WP/21/202 A Diversification Strategy for South Asia by Weicheng Lian, Fei Liu, Katsiaryna Svirydzenka, Biying Zhang IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. © 2021 International Monetary Fund WP/21/202 IMF Working Paper Asia and Pacific Department A Diversification Strategy for South Asia Prepared by Weicheng Lian, Fei Liu, Katsiaryna Svirydzenka, Biying Zhu Authorized for distribution by Ranil Salgado July 2021 IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. Abstract While South Asia has gone a long way in diversifying their economies, there is substantial scope to do more. Some countries – India, Nepal, and Sri Lanka – can build on their existing production capabilities; others – Bangladesh, Bhutan, and the Maldives – would need to undertake a more concerted push. We identify key policies from a large set of potential determinants that explain the variation in export diversification and complexity across 189 countries from 1962 to 2018. Our analysis suggests that South Asia needs to invest in infrastructure, education, and R&D, facilitate bank credit to productive companies, and open to trade in order to diversify and move up the value chains. Given the COVID-19 pandemic, investing in digital technologies as part of the infrastructure push and improving education are of even greater importance to facilitate the ability to work remotely and assist resource reallocation away from the less viable sectors. JEL Classification Numbers: F63, L52, O14, 053 Keywords: diversification, economic complexity, economic development, South Asia Author’s E-Mail Address: WLian@imf.org; FLiu@imf.org; KSvirydzenka@imf.org; BZhu@imf.org Contents Abstract ..................................................................................................................................... 2 I. Introduction ........................................................................................................................... 5 II. Diversification of Exports: A First Look ............................................................................. 6 III. South Asia’s Progress on Diversification ........................................................................... 9 IV. Which Policies Could Foster Diversification in South Asia?........................................... 16 A. A Conceptual Framework .............................................................................................. 16 B. Regression Methodology................................................................................................ 19 C. Drivers of Export Diversification and Economic Complexity....................................... 21 V. Diversification in Times of COVID-19 ............................................................................. 30 VI. Conclusions....................................................................................................................... 35 References............................................................................................................................... 36 Figures Figure 1. Diversification and Income Per Capita, 2001-2014 .................................................. 8 Figure 2. Diversification and Volatility, 1962 - 2014............................................................... 8 Figure 3. Export Diversification ............................................................................................... 9 Figure 4. Economics Complexity ............................................................................................. 9 Figure 5. Diversification in South Asia Improved Over Time, 1972 – 2016 ......................... 11 Figure 6. Extensive and Intensive Margin .............................................................................. 13 Figure 7. Quality Ladder, 2014............................................................................................... 13 Figure 8. Economic Complexity Outlook Index, 2016........................................................... 14 Figure 9. The Product Space in India and Bangladesh ........................................................... 15 Figure 10. What Factors Drive Diversification and Complexity ............................................ 17 Figure 11. Mapping Factors to Observable Data .................................................................... 19 Figure 12. Impact of Structural Indicators on Economic Complexity Relative to One Standard Deviation of the Distribution of the Economic Complexity Index.......................... 26 Figure 13. Impact of Structural Indicators on Export Diversification Relative to One Standard Deviation of the Distribution of the Export Diversification Index ......................................... 26 Figure 14. Impact of Structural Indicators on Export Complexity Relative to 75 Percentile of the Cross-Country Distribution of Annual Changes in Economic Complexity...................... 27 Figure 15. Impact of Structural Indicators on Export Diversification Relative to 75 Percentile of the Cross-Country Distribution of Annual Changes in Export Diversification.................. 27 Figure 16. South Asia: Selected Structural Indicators ........................................................... 28 Figure 17. Potential Gains from Improvements in Underlying Structural Indicators............. 29 Figure 18. Tele-workability by Sector .................................................................................... 31 Figure 19. Diversification versus the Ease of Working Remotely ......................................... 32 Figure 20. Factors that Facilitate Tele-Workability................................................................ 33 Figure 21. Digitalization in South Asia: Room for Improvement .......................................... 35 Tables Table 1. Impact of Structural Factors on Economic Complexity ........................................... 23 Table 2. Impact of Structural Factors on Export Diversification............................................ 24 3 Annexes Annex 1. Data Sources and Definitions ................................................................................ 39 Table A.1. Data Sources ......................................................................................................... 