Economic Diversification for Sustainable and Inclusive Growth

1. Economic Diversification for Sustainable and Inclusive Growth Vandana Chandra (PRMED)Inclusive Growth Course March 24, 2009

2. Rationale • By the mid-1990s, most developing countries had implemented the macroeconomic reforms that are a necessary condition for economic growth. Various other reforms also followed. BUT • Economic diversification that was expected to follow ex post reform and is essential for sustained prosperity and inclusive growth did not ensue in many of the Bank’s client countries. • Absence of economic diversification – has become the source of social and political pressures. • Impatient to diversify, some client governments have announced industrial policies targeted at industries they believe can deliver faster and more inclusive growth. • Government’s choice of industries is often ad hoc anduninformed, and targets non-traditional industries in which the country has no comparative advantage. Most choices are also driven by pro-poor or inclusive growth considerations. • This recent shift in public policy from an industry-neutral to an industry-specific approach in our client countries has created among their development partners a demand for analytical tools to study the economic growth implications of active development policies.

3. Course Objective • Introducequestions and concepts that can be useful in exploring the nexus between economic diversification and income-enhancing, sustainable, and inclusive growth. • Provide a measure of the income potential of a country’s total exports based on Hausmann, Hwang and Rodrik (2007). • Offer an EXCEL-based toolkit (A) to study these approaches and measures. • The country economist (CE) may not be able to dissuade an impatient client (government) from implementing its industrial policy but may find the concepts useful in informing policy decisions.

4. Warning • Industrial policy discussions warrant industry-level analysis. BUT • The toolkits are not intended to produce a menu of industries that should be recommended to clients as candidates that deserve government’s special attention. • Wanting a hi Tech industry does not imply that the country will be able to develop an efficient and competitive hi Tech industry . • The application of the toolkit is a desk exercise that uses disaggregated product-level statistical evidence from the trading patterns of all countries, developed and developing over a long time series. • Strength: Statistically robust. Objective. Transparent. • Weakness: Cannot substitute for in-depth country-knowledge. • Needs to be complemented with a proper field assessment of the state of existing industries, what works and why.

5. Why does economic diversification matter for sustainable growth in developing countries? -Outline • How can we measure economic diversification? • What is the relationship between economic diversification and sustained growth ? • Openness, diversification and growth – some stylized facts • Are some patterns of diversification more income-enhancing than others? Examine the traditional approaches to diversification. • Explain PRODY - a concept that measures a product or industry’s export sophistication by linking it with a notional level of income. • Explain EXPY - a concept that measures the sophistication of a country’s export basket by linking it with a notional level of per capita income. • The framework we use is useful for cross-country and country-specific analysis over a long period. Example: an application to Burkina Faso.

6. Two simple measures of economic diversification 6 6 6

7. The Herfindahl Index of export concentration has remained high for Nigeria (dominance of oil exports) and increased for Burkina Faso (rising dominance of cotton) in comparison to low levels for large and highly diversified countries like China, India and Brazil.

8. Another measure of diversification: trends in the export share of the top 5, 10 or 20 products is consistent with the Herfindahl Index

9. The share of the top five exports in Nigeria (oil), Burkina Faso (cotton) and Bangladesh (garments) are high and consistent with their Herfindahl Index. Q: To reduce the share, what else can these countries export?

10. The relationship between sustained growth and openness/exports Conventional theory - as economies diversify, their income grows (positive relationship). Hesse (2009) confirms that diversification and per capita income are positively correlated. Imbs and Wacziarg (2003) – empirical evidence indicates that there is a U-shaped relationship between sectoral diversification and income. Initially, negative, i.e., as diversification increases, per capita income increases. After reaching $10,000 (2000 constant USD), sectoral diversification decreases and the relationship becomes positive (based on employment and production data for developed and developing countries). In natural resource-based economies, diversification helps to dissipate the negative effects of terms of trade shocks. In more developed ones, agglomeration effects reinforce economic concentration. We find that for most of the Bank’s client countries, the relationship is L-shaped. Along the vertical axis are low income countries in Sub-Saharan Africa, South Asia and even China. The range of the HI is very large. Close to 0.9 for Nigeria and 0.02 for India! Hesse (2009) confirms that diversification and per capita income are positively correlated. We need a better measure of diversification that links exports to a country’s per capita GDP. Q: What type of products should China export to catch up with Brazil? Cannot answer with the HI. 10

11. In low income countries, the relationship between HI and income is L-shaped. The HI for China and Korea is similar but it does not tell us what China must export to catch up with Korea. Korea China 11

12. Burkina Faso: A high HI has constrained sustained growth in per capita income – what else can it export?

13. A drop in HI drove growth in per capita GDP but the level of the HI is still very high and of income too low. What else can Bangladesh export?

