Structural reforms and regional convergence

Natasha Che, Antonio Spilimbergo 11 July 2012

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The Eurozone crisis is at heart a crisis of failed regional convergence and lack of structural reforms. The euro was supposed to facilitate a rapid convergence in the level of income and, most importantly, of productivity across countries. The founding fathers of the euro saw the single currency as a necessary condition for a single market, which, however, turned out to be incomplete without structural reforms. While the focus has been on the financial and fiscal aspects of the crisis, structural reforms that facilitate more cohesion and growth are the key to a long-term solution to the Eurozone crisis.

Regional disparities in income are important. Countries that have higher regional disparity in output per capita are usually poorer (Figure 1).

Figure 1. Correlation between regional GDP dispersion and country GDP level

Within the neoclassical framework, relatively poor regions with less capital and lower productivity should attract capital from rich and capital-abundant areas.1  Capital would also facilitate the catching up of productivity, not the least by spreading new ideas and technologies from the advanced to the backward parts of the world. Although convergence can happen both across countries that use different currencies and across regions within a country, sharing a single currency should accelerate the convergence process, because capital and technology can move more easily within the area.

However, the speed of convergence in Europe does not seem to bear much correlation with the introduction of a single currency. In fact, the speed of regional convergence in Europe has changed considerably over time: conditional beta-convergence was strong up to the end of the 1970s, stagnated during the 1980s, and then re-emerged at a slow pace (Magrini 2004). Was the slow (or slower-than-expected) convergence due to the lack of structural reforms that should have accompanied the currency union? What are the structural reforms that encourage regional convergence?

The current literature on the impact of structural reforms on convergence takes the country as the basic unit of observation and does not consider the impact of structural reforms on different regions within a country. For example, Aghion et al. (2005), with data of 71 countries from 1960 to 1995, interacted financial development variable with country's initial GDP in their growth regression, and found that domestic financial development speeds up convergence. However, a way in which structural reforms can help a country grow is by accelerating the catch up of the lagging regions to the advanced regions, though they sometimes do push further the growth of the latter.

Simple observation suggests that countries with less financial development also had more income disparity across regions. The same correlation holds for trade liberalisation.

Figure 2. Financial development and country GDP level

Figure 3. Trade liberalisation and country GDP level

But this evidence is only suggestive, because the correlation could be driven by other unobserved factors.

In recent research (Che and Spilimbergo 2012), we analyse if structural reforms affect the speed of regional convergence within a country. Using a large dataset comprising regional data for 32 (advanced and emerging) countries over the period of decades (for some countries like the US, 40 years) in a panel setting, they find that financial development, trade and current-account openness, low minimum wage, low severance payment, and good institutional infrastructure (rule of law, bureaucratic quality, low corruption) are indeed associated with faster convergence to the frontier regions, while low unemployment benefit and small labour tax wedge have the opposite effect. The impact of reforms on regional convergence is economically significant. For instance, when financial development moves from a minimum level to a very high level, annual growth rate is boosted by around 3% for regions whose distance to country frontier is at the 90 percentile. In fact, when the indicators for certain structural reforms are at the minimum level, regions simply do not converge at all.

But convergence-inducing structural reforms do not necessarily boost the growth of frontier regions. For example, there is not much evidence that financial development has a positive effect on the advanced regions. This is consistent with the idea that internal capital mobility does enhance the convergence process as the neoclassical growth framework suggests. Also, a good institutional environment is particularly beneficial for regions that are catching up, possibly indicating that good institutions make the reallocation of resources easier. In addition, we also find that certain structural reforms, such as more trade openness, higher unemployment benefit, and lower minimum wage, seem to make the backward regions benefit more from the growth of the advanced regions. This is possibly because some structural reforms can facilitate the transferring of ideas and technologies.

But at the end of the day, how much can a country gain from reducing regional income disparity? To answer this question we calculated what the hypothetical GDP per capita of a country would be if the GDP of the poorer part of a country (the poorer regions that consist 2/3 of the population) increased to the extent that the ratio of GDP per capita between the richer part of the country (the richer regions that consist 1/3 of the population) and the poor part would be equal to the ratio for the US. Table 1 reports the result. For a country like Thailand, for example, the country’s GDP per capita would be almost 50% higher.

Table 1. Comparison between hypothetical and actual GDP (1995-2005)

Country Hypothetical GDP per capita Actual GDP per capita Percentage change from actual to hypothetical GDP
Japan 29,723 29,385 1.15
Canada 31,812 31,383 1.36
Germany 30,925 29,392 5.08
Finland 29,175 27,726 5.10
Ireland 34,079 32,268 5.46
Belgium 32,247 30,353 6.05
Sweden 30,943 29,083 6.20
Greece 23,135 21,724 6.29
Slovenia 24,721 23,136 6.63
UK 31,245 29,172 6.86
Norway 41,114 38,203 7.35
Poland 12,642 11,626 8.37
Czech R. 19,155 17,614 8.38
Austria 31,371 28,694 8.92
Spain 26,323 23,834 9.93
Italy 30,957 27,728 11.02
Portugal 20,931 18,721 11.16
Slovakia 10,754 9,566 11.71
Hungary 17,633 14,069 22.58
India 2,585 2,041 23.65
Indonesia 5,435 4,250 24.59
Turkey 8,599 6,660 25.55
Sri Lanka 5,482 4,126 28.42
China 6,434 4,666 32.12
Mexico 12,500 8,968 33.21
Thailand 12,953 7,979 48.45

Note: Both the hypothetical and actual GDP numbers are averages over the period of 1995-2005.

Overall, the evidence points to the fact that some structural reforms are very instrumental in fostering the development of the lagging regions within a country. This suggests that the same reforms can also be very useful in accelerating the convergence within a currency union. For the EU in particular, strong structural reforms are a key factor to convergence across regions and countries. This is even more important for the European countries with large regional disparities.

References

Aghion, Philippe, Peter Howitt, and David Mayer-Foulkes (2005), “The effect of financial development on convergence: theory and evidence”, The Quarterly Journal of Economics, February, 173-222.

Cashin, Paul (1995), "Economic growth and convergence across the seven colonies of Australia: 1861-1991", Economic Record, 71(213):132-144.

Che, Natasha Xingyuan and Antonio Spilimbergo (2012), “Regional Convergence and Structural Reforms”, CEPR Discussion Paper 8951.

Coulombe, S and F Lee (1995), "Convergence across Canadian provinces, 1961 to 1991". Canadian Journal of Economics, 28(4a):886-898.

Holtz-Eakin, D (1993), "Solow and the states: Capital accumulation, productivity, and economic growth", National Tax Journal, 46(4):425-439.

Magrini, S (2004), “Regional (di) convergence”, Handbook of Regional and Urban Economics, 4:2741-2796.

Neven, D and C Gouyette (1995), "Regional convergence in the European Community", Journal of Common Market Studies, 33(1):47-65.

Sala-i-Martin, Xavier (1996), "Regional cohesion: Evidence and theories of regional growth and convergence", European Economic Review, 40(6):1325-1352.


1 This is the basis for a large empirical literature that documents evidence of regional convergence. For example, Sala-i-Martin (1996) found the existence of unconditional convergence across US states, Japanese prefectures, and several European countries and conditional convergence across a group of European regions. A similar exercise has been carried out for regions in different countries; e.g. Holtz-Eakin (1993) for US regions, Cashin (1995) for Australian regions, Coulombe and Lee (1993) for Canadian regions, and Neven and Gouyette (1995) for European regions.

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Topics:  Europe's nations and regions Global economy

Tags:  structural reforms, Eurozone crisis, regional convergence

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