Author: Admin
“New Goods” Trade in the Baltics
We analyze the role of the new goods margin—those goods that initially account for very small volumes of trade—in the Baltic states’ trade growth during the 1995-2008 period. We find that, on average, the basket of goods that in 1995 accounted for 10% of total Baltic exports and imports to their main trade partners, represented nearly 50% and 25% of total exports and imports in 2008, respectively. Moreover, we find that the share of Baltic new-goods exports outpaced that of other transition economies of Central and Eastern Europe. As the International Trade literature has recently shown, these increases in newly-traded goods could in turn have significant implications in terms of welfare and productivity gains within the Baltic economies.
New EU members, new trade opportunities
The Eastern enlargements of the European Union (EU) that have taken place since 2004 included the liberalization of trade as one of their main pillars and consequently provided new opportunities for the expansion of trade among the new and old members. Growth in trade following trade liberalization episodes such as the ones contemplated in the recent EU expansions could occur because of two reasons. First, because countries export and import more of the goods that they had already been trading. Alternatively, trade liberalization could promote the exchange of goods that had previously not been traded. The latter alternative is usually referred to as increases in the extensive margin of trade, or the new goods margin.
The new goods margin has been receiving a considerable amount of attention in the International Trade literature. For example, Broda and Weinstein (2006) estimate the value to American consumers derived from the growth in the variety of import products between 1972 and 2001 to be as large as 2.6% of GDP, while Chen and Hong (2012) find a figure of 4.9% of GDP for the Chinese case between 1997 and 2008. Similarly, Feenstra and Kee (2008) find that, in a sample of 44 countries, the total increase in export variety is associated with an average 3.3% productivity gain per year for exporters over the 1980–2000 period. This suggests that the new goods margin has significant implications in terms of both welfare and productivity.
In a forthcoming article (Cho and Díaz, in press) we study the patterns of the new goods margin for the three Baltic states: Estonia, Latvia and Lithuania. We investigate whether the period of rapid trade expansion experienced by these countries after gaining independence in 1991—average exports grew by more than 700% between 1995 and 2008 in nominal terms, and average imports by more than 800%—also coincided with increases in newly-traded goods by quantifying the relative importance of the new goods margin between 1995 and 2008. This policy brief summarizes our results.
Why focus on the Baltics?
The Baltic economies present an interesting case for a series of reasons. First, along a number of dimensions, the Baltic countries stood out as leaders among the formerly centrally-planned economies in implementing market- and trade-liberalization reforms. Indeed, those are the kind of structural changes that Kehoe and Ruhl (2013) identify as the main drivers of extensive margin increases. Second, unlike other transition economies, as part of the Soviet Union the Baltics lacked any degree of autonomy. Thus, upon independence, they faced a vast array of challenges, among them the difficult task of establishing trade relationships with the rest of the world, which prior to 1991 were determined solely from Moscow. Lastly, as former Soviet republics, the Baltic states had sizable portions of ethnic Russian-speaking population, most of which remained in the Baltics even after their independence. At least in principle, this gave the Baltic economies a unique potential to better tap into the Russian market.
Defining “new goods”
We use bilateral merchandise trade data for Estonia, Latvia and Lithuania starting in 1995 and ending in 2008, the year before the Global Financial Crisis (GFC). The data are taken from the World Bank’s World Integrated Trade Solution database. The trade data are disaggregated at the 5-digit level of the SITC Revision 2 code, which implies that our analysis deals with 1,836 different goods.
To construct a measure of the new goods margin, we follow the methodology laid out in Kehoe and Ruhl (2013). First, for each good we compute the average export and import value during the first three years in the sample (in our case, 1995 to 1997), to avoid any distortions that could arise from our choice of the initial year. Next, goods are sorted in ascending order according to the three-year average. Finally, the cumulative value of the ranked goods is grouped into 10 brackets, each containing 10% of total trade. The basket of goods in the bottom decile is labeled as the “new” goods or “least-traded” goods, since it contains goods that initially recorded zero trade, as well as goods that were traded in positive—but low—volumes. We then trace the evolution of the trade value of the goods in the bottom decile, which represents the growth of trade in least-traded goods.
Findings
For ease of exposition, we present the results for the average Baltic exports and imports of least-traded goods, rather than the trade flows for each country. Results for each individual country can be found in Cho and Díaz (in press). We report the least-traded exports and imports to and from the Baltics’ main trade partners: the EU15, composed of the 15-country bloc that constituted the EU prior to the 2004 expansion; Germany, which within the EU15 stands out as the main trade partner of Latvia and Lithuania; the “Nordics”, a group that combines Finland and Sweden, Estonia’s largest trade partners; and Russia, because of its historical ties with the Baltic states and its relative importance in their total trade.
Least-traded exports
Figure 1 shows the evolution over time of the share in total exports of the goods that were initially labeled as “new goods”, i.e., those products that accounted for 10% of total trade in 1995. We find that the Baltic states were able to increase their least-traded exports significantly, and by 2008 such exports accounted for nearly 40% of total exports to the EU15, and close to 53%, 49% and 49% of total exports to Germany, the Nordic countries, and Russia, respectively. Moreover, we find that the fastest growth in least-traded exports to the EU15 and its individual members coincided with the periods when the Association Agreements and accession to the EU took place. Finally, we discover that the rapid increase in least-traded exports to the EU15 during the late 1990s and early 2000s is accompanied by a stagnation of least-traded exports to Russia. This suggest that, as the Baltics received preferential treatment from the EU, they expanded their export variety mix in that market at the expense of the Russian. Growth in least-traded exports to Russia only resumed in the mid 2000s, when the Baltics became EU members and were granted the same preferential treatment in the Russian market that the other EU members enjoyed.
Figure 1. Baltic least-traded exports
Source: Cho and Díaz (in press).
Least-traded imports
Figure 2 plots the evolution of Baltic least-traded imports between 1995 and 2008. We find that new goods imports also grew at robust rates, but their growth is about half the magnitude of the growth in the least-traded exports—the least-traded imports nearly doubled their share, whereas the least-traded exports quadrupled it. The least-traded imports from the EU15 and its individual members exhibited consistent growth throughout. On the other hand, imports of new goods from Russia—which had also been growing since 1995—started a continuous decline starting in 2003. This change in patterns can be attributed to the Baltics joining the EU customs union. Prior to their EU accession, the average Baltic tariff was in general low. Upon EU accession, the Baltics adopted the EU’s Commercial Common Policy, which removed trade restrictions for EU goods flowing into the Baltics, but—from the perspective of the Baltic countries—raised tariffs on non-EU imports, in turn discouraging the imports of Russian new goods.
Figure 2. Baltic least-traded imports
Source: Cho and Díaz (in press).
Are the Baltics different?
Figure 1 shows that the Baltic states were able to increase their least-traded exports by a significant margin. A natural question follows: Is this a feature that is unique of the Baltic economies, or is it instead a generalized trend among the transition countries?
Table 1: Growth of the share of least-traded exports (percent, annual average)
Source: Cho and Díaz (in press).
Table 1 reveals that the new goods margin played a much larger role for the Baltic states than for other transition economies such as the Czech Republic, Hungary and Poland (which we label as “Non-Baltics”), for all the export destinations we consider. Moreover, we find that while until 2004—the year of the EU accession—both Baltic and Non-Baltic countries displayed high and comparable growth rates of least-traded exports, this trend changed after 2004. Indeed, while there is no noticeable slowdown in the Baltic growth rate, after 2004 the Non-Baltic growth of least-traded exports to the world and to the EU15 all but stops, with the only exception being the Nordic destinations.
Conclusion
The Baltic states, and in particular Estonia, are usually portrayed as exemplary models of trade liberalization among the transition economies. Our results indicate that the Baltics substantially increased both their imports and exports of least-traded goods between 1995 and 2008. Since increases in the import variety mix have been shown to entail non-negligible welfare effects, we expect large welfare gains for the Baltic consumers experienced due to the increases in the imports of previously least-traded goods. Moreover, the literature has documented that increases in export variety are associated with increases in labor productivity. Our findings reveal that the Baltics’ increases in their exports of least-traded goods were even larger than their imports of new goods, thus underscoring the importance of the new goods margin because of their contribution to labor productivity gains.
References
- Broda, Christian; and David E. Weinstein, 2006. “Globalization and the gains from variety,” Quarterly Journal of Economics, Vol. 121 (2), pp. 541–585.
- Chen, Bo; and Ma Hong, 2012. “Import variety and welfare gain in China,” Review of International Economics, Vol. 20 (4), pp. 807–820.
- Cho, Sang-Wook (Stanley); and Julián P. Díaz. “The new goods margin in new markets,” Journal of Comparative Economics, in press.
- Feenstra, Robert C.; and Hiau Looi Kee, 2008. “Export variety and country productivity: estimating the monopolistic competition model with endogenous productivity,” Journal of International Economics, Vol. 74 (2), pp. 500–518.
- Kehoe, Timothy J.; and Kim J. Ruhl, 2013. “How important is the new goods margin in international trade?” Journal of Political Economy, Vol. 121 (2), pp. 358–392.
Independent Media and Contemporary Military Doctrines
Governments often take unpopular measures. To minimize the political cost of such measures policy makers may strategically time them to coincide with other newsworthy events, which distract the media and the public. We test this hypothesis using data on the recurrent Israeli-Palestinian conflict. We show that Israeli attacks are more likely to be carried out when the U.S. news are expected to be dominated by important (non-Israel-related) events on the following day. In contrast, we find no evidence of strategic timing for Palestinian attacks.
The role of media in today’s conflicts is enormous. Parties to conflicts use propaganda in state-sponsored media and enroll state-sponsored trolls in social media to gain domestic public support for their military campaigns and, more generally, to raise own popularity. Involvement of Russia in Syria and Eastern Ukraine and its coverage on Russia-sponsored TV is a forceful illustration of this. Some most devastating conflicts used state media to enroll paramilitary. For example, Yanagizawa-Drott (2014) estimated that 51,000 perpetrators in Rwandan genocide were persuaded to participate in mass killings by RTLM radio.
Not all the media are under control of parties involved in conflicts. What is the role of independent media during conflicts? It is one thing to use the dependent media to portray one’s participation in conflict in a slanted manner; it is another to change one’s military strategy in order to improve one’s image in the independent media. Do military choose the timing and the weapon for their offences depending on the expectation of how their actions will be portrayed by the independent media? A statement on June 4, 2002, by Major General Moshe Ya’alon, then the Israel Defense Forces (IDF) chief of staff designate and until recently the defense minister of Israel, strongly suggests this is the case for the Israeli-Palestinian conflict. Mr. Ya’alon said: “This is first and foremost a war of ideology, and as such the media factor, the psychological impact of our actions, is critical. If we understand that a photograph of a tank speaks against us on CNN, we can take this into account in our decision as to whether or not to send in the tank. We schedule helicopter operations for after dark so they cannot be photographed easily. … Such considerations are already second nature to us. Officers … must understand that there are strategic media considerations. The tension between the need to destroy a particular building or to use a tank or helicopter, and the manner, in which the world perceives these actions, can affect the ultimate success or failure of the campaign. Even if we triumph in battle, we can lose in the media and consequently on the ideological plane.”
