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Chapter 3: Policy Implications for the CLMV

Author(s):
Koshy Mathai, Geoff Gottlieb, Gee Hee Hong, Sung Eun Jung, Jochen M. Schmittmann, and Jiangyan Yu
Published Date:
September 2016
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This chapter tries to draw out what the preceding analysis means for CLMV policies. So far, we have seen that China is indeed moving up the value chain and bringing upstream activities onshore, and we have found some evidence that China may be beginning to exit downstream, labor-intensive activities. At the same time, China’s rebalancing will likely challenge commodity exporters like Lao P.D.R. and Myanmar, while it provides new markets for manufactured goods as well as service exports.23How can the CLMV—open, export-driven economies that are increasingly integrated with China—best capitalize on the opportunities, and deal with the challenges, presented by China’s transformation? This chapter starts by examining the drivers of trade growth and GVC participation—both what the literature has found before, and what we uncover in new econometric work. It then goes on to benchmark the CLMV—how well do these countries do in terms of the factors that are found to be most important for fostering trade? It concludes with some general policy recommendations that apply to all four countries in the region, followed by some lessons tailored to each of the countries.

Low Labor Cost in the CLMV

Low wages have been an important factor in attracting foreign investments to the CLMV. Labor costs in the CLMV are below even those in China’s poorer inland regions. The wage gap between the CLMV and China has opened up since 2009; in the same time period Vietnam saw increasing foreign investment in manufacturing. CLMV wages are also below those of Asian emerging market economies including Thailand and Malaysia, and comparable to other Asian LICs. Among the CLMV, Vietnam and Cambodia have the highest wage levels, while labor in Myanmar is very cheap, which may attract labor-intensive manufacturing in the coming years.

Figure 3.1.Manufacturing Worker: Total Annual Salary, FY 2014 (April–March)

(U.S. dollars)

Source: Japan External Trade Organization (JETRO) FY2014 Survey.

Figure 3.2.Annual Average Wage

(U.S. dollars)

Sources: CEIC Data Company Ltd.; JETRO; and IMF staff estimates and calculations.

1/ Estimated wage of workers in manufacturing.

Will low wages alone make the CLMV competitive? Unit labor costs are clearly an important factor. Countries with low wages, adjusted for productivity, typically have an advantage in labor-intensive production, as has certainly been the case for the CLMV. As steep wage increases have occurred in the coastal region of China, Cambodia and Vietnam have been among the biggest beneficiaries. Success in labor-intensive light manufacturing can, in turn, be a gateway to moving into more sophisticated goods, as shown by the so-called Asian tigers, referring to Hong Kong SAR, South Korea, Singapore and Taiwan Province of China. But more may be needed than just low wages.

Figure 3.3.Wage and Changes in Global Market Share: Labor-Intensive

Sources: UN Comtrade; and JETRO.

The importance of fundamentals in trade

There is a large literature, going back decades, that tries to explain why some countries are successful in trade. Some studies look at export growth, others look at export diversification, and yet others look at the sophistication of exports. Distance and income level—which often proxies for wage costs—are almost universally found to be significant, and exchange rate measures also frequently matter. Many structural variables are also important—Cadot and others (2013), in surveying the literature, identify infrastructure, education, and institutional quality as particularly important. Agosin and others (2012) look at export sophistication and come up with a similar list of relevant variables, though the real effective exchange rate is found not to be significant, nor is the degree of financial development. Cadot and others (2013) find that FDI is also important, consistent with Iwamoto and Nabeshima (2012) and Banga (2006), but inconsistent with other papers that note that FDI targeted at already important sectors can lead to further concentration and lack of diversification.

We complement the literature by running cross-country panel regressions of our own. The results highlight the importance of structural and institutional factors, aside from labor costs, that are crucial in the growth of trade in general, and in improving export sophistication. Aside from labor cost, economic and institutional fundamentals are found to be key determinants of the performance of labor-intensive sectors in the global market. We group industries at the SITC two-digit level into five groups (raw material intensive goods, labor-intensive goods, capital-intensive goods, easy-to-imitate research-intensive goods and difficult-to-imitate research-intensive goods).

