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After reading chapter-6(attached link between trade and growth) from the attached screen shot and from the attached journal articles(Trade and growth link-1,2,3). Explain about the research topic ‘Link between Trade and Growth’.
Answer should be based on the attached three journal articles and text book(screenshot).
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Oxford Development Studies, Vol. 30, No. 3, 2002
Trade Policy, Equipment Investment and Growth in
India
KUNAL SEN
ABSTRACT The relationship between trade policy and economic performance is one of the
oldest controversies in economic development. In this paper, we examine an alternative
mechanism through which trade reforms may impact on economic growth to those commonly
discussed in the literature. This mechanism builds on the link between equipment investment
and growth that has been observed in cross-country data. We argue that that in countries
which have had highly restrictive trade policies with respect to capital goods, liberalization
measures that speciŽ cally target capital goods imports may bring about a fall in the relative
price of capital goods, leading to an increase in the rate of investment in equipment.
Quantifying the link between trade policy, equipment investment and economic growth in the
Indian case, we Ž nd strong support for this mechanism.
1. Introduction
The relationship between trade policy and economic performance is one of the oldest
controversies in economic development. In recent years, there has been a revival of
interest in the debate on trade and growth due in part to current widespread trade
liberalization in developing countries and in part to developments in economic theory–
most notably, the endogenous growth theories pioneered by Romer (1986) and Lucas
(1988). The endogenous growth theories identify several mechanisms by which trade
reforms may have a sustained impact on economic growth. First, trade liberalization
increases the variety of goods, and raises productivity by providing higher quality
intermediate and capital goods. Second, trade liberalization leads to the exploitation of
scale economies as Ž rms in the reforming economy expand into world markets. Finally,
trade reforms may lead to greater technological progress in the reforming economy as
Ž rms are able increasingly to capture new ideas being generated in the rest of the world.
While the endogenous growth theories provide new and important insights on the
dynamic effects of trade on growth, the theoretical literature does not yield an unam-
biguous conclusion on whether trade reforms have a positive impact on economic
growth (Rodrik, 1988; Tybout, 1992). Furthermore, systematic attempts at
quantiŽ cation have failed to single out trade policy as a major factor in economic
growth (Rodrik, 1992). Both the ambiguity in the theoretical literature and the weak
empirical evidence have led trade liberalization sceptics to argue that “the effect of trade
Kunal Sen, School of Development Studies, University of East Anglia, Norwich NR4 7TJ, UK.
This paper has beneŽ ted considerably from the helpful and detailed comments received from the Editors of the
journal, the late George Peters and Sanjaya Lall. The usual disclaimer applies.
ISSN 1360-0818 print/ISSN 1469-9966 online/02/030317-15 Ó 2002 International Development Centre, Oxford
DOI: 10.1080/1360081022000012725
318 K. Sen
liberalisation on growth is, at best, very tenuous, and at worst, doubtful” (Edwards,
1998, p. 383).
A separate line of enquiry in the growth literature has explored the link between
equipment (or machinery) investment and economic growth, arguing that equipment
investment is strongly and robustly correlated with long-run growth rates in cross-coun-
try data (De Long & Summers, 1991, 1992, 1993). In particular, for developing
countries, the magnitude of the estimated returns to equipment investment is extremely
high–well over 50%–and much higher than the estimated returns to investment in
structures (Temple, 1998). Furthermore, there is a strong negative relationship be-
tween the relative price of equipment and economic growth (Jones, 1994). Thus,
policies that decrease the relative price of equipment will encourage the accumulation
of equipment capital, leading to favourable effects on economic growth in developing
countries.
In this paper, we propose an alternative mechanism by which trade policy may
impact on economic growth to those that have been discussed in the endogenous
growth literature. This mechanism builds on the link between equipment investment
and growth observed in cross-country data. We argue that in countries which have had
highly restrictive trade policies with respect to capital goods, liberalization measures
that speciŽ cally target capital goods imports may bring about a fall in the relative price
of capital goods, leading to an increase in the rate of investment in equipment. This
provides a simple mechanism by which trade policy can have an unambiguous positive
and sustained impact on economic growth. We attempt to quantify the link between
trade policy, equipment investment and economic growth by examining the Indian
case.
As is well known, since independence India has had one of the most highly
restrictive trade regimes with respect to capital goods in the world. Since 1977–78,
there has been a slow but steady liberalization of capital and intermediate goods
imports, culminating in the comprehensive reforms of 1991. In this paper, we examine
whether trade reforms enacted since the late 1970s have had an appreciable positive
impact on the rate of equipment investment and whether this has contributed to higher
economic growth in India.
The rest of the paper is divided into six sections. In the next section, we provide a
brief overview of trade policies in India since independence. In Section 3, we set the
stage for the empirical analysis by attempting to identify patterns in investment
behaviour in India during the period of our study. Section 4 presents the conceptual
framework and Section 5 the empirical results. In Section 6, we examine an alternative
explanation of the observed rise in the equipment investment rate in the post-1991
period: the role of domestic deregulation of industrial policy. Section 7 concludes.
2. Trade Policy in India
The import and exchange rate regime that Indian policy-makers followed since inde-
pendence was aimed at the comprehensive, direct control over foreign exchange
utilization, with an overwhelming reliance on quotas rather than tariffs (Bhagwati &
Srinivasan, 1975). The allocation of import licences re ected two major criteria: (1)
“essentiality”; and (2) “indigenous non-availability”. Thus, imports, in terms of both
magnitude and composition, were permitted only if the Ž rm in question certiŽ ed to the
government that they were “essential” (as inputs or equipment for production). At the
same time, the government had to clear the imports from the viewpoint of indigenous
availability: if it could be shown that there was domestic production of the goods
Trade Policy in India 319
demanded, then imports were not permitted (regardless of cost and quality consider-
ations).
Nearly all imports were subject to discretionary import licensing or were “canalized”
by government monopoly trading organizations. The only exceptions were commodi-
ties listed in the Open General Licence (OGL) category. Capital goods were divided
into a restricted category and the OGL category. While import licences were required
for restricted capital goods, those in the OGL category could be imported without a
licence subject to several conditions. Intermediate goods were also classiŽ ed into the
banned, restricted and limited permissible categories plus an OGL category. As the
names suggest, the Ž rst three lists were in order of import licensing stringency. OGL
imports of intermediate goods were also governed by the “actual user” condition. The
import of consumer goods was, however, banned (except those that were considered
“essential” and could only be imported by the designated government canalizing
agencies).
Beginning with the export—import policy of 1977–78, there was a slow but
sustained relaxation of import controls. Several capital goods that were not allowed to
be imported without an import licence were shifted to the OGL category. The number
of capital goods on the OGL list increased from 79 in 1976 to 1170 in April 1988.
These changes were made with the intention of allowing domestic industries to
modernize. Moreover, during the 1980s the import licensing of capital goods in the
restricted list was administered with less stringency (Pursell, 1992). As a consequence,
the import penetration ratio in the capital goods sector increased from 11% in 1976–77
to 18% in 1985–86 (Goldar & Renganathan, 1990). In the case of intermediate goods
too, there was a steady shift of items from the restricted and limited permissible
categories to the OGL category. However, in practice a capital or an intermediate good
was placed in the OGL list only if it was not domestically produced. Thus, import
liberalization during this period may have led to some degree of competition to
established producers of intermediate and capital goods in India (though in several
instances, the goods that were allowed to be imported were imperfect substitutes of
domestically produced goods). On the other hand, there was an increase in tariff rates
across all commodities and, in particular, on capital goods. By 1987/88, the unweighted
average of tariffs on manufactured goods was 147%, with most tariff lines for manufac-
turing clustered around a range of 140–160%.
The pace of the trade reforms–in particular, the shift from quantitative import
controls to a protective system based on tariffs–initiated in the mid-1970s was consid-
erably quickened by the government (led by Rajiv Gandhi) that came into power in
November 1985. Restrictions on the import of capital goods were further eased to
encourage technological modernization. Also, beginning in the mid-1980s, there was a
renewed emphasis on export promotion. The number and value of incentives offered to
exporters were increased and their administration streamlined. The allotment of REP
licences–tradable import entitlements awarded to exporters on a product-speciŽ c basis–
became increasingly generous (Agrawal et al., 1995). Finally, the duty exemption
scheme for imported inputs was extended to cover all imported inputs for both direct
and indirect exporters.
In 1991, as a part of the comprehensive economic reform programme, there was a
signiŽ cant liberalization of the trade regime with respect to capital goods. Import
licensing was virtually abolished with respect to most machinery and equipment and
manufactured intermediate goods (Ahluwalia, 1999). There was also a signiŽ cant cut
in tariff rates, with the peak rate reduced from 300 to 150% and the peak duty on
capital goods cut to 80%.1 Import-weighted custom duty rates fell from an average of
320 K. Sen
97% in 1990–91 to 29% in 1995–96. There was, however, little change in trade policy
with respect to consumer goods which remained in the “negative” (banned) list.
The reforms of the trade regime in 1991 coincided with an equally signiŽ cant set of
reforms in industrial policy. Prior to 1991, there was a system of industrial licensing of
private industry in place which governed almost all aspects of Ž rm behaviour in the
industrial sector, controlling not only entry into an industry and expansion of capacity,
but also technology, output mix, capacity location and import content. In 1991,
previous piecemeal efforts towards liberalization of controls were consolidated in a
comprehensive wave of domestic deregulation. Industrial licensing was abolished alto-
gether, except for a list of environmentally sensitive industries. Along with this came the
removal of restrictions on large business groups to merge or expand, and the opening
up of several industries, previously reserved for the public sector, to the private sector.
Since the 1991 reforms encompassed both the domestic deregulation of private industry
and trade reforms that facilitated the purchase of low-cost imported capital goods, this
implies that any changes in India’s growth performance in the post-1991 period cannot
be directly attributed to one set of reforms. This important issue will need to be dealt
with in the empirical sections that follow.
