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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 SchmidtHebbel 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 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 -0.1 6.2 6.5 6.8 7.1 7.3 7.6 7.9 8.1 8.4 8.7 9.0 -0.2 Real GDP per capita (in logs) 9.2 9.5 9.8 10.0 Changes in GDP growth vs. Changes in Openness between the 1980s and 90s Ranking Criterion: Governance 8 y = 5.7808x - 1.6051 change in growth 6 4 2 0 -0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 -2 -4 -6 y = 0.6847x + 0.8104 -8 change in openness top group Linear (top group) bottom group Linear (bottom group) 1 Changes in GDP growth rates versus changes in openness between the 1990s and 1980s Ranking Criterion: Education Ranking Criterion: Infrastructure 8 8 y = 4.6347x - 0.9803 6 4 2 0 -0.6 -0.4 -0.2 -2 0 0.2 0.4 0.6 0.8 1 -4 y = 1.0697x + 0.6745 -6 change in growth change in growth y = 3.8348x - 0.9299 4 2 0 -0.6 -0.4 -0.2 -2 0 0.2 0.4 0.6 0.8 1 -4 y = 0.9883x + 0.5745 -8 6 -6 -8 change in openness top group Linear (top group) change in openness bottom group Linear (bottom group) top group Linear (top group) Ranking Criterion: Governance bottom group Linear (bottom group) Ranking Criterion: Labor Market Flexibility 8 8 6 y = 1.5203x - 0.0371 4 2 0 -0.6 -0.4 -0.2 -2 0 0.2 0.4 0.6 0.8 -4 y = 0.6847x + 0.8104 -6 change in openness bottom group Linear (bottom group) 6 4 2 0 -0.6 -0.4 -0.2 -2 0 0.2 0.4 0.6 0.8 -4 y = 0.9256x + 0.5571 -8 top group Linear (top group) 1 change in growth change in growth y = 5.7808x - 1.6051 -6 -8 change in openness top group Linear (top group) bottom group Linear (bottom group) 1 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 HarrisTodaro 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: yi ,t yi ,t 1 0 yi ,t 1 REF ' REFi ,t OPENOPENi ,t INT REFi ,t * OPENi ,t t i i ,t • Sample: 82 countries, 8 non-overlapping five-year observations per country, 1960-2000 • Methodology: Generalized Method of Moments (GMM) for models using panel data 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: yi ,t yi ,t 1 ' X i ,t i i ,t • Instruments: lagged differences of the explanatory and lagged dependent variables – Regression in Differences: yi ,t yi ,t 1 ( yi ,t 1 yi ,t 2 ) ' ( X i ,t X i ,t 1 ) ( i ,t i ,t 1 ) • Instruments: previous observations of the explanatory and lagged dependent variables in levels Economic Growth and the Interaction between Openness and Other Economic Reforms Dependent variable: Growth rate of real GDP per capita [1] Benchmark: No Interactions Interaction of Openness with: [2] [3] [4] Human Capital Financial Depth Inflation Investment [5] Public Infrastructure Control Variables: Initial GDP per capita (in logs) -3.1713 ** 0.18 -3.2036 ** 0.21 -3.2627 ** 0.17 -3.2059 ** 0.18 -3.3552 ** 0.23 Human capital investment (secondary enrollment, in logs) 1.1621 ** 0.15 -0.8610 ** 0.42 1.2105 ** 0.16 1.1402 ** 0.16 1.2594 ** 0.17 Financial depth (private domestic credit/GDP, in logs) 1.0272 ** 0.11 0.9421 ** 0.09 0.0262 0.21 1.0071 ** 0.11 0.9234 ** 0.07 -0.4580 ** 0.08 -0.4350 ** 0.07 -0.4895 ** 0.07 1.5764 ** 0.13 1.5904 ** 0.16 1.6053 ** 0.14 1.1959 ** 0.16 -2.0421 ** 0.59 Inflation (deviation of inflation rate from -3%, in logs) Public infrastructure (main telephone lines per capita, in logs) -0.3243 0.21 -0.4364 ** 0.07 1.6050 ** 0.14 0.6423 ** 0.19 1.3497 ** 0.28 3.2821 ** 0.48 Openness: Trade Openness (TO) (structure-adjusted trade volume/GDP, in logs) -0.2553 0.28 Interactions: TO * Human capital investment TO * Financial depth TO * Inflation TO * Public infrastructure 1.0031 ** 0.18 0.4629 ** 0.08 -0.0725 0.10 0.4970 ** 0.09 Economic Growth and the Interaction between Openness and Institutional Reforms Dependent variable: Growth rate of real GDP per capita [1] Governance Interaction of Openness with: [2] [3] Labor market Firm entry flexibility flexibility [4] Firm exit flexibility Control Variables: Initial GDP per capita (in logs) -3.4019 ** 0.33 -4.0229 ** 0.24 -3.0202 ** 0.21 -3.2063 ** 0.18 Human capital investment (secondary enrollment, in logs) 1.2845 ** 0.16 1.5146 ** 0.16 1.7603 ** 0.16 1.2424 ** 0.11 Financial depth (private domestic credit/GDP, in logs) 0.9632 ** 0.12 1.2870 ** 0.12 0.9063 ** 0.12 1.3196 ** 0.12 -0.3830 ** 0.08 -0.3513 ** 0.08 -0.5266 ** 0.08 -0.2848 ** 0.07 1.5912 ** 0.17 1.6379 ** 0.12 1.4037 ** 0.14 1.0532 ** 0.13 -3.7359 ** 0.64 -3.5333 ** 0.69 1.6581 ** 0.27 Inflation (deviation of inflation rate from -3%, in logs) Public infrastructure (main telephone lines per capita, in logs) Openness: Trade Openness (TO) (structure-adjusted trade volume/GDP, in logs) 0.0802 0.33 Interactions: TO * Governance (governance: index from ICRG, 0 - 1) TO * Labor market flexibility (labor: index from DB, 0 - 1) TO * Firm entry flexibility (entry: index from DB, 0 - 1) TO * Firm exit flexibility (exit: index from DB, 0 - 1) 2.9617 ** 0.87 8.9986 ** 1.36 7.4593 ** 1.31 -0.8598 0.73 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 B. Financial Depth 2.5 2 2 1 0.5 growth of GDP per capita (%) South Africa Thailand Morocco Peru India Congo, Dem. Rep. 0 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 -0.5 South Africa Morocco 1 0.5 0 -1.1 -0.1 0.9 1.9 2.9 3.9 -0.5 -1.5 -1 -2 log of domestic credit to private sector/GDP log of secondary school enrollments C. Telecommunications Infrastructure 2.5 2 1.5 South Africa Thailand Peru Morocco India 1 0.5 0 -9 -8 -7 -6 -5 -4 -3 -2 -1 -0.5 Congo, Dem. Rep. -1 -1.5 log of per capita phones Thailand India Peru -1 growth of GDP per capita (%) growth of GDP per capita (%) 1.5 1.5 4.9 Growth Effect of Trade Openness as a Function of Complementary Reforms (Cont.) E. Governance D: Labor Market Flexibility 2.4 3 growth of GDP per capita (%) South Africa 1 Morocco India Thailand 0 0.2 0.3 0.4Congo, Dem.0.5 0.6 0.7 0.8 Rep. -1 Peru 1.8 1.5 1.2 South Africa 0.9 India Morocco Thailand Peru 0.6 0.3 Congo, Dem. Rep. 0 0 0.2 0.4 0.6 -0.3 -2 -0.6 labor market flexibility ICRG governance index F: Firm Entry Flexibility 3 2 growth of GDP per capita (%) growth of GDP per capita (%) 2.1 2 South Africa Morocco 1 Thailand 0 0.25 Peru India 0.35 0.45 0.55 0.65 Congo, De. Rep. -1 -2 firm entry flexibility 0.75 0.85 0.8 1 Economic Growth and the Interaction between Openness, Reforms, and Income Dependent variable: Growth rate of real GDP per capita 1 Interaction of Openness with: TO * Initial GDP per Capita [1] [2] [3] [4] Benchmark Human Capital Investment Financial Depth Public Infrastructure 1.0067 ** 0.21 TO * Human capital investment 0.9237 0.27 ** 1.2174 ** 0.30 0.1200 0.30 TO * Financial depth -0.2711 * 0.15 TO * Public infrastructure Countries / Observations -0.1550 0.17 82/544 82/544 82/544 Interaction of Openness with: [5] [6] [7] Governance Labor market flexibility Firm entry flexibility TO * Initial GDP per Capita 0.9340 0.36 TO * Governance (governance: index from ICRG, 0 - 1) -0.7291 1.36 TO * Labor market flexibility (labor: index from DB, 0.21-0.80) TO * Firm entry flexibility (entry: index from DB, 0.25 - 0.94) 1.2644 0.41 ** 0.3532 ** 0.16 0.2452 0.35 9.5158 ** 1.39 6.3057 ** 2.04 82/544 ** 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 PISA results vs. GDP per capita 6 600 y = 0.3308x + 1.3548 R2 = 0.7256 y = 63.612x - 137.68 R2 = 0.5859 5 4 PISA results (average) Secondary Enrollment 550 3 2 1 500 450 400 350 0 4 5 6 7 8 9 10 11 GDP per capita 12 300 7 8 9 10 11 Ln GDP per capita Rest of LAC Rest of countries Peru Rest of countries LAC Peru 12 Infrastructure in Peru Phones vs. GDP per capita Port Infrastructure Quality vs. GDP per Capita 7 Port quality score Number of phones per 10.000 habitants 1 0 -1 y = 0.9823x - 10.335 R2 = 0.8842 -2 -3 -4 -5 -6 y = 0.9622x - 4.4352 R2 = 0.5446 6 5 4 3 2 -7 1 -8 0 4 -9 0 2 4 6 8 10 5 6 Rest of countries 8 9 10 11 12 GDP per capita GDP per capita Rest of LAC 7 Peru Rest of LAC Rest of countries Peru 12 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