Essays on export diversification, transaction costs and regional integration among developing countries

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Thesis

Reference

Essays on export diversification, transaction costs and regional integration among developing countries

REGOLO, Julie

Abstract

One of the most important factors which prevent developing countries from reaching a sustainable development is their vulnerability to international price shocks and to natural shocks. Opening trade with developed countries, which are far geographically and different in terms of production patterns could increase developing countries' vulnerability. On the one hand, this leads to a high concentration of their exports in primary commodities which results in greater vulnerability to terms-of-trade volatility. On the other hand, the dependence on food imports from the world suppliers, in particular during climatic shocks, threatens their food security. This thesis studies the extent to which an expansion of regional trade could reduce countries' vulnerability. The first two chapters show that fostering trade with regional and economically similar partners could contribute to increase export diversification. The third chapter provides a new examination of the main barriers preventing regional trade of staple foods between east and central African countries.

REGOLO, Julie. Essays on export diversification, transaction costs and regional

integration among developing countries . Thèse de doctorat : Univ. Genève, 2014, no. SES 841

URN : urn:nbn:ch:unige-370477

DOI : 10.13097/archive-ouverte/unige:37047

Available at:

http://archive-ouverte.unige.ch/unige:37047

Disclaimer: layout of this document may differ from the published version.

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Transaction Costs and Regional Integration among Developing

Countries

Thèse présentée à la Faculté des sciences économiques et sociales

de l’Université de Genève par

Julie Régolo

pour l’obtention du grade de

Docteur ès sciences économiques et sociales mention économie politique

Membres du jury de thèse:

Prof. Céline CARRERE, co-directrice, Université de Genève Prof. Jaime DE MELO, co-directeur, Université de Genève

Prof. Frédéric ROBERT-NICOUD, président du jury, Université de Genève

Prof. Marcelo OLARREAGA, Université de Genève Prof. Jean IMBS, Paris School of Economics

Thèse no 841

Genève, 9 Mai 2014

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La Faculté des sciences économiques et sociales, sur préavis du jury, a autorisé l’impression de la présente thèse, sans entendre, par là, n’émettre aucune opinion sur les propositions qui s’y trouvent énoncées et qui n’engagent que la responsabilité de leur auteur.

Genève, le 9 mai 2014

Le doyen

Bernard MORARD

Impression d'après le manuscrit de l'auteur

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List of Figures and Tables

Chapter 1:

Figures

Figure 1: The diversification of South-South exports compared to South-North

exports ...32

Figure A. 1: Illustration for Lorenz curves of Southern bilateral exports ...52

Figure I. 1: Semi-parametric and linear estimates for the empirical specification...74

Figure G. 1: South-South export concentration (Gini) and South-South transport costs. ...70

Figure G. 2 : South-North export concentration (Gini) and South-North transport costs. ...71

Figure J. 1: The diversification of North-North exports compared to North-South exports...76

Tables Table 1: Selected examples of diversification of bilateral exports, distance and endowment differences^(a)...37

Table 2: Transport costs, factor endowments and concentration of exports. Panel regression between country pairs (whole sample, averages on 1995-2007)...40

Table G. 1: The impact of South-South transport costs on export concentration between southern countries. ...70

Table G. 2: The impact of South-North transport costs on the concentration of South-North exports. ...71

Table H. 1: Pattern of Regional Trade Diversification. ...72

Table H. 2:Transport Costs Configurations and Regional Trade Diversification...73

Table J. 1: descriptive statistics of the concentration indexes ...76

Table J. 2: correlation between concentration indexes ...76

Table J. 3: correlation between relative factor endowments measures ...77

Table J. 4: correlation between main variables...77

Table J. 5: Panel regression with time dimension on 1995-2007(whole sample) ...78

Table J. 6: Panel regression with time dimension on 1995-2007 (whole sample) ....79

Table J. 7: Panel regression with time dimension on 1995-2007(whole sample) ...80

Table J. 8: Panel regression between country pairs ...81

Table J. 9: Panel regression between country pairs with all relative endowments ...82

Table J. 10: Panel regression between country pairs, manufacturing goods ...83

Table J. 11: Panel regression between country pairs, splitting symmetric country pairs in two groups, Averages on 1995-2007...84

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Chapter 2:

Figures

Figure 1: Evolution of the share of intra-regional trade between 2000 and 2010. ....87 Figure 2: Definition of newly exported goods over 2000-2010 and of traditionally exported goods...93 Figure 3: Average distance of trade (ADOT) of newly and traditionally exported goods by region (average over 2000-2010). ...95 Figure 4: Destination pattern of exported goods. ...99 Figure 5: Fitted probability of entry into markets for Tanzanian industries. (once adjusted for the country’s average and controlled for destination fixed effects) ...105 Figure 6: Share of newly exported goods across estimated ranks for countries’

industries (from the least to the most costly)...107 Figure 7: Kernel density of newly exported goods and traditionally exported goods over estimated (HS2) industries’ distance elasticity...108 Figure 8: The evolution of the predicted probability of entry into destinations (ranked according to the distance) with the age of the exported good. (Average over the sample)...112 Figure A. 1: Average distance of trade (ADOT) of newly and traditionally exported goods by region (by country, average over 2000-2010). ...119 Figure A. 2: Average distance of trade (ADOT) of newly and traditionally exported goods by region (by country, average over 2000-2010). Alternative definition for newly exported goods...120 Figure A. 3: Share of newly exported goods according to estimated rank of countries’ industries performance in terms of export entry (from the least to the most performant) ...121 Tables

