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WPS5552 Policy Research Working Paper 5552 Public Disclosure Authorized Services Liberalization in Preferential Trade Arrangements Public Disclosure Authorized The Case of Kenya Edward J. Balistreri David G. Tarr Public Disclosure Authorized The World Bank Public Disclosure Authorized Development Research Group Trade and Integration Team January 2011 Policy Research Working Paper 5552 Abstract Given the growing importance of commitments to all business services by Kenya with its African partners foreign investors in services in regional trade agreements, would be somewhat beneficial for Kenya. If a preferential it is important to develop applied general equilibrium agreement with African partners is combined with an models to assess the impacts of liberalization of barriers to agreement with the European Union, the gains would multinational service providers. This paper develops a 55 more than triple the gains of an Africa only agreement. sector applied general equilibrium model of Kenya with Multilateral reduction of services barriers, however, would foreign direct investment and Dixit-Stiglitz productivity yield gains about 12 times the gains of an agreement effects from additional varieties of imperfectly with the Africa region alone. These results suggest that competitive goods or services, and uses the model to preferential liberalization in the region is a valuable first assess its regional and multilateral trade options, focusing step, but wider liberalization, with larger partners and on commitments to foreign investors in services. To liberal rules of origin or multilaterally, will yield much assess the sensitivity of the results to parameter values, the larger gains due to providing access to a much wider set model is executed 30,000 times, and results are reported of services providers. The largest gains would come from as confidence intervals of the sample distributions. domestic regulatory reform in services, as this would The analysis reveals that a 50 percent preferential almost triple the gains of multilateral liberalization. reduction in the ad valorem equivalents of barriers in This paper is a product of the Trade and Integration Team, Development Research Group. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at [email protected]. The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent. Produced by the Research Support Team Services Liberalization in Preferential Trade Arrangements: The Case of Kenya by Edward J. Balistreri and David G. Tarr January 27, 2011 Abstract: Given the growing importance of commitments to foreign investors in services in regional trade agreements, it is important to develop applied general equilibrium models to assess the impacts of liberalization of barriers to multinational service providers. This paper develops a 55 sector applied general equilibrium model of Kenya with foreign direct investment and Dixit-Stiglitz productivity effects from additional varieties of imperfectly competitive goods or services, and uses the model to assess its regional and multilateral trade options, focusing on commitments to foreign investors in services. To assess the sensitivity of the results to parameter values, the model is executed 30,000 times, and results are reported as confidence intervals of the sample distributions. The analysis reveals that a 50 percent preferential reduction in the ad valorem equivalents of barriers in all business services by Kenya with its African partners would be somewhat beneficial for Kenya. If a preferential agreement with African partners is combined with an agreement with the European Union, the gains would more than triple the gains of an Africa only agreement. Multilateral reduction of services barriers, however, would yield gains about 12 times the gains of an agreement with the Africa region alone. These results suggest that preferential liberalization in the region is a valuable first step, but wider liberalization, with larger partners and liberal rules of origin or multilaterally, will yield much larger gains due to providing access to a much wider set of services providers. The largest gains would come from domestic regulatory reform in services, as this would almost triple the gains of multilateral liberalization. Edward J. Balistreri is in the economics department at Colorado School of Mines; and David G. Tarr (corresponding author, [email protected]) is a consultant for DECRG, the World Bank. We thank Ana Margarida Fernandes, Jesper Jensen, Thomas Rutherford, Christopher Worley, Josaphat Kweka, Nora Dihel, Francis Ng and Grigol Modebadze for their contributions to this project, and Paul Brenton, Paulo Zacchia and Maryla Maliszewska for valuable suggestions. Financial support from the Bank-Netherlands Partnership Program under the Regional Services in Africa project is gratefully acknowledged. The views expressed are those of the authors and do not necessarily reflect those of the World Bank, its Executive Directors, the Government of Kenya or those acknowledged. 1 Services Liberalization in Preferential Trade Arrangements: The Case of Kenya by Edward J. Balistreri, Colorado School of Mines and David G. Tarr, The World Bank I. Introduction Both economic theory and empirical literature have shown that wide availability of business services results in productivity gains to the manufacturing sector and contributes to its international competitiveness.1 International commitments to national treatment and market access for foreign investors in key business services sectors may help developing countries obtain better access to these services that contribute to the productivity gains. Some developing countries, however, are hesitant to make substantial multilateral commitments, but may be more inclined to proceed in regional arrangements with other neighboring developing countries, rather than with a major Northern partner. Commitments in services, however, are often limited in South-South arrangements. 1 Arnold et al. (2007), Fernandes (2007) and Fernandes and Paunov (2008) have provided econometricestimates of the gains from services liberalization. Marshall (1988) shows that in three regions in the United Kingdom (Birmingham, Leeds and Manchester) almost 80 percent of the services purchased by manufacturers were bought from suppliers within the same region. He cites studies which show that firm performance is enhanced by the local availability of producer services. In developing countries, McKee (1988) argues that the local availability of producer services is very important for the development of leading industrial sectors. Both the urban economics literature (Vernon, 1960; Chinitz, 1961) and the modern economic geography literature (e.g., Krugman, 1991; Fujita, Krugman and Venables, 1999) have focused on the fact that related economic activity is economically concentrated due to agglomeration externalities (e.g., computer businesses in Silicon Valley, ceramic tiles in Sassuolo, Italy). Evidence comes from a variety of sources. Ciccone and Hall (1996) show that firms operating in economically dense areas are more productive than firms operating in relative isolation. Caballero and Lyons (1992) show that productivity increases in industries when output of its input supplying industries increases. Hummels (1995) shows that most of the richest countries in the world are clustered in relatively small regions of Europe, North America and East Asia, while the poor countries are spread around the rest of the world. He argues this is partly explained by transportation costs for inputs since it is more expensive to buy specialized inputs in countries that are far away for the countries where a large variety of such inputs are located. 2 Since the early 1990s, regional trade agreements have surged; 283 have been notified to the WTO and were in force as of February 2010. 2 Given the inclusion of services in modern FTA agreements negotiated with the EU, the US and in some other agreements, economists need to be able to assess the impact of services commitments as part of their advice to governments regarding preferential trade agreements. Services commitments in regional agreements could lead to substantial productivity improvements. But is there an analogy to trade diversion in goods whereby preferential commitments in services could be immiserizing? Are developing countries likely to obtain substantially larger gains from an agreement with a developed country, rather than a developing country? How do the gains of preferential versus global liberalization compare? Given that preferential trade liberalization discriminates against excluded countries, it is well known from the vast theoretical literature that