Thursday, July 22, 2010

New measure of structural transformation: Index of Opportunities

Abdon, Felipe and Kumar have used Hidalgo et al. (2007) and Hausmann et al. (2007)’s concept of product space to come up with an “Index of Opportunities” (full paper here), which captures the potential for further upgrading production, economic growth, and development. It is based on a country’s accumulated capabilities (human and physical capital, legal system, institutions, etc.) to undergo structural transformation.

The idea is that “in the long run, a country's income is determined by the variety and sophistication of the products it makes and exports, and by the accumulation of new capabilities.” Hidalgo and Hausmann have shown that structural transformation occurs when countries grow sustainable by continually upgrading production structure, i.e. redeploying existing production structure to produce (upgraded) new products. It is related to “nearby goods”, “proximity”, and “open forests” concepts used in product space analysis. It is also used to see if coordination failures are binding constraints to growth while doing growth diagnostics of an economy. (An interesting idea that I have used to do growth diagnostics of the Nepalese economy).

Anyway, back to the new Index of Opportunities. It includes:

  • Exports sophistication (EXPY--a weighted average of the income level of the products exported, where the latter is calculated as a weighted average of the GDP per capita of the countries that export a given product)
  • Sophistication of the core commodities (machinery, chemicals and metals)
  • Overall diversification (the number of products in which the country has acquired revealed comparative advantage)
  • Diversification of core products (the number of core products in which the country has acquired revealed comparative advantage)
  • Share of complex capabilities (the ratio of the number of core commodities with revealed comparative advantage to the total number of commodities with revealed comparative advantage)
  • Standardness/uniqueness of the export basket (how many countries export the same product; this measure of uniqueness of the export basket has been called “standardness”)
  • Open forest (measure of the potential for further structural change. This variable provides a measure of the (expected) value of the goods that a country could potentially export, i.e., the products that it currently does not export with revealed comparative advantage)

“We estimate cross-country regressions of each of the seven indicators on the level of GDP per capita. Each indicator has two components that enter the construction of the Index. One is the actual value of the indicator, which captures the actual capabilities. The other one is the residual from the regression of the indicator on GDP per capita. This shows whether a country is a positive or a negative outlier given its income per capita. The residual obtained in each case is considered a “reward” or a “penalty”, respectively. A lower value of standardness is considered better. In this case, therefore, a negative residual corresponds to a reward and a positive residual to a penalty. We use highly disaggregated trade data covering 779 products for the years 2001-2007.

We rescale all seven indicators and the residuals such that they lie between 0 (minimum value) and 1 (maximum value). With all the seven indicators (and their residuals) scaled to lie between 0 and 1, and an increasing value corresponding to an improvement, we averaged the fourteen components to obtain the Index of Opportunities.”

The result shows that China has the highest score, followed by India, Poland,Thailand, and Mexico. Nepal stands at number 33 with an index of 0.4729.

The authors use the index to predict average annual economic growth rate between 2010-2030. For instance, the average annual growth rate of Nepal between 1990-2007 was 4.33 percent. Based on the index, growth projection, average annual growth rate, for Nepal, between 2010-2030 is 5.49 to 6.61 percent. For the same timeframe, China’s is 10.34 and 4.15 to 5.12 percent and India’s is 6.47 and 5.78 to 7.07 percent. Their result is pretty close to the one done by Uri Dadush and Benn Stancil (2010) from Carnegie Endowment.

The conclusion is that countries (such as China, India, Poland, Thailand, Mexico, and Brazil) that have diversified and increased the level of sophistication of their export baskets have accumulated a significant number of capabilities, allowing them to perform well in the long run. For countries that have not done so yet, they will have hard time having structural transformation. The authors vouch for “soft” industrial policies advocated by Harrison and Rodriguez Clare (2010). [Soft industrial policies promote collaboration among government, industry, and cluster-level private organizations with an aim to directly increase productivity. It basically seeks to directly address coordination failures that keep productivity low in existing or promising sectors rather than engage in direct interventions that might distort prices. This is like facilitating the process that already looks promising but is not realizing its full potential, rather than instituting one all anew whose success is unclear.]

I am not sure how much impact this index will have but it does not add much new information than EXPY and PRODY analysis developed by Hausmann et al.. It just reaffirms the results that are already there (it reaffirmed the conclusion of the product space analysis and the projections done by Dadush and Stancil). Nevertheless, a series of interesting papers and one more index to look at export-led structural transformation. Also, read the papers I have linked to. The whole concept is amazing!