Trade, Employment, and Structural Transformation

Photo: istockphoto.com

There is a shared sense that globalization has a strong potential to contribute to growth and poverty alleviation.  There are several examples of countries in which integration into the world economy was followed by strong growth and a reduction of poverty, but evidence also indicates that trade opening does not automatically engender growth. The question therefore arises, why the effects of globalization have been so different among countries of the world.

A look at changes in the structure of employment in Latin America and in Asia hints at possible explanations for observed differences in the growth effects of trade.  Since the 1980s, Asia and Latin America have both rapidly integrated into the world economy.  Asia has enjoyed rapid employment and productivity growth, but the consequences for Latin America have been less stellar.

The chart below shows how the pattern of structural change has differed in the two continents. The chart decomposes labor productivity growth in the two regions into three components: (i) a “within” component that is the weighted average of labor productivity growth in each sector of the economy; (ii) a “between” component that captures economy-wide gains (or losses) from the reallocation of labor between sectors with differing levels of labor productivity; and (iii) a “cross” component that measures the gains (or losses) from the reallocation of labor to sectors with above-average (below-average) productivity growth.  The underlying data for the charts come from the Groningen Growth and Development Centre.

The chart illustrates that Latin America is not that different from Asia in terms of the “within” component (the blue bars), reflecting that the representative Latin America country has experienced rapid productivity growth in its individual economic sectors.

Why then did Latin America do so much worse overall? Because the cross term has contributed negatively to overall economic growth. In Latin America, labor has moved from sectors with high productivity growth to sectors with low (or negative) productivity growth, which is reflected in the hugely negative “cross” term for Latin America (the green bar in the chart). This negative effect is so strong that it offsets to a large extent the large “within” effect and the much smaller (but still positive) “between” effect.

Here is further detail on what’s behind the large and negative cross effect. The scatter plot below shows the correlation for Latin America between the change in a sector’s employment share and the sector’s labor productivity growth.

Click here to see a larger version of thsi chart.

The main message is that labor has moved from tradable sectors (agriculture and manufacturing) where labor productivity growth has been rapid to non-tradables, especially wholesale and retail trade, where productivity growth has been negative.  Note that much of wholesale and retail trade is informal, so the expansion of that sector is indicative also of the growth in informality in Latin America.
In Asia by contrast, there is virtually no correlation between the change in a sector’s employment share and its productivity growth.

Put differently, the mechanism through which tradables have achieved significant productivity growth in Latin America (remember the large “within” terms noted above) has been to lay off workers. This finding is in line with recent firm level evidence for Brazil showing that successful exporters reduce employment levels by laying off workers.  Such “rationalization” is fine from a partial-equilibrium perspective, but doesn’t look great when the displaced labor moves to sectors with worse performance.

Asian and Latin American economies differ significantly both in their endowments and in the policies they have pursued. One key difference is that most Asian countries have complemented openness with policies specifically geared towards promoting their tradable industries: competitive currencies and industrial policies.  Latin America, by contrast, has arguably relied more on the stick (low tariff barriers and import-competition) and less on the carrot (in the form of industrial policies or undervalued currencies). These differences in the policy mix used provide a possible explanation for the finding that tradable sectors have shrunk in Latin America to a much greater extent than in Asia and that labor has tended to get reallocated from above-average performing sectors (tradables) to below-average performing sectors (informality) in the former.