer of technical knowhow and capital. Any such promotion of domestic industries should have industry-specific sunset clauses to eschew misallocation of resources, price distortion, and repression of incentives.

The state has to play a vital role in propping up markets when there is substantial underinvestment in promising sectors. Just setting up 'enabling' environment is not enough amidst information asymmetries and coordination failures in the market. In Nepal's case, the state could speed up the establishment of Special Economic Zones (SEZs), Export Processing Zones (EPZs) and Garment Processing Zones (GPZs); extend tax holiday in key industries; guarantee investment insurance in hydropower sector; facilitate export of labor services to growing middle-income countries facing shortage of manual and semi-skilled labor; subsidize loans and provide easy credit to strategic firms; train human resources; promote tourism; facilitate trade; create backward and forward linkages in the industrial sector; and borrow new technology to enhance efficiency and productivity, among others. 

A good industrial policy helps to stimulate the economy and speed up industrialization, leading to absorption of surplus agricultural labor in industrial sector. A potential source of investment in the short term could be remittances, if only the policymakers can figure out how to channel it into the productive sectors for investment rather than for consumption of imported goods and for investment in real estate sector.

For a vibrant market and a sustainable growth rate, it is equally important to ensure smooth supply of quality human capital. To make the previous two reform agendas sustainable, it is necessary to reform the existing Nepali education and health sectors. An education sector that is geared towards the need of the domestic and international markets is vital to fulfill the demand for human resources in rapidly growing sectors. The banking sector is already suffocating from a short supply of competent human resources. Given the immature state of our financial markets, there is a huge demand for educated, well-trained young professionals who are capable of analyzing market fluctuations and investments. Along with the education sector, we need to improve on the provision of health services, especially in rural areas. It will ensure a constant supply of healthy, competent human capital to the industrial sector.

With booming economic activity also comes complexity. Some agents in the economy always want to earn more profits than others, often by going roundabout established rules. To keep unhealthy competition and risky investment activities at bay, it is necessary to have good governance and regulations. Nepal's notorious public sector, which is infested with corruption culture, needs to be reformed. This will not happen overnight. But we can at least take corrective steps by empowering the Commission for Abuse of Authority (CIAA), the main corruption watchdog, with more manpower, expertise and funding so that it can spread its wings to all districts. Furthermore, having proper regulation in place for the rapidly growing financial markets, which usually is the main artery from where investment spending is pumped out into the economy, is essential. This helps to check malpractices in the public and private sectors, and the financial markets.

Finally, with booming economic activity and growth of financial markets, also come unpleasant and unintended outcomes: rise in inequality, which retards growth rate, and increase in vulnerability of poor people. This is why we need to have adequate safety nets, which can be funded by taxing the richest people in the highest income quintile. This has to be done without killing incentives of entrepreneurs. To uplift living standard of the lowest quintile and to stimulate rural economy, we need public work programs, conditional (or unconditional) cash transfer programs, short-term employment during lean agricultural season, and training programs aimed at graduating low-skill workers with updated skills consistent with market demand.

Let me emphasize that these reform agendas are not comprehensive. Depending on objectives, there could be an entirely different set of hierarchy of reforms. However, to achieve a five percent plus growth rate in an undeveloped but budding economy likes ours, it is necessary to start from something that will first lubricate the growth engine, then speed it up, then attain stability, and then ensure sustainability of growth rate. Drawing out a simple set of national reform agenda endorsed by all political parties despite their divergent ideology would do a lot in terms of generating high and sustainable growth rate in Nepal.

[Published in Republica, April 22, 2010, pp.6]

Thursday, April 22, 2010

Lessons from the Chinese miracle

Here is a replication of Justin Lin's blog post at Africa Can...End Poverty


Since beginning its transition 30 years ago, China’s economic development has been miraculous.

The average annual growth rate of GDP reached 9.8 percent, far exceeding the expectations of most people in the 1980s or even early 1990s, including Deng Xiaoping who initiated the reforms. Deng’s goal was to quadruple China’s economy in twenty years, implying an average annual growth rate of 7.2 percent per year.

In 1979, China was inward-looking and its trade as a percentage GDP was only 9.5 percent. Now China is the world’s largest exporter and the third largest importer, with trade contributing around 70 percent of GDP. Over 30 years, more than 600 million people got out of poverty.

1. What was behind China’s extraordinary performance?

After the industrial revolution, sustained growth in any economy depended on continuous technological innovation as well as industrial diversification and upgrading.