3. Investment Behaviour in India: Trends and Patterns
In this section, we present a brief overview of investment behaviour in India over the
period 1955/56–1998/99, highlighting the key features of the data. We begin with a
graph of GDP growth (Figure 1). As expected of an economy where climactic factors
play an important role in determining total output, growth shows a great deal of
variation from year to year. There is, however, a clear rise in the trend rate of growth
of output in the 1980s and 1990s as compared with the earlier period–the average
annual growth rate in 1981/82–1998/99 was 5.6%, while that for the period 1955/56–
1980/81 was 3.6%. There has also been an increase in gross Ž xed capital formation
(GFCF) as a ratio of GDP since the 1980s, with a signiŽ cant acceleration in the 1990s
(Figure 2). The increase in the GFCF-to-GDP ratio in this period can clearly be
attributed to a rapid increase in the ratio of equipment investment to GDP, particularly
since 1991. In contrast, the ratio of structures investment to GDP has been stagnant
since the mid-1970s.
The increase in Ž xed investment as a ratio of GDP since the 1980s cannot have
resulted from an increase in public Ž xed investment, since this had been falling as a
ratio of GDP (both in the aggregate and in each of the components) since the
mid-1980s (Figure 3). The rise must be attributed to the sharp increase in private Ž xed
investment since the mid-1980s (Figure 4). The ratio of private Ž xed investment to
GDP increased from 9.1% in 1981/82–85/86 to 14.9% in 1991/92–98/99. This was
primarily due to a sharp rise in the rate of private equipment investment, with the
private investment in buildings and structures showing no signs of buoyancy.
One possible explanation of the sharp rise in private equipment investment could be
the fall in the relative price of equipment. The latter has shown a negative trend since
the late 1970s, in contrast to the relative price of construction investment, which
showed a signiŽ cant increase in the 1980s.
This suggests a clear upward trend in the series as a ratio of GDP since the 1980s,
driven by a spectacular increase in private equipment investment. At the same time,
there was an increase in the average annual growth rate of output and a fall in the
relative price of equipment. In the econometric analysis, we shall explore more rigor-
Trade Policy in India 321
Figure 1. Growth of GDP.
ously whether the behaviour of these three series–the relative price of equipment, the
rate of equipment investment and the growth rate of output–can be causally linked.
4. The Analytical Framework
The argument that trade policy can positively affect economic growth via an increase
in equipment investment is based on three behavioural relationships. These are: (i) the
link between equipment investment and economic growth; (ii) the link between the
relative price of equipment and the rate of equipment investment; and (iii) the link
between trade policy and the relative price of equipment. We discuss each in turn:
4.1 The Link Between Equipment Investment and Economic Growth
There is now a vast number of cross-country studies of the determinants of economic
growth using a wide range of explanatory variables. While the factors found to be
important in explaining economic growth have differed from study to study, Levine &
Renelt (1992) found that the signiŽ cance of the investment rate in explaining economic
growth remains robust to different speciŽ cations. There seems to be little doubt that
the investment rate is a crucial determinant of economic growth, if not the key
determinant. Furthermore, the new growth literature has argued that among the three
components of total investment–investment in equipment, investment in construction
and investment in inventories–the most important for growth is equipment investment
(De Long & Summers, 1991, 1992, 1993; Temple, 1998). This view argues that the
322 K. Sen
Figure 2. Investment in Ž xed capital and its components, as a percentage of GDP.
social return to equipment investment is higher than that for other types of investment.
The reasons are not very clear, though as De Long & Summers argue (1991, p. 447),
“historical accounts of economic growth invariably assign a central role to mechaniza-
tion”. It could be that the role of external economies may be greater for equipment
investment than for buildings and construction investment, possibly due to the greater
amount of research and development expenditure in the machinery sector.
To assess the impact of equipment investment on the growth rate of output, we use
a simple empirical formulation similar to that used by De Long and Summers. We take
the growth rate of output to be a linear function of the rates of equipment and buildings
construction investment. However, in our context, it would be useful to keep the rate
of private equipment investment separate from the rate of public equipment investment
in the output growth equation. This is for two reasons. First, the rate of return on
private equipment investment may be different from that on public equipment invest-
ment. Second, our purpose in the next stage of the analysis is to explain the behaviour
of equipment investment, and it can be argued that public investment is, in great part,
exogenously determined and in uenced more by political and institutional variables
than by economic variables. Thus, the determinants of public investment may be quite
different from those of private investment.
The Ž nal speciŽ cation is as follows:2
GY 5 a1PVRE 1 a2PBRE 1 a3RS, (1)
Trade Policy in India 323
Figure 3. Public Ž xed investment and its components, as a percentage of GDP.
where GY is the growth rate of GDP, PVRE is the ratio of private sector investment in
equipment to GDP, PBRE is the ratio of public sector investment in equipment to
GDP and RS is the ratio of investment (both private and public) in structures to GDP.
4.2 The Link Between the Relative Price of Equipment and the Rate of Equipment Investment
Since we are interested in examining the relationship between the relative price of
equipment and the rate of equipment investment, we conŽ ne our empirical analysis for
this section to the determinants of private equipment investment (as we have argued
earlier, public investment may be taken to be exogenously determined). We model the
rate of equipment investment by the private sector as follows:
PVRE 5 b0 1 b1RPE 1 b2RPS 1 b3FINT 1 b4RINT 1 b5PBRI 1 b6DUM91
1 b7PVRE( 2 1), (2)
where RPE is the relative price of equipment (price de ator for equipment investment
as a ratio of the GDP de ator), RPS is the relative price of structures investment (price
de ator for structures investment as a ratio of the GDP de ator), FINT is Ž nancial
deepening, RINT is the real interest rate (the bank lending rate minus the in ation
324 K. Sen
Figure 4. Private Ž xed investment and its components, as a percentage of GDP.
rate), PBRI is total public investment as a ratio of GDP and DUM91 is a dummy
variable for the 1991 reforms (value of one from 1991 onwards, zero otherwise).
We would expect from theory that the sign of the coefŽ cient for the relative price of
equipment, b1, will be negative–an increase in the latter will decrease the rate of
equipment investment in the economy. The sign for the coefŽ cient for the relative price
of structures, b2, cannot be determined a priori and will depend on whether construc-
tion capital is a complement or substitute for equipment capital. Financial deepening
is expected to have a positive impact on equipment investment. Financial deepening
can increase both the volume and efŽ ciency of investment. The “debt accumulation”
hypothesis of Gurley & Shaw (1955), formalized more recently by Bencivenga & Smith
(1991), argues that the spread of organized Ž nance can help overcome indivisibilities in
investment through the mobilization of otherwise unproductive resources. Moreover,
Ž nancial intermediaries and markets play an important role in selecting the most
promising Ž rms and households for lending purposes and thus contributing to the more
efŽ cient use of capital (Levine, 1997). Financial intermediaries may also enhance the
quality of investment by identifying entrepreneurs with the best chances of successfully
initiating new activities (King & Levine, 1993). In the Indian case, Bell & Rousseau
(2001) found conclusive evidence of the positive impact of Ž nancial deepening on gross
Trade Policy in India 325
Figure 5. Relative prices of structures and equipment.
domestic Ž xed investment in the post-1950 period. Following Bell and Rousseau, we
use the ratio of real bank credit to the private sector as a ratio of GDP as our preferred
measure of Ž nancial deepening (FINT).3
An increase in the real interest rate is expected to have a negative effect on the rate
of equipment investment via an increase in the cost of capital. Public investment may
affect private investment via both supply and demand. On the supply side, the private
sector relies on public investment for most of the infrastructure, because this is either
a natural or a legal monopoly of the government. Public infrastructural investment can
affect private equipment investment by in uencing its rate of return–poor roads, an
erratic supply of electricity or inadequate communication facilities can negatively affect
the amount of output that it is possible to obtain from a given amount of investment.
Thus, public investment in infrastructure and private investment should be comple-
mentary (Blejer & Khan, 1984). On the demand side, the relationship is ambiguous. If
there is some slack in the economy one would expect a change in public investment to
push private investment in the same direction. Otherwise, some private investment may
be “crowded out” (Athukorala, 1998).
We also add a post-1991 period dummy (DUM91) to capture the effect of the 1991
deregulation of industrial policy which may have had a positive effect on the private
investment rate over and above the effect of trade reforms on the latter working
through the relative price of capital goods. Finally, we include the one-period lagged
private equipment investment rate to capture the high degree of persistence in the
latter.
326 K. Sen
Table 1. Summary data of variables used in econometric analysisa,b
Years GY PVRE PBRE RS PBRI RPE RPS FINT RINT RER
1955/56–60/61 3.98 4.61 2.12 8.86 6.42 0.74 0.90 0.09 0.63 8.38
1961/62–65/66 2.84 5.05 2.78 9.64 8.47 0.81 0.88 0.11 2 0.13 6.64
1966/67–70/71 2.28 4.67 2.46 10.06 7.07 0.89 0.87 0.15 2 1.12 7.51
1971/72–75/76 4.66 4.06 2.38 11.20 7.03 0.89 0.81 0.13 1.73 7.38
1976/77–80/81 3.08 4.68 2.68 9.89 7.23 0.92 0.89 0.16 0.60 8.44
1981/82–85/86 4.69 4.50 3.22 9.99 7.66 0.96 0.91 0.18 3.75 9.39
1986/87–90/91 6.30 7.60 5.03 7.73 9.27 0.91 1.36 0.25 8.02 10.28
1991/92–98/99 5.77 10.53 4.18 7.57 7.47 0.86 1.40 0.24 7.58 14.09
SD: 0.033 0.026 0.011 0.013 0.012 0.089 0.236 0.061 0.055 2.56
a All variables in percentages except RER, RPE and RPS.
b Annual averages, except Ž nal row which contains standard deviation of variables over period 1955/56–1998/99.
4.3 The Link Between Trade Policy and the Relative Price of Equipment
Machinery is a key tradable commodity and its relative price will be greatly in uenced
by trade policy. In addition, the relative price of machinery would be affected by the
real exchange rate as movements in the latter would lead to change in the price of
tradables relative to that of non-tradables. We choose a very simple speciŽ cation for the
relative price of equipment, modelling it as a function of trade policy and the real
exchange rate. As is evident from the discussion in Section 2, the most important shifts
in Indian trade policy occurred in the years 1977, 1985 and 1991. We use dummies to
capture the changes in the trade regime in these 3 years. We also add a time-trend to
the speciŽ cation to capture the upward drift in the relative price series, is evident from
Figure 5.
