Earlier a country’s economic development was based either on the degree of specialization or diversification of a country’s production and trade structure. Based on Adam Smith’s concept towards the division of labor and specialization for economic growth and development to Heckscher-Ohlin Samuelson (HOS) model of international trade, countries should specialize in producing and specializing in the goods in which they have a comparative advantage. However, after the Second World War, the idea was that economic growth and development may be achieved by export diversification (not specialization). There were active efforts by the government to promote industrialization and economic growth.
Export diversification is often the primary objective of many developed countries. Export diversification is also equally important for many developing countries. Some of the developing countries are dependent on a relatively small range of products, generally agricultural commodities. In other words, primary products constitute a large percentage of their overall export earnings. Some economists have even suggested that there is a long-term tendency for primary product prices to decline vis-à-vis those for manufactured goods. Countries that are commodity dependent or have a narrow export basket usually face export instability which arises from inelastic and unstable global demand. This can consequently have a significant adverse impact on the macroeconomy of least developed economies in terms of investment and employment. Thus export diversification is one means to alleviate these constraints. Export diversification refers to the move from “traditional” to “non-traditional” exports. Developing countries should diversify their exports since this can; for example, help them to overcome export instability. Diversifying the export portfolio could intensify and accelerate economic growth. Export instability could discourage necessary investments in the economy by risk-averse firms, increase macroeconomic uncertainty, and be damaging to long-term economic growth. Export diversification could therefore help to stabilize export earnings in the longer run. Countries with the slightest level of export diversification are those which face instability in export earnings.
Reasons for Export Diversification
Export diversification may be an important issue for developing countries for several reasons. First, a diversified bundle of export products provides a hedge towards price variations and shocks in specific product markets. Second, the type of products exported might affect economic growth and the potential for structural change. Third, export diversification in the direction of more sophisticated products may be beneficial for economic development. Given these potential benefits of export diversification, an important policy question is what a country can do to diversify its exports.
For poor countries to grow rich, it is important for them to modify the composition of their exports which will enable them to look more like that of rich countries. For over 50 years, economic and export diversification has been given high importance on the list of priorities for development policy. The argument was based on the observation that dependence on primary commodity production and exportation by developing countries expose them to commodity shocks, price fluctuations, and declining terms of trade. As a result, a country’s foreign exchange reserves and the ability to have funds for imported inputs become subject to instability and uncertainty. The debates about the Prebisch-Singer hypothesis (1959) and the need for industrialization gave priority to diversify economies away from primary commodities because of unfavorable and declining terms of trade, slow productivity growth, and relatively low value-added.
There are several reasons for developing countries to have export diversification. Firstly, diversifying their bundle of exports will protect them from the risk of an unpredictable declining trend in international prices of primary exportable commodities that, in turn, lead to unstable export earnings. Export diversification could therefore help out to stabilize export earnings in the long run. Due to the absence of export diversification in developing countries, decline and fluctuations in export earnings have negatively influenced income, investment, and employment. Diversification provides the opportunities to extend investment risks over a wider portfolio of the economic sector which eventually increases income. Diversification can be seen as an input factor that has the effect of increasing the productivity of other factors of production. Through exports, it is also possible to build an environment that creates competition and as a result acquire new skills. Overall economic growth and acquisition of human capital may be slow if there is an absence of pressure from outside competitive forces.
Diversification helps countries to hedge against adverse terms of trade shocks by stabilizing export revenues. It enables them to direct positive terms of trade shocks into growth, knowledge spillovers, and increasing returns to scale. Other industries in the country can also gain as export diversification can lead to knowledge spillovers from new techniques of production, management, or marketing practices. Furthermore, economic growth and structural change depend upon the type of products that are being traded. Thus through export diversification, an economy can progress towards the production and exportation of sophisticated products which may highly contribute towards economic development. Export diversification allows the government of an economy to achieve some of its macroeconomic objectives namely sustainable economic growth, the satisfactory balance of payment situation, employment, and redistribution of income.
Strategies to Promote Export Diversification
As we see there are potential benefits of export diversification, but the question remains that what a country can do to diversify its exports. Potential determinants of export diversification, such as country size and level of development, trade costs, international distance, and the costs of domestic entry are all potentially associated with larger diversification. What can encourage export diversification? All successful high-growth economies have had strategies to promote export diversification. These strategies include:
- Financial sector development and Foreign Direct Investment (FDI) – FDI can encourage exports of host countries by boosting domestic capital for exports, serving to transfer technology and new products for exports, making access to new and large foreign markets easy, and improving technical and management skills.