Table 3.1.What Explains Export Market Shares (EMS)?1
(1)(2)(3)(4)(5)(6)
VARIABLESGlobal EMS Capital IntensiveGlobal EMS Difficult ResearchGlobal EMS Easy ResearchGlobal EMS Labor IntensiveGlobal EMS ApparelGlobal EMS Electronics
Infrastructure0.171***0.155***0.0850.0430.0640.234***
(0.049)(0.045)(0.066)(0.033)(0.058)(0.064)
Education2.702***3.138***1.685**1.461***2.661***2.591***
(0.526)(0.486)(0.715)(0.353)(0.627)(0.690)
Governance0.209***0.159***0.156*0.077*0.369***0.144*
(0.061)(0.057)(0.084)(0.041)(0.073)(0.081)
Labor Reg.−0.055−0.034−0.091−0.118***−0.235***−0.081
(0.044)(0.041)(0.060)(0.030)(0.053)(0.058)
Free Trade0.191***0.186***0.113***0.136***−0.0180.213***
(0.027)(0.025)(0.036)(0.018)(0.032)(0.035)
Observations694694694694694694
R-squared0.3870.3530.1280.2240.5050.169
Sources: UN Comtrade; World Bank, World Development Indicator; Heritage Foundation; and IMF staff estimates.

The panel is detrended and includes country and time fixed effects for 48 countries from 1995 to 2011. The control variables used are as follows: “infrastructure” is the first principal component of infrastructure, following Seneviratne and Sun (2013); “education” is years of schooling from World Development Indicators data; “governance” is from the World Bank’s governance database, extracting the principal component of all the subindices; “labor regulation” is from the International Institute for Management (IMD)world competitiveness database; and “free trade” is the number of preferential trading agreements from the WTO (http://rtais.wto.org/UI/PublicMaintainRTAHome.aspx).

Sources: UN Comtrade; World Bank, World Development Indicator; Heritage Foundation; and IMF staff estimates.

The panel is detrended and includes country and time fixed effects for 48 countries from 1995 to 2011. The control variables used are as follows: “infrastructure” is the first principal component of infrastructure, following Seneviratne and Sun (2013); “education” is years of schooling from World Development Indicators data; “governance” is from the World Bank’s governance database, extracting the principal component of all the subindices; “labor regulation” is from the International Institute for Management (IMD)world competitiveness database; and “free trade” is the number of preferential trading agreements from the WTO (http://rtais.wto.org/UI/PublicMaintainRTAHome.aspx).

Infrastructure, education, governance, and trade freedom all contribute positively toward export market share, and are particularly important for more sophisticated goods. Using an unbalanced panel of 48 countries over the period 1995–2011, we estimate a model to explain a country’s share in world exports in a given sector by various institutional variables. A lack of comparable panel data on unit labor costs or even on wages prevents inclusion of such measures. We find that the openness of trade, infrastructure, education, and governance are strongly positively correlated with export performance at all levels of technology sophistication. Moreover, as an industry requires more technological sophistication, these structural factors increases become even more important for performing better in the global market—for example, education is more important to difficult-to-imitate research industries than in easy-to-imitate research or labor-intensive industries.

These findings are consistent with the literature. Several papers, for instance, highlight the importance of human capital and R&D and institutional quality (Henn, Papageorgiou, and Spatafora 2012) in allowing a country to improve export quality and sophistication. Empirically, education and export sophistication are important determinants of growth (Hausman, Hwang, and Rodrik 2007; Cherif and Hasanov 2015). Eichengreen, Park, and Shin (2013) show that countries with high levels of secondary and tertiary education as well as a large share of high-technology exports are less likely to experience growth slowdowns.

Benchmarking the CLMV

The CLMV still fall short on many of the institutional variables associated with export success. In particular, further progress in education, governance, infrastructure, and the trade regime will benefit the CLMV. These countries have improved on production technologies, structural determinants, the cost of inputs, and trade policy (World Bank 2014). But except for Vietnam, which fares on par with China on many of the structural factors including education, cost of export, and some measures of infrastructure, the CLMV need to make further progress in order to benefit from the changing landscape of trade.

Further improvements in basic education are needed, especially in Cambodia, Myanmar, and Lao P.D.R. While the CLMV have seen improvements in school enrollment and literacy rates, as well as declining pupil–teacher ratios, more progress is needed. Business surveys indicate that skill shortages and mismatches continue to hamper industrial activity and impede private investment in these countries. Cambodia has relied on low-skilled manufacturing and services to support growth. Significant progress has been made in primary school enrollment, but secondary and tertiary school enrollment remain low. Furthermore, education spending in Cambodia is very low compared with such spending in peer countries. The situation is similar in Lao P.D.R. and Myanmar, where education spending remains very low, and low vocational and tertiary education enrollment limit the supply of high-skilled workers. Of course, increasing education spending presents budgetary challenges and needs to be embedded in an appropriate fiscal framework. In Vietnam, relatively high spending on primary and secondary education has paid off, with Vietnamese students scoring above the OECD average in the Program for International Student Assessment (PISA)study, but tertiary education and vocational training are lagging.

