Reallocation, Productivity, and the Ecuadorian Economic Crisis

Reallocation, Productivity, and the Ecuadorian Economic Crisis German Cubas∗ Anson T.Y. Ho† Kim P. Huynh‡ David T. Jacho-Chávez§ February 16, 2011 Abstract Ecuador’s large economic crisis in the late 1990s serves as an important case study of resource reallocation. We conduct an empirical analysis using firm level data for 1998-2007 to investigate resource reallocation, firm turnover, and productivity patterns. We use the model by Restuccia and Rogerson (2008) to examine firm-level distortions and productivity during the crisis. Our results indicate that distortions increased as the crisis deepened and decreased after the Ecuadorian economy recovered. Additionally, we decompose productivity changes as suggested by Petrin and Levinsohn (2010) and find that there is a large negative reallocation effect during the crisis. Keywords and phrases: Reallocation, Productivity, Distortions, Firm Dynamics. JEL codes: F31, D24, L11, O11. ∗Bank of Uruguay, Diagonal Fabini 777, Oficina 501 Montevideo, Uruguay CP 11100. Email: german- [email protected]. †Department of Economics, University of Iowa, W210 John Pappajohn Bus Bldg, Iowa City, IA 52242, USA. Email: [email protected]. ‡Corresponding Author: Bank of Canada, 234 Wellington Ave., Ottawa ON, K1A 0G9, Canada. Email: [email protected] and Department of Economics, Indiana University, 105 Wylie Hall, 100 S Woodlawn, Bloomington, IN 47405, USA. E-mail: [email protected]. §Department of Economics, Indiana University, 105 Wylie Hall, 100 S Woodlawn, Bloomington, IN 47405, USA. E-mail: [email protected]. 1 1. Introduction Ecuador’s economic crisis serves as an important case study of economic reallocation. In the late 1990s, the Ecuadorian economy suffered a series of shocks including natural disasters, worsening balance of trade, and the spillover effects from other financial crises. These unfavourable events resulted in a domestic financial crisis that led to large industrial reallocation. In short, Ecuador was a developing small open economy that underwent structural reforms in the labour market. Also, Ecuador was the first country to officially dollarize in 2000. To understand the impact of this crisis, we undertake a study of firm dynamics in Ecuador during this period. In this paper, we document the stylized facts for firm reallocation and productivity patterns during the period 1998-2007. We use data from the Annual Survey of Manufacturing and Mining to look at two broad industries classified as Light and Heavy. The Heavy industry is classified as capital-intensive while the Light industry is considered labour-intensive. The stylized facts are: One, both industries underwent large amounts of resource reallocation in terms of job reallocation and firm turnover in terms of entry and exit. Two, firm employment size for the Light industry became right-skewed as there was a trend to bigness in the vein of Lucas (1978). The proportion of large firms (200+ employees) increased from 0.09 in 1998 to 0.14 in 2007. For the Heavy industry, the proportion of intermediate firms (50-99 and 100-199 employees) also increased from 0.24 in 1998 to 0.31 in 2007. Three, the entrant labour productivity increased for both industries. Understanding the role of reallocation is of utmost importance. Works by Davis and Halti- wanger (1990) and Caballero and Hammour (1994) highlight the role of allocative efficiency during recessions or the cleansing effect of recessions. Barlevy (2002) counters that search frictions may prevent firms from efficiently reallocating resources or the sullying effects of recessions. However, little is known about the role of reallocation during an economic crisis. Evidence from Japan indicates that the natural selection mechanism may not lead to efficient reallocation, see Nishimura, Nakajima, and Kiyota (2005). Whereas Hallward-Driemeier and Rijkers (2010) document the case for Indonesia and find that financial market imperfections could account for the attenuated relationship between productivity and survival. However, there maybe alternative explanations for these phenomena. We are agnostic on the catalyst for reallocation. Rather, we view reallocation from the lens of industry dynamic model suggested by Hopenhayn and Rogerson (1993). We use this model to quantify the output distortions before, during, and after the crisis period. Previous examples of this methodology such as Restuccia and Rogerson (2008) and Hsieh and Klenow (2009) were applied to a snapshot of the various economies. We extend this methodology by quantifying the dynamic evolution of the output distortion and total factor productivity distributions of firms in Ecuador. To understand the source of changes in labour productivity we compute TFP and distortions at the firm level. 