Week-6

Complementary Reforms and the Link between Trade

Openness and Growth in Albania

LINDA KALTANI

Abstract

This article uses previous findings by Chang, Kaltani & Loayza on the important role that reform complementarities play in the link between trade openness and economic growth to investigate whether reforms in a particular country, Albania, are sufficient for trade to be good for growth. The study simulates the growth-producing effect of Albania’s reforms given a pre-established change in trade openness and contrasts it with other countries’ performance. It then studies the reform variables and their alternative proxies by comparing their levels with those predicted by Albania’s per capita income. The article concludes that Albania’s most urgent reforms are in the areas of financial development, infrastructure and governance.

From the start of its transition to a market economy, Albania’s goal has been to one day join the European Union (World Bank 2006). Between 1992—the year in which the new democratic government undertook a ‘shock therapy’ programme to establish a market economy—and 1999 the country benefited from a preferential trade regime, known as a trade and cooperation agreement, with the EU which facilitated access to EU markets for textiles and agricultural goods (ACIT 2004). In 2000 the EU placed Albania under the Autonomous Trade Preference (ATP) scheme which allows almost all of Albania’s exports to enter the Union without facing any duties or quotas (World Bank 2005c). More recently, in January 2003 negotiations on the Stabilisation and Association Agreement (SAA) between Albania and the EU officially started, and the SAA was signed in June 2006.

1 The recognition of the July 2005 elections by

the international community and the peaceful transition to a new government make the vision of a European future a bit more real for Albania. Although EU accession is still far away, the signing of the SAA will entail further liberalisation between Albania and the EU. For this reason, it is important to question to what extent Albania is prepared to take advantage of the fast-approaching wave of trade liberalisation.

This article builds on the findings of Chang, Kaltani & Loayza (2005) which corroborate the positive link between trade openness and economic growth. More

ISSN 1463-1377 print/ISSN 1465-3958 online/07/020225-29 q 2007 Taylor & Francis

DOI: 10.1080/14631370701312329

Dr Linda Kaltani, The World Bank, Washington, DC, USA. Email: [email protected] 1

In general a Stabilisation and Association Agreement is a treaty between the EU and non-member countries

that creates a framework of cooperation among them. In the case of the countries of the Western Balkans an

SAA is part of the Stabilisation and Association process (SAp) and includes explicit provisions for future EU

membership.

Post-Communist Economies, Vol. 19, No. 2, June 2007

importantly, these findings indicate that there are significant reform complementarities in the areas of financial depth, human capital investment, infrastructure development, governance, labour market flexibility and firm entry flexibility that strengthen the link between trade openness and economic growth. These results suggest that the advisability of trade liberalisation may depend on the level of complementary reforms present in a country at the time of the trade policy change.

Driven by the findings of Chang et al., this article analyses the state of reforms in Albania. The goal of this work is to question whether the level of reforms in Albania is sufficient for trade liberalisation to promote economic growth. First, the analysis presents simulation results of the growth effect of a predetermined change in trade openness given complementarities in six areas of reform found significant by Chang et al. The simulations highlight Albania’s (as well as two comparator countries’) potential gain in terms of economic growth given the current level of development in the complementary reform areas. The adequacy of each reform variable is also compared with the level predicted by Albania’s per capita income level, a measure of overall economic development. Subsequently, we study alternative reform proxies for the six complementary reform areas mentioned above. The goal here is to examine each reform area in more depth and to highlight those that may require additional improvement. The adequacy of the additional proxies is assessed by comparing their actual level in Albania with the level that would be expected given the country’s per capita income. Given the intention to highlight areas for further improvement, only those proxies that are inadequate given Albania’s per capita level of income are discussed more extensively in this article.

The article is organised as follows. First it reviews Albania’s economic performance during the transition years. Next it discusses reform complementarities in the link between trade openness and growth. Then it discusses the empirical findings of Chang et al. Following this it evaluates Albania’s state of reforms. The final section concludes.

Albania’s Trade Performance during Transition

From the accession to power of the communist regime after World War II until its first democratic elections in 1992, Albania was one of the best examples of autarchy around the globe. In fact, aside from the alliances with the Soviet Union and China which ended in 1956 and 1978 respectively, Albania relied very little on foreign trade. As Kaplan (1994) vividly describes, ‘Albania’s was a primitive service economy: little was imported and there were no factories mass producing shoes or clothes. A . . . youth . . . begged me for gum: even in the poorest Third World countries, children sold gum: here there was none to sell’.

Eager to overcome more than 40 years of isolation, Albania pursued a policy of multilateral liberalisation right from the beginning of its transition period. In 1992 Albania signed the Trade and Cooperation Agreement with the EU, and in 1993 it applied for WTO membership. Albania became a WTO member in 2000 (World Bank 2004). In this process of global integration, Albanian tariff rates, as depicted in Figure 1, have steadily declined from 15% in 1996 to 7.3% in 2004. Albania now has one of the most liberal trade regimes in its region (World Bank 2005c).

Furthermore, the negotiations for the SAA with the EU have required Albania and other SAA candidates to foster regional cooperation with each other. As a consequence, the simplification of commercial logistics through the enhancement of simpler and more transparent customs procedures has allowed freer trade among the

226 Linda Kaltani

eight countries of South Eastern Europe (SEE-8). 2

Perhaps because of the pressure from the EU, at the end of 2004 Albania had signed free trade agreements with all the other SEE-8 countries as well as Kosovo (EIU 2005). In addition, the Albanian government is also trying to sign a free trade agreement with Turkey.

Figure 2 depicts the significant increase in Albania’s trade openness since the beginning of transition. Albania’s trade as a share of GDP has climbed from 12% in 1991 to 73% in 2003. Although imports as a share of GDP are clearly larger, the share of exports to GDP has steadily increased since 1997. The persistent current account deficit has been financed to a large extent by remittance flows from Albanians living abroad, mainly in Greece and Italy. Korovilas (1999) has estimated that remittances to Albania may have been a lot larger than has been estimated by the International Monetary Fund, that they have allowed a situation of economic stability without a balance of payments crisis, and that they have provided the hard currency to import building materials and capital goods which were vital to Albania’s economic recovery.