14. A low HI has helped but what China exports explains why it has grown so fast

15. Openness fosters diversification and sustained growth • Export led-growth played an important role in fostering fast and sustained growth. • In small or poor countries, the purchasing power of the domestic market is low and exports are often the only source of growth. • Between 1980 – 2007: in most low and middle income countries, the export/GDP ratio was small – less than 20 percent. In these economies, per capita GDP (constant USD) increased little. • Examples: Brazil, India, Burkina Faso, Ghana. • In fast growing countries, growth was export-led and compensated for small domestic markets. A high share of exports in GDP was matched by a faster increase in per capita income. Many countries graduated from a low to a middle income status. Examples: South Korea, Malaysia. More recently, China.

16. Openness and its nexus with per capita income. Note, SSA is more open than even China. What explains the differences in income within a region, and between regions? • Macro Stability? • Openness? • Or • Is it the Export Mix?

17. Sustained growth was led by exports in East Asia 17

18. Herfindahl Index of export concentration (0 – 1) and share of exports in GDP (%) – no clear relationship! 18

19. When can diversification be income-enhancing and inclusive? • Is there empirical evidence to suggest that certain patterns of diversification can be more income-enhancing than others? • East Asia relied on export diversification in manufactured products to achieve faster and sustained growth. Is the East Asian diversification pattern optimal and feasible for all developing countries that are eager to catch up? • Are natural resources a curse for a low income country?” •  Country-specific level examination: • Can Burkina Faso’s (BF) current exports transform it into a MIC even in the next several decades? • Do the trends in BF’s exports reflect the level of its technological capabilities and indicate how it compares with comparators, ie., other landlocked, cotton or primary product exporters over the longer term?

20. Some hypotheses about the export mix and the growth path • Technology classification (Lall, 2005) • Links a product to its technology content. • Cereals and fish are primary (PP), minerals are resource-based (RB) and manufactured products are low, medium or hi tech (LT, MT,HT) • Is there a natural resource curse? Prebisch and Singer in 50s and 60s and Sachs and Warner ’90s). “Natural Resources are Neither Curse nor Destiny” – Lederman and Maloney, 2006. • Is Sub-Saharan Africa special? Transactions costs, and risks of manufactured exports (Collier, 1998, 1999), Primary Commodity Dependence and Africa’s Future, Paul Collier (2002), low skills, land abundance (Mayer and Woods, 2001) and low Net TFP (Eifert, Gelb and Ramachandran, 2005); infrastructure (Habiyaremya and Ziesemer,2006). • Deterministic – These hypotheses suggest that in poor countries, manufactured exports are the PATH to growth

21. Why natural resources and primary products appear to be a curse? Ex: the relationship between the export share of cotton and per capita income is negative. Burkina Faso, Benin and Mali did not diversify away from it. 21

22. Most countries in Sub-Saharan Africa did not grow. Exception: Lesotho (LSO) diversified into garments and water exports and enjoyed sustained growth.

23. Technology hypothesis: High and sustained growth has occurred in countries that export mostly LT, MT and HT products Cereals and fish are primary (PP), minerals are resource-based (RB) and manufactured products are low, medium or hi tech (LT, MT,HT) • Problem: Too deterministic and ad hoc. Implies manufactured exports are the only path to growth. Can PP and RB exporters leapfrog into LT, MT and HT exports?

24. Must all countries export manufactured products to grow? Trade patterns have changed and are indeterminate in this era of globalization. Production networks are fragmented globally. For example: • East Asia – exports mostly Hi-tech products now. China is replicating the East Asian model. Imports parts and exports hi Tech products. They have acquired a competitive advantage in these products. • Some other countries have successfully reversed export patterns and discovered new products. Chile has diversified from copper to fish and wine; Columbia from coffee to cut flowers ; Kenya and Uganda from coffee, tea and cotton to fish and flowers. India has reversed the historical flow of services exports. Where the share of new exports is large, income growth has been fast and sustained. These approaches to diversification do not offer a metric that objectively indicates whether the new products are good or bad for a sustained increase in per capita income.

25. Metric: PRODY denotes a product’s sophistication which suggests a notional level of per capita income Designed by Hausmann, Hwang, and Rodrik (2007). PRODY and EXPY are indexes that measure export sophistication or which suggest a notional level of income for a product and country’s exports respectively. The core idea is that (ceteris paribus) “An economy is better off producing goods that richer countries export.” “Countries that export goods associated with higher productivity levels grow more rapidly” Sources: Hausmann, Ricardo, Jason Hwang, and Dani Rodrik. 2007. What you export matters. Journal of Economic Growth (U.S.) 12, No. 1:1-25. Rodrik, D. (2006). “What’s So Special About China’s Exports,” NBER Working Paper Series, No. 11947. 25

26. Export Sophistication (Hausmann, Hwang, and Rodrik (2007). How sophisticated is a particular product? where the PRODY of product k is the ratio of the export share of k in country j to the sum of the export shares of k in all countries weighted by their per capita incomes of the countries that export the product. In a sense, it reflects a notional income level of k. The higher the PRODY, the ‘richer’ or more sophisticated the product. Using this measure, how sophisticated is a country’s export basket? EXPY measures the sophistication or notional income level of a country’s total exports. It is the sum of the export share of each product weighted by that product’s PRODY. High is better. 26