Table 1: Number of newly and traditionally exported goods by income group, over the 2000-2010 period (average by country and income group) *...94 Table 2: Number and characteristics of destinations of newly exported goods, comparison with traditionally exported goods. ...96 Table 3: Distance elasticity, export entry and share of newly exported goods, by industry category. ...104 Table 4: Export entry into new markets and age of the exported goods...110 Table A. 1: Average number of newly exported goods and age (average by country- year). (Preferred definition)...122 Table A. 2: Average number of newly exported goods and age (average by country- year). (Alternative definition)...122 Table A. 3: Number of newly and traditionally exported goods by income group, over the 2000-2010 period (average by region) *...123 Table A. 4: Number and characteristics of destinations of newly exported goods and countries’ experience, comparison with traditionally exported goods (average value and ratio with respect to traditionally exported goods).Details of Table 2....123

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Table A. 5: Number and characteristics of destinations of newly exported goods and countries’ experience, comparison with traditionally exported goods (average and ratio with respect to traditionally exported goods). Only newly exported goods successively exported for at least eight years (92 countries)....124 Table A. 6: Number and characteristics of destinations of newly exported goods and countries’ experience, comparison with traditionally exported goods (average value and ratio with respect to traditionally exported goods). Alternative definition of newly exported goods (131 countries)...125 Table A. 7: Descriptive Statistics of variables used in section 4.1. ...125 Table A. 8: Student test for the difference of average distance elasticity of newly exported goods and traditionally exported goods (across country-HS4) ...125 Table A. 9: Student test for the difference of average distance elasticity of newly exported goods and traditionally exported goods (difference of average by country) ...126 Table A. 10: Descriptive Statistics of variables used in section 4.2. ...126 Table A. 11: Results of estimations of equation (2.3). ...127

Chapter 3:

Figures

Figure 1: A map of market integration and border effects of the east and central Africa region...152 Figure A. 1: A map of market integration and border effects of the east and central Africa region (with full corrected sample according to methodology in Appendix C).

...158 Tables

Table 1: Countries, towns and commodities in the sample...143 Table 2: Summary statistics of within-country and between-country price differentials. ...144 Table 3: Border coefficients, distance and price stickiness, average effect in the region...146 Table 4: Domestic Impediments to market integration (country are ranked from the one with the lowest to the one with the highest impediments)...149 Table 5: Border effects and Regional Trade agreements. ...150 Table A. 1: Relative prices, domestic and cross border market integration...159 Table A. 2: Border coefficients, distance and price stickiness, average effect in the region. (with the correlation between town-product prices as dependent variable) 161 Table A. 3: Border coefficients, distance and price stickiness, average effect in the region (uncorrected sample). (Corrected full sample with methodology detailed in Appendix C)...162

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Table A. 4: Relative prices, domestic and cross border market integration. Panel regression over monthly relative prices, May 2008-September 2009. (Corrected full

sample with methodology detailed in Appendix C)...163

Table A. 5: Domestic Impediments to market integration (country are ranked from the one with the lowest to the one with the highest impediments). (Corrected full sample with methodology detailed in Appendix C)...165

Table A. 6: Border effects and Regional Trade agreements. (Corrected full sample with methodology detailed in Appendix C) ...166

Table A. 7: Countries’ membership to Regional Trade Agreements...167

Table A. 8: Average tariff between country-pairs (simple average) over Rice, Sorghum and Maize and the period 2008-2009...167

Table A. 9: Average tariff in the sample (simple average) over Rice, Sorghum and Maize and the period 2008-2009...168

Table A. 10: Net bilateral trade by product, average value over 2008-2009 (000USD) ...168

Table A. 11: Summary of government interventions in staple food markets for some countries. ...169

Table B.1: Summary statistics of the price variables...170

Table B. 2: Distribution of price ratios, by good...171

Table C. 1: Estimation of transport costs ...173

Table C. 2: Descriptive statistics before and after the sample correction. ...174

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Résumé

La vulnérabilité des pays en développement aux chocs internationaux et climatiques empêche ces pays d’atteindre un développement soutenable. L’impact de l’ouverture au commerce international sur la vulnérabilité de ces pays est ambigu.

D’une part, la forte concentration de leurs exportations ainsi que leur spécialisation dans les matières premières les rendent fortement vulnérables à la volatilité des termes de l’échange and bloquent leur croissance. D’autre part, leur forte dépendance vis-à-vis des importations de nourriture en provenance des producteurs internationaux, en particulier lors de chocs climatiques, menace leur sécurité alimentaire. Cette dépendance est particulièrement forte sur le continent Africain.

Cette thèse étudie, au fil de ses trois chapitres, dans quelles mesures l’expansion du commerce régional peut réduire la vulnérabilité des pays en développement.

