The Importance Of Export Diversification

Earlier a country’s economic development was based either on the degree of specialization or diversification of a country’s production and trade structure. Based on Adam Smith’s concept towards division of labour and specialization for economic growth and development to Heckscher-Ohlin Samuelson (HOS) model of international trade, countries should specialize in producing and specializing in the goods in which they have a comparative advantage. However, after the Second World War, the idea was that economic growth and development may be achieved by export diversification (not specialization). There were active efforts by the government to promote industrialization and economic growth.

Export diversification is often the primary objective of many developed countries. Export diversification is also equally important for many developing countries. Some of the developing countries are dependent on relatively small range of products, generally agricultural commodities. In other words, primary products constitute a large percentage of their overall export earnings. Some economists such as Prebisch have even suggested that there is a long term tendency for primary product prices to decline vis-à-vis those for manufactured goods. Countries that are commodity dependent or have a narrow export basket usually faces export instability which arises from inelastic and unstable global demand. This can consequently have a significant adverse impact on the macro economy of least developed economies in terms of investment and employment. Thus export diversification is one means to alleviate these constraints. Export diversification refers to the move from “traditional” to “non traditional” exports. Developing countries should diversify their exports since this can; for example, help them to overcome export instability. Diversifying the export portfolio could intensify and accelerate the economic growth. Export instability could discourage necessary investments in the economy by risk-averse firms, increase macroeconomic uncertainty and be damaging to longer term economic growth. Export diversification could therefore help to stabilize export earnings in the longer run (Ghosh and Ostry, 1994; Bleaney and Greenaway, 2001). Countries with the slightest level of export diversification are those which face instability in export earnings. Some examples of countries which have instability in export earnings due to very heavy reliance on exports of one or two commodities are Kiribati, Samoa, Tuvalu and the Marshall Islands.

Reasons for export diversification

Export diversification may be an important issue for developing countries for several reasons. First, a diversified bundle of export products provides a hedge towards price variations and shocks in specific product markets (Bertinelli et al., 2006; Levchenko and di Giovanni, 2006). Second, the type of products exported might affect economic growth and the potential for structural change (Hausmann et al., 2007; Hausmann and Klinger, 2006; Whang, 2006). Third, export diversification in the direction of more sophisticated products may be beneficial for economic development. Given these potential benefits of export diversification, an important policy question is what a country can do to diversify its exports.

For poor countries to grow rich, it is important for them to modify the composition of their exports which will enable them to look more like that of rich countries. For over 50 years, economic and export diversification has been given high importance on the list of priorities for development policy. The argument was based on the observation that dependence on primary commodity production and exportation by developing countries expose them to commodity shocks, price fluctuations and declining terms of trade. As a result, a country’s foreign exchange reserves and the ability to have funds for imported inputs become subject to instability and uncertainty. The debates about the Prebisch-Singer hypothesis (1959) and the need for industrialization gave priority to diversify economies away from primary commodities because of unfavorable and declining terms of trade, slow productivity growth, and relatively low value added.

There are several reasons for developing countries to have export diversification. Firstly, diversifying their bundle of exports will protect them from the risk of unpredictable declining trend in international prices of primary exportable commodities that, in turn, lead to unstable export earnings. Export diversification could therefore help out to stabilize export earnings in the longer run (Ostry, 1994; Greenaway, 2001). FAO (2004) maintains that due to the absence of export diversification in developing countries, decline and fluctuations in export earnings have negatively influenced income, investment and employment. Diversification provides the opportunities to extend investment risks over a wider portfolio of economic sector which eventually increase income (Acemoglu and Zilibotti 1997). Romer (1990) believes that diversification can be seen as an input factor that has an effect of increasing the productivity of other factors of production. Through exports it is also possible to build an environment that creates competition and as a result acquire new skills. Overall economic growth and acquisition of human capital may be slow if there is the absence of pressure from outside competitive forces (Husted and Melvin, 2007).

Diversification helps countries to hedge against adverse terms of trade shocks by stabilizing export revenues. It enables them to direct positive terms of trade shocks into growth, knowledge spillovers and increasing returns to scale. Other industries in the country can also gain as export diversification can lead to knowledge spillovers from new techniques of production, management or marketing practices (AminGutierrez de Pineresand Ferrantino, 2000). Furthermore economic growth and structural change depends upon the type of products that is being traded (Hausmann et al., 2007; Hausmann and Klinger, 2006; Whang, 2006). Thus through export diversification, an economy can progress towards the production and exportation of sophisticated products which may highly contributes towards economic development. Export diversification allows the government of an economy to achieve some of its macroeconomic objectives namely sustainable economic growth, satisfactory balance of payment situation, employment and redistribution of income.