Our recent paper “Attack When the World Is Not Watching? U.S. News and the Israeli-Palestinian Conflict” (Durante and Zhuravskaya, 2017) forthcoming in the Journal of Political Economy investigates how Israeli military changes the planning of its operations in Gaza and the West Bank in the face of coverage by US media. In particular, we test whether Israeli authorities choose the timing of their attacks strategically to coincide with other newsworthy events so as to minimize the negative impact of their actions on U.S. public opinion by avoiding U.S. media coverage of their military operations, especially when they might lead to civilian casualties.
Methodology
We compile a list of fully exogenous events from forward-looking political and sports calendars in the U.S. between 2001 and 2011 and verify which of these events actually dominate US TV news, leaving little or no time to coverage of other events. Then, we compare the timing of these events to the timing of Israeli attacks on a daily basis.
We also use another, more continuous measure of whether the U.S. media and the public are distracted by other important events, namely the length of top three non-conflict-related news stories during evening news on three U.S. TV networks, where the evening newscasts are limited to 30 minutes, namely ABC, CBS, and NBC. As Eisensee and Stromberg (2007) point out, due to the competition between networks for audience, we can measure the importance of newsworthy events featured on the evening broadcasts because more important stories appear before less important stories, and they are longer.
Results
Timing of Israeli attacks and their coverage in US media
We find that both the incidence and the severity of Israeli attacks increased sharply when U.S. news were dominated by other events, such as US primaries and caucuses, general elections, and Presidential inaugurations. The probability that Israel carried out an attack against Palestinians rose to 53.2% one day before these important U.S. events from 38.7% on days that did not coincide with these events (over our observation period of 11 years, which includes heavy fighting during the Second Intifada). Figure 1 illustrates this finding. Attacks which coincide with the major political and sports events are also more deadly; as a consequence, the number of victims of Israeli attacks per day is 1.51 times higher during the days that coincide with major political and sports events compared to days that do not coincide with major events.
Figure 1. IDF attacks and exogenous predictable newsworthy events in the U.S.
Source: Durante and Zhuravskaya, 2017.
Using another measure, the length of top three non-conflict-related news stories during evening news on three U.S. TV networks, we also find that Israeli attacks are significantly more likely to occur and are more deadly when top three non-conflict-related news are longer on the following day.
Does it matter which military operation?
As some military operations are more costly to postpone than others, one should expect that only attacks that are less costly to more be strategically timed to other important events. This is exactly what we find: the timing of special targeted-killing operations, which are considered as extremely urgent by IDF, is not related to U.S. news cycle. In addition, one should expect military operations to be timed to other newsworthy events only when they are likely to generate negative publicity. As negative publicity about the conflict is mainly associated with civilian casualties, and civilian casualties are more likely when the operations are executed with heavy weapons, we find that the relationship between occurrence and severity of Israeli attacks and U.S. newsworthy events on the following day holds only for operations that involve the use of heavy weapons. We also check that the attacks are only timed to predictable newsworthy events.
Why tomorrow’s coverage matters more?
Israeli attacks get news coverage in U.S. media both on the day of the attack and one day later. Why, then, Israel times its attacks to news pressure on the following day rather than on the same day? To answer this question, we analyzed the content of news broadcasts and found that the type of coverage of Israeli attacks differs substantially between same-day and next-day reports. While the same-day and next-day news stories are equally likely to report information on the number of victims, news stories that appear on the day after the attack are much more likely to present personal stories of civilian victims and include interviews with their relatives or friends. Furthermore, next-day coverage is significantly more likely to include emotionally charged visuals of burial processions and scenes of mourning. Anecdotal evidence suggests that it is both easier and safer for a foreign journalist to get details of the story on the next day; and that the next day affords an opportunity to produce emotionally charged videos of funerals. Figure 2 illustrates these findings.
Figure 2. Comparison of the content of news casts about attacks that aired on the same day as an attack and on the day following the attack.
Source: Here you can write notes to the figure, graph or table. Do not forget to state the source of the figure, graph or table.
Since people react more strongly to personal stories than to statistics and facts, and since information transmitted only through words is less likely to be retained than information accompanied by images, it is not surprising that Israel times its attacks to predictable international newsworthy events expected on the following day, as the next-day news stories are more damaging to Israel’s public image.
Conclusion
These results have broader implications. Policy makers in other policy domains and other countries may also strategically manipulate the timing of their unpopular actions to coincide with other important events that distract the mass media and the public. Examples of unpopular policies characterized by suspicious timing abound: Silvio Berlusconi’s government passed an emergency decree that freed hundreds of corrupt politicians on July 13, 1994, the day Italy qualified for the FIFA World Cup final. Russian troops stormed into Georgia on August 8, 2008, the opening day of the Beijing Summer Olympics. Political spin-doctors often release potentially harmful information in tandem with other important events. This is exemplified by a notorious statement from the former UK Labour Party’s spin doctor, Jo Moore, who, in a leaked memo sent to her superiors on the afternoon of 9/11, said that it was “a very good day to get out anything we want to bury” (see http://www.telegraph.co.uk/news/uknews/1358985/Sept-11-a-good-day-to-bury-bad-news.html (accessed on July 7, 2015) and http://www.theguardian.com/politics/2001/oct/10/uk.Whitehall (accessed on July 7, 2015)).
Overall, policy makers’ strategic behavior may undermine the effectiveness of mass media as a watchdog, thus reducing citizens’ ability to keep public officials accountable
References
- Durante, Ruben; and Ekaterina Zhuravskaya, 2017. “Attack When the World Is Not Watching? U.S. News and the Israeli-Palestinian Conflict”, Journal of Political Economy (forthcoming)
- Eisensee, Thomas; and David Stromberg, 2007. “News Droughts, News Floods, and U.S. Disaster Relief,” Quarterly Journal of Economics, 05, 122 (2), 693–728.
- Nevo, Baruch; and Shur Yael, 2003. The IDF and the press during hostilities, Jerusalem: The Jerusalem Democracy Institute, pp. 84-85, available at http://en.idi.org.il/media/1431355/IDFPress.pdf, accessed on May 18, 2016.
- Yanagizawa-Drott, David, 2014. “Propaganda and Conflict: Evidence from the Rwandan Genocide,” Quarterly Journal of Economics, 129(4), pp.1947-1994.
Intergenerational Mobility of Russian Households
To understand the nature of income inequality one needs to know how persistent the inequality is across generations. The same inequality levels could conceal different intergenerational mobility. We utilize the Russian Longitudinal Monitoring Survey (RLMS-HSE) to find out how large intergenerational mobility in Russia is as measured by income, educational and occupational mobility. We find that although a sizeable upward intergenerational educational mobility, there is a pronounced occupational immobility and a low level of intergenerational income mobility. Indeed, the position of children in the income distribution is highly correlated with the income position of their parents, especially their mothers.
Sizeable and non-decreasing inequality in Russia poses a threat to social stability and long-term sustainability. Inequality in Russia has remained high throughout the transition period, and even slightly increased in the 2000s; the Gini inequality index rose from 0.397 in 2001 to 0.416 in 2014. The ratio of average incomes of the highest decile to those of the lowest decile also increased from 13.9 to 16 during this same period. This income gap is driven primarily by the gap between incomes of the top decile and all of the others: the top decile is estimated to have thirty percent of total monetary income in the economy. Furthermore, income inequality originates in earnings inequality: the top decile of wage earners gets thirty five percent of total wage earnings in the economy.
A key question is how persistent the inequality is, given that the same inequality levels could conceal different intergenerational mobility. In particular, social stability is challenged when income inequality is stable across generations, or put differently; there is little intergenerational mobility. Economic developments of the last 25 years seem to increase the risks of getting this problem in Russia.
Data and research methodology
We employ Russian Longitudinal Monitoring Survey (RLMS-HSE) to find out how large intergenerational mobility in Russia is as measured by income, educational and occupational mobility (Denisova and Kartseva, 2016). The RLMS-HSE questionnaires in 2006 and 2011 contain questions on dates of birth, education and occupation of the father and mother of the respondent when the respondent was 15 years old.
To study occupational and educational mobility, we use the subsample of respondents of 25-55 years old and utilize the information on education and occupation of the respondent and his/her parents. We then estimate whether the parental education level predicts the probability that children have a university degree, a secondary or a junior professional degree.
To study intergenerational occupational mobility, we estimate influence of parental occupation on the probability that the child works as a manager, a professional, a technician or professional associate, a clerk, a qualified worker or an unskilled worker.
To study the child-parent income correlation based on RLMS is trickier. There is a panel component in RLMS but it is not long enough to study intergenerational mobility directly since we for most cases are not able to observe both parents and children during their working ages. To overcome the problem we impute wages for parents. In particular, we choose respondents aged 25-35 (children) in 2006 (and 2011). We then identify respondents born in the period 1945-1961 (1945-1966 for children in 2001) (‘parents’) and use the labor market information for this group as of 1995 (2001 as robustness check) to impute parental wages. We estimate a wage equation (separately for males and females) on the sample of ‘parents’ and then use the estimated returns (coefficients) and the reported age and education of respondent’s mother and father to impute wages of respondent’s parents.
We follow Björklund and Jantti (1997) to estimate the child-parent correlation of earnings based on the equation:
delta= β0 + β1X+ β2 delta_father + β3 delta_mother + ε
where delta=log(wage/average wage in respective sample), X – age, education, settlement type, region. Standard errors are clustered on primary sampling unit.
Intergenerational educational mobility
Our analysis shows that the education of parents, high professional (university) and secondary professional in particular, is a major determinant of children’s education. Moreover, there are clear signs of upward educational mobility across generations for both males and females: the coefficients in the transition parent-child matrix are significantly higher above the diagonal (Table 1).
Table 1. Father-child education matrix
Source: Authors’ calculations based on RLMS
The probability to have a university degree is 2.4 percentage points higher if the mother’s education is at university level (as compared to secondary school), and 2.1 percentage points higher if the father’s degree is at university level (as compared to secondary school). A secondary professional degree of parents also increases the probability of a child getting a university degree by about 1 percentage point. The probability of having secondary professional degree decreases if the father or mother has a university degree.
Intergenerational correlation of occupations
There are signs of sizeable occupational rigidity between generations, especially for the top two occupational groups (managers and professionals). The probability that a child works in the same occupational group is the highest for parents-professionals: it is 40% for fathers-professionals and 35% for mothers-professionals. Surprisingly, it is also rather high for parents employed as skilled workers – about 20%. These patterns survive controlling for other variables.
