June 2002

Trade, FDI and “backbone” services in the MENA region

(A report to the World Bank)

By Khalid Sekkat (University of Brussels and the ERF) (Work in progress - Please do not quote)

The findings, interpretations and conclusions expressed in this paper are entirely those of the authors and do not necessarily represent the views of the World Bank, its Executive Directors, or the countries they represent.

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1. Introduction The present study investigates the linkages between the perfo rmance of “backbone” services and trade and FDI in the MENA region. It is motivated by the observation that countries which have improved the performance of trade related services (transport, utilities, finance, and telecommunications) seem to have achieved substantial increase of their exports and FDI inflows. Domestic reforms aiming at lowering the cost of transport; creating competitive product markets; and reducing the cost of doing business may therefore play a crucial role in improving linkages to the global markets and production networks. One the one hand, improved regulation and competition in trade-related services could strengthen the export response to trade liberalization, by reducing the cost of exporting. On the other hand, creating efficient trade-related services may enable local producers to better coordinate their activities with intermediate input suppliers located in high- income countries and hence may make the countries more attractive to foreign direct investment. In turn, the later could help upgrading their technological base, and improving their position in vertically integrated production networks.

The study investigates the relevance of such expectations for the MENA region. It first provides a brief analysis of the ongoing liberalization in “backbone” services and its potential impact on trade and FDI. Then the study conducts an econometric investigation of the relationship between telecommunication services performance on the one hand and manufactured exports, intermediate good exports and FDI inflows in the MENA region on the other hand. The estimation is conducted on a panel of developing countries and uses four performance indicators of telecommunication services: number of fixed phone, waiting list, cost of 3 minutes local call and number of mobile phone. The main question is whether, after controlling for other structural determinants, better performance in telecommunication services is associated with better manufactured and intermediate good exports performance and higher FDI inflows.

The econometric analysis shows that, after controlling for other determinants, good telecommunication services have a significant and positive impact on both manufactured and intermediate good exports and on FDI inflows. The MENA is, however, among the

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low performing regions of the world in terms of telecommunication services. Except for the cost of local calls, all the indicators of telecommunication services performance in the region are among the lowest in the world. Taking the two results together sheds light on the well documented observation that the MENA region is lagging behind other regions in the world in terms of manufactured exports and FDI inflows as shares of GDP. It also implies that policy aiming at improving the performance of telecommunication services in the MENA region can entail important gains in terms of exports and FDI inflows and complement other policies (e.g. trade and exchange rate policies) undertaken in the region.

The rest of the report is organized as follows. Section 2 briefly presents the ongoing liberalization in “backbone” services and its potential impacts on trade and FDI. Section 3 presents the econometric analysis. Section 4 concludes.

2. Services liberalization, production fragmentation and economic performance. The world economy has experienced dramatic changes over the last two decades. Two important changes are of particular relevance to the present study: the multilateral process of liberalization of trade in services and the process of international fragmentation of production.

2.1 Liberalization of trade in services: framework and expected gains Traditionally, liberalization of trade in services was done on a bilateral and reciprocal basis. The General Agreement of Trade in Services (GATS), which has emerged from the Uruguay Round, has established a basic set of rules for world trade in services. The GATS has set up a framework for making a real progress in reducing barriers to trade in services. It provided a clear set of obligations for each me mber country and a framework for multilateral negotiations. The Agreement covers, in principle, all commercially traded services. Since the Uruguay Round, two major liberalization negotiations have been concluded:

telecommunications

and

financial 3

services. Negotiations

on

basic

telecommunications were concluded in February 1997 and on those financial services in December 1997.

The motivation behind liberalizing trade in services has been to allow rationalization of service activities along the lines of comparative advantages. It was also intended to expand the sales and profits of those service providers who were operating from the base of such comparative advantages. The fundamental gains from free trade in services are really no different from those of trade in goods. It is only the difficulties in measuring and monitoring trade in services that make them distinctive, from a practical policy perspective.

The justification of the expected gains from free trade in services is the following. Trade in goods typically accounts for less than half of GDP in most countries, and even less than a third of output in the industrial economies. Its liberalization is expected to affect economic growth. Hence, comparable gains from liberalizing trade in services should be expected since services are becoming increasingly tradable and that they account for a large and growing share of GDP in most countries (Matoo et al. 2001).