Strategies to promote export diversification

As we see there are potential benefits of export diversification, but the question remains that what a country can do to diversify its exports. Potential determinants of export diversification, such as country size and level of development, trade costs, international distance, and the costs of domestic entry are all potentially associated with larger diversification. What can encourage export diversification? All successful high growth economies have had strategies to promote export diversification. These strategies include:

1. Financial sector development and Foreign Direct Investment (FDI)

Harding and Javorcik (2007) consider financial sector development and Foreign Direct Investment (FDI) can be helpful in promoting diversification. FDI can encourage exports of host countries by boosting domestic capital for exports, serving to transfer technology and new products for exports, making access to new and large foreign markets easy and improving technical and management skills.

2. Reduce Costs

The main debate is associated to cost as export diversification is rather sensitive to costs. Kehoe and Ruhl (2003) with episodes of trade liberalization across 18 countries found variable trade costs to be related with extensive growth margin. Lower cost means that there are fewer obstacles for domestic firm when exporting. The World Bank Doing Business survey through its “Trading Across Borders” section has included information on the number of procedures required for importing and exporting, as well as the time taken to comply with them. It also included trade costs such as document costs, inland transport costs, customs costs, ports costs, administrative costs and so on. In broad terms, for the promotion of export diversification there must be incentive to make improvement on trade facilitation, i.e. set policy measures to reduce costs. Such policy measures include lowering domestic barriers to entry; facilitate company registration by reducing number of procedures and applying a fixed registration fee, and removing the need for pre-tax payments.

3. Lowering barriers

Lower barriers to firm entry and lower international trade costs, constitutes an important way in which developing countries can help diversify their export baskets. Export margin can be affected by changes in tariff rates and preferences (Debaere and Mostashari, 2005). In policy terms, one efficient way for developing countries to promote export diversification is to center regulatory reform efforts on making entry procedures simpler and less expensive, as well as on trade facilitation measures.

4. Learning-by-doing

The endogenous growth model states that exports can be more diversified through learning-by-doing and learning-by-exporting and by adopting practices of developed countries (Pineres and Ferrantino, 1997)

5. Role of Government

The government of an economy should play a leading role in the promotion of export. Investment should be directed into various sectors of industry. In so doing, the Government can make sure that investment is not being undertaken on more than just one specific sector so that a diverse industrial base can be built. The Government should provide a favorable environment to attracting new investment in the country. There may also be provision for favorable tax treatment to firms, tax holidays for export oriented undertakings, input used in the production of exports can also be exempted from value-added tax. Subsidies play an important role in promoting exports. Government can introduce cash incentive scheme which may benefit firms such as providing them with subsidies which will consequently encourage trade..

6. Research and Development

Efforts can be put into the R&D activities to upgrade the level of industry. This can be done by the help of fiscal and financial incentives which will stimulate R&D and technological innovation activities. Besides the Government, the banking system and other financial authorities should offer services to diversify and strengthen a country’s export. The banking system can facilitate diversification by its loan patterns. Schemes to diversify and promote exports need to be complemented by a suitable combination of fiscal, monetary and exchange rate policies in order to be successful.

7. Variation in the structure of demand

Imbs and Wacziarg (2003) proposed that a growing demand for a range of goods followed by an increase in a country’s income may lead to diversification. In other word, variation in the structure of demand leads to change in a country’s production pattern.

Constraints to export diversification

In spite of the liberalization in the export sector, there are still the presence of certain issues which limit export diversification especially in least developed countries. Klinger and Lederman put together on Hausmann and Rodrik (2003) to investigate a causal relationship from market failures to inadequate diversification. There may be clash with other national policies in an attempt to promote exports. Export diversification at times may be hindered by a number of factors:

Low income elasticities of Demand

Some developing countries are failing to export primary products due to the low income elasticities of demand for their primary products. Furthermore, prospects for developing countries to provide manufactured exports are poor because of the competition faced with the industrialized countries.

Lack of finance

Lack of adequate export finance is identified as a major constraint. Small and medium exporters tend to be more severely affected by this constraint. A fundamental problem of export diversification is the lack of adequate investment in the country, both domestic and foreign. Exporters may face the problem of acquiring export finance. High rate of interest on bank capital is also a constraint since it discourages them to take loan. In other words, exports are being restricted due deficiency in financing of trade by the country’s banking system.

Lack of Adequate Infrastructure

Efficient infrastructure is the pre-condition for good export performance. Inadequate functioning of infrastructure may adversely affect enterprises in many ways. There may be difficulty in the transportation of goods due to limitations in infrastructure. It obstructs production activities, delays movement of goods and passengers, leading to delay in the delivery of goods. It adds to business uncertainty and risk and imposes additional costs.

