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Issue 24/9 June 2010

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Today’s Issue Includes:


1) Developing Countries: The advantages of openness versus the dangers of volatility by Nigel Tree.

nigelcropforezineIntroduction
There are a number of clear advantages to outward-oriented growth for developing countries, but at the same time as countries become more open through trade, they leave themselves open to the volatility of demand shocks from overseas.

Recent research by Haddad, Lim and Saborowski at The World Bank has just been published, under the title: “Managing openness and volatility: The role of export diversification.”

In this they show the important benefits of outward-oriented growth, including access to foreign technology and high quality intermediate inputs which allows for improvements in domestic productivity. On top of this, margins can be lowered and consumers get the benefit of a wider choice of goods at lower prices. Plus, specialisation according to comparative advantages will use scarce resources more efficiently.

However, there are risks to this policy as has been seen in the recent global crisis. More openness to trade means more sensitivity to overseas demand shocks.

Haddad, et al, argue that the prospect of increased volatility should not put countries off pursuing a more open trade policy, but they do need to manage the risks, and one way they can do this is through diversifying their exports.

What are the links between outward orientation and volatility?

Firstly, there is a transmission mechanism from any volatility in the terms of trade to the domestic country’s output. The more important export earnings become, the more any fall in overseas demand will impact exports and producer revenues and will also worsen the terms of trade.

Secondly, as the export sector becomes more in tune with overseas cycles, it becomes less attached to domestic market conditions. Because shocks to markets at home and overseas do not necessarily happen at the same time, this will serve to reduce overall volatility in output. This, therefore, works in the opposite direction to the first mechanism above.

Thirdly, outward-orientation means the export of more products to more markets. Reliance on a single product is very dangerous but diversifying into a range of products and markets acts as a kind of insurance, although it is not possible to hedge against a global downturn.

Finally, given comparative advantage and specialisation, there is a tension between international diversification from increased openness and the specialisation which comparative advantage demands. The authors suggest that specialisation does not dominate until countries achieve high levels of income.

Export diversification weakens the volatility of openness
The authors provide new evidence of the links between outward orientation and growth volatility. Their hypothesis is that although other mechanisms result in a predominantly positive relationship between openness and volatility, in more diversified countries this relationship will become weaker and even negative.

They use data for 77 developing and developed countries over the period 1976-2005. Their evidence suggests that a higher level of product diversification weakens the link between openness and growth volatility and for a majority of countries actually causes it to become negative.

Conclusion
They conclude that the stabilisation effects of export product diversification are more consistent than that for export market diversification. This suggests that policymakers in developing countries should do more to broaden their country’s manufacturing base, to enable them to expand the range of exportable products.

Rather than using the protectionist strategy of “infant industry” tariffs, policymakers should remove the barriers to domestic market entry, thus encouraging innovation and the development of new markets by domestic companies. Countries can also facilitate trade by reducing the fixed and variable costs of moving goods across borders.

Finally, countries can take practical steps such as removing red tape affecting trade, and by developing infrastructure and services which will enable trade. All of this can make a major contribution to export diversification and help manage outward orientation.


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2) A silver lining lurks behind the dark clouds by Karim Foda, Senior Research Assistant at the Brookings Institution, and Eswar Prasad, Tolani Senior Professor of Trade Policy at Cornell University, Senior Fellow of the Brookings Instititution and Rese

karim_photoIs the worst of the crisis behind us, or is this just the eye of the storm? This column provides a snapshot from a new index provided jointly by the Brookings Institution and the Financial Times known as TIGER – Tracking Indices for the Global Economic Recovery. It argues that while some dark clouds remain, the economic picture looks far better now than it did a year ago

The world economy took a pounding during the financial crisis but seemed to be getting back on its feet over the last year (IMF 2010). Now the Greek debt crisis has rocked it back on its heels. Despite all the portents of doom, however, the world economy has in fact been quietly mending itself. This is not to say that the recovery is firmly entrenched or that few risks remain, but there are distinct glimmers of hope. The economic picture looks far better now than it did a year ago.
But is the worst is behind us, or is this just the eye of the storm? The answer to this question is of critical importance. It informs judgments on whether it is time for more stimulus, or, by contrast, execution of exit strategies to reduce the risks of rising debt levels and unstable inflation. But before we know where the world economy is going, we need to know where it now stands.