Trade openness is another crucial factor in boosting trade activities at all levels of export goods sophistication. Ongoing revisions to trade-related laws and regulations to meet WTO and ASEAN Economic Community (AEC) commitments are likely to support international trade integration by reducing trade tariffs, improving the business climate, and promoting private investment and institutional reform. The CLMV have made major strides in reducing trade costs, but tariff liberalization is far from complete—for instance, the CLMV were given extra time to comply with agreed tariff reduction under the ASEAN Free Trade Agreement. The CLMV—and Vietnam in particular—have also participated actively in preferential trading arrangements, mostly within Asia. The TPP is also expected to significantly boost exports from Vietnam (the sole CLMV party to the agreement), as is a recently signed comprehensive trade agreement with the European Union. In addition to free trade in goods, increased openness in services trade is important for the competitiveness of the goods sector, especially for higher-value-added activities.

While the investment climate and infrastructure have improved, considerable infrastructure gaps remain. According to the 2015 World Bank Doing Business Index, Lao P.D.R.’s cost to export is the highest in the region. Inland transportation and handling make up 70 percent of this cost, indicating that investments to improve transportation infrastructure are crucial to promoting further trade. For Cambodia, the high cost of electricity is one of the major concerns among firms.24

For Myanmar, improvements in transport infrastructure, transit corridors, and power generation and supply are top priorities. A study by the Asian Development Bank (ADB) estimates that the country needs to invest as much as US$80 billion to address major infrastructure gaps by 2030. Myanmar is ranked low in the quality of infrastructure index among LICs. In particular, high transport costs have hampered trade integration. Lack of reliable electricity supply has been a major impediment to investment.

The high cost of doing business also contributes to higher dependence on natural resources in Lao P.D.R. In a poor investment climate, the very high returns associated with natural resource investments are viable and compensate investors for the high costs of doing business, while the lower or more uncertain returns to non-natural-resource investments limit diversification.

Reducing impediments to lower the cost of doing business can help stimulate further private investment. Although Cambodia has one of the most liberal investment regimes in developing Asia, there is still considerable room for improving the business climate. Improving transparency and predictability, as well as streamlining bureaucratic procedures, should be the main focus for improvement.

The CLMV all need to strengthen public sector financial and project management, given limited fiscal space to increase spending in infrastructure. In general, the efficiency of capital spending in the CLMV is very low (see Dabla-Norris and others 2011). In a broad sample of low-income and middle-income countries, the CLMV score in the lowest quartile in project selection, project management and implementation, and project evaluation and audit. Thus, strengthening public sector financial and project management would help improve the basic processes and controls that are likely to yield efficient public investment decisions.

Lack of diversification translates into more vulnerability to external shocks. This is a common concern for these countries, with the exception of Vietnam. Exports from the CLMV are still concentrated in a small number of goods and markets. For instance, while the garments industry in Cambodia accounts for the bulk of exports, its competitiveness remains weak and is driven largely by preferential access to key markets. As there is no local fabric and yarn industry, Cambodia is subject to volatile input prices from China. Thus a key priority should be upgrading skills and infrastructure so as to create conditions for diversification.

Apart from the diversification of the type of exporting goods, there may also be a need to diversify export markets. During the global financial crisis, countries with high exposure to advanced economies as export destinations were adversely affected by the reduction in the external demand. Cambodia, for instance, saw its exports drop by 10 percent in 2009. In this regard, further integration into regional trade may offer the promise of a new source of demand and growth in the future. Estrada and others (2010) and Asian Development Bank (2009) highlight that strengthening intraregional trade would enable the region’s economies to exploit potentially large, but yet under-realized, gains from trade.

Figure 3.4.Access to Electricity, 2010

(Percent of population)

Sources: World Bank, World Development Indicators; and IMF staff calculations.

Figure 3.5.Time Required to Start a Business, 2014

(Days)

Sources: World Bank, World Development Indicators; and IMF staff calculations.

Figure 3.6.Years of Schooling, 2010

(Years)

Sources: Barro, R. and J. Lee (2013); and IMF staff calculations.

Figure 3.7.Rule of Law, 2012

(Index; higher values = better rule of law)

Sources: World Bank, Worldwide Governance Indicators; and IMF staff calculations.

