Optimal policy design for industrialization in anopen economy.

Kjetil Bjorvatn1 and Nicola D. Coniglio1,21Norwegian School of Economics and Business Administration∗

2 University of Bari

May 10, 2006

Abstract

Economic integration has considerably increased the access of less de-veloped countries to markets in the North. Yet many countries have notbeen able to benefit from this potential for growth. Complementary poli-cies appear to be an important factor in determining the effect of opennesson growth. The present paper explores the optimal industrial policy designfor a less developed economy in an open economy. In particular, we focuson whether the policy should be targeted to a few sectors or more broadbased and therefore more neutral. Our theoretical and empirical analysisshows that optimal policy design is a function of the degree of openness.More precisely, while limited foreign market access calls for selective in-dustrial policies, the optimal policy response to increased openness is tobroaden these policies.

Keywords: Industrialization, policy design, market integration, eco-nomic growth

JEL codes: F15, O14, O20,

1 Introduction”In the advanced countries, barriers to trade on manufactured goods and inmany services are at a historic low. It would be hard to identify any poorcountry whose development prospects are seriously blocked by restrictions onmarket access abroad. Any country with a sensible development strategy hasthe opportunity to grow its economy, with assistance from trade.” Dani Ro-drik, “Failure in Trade Talks Would Be No Disaster,” November 19, 2005, ks-ghome.harvard.edu/~drodrik/shortpieces.html

Markets in the North have in recent years become increasingly accessible forproducers from the South. The increased market integration is due to both a∗Contact information: Department of Economics, NHH, Helleveien 30, N-5045 Bergen,

Norway, Phone: +47 55 95 95 85, Email: Kjetil.Bjorvatn@nhh.no, Nicola.Coniglio@nhh.no

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liberalization of trade policy, amplified by preferential access offered to the leastdeveloped countries, and falling transportation costs. However, not all develop-ing countries have been able to benefit from this increased market opportunity.In particular, many countries in Africa have failed to translate open access tothe markets in the North into increased exports and growth. A recent studyassessing the impact of World Bank trade related support, concludes that accessto foreign markets and export promotion alone do not necessarily lead to ex-port led economic growth (World Bank Independent Evaluation Group, 2006)).Complementary policies need to be implemented in order to realize the growthpotential from lower trade barriers. The present paper aims at analysing howa “sensible development policy”, to quote Rodrik, should be designed so as tocreate industrialization and growth in a more integrated world economy.Industrial policy appears to have been an important ingredient in the devel-

opment of many of today’s rich countries. With differing intensity and scale,big-push policies seeking to overcome coordination failures by stimulating si-multaneous investments in multiple sectors, have been implemented in manyWestern European countries, in Japan, as well as the first generation of theEast Asian Tiger economies. According to Rodrik (1995), while the role of ex-port was important in explaining the take-off of Taiwan and Singapore, a largecomponent of the ’economic miracle’ should be ascribed to the active role ofthe governments in implementing several industrial policy measures aimed atremoving coordination failures in investments. However industrial policy mea-sures, intended as the broad range of tools in the hands of the governmentsaimed at altering the sectoral structure of the economy by offering selectivebenefit, have not always eased the path toward economic development (for acritical survey on the case for industrial policy see Pack and Saggi, 2006)Many developing countries today look at these success stories for inspira-

tion on how to engineer growth at home. While many observers agree that inprinciple the existence of a wide variety of coordination failures justify the useof industrial policy, many are sceptical to the ability of governments in devel-oping countries to replicate the detailed intervention carried out by the nowindustrialized countries. An important reason for this scepticism is that in anenvironment of weak political institutions, such policies may be captured byinterest groups and give rise to costly rent seeking (see Bjorvatn and Coniglio2006).The present paper emphasizes another reason why poor countries today

should exercise caution when drawing lessons from past experience. Not onlyinternal conditions may be different, but also external conditions are not thesame. In particular, by increasing the access to foreign markets, the process ofglobalization has reduced the relative importance of the domestic market sizeas a limiting factor for industrialization. This change in external conditions hasimplications for the optimal policy design.1

1Also the international policy environment has substantially changed in the last decade.New constraints on national policies are now in place, for instance through WTO agreements,and, at least in principle, the policy-path followed by industrialized countries might not befeasible for LDCs.

