51634 The World Bank notes September PREM TRADE POLICY 2009 NUMBER 143 Breaking into New Markets, Raising Quality, and Improving Services: Neglected Avenues for Export Diversification Paul Brenton and Peter Walkenhorst, International Trade Department, World Bank Expanding international trade is an impor- horst (2009). The analysis suggests that tant avenue for growth and development in there has been too much focus on simply low-income countries. In addition to increas- adding new products to export portfolios, ing the quantity of existing export flows, which often underscores the use of industrial many countries seek to diversify into produc- policies. While such actions are important, tion and export activities that provide a high- a more comprehensive view of diversifica- er return to the labor and capital resources tion--and hence a more comprehensive employed. Export diversity also reduces a trade policy--is needed that improves the country's vulnerability to pronounced price quality of existing exports, breaks into new swings in international markets. geographic markets, and increases services As experience over the past 50 years exports. These often-neglected avenues of demonstrates, there is no magic recipe to diversification offer untapped opportunities promote export diversification in developing for many low-income countries. The note countries. While some developing countries argues that a broad array of policies can help have been very successful in diversifying a country's exporters upgrade existing prod- their exports, others have lagged behind. ucts, break into new geographic markets, and These divergent developments give rise to launch and consolidate new lines of business several questions: How do different forms abroad; such policies range from getting the of export diversification affect growth? incentive structure right, to lowering the Do particular market and policy failures costs of transportation, telecommunication inhibit diversification in low-income coun- and other backbone services, to proactive tries? How can governments in developing interventions by governments. The underly- countries foster productive diversification ing objective is to raise international com- without overstretching their administrative petitiveness and help the most productive capacity? firms overcome market and policy failures This note reviews the findings of a se- that constrain their ability to exploit export ries of papers on the diversification process opportunities, without trying to pick winners contained in Newfarmer, Shaw, and Walken- from the outset. FROM THE POVERTY REDUCTION AND ECONOMIC MANAGEMENT NETWORK Potential diversification constrained by infrastructure, regulatory, into new, higher-quality informational, and logistical weaknesses. markets and services At the extensive margin, diversification Many developing countries, including some of existing products into new markets is of the poorest, have significantly diversified likely just as effective for growth as develop- the goods that they produce and export over ing new export products, and arguably easier the past two decades. Some initially upper- to achieve. For many developing countries, the middle-income countries, like the Republic potential for further geographic diversification of Korea and Singapore, have even begun is substantial, given how few markets these producing and exporting high-tech prod- exporters actually have been serving. A ucts. On the other hand, not all countries country's exploitation of market opportu- have successfully broadened the range of nities for its existing set of export products export products and a few, poorly perform- can be measured through the index of ex- ing low-income countries have made almost port market penetration (IEMP). For a given no progress. This has led to much research range of exports, the IEMP will be higher on how lagging countries can diversify for exporting countries that reach more of exports. the international markets that import the Two empirical observations are par- type of products they export. Looking at ticularly relevant. First, most export growth cross-section data, the IEMP is positively derives from expanding the intensive mar- correlated with GDP per capita (see Brenton gin--that is, exports of existing products to and Newfarmer 2009). current markets. Second, within the extensive Countries with relatively low per capita margin (that is, new export flows) the export incomes tend to do less well in exploiting of existing products to new geographic available export markets. For example, Ko- markets has accounted for a greater share rea has been a much more effective exporter of developing countries' export growth than than Kenya, where income per capita is the export of new products. just one thirtieth of Korea's. Korea's IEMP The first observation implies that ignor- score doubled from 21 percent in 1985 to ing growth potential at the intensive margin 42 percent in 2005, while Kenya's score only will miss important opportunities for export increased from 6 percent in 1985 to 8.5 expansion--and for propelling economic percent in 2005, even though Kenya's lower growth. Further, it supports the view that market penetration should have facilitated more important than the type of goods a geographic expansion of the country's ex- country produces is how the available bundle ports. High trade and transaction costs are of products is produced (see box 1). Of likely a key reason why low-income countries particular importance is the capacity to raise the cannot better exploit opportunities for geo- quality of existing products over time. Mauritius, graphic expansion. for example, has created an environment In addition to the potential in geo- that has enabled clothing producers to graphical diversification, there are emerging improve quality and advance from simple opportunities for diversification into services assembly to more integrated production. exports. Nearly all of the literature and In many low-income countries, agricultural policy discussion on diversification focuses products offer important opportunities for on merchandise exports. Yet, recent studies quality improvements and product differen- show that services can contribute to growth tiation. Often, however, improvements are and export diversification in several ways: 2 PREMNOTE SEPTEMBER 2009 Box 1. Does the sophistication of exports matter? A recent argument suggests that countries exporting goods associated with higher productivity levels will grow more rapidly than countries with exports associated with lower productivity levels. Hausmann, Hwang, and Rodrik (2006) measure this "notion of the productivity" of products in terms of the income levels of countries that export a particular product, weighted by