Income mobility
The correlation of parent-child wages measured for 2006 data are presented in Table 2. The results point to the sizeable average intergenerational rigidity of relative wages: the wage elasticity of children’s wages with respect to parental wages is about 0.4. This is at the level of the intergenerational wage rigidity in the US (Solon 1999).
There is sizeable gender asymmetry in the rigidity: we observe a high and significant correlation of son-mother wages, but an insignificant correlation of son-father wages. There is no significant correlation of daughter-parents wages.
Table 2. Parent-child income correlations, 2006
Source: Authors’ calculations based on RLMS
Conclusion
Generational poverty stemming from low intergenerational income mobility is a threat for sustainable development in any country. The economic and social development in transition seems to increase the risks of having this problem in Russia. Our estimates show that although there is sizeable upward intergenerational educational mobility in Russia, there is a pronounced occupational immobility, and low level of intergenerational income mobility. Indeed, the position of children in the income distribution is highly correlated with the income position of their parents, especially mothers. These findings are worrisome signals important for the design of policies of sustainable development.
References
- Björklund, Anders; and Markus Jantti, 1997. “Intergenerational Income Mobility in Sweden Compared to the United States,” American Economic Review, 87(5), 1009–18.
- Denisova, Irina; and Marina Kartseva, 2016, “Intergenerational Mobility of Russian Households”, mimeo
- Solon, Gary, 1999. “Intergenerational Mobility on the Labor Market,” Chapter 29 in Handbook of Labor Economics, Vol.3 edited by O.Ashenfelter and D.Card , 1761-1800.
Operating and Financial Hedging: Evidence from Trade
There is a large and growing literature that has modeled how real policies affect and interact with financial policies. It is important to consider such an interaction since a firm, just as a single value-maximizing agent, should make its strategic decisions optimally, taking into account all of its multi-dimensional facets (contracts with employees and suppliers, situation with market competitors, innovation, foreign-market operations and others – on the real side, and capital structure, dividend policy, IPO, hedging behavior – on the financial side). This policy brief introduces a new type of hedging exchange-rate risks through matching currencies of export revenues and import costs, and shows how it substitutes out financial hedging using currency derivatives.
Exchange-rate exposure and financial hedging around the world
Many firms are exposed to exchange-rate fluctuations in one way or the other. Because volatility is typically considered to be bad for a firm – either because small firms are risk-averse or because it may reduce the value of a risk-neutral firm through costly distress or agency costs – firms attempt to hedge it. Indeed many successfully do so. Bartram et al. (2009) report that about 60% of non-financial firms around the world use financial derivatives (forwards, futures, swaps, etc.), with the most popular type being currency derivatives (44%). These large numbers indicate the importance of risk management in general and hedging exchange-rate shocks in particular. There is also a considerable heterogeneity across countries. According to their investigation based on a subsample of world firms, currency derivative usage ranges from 6% in China and 15% in Malaysia, to 37% in the United States and 48% across Europe, to 80% in New Zealand and 88% in South Africa.
There is also some cross-sectional variation across firms. Geczy et al. (1997) report that among U.S. firms those with greater growth opportunities, tighter financial constraints, extensive foreign exchange-rate exposure and economies of scale in hedging activities are more likely to use currency derivatives.
Operational hedging
So what are potential alternatives to hedging exchange-rate exposure through currency derivatives? The literature has suggested other ways of reducing such cash-flow volatility – through operational hedges. The examples include diversifying the company’s operations and production geographically (as in Allayannis et al., 2001). The authors provide an example of Schering-Plough (a United States-based pharmaceutical company) that in their 1995 annual report suggested that hedging using financial instruments was not considered cost-effective, since the company operated in many foreign countries where the currencies would not generally move in parallel. More recent studies (e.g. Kim et al., 2006; Hankins, 2011) also support the geographical diversification of production and acquisition of foreign subsidiaries as important channels of operational hedging, and as such they can act as substitutes for financial hedging.
These papers are also part of the larger literature on the interrelations between real and financial strategies, and in particular the literature that has modeled how real policies, aimed at lowering operational risks (or alternatively increasing operating flexibility), reflect in various financial decisions (such as e.g. capital structure). Examples of such policies include the use of flexible manufacturing systems that allow changing the level of output, the product mix, or the operating “mode” (as in Brennan and Schwartz, 1985; He and Pindyck, 1992; and Kulatilaka and Trigeorgis, 2004); employing a contingent workforce (e.g. part-time and seasonal labor, as in Hanka, 1998 or workers on temporary contracts, as in Kuzmina, 2014); adopting a defined contribution, rather than a defined benefit or pension plan (as in Petersen, 1994); and many others.
Trade-related operational hedges
In Kuzmina and Kuznetsova (2016), we explore a different type of operational hedging – the one arising from exporting final goods and importing intermediate inputs from abroad at the same time. As previous literature has suggested, firms that export their final goods are naturally more exposed to exchange-rate risks due to their foreign-denominated contract obligations that have to be translated into domestic currency when the transaction clears in the future, the so-called transaction exposure of companies (Glaum, 2005). As long as volatility is costly for firms, higher exchange-rate exposure leads to more financial hedging, so previous papers indeed find a positive correlation between exporting and currency hedging (e.g. Geczy et al., 1997; He and Ng, 1998; Allayannis and Ofek, 2001).
This argument would similarly apply to firms that import their intermediate inputs from abroad, since they are similarly exposed to exchange-rate fluctuations on the cost side. In our paper, we attempt to provide new evidence on these channels, as well as to introduce a novel explanation to why not all firms hedge using financial derivatives. We show that firms that export and import at the same time hedge less using currency derivatives, and especially when volatility of exchange rate is high. We argue that when firms both export and import at the same time, their net foreign-denominated position (and thus exchange-rate exposure) becomes lower on average, and hence there is less incentive to hedge against it. This is consistent with foreign-currency matching of costs and revenues, which is a phenomenon also observable in other data. Although in our data we cannot observe currency of individual transactions for each firm, we do so in another project based on the data from Russia. Our calculations for Russian data, based on the whole universe of import and export declarations, suggest that for the major currencies, the probability of importing in the same currency is higher than in any other currency when a firm also exports in this currency. For example, out of all firms that have exports in Euro and some imports, 82% would import in Euro. The similar number for the U.S. dollar is 71%. Such trade-related operational hedge may arise naturally for firms in the global world, thus reducing their need to use financial instruments.
Germany as an interesting laboratory
To test our hypotheses, we use hand-collected data on a sample of German public firms during 2011-2014. Germany is a particularly relevant country for testing our hypotheses for at least three reasons.
First of all, it is the world’s third largest exporter and importer and the top one in Europe. Second and most importantly, if we want to explore currency risk arising from exporting and importing, at least some (and preferably many) of the export and import transactions have to occur in a foreign currency. This means that, for example, looking at the U.S. data would not give us a lot of power in identifying our mechanism, since according to Goldberg and Tille (2008), only 5% of all U.S. export contracts are set in a currency other than the U.S. dollar. On the other hand, more than half of German exports and imports outside the euro area are denominated in a currency other than the Euro, and in particular about 30-40% of all contracts are set in U.S. dollars. This means that our measured shares of non-euro zone exports and imports will actually have a large component of non-euro-denominated contracts, and we will have more power to measure the actual exchange-rate exposure arising from exporting and importing. Finally, we analyze the largest companies in Germany – those that trade on the Prime Standard segment of the Frankfurt Stock Exchange, since they have to disclose their use of derivatives due to the highest accounting and transparency requirements of this listing. These mandatory disclosure rules enable us to collect the data on hedging from companies’ annual reports and perform the analysis.
Identification strategy and results
To start the analysis, we provide some cross-sectional correlations. We find that firms in industries with more out-of-euro-zone exporting (importing) have a higher propensity to hedge using currency derivatives. In particular, a firm in an industry with 10pp higher export (import) shares has on average a 10.5pp (28.9pp) higher probability of currency hedging.
Although many industries simultaneously export and import a lot, others have a substantial imbalance in terms of export and import shares. We are therefore interested in whether this translates into different hedging behaviors. By adding the interaction between export and import shares in our regression specifications, we find that firms that simultaneously export and import hedge less than firms that just export or import. This is consistent with our hypothesis that firms decrease their effective exchange-rate exposure by having both revenues and costs in foreign currency and implies that operational hedging through matched currencies is a substitute for financial hedging.
In order to strengthen the result, we complement our cross-sectional correlations with a difference-in-differences methodology. To do this, we compare firms in industries with higher and lower out-of-euro-zone export and import shares during times of higher and lower exchange-rate volatility. We find that the higher the exchange-rate volatility, the larger this substitution effect is. This finding is stronger than a simple cross-sectional correlation between exporting, importing and hedging (which can be driven by omitted factors), since it uses an arguably exogenous volatility shock to show that operational hedging substitutes for financial hedging precisely during times when firms have highest incentives to hedge. The results are robust to using a set of control variables and firm and year fixed effects.
Implications
From an applied perspective, the interrelation between operational and financial strategies of the firm suggests that the decisions of the CEO and CFO should be complementary to each other to achieve the value-maximization goal of the firm. From a policy perspective, they imply that exogenous changes in government policies aimed at certain organizational changes in the firm (e.g. export promotion policies) could have indirect consequences for their riskiness and financing decisions.
References
- Allayannis, G., J. Ihrig, and J. P. Weston (2001), “Exchange-rate hedging: Financial versus operational strategies”. American Economic Review 91 (2), 391-395.
- Allayannis, G. and E. Ofek (2001), “Exchange rate exposure, hedging, and the use of foreign currency derivatives”, Journal of International Money and Finance 20 (2), 273-296.
- Bartram, S. M., G. W. Brown, and F. R. Fehle (2009), “International evidence on financial derivatives usage”, Financial Management 38 (1), 185-206.
- Brennan, M. and E. S. Schwartz (1985), “Evaluating natural resource investments”, The Journal of Business 58 (2), 135-157.
- Geczy, C., B. A. Minton, and C. Schrand (1997), “Why firms use currency derivatives”, Journal of Finance 52 (4), 1323-1354.
- Glaum, M. (2005), “Foreign-Exchange-Risk Management in German Non-Financial Corporations: An Empirical Analysis”, Springer.
- Hanka, G. (1998), “Debt and the terms of employment”, Journal of Financial Economics 48 (3), 245-282.
- Hankins, K. W. (2011), “How do financial firms manage risk? Unraveling the interaction of financial and operational hedging”, Management Science 57 (12), 2197-2212.
- He, H. and R. S. Pindyck (1992), “Investments in flexible production capacity”, Journal of Economic Dynamics and Control 16 (3-4), 575-599.
- He, J. and L. K. Ng (1998), “The foreign exchange exposure of Japanese multinational corporations”, Journal of Finance 53 (2), 733-753.
- Kim, Y. S., I. Mathur, and N. Jouahn (2006), “Is operational hedging a substitute for or a complement to financial hedging?” Journal of Corporate Finance 12 (4), 834-853.