Trade liberalization in service industries such as transportation, insurance, and finance – can play a prominent role both in stimulating trade in services and trade in goods. Liberalization of trade in services can yield benefits beyond the service sectors themselves by reducing the real barriers to trade in other sectors. In that respect, the paper by Deardorff (2001) illustrates, with simple trade theory, how liberalization of trade in services can improve the gains from trade in goods. The paper suggests that removing barriers to cross border provision of services can lower their costs and foster trade in goods. For instance, eliminating barriers to trade in transport can facilitate trade in goods and induce particularly large gains. Hence, in addition to the standard triangles of deadweight loss gained in the services sector itself, there are rectangles of efficiency gains in the user sector from lower trading costs. In contrast, imposing restrictions on the ability of national service providers to supply these services across borders and within foreign countries generate additional costs and barriers to international trade.

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To be specific, there are many ways in which efficient and liberalized services contribute to improved economic performance. First, an efficient and well-regulated financial sector leads to an effective transformation of savings to investment, ensuring that resources are employed where they have the highest returns. Moreover, benefits also arise from increased financial product variety and better risk-sharing in the economy. Second, improved efficiency in telecommunications, ge nerates economy-wide benefits since telecommunications are becoming vital intermediate input and are also crucial to the dissemination of knowledge. The spread of the internet and the dynamism that it has induced in many economies around the world provide a clear evidence on the importance of telecommunications services. Third, transport services contribute to the efficient distribution of goods within and across countries. It ,then, determines country’s ability to participate in global trade, thus helping realize the benefits of integration. Finally, business services (accounting and legal services) play an important role in reducing transaction costs. For instance many observers argue that the single most important innovation in the history of the American capital markets was the idea of generally accepted accounting principles.

2.2 The process of international fragmentation of production and services trade liberalization The process of fragmentation is not new in the literature of international trade but took several forms and different names – such "disintegration” Feenstra (1998), “internationalization” Grossman and Helpman (1999), “intra-product specialization” Arndt (1997), “multistage production” Dixit and Grossman (1982), and “vertical specialization” Hummels et al. (1998). Others have used standard terms such as “subcontracting” and “outsourcing” (Feenstra and Hanson 1996). Fragmentation allows countries to specialize in the components of production processes in which they have the greatest comparative advantages. Therefore, by locating these different parts of the production process in different countries and coordinating them internationally, the world economy can achieve significant gains in productive efficiency.

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For developing countries, fragmentation of production may bring other gains. In addition to managerial and technological expertise, another important advantage is that foreign participation—in form of either ‘outsourcing’ or direct investment—may offer direct access to global networks of a parent company. Becoming part of a production and distribution network of an MNC offers a ‘cheap way’ to market products. Firms do not incur marketing cost, which are usually quite significant for new comers (Roberts and Tybout 1998).

The increased possibilities of ‘dividing up the value chain’ of production allowed the development of internationalization of the production process on unprecedented scale with deep implications for the global division of labor. The result of these developments is (Feenstra (1998)) integration of trade and disintegration of production in the global economy. In other words, the rising integration of world markets has brought with it a disintegration of the production process, in which manufacturing or services activities done abroad are combined with those performed at home. Companies are now finding it profitable to outsource increasing amounts of the production process, a process which can happen either domestically or abroad. This represents a breakdown in the verticallyintegrated mode of production – the so-called “Fordist” production, exemplified by the automobile industry – on which American manufacturing was built.

The gains from services liberalization become larger if the phenomenon of fragmentation, which is attracting increasing attention among trade economists, is also taken into account. The incentives for fragmentation, where production processes can be separated across locations, can be larger across countries due to the greater differences in factor prices and technologies that are available. However, the service costs of international fragmentation can also be larger, if regulations and restrictions prevent the international provision of services. Hence trade liberalization in services can lead to fragmentation of production of both goods and services, thus increasing international trade and the gains from trade even further. The gains of fragmentation are conditional upon the availability of such services at low cost. It seems that the recent emergence of fr agmentation as an

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increasingly important phenomenon in various parts of the world owes its existence to technological improvements that have brought these costs down to historically low levels.

3. The empirical analysis The above conceptual analysis has shown that technological progress has created new opportunities by boosting fragmentation of production at the international level. This allows dividing the industry’s value chain into smaller functions that can be contracted out to independent suppliers and offers unprecedented opportunities to small producers to move from servicing small local markets to supplying large firms abroad. The benefits from these developments driven by technological progress are highly influenced by the liberalization of trade in goods and the liberalization and performance in services. The later also has important implications for foreign investment. The economic success of the so-called third tier of East Asian economies— Malaysia and Thailand—has hinged heavily on foreign investment inflows. Since foreign involvement brings managerial and technological know how, it may be critical for a firm to become part of a network.