RPE 5 c0 1 c1TIME 1 c2DUM77 1 c3DUM85 1 c4DUM91 1 c5RER, (3)
where TIME is the time-trend, DUM77 is a dummy variable for the 1977 reforms
(value of one from 1977 onwards, zero otherwise), DUM85 is a dummy variable for the
1985 reforms (value of one from 1985 onwards, zero otherwise), DUM91 is a dummy
variable for the 1991 reforms (value of one from 1991 onwards, zero otherwise) and
RER is the real exchange rate (equal to eP*/P, where e is the nominal exchange rate, P*
is the foreign price level and P is the domestic price level).4
5. Results
We estimate equations (1), (2) and (3) using ordinary least squares (OLS) regression.
Our period of analysis is 1955/56–1998/99. A summary of the data used in the
regressions is provided in Table 1.
There is a possibility that equation (1) would be subject to simultaneity bias if we
used current equipment and structures investment rates as explanatory variables in the
regression. This is because positive and signiŽ cant coefŽ cients on the rates of private
equipment investment and structures investment could imply that higher investment
rates are the result of economic growth, not the other way around. Therefore, we use
one-period lagged investment rates in the Ž nal estimation. We also include dummy
variables for the years 1965 and 1979 (denoted DUM65 and DUM79, respectively) to
Trade Policy in India 327
Table 2. Regression results
1. GY 5 0.544*PVRE( 2 1) 1 0.189*RS( 2 1) 2 0.084*DUM65 2 0.10DUM79
(3.29)*** (1.73)* (3.04)*** (3.56)***
R2 5 0.41 SE 5 0.027 SERCOR 2 c2(1) 5 3.10 NORM 2 c2 (2) 5 0.68
2. PVRE 5 0.072 2 0.084*RPE 1 0.174*FINT 1 0.017*DUM91 1 0.490*PVRE( 2 1)
(5.34)*** (5.14)*** (5.73)*** (3.60)*** (5.13)***
R2 5 0.92 SE 5 0.007 SERCOR 2 c2(1) 5 3.10 NORM 2 c2(2) 5 1.44
3. RPE 5 0.707 1 0.011*TIME 2 0.049*DUM77 2 0.13*DUM85 2 0.13*DUM91
(26.07)*** (5.77)*** (1.30) (3.97)*** (3.47)***
(3.47)***R2 5 0.62 SE 5 0.058 SERCOR 2 c2 (1) 5 2.65 NORM 2 c2 (2) 5 0.78
Notes: t-Ratios of regression coefŽ cients are given in parentheses. Approximate critical values for the t-ratios are
as follows: 10% 5 1.66 (*), 5% 5 2.04 (**) and 1% 5 2.75 (***); R2 5 R-squared; SE 5 standard error of
regression; SERCOR 5 Lagrange multiplier test of residual serial correlation; and NORM 5 Jarque-Bera test for
the normality of residuals.
capture the large dips in the growth rate of output in these 2 years (due to a negative
weather shock in 1965 and an oil price shock in 1979). The rates of public equipment
investment (PBRE) for equation (1) and total public investment (PBRI), the relative
price of structures (RPS) and the real interest rate (RINT) for equation (2) consistently
had statistically insigniŽ cant coefŽ cients in the experimental runs and were dropped in
the Ž nal speciŽ cation.5 Similarly, in our initial estimate of equation (3), the coefŽ cient
for the real exchange rate failed to attain statistical signiŽ cance at the 10% level and was
omitted.6 The Ž nal results are presented in Table 2.
As the estimates indicate, the explanatory power of the regressions is high and they
perform well by all diagnostic statistics. While both the coefŽ cients of PVRE and RPS
are statistically signiŽ cant (at the 1% and 10% level, respectively), we found that an
increase in the rate of private equipment investment has a far stronger positive impact
on the growth of output than an increase in the rate of construction investment–the
coefŽ cient on the former is more than double that of the latter. This is consistent with
what has been observed in the cross-country studies.7In the case of private equipment
investment, the relative price of equipment plays a decisive role in its determination–its
coefŽ cient is negative and highly signiŽ cant. Financial deepening has also been a key
determinant of the private equipment investment rate in India. In addition, the dummy
for the post-1991 period indicates a clear increase in equipment investment associated
with that period. This provides some support for the argument that the deregulation of
industrial policy in 1991 played an important role in the observed increase in equip-
ment investment in the post-1991 period (see Section 3) and may provide an alternative
explanation to that of trade policy of the post-1991 surge in private investment in India.
We shall investigate this explanation in a separate section later.
From equation (3), we see that while the trade liberalization episodes of 1977, 1985
and 1991 led to a fall in the relative price of equipment, the most signiŽ cant were the
episodes of 1985 and 1991. This is perhaps not surprising, given the muted nature of
the 1977 liberalization episode. However, we found that the 1985 liberalization episode
led to a similar fall in the relative price of equipment as the more comprehensive 1991
reforms. While somewhat counter-intuitive, this result is in accord with the Ž ndings
from previous studies that the 1985 reforms have had signiŽ cant positive effects on
industrial productivity and growth (Ahluwalia, 1991; Srivastava, 1996; Chand & Sen,
328 K. Sen
2002) by beginning the process of relaxing the quotas on capital and intermediate
goods. By doing so, the reforms brought about competition in the domestic capital and
intermediate goods sectors (albeit in a limited way).
Using the coefŽ cients estimated from equations (1)—(3), it is possible to obtain an
estimate of the contribution of the trade reforms of 1985 and 1991 to the average
annual growth of GDP following the reforms.8 Our estimates indicate that the com-
bined effect of the trade reforms of 1985 and 1991 was to increase the average annual
growth rate of GDP during this period by 1.2 percentage points.
6. An Alternative Explanation of the Post-1991 Increase in Investment
As noted in Section 3, the timing of the trade reforms in 1991 coincided with the
removal of the industrial licensing system in the same year. This implies that the
spectacular rise in private investment, and in particular in equipment investment,
can in part be attributed to the domestic deregulation measures. The results in
the previous section, and in particular our estimates of equation (2), support this
hypothesis. One possible way of disentangling the effects of trade reforms from reforms
in industrial policy on investment is to examine the behaviour of imported and
domestically produced capital goods in the post-1991 period. Figure 6 provides
time-plots of imported and domestic capital goods, and total capital goods as a
percentage of GDP over the period 1955/56–1998/99. All three ratios show a signiŽ cant
rise in the post-1991 period. This is consistent with arguments that stress the import-
ance of trade policy and those that highlight domestic deregulation in explaining
investment behaviour. Trade-induced changes in equipment prices could have both
income and substitution effects and a fall in the latter may have led to an increase in
both imported and domestically produced goods since 1991. On the other hand, the
rise in the shares of imported and domestic capital goods in income could also be due
to the domestic deregulation measures that allowed Ž rms in India to expand and enter
new industries.
To establish the role of trade policy in India’s post-1991 investment performance,
we assess whether changes in the relative price of capital have led to a substitution away
from domestic capital goods and towards imported capital goods. To do this, we
estimate a simple OLS regression, where the share of imported capital goods in total
capital goods (MSI) is regressed against an intercept (INT), its past value and the
lagged relative price of capital (RPE). We present the estimates (t-ratios in parenthe-
ses):
MSI 5 0.160*INT 2 0.140*RPE( 2 1) 1 0.80*MSI( 2 1)
(2.16) (1.93) (13.84)
R2 5 0.92.
The coefŽ cient on lagged RPE is negative and statistically signiŽ cant at the 10% level.
This indicates that changes in the relative price of capital are induced by changes in the
trade regime as such changes lead to a substitution away from domestic towards
imported capital goods in the Indian context. Thus, there is indirect evidence that the
radical reforms of the trade regime in 1991 pertaining to capital goods was a key
contributing factor to the increase in the equipment investment rate.
Trade Policy in India 329
Figure 6. Imported, domestically produced and total capital goods as percentage of GDP.
7. Conclusions
In this paper, we examine an alternative mechanism though which trade reforms may
impact on economic growth to those commonly discussed in the empirical growth
literature. We argue that trade policy may positively affect output growth via an
increase in the rate of equipment investment. There is strong support for this mechan-
ism in the Indian case. We Ž nd that the rate of private equipment investment has a
strong positive impact on economic growth, and that the former is signiŽ cantly and
negatively in uenced by the relative price of equipment, which fell sharply during the
trade policy reforms of 1985 and 1991.
The mechanism that we have focused on in the paper provides a strong link between
trade liberalization of the capital goods sector and economic growth. Earlier studies on
the link between trade policy and economic performance do not make any distinction
between reforms in the capital goods and other sectors. Our paper makes the point that
trade reforms in the capital goods sector can be a key contributing factor to economic
growth.
Notes
1. As Joshi & Little (1997) argue, the concentration of emphasizing an early reduction in tariffs
on capital goods in the reform process was probably intended to avoid discouraging
investment because of the expectation of a later reduction in tariffs.
330 K. Sen
2. We omit the constant term, as in the standard growth models (both in the neo-classical and
endogenous growth tradition), growth of output will be zero if the investment rate is zero.
3. Real bank credit to the private sector is obtained by de ating nominal bank credit to the
private sector by the price de ator for Ž xed investment.
4. For e, we use the rupee—US dollar bilateral exchange rate; for P*, we use the wholesale price
index in the USA; and for P, we use the consumer price index for India.
5. The possibility of simultaneity bias also exists in the case of OLS estimates of equation (2),
as the investment rate is an important demand-side determinant of both the relative price of
capital and bank credit to GDP ratio, and so the coefŽ cients on these two explanatory
variables in the regression may be biased upwards. The Wu-Hausman test statistic on the
endogeneity of the error term, however, does not indicate the presence of simultaneity bias
in the regression estimates.
6. The F-statistic associated with the deletion of RER from the Ž nal equation was 2.28 and not
signiŽ cant at the 10% level.
7. Given that the growth rate of total output seems to be heavily in uenced by weather-related
factors in the Indian context (see the discussion in Section 3), we also experimented with
replacing this variable with the growth rate of non-agricultural output. We found, however,
that such a model has less explanatory power (as evidenced by a lower R-squared) as
compared with the model reported in Table 2. As expected though, the coefŽ cient on PVRE
was higher when growth of non-agricultural output was used as the dependent variable
instead of total output.
8. It is possible to obtain such an estimate by substituting equation (3) in equation (2), and
equation (2) so obtained in equation (1). Using this method, we found that the 1985 and
1991 reforms increased GDP growth by 0.59 percentage points each.
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Research Observer, 6, pp. 189–211.