Les deux premiers chapitres montrent que le renforcement des liens commerciaux avec des partenaires régionaux et économiquement similaires peut contribuer à augmenter la diversification des exportations. Le premier chapitre prouve, théoriquement et empiriquement, que les exportations bilatérales sont plus diversifiées lorsque les partenaires commerciaux ont des dotations factorielles similaires, des niveaux de technologie similaires et lorsque les coûts de transports pour les atteindre sont faibles. L’expansion du commerce entre pays du Sud devrait donc conduire à une diversification de leurs exportations.

Le second chapitre étudie les caractéristiques des biens nouvellement exportés, dans le cadre de la diversification des exportations des pays, et analyse particulièrement leurs marchés de destination. Il met en évidence que la majorité de ces biens sont situés dans des industries où les pays ont de fort coûts de production. Par conséquent, ces nouvelles exportations, peu compétitives, atteignent seulement les marchés les plus accessibles en termes de distance, de langage et de préférence commerciales, c’est-à-dire les marchés régionaux. Les résultats de ce chapitre établissent donc un lien structurel entre la diversification des exportations et la régionalisation du commerce.

Le troisième chapitre s’intéresse à un autre aspect de la vulnérabilité des pays en développement sur lequel le commerce régional peut jouer un rôle majeur : l’insécurité alimentaire. Une bonne intégration des marchés régionaux assure en cas de sécheresse ou d’autres chocs climatiques imprévisibles, de pouvoir acheminer les biens alimentaires rapidement des régions qui ont un surplus de production vers celles qui souffrent de pénurie. De plus, cela permettrait d’atténuer la dépendance des pays vis-à-vis des marchés internationaux de biens alimentaires.

Le troisième chapitre identifie dans quelles mesures la mauvaise qualité des routes et les autres obstacles aux frontières gênent le commerce régional de trois biens alimentaires de base en Afrique de l’Est et du Centre.

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Dans son ensemble, cette thèse contribue à la littérature sur les effets potentiellement bénéfiques du commerce régional pour les pays en développement.

D’une part, elle comprend deux nouvelles analyses des déterminants de la diversification des exportations, un facteur essentiel à la diminution de la vulnérabilité de ces pays. D’autre part, cette thèse fournit un nouvel examen des principales barrières qui empêchent les pays d’Afrique de l’Est et du Centre de se protéger contre l’impact négatif des chocs climatiques sur la sécurité alimentaire à travers le commerce régional. Les résultats de ces études soutiennent les politiques visant à réduire les obstacles aux échanges régionaux entre pays en développement.

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Summary

One of the most important factors which prevent developing countries from reaching a sustainable development is their vulnerability to international price shocks and to natural shocks. The impact of openness to international trade on these countries’

vulnerability is ambiguous. On the one hand, the high concentration of their exports combined with their specialization in primary commodities results in greater vulnerability to terms-of-trade volatility and impedes their growth. On the other hand, their high dependence on food imports from the world suppliers, in particular during climatic shocks, threatens their food security. This dependence is especially high in the African continent. This thesis studies the extent to which an expansion of regional trade could reduce developing countries’ vulnerability along three chapters.

The first two chapters show that fostering trade with regional and economically similar partners could contribute to increase export diversification.The first chapter demonstrates, theoretically and empirically, that bilateral exports are more diversified when trading partners have similar endowments, similar levels of technology and when trade costs are low. Therefore, the expansion of trade between southern countries should lead to a diversification of their exports.

The second chapter studies the characteristics of newly exported goods in the context of countries’ export diversification, and focuses on the analysis of their destination markets. It highlights that most newly exported goods emerge in industries in which countries have high production costs. As a consequence, these new exports, weakly competitive, only reach the most accessible markets in terms of distance, language and tariffs preferences, i.e. regional markets in the medium term.

Hence, this chapter’s results establish a structural link between export diversification and trade regionalization.

The third chapter focuses on another aspect of developing countries’ vulnerability on which regional trade could play a key role: food insecurity. Well-integrated markets for staple foods imply that, during drought or other climatic shocks, staple foods could be easily and quickly moved from food surplus areas towards areas which suffer from food shortage. Moreover, regional market integration would lead to mitigate countries’ dependence on international markets of primary commodities.

The third chapter identifies the extent to which the poor road quality and the others barriers at the borders impede regional trade of three staple foods in Eastern and Central Africa.

Overall, this thesis contributes to the literature on the potential benefits of regional trade for developing countries. On the one hand, it includes two new analyses of the determinants of export diversification, a key factor to mitigate developing countries’

vulnerability. On the other hand, this thesis provides a new examination of the main

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barriers preventing east and central African countries to protect themselves from negative impacts of climatic shocks on food security through regional trade. The findings of these three chapters support a reduction of barriers to regional trade between developing countries.

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Acknowledgments

I would like to take this opportunity to thank all the people who have, directly or indirectly, contributed to the completion of this Ph.D. thesis.

First, I would like to thank my two thesis supervisors, Jaime de Melo and Céline Carrère, for having accepted to supervise my work during the past five years. I thank them for having debated my research questions with me and for having continuously supported me and given me valued advices on the writing of the thesis and on the preparations for conferences. I thank them for their availability and for having read carefully my article several times and given me comments. I also thank them for having helped me to write the successive answers to the comments of the referees of the Journal of International Economics, which has led to the publication of the first chapter of this thesis.

