International Competitiveness, Investment and Finance

A. Ganesh Kumar, Kunal Sen, Rajendra Vaidya

• Publisher: Routledge
• Year: 2003
• ISBN:
  9781134383078
• Edition: 1
• Topic: Commerce
• Subtopic: Commerce Général

The three authors have been working on this topic for several years and bring considerable expertise to the book What determines international competitiveness is of great interest and relevance to policy makers and academics India is a particularly relevant case study for international competitiveness theories The book is concise and well written

1

Competitiveness, investment and finance

Analytical links

International competitiveness generally refers to the ability of a country to expand its share in world markets. It is well known that most of the developing countries export mainly primary commodities (agricultural products and minerals), which have been facing a long-run decline in prices in the world market (this is the Prebisch-Singer thesis; see Sarkar and Singer 1991; Bleaney and Greenaway 1993; Sapsford and Chen 1998 for recent evidence). Thus, it is being increasingly recognised both among academicians and policy-makers that the capacity of a country to increase its standard of living in the long term depends on the competitiveness of the manufacturing sector (Singh and Howes 2000; Fanelli and Medhora 2002).

At a fundamental level, the competitiveness of a country in a particular commodity depends on the price at which it delivers the commodity in a foreign market in comparison with the price offered by competing countries for that commodity in the same market. At an analytical level, the evolution of overall competitiveness of a country over time depends on both macroeconomic and microeconomic factors.

The most important macroeconomic variable influencing international competitiveness is the real exchange rate. In the standard neo-classical model, given its assumption of complete wage-price flexibility, any disequilibrium in balance of payments (BOP) in the country in question (possibly arising from differences in the ability of countries to compete in world markets) can only be resolved by adjustments in the real exchange rate.

At the micro level, traditional trade theories have seen competitiveness in terms of factor endowments (labour, capital, natural resources, etc.) of a country and have argued that unit labour costs are the key determinants of international competitiveness. New trade and technology-based theories, on the other hand, have stressed the importance of non-price factors such as investment, technological capability and quality as being more important than price factors in the ability of an industry or firm to gain international competitiveness. A thread common to both the traditional and new trade theories is that all the factors identified as influencing competitiveness are ‘real’ factors. Both these sets of theories, and the empirical literature following these two approaches, ignore important financial factors that can affect the capacity of a firm to compete internationally. Yet, modern views on finance, originating from the asymmetric information/agency costs framework, argue that the financial environment could impose constraints on firms to obtain investible funds and thus constrain their ability to under-take costly investments required to compete in international markets.

The relationship between finance and international competitiveness has remained under-researched in the literature on finance and development. In the presence of asymmetric information/agency costs in financial markets, a country's level of financial development may have a significant impact on its ability to compete in manufacturing exports. This is because the manufacturing sector is characterised by two features that make firms in this sector depend greatly on external funds for financing their investments. First, the manufacturing sector is often characterised by increasing returns to scale, as compared to the agricultural sector, which is characterised by constant or decreasing returns to scale (Young 1928; Kaldor 1967). Second, typically, firms in this sector need to obtain credit for working capital purposes prior to the production process. Due to asymmetric information/agency costs, financial intermediaries will incur transaction costs when channelling savings to entrepreneurs. A more efficient financial system leads to a decrease in these transaction costs and consequently, an easier access to external finance. This would imply that the structure of incentives for production can easily shift to the sector that relies more on external finance for investment needs, that is, the manufacturing sector (Kletzer and Bardhan 1987; Beck 2002). Thus, economies with a strong or well-developed financial system will be more able to channellise savings to firms in the manufacturing sector and thereby, overcome finance constraints. This provides a robust positive link between the level of financial development in a particular country and the ability of the country to compete in manufacturing goods in world markets.

There have been few empirically grounded country-level studies of the determinants of international competitiveness that examine the latter within an analytical framework that stresses financial and real constraints to international competitiveness.¹ This study attempts to fill this gap in a developing country context. From a policy perspective, especially in the context of a developing country, it is important to study the links between the real and financial factors in affecting international competitiveness, as reforming the financial sector may have implications for export performance if the level of financial development is an important determinant of the country's international competitiveness.