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Industrial policy typically consists of a “package” of policies that affect boththe cost of investing and operating a firm, as well as measures that directlyaffect the market structure, which in turn determines the income potential offirms in their home markets. Industrial policy includes interventions in themarket for credit and foreign exchange, licensing procedures, trade policies, anddirect control of firms and sectors through state ownership of manufacturingenterprises and banks. The dimension of industrial policy that we focus on hereis the degree of selectivity of the government intervention. With limited access toresources with which to carry out industrial policy, the government must decidewhether to implement a targeted policy, offering strong investment incentives toa limited number of firms or sectors, or to implement a more broad based andneutral policy that gives a more moderate stimulus to a wider range of firmsand sectors. The targeted policy would typically be more interventionistic andassociated with the concept of “state led development”, with a substantial degreeof state ownership in ”strategic” industries and heavy regulation of the economy.A broad based policy, on the other hand, would be characterized by a more arms-length relation between government and businesses, with the government seekingto facilitate investment through general policies like infrastructure investmentrather than actively seeking to pick winners. The broad policy has the advantageof potentially enabling a large number of firms to upgrade their technology andthereby trigger big push economic growth. However, the risk is that by spreadinggovernment support too thinly, the policy may fail in creating the critical massof support necessary to induce firms to invest.The question of broadness of policy intervention is not new. This issue was

very much at the forefront of the discussion on big push industrialization inthe 1940s and 1950s. Rosenstein-Rodan (1943, 1961) and Nurkse (1952, 1953)argued that for industrial policy to be successful, it should promote industrializa-tion in a broad range of sectors simultaneously. Hirshman (1958), on the otherhand, held that industrial policy should be more focused. Given the scarcity ofresources available to policy makers, spreading these resource too thinly acrosssectors could thwart any effort of technology upgrading. Similarly, Rostow (1960) argued that policy should be targeted to promote investment in a fewleading sectors, and then relying on their development to stimulate technologyupgrading in other sectors. While the question of optimal policy design is notnew, the answers may differ, since the economic environment is not the same.In particular, globalization and preferential trade agreements provide countrieswith the opportunity to grow through exports, and reduce the relative impor-tance of domestic market size as a constraining factor for investing in large scaleproduction technology.Formal analysis of optimal policy design for big push industrialization is

relatively scarce. One exception is Gans (1998). He describes a competitivedownstream sector and an imperfectly competitive upstream sector, character-ized by monopolistic competition. Investment in upstream activities may haveboth competition effects and market size effects, and the net effect on prof-itability is uncertain. Gans assumes that the market size effect appears onlywith a lag: Each investor has an incentive to postpone investment, waiting for

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other entrepreneurs to invest first and thereby increase the market size. Themarket equilibrium may therefore be characterized by a prisoner’s dilemma,resulting in underinvestment. The government may solve this inefficiency byindustrial policy. Gans derives the critical level of upstream firms necessary tobreak the waiting game, and thus induce industrialization. The critical numberof upstream investment needed to achieve this, which is a measure of policybroadness, depends on the discount rate, the size of the labor force, and the sizeof fixed investment costs. The higher is the discount rate, the larger is the laborforce, and the lower is fixed investment costs, the more targeted the policy canbe. Our paper adds to the analysis of Gans by analysing the effect of foreignmarket access on optimal policy design.Our paper is also related to Da Rin and Hellman (2002), who discuss the

role that the banking system has played in triggering industrialization in manycountries by coordinating investments. The authors present a big-push modelwhere the role of banks in inducing the economy to move out of a poverty trapis analysed. Banks are more likely to solve the initial coordination failure ifthey are large enough and if they have sufficient market access. One of thecorollary stemming out of their model is that the control of the governmenton the banking system might be crucial in enhancing their role of catalyst forindustrialization. While their analysis considers the positive role of the bankingsystem in activating (or failing to activate) a big-push industrialization, our aimis to consider the optimal policy measures that governments, also through thebanking system, need to implement in an open economy framework.The analytical framework we use to analyse the efficiency of development