each country's revealed comparative advantage in that product (defined as the variable PRODY). For each exporter they then calculate a measure of the overall productiv- ity of their export bundle by weighting each of the PRODYs by the share of the product in that country's total exports. They find a strong correlation between (i) this measure of the productivity of a country's export bundle and per capita income and (ii) initial values of the measure and subsequent growth. Rodrik (2006) suggests, on the basis of this measure, that China is an outlier in terms of export sophistication because it exports products normally associated with countries that have per capita incomes three times higher. This apparent capacity to make advanced, high-productivity products is then seen as having been an important factor in China's strong recent growth. However, recent studies have challenged this view by taking into account differences in product quality. By ignoring the quality of products, the Hausmann-Hwang-Rodrik measure tends to overestimate the importance of sophisticated products in low-income country exports. Since product quality is correlated with income, correlations between the measure of export productivity and per capita income are likely to be biased, it is argued. For example, Xu (2006) conditions the Hausmann-Hwang-Rodrik measure by relative unit values of exports, which are used to proxy relative quality. This analysis shows that once product quality is taken into account, the structure of China's exports appears consistent with its level of development. Minondo (2007) finds that the relationship between initial export sophistication and subsequent economic growth no longer holds once differences in quality are taken into account. In addition, emerging global production chains complicate the analysis of an export basket as in the Haus- mann-Hwang-Rodrik measure. Technological change and declining transport costs have led to a splitting of the production chain for many processed products and the reallocation of production throughout the world. Successful exporting in many developing countries, especially those in East Asia, has been driven by the importation of parts and components for further processing and assembly. However, the trade data used in these measures of diversification and export sophistication relate to gross exports and do not capture the impact of outsourcing. For example, China's export of sophisticated iPods largely reflects assembly activities, while most of the advanced, high-productivity activities that are combined to produce the iPod take place in other countries. by expanding exports of existing services to Many of the endowments that drive existing markets; by developing new services countries' comparative advantage in cross- exports or exporting existing services to new border services trade are amenable to markets; and by lowering input and trans- policy action. Key conditions for success are action costs to make merchandise products competition in "delivery" services such as more competitive in international markets. telecommunications and transport, higher Services exports have grown dynamically, education systems that are capable of pro- driven recently by the ongoing trend of viding a large number of graduates with outsourcing back office and information advanced skills, and regulatory institutions technology functions to take advantage of that can credibly signal quality to foreign advanced skills and lower labor costs of buyers. It is illuminating to contrast the suc- specialized service providers in a growing cesses of Brazil and India in growing exports number of developing countries. However, of business services with the relatively poor developing trade in services is a complicated performance of, for example, Sri Lanka, process, for which many countries do not Pakistan, or Zambia, where the pool of have an explicit policy. highly qualified individuals is shallow, the SEPTEMBER 2009 PREMNOTE 3 telecommunication infrastructure is defi- profits or discourage discovery. If demand cient, and the financial sector and business in global markets is practically limitless-- climate are insufficiently developed. Ad- normally the case for an exporter in a devel- dressing and overcoming these impediments oping country--then expanding supply from is of crucial importance for developing an new entry will have minimal, if any, adverse export-oriented services sector. implications for the first-movers' profits. Tourism can be an important element Moreover, new entry often brings economies of services exports. The experience of Mau- of agglomeration and lowers transportation ritius, for example, underlines the proactive costs for all firms in the industry. Thus, the role that government can play in encourag- presence of a critical mass of firms produc- ing tourism development, through ensuring ing similar products or using common in- a stable and secure business environment, puts allows firms to move down the long-run establishing a sound regulatory framework cost curve and expand and diversify exports. for the sector, playing a coordinating role In Peru, the success of the initial asparagus among stakeholders, and protecting the producers demonstrated the industry's vi- environmental resources essential for pro- ability, attracting many new farmers into the viding tourists with a positive experience. industry, and the greater scale consequently lowered costs of transportation, standards Market failures in the administration, and logistics for all farm- export cycle are difficult to ers. In Kenya, pioneer call center operators pin down and address reported that new entry would help them by Export diversification is encouraged by widening the pool of available, flexible labor ensuring the quality of institutions that to respond to fluctuating demand. Also, sur- support trade, by relying on the market to vey evidence suggests that imitation is not a determine prices where private firms inter- major concern for exporters in the Middle nalize costs and benefits, and by addressing East and North Africa, and indeed export- market failures where feasible. Compared to ing firms are eager to share information to institutional and pricing problems, market achieve economies of agglomeration. failures are more difficult to define and more Discovery is only one phase of the controversial to address. export cycle. Once a new export has been In developing countries, within-the- sold abroad, ensuring that it grows and can frontier innovations can generate valuable eventually be placed in other markets may social knowledge. Successfully exporting be the more important obstacle. Recent a product for the first time (from a given research has shown that while the num- country) generates valuable information