On the empirical front, many studies (e.g. Dollar (1992), Sachs and Warner (1995), BenDavid (1993), Edwards (1998) and Coe et. al. (1997)) investigated the impacts of liberalization of trade in goods. Surprisingly, however there is almost no comparable analysis of the impacts of services trade liberalization. One exception is Matoo et al. (2001) who found econometric evidence that openness to trade in services influences long run growth performance. This section contributes to filling this gap by investigating the impact of telecommunication services performance on manufactured and intermediate good exports and FDI inflows.

3.1 Manufactured export

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One major problem with MENA exports is its high specialization in energy which the region very vulnerable to terms of trade changes. The region should, therefore, undertake the necessary reforms to diversify its export. Export diversification implies a move from primary commodity exports to manufactured exports. It is viewed as an important factor of sustained economic growth for at least two reasons. First, the demand for manufactured goods increases more with income increases than the demand for primary products. Hence, growth prospects for a country’s exports are higher by specializing in manufacturing. Second, the development of the manufacturing sector induces substantial dynamic productivity gains, and hence growth, arising from economies of scale, learning effects, and externalities among firms and industries.

In this section we examine the relationship between manufactured exports and telecommunication services using a specification suggested by Sekkat and Varoudakis (2000). 1 We add to the original specification a telecommunication availability indicator as an explanatory variable. The specification assumes that the exporter is small with respect to the market for manufactures and gives the following relationship between export volume and a set of explanatory variables: log (X i ) = α 0 + α 1Rypar + α 2 log (E ) + α 3 log (Telecom ) + µ

(1)

where: Xi

is the ratio of manufactured exports to GDP

Rypar

is the growth rate of main trading partners

E

is the real effective exchange rate. An increase in E implies an appreciation of the exporter’s currency

Telecom

is the first principal components of the four telecommunication indicators presented in table 1 2

µ

is the error term.

1

This is a traditional specification in the literature. It may be derived from a formal model of export supply in LDCs. 2 This component explains 54% of the total variance. The loading factors are 0.93, 0.83, -0.36 and 0.67 for the fix, wait, cost and mobile respectively.

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Using the ratio of exports to GDP as a dependent variable avoids the problems due to the difference in countries’ sizes. As far as the determinants of export supply are concerned, the role of foreign demand is captured by Rypar. The coefficient α 1 should, therefore, be positive because an increase in demand is beneficial to exports. As an appreciation of the exporter’s currency (i.e. an increase in E) should harm exports, α 2 < 0 . Finally, we expect α 3 to be positive because well performing telecommunication services should improve manufactured exports performance.

Equation (1) was estimated using a sample of cross-section and time series data. The series of GDP, manufactured exports, trading partner growth rate and real exchange rate are drawn from the World Development Indicators. Telecommunication series are drawn from World Telecommunication Indicators

The sample includes annual data for 37 countries. The period of observation is 1990 1999. We use panel data econometric methodology: tests of fixed and random effects are conducted to select the most adequate models.

The estimates are heteroskedastic

consistent.

log (Xi ) = 0.09 * Rypar − 0.48 * log (E ) + 0.37 * log (Telecom ) (2.94) (-2.03) (2.34)

(2)

R 2 =0.96 Fixed effects (70,203) = 69.48 Random effects Hausman (3) = 0.55 Number of observation = 146 Equation (2) gives the estimation results. The level of the R 2 is high and comparable, or even higher, to that obtained in other studies focusing on developing countries (e.g. Ghura and Grennes (1993)). It appears that the test for common intercepts rejects the null hypothesis and that the Hausman test statistics for fixed versus random effects does not reject the hypothesis. These two observations justify the focus upon fixed effects models. To save on space fixed effects coefficients are, however, not reported. All coefficients are

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significant and have the expected sign. The coefficient of Telecom implies that availability of good telecommunication services foster manufactured export. A one percent improvement of the indicator increases the ratio of manufactured export to GDP by 0.37 percent.

3.2 Intermediate good exports The

process

of

fragmentation

of

production

allows

the

development

of

internationalization of the production process on unprecedented scale with deep implications for the global division of labor. By locating different parts of the production process in different countries and coordinating them internationally, firms can achieve significant gains in productive efficiency. Such a process also offers specific advantages to developing countries: managerial and technological expertise and direct access to global networks of a parent company. The purpose in this section is examine whether telecommunication services performance allows developing countries to better participate to the process of international fragmentation. This is done by examining the impact of such performance on intermediate goods exports. We use a similar specification to section 3.1 except that the dependent variable (Xi) is the ratio intermediate good exports to GDP. The other variables and the expected sign of the coefficients remain the same. The equation was estimated using a sample of crosssection and time series data. The series intermediate good exports are drawn from the CHELEM data base built by the Centre d’Etudes Prospectives et d’Information Internationale (CEPII, Paris).