policies is based on the dual technology, limit pricing model of Murphy, Shleiferand Vishny (1989). The point of departure is a poor country with limitedaccess to foreign markets. The country is caught in a poverty trap. The trap isexplained by a demand side externality which causes a coordination failure: firmsdo not internalize the effect of their investment on aggregate income and henceaggregate demand. A coordinated investment, by expanding the market size,would make investment profitable for each entrepreneur. However, no individualentrepreneur has the incentive to invest in an economy dominated by traditionalproduction. There is thus a rationale for government intervention to stimulateinvestment. The resources available to the government in implementing thisindustrial policy are limited, and, as discussed above, the government mustdecide on whether to implement a focused or more broad based policy. Inparticular, we are interested in the way in which foreign market access affectsthis policy choice.Our main argument is that the potential of trade to promote economic

growth is affected by complementary policies. More specifically, the strengthof the various mechanisms that theoretically link growth to trade, like accessto larger markets and new technologies and ideas, is affected by the invest-ment environment in the domestic market. If industrial policy promotes a fewleading firms, and negatively discriminates the entry of new entrepreneurs, thespillover effect of trade to the rest of the economy can be expected to be limited,and therefore also limit the growth impact of trade. On the other hand, when

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industrial policy is less discriminatory and more broad based, trade can be ex-pected to have a stronger, positive effect on economic growth. The theoreticalmodel highlights the importance for industrial policies to be flexible, and adaptto a new economic environment. Selective policies strategy for stimulating in-vestment at an early stage, when access to foreign markets was low. But in aprocess of globalization, policies of privatization and deregulation are necessaryfor a country to benefit fully from the increased potential of trade.We present empirical evidence on the importance of policy in explaining

the link between openness and growth. Our regression analysis on a sampleof 79 countries shows that trade and economic growth are positively correlatedonly for countries where the degree of direct government involvement in theeconomy is not too high. This observation supports the main message from ourtheoretical model.The paper is organized as follows. The next section develops the theoretical

model. Growth regressions examining the relation between openness and eco-nomic growth, emphasizing the importance of policy, are presented in Section3. Section 4 concludes.

2 ModelConsider an economy consisting of L workers operating in N sectors, each sec-tor producing a good xi. Labor is the only factor of production. Goods canbe produced by means of two technologies, traditional and modern. The tra-ditional technology is constant returns to scale, one unit of labour producingone unit of output. Modern production requires entrepreneurial talent and afixed investment f . Amongst the L workers, there are η < L entrepreneurs.Each entrepreneur can only be involved in one production activity. Hence, ηalso gives the number of sectors that can be modernized. Modern productionis increasing returns to scale, identical across all goods, and described by thefollowing labor input requirement:

lirs = f + βxirs, (1)

where β < 1 is the marginal labor input requirement in production. Thegoods consumed locally are also supplied on the international market. The localfirms are price takers on the international market. For simplicity, we normalizeinternational prices to unity. We shall abstract from trade costs. Hence, theinternational price of unity also defines the equilibrium price in the home coun-try, and therefore also income per worker in traditional production. Since thereare no gains from trade in a traditional economy, small scale producers can beseen as supplying only local demand and the economy is effectively an autarky.Upgrading to increasing returns to scale technology opens up for profitable ex-ports. The ability of a modern firm to export to the international market is,however, limited by two factors; protectionistic policies imposed by the North,and a country’s physical and administrative infrastructure, such as ports and

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the efficiency of customs. Let x denote this export constraint. In order to fi-nance the fixed investment cost f , an entrepreneur must take up a loan. Thecost of capital is r. Hence, the cost of investing f is f (1 + r). Capital marketsare imperfectly competitive, and we shall view the cost of capital r as a profitmargin in financial intermediation.Consumption is based on a Cobb-Douglas utility function with equal budget

shares. The technological edge of the modern producer over traditional produc-ers gives him some market power at home. The profit maximizing strategy ofa modern firm for domestic sales is limit pricing, choosing a price (marginallybelow) the price of unity. In this way, a modern firm captures the entire mar-ket for its product at home. Its monopoly power is, however, limited by thepotential entry of small scale producers and imports. The price on exports isgiven by the international price of unity, so that export earnings equal x. Weshall assume that x and η are sufficiently small so that there are always someworkers at home involved in traditional production. These workers represent aresource that can be mobilized to satisfy increased labor demand from modernproducers, without placing an upward pressure on wages.The government wishes to stimulate investment in large scale production,

