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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 |
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b. Developed countries |
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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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