Bureaucracy and market access

Government rules and regulations relating to exports are complicated and too much paper work is needed. Considerable time is spent and officers should be appointed for sorting out matters with the government and agencies. Market access issues are complex. The major market access problems relate to i) non-tariff and para-tariff barriers, ii) stringent quality and standard requirements, iii) stringent rules of origin, iv) labour and environmental standards. Environmental conditionalities are a kind of new protectionism which can hamper market access. Tariff and non-tariff barriers also obstruct market access.

Lack of strength in the public institutions

The World Bank noted that the lack of strength in the public institutions hinder private sector activities. There is the weakening of sound policy-making and public management, frustration of private entrepreneurship, prevention of competition and rising of corruption due to heavy regulatory and judicial systems and loss-making state-owned enterprise. Private investment can be deterred due because of poorly regulated and undercapitalized commercial banks, problem of telecommunications, infrastructure and law and order problem.

Dearth of Skilled Manpower

Other constraints include domestic resource scarcity, shortage of skilled labour, and lack of professionalism. There may be lack of skilled manpower in some sectors. Lack of skilled manpower has resulted in under utilization of potential export of services through manpower export as they are catering to only unskilled and semi-skilled needs.

Economic growth

Economic growth is a long run concept. It is usually defined as an increase in real gross domestic product (GDP), that is, GDP adjusted for inflation. In other words, it is as an increase in the real value of goods and services produced in the economy. For comparing one country’s economic growth to another, GDP or GNP per capita should be used as these take into account population differences between countries. Economic growth can be shown by an outward shift of the Production Possibility Curve (PPC). Economists see dissimilarity between potential and actual growth rates. Potential economic growth represents maximum efficiency with resources. It is determined by the factors of production that a country has as its command. However, actual growth represents resource utilization in practice and shows the result. This is determined by how effectively factors of production available to a nation are developed and combined. There are many factors which determine economic growth in a country.

Determinants of economic growth

Natural Resources

Countries which are gifted with natural resources are expected to have rapid economic growth, assuming that these resources are employed for the production of goods and services. However a large amount of natural resources is not adequate to guarantee economic growth. There are a number of less-developed countries which have high natural resources, but still due to various reasons, they have not been successful in exploiting them. To benefit from economic growth, these natural resources must be converted to useful forms, which will need people to be equipped with appropriate skills.

Human Capital

Human capital and education are considered to be necessary conditions for economic growth. Lucas (1988) focused on the impact of human capital on long-run growth. The rise in productivity needed for economic growth can be achieved by increasing domestic human resources through education and training. Skills acquisition and the ability to keep on learning throughout the lifecycle are needed to develop individuals. Developing human resources through education and training is considered to be a long term process which will upgrade the innovative capacity of an economy. Apart from affecting factor of production, education and human capital can also have impact on factors such as physical capital and natural resources (Bravo-Ortega and De Gregorio 2002. Azariadis and Drazen (1990) proposed that an economy can experience long-run economic growth if the government designs policies toward the promotion of education and human capital. Lucas (1993) pointed out, the accumulation of human capital – specially, knowledge – is a key factor in explaining the growth experiences of countries.

Capital Accumulation

Capital accumulation refers to buildings, machinery, infrastructure and the amount of tools available to the economy. A necessary prerequisite for economic growth is a large capital stock. Developed countries do spend a significant amount on capital formation. For example, in UK in the year 1998 and 1999, 12% of annual GDP was spent on fixed capital. Capital is a major factor affecting growth. The more an economy has as capital, the more it can produce and the higher will be real income. If there are few machines available, a nation will be able to make fewer goods and services. More machines will mean more income can be generated. Therefore, the larger the capital stock, the larger is the potential income. In short, we can say that investment in capital should increase the productive potential of an economy. Young (1994) found that Asian tiger’s success resulted from rapid accumulation of capital (through high investment). The Solow model predicts that investment rate is a key determinant of whether a country is rich or poor. Fingleton (1999) found capital accumulation as being the determinant of European region productivity growth.