As Angus Maddison shows, before the 18th century, the average annual growth rate of per capita income in the West was only 0.05 percent for years. That means it took 1,400 years for Europe’s per capita income to double prior to the 18th century. In the 19th century, it took about 70 years; and in the 20th century, 35 years.
The industrial revolution sped the move away from an agrarian society where 85 to 90 percent of the labor force worked in traditional agriculture. The move from agriculture to nonagricultural and manufacturing sectors was gradual but inexorable. In the manufacturing sector, it was at first very labor-intensive, and then became more capital-intensive as technology advanced. Ultimately, the service sector dominated. Overall, the process was one of continuous structural change.

As a late-comer to this modernization process in 1949, China had the advantage of backwardness. To innovate, China did not have to invent the technology or industry by doing R&D. It could borrow technology, industries and institutions from the advanced countries with low risk and costs. East Asian economies, including Japan and the four small dragons as well as China after the transition in 1979, all tapped into this advantage.

2. Why Did China Fail before the Transition in 1979?

China didn’t tap into that potential until 1979 because it adopted a misguided modernization strategy.

Revolutionary leaders such as Mao Zedong and Zhou Enlai hoped to make China an advanced country immediately after the founding of the People’s Republic of China in 1949. They adopted a strategy to build up advanced capital- and technology-intensive industries even though China was an agrarian economy.

The government’s priority industries went against China’s comparative advantage. The government needed to protect them by giving them monopoly positions and subsidizing them through various price distortions, including suppressed interest rates, over-valued exchange rates and so on. The price distortions created shortages and the government was obliged to use administrative measures to mobilize and allocate resources directly to the non-viable firms in the priority industries.

Through those interventions the government was able to set up modern advanced industries, but the resources were misallocated and the incentives repressed. Economic performance was very poor. Haste made waste.

3. Why Didn’t Other Transition Economies Perform Equally Well?

Not only China but also all the socialist countries and most developing countries after WWII adopted a similar development strategy. In the 1980s and 1990s, they all engaged in reforms to transit to a market economy. However, their governments did not realize that the existing distortions were endogenous in a sense that they were instituted to protect the non-viable firms in the priority sectors.

Some of them eliminated the distortions immediately. The priority sectors collapsed, causing a contraction of GDP, surge of unemployment, and acute social disorder.  Others, to avoid this, continued to subsidize those non-viable firms through disguised subsidies and protection, and efficiency suffered.

China adopted a pragmatic, gradual, dual-track approach. On the one hand, the government continued to provide transitory protection to the non-viable firms in the priority sectors, and on the other hand, it liberalized private enterprises and allowed joint-ventures’ entry to labor-intensive sectors--areas in which China had comparative advantage, but were repressed before. In this way, China achieved stability and dynamic growth simultaneously.

4. What Costs Did China Pay for Its Success?

One of the main drawbacks of China’s gradual, dual-track approach to transition is the widening of income disparities. From a relatively egalitarian society in 1979, the Gini coefficient reached .47 in 2007.
The reason was the continuation of distortions in various sectors, including the overconcentration of financial services by the four large state-owned banks, the almost zero royalty on mining, and the monopoly of major service industries, including telecommunication, power, and finance.

Those distortions are used to subsidize or protect the non-viable firms in the old priority sectors. They also favor big corporations and rich people. For example, the interest rates that big banks charged are kept artificially low, allowing big companies and rich people to benefit at the expense of middle class depositors who have limited access to credit services.

The result is a widening of income disparities.The large corporations and rich people have a higher saving propensity than low-income households. The widening of income disparities also contributes to the saving-consumption imbalance and China’s large trade surplus, which reflects the disparity in saving and consumption in recent years. Therefore, it is imperative for China to remove the remaining distortions and complete the transition to a market economy.

5. Can Other Developing Countries Replicate the Miracle?

Other developing countries can replicate China’s performance. Every developing country has a similar opportunity if they know how to tap into the advantage of backwardness, learn to borrow technology from advanced countries and upgrade their industries step by step.

Most developing countries also have all kinds of distortions and non-viable firms due to their governments’ past development strategies and inappropriate interventions. In this respect, China’s experience in the past 30 years provides useful lessons.

In the transition process, it may be desirable to adopt a dual-track approach, providing some transitory protection to those non-viable firms to maintain stability, but liberalizing entry to sectors in which the country has comparative advantage.

Ultimately, however, sustained and inclusive growth requires eliminating all distortions and completing the transition to a well- functioning market economy.


Wednesday, April 21, 2010

IMF proposes new taxes on financial institutions

In the paper called "A Fair and Substantial Contribution by the Financial Sector", the IMF argues the case for two new levies to be applied on financial institutions in as many countries as possible: More here and here. The full document is here.

(1) A "financial stability contribution" to pay for "the fiscal cost of any future government support to the sector". The levy would be paid by all financial institutions, not just banks, initially at a flat rate but eventually refined so that riskier institutions paid more.