- Kulatilaka, N. and L. Trigeorgis (2004), “The general flexibility to switch: Real options revisited”, Real options and investment under uncertainty: classical readings and recent contributions, 179-198.
- Kuzmina, O. (2014), “Operating flexibility and capital structure: Evidence from a natural experiment”, American Finance Association Conference, Philadelphia.
- Kuzmina O. and O. Kuznetsova (2016), “Operating and Financial Hedging: Evidence from Trade”, CEFIR Working paper.
Petersen, M. (1994), “Cash flow variability and a firm’s pension choice: A role for operating leverage”, Journal of Financial Economics 36, 361-383.
To Commemorate the 1917 Revolution in Russia – Occasions More for Reflections than for Celebrations
The centennial of the 1917 revolution in Russia provide opportunities for the public to refresh knowledge of the tumultuous events that dramatically changed the country’s history. Conferences, television series and debates, exhibitions at historical and art museums are some of the activities that will illuminate the February and October revolutions in 1917. The complex, intertwined and contradictory historical process and the following tragic Civil war 1918 – 1922 calls for careful, objective and dispassionate approaches and evaluations.
Over the last years, Russia has officially sponsored or encouraged great historical commemorations, e.g. the bicentennial of the war against Napoleon in 1812 and the centenary of the outbreak of the First World War. In contrast, this year’s commemoration of the 1917 revolution(s) in Russia – the first in February and the other in October (old style calendar) – pose a whole range of difficult questions. In the contemporary school curriculum in Russia, the most often used concept is ‘the Great 1917 Revolution in Russia’, thereby avoiding the previous, inappropriately counter posed February vs. October revolution. Instead, emphasis shifts to a continuous spectrum of revolutionary processes on different levels of the state and in various social groups throughout 1917. Likewise, this concept captures the multi-ethnic character of the revolution better than ‘the Russian revolution’.
In this brief, I outline the expected results from professional historians and archivists, by academic institutions and museums. In a forthcoming study of recent Russian historiographic debates (Samuelson, 2018), I intend to analyze also the changing official assessments of the 1917 revolutions.
In the Soviet era until the glasnost in the late 1980s, party-controlled historians described the ‘Great Socialist October revolution’ tendentiously, with many obfuscations and ‘white spots’. Not only were the opponents of the Bolsheviks depicted in caricature forms; also, the later oppositionists to Stalin’s party line were eliminated from the 1917 history, or mentioned merely for the alleged mistakes. In the West, on the other hand, there existed a plethora of interpretations of the Russian revolution, reflecting ideologies and worldviews of liberals, conservatives, as well as exiled Russian politicians (see e.g. Mazour, 1971 or Laqueur, 1967).
In the decades since the fall of the Soviet Union, Russian historians have profoundly enriched our knowledge of the 1917 revolutionary process as well as the ensuing Civil war. ‘Un-persons’ like Lev Trotsky, and hundreds of other who were expelled later from the Communist party, got back their due place in history. Works have been published of monarchists, liberals and socialists who led the Provisional governments during 1917. Historical studies by exiled scholars, as well as memoirs by politicians and diplomats that were once published in the West, have now been reprinted by Russian publishing companies (for the best survey, see Gennadyi Bordiugov, 2013 (1,520 pages!!)).
In today’s Russia, there co-exist an abundance of interpretations and assessments of the 1917 revolutions. The February strikes and uprising in Petrograd triggered the abdication of tsar Nikolay II, led to the founding of a republic and the formation of new government. The revolutionary changes outside the capital, throughout the whole empire, took quite different forms and only in recent years, regional scholars could describe them objectively.
Naturally, the fundamental changes in the political landscape in Russia after the return from exile of Vladimir Lenin in spring 1917 have attracted interest by scholars. Solid biographies of Lenin by Dmitrii Volgogonov (1994), Vladlen Loginov(2017), Anatolii Latyshev(1996) and Elena Kotelenets(2017), to mention only a few, give the Russian public a more nuanced figure than the more hagiographic works published in the Soviet epoch. The British historian Catherine Merridale (2016) gives a fascinating narrative of how Lenin’s return from exile in Switzerland would completely change the perspectives of the revolution. The renowned Russian specialist Vladimir Buldakov wrote profound reinterpretations of the ‘Red Troubled times’ (Krasnaya smuta) of 1917 in the first of a series of path-breaking research in the central and regional archives (Buldakov 2010, 2015).
As we approached the centennial of this decisive and deeply divisive year in Russia’s long history, many observers wondered how it was to be officially observed. Just like similar jubilee years, for example in 1989 of the French Revolution, it seemed obvious that this was not a time for triumphant celebrations as had been the case of the annual October Revolution holiday (on 7th November, new calendar) in the Soviet era. On the other hand, it would equally be unfortunate to pass over in silence this eventful revolutionary year. So by support from the Ministry of Culture, the Russian Historical Society (abbrev. RIO) set up a vast program of conferences, round tables, exhibitions and publications. Universities all over the Russian Federation will organize gatherings for historians and students. Central and regional archives arrange exhibitions, the explicit purpose of which is, not to give any definite value judgments, but to let the public form their own views on the personalities by pondering over original documents on Tsar Nikolai II and the tsarist family, the politicians of various parties, as well as on Lenin, Bolsheviks and others of the Left.
The call from the Russian political leaders has been to strive for a balanced, as dispassionate as possible, reassessment of the 1917 revolution in Russia. The ensuing civil war 1918–1922 created a generation-long, deep division among Russians, inside the country and in exile. Just as was the case in other countries, e.g. Finland and Spain, where civil wars scarred the national fabric in the 20th century, at present, the goal should be for reconciliation and mutual understanding of the historical actors on all sides of the political spectrum.
This spring, the Siberian branch of the Academy of Sciences in Novosibirsk organized a round-table on the 1917 revolution. Dozens of scholars presented their research findings and opinions on various events in the region; the protocol’s understatement that “the discussions had often a polemical character” indicate that the Russian revolution is still a subject of hot controversies, even in academic circles. On 29–31 March, the Moscow State University arranged the first of several grand international conferences planned this year. In twenty sessions, hundreds of scholars from all over Russia and from foreign countries gave papers on widely different aspects of the revolutionary processes. Likewise, universities in Samara, Volgograd, Cheliabinsk and other cities have announced their forthcoming conferences on the 1917 Revolution.
The main depository of political archives, RGASPI, in Moscow has contributed over 800 archival documents to a special exhibition, ‘1917. The Code of the Revolution’ at the Central Museum of Contemporary Political History. (https://www.sovrhistory.ru/events/exhibition/58becc2aa0e5981d9da515c4, accessed 31.03 2017). Two grand exhibitions projects with less-known archival documents attempt to give new perspectives, first, on Tsar Nikolai II, and, later this year, on Vladimir Lenin; both are of course well-known personalities, but the archivists and museums’ commissars hope to inspire visitors to renew their perspectives. In St. Petersburg, besides conferences, round-tables and exhibitions, there will be theatrical performances to reproduce dramatic events of 1917 and precisely on the streets and squares where they once upon a time took place. Russian Internet sites will provide pieces of contemporary news from 1917 for each day (https://project1917.com/).
Publishing houses have started new series devoted to the 1917 revolution in Russia, and the shelves in bookshops give abundant ‘food for thought’ for eager readers. Here one can find not only Trotsky’s own renowned History of the Russian Revolution written in his exile in the USSR. There are also memoirs by officers in the White Army during the Civil war, and a multitude of new popular-history works that reflect today’s ‘lessons of history’. The leading publishing company Rosspen will edit an archival documentary series, and compile an encyclopedia on the 1917 Revolution, thus hopefully summing up what has been accomplished in the former states of the USSR concerning the dramatic year of 1917 that was to profoundly change not only the country’s history, but even global history for many years ahead.
References
- Dmitrii Volkogonov, Lenin: A New Biography, New York, 1994;
- Vladlen Loginov, Lenin: How to become a leader, Glasgow 2017;
- Anatolii Latyshev, Rassekrechennyi Lenin (The declassified Lenin), Moscow 1996;
- Elena Kotelenets, Bitva za Lenina. Noveishie issledovaniia i diskussii (The Fight over Lenin: Recent research and discussions), Moscow 2017.
- Catherine Merridale, Lenin on the train (Swedish edition Lenins resa: Vägen till revolutionen 1917), London 2016.
- Vladimir Buldakov, Krasnaya smuta: Priroda i posledstviia revoljutsionnogo nasiliya (The Red Troubled Times: The nature and consequences of revolutionary violence), Moscow 2010;
- Vladimir Buldakov, Voina, porodivshaia revoliutsiiu (The War that brought along the revolution), Moscow 2015.
- Lennart Samuelson, Sovjetepoken i backspegeln.The Soviet Epoch in the Rear-view Mirror’, forthcoming in 2018
- Anatole G. Mazour, The Writing of History in the Soviet Union, Stanford: Hoover University Press, 1971;
- Walter Laqueur, The Fate of the Revolution: Interpretations of Soviet History from 1917 to the Present, London: Macmillan, 1967.
- Gennadyi Bordiugov (ed.), Mezhdu kanunami: Istoricheskie issledovaniia v Rossii za poslednie 25 let, Moscow: AIRO-XXI, 2013
The photograph to this policy brief shows Bolshevik leader Vladimir Lenin and other Russian exiles in Stockholm, 13 April 1917, on their way from Switzerland, to change the course of the Russian Revolution and world history of the 20th century. Social democrat Ture Nerman is talking with Lenin (4th from right, with umbrella).; behind them – mayor Carl Lindhagen and Aleksandra Kollontay, radical feminist who spent World War One here and in the 1930s to return to Stockholm as ambassador of the USSR.
Note: This Swedish photograph is in the public domain in Sweden because one of the following applies: (i) The work is non-artistic (journalistic, etc.) and has been created before 1969, (ii) The photographer is not known, and cannot be traced, and the work has been created before 1944.
Trade Preferences Removal – The Case of Belarus
How does the removal of trade preferences influence the exports of the affected country? We study this question on the example of Belarus’ loss of trade preferences granted by the EU to developing countries. Our brief argues that trade preferences are most important for simple non-manufactured goods. As a result, removal of trade preferences should increase the manufactured goods in the export structure. Indeed, the overall complexity of Belarusian exports was not harmed by the removal of EU preferences and the manufactured exports increased relative to non-manufactured exports.
Belarus losing trade preferences
As a developing country, Belarus used to receive trade preferences from the US and EU. These preferences grant duty-free imports or provide a discount on the import tariff under the so-called Generalized System of Preferences (GSP). The preferences are provided on a unilateral basis to developing countries and can also be removed on a unilateral basis for various reasons. Their stated objective is to support the economic development of poorer countries (Ornelas 2016). In particular, the US removed Belarus’ preferences in 2000 for worker rights violations. Later, the EU removed the preferences in 2007 for similar reasons. It is a relevant question for policy to understand how the removal of trade preferences affected exports.