Second, I also owe a special thank you to Frederic Robert–Nicoud who provided me with very helpful comments during my thesis, in particular concerning the theoretical part of the first chapter of this thesis. I thank him for having taken of his time to revise my theoretical proofs and for having accepted to be part of this committee. A special thank you goes also to Marcelo Olarreaga who has continuously been available to advise me on the literature on trade and development and who has given me helpful comments. I also thank him for having organized several informal seminars with the other doctoral students working on trade and development, which have been very helpful for the emergence of the research questions of this thesis. I am also grateful for his constant support concerning my professional perspectives and for having encouraged me to acquire a professional experience on the field. I thank Jean Imbs for his inspiring paper on export diversification and economic development and for accepting to be part of the thesis committee.

Third, I would like to thank my colleagues and friends at the Department of Economics at the University of Geneva who have supported me during this thesis. In particular, I thank Gisèle, Liliana, Estefania, Maria and Brahim for their constant support. Special thanks to Liliana Foletti for having helped me to write this thesis in decent English. I would like also to thank Alexis Gabadinho for his support and his attention during the last year of this thesis.

Fourth, I would like to thank my family who were always very supportive of my work and my friends, who were always there to take my mind off my thesis and make me laugh after a hard day.

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Introduction

“Vulnerability has become the defining challenge of our times. More than one billion people worldwide live in extreme poverty. Facing risks exacerbated by natural hazards, ill-health and macroeconomic volatility, many are mired in inescapable poverty while millions others are on the brink of poverty” (Naudé, Santos-Paulino and McGillivray, 2009). Mitigating vulnerability of developing countries to natural and economic external shocks is a necessary condition to reduce economic poverty and food insecurity sustainably and to reach the Millennium Development Goals¹. Since 2000, the structural economic vulnerability, as measured by the Economic Vulnerability Index (EVI), is one of the three identification criteria of Least Developed countries (Guillaumont 2009), i.e. low income countries suffering from the most severe structural impediments to sustainable development.²

The structural vulnerability of countries refers to the amplitude and to the degree of exposition to two main categories of shocks. The first category includes external and trade shocks related to international price volatility and to world demand fluctuations of primary goods. Exposure to these shocks is higher for developing countries specialized in primary commodities and with low export diversification. The second is composed of natural shocks, as for example, natural disasters, droughts or floods which threaten countries’ food security and increase poverty sharply.

International trade can play a role in lowering countries’ vulnerability. International trade improves resource allocation, lowers prices for consumers, and leads to a more efficient production. Furthermore, it is acknowledged that well-integrated markets for staple foods provide a mechanism for reducing the adverse impacts of food shortages during drought or other climatic shocks, by allowing food staples to be easily and quickly moved from food surplus areas towards food deficit areas (World Bank, 2013). Most empirical works establish a consistent and significant positive correlation between trade liberalization, growth and poverty reduction (Edwards, 1993; Frankel and Romer, 1999; Sachs and Warner, 1995; Dollar and Kraay, 2002, 2004; Winters, 2004)³. Accordingly, international organizations advocate policy reforms centered on trade liberalization to fight vulnerability and

1 The eight Millennium Development Goals (MDGs) – which range from halving extreme poverty rates to halting the spread of HIV/AIDS and providing universal primary education, all by the target date of 2015 – form a blueprint agreed to by all the world’s countries and all the world’s leading development institutions.

2 The three identification criteria for Least Advanced countries are the level of income (GDP per capita), the level of human capital (measured by the Human Asset Index) and the level of vulnerability (measured by the EVI). This definition of Least Developed Countries is given by the Committee for Development Policy of the United Nations at its plenary session in 2011.

3 However the drawbacks to trade openness are acknowledged in terms of short and medium run adjustment costs. The pervasive effects of trade openness on poverty and inequality, even in the long run, are acknowledged as well (Goldberg and Pavcnik, 2004; Lundberg and Squire, 2003; McCulloch et al, 2001; Winters et al., 2004).

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poverty and to stimulate growth, and the development of an open trading system is viewed as one of the strategies to reach Millennium Development Goals.

However, a wide strand of the literature also shows that openness to international trade could increase developing countries’ vulnerability to external shocks. The main reason highlighted by this literature is that trade openness leads to specialization which increases the exposure to random shocks in the export markets of open economies (Koren and Tenreyro, 2007; Di Giovanni and Levchenko, 2009).

Developing countries are mainly affected by this greater exposure because commodities are at the core of their specialization process and commodity prices are more volatile than those of manufacture goods (Malik & Temple, 2009)⁴. Therefore, many studies find that an increase in the degree of trade openness leads to higher volatility on a wide set of outcome variables (aggregate income, consumption, employment, salaries, and prices), especially in developing countries (Lutz and Singer 1994; Karras and Song, 1996; Easterly et al., 2001; Kose et al., 2003; Loayza and Raddatz, 2007; Raddatz, 2007; Di Giovanni and Levchenko, 2006 and 2009; Krishna and Levchenko, 2009; Haddad et al. 2010). Moreover, the dependence of developing countries on food imports in case of food deficit makes them vulnerable to international price picks. The 2008 global food crisis has revealed that the dependence on global food supply may have catastrophic consequences in terms of food security.