(2) A "financial activities tax", which would be levied on the sum of financial institutions' profits and the remuneration they pay.

Industrial Policy of Nepal 2010

Finally, the Nepali government is going to update its outdated industrial policy of 1992 with a new one. I have not got hold of the official document yet. The following is a brief highlight of what is coming:

  • High priority industries: IT, cement, hydropower, vehicle and motor parts, chemical fertilizer, bio-technology and adventure tourism
  • Priority industries: Agriculture, forest-based Ayurvedic and homeopathic medicine, manufacturing, minerals and handicrafts
  • Finance support to construct infrastructures such as roads, electricity lines and water supplies up to factory sites.
  • Promotional incentive package for export-oriented industries, specially SMEs. It promises 25 percent income tax concessions to small, medium and large industries that directly employ 100, 300 and 600 people, respectively.
  • Industries promoted by women to get income tax incentives.
  • Tax holidays for 10, 7 and 5 years to firms that invest respectively in highly underdeveloped, undeveloped, and underdeveloped industrial regions.
  • Promotion of Special Economic Zones (SEZs) and Agro-Export Promotion Zone (AEPZ). Firms located within in these zones to be exempted from customs duty, excise duty and VAT.
  • Income tax deductions for R&D and market promotion.
  • Simple exit policy to promoters, freeing them from long-term labor and other liability.
  • Subcontracting of production to promote specialization in the manufacturing process and to enable firms to meet international orders without investing further in its production units. This is expected to foster backward linkages.
  • Differential tariff rates for raw material imports and import of finished goods. The protection rate (difference in tariff favoring local manufacturing over direct import) will be 25 percent.

It sounds all good. I will have to see the full document to comment on specific topics. But, a general observation reading this article is that there seems to be no sunset clauses for industries. Any policy to help domestic industries should have a clear end sight, i.e. sunset clause. Policy help cannot be for infinite time as this dampens competition and leads to inefficiency. There should be policies to deliberately promote domestic industries without violating international trade treaties but it also should have clear sunset clauses. More comments when I get and read the full document.

Meanwhile, here is a list of loss making public enterprises, which borrowed Rs 1.6 billion in ten months instead of the allocated Rs 800 million for the whole fiscal year, in Nepal.

Saturday, April 17, 2010

Who is John Maynard Keynes?

Rob Johnson introduces John Maynard Keynes:

Advice to young economists:

Check out the Institute for New Economic Thinking (INET) for more interesting stuff.

Growth and Inequality in India

The Indian economy has been growing at a rate of more than 7 percent, on average since 2000, but it has not fully translated into the lives of poor people. Poverty and inequality levels are still high.
Poverty in rural areas fell from 37.3 percent in 1993-94 to 27.1 percent in 1999-2000, while in urban areas it fell from 32.4 to 23.6 percent, according to official estimates.

The HDI value was 0.427 in 1980, 0.556 in 2000, 0.604 in 2006 and 0.612 in 2007.

Percentage of population below different poverty lines:
  • $1.25 a day: 41.6%
  • $2 a day: 75.6%
  • National poverty line: 28.6%; (National poverty line: rural is Rs 356.30 and urban is Rs 538.60, according to the National Planning Commission)
Share of income or expenditure of:
  • Poorest 10 percent: 3.6%
  • Richest 10 percent: 31.1%
  • Richest 10 percent to poorest 10 percent: 8.6%
  • Gini index: 36.8 (0 is absolute equality and 100 is absolute inequality)
Source: HDRs and Kakwani 2004 One Pager #2

Friday, April 16, 2010

Inclusive growth in India: Is it happening?

The Brookings Institution organized an event about Indian polity and inclusive growth at Carnegie on Tuesday. Tarun Das, former chief mentor of Confederation of Indian Industry, shared his optimism about the Indian economy and economic development.

According to Das, some of the main features of the Indian economy right now:

  • Increasing number of CEOs of private companies are joining the public sector. Examples, Nandan Nilkani and Arun Maira
  • Skill development: India plans to train 500 million people by 2022. The private sector is playing a key role in this initiative. It has established National Skills Development Corporation (NSDC). A large part of its skill development efforts are directed at the unorganized sector. It is a PPP initiative.
  • Emphasis in innovation and technology, both in the urban as well as rural areas. Example: solar lamps and telecommunication
  • Enhancement of efficiency in the public sector.
  • Education sector has been open to the private sector. Private foundations such Azim Premji Foundation and Bharti Foundation are contributing to uplift the education sector.
  • Health care sector: spread of mobile health clinics; new technologies with improved supply lines; with improved technology almost 30 percent of wasted food is now stored, thus increasing supply and preserving nutrients
  • Young entrepreneurship: Emergence of self-employed youths; more than 100,000 successful SMEs…becoming more and more competitive…more will come
  • Private sector is emerging as the driving force of growth and development…dynamic private sector
  • Transformation of rural area: more rural connectivity, impact of TVs, ICT
  • Prudent entrepreneurs: high savings rate (25 to 35 % of GDP) and increasing investment rate
  • Government development schemes such as rural employment and rights to food act are helping the poor people that are not seeing the direct benefits of economic growth. Poor people and women are slowly getting empowered.
  • New economic and social development model: India realizes that both private as well as government sector is needed. It has a centrist economic model. The liberal economic policies would stimulate the private sector and social development policies of the government would uplift the poor people, thus narrowing the gap. This would then help India achieve above 10 percent growth rate.

Few comments about Das’s comments:

Das did not go in detail about how India can achieve inclusive growth. Large swathe of the people are still poor and depend on agriculture. The discussion on agricultural sector was minimal. He focused more on the corporate-end of the growth equilibrium and talked about CSR-type development initiatives led by the private foundations. I had expected from him a little bit more discussion about NREGA, the largest public employment guarantee program in the world. Even the UPA government’s election victory in the last election is accredited to this reform. It seems that this would be one of the main vehicles to creating an inclusive society and possible inclusive growth.

Additionally, the rise of Maoists and the government’s lack of reach in the remote villages were not discussed. This obviously will have a strong bearing on the growth rate at some point in the future. Right now, the urban-led activities seem to lead growth. It will saturate at some point. Then, some of the variables of drivers of growth would be based on rural economic activities. This is where the Maoists insurgents could become villain to growth. It has been one of the main internal threats to the Indian democracy, according to Prime Minister Manmohan Singh.

There were many issues that were left out. The talk was heavily focused on how to achieve high growth rate, which could not be necessarily inclusive. The inclusive growth part was discussed very little. Also, sweeping generalization about the reach and impact of mobiles and TVs was a bit too much. It has its own limit!

Overall, the discussion was a good primer on the existing Indian political economy.

Wednesday, April 14, 2010

The idea of comparative advantage is not dead!

Pascal Lamy on Krugman, Samuelson and comparative advantage:
“At the outset, let me recognize Paul Krugman’s intellectual contribution to international trade theory — the so-called “new trade theory” — in which he shows that, even in the absence of productivity differences between two countries, trade benefits them both. He focuses on the presence of increasing returns to scale, in which a firm’s average cost per unit declines as production increases and underscores that consumers value variety in consumption. While the new trade theory reduces the role played by comparative advantage, it identifies new sources of benefits from trade that were not emphasized or recognized by the classical economists. More trade benefits all countries because specialization in production reduces average cost and consumers gain access to a wider variety of products. In contrast, traditional theories of trade assume the variety of goods remains constant even after trade-opening.
There is a much-cited paper by Paul Samuelson in the Summer 2004 issue of the Journal of Economic Perspectives which showed theoretically how technical progress in a developing country like China had the potential to reduce the gains from trade to a developed country like the United States. This paper appeared to be a dramatic about-face against the idea that open trade based on comparative advantage is mutually beneficial.

There is a much-cited paper by Paul Samuelson in the Summer 2004 issue of the Journal of Economic Perspectives which showed theoretically how technical progress in a developing country like China had the potential to reduce the gains from trade to a developed country like the United States. This paper appeared to be a dramatic about-face against the idea that open trade based on comparative advantage is mutually beneficial.

I emphasize the word “appeared” because subsequent analysis by Jagdish Bhagwati, Arvind Panagariya, and T. N. Srinivasan contradicted this view. In that paper, starting from autarky, China and the United States open up to trade and experience the usual gains based on comparative advantage. In the following part of the paper, Samuelson considers how technological improvements in China will affect the United States. In the case where China experiences a productivity gain in its export sector, both countries benefit. China gains from the higher standard of living brought about by the increase in productivity while the United States gains from an improvement in its terms of trade. In the case where China experiences a productivity gain in its import sector, there is a narrowing of the productivity differences between the countries which reduces trade; and as trade declines, so too do the gains from trade.

So what Samuelson has showed is not that trade along lines of comparative advantage no longer produces gains for countries. Instead, what he has shown is that sometimes, a productivity gain abroad can benefit both trading countries; but at other times, a productivity gain in one country only benefits that country, while permanently reducing the gains from trade that are possible between the two countries. The reduction in benefit does not come from too much trade, but from diminishing trade. Furthermore, even in this case, Samuelson himself does not prescribe protectionism as a policy response since, as he put it ,“what a democracy tries to do in self defense may often amount to gratuitously shooting itself in the foot”.

