openness can be good for growth the role of policy complementarities roberto chang (rutgers u.)...

OPENNESS CAN BE GOOD FOR GROWTH The Role of Policy Complementarities

Roberto Chang (Rutgers U.)

Linda Kaltani (American U.)

Norman Loayza (World Bank)

Inter-American Development Bank

March 2006

A long and contested debate

Ever since D. Ricardo’s objection to the “Corn Laws” to J. Stiglitz’ critique of globalization, economists have hotly debated:

Does international integration contribute to economic development?

The arguments in favor

• (Neo) classic perspective: Openness promotes,– an efficient distribution of resources– the diffusion of knowledge– competition

• Endogenous growth literature: Specialization can render increasing returns (Young 1991, Grossman and Helpman 1991)

The doubts

• In the presence of market or institutional imperfections, openness can– cause unemployment (Brecher 1974)

– promote specialization in “non dynamic” sectors (Matsuyama 1992)

– induce a concentration in extractive activities (Sachs and Warner 1999)

What does the empirical evidence show?

• It is also ambiguous

• In favor: international comparisons of the levels of trade volumes and economic growth – Dollar 1992, Sachs and Warner 1995

• The objections: loose indicators, omitted variables, endogeneity– Rodríguez and Rodrik 2000

The empirical response in favor of openness

International comparisons of the effects of changes in openness on changes in growth:

• Using large samples: positive average effects– Dollar and Kraay 2004; Calderón, Loayza, and Schmidt-

Hebbel 2005

• Case studies: also positive average effects, but with a noticeable heterogeneity– Wacziarg and Welch 2003

A first conclusion:

The average effect of openness on growth is positive,

but the individual country experiences vary from each other

Question:

Is there a systematic pattern to this diversity?

The growth effect of openness increases with income – Calderón, Loayza, and Schmidt-Hebbel 2005:

Growth Effect of Outcome Trade Openness as a function of GDP per capita

-0.2

-0.1

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

6.2 6.5 6.8 7.1 7.3 7.6 7.9 8.1 8.4 8.7 9.0 9.2 9.5 9.8 10.0

Real GDP per capita (in logs)

Changes in GDP growth vs. Changes in Openness between the 1980s and 90s

Ranking Criterion: Governance

y = 5.7808x - 1.6051

y = 0.6847x + 0.8104-8

-6

-4

-2

0

2

4

6

8

-0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 1

change in openness

chan

ge

in g

row

th

top group bottom groupLinear (top group) Linear (bottom group)

Changes in GDP growth rates versus changes in openness between the 1990s and 1980s

Ranking Criterion: Education

y = 3.8348x - 0.9299

y = 1.0697x + 0.6745-8

-6

-4

-2

0

2

4

6

8

-0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 1

change in openness

chan

ge in

gro

wth

top group bottom groupLinear (top group) Linear (bottom group)

Ranking Criterion: Infrastructure

y = 4.6347x - 0.9803

y = 0.9883x + 0.5745-8

-6

-4

-2

0

2

4

6

8

-0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 1

change in openness

chan

ge in

gro

wth

top group bottom groupLinear (top group) Linear (bottom group)

Ranking Criterion: Governance

y = 5.7808x - 1.6051

y = 0.6847x + 0.8104-8

-6

-4

-2

0

2

4

6

8

-0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 1

change in openness

chan

ge in

gro

wth

top group bottom groupLinear (top group) Linear (bottom group)

Ranking Criterion: Labor Market Flexibility

y = 1.5203x - 0.0371

y = 0.9256x + 0.5571-8

-6

-4

-2

0

2

4

6

8

-0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 1

change in openness

chan

ge in

gro

wth

top group bottom groupLinear (top group) Linear (bottom group)

The role of complementary reforms

The success of openness depends on the economic and institutional characteristics that allow firms to adjust to the new conditions imposed by international competition

• Education• Public infrastructure• Financial depth• Labor and regulatory flexibility• Rule of law• Macroeconomic stability

An illustrative model• An application of the theory of second best:

– A change in policy is evaluated in the context of a distorted economy

• Stylized model: Extension to open economies of Harris-Todaro model– Evaluation of international trade policy in a segmented

economy– Segmentation occurs because of a sector-specific distortion in

labor markets– Labor flexibility as representative of all complementary

reforms

The mechanism• The distorted economy:

– 2 sectors– One of them (formal sector) is subject to a minimum wage– Loss of efficiency: under-employment in the formal sector

• Trade policy:– Protection to formal sector through a tariff

• Result: – The effect of a tariff reduction on productive efficiency is

ambiguous. – Trade liberalization increases income/production only if the

labor distortion is not too large

• Conclusion: The effect of openness depends on complementary reforms

The econometric evidence

• An empirical growth model of interactions:

• Sample: 82 countries, 8 non-overlapping five-year observations per country, 1960-2000

• Methodology: Generalized Method of Moments (GMM) for models using panel data

*' ,,,,,1,01,, tiittitiINTtiOPENtiREFtititi OPENREFOPENREFyyy

Econometric methodology

• Estimation challenges:– Joint endogeneity– Unobserved country factors– Dynamic equation