The sample includes annual data for 32 countries. The period of observation is 1990 1999. We use panel data econometric methodology: tests of fixed and random effects are conducted to select the most adequate models. consistent.

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The estimates are heteroskedastic

log (Xi ) = 0.04 * Rypar − 0.66 * log (E ) + 0.18 * log(Telecom ) (2.11) (-2.18) (3.55)

(3)

R 2 =0.98 Fixed effects (70,203) = 175.85 Random effects Hausman (3) = 0.35 Number of observation = 153 Equation (3) gives the estimation results. The level of the R 2 is very high. The tests for common intercepts and for fixed versus random effects justify the focus upon fixed effects models. To save on space fixed effects coefficients are, however, not reported. All coefficients are significant and have the expected sign. The coefficient of Telecom implies that availability of good telecommunication services foster manufactured exports. A one percent improvement of the indicator increases the ratio of manufactured export to GDP by 0.18 percent.

3.3 FDI inflows FDI inflows to developing countries are though to represent additional resources they need to improve their economic performance. FDI inflows are expected to increase a country’s output and productivity, to encourage local investment and to stimulate the development and dispersion of technology. However, the record of the MENA in terms of FDI attractiveness is very disappointing. The region’s share in global investment and private capital inflows is small and falling. The region is, therefore,

losing the

opportunity of benefiting from FDI effect on export diversification, technology spillovers and growth prospects.

Previous empirical studies differ with respect to FDI specifications (see for instance Schneider and Frey (1985)). The differences concern both the variables to be included in the specification and their definition (nominal versus real measures and levels versus increase). For instance, while Agarwal (1980) emphasized the importance of the market size of the host country, Lucas (1993) challenged this view and showed a weak 11

relationship between the size of domestic market and the volume of FDI and a high degree of responsiveness of FDI to incomes in major export markets. Other authors pointed to the role of sound economic policies in attracting FDI (see for instance Gubert and Mutti (1991), Brewer (1993), Loree and Guisinger (1995) and Castanaga et al. (1998)). Finally, Hufbauer et al. (1994) has shown that the size and openness of the host countries are important determinants of FDI flows. Drawing on these findings, the following specification is used: log (FDI ) = α 0 + α 1Ry + α 2 Rypar + α 3 log (Open) + α 4 Rcpi + α 5 log (Telecom ) + µ (4)

Where:

FDI

is the ratio of FDI to GDP

Ry

is the real GDP growth rate of the host country

Rypar

is the growth rate of main trading partners of the host country

Open

is the ratio of exports to GDP

Rcpi

is the inflation rate in the host country

Telecom

is the first principal components of the four telecommunication indicators

µ

is the error term.

Like for equation 1 the ratio of FDI to GDP is used to abstract from countries’ size. A high real GDP growth is assumed to imply good market opportunity in the host country and then more attractiveness for FDI ( α 1 > 0) . An increase of the real GDP of trading partners implies good export opportunity of the host country and then more attractiveness for FDI ( α 2 > 0) . Openness is associated with an improved competitiveness and more FDI inflows ( α 3 > 0) . Inflation is used to capture the quality of host country’s economic policy. A high inflation rate is associated with bad policies which might deter FDI inflows (α 4 < 0 ) . Finally, good telecommunication services are assumed to contribute to creating a good environment for investment (α 5 > 0)

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Equation (4) was estimated using a sample of cross-section and time series data. The series of GDP, FDI exports, trading partners growth rate, host country growth rate, openness and inflation rate are drawn from the World Development Indicators. Telecommunication series are drawn from World Telecommunication Indicators

The sample includes annual data for 71 countries. The period of observation is 1990 1999. We use panel data econometric methodology: tests of fixed and random effects are conducted to select the most adequate models.

