Debate: “Should governments push for higher domestic value added in export sectors?”

David Dollar, Arkebe Oqubay & Christopher Cramer
Jun, 2024
#Trade and FDI
#Services

Debate between David Dollar, Arkebe Oqubay & Christopher Cramer

David Dollar is a senior fellow in the John L. Thornton China Center at the Brookings Institution. Before he joined Brookings, David was the U.S. Treasury’s economic and financial emissary to China. He has also worked 20 years for the World Bank, serving among others as country director for China and Mongolia and in the World Bank’s research department. He has written highly influential publications on economic reform, globalization, and economic growth and poverty and is co-editor of the Global Value Chain Development Report 2019.

Arkebe Oqubay is a Senior Minister and has been at the centre of policymaking for three decades. He spearheaded Ethiopia’s industrial policy, which included, among other things, a deliberate strategy to attract productive FDI into Ethiopia’s light manufacturing industries and promote domestic linkages. Arkebe serves as board chair and vice-chair in many leading public enterprises, including Ethiopian Airlines. He is a Professor of Practice at the University of Johannesburg and at SOAS, University of London and also was the African candidate for the post of UNIDO’s Director General.

Christopher Cramer is Professor of the Political Economy of Development at SOAS, University of London, and Distinguished Visiting Professor at the University of Johannesburg. He has published extensively on economic development and rural labour markets in Africa, among other topics. Arkebe and Christopher have jointly authored (with John Sender) the freely downloadable African Economic Development: Evidence, Theory, and Policy (OUP 2020) and co-edited The Oxford Handbook of Industrial Policy with the Oxford University Press as well as the Oxford Handbook on the Ethiopian Economy.

Developing countries often try to increase the domestic value added of their exports. Those exporting natural resources try to create forward linkages, processing minerals or agricultural products locally. Countries that successfully export labour-intensive manufactures, assembling garments for example, often try to integrate backwards – producing yarn and cloth or even cotton locally. The basic idea is to retain value in their countries and diversify their economies. David Dollar argues that governments should avoid creating “artificial” incentives to use of local inputs, as this lead to exports of inferior quality and decreased competitiveness. Governments are not good at interfering in how much value added of a product must be produced locally. Countries should rather specialise on those steps of the production process in which they have comparative advantages. Arkebe Oqubay & Christopher Cramer challenge this proposition. They see the need for industrial policies that coordinate and stimulate targeted investments to increase domestic value, secure better positions within global value chains and steer structural change.

David Dollar: In assessing Global Value Chains, developing countries should target total value added, not the value-added share.

The emergence and expansion of Global Value Chains (GVCs) has been a boon to developing countries. Traditionally, international trade consisted of a product produced in one country, consumed in another. Trade enabled countries to export the items that they had in abundance and to import ones that they lacked. GVCs opened up new trading opportunities by breaking up the production process into a series of discrete steps and intermediate products. GVC trade crosses at least two borders during the production process, and often many more. GVC trade now accounts for about two-thirds of world trade. Widely traded products such as autos and electronics often have hundreds if not thousands of components, which can now be produced in different countries.

The emergence of GVCs has had a major effect on development opportunities by making it easier for developing countries to participate in manufacturing GVCs. Under traditional trade, developing countries tended to export primary products that they had in abundance – oil, minerals, agricultural products. It was difficult to break into manufactures because this involved producing a complete good, with design, technology, different types of inputs, and branding and marketing. With GVCs, on the other hand, it is possible for a developing country to specialize in certain activities along the production chain, without having to produce a complete product. The decade of the 2000s, in particular, was a time in which GVCs expanded; the number of discrete steps in almost all production chains increased; and developing countries became a key locus of manufacturing production. In 1985 developing country manufactured exports were less than 1% of world GDP; by 2008 that share had increased more than five-fold. This period was one of particularly rapid GDP and employment growth for developing countries, with a concomitant fall in absolute poverty.

While developing countries have benefited from GVCs, they worry that they will be stuck permanently with an unfavourable role in the division of labour. Studies have documented that for iconic products like the IPhone, only a tiny fraction of value added is contributed by developing countries, whereas more advanced economies provide and profit from the high-value inputs. A question that naturally arises then is whether developing countries should set, as a target of policy, to increase the domestic value- added share in their exports. Paradoxically, such a target does not make sense and may be counter-productive.