With the exception of 1997, Albania has made remarkable progress in its integration into the world economy, although from a very low base. Since 2000 the country’s openness seems to have peaked at around 73% of real GDP. This may be a converging point given the country’s structural characteristics. However, it may still be too early to make such an assessment given the possible detrimental impact of the past regional conflicts on Albania’s foreign trade. In a comparative context, the rate of growth of Albania’s openness, although significantly higher in the 1990s, appears to have tapered off since 2000 and has become similar to the rest of the transition countries and the SEE-8 (Figure 3). Nevertheless, convergence of the growth rates of trade openness would imply that the level of openness for Albania is likely to remain significantly below the rest of the SEE-8 countries.

In the aftermath of the communist experiment, many economists questioned where and to what extent trade should be redirected. Wang & Winters (1991), Baldwin (1993) and Collins & Rodrik (1991) concluded that high integration potentials were likely for the former communist countries vis-à-vis Western European economies. Jakab et al. (2001) have confirmed these earlier studies. However, they have also suggested that trade reorientation has been heterogeneous among transition countries

Figure 1. International trade regime, 1996 – 2004.

2 The other seven SEE-8 countries are Bosnia and Herzegovina, Bulgaria, Croatia, Macedonia, Moldova,

Romania and Serbia and Montenegro.

Reforms, Trade Openness and Growth in Albania 227

with those with more sophisticated product structures and more FDI converging at a faster rate. These findings would lead to the expectation of high reorientation for Albania’s trade that would continue into the future as the country’s export structure evolves into more high-technology products that would change its trade relationship with the EU away from one of centre to periphery.

Albania’s experience so far confirms the expectations of the abovementioned literature by displaying an almost complete reorientation of trade toward the EU (Figures 4 and 5). In 2004 more than 90% of Albania’s exports went to the EU, with Italy importing 74% of the total. The EU is also Albania’s primary source of imports, accounting for 70% of the total in early 2004. This is a significant change from the pre- 1990 period when close to 50% of Albania’s exports and imports where going to and coming from other communist countries. Albania’s trade with countries other than the EU (i.e. transition countries as well as Turkey and China) has steadily increased in

Figure 2. Albania’s trade as a share of GDP, 1991 – 2003.

Figure 3. Trade openness in transition countries.

228 Linda Kaltani

recent years. Trade is likely to increase at an even faster rate in the future due to the free trade agreements with the rest of the SEE-8 and the likely agreement with Turkey. Nevertheless, the growth rate of exports and imports with the EU is still higher than any other comparator group. It seems clear that Albania’s eyes are on the EU both as a trading partner in the short and medium run and as a full member in the long run.

Albania’s composition of trade has also drastically changed from the communist years when the country was exporting very little and exports were unprocessed primary materials, fuels and minerals (Figure 6). Today Albania’s main exports are determined by its proximity to its trading partners and low labour costs, and are mainly manufactured goods in the form of textiles and footwear and re-exports of semi- finished goods. Like exports, the composition of imports has become heavily skewed toward the manufacturing sector (Figure 7). Albania’s reliance on foreign manufacturing products lies mainly in capital equipment and building materials. In addition, in the recent past (since 1999) the country has relied less on foreign food imports but more so for minerals and fuels; this is partly due to the country’s continued

Figure 4. Albania’s sources of imports.

Figure 5. Albania’s destinations of exports.

Reforms, Trade Openness and Growth in Albania 229

electricity crises that reached unprecedented levels in 2001 – 02 and the last quarter of 2005.

With the exception of 1997, the year of the collapse of the pyramid investment schemes, Albania has experienced substantial economic growth during the transition period (Figure 8).

3 The high growth is greatly due to the reorientation of resources to

more efficient uses, in part through trade liberalisation and the ability of technological know-how to enter the country (World Bank 2004).

4 Further trade integration with the

EU and neighbouring countries is likely to continue in the future. For these reasons and in light of the empirical findings of Chang et al., it is informative to analyse whether the complementary reforms that strengthen the link between openness and growth are in place and adequate in extent in Albania. Although full EU membership

Figure 6. Albania’s composition of exports.

Figure 7. Albania’s composition of imports.

3 In the years leading to 1997 a large number of Albanians invested big portions of their savings in fictitious

businesses promising exuberant returns. The whole set-up collapsed when in early 1997 one of the companies

was unable or unwilling to pay back its customers, causing a run that threw the country into unrest and near

civil war. 4

World Bank (2004) provides in-depth discussion of the sources of growth in Albania.

230 Linda Kaltani

is still in the distant future, Albania needs to focus on removing the impediments to trade and to complete non-trade reforms so as to be able to take full advantage of trade openness in generating economic growth.

The Role of Policy Complementarities

After reviewing both the theoretical arguments for and against trade liberalisation and the findings of the empirical literature, Chang et al.

5 draw two conclusions from which

they build their work. 6

The first is that the average effect of trade opening on economic growth is positive. The second is that behind this positive average effect there is considerable diversity regarding the aftermath of trade liberalisation. This raises the question whether the observed heterogeneity is random or follows a systematic pattern. The theoretical literature indicates that the diverse growth response to openness is not arbitrary but depends on a variety of conditions related to the structure of the economy and its institutions. Two simple illustrations may serve to convey this point. The first is taken from >Calderón, Loayza & Schmidt-Hebbel (2004). They allow the effect of trade openness on growth to depend (non-linearly) on the level of per capita GDP. Figure 9 shows their results by plotting the estimated growth effect of a one-standard deviation increase in openness as a function of per capita GDP. The growth effect of openness is nearly zero for low levels of per capita GDP, increases at a decreasing rate as income rises, and reaches a maximum only at high levels of income. The conclusion would be that the growth effect of openness would be economically significant for middle and high-income countries.

Finding that the growth effect of openness increases with income in turn raises another interesting question: what is it about overall development (proxied by per capita income) that makes a country take better advantage of openness? Consider the next illustration. Figure 10 plots changes in growth rates of per capita GDP between the 1980s and 1990s versus changes in the volume of trade (as a ratio to GDP) between those two decades for a worldwide sample of 82 countries. This figure has four panels;

Figure 8. Albania’s real GDP per capita, 1980 – 2003.

5 This section and the next draw heavily on the work of Chang et al. (2005).

6 See Chang et al. for an in-depth discussion of the arguments for and against trade liberalisation and for the

most prominent empirical findings on this topic.