2 We find that output distortions fell after 2000 when the economy started to recover and substantial economic reforms took place in Ecuador. Moreover, post-2000 the output distribution, especially in the Heavy industry, has a lower variance and mean which imply that frictions in the economy were lessened. Furthermore, the mean of the TFP distribution increased and firms became more productive. A decomposition of the TFP and labour productivity indicates that there were large changes in productivity within firms, reflecting the substantial output distortion during the economic crisis. Finally, we use a novel method of functional principal components to analyze the dynamic evolution of these distributions. This methodology provides an econometric test to evaluate whether the densities have actually changed or whether it was due to randomness. We find that the changes to firm size are mostly transitory, while changes to labour productivity, output distortions, and total factor productivity are permanent. The overall results indicate a selection effect, that is, firms that survived got larger and more productive. This paper is organized in the following fashion: Section 2 offers a background on the economic conditions during this period; Section 3 describes the data used, offers some descriptive statistics, and investigates the reallocation and productivity patterns; Section 4 analyzes the output distortions and links it to the results on aggregate productivity growth decompositions; Section 5 utilizes a statistical methodology to analyze the evolution of firm distributions through time; and, Section 6 concludes. 2. Background This section aims to provide a stylized summary about the currency crisis, and the subsequent official dollarization in Ecuador from 1998 to 2000. For a detailed analysis of the Ecuadorian currency crisis, see Beckerman (2002), and Jácome (2004).1 The Ecuadorian currency crisis originated from a series of external shocks. While agriculture products and crude oil were the major exports of Ecuador, El Niño floods in the late 1997 and 1998 destroyed vast agricultural areas in the coastal region and reduced Ecuador’s agricultural productions. Oil prices in the world market also sank to its historically low - less than 10 USD per barrel - significantly reducing the total revenue of the debt-ridden Ecuadorian government, whose fiscal deficit was 6.2 percent and total debt/GDP ratio was 66.3 percent. Worse still, as the effects of the Asian financial crisis spilled over to Latin America, the foreign loanable funds available to the Ecuadorian government and private banks were further reduced. The outbreak of the crisis was triggered by the closure of a small bank in April 1998. It 1We thank former Ecuadorian president Jamil Mahuad for personally explaining the political and socio- economic situation of his presidency in the period 1998-2000 during his Indiana University campus visit last March 23rd - 28th, 2010. 3 deteriorated market sentiment and evolved into widespread bank runs. As the lender of last resort, the Central Bank of Ecuador (CBE, hereafter) provided emergency loans to illiquid banks, reaching about 30 percent of the money base by the end of September 1998. Bank deposits fled from Ecuadorian Sucre, the domestic currency, to US dollars and created pressure on the international reserves. In the last quarter of 1998, the CBE’s net international reserves shrank by 7.6 percent and the cumulative inflation reached 15 percent and real GDP grew only 0.1 percent. In early December 1998, as a measure to restore stability in the banking sector, the AGD law was passed to establish the Guarantee of Deposit Agency (Agencia de Garant´ıade depósitos - AGD) for providing deposits guarantee. The government also introduced a one percent financial transaction tax aimed at supporting the weak public finance. However, this tax proved critical to the massive withdrawals of deposit holders from the banking system in order to avoid the transaction tax. It aggravated the insolvency in banks and led to more bank failures, which in turn deepened the monetization of the banking crisis through the deposit guarantee. By early 1999, speculations on the depreciation of Sucre further intensified, see Figure 1. The CBE could no longer defend its crawling band exchange rate and moved to free floating in February 1999. Between January and February, Sucre had depreciated about 50 percent, causing substantial balance sheet effects on banks and further damaged their solvency. In March, the Ecuadorian government declared a bank holiday and a widespread freeze of bank deposits. Although these measures temporarily halted the fall of the Sucre exchange rate and stabilized inflation, the payment system was severely impaired and led to a seven percent drop of GDP in 1999. Nonetheless,

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