and implements an industrial policy for this purpose. As discussed in the intro-ductory section of this paper, such policies in practice have many dimensions.Here, we shall reduce policy intervention to a single dimension. Assume that thegovernment has access to resources S that can be used to subsidize investment,think of it as the supply of interest free loans. For simplicity, we shall assumethat S is an additional resource available for the economy such as foreign aid.The government has to decide how to allocate S between sectors. A broad pol-icy would imply spreading S thinly across a large number of sectors. A moretargeted intervention would be associated with a larger support for a smaller setof sectors. Let n1 denote the number of sectors targeted by the policy, with eachinvestor receiving s = S/n1. Hence, n1 measures the degree to which industrialpolicy is targeted. When a modern sector firm is set up primarily by governmentfunds, we can think of it as a state operated enterprise. Non-targeted investorsreceive zero investment subsidies: For this group, s = 0. The effective interestrate r (s) as a function of subsidies is:

r (s) = r (1− s) . (2)

Hence, fr (1− s) is the profit to financial intermediaries when a firm investsf and where a share s of this investment is financed by an interest free loanfrom the government. The more competitive is the financial sector, the lower isr, and hence the lower are profits in financial intermediation.With equal budget shares in domestic demand, local sales for each modern

firm, xirs, equals Y/N ≡ y, where Y is total income. To save on notation, letthe mass of goods be measured by unity; N = 1, which also implies that Y = y.In addition to local sales, each modern firm earns x from exports. Using theequilibrium condition that xirs = y + x and the technology given by (1), theprofits for a modern sector producer can be expressed as:

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π = (y + x) (1− β)− f (1 + r (s)) (3)

Let the number of investing firms be given by n ≤ η. Local demand facingeach modern firm is therefore given by: the average income of the economy:

y = l + nπ + nfr (1− s) , (4)

where l = L/N . The key variables determining individual profits are ag-gregate profits nπi and the cost of capital, r (s). We shall assume that whenmaking an investment decision, the entrepreneur takes the income level in theeconomy as given. Thus, he does not internalize the effect of his own investmenton aggregate income. Neither does he internalize the effect of his own invest-ment on the investment decisions of other entrepreneurs. Hence, there will be adifference between perceived profits and realized profits, and this is a source ofinefficiency in the investment choices.We shall assume the difference between perceived and realized profits gives

rise to a coordination failure. Such a failure exists if in an economy characterizedby only traditional producers, and where there is no government intervention(so that s = 0 and n = 0), the perceived profit of investment is negative. At thesame time, a coordinated upgrading of technology by all η entrepreneurs wouldhave resulted in positive profits. Perceived profits from investing in a purelytraditional economy, with no subsidies, are given by:

πtrad = (l + x) (1− β)− f (1 + r) . (5)

The condition that profits of investment are negative in this environmentcan be expressed as:

πtrad < 0⇒ r >(l + x) (1− β)− f

f≡ rtrad . (6)

Similarly, when all entrepreneurs invest, and subsidies are zero, local demandis y = l + ηπ + ηfr and profits are given by

πmod =(l + x+ ηfr) (1− β)− f (1 + r)

1− η (1− β). (7)

We can then find that:

πmod > 0⇒ r <(l + x) (1− β)− f(1− η (1− β)) f

≡ rmod. (8)

Clearly, rmod > rtrad for any η > 0. A coordination failure therefore existsif the following condition holds:

rtrad < r < rmod. (9)

The presence of a coordination failure provides a motive for industrial policy,exemplified here by the supply of subsidized credit. Given an initial situation

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with only traditional production, government intervention through the creditmarket is necessary to induce investment. If the perceived profits of a subsi-dized investment is positive, an investment will take place. Once an investmentby subsidized firms has taken place, also the profitability of investment by en-trepreneurs who do not directly benefit from subsidies will change. If the policyis successful, the increase in income generated by the first round of investmentexpands the market and may thus make investment profitable also for lattergroup. In this way, although the model is not explicitly dynamic, we can thinkabout investment as (potentially) taking place in “waves”, with subsidized in-vestors taking part in the first wave (which we denote with subscript 1), andthe unsubsidized investors in the second (denoted by subscript 2).