- Reduce Costs – The main debate is associated to cost as export diversification is rather sensitive to costs. Lower cost means that there are fewer obstacles for the domestic firms when exporting. The World Bank Doing Business survey through its “Trading Across Borders” section has included information on the number of procedures required for importing and exporting, as well as the time taken to comply with them. It also included trade costs such as document costs, inland transport costs, customs costs, ports costs, administrative costs, and so on. In broad terms, for the promotion of export diversification there must be an incentive to make improvements on trade facilitation, i.e. set policy measures to reduce costs. Such policy measures include lowering domestic barriers to entry; facilitate company registration by reducing the number of procedures and applying a fixed registration fee, and removing the need for pre-tax payments.
- Lowering barriers – Lower barriers to firm entry and lower international trade costs constitutes an important way in which developing countries can help diversify their export baskets. Export margin can be affected by changes in tariff rates and preferences. In policy terms, one efficient way for developing countries to promote export diversification is to center regulatory reform efforts on making entry procedures simpler and less expensive, as well as on trade facilitation measures.
- Learning-by-doing – The endogenous growth model states that exports can be more diversified through learning-by-doing and learning-by-exporting and by adopting practices of developed countries.
- Role of Government – The government of an economy should play a leading role in the promotion of export. Investment should be directed into various sectors of industry. In so doing, the Government can make sure that investment is not being undertaken in more than just one specific sector so that a diverse industrial base can be built. The Government should provide a favorable environment to attracting new investment in the country. There may also be provided for favorable tax treatment to firms, tax holidays for export-oriented undertakings, the input used in the production of exports can also be exempted from value-added tax. Subsidies play an important role in promoting exports. Government can introduce a cash incentive scheme that may benefit firms such as providing them with subsidies which will consequently encourage trade.
- Research and Development – Efforts can be put into the R&D activities to upgrade the level of the industry. This can be done with the help of fiscal and financial incentives which will stimulate R&D and technological innovation activities. Besides the Government, the banking system and other financial authorities should offer services to diversify and strengthen a country’s export. The banking system can facilitate diversification by its loan patterns. Schemes to diversify and promote exports need to be complemented by a suitable combination of fiscal, monetary, and exchange rate policies in order to be successful.
- Variation in the structure of demand – Growing demand for a range of goods followed by an increase in a country’s income may lead to diversification. In another word, variation in the structure of demand leads to change in a country’s production pattern.
Constraints to Export Diversification
In spite of the liberalization in the export sector, there is still the presence of certain issues which limit export diversification, especially in the least developed countries. There may be a clash with other national policies in an attempt to promote exports. Export diversification at times may be hindered by a number of factors:
- Low income elasticities of Demand – Some developing countries are failing to export primary products due to the low income elasticities of demand for their primary products. Furthermore, prospects for developing countries to provide manufactured exports are poor because of the competition faced with the industrialized countries.
- Lack of finance – Lack of adequate export finance is identified as a major constraint. Small and medium exporters tend to be more severely affected by this constraint. A fundamental problem of export diversification is the lack of adequate investment in the country, both domestic and foreign. Exporters may face the problem of acquiring export finance. High rate of interest on bank capital is also a constraint since it discourages them to take loan. In other words, exports are being restricted due deficiency in financing of trade by the country’s banking system.
- Lack of Adequate Infrastructure – Efficient infrastructure is the pre-condition for good export performance. Inadequate functioning of infrastructure may adversely affect enterprises in many ways. There may be difficulty in the transportation of goods due to limitations in infrastructure. It obstructs production activities, delays movement of goods and passengers, leading to delay in the delivery of goods. It adds to business uncertainty and risk and imposes additional costs.
- Bureaucracy and market access – Government rules and regulations relating to exports are complicated and too much paper work is needed. Considerable time is spent and officers should be appointed for sorting out matters with the government and agencies. Market access issues are complex. The major market access problems relate to i) non-tariff and para-tariff barriers, ii) stringent quality and standard requirements, iii) stringent rules of origin, iv) labor and environmental standards. Environmental conditionality’s are a kind of new protectionism which can hamper market access. Tariff and non-tariff barriers also obstruct market access.
- Lack of strength in the public institutions – The World Bank noted that the lack of strength in the public institutions hinder private sector activities. There is the weakening of sound policy-making and public management, frustration of private entrepreneurship, prevention of competition and rising of corruption due to heavy regulatory and judicial systems and loss-making state-owned enterprise. Private investment can be deterred due because of poorly regulated and undercapitalized commercial banks, problem of telecommunications, infrastructure and law and order problem.
- Dearth of Skilled Manpower – Other constraints include domestic resource scarcity, shortage of skilled labor, and lack of professionalism. There may be lack of skilled manpower in some sectors. Lack of skilled manpower has resulted in under utilization of potential export of services through manpower export as they are catering to only unskilled and semi-skilled needs.