Measuring Trade Openness: A Systematic Review
Conventional measures of trade openness based on trade volumes relative to GDP have come under criticism. Such an approach may overlook economies of scale, potential for monopolistic pricing practices, and whether weather shocks on one sector in one country may be offset by offsetting demand from nearby countries.
Methods
Conventional measures of trade openness rely on import and export measures that do not sufficiently normalize or filter to isolate value added, distorting exposure to foreign shocks. We propose an alternate measure, high order trade (HOT), that abstracts from direct trade.
This measure represents the degree to which a country depends on foreign production and is more accurate than conventional welfare cost of autarky calculations because it takes into account any potential gains that would arise from shifting closer toward free trade. Furthermore, HOTT measurements tend to be more consistent as they don’t vary based on variables like GDP per capita which may differ widely among nations.
Empirical results support our general perception that HOTT provides an accurate measure of openness and growth. We present pooled cross-section regression results as well as conditional correlation analyses taking account of country size effects.
Results
Trade-to-GDP ratio is an increasingly widely-accepted proxy of how dependent an economy’s producers and consumers are on foreign supply, making trade a proxy measure of integration into global markets. Research on openness and growth has focused heavily on this indicator as an indication of country integration into international trade markets; its findings demonstrate clearly: countries more open to trade grow faster than those less open; this effect holds even when controlling for additional variables including quality instruments.
Conventional measures of openness tend to have an extremely skewed distribution across sectors: closed sectors are more often the norm. Therefore, as Alcala and Ciccone emphasize, conducting growth regressions with multiple indicators or robustness tests is key in order to understand their consequences. HOT is one such de-facto measure which, like its predecessors, has been found associated with higher economic growth, labor productivity and import synchronization; in addition to that it also corrects for the uneven distribution of sectoral openness.
Conclusions
Conventional measures of trade openness tend to use ratios of imports and exports to GDP as an indicator of trade openness, with this measure offering an overview of what forces drive economic development. Unfortunately, this approach can present several problems.
First, trade openness increases productivity by stimulating demand for tradable goods; however, this may have an adverse impact on nontradables, increasing denominator levels more than numerator counts and thus decreasing conventional measures of trade and thus their capacity to explain growth.
Numerous studies have addressed this topic by employing either real or hybrid measures of openness that take into account both its de-facto and financial components, adding regressors to account for country size or other potential confounders, with results usually suggesting openness is an excellent predictor of growth and income levels.
Recommendations
Economic openness is generally expected to promote growth for numerous reasons, including its ability to help countries take advantage of comparative advantages, specialize their workforces and foster innovation. Yet evidence supporting this prediction may be lacking.
One reason is that the choice of openness measure has an outsized influence on regression results, for instance the effects of various de-facto openness measures can vary dramatically on growth regression results (Rodriguez and Rodrik 2001; Yanikkaya 2003).
At present, various measures of economic openness rely on different sources of data and emphasize different aspects of it. Therefore, when selecting an openness measure it is crucial that due consideration be given to selecting one based on case-based theoretical justification and robustness checks – ideally using only one indicator across all growth regressions; an exports and imports ratio to GDP ratio remains one widely used de-facto measure of trade openness.