We posit the relation between the real factors and the financial factors through the volume of investments undertaken by a firm. That is, productivity growth, technological upgradation and the capacity to deliver the required quantities (i.e. the scale of operation) are firm-level factors that affect the ex-factory competitiveness and these are directly influenced by the firm's investment decisions. The decision to invest would of course depend on the firm's perception of the future returns that the investment would yield. However, how much is actually invested depends on the availability and the cost of funds. The latter in turn depends on the institutional setting in the financial sector and the efficiency of this sector in making funds available at the right cost to those sectors and firms where the potential for growth is the highest. A weak institutional setting in the financial sector, which is typical of most developing countries, can raise the cost of investible funds for a firm, and thus reduce the amount that a firm actually invests, which in turn would restrict its ability to compete in international markets. We test our hypothesis empirically using India as a case study.

Past studies that empirically examined international competitiveness have been at an aggregate level in terms of overall export performance, and/or at the sectoral level, where export performance of individual sectors was related to various real factors such as unit labour costs, investment, measures of technology, etc. (Fagerberg 1988; Amendola et al. 1993; Magnier and Toujas-Bernate 1994; Agenor 1997). The modern literature on empirical industrial organisation has emphasised the presence of significant inter-firm heterogeneity within a sector/industry, which if unaccounted for may lead to incomplete understanding of the underlying phenomena and in the worst case even misleading conclusions.² For example, many studies in various contexts have stressed the importance of differences in firm size, which a study at the sectoral/industry level would be unable to take into account. In our empirical investigations, we attempt to account for heterogeneity in some selected firm characteristics, including firm size. As we shall see later, accounting for firm heterogeneity enriches our understanding of the determinants of international competitiveness.

In this book, we study international competitiveness at the aggregate level, at the sectoral (industry) level and at the firm level. We test our hypothesised link between investments and exports at both sectoral and firm levels, and then proceed further to examine the link between financial factors and firmlevel investments, thus completing the chain of reasoning. We provide below the theoretical framework used to establish the above mentioned links.

1.1

The theoretical framework

BOP constraint, international competitiveness and economic growth

Perhaps the clearest statement on the importance of international competitiveness in exerting a positive impact on economic growth comes from Thirlwall (1979). In Thirlwall's framework, a country's ability to move to a higher growth path would depend on whether it can relax the BOP constraint on economic growth, that is, a higher growth path would inevitably lead to an increase in imports and a worsening of the balance of trade (and consequently, the BOP). For the country to observe rapid economic growth without coming up against the BOP constraint, it would need to increase its export growth. This would depend both on world income growth (which would determine the overall growth of exports) and on the ability of the country to move into the more dynamic commodities and markets in world trade. Given that world income growth is exogenously determined, it is critical for the country's policy-makers to increase the international competitiveness of its commodities in order to observe faster growth in exports, and thus, of output. In Thirlwall's model, an increase in the international competitiveness of a country's commodities would come about by an increase in the income elasticity of world demand for the country's exports. Such an increase would be through both price and non-price channels, the latter including infrastructural improvements, technological upgradation and faster capital accumulation.

The increase in the income elasticity of world demand can manifest itself as a change in the export basket towards commodities whose world demand is relatively more rapidly growing, and/or towards markets that are growing faster than the world average. The constant market shares (CMS) model provides a framework for tracing the changes in a country's export basket and market focus, by decomposing growth in exports into four components, namely a world trade effect, commodity composition effect, market distribution effect and a competitiveness effect. This analysis would enable us to evaluate export performance at the sectoral level setting the stage for identifying the factors affecting sectoral competitiveness.

Investment and sectoral competitiveness

Most analyses of sectoral competitiveness distinguish between price and non-price factors. Evolution of sectoral unit labour costs is the most critical price determinant of international competitiveness. Among non-price determinants, perhaps the variables most widely discussed in the literature are investment and technology. Much of the empirical studies on international competitiveness, mostly in the developed country context, have concentrated on the role of technology in determining the latter, with technology being measured by patents, research and development activity, scientists and engineers in total population, etc. (Dosi et al. 1990; Grossman and Helpman 1991; Lall 1998). There is little doubt that technological progress has been a crucial determinant of economic growth in the advanced market economies (Fagerberg 1994). Furthermore, the ability of manufacturing firms in the newly industrialising countries to close the ‘technology gap’ between these countries and ‘technology leaders’ in the West can explain to a great extent the increasing international competitiveness demonstrated by the manufacturing sectors of these countries (Amsden 1989, 2001; Wade 1990). However, it is arguable whether technology catchup factors such as the ability to innovate or to invest in research and development can play an important role in influencing the international competitiveness of the majority of developing countries, many of whom have primitive institutional structures for research and development activity and a weak legal framework relating to intellectual property rights (Evenson 1995).³ In this book, we instead emphasise capital accumulation as the crucial non-price determinant of international competitiveness in developing countries. In so arguing, we follow Fagerberg (1988) who had originally put forward the thesis that ‘the growth in market shares for a country at home and abroad does not only depend on technology and prices, but also on its ability to deliver’ (Fagerberg 1988:359). As Fagerberg argues, this ability to deliver is in turn determined by the country's investment rate. To the extent that investment in new plant and machinery embodies new technology, this variable in fact could partly capture some of the technology-related factors stressed in the literature mentioned earlier. We apply Fagerberg's hypothesis to industry-level data in India for the period 1989–90⁴ to 1997–98. In our empirical analysis, we try and disentangle the role of price factors from investment in determining sectoral competitiveness, as measured by the industry's share in world total exports of the commodity.

Exporting behaviour at the firm level

The use of industry as the unit of analysis has significant conceptual weakness as argued earlier. We take our analysis of international competitiveness one step further by examining this issue at the level of the firm. Traditionally, the analysis of export performance at the firm level has borrowed from theories of industrial economics and the literature on multinational corporations. Based on the various theories of firm performance (especially the structure-conduct-performance paradigm) researchers have incorporated size/scale and market structure as variables that explain inter-firm variations in export performance. Firm size is used to indicate scale economies in producing and exporting and the capacity to overcome the inherent risks and information costs involved in exporting. Market structure variables (typically measures of concentration and entry barriers) are included to account for inter-industry differences in the incentive to export (White 1974; Glejser et al. 1980).

The literature on multinational corporations has emphasised the need to understand how international comparative advantage is acquired by the firm. This approach recognises that skills, technology and in fact scale economies are firm specific because they have been created, at least partly, by the firms themselves by their past effort and investment. The set of variables that this approach stresses include expenditure on research and development (R&D), royalty payments, expenditure on advertising/marketing and managerial and technical skills (Caves 1996). We review in Chapter 5, some of the empirical work in this regard with respect to India.

In our own empirical work, we borrow from two strands in the recent literature. The first emphasises the presence of sunk costs which a nonexporting firm must incur to enter export markets for the first time (Dixit 1989a,b; Krugman 1989). The two most important sunk costs include the cost of gathering information about demand conditions in foreign markets and the cost of establishing or gaining access to a distribution system in foreign markets. It is generally assumed that these sunk costs recur in full if the firm exits the export market and wishes to re-enter those markets. These one time sunk costs and uncertainty (which is inherent in the production decision) would induce persistence in a firm's exporting status. In other words, a firm that has already incurred the sunk costs in the past would be more likely to export in the current period. An implication of this at the aggregate level is that export supply function becomes sensitive to the nature and number of firms that are exporting at any given point in time. If the number of exporting firms changes very slowly over time then it automatically restricts the responsiveness of exports to changing relative prices, growth in world trade and the policy environment (the so-called hysteresis in trade flows).⁵

The second strand of literature that we use relates to the lumpiness of investment activity arising due to the non-convex cost of adjusting capital stock. This approach stresses that small adjustments to capital stock are not feasible because almost all investment projects of consequence (e.g. investment in plant and machinery) are not available in small quantities (Cooper et al. 1999; Cooper and Haltiwanger 2000). Consequently, investments at the firm level are likely to be characterised by bursts of investment activity (investment spikes) followed by relatively long periods of inactivity. This is in stark contrast to the traditional neo-classical model of investment/capital accumulation that assumes convex cost of adjusting capital stock leading to smooth adjustment of capital stock to its optimal level.

The recent empirical studies on exporting behaviour at the firm level have restricted themselves to analysing the role of sunk costs (Roberts and Tybout 1997; Bernard and Jensen 1999, 2001). Our empirical analysis of the exporting behaviour of firms integrates the above two strands of literature, which we believe adds substantially to our understanding of exporting behaviour. Moreover, it provides us a link to analyse the role of financial factors in influencing investments and ultimately export behaviour.

Investment and finance

The relationship between investment and finance has remained a controversial issue in the literature on economic development. Much of the earlier debate in this area has revolved around the arguments of McKinnon (1973) and Shaw (1973) who postulated a strong complementarity between the accumulation of financial assets and physical capital. Recent developments in the theories of asymmetric information and contract enforcement as applied to financial markets provide further support for the view that the availability of loanable funds has a strong positive relationship with investment expenditures of firms, independent of other determinants of the latter. According to this literature, external finance, if available at all, may be more costly than internal finance because of transaction costs, contract enforcement (agency cost) problems and asymmetric information.⁶ The argument rests on the distinction between ‘insiders’ (the firm's owners/managers) who have full information about a particular firm's investment prospects, and ‘ou...