Complementary Reforms and the Link between Trade
Openness and Growth in Albania
LINDA KALTANI
Abstract
This article uses previous findings by Chang, Kaltani & Loayza on the important role
that reform complementarities play in the link between trade openness and economic
growth to investigate whether reforms in a particular country, Albania, are sufficient
for trade to be good for growth. The study simulates the growth-producing effect of
Albania’s reforms given a pre-established change in trade openness and contrasts it
with other countries’ performance. It then studies the reform variables and their
alternative proxies by comparing their levels with those predicted by Albania’s per
capita income. The article concludes that Albania’s most urgent reforms are in the
areas of financial development, infrastructure and governance.
From the start of its transition to a market economy, Albania’s goal has been to one
day join the European Union (World Bank 2006). Between 1992—the year in which
the new democratic government undertook a ‘shock therapy’ programme to establish a
market economy—and 1999 the country benefited from a preferential trade regime,
known as a trade and cooperation agreement, with the EU which facilitated access to
EU markets for textiles and agricultural goods (ACIT 2004). In 2000 the EU placed
Albania under the Autonomous Trade Preference (ATP) scheme which allows almost
all of Albania’s exports to enter the Union without facing any duties or quotas (World
Bank 2005c). More recently, in January 2003 negotiations on the Stabilisation and
Association Agreement (SAA) between Albania and the EU officially started, and the
SAA was signed in June 2006.
1
The recognition of the July 2005 elections by
the international community and the peaceful transition to a new government make the
vision of a European future a bit more real for Albania. Although EU accession is still
far away, the signing of the SAA will entail further liberalisation between Albania and
the EU. For this reason, it is important to question to what extent Albania is prepared
to take advantage of the fast-approaching wave of trade liberalisation.
This article builds on the findings of Chang, Kaltani & Loayza (2005) which
corroborate the positive link between trade openness and economic growth. More
ISSN 1463-1377 print/ISSN 1465-3958 online/07/020225-29 q 2007 Taylor & Francis
DOI: 10.1080/14631370701312329
Dr Linda Kaltani, The World Bank, Washington, DC, USA. Email: lkaltani@worldbank.org
1
In general a Stabilisation and Association Agreement is a treaty between the EU and non-member countries
that creates a framework of cooperation among them. In the case of the countries of the Western Balkans an
SAA is part of the Stabilisation and Association process (SAp) and includes explicit provisions for future EU
membership.
Post-Communist Economies, Vol. 19, No. 2, June 2007
importantly, these findings indicate that there are significant reform complementarities
in the areas of financial depth, human capital investment, infrastructure development,
governance, labour market flexibility and firm entry flexibility that strengthen the link
between trade openness and economic growth. These results suggest that the
advisability of trade liberalisation may depend on the level of complementary reforms
present in a country at the time of the trade policy change.
Driven by the findings of Chang et al., this article analyses the state of reforms
in Albania. The goal of this work is to question whether the level of reforms in
Albania is sufficient for trade liberalisation to promote economic growth. First, the
analysis presents simulation results of the growth effect of a predetermined change
in trade openness given complementarities in six areas of reform found significant
by Chang et al. The simulations highlight Albania’s (as well as two comparator
countries’) potential gain in terms of economic growth given the current level of
development in the complementary reform areas. The adequacy of each reform
variable is also compared with the level predicted by Albania’s per capita
income level, a measure of overall economic development. Subsequently, we study
alternative reform proxies for the six complementary reform areas mentioned above.
The goal here is to examine each reform area in more depth and to highlight
those that may require additional improvement. The adequacy of the additional
proxies is assessed by comparing their actual level in Albania with the level that
would be expected given the country’s per capita income. Given the intention to
highlight areas for further improvement, only those proxies that are inadequate
given Albania’s per capita level of income are discussed more extensively in this
article.
The article is organised as follows. First it reviews Albania’s economic performance
during the transition years. Next it discusses reform complementarities in the link
between trade openness and growth. Then it discusses the empirical findings of Chang
et al. Following this it evaluates Albania’s state of reforms. The final section concludes.
Albania’s Trade Performance during Transition
From the accession to power of the communist regime after World War II until its first
democratic elections in 1992, Albania was one of the best examples of autarchy
around the globe. In fact, aside from the alliances with the Soviet Union and China
which ended in 1956 and 1978 respectively, Albania relied very little on foreign trade.
As Kaplan (1994) vividly describes, ‘Albania’s was a primitive service economy: little
was imported and there were no factories mass producing shoes or clothes. A . . .
youth . . . begged me for gum: even in the poorest Third World countries, children
sold gum: here there was none to sell’.
Eager to overcome more than 40 years of isolation, Albania pursued a policy of
multilateral liberalisation right from the beginning of its transition period. In 1992
Albania signed the Trade and Cooperation Agreement with the EU, and in 1993 it
applied for WTO membership. Albania became a WTO member in 2000 (World Bank
2004). In this process of global integration, Albanian tariff rates, as depicted in
Figure 1, have steadily declined from 15% in 1996 to 7.3% in 2004. Albania now has
one of the most liberal trade regimes in its region (World Bank 2005c).
Furthermore, the negotiations for the SAA with the EU have required Albania and
other SAA candidates to foster regional cooperation with each other. As a
consequence, the simplification of commercial logistics through the enhancement of
simpler and more transparent customs procedures has allowed freer trade among the
226 Linda Kaltani
eight countries of South Eastern Europe (SEE-8).
2
Perhaps because of the pressure
from the EU, at the end of 2004 Albania had signed free trade agreements with all the
other SEE-8 countries as well as Kosovo (EIU 2005). In addition, the Albanian
government is also trying to sign a free trade agreement with Turkey.
Figure 2 depicts the significant increase in Albania’s trade openness since the
beginning of transition. Albania’s trade as a share of GDP has climbed from 12% in
1991 to 73% in 2003. Although imports as a share of GDP are clearly larger, the share
of exports to GDP has steadily increased since 1997. The persistent current account
deficit has been financed to a large extent by remittance flows from Albanians living
abroad, mainly in Greece and Italy. Korovilas (1999) has estimated that remittances to
Albania may have been a lot larger than has been estimated by the International
Monetary Fund, that they have allowed a situation of economic stability without a
balance of payments crisis, and that they have provided the hard currency to import
building materials and capital goods which were vital to Albania’s economic recovery.
With the exception of 1997, Albania has made remarkable progress in its
integration into the world economy, although from a very low base. Since 2000 the
country’s openness seems to have peaked at around 73% of real GDP. This may be a
converging point given the country’s structural characteristics. However, it may still
be too early to make such an assessment given the possible detrimental impact of the
past regional conflicts on Albania’s foreign trade. In a comparative context, the rate of
growth of Albania’s openness, although significantly higher in the 1990s, appears to
have tapered off since 2000 and has become similar to the rest of the transition
countries and the SEE-8 (Figure 3). Nevertheless, convergence of the growth rates of
trade openness would imply that the level of openness for Albania is likely to remain
significantly below the rest of the SEE-8 countries.
In the aftermath of the communist experiment, many economists questioned where
and to what extent trade should be redirected. Wang & Winters (1991), Baldwin
(1993) and Collins & Rodrik (1991) concluded that high integration potentials were
likely for the former communist countries vis-à-vis Western European economies.
Jakab et al. (2001) have confirmed these earlier studies. However, they have also
suggested that trade reorientation has been heterogeneous among transition countries
Figure 1. International trade regime, 1996 – 2004.
2
The other seven SEE-8 countries are Bosnia and Herzegovina, Bulgaria, Croatia, Macedonia, Moldova,
Romania and Serbia and Montenegro.
Reforms, Trade Openness and Growth in Albania 227
with those with more sophisticated product structures and more FDI converging at a
faster rate. These findings would lead to the expectation of high reorientation for
Albania’s trade that would continue into the future as the country’s export structure
evolves into more high-technology products that would change its trade relationship
with the EU away from one of centre to periphery.
Albania’s experience so far confirms the expectations of the abovementioned
literature by displaying an almost complete reorientation of trade toward the EU
(Figures 4 and 5). In 2004 more than 90% of Albania’s exports went to the EU, with
Italy importing 74% of the total. The EU is also Albania’s primary source of imports,
accounting for 70% of the total in early 2004. This is a significant change from the pre-
1990 period when close to 50% of Albania’s exports and imports where going to and
coming from other communist countries. Albania’s trade with countries other than the
EU (i.e. transition countries as well as Turkey and China) has steadily increased in
Figure 2. Albania’s trade as a share of GDP, 1991 – 2003.
Figure 3. Trade openness in transition countries.
228 Linda Kaltani
recent years. Trade is likely to increase at an even faster rate in the future due to the
free trade agreements with the rest of the SEE-8 and the likely agreement with Turkey.
Nevertheless, the growth rate of exports and imports with the EU is still higher than
any other comparator group. It seems clear that Albania’s eyes are on the EU both as a
trading partner in the short and medium run and as a full member in the long run.
Albania’s composition of trade has also drastically changed from the communist
years when the country was exporting very little and exports were unprocessed
primary materials, fuels and minerals (Figure 6). Today Albania’s main exports are
determined by its proximity to its trading partners and low labour costs, and are mainly
manufactured goods in the form of textiles and footwear and re-exports of semi-
finished goods. Like exports, the composition of imports has become heavily skewed
toward the manufacturing sector (Figure 7). Albania’s reliance on foreign
manufacturing products lies mainly in capital equipment and building materials. In
addition, in the recent past (since 1999) the country has relied less on foreign food
imports but more so for minerals and fuels; this is partly due to the country’s continued
Figure 4. Albania’s sources of imports.
Figure 5. Albania’s destinations of exports.
Reforms, Trade Openness and Growth in Albania 229
electricity crises that reached unprecedented levels in 2001 – 02 and the last quarter of
2005.
With the exception of 1997, the year of the collapse of the pyramid
investment
schemes, Albania has experienced substantial economic growth during the transition
period (Figure 8).
3
The high growth is greatly due to the reorientation of resources to
more efficient uses, in part through trade liberalisation and the ability of technological
know-how to enter the country (World Bank 2004).
4
Further trade integration with the
EU and neighbouring countries is likely to continue in the future. For these reasons
and in light of the empirical findings of Chang et al., it is informative to analyse
whether the complementary reforms that strengthen the link between openness and
growth are in place and adequate in extent in Albania. Although full EU membership
Figure 6. Albania’s composition of exports.