Technology

The most important determinant for an economy to grow is associated to its pace of technological progress. This is because with technology, we can obtain more output from same amount of input as before. Neoclassical economists regarded technological progress as a critical source of economic growth. Romer (1990), Aghion and Howitt (1992), Grossman and Helpman (1994) and Basu and Weil (1998), among others, concentrated on the role of innovation and technological progress on long-run growth. Economies must invest in knowledge just as they must invest in fixed capital. The productivity of capital can be increased if machinery is updated so that firms use the latest technologies available. Technological advances are encouraged when there is investment in research and development. De Long and Summers (1993) has shown that the only variable that have a significant positive effect on growth of less-developed economies is the investment in equipment Technological progress, along with accumulation of human and capital, is essential in determining a nation’s rate of growth. For example, the large growth in the U.S. economy during the introduction of the Internet and the technology that it brought to U.S. industry as a whole. The Solow-Swan Growth Model which entailed a series of equations shows the concept of growth as an increased stock of capital goods. According to this view, the role of technological change became crucial, even more important than the accumulation of capital.

(e) Openness

Openness to international trade accelerates productivity and promotes export as well as economic growth. Romer (1989) stressed on the issue that growth in the volume of trade is positively correlated with the growth of output for a country. Edwards (1993) and Rodriguez and Rodrik (2001) also carried an extensive review of the empirical literature on the growth effects of openness. Increasing importance is being attributed to the opening up of the world economy. Globalization is seen to be good for the World’s economy. Detailed studies suggest that there is a positive correlation between trade liberalization and an increase in per capita income. In other words, the more an economy is open, the higher is rate of growth. Development in Eastern Europe and the World Trade Organization highlight that during the last twenty years, more and more areas of the world economy have been brought into the competitive market-place. Such openness to trade, investment and competition are clearly important determinants to productivity growth. For example until 1858 Japan was inaccessible to world trade. The Japanese Government banished the trade restrictions which allowed trading with the rest of the world. Consequently this had lead to a 65% rise in real national income (Huber, 1971; Husted and Melvin, 2007).

FDI Inflow

There are various channels through which FDI can positively affect economic growth: technological transfer, capital accumulation, access to international markets, managerial and marketing practices and employment (Lall [2000], Te Velde [2001], Borensztein [1998]). FDI can increase competition which will eventually make domestic companies more efficient and encourage diversification. FDI benefits economic growth at large as it contributes to the domestic accumulation of resources. Many studies have been carried out which demonstrated a positive link between FDI an economic growth. Campos and Kinoshita (2002) examined the effects of FDI on growth for 25 Central and Eastern European and former Soviet Union economies and found a positive relationship between them. However there are certain studies which are undertaken that do show any influence of FDI on economic growth for example, Carkovic and Levine (2002), Bacha (1974), Saltz (1992) and Alfaro et al. (2002).

Inflation

There are many evidence which suggest that sustained high rate of inflation can be detrimental to real economic growth even in the long run. Fisher (1993) found negative links between inflation and growth in pooled cross-section, time series regressions for a large set of countries. Investors may face uncertainty about future profitability of investment projects. Barro (1995) put forward that inflation diminishes the propensity to investment which eventually decreases growth. Inflation may also have a negative impact on the balance of payments as it reduces a country’s international competitiveness by making export dearer. Inflation can affect growth by altering borrowing and lending decisions. However whether inflation is good or bad for economic growth depends on its degree. That is, at lower rates of inflation, the relationship is not significant or even positive; but at higher rates, inflation has a significantly negative effect on growth. In their analysis, Bruno and Easterly (1998) showed that some countries did not go through adverse consequences even if they were experiencing sustained inflations of 20% to 30%. On the other hand, once the rate of inflation go beyond certain critical level (which Bruno and Easterly estimated to be about 40 %), this causes negative effect to growth.

However besides the factors mention above, there are also other factors that affect growth. Non-economic factors such as political and social factors too play an important role. The geographic location of a country may also affect economic growth. Government also can adopt both demand and supply-side measures in order to stimulate economic growth. Factors such as population growth, rapid growth of manufactured exports, stable macroeconomic and institutional environment creating confidence in policy makers, exchange rate, and labour force can affect growth in an economy.

Link between economic growth and export diversification

Policy-makers have tended to emphasize the potential benefits that export diversification can bring to the host economy. One of the main advantages which has been put forward by economists is that export diversification tends to increase economic growth in the host economy. There has been little empirical research on the relationships between export diversification and economic growth. There are two essential questions that the literature on this matter has tried to answer: Does export diversification affect long run economic growth? Can a country improve its economic performance by exporting different types of goods? (Gutiérrez-de-Piñeres and Ferrantino, 2000). The primary questions are why do countries diversify their exports and does it always benefit countries’ economic growth? Export instability can adversely affect growth in an economy. Countries which are dependent on a limited amount of commodities may suffer from export concentration. This is because commodity products are often subject to volatility in market prices leading to swings in foreign exchange revenues. Volatility and instability can thus discourage investment in an economy by risk adverse firms, reduce import capacity, increase macroeconomic uncertainty and thus be detrimental to longer-economic growth.

