Income Inequality and Poverty after Trade Liberalization in MENA Countries

FEM33-02 | November 2009

Title

« Income Inequality and Poverty after Trade Liberalization in MENA Countries »

By

Roby Nathanson, Macro Center for Political Economics, Israel

Contributeurs

Khalid Sekkat, University of Brussels, Belgium; Hagar Tzameret-Kercher, Macro Center for Political Economics, Israel; Oleg Glybchenko, Macro Center for Political Economics, Israel

Note :

This document has been produced with the financial assistance of the European Union within the context of the FEMISE program. The contents of this document are the sole responsibility of the authors and can under no circumstances be regarded as reflecting the position of the European Union.

Summary :

The Middle East and North Africa (MENA) region track record of growth achievements has remained bleak for years. As a striking feature of the region’s economy for the last three decades has been little or no integration with the rest of the world. Whereas trade has been growing in volumes in the highly developed countries with greater increases in the east of Asia, former communist European countries and Latin America, up until the mid 90s in the MENA region such trade expansion would not occur due to barriers and protectionist tariffs with only the exception of oil exports. In order to whip up region’s trade growth policy makers in the EU pushed economic reform programmes, aimed at fostering growth and poverty reduction through free trade. However, in terms of the World Bank’s definition of absolute poverty in international purchasing power standards of $1.00 or $2.00 per person a day, compared to other regions MENA stands out as the developing region with the lowest incidence of extreme poverty in the 90s (Page et al, 2002).

This report aims at highlighting notable macro economic trends following this initiative as regards region’s wealth, inequality and poverty.

The relation between openness, inequality and poverty has been in the spotlight of academic and political debate in the last decades which has been growing in volume and importance keeping in pace with the expansion of globalization. The precise theoretical ties linking between openness, inequality and poverty remain obscure regardless of academic effort to achieve definitive results.

It has been suggested that lack of support of the Heckscher-Ohlin (HO) international trade model could be explained by examining alternative channels effecting overall inequality and poverty. In particular, increased openness may reduce absolute poverty via expanding economic growth, when welfare gains reach the lower strata of society. It is worth noting, that there is a considerable difference between types of poverty and inequality, as trade liberalisation may induce higher rates of relative poverty while at the same time create economic opportunities, consequently reducing absolute poverty.  After all, the HO theory should only be expected to inform us about the relation between endowments and factor rewards in response to a reform-induced change in relative factor demands rather than between endowments and overall income inequality which is determined by many other factors. Economic growth is sustained due to increases in productivity, and most of the evidence suggests that trade liberalization operates through this route. However, if in the short run productivity increases faster than output, dwindling profit margins will result in wage reduction.

Several notable papers (Dollar, 1992; Sachs and Warner, 1995; Edwards, 1992), supporting this view, have found that trade openness is associated with more rapid growth. Recently, the study by Dollar and Kraay (2005) using the GMM estimation of roughly 100 countries in the 1980s and 1990s confirmed these findings, concluding that a 100% increase in trade volumes resulted in a 25% cumulative rise in incomes during over a decade. According to the recent survey Bannister and Thugge (2001) there seems to be no strong systematic relationship between openness and the income of the poorest. Furthermore, in Dollar and Kraay (2001) a panel based on 137 countries estimation shows that openness has a tiny and statistically insignificant effect on the lowest quintile (bottom 20%) on mean per capita income. Thus, while inflation appears to have an adverse effect on the poor in addition to its growth-reducing effects, countries’ income distributions are not significantly affected by other variables, like government consumption, the rule of law, democracy, social expenditure, primary school enrolment and two measures of openness.

In the present study we closely examined whether the economic climate, following trade liberilization in the late 90s in the MENA region, brought real benefits. Judging from the descriptive analysis of the MENA, the region’s economies (Egypt, Jordan, Tunisia, Morocco and Israel) have moved from the period of chaotic growth to a more stable phaze with growth of average 5%. However, region’s trade growth was modest notwithstanding numerous trade partnerships and agreements. In fact, the figures suggest, that after trade liberalization the potential of growing exports and imports was not realized. It may be surprising, that Egypt and Lebanon started to export less after 1995, but only during the last few years the trend has reversed. Another evidence of little change of trade flows is the share of import and export destinations. The data from the IMF shows, on the one hand, that Euro area share of exports has remained virtually unchanged, rising only 7% compared to 1980. Imports, on the other hand, have shrunk from 55% (1980) to 50% (2003), which is negligible for the time span of two decades.

Anyway, the trends in business regulations, trade barriers policy show encouraging signs, especially during the last five years of development. An important characteristic of the region remains its relatively low levels of inequality.

Our objective of assessing the impact of trade reform on the real incomes of the poorest individuals in the MENA using econometric tools implies the “intermediate objective” of assessing the impact of trade reform on average per capita income. The impact of openness on average per capita income can be decomposed in two components. The first one concerns the level of openness in the Region. Given an estimate of the sensitivity of per capita income to openness, one can compute the impact of a higher or lower openness of the MENA on income. The second one concerns the sensitivity of income to change in openness (i.e. coefficients of the explanatory variables).

Examining the interaction terms which give the difference in MENA income’s sensitivity of to change in the explanatory variables, our results broadly confirms Makdissi et al (2006)’s except for openness. The coefficient pertaining to the lagged income is significant (at the 10%) and positive implying that catch-up process had taken place to a lower extent in the MENA as compared to other regions. The results also show that the coefficient pertaining to investment is significantly negative. This means that the impact of physical capital on growth is much lower than for the whole sample. There seems to be a problem of capital efficiency in the MENA countries. Page (1998) suggests that this low efficiency of capital is due to the dominant role of the state and the nature of capital inflows in the region destined mainly to finance public investments and low-productivity projects in the non-tradable sector such as housing.  Finally, the coefficient pertaining to the openness indicator is not significant implying that a given degree of openness has the same impact in the MENA than in other regions.