Reforms, Trade Openness and Growth in Albania 231

in each of them the country observations are separated according to whether they belong to the top one-third (diamonds) or bottom two-thirds (squares) of a rank distribution given by, in turn, each of the following criteria: a) secondary enrolment rates (a proxy for human capital investment); b) main telephone lines per capita (a proxy for public infrastructure); c) a subjective index of the quality of governance;

Figure 10. Changes in growth rates of per capita GDP versus changes in openness between the 1990s and 1980s.

Figure 9. Growth effect of trade openness as a function of overall development.

232 Linda Kaltani

and d) a de facto and de jure index of labour market flexibility. Each criterion used for ranking country observations is measured over the 1980s, the initial period.

Dividing the country observations into top and bottom groups makes it possible to compare the corresponding slopes for the relationship between changes in trade volume ratios and changes in economic growth rates. In all panels, the OLS line described by the bottom observations is basically flat, implying no relationship between trade opening and growth improvements. However, for the top observations, the slope of the OLS line is positive and steeper than that for the bottom group.

7 This is

quite a simple exercise, but it points to the heterogeneous growth response to trade opening which depends on specific country conditions, such as educational achievement, public infrastructure, governance and labour flexibility.

In conclusion, it appears that the eventual success of openness in terms of growth performance—and all the good things that come with growth such as employment and poverty alleviation—depends on the economic and institutional characteristics that make economic agents, both workers and firms, able to adjust to the new conditions and opportunities presented by international competition. Will firms be able to increase productivity to make their products attractive in foreign markets? Will the creation of new firms and destruction of obsolete ones (the Schumpeterian process of ‘creative destruction’) proceed smoothly, without large dislocation of employment and capital? Will workers be able to refocus their skills to be employed in emerging sectors? Will the financial system recognise and provide resources for good investment opportunities? Will public infrastructure in telecommunications, roads and ports support the process of transformation with inexpensive costs and sufficient availability? Will entrepreneurs direct their resources to activities where the country has a comparative advantage from a long-run perspective or will they concentrate on short-lived extractive sectors? Will firm owners choose a technology that takes advantage of the country’s abundant labour resources or will they regard labour costs and regulations as something to avoid? Finally, will economic agents concentrate their energies in productive activities or will they divert them to rent seeking? The answers to these questions will condition and determine the performance of the economy in the aftermath of liberalisation. They will depend on the progress the economy can make in educational achievement, financial development, public infrastructure, good governance and product and labour market flexibility.

Cross-Country Econometric Evidence

This section presents some cross-country empirical evidence developed by Chang et al. on how the growth effect of openness depends on a variety of structural characteristics, which at least in principle are subject to reform. The panel data growth regressions presented use a Generalised Method of Moments (GMM) procedure that controls for endogeneity and unobserved country-specific factors in order to estimate the growth effect of openness, as well as that of other policy and non-policy variables. In addition, and unlike previous studies mentioned, Chang et al. allow for a heterogeneous impact of openness on growth by interacting the openness measure with proxies of, respectively, educational investment, financial depth, inflation stabilisation, telecommunications infrastructure, governance, labour market flexibility and ease of firm entry and exit.

7 This is significantly so in the cases of educational investment, public infrastructure and governance. Labour

market regulation is not a statistically significant criterion in this simple example but becomes so once we use

more satisfactory econometric methods later in the article.

Reforms, Trade Openness and Growth in Albania 233

Chang et al. work with pooled cross-country and time series data, focusing on comparative information from within-country changes. The sample consists of an unbalanced panel dataset that comprises 82 countries. For each of them, there are at most eight observations, consisting of non-overlapping five-year averages spanning 1960 – 2000.

The regression specification studying reform complementarities is obtained by interacting the openness measure with each of the control variables in turn and can be written as

yi;t 2 yi;t21 ¼ b0yi;t21 þ b 0 1cvi;t þ b2OPi;t þ b3cvi;t*OPi;t þ mt þ hi þ 1i;t ð1Þ

where the subscripts i and t represent country and time period, respectively; y is the log of GDP per capita, CV is a set of control variables, and OP represents trade openness; mt and hi denote unobserved time and country-specific effects respectively; and 1 is the regression residual. Openness is interacted with the control variables one at a time in order both to simplify the interpretation of the results and not to overextend the parameter requirements on the data.

Regression results are presented in Tables 1 and 2. Table 1 shows the results of the basic regression with no interaction terms (column 1) and the results of the regressions where openness is interacted with time-varying variables (columns 2 – 5). These variables represent areas where economic reform has been most active; they are educational investment, financial depth, macroeconomic price instability and public infrastructure. Table 2 shows the regression results where openness is interacted with time-invariant variables. They represent institutional and regulatory areas where reform—often called ‘second generation’—has been most sluggish. They are indices of governance, labour market flexibility, firm entry flexibility and firm exit flexibility. These are treated as constant per country because their underlying institutional characteristics vary little over time and, partly reflecting this, there are quite limited data on their time dimension.

8

The basic regression (Table 1, column 1) shows results consistent with the previous empirical literature. Table 1 also shows the regression results that consider interaction effects between openness and time-varying variables (columns 2 – 5). An interesting pattern of reform complementarity emerges: the coefficient on the interaction between the trade volume ratio and, in turn, the secondary enrolment rate, the private domestic credit ratio and the number of telephone lines per capita is positive and significant. This indicates that the growth effect of an increase in openness depends positively on the progress made in each of these areas: more openness results in a larger increase in economic growth when investment in education is stronger, financial markets are deeper and telecommunications infrastructure is more readily available. The shared explanation for these results is related to the competitiveness of domestic firms in international markets: when domestic firms find a better educated labour force and less costly credit and communications, they are able to compete with foreign firms and expand their markets effectively. The interaction between trade volumes and inflation is not significant,

8 The ICRG governance index is available since the mid-1980s and shows some time variation. Given that we

are forced to assume that its value was the same in the 1960s and 1970s as in the mid-1980s, we make the

conservative assumption that its growth effect cannot be estimated separately from that of the unobserved

fixed effect, as is the case with the other institutional variables that are completely constant over time.

234 Linda Kaltani

possibly reflecting the fact that, for most inflation values, relative price distortions are not severe.