40 Table A.2. Summary Statistics................................................................................................ 41 Annex 2. List of Countries and Time Samples Used in Regressions ................................... 42 Table A.1. Economic Complexity .......................................................................................... 42 Table A.2. Export Diversification........................................................................................... 43 Annex 3. Summary Statistics of the Regression Sample ...................................................... 44 Table A.1. Economic Complexity .......................................................................................... 44 Table A.2. Export Diversification........................................................................................... 45 Annex 4. Robustness Checks ................................................................................................. 46 Table A.1. Lagged Regressors – Economic Complexity ........................................................ 46 Table A.2. Lagged Regressors – Export Diversification ........................................................ 47 Table A.3. Clustered Standard Errors – Economic Complexity ............................................. 48 Table A.4. Clustered Standard Errors – Export Diversification ............................................. 49 4 I. INTRODUCTION Diversification and structural transformation play important roles in the process of economic development. Increases in income per capita, especially at the early stages of development, are often accompanied by a transformation of production and export structures, diversification into new products and trading partners, and increasing the quality of existing products – quality upgrading. This relationship has been found and discussed in “Sustaining Long-Run Growth and Macroeconomic Stability in Low-Income Countries: The Role of Structural Transformation and Diversification” (IMF 2014). Cherif et al. (2018) found that export sophistication is the only robust determinant of growth among standard growth determinants such as human capital, trade, financial development, and institutions, and that other growth determinants may be important to the extent they help improve export sophistication. More recently, the COVID-19 pandemic has given an even greater impetus for countries to diversify and, as the permanent impact on sectors becomes clearer, creating the need to facilitate the reallocation of resources from less viable to more viable sectors. In this paper, we document South Asia1’s progress on diversification and explore policy options to promote greater export diversification and economic complexity. The main findings of this paper are as follows: • South Asia’s liberalization path has been associated with greater diversification of exports – from raw agricultural to garments and services. However, there is still substantial scope to increase the diversity of South Asian exports to catch up with its neighbors. India, Nepal, and Sri Lanka are especially well positioned to improve the complexity of their exports, given their existing production facilities. Bangladesh, Bhutan, and the Maldives have more clustered product space and would need to undertake a more concerted push, integrating economic diversification strategy into their national development plans. • To improve the diversity and complexity of its exports, South Asia needs to invest in infrastructure, education, and R&D, facilitate bank credit to productive companies, and increase openness to trade, even if reducing trade barriers could lead to greater specialization by accelerating the reallocation of resources towards the country’s comparative advantage at the time of opening. Other factors – such as a stable macroeconomic environment and the level of investment more broadly – could also potentially assist the process of increasing diversification and complexity of exports.2 1 In this paper, South Asia includes Bangladesh, Bhutan, India, the Maldives, Nepal, and Sri Lanka. 2 These other factors do not have a statistically significant link to diversification and complexity in regressions controlling for other structural indicators. 5 • Given the COVID-19 pandemic, adopting and investing in digital technologies as part of the infrastructure push and improving education are of even greater importance to facilitate the ability to work remotely and assist resource reallocation away from the less viable sectors. The rest of the paper is structured as follows. Section II explores the benefits of diversification, and Section III assesses South Asia’s progress on diversification. Section IV discusses the conceptual framework of diversification drivers and studies what policies can have a significant impact on diversification and complexity in regressions using a large cross-country dataset. Section V links to the current COVID-19 context, and Section VI concludes. II. DIVERSIFICATION OF EXPORTS: A FIRST LOOK Diversification is an important element of economic development. Diversification can occur in the structure of the domestic economy more broadly or in the composition of its tradable goods baskets. More diversified trade not only means a richer set of products – it is obviously desired if expanding product sets occurs through moving up the value chain into higher quality products – but also export destinations and sources of imports. This paper studies the evolution of export diversification and export complexity in South Asia and the structural forces behind their evolution. Both measures are based on trade in goods, whereas in a few places, the analysis is supplemented by information related to service exports. Output diversification, measured by value added of real sectors, and diversification in terms of trading partners are interesting issues, but not the subject we study in this paper. Export diversification captures how varied a country’s export basket is in terms of its products. It is constructed using Theil index, which sums the extensive and intensive margins of diversification (IMF, 2014):
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