First, let’s stipulate that it is natural for developing countries to want to produce more value added overall (economic growth). Most value added comes from labour so this is also a target to create more jobs, especially formal sector jobs that have better pay and benefits. Jobs in the export sectors will typically fall into this category. To expand the total number of jobs in exports will require improvements in key foundations such as schooling and infrastructure. The government plays a key role in fostering the expansion of these inputs. This argument is not about a laissez-faire approach versus an interventionist government; it is about what government interventions are effective at increasing total value added and enhancing human welfare.

Second, let’s note that as successful economies develop, the value added share in specific exports will typically go up in some sectors and down in others. GVCs are organized by multinational firms, and they will be looking for ways to cut costs by shifting more production to suppliers in the developing world. However, there are also country-sector cases in which the domestic value added share of exports goes down. Korea’s exports of electronic products, which have been phenomenally successful, has been accompanied by a steady decline in domestic value added versus imported value added. Korean firms use the best imported components and services, and that enables them to be globally competitive. If the government had tried to restrict imports of components and services for electronics production, the industry would have been less successful with less overall export and value added production.

In theory, an all-knowing government might be able to distinguish sectors in which some protection of domestic suppliers would encourage successful development of clusters, versus sectors in which the protection makes the whole industry globally uncompetitive. But in practice governments do not have a good track record with these kinds of import-substituting policies. A relevant contrast is between Bangladesh and Pakistan. The latter encouraged backward linkages from garments to cloth and yarn and cotton. Bangladesh opened up more and gave its garments producers access to the best global inputs. The result is that Bangladesh is a much more successful exporter and its approach has led to more total value added exported and more manufacturing jobs. Aside from information asymmetries that make government intervention problematic, there is also a political economy issue: corruption will tend to distort government choices. Industries lobby for temporary, “infant- industry” protection, but once in place the protection becomes permanent. A few favored firms benefit, but not the larger economy. In my 20 years in the World Bank, I found that this was the best argument for trade liberalization: industrial policy inventions were generally made on political, not economic grounds.

Most developing countries have learned these lessons and allow duty-free imports of parts and components. Without this, it is hard to get MNCs to consider your production location. But an interesting trend in global trade is that more and more value added in manufactures trade comes from services sectors. This reflects several trends: there is a growing Intellectual Property – especially software – contribution to value chains; also, the management of complex chains relies on services like telecom, transport, and finance. While developing countries are relatively open to trade in goods, especially parts and components, they tend to be relatively closed to trade and investment in services. This is the new frontier in liberalization for developing countries.

In summary, developing countries would do well to open their economies widely, including to intermediate parts and services. There is an enormous agenda of things that the government must do to underpin success, including education, infrastructure, regulatory framework, financial stability, to name some key ones. The issue is not government versus market but rather the division of labor between the two. The government interfering in how much value added of a product must be produced locally is not likely to be a priority use of scarce government resources.
Arkebe Oqubay & Christopher Cramer reply to David Dollar: Why governments need to push for local value added?

David Dollar rightly emphasises the astonishing expansion of Global Value Chains (GVCs) and the trade in intermediaries that has been a key feature of this. And he rightly emphasises that integrating into GVCs has helped developing countries (well, some of them) overcome barriers to securing a greater share of global manufacturing exports. But he is too complacent about how difficult it is in fact to thrive and ‘upgrade’ within a world dominated by GVCs.

He also rightly states that thanks to the rise of GVCs developing countries have come to claim a share of global manufactured exports five times higher than in 1985 and that this period was also associated with fast growth, rising employment, and poverty reduction. What he fails to point out is that this growth in manufactured exports was far from evenly distributed; rather it was highly concentrated – as was the growth and the poverty reduction – in countries characterised by a variety of policies that despite their differences were united in defying free market theories: they were not the paragons of ‘openness’ and small states that Dollar goes on to recommend.

And his argument that targeting a rise in the domestic value-added share of their exports may ‘paradoxically’ be counterproductive for developing countries oversimplifies the challenge. The realities are more complicated. Yes, manufacturing export jobs are very important and often have better pay and conditions than alternatives; but at the same time the rapid rate of growth of manufacturing export jobs has often involved systematic, artificial institutional repression (at best) of wages, especially women’s wages and where there have been improvements these owe a lot to collective union pressure and conflict. Yes, states can be corrupt and fail; but they don’t fail equally and markets also fail societies frequently and dismally. Yes, encouraging transnational companies (TNCs) and FDI can bring many benefits; but those countries that have done best through integrating into GVCs have managed FDI rather than simply opening the floodgates.