2.1 First wave investment

In a purely traditional economy, profits are zero and hence the perceived localdemand facing first wave investors is y1 = l. Perceived profits are thereforegiven by:

π1 = (l + x) (1− β)− f (1 + r (s)) . (10)

The credit subsidy to each first wave investor is given by s = S/n1. Thebreak-even condition for the subsidized investors can then be expressed as:

π1 > 0⇒ n1 <frS

f (1 + r)− (l + x) (1− β)≡ n1. (11)

In other words, given the fact that market interest rates are prohibitivelyhigh to allow autonomous investment, the policy of interest free loans needsto be sufficiently focused, i.e., n1 < n1, in order to spark off a first round ofinvestment. In this way, n1 shows the maximum broadness of policy, given thepublic resource constraint S, that will induce a first wave of investment. Weobserve that n1 increases in x and l and falls in r, f , and β: Increased accessto foreign markets or increased domestic market size allows a broadening of theindustrial policy, while increased investment costs or higher variable productioncosts (higher β) calls for a more focused policy in order to provide the necessaryincentives for investment.Given a first round of investment, realized income and demand facing each

investor is y1 = l+n1 (π1 + fr (1− s)). Realized first wave profits are therefore:

π1 =(l + x+ n1fr (1− s)) (1− β)− f (1 + r (1− s))

1− n1 (1− β). (12)

The success of the policy is associated with its ability to induce investmentin technology upgrading also in those sectors not directly supported by thegovernment. If the policy fails to do so, the first wave investment is not sus-tainable, in the sense that without support, the economy will fall back to thetraditional equilibrium. In the following paragraphs we explore the necessaryconditions for the policy to create a big push, which moves the economy to thefully industrialized equilibrium.

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2.2 Second wave investment

Only first wave investors are offered zero-interest loans from the government.All second wave investors therefore face capital cost f (1 + r). The perceivedincome of a second wave investor, y2, equals the actual income after the firstwave of investment, y1. Using (12) in (4), the expected profit of a second waveinvestor can be expressed as:

π2 =(l + x) (1− β)− f1− n1 (1− β)

− fr. (13)

From the above expression it can easily be noted that π2 rises in n1. Hence,the broader is the policy and therefore the larger is the number of first waveinvestors, the higher are perceived profits for potential second wave investors.The critical number of first wave investors necessary to make a second waveinvestment profitable can be found as:

π2 > 0⇒ n1 >f (1 + r)− (l + x) (1− β)

(1− β) fr≡ n∗1. (14)

We observe that n∗1 is falling in x and l, and increasing in r, f and β: Anincrease in x or l means a larger market size and therefore a larger profitabilityof second wave investment for any given number of first wave investors. Anincrease in x or l therefore lowers the critical number of first wave investmentsnecessary to make the second wave investment profitable. A higher r or frepresent increased investment costs while a higher β represents higher variableproduction costs, which make a second wave investment less likely. Figure1 illustrates the effect of changes in market access on the optimal industrialpolicy.2

The n1-curve shows the maximum broadness of the reform as a function offoreign market access x, for a given budget S available for industrial policy.Spreading this budget too thinly across firms, i.e., choosing n1 > n1 will notachieve anything: The critical mass of support is not supplied, and no entre-preneur has an incentive to upgrade to modern technology. Policy needs to besufficiently targeted, i.e., n1 < n1, in order to induce investment. A governmentinterested in creating maximum investment for the given x and S would choosen1. As is clear from the Figure, increased access to foreign markets should opti-mally be met by a broadening of the industrial policy. Intuitively, the increasedpotential for making profits through exports allows the government to increasethe level of investment in the economy, by reducing the subsidy to each firm,and thereby offering incentives to more firms. If a sufficiently large number offirms have participated in the first wave of investment, the effect on aggregatedemand may be large enough to create a second wave of investment. This hap-pens when n1 > n∗1. For n1 < n∗1, the number of first wave investors is notsufficiently large to create full industrialization. In fact, as long as n1 < n∗1,the first wave investment is only profitable ex ante and ex post with the credit

2 In Figure 1, f = r = β = 12, S = 1

5.