This thesis explores the idea that an expansion of regional trade between similar developing countries may be more appropriate to decrease their vulnerability to the two main categories of shocks presented above.

First, according to the literature, trade openness may have a positive impact on countries’ vulnerability to external shocks if exports are sufficiently diversified.

Diversification into new products leads to higher sustained growth to the extent that diversification facilitates progressively more rapid moves into higher value-added production, less macroeconomic volatility and less elite misappropriation of rents associated with a narrower economic base. Furthermore, diversification into manufactures favors knowledge spillovers from exporters, such as information on the size of foreign demand and quality specifications as well as on new production processes and management techniques, and creates learning opportunities that lead to new forms of comparative advantage. However, one of the reasons of the decreasing export diversification of developing countries’ exports with trade openness, suggested by trade theory, is that their exports are mainly orientated towards developed countries which are geographically far and very differently endowed (Helpman and Krugman, 1985; Bergstrand 1990; Hummels and Levinsohn, 1995; Rice, Venables and Stewart, 2003). Second, in the context of 4 Loayza et al. (2007) underline as well that developing countries not only face more volatility than industrial countries but suffer more from volatility effects, because of the intrinsic instability of the developing process (e.g. the weakness of their financial).

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rising global food prices, importing staple foods from the global market and not from regional farmers increases sharply food import bills and may not prevent food crisis (the World Bank, 2012).

However, high trade costs, due to deficient infrastructure, both soft and hard, and to inappropriate domestic policies, impede the expansion of regional trade between developing countries. For example, Africa’s growing demand for food has not been met by regional farmers because trade barriers to access inputs they need and trade constraints in getting their food to consumers in African cities are higher than those faced by suppliers from the rest of the world. Nevertheless, since recently, regional trade between developing countries has increased substantially and an increasing prominence of regional trade agreements has been observed (World Trade Report, 2011). Developing countries have started to adopt policies to improve market liberalization, including the liberalization of domestic staple food markets.

In this context, the first two chapters of this thesis show that the benefits from trade are different according to trading partners and that fostering trade with regional and economically similar partners could contribute to increase export diversification. The third chapter identifies barriers impeding regional trade of three staple foods in Eastern and Central Africa.

The first chapter, “Export Diversification: How Much Does the Choice of the Trading Partner Matter?”, studies theoretically and empirically, how a country’s export diversification varies across destination markets. It develops an extension of the Romalis (2004) model and shows that similar endowments, similar levels of technology and low bilateral trade costs between southern countries lead to greater bilateral export diversification. The predictions are validated in a panel of 102 trade partners and 4998 HS-6 industries over the period 1995-2007. Results show that similarities between trading partners in factor productivity and physical capital, land and human capital endowments per worker are associated with more diversified bilateral exports. Exports are also more diversified when bilateral trade costs are relatively low.

The second chapter, “Manufacturing Export Diversification and Regionalization of Trade: Which Destinations for Newly Exported Goods?”, studies the extent to which export diversification in manufactures is related to the regionalization of trade by examining the destination pattern of newly exported goods. By comparing destinations of newly exported goods with destinations of traditionally exported goods over the period 2000-2010, it shows that for almost all countries in the sample of 116 countries, destinations of newly exported goods are on average more

“accessible” in terms of distance, language or tariffs preferences. This chapter finds that the destination pattern of newly exported goods is weakly dependent on the

“age” of the exported goods but rather is explained by the fact that these newly exported goods have emerged in industries where the country has high production

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costs. It follows that export diversification is accompanied by trade regionalization, at least in the medium term.

The third chapter of this thesis, “Distance, Road Quality and other Domestic and Cross-border Impediments to Market Integration in Central and Eastern Africa”, studies the impact of poor infrastructure, especially roads, and burdensome barriers- at-the-border on the lack of regional market integration in Eastern and Central Africa⁵for three key staple goods: Maize, Rice and Sorghum. This paper attempts to evaluate by how much trade of agricultural products is impeded by transport costs and transactions costs between domestic cities and at the borders as a first step towards the implementation of well-targeted policies to improve food security in the region. Using a database on monthly consumer prices for 150 towns and data on length and quality of roads separating towns, it finds a substantial effect of distance on the level of market integration. This chapter finds also that markets are better integrated between members of the same regional trade agreements.

Overall, this thesis contributes to the literature on the potential benefits of regional trade for developing countries. On the one hand, it includes two new analyses of the determinants of export diversification, a key factor to mitigate developing countries’

vulnerability. On the other hand, this thesis provides a new examination of the main barriers preventing east and central African countries to protect themselves from negative impacts of climatic shocks on food security through regional trade. The findings of these three chapters suggest that regional market integration could play an important role in the economic development of poor countries and justifies giving priority to reducing behind-the-border measures and to improving trade facilitation between developing countries.

5 Countries examined are Burundi, Djibouti, Democratic Republic of Congo, Ethiopia, Kenya, Mozambique, Malawi, Sudan, Somalia, Rwanda, Tanzania, Uganda and Zambia.

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CHAPTER 1 Export Diversification: How Much Does the Choice of the Trading Partner Matter?

