Trade Liberalization and Productivity Growth

Trade liberalization and productivity growth

Ksenia Yudaeva, CEFIR This Chapter looks at the Russian experience with trade liberalization, and the effect trade policy has had on domestic enterprisers. As you remember, in Chapter XXX we looked at the international experience and tried to figure out what effect trade openness has on economic growth and poverty. The major conclusion was that policies, aimed at increase in the volume of trade flows, have positive effect on economic growth and help to decrease poverty level. Firm-level studies show that there are two processes, which are behind the effect on growth. Firstly, economic structure changes toward increasing presence of efficient companies. Secondly, more efficient companies become even more efficient because of better possibilities to explore economy of scale, or because they become more efficient because of increased pressure from external competition. However, this process can be successful only if there are no significant institutional barriers to growth, and of the country simultaneously conducts institutional reforms. Bolaky and Freund (2004) show that in the heavily regulated economies, i.e. those, where there are strict regulations concerning opening new business or labor market regulations, the effect of trade liberalization on growth is negative. In this chapter we present the results of analysis of the effect of trade liberalization in Russia on Russian enterprisers. The following conclusions were made after analyzing the balance sheets of Russian enterprisers and conducting the survey, evaluating the expected effect of WTO accession on Russian government:  In the last 10 years international trade policy had smaller effect on Russian enterprisers than other institutional and macroeconomic reforms, which took place in the country during this period of time.  A large part of Russian enterprisers, including those, which confront with heavy competition with import, were able to increase their total factor productivity after the 1998 crisis. The crisis seems to have helped to overcome many institutional problems such as breaking up of relationships between technologically related firms (“disorganization” problem). In the pre- crisis time this problem had a significant negative effect on productivity of companies in the sectors with technological processes, which consists of many steps.  In Russia as in other countries with transition economy foreign-owned firms can be significantly more effective than their domestic competitors. Policies of local and regional governments, however, can install significant barriers to foreign capital inflows, and have a negative effect on the decision of the foreign companies to bring to Russia the most recent and/ or productive technologies.  In contrast to many Eastern European countries, in Russia there are positive spillovers from foreign-owned to domestic firms. This effect is particularly important in the regions, which have well-educated labor force.  The survey of firms regarding the potential effects of the WTO accession shows that further trade liberalization will rather lead not to labor shedding but to active restructuring of companies, i.e. to changes in the range of goods produced and modernization of production.

Theory and evidence from developing countries. Theory and some results of empirical estimations of the effect of trade liberalization on productivity of companies are presented in Chapter XXXX. The main finding if that, excluding those cases, when in the economy there is an external to firms learning by doing effect, trade liberalization has positive influence on productivity of companies. The positive effect originates both because of increase information about foreign goods and technologies, and because of increase in incentives of managers to develop production and to increase productivity. Moreover, trade liberalization can affects different firms in different way (Melitz (2003)). The most productive firms usually become even more productive and increase their profits. The least productive firms have to close down. In some cases, for example in the case of decrease of trade costs, overall productivity increase in the country may happen because of entry of new firms, and not because of productivity improvements on the existing firms. Since theory is so inconclusive, empirical studies are needed to test the effect of trade liberalization on productivity of different countries. Chapter XXX presents some results of such analysis conducted in developing countries. The review of the studies based on data from transition economies can be found in Djankov and Murrel (2000) [6]. In most cases trade liberalization is associated with risings average productivity of domestic firms. This productivity increase is mainly due to intra-plant improvements, and not related to internal or external economies of scale. Trade liberalization, and corresponding increase in foreign competition stimulates managers to work more efficiently, improve management and technological capacities. At the same time access to better intermediate and capital goods improves, and information about foreign technologies and management techniques becomes more accessible, creating additional channels for productivity improvements of domestic firms. Trade liberalizations are often accompanied with liberalization of conditions for foreign direct investments (FDI). Increase in FDI can serve as an additional source of technological improvements. Direct effect, that foreign –owned firms are more productive than the domestic ones, is observed almost everywhere. However, the direct effect on productivity of firms, purchased by foreigners, is not the major reason why politicians and economists support attraction of FDI to a country. One of the most important effect of FDI is spillovers on domestic firms. It is expected that FDI inflows lead to productivity improvements on domestic firms because of better opportunities for copying foreign technologies and organizational techniques, and attraction of labor, which was trained by foreign investors. One more important factor is increased competition, which may force domestic companies to restructure. However, the empirical evidence regarding spillover effect on the domestic firms is mixed. In transition economies, for example, Javorcik and Spatareanu (2004) and Damijan et al (2003) find positive spillovers in Romania, while Djankov and Hoekman (2000), Konings (2001) Javorcik and Spatareanu (2004) and Damijan et al (2003) observe negative effects for some other Eastern-European countries. Recently, empirical studies started to pay more attention to backward linkages from FDI to domestic firms. In her pioneering work Javorcik (forthcoming) argues that there are several channels for such spillovers. Firms, which would like to work for foreign consumers can restructure faster in order to satisfy foreign companies quality requirements. Moreover, foreign companies can help domestic suppliers to restructure by providing them with technologies and capital. Empirically, though, one has to try to distinguish between these two situations, and the case when foreign companies work with more advances domestic firms. In the case of Czech and Latvian companies, Javosick and Spatareanu (2004) show that domestic companies indeed make special effort to get contracts from multinationals, while foreign companies often provide assistance to their suppliers.

