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Jorge Braga de Macedo (U. Nova of Lisbon, NBER)Joaquim Oliveira Martins (OECD)

Bruno Rocha (U. of Coimbra)

Policy complementarities and Growth

OECD/CESifo/Ifo Workshop “Regulation: Political Economy, Measurement and Effects on Performance”,

Munich, 29-30 January 2010

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Motivation• Structural reforms are mutually interdependent. They

are a system. With fragmented reforms the expected benefits may not materialize

• Some examples:

– Budget stabilisation requires large enterprise restructuring in transition countries (eg. Romania 1990s)

– Banking sector liberalisation requires bankruptcy laws, supervision and protection of creditor rights, (e.g. Baltic countries, Brazil)

– Fixed exchange rates may generate upward pressures in the relative price of non-tradables, which calls for competition policy/regulatory framework (eg. Argentina, Portugal , Spain)

– Pension reform through longevity indexation only produces benefits if labour market generates jobs for old workers

– Increasing tuition fees requires individual financing of tertiary education– etc.

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Blockages to broad reforms

• There are political economy arguments against very broad reform programmes (shock-therapy type):

– Sometimes large and uncompressible time is needed to change institutions

– Lack of political capital: political cycles are typical much shorter than the time needed to materialise the benefits from reforms

In practice, removing all distortions simultaneously is obviously impossible because of:

– Imperfect knowledge– Transaction costs– Implementation constraints

There are very few examples of countries that succeeded to implement bold & comprehensive reform programmes (e.g. Chile, Estonia)

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Reforms & Growth• Despite accumulated evidence on the impact of

structural reforms on growth, there is still some scepticism about this link, somewhat exacerbated by the current crisis

• Hausman, Prichett & Rodrik(2004) show that reforms do not explain growth accelerations:

Reforms Growth (+/-)? Require growth diagnostics

• Focusing on complementarity may help to clarify the link between reforms and growth.In this paper: complementary reforms sustainable growth (+)

2nd Best & Policy Complementarities• 2nd Best theory:

– Lipsey and Lancaster (1956): need to remove all distortions simultaneously (e.g. shock therapy)

– Foster and Sonnenschein (1970): define a reform metric and implement radial reform approach

– Milgrom and Roberts (1995): Supermodularity property of a system of complementarity reforms

• Policy complementarities:– Policy coherence is often defined on the basis of non-contradictory

effects of reforms or broad-reform approach– The notion of complementarity goes beyond that. When reforms are

mutually reinforcing, a broader reform generates higher returnsPolicy complementarity signals a benefitBut complicates policy evaluation because performance of one reform area may be closely related to progress in other policies

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Recent papers on policy complementarities

Paper  Sample (years; countries)  Subject 

Method for capturing Policy 

Complementarities Conclusions 

Bolaky and Freund (2004) 1990‐2000 (2000 for level regressions);  98 (108) 

Complementarity between trade openness and regulation (labour and business entry regulations) 

Interaction term in (cross‐country) level and growth regressions 

Increased trade does not stimulate growth in economies with high regulation – trade may even hamper growth in those with excessive regulation. 

Chang, Kaltani and Loayza (2005) 

1960‐2000; (5‐year periods; 82) 

Complementarities between  trade openness and other policies 

Interaction coefficients in growth regressions 

More trade openness results in a larger increase in economic growth when the investment in human capital is stronger, financial markets are deeper, public infrastructure is more available, governance is better, labour market flexibility is higher, and firm‐entry is easier. 

Staehr (2005)  1989‐2001; 25  Growth in transition Principal components in growth regressions 

Broad‐based reforms are good for output growth (but so is a policy of liberalisation and small‐scale privatisation without structural reforms. Conversely, large‐scale privatisation without adjoining reforms, market opening without supporting reforms and bank liberalisation without enterprise restructuring affect growth negatively. 

Dennis (2006)  2 countries (Morocco and Tunisia) 

Complementarity between  trade openness and labour market flexibility  

Simulation using GTAP model  

The gains of liberalising the trade regime are significantly higher under the flexible market scenario: three times for Morocco, six times for Tunisia. 

Calderón and Fuentes (2006)  1970‐2000  (5‐year periods); 78 

Complementarities between  trade and financial openness  and the quality of institutions 

Interaction coefficients in growth regressions 

The impact of increased financial openness becomes positive for higher levels of institutional quality (nonlinear effect). Trade openness has a larger impact on growth when institutional quality is higher (monotonic relationship). 

Braga de Macedo and Oliveira Martins (2008) 

1989‐2004; 27  Growth in transition Hirschmann‐Herfindhal  (reciprocal of) used in growth regressions 

Reform level and the change in reform complementarity are positively related to output growth. The former provides a long‐run target for reforms, while the latter provides guidance on the conduct of the transition process. 

Rocha (2007)  

1995‐97‐00‐02‐03;  4 (Korea, Thailand, Malaysia and Indonesia) 

Recovery after the Asian crisis 

Hirschmann‐Herfindhal  (reciprocal of); policy groupings 

“Orthodox” policies must be complemented with other policies (e.g. unemployment benefits and good exit mechanisms). The complementarity indicator and the reform level indicator adjusted for complementarity are related to better immediate reactions and faster recoveries.  