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0

x

n1

xa xb

n1* n1

^

xc

na

nb

Figure 1: Openness and policy design

subsidy in place. For n1 > n∗1, on the other hand, after a second wave invest-ment has taken place so that the economy is fully industrialized, subsidies canbe withdrawn without making ex post profits negative.Note also that for n1 > n∗1, an increase in x allows the total budget for indus-

trial support to be reduced without affecting the ability of the policy to realizefull industrialization. Following the n∗1-curve downward as x increases involvesincreased targeting of policy and a reduction in the total support budget. Forsufficiently high levels of x, namely x ≥ xc, all firms have an incentive to investeven without any government support. In this way we observe that the optimaldegree of policy targeting first increases in x (up to xa) and then falls.We observe that the optimal policy requires some flexibility on the part of

the government, to update policies in light of increased foreign market access.Broadening the policy implies giving a lower subsidy to each firm, and this canreasonably be expected to be controversial. The firms targeted prior to theexpansion of trade opportunities are likely to protest a reduction in their privi-leges. Governments may find it politically difficult or impossible to implementthe broadening of policy prescribed here.

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For illustrative purposes, assume two countries, a and b, identical in all re-spects. Initially, the two countries have zero access to foreign market, i.e. x = 0.As illustrated in Figure 1, the optimal policy in the initial situation is to tar-get nb.sectors. Assume now that in a process of economic integration, accessto foreign markets increases. The strategy followed by country a is to pursuea flexible policy, broadening its industrial support in tandem with increasedeconomic integration, following the n1-curve. Country b, on the other hand,retains the, initially optimal, focused policy nb. Both countries will experienceincreased volumes of trade due to increased market access. But the increase inexports is more likely to trigger self-sustainable industrialization in country awhere industrial policy is less rigid. An increase in openness, such that we inFigure 1 move from x < xa to x > xa will lead to big push industrialization forcountry a. For country b, the growth effect will be much more limited, as thesecond (autonomous) wave of investment, and therefore full scale industrializa-tion, will not take place until x reaches xb. Hence, while increased integrationwill be conducive to more trade in both countries, the increased trade may havea stronger growth effect in the country that has chosen to adopt more neutralpolicy measures in the process of globalization than in the country that haschosen to hold on to a more interventionistic and focused policy.A rigid system of industrial policy, supported by a limited number of estab-

lished firms and sectors that enjoy substantial benefits, may therefore consti-tute a strong obstacle to a self-sustainable industrialization and modernizationprocess in poor countries. Established industrial lobbies will always exercisepressure against reforms in industrial policy aimed at redistributing the scarceresources among a larger number of beneficiaries. Success stories are often asso-ciated with strong governments that are committed to flexible policy-making, asindicated by the following quote from the World Bank (1987, page 115): “Somedeveloping countries, notably in East Asia and Latin America have avoided us-ing rigid systems to influence the pattern of investment. Their resources havebeen better able to respond to changes in incentives following trade liberaliza-tion and to flow to industries offering the highest financial returns.”

3 Empirical evidenceThe theoretical model presented above suggests that the link between opennessto trade and economic growth may depend crucially on the type of industrial pol-icy that countries pursue. In particular, we analyse how the degree of selectivityversus broadness of interventions affects the outcome. The model shows thatthe growth effect of increased access to foreign markets is likely to be strongerin countries where the increased openness is accompanied by a broadening ofindustrial policies, rather than rigidly targeting a given set of existing firms andsectors.The prediction that trade is not necessarily positively correlated with growth

finds support in the data. Figure 2 shows the correlation between economicgrowth and (the log of) openness for 63 poor and middle-income countries.

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Economic growth is measured as average growth in real GDP per capita for theperiod 1980-1992. The trade variable measures real exports and imports as ashare of GDP for the period 1980-1995.3 The regression line is positive, butthe correlation is statistically insignificant. Hence, this first look at the datasuggests that the association between openness and growth is mixed.

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510

2.5 3 3.5 4 4.5 5openness

GDP growth per capita Fitted values

Figure 2: Economic growth and openness in developing countries

We now split the sample into two subgroups according to the degree of gov-ernment intervention in the economy. As a measure of the extent and magnitudeof government intervention, we use an index (Index of Government Intervention,IGI ) constructed by the Fraser Institute on the importance of state operatedenterprises (SOEs) and government investment. This index ranges from 0 to 10,where a high value reflects less interventionistic policies (see Table 1 in the Ap-pendix for a description of this variable). Since governments may intervene inmany ways, it is impossible to find a single variable that captures all aspects ofintervention. Our interest is mainly in the degree to which governments choosedirect and targeted interventions versus more neutral policies. For this purpose,

3The data are collected from Demirguc-Kunt and Levine (2001), available atwww.econ.brown.edu/fac/Ross_Levine/IndexLevine.htm. We have excluded OECD coun-tries and oil exporting countries (the latter since the literature on the resource curse showsthat oil exports in less developed countries may have a distinctly negative effect on growth, forinstance by triggering corruption). Moreover, we have excluded Hong Kong and Singapore,which due to their extremely high level of trade are outliers in the present data set.