Figure 3.8.Regulatory Quality, 2012

(Index; higher values = better quality)

Sources: World Bank, Worldwide Governance Indicators; and IMF staff calculations.

Figure 3.9.Cost to Export, 2012

(U.S. dollars per container)

Sources: World Bank, World Development Indicators; and IMF staff calculations.

Country-Specific Policy Recommendations

Cambodia

Cambodia needs to take several steps to take full advantage of opportunities arising from China’s potential exit from labor-intensive industries. It should improve the business climate and enhance competitiveness by upgrading infrastructure, improving the quality of labor, and strengthening governance. Specific recommendations include the following:

  • Upgrading infrastructure to reduce logistics costs—Cheaper, more reliable, and more accessible electricity remains a top priority. This, along with highway and secondary road development, is needed to reduce operation/transportation costs and to improve competitiveness. Strengthening the legal framework for public-private partnership projects could facilitate infrastructure investment—both foreign and domestic.
  • Improving human capital to increase productivity and capture higher-value-added production—Rapidly increased elementary school enrollment is encouraging, but the quality of elementary education needs to be lifted. Addressing skill gaps would require work on multiple fronts: vocational and industry-led training, better dissemination of market information on skills shortages, and apprenticeship programs to explore “learning by doing” and “learning by earning.”
  • Streamlining red tape in doing business—More transparent and predictable customs procedures and permit and authorization requirements would expedite cross-border flows of goods and integration with regional supply chains. Encouraging small medium enterprises (SMEs) to enter the formal sector, by simplifying registration and accounting standards, would help SMEs flourish and better integrate with China’s supply chains.

Lao P.D.R.

Despite substantial progress, future productivity growth will depend in part on further improvements in human capital. Significant progress has been made in education, as reflected in the increase in school enrollment and literacy rates and declining pupil–teacher ratios. However, low vocational and tertiary education enrollment limits the supply of high-skilled workers, and there is some evidence that this has constrained the benefits from trade integration. Additionally, education spending in Lao P.D.R. remains low compared with that of its peers. Government budget spending increases in recent years have mainly gone to public sector wages. In the face of limited fiscal resources, reallocation of budget resources and securing more donor support for education remain high priorities. As the country develops toward a more sophisticated economic base, it will require more high-skilled labor to sustain its rapid growth and to be competitive in a more integrated world.

Accelerating trade integration and increasing social spending would build on existing strengths, and promote competitiveness and growth inclusiveness. Ongoing revisions to trade-related laws and regulations to meet WTO and AEC commitments will support international trade integration, reduce trade tariffs, improve the business climate, and promote private investment and institutional reform. Increasing social spending, in particular improved social safety nets for vulnerable workers, including those with less formal work arrangements, would offer the potential to bring more workers into productive employment and make growth broader-based and more inclusive.

A high regulatory burden has hindered trade development. Evidence suggests that exporters in Lao P.D.R. continue to face a higher regulatory burden than non-exporters (World Bank 2010). A regulatory environment that minimizes transactions costs and levels the playing field for all types of investors needs to be put in place to support existing and new exporters.

While the investment climate has improved in recent years, further work remains, particularly for investments to promote economic diversification. As noted earlier, Lao P.D.R.’s cost to export is the highest in the region. Inland transportation and handling make up 70 percent of this cost, indicating that investments to improve transportation infrastructure are crucial to promoting further trade. In a poor investment climate, high returns associated with natural resource investments compensate investors for the high costs of doing business, while lower and more uncertain returns, coupled with the high cost of domestic credit, tend to limit diversification to non-natural-resource investments. There is evidence that high-value perishable agricultural products, on which Lao P.D.R. might focus for export growth, are disproportionately affected by high trade costs. Lowering such costs might therefore have a large impact on the export of new products.

Strengthening public sector financial and project management is also a priority, given the limited fiscal space to increase spending on infrastructure. An IMF study assesses the efficiency of capital spending in Lao P.D.R. to be very low (Dabla-Norris and others 2011). In a broad sample of low-income and middle-income countries, Lao P.D.R. scores in the lowest quartile in project selection, project management and implementation, and project evaluation and audit. Thus, strengthening public sector financial and project management would help improve the basic processes and controls that are likely to yield efficient public investment decisions. This would allow capital spending to be more in line with comparators, particularly as grants (currently 40 percent of public investment spending) are expected to decline.