Figure 7. Albania’s composition of imports.
3
In the years leading to 1997 a large number of Albanians invested big portions of their savings in fictitious
businesses promising exuberant returns. The whole set-up collapsed when in early 1997 one of the companies
was unable or unwilling to pay back its customers, causing a run that threw the country into unrest and near
civil war.
4
World Bank (2004) provides in-depth discussion of the sources of growth in Albania.
230 Linda Kaltani
is still in the distant future, Albania needs to focus on removing the impediments to
trade and to complete non-trade reforms so as to be able to take full advantage of trade
openness in generating economic growth.
The Role of Policy Complementarities
After reviewing both the theoretical arguments for and against trade liberalisation and
the findings of the empirical literature, Chang et al.
5
draw two conclusions from which
they build their work.
6
The first is that the average effect of trade opening on
economic growth is positive. The second is that behind this positive average effect
there is considerable diversity regarding the aftermath of trade liberalisation. This
raises the question whether the observed heterogeneity is random or follows a
systematic pattern. The theoretical literature indicates that the diverse growth response
to openness is not arbitrary but depends on a variety of conditions related to the
structure of the economy and its institutions. Two simple illustrations may serve to
convey this point. The first is taken from >Calderón, Loayza & Schmidt-Hebbel
(2004). They allow the effect of trade openness on growth to depend (non-linearly) on
the level of per capita GDP. Figure 9 shows their results by plotting the estimated
growth effect of a one-standard deviation increase in openness as a function of per
capita GDP. The growth effect of openness is nearly zero for low levels of per capita
GDP, increases at a decreasing rate as income rises, and reaches a maximum only at
high levels of income. The conclusion would be that the growth effect of openness
would be economically significant for middle and high-income countries.
Finding that the growth effect of openness increases with income in turn raises
another interesting question: what is it about overall development (proxied by per
capita income) that makes a country take better advantage of openness? Consider the
next illustration. Figure 10 plots changes in growth rates of per capita GDP between
the 1980s and 1990s versus changes in the volume of trade (as a ratio to GDP) between
those two decades for a worldwide sample of 82 countries. This figure has four panels;
Figure 8. Albania’s real GDP per capita, 1980 – 2003.
5
This section and the next draw heavily on the work of Chang et al. (2005).
6
See Chang et al. for an in-depth discussion of the arguments for and against trade liberalisation and for the
most prominent empirical findings on this topic.
Reforms, Trade Openness and Growth in Albania 231
in each of them the country observations are separated according to whether they
belong to the top one-third (diamonds) or bottom two-thirds (squares) of a rank
distribution given by, in turn, each of the following criteria: a) secondary enrolment
rates (a proxy for human capital investment); b) main telephone lines per capita
(a proxy for public infrastructure); c) a subjective index of the quality of governance;
Figure 10. Changes in growth rates of per capita GDP versus changes in openness
between the 1990s and 1980s.
Figure 9. Growth effect of trade openness as a function of overall development.
232 Linda Kaltani
and d) a de facto and de jure index of labour market flexibility. Each criterion used for
ranking country observations is measured over the 1980s, the initial period.
Dividing the country observations into top and bottom groups makes it possible to
compare the corresponding slopes for the relationship between changes in trade
volume ratios and changes in economic growth rates. In all panels, the OLS line
described by the bottom observations is basically flat, implying no relationship
between trade opening and growth improvements. However, for the top observations,
the slope of the OLS line is positive and steeper than that for the bottom group.
7
This is
quite a simple exercise, but it points to the heterogeneous growth response to trade
opening which depends on specific country conditions, such as educational
achievement, public infrastructure, governance and labour flexibility.
In conclusion, it appears that the eventual success of openness in terms of growth
performance—and all the good things that come with growth such as employment and
poverty alleviation—depends on the economic and institutional characteristics that
make economic agents, both workers and firms, able to adjust to the new conditions
and opportunities presented by international competition. Will firms be able to
increase productivity to make their products attractive in foreign markets? Will the
creation of new firms and destruction of obsolete ones (the Schumpeterian process of
‘creative destruction’) proceed smoothly, without large dislocation of employment
and capital? Will workers be able to refocus their skills to be employed in emerging
sectors? Will the financial system recognise and provide resources for good
investment opportunities? Will public infrastructure in telecommunications, roads and
ports support the process of transformation with inexpensive costs and sufficient
availability? Will entrepreneurs direct their resources to activities where the country
has a comparative advantage from a long-run perspective or will they concentrate on
short-lived extractive sectors? Will firm owners choose a technology that takes
advantage of the country’s abundant labour resources or will they regard labour costs
and regulations as something to avoid? Finally, will economic agents concentrate their
energies in productive activities or will they divert them to rent seeking? The answers
to these questions will condition and determine the performance of the economy in the
aftermath of liberalisation. They will depend on the progress the economy can make in
educational achievement, financial development, public infrastructure, good
governance and product and labour market flexibility.
Cross-Country Econometric Evidence
This section presents some cross-country empirical evidence developed by Chang
et al. on how the growth effect of openness depends on a variety of structural
characteristics, which at least in principle are subject to reform. The panel data growth
regressions presented use a Generalised Method of Moments (GMM) procedure that
controls for endogeneity and unobserved country-specific factors in order to estimate
the growth effect of openness, as well as that of other policy and non-policy variables.
In addition, and unlike previous studies mentioned, Chang et al. allow for a
heterogeneous impact of openness on growth by interacting the openness measure
with proxies of, respectively, educational investment, financial depth, inflation
stabilisation, telecommunications infrastructure, governance, labour market
flexibility
and ease of firm entry and exit.
7
This is significantly so in the cases of educational investment, public infrastructure and governance. Labour
market regulation is not a statistically significant criterion in this simple example but becomes so once we use
more satisfactory econometric methods later in the article.
Reforms, Trade Openness and Growth in Albania 233
Chang et al. work with pooled cross-country and time series data, focusing on
comparative information from within-country changes. The sample consists of an
unbalanced panel dataset that comprises 82 countries. For each of them, there are at
most eight observations, consisting of non-overlapping five-year averages spanning
1960 – 2000.
The regression specification studying reform complementarities is obtained by
interacting the openness measure with each of the control variables in turn and can be
written as
yi;t 2 yi;t21 ¼ b0yi;t21 þ b
0
1cvi;t þ b2OPi;t þ b3cvi;t*OPi;t þ mt þ hi þ 1i;t ð1Þ
where the subscripts i and t represent country and time period, respectively; y is the log
of GDP per capita, CV is a set of control variables, and OP represents trade openness;
mt and hi denote unobserved time and country-specific effects respectively; and 1 is
the regression residual. Openness is interacted with the control variables one at a time
in order both to simplify the interpretation of the results and not to overextend the
parameter requirements on the data.
Regression results are presented in Tables 1 and 2. Table 1 shows the results of the
basic regression with no interaction terms (column 1) and the results of the regressions
where openness is interacted with time-varying variables (columns 2 – 5). These
variables represent areas where economic reform has been most active; they are
educational investment, financial depth, macroeconomic price instability and public
infrastructure. Table 2 shows the regression results where openness is interacted with
time-invariant variables. They represent institutional and regulatory areas where
reform—often called ‘second generation’—has been most sluggish. They are indices
of governance, labour market flexibility, firm entry flexibility and firm exit flexibility.
These are treated as constant per country because their underlying institutional
characteristics vary little over time and, partly reflecting this, there are quite limited
data on their time dimension.
8
The basic regression (Table 1, column 1) shows results consistent with the
previous empirical literature. Table 1 also shows the regression results that consider
interaction effects between openness and time-varying variables (columns 2 – 5). An
interesting pattern of reform complementarity emerges: the coefficient on the
interaction between the trade volume ratio and, in turn, the secondary enrolment rate,
the private domestic credit ratio and the number of telephone lines per capita is
positive and significant. This indicates that the growth effect of an increase in
openness depends positively on the progress made in each of these areas: more
openness results in a larger increase in economic growth when investment in
education is stronger, financial markets are deeper and telecommunications
infrastructure is more readily available. The shared explanation for these results is
related to the competitiveness of domestic firms in international markets: when
domestic firms find a better educated labour force and less costly credit and
communications, they are able to compete with foreign firms and expand their markets
effectively. The interaction between trade volumes and inflation is not significant,
8
The ICRG governance index is available since the mid-1980s and shows some time variation. Given that we
are forced to assume that its value was the same in the 1960s and 1970s as in the mid-1980s, we make the
conservative assumption that its growth effect cannot be estimated separately from that of the unobserved
fixed effect, as is the case with the other institutional variables that are completely constant over time.
234 Linda Kaltani
possibly reflecting the fact that, for most inflation values, relative price distortions are
not severe.
Table 2 shows the growth regression results when openness is interacted with the
proxies of institutional and regulatory reform. Interestingly, as in the results related to
time-varying variables, a pattern of complementarity emerges between openness and
other reforms: the estimated coefficients on the interaction between the trade volume
ratio and, in turn, the proxies for governance, labour market flexibility and firm entry
flexibility are positive and statistically significant. The beneficial impact of an increase
Table 1. Economic growth and interaction between openness and other economic
reforms
Interaction of openness with:
[1]
Benchmark:
no interactions
[2]
Human capital
investment
[3]
Financial
depth
[4]
Inflation
[5]
Public
infrastructure
Control variables:
Initial GDP per capita 23.1713** 23.2036** 23.2627** 23.2059** 23.3552**
(in logs) 0.18 0.21 0.17 0.18 0.23
Human capital
investment
1.1621** 20.8610** 1.2105** 1.1402** 1.2594**
(secondary enrolment, in logs) 0.15 0.42 0.16 0.16 0.17
Financial depth 1.0272** 0.9421** 0.0262 1.0071** 0.9234**
(private domestic
credit/GDP,
in logs)
0.11 0.09 0.21 0.11 0.07
Inflation 20.4580** 20.4350** 20.4895** 20.3243 20.4364**
(deviation of inflation
rate
from 23%, in logs)
0.08 0.07 0.07 0.21 0.07
Public infrastructure 1.5764** 1.5904** 1.6053** 1.6050** 0.6423**
(main telephone lines
per capita, in logs)
0.13 0.16 0.14 0.14 0.19
Openness:
Trade Openness (TO) 1.1959** 22.0421** 20.2553 1.3497** 3.2821**
(structure-adjusted
trade volume/GDP,
in logs)
0.16 0.59 0.28 0.28 0.48
Interactions:
TO * Human capital
investment
1.0031**
0.18
TO * Financial depth 0.4629**
0.08
TO * Inflation 20.0725
0.