This brief discusses the effect of trade preferences removal on the value of Belarus’ exports to the EU and on the structure of exports. Utilization of trade preferences might not be uniform across sectors. In fact, a preference-receiving country should satisfy the Rules of Origin (ROO) requirements and demonstrate that a large enough share of the exported product was produced in the country. This requirement might be more difficult to satisfy for complex manufactured goods with many components from several countries (Hakobyan 2015). Exporters of such products might find satisfying the ROO more costly than what they could gain from receiving an import tariff preference. Exporters of simple or raw products, on the other hand, face a lower cost of demonstrating the origin.
The remainder of the brief develops the hypothesis of a differential impact of trade preferences removal on manufactured and non-manufactured goods; and makes an event study of Belarus’ loss of EU trade preferences in 2007. Our findings suggest that GSP withdrawal affected disproportionally non-manufactured exports, leading to an increase in the manufacturing exports share. This means that harm caused by losing trade preferences was, to some extent, reduced by higher incentives to export more complex manufactured exports.
The complexity of Belarusian exports
To understand the overall structure of Belarusian exports, we first look at the complexity of Belarusian exports over time. Figure 1 presents the economic complexity index (ECI), developed by Hausmann et al. (2014), of exports of Belarus relative to Russia from 1995 to 2014. The ECI measures the diversity and ubiquity of a country’s exports. It considers the number of products a country exports with revealed comparative advantages and how complex these products are. In turn, the complexity of the products is accessed by a so-called product complexity index, PCI. It is determined in an analogous fashion: if few countries are able to export a good and these countries have diversified exports, this product is complex. For example, fertilizers and oil (important exports of Belarus) have low complexity scores, as countries that export these products tend to not have diversified exports.
Figure 1 shows that the difference between the economic complexity of Belarus and Russia increased following the two incidents of Belarus losing trade preferences; first from the US and then from the EU. The incidents of removal of trade preferences are associated with an increase in economic complexity of Belarusian exports relative to Russia. That is, the export of more complex manufactured goods became more important in the export basket of Belarus when it lost the trade preferences. This is consistent with the hypothesis that trade preferences are more important for simpler goods, and following a preference removal their share will go down. Russia is chosen for comparison due to its similarity in economic perspective (economies in transition, similar complexity, GDP trends, dependence on oil and fertilizer prices) and because it also received trade preferences from both the US and EU throughout the considered period.
Figure 1. GSP withdrawal and Export Complexity in Belarus relative to Russia
Note: the figure presents the ECI of Belarus over ECI of Russia in logarithmic form. Source: Authors’ calculations using the ECI data from the Observatory of Economic Complexity.
Export structure of Belarus
To make a first pass at understanding how GSP withdrawal affects the composition of exports, we conduct an event study centered on the year of 2007, when the EU withdrew its GSP preferences for Belarus. We consider the three years before and after the revocation, and benchmark the share of manufacturing exports from Belarus to the EU with its share of manufacturing exports to the US. Since the US had already withdrawn its preferences earlier, its trade regime with Belarus stayed unchanged throughout the period. This makes the US a natural point of comparison to understand the effect of GSP withdrawal.
Findings
As Figure 2 shows, the average share of manufactured products in Belarusian exports to the EU increased slightly after the GSP withdrawal, increasing to 40.4% from its earlier level of 37.9%. At the same time, mineral and fuel exports, though falling slightly, remain the backbone of Belarusian exports accounting for 50% of total exports to Europe. Interestingly, the share of non-fuel exports to the EU remained approximately unchanged at 9%. In other words, the composition of exports to Europe did not drastically change after the GSP withdrawal, as had been anticipated by some ex-ante studies (e.g. BISS 2007).
This comparison alone does not address the question of what might have happened to Belarusian manufacturing exports had the GSP preference not been removed. One possible counterfactual is that the trends in the European export market would have been the same as in the US, where Belarusian manufacturing exports massively lost ground. Their share decreased from 53.4% to 19.3%. Hence, a difference-in-difference estimator would suggest that perhaps the withdrawal of the GSP reduced non-manufacturing export growth to Europe. In turn, the Belarusian manufacturing export share is estimated to be 36.5% higher than it might have been if the GSP had not been withdrawn (statistically significant at the 1% level). This estimate may be a result of trade diversion of non-manufactured goods from the EU to the US. To the extent that non-manufacturing products benefit more from the GSP preferences, these should be stronger affected by trade diversion and would therefore reduce the manufacturing share of Belarus’ exports to the US.
Figure 2. Share of Manufacturing Exports
Note: Manufacturing includes sectors 5, 6, 7 and 8 according to the SITC classification. Source: Authors’ calculations using data from the UN COMTRADE.
Alternatively, one could consider the Belarusian manufacturing export share in relation to Russia, within the European market. For Russia, there is a pattern of declining manufacturing shares. Before 2007, manufacturing accounted for 17.7% of exports to the EU, but afterwards it declined to 14.2%, a 2.5% fall. If Belarus had experienced the same trend, its manufacturing share would have fallen from 37.9% to 34.4%. Instead, Belarusian manufacturing share grew from 37.9 to 40.4%, which suggests that due to the GSP removal, the Belarusian manufacturing export increased by 6%. Given the smaller effect size and the short sample period, this increase is not statistically significant. However, in economic terms, it would still be an important shift.
Conclusion
Although development is one of the main goals of the GSP, there is little evidence that the EU’s Generalized Scheme of Preferences supported the development of advanced industries in Belarus. To the contrary, after the GSP withdrawal the export complexity of Belarus increased relative to that of Russia. There is also some suggestive evidence that the GSP may have encouraged an export profile more focused on non-manufactured products, for which rules of origin are easier to satisfy in practice. More research is clearly needed, not least to analyze other cases of GSP withdrawal for external validity.
Our preliminary findings suggest that GSP in its current form might have created incentives for exporting relatively simple goods, thus creating a risk of “middle-income trap”. Policy implications are twofold: First, the goal of preference programmes like the GSP is development, i.e. more advanced economy with more complex production, and if the preferences in fact foster simple exports, it could create a barrier to development; Second, removal of preferences might have a large negative impact overall but the observation that it removes the previous incentive of producing simple non-manufacturing goods can be seen as positive and thus cushion the negative impact.
References
- Belarusian Institute for Strategic Studies (BISS), 2007. “Belarus exclusion from the GSP: possible economic repercussions”, at: http://www.belinstitute.eu.
- Hakobyan, Shushanik, 2015. “Accounting for underutilization of trade preference programs: The US generalized system of preferences.” Canadian Journal of Economics/Revue canadienne d’économique, 48.2, 408-436.
- Hausmann, Ricardo; Hidalgo, Cesar A., Bustos, Sebastian; Coscia, Michele, Simoes, Alexander, & Yildirim, Muhammed A. (2014). The atlas of economic complexity: Mapping paths to prosperity. Mit Press.
- Ornelas, Emanuell, 2016. “Special and differential treatment for developing countries.” Handbook of Commercial Policy 1, 369-432.ilable online, please hyperlink the title.
Too High or Too Low? The Pros and Cons of Regulating the Reserve Price in Public Procurement in Russia
In theory, an optimally set reserve price leads to an optimal outcome in all standard auctions. In reality, however, it is difficult to identify the optimal reserve price. In public procurement auctions, a higher reserve price may lead to a higher competition for the contract, because more suppliers will find the contract profitable. Thereby a higher reserve price may lead to lower prices. But on the other hand, if competition in the market is already quite low or the risk of collusion is high, a higher reserve price will just lead to higher contract prices. The controlling bodies in Russia become suspicious when the reserve price in public procurement auctions is too low because they are afraid it is a sign of collusion between the procurer and the seller. Indeed it may be the case that the reserve price is set low to exclude other sellers from competing, thus acting against efficiency. Using data on public procurement of gasoline in 11 Russian regions in 2011-2013, we show that a higher reserve price did not lead to lower contract prices, and that low competition in the private market was a major obstacle to efficiency.
Why is the reserve price important?
The reserve price is widely discussed in the auction and procurement literature. Standard auction theory says that an optimally set public reserve price results in the optimal outcome in all standard forms of auctions with risk-neutral agents and independent private values (Myerson, 1981). But practice is far from pure theory. The procurer does not have all information to set the optimal price and this leads to losses in social welfare (Klemperer, 2004; Dimitri et al, 2006).
There are several concerns for a practitioner here. First, there is the question of whether the reserve price should be known to everybody in advance (Dimitri et al, 2006; Brisset et al, 2015; Eklof&Lunander, 2003). Second, the reserve price influences the entry decision and competition for the contract (Klemperer, 2004; Krishna, 2009; Wang, 2016). Generally, a higher reserve price may lead to higher competition for the contract, because more suppliers will find that contract profitable, which may in turn lead to lower prices. But on the other hand, if there is a high probability of collusion in the market, a higher reserve price will just lead to higher contract prices due to coordinated behavior of the potential sellers (Wang, 2016). The procurer could use lower reserve prices to decrease gains from collusion (Krishna, 2009), but in a corrupt environment a lower reserve price is treated as an instrument to restrict entry for the favor of preferred bidders in exchange for bribe (Guide to Combating Corruption & Fraud in Development Projects).
Hence, there are various arguments for and against setting the reserve price in public procurement auctions higher rather than lower. We are interested in showing which of them hold true in practice, or in other words, do higher reserve prices lead to lower contract prices in public procurement auctions?
In Russian public procurement, the reserve price in an auction is set by the procurer and is visible to everybody. Moreover, before April 2011, procurers were free to set the reserve price, and they could easily set it unreasonably high, and then share the surplus with a seller. Starting from April 2011, procurers are obliged to prove that the reserve price is set at a reasonable level. In the explanations to the Law from Ministries of Economy and Finance, there are recommendations to set the reserve price higher rather than lower. Regulators are much more afraid of corruption than a high price of the contract.
Using data on public procurement of gasoline in 11 Russian regions in 2011-2013, we show that a higher reserve price did not lead to lower contract prices, and that low competition in the private market was a major obstacle to efficiency.
How does public procurement of gasoline work in Russia?
To make it clear how auctions in Russia are held, we will now present some details on Russian public procurement of gasoline.
First, the public procurement law is the same for all Russian regions. Second, the detailed information on public procurements – including calls for bids, chosen procedure, auction protocols, and supporting technical documentation – is published online at a unified website. If the reserve price is below 500000 rubles, public buyers of gasoline may choose between sealed-bid “paper” auctions and open-bid electronic auctions. If the reserve price is above 500000 rubles, they should use open electronic auctions.
To set the reserve price, a procurer may ask a few firms to provide estimates of an expected price of the contract at which they would agree to sign the contract. Alternatively, procurers may search for price information on the Internet or in other open sources on prices of goods and services (some gasoline stations publish its prices online, e.g.). The reserve price may then be calculated on the basis of these prices.