27. PRODY for Selected Products – natural resources are neither curse nor destiny – it all depends on what you do with them High and Medium Tech Low Tech Resource Based Primary Products Source: Authors’ calculations using UN Comtrade Database 27

28. Certain products have been good for Catch-up in East Asia, (see Rodrik (2006)) Leapfrogging does not require all exported products to be transformed immediately into high PRODY ones. China’s catch up with Hong Kong and Korea occurred when it started exporting some High Prody products. 28

29. Manufactured Exports are not the only path to faster and sustainable growthOther developing countries’ success stories are natural resource-based Netherlands: Cut flowers USA and Canada: Fish fillet and Frozen Fish 29

30. EXPY is a good measure of the export sophistication of a country’s exports. EXPY & GDP per capita are highly correlated Source: Hausmann, Hwang and Rodrik (2005) 30

31. Summing up (1) • Openness and diversification matter for sustainable growth. But not any type of diversification. The L-shaped curve for the Herfindahl Index and per capita income in low income countries shows this. • There are alternative growth paths for primary and natural resource-based product exporters. They are not cursed. • To leapfrog and grow faster – a country needs to diversify into and scale up at least some sophisticated (higher PRODY) products. • Country and product/industry specificity are key. • The diversity of country experiences indicates that there is more than one way to do it. • Comparative advantage can be created/developed. Technological capabilities can be acquired and can change what you export. There is no need to rely only on your natural endowments to guide export patterns. • As usual, there are trade-offs.

32. Summing up (2)Should we make policy recommendations based on these new concepts that link a product to its sophistication level – NO. • EXPY indicates that higher PRODY products can lead to a higher level of per capita income. BUT it does not tell us which high PRODY products. • A higher PRODY suggests that one product is more sophisticated than another. BUT it does not indicate whether the country has a comparative advantage in exporting that product. • Judging whether a high PRODY product is optimal for a country depends on whether the country has the technological capabilities and other complementary inputs required to produce that product profitably. • This requires a lot more homework, analysis and in-depth knowledge of what constrains the emergence and scaling up of high PRODY products that seems suitable for a country.

33. An analysis of diversification and growth in Burkina Faso Brief background: In 1977, BF had a per capita income of US$ 186 (constant 200 dollars). In 2004, after 27 years, it had increased to only $248. Annual growth rate was only 1.1%. Central question: If Burkina Faso wants to become a middle income country, can it continue to pursue the same growth path that it has tread in the past 30 or more years? Outline: International comparisons are useful Sources of growth Why exports matter Why diversification matters Into what can it diversify? Whatever it is, it must be income-enhancing diversification. For more details, refer to the diversification and growth chapter in CEM 2009 (draft)

37. Our framework: A classification of Burkina Faso’s exports by Revealed Comparative Advantage (table 1)

38. A classification of Burkina Faso’s exports by Revealed Comparative Advantage and PRODY (table 2)

39. A classification of Burkina Faso’s exports – thinking at the industry or more aggregated level (table 3 ) Classics:These are Burkina Faso’s traditional exports and the group is formed by 6 product categories. It includes some fresh or chilled vegetables; fresh fruits, sesame seeds, oil seeds and oleaginous fruits; not carded cotton; and leather of other hides or skins. They tend to have low PRODYs but the highest densities for Burkina Faso. Disappearances: It includes 4 categories of bovine, goat, sheep, and lamb skins; basketwork; and notably gold. Hides and skins exports to Europe have declined systematically. Gold was one major product exported by Burkina Faso whose production decline. Now gold mining has a promising recovery. Emerging champions,High PRODY products but small in number (only 15) and export values. Some reversals in exports during 2005-06 suggest the existence of constraints in the economic environment that prevents them from scaling up. Cotton seed oil, soap, horticultural products, some low tech manufactures, and two leather and skin products.

40. A classification of Burkina Faso’s exports by Revealed Comparative Advantage, tech code, PRODY and share – detailed (table 4)

41. Policy Implications - What can this framework tell us of income-enhancing export possibilities in Burkina Faso? Part 1 • GOOD NEWS: there are alternative growth paths for Burkina Faso which is a primary commodity exporter. • What our framework shows: • That Burkina Faso’s traditional or “Classic” export products are mostly low PRODY. • That there are some “Disappearing” exports. Some are high PRODY. We don’t know why they are disappearing but we need to get more information. • There is a long list of “Marginal “ products. We should be reluctant to suggest they might be good products. We need more information. • There is a set of high PRODY “Emerging Champions” which seems attractive. We don’t know why they have not scaled up and what is holding them back. We need more information. • MOST importantly, we do not know whether Burkina Faso has the technological capabilities and inputs to produce the “Emerging Champions.” We need more information.

42. Are we ready to comment on Burkina Faso’s industrial policy yet? NO We should feel comfortable sharing information and comment on the sophistication of the Classics, Disappearances, Marginals and Emerging Champions as identified by our framework. BUT We are not ready to endorse any product or industrial policy. We need to do more homework. How much more? Some answers can be found in a companion course. How do we prepare a report that helps us how to replicate the concepts in this course for other countries or products? We recommend that you play with our toolkit, and cut and paste charts and tables into your reports.