RESEARCH AND ANALYSIS

Managing Openness and Volatility: The Role of Export Diversification

Mona Haddad: Sector manager, International Trade Department, The World Bank.
Jamus Jerome Lim: Economist, Development Prospects Group, The World Bank.
Christian Saborowski: Economist, Middle East and North Africa Region, The World Bank.

Editorial assistance was provided by Benjamin Shepherd

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Outward-oriented growth can have many important benefits for developing countries. Access to foreign technology and high-quality intermediate inputs enables productivity upgrading. The pro-competitive effects of openness can shrink margins, improve quality, and provide consumers with access to a wider range of goods at lower prices. There are also the traditional gains from trade: specialization by comparative advantage enables a country to allocate scarce economic resources more efficiently.

Like any development strategy, outward orientation also comes with a certain number of risks that policy makers need to manage. One of the most important risks is volatility. By opening itself to the benefits of international trade, a country also makes itself more sensitive to demand shocks from overseas. At no time has this mechanism been more relevant than now, in the wake of the global financial crisis and the sharpest trade contraction in recorded history.

Does the potential for increased volatility mean that countries should rethink their outward-oriented growth strategies? This note argues that it is rather a question of risk management: Policymakers need to identify and implement strategies for managing the risks that come with the benefits of openness. One way of doing so is through export diversification.

What Are the Links between Outward Orientation and Volatility?

A number of distinct economic mechanisms are at play in the relationship between outward orientation and volatility.

The first important mechanism is transmission of terms-of-trade volatility to output. As export earnings become a more important source of national income, the terms of trade can directly affect output and growth. Falling demand abroad therefore translates into not only reductions in exports and producer revenues, but also export price reductions and worsening terms of trade.

A second mechanism works in the opposite direction. As a country’s export sector starts to operate more closely in tune with overseas market conditions, it necessarily becomes less strongly correlated with home market conditions. Because demand shocks at home and overseas are only imperfectly correlated, this force tends to reduce overall volatility in output.

The third mechanism is international diversification: outward-orientation means that a country is more likely to export more products to more markets. A country’s exports can be thought of as akin to an investment portfolio. Exporting one product to one foreign market is a very risky endeavor, because the exporting country is completely dependent on demand conditions in that one importing country. Exporting multiple products to a range of foreign markets reduces this risk through diversification: because demand shocks usually are not perfectly correlated among products and foreign markets, there is scope for positive shocks in some areas to partially offset negative shocks in others. Diversification acts as a kind of insurance, which offers a way of “buying” the benefits of openness while managing the downside risks. Of course, diversification cannot hedge away shocks arising from global downturns.

The final mechanism relates to the traditional gains from trade, which operates through specialization by comparative advantage. Here, the tension is between international diversification from increased openness, and the specialization that trade induces. However, evidence suggests that specialization does not dominate until countries achieve high levels of income.

Export Diversification Weakens the Volatility Effects of Openness

This note provides new evidence on the links between outward orientation and growth volatility. The innovation of the work presented here (based on Haddad, Lim, and Saborowski 2010) is that it examines an important mediating factor in the relationship between openness and volatility: export diversification. Assuming that other mechanisms result in a predominantly positive relationship between openness and volatility, it should still be true that the relationship is weaker—and may even become negative—in more diversified economies.

An empirical model using data for 77 developing and developed countries over the period 1976–2005 lends some support to this contention. The model strongly suggests that a higher level of product diversification weakens the link between openness and growth volatility, and, for a majority of countries in our sample, renders it negative. Export diversification acts as a stabilizing force, and can serve as an effective way for managing the risks associated with outward orientation.

There is a crucial turning point in the relationship between openness and growth volatility: countries that are relatively diversified experience either less volatility as they become more open (or no effect at all), while countries with relatively concentrated export bundles tend to experience more volatility. But where is this turning point? More importantly, which countries fall on the “wrong” side, in that greater openness increases growth volatility?

Figure 1 shows that the majority of the 77 developing and developed countries in this sample fall on the “good” side of the diversification threshold (below the red line): openness either has no significant effect on growth volatility, or a negative one.

Figure 1. Volatility Has No Significant Effect on Growth for Most Developing Countries
 

a. Developing countries

 

b. Developed countries

 

Moving Forward on Risk Management through Export Diversification

How can countries use export diversification to help maximize the cost-benefit ratio of outward-oriented development? The econometric results suggest one important part of the answer: The stabilization effects of export product diversification are noticeably more consistent than that for export market diversification. This finding suggests that developing-country policymakers should emphasize measures that help broaden their countries’ manufacturing base, and expand the range of exportable products.

There are also a number of steps that governments can take domestically to help the private sector diversify its export base. Rather than protecting domestic producers with “infant-industry” tariffs—a classic inward-oriented strategy—policymakers can remove barriers to domestic market entry, and thereby encourage innovation and development of new markets by companies at home. There is also strong evidence that better trade facilitation (that is, the reduction of fixed and variable costs associated with moving goods across borders) can be highly effective in promoting export diversification. Practical steps—such as the removal of red tape affecting exports and imports, and developing trade-related infrastructure and services—can make a major contribution to export diversification and help manage outward orientation.

 

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