The procedures start when a procurer publishes the call for bids, stating basic characteristics of the contract and the reserve price. In sealed-bid auctions the bidders send their price quotations and the supporting documents. The bids are opened simultaneously, and the lowest bid (or the earliest bid in case where two or more equal prices are announced) wins. Open-bid auctions are conducted in two stages. By the first deadline all perspective bidders should provide a statement of interest, including the supporting documents and in some cases monetary deposits. Procurer may assess the statements of interest and exclude the firms that do not meet the basic requirements at the bidding stage. At the second stage, the preselected bidders show up at the auction and make descending open bids. The lowest bid wins the contract.
Data, empirical strategy, and results
To figure out whether higher reserve prices lead to lower contract prices in public procurement auctions, we used data on public procurement procedures available at a unified official public procurement website. In particular, we collected data on all public purchases of gasoline with octane number 92 at the regional level in 2011-2013 in 11 regions of Russia (1559 observations).
Among the characteristics of the procurement procedures, the most important are the number of bidders, the type of the procurement procedure (sealed-bid or open), and the characteristics of the contract (the volume and duration). We also take into account the number of price quotations the procurer uses to calculate the reserve price and some other characteristics of the purchase: the number of procurers in centralized purchase, the number of purchases of gasoline this procurer made in 2011-2013, and whether the procurer requested some special conditions from the seller (e.g., that the seller should have a network of gasoline stations).
The information allowed identifying:
- Procurements with only one bidder;
- Procurements with no or a very small price decrease as a result of the auction;
- Procurements with a reserve price higher than the market price;
- Procurements with a reserve price higher than the maximum of the price quotations.
Using these new variables, we test whether the probability that there is only one bidder (which is not what a regulating body would wish to see) correlates with auction characteristics and the fact that the reserve price is higher than the maximum of the price quotations (implying it is unreasonably and probably inefficiently high).
Table 1 Regression results
| Probabilty | Probabilty | |
| VARIABLES | One bidder | Discount = 0 |
| one bidder | 1.074*** | |
| (0.115) | ||
| open auction | 0.749*** | -0.191* |
| (0.0973) | (0.115) | |
| volume | 8.62e-06*** | -3.03e-06 |
| (2.51e-06) | (1.96e-06) | |
| duration | 0.000828* | 0.00209*** |
| (0.000454) | (0.000610) | |
| number of price quotations | -0.126*** | 0.386*** |
| (0.0436) | (0.0539) | |
| reserve price is higher than max of quotations | -0.469*** | 0.560*** |
| (0.108) | (0.136) | |
| Constant | -0.264** | -0.694*** |
| (0.126) | (0.160) | |
| Observations | 931 | 932 |
Standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1
We also test whether the probability that there is no price decrease during the auction (discount equals zero) correlates with the auction characteristics and the fact that the reserve price was higher than the maximum of the price quotations or just higher than the market price.
Table 1 shows that a higher reserve price does not lead to a higher competition, but leads to higher probability of the situation that there will be no price decrease at all. Hence, there is no evidence that setting the reserve price at a higher level will attract more bidders and result in lower contract prices.
Conclusion
Auctions are viewed as one of the best ways to achieve lower prices. But in reality there are many factors that make this questionable. In this policy brief, we focus on the regulation of the reserve prices in public procurement. Is it reasonable to recommend procurers to set high reserve prices? We look at a specific market with high entry barriers, and a relatively low number of suppliers active on the public procurement market. Such markets face high collusion risk. We show that high prices do not attract more bidders and auctions with reserve prices set higher than all quotations end up with no price decreases during the auction. A big share of auctions (46% in our data set) in Russia is inconsistent (only one bidder comes to bid), and in such an environment high reserve prices can only increase government spending. It is more reasonable to follow the ideas mentioned by Krishna (2009) and use low reserve prices to decrease contract prices and, thus, gains of suppliers from colluding behavior, even if it happens. Our study shows that general recommendations that do not take into account market specifics could not help procurers achieve efficient results.
References
- Krishna, Vijay. Auction theory. Academic press, 2009, ch.11.
- Klemperer, Paul. “Auctions: Theory and Practice.” Princeton University Press, 2004, ch.1,3,4.
- Dimitri, Nicola, Gustavo Piga, and Giancarlo Spagnolo, eds. Handbook of procurement. Cambridge University Press, 2006, ch.11.
- Myerson, Roger B. “Optimal auction design.” Mathematics of operations research 6.1 (1981): 58-73.
- Brisset, Karine, François Cochard, and Julie Le Gallo. “Secret versus public reserve price in an “outcry” English procurement auction: Experimental results.” International Journal of Production Economics 169 (2015): 285-298.
- Eklöf, Matias, and Anders Lunander. “Open outcry auctions with secret reserve prices: an empirical application to executive auctions of tenant owner’s apartments in Sweden.” Journal of Econometrics 114.2 (2003): 243-260.
- Wang, Hong. “Information Acquisition Versus Information Manipulation in Multi-period Procurement Markets.” Information Economics and Policy (2016).
- Guide to Combating Corruption & Fraud in Development Projects, http://guide.iacrc.org/
Intimate Partner Violence, Norms and Policies
Violence against women has been called by then UN Secretary-General and Nobel Peace Prize laureate Kofi Annan, “perhaps the most shameful human rights violation. And, it is perhaps the most pervasive.” Although the spread of domestic violence is difficult to quantify precisely, this is uncontroversially an issue worthy of policy concern. As is often the case, the developing world lags behind. What can development cooperation do? A growing body of economic research, including our recent results, shows that improving women’s economic opportunities matters.
It is not easy to put a figure on the prevalence of violence against women. A recent review (Alhabib et al., 2010) reports that “the prevalence of lifetime domestic violence varies from 1.9% in Washington, US, to 70% in Hispanic Latinas in Southeast US.” As the quote shows, most of the currently available studies were conducted in the US or Europe, although the focus on the developing world is rapidly growing. Besides the geographic bias, the nature of data available on the matter further limits the precision of our knowledge. Surveys (used by the vast majority of studies), crime statistics and administrative health data each suffer from different limitations. One detail, though, consistently emerges in the big picture: the largest share of violence against women is perpetrated by a cohabiting partner or other family members, what is commonly referred to as intimate partner violence or domestic violence.
In addition to the human costs, a growing body of research shows that domestic violence has huge economic costs, including the direct costs of health, legal, police and other services. There are also broader social costs, more difficult to quantify. Domestic violence is likely to reduce women’s participation in productive employment and education, and has also been shown to affect the welfare and education of children.
Legislation and policy
While specific domestic violence laws were uncommon just a few decades ago, many countries have, over the past two decades, adopted or revised legislation. In 2008, the United Nations (UN) launched a dedicated initiative advocating for universal ”adoption and enforcement of national laws to address and punish all forms of violence against women and girls, in line with international human rights standards.”
Even though issues of implementation and enforcement are more important than the letter of these laws, it is still crucial that laws are there. In such an area where culture and social norms play a big role, legislation can function as a signal of what a society deems acceptable and coordinate behavior to ultimately change social norms. This is why for example the recent law change in Russia was strongly criticized, regardless of the alleged advantages of the new formulation in terms of practical implementation. [A/N: The reform decriminalized and reduced the punishment for attacks that result in “minor injuries”, as long as they do not happen more than once a year, from two years to 15 days in prison. Proponents claimed that declassifying this form of violence from criminal to administrative offense would lower the threshold for reporting, and avoid misapplication by the police for extortion purposes.]
Besides legislation, a broad range of policies in different areas play a role for the prevalence of domestic violence and the fight against it. The knowledge gaps in terms of prevalence hinder the investigation of the factors that amplify or dampen the incidence of domestic violence, and as a consequence make it more difficult to draw implications for policy strategies. Whatever improves the parity between genders and the status of women in a society is however likely to work in the right direction, at least in the long run. Among the policies with established effects in this direction are legal rights for women (for example in terms of political representation); the introduction of role models (for example through cable TV); an improved balance of economic resources within the household (see Jayachandran, 2015 for an overview of the literature).
Development policy
As for many other areas, developing countries tend to lag behind in this respect. In Sub-Saharan Africa (SSA), domestic violence is considered a barrier to sustainable development, with 36%-70% prevalence (Garcia et al., 2005) and an estimated cost of 1.2%-3.7% of GDP (Duvvury et al., 2013). These estimates take into account a broad range of consequences for women and children. Besides direct and indirect health and life expectancy consequences, distorted outcomes for women include lower autonomy, affecting economic and financial decisions, effectiveness of home production, freedom of movement, education and labor market participation and healthcare decisions. Children are affected by distorted reproductive decisions, for example in regard to birth spacing, resulting in lower birth weights and worse chances of survival, and rearing decisions in general. Still these costs can be thought of as a lower bound, given the conservatism of the methodology and the gross under-reporting of violence. Although the main responsibility for policy lies of course within the country, we might still wonder what the international community can do to help, within the framework of development cooperation.
Aid and domestic violence
Even though the donor community agreed, in Addis Abeba in 2015, on a ”beyond aid” agenda to reach the 17 sustainable development goals (see UN, 2015), the main tool of development cooperation is currently still foreign aid. In recent research with Anders Olofsgård and Evelina Bonnier, we investigate the impact of aid on gender-related outcomes, and among them domestic violence. There are three reasons why we expect an impact of development aid on these outcomes. First of all, there may be a direct effect of aid-financed projects on the intended beneficiaries. Many aid projects have nowadays an explicit component targeting women and girls. Moreover, donors also agreed to gender ”mainstreaming” (Beijing Platform for Action, 1995), which implies that gender concerns should be integrated into all policy and program cycles, and that governments should engage in a dialogue on gender and development. This is because women and girls are seen as particularly vulnerable in situations of poverty and conflict, but also potentially instrumental in the general process of development (Duflo, 2012).
Second, aid projects are typically intended to benefit whole communities, and there are often positive externalities that extend beyond the immediately targeted beneficiaries and beyond the stated objectives of the project. Think for instance of immunization drives against infectious diseases (Miguel and Kremer, 2004). When a big enough group of school children are treated against, for example, intestinal worms, far larger communities are also protected due to the now lower probability of contagion, and also the indirect benefits extend to them. Projects targeting livelihoods and jobs can also increase aggregate demand in the community, benefiting those not directly involved in the projects. The ultimate level of spillover goes through economy-wide growth and development. Research shows that gender relations tend to become more equal with economic development and that women tend to gain more than men (Duflo, 2012).
Finally, beyond economic opportunities, positive spillovers can come through transmission of information and attitudes, changing social norms through personal networks, including both direct beneficiaries and others.