(Published in the Journal of International Economics, 2013, vol. 91, pp. 329-342)

Abstract:

This paper studies how a country’s export diversification varies across destination markets. It develops an extension of the Romalis (2004) model which yields two testable predictions. According to the first, exports between similarly endowed countries (“South-South” and “North-North”) are more diversified than exports between differently endowed countries (“South-North” and “North-South”). The second implication is that, for given countries’ production patterns, low bilateral trade costs lead to greater export diversification. These predictions find empirical support in a panel of 102 trade partners and 4998 HS-6 industries over the period 1995- 2007. Results show that similarities between trading partners in physical capital, land and human capital endowments per worker are associated with more diversified bilateral exports. Exports are also more diversified when bilateral trade costs are relatively low.

Keywords: Export diversification, comparative advantage, trade costs, intra-industry trade, North-South trade

JEL Classification: F1, 01

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1. Introduction

This paper studies, both theoretically and empirically, the potential diversification of exports that could be expected from increased trade between developing (i.e.

Southern) countries. In the first part, determinants of the diversification of bilateral exports are studied in an extended version of the North-South trade model of Romalis (2004) in which differences in factor endowments and intra-industry trade in differentiated products determine the pattern of exports along a continuum of goods.

In this extended version, barriers to trade differ within and across regions and factor price equalization does not hold so that the commodity structure of trade is fully determined and varies across destinations. The model yields two testable predictions. First, export diversification is greater between similarly endowed partners (South-South or North-North) than between differently endowed partners (the South and the North) (Proposition 1). Secondly, for a given production pattern of countries, a decrease in transport costs between partners increase the bilateral diversification (Proposition 2). In the second part of the paper, I use highly disaggregated trade data for a sample of 102 countries and show that Propositions 1 and 2 find substantial support empirically. For example, Hungarian exports to the market of a similarly endowed country like Romania are more diversified than exports to the equally distant Austrian market. Country pairs with low trade costs (e.g. geographically close and involved in trade agreements) also have more diversified bilateral exports. For example, Mexican exports are more diversified in the Canadian market than in the more distant Chinese market.

In the model, the diversification of bilateral exports depends on the association between the exporting country’s comparative advantage and the relative toughness of the competition in the importer’s market. A country’s export diversification is greater in a market the less this country exports relatively in its comparative advantage and, in the presence of identical trade costs between countries, the competition in markets is relatively high in the importer’s comparative advantage (Davis and Weinstein, 1997; Lai and Zhu, 2007). As a result, bilateral diversification is greater when trading partners are similar in terms of comparative advantage.

Countries only differ in their factor endowments. The South is better endowed in unskilled labor and has a comparative advantage in low-skill intensive goods.

Exports of southern countries are therefore higher in high-skill intensive goods and lower in low-skill goods in the markets of other southern countries than in Northern markets (and vice versa for Northern exports). It follows that bilateral diversification is higher between partners with similar factor endowments. Extending the model to allow for different transport costs between and within regions and examining bilateral exports in partial equilibrium, i.e. for constant countries’ production patterns, yields the second Proposition. Proposition 2 establishes that lower transport costs between partners increase their bilateral diversification. The better access of the exporter

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decreases relatively more the competition in its comparative disadvantage in the importer’s market.

I find strong support for the model’s predictions in a panel of 9826 pairs of countries (102 importer and exporter countries) and 4998 HS6-digit sectors over the period 1995-2007. I study the impact on bilateral diversification of endowment differences between trading partners of physical capital, human capital and arable land per worker. The effects of trade costs are tested by introducing variables capturing transport costs and trade integration. The results are in line with the theoretical predictions of Propositions 1 and 2 and significant quantitatively. I find that if China were to increase its physical capital to the level of South Korea, its exports to South Korea would be more diversified than Japanese exports to South Korea. Bilateral trade costs also impact significantly export diversification. According to the findings, raising the depth of trade integration between Tanzania and Zambia to the level of trade integration between France and Germany, would substantially increase their bilateral export diversification.

In this paper, the pattern of trade and of comparative advantage of Southern and Northern countries is only based on factor endowment differences, as in Romalis (2004). To explore the sensitivity of results to the underlying trade model, I also analyze export diversification in models with firm heterogeneity in productivity within sectors (e.g. Bernard et al. 2007) ¹ and in models which introduce differences in sectoral productivities between countries in addition to endowment differences in the determination of countries’ comparative advantage (e.g. Burstein and Vogel, 2011)². I also discuss the determination of diversification from the demand side, i.e. in models with non-homothetic demand structure and monopolistic competition (Fajgelbaum et al., 2011 and Fieler, 2011)³. Empirically, I show that results are robust to the introduction of per capita GDP differences and to the introduction of total factor productivity differences that capture respectively the impact of preferences-based and productivity-based comparative advantage differences.

Coefficients on these variables have the impact expected from theory, i.e. income similarities decrease the diversification while similarities of total factor productivity 1 The recent literature which incorporates firm heterogeneity in two-sector models with factor endowments and monopolistic competition shows that patterns of comparative advantage are not affected by firm heterogeneity in productivity (Bernard et al. 2007; Burstein and Vogel, 2011). Moreover, it shows that when firms enter and exit according to their productivity within sectors, this enhances the effect of differences of endowments on the commodity structure of trade. With firm heterogeneity, the main predictions of this paper remain unchanged except that the effects of endowment differences and transport costs on diversification would be magnified. I show in Appendix D that the predictions of this paper hold in the model of Bernard et al. (2007).