And yes, states do need to invest in education and infrastructure – ever more so, in fact. But they need to do significantly more than this light touch ‘facilitative state’ of the sort encouraged by the recently (finally) disgraced Doing Business Index. Dollar suggests that South Korea, where as electronic exports have risen in a phenomenal success story so domestic value added share has fallen, is somehow a vindication of the government standing back: “If the government had tried to restrict imports of components and services for electronics production, the industry would have been less successful with less overall export and value added production”. He argues that developing economies should open up widely, not only to imported inputs but also to global services, given how much of the final value of today’s goods derives from branding, telecoms, finance, logistics.

We interpret South Korea’s experience differently. It is a very good example of what Keun Lee calls the ‘in-out-in again’ sequence. It may well be that what Dollar envisions – opening up tout court to TNCs – is at least to some extent effective early on but that it is extremely limiting over the longer run. Developing countries that attract TNCs and through them get a foot on the ladder of upgrading are not then automatically propelled on an escalator: they need to clamber and pick their way upwards. For that they need some degree of independence. As Lee and others observed, foreign value added (FVA) rose in South Korea, fell during a period of retreat from GVCs (for example, in the auto industry), then rose again when Hyundai and others re-entered GVCs but with capabilities in place to compete at a more sophisticated level. While this non-linear development unfolds, domestic productive capabilities and the ‘ecosystem’ of production linking firms, infrastructure, and knowledge all develop domestically, bringing more jobs, and many better jobs, as well as higher shares of the profit from global trade.

GVCs have varied enormously – they cannot all be grouped together glibly. Some have clearly opened up learning opportunities, decent employment prospects, and developmental dynamics. Some have led to countries and sectors getting stuck with few spillovers or learning dynamics. This variation is what matters and looking more closely at it can be illuminating. What has made the difference between South Korea and Mexico, between Taiwan or China and Romania? Private sector dynamism is a huge part of it but again and again we have to acknowledge the role of states: targeted credit and export subsidies, conditional openness to FDI, and indeed at times import protection, and the targeted use of SEZs.

There are many variants. Morocco combines incentives to the private sector with a dramatic state-backed social housing programme and uses state-owned holding companies as spearheads of industrial policy. As one Standard & Poors analyst put it: ‘A well-run state-owned company is better than a badly run private- sector company’. One of the success stories has been Morocco’s auto industry, where a large number of foreign companies now operate and where the government (‘extremely demanding but extremely supportive’ as Renault’s Morocco managing director told the Financial Times) has also forced them to draw on local suppliers.

If institutional streamlining has helped in Morocco just as much as tax breaks, clear institutional support was one of the key features of Ethiopia’s dramatic rise in foreign investment through the 2010s. Ethiopia in its own way also engaged in the kind of ‘managed opening’ that in different ways characterised Taiwan, South Korea, and others. One of the most striking corporate successes in Africa in recent years has been the expansion of Ethiopian Airlines, evolving as Africa’s largest air carrier. A state-owned enterprise, Ethiopian Airlines has been at the heart of a government- backed set of coordinated investments (by the state, TNCs, international financial institutions, and Ethiopian investors) for example in high value agricultural export production and in freight handling capacity. Its expansion has been part of a network of linkage effects drawing in high value exports, tourism, and even initiatives to manage the global pandemic. It has also been extraordinarily well led for many years but one of its moves in recent years was – precisely appreciating the need for service sector opening that Dollar notes – to forge a partnership with DHL to expand logistics capabilities and competitiveness.

Foreign investment in Ethiopia had grown slowly in the years to 2013 but then after 2014 inflows jumped four-fold, reaching $4.3 billion in 2017. That happened because of government policies that included targeting leading brand investors (e.g. in garments) and massive investment in developing an industrial ecosystem through specialized industrial parks aiming to develop forward and backward linkages or verticality, supported by productive infrastructure (air freight capacity, rail and dry port facilities) and mechanisms for dialogue with investors to develop productive partnerships which have facilitated skills development, knowhow transfer, and inter-firm linkages. Although it is early days, linkages have developed already: to fabric mills, accessory production, and packaging in the textiles and garment sector, to production in Ethiopia of malt for the rapidly growing brewery sector, and to aerospace manufacturing, aviation training and maintenance, and airport management around initial expansion of Ethiopian Airlines. Without building new industrial parks with a clear commitment to sustainability, leading investors would not have arrived. And without the investment, there would not have been the pressure on the government to gradually improve policymaking in a process of trial-and-error (to ‘fail better’, as Samuel Beckett would have it) by addressing constraints that were then revealed.