Table 2 shows the growth regression results when openness is interacted with the proxies of institutional and regulatory reform. Interestingly, as in the results related to time-varying variables, a pattern of complementarity emerges between openness and other reforms: the estimated coefficients on the interaction between the trade volume ratio and, in turn, the proxies for governance, labour market flexibility and firm entry flexibility are positive and statistically significant. The beneficial impact of an increase

Table 1. Economic growth and interaction between openness and other economic reforms

Interaction of openness with:

[1]

Benchmark:

no interactions

[2]

Human capital

investment

[3]

Financial

depth

[4]

Inflation

[5]

Public

infrastructure

Control variables:

Initial GDP per capita 23.1713** 23.2036** 23.2627** 23.2059** 23.3552** (in logs) 0.18 0.21 0.17 0.18 0.23

Human capital

investment

1.1621** 20.8610** 1.2105** 1.1402** 1.2594**

(secondary enrolment, in logs) 0.15 0.42 0.16 0.16 0.17

Financial depth 1.0272** 0.9421** 0.0262 1.0071** 0.9234** (private domestic

credit/GDP, in logs)

0.11 0.09 0.21 0.11 0.07

Inflation 20.4580** 20.4350** 20.4895** 20.3243 20.4364** (deviation of inflation

rate from 23%, in logs)

0.08 0.07 0.07 0.21 0.07

Public infrastructure 1.5764** 1.5904** 1.6053** 1.6050** 0.6423** (main telephone lines

per capita, in logs)

0.13 0.16 0.14 0.14 0.19

Openness:

Trade Openness (TO) 1.1959** 22.0421** 20.2553 1.3497** 3.2821** (structure-adjusted

trade volume/GDP,

in logs)

0.16 0.59 0.28 0.28 0.48

Interactions:

TO * Human capital

investment

1.0031**

0.18

TO * Financial depth 0.4629** 0.08

TO * Inflation 20.0725

0.10

TO * Public

infrastructure

0.4970**

0.09

Period Shifts:

Intercept (base period:

1966 – 70)

26.6266** 33.8398** 30.5385** 26.8523** 24.3839**

—71 – 76 Period shift 20.2987* 20.2371 20.2168 20.2698 20.2973** —76 – 80 Period shift 21.1300** 21.1488** 21.0385** 21.1052** 21.1850** —81 – 85 Period shift 23.3327** 23.3847** 23.2966** 23.3011** 23.4343** —86 – 90 Period shift 22.9064** 23.0726** 22.9450** 22.8904** 23.1684**

Reforms, Trade Openness and Growth in Albania 235

in trade openness on economic growth is larger when society has a more efficient, accountable and honest government and where the rule of law is more respected. Likewise, the positive growth effect of trade opening is stronger when flexible labour markets make it easier for domestic firms to transform and adjust to changing environments, particularly those in highly competitive foreign markets. These results also point out the importance of unrestricted firm renewal if trade opening is to have a positive growth impact, particularly regarding the firm entry margin. The interaction term between openness and firm exit flexibility is, however, not significant; whether this reflects data quality problems or a more substantial difference with the opposite margin of firm dynamics is unclear.

Albania’s State of Reforms in the Face of Increased Trade Openness

The econometric analysis presented above can be used to assess how well prepared a country is to assume the challenges and opportunities of trade openness. This can be done by calculating the growth impact of a change in openness given the country’s level of progress in each area of complementary reform. Moreover, the analysis can serve to highlight the areas where further progress will allow the country in question to increase the positive growth impact of international trade openness.

For this purpose, it is necessary to ascertain what the total growth impact of a change in openness is. This requires considering the regression coefficients on both the interaction term and the openness variable itself. Since the total impact depends on the values of the variables with which openness is interacted, it will vary from country to country. Specifically, from regression equation (1), the total impact on growth is given by the first derivative of the growth equation with respect to the openness variable then multiplied by a predetermined change in openness, here denoted D Openness:

D Growth ¼ ðb2 þ b3*Complementary ReformÞ*DOpenness ð2Þ

Table 1. Continued

Interaction of openness with:

[1]

Benchmark:

no interactions

[2]

Human capital

investment

[3]

Financial

depth

[4]

Inflation

[5]

Public

infrastructure

—91 – 95 Period shift 23.6060** 23.8088** 23.6621** 23.6020** 23.9486** —96 – 00 Period shift 24.3282** 24.6922** 24.4665** 24.3250** 24.8331**

Countries/observations 82/544 82/544 82/544 82/544 82/544

Specification tests ( p-values)

—Sargan test 0.42 0.42 0.37 0.39 0.47

—2nd. order correlation 0.15 0.14 0.15 0.14 0.14

Notes: Cross-country panel data consisting of non-overlapping five-year averages spanning 1960 – 2000.

Dependent variable: Growth rate of real GDP per capita.

Estimation method: GMM-IV system estimator (Arellano & Bover 1995; Blundell & Bond 1997).

Numbers below coefficients are the corresponding robust standard errors. * (**) denotes statistical

significance at the 10 (5)% level.

Source: Chang et al. 2005.

236 Linda Kaltani

where the symbol D means change and b2 and b3 are the estimated coefficients on openness by itself and the interaction term. Here ‘complementary reforms’ are those variables that have a significant interaction with openness in the growth regression. Clearly, the growth effect of a change in openness will be a linear function of each complementary reform. To scale the function at reasonable values, the change in openness is set equal to one standard deviation of the openness measure used in the regression analysis. Figure 11 plots (or simulates) the function in expression (2) for the full range of sample values of each of the six complementary reforms: educational

Table 2. Economic growth and interaction between openness and institutional/ regulatory reforms

1

Interaction of openness with:

[1]

Governance

[2]

Labour market

flexibility

[3]

Firm entry

flexibility

[4]

Firm exit

flexibility

Control variables:

Initial GDP per capita 23.4019** 24.0229** 23.0202** 23.2063** (in logs) 0.33 0.24 0.21 0.18

Human capital investment 1.2845** 1.5146** 1.7603** 1.2424** (secondary enrolment, in logs) 0.16 0.16 0.16 0.11

Financial depth 0.9632** 1.2870** 0.9063** 1.3196** (private domestic

credit/GDP, in logs)

0.12 0.12 0.12 0.12

Inflation 20.3830** 20.3513** 20.5266** 20.2848** (deviation of inflation rate

from 23%, in logs)

0.08 0.08 0.08 0.07

Public infrastructure 1.5912** 1.6379** 1.4037** 1.0532** (main telephone lines

per capita, in logs)

0.17 0.12 0.14 0.13

Openness:

Trade Openness (TO) 0.0802 23.7359** 23.5333** 1.6581** (structure 2 adjusted trade

volume/GDP, in logs)

0.33 0.64 0.69 0.27

Interactions:

TO * Governance 2.9617** (governance: index from

ICRG, 0 – 1)

0.87

TO * Labour market flexibility 8.9986** (labour: index from DB,

0.21 – 0.80)

1.36

TO * Firm entry flexibility 7.4593** (entry: index from DB,

0.25 – 0.94)

1.31

TO * Firm exit flexibility 20.8598

(exit: index from DB, 0 – 1) 0.73

Period shifts:

Intercept (base period: 1966 – 70) 30.1810** 39.9023** 34.5819** 20.0764** —71 – 76 Period shift 20.2943* 20.6062** 20.3485* 20.6757** —76 – 80 Period shift 21.1737** 21.5945** 21.2628** 21.5267** —81 – 85 Period shift 23.4484** 23.7077** 23.6949** 23.5881** —86 – 90 Period shift 23.1087** 23.3740** 23.3734** 22.9243** —91 – 95 Period shift 23.9498** 23.9600** 24.0722** 23.5820** —96 – 00 Period shift 24.6800** 24.4676** 24.8611** 23.8035

Reforms, Trade Openness and Growth in Albania 237

investment, financial depth, telecommunications infrastructure, governance, labour market flexibility and firm entry flexibility. Therefore, the range of the x-axis in each panel varies and corresponds to that of each complementary reform proxy. Moreover, the proxies for educational investment, financial depth and telecommunications infrastructure are in log form, and thus their ranges may take on negative and positive values. Governance, labour market flexibility and firm entry flexibility are captured by indices spanning only the positive space.

Since for policy analysis the most current reform values are the most relevant, the range corresponding to the latest period (1996 – 2000) is highlighted in bold.

9 This

bold line is reform-specific and thus varies from panel to panel, but it has the common feature of lying to the right of the all-period range since reforms have advanced since 1960, and improvement is captured by movement to the right on the x-axis of each panel.

For all the reform variables in Figure 11 except the governance index, the total growth impact of openness changes from negative to positive as progress occurs. Therefore, in principle, for five out of the six complementary reforms an increase in openness could bring a reduction in economic growth if a given complementary area is not sufficiently advanced. In practice, given the current state of reform progress around the world (highlighted by the bold horizontal lines), this concern is presently relevant for half the complementary areas under consideration. For educational enrolment, financial development and governance, the results indicate that they would not cause growth to decline with increased openness given that their current values exceed the corresponding threshold below which trade liberalisation would damage growth (this would be any value to the left of each line’s intersection with the x-axis in Figure 11). However, regarding telecommunications infrastructure, labour market flexibility and firm entry flexibility, there are countries that currently stand to lose

Table 2. Continued

Interaction of openness with:

[1]

Governance

[2]

Labour market

flexibility

[3]

Firm entry

flexibility

[4]

Firm exit

flexibility

Countries/observations 82/544 79/523 82/544 78/518

Specification tests ( p-values)

—Sargan test 0.37 n.a. 0.38 n.a.

—2nd. order correlation 0.12 0.28 0.13 0.25

Notes: Cross-country panel data consisting of non-overlapping five-year averages spanning 1960 – 2000.

Dependent variable: Growth rate of real GDP per capita.

Estimation method: GMM-IV system estimator (Arellano & Bover, 1995; Blundell & Bond 1998).

Numbers below coefficients are the corresponding robust standard errors. * (**) denotes statistical

significance at the 10 (5)% level. 1 The measures of institutional and regulatory reform do not vary, or vary little, over time. Their

direct impact on growth cannot be separated from that of the country-specific effect; however, we

include them as an additional control.

Source: Chang et al. 2005.

9 Clearly, for time-invariant variables the bold line will cover the whole range.

238 Linda Kaltani

from opening their markets. Focusing only on the reform indicators used in this article and taking a worldwide perspective, the implication would be that the most urgent reforms to ensure that trade promotes growth are related to infrastructure, labour markets and firm renewal, since their level in some countries is so low as to cause a negative growth effect. This is not to say, however, that countries will not benefit more from trade openness if they improve their educational attainment, financial depth and overall governance.

In addition to total growth effects (based on the coefficient point estimates), Figure 11 shows two dotted lines which are the corresponding 90% confidence bands (constructed with the estimated coefficient standard errors). Finally, each plot in Figure 11 identifies where Albania is located in 1996 – 2000 in terms of its

Figure 11. Growth effect of a change in one standard deviation of openness for various reform areas.

Reforms, Trade Openness and Growth in Albania 239

complementary-reform value and the corresponding growth effect of openness. In addition, two comparator countries are also identified. They are Croatia and Ireland. Both countries have performed like Albania or better in terms of growth and complementary reforms.

10

Given Albania’s state of reforms, a one standard deviation change in trade openness would lead to approximately a 0.9% increase in growth in the regressions with education, infrastructure and labour market flexibility, while it would lead to a 0.2%, 0.7% and 0.7% increase in the regressions with financial development, governance and firm entry flexibility respectively.

Clearly, if Albania were to make progress in any of the six reform indicators by moving further to the right on the x-axis of each panel, the effect on economic growth would be even larger. Thus, although Albania can only gain from trade openness given its state of reforms (i.e. in all six panels Albania’s impact on economic growth is a positive value), it has a lot of room for improvement in each of these areas to get closer to the best practice countries (those lying to the extreme right of the x-axis).

One limitation of the empirical estimation, and consequently of the simulations, is the fact that the reform variables are proxies commonly used in the economic literature to capture development in areas such as human capital investment, financial depth, infrastructure development, governance, labour market flexibility and firm entry flexibility. As proxies they are typically highly correlated with other variables that describe the same reform area and are therefore very often interchangeably used in the literature.

11 The choice of proxies in the Chang et al. empirical estimation was driven

by their wide availability both across countries and over time, which, in turn, guaranteed the largest possible sample from which to draw conclusions on the role of reform complementarities in the link between trade openness and economic growth. It is, however, conceivable that for some countries where reforms have been uneven, alternative proxies may portray a very different picture of the state of development of a particular reform area.