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we believe the intervention-index constructed by the Fraser Institute can be areasonable proxy. In developing countries, which we focus on here, selectiveindustrial policy is often carried out through SOEs. These enterprises are typ-ically heavily subsidized, absorbing resources that could otherwise have beenused to support private sector investment. For instance, according to WorldBank (1995) report “Bureaucrats in Business”, in Tanzania, subsidies to SOEsin 1995 amount to 72 percent of government spending on education and 150percent of health expenditure.An important source of subsidization is through the provision of cheap loans,

as emphasized in the theoretical model. In Bangladesh, according to the samestudy, SOEs take about one fifth of domestic credit, although their outputaccounts for less than three percent of GDP. As witnessed by the experienceof reformist countries, such as Chile, South Korea and Mexico, an importantingredient in a shift towards a less interventionistic industrial policy is the re-duction in state ownership in manufacturing. A broadening of industrial policycan therefore be expected to be associated with an increase in the intervention-index.We divide the group of developing countries in approximately two equally

sized groups. The first group of countries is characterized by less intervention,more specifically by 4-10 on the intervention-index. There are 30 countries inthis group. The second group consists of countries with a high degree of inter-vention, characterized by 0-3 on the intervention-index. There are 33 countiesin this second group. Figure 3 shows the correlation between openness andeconomic growth for the less interventionistic countries, and Figure 4 the cor-relation between openness and economic growth for the more interventionisticcountries. We observe that increased openness is associated with higher eco-nomic growth on average for countries with a low degree of intervention (witha positive slope 1.86, significant at 5% level), while the opposite is true for thegroup of countries with more interventionistic policies (with a negative, butstatistically insignificant slope).

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510

2.5 3 3.5 4 4.5 5openness

GDP growth per capita Fitted values

Figure 3. Economic growth and openness: Low degree of intervention

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5

2.5 3 3.5 4 4.5 5openness

GDP growth per capita Fitted values

Figure 4. Economic growth and openness: High degree of intervention

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The simple correlations reported above of course only represent a first lookat the data. Still, they are indicative of a remarkably different associationbetween growth and openness in the two groups of countries. Note first thatthe level of openness is substantially different for the two groups. The volumeof trade in highly interventionistic countries is. lower than that of the othergroup. For the non-OECD countries in the sample with a less dominant role ofthe government, import plus export as a share of GDP is on average 15% higherthan in countries where the government plays a more leading role. Apparentlya higher direct involvement of the state in business activities reduces the abilityof the economy to fully exploit its trade potentialIn addition to modest volumes of trade, there is no clear association between

openness and growth in countries with pervasive and highly targeted policies.This finding might suggest that for this set of developing countries, foreign mar-ket access does not translate into opportunities for investment, modernizationof the productive apparatus, and in turn growth. On the contrary, countrieswith less “bureaucrats in business” not only trade more but also experience astronger, and positive, association between levels of trade and average growthrates.In the next step we include explanatory variables typically used in growth

regressions to investigate whether the correlations above survive in a more com-plete model of growth. The dependent variable is real GDP per capita growth,averaged over the period 1980-1992. The explanatory variables employed in theempirical analysis (see Table 2 for more details) are the following: real GDP percapita in 1980 (in log); private savings in the economy as a share of disposableincome; the ethnic fractionalization index used by Demirguc-Kunt and Levine(2001); a dummy variable for countries in Latin America; openness, measuredas the import plus export as a ratio of a country’s GDP; the Index of Govern-ment Intervention (IGI), mentioned above and described in Table A2 in theAppendix. The intervention-index captures the selectivity of industrial policyinterventions in the economy at the beginning of the period considered (1980).Note that a high value on the index means a less interventionistic policy. In ad-dition, we consider the change in the intervention-index that occurred between1980 and 1990 by including among our explanatory variables.IGI change. Thisvariable captures the effect on growth of a policy shift toward less (or perhapsmore) selective government intervention in the economy.The results are presented in Table 1 below. We report estimations for both

