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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.

Remittances in Nepal after (during) the global economic crisis

This one comes from the IMF 2010 Article IV consultation in Nepal conducted last month. Here is a more comprehensive assessment done by the World Bank analysts.

Things to note:

• Share of remittances to GDP has increased substantially since 2000
• Number of outflow of workers is in line with increasing remittances inflow
• Volatility in remittances is higher than in exports and aid but lower than in FDI
• Remittances are driven by domestic GDP, host GDP and the stock of workers
• As expected due to global financial and economic crises, the outflow of workers has declined.
• The Gulf countries remains to be the most important destination for Nepali workers. The demand of Nepali workers in Malaysia is declining since FY2005/06 but this might increase as there is renewed demand recently. The growth rate in GCC and Malaysia is expected to be at pre-crisis level by 2012, which means there could be more demand (or at least no cut back) of Nepali workers.
• Remittances are expected to grow but at a slower rate.
• The decline in remittances have affected domestic financial system, consumption, and imports. It has indirectly affected tax revenue growth. The slow growth in remittances would mean that the economy needs to adapt with the negative facets of declining remittances.

The following are few charts that substantiate the main point discussed above:

What is wrong with the Nepali economy?

The Under-Secretary at Ministry of Finance, Yoga Nath Poudel, in Nepal questions the increase in tax revenue, limited public services and low saving.

The underlying problem is the conflict between the large demands for investment and paucity of domestic savings. Lowering taxes, reducing public sector prices and improving infrastructure and education could lower public revenue in the short run; but it is the only avenue to save the country from being doomed to sink to the bottom of development failures. Rigorously stringent measures may not be politically feasible at this time, but the government can contain expenditure at a sustainable level so that the incoming government may not have to bear the unsound scale of expenditure. The times demand that we hammer out a plan of action that will not further burden the governments to come after the new constitution is written.

The questions is: if you lower taxes, where will the revenue come from to fund the existing meager public goods. Reducing public sector prices is not politically feasible. The tax revenue has been increasing with no increase in tax rates. How is it possible? Stemming corruption and loopholes in tax collection could be the two reasons. Another might be the incentives provided to tax collectors and tax payers to do fulfill their responsibilities as required. If revenue is higher than recurrent expenditures, then there is something wrong with the bloated public sector. Trimming its size is one evil option. Also, rather than nominal increase in revenue, we need to look at real increase in revenue.

The economy is in a bad shape-- expenditures are higher than revenues; huge balance of trade deficit; strain in exchange rate; balance of payments deficit in more than four decades; strains in fixed exchange rate between Indian rupee and Nepali rupee; decline in remittances; tightening of overall liquidity; real estate bubble; strained financing in the productive sectors; huge unemployment problem in the rural as well as urban areas; population growth rate that matches real GDP growth rate; low development expenditures; high recurrent expenditures; double-digit inflation rate; low productivity; demise of garment industry; slackness in total production in the agricultural sector; increasing migration from the rural areas to the urban areas; the inability of the economy to absorb new labor force entering the labor market, thus triggering massive exodus of talented citizens; inequality is increasing … the economic situation is as gloomy as it could get!

But, there are positive signs waiting to show up in the economy, if only there is improvement in law and order; political stability; restraint in YCL and similar organizations disruptive activities; restraint in militant trade unions; a selective industrial policy; (improvement in infrastructure) … Notice that almost all of these are largely related to political factors. The economic fundamental are still strong but the political fundamentals are constraining them and nipping their growth.

The economics of happiness

David Brooks explains:

Marital happiness is far more important than anything else in determining personal well-being. If you have a successful marriage, it doesn’t matter how many professional setbacks you endure, you will be reasonably happy. If you have an unsuccessful marriage, it doesn’t matter how many career triumphs you record, you will remain significantly unfulfilled.

If the relationship between money and well-being is complicated, the correspondence between personal relationships and happiness is not. The daily activities most associated with happiness are sex, socializing after work and having dinner with others. The daily activity most injurious to happiness is commuting. According to one study, joining a group that meets even just once a month produces the same happiness gain as doubling your income. According to another, being married produces a psychic gain equivalent to more than $100,000 a year.

The second impression is that most of us pay attention to the wrong things. Most people vastly overestimate the extent to which more money would improve our lives. Most schools and colleges spend too much time preparing students for careers and not enough preparing them to make social decisions. Most governments release a ton of data on economic trends but not enough on trust and other social conditions. In short, modern societies have developed vast institutions oriented around the things that are easy to count, not around the things that matter most. They have an affinity for material concerns and a primordial fear of moral and social ones.

