73272 POVERTY THE WORLD BANK REDUCTION AND ECONOMIC MANAGEMENT NETWORK (PREM) Economic Premise JUN 2012 OCTOBER 010 • Numbe 93 • Number 18 Competitiveness and Connectivity: Integrating Lagging Regions in Global Markets Thomas Farole In recent decades, as integration of global trade and investment has accelerated, many countries—both developing and developed—have experienced widening disparities of output and income across regions within their borders. The emer- gence of entrenched “leading� and “lagging� regions is becoming an important policy challenge, particularly in many middle-income countries. This note discusses the role of trade integration in shaping and addressing the challenges of lagging regions. Twenty years ago, virtually all of the world’s poor people whelming the infrastructural, environmental, and institu- could be found in poor countries. Today, the picture has tional capacities of metropolitan regions in many developing changed dramatically. Nearly three-quarters of those living countries. The World Development Report 2009 (WDR; World in poverty1—close to 1 billion people—are in middle-income Bank 2009) brought this issue of economic geography to the countries (Sumner 2010). This reversal reflects the complex fore of the mainstream development agenda, arguing that effects of the globalization of trade and investment on devel- structural issues of location and geography play an important opment outcomes. On one hand, the rapid integration of role in shaping the uneven spatial patterns of development, many developing countries into global markets has contrib- but that these are often compounded by policy. A recent re- uted to a convergence of incomes across countries, pulling port, The Internal Geography of Trade Competitiveness: Lagging large economies like China, India, and Indonesia into the Regions and Global Markets (World Bank 2012), draws on the middle-income ranks. On the other hand, these same factors WDR 2009 framework to explore more specifically the nexus have contributed to widening income disparities within between trade and location to inform policies to address the countries. challenge of lagging regions. One of the principal manifestations of these within- Trade and the Challenge of Lagging country disparities is spatial, with growth accelerating in well- Regions located, typically metropolitan regions, while more peripher- al regions fall further behind. The resulting pattern of leading Trade plays a crucial role in the interaction between location, and lagging regions matters not just for social and political growth, and inequality. Expanded market access can have a cohesion, but also because the failure to integrate lagging re- transformational impact on regional growth. For example, in gions may have a dampening effect on national growth, and the five years following the implementation of the North contributes to the massive rural-urban shifts that are over- American Free Trade Agreement (NAFTA), Mexico’s border 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise regions grew more than three times faster than the rest of the industry partners, making it impossible to generate scale country (Baylis, Garduno-Rivera, and Piras 2009). But for re- economies. gions that are already lagging—particularly those affected both The scale-related challenges of lagging regions are com- by distance (remote) and density (sparsely populated)—the pounded by problems of location and connectivity. The struc- trends of global and regional trade integration can result in tures imposed by physical networks and poor virtual networks further isolation, as firms and consumers in the core increas- for management of information and payments make it diffi- ingly engage outward at the expense of the domestic hinter- cult for firms in peripheral regions to compete in the context land. Meanwhile, firms in remote regions may struggle to take of modern supply chains organized around the demands of advantage of the opportunities available from integration in shared production networks (Kunaka 2011). Such barriers global markets due to higher transport costs and lack of scale, may result in export-capable firms in peripheral regions trad- among other factors. For example, while overall poverty de- ing through intermediaries. Firms in core regions, meanwhile clined significantly in Mexico following NAFTA, the gap be- benefit from easier access to trade gateway infrastructure, the tween rural and urban regions grew due to declining relative opportunity to benefit from logistics consolidation, and in- returns in agriculture and lower skills in rural regions (Nicita formational benefits from the opportunities for face-to-face 2004). Thus, while trade brings opportunities, it has the po- contact. tential to accentuate regional disparities. Finally, institutional factors can also favor core regions. Indeed, drawing on evidence from 28 countries over the This is less an issue of governance quality, which as noted ear- period 1975–2005, Rodriguez-Pose (2010) shows that trade lier is often perceived as worse in the core. Instead, it is a func- openness often leads to spatial divergence, and that it is much tion of the capabilities of institutions, which are highly de- more likely to do so in developing countries. This is not be- pendent on the availability and quality of human capital, and cause trade inherently leads to regional inequality, but