In my view, the analysis by Bhagwati, Panagariya and Srinivasan should convince us that the principle of comparative advantage, and more generally, the principle that trade is mutually beneficial, remains valid in the 21st century.”

Lamy attempts to debunk some fallacies in trade discussions:

  • Fallacy #1: Comparative advantage does not work anymore
  • Fallacy #2: It is unhealthy for trade to grow faster and faster compared to output (there is a problem with the way we interpret (and measure )volume of trade and value addition)
  • Fallacy #3: Current account imbalances are a trade problem and ought to be addressed by trade policies.
  • Fallacy #4: Trade destroys jobs
  • Fallacy #5: Trade leads to a race to the bottom in social standards.
  • Fallacy #6: Opening up trade equals deregulation

It is worth reading the full text.

Tuesday, April 13, 2010

Nepal-US Trade & Investment Framework Agreement (TIFA) & Exports

My latest column is about the implications of the US-Nepal TIFA. I make the point that there is little, if any, immediate gains in terms boosting exports. However, the pact is a right move in promoting Nepali exports industry and exports. A high level delegation led by Nepal’s commerce secretary was in DC. I met them twice last week.
There has been a lot of discussion about the proposed US-Nepal Trade and Investment Framework Agreement (TIFA). The Nepali delegation led by Commerce Secretary Purushottam Ojha is in Washington DC to finalize the pact, which the two countries will formally sign soon. The proposed new pact with the biggest economy in the world has reignited optimism among Nepali exporters. It is seen as a precursor to a free trade agreement (FTA) between the two countries.

Nepali investors and exporters should understand that TIFA is not a panacea for the ailing exports sector. In fact, nobody knows if the enactment of TIFA would boost exports to the US. It does not give additional tariff concessions for the beleaguered export-oriented industries, including ready-made garments. It is merely a pact that establishes a framework for enhancing trade, technical cooperation, and resolving outstanding disputes between the US and Nepal. It is not a silver bullet to regain the lost glory of Nepal’s exports to the US.

When the Nepali delegation floated the idea that Nepali ready-made garments be given the same preferential treatment that the US provides some African countries for quota and duty-free entry into the United States following the African Growth and Opportunities Act (AGOA) of 1992, the US representatives gave an apt advice: Improve domestic business environment and make it easier for the US companies that are already investing in other South Asian countries, mainly India, to invest in Nepal. Additionally, they asked the Nepali delegation to diversify exports basket. The probability of investment by a company that has experience of operating in South Asia is higher than a company that has no experience running business in the Indian sub-continent. The investors that are already investing in this region understand relevant business constraints better and, if given enough incentives, might invest in Nepal as well.

Source: USTR

Enough has been said about the demise of the garment industry in Nepal. But, no trade related discussion is complete without mentioning the downfall of this industry and its impact on the economy. Concerning the US market, the only notable item we were exporting with comparative advantage before 2005 was ready-made garments. This was possible not because our exports were price and quality competitive, but because the international market was not a level playing field for all garment exporters in the world. The end of Multi-Fiber Agreement (MFA)—which eliminated quotas on the trade of textiles and clothing— in 2005 crippled the domestic garment industry. It struggled to compete, both in terms of price and quality, with superiorly competitive garment producers from other countries. The message was loud and clear: We desperately need to enhance our competitiveness, diversify our export basket, and effectively market our goods and services abroad.

The policymakers need to realize that nothing will move forward unless there is political stability and cessation of incessant harassing of investors and entrepreneurs by militant labor unions and political youth wings. No matter how many TIFAs are inked, in the absence of security and political stability, there will be no substantial positive change in exports. The only direction exports and exports revenue can go are downward. Forget about foreign investors; even domestic investors will not invest if there is constant threat to life and private property.

To make TIFA effective, there is a need to look at binding constraints on investment and trade. Importantly, we need to upgrade technology and human capital capable of producing ‘nearby’ goods, which are in close ‘proximity’ with products that the economy is already producing. This would speed up transformation of not only the export-oriented industries but also the whole economy as rural and informal sector workers will be absorbed into the industrial and formal sectors. Furthermore, the country needs to address energy crisis and shortfall of infrastructure, which several studies have identified as the most binding constraint on Nepal’s economic growth.

Given this bitter reality, there is hardly any immediate tangible benefit out of the US-Nepal TIFA to the Nepali export-oriented industries. It does nothing except to implant optimism among investors that things are moving in the right direction and, if situation improves, trading opportunities will be much more reliable, secure and better.

