Trade openness reduces growth volatility when countries are well diversified

Abstract

This paper addresses the mechanisms by which trade openness affects growth volatility. Using a diverse set of export concentration measures, we present strong evidence pointing to an important role for export diversification in conditioning the effect of trade openness on growth volatility. Indeed, the effect of openness on volatility is shown to be negative for a significant proportion of countries with relatively diversified export baskets.Keywords: Export diversification, growth volatility, trade openness JEL Classification: F15, F43, O24 Non-Technical SummaryWhile it is widely believed that trade openness is, under suitable conditions, positively associated with growth outcomes (Frankel and Romer 1999), the link between openness and growth volatility is less well understood. As trade integration deepens, economies are naturally more exposed to external shocks. However, does this automatically imply that more open economies must experience greater growth volatility, or are there factors that may condition whether the larger exposure translates into a more volatile growth path? Despite an extensive existing literature on the subject, there is no clear consensus to date. This paper seeks to contribute to this line of research and thus proceeds by asking two questions: first, does the effect of trade openness on growth volatility vary with the degree of concentration of a country's export basket? Second, if such conditioning exists, is there a level-in terms of a given export concentration measure-where, for the average country, the total effect of trade openness on growth volatility changes from negative to positive?Our empirical strategy begins with the computation of a variety of export concentration indicators, which we use as measures of the extent of export concentration in any given country, across both products and markets. We then utilize these measures to explore the relationship between concentration, trade openness, and volatility, while controlling for important additional sources of income volatility. We also obtain standard errors for the joint effect of the openness indicator and its interaction with concentration, and establish confidence-bound threshold values whereby the total effect of the openness variable on growth volatility switches sign. One major empirical concern is the possible endogeneity in the link between growth volatility and trade openness. While we have postulated a direct effect stemming from openness to volatility, we are aware that the converse is also possible, namely that trade policy responds to an increase in growth volatility. Our preferred choice of estimator to deal with the likely (weak) endogeneity in the relationship is the system GMM procedure proposed by (Arellano and Bover 1995; Blundell and Bond 1998); as an additional robustness check, however, we also explicitly control for reverse causality in the openness variable via the explicit incorporation of predicted trade flows (Frankel and Romer 1999) as an exogenous instrument.With regard to the first ques...

Export characteristics and output volatility: comparative firm-level evidence for CEE countries

“…They show that the main mechanism behind the positive correlation of openness and volatility is the higher specialisation of more open countries. Haddad et al (2013) demonstrate that trade diversification alters the relationship between openness and growth volatility. Very open economies have lower volatility when their exports are diversified and the diversification of products has a stronger effect on volatility than the diversification of markets.…”

“…This view hinges on the two assumptions that openness to trade increases specialisation and that GDP volatility is dominantly led by sector-specific shocks. However, Bejan (2006) and Haddad et al (2013) show that openness to trade does not necessarily increase growth volatility if the export basket is diversified.…”

“…More recent literature indicates that openness to trade does not increase volatility if trade is well diversified (see e.g. Bejan (2006) and Haddad et al (2013)). …”

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“…Cavallo (2007), for 21 OECD and 56 non-OECD countries, concludes that there exists a negative relation between trade openness and volatility. Haddad et al (2012), utilizing data for 77 developing and developed countries, argue that the nature of the relationship between trade openness and volatility depends on the diversifi cation of a country's export base.…”

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