ber of new export flows tends to be larger on the structure of foreign demand and (relative to income) in low-income than in production costs, and facilitates imitation. middle- and high-income countries, average While imitation has a positive social benefit, disappearance rates are also higher. This is it can also reduce the return to first movers, consistent with the available information on who in the case of within-the-frontier dis- the dynamics of exporting at the firm level coveries cannot be protected by intellectual The reasons for the high "death" rates property rights. The result is a tendency to in what should be the growth phase of an ex- underinvest in innovation (Hausmann and port product have not been fully researched Rodrik, 2003). but clearly relate to the uncertainties, espe- However, the threat of new imitative cially with regard to costs, of undertaking entry may not in fact reduce first-movers' new activities in foreign markets. Another 4 PREMNOTE SEPTEMBER 2009 cause for premature "death" of exports may a clear understanding of how trade, tax, be instability in the business environment, investment promotion, and labor market including, for example, unpredictable delays policies interact to affect investment and in customs, changes in tax policy, or unan- trade decisions. ticipated rent-seeking from officials expect- · Lowering the costs of backbone services and ing payments. In any case, low survival rates of doing business in general. Of great im- for initially small flows suggest caution in portance in today's globalized economy public policy interventions that are aimed is domestic firms' access to efficiently specifically at exporters that start small. produced, critical, "backbone" services. Firms that pay more than competitors A portfolio of policies is for energy, telecommunications, trans- needed to foster export port, and logistics, finance, and security growth and diversification will find it hard to compete in domestic How can countries best position themselves and overseas markets. Reducing policy to take advantage of new opportunities in barriers to competition and improving the global market and the available avenues regulatory effectiveness in these services for diversify exports? The emerging lessons lies at the heart of the policy challenge. from country experiences suggest a range of In many developing countries lack of policies that focuses on reducing trade costs infrastructure is a critical constraint on and improving competitiveness and that the availability and cost of backbone considers both the intensive and extensive services. margins. Clearly one size does not fit all. · Being proactive in supporting trade. Both Diversifying exports is a complex process market and government failures tend and obstacles are specific to countries. Policy to afflict low-income countries trying to makers in every country have to craft a expand exports and growth. In many portfolio of policy and institutional reforms cases these constraints to competitive- based on a country's level of income, initial ness require specific interventions and policy framework, supply-side assets, and institutions. For example, export deaths binding constraints. and weak IEMP performance tend to un- Three elements of a strategy for competi- derscore the importance of export pro- tiveness appear essential in helping countries motion agencies--and even economic exploit opportunities in international mar- officers in foreign embassies--in over- kets: coming informational asymmetries. · Getting the incentives right. A key challenge In tackling government and market for policy makers is ensuring that domes- failures, trade ministries are typically weak tic resources are channeled to their most and their policy purview limited to border productive activities. Creating a modern barriers. Large domains of policy that affect incentive framework that spurs national competitiveness reside outside the normal competitiveness requires careful analysis trade minister's ambit--investment policies, to ensure that land, labor, capital, and infrastructure services, and transport, to technology are moving to sectors in name a few. It is important to bring these which the country has a long-term capac- initiatives together in a strategy for competitive- ity to compete and to the most produc- ness rather than as a series of unconnected tive firms within sectors. This necessitates interventions. . In isolation trade agencies SEPTEMBER 2009 PREMNOTE tend to focus on narrow objectives, some de Ferranti, David, Guillermo E. Perry, of which may even be inconsistent with a Francisco H. G. Ferreira, and Michael broader competitiveness strategy. Walton. 2004. Inequality in Latin America: Implementing such a comprehensive Breaking with History? Washington, DC: competitiveness strategy is very demanding World Bank. and requires effective mechanisms to review Hausmann, Ricardo, and Dani Rodrik. 2003. and coordinate policies. Criscuolo and Pal- "Economic Development as Self-Discov- made (2008) discuss how specialist reform ery." Journal of Development Economics 72: teams have often been at the heart of suc- 603­33. cessful growth performance in developing Hausmann, Ricardo, Jason Hwang, and countries. One option is to create an inter- Dani Rodrik. 2006. "What You Export ministerial council on competitiveness with Matters." CEPR Discussion Paper 5444. the mandate of analyzing the existing policy London: Centre for Economic Policy and framework and reviewing policies before Research. they are put in place. A second approach is Minondo, Asier. 2007. "Exports' Qual- to set up a consultative group that involves ity-Adjusted Productivity and Economic the private sector in identifying policies that Growth." San Sebastian: Universidad de impede diversification or information or co- Deusto-ESTE. ordination gaps that the government could Newfarmer, Richard, William Shaw, and fill. In any case, given the country-specific Peter Walkenhorst, eds. 2009. Breaking nature of constraints to competitiveness and into New Markets: Emerging Lessons for export diversification, policy makers need to Export Diversification. Washington DC: craft a set of institutional arrangements that World Bank. is tailored to their particular situation. Rodrik, Dani. 2006. "What's So Special about China's Exports." NBER Working References Paper 11947. Cambridge MA: National Brenton, Paul, and Richard Newfarmer. Bureau for Economic Research. 2009. "Watching More Than the Dis- Xu, Bin. 2006. "Measuring the Technology covery Channel to Diversify Exports." In Content of China's Exports." Working Newfarmer et al. 2009, pp. 127­144. Paper. Shanghai: China Europe Business Criscuola, Alberto, and Vincent Palmade. School. 2008. 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