Figure 1. Effect of aid on domestic violence
Source: Berlin et al., forthcoming
Figure 1 is based on our empirical investigation linking the most recent Demographic and Health Surveys (DHS) in Uganda and Malawi to information on the geographical coordinates of aid projects placement, provided by AidData. Men in the areas exposed to aid (which we define to be within a 15 km radius of at least one aid-financed project) are 11% more likely to share the opinion that beating one’s wife is not justifiable, as compared to men not exposed to aid. This difference is even larger than for women (4%). Most importantly, women exposed to aid are less likely to have experienced some form of violence, physical (–3%), emotional (–9%) and in particular sexual (–24%). We think this might be connected to the improved status of the woman in economic terms. In fact, we find much more modest impacts from exposure to specifically gender-targeted projects (examples of which include “Community participation and development”, “Support for vulnerable groups”, “Improvement of outpatient, maternal and child health services”, “Women’s empowerment for peace”, and “Anti-trafficking for women and children”). We also find that aid presence affects labor market participation for women, but do not find this effect from gender-specific aid. This is consistent with the idea that women’s relative status within the household improves as a consequence of better economic opportunities, in this case induced by aid. Evidence supporting this mechanism is piling up, see Aizer (2010), Bobonis et al. (2013), Heath (2014), Anderberg et al. (2016), Hidrobo et al. (2016), to cite just a few. The types of activities that fall under our definition of gender-specific aid, instead, do not seem to contribute in this respect.
Conclusion
Summarizing recent research, the World Development Report 2015 called for development policy to focus on norms and mental models. These are often highly persistent and hard to change. We know that gender-related norms are important for outcomes that deeply affect the lives of women and girls. We do not know a lot about how to change them, but improving the status of women and girls in society seems to be one important piece of the puzzle. Our recent findings about the impacts of aid imply, echoing the WDR 2015, that this should be an important goal for development cooperation.
References
- Alhabib, Samia; Ull Nur; and Roger Jones. 2010. ”Domestic Violence Against Women: Systematic Review of Prevalence Studies”, Journal of Family Violence, 25, pp 369–382.
- Aizer, Anna, 2010. ”The Gender Wage Gap and Domestic Violence”, The American economic review. 100(4),1847-1859.
- Anderberg, Dan; Rainer, H., Wadsworth, J., & Wilson, T., 2016. “Unemployment and Domestic Violence: Theory and Evidence.” The Economic Journal 126.597, pp 1947-1979.
- Berlin, Maria P.; Evelina Bonnier; and Anders Olofsgård, forth. “The Donor Footprint and Gender Gaps”, UNU-WIDER Working Paper Series.
- Bobonis, Gustavo J.; Melissa González-Brenes; and Roberto Castro, 2013. “Public Transfers and Domestic Violence: The Roles of Private Information and Spousal Control.” American Economic Journal: Economic Policy 5, no. 1
- Duflo, Esther, 2012. “Women empowerment and economic development”, Journal of Economic Literature, 50(4), 1051-79.
- Duvvury, Nata; Callan, A.; Carney, P.; and Raghavendra, S.; 2013. ”Intimate partner violence: Economic costs and implications for growth and development.” Women’s Voice, Agency, & Participation Research Series, 3.
- García-Moreno, Claudia; Jansen, H. A. F. M.; Ellsberg, M.; Heise, L.; and Watts, C., 2005. ”WHO Multicountry Study on Women’s Health and Domestic Violence against Women: summary report of initial results on prevalence, health outcomes and women’s responses.” World Health Organization. Geneva.
- Jayachandran, Seema. 2015. “The roots of gender inequality in developing countries.” economics 7.1, pp 63-88.
- Heath, Rachel, 2014. “Women’s access to labor market opportunities, control of household resources, and domestic violence: Evidence from Bangladesh.” World Development 57, pp 32-46.
- Hidrobo, Melissa; Amber Peterman; and Lori Heise, 2016. “The Effect of Cash, Vouchers, and Food Transfers on Intimate Partner Violence: Evidence from a Randomized Experiment in Northern Ecuador.” American Economic Journal: Applied Economics 8.3, pp 284-303.
- UN, 2015. ”Transforming our World: The 2030 Agenda for Sustainable Development.” United Nations – Sustainable Development knowledge platform.
Higher Competition in the Domestic Market – A Way to Boost Aggregate Productivity
Competition is a good thing not only because of lower prices and larger variety. Higher competition in the domestic market also shifts necessary labour and capital resources from less productive domestic-oriented firms to export-oriented productivity champions. Such firms will make better use of production factors and generate larger output. Thus, simply increasing the level of competition in the domestic market can boost the aggregate productivity of a country.
The aggregate productivity of a country can be boosted even without changing the productivity of individual enterprises. This can be achieved by improving the allocation of resources – the redistribution of labour and capital towards more productive firms. These firms will make better use of production factors and generate larger output. But how can one affect the allocation of resources? Economic theory says that allocation depends on the productivity of individual firms: more productive enterprises attract more labour and capital. However, there exists another factor behind allocation: distortions.
Distortions affect the allocation of resources
A model developed by Hsieh and Klenow (2009) – one of the most popular frameworks to study the allocation of resources – has a very important and realistic feature: it acknowledges that firms are not treated equally. Some firms may face lower supply of banking loans ending with higher capital costs. Other firms could confront with trade unions and higher wages. Tax rates may also differ across firms. These are all examples of distortions. Firms facing larger distortions are forced to underuse respective production factor, while firms that enjoy more favourable conditions tend to overuse capital and labour, generating more output.
While it is virtually impossible to imagine an economy without any distortions (the one where all firms face the same taxes, costs of labour, capital etc.), not all distortions damage the allocation of resources. Only distortions to productive firms create misallocation of resources by shifting labour and capital towards unproductive firms. Thus, removal of such distortions can improve the efficiency of allocation and raise the aggregate output of the country.
According to Hsieh and Klenow (2009) the distortions faced by every individual firm can be quantified from the balance sheets and profit/loss data. For example, observing lower-than-usual ratio of capital to intermediate inputs (comparing with other enterprises in a narrowly defined industry) indicates a capital distortion, possibly related with limited access to banking loans. Similarly, lower-than-usual share of wages in total production costs implies high labour distortions. Finally, the size of the distortion can be detected as a case of abnormally low share of intermediate inputs in total output, and signals about the restrictions to total output (e.g. due to higher taxes for large enterprises).
Misallocation of resources is small in Latvia
In my recent research (see Benkovskis, 2015), I use anonymised firm-level dataset for 2007–2013 and apply the Hsieh and Klenow (2009) model to study the allocation of resources in Latvia – a unique example of a small and open economy facing extreme structural shifts during the financial crisis. According to my estimates, the negative contribution of misallocation to aggregate productivity was close to 27% in 2013 (see Figure 1). In other words, it suggests that actual aggregate productivity could be boosted by 27% if all distortions were removed!
This may seem large but in fact 27% is a comparatively low figure. Hsieh and Klenow (2009) argue that full liberalisation would boost aggregate manufacturing productivity by 86–115% in China, 100–128% in India, and 30–43% in the US. Dias et al. (2015) show that removing distortions would lead to a 30% gain in output of Portugal in 2011. Thus, misallocation of resources is relatively small in Latvia. Even more important: the misallocation of resources decreased after the crisis in Latvia (contrary to the case of Portugal), adding more than 10 percentage points to aggregate productivity growth between 2010 and 2013.
Figure 1. Contribution from misallocation of resources to aggregate total factor productivity, %
Source: Benkovskis (2015). Note: shows the contribution of misallocation comparing with the counterfactual case of no distortions.
The finding that allocation of resources improved after the crisis is interesting per se, but uncovering the reasons behind the improvement is even more important. Figure 1 provides a decomposition, which shows that labour distortions are minor in Latvia due to high flexibility of labour market (in line with recent findings by Braukša and Fadejeva, 2016). The capital distortions, while being minor in 2007–2008, increased afterwards, pointing to some credit supply constraints faced by the highly productive enterprises after the financial crisis. However, by far largest contribution comes from the misallocation of intermediate inputs – the turnover of the most productive firms face some constraints. And it was the ease of constraints to turnover for the most productive firms that determined the improvements in aggregate productivity since 2010.
The level of competition matters for misallocation
My research stresses the importance of the competition level on the market, since higher competition serves as a natural constraint for the firm to increase its turnover. What if the most productive Latvia’s firms systematically come up against higher competition? I found that indeed this is the case. First, recent results by Fadejeva and Krasnopjorovs (2015) show that Latvia’s domestic market has lower competition level comparing with external markets. Second, it is widely acknowledged that exporters tend to be more productive comparing with domestically oriented firms (see e.g. Bertou et al., 2015, who report positive export premiums for EU countries, while Benkovskis and Tkačevs, 2015, find higher productivity of exporters in Latvia). Thus, Latvia’s productive export-oriented firms are subject to higher competition and cannot enlarge their turnover as easy as other entities. This shifts labour and capital towards small and less productive firms working solely on domestic market, creating the misallocation of resources.
The domestic competition factor can also explain the improving allocation of resources after 2010. The study by Fadejeva and Krasnopojorovs (2015) reveals that the competition gap between domestic and foreign markets narrowed after the financial crisis (see Table 1). Namely, life was too easy on the local Latvia’s market during the boom time, allowing unproductive firms to survive and drain away resources from more productive firms. But conditions became tougher after the crisis (although the competition level still remained lower than abroad). We can view this as a “cleansing effect of the crisis”: some of the least productive domestic oriented firms went bankrupt (or decreased their turnover), freeing the necessary capital and labour resources for productive exporters.
Table 1: Change in the competitive pressure on main product in domestic and foreign markets compared to the situation before 2008, %
| Domestic market | Foreign market | |||
| 2008–2009 | 2010–2013 | 2008–2009 | 2010–2013 | |
| Strong decrease | 2.9 | 2.2 | 0.9 | 1.0 |
| Moderate decrease | 11.8 | 3.8 | 7.6 | 5.9 |
| Unchanged | 33.8 | 24.7 | 45.7 | 51.5 |
| Moderate increase | 30.0 | 28.1 | 25.2 | 19.7 |
| Strong increase | 18.7 | 38.5 | 11.2 | 8.8 |
| Does not apply | 2.8 | 2.8 | 9.4 | 13.1 |
Source: Fadejeva and Krasnopjorovs (2015), Table A.102. Notes: based on the sample of 557 Latvia’s firms; results are weighted to represent firm population.
Conclusion
This research has an important policy conclusions applicable to any country that seeks to increase aggregate productivity. The competition level in the domestic market is important not only for consumers, who enjoy lower prices and higher variety. Higher competition in the domestic market also shifts necessary resources from less productive domestic-oriented firms to export-oriented productivity champions.
References
- Benkovskis, Konstantins; 2015. “Misallocation of resources in Latvia: did anything change during the crisis?”, Latvijas Banka Working Paper No.5/2015.