10
TO * Public
infrastructure
0.4970**
0.09
Period Shifts:
Intercept (base period:
1966 – 70)
26.6266** 33.8398** 30.5385** 26.8523** 24.3839**
—71 – 76 Period shift 20.2987* 20.2371 20.2168 20.2698 20.2973**
—76 – 80 Period shift 21.1300** 21.1488** 21.0385** 21.1052** 21.1850**
—81 – 85 Period shift 23.3327** 23.3847** 23.2966** 23.3011** 23.4343**
—86 – 90 Period shift 22.9064** 23.0726** 22.9450** 22.8904** 23.1684**
Reforms, Trade Openness and Growth in Albania 235
in trade openness on economic growth is larger when society has a more efficient,
accountable and honest government and where the rule of law is more respected.
Likewise, the positive growth effect of trade opening is stronger when flexible labour
markets make it easier for domestic firms to transform and adjust to changing
environments, particularly those in highly competitive foreign markets. These results
also point out the importance of unrestricted firm renewal if trade opening is to have a
positive growth impact, particularly regarding the firm entry margin. The interaction
term between openness and firm exit flexibility is, however, not significant; whether
this reflects data quality problems or a more substantial difference with the opposite
margin of firm dynamics is unclear.
Albania’s State of Reforms in the Face of Increased Trade Openness
The econometric analysis presented above can be used to assess how well prepared a
country is to assume the challenges and opportunities of trade openness. This can be
done by calculating the growth impact of a change in openness given the country’s
level of progress in each area of complementary reform. Moreover, the analysis can
serve to highlight the areas where further progress will allow the country in question to
increase the positive growth impact of international trade openness.
For this purpose, it is necessary to ascertain what the total growth impact of a
change in openness is. This requires considering the regression coefficients on both
the interaction term and the openness variable itself. Since the total impact depends on
the values of the variables with which openness is interacted, it will vary from country
to country. Specifically, from regression equation (1), the total impact on growth is
given by the first derivative of the growth equation with respect to the openness
variable then multiplied by a predetermined change in openness, here denoted D
Openness:
D Growth ¼ ðb2 þ b3*Complementary ReformÞ*DOpenness ð2Þ
Table 1. Continued
Interaction of openness with:
[1]
Benchmark:
no interactions
[2]
Human capital
investment
[3]
Financial
depth
[4]
Inflation
[5]
Public
infrastructure
—91 – 95 Period shift 23.6060** 23.8088** 23.6621** 23.6020** 23.9486**
—96 – 00 Period shift 24.3282** 24.6922** 24.4665** 24.3250** 24.8331**
Countries/observations 82/544 82/544 82/544 82/544 82/544
Specification tests ( p-values)
—Sargan test 0.42 0.42 0.37 0.39 0.47
—2nd. order correlation 0.15 0.14 0.15 0.14 0.
14
Notes: Cross-country panel data consisting of non-overlapping five-year averages spanning 1960 – 2000.
Dependent variable: Growth rate of real GDP per capita.
Estimation method: GMM-IV system estimator (Arellano & Bover 1995; Blundell & Bond 1997).
Numbers below coefficients are the corresponding robust standard errors. * (**) denotes statistical
significance at the 10 (5)% level.
Source: Chang et al. 2005.
236 Linda Kaltani
where the symbol D means change and b2 and b3 are the estimated coefficients on
openness by itself and the interaction term. Here ‘complementary reforms’ are those
variables that have a significant interaction with openness in the growth regression.
Clearly, the growth effect of a change in openness will be a linear function of each
complementary reform. To scale the function at reasonable values, the change in
openness is set equal to one standard deviation of the openness measure used in the
regression analysis. Figure 11 plots (or simulates) the function in expression (2) for
the full range of sample values of each of the six complementary reforms: educational
Table 2. Economic growth and interaction between openness and institutional/
regulatory reforms
1
Interaction of openness with:
[1]
Governance
[2]
Labour market
flexibility
[3]
Firm entry
flexibility
[4]
Firm exit
flexibility
Control variables:
Initial GDP per capita 23.4019** 24.0229** 23.0202** 23.2063**
(in logs) 0.33 0.24 0.21 0.18
Human capital investment 1.2845** 1.5146** 1.7603** 1.2424**
(secondary enrolment, in logs) 0.16 0.16 0.16 0.11
Financial depth 0.9632** 1.2870** 0.9063** 1.3196**
(private domestic
credit/GDP, in logs)
0.12 0.12 0.12 0.
12
Inflation 20.3830** 20.3513** 20.5266** 20.2848**
(deviation of inflation rate
from 23%, in logs)
0.08 0.08 0.08 0.07
Public infrastructure 1.5912** 1.6379** 1.4037** 1.0532**
(main telephone lines
per capita, in logs)
0.17 0.12 0.14 0.13
Openness:
Trade Openness (TO) 0.0802 23.7359** 23.5333** 1.6581**
(structure 2 adjusted trade
volume/GDP, in logs)
0.33 0.64 0.69 0.27
Interactions:
TO * Governance 2.9617**
(governance: index from
ICRG, 0 – 1)
0.87
TO * Labour market flexibility 8.9986**
(labour: index from DB,
0.21 – 0.80)
1.36
TO * Firm entry flexibility 7.4593**
(entry: index from DB,
0.25 – 0.94)
1.31
TO * Firm exit flexibility 20.8598
(exit: index from DB, 0 – 1) 0.73
Period shifts:
Intercept (base period: 1966 – 70) 30.1810** 39.9023** 34.5819** 20.0764**
—71 – 76 Period shift 20.2943* 20.6062** 20.3485* 20.6757**
—76 – 80 Period shift 21.1737** 21.5945** 21.2628** 21.5267**
—81 – 85 Period shift 23.4484** 23.7077** 23.6949** 23.5881**
—86 – 90 Period shift 23.1087** 23.3740** 23.3734** 22.9243**
—91 – 95 Period shift 23.9498** 23.9600** 24.0722** 23.5820**
—96 – 00 Period shift 24.6800** 24.4676** 24.8611** 23.8035
Reforms, Trade Openness and Growth in Albania 237
investment, financial depth, telecommunications infrastructure, governance, labour
market flexibility and firm entry flexibility. Therefore, the range of the x-axis in each
panel varies and corresponds to that of each complementary reform proxy. Moreover,
the proxies for educational investment, financial depth and telecommunications
infrastructure are in log form, and thus their ranges may take on negative and positive
values. Governance, labour market flexibility and firm entry flexibility are captured by
indices spanning only the positive space.
Since for policy analysis the most current reform values are the most relevant, the
range corresponding to the latest period (1996 – 2000) is highlighted in bold.
9
This
bold line is reform-specific and thus varies from panel to panel, but it has the common
feature of lying to the right of the all-period range since reforms have advanced since
1960, and improvement is captured by movement to the right on the x-axis of each
panel.
For all the reform variables in Figure 11 except the governance index, the total
growth impact of openness changes from negative to positive as progress occurs.
Therefore, in principle, for five out of the six complementary reforms an increase in
openness could bring a reduction in economic growth if a given complementary area is
not sufficiently advanced. In practice, given the current state of reform progress
around the world (highlighted by the bold horizontal lines), this concern is presently
relevant for half the complementary areas under consideration. For educational
enrolment, financial development and governance, the results indicate that they would
not cause growth to decline with increased openness given that their current values
exceed the corresponding threshold below which trade liberalisation would damage
growth (this would be any value to the left of each line’s intersection with the x-axis in
Figure 11). However, regarding telecommunications infrastructure, labour market
flexibility and firm entry flexibility, there are countries that currently stand to lose
Table 2. Continued
Interaction of openness with:
[1]
Governance
[2]
Labour market
flexibility
[3]
Firm entry
flexibility
[4]
Firm exit
flexibility
Countries/observations 82/544 79/523 82/544 78/518
Specification tests ( p-values)
—Sargan test 0.37 n.a. 0.38 n.a.
—2nd. order correlation 0.12 0.28 0.13 0.25
Notes: Cross-country panel data consisting of non-overlapping five-year averages spanning 1960 – 2000.
Dependent variable: Growth rate of real GDP per capita.
Estimation method: GMM-IV system estimator (Arellano & Bover, 1995; Blundell & Bond 1998).
Numbers below coefficients are the corresponding robust standard errors. * (**) denotes statistical
significance at the 10 (5)% level.
1
The measures of institutional and regulatory reform do not vary, or vary little, over time. Their
direct impact on growth cannot be separated from that of the country-specific effect; however, we
include them as an additional control.
Source: Chang et al. 2005.
9
Clearly, for time-invariant variables the bold line will cover the whole range.
238 Linda Kaltani
from opening their markets. Focusing only on the reform indicators used in this article
and taking a worldwide perspective, the implication would be that the most urgent
reforms to ensure that trade promotes growth are related to infrastructure, labour
markets and firm renewal, since their level in some countries is so low as to cause a
negative growth effect. This is not to say, however, that countries will not benefit more
from trade openness if they improve their educational attainment, financial depth and
overall governance.
In addition to total growth effects (based on the coefficient point estimates), Figure 11
shows two dotted lines which are the corresponding 90% confidence bands
(constructed with the estimated coefficient standard errors). Finally, each plot
in Figure 11 identifies where Albania is located in 1996 – 2000 in terms of its
Figure 11. Growth effect of a change in one standard deviation of openness for
various reform areas.
Reforms, Trade Openness and Growth in Albania 239
complementary-reform value and the corresponding growth effect of openness. In
addition, two comparator countries are also identified. They are Croatia and Ireland.
Both countries have performed like Albania or better in terms of growth and
complementary reforms.
10
Given Albania’s state of reforms, a one standard deviation change in trade
openness would lead to approximately a 0.9% increase in growth in the regressions
with education, infrastructure and labour market flexibility, while it would lead to a
0.2%, 0.7% and 0.7% increase in the regressions with financial development,
governance and firm entry flexibility respectively.