The estimates are heteroskedastic

consistent.

log (FDI ) = 0.2 * Ry + 0.11 * Rypar + 0.21 * log (Open) − 0.01 * Rcpi + 0.61* log (Telecom ) (1.32) (2.46) (0.58) (-1.87) (2.54) (5)

R 2 =0.72 Fixed effects (70,228) = 10.50 Random effects Hausman (3) = 4.06 Number of observation = 304 Equation (5) gives the estimation results. The level of the R 2 is high i.e. 0.72. The fixed effects and the Hausman tests induce us to focus will be on fixed effects models. All coefficients have the expected sign. However, openness and Ry are not significant. The coefficient of Telecom implies that availability of good telecommunication services increases the host country attractiveness with respect to FDI. A one percent improvement of the indicator increases the ration of FDI to GDP by 0.6 percent.

3.4 A synthesis and a discussion Number of authors have pointed to the heavily distorted and inward- looking policies which have prevailed for a long time in the region as a reason for the MENA bad record (see for instance Page (1998) and Nabli and De Kleine (2000). Protectionism and lack of integration in world economy have precluded the countries in the region from boosting

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their efficiency and competitiveness. Moreover, most countries in the region provide an inadequate institutional support for investment and private sector development (El Badawi (1999)). Although some countries have started reforming they are still far behind international standards.

Recent empirical evidence lend support to these explanations. For instance Sachs and Warner (1995) have showed that open economies tend to adjust more rapidly from primary-intensive to manufactures- intensive exports. Sekkat and Varoudakis (2002)) focused specifically on the MENA region and found that trade and exchange rate policies matter for manufactured exports performance.

However, while reforming economic policies is clearly a crucial factor for improving the MENA integration into the world economy, our econometric results suggest that this might not be sufficient. Indeed, even when controlling for their structural determinants (including economic policy), trade and FDI increase with an improvement of telecommunication services. Hence, a good functioning of “backbone” services (e.g. transport, telecommunications, and finance) is important for industry performance and competitiveness.

Despite steps taken recently, especially in telecom privatization (e.g., Morocco, Jordan), MENA still lags behind in regulatory reform of the services sector. For example, telecommunications markets remain less open to competition in MENA than elsewhere in the developing world (Varoudakis and Rossotto (2001)). The lag of the MENA in this respect is reflected in the availability of tele communications services in the region. Table 1 compares four indicators of such availability across five regions of the World. Except for the cost of local call the MENA is among the low performing regions irrespective of the indicator.

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Table 1: Indicators of telecommunication availability in selected regions (1990-1999)

Region Cost Latin America East. Europe MENA S-S Africa East Asia

0.118 0.041 0.041 0.183 0.043

Indicators Fixed Wait 210.236 164.831 45.738 4.379 40.358

11.368 59.221 30.783 3.143 2.341

Mobile 45.914 4.874 1.446 0.223 7.174

Cost= Cost of 3 min. local call in $ Fixed= Number of fixed phone per 1000 inhabitants Wait= Waiting list per 1000 inhabitants Mobile= Number of mobile phone per 1000 inhabitants

Taking these results together with those of the econometric analysis sheds light on the well documented observation that the MENA region is lagging behind a number of other regions in the world both in terms of manufactured exports and FDI inflows. Therefore, policy aiming at improving the performance of telecommunication services in the MENA region can entail important gains in terms of exports and FDI inflows and complement other policies (e.g. trade and exchange rate policies) undertaken in the region.

4. Conclusion The paper investigated the linkages between liberalization and performance of “backbone” services on the one hand and trade and FDI in the MENA region on the other hand. It provided a conceptual analysis of the ongoing liberalization in “backbone” services and its potential impact on trade and FDI. The study also conducted an econometric investigation of the relationship between telecommunication services performance and manufactured exports, intermediate good exports and FDI inflows in the MENA region.

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The conceptual analysis showed that technological progress has created new opportunities by boosting fragmentation of production at the international level. This allows dividing the industry’s value chain into smaller functions that can be contracted out to independent suppliers and offers unprecedented opportunities to small producers to move from servicing small local markets to supplying large firms abroad. The benefits from these developments driven by technological progress are highly influenced by the liberalization of trade in goods and the liberalization and performance in services. The later also has important implications for foreign investment. Since foreign involvement brings managerial and technological know how, it may be critical for a firm to become part of a network.

The econometric analysis showed that, after controlling for other determinants, good telecommunication services have a significant and positive impact on both manufactured and intermediate good exports and on FDI inflows. Given that the MENA is among the low performing regions of the world in terms of telecommunication services, these results shed light on the well documented observation that the region is lagging behind other regions in the world in terms of manufactured exports and FDI inflows. The analysis suggests that policy aiming at improving the performance of “backbone” services in the MENA region can entail important gains in terms of exports and FDI inflows and complement other policies (e.g. trade and exchange rate policies) undertaken in the region.

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