Introducing TIGER

To get an accurate picture of the present condition of the world economy, we need to look at a broad set of economic data. We have gathered data from most of the G20 economies for three types of indicators.

  • Real economic activity, captured by GDP, industrial production, employment, imports and exports.
  • Financial indicators such as national stock market indices, stock market capitalisation and, in the case of emerging markets, their bond spreads relative to US treasuries.
  • Finally, indicators of business and consumer confidence.

By combining information from these variables using statistical techniques, we have created the Brookings Institution-Financial Times index for the world economy, which we have christened as TIGER – Tracking Indices for the Global Economic Recovery. In addition to the global index, we have also created indices for each country, so TIGER allows us to take the pulse of the world economy as well as individual economies. We have also constructed indices broken down by indicator allowing us to examine, for instance, how business and consumer confidence are doing across the world (see Prasad and Foda 2010a at Brookings and Prasad and Foda 2010b at FT.com for more details).

Dominant themes from TIGER

The composite indices reveal five dominant themes.

  • First, the global economy turned the corner by mid-2009 and has strengthened gradually since.

Growth rates of many indicators have rebounded strongly after plunging into negative territory during 2008. Of course, these high growth rates are coming from a lower base and there is still a lot of ground to be made up before the levels of these indicators are back at their pre-crisis levels. For instance, growth rates of industrial production in many G20 economies are now higher than before the crisis but, because growth rates fell sharply during 2008, the levels of industrial production are still below pre-crisis levels. Still, the recovery has clearly gathered momentum. Moreover, some indicators such as global trade are already at or slightly above their pre-crisis levels.

  • Second, the recovery has been rather uneven.

Growth rates of industrial production and trade volumes have recovered strongly, while the recovery in GDP and employment has been modest at best. Employment growth, which tends to be a lagging indicator of the business cycle, was very weak in advanced economies until the beginning of 2010 but is now showing some signs of life. So the recovery is ever so slowly becoming more broad-based.

  • Third, the performance of world financial markets has outpaced that of key macro variables.

In the last two months, however, financial markets have dipped as they have been rattled by the problems in Europe. This could signal that financial markets are concerned about more difficult times ahead or it could just be a temporary pullback from an earlier surge of unfounded optimism. Either way, this is not good for the recovery. Then again, a more tempered financial market performance may not be such a bad thing for the longer term.

  • Fourth, confidence measures have regained some of the ground they lost during the worst of the crisis.

In both advanced and emerging market economies, business confidence is still rising gradually but consumer confidence in advanced economies has been stuck in a rut in recent months. Resurgent business confidence is a positive sign as it could boost investment. But weak consumer confidence and minimal employment growth could dampen the recovery if they translate into tepid growth in private consumption.

  • Fifth, emerging markets felt the effects of the global crisis later than the advanced economies and have also recovered more sharply.

Among the major emerging markets, the recoveries in China and India have been particularly strong. So far in 2010, emerging markets are still barrelling their way to a strong performance despite the problems that have beset advanced economies. Perhaps, in a long-term structural sense, they are becoming less dependent on advanced economies (see Kose et al. 2008). But emerging markets cannot pull the world economy along by themselves. If advanced economies continue to turn in a weak performance, we are in for a long and hard slog towards a durable global economic recovery.

Conclusion

We are certainly not out of the woods yet and a number of risks could still forestall the recovery. While it is easy to paint dire scenarios, it is still worth recognising that there is a lot of positive news relative to the desperate circumstances that the world economy was in a year ago.

References

IMF (2010), “World Economic Outlook Update. A Policy-Driven, Multispeed Recovery”, WEO IMF, 26 January.
Kose, M. Ayhan, Christopher Otrok, and Eswar Prasad (2008), “Dissecting the Decoupling Debate”, VoxEU.org, 4 October.
Prasad, Eswar and Karim Foda (2010a), “TIGER: Tracking Indexes for the Global Economic Recovery”, The Brookings Institution.
Prasad, Eswar and Karim Foda (2010b), “Interactive: Tracking the global economic recovery”,FT.com.

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