Clearly, if Albania were to make progress in any of the six reform indicators
by moving further to the right on the x-axis of each panel, the effect on economic
growth would be even larger. Thus, although Albania can only gain from trade
openness given its state of reforms (i.e. in all six panels Albania’s impact on
economic growth is a positive value), it has a lot of room for improvement in
each of these areas to get closer to the best practice countries (those lying to the
extreme right of the x-axis).
One limitation of the empirical estimation, and consequently of the simulations, is
the fact that the reform variables are proxies commonly used in the economic literature
to capture development in areas such as human capital investment, financial depth,
infrastructure development, governance, labour market flexibility and firm entry
flexibility. As proxies they are typically highly correlated with other variables that
describe the same reform area and are therefore very often interchangeably used in the
literature.
11
The choice of proxies in the Chang et al. empirical estimation was driven
by their wide availability both across countries and over time, which, in turn,
guaranteed the largest possible sample from which to draw conclusions on the role of
reform complementarities in the link between trade openness and economic growth. It
is, however, conceivable that for some countries where reforms have been uneven,
alternative proxies may portray a very different picture of the state of development of a
particular reform area.
Driven by such considerations and recognising the general pattern of high
cross-country correlations between variables capturing a specific reform area, this
article questions whether Albania’s level of reforms, as measured by various
proxies, is adequate for reform complementarities to ameliorate the positive link
between trade liberalisation and economic growth. What we are looking to find is
whether there are reform areas in Albania that are not as advanced as the
regression proxies would suggest. These findings, in turn, would question
Albania’s placement in Figure 11.
10
Croatia was picked as a regional comparator despite the fact that its growth rate for 1996 – 2000 was 4.8%,
slightly lower than Albania’s, which amounted to 5%. Ireland was picked as an example of a reformer around
the world. There was no country that scored higher than Albania in terms of labour market flexibility and also
experienced higher growth.
11
For example, in the specific case of infrastructure development, the economic literature interchangeably uses
roads, telephone lines or energy consumption. Other reform areas display the same variety of choices. Here are
some cross-country correlations of the alternative variables that are in the analysis below. The correlation
between education enrolment and education quality is 0.66. The correlation between measures of energy
sector efficiency and telecommunications is 0.5. The correlation between the quantity of credit and the quality
of the regulatory environment in the financial sector is 0.54. The correlation between the composite
governance index and its sub-components ranges from 0.76 to 0.86. The correlation of the governance index
with other measures of governance such as, for instance, the number of procedures required to enforce
contracts is 2 0.54.
240 Linda Kaltani
This exercise first compares Albania’s progress in each of the six complementary
reforms used in the regressions with the level predicted by the country’s per capita
income, which is the best available measure of overall development. This makes it
possible to assess whether Albania is at a level of reform progress adequate for its
development. Then alternative measures capturing the six reform areas are plotted
against Albania’s per capita income. In those cases in which Albania’s performance is
poor given its level of development, the graphical evidence would highlight areas
where the country’s progress may have been uneven so as to create potential
bottlenecks in the relationship between trade liberalisation and economic growth.
Specifically, Figures 12 – 24 are scatter plots which display GDP per capita on the x-
axis for the largest possible sample available and on the y-axis have either the actual
reform proxies used by Chang et al. in their empirical analysis or alternative variables
for these reform areas. The regression line described by each scatter plot can provide a
prediction of Albania’s reform level given its income per capita. This in turn makes it
possible to compare the actual level of the reform variable with its prediction and to
conclude whether it is adequate. The discussion below will emphasise only those cases
in which Albania’s performance is poor given its level of development.
The sub-sections that follow discuss complementary reforms in the areas of
educational achievement, financial development, public infrastructure, governance,
labour and firm entry flexibility. The analysis starts with the reform variables
considered in the cross-country estimation above in the most current year available
(usually 2003); then it is extended to aspects that seem most relevant for the case of
Albania as determined by experts’ advice and data availability.
12
Figure 12. Infrastructure vs. income level.
12
An initial analysis looked at telephones, electricity and water for infrastructure development; school
enrolments, international educational assessment scores, teacher – pupil ratios and expenditure on education
for human capital investment; availability of private credit, legal rights, cost of collateral and creditor
information for financial development; corruption, rule of law, quality of bureaucracy, accountability of public
officials, contract enforcement, property registration and investor protection for governance; difficulty of
hiring and firing workers, rigidity of work hours and the size of the informal sector for labour market
flexibility; number of procedures, duration, cost and minimum capital for firm entry flexibility. Then, only
those proxies that appeared problematic given Albania’s level of development and given comments from
experts are discussed below.
Reforms, Trade Openness and Growth in Albania 241
Infrastructure
The cross-country regression equations presented above use as a proxy for
infrastructure the per capita number of main telephone lines. This choice is driven
mainly by the need to have large data coverage in terms of both countries and years.
The drawback of this variable is its inability to fully depict the state of infrastructure in
a particular country since it fails to consider transport, energy or roads, which are
equally vital to international trade.
Regarding telecommunications infrastructure, the simulation exercise indicates
that, given its level in 1996 – 2000, Albania would gain from increased trade openness.
In addition, Figure 12 plots countries’ measure of per capita telephone lines against
their income per capita and shows that Albania’s telecommunications infrastructure is
Figure 13. Electrical transmission and distribution losses vs. income level.
Figure 14. Electricity constraints vs. income level.
242 Linda Kaltani
adequate for its level of development although far lower than that of other SEE-8
countries.
When considering alternative proxies for infrastructure development, it becomes
evident that the area that is most problematic for Albania’s infrastructure is that of
energy. In fact, transmission and distribution losses, which are due to technical faults
and energy theft, are very large for Albania although they have demonstrated a
declining trend since the 63% peak in 1999. As Figure 13 demonstrates, Albania’s
energy losses are beyond what would be expected at its level of development and are
lower only than Moldova among all transition countries.
Figure 15. Electricity services vs. income level.
Figure 16. Financial development vs. income level.
Reforms, Trade Openness and Growth in Albania 243
The effect of the electricity crisis on economic activities becomes clearer in Figure
14; nearly 60% of Albanian businessmen interviewed in 2002 consider electricity
constraints to be large and a major obstacle to production. This is the largest share
among all transition countries and is lower only than Bangladesh in the world sample
available.
The crisis in the power sector has been driven by a combination of factors. The rise
in the demand for electricity over the transition years has been coupled with Albania’s
unpredictability of energy supply due to its exclusive reliance on hydropower. To
these constraints one can also add vast losses in transmission and distribution due to
theft and technical faults. Furthermore, financial constraints (i.e. insufficient revenue
Figure 17. Credit information vs. income level.
Figure 18. Education vs. income level.
244 Linda Kaltani
collection) as well as a lack of connectivity to the rest of Europe and limitations in the
distribution network have put a ceiling on the amount of electricity that can be
imported at any particular time and forced KESH (Albanian Energy Corporation) to
resort to load shedding. These difficulties, in turn, have forced private individuals and
businesses to resort to expensive back-up generators and have had a negative impact
on potential investment in Albania (UNDP 2004).
When businessmen are asked about the number of days during which power cuts
were experienced, Albanians again reiterate their electricity problems by counting
over 40 days with power cuts per year, significantly above the rest of the SEE-8
countries (Figure 15). Although the most recent data for these figures are from 2002
and 2003, the crisis in the power sector remains relevant today and has escalated to
even higher levels. The weather conditions in the last quarter of 2005 led to a
Figure 19. Brain drain vs. income level.
Figure 20. Governance vs. income level.
Reforms, Trade Openness and Growth in Albania 245
widespread energy crisis (European Commission 2006). It is still unclear how large an
effect this crisis will have on the economy, but the repercussions are likely to be
substantial.
Financial Development
Based on the simulations of Figure 11, it can be deduced that, given Albania’s level of
financial development, changes in trade openness would be beneficial to economic
growth. However, the amount of private credit as a share of GDP for Albania is the
lowest among the SEE-8 countries and is quite low given Albania’s level of
development (see Figure 16).
Figure 21. Law and order vs. income level.
Figure 22. Enforcing contracts: number of procedures vs. income level.
246 Linda Kaltani
It is important to note that Albania has made significant progress in the past years,
and the growth rate of private credit has been substantial although from a very low
base (World Bank 2006). Despite such progress, Albania still lacks the rules and
regulations that would permit efficient functioning of the financial sector. There is in
fact concern that the credit market may be put at risk by new, increased competition in
the face of poor regulations (EIU 2005). An illustration of this regulatory weakness
can be found in World Bank (2005a) which, based on La Porta et al. (1998), develops
measures on credit information sharing and the legal rights of borrowers and lenders.
As depicted in Figure 17, the lack of information through public and private registries
that keep track of borrowers’ credit histories earns Albania a very low score on the
Doing Business credit information index. The lack of creditor history creates a
situation of credit rationing due to imperfect information: lenders cannot verify
Figure 23. Labour market flexibility vs. income level.
Figure 24. Firm entry flexibility vs. income level.
Reforms, Trade Openness and Growth in Albania 247
potential borrowers’ credit worthiness and either provide a smaller loan than the
borrower demands at the quoted interest rate (Jaffee & Russell 1976) or impose a
higher interest rate on larger loans (Jaffee & Stiglitz 1990). Imperfect information can
be particularly burdensome for small firms that would have difficulty getting funding
from non-bank sources and thus would be forced either to resort to the informal sector
or to contract their business activities (Walsh 1998).
The lack of integration of the financial sector in people’s lives is also highlighted
by the fact that although Albania receives among the largest per capita remittances in
the world, these mainly occur in cash and, even when not used for household
consumption, do not enter the banking system where they could be efficiently
channelled to large-scale, high-return investments (IMF 2006). This is part of a larger
pattern of a cash-based society with the highest level of currency outside the banking
system in the SEE-8 countries. Recently, however, as part of an effort to increase the
use of the financial system by its citizens, the government has started to pay public
sector salaries into the banking system (EIU 2005).
Educational Achievement
The simulation results in Figure 11 indicate that Albania’s level of secondary school
enrolment is adequate to ensure a positive growth effect of openness. Figure 18 also
suggests that Albania’s quantity of education is broadly in line with the level predicted
by its level of per capita income.