be- the depth of local markets. For example, while many tradi- cause developing countries tend to have structural features tional measures of the investment climate appear to be rated that potentiate the polarizing effect of trade openness, includ- worse by exporters in the core, access to finance is a critical ing existing inequalities, lower government social expendi- area in which firms in the core benefit more than those in the ture, higher variations in regional sector structures, and high periphery. internal trade costs. What Does It Mean for Lagging Region Using Enterprise Surveys data across more than 100 de- Policy? veloping countries, Farole and Winkler (2011) show that firms located in core regions trade substantially more than These dynamics suggest that interventions focused on boost- those located outside the core.2 Conversely, firms in the core ing the competitiveness of existing agglomerations in core re- also perceive a significantly worse investment environment, gions may have a bigger impact on aggregate competitiveness particularly with respect to regulation, bureaucracy, and gov- than interventions targeting peripheral ones. On the other ernance, indicating the presence of large congestion costs in hand, focusing exclusively on the core is likely to exacerbate the core. Given such congestion costs, what is it that makes existing inequalities and may ultimately constrain growth in the core so much more attractive than the periphery to ex- the long run. Therefore, it remains critical to balance aggre- porters and importers? gate national competitiveness with building the endogenous capacity for improved competitiveness in peripheral regions. Benefits of the Core: Agglomeration, To this end, lagging regions have long been subject to tar- Connectivity , and Institutions geted interventions designed expressly to reduce spatial dis- Core regions are more likely to allow firms to exploit several parities, including infrastructure investments, wage policies, types of agglomeration economies. Firms in regional econo- deregulation, promotion of clusters, development of indus- mies, where there is substantial diversity across sectors (ur- trial parks and special economic zones (SEZs), and, most com- banization economies) as well as a concentration of firms and monly, fiscal incentives to encourage investment. Such spa- exporters in specific sectors (localization economies and ex- tially targeted policies have largely failed. In some cases, for port spillovers), are more likely to become exporters. As a re- example, Italy’s Mezzogiorno policies, this has led to perverse sult of agglomeration, firms in core regions benefit over time development outcomes, subsidizing inefficient investment, from technology and knowledge spillovers. They can also le- aggravating leakage of the best firms and most talented work- verage scale economies through access to deep and specialized ers, and contributing to an unfavorable institutional environ- labor and suppliers. This raises productivity and helps over- ment. More commonly, the impact of such policies has been come the fixed cost barriers to exporting. In contrast, firms minimal relative to their cost. For example, targeted interest and farms in peripheral regions must contend with thin input rate subsidies in Brazil did succeed in attracting firms into lag- markets and have few opportunities to share resources with ging regions, but at a cost of several billion dollars annually 2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise (Carvalho, Lall, and Timmins 2006). While fiscal incentives and regional lifecycles—that is, the process by which in- may be effective at the margin, evidence shows that the level dustrial activities shift from those locations that offer of incentives that most countries offer falls far short of what it advanced technological inputs and urbanization econo- would take to overcome competitiveness gaps in lagging re- mies to those that offer low-cost production, scale, and gions—and the level that would be required to do so would, in possibly clusters of specialized inputs—offer scope for de- most cases, be simply unaffordable (World Bank 2012). velopment and integration of some lagging regions. Overall, there is now widespread recognition that past at- These opportunities are likely to fall first to the urban tempts to use blunt instruments to raise investment in lagging fringe, then to intermediate regions. While lagging, pe- regions have failed, and more nuanced—yet comprehensive— ripheral regions should seek opportunities to benefit approaches to building regional competitiveness are needed. from these developments, and should do so in the con- In this context, it is worth noting that integrating lagging re- text of strategies that are defined tightly aligned with the gions into the global trading system has not yet been at the regional comparative advantage. Given the challenges of forefront of regional development policies. achieving scale in peripheral regions, effective strategies may focus on linking into established production chains Targeting Interventions and Focusing on anchored in the core or focusing on niche production. Competitiveness and Connectivity • Attracting and linking foreign and domestic capital: Foreign Not all lagging regions are the same. Some have greater poten- investors in industrial and services sectors are strongly tial to