Driven by such considerations and recognising the general pattern of high cross-country correlations between variables capturing a specific reform area, this article questions whether Albania’s level of reforms, as measured by various proxies, is adequate for reform complementarities to ameliorate the positive link between trade liberalisation and economic growth. What we are looking to find is whether there are reform areas in Albania that are not as advanced as the regression proxies would suggest. These findings, in turn, would question Albania’s placement in Figure 11.

10 Croatia was picked as a regional comparator despite the fact that its growth rate for 1996 – 2000 was 4.8%,

slightly lower than Albania’s, which amounted to 5%. Ireland was picked as an example of a reformer around

the world. There was no country that scored higher than Albania in terms of labour market flexibility and also

experienced higher growth. 11

For example, in the specific case of infrastructure development, the economic literature interchangeably uses

roads, telephone lines or energy consumption. Other reform areas display the same variety of choices. Here are

some cross-country correlations of the alternative variables that are in the analysis below. The correlation

between education enrolment and education quality is 0.66. The correlation between measures of energy

sector efficiency and telecommunications is 0.5. The correlation between the quantity of credit and the quality

of the regulatory environment in the financial sector is 0.54. The correlation between the composite

governance index and its sub-components ranges from 0.76 to 0.86. The correlation of the governance index

with other measures of governance such as, for instance, the number of procedures required to enforce

contracts is 2 0.54.

240 Linda Kaltani

This exercise first compares Albania’s progress in each of the six complementary reforms used in the regressions with the level predicted by the country’s per capita income, which is the best available measure of overall development. This makes it possible to assess whether Albania is at a level of reform progress adequate for its development. Then alternative measures capturing the six reform areas are plotted against Albania’s per capita income. In those cases in which Albania’s performance is poor given its level of development, the graphical evidence would highlight areas where the country’s progress may have been uneven so as to create potential bottlenecks in the relationship between trade liberalisation and economic growth. Specifically, Figures 12 – 24 are scatter plots which display GDP per capita on the x- axis for the largest possible sample available and on the y-axis have either the actual reform proxies used by Chang et al. in their empirical analysis or alternative variables for these reform areas. The regression line described by each scatter plot can provide a prediction of Albania’s reform level given its income per capita. This in turn makes it possible to compare the actual level of the reform variable with its prediction and to conclude whether it is adequate. The discussion below will emphasise only those cases in which Albania’s performance is poor given its level of development.

The sub-sections that follow discuss complementary reforms in the areas of educational achievement, financial development, public infrastructure, governance, labour and firm entry flexibility. The analysis starts with the reform variables considered in the cross-country estimation above in the most current year available (usually 2003); then it is extended to aspects that seem most relevant for the case of Albania as determined by experts’ advice and data availability.

12

Figure 12. Infrastructure vs. income level.

12 An initial analysis looked at telephones, electricity and water for infrastructure development; school

enrolments, international educational assessment scores, teacher – pupil ratios and expenditure on education

for human capital investment; availability of private credit, legal rights, cost of collateral and creditor

information for financial development; corruption, rule of law, quality of bureaucracy, accountability of public

officials, contract enforcement, property registration and investor protection for governance; difficulty of

hiring and firing workers, rigidity of work hours and the size of the informal sector for labour market

flexibility; number of procedures, duration, cost and minimum capital for firm entry flexibility. Then, only

those proxies that appeared problematic given Albania’s level of development and given comments from

experts are discussed below.

Reforms, Trade Openness and Growth in Albania 241

Infrastructure

The cross-country regression equations presented above use as a proxy for infrastructure the per capita number of main telephone lines. This choice is driven mainly by the need to have large data coverage in terms of both countries and years. The drawback of this variable is its inability to fully depict the state of infrastructure in a particular country since it fails to consider transport, energy or roads, which are equally vital to international trade.

Regarding telecommunications infrastructure, the simulation exercise indicates that, given its level in 1996 – 2000, Albania would gain from increased trade openness. In addition, Figure 12 plots countries’ measure of per capita telephone lines against their income per capita and shows that Albania’s telecommunications infrastructure is

Figure 13. Electrical transmission and distribution losses vs. income level.

Figure 14. Electricity constraints vs. income level.

242 Linda Kaltani

adequate for its level of development although far lower than that of other SEE-8 countries.

When considering alternative proxies for infrastructure development, it becomes evident that the area that is most problematic for Albania’s infrastructure is that of energy. In fact, transmission and distribution losses, which are due to technical faults and energy theft, are very large for Albania although they have demonstrated a declining trend since the 63% peak in 1999. As Figure 13 demonstrates, Albania’s energy losses are beyond what would be expected at its level of development and are lower only than Moldova among all transition countries.

Figure 15. Electricity services vs. income level.

Figure 16. Financial development vs. income level.

Reforms, Trade Openness and Growth in Albania 243

The effect of the electricity crisis on economic activities becomes clearer in Figure 14; nearly 60% of Albanian businessmen interviewed in 2002 consider electricity constraints to be large and a major obstacle to production. This is the largest share among all transition countries and is lower only than Bangladesh in the world sample available.

The crisis in the power sector has been driven by a combination of factors. The rise in the demand for electricity over the transition years has been coupled with Albania’s unpredictability of energy supply due to its exclusive reliance on hydropower. To these constraints one can also add vast losses in transmission and distribution due to theft and technical faults. Furthermore, financial constraints (i.e. insufficient revenue

Figure 17. Credit information vs. income level.

Figure 18. Education vs. income level.

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collection) as well as a lack of connectivity to the rest of Europe and limitations in the distribution network have put a ceiling on the amount of electricity that can be imported at any particular time and forced KESH (Albanian Energy Corporation) to resort to load shedding. These difficulties, in turn, have forced private individuals and businesses to resort to expensive back-up generators and have had a negative impact on potential investment in Albania (UNDP 2004).

When businessmen are asked about the number of days during which power cuts were experienced, Albanians again reiterate their electricity problems by counting over 40 days with power cuts per year, significantly above the rest of the SEE-8 countries (Figure 15). Although the most recent data for these figures are from 2002 and 2003, the crisis in the power sector remains relevant today and has escalated to even higher levels. The weather conditions in the last quarter of 2005 led to a

Figure 19. Brain drain vs. income level.

Figure 20. Governance vs. income level.

Reforms, Trade Openness and Growth in Albania 245

widespread energy crisis (European Commission 2006). It is still unclear how large an effect this crisis will have on the economy, but the repercussions are likely to be substantial.