Global trade forecast: Trade to expand by 6.5 percent in 2010

The WTO has estimated that global trade would increase by 9.5 percent in 2010. Last year, trade plunged by 12.2%, the sharpest decline since the WWII. The last time global trade volume fell were in 1975 (-7%), 1982 (-2%), and 2001 (-0.2%). Trade in US dollar terms declined even higher (-23%) than in volume terms. Meanwhile, global output fell by 2.3% last year.

 

Volume of world merchandise exports, 1965-2009 (Annual % change)

Exports from developed countries are expected to increase by 7.5% in volume terms. Meanwhile, shipments for the rest of the world are expected to increase by 11%. This projection is based on the assumptions that global GDP growth would be 2.9% at market exchange rates and the will be stability in oil prices and exchange rates. The WTO warns that a 9.5% growth rate for trade is not sufficient to attain pre-crisis levels of trade volume next year. But, two years of growth at the same rate (12.2%) would surpass the peaks of 2008 for developing countries. The developed countries would require three years of growth at the same rate (9.5%).

 

Despite the decline in trade and a severe recession, governments around the world, in most cases, refrained from imposing trade barriers. The WTO warns that persistent unemployment might intensify protectionist pressures.

The main reason for the sharp fall in global trade was a contraction in global demand. The complex web of supply chains led to a synchronized drop in trade across countries and regions. The source of all these: global recession triggered by the sub-prime mortgage crisis in the US. A fall in wealth caused households and firms to cutback expenditure on consumer durables and industrial machinery.

 

Ratio of world exports of goods and commercial  services to GDP, 1981-2009 (Index 2000=100)

What could dampen the optimistic trade forecasts? The WTO lists increases in oil prices, appreciation or depreciation of major currencies, and additional adverse developments in financial markets as the possible factors that could dampen global trade. But, if the unemployment rates fall quickly, trade could recover faster than expected. [This is not going to happen though, according to economists such as Krugman and Stiglitz because the stimulus packages around the world have not been in proportion to the severity of the crisis.]

Q&A: Fixed Exchange Rate between Nepali Rupee (NRs) and Indian Rupee (IRs)

Following the previous op-ed on the pegged exchange rate between Nepali rupee and Indian rupee, here are some of the questions/ comments raised by readers. The replies are very raw!

Question 1: " Devaluation – a deliberate downward adjustment in the official exchange rate – will reduce the currency’s value. By making exports less expensive, and discouraging imports, devaluation can indeed help reduce current account deficit." less expensive or more expensive ??

Adnan: Once you devalue, one Indian rupee now buys more of Nepali rupees. The exports are now relatively less expensive for foreigners. And imports more expensive for domestic users as it now takes more Nepali rupees to buy one Indian rupee.

Chandan: In other words, devaluation would increase the demand of Nepali goods (i.e. exports less expensive), decrease demand of Indian goods (decrease imports) = net effect would be a positive effect on balance of trade and potentially on balance of payments as well if negative net transfers are not higher than positive net exports.

Question 2: I would think that 'higher interest rates' will increase foreign investment.I agree with the idea of “growing” itself out of this crisis...Also focusing on areas where Nepal has comparative advantage will help.

Adnan: My own thinking has been, for some time now, that money attracted at higher interest rates cannot be loaned at lower interest rates. At the end of the day, any govt wants to provide affordable financing to its small businesses or consumers. In a small and poor country like Nepal, there aren't that many opportunities for businesses to overcome the high hurdle rate and make profit.

One argument can be that govt should subsidize the interest payments which will be "due" to these investors and offer cheaper loans to struggling industries or key sectors like agriculture. But this approach also comes back to bite the govt. Those subsidies will have to be financed by raising taxes. But if the businesses will be taxed through the nose to fund the subsidies, less incentive for businesses to make profits and ultimately less incentive to borrow money from bank. Ultimately, govt do not need to attract those higher interest rate investments. One has to assess the risk appetite of the domestic economy.

In other words, some of these countries may not have the capacity to absorb all these investments. 

Chandan: Usually, high interest rates entice "hot money", not foreign investment....

Question 3: What happens if Indian currency switches to fully convertibility ? Government of India is gradually planning to do that ...

Chandan: There are talks about India switching to full currency convertibility. This issues emerged after an Indian mobile company was unable to buy a South African telephone firm primarily due to restrictions on currency convertibility. The Indian finance minister said that they will slowly move in that direction. It will take some time before that happens. Meanwhile, Nepal can still opt to stay with the peg. I think the Indians will have no problem with that. :)

Question 4: Great stuff - though one thing is confusing me. The Marshall-Lerner Condition? Can you help me out?

Chandan: The sum of price elasticity of exports and imports seems to be definitely greater than 1. It means that devaluation might actually improve BOT and, given the conditions I mentioned above, possible BOP. So, M-L condition is satisfied. But, it says nothing about inflation, which is already high. (The J-curve effect also looks applicable in this context.)