support agglomeration, others may benefit from cross- biased to locating in the core. Therefore, efforts to attract border integration, while others may have fewer realistic op- foreign direct investment (FDI) should consume a limit- portunities to integrate directly into global production ed share of resources devoted to lagging regions and be networks, but can effectively serve domestic markets. Table 1 targeted to those sectors in which a region has clear com- provides a basic framework for the regional policies that may parative advantage. FDI attraction policies should target be most effective in enhancing trade integration and competi- sectors and firms with reasonable prospects for integra- tiveness in different types of lagging regions. tion with the regional economy, particularly if fiscal in- At the heart of these policies is a focus on interventions centives are being offered. targeted at two objectives: building the competitiveness of the • Firm-level interventions for skills and access to technology region and its firms and improving its connectivity with do- and finance: Efforts to improve the export competitive- mestic and international markets. With these objectives in ness of lagging regions must go beyond the external envi- mind, following is a brief summary of some of the important ronment to address firm-level competitiveness. This policy recommendations derived from research outlined by means introducing new tools and instruments into re- the World Bank (2012): gional policy, including vocational development and • Aligning trade and growth strategies with regional compara- training, access to technology and finance, and address- tive advantage: Opportunities emerging from industrial ing management skills and capacity. Table 1. Policies for Trade Integration and Competitiveness in Different Types of Lagging Regions Region type Nature of policies Near the core Many of the traditional regional policies may be effective, including investment incentives and export- oriented incentives Promotion and facilitation of agglomeration, including industrial parks/SEZs and cluster policies Investment climate reforms Peripheral but with economic mass Targeted foreign direct investment attraction (following comparative advantage and industry lifecycles) Support to existing industry clusters Transport connectivity and infrastructure Investment climate reforms Firm-level competitiveness interventions (training, finance, and others) Critical importance of governance Peripheral and without density Limited prospects for export-oriented investment—focus on endowment-based opportunities (mining, agriculture, tourism) Focus on social infrastructure and connectivity Firm-level competitiveness interventions Source: World Bank 2012. 3 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise • Developing and empowering labor: Too little attention has markets in neighboring countries than their own domes- been paid to the local labor force in lagging region poli- tic core. cies. As recommended in the WDR 2009 (World Bank Connectivity policies are, however, particularly difficult 2009), policies to promote labor mobility are important, when it comes to lagging regions. Indeed, one of the main les- but it is also important for regional policy to focus on sons learned from the failed Mezzogiorno policies in Italy in education and training to build local skills. Targeting in- the 1950s and 1960s is the problem of the “two-way road,� vestment incentives toward training and skills develop- and the risks of subsequent brain drain and hollowing out of ment rather than broad tax reductions may be a more local production. While recognizing these challenges, improv- effective long-term approach for lagging regions. ing domestic connectivity must be central to the policy agen- • Leveraging agglomeration—a balancing act: While agglom- da to raise a region’s competitiveness. This requires invest- erations have a powerful impact on export competitive- ment in hard infrastructure, but also improvements in trade ness, policy makers should avoid the temptation to build facilitation and, critically, efforts to address regulatory and agglomerations where they have not developed organi- competition barriers that hinder market access. Domestic cally. Instead, both core and noncore regions should elim- trade in India, for example, has long been hampered by a range inate barriers to natural agglomeration, ensuring appro- of interstate barriers, including standards and licensing re- priate trade and social infrastructure, but also removing quirements. And barriers to competition in the transport sec- regulatory barriers that distort land markets and frag- tor raise the cost of domestic connectivity in many coun- ment goods and factor markets. Policies to support the tries—like everything else, this hits peripheral regions hardest competitiveness of existing clusters may also have a posi- because they already suffer from lower levels of competition tive impact. In this context, SEZs should be used to ac- and lack of scale in transport markets. celerate existing agglomerations rather than to catalyze Concluding Remarks “latent� ones. • Exploiting nontraditional channels: Integrating small pro- The concentration of the world’s poor in lagging regions of ducers from remote regions into global markets also re- increasingly rich countries presents serious challenges to the quires