• Methodology: GMM for dynamic models of panel data (Arellano and Bond 1991, Arellano and Bover 1995) – GMM system estimator– Joint endogeneity: “Internal instruments” -lagged levels and differences– Unobserved country factors: Differencing and stationarity assumptions– Specification tests: Sargan and serial correlation tests

• Previous applications:– Growth: Levine, Loayza, and Beck (2000)– Saving: Loayza, Schmidt-Hebbel, and Serven (2000)– Crime: Fajnzylber, Lederman, and Loayza (2002)

GMM for dynamic models of panel data

• GMM system estimator: Combines regression in differences and regression in levels into one system

– Regression in levels:

• Instruments: lagged differences of the explanatory and lagged dependent variables

– Regression in Differences:

• Instruments: previous observations of the explanatory and lagged dependent variables in levels

tiitititi Xyy ,,1,, '

)()(')( 1,,1,,2,1,1,, titititititititi XXyyyy

Economic Growth and the Interaction between Openness and Other Economic ReformsDependent variable: Growth rate of real GDP per capita

Control Variables:

Initial GDP per capita -3.1713 ** -3.2036 ** -3.2627 ** -3.2059 ** -3.3552 ** (in logs) 0.18 0.21 0.17 0.18 0.23

Human capital investment 1.1621 ** -0.8610 ** 1.2105 ** 1.1402 ** 1.2594 ** (secondary enrollment, in logs) 0.15 0.42 0.16 0.16 0.17

Financial depth 1.0272 ** 0.9421 ** 0.0262 1.0071 ** 0.9234 ** (private domestic credit/GDP, in logs) 0.11 0.09 0.21 0.11 0.07

Inflation -0.4580 ** -0.4350 ** -0.4895 ** -0.3243 -0.4364 ** (deviation of inflation rate from -3%, in logs) 0.08 0.07 0.07 0.21 0.07

Public infrastructure 1.5764 ** 1.5904 ** 1.6053 ** 1.6050 ** 0.6423 ** (main telephone lines per capita, in logs) 0.13 0.16 0.14 0.14 0.19

Openness:

Trade Openness (TO) 1.1959 ** -2.0421 ** -0.2553 1.3497 ** 3.2821 ** (structure-adjusted trade volume/GDP, in logs) 0.16 0.59 0.28 0.28 0.48

Interactions:

TO * Human capital investment 1.0031 **0.18

TO * Financial depth 0.4629 **0.08

TO * Inflation -0.07250.10

TO * Public infrastructure 0.4970 **0.09

[4] [5]Public

Infrastructure

Interaction of Openness with:

Inflation

[1]Benchmark: No

InteractionsHuman Capital

InvestmentFinancial Depth

[2] [3]

Economic Growth and the Interaction between Openness and Institutional ReformsDependent variable: Growth rate of real GDP per capita

Control Variables:

Initial GDP per capita -3.4019 ** -4.0229 ** -3.0202 ** -3.2063 ** (in logs) 0.33 0.24 0.21 0.18

Human capital investment 1.2845 ** 1.5146 ** 1.7603 ** 1.2424 ** (secondary enrollment, in logs) 0.16 0.16 0.16 0.11

Financial depth 0.9632 ** 1.2870 ** 0.9063 ** 1.3196 ** (private domestic credit/GDP, in logs) 0.12 0.12 0.12 0.12

Inflation -0.3830 ** -0.3513 ** -0.5266 ** -0.2848 ** (deviation of inflation rate from -3%, in logs) 0.08 0.08 0.08 0.07

Public infrastructure 1.5912 ** 1.6379 ** 1.4037 ** 1.0532 ** (main telephone lines per capita, in logs) 0.17 0.12 0.14 0.13

Openness:

Trade Openness (TO) 0.0802 -3.7359 ** -3.5333 ** 1.6581 ** (structure-adjusted trade volume/GDP, in logs) 0.33 0.64 0.69 0.27

Interactions:

TO * Governance 2.9617 ** (governance: index from ICRG, 0 - 1) 0.87

TO * Labor market flexibility 8.9986 ** (labor: index from DB, 0 - 1) 1.36

TO * Firm entry flexibility 7.4593 ** (entry: index from DB, 0 - 1) 1.31

TO * Firm exit flexibility -0.8598 (exit: index from DB, 0 - 1) 0.73

Interaction of Openness with:

Firm entry flexibility

GovernanceLabor market

flexibility

[1] [2] [3] [4] Firm exit flexibility

The effect of openness on growth

Growth = (OPEN + INT REF) Openness

• Simulations: – Effect of a 1-standard-deviation change in openness– Depending on the level of each complementary reform– Where do countries stand?

• Let’s consider some representative examples

Growth Effect of Trade Openness as a Function of Complementary Reforms

A. Educational Enrollment

Congo, Dem. Rep.