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Policy Indicators used in this study

• All the variables are in a 0-100 scale

• Dataset contains 130 countries and covers a time span of 13 years (1994-2006)

variable name*  (original database) 

Description (original database)  Sources (in order of priority) 

1. Trade (Heritage) 

Trade‐weighted average tariff rate (weights for each tariff are based on the share of imports for each good) and non‐tariff barriers (NTBs).  

World Bank, WTO  

2. Business Regulations (Heritage) 

Ability to start, operate, and close a business that represents the overall burden as well as the efficiency of government regulations.   

World Bank, U.S. Department of Commerce 

3. Free flow of capital (Heritage) 

Policies toward foreign investment, as well as its policies toward capital flows internally, in order to determine its overall investment climate.  

International Monetary Fund,Economist Intelligence Unit, Office of the U.S. Trade Representative and U.S. Department of Commerce 

4. Banking and Finance (Heritage) 

Relative openness of each country’s banking and financial system.  Economist Intelligence Unit, U.S. Department of Commerce, others.  

5. Property Rights  (Heritage) 

Degree to which a country’s laws protect private property rights and the degree to which its government enforces those laws.  

Economist Intelligence Unit; U.S. Department of Commerce, U.S. Department of State 

6. Infrastructure index –  authors’ calculations 

A simple infrastructure index was computed for the purposes of this article, using (fixed line and mobile) phone subscribers as a proxy. 

World Bank, World Development Indicators. 

7. Monetary Stability (Heritage) 

The weighted average inflation rate for the most recent three years International Monetary Fund  

8. Government size (Heritage) 

Government expenditures as a percentage of GDP.   

World Bank, Economist Intelligence Unit, OECD; others. 

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Matrix of Policy Complementarities

These n.(n-1) two-by-two complementarity relations ensure supermodularity of the system

linkage from lines to

columns Business regulations  Trade openness 

Free flow of capital (Investment) 

Banking and financial system  Property rights 

Infrastructure (ICT, transport, energy) 

Business regulations  ‐ 

Improved entry‐exit mechanisms facilitate  

trade‐induced resource allocation 

Enhances investment e.g. FDI (increased attractiveness);  increases the return of this investment (reduction of 

costs) 

Improved entry‐exit mechanisms enhance better intermediation (e.g. better 

selection of investment projects); easier to create and run financial services firms 

(more competition and efficiency in the sector) 

Enhances investment and entrepreneurship;  

simple and clear regulations gives less space to corruption and favours effective  

protection  of private property 

Effect of good infrastructure increases when firms can operate in a more flexible environment;  

easier to open and run infrastructure‐related firms 

Trade openness 

Increases the scope of resource allocation;  

more (trade‐related) business opportunities materialize 

‐ Increases the potential 

profitability of investment (larger markets);  

more trade‐related investment projects 

Increases the scope of (viable) investment projects;  

easier imports of technological equips. (favours 

financial innovation and banking efficiency) 

Protection of property rights favours investment and this is enhanced by 

easier imports of investment goods (e.g. technology‐intensive goods); eased 

imports of technologic equips. for the court system; low and clear NTBs 

reduce the probability of cases in courts and eases courts’ work 

Stimulates demand for (good) infrastructure and logistics;  

eases importation of technological equips. and other capital goods 

Free flow of capital 

(Investment) 

More business opportunities (e.g. FDI projects) materialize; 

more competition among domestic‐ and foreign‐owned/financed firms 

Intra‐industry trade requires complementarity between traded goods and factor inputs; development of trade (e.g. due to easier international payments);  

favours export‐oriented FDI 

 

‐ Increased supply of funds; 

increased competition between domestic and foreign 

banks improves credit conditions and financial 

intermediation 

Protection of property rights favours investment and this is enhanced by 

increased supply of funding 

Favours investment in the sector (namely infrastructure‐oriented 

FDI);   more competition  among domestic 

and foreign firms (e.g. ICT) 

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Reform stages & Policy Dispersion

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Reform stages & Policy Dispersion

Policy dispersion vs. Reform level by country

Reform level (RL)

Policy Dispersion (DP)

Reform level (RL)

RL = simple average across 6 reform areas using Heritage indicators

DP = standard deviation of the six individual policy indicators

1994199519961997 1998

19992000

20012002

20032004

2005

2006

810

1214

16P

olic

y D

ispe

rsio

n (D

P)

65 66 67 68 69Reform Level (RL)

France1994

19951996

1997

1998

19992000

200120022003

20042005

2006

46

810

12P

olic

y D

ispe

rsio

n (D

P)

80 82 84 86 88Reform Level (RL)

UK

Policy Dispersion (DP)

Policy dispersion vs. Reform level by country

Reform level (RL)

Policy Dispersion (DP)

Reform level (RL)

RL = simple average across 6 reform areas using Heritage indicators

DP = standard deviation of the six individual policy indicators

Policy Dispersion (DP)