Myanmar

The following policy steps to increase trade and FDI would be helpful:

  • Moving ahead with the AEC initiative could help facilitate trade liberalization through dismantling tariff and nontariff barriers while promoting integration with regional and global value chains. For instance, the commercial tax on exports should be phased out. Tariffs, especially on intermediate input imports, should be reduced—empirically there is a strong, negative correlation between intermediate good tariff rates and GVC participation.
  • Creating conditions for export diversification and increasing sophistication should be a policy priority. Labor-intensive manufacturing and commodity-related sectors could be potential candidates for diversification—these would include final assembly of electronics, garments, footwear, and lumber processing.
  • Improving the business climate, particularly through regulatory reform, could help to attract FDI in strategically important areas, including manufacturing and infrastructure.

Improving infrastructure, particularly for transport and electricity, should be a priority. Myanmar is now opening itself to the outside world, and building physical connectivity is a prerequisite for the desired regional and global integration, and for capitalizing on its advantage as a natural bridge between South and Southeast Asia. Myanmar is ranked low in the overall logistics performance index by the World Bank and urgently needs infrastructure development, especially in the areas of transport and electricity generation. The regional physical connectivity initiative under the AEC initiative, if successfully implemented, is expected to reduce trade costs and enhance trade competitiveness as well as enhance mobility. Developing the energy and information technology infrastructure is also a major priority.

Human capital formation must also be promoted. This is a longer-term priority that will eventually position Myanmar to move upstream in the GVCs that it hopes to enter in the future. Despite recent increases, government spending on health and education remains low compared with other low-income countries. Strategic increases in investment in these sectors with corresponding improvement in absorptive capacity would help strengthen Myanmar’s long-term competitiveness.

Finally, sound governance is critical. Stable and transparent business conditions, based on political and social stability and sound legal and institutional frameworks, are particularly important for Myanmar and will contribute to greater GVC participation. Myanmar can also make better use of its natural resource rents to help upgrade its infrastructure and human capital. This can usefully be pursued through continued efforts under the Extractive Industries Transparency Initiative and by reviewing its fiscal regime for extractive industries.

Vietnam

Vietnam needs to work on several policy fronts to further strengthen its already impressive export performance. Vietnam remains a relatively poor country, with per capita GDP only slightly above US$2,000, and while growth has been admirable, it has lagged that of East Asia’s most successful countries when they were at a similar stage of development. In addition, it is on track to become one of the world’s fastest-aging societies, and the working-age population ratio has already started to decline, which could become a drag on growth. Growing exports have been driven by the FDI sector (70 percent of exports), while domestic manufacturing has lagged.

Boosting total factor productivity growth, which has declined since the mid-2000s, is essential. The potential for productivity gains from reallocation of labor is still large, with almost half the workforce in agriculture and three-quarters employed at the household level, both with very low productivity. In addition, boosting productivity in domestic manufacturing and, in particular, in state-owned enterprises (SOEs), which absorb a significant amount of capital, is important. Output per worker in domestic manufacturing, which includes SOEs, stands at around twenty percent in foreign-owned enterprises. Integration between the FDI sector and domestic suppliers needs to be deepened to achieve productivity spillovers and to internalize more production value.

Structural reforms, stronger governance, and policies to strengthen the private sector are critical for raising Vietnam’s long-term growth potential. They are also needed for Vietnam to take full advantage of new FTAs, including TPP. Improvements to the business environment are essential to develop domestic private business. Although improving consistently, Vietnam still ranks just 90th in the World Bank’s Doing Business report and scores low on most indices of governance quality. Property rights and the enforcement of competition policy need to be strengthened to encourage domestic private firms to scale up and join the formal sector. Reform of the SOE sector needs to be accelerated, including governance reform, privatization, divestment from noncore business areas, and the creation of a level playing field with the private sector by curtailing SOEs’ preferential access to credit and other resources. Spending on research and development, which is very low compared with that in peer countries, would support further moves up the value chain. Higher and more efficient public investment to strengthen infrastructure is also needed. Investment in human capital is paying off, but weaknesses remain in vocational and tertiary education.

Summary

Changes in China present significant opportunities to the CLMV, but also challenges, and with the right policies, the region should have a bright future. The CLMV cannot rely on low wages alone—especially given China’s high productivity and the presence of low-wage inland provinces. Rather, structural reforms are needed to improve along the various dimensions that are typically associated with success in trade. And, of course, macroeconomic policies must be kept prudent in order to provide stable conditions. Rebalancing may lead to declining demand for commodities, which will be a challenge for Lao P.D.R. and Myanmar, but with reforms of the type discussed in this report, new export opportunities will emerge.

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