Trade Partner Diversification and Growth: How Trade Links Matter
One sentence summary: On top of the standard trade openness measures, centrality measures for a country’s position in the international trade network (which we refer to as the Trade Partner Diversification-TPD) are shown to enter growth regressions positively and significantly, where one standard deviation increase in TPD is associated with a 1 to 1.5 percentage point increase in the annual growth rate.
The corresponding paper by Ali Sina Önder and Hakan Yilmazkuday has been accepted for publication at Journal of Macroeconomics.
The working paper version is available here.
Abstract
We analyze the effects of a country's export connections on its income growth using Trade Partner Diversification (TPD) measures that capture the country's relative importance in the international trade network. On top of the standard trade openness measures, TPD measures are shown to enter growth regressions positively and significantly, where one standard deviation increase in TPD is associated with a 1 to 1.5 percentage point increase in the annual growth rate. Threshold analyses show that TPD measures are positively and significantly correlated with growth in countries that have low financial depth, high inflation, low levels of human capital, or high trade openness.
Non-technical Summary
Trade openness can support growth by providing access into large markets, low-cost intermediate inputs, and higher technologies. Empirical analyses in the literature provide evidence for a robust, statistically significant, and positive effect of international trade on income growth. Nevertheless, measures for a country's trade openness and trade volume usually do not differentiate between trade partners so that two countries with the same trade volume but trading with different sets of countries are identical in the eyes of these measures. We investigate in this paper whether and in what ways a country's connectivity in international trade matters in addition to its trade openness (measured by residual openness, to be defined below); hence, we ask: Does the way a country is connected within the web of international trade explain this country's per capita income growth above and beyond what can solely be explained by conventional measures of trade openness, and moreover, how does this connectivity correlate with growth in countries at different stages of economic and financial development?
We measure a country's connectivity by evaluating the overall position of this country in the web of international trade. This requires paying attention not only to trade partners of this country but also to trade partners of its trade partners, because a country's connectivity depends on quantity as well as quality of its trade partners. Although a country may have fewer trade partners than some other countries, it may still be deemed better connected than others if its trade partners are better connected than those of other countries. Similarly, between two countries that have the same number of trade partners, the one that has better connected trade partners is also deemed better connected than the other country. We employ conventional network centrality measures to capture the connectivity of a country and will refer to these centrality measures as trade partner diversification (TPD) measures throughout this paper.
We measure a country's connectivity by evaluating the overall position of this country in the web of international trade. This requires paying attention not only to trade partners of this country but also to trade partners of its trade partners, because a country's connectivity depends on quantity as well as quality of its trade partners. Although a country may have fewer trade partners than some other countries, it may still be deemed better connected than others if its trade partners are better connected than those of other countries. Similarly, between two countries that have the same number of trade partners, the one that has better connected trade partners is also deemed better connected than the other country. We employ conventional network centrality measures to capture the connectivity of a country and will refer to these centrality measures as trade partner diversification (TPD) measures throughout this paper.
Using a cross-country panel data set for 83 countries, we first analyze whether TPD has any role in explaining growth, given the degree of trade openness together with other control variables. Such an investigation requires a measure for TPD, for which we consider three alternative definitions, all obtained by using international bilateral trade data. The baseline regression analysis, which is robust to endogeneity concerns, shows that TPD enters growth equations positively and significantly on top of the control variables, including the financial system (measured by financial depth), price stability (measured by inflation), human capital (measured by secondary education level), government size (measured by government expenditure as a percentage of GDP), per capita income level, and trade openness (measured by residual openness).
TPD measures are shown to enter growth regressions positively and significantly, where one standard deviation increase in TPD is associated with a 1 to 1.5 percentage point increase in the annual growth rate. A country's measures of TPD increase as this country gains access to more and/or better export markets, better in the sense that these export markets are well connected with the rest of the world.
In order to take into account that countries having different macroeconomic conditions may be affected asymmetrically by their respective positions in the web of international trade regarding their growth, we investigate nonlinear effects of countries' positions in the international trade network using a threshold analysis. In particular, this methodology enables us to observe how coefficients of network measures change continuously over the whole range of other explanatory variables so that we do not need to consider discrete categories or interaction terms and we are able to prevent any potential problems of over-representation and biases created as a result thereof.
In our threshold investigation, we consider alternative sets of countries distinguished with respect to their financial system (measured by financial depth), price stability (measured by inflation), human capital (measured by secondary education level), government size (measured by government expenditure as a percentage of GDP), per capita income level, and trade openness (measured by residual openness). Our threshold analysis results show that TPD is positively and significantly correlated with the growth of countries that lack a developed financial system, price stability, or advanced human capital, after controlling for the degree of trade openness. Therefore, a plausible interpretation is that the TPD provides channels to hedge against a lack of financial development or human capital as well as against macroeconomic volatility borne by high inflation.
This result is important especially for developing economies where, on average, financial depth is low, inflation is high, and human capital is low. Developing (or underdeveloped) countries that experience higher growth rates than their counterparts are those that are well connected to export markets or have export partners that are themselves well connected. Moreover, TPD positively and significantly correlates with the growth rate in countries that have large trade openness, which implies the importance of TPD in creating channels for a country to avoid vulnerability borne by the vulnerability of its trading partners. Finally, TPD correlates positively and significantly with growth irrespective of government size or per capita income level.