2 See Appendix F.

3 This literature introduces monopolistic competition in models with non-homothetic preferences and transport costs and shows that countries with similar incomes tend to trade goods of similar quality. In those models, countries have a comparative advantage in goods preferred by domestic consumers and high income countries’ demand is higher for high quality goods. It results that income differences between countries could impact positively bilateral diversification.

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strengthen it. However, these factors do not put into question the predominance of factor endowments in the determination of the pattern of diversification between Southern and Northern countries. This is in line with the findings of a large literature comparing the impact of differences of factor endowments, of sectoral productivities and of consumers’ preferences on the pattern of bilateral trade (Morrow, 2010; Lai and Zhu, 2007; Debaere, 2003; Gourdon, 2009).

This paper belongs to the body of research on the various aspects of trade patterns of developing countries that has emerged recently with the availability of disaggregated trade data. One strand of this literature emphasizes the importance of the content of exports on overall country performance in terms of economic growth (Hausmann et al. 2007). Another focuses on the determinants of export diversification as countries develop (e.g., Cadot et al. 2011; Imbs and Wacziarg, 2003) and shows its importance in decreasing countries’ vulnerability to external shocks and promoting growth (Loayza and Raddatz, 2007; Haddad et al., 2010; Di Giovanni and Levchenco, 2009 and 2010). From these latter studies, export concentration combined with specialization in primary commodities come out as the major factors which impede developing countries from benefiting from trade and reaching sustainable growth. Despite its importance, export diversification has mainly been studied empirically, but not clearly determined theoretically. Moreover, while the current context of regional trade integration raises the need to understand the potential benefits of an intensification of trade between Southern countries, little attention has been paid to analyzing the effect of the choice of trading partners on the pattern of exports. This paper contributes to fill these gaps by showing theoretically and empirically the link between the destination pattern of exports and the diversification.

This paper is close to the literature on the extensive margin of bilateral trade in gravity models which documents the effect of trade costs on the diversity of products exported bilaterally (e.g. Helpman et al. 2008; Amurgo-Pacheco and Pierola, 2008;

Sanguinetti et al. 2004, Dennis and Shepherd, 2011). Product diversity in these papers varies between destinations because the presence of fixed export costs limits the number of firms which find it profitable to sell their goods across markets.

My contribution with regard to this literature is as follows. First I examine diversification more generally, i.e. according to the relative share of goods in exports whereas these papers focus on the number of bilaterally exported goods. To do this, I use a model that assumes no fixed export costs. However, it can be shown that adding fixed export costs to my model gives similar determinants as this literature for the number of bilaterally exported goods⁴. Second, my model has many sectors which differ in skill intensity and thus is able to show the role of countries’

comparative advantage on diversification. Third, the role of relative transport costs on diversification is highlighted, not only as an impediment for bilateral trade flows

4 see Appendix E

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but also as a determinant of the relative competition faced by exporters across goods in importers’ markets. Finally, though it focuses on export diversification, my framework also yields predictions relating intra-industry trade to endowment differences between countries (Helpman and Krugman, 1985; Bergstrand, 1990;

Hummels and Levinsohn, 1995; Rice et al., 2003; Song and Sohn, 2011).

The rest of the paper is organized as follows. Section 2 develops the model and studies the theoretical determinants of the diversification of bilateral exports. Section 3 presents the data, describes the sample, and discusses the results from testing both Proposition 1 and 2 on a panel of 102 trading partners (80 developing countries) between 1995 and 2007. Robustness is discussed in the text with detailed results reported in appendices. Section 4 provides my main conclusions.

2. Diversification of Bilateral Exports in a North-South model.

2.1. The Model.

The world is symmetric, with M countries in the North and M countries in the South.

There are two factors of production, skilled and unskilled labor. The proportion of skilled labor is relatively higher in the North (hN>hS). Following Dornbush, Fisher and Samuelson (1980), these factors are employed in a continuum of industries 0<z<1 that are ranked in increasing order according to their skilled-labor intensity. There is monopolistic competition in each industry. Production technology and fixed costs of production are assumed to be identical across firms irrespective of the region to which they belong and firms are homogenous in productivity within each industry z.

In the industry z of a Southern (Northern) country, each one of the nS (nN) firms supplies a different variety and sets the same ex-factory pricepS(pN). The number of varieties of good z in the world is given by:N(z)=M.nS(z) + M.nN(z). Technology is represented by a total cost function (TC) and is assumed to be Cobb-Douglas in both factors and identical in all countries:



^S^{( , )}

 

^S^{( , )}

   

^s ^z ^u ¹ ^z

TC q z k  q z k w w ^

In this expression, w^s and w^u are the wage of respectively skilled and unskilled workers,q^S(z, k) is the quantity of varietyk of goodz supplied by the firm and α is the fixed number of units of the sectoral composite input bundle incurred by firms to produce. With this technology, factor shares do not depend on factor rewards andz denotes both the industry and the skilled labor's share of income in that industry.