There are several channels through which diversification may influence growth. It is therefore essential to make a difference between horizontal and vertical diversification. Both of them are positively related to economic growth. Horizontal diversification means the alteration of the primary export mix in order to neutralize the volatility of global commodity prices. Horizontal export diversification benefits an economy in such a way that it diminishes dependence on a narrow range of commodities that are subject to major price and volume fluctuations. Dawe 1996, Bleaney Greenaway (2001) discovered that horizontal export diversification may present considerable development benefits as this may lead to well-directed economic planning and also contribute towards investment. Vertical export diversification on the other hand refers to contrive further uses of existing and new innovative commodities using value-added venture such as processing and marketing. The Prebish-Singer thesis is of the view that a tendency towards declining terms of trade of primary products (Athukurola 2000) may make vertical diversification into manufactures more useful. By highlighting the role of increasing returns to scale and dynamic spillover effects (Amin Gutiérrez de Piñeres and Ferrantino 2000), the endogenous growth theory suggested that it can be assumed that export diversification affects long-run growth.

Export may benefit economic growth through generating positive externalities on non-exports (Feder, 1982), increased scale economies, improved allocative efficiency and better ability to produce dynamic comparative advantage (Sharma and Panagiotidis, 2004). Esfahani (1991) concluded that export enables developing countries to alleviate the import shortage they may face up to. Speaking differently, revenue from exports can fill “the foreign exchange gap” which is identified as barrier to growth.

A number of empirical studies have shown that export diversification is contributing to higher per capita income growth. The main theory is that, compared to nations with concentrated export structures, those countries with more diverse economic structures have greater possibilities to sustain periods of high economic growth. Love (1986) suggest that a country should avoid heavy dependence on limited products as it diminishes a country’s potential of partially offsetting fluctuations in some export sectors with sectors in which stability prevails. In his study, Al-Marhubi (2000) put forward that market investment becomes riskier because instability in export earnings is a main cause of economic uncertainty in many commodity-exporting nations. In other words, this may adversely affect investments and in turn negatively impact economic growth. Using a cross-country sample of 91 countries for the period of 1961-88, Al Marhubi concluded that there is a positive and strong relationship between export diversification and economic growth. His regression was undertaken by adding different variables affecting export concentration to the basic growth equation. Regressions on cross-sections of countries (Sachs and Warner 1995, or more recently Gylfason 2004) and panels (de Ferranti et al. 2002) proposed that export concentration is certainly statistically related with slow growth, mostly when export concentration reflects the high proportion of primary products. A broad literature review on export diversification and economic growth was offered by Hesse (2008), where he estimated a simple augmented Solow growth model to examine the connection between export diversification and income per capita growth. There was strong support in Hesse’s findings that export concentration, measured by a Herfindahl index, is harmful to economic growth in developing countries. The relationship between a country’s productivity and sectoral export variety was studied by Feenstra and Kee (2004). From an estimation of a translog GDP function system for a sample of 34 countries going from 1984 to 1997, they found that a 10 percent boost in export variety of all industries leads to a 1.3 percent increase a country’s productivity.

Moreover another model of export diversification and economic growth was developed by Agosin (2007) where countries which lack technology, expand their comparative advantage by learning from and adapting to existing products. The cross-sectional regression of Agosin (2007) found that export diversification strongly affect economic growth. In addition, models in the product life cycle literature (Vernon, 1966; Krugman, 1979; Grossman and Helpman, 1991) gained variety of export products by advancement made by the North and consequently the South adopting and exporting the products from countries where labour cost are low. In his cross-country panel model, Lederman and Maloney (2007) concluded that one cause of diminution in growth prospects is the concentrations in export earnings. The advantages of export diversification for economic growth have been examined both empirically and theoretically in a new literature by Hausmann and Rodrik (2003), Hausmann, Hwang, and Rodrik (2006), and Hausmann and Klinger (2006). Their studies demonstrated that comparative advantage do not lead to economic growth. Instead, growth is achieved when countries diversify their investments into new or a range of activities. The model of Hausmann and Rodrik (2003) explained that there are various uncertainties related to cost in the production of new goods. They believed that the government should help in industrial growth and structural transformation by encouraging entrepreneurship and providing incentives to motivate entrepreneurs to invest in a new range of activities. Hausmann, Hwang, and Rodrik (2006) developed an indicator (EXPY) that determines the productivity level related with a country’s export basket. This measure is significantly affecting economic growth. Faster growth is achieved by countries that produce high-productivity goods than countries with poorer productivity growth. Economic growth is experienced when a country shift its resources from lower-productivity to higher productivity goods with elastic demand of these goo