19941995

19961997

1998

19992000

2001

2002 2003 20042005

2006

1520

25P

olic

y D

ispe

rsio

n (D

P)

62 64 66 68 70 72Reform Level (RL)

Chile

1994

1995

19961997

19981999

2000

2001

20022003

20042005

2006

1819

2021

22P

olic

y D

ispe

rsio

n (D

P)

40 42 44 46 48 50Reform Level (RL)

The Philippines

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Variables used in the empirical test LHS: GDP per capita growth

RHS:• Average level of reforms (RL and ΔRL)• Policy dispersion (DP and ΔDP)• Interaction between RL and DP

Other controls (depending on the specification):• Monetary stabilization• Human K (Education level, Immunization rate)• Regional dummies• Fixed-effects (country, time)• Governance (legal origin, Corruption, Political

stability)• Size (log of population)

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Policy Complementarities & Growth: cross-section

(1) (2) (3) Dependent variable:

GDP pc growth

Change Reform

Level (ΔRL)

Policy dispersion

(DP) Change reform level (ΔRL) 0.0887* (0.0534) Policy dispersion (DP) -0.275** (0.127) Log GDP pc 1993 -1.069** -2.405*** -0.942*** (0.422) (0.858) (0.363) …. Growth rate of GDP pc 1.464** -0.238 (0.611) (0.261)

Dependent variable (1) (2) (3) (4) (5) (6) (7) (8) GDP pc growth 1993-2006 all all all all all GDP(93)<$14,000 DP<18.2 DP>18.2 Reform level (RL) -0.00147 (0.0316) Change reform level (ΔRL) 0.0536** 0.0504** 0.0676*** 0.0529** 0.0517** 0.0389* 0.1000*** 0.0210 (0.0236) (0.0250) (0.0250) (0.0223) (0.0222) (0.0219) (0.0295) (0.0264) Policy dispersion (DP) -0.160** -0.145*** -0.134*** -0.112** -0.147** -0.170** (0.0665) (0.0520) (0.0458) (0.0501) (0.0594) (0.0746) Change Policy dispersion (ΔDP) -0.0514 (0.0378) Log GDP pc 1993 -1.179*** -1.090*** -1.023*** -0.912*** -0.927*** -0.984*** -0.628* -0.665** ....

Cross-section estimates

Simultaneous equation estimates (3SLS)Reduced sample for less-

developed countries

Effect of reforming is larger with lower policy dispersion

NB: Other control variables and tests not shown (see text). Nb. obs: 94

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Policy Complementarities & Growth: Panel data

Preferred specification Hausman test rejects

correlation between RE and other regressors

Reduced sample for less-developed countries

GDP pc growth Pooled OLS all

Pooled OLS all

FE all FE & Time effects all

RE all RE & Time effects all

RE & Time effects GDP(93)<$14,000

Reform level (RL) -0.00448 (0.014) Change reform level (ΔRL) 0.147*** 0.132*** 0.102*** 0.0856** 0.112*** 0.101*** 0.0993*** (0.046) (0.046) (0.035) (0.034) (0.034) (0.034) (0.038) Policy dispersion (DP) -0.133*** -0.138*** -0.0488 -0.0437 -0.0932*** -0.0976*** -0.109*** (0.026) (0.025) (0.039) (0.041) (0.033) (0.033) (0.038) Change Policy dispersion (ΔDP) -0.0694 (0.057) Log GDP pc 1993 -1.132*** -1.161*** -- -- -1.154*** -1.187*** -1.048*** (0.14) (0.12) (0.19) (0.18) (0.21) Monet. stabilisation 0.0213* 0.0205* 0.0360*** 0.0453*** 0.0265*** 0.0303*** 0.0269*** (0.012) (0.011) (0.0094) (0.010) (0.0083) (0.0089) (0.0099) Education level 0.372*** 0.362*** -- -- 0.403*** 0.447*** 0.521*** (0.059) (0.054) (0.095) (0.086) (0.096) Immunization rate 0.0315*** 0.0316*** 0.0339** 0.00678 0.0334*** 0.0229** 0.0138 (0.0087) (0.0087) (0.015) (0.015) (0.010) (0.0099) (0.011) Constant 6.925*** 7.129*** -1.957 0.128 5.469*** 7.145*** 7.232*** (1.40) (1.40) (1.54) (1.58) (1.61) (1.52) (1.72) Observations 1175 1175 1175 1175 1175 1175 968 R2 0.12 0.12 0.03 0.11 . . . Number of countries 104 104 104 104 104 104 86 Hausman test: Chi2(15) 8.27 2.39 1.99 Pr >Chi2(15) 0.08 0.99 1.00

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How the impact of Policy Dispersion depends on the stage of reforms

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

0

0.1

0.2

15 35 55 75 95

dY/dDP cross_section

dYi/dDP Panel

Reform Level (RL)

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Main conclusions

• Reforming (ΔRL) and policy dispersion (DP) are, respectively, positively and negatively related to GDP per capita growth.

• Without higher complementarity, the effect of reforms exhausts and does not have a lasting effect on growth. Complementarity is a condition for sustainable growth

• The effect of policy complementarities is higher in developing countries.