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