What goods can we export with comparative advantage to the US market? Neither the policymakers nor the exporters have a definite answer. A comprehensive analysis of the potential for new exportable items to the US market is long overdue. In fact, a product-level and state-level analysis of the markets for Nepali goods in the US will be helpful to exporters because taste and preference of consumers in the $14 trillion economy are vastly different. The items under consideration right now are mostly a narrow set of agricultural and handicraft goods.

Not only there is a need to diversify our export basket, there is also a need to export goods that will help to increase exports revenue so that trade surplus with the US partly offsets overall trade deficit. The existing concentration of Nepal’s exports is extremely high, i e the export basket is composed of few goods upon whose international demand our export industry depends on. It is exposing the economy to greater trade and growth volatility. Studies have shown that the more diversified the export portfolio is, the lesser would be growth and export volatility. In addition, identifying and focusing on exporting goods and services that have high value-addition would mean sustainability of the export-based industries.

The US-Nepal TIFA will not provide immediate relief to Nepal’s ailing exports sector. However, this treaty is a right move in terms of smoothening and settling investment and trade issues, and enhancing trade and technical cooperation between the biggest economy in the world and the poorest country in Asia. There will not be any marked improvement in exports unless the binding constraints on investment and trade are addressed right away.

[Published in Republica, April 10, 2010, pp.6]

Monday, April 12, 2010

Doctors to the rescue in the forest…

Caption: A combo picture of a 26-year old woman in labor pain while grazing goats at a forest in Kalikastan, Achham, Nepal, and giving birth to a baby. Locals say around 50 women deliver babies in a similar circumstance in the jungle. The nearest health post is 500 meters from the forest. Only 13.3 percent of the total pregnant women go to Kalikasthan district health center for delivery.

[Source: The Kathmandu Post, 2010-4-12, pp 4]

A three-year national plan for Nepal

The National Planning Commission (NPC) has come up with an investment plan to steer the economy at a moderate growth rate (5-6%) in the next three years beginning mid-July 2010.

Here are some of the details:

  • Aim to achieve GDP growth rate of 5 to 6 percent
  • Lower absolute poverty to below 21 percent
  • Generate 200,000 jobs
  • Private sector estimated to invest 64 percent of the total estimated investment; the government will invest the rest. The service sector is expected to absorb an estimated Rs 732.17 billion, the industrial sector Rs 153 billion, and the agricultural sector Rs 133.5 billion.
  • Expected size of the economy in 2013: Rs 1397.4 billion (around US$ 20 billion) at producer prices. This fiscal year it is expected to reach Rs 1176.56 billion.
  • Total consumption in mid-July 2013 is expected to reach Rs 1239.5 billion (88.79 percent of the estimated GDP). Meanwhile, total investment is expected to reach Rs 359.3 billion.
  • Estimated total revenue mobilization: Rs 678 billion (17.4 percent of estimated GDP)
  • Estimated government capital expenditure: 9.1 percent of estimated GDP
  • Estimated internal loan: 2.1 percent of estimated GDP
  • Sub-sector wise, transport, storage and communication is getting Rs 223 billion while agricultural and forestry sector is getting Rs 130 billion.

Few preliminary comments by just reading the news (I have not read the official document and looked at the estimates!):

  • It is encouraging to see that the infrastructure sector is getting the most priority. It has been identified as the most binding constraint on Nepal’s economic growth. But, where is the investment in generating electricity?
  • Generating an estimated 200,000 jobs will be a challenge, unless this one is temporary target.
  • How are we going to channel remittances, which amount to approximately 20 percent of GDP, in the domestic (productive) sectors? Most of the remittances are either going to the real estate market or being driven to India (through increasing consumption of Indian goods and services, thus contributing to ballooning trade deficit with India)
  • How will this plan help to remedy the most pressing macroeconomic challenges and macroeconomic paradoxes in the Nepali economy?
  • Investment alone does not increase employment. There could be job less growth, fuelled by over-investment in few sectors such as real estate. In fact, with substantial leakages and weak institutions, the growth rate might not be as expected even if there is increasing ‘investment’ in the form of money being channeled to the specified purposes.
  • What will happen to macroeconomic balance (fiscal and monetary)? How will the central bank react to rise in general price level (demand side effect coming from the injecting of new investment money and supply side effect coming from supply bottlenecks, deficit production and imports from India)?

Sunday, April 11, 2010

Africa is growing...

Source: WDI 2009

Note that we need to differentiate between oil exporting countries and non-oil exporting countries. Most of the high performers in Africa are oil exporting countries.

