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
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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?
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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)
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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)
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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
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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
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A first conclusion:
The average effect of openness on growth is positive,
but the individual country experiences vary from each other
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Question:
Is there a systematic pattern to this diversity?
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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)
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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)
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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)
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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
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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
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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
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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
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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)
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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
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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]
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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
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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
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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
(%
)
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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
(%
)
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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]
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Lesson (I)
International integration is not necessarily beneficial... But it can become beneficial
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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?
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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
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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
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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
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A final (very policy oriented) analogy:
It’s not a good idea to do aerobics wearing a steel body armor
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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)
October 2005