the entire sample of countries and for the non-OECD countries only. We ob-serve from regression (A) that the estimated coefficient on the openness variableis not statistically different from zero. For the sample of non-OECD countriesanalysed in regression (B), however, the coefficient for openness is significantand negative. In regressions (C ) and (D) we introduce the Index of GovernmentIntervention and its interaction effect with our measure of openness. Both vari-ables are statistically significant. Finally, in the last two regressions in Table3, (E) and (F ), we add the change in the IGI between 1980 and 1990 and itsinteraction effect with openness.

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Table 1. Regression results

Focusing on the last regression, the results show that the effect of opennesson growth depends both on the level of government intervention and its change.In particular, countries with a less dominant role of the state in the economy,through SOEs and public investment, seem to benefit the most from trade. Theimpact of a marginal increase in openness is:

∂ (GDP growth)

∂ (openness)= −2.47 + 0.66 ∗ (IGI) + 0.63 ∗ (IGI change)

For an average poor country in the sample, where no substantial reduction ofthe role of the government is undertaken in the period considered (IGI change =0), the growth effect of increased openness can be expected to be positive onlyif IGI > 3.64. Countries, may, however increase the benefit from trade byimplementing policy reform. To illustrate, Mexico started out with IGI = 2 in1980, thus placing it in the group of countries whose growth is not significantlyaffected by increased openness. Through policy reform during the 1980s, thecountry reached an IGI = 4 in 1990. From the regression analysis, we see thatthis reduction in intervention (IGI change = 2) would imply a positive growtheffect of increased openness for Mexico.

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Similarly, the analysis shows that the effect on economic growth of gov-ernment intervention depends on the level of openness. In line with the pre-diction of the theoretical model, a more selective industrial policy (implying adecrease in IGI) might induce stronger growth in countries with limited accessto foreign markets. For instance, abstracting from changes in IGI over time(IGI change = 0), the effect on economic growth of a change in the level ofintervention can be found as:

∂ (GDP growth)

∂ (IGI)= −2.4 + 0.66 ∗ (openness)

We observe that the critical level of openness below which increased selec-tivity of industrial policy is growth enhancing is openness = 3.74, which isequivalent to a share of exports and imports in GDP of 42 percent. From thisanalysis we see that only countries that are sufficiently open can expect a positivegrowth effect from policy reforms towards a more neutral industrial policy. Theregression analysis thus supports the implications from the theoretical model.

4 ConclusionNot all countries have benefited from increased trade openness. The invest-ment environment in a country is an important factor determining the impactof openness on growth. The investment environment, in turn, is affected by thetype of policies that governments pursue. Policies can be highly intervention-istic, targeted at a few “strategic” sectors through state ownership and heavyregulation. Alternatively, policies can be more neutral and broad based, forinstance aimed at improving physical infrastructure. While the targeted policymay have been the optimal intervention to stimulate investment in an economywith very limited access to foreign markets, we argue that increased opennesscalls for a broadening of industrial policy, for instance through privatization andderegulation. These policies would improve the profitability of investment forbroader segments of the economy.The theoretical model shows that a country broadening its industrial policy

in tandem with increased export opportunities, is more likely to experience big-push economic growth than a country sticking to more interventionistic policies.This broad message from the theoretical model finds support in the data. Weuse the importance of state owned enterprises and government investment as aproxy for the degree of direct government involvement, and thus the selectiv-ity of industrial policy. The regression analysis shows that increased opennesshas a stronger positive impact on economic growth in countries with a lowerlevel of government intervention and where the increase in openness has beenaccompanied by policy reform.Our analysis therefore suggests caution should be exercised when designing

industrial policy. Countries seeking inspiration from earlier growth successes inWestern Europe and East Asia should keep in mind that the world has changed.

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Increased economic integration between countries has reduced the relative im-portance of domestic markets and thereby reduced the case for selective bigpush policies.

5 Appendix

Table A1. Description of variables

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Table A2. Description of intervention-index

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