A chart disaggregated by oil-exporting and non-oil exporting countries with population share in Africa is below:

Saturday, April 10, 2010

RCTs to measures the effect of menstruation on girls education in Nepal

Thornton and Oster, did a randomized controlled trial about the relationship between menstruation and attendance of girls in school in southern Nepal. Their finding is surprising: only about a third of a
day per year is missed due to girls’ period. The allocation of menstrual cups to girls has no effect on scores. Girls not allocated menstrual cups in the initial randomization were 2.6 percentage points less likely to be in school on days they were menstruating. This falls well below the 10-20% estimates made by policy makers.

Researchers randomly selected half of the girls in our sample and provided them with a menstruation cup to replace the cloths they had been using. They compared the increase in attendance rates on period days for girls with and without this improved sanitary protection and found no impact: both groups missed slightly more school on days with their period.

Does this mean that sanitary-related intervention is not worthwhile? They say No!

It is important to note that this does not imply that there are no benefits to better sanitary products. Girls in the study were very happy to have the menstrual cup: it limited the amount of time they spent doing laundry, and the majority of girls used the menstrual cup regularly and would recommend it to their friends. The bottom line is while policies to provide better sanitary products in the developing world may have positive value, we should not expect them to impact schooling.

Here is a related paper by the same authors on peer effects on menstrual cup take-up.

We estimate the role of peer effects in technology adoption using data from a randomized distribution of menstrual cups in Nepal. Using individual randomization, we estimate causal effects of peer exposure on adoption. We find strong evidence of peer effects: two months after distribution, one additional friend with access to the menstrual cup increases usage by 18.6 percentage points. Using the fact that we observe both trial and usage of the product over time, we examine the mechanisms driving peer effects. Our results suggest that successful uses by peers are more important than peer unsuccessful usage attempts. In addition, we argue that peers matter because individuals learn how to use the technology from their friends, but that peers do not a effect an individual's desire to use or attempt to use.

Thursday, April 8, 2010

Can Africa meet the MDGs target by 2015?

In 2001, all 192 United Nations member states agreed to a set of eight international development goals to be achieved by 2015. With only five years to go before the deadline, only a third of those targets have been reached. Most countries are not expected to meet the Millennium Development Goals (MDGs) target in time. What is going on with MDGs and why Africa is lagging behind? Can Africa really meet the MDG targets by 2015?
There questions were discussed at an event in Carnegie Endowment last week, Jan Vandemoortele, a former UN staff member and co-architect of the MDGs, highlighted the progress made so far at the global level. Shanta Devarajan, chief economist of the World Bank’s Africa Region, focused on the progress so far in Africa toward achieving the MDGs. Selim Jahan, director of Poverty Division at UNDP, discussed the successful policy interventions that could assist countries in achieving the MDGs target by 2015. Carnegie’s Eduardo Zepeda moderated the event.

Regional vs Global Progress

The Millennium Development Goals are, by their nature, collective goals applied in a broad global canvas. The targets themselves are set by extrapolating global trends through 1990. The panelists agreed that applying the targets to individual regions can be problematic:

  • Since the MDG targets for 2015 are extrapolated from global trends, it is incorrect to look at a single region, such as Africa, and say that they are off-track for the 2015 targets, argued Vandemoortele. MDGs are collective global targets. They are not targets for Africa only. It is the international community missing the point, insisted Vandermoortele.
  • The MDG targets set a bar particularly difficult to achieve for African nations, which started the twenty-first century at very low development levels, Vandermoortele reminded the panel.
  • Jahan agreed that vast disparities in the regional and national levels require a consideration of the MDG targets that goes beyond global averages. With only five years remaining to meet the MDG targets, he suggested that an analysis of proven interventions that could be scaled up and replicated in the regions that are lagging could help accelerate progress.
From a global perspective, the world is on track to achieve the income poverty targets, mainly due to massive poverty reduction in China. However, Devarajan pointed out, global progress does not mean that Africa is equally on track to achieve the targets.

The Pattern of Progress

Panelists discussed some of the factors contributing to slow progress toward the MDG targets in Africa, including inequality, structural constraints, and unemployment:

  • Increasing economic inequality in African nations has meant that when progress toward the MDG targets has yielded tangible benefits, those benefits have bypassed the poorest citizens who need them the most. Vandermoortele pointed out that there is evidence that in a more economically equal society, fewer people live in poverty and there are fewer health and social problems. An increase in social inequality will thus impede progress toward achieving the MDGs.
  • To sustain the progress made so far, it is necessary to address the social, political, and economic constraints that are hindering sustained economic growth, increase in trade, and improvement in human development, said Jahan. He suggested the implementation of a comprehensive, integrated reform package to deal with all facets of the existing constraints. He also suggested using models from other successful southern hemisphere development initiatives to help African nations move forward on the MDGs. 
  • Jahan argued that employment creation could be the missing link between economic growth and poverty reduction. “For a long time, we depended on growth-led employment generation, which basically turned out to be jobless growth. Can we have employment-led growth?” he wondered.
Africa and the Global Economic Crisis
The global economic crisis has slowed down and perhaps even reversed the progress made towards the MDGs. “Fortunately, the timely and appropriate responses of African policymakers have helped dampen the impact and set the stage for the continent to benefit from a global recovery,” argued Devarajan. He contended that Africa’s rapid growth since 1995, improvements in service delivery, and better policies have changed the MDG outlook for AfricaAfrica can meet the MDGs, “if not by 2015 then soon thereafter,” he concluded.