- Benkovskis, Konstantins; and Olegs Tkacevs, 2015. “Everything you always wanted to know about Latvia’s service exporters (but were afraid to ask)”, Latvijas Banka Working Paper No.6/2015.
- Berthou, Antoine; Emmanuel Dhyne; Matteo Bugamelli; Ana-Maria Cazacu; Calin-Vlad Demian; Peter Harasztosi; Tibor Lalinsky; Jaanika Meriküll ; Filippo Oropallo; and Ana Cristina Soares, 2015. “Assessing European Firms’ Exports and Productivity Distributions: The CompNet Trade Module”, ECB Working Paper, No. 1788.
- Braukša, Ieva; and Ludmila Fadejeva, 2016. “Internal labour market mobility in 2005–2014 in Latvia: the micro data approach”, Baltic Journal of Economics, 16(2), 152–174.
- Dias, Daniel A.; Carlos Robalo Marques; and Christine Richmond, 2015. “Misallocation and Productivity in the Lead Up to the Eurozone Crisis“, International Finance Discussion Papers 1146.
- Fadejeva, Ludmila; and Olegs Krasnopjorovs, 2015. “Labour Market Adjustment during 2008–2013 in Latvia: Firm Level Evidence”, Latvijas Banka Working Paper, No. 2/2015.
- Hsieh, Chang-Tai; and Peter J. Klenow, 2009. “Misallocation and manufacturing TFP in China and India“, The Quarterly Journal of Economics, 124(4), 1403–1448.
Gaming the System: Side Effects of Earnings-Dependent Benefits
Today policy makers in developing and middle-income countries face tremendous challenges in combating various forms of tax evasion. Increasingly it is proposed to tie social security benefits to the reported income and in this way increase tax compliance incentives. We use administrative data from Latvia to study generous childcare benefits, which depend on the reported wages in the pre-childbirth period. Our analysis reveals pronounced wage growth shortly before the childbirth, which we rationalize by the legalization of previously undeclared wages. Obtained results show that the wage growth is temporary and lasts only until the end of the period, which is taken into account when calculating parental benefits.
Today policy makers around the world are increasingly preoccupied with reducing various forms of tax evasion. To provide tax compliance incentives it is often proposed to tie social security benefits to declared wages. For example, Kumler et al. (2013) show that a reform tying future pension benefits to the payroll tax in Mexico increased tax payments after the reform. Similarly, Cruces and Bergolo (2013) and Bergolo and Cruces (2014) demonstrate that a reform tying health care insurance of children to the reported earnings of parents increased “legal” labor supply in Uruguay.
On the other hand, Kreiner et al. (2016) document inter-temporal wage shifting in Denmark to enjoy significantly lower marginal tax rates. In light of the results by Kreiner et al. (2016), it is possible that employees and employers collude to increase the wage during the period, which is taken into account when calculating social security benefits. If the wage increase is temporary then the result of tying social security benefits to wages might be a net loss to the government finances. Hence, the question of whether tying social security benefits to reported wages is a solution to the problem of payroll tax evasion is still open.
We demonstrate that tying social security benefits to the declared wages can backfire to the extent that it can lead to the excessive payments of social security benefits, while doing almost nothing to reduce payroll tax evasion, in this way producing net fiscal loss to government finances. More specifically, we show that if the contribution period that determines the size of the benefit is relatively short and social security benefits are generous, then by colluding, employees and employers can temporally increase the legal wage to extract generous benefits afterwards. This result can have implications for the design of social benefit systems in many countries, where relatively short contribution periods ensure generous long-lived benefits afterwards.
Institutional background and methodology
We illustrate this phenomenon by studying the childcare benefit in Latvia, which in 2005-2008 depended on parents’ declared wage in the pre-childbirth period. This system, introduced in 2005, replaced a universal (very modest in size) childcare benefit. The new rules foresaw that one of the parents could receive a benefit that was equivalent to the parent’s previous net wage until the child became one year old. The average wage that determined the size of the benefit was calculated over the 12-months period that ended three months before the childbirth (hereinafter – benefit qualification period) and therefore included 5 months of pregnancy. Initially the benefit was not compatible with employment but as of March 2007 it became possible to simultaneously work full-time and receive the benefit.
Presumably, the 2005 reform created incentives to report higher earnings before the childbirth, because of the generosity of the new benefit and because the benefit qualification period included pregnancy, i.e., the period when the mother knows if/when she will be eligible for the benefit. To uncover the effects of the incentives to report more income, we use administrative data on declared monthly wages and use three sources of identifying variation in a difference in differences setup.
First, we compare wage growth during pregnancy with wage growth of women who did not become pregnant. The identifying assumption is that, in the absence of pregnancy, the wages of women who became pregnant would follow the same trend as the wages of other women. Under this assumption, any difference in the wage growth can be interpreted as a legalization of previously undeclared wages. However, this assumption may not hold because pregnancy is not randomly assigned across women: women can anticipate a wage increase (e.g. anticipate a promotion) and adjust the decision to have a child. Therefore, we use a second source of identifying variation by comparing wage growth during pregnancy for women employed in the private sector with wage growth for women employed in the public sector, where tax evasion is presumably absent. Assuming that promotion anticipation effects in the private and the public sector are identical, this difference in wage growth can be interpreted as the growth of wages resulting from wage legalization.
Our previous assumption might be violated if promotions in the public sector can be easier to predict (which means that anticipation effects in the private and the public sectors are not necessarily identical). To address this challenge, we use a third source of identifying variation coming from the 2005 reform, which tied the childcare benefit to the previous earnings. Since this reform increased incentives to disclose higher earnings during pregnancy, the difference in wage growth in the private sector versus public sector should not be observed before the reform.
Estimations are based on a matched employee – employer administrative dataset, which covers monthly-declared earnings of all employed workers in Latvia from 1996 to 2010.
Results
There are three main findings. First, wage growth during the first five months of the pregnancy in the private sector is always higher than that in the public sector. If we use this observation to obtain an estimate of the wage growth due to the legalization of previously undeclared wages, we find, depending on the regression specification, that it varies between 5 and 7 percent.
Second, this effect is mainly driven by the time period after the reform of 2005 (see Figure 1). Thus, if we use the time period before the reform of 2005 only to difference out permanent differences in the anticipation effects between public and private sector, our preferred regression specifications provide us with an estimate that varies from 5 to 6 percent.
Figure 1. Difference-in-difference-in-difference estimate by year, %
Note: difference in difference in differences estimate for a given year is calculated by first comparing wages of pregnant women with those of not pregnant before and during first five months of the pregnancy. Then this estimate is compared between public and private sectors. Everything is compared with respect to one year before the reform announcement – 2003.
The final finding shows that the sharp jump in the wage growth in private sector versus the public sector starts to appear exactly in the first month of the pregnancy (see Figure 2). It is important to note that we do not see any differential wage growth between the public and the private sector before the date of conception, indicating that potential anticipation effects are limited.
Figure 2. Difference-in-difference-in-difference-in-differences estimate by pregnancy month, %
Note: difference in difference in difference in differences estimate for a given month is calculated by first comparing wages of pregnant women with those of not pregnant in a given month with respect to one month before the date of conception. Then this estimate is compared between public and private sectors and finally previously calculated difference is contrasted before and after the reform tying parental benefits to reported wages.
Due to the fact that many women do not return to the same employer after childbirth, it is problematic to make inferences about the wage a woman receives once she returns to the labor market. To overcome this challenge we use the same social security data for men for the time period covering January 2007 until August 2010.
As explained previously, starting in March 2007 the childcare benefit became compatible with full time employment. The outcome of this reform was that many men started to receive the benefit, while continuing to work. This allows us to perform the previous analysis for the sample of men.
Results presented in the Figure 3 show that similarly as in the sample of women we see a sharp increase in the wage during the qualification period. Additionally, we see a slowdown in the wage growth once the qualification period ends. It is important to mention that displayed coefficients describe the difference between public and private sector in the change in wages between men whose partners became pregnant and those who did not with respect to the reference period (here one month before the conception date). We also record a sharp growth in wages in the public sector in the months following the childbirth. On the contrary, wages in the private sector stay the same, hence the large difference in the months following the childbirth.
Figure 3. Difference-in-difference-in-differences estimate for men by month of partner’s pregnancy, %
Note: difference in difference in differences estimate for a given month is calculated by first comparing wages of men whose partner became pregnant with those men whose partner did not become pregnant with respect to one month before the date of conception. Then this estimate is compared between public and private sectors
Conclusion
Drawing on the example of the childcare benefit in Latvia, we show that declared wages sharply increase during the period that is taken into account when calculating social security benefits. This wage growth is temporary and does not continue once the benefit qualification period is over. We interpret this phenomenon as the legalization of previously undeclared wages: this temporary legalization of earnings is possible, because the benefit qualification period is relatively short (12 months), and includes 5 months of pregnancy, which makes the average wage during the qualification period relatively easy to affect. Such setting creates bad incentives – an employee and an employer can collude to increase the average wage that determines the size of the benefit.
Additionally, our research casts doubts on policies tying parental benefits to declared earnings with an aim to reduce opportunity costs of high earners and increase their fertility. Researchers analyzing such policies should be very cautious when interpreting their results because the effect that they capture might not come from high earning women, but rather from women who manage to increase their income during pregnancy. Absent monthly data, it might be challenging to disentangle the two.
Many countries implement earnings-dependent benefits. Our results show that even very well designed social security benefits can and will be abused if people are given wrong incentives. Thus to achieve the best outcomes policy makers when deciding whether to tie social security benefits to declared earnings should take into account side effects described in this brief.
References
- Bergolo, Marcelo & Guillermo Cruces, 2014. “Work and tax evasion incentive effects of social insurance programs,” Journal of Public Economics, Elsevier, vol. 117(C), pages 211-228.
- Cruces, Guillermo & Marcelo Bergolo, 2013. “Informality and Contributory and Non-Contributory Programmes. Recent Reforms of the Social-Protection System in Uruguay,” Development Policy Review, 31, issue 5, p. 531-551.
- Kleven, Henrik Jacobsen & Claus Thustrup Kreiner & Emmanuel Saez, 2016. “Why Can Modern Governments Tax So Much? An Agency Model of Firms as Fiscal Intermediaries,” Economica 83, no. 330 (April 1, 2016): 219–46. doi:10.1111/ecca.1218Kreiner, Claus Thustrup & Søren
- Kreiner, Claus Thustrup & Søren Leth-Pedersen & Peer Ebbesen Skov, 2016. “Tax Reforms and Intertemporal Shifting of Wage Income: Evidence from Danish Monthly Payroll Records,” American Economic Journal: Economic Policy, 8(3):233–257, August 2016.
- Kumler, Todd & Eric Verhoogen & Judith A. Frías, 2013. “Enlisting Employees in Improving Payroll-Tax Compliance: Evidence from Mexico,” NBER Working Papers 19385, National Bureau of Economic Research, Inc.