finding solutions outside established channels. In growth and stability of emerging economies. However, the terms of infrastructure, beyond traditional roads, ports, opportunity for integrating firms and households in these re- and airports, investment in information and communi- gions into national and global trade networks is substantially cation technology networks can allow firms in remote greater than it was only a decade ago. Clearly growth will al- regions to take advantage of electronic platforms to de- ways be unevenly distributed. And it is unrealistic to expect a liver goods and services to international markets. Recent sparsely populated, remote, and mountainous region to be- research, for example, finds that the effect of distance come the next Shenzhen. But even marginal improvements in on trade is 65 percent lower via eBay than in offline mar- integrating lagging regions effectively into global markets have kets (Lendle et al. 2012). Similarly, using existing distri- potential for significant impacts on global poverty. bution networks that penetrate peripheral regions can Acknowledgments open connectivity opportunities. Brazil and Peru both had notable successes in using their postal networks to The author is grateful to Bernard Hoekman and Mona Had- facilitate simplified exporting for small firms in rural dad for valuable comments and suggestions, and to Deborah regions. Winkler, Andrés Rodriguez-Pose, Vassilis Tselios, Megha Mu- • Connecting and integrating with domestic and regional mar- kim, Della Temengung, Aradhna Aggarwal, Prakash Singh kets: Facilitating exports relies on improved connectivity Archa, Somik Lall, and Taye Mengistae for their contribu- of peripheral regions not only with global markets, but tions to the report on which this note is based. also with national markets. This is important because About the Author firms in lagging regions are more likely to be competitive participants in global markets by providing inputs to Thomas Farole is a Senior Trade Specialist in the World Bank’s firms in the core that ultimately export, or by trading in- Poverty Reduction and Economic Management (PREM) Net- directly, through agents and distributors based in the work, International Trade Department. core. It also gives firms in lagging regions the chance to Notes leverage scale economies and opens up opportunities for investment from the core. Beyond domestic connectivi- 1. Based on the US$1.25 international poverty line, as de- ty, addressing trade policy barriers that prevent integra- fined by the World Bank. tion with regional markets is also critical, particularly for 2. This research also finds striking differences in a number of border regions that may be located much closer to large firm-related factors that have previously been associated with 4 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise exporting. Relative to firms in noncore regions, firms in the Policy Research Working Paper 5780, Washington, DC. core are on average larger, have a greater share of foreign own- Kunaka, C. 2011. Logistics in Lagging Regions: Overcoming Local Bar- ership, have a top manager with more experience, make great- riers to Global Connectivity. Washington, DC: World Bank. er use of technology, and are more likely to have an interna- Lendle, A., M. Olarreaga, S. Schropp, and P.-L. Vézina. 2012. “There Goes Gravity: How eBay Reduces Trade Costs.� Centre for Eco- tional quality certification and provide formal training for nomic Policy Research Discussion Paper 9094, London. their workers. What is not clear is whether these firm charac- Nicita, A. 2004. “Who Benefited from Trade Liberalization in teristics are endogenous to the core, or it is a case of spatial Mexico: Measuring the Effects on Household Welfare.� World sorting—that is, do core regions breed export-ready firms or Bank Policy Research Working Paper 3265, Washington, DC. do export-ready firms seek out core regions? Rodriguez-Pose, A. 2010. “Trade and Regional Inequality.� World Bank Policy Research Working Paper 5347, Washington, DC. References Sumner, A. 2010. “Global Poverty and the New Bottom Billion: Baylis, K. R., R. Garduno-Rivera, and P. Piras. 2009. “The Distribu- What If Three-Quarters of the World’s Poor Live in Middle- tional Effects of NAFTA in Mexico: Evidence from a Panel of Income Countries?� Working Paper, Institute of Development Municipalities.� Agricultural and Applied Economics Associa- Studies, Brighton, UK. tion Annual Meeting, July 26–28, Milwaukee, Wisconsin. World Bank. 2009. World Development Report 2009: Reshaping Carvalho, A., S. V. Lall, and C. Timmins. 2006. “Regional Subsidies Economic Geography. Washington, DC. and Industrial Prospects of Lagging Regions.� World Bank Policy ———. 2012. “The Internal Geography of Trade Competitiveness: Research Working Paper 3843, Washington, DC. Lagging Regions and Global Markets.� International Trade Farole, T., and D. Winkler. 2011. “Firm Location and the Deter- Department, Poverty Reduction and Economic Management minants of Exporting in Developing Countries.� World Bank Network, Washington, DC. The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. They are produced by the Poverty Reduction and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect those of the World Bank. The notes are available at: www.worldbank.org/economicpremise. 5 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise