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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