We think that David Dollar’s suggestion that industrial policy requires an ‘all-knowing’ state does not reflect today’s understanding of industrial policy. Industrial policy is about coordinating and stimulating investments, securing a place within global value chains and helping to steer structural change rather than simply accepting what ‘the market’ doles out; it is about balancing public interests with those of private firms, and it is about encouraging the myriad intimate connections of learning and productive links among actors in an economy. During the Covid-19 crisis, which threatened the existence of firms and jobs, industrial policy in Ethiopia meant building on established capabilities and relationships to protect against disaster and even to grab new opportunities for repurposing production and increasing exports.

Of course, the South Korean experience also reminds us (if we have been paying attention to Parasite and Squid Games) what strains societies face if they do embrace the ideology of growth above all and with full liberalization, as the country shifted in a more ‘neoliberal’ direction from the early 1990s onwards. Let us be clear: states fail and markets fail, repeatedly. The trick is to fail better, and states can both help markets fail better and fail better themselves: they also have to help create and join markets in the first place.

Beyond the narrow imagination of much economics, we can learn from experiences in the USA and UK and others especially during and in the wake of wars, from earlier experiences of catching up with the UK, and from the long history of economic thought in China. These experiences all deepen the ideas of markets as social institutions rather than outside society and governance, and as institutions that states have often governed and participated in to promote strategic goals of welfare, survival, and development. An essential feature of industrial policy has been experimenting, trial and error, and learning. That will continue to be the case for effective integration into GVCs. Abundant evidence shows that optimal outcomes are not automatic and that targeted policies are what enables successful structural change through integration into GVCs.
Reply to Arkebe Oqubay & Christopher Cramer:

The specific question that we are debating is not whether governments should have industrial policy – all governments do. The question is whether it makes sense to set specific goals for the share of domestic value added in exports. In reality, the share of domestic value in exports varies enormously across sectors and products, so having a single numerical target is impossible. The question then is whether it is effective for the government to set product-by- product targets. Are these binding regulations or aspirations? No successful exporter has taken this approach. There are lots of policies that can encourage backward linkages, such as infrastructure and human capital investments. If governments do these things, backward linkages will naturally occur – but to a different extent in each industry because production chains are so different. If governments require the use of domestic inputs but have not made these investments in infrastructure and people, then the policy condemns one’s firms to low productivity and poor competitiveness.

Most developing countries have learned these lessons and have open trade for parts and components. But many countries still protect their service sectors, and services are becoming an increasingly important input into manufacturing production. This is because products are increasingly “smart,” with software and design being a big input. Also, services such as finance, transport, and telecom are essential for managing modern value chains. There is research evidence that using imported services increases the quality of manufactured exports of developing countries. Hence opening up service sectors is the new frontier of trade liberalization.
Reply to David Dollar:

The question of specific quantitative targets is a bit of a diversion. We have no difficulty agreeing that specific quantitative targets for the share of domestic value-added in exports are not the most effective policy focus. But David Dollar argues that the best way for developing countries to secure benefits within GVCs is by liberalising almost everything, and that the wave of liberalisation should now wash over services trade.

However, to make the most of integrating into GVCs and to drive up domestic value- added overall requires strategic public-private coordination and a strategy that goes beyond infrastructure, generic human capital investment, and trade openness tout court. The record of economic history makes that very plain.

This goes just as much for services as it always has for manufacturing. Service sector liberalisation, including in GVCs, has not been key to remarkable structural change in Japan or China, nor to Brazilian or Chilean high-value agricultural exporting. Developing countries need to be open to imported services, for sure, in some areas (we gave Ethiopian Airlines’ joint venture with DHL for logistics as a good example). Nevertheless, they also need to nurture domestic service value-added capabilities, which do not just flow ‘naturally’. Building capabilities for knowledge-intensive service activities is about far more than investing in training colleges and schools. These capabilities need firm-level tacit knowledge, acquired through learning-by-doing. That needs time, market space, and patient finance. The key to financing and creating space for learning by doing lies in public-private dialogue; it also relies not just on incentives but, above all, on linking incentives to performance. If the learning is too slow and capabilities do not build, TNCs may up sticks and move on.
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