Consumers have identical Cobb-Douglas preferences on the continuum of goods z and they spend a fractionb(z)of their income on eachz.To simplify, this constant fraction is assumed to be identical across countries and goods⁵: b(z)=b=1. YS and YN are respectively the income of a Southern and a Northern country. A CES 5 The results below hold with arbitrary fractions across industries as long as they are identical across countries.

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aggregator with elasticity of substitution σ>1 represents preferences over varieties of each z so that varieties are consumed in proportions that depend only on their relative prices⁶.

There are trade costs between and within regions so that it is costly to buy varieties from abroad. LetτNSrepresent symmetric transport costs for inter-regional trade and τSS and τNN transport costs for intra-regional trade within the South and within the North, respectively. The main difference with Romalis (2004) is that transport costs between and within regions may differ (τSN ≠ τSS ≠ τNN), in which case countries’

access varies across importers’ markets. There are no fixed costs to export and consumers have a preference for varieties which implies that each produced good is also exported to all destinations. I discuss later the implications of introducing fixed costs to export in the model and explain that it doesn’t change the predictions.

In the model, the expression for exports from countryito countryjin sectorz(Xij(z)) is:

   

( )

1

( ) ; with , , .

( )

ij i

ij j i

j

X z Y n z p z i j N S

P z



^

 

       

^(1.1)

where Pj(z) denotes the price index of good z in importer j’s market. Consider expression (1.1) for bilateral exports. Ifzis produced, exports of goodzfrom country i to any importer increase with the number of varieties of good z, ni(z) it produces, and decrease with the pricepi(z)set by its firms relative to the price indexPj(z)in the importer market. Exports of any good z will also be greater in a market the lower the transport costs, τij, to reach this market and the higher the importer’s income, Yj. Determinants of exports in this model are similar to those in models which deliver analytic gravity equations. The difference is that the expression (1.1) here is for the bilateral exports of one good z and that export values may vary across z⁷.

2.2. Definition of export diversification.

The diversification of exports between countries i and j is measured by the Lorenz curve which evaluates the inequality of export flows among goods z. As shown below, the shape of the Lorenz curve depends on the shape of good export shares when goods are ranked from the least to the most exported. Define vij, with i,j{N, S}, a variable which denotes and ranks goods z on [0,1] not according to skill intensity but according to their export values between countries i and j, from the

6 The model is fully developed in appendix C.

7 See Anderson and Van Wincoop (2003) that have a similar expression for total bilateral exports.

Similarly, the model of Helpman, Melitz and Rubinstein (2008) use the expression of the Anderson-Van Wincoop model and add fixed costs to exports so they can characterize both the intensive and the extensive margin of exports using the gravity variables mentioned above.

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least to the most exported, such that dXij (vij)/dvij>0, with Xij the exports from i to j.

The Lorenz curve gives the cumulative share of exports of the vij least exported goods. The closer the Lorenz curve to the 45° line, the greater the diversification. As each good has a specific export valueXij(vij), the Lorenz curve for exports fromitoj, Lijcan be expressed as:

 

0

, {

) ; , }

(

vij

ij ij

s

ij

with i j S N

L v      d 

^(1.2)

with  

 

1 0

( ) ^ij ^ij

ij v X

X t dt ij ij

s v 

 the share in bilateral exports of the

v

_ij^th exported good.

Lemma 1 states that for Southern (Northern) countries, exports are decreasing (increasing) with the skill intensity of goods.

Lemma 1: Rank of goods in bilateral exports:

For any exporting country i,

v

_ij is invariant across destination countries j, i.e.

v

_ij

 v

_i

, and for all j{N S, }:

v

_Sj

   1 z v

_Sand

v

_Nj

  z v

_N , z∈[0,1].

Proof: see Appendix A

In the model, full employment conditions in the South and the North imply that unskilled labor is relatively cheaper in the South (

u u

S N

s s

S N

w w

w  w

), so that Southern firms are the low-cost producers of unskilled labor intensive goods. Therefore, at the equilibrium, the South produces relatively more varieties and sets a lower price for unskilled labor intensive goods (see Romalis, 2004)⁸. It follows that Southern exports to each destination are decreasing in the skill intensity of goods and symmetrically for Northern exports (see Appendix A).

Lemma 1 says that the ranking of goods in Southern exports is the same across destinations (

v

_Sj

 v

_S) and decreases with the skill intensity of goods on [0,1]. On the contrary, Northern exports to any destination rank from the least to the most skill-intensive goods. By definition,vialso ranks goods according to their intensity in

8 Under monopolistic competition, the price of good z in each country is determined by the marginal cost of production up to a constant and identical markup. Moreover, the number of firms (and hence of varieties) is determined by the zero profit condition. If factor proportions are sufficiently different between countries, some high-skill goods (high z) will not be produced in the South (nS=0), because the relative costs of the South (inclusive of the mark-up) are too high (i.e. if p z( ) ^p^N^{( )}^z p_S^{( )}z  p). By symmetry, some low-skill intensive goods will only be produced in the South (nN=0) if p  p. Both the North and the South will produce all the goods when factor endowments are not too different.

Essays on export diversification, transaction costs and regional integration among developing countries

Thesis

Reference