Penny Goldberg Princeton, BREAD, NBER

1. Trade and Growth: What can we learn from micro data? Sargan Lecture April, 21 2009 Penny Goldberg Princeton, BREAD, NBER This talk draws on work with Amit Khandelwal (Columbia), Nina Pavcnik (Dartmouth) and Petia Topalova (IMF), whom I thank for their numerous insights and feedback.

2. Motivation • Protectionists’ demands on the rise • e.g., Recovery Act: “Buy American” clause forbids spending on public works unless all of the iron, steel, and manufactured goods used are produced in the United States. • Trade important for all countries, but particularly for developing countries that may have limited access to high quality intermediate products • Indian policymakers: “Trade liberalization and tariff reforms have provided increased access to Indian companies to the best inputs available globally at almost world prices.” –Rakesh Mohan, Deputy Governor of Reserve Bank of India (2008)

3. Trade and Growth: Mechanisms • Efficiency Gains arising from Specialization and/or Selection • Benefits of Scale and Competition • Access to New Technology, Intermediate and Capital Goods. On the other hand: • Potentially Adverse Effects (e.g., specialization in less dynamic sectors that reduces long-run growth rate, infant-industry arguments, imperfect competition) Ultimately: Empirical Question

4. Evidence Evidence (largely based on cross-country studies) highly contentious Reasons: • Measurement Problems (particularly regarding “openness”) • Reverse Causality and Omitted Variable Bias • Trade Policies need to be combined with other measures • Most Studies focus on pre-1990 data and ignore recent liberalization waves in developing countries Critical Reviews of this Literature by: Rodriguez and Rodrik (2001), Hallak and Levinsohn (NBER Wo. Paper, 2004), Winters, McCulloch and McCay (JEL, 2004), Estevadeordal and Taylor (NBER Wo. Paper, 2008), and many others.

5. Focus • Micro- instead of macro-based evidence: • Focus on specific mechanisms and not macro-economic outcomes. • Focus on a particular countries/trade liberalization episodes • Here I focus on one particular channel through which trade may promote growth: • Efficiency Gains arising from Specialization and/or Selection • Benefits of Scale and Competition • Access to Intermediate and Capital Goods. Advantages: • Results hopefully more credible • Mechanisms  policy-relevant question Disadvantage: Approach more limited in scope.

6. Focus (continued) • Approach philosophically similar to the one used in sectoral studies of effects of trade liberalization on TFP • Part of growing literature that exploits micro data in order to understand the determinants of growth. Examples include: • Hsieh and Klenow (2009): Allocative efficiency and growth • Bloom and Van Reenen (2007): Importance of managerial practices • Bloom and Van Reenen (2008): Impact of trade (Chinese imports) on innovation and information technology • Here: Focus on the role of intermediate inputs rather than final goods trade. The former is arguably more important for the developing world.

7. Road Map • Theory • Difficulties in bringing the theory to the data • What is different these days? • More disaggregate data at the plant or firm level • Trade liberalization episodes in developing countries • Evidence Based on India

8. Theory • Endogenous Growth Models: • Many different versions, but common theme: new varieties play an important role in growth (Rivera-Batiz and Romer, Romer, Grossman and Helpman) • Two Effects: • Level (static) effect: New Intermediate and Capital Goods lead to increases in measured TFP • Growth (dynamic) effect: Arises from a linkage between new variety creation and research activity. As productivity increases, the rate of variety creation will rise  long-run growth rate increases

9. Level Effect • Simplest possible model: • Consider production function: • Under standard assumptions, • Output Growth: and

10. Level Effect (continued) • Love of Variety: Increase in N (through trade) leads to increase in TFP • Many reasons simple version empirically undesirable • More general models in empirical work  still “variety” effect remains • Effects operates WITHIN firms, not through selection. • Most compelling empirical evidence so far: • Amiti and Konings (AER): Reduced Form • Show reductions of INPUT tariffs in Indonesia  TFP increase • Halpern, Koren and Szeidl (2008): Data on imported inputs • Show imports of intermediates associated with higher TFP (no liberalization) • Potential Problem: Measurement of TFP • Is it “efficiency” or “markup”? (De Loecker, 2008)

11. Growth Effect Dynamic Gains from Trade • Trade has two effects in the short- run: • Lowers prices of imported products price effect • Brings new products to the domestic country variety effect • These two effects can by captured through the changes in the exact import price index. The exact price index has two components: • Conventional price index (captures price changes of existing products) • Variety component: captures the price change for NEW products from their virtual price (0 imports) to the price we observe upon entry • Import of new intermediate products corresponds to a decrease in the exact price index of intermediates

12. Growth Effect (continued) Implications for Growth: • Consider a domestic firm facing a fixed cost of introducing a new product. The decrease in the price index for intermediates implies that the firm is more likely to introduce new domestic products. • Feedback Effect: Some of these new products will be used as inputs in the production of other domestic goods. If new products = final goods, pos. externalities if fixed costs of production decreasing in N of products • “Lab-Equipment” Model: Innovation requires capital or intermediate inputs. Since new imported intermediates lower the exact price index for intermediates, they lower the cost of doing research. This creates a DIRECT link between imported intermediates and R&D. More formally, consider the following production technology:

13. Production Technology • Production is CRTS and Cobb-Douglas • Each input sector is comprised of domestic and foreign inputs that are combined using a CES aggregator • The foreign input is also given by the CES aggregator:

14. Exact Input Price Index • The exact price index associated with foreign input sector is: where are the Sato-Vartia ideal weights and and ‘ denotes the previous time period

15. Minimum Cost Function • The exact price index for the input sector is is the domestic price index where are Sato-Vartia ideal weights between foreign and domestic input varieties • We can re-write the minimum cost function as • The import of new varieties lowers the variety component and hence lower the minimum cost of producing Y.

16. Mechanism (continued) • In addition, direct effect on research activity of firms, if research requires capital and intermediate products.

17. Summary of Mechanism • Trade Liberalization leads to lower prices for imported intermediate and capital goods as well as the import of new varieties of these goods • Intensive margin  lower prices • Extensive margin  new goods (leads to higher measured TFP) • As a result, the minimum unit cost associated with the production of a domestic good falls • Domestic producers may now find it profitable to start producing products that were unprofitable prior to the liberalization. • The introduction of new domestic varieties further contributes to growth • Domestic Intermediate Products: Same argument as with imported feedback effect • Domestic Consumer Products: Lead to further growth if: • Externalities through fixed costs declining in the number of goods • Concave Transformation Curve

18. Difficulties in Bringing the Theory to the Data • Lack of Information on Domestic Product Creation and R&D • Potential reverse causality between imports of new intermediates and outcomes of interest What is different now? • Better data (at the plant or firm level) • Trade Liberalization Episodes in Developing Countries  Provide plausibly exogenous variation for identifying the effects of interest.

19. DataIndia: Prowess Database • Center for Monitoring of Indian Economy (CMIE) • Covers 60-70% of India’s economic activity in industrial sector. • Firm-level panel data 1989-2003 • Spans the period of trade reforms • Medium and large Indian firms • Not well suited to study firm entry and exit • Well suited to study product mix changes among mfg firms • Mfg firms required by law to disclose product-level information in their annual reports (1956 Companies Act) • Product module contains annual product-level information • Information on unit values • Information on R&D

20. Data: Definition of a Product • Based on CMIE’s internal product classification and products reported in companies’ annual reports • 1,886 products • Comparable to BRS (2006a) product definition (~1500 5-digit SIC) • Linked to 108 4-digit NIC industries • Coverage across firms • Product info available for vast majority (85%) of mfg firms • 85% of manufacturing output

21. Examples of Products

22. India’s Trade Liberalization • Twenty years ago, the infamous “license raj” required firms to obtain official permission to expand into new product lines and upgrade capacity. • India’s pre-reform trade regime was very restrictive • During the 1980s, India initiated a process of liberalization • Import and industrial licensing eased, but tariffs remained very high • In August 1991, India faces a BOP crisis and calls the IMF • Tariff changes 1992 - 97 largely set as part of IMF conditions in 1991 • Avg nominal tariffs fall from 90% in 1987 to 30% in 1997 • Unanticipated & unlikely to be foreseen in pre-reform industry decisions Topalova (2007), Gang and Pandey (1996)

23. India’s Trade Liberalization Source: Topalova (2007)

24. India’s Liberalization

25. Trade Data • India’s import data (1987-2000) at the HS8-country level of disaggregation • Tariff data is reported at the HS6-level • Generate input tariffs using India’s input-output matrix • Average input tariffs fall from 36% in 1987 to 12% in 1997 • Nourez (2001) classifies India’s products as intermediates (intermediates, basic & capital goods) or final goods • Note: will use this classification for descriptive tables & rely on IO matrix for empirical analysis

26. Examples of Consumer & Intermediate Products(Import Data, Nouroz, 2001)

27. Evidence Arguments has three main parts: • Descriptive Part 1) Indian firms add products after its large-scale trade reform GKPT (2008). • Net product additions account for 25 percent of growth in India’s manufacturing growth in 1990s 2) Tariff liberalization is “real” surge in imports, particularly of intermediate products. • 2/3 of the growth in intermediate imports accounted for by new varieties B. Reduced Form Evidence Input tariff reductions lead to an expansion of domestic products and R&D C. Semi-Structural Part: Impose more structure in order to identify channels: Lower prices versus increased variety.