Aid Effectiveness and International Financial Institutions

Panelists discussed the effectiveness of international aid and international financial institutions in making significant and long-lasting progress toward achieving the MDG targets.

  • Jahan argued that a multi-pronged strategy and multi-actor involvement is necessary to enable international development aid to contribute to progress on the MDGs. He suggested that international financial institutions have three crucial roles they can play:
    1. They can play a positive role in international development by speeding up the process of meeting development goals. 
    2. They can bring outside knowledge and expertise to developing countries; 
    3. They can effectively deal with global constraints related to a country’s growth such as international trade, innovation, and acquisition and use of new technology.
  • Vandermoortele stated that sustainability depends on achieving a deep transformation at the local level. International donors and financial institutions cannot create local change, and there is a risk that international involvement will keep the MDGs from the grassroots effect they are intended to have.


[Btw, the event was organized by TED program and, yours truly, noted the main points!]

Tuesday, April 6, 2010

Export Promotion Agencies (EPA): It worked but small is beautiful!

Export promotion agencies have done a fantastic work to solve coordination failures and asymmetric information problems associated with exports of heterogeneous goods. Though these agencies have been successful in boosting exports, the smaller they are in size, the better it is because of “strong” diminishing returns, says Lederman and Olarreaga in a new policy research working paper #5125. [Also, check this blog post about the positive relationship between sufficiently diversified trade and low growth volatility.]

The objectives of EPAs are to help exporters understand and find markets for their products. They engage in (a) country image building (advertising, promotional events, advocacy); (b) export support services (exporter training, technical assistance, capacity building including regulatory compliance, information on trade finance, logistics, customs, packaging, pricing); (c) marketing (trade fairs, exporter and importer missions, follow-up services offered by representatives abroad; and (d) market research and publications (general sector, and firm level information, such as market survey, on-line information on export markets, publications encouraging firms to export, importer and exporter contact databases). EPAs are required because there are market failures (coordination externalities and information externalities).

The first EPA was created in 1991 in Finland to boost exports and reduce trade deficits. Many EPAs were established after that but they became controversial in the developing countries. The were criticized for “lacking of strong leadership, being inadequately funded, hiring staff which was bureaucratic and not client oriented, and suffering from government intervention.” Many development agencies withdrew support for EPAs because they were promoting import substituting trade regimes. After 1991, EPAs resurged partly because of more involvement of private sector, larger funding, and a stronger organization and leadership. What is the impact of EPAs  and are they effective in increasing exports?

Lederman and Olarreaga argue that on average EPAs have a positive and statistically significant effect on national exports. They seems to be effective when they are most needed, namely, when exporters face onerous trade barriers abroad, and when a large share of the export bundle is composed of heterogeneous goods. However, there are decreasing returns to scale in resources devoted to export promotion. So, they recommend that small EPAs are “beautiful” and effective.

The elasticity of export promotion agencies at work with respect to increase in exports is 12 percent. This means that “a point estimate of 0.12 suggests there are strong diminishing returns to scale.” Also, they find that GDP per capita has a positive and statistically significant sign in all specifications (this means richer countries, with stronger and better institutions export more). Furthermore, the restrictiveness faced by exporters, exchange rate volatility and geography component of trade negatively affects exports. Interestingly, the number of years since the EPA was created may be negatively correlated with exports at the time of EPA’s creation.

They find that a 10 percent increase in EPA budgets at the mean leads to a 0.6 to 1.0 percent increase in exports, after correcting for selection and endogeneity biases. Also, EPAs that have larger private sector representation in the board and larger public sector funding for operation are associated with higher national exports. This means that full privatization of EPAs may not be ideal. This could be a part of selective industrial policy.

Monday, April 5, 2010

Romance and Innovation!

Sufficiently Diversified Trade Lowers Growth Volatility

If exports of a country are sufficiently diversified, then there is less volatility even when there is increased openness, argue Haddad, Lim and Saborowski. Before opening to trade it is usually not clear if greater openness would have a positive or a negative impact on growth, i.e. the growth volatility. However, they argue that the composition of the export basket matters in determining if growth volatility is positive or negative.

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.