Outward-Oriented Developing Economies Really Do Grow More Rapidly: Evidence from 95 LDCs, 1976-1985

Abstract

The long run trade orientation of an economy is measured in this article by an index which measures the extent to which the real exchange rate is distorted away from its free trade level by the trade regime. The technique for estimating a cross country index of real exchange rate distortion uses the international comparison of prices prepared by Robert Summers and Alan Heston. Resource endowment constitutes the norm and real overvaluation or undervaluation relative to this norm reveals whether incentives are directed to the domestic or international market. The index is constructed based on data for GDP/capita average price level in US dollars 1976-85 and GDP growth rate/capita 1976-85. Other sections are devoted the comparison of the procedure for 117 countries between 1976-85 and an examination of the empirical relationship between outward orientation and economic growth and sensitivity analysis. The results indicate that Latin America generally was overvalued by 33% relative to Asia and Africa was overvalued by 86%. The real exchange rate distortion index supports the view that Asian countries are more outward oriented. Asian economies have lower price levels which reflect relatively modest protection and incentives oriented to external markets. Latin American countries with moderately high price level and African countries with very high price levels reflect strong protection and incentives directed to production for the domestic market. An alternative specification which eliminates the dummy variables for Africa yields similar results with slightly lower magnitude; i.e. overvaluation is 60% instead of 86% for Africa and Latin America is overvalued by 39% instead of 33% over Asia. A table is provided which indicates by country the distortion and variability of the real exchange rate the GDP growth the 1976 GDP/capita and the investment rate. Another finding was that there is a significant negative relationship between distortion of the real exchange rate and growth of GDP/capita after controlling for the effects of real exchange rate variability and investment level with both the original specification and the alternative. The growth rate/capita of Latin American and African countries would increase 1.5-2.1% with a shift to move outward oriented trade policies. This gain as well as devaluation of the real exchange reate trade liberalization and maintenance of a stable real exchange rate would contribute to positive growth rates. In the analysis of the poorest 24 countries the result was that only rate distortion and not variability and investment rate explained the growth rate. The gain for Ghana for example of adopting the trade policies and exchange rate of Bangladesh would be 5% to its growth.