Financial Development

Based on the simulations of Figure 11, it can be deduced that, given Albania’s level of financial development, changes in trade openness would be beneficial to economic growth. However, the amount of private credit as a share of GDP for Albania is the lowest among the SEE-8 countries and is quite low given Albania’s level of development (see Figure 16).

Figure 21. Law and order vs. income level.

Figure 22. Enforcing contracts: number of procedures vs. income level.

246 Linda Kaltani

It is important to note that Albania has made significant progress in the past years, and the growth rate of private credit has been substantial although from a very low base (World Bank 2006). Despite such progress, Albania still lacks the rules and regulations that would permit efficient functioning of the financial sector. There is in fact concern that the credit market may be put at risk by new, increased competition in the face of poor regulations (EIU 2005). An illustration of this regulatory weakness can be found in World Bank (2005a) which, based on La Porta et al. (1998), develops measures on credit information sharing and the legal rights of borrowers and lenders. As depicted in Figure 17, the lack of information through public and private registries that keep track of borrowers’ credit histories earns Albania a very low score on the Doing Business credit information index. The lack of creditor history creates a situation of credit rationing due to imperfect information: lenders cannot verify

Figure 23. Labour market flexibility vs. income level.

Figure 24. Firm entry flexibility vs. income level.

Reforms, Trade Openness and Growth in Albania 247

potential borrowers’ credit worthiness and either provide a smaller loan than the borrower demands at the quoted interest rate (Jaffee & Russell 1976) or impose a higher interest rate on larger loans (Jaffee & Stiglitz 1990). Imperfect information can be particularly burdensome for small firms that would have difficulty getting funding from non-bank sources and thus would be forced either to resort to the informal sector or to contract their business activities (Walsh 1998).

The lack of integration of the financial sector in people’s lives is also highlighted by the fact that although Albania receives among the largest per capita remittances in the world, these mainly occur in cash and, even when not used for household consumption, do not enter the banking system where they could be efficiently channelled to large-scale, high-return investments (IMF 2006). This is part of a larger pattern of a cash-based society with the highest level of currency outside the banking system in the SEE-8 countries. Recently, however, as part of an effort to increase the use of the financial system by its citizens, the government has started to pay public sector salaries into the banking system (EIU 2005).

Educational Achievement

The simulation results in Figure 11 indicate that Albania’s level of secondary school enrolment is adequate to ensure a positive growth effect of openness. Figure 18 also suggests that Albania’s quantity of education is broadly in line with the level predicted by its level of per capita income.

A fairly similar conclusion can be given regarding the quality of education in Albania. Albania participated in the 2000 Programme for International Student Assessment (PISA), which evaluates how far students in the last years of secondary school have acquired essential knowledge and skills in the areas of reading, mathematical and scientific literacy. Although Albanian students performed worse than their peers in other transition countries, the scores were consistent with what would be predicted given Albania’s level of development. Despite such findings, it is clear that Albania needs to invest more in education and human capital development in order to better face the potential competition from the more skilled labour present in its neighbourhood (World Bank 2006).

Whether Albania’s students will be able to perform well in the future is uncertain. One indicator of concern comes from statistics from UNICEF which indicate that expenditure on education by the Albanian government was 2.6% of GDP in 2002, the lowest of the SEE-8 and higher only than Georgia and Armenia among all transition countries (UNICEF 2003). Although it is possible that reductions in government spending on education are caused by a reduction in inefficiencies in the budget, there is evidence that the cost of schooling has become a reason for children to drop out of school as transport costs due to school closures have become a significant family burden, and drastic cuts have occurred in teacher training and school maintenance (Hertz, Meurs & Satarkulova 2005).

Another area of concern that seems to be emerging from the BEEPS (2002) data is the widespread impact of the brain drain phenomenon on Albania’s businesses. On a scale of 1 – 5 Albania’s firms rate the impact of the departure of skilled workers to foreign countries on the survival of their business at 3.2, which is the highest rating among the transition countries and matched only by Macedonia among the SEE-8 countries (Figure 19). The critical impact of the brain drain on the Albanian economy is also highlighted by UNDP (2006), which points out that during 1990 – 2005 more than 50% of Albania’s scientists and researchers left the country, and nearly 50% of

248 Linda Kaltani

those were under the age of 40. Moreover, the report points out that there is evidence that nearly 60% of highly educated Albanians abroad are not working in their field of expertise, warranting concerns not just of ‘brain drain’ but ‘brain waste’.

Although mass emigration has served as a safety valve on the Albanian labour market during the transition years and has significantly contributed to Albania’s economy through large amounts of remittances, it has also restricted Albania’s pool of qualified human resources. This vicious circle can be quite detrimental to the country as educated individuals leave to find opportunities abroad and the government, in turn, finds it not worthwhile to invest in educating its citizens better, as possibly highlighted by the lower share of education expenditure in GDP.

Governance

The governance indicator used in the regressions is a composite index from Political Risk Services (2003). The components used, which are based on subjective opinions of domestic and international experts, measure the prevalence of the rule of law, democratic accountability of state actions, absence of corruption and the efficiency of the bureaucracy. By looking at the simulations, one can deduce that Albania’s level of governance would allow a positive effect of trade openness on growth. However, Albania’s level of governance is below what would be predicted by its level of economic development and is the lowest among the SEE-8 countries (Figure 20). Clearly there is a lot of room for improvement which would strengthen the positive impact of trade liberalisation on growth.

It can also be helpful to look at each individual component making up the governance index in order to pinpoint the areas that are most problematic given Albania’s level of development. It appears that, although corruption seems to be widespread within the political system, the area of governance where Albania is most lagging behind is law and order (Figure 21).

13 The indicator measuring law and order

assesses both the strength and impartiality of the legal system and popular observance of the law. In this particular area of governance Albania is lagging behind not only the SEE-8 countries but also all the transition countries. This seems to indicate that the legal system has failed to generate trust—partly because the courts are not independent enough and partly due to the legacy of the communist years—and has thus contributed to a widespread tendency for citizens to ignore the laws of the country (Broadman et al. 2004).

The weakness of the courts and legal institutions can be particularly detrimental to potential investment and business relations if contract enforcement is lengthy and unpredictable. For instance, as depicted in Figure 22, in instances of contract enforcement of overdue debt, the number of procedures mandated by law or court that demand interaction between the parties or between them and the judge or a court administrator are excessive in the case of Albania (only Serbia and Montenegro has more procedures than Albania among the SEE-8 countries). A large number of procedural steps has the potential to increase the length of a court case, impose more regulation and complexity on dispute resolution, imply higher costs, and fuel more corruption and bribe extraction.