28. A. Domestic Product Growth • Extensive Margin important for growth  new products account for one quarter of growth in manufacturing • Net = Gross  No product dropping • Stark contrast to the U.S. and also other developing countries  no evidence of “creative destruction” • Explanations: • Remnants of license-raj: High sunk costs associated with earlier regulation • Large developing country with huge income disparities  always demand for “older” products (consistent with the fact that there are few product categories that are “shrinking”) • No concern that higher imports are displacing domestic products

29. A. Tariff Declines and Import Growth • India’s liberalization had “real” impacts on India’s imports • Within HS6 products, lower tariffs implied • Higher import volumes • Lower unit values • More import varieties (particularly for intermediate goods) • The importance of variety growth is seen in the following decomposition table

30. Decomposition of India’s Imports Shrinking Growing • Messages of table: • India experienced a surge in overall imports • Intermediate imports increased by more than 200% during the 1990s • New products account for 2/3 of intermediate import growth • Intermediate extensive margin growth driven by imports from OECD + E. Asian countries GKPT (2009) • Within HS6-Year pairs, higher unit values for new varieties

31. Decomposition of India’s Imports, by Source • Extensive margin growth driven new products/varieties from OECD (plus HK, Singapore, Taiwan) • HS6 intensive margin driven by new varieties (HS6-country) • We also observe higher unit values for added varieties within HS6-year Notes: OECD includes Hong Kong, Singapore and Taiwan

32. New HS6 Codes

33. B. Reduced Form Relationship • Why might declines in trade costs lead to expansion of firm product scope? • Firms face a fixed cost of manufacturing a product. Lower variable costs due to the liberalization enable firms to cover the fixed costs of entering new product lines • Reduced-form specification relates firm scope to the input tariff faced by firms in sector s • Input tariff of industry line m • Year fixed effects (t), firm fixed effects (f) • Standard errors clustered at the industry level • Restrict sample to 1989-1997

34. Expansion of Product Scope and Input Tariffs • Avg input tariffs fell 24 pp  7.7 % increase in firms’ product scope • Accounts for about 31% of overall firms’ product scope expansion • From GKPT (2008), new products account for 25% of India’s mfg growth • This particular channel accounts for ~8% of overall mfg growth

35. Input Tariffs and Other Firm Outcomes • Lower input tariffs associated with higher • Output • Productivity (note: TFP taken from Topalova (2007)) • Probability of conducting R&D among the (initially) large firms Source: Regressions include firm and year fixed effects

36. C. Mechanism • So far: Strong and robust relationship between input tariffs and product scope expansion, R&D, sales and TFP. • Impose additional structure to assess the relative contribution of lower existing input prices and firms’ access to new imported input varieties • Rely on production technology described above to decompose exact import price index into a price and variety channel

37. Minimum Cost Function • Explicit assumptions on the structure • The Cobb-Douglas weights are the coefficients from India’s input-output matrix • Impose proportionality in the input-output coefficients between domestic inputs and foreign inputs

38. Next Steps • Compute the exact price index, conventional price index and variety component for each sector. • Run those through Input-Output tables to create input price indices. • Relate changes in firm product scope to the changes in the exact price index as well as its components

39. Variety Index • Mean variety index for intermediates is 0.881 between 1989-1997 (A lower variety index implies larger gains from variety) • Right column reports the aggregate variety component of the import price index from 1989-1997 • Aggregate exact import price index for intermediates is about 4.7% lower per year due to new varieties • These variety gains are substantially larger than those reported for U.S. and Costa Rica Broda & Weinstein (2004), Arkolakis et al (2008)

40. Input Indexes • Using the IO tables, construct input indexes for each sector • Relate firm product scope to changes in each index

41. Input Tariffs and Imported Input Price Index Long difference regression: 1989 and 1997.

42. Decomposing Channels(OLS Regressions) Long difference regression: 1989 and 1997.

43. Identification Assumptions • Explicit assumptions on the structure • Error term certainly correlated with right-hand side variables. • Identification assumption: • Input tariffs affect domestic prices and final sector TFP only through the import channel

44. Instruments • Tariffs: plausibly exogenous in this setting and highly correlated with variables on the right hand side (see above, tariffs affect unit values and range of imported intermediates). • Country–specific fixed costs of entry into the Indian market (variables suggested by gravity-type models, such as language) interacted with measures of sector-specific comparative advantage • Idea: • Conditional on changes in tariffs, sectors in which potential exporters face a lower fixed cost of exporting to India will experience differential changes in the new varieties imported • Preliminary results stronger than OLS results  Domestic product scope expansion due to firms’ access to new intermediate inputs. Same is true for R&D.

45. Conclusions • New products account for 25% of India’s mfg growth in 1990s • Imports of intermediates surge with 2/3 of growth due to new products • Connect these two facts  • Firms’ access to new inputs from abroad leads to product scope expansion • New inputs associated with R&D • Empirical support for the microeconomic mechanism of domestic variety expansion in endogenous growth models

46. Final Remarks • Mechanism not unique to India. • Anecdotal Evidence from Coca-Cola Factory in Shanghai • Reminder: Trade is about imports, not just exports. • Paul Krugman: “Moreover, the purpose of international trade -- the reason it is useful -- is to import, not to export. That is, what a country really gains from trade is the ability to import things it wants. Exports are not an objective in and of themselves; the need to export is a burden that a country must bear because its import suppliers are crass enough to demand payment.”

47. THANK YOU!