A fairly similar conclusion can be given regarding the quality of education in
Albania. Albania participated in the 2000 Programme for International Student
Assessment (PISA), which evaluates how far students in the last years of secondary
school have acquired essential knowledge and skills in the areas of reading,
mathematical and scientific literacy. Although Albanian students performed worse
than their peers in other transition countries, the scores were consistent with what
would be predicted given Albania’s level of development. Despite such findings, it is
clear that Albania needs to invest more in education and human capital development in
order to better face the potential competition from the more skilled labour present in
its neighbourhood (World Bank 2006).
Whether Albania’s students will be able to perform well in the future is uncertain.
One indicator of concern comes from statistics from UNICEF which indicate that
expenditure on education by the Albanian government was 2.6% of GDP in 2002, the
lowest of the SEE-8 and higher only than Georgia and Armenia among all transition
countries (UNICEF 2003). Although it is possible that reductions in government
spending on education are caused by a reduction in inefficiencies in the budget, there
is evidence that the cost of schooling has become a reason for children to drop out of
school as transport costs due to school closures have become a significant family
burden, and drastic cuts have occurred in teacher training and school maintenance
(Hertz, Meurs & Satarkulova 2005).
Another area of concern that seems to be emerging from the BEEPS (2002) data is
the widespread impact of the brain drain phenomenon on Albania’s businesses. On a
scale of 1 – 5 Albania’s firms rate the impact of the departure of skilled workers to
foreign countries on the survival of their business at 3.2, which is the highest rating
among the transition countries and matched only by Macedonia among the SEE-8
countries (Figure 19). The critical impact of the brain drain on the Albanian economy
is also highlighted by UNDP (2006), which points out that during 1990 – 2005 more
than 50% of Albania’s scientists and researchers left the country, and nearly 50% of
248 Linda Kaltani
those were under the age of 40. Moreover, the report points out that there is evidence
that nearly 60% of highly educated Albanians abroad are not working in their field of
expertise, warranting concerns not just of ‘brain drain’ but ‘brain waste’.
Although mass emigration has served as a safety valve on the Albanian labour
market during the transition years and has significantly contributed to Albania’s
economy through large amounts of remittances, it has also restricted Albania’s pool of
qualified human resources. This vicious circle can be quite detrimental to the country
as educated individuals leave to find opportunities abroad and the government, in turn,
finds it not worthwhile to invest in educating its citizens better, as possibly highlighted
by the lower share of education expenditure in GDP.
Governance
The governance indicator used in the regressions is a composite index from Political
Risk Services (2003). The components used, which are based on subjective opinions
of domestic and international experts, measure the prevalence of the rule of law,
democratic accountability of state actions, absence of corruption and the efficiency of
the bureaucracy. By looking at the simulations, one can deduce that Albania’s level of
governance would allow a positive effect of trade openness on growth. However,
Albania’s level of governance is below what would be predicted by its level of
economic development and is the lowest among the SEE-8 countries (Figure 20).
Clearly there is a lot of room for improvement which would strengthen the positive
impact of trade liberalisation on growth.
It can also be helpful to look at each individual component making up the
governance index in order to pinpoint the areas that are most problematic given
Albania’s level of development. It appears that, although corruption seems to be
widespread within the political system, the area of governance where Albania is most
lagging behind is law and order (Figure 21).
13
The indicator measuring law and order
assesses both the strength and impartiality of the legal system and popular observance
of the law. In this particular area of governance Albania is lagging behind not only the
SEE-8 countries but also all the transition countries. This seems to indicate that the
legal system has failed to generate trust—partly because the courts are not
independent enough and partly due to the legacy of the communist years—and has
thus contributed to a widespread tendency for citizens to ignore the laws of the country
(Broadman et al. 2004).
The weakness of the courts and legal institutions can be particularly detrimental to
potential investment and business relations if contract enforcement is lengthy and
unpredictable. For instance, as depicted in Figure 22, in instances of contract
enforcement of overdue debt, the number of procedures mandated by law or court that
demand interaction between the parties or between them and the judge or a court
administrator are excessive in the case of Albania (only Serbia and Montenegro has
more procedures than Albania among the SEE-8 countries). A large number of
procedural steps has the potential to increase the length of a court case, impose more
regulation and complexity on dispute resolution, imply higher costs, and fuel more
corruption and bribe extraction.
The failure of contract enforcement, in turn, forces firms to avoid local courts
as much as possible and affects their willingness to acquire new (potentially more
13
The idea here is that there is an expected negative link between the level of corruption and a country’s
economic performance. However, this view has been countered by arguments that corruption may not
necessarily be inconsistent with the level of development; see Kaufmann (1997) for a discussion.
Reforms, Trade Openness and Growth in Albania 249
profit-generating) clients and suppliers due to the fear of being cheated and not being
protected by the judicial system, thus leading to lost opportunities to trade (Broadman
et al. 2004). Evidence from the BEEPS data, in fact, confirms that firms rely on mutual
trust and long-lasting relations in their business and tend to structure transactions in
ways that minimise contractual risk (i.e. prepayment, non-use of credit). Moreover,
what makes the bottleneck in the legal system and its associated institutions an ever
more pressing issue is the underdevelopment of alternative resolution channels such as
mediation or arbitration (Broadman et al. 2004). In the case of Albania, improving
governance has become a major priority as it is a precondition for the country’s
negotiations on the SAA. Therefore, Albania has a lot to gain from improved
institutions both in terms of economic growth and a European future (European
Commission 2006).
Labour and Firm Flexibility
The measure used to capture labour market flexibility is a de jure index presented in
the Doing Business database (World Bank 2005a) which captures three aspects of
labour market conditions: difficulty of hiring workers, difficulty of dismissing workers
and rigidity of working hours. The firm entry flexibility index is derived from Doing
Business and Index of Economic Freedom (Heritage Foundation 2003). It measures de
facto and de jure challenges of establishing a new business which come in the form of
the associated time and cost as well as the number and leniency of the application for
entry procedures.
14
The regression results show that labour and firm entry flexibility are the areas of
reform that are most important to the positive relationship between openness and
growth. In the case of Albania the simulations imply a positive impact on economic
growth given the level of regulations on labour and firm entry in the country. In
addition, the overall indices of labour and firm entry flexibility are both satisfactory
given the country’s level of per capita income (Figures 23 and 24). Albania also fares
quite well relative to neighbouring countries. Thus, given its level of reforms in these
areas, Albania is likely to benefit significantly from trade openness. This conclusion
holds true even when individual components making up the indices or alternative
regulation proxies (for instance, the extent of the informal sector) are taken into
consideration.
In the case of the labour market flexibility index, it appears that in Albania it is
quite easy to hire workers without much regulation on the use of term contracts or a
minimum wage. The component that evaluates the ability of firms to shed workers
looks at whether firms are required by law to notify and possibly get permission
from trade unions or the labour ministry. Albania’s regulations again do not appear
stringent in this category. The last component of the labour flexibility index looks at
the rigidity of hours and measures whether night or weekend work is allowed and
whether the days of vacation provided meet a minimum criterion. In this category
Albania performs slightly worse that its level of income would predict but
the difference does not appear to be substantial and is similar to other transition
countries.
As for the firm entry flexibility index, it seems that the number of procedures that a
start-up would have to comply with in Albania is close to what would be predicted by
its level of income. The same can be said of the costs associated with starting a
14
See O’Driscoll et al. 2003.
250 Linda Kaltani
business, the days it takes to complete a procedure, and the overall level of regulation
of the start-up process by the government.
Therefore, it appears that when it comes to the ability of the private sector to
reinvent itself by either adjusting the demand for labour or changing the number of
firms in the market, Albania’s businessmen are able to compete with the rest of the
transition countries and with their SEE-8 counterparts.
Conclusions
This article is based on new evidence by Chang et al. (2005) on the positive link
between trade openness and economic growth and the important role of certain reform
complementarities in this relationship. These reform complementarities are
educational investment, financial depth, public infrastructure, governance, labour
market flexibility and firm entry flexibility. The goal of the article is to investigate
whether Albania’s level of complementary reforms can enhance the link between trade
openness and economic growth. Since the collapse of the communist regime in 1992
Albania has been writing a new history for itself and has been slowly integrating with
the rest of Europe after decades of isolation. If Albania is to benefit from the
opportunities offered by global integration, it is important to focus on non-trade
reforms and to analyse their adequacy to foster a positive link between trade openness
and economic performance.
The article first reviews Albania’s trade and output performance in the years of
transition, highlighting the country’s continued efforts to liberalise its trade regime, its
reorientation of trade towards the EU and the drastic change in the composition of both
imports and exports to reflect its revealed comparative advantage. Subsequently, the
article simulates the growth-producing effect of Albania’s reforms in light of a pre-
established change in trade liberalisation and places such performance in a context by
comparing it with two other European economies. The main conclusion of the exercise
is that, despite being much lower than the comparator countries’, Albania’s reforms
would be conducive to positive economic growth in the event of a change in trade
openness. Furthermore, the level of each reform proxy is compared with that predicted
by Albania’s per capita income, which is used as a broad measure of overall
development and provides a way of gauging whether reforms have progressed at the
same pace as the performance of the overall economy. This exercise makes it possible
to highlight certain reform areas that seem inadequate given Albania’s level of per
capita income. Finally, to arrive at a thorough assessment of the progress of each
reform area, other reform proxies are compared with the level predicted by Albania’s
per capita income.
The overall exercise highlights three areas of reform that are crucial for Albania’s
link between trade openness and economic growth. First, in the area of infrastructure,
the energy sector comes at the top in terms of its needs for further reform. Second,
Albania’s level of financial development remains inadequate despite recent rapid
progress. In this context, of vital importance is the creation of credit information
agencies that would streamline the assessment of the creditworthiness of potential
borrowers. Finally, the issue of governance is particularly important for Albania both
for its link to economic outcomes and its crucial role in the continuation of
negotiations between Albania and the EU. Within this broad realm, improvement in
the indicators of law and order, which capture aspects of the judicial system and the
business climate, are found to be particularly crucial.
Reforms, Trade Openness and Growth in Albania 251
Although Albania’s much-desired reintegration with the world has been successful in
generating higher trade, there is significant room for the country to improve its ability to
benefit from its trade liberalisation by lowering the non-trade policy and institutional
barriers that make it difficult for Albanian firms to compete abroad. Despite the fact that
this article has focused on the areas that seem most in need of further improvements, it
may be useful to reiterate that the empirical findings on which this work is based are clear
in indicating that any reform progress will always be beneficial to economic growth.
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