NIST service models, cloud computing benefits and risks

Database Exercise
· Complete Review Question 3.10 on page 96 in the Connolly
text. Include a description of the 3 service models defined by
NIST.
· Which cloud computing benefit do you feel is the most
important and why?
· Which cloud computing risk do you feel is the most important
and why?
Include the questions with your answers
The submission should be well organized, demonstrate your
understanding of the assigned material and be in the order of
~1,000+ words in length.
Your submission must be original, include supporting sentences
using the terms, concepts, and theories with the page number or
website from the required readings or other material. Your
submission should paraphrase the material you reference,
restrict your use of direct quotes (copy and paste) to less than
20% of the submission (the grade will be impacted if you
exceed this limit).
***Turnitin Report Needed
Complementary Reforms and the Link between Trade
Openness and Growth in Albania
LINDA KALTANI
Abstract
This article uses previous findings by Chang, Kaltani & Loayza

on the important role
that reform complementarities play in the link between trade
openness and economic
growth to investigate whether reforms in a particular country,
Albania, are sufficient
for trade to be good for growth. The study simulates the growth-
producing effect of
Albania’s reforms given a pre-established change in trade
openness and contrasts it
with other countries’ performance. It then studies the reform
variables and their
alternative proxies by comparing their levels with those
predicted by Albania’s per
capita income. The article concludes that Albania’s most urgent
reforms are in the
areas of financial development, infrastructure and governance.
From the start of its transition to a market economy, Albania’s
goal has been to one
day join the European Union (World Bank 2006). Between
1992—the year in which
the new democratic government undertook a ‘shock therapy’
programme to establish a
market economy—and 1999 the country benefited from a
preferential trade regime,
known as a trade and cooperation agreement, with the EU which
facilitated access to
EU markets for textiles and agricultural goods (ACIT 2004). In
2000 the EU placed
Albania under the Autonomous Trade Preference (ATP) scheme
which allows almost
all of Albania’s exports to enter the Union without facing any
duties or quotas (World
Bank 2005c). More recently, in January 2003 negotiations on
the Stabilisation and
Association Agreement (SAA) between Albania and the EU

officially started, and the
SAA was signed in June 2006.
1
The recognition of the July 2005 elections by
the international community and the peaceful transition to a new
government make the
vision of a European future a bit more real for Albania.
Although EU accession is still
far away, the signing of the SAA will entail further
liberalisation between Albania and
the EU. For this reason, it is important to question to what
extent Albania is prepared
to take advantage of the fast-approaching wave of trade
liberalisation.
This article builds on the findings of Chang, Kaltani & Loayza
(2005) which
corroborate the positive link between trade openness and
economic growth. More
ISSN 1463-1377 print/ISSN 1465-3958 online/07/020225-29 q
2007 Taylor & Francis
DOI: 10.1080/14631370701312329
Dr Linda Kaltani, The World Bank, Washington, DC, USA.
Email: [email protected]
1
In general a Stabilisation and Association Agreement is a treaty
between the EU and non-member countries
that creates a framework of cooperation among them. In the
case of the countries of the Western Balkans an

SAA is part of the Stabilisation and Association process (SAp)
and includes explicit provisions for future EU