South Africa

MoroccoThailand

IndiaPeru

-2

-1.5

-1

-0.5

0

0.5

1

1.5

2

2.5

0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5

log of secondary school enrollments

grow

th o

f GD

P p

er c

apita

(%

)

B. Financial Depth

South AfricaMorocco

Thailand

IndiaPeru

-1

-0.5

0

0.5

1

1.5

2

-1.1 -0.1 0.9 1.9 2.9 3.9 4.9

log of domestic credit to private sector/GDP

grow

th o

f GD

P p

er c

apita

(%

)

C. Telecommunications Infrastructure

Congo, Dem. Rep.

South AfricaMoroccoThailand

India Peru

-1.5

-1

-0.5

0

0.5

1

1.5

2

2.5

-9 -8 -7 -6 -5 -4 -3 -2 -1

log of per capita phones

grow

th o

f GD

P p

er c

apita

(%

)

Growth Effect of Trade Openness as a Function of Complementary Reforms (Cont.)

E. Governance

Congo, Dem. Rep.

South AfricaMorocco

Thailand

India

Peru

-0.6

-0.3

0

0.3

0.6

0.9

1.2

1.5

1.8

2.1

2.4

0 0.2 0.4 0.6 0.8 1

ICRG governance index

grow

th o

f GD

P p

er c

apita

(%

)

D: Labor Market Flexibility

Congo, Dem. Rep.

South Africa

Morocco

ThailandIndia

Peru

-2

-1

0

1

2

3

0.2 0.3 0.4 0.5 0.6 0.7 0.8

labor market flexibility

grow

th o

f GD

P p

er c

apita

(%

)

F: Firm Entry Flexibility

Congo, De. Rep.

South AfricaMorocco

Thailand

IndiaPeru

-2

-1

0

1

2

3

0.25 0.35 0.45 0.55 0.65 0.75 0.85

firm entry flexibility

grow

th o

f GD

P p

er c

apita

(%

)

Economic Growth and the Interaction between Openness, Reforms, and Income1

Dependent variable: Growth rate of real GDP per capita

TO * Initial GDP per Capita 1.0067 ** 0.9237 ** 1.2174 ** 1.2644 **0.21 0.27 0.30 0.41

TO * Human capital investment 0.1200 0.30

TO * Financial depth -0.2711 *0.15

TO * Public infrastructure -0.15500.17

Countries / Observations 82/544 82/544 82/544 82/544

[7]

Firm entry flexibility

TO * Initial GDP per Capita 0.9340 ** 0.3532 ** 0.24520.36 0.16 0.35

TO * Governance -0.7291 (governance: index from ICRG, 0 - 1) 1.36

TO * Labor market flexibility 9.5158 ** (labor: index from DB, 0.21-0.80) 1.39

TO * Firm entry flexibility 6.3057 ** (entry: index from DB, 0.25 - 0.94) 2.04

Interaction of Openness with:

[1]

BenchmarkHuman Capital

InvestmentFinancial Depth

[2] [3] [4]

Public Infrastructure

Interaction of Openness with:

GovernanceLabor market

flexibility

[5] [6]

Lesson (I)

International integration is not necessarily beneficial... But it can become beneficial

Lesson (II)

We can design a growth strategy based on openness by addressing the reforms that help the country to face and take advantage of foreign competition :– What is needed?– What is lacking?– What is lacking more?

The limitations ...

• Deeper country analysis is needed: – Reforms require analysis beyond rough proxies

• Ex. Education quantity vs. quality

• Why are necessary reforms not undertaken? – Are they too costly?– What’s the role of political economy?

• Ex. Infrastructure in Peru

Education in Peru

Secondary Enrollment vs. GDP per capita

y = 0.3308x + 1.3548R2 = 0.7256

0

1

2

3

4

5

6

4 5 6 7 8 9 10 11 12GDP per capita

Seco

ndar

y En

rollm

ent

Rest of LAC Rest of countries Peru

PISA results vs. GDP per capita

y = 63.612x - 137.68R2 = 0.5859

300

350

400

450

500

550

600

7 8 9 10 11 12

Ln GDP per capita

PISA

resu

lts (a

vera

ge)

Rest of countries LAC Peru

Infrastructure in Peru

Phones vs. GDP per capita

y = 0.9823x - 10.335

R2 = 0.8842

-9

-8

-7

-6

-5

-4

-3

-2

-1

0

1

0 2 4 6 8 10 12

GDP per capita

Num

ber o

f pho

nes

per 1

0.00

0 ha

bita

nts

Rest of LAC Rest of countries Peru

Port Infrastructure Quality vs. GDP per Capita

y = 0.9622x - 4.4352R2 = 0.5446

0

1

2

3

4

5

6

7

4 5 6 7 8 9 10 11 12

GDP per capita

Port

qua

lity

scor

e

Rest of LAC Rest of countries Peru

A final (very policy oriented) analogy:

It’s not a good idea to do aerobics wearing a steel body armor

OPENNESS CAN BE GOOD FOR GROWTH:

The Role of Policy Complementarities

Roberto Chang (Rutgers U.)

Linda Kaltani (American U.)

Norman Loayza (World Bank)

October 2005