The last result differs from the pervious finding. Such difference seems to be linked to the period of observation. Rerunning the regression over the same period as Makdissi et al (2006), we uncover their finding. It seems that the process of trade policy reforms initiated by the mid-1980s and accelerated since the mid-1990s has made openness more conductive to growth than before; a statement corroborated by Sekkat and Varoudakis (2002).

Having shown that openness is conductive to the average per capita income growth we move to openness-to-trade effects on the income of the poor directly and indirectly through its impact on growth.

We start with the indirect impact. Among several estimation technics we chose the 2SLS estimation method with 2 instruments; the level of mean income at the beginning of the period and growth in the five years preceding t. The results are much better than the other ones from both an economic and a statistical point of views. The quality of the fit is very good (the adjusted R2 is equal to 0.63) and the coefficient of average income is significant and positive. Its level is not significantly different form 1; which is in accordance with the literature findings that income of the poor increases one-for-one with the average income. Growth seems to benefit the poor in a similar way as other categories of the population.

Next, we are interested in the specific direct effect of openness on the real incomes of the poorest individuals in MENA countries. To address this question we use the second specification as our basic specification to which we add the indicator of openness (freedom-to-trade internationally) as an additional explanatory variable. The overall quality of the fit increases slightly.

The coefficient of the dummy is positive suggesting that, once we control for the specific effect of MENA’s openness, income of the poor has improved over the period beyond the effect of the increase in average income; may be due to active social policies. The coefficient of the interaction term is negative implying that, contrary to the results for the whole sample, openness has a negative direct effect income of the poor. Taken together, these results imply that in the MENA income of the poor increase because of the increase in average income and because of the impact of other unobservable factors. It, however, decreases with openness.

The introduction of the additional control variables, either separately or together, does not change the quality of the fit and none of their coefficient is significant except domestic credit’s which is significant (at 10%) and positive.

On a more detailed level the Israeli economy has benefited from opening to trade. It became more sensitive to foreign business cycles. Yet the economy specializes on positively enhancing its orientation for more high tech manufacturing and services.

The main measures of the recent economic policy were tax cuts and social benefits reduction. These changes have begun in the early 2000s and some are still coming into effect today as part of the long term government reform. The resulting growth and underemployment decrease did not reduce the poverty rate, after transfer payments.

The labour markets policies were in a vicious trap because the weak labour laws enforcement and the loss of eligibility to social benefits for workers even in vulnerable situation. Two programs were launched by the Israeli Government in the aim to reduce the work discouragement of the potential low paid employees, the negative income tax program (earned income tax credit) and the “Israel Wisconsin Plan” (for more details see appendix 9.2).

Facing the global financial and economic crisis, the Israeli Government afforded incentives and credit facility to high tech industries as well as to various other industries, including corporations and factories in need. This orientation would facilitate preventing deterioration in low-skill workers unemployment caused by the crisis. However, one may expect from this response to crisis no impact on poverty and inequality reduction. The “package deal” was an attempt to provide incentives for employers and workers, allowing the Government to pursue reforms in agreement with the workers, unions and economic organizations, together with improving the conditions of the labour force, corporations and the overall economy.

Improving its productivity is a good way for a firm to increase its competitiveness on national and international markets. Such improvement may be achieved by different means among which workers training has attracted much attention in recent years. Training is especially important for developing countries which face the double challenges of opening up to international competition and the inadequacy between supplied and demanded skills. This paper investigates the extent to which the provision of training to workers by firms helps them improving their productivity.

The analysis combines a unique data set from Morocco, which gives detailed information about firms’ decision concerning training, corporate governance, institutional environment and so forth in 1999, and the yearly survey of manufacturing  (giving a limited set of information) to investigate the relationship between a firm’s training decision in 1999 and its productivity in subsequent years. The analytical framework assumes a Cobb-Douglas production function for firms where technical progress is not exogenous but depends on training. It also allows for output to depend on unobserved-time-invariant firm characteristics.

Controlling for unobserved heterogeneity among firms and endogeneity of production factors, the estimation shows that training has a significant and positive impact on firms’ productivity. Two firms with one standard deviation difference in training efforts will have 6% difference in productivity. The magnitude of this effect is slightly higher than in comparable studies but remains reasonable. Moreover, the finding is robust to the introduction of various control variables. The implication is that investing in human capital (through workers training) is potentially an important tool for firms to meet the challenge of globalization. The results also have a policy implication for developing countries. Since investment in human capital may be subject to market failures, governments support may be needed to further spread training among firms.

In a world of interconnectedness countries face new challenges alongside with opportunities. According to the econometric analysis, conducted by the authors, indirect trade impact has pronounced benefits. These are opportunities for growth and industrial development available for the MENA countries. This report has found that the full potential of trade reforms is yet to be completely understood and thus far from being fully realized. Egypt and Jordan seem to be on the right track implementing business-friendly reforms and fostering better investment climate.

However, the governments must be focused on immediate and long-term challenges too. Econometric parameters stress the direct negative influence on the incomes of the poor. So far the rise in inequality and poverty in the region, according to available statistics has been mild or slowing in some countries, compared to other developing regions. Yet these trends are easily reversed if the policy focus shifts elsewhere.