The failure of contract enforcement, in turn, forces firms to avoid local courts as much as possible and affects their willingness to acquire new (potentially more

13 The idea here is that there is an expected negative link between the level of corruption and a country’s

economic performance. However, this view has been countered by arguments that corruption may not

necessarily be inconsistent with the level of development; see Kaufmann (1997) for a discussion.

Reforms, Trade Openness and Growth in Albania 249

profit-generating) clients and suppliers due to the fear of being cheated and not being protected by the judicial system, thus leading to lost opportunities to trade (Broadman et al. 2004). Evidence from the BEEPS data, in fact, confirms that firms rely on mutual trust and long-lasting relations in their business and tend to structure transactions in ways that minimise contractual risk (i.e. prepayment, non-use of credit). Moreover, what makes the bottleneck in the legal system and its associated institutions an ever more pressing issue is the underdevelopment of alternative resolution channels such as mediation or arbitration (Broadman et al. 2004). In the case of Albania, improving governance has become a major priority as it is a precondition for the country’s negotiations on the SAA. Therefore, Albania has a lot to gain from improved institutions both in terms of economic growth and a European future (European Commission 2006).

Labour and Firm Flexibility

The measure used to capture labour market flexibility is a de jure index presented in the Doing Business database (World Bank 2005a) which captures three aspects of labour market conditions: difficulty of hiring workers, difficulty of dismissing workers and rigidity of working hours. The firm entry flexibility index is derived from Doing Business and Index of Economic Freedom (Heritage Foundation 2003). It measures de facto and de jure challenges of establishing a new business which come in the form of the associated time and cost as well as the number and leniency of the application for entry procedures.

14

The regression results show that labour and firm entry flexibility are the areas of reform that are most important to the positive relationship between openness and growth. In the case of Albania the simulations imply a positive impact on economic growth given the level of regulations on labour and firm entry in the country. In addition, the overall indices of labour and firm entry flexibility are both satisfactory given the country’s level of per capita income (Figures 23 and 24). Albania also fares quite well relative to neighbouring countries. Thus, given its level of reforms in these areas, Albania is likely to benefit significantly from trade openness. This conclusion holds true even when individual components making up the indices or alternative regulation proxies (for instance, the extent of the informal sector) are taken into consideration.

In the case of the labour market flexibility index, it appears that in Albania it is quite easy to hire workers without much regulation on the use of term contracts or a minimum wage. The component that evaluates the ability of firms to shed workers looks at whether firms are required by law to notify and possibly get permission from trade unions or the labour ministry. Albania’s regulations again do not appear stringent in this category. The last component of the labour flexibility index looks at the rigidity of hours and measures whether night or weekend work is allowed and whether the days of vacation provided meet a minimum criterion. In this category Albania performs slightly worse that its level of income would predict but the difference does not appear to be substantial and is similar to other transition countries.

As for the firm entry flexibility index, it seems that the number of procedures that a start-up would have to comply with in Albania is close to what would be predicted by its level of income. The same can be said of the costs associated with starting a

14 See O’Driscoll et al. 2003.

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business, the days it takes to complete a procedure, and the overall level of regulation of the start-up process by the government.

Therefore, it appears that when it comes to the ability of the private sector to reinvent itself by either adjusting the demand for labour or changing the number of firms in the market, Albania’s businessmen are able to compete with the rest of the transition countries and with their SEE-8 counterparts.

Conclusions

This article is based on new evidence by Chang et al. (2005) on the positive link between trade openness and economic growth and the important role of certain reform complementarities in this relationship. These reform complementarities are educational investment, financial depth, public infrastructure, governance, labour market flexibility and firm entry flexibility. The goal of the article is to investigate whether Albania’s level of complementary reforms can enhance the link between trade openness and economic growth. Since the collapse of the communist regime in 1992 Albania has been writing a new history for itself and has been slowly integrating with the rest of Europe after decades of isolation. If Albania is to benefit from the opportunities offered by global integration, it is important to focus on non-trade reforms and to analyse their adequacy to foster a positive link between trade openness and economic performance.

The article first reviews Albania’s trade and output performance in the years of transition, highlighting the country’s continued efforts to liberalise its trade regime, its reorientation of trade towards the EU and the drastic change in the composition of both imports and exports to reflect its revealed comparative advantage. Subsequently, the article simulates the growth-producing effect of Albania’s reforms in light of a pre- established change in trade liberalisation and places such performance in a context by comparing it with two other European economies. The main conclusion of the exercise is that, despite being much lower than the comparator countries’, Albania’s reforms would be conducive to positive economic growth in the event of a change in trade openness. Furthermore, the level of each reform proxy is compared with that predicted by Albania’s per capita income, which is used as a broad measure of overall development and provides a way of gauging whether reforms have progressed at the same pace as the performance of the overall economy. This exercise makes it possible to highlight certain reform areas that seem inadequate given Albania’s level of per capita income. Finally, to arrive at a thorough assessment of the progress of each reform area, other reform proxies are compared with the level predicted by Albania’s per capita income.

The overall exercise highlights three areas of reform that are crucial for Albania’s link between trade openness and economic growth. First, in the area of infrastructure, the energy sector comes at the top in terms of its needs for further reform. Second, Albania’s level of financial development remains inadequate despite recent rapid progress. In this context, of vital importance is the creation of credit information agencies that would streamline the assessment of the creditworthiness of potential borrowers. Finally, the issue of governance is particularly important for Albania both for its link to economic outcomes and its crucial role in the continuation of negotiations between Albania and the EU. Within this broad realm, improvement in the indicators of law and order, which capture aspects of the judicial system and the business climate, are found to be particularly crucial.

Reforms, Trade Openness and Growth in Albania 251

Although Albania’s much-desired reintegration with the world has been successful in generating higher trade, there is significant room for the country to improve its ability to benefit from its trade liberalisation by lowering the non-trade policy and institutional barriers that make it difficult for Albanian firms to compete abroad. Despite the fact that this article has focused on the areas that seem most in need of further improvements, it may be useful to reiterate that the empirical findings on which this work is based are clear in indicating that any reform progress will always be beneficial to economic growth.

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