Trade liberalization and firm productivity in Russia: the results of the enterprises balance sheets studies. Major trade liberalization in Russia happened in the early 1990s, when state monopoly on foreign trade was abolished, and almost no trade barriers. At the Soviet times the major problem for the government was deficit of goods. Being trained to fight with this problem, the government did not introduce any protection measures against inflow of imports, but, rather introduced import subsidies and export tariffs. Different estimates evaluated these import subsidies to amount to 10-25% of GDP, and losses from introduction of the subsidies amounted at as much as 10% of GDP.1 In 1993, confronted with massive output declined, the government started to reinstall trade barriers. This process was reverted by the stabilization agreement with the IMF in the mid-1990s, which stipulated decline in both import and export tariffs. At the same time, some tariffs, for example the one on sugar or cars, tariffs were quite high or were increased later on under the pressure of interest groups. Unification of tariff rates in 2001 resulted in decrease in tariff rates in some sectors. Nonetheless all this changes were much smaller than the massive trade liberalization of the early 1990s. Volatility of exchange rate had a much more pronounced effect on trade than changes in trade policy. Major change in relative prices for exports and imports happened in 1998, when ruble devalued massively toward the dollar, but ruble started to appreciate very fast already in 1999-20000. Policy toward foreign direct investors followed similar trend as the trade policy. Joint ventures were first allowed in 1989, and in 1991 fully-owned foreign companies were allowed to function in Russia. In theory, with exception of strategic industries, foreigners and foreign companies had the same rights in privatization as Russians and Russian companies. The exception was made for the so-called strategic enterprisers. In practice, however, the rights of foreign investors were often

1 World Bank (1993), Konovalov (1993), Gros and Steinherr (2004???). abused by Russian enterprise owners and managers. Usually local authorities helped, or at least did not prohibited Russian managers from unfair behavior toward foreign owners. A similar situation continues until nowadays: although Russian legislation has almost no barriers for FDI, and Russian officials often claim that their goal is to attract FDI, in practice foreign direct investments often face a lot of problems with the authorities. As a result, Russia still lags behind many other transition countries in terms of FDI inflows. The effect of competition with imports and FDI on productivity of Russian firms, as well as backward and upward linkages of foreign firms, and productivity effect of usage of imported inputs is analyzed in the paper by Bessonova et al (2003). The paper uses firm-level data for 1994-2000. So it has data for the period, which follows trade liberalization, and covers 1998 devaluation. Liberalization of exchange rate regime, and devaluation of the currency often accompanies trade liberalizations. Many countries, which liberalized trade policy in the last 40 years liberalized currency regime at the same time, and in many countries trade liberalization was accompanied with devaluation of the currency. In fact, Russian trade liberalization of the early 1990s was also accompanied with massive currency devaluation. In this sense, 1998 crisis maybe considered as one more step in correcting trade-related distortions. Nonetheless, while interpreting results, one have to bear in mind that trade liberalization and devaluation can have an opposite effect on firm performance. The regression results show dramatic difference in direction of the horizontal and vertical effects of import competition and FDI before and after the 1998 financial crisis. In the sub-sample for the 1994-1998 period, most of which precedes the 1998 financial crisis in Russia, competition with imports does not seem to have any statistically significant effect on productivity, while using more imported inputs leads to higher productivity growth rate in comparison to other firms. In the post-crisis period, the effect from import competition became positive and statistically significant, while the effects of imported components became negative and also statistically significant. This later result can be easily explained by the devaluation of the ruble, which happened in 1998: foreign- produced inputs became too expensive, and firms that relied on such inputs lost some of their competitiveness in comparison to firms relying on domestic inputs only. Here is some supporting evidence to this conjecture: the negative effect from using imported inputs tends to disappear quickly after the crisis, when the exchange rate started to appreciate. In the sample for 2000-2001, the coefficient at imported inputs variable is still negative, but much smaller in absolute value than in the

1999-2001 sample, and statistically insignificant. Interestingly, the coefficient at export/output variable is statistically insignificant, suggesting no influence of export orientation on productivity, and in some specifications is even negative. The last section of Bessonova et al (2003) paper pay special attention to manufacturing industries with more complex, i.e. having more production stages, production process. The paper by Blanchard and Kremer (1997) attributes a large part of output decline in early 1990s to disorganization of inter-enterprise connections. This disorganization particularly heart complex industries , which experienced the largest output decline. Bessonova et al (2003) show that prior to the 1998 crisis it was more difficult for firms in complex industries to restructure and to increase their competitiveness if they faced high import competition. The potential reason for this effect is that in such industries effective competition with imports requires collective action of a large number of firms, which was impossible because of disorganization. However, after the crisis this effect disappeared, and was even reversed: total factor productivity of such firms started to increase with a higher rate than TFP of other firms. This finding suggests that after 1998 crisis disorganization problem in Russia has been solved, and firms in the complex industries now can adjust to trade liberalization as efficiently as firms from les complex sectors. It is difficult to draw any clear conclusion from these regression results as far as the effect of trade liberalization of 1990s is concerned. The effect of competition on import in during the period of consideration is probably insignificant, and the only clear effect, which was observed, is the effect of devaluation. More research and more data from later time period is needed to make a clear conclusion about how productivity of Russian firms is affected by trade liberalization. There are two observations, which can be made, though. The 1998 devaluation is not the first one, which Russia experienced in 1990s. In the early 1990s ruble also devalued, and the level of the exchange rate was much smaller in that time than in 1998. It is well known, on the other hand, that Russian production collapsed in the early 1990s, and devaluation of the ruble did not play almost any role in fixing the situation. The fact that in 1998-1999 Russian firms reacted to currency devaluation in theoretically predictable way suggest, that by the time Russian companies restructured and adjusted to working in the market economy to the degree large enough to be able to explore the positive influence of devaluation. The second observation, which can be useful in order to address the potential effect of WTO accession, is that small changes in tariff rates, which were observed in the recent years, did not seem to have a lot of influence on enterprise behavior. The results about foreign direct investment are also slightly different for the two sub-periods, although more straightforward than the international trade results. In the first sub-period, horizontal spillovers were positive, and highly significant. In the second sub-period spillovers remained positive, but became statistically insignificant. This finding is difficult to explain; it may be related to the fact that some foreign-owned firms closed after the 1998 crisis. Surprisingly, the coefficient at the share of FDI among suppliers is always negative and significant. At the same time, FDI in downstream industries is positive and statistically significant in all specifications and sub-periods. This result corresponds to anecdotal evidence on the positive effect of FDI on downstream industries in transition countries. It is also consistent with findings from other countries, discussed earlier. The paper by Yudaeva et al (2003) studies FDI in more details. Using data for 1994-1998 the paper shows that foreign-owned firms in Russia are more than 2 times as efficient as the domestic firms. There are positive and significant spillovers from foreign-owned to domestic firms, so domestic firms are catching up with the foreign ones. Interestingly, regional policy can substantially harm productivity of foreign firms. In those regions, authorities of which are less reform oriented, productivity of FDI was significantly lower during the period of consideration, than in other regions. This result may suggest that not only foreign companies invest less in less politically attractive regions, but they also make investments of not so good quality. As far as productivity of domestic firms is concerned, the factor, the size of spillover effect depends crucially on the education level of the regions. Firms from the regions, which have better educated labor force, catch up with foreign firms faster than firms from less educated regions. So educational policy is one of the most important factors, which can lead to increase in economic efficiency of Russian firms in the future. So, to summaries the results concerning FDI, they exert both direct and indirect positive effect on productivity of Russian firms. FDI friendly policy improve direct effect. The major factor, which stimulates spillover effect is education.

Evidence from Enterprise Survey In preparation for the accession to the WTO, many politicians, businessmen and economists in Russia are arguing that one needs to run an enterprise survey to figure out to what extend further trade liberalization of the Russian economy will be harmful for the Russian business during the adjustment period. The disadvantage of such approach is, of course, that it can only estimate perception, not the real behavior, as the analysis of accounting data allows. The advantage of such approach is that it can be conducted in a forward looking way, while analysis of accounting data can only be based on information from several years ago. An attempt to conduct such a survey is summarized in a forthcoming paper by Yudaeva (2004). The survey, results of which are reported in the paper, was conducted by mail. The questioner was sent to 1332 firms, of which 634 answered the question. While interpreting the results of the survey, one should bear in mind that by construction this is not a random sample. The questioner was sent to the firms, which participated in the surveys, which the IET laboratory headed by S. Tsukhlo has been running for the last 10 years. So the sample is biased toward old manufacturing firms. Apart from that, the sample is more or less representative both in industrial and regional breakdown (see Figure 2). Another peculiarity of this sample is that it only includes medium and large size firms, which existed prior to the collapse of the Soviet Union. Goskomstat Questioner sent Reply 50% 40% 30% 20% 10%

0% Fue Met Che Ma pap mat Lig Foo Oth l als Wo mic chi er Coneria ht d ers and als ner od struls ene y and ctio rgy n m at

As far as competition with imports is concerned, the firms were asked a question about their behavior in the case of decline of import prices by 10%. The firms were offered several choices. One group of these choices can be named “defensive” restructuring. It includes firing employees and decreasing production. The second group of choices can be named “active” restructuring, and it involves changing the range of goods produced, equipment modernization, change of suppliers, and so on. Interestingly, as the numbers, presented in Table 1 suggests, more of enterprises were thinking on reliance on active restructuring, than on the defensive restructuring. In fact, only 9% of firms were thinking of using only defensive restructuring, in comparison to 25% of firms, which were thinking of using only active restructuring. Hence, a large percentage of Russian enterprises think that they can increase their efficiency, while facing more import competition, by increasing productivity, and not by decreasing employment and or output. Other results of the same survey show that a large percentage of firms expect to increase the degree of restructuring if prices of foreign inputs or equipment will decline. Many firms also expect to make attempts to increase efficiency of energy consumption if energy prices will increase. All these finding suggest that most of Russian firms passed the stage of defensive restructuring. As a result, most of them expect that WTO accession will not result in production decline of firing of labor. Instead, firms believe that they will be able to respond to trade liberalization by restructuring even further and increasing their productivity.

Conclusions. Russia’s accession to the WTO will result in small decrease in trade barriers, reduction of red tape for imported goods, and improvement of the climate for foreign direct investments. The results of three papers, summarized in this study, suggest that these measures will not lead to massive reduction of output of Russian firms, and may result in improvement of productivity of such firms. The survey results suggest that further trade liberalization can stimulate restructuring, as it happened in other counties. More importantly, WTO accession may lead to increase in inflows of FDI. Research shows that FDI not only improve productivity of those firms, which get them, but also have positive spillovers on domestic firms. Spillovers effect is higher in the regions with higher education level, so improving education system, particularly managerial education, may increase positive influence of FDI on productivity. In order to minimize the negative effects of trade liberalization, Russia needs to improve its institutions. Bad institutions, which prevent creation of small business and reallocation of factors of production, are the major factor, which does not allow Russian economy to become more efficient. Defensive restructuring No Yes Active restructuring No 45% 9% Yes 25% 21%

References

[1] Bessonova, E., Kozlov, K., and K.Yudaeva (2003), “Trade Liberalization, Foreign Direct Investment, and Productivity of Russian Firms”, mimeo, CEFIR. The paper can be downloaded from www.cefir.ru.

[2] Blanchard, O., Kremer, M. (1997), “Disorganization”, Quarterly Journal of Economics, 112 (4), 1091-1126

[3] Bolaky, B., and C. Freund (2004), “Trade Regulations and Growth”, mimeo, World Bank.

[4] Danijan, Jose P., Mark Knell, Boris Majcen and Matija Rojec (2003), “The Role of FDI, R&D Accumulation and Trade in Transferring Technology to Transition Countries: Evidence from Firm Panel Data for Eight Transition Countries,” Economic Systems, 27: 189-204.

[5] Djankov S., and B. Hoekman (2000), ''Foreign Investment and Productivity Growth in Czech Enterprises.'', WorldBank Working Paper N 2115.

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[7] Daniel Gros and Alfred Steinherr (2004???) Winds of Change, Economic Transition in Central and Eastern Europe. Longman ?????

[8] Javorcik, Beata Smarzynska (forthcoming), “Does Foreign Direct Investment Increase the Productivity of Domestic Firms? In Seach of Spillovers through Backward Linkages,” American Economic Review.

[9] Javorcik, Beata Smarzynska and Mariana Spatareanu (2004), “Disentangling FDI Spillover Effects: What do Firm Perceptions Tell Us?”, mimeo, World Bank. [10] Konings J. (2001), ''The Effect Of Direct Foreign Investment on Domestic Firms.'', Economics of Transition, 9(3): 619-633.

[11] Konovalov (1993) “Russian Trade Policy” in Constantine Michalopoulos and David G. Tarr ed. Trade in the New Independent States, The World Bank Group/UNDP.

[12] Melitz, Marc J. (2003) “The Impact of Trade on Intra-Industry Reallocations and Aggregate Industry Productivity,” Econometrica, 71(6),1695-1725.

[13] World Bank (1993). Russia Joining the World Economy. Report No. 12108-RU

[14] Yudaeva (2004), “Effect of WTO accession on Russian Firms”, mimeo, Carnegie Moscow Center. The paper can be downloaded from www.carnegie.ru.

[15] Yudaeva, Ksenia, Konstantin Kozlov, Natalia Melentieva, Natalia Ponomaryova (2003), “Does Foreign Ownership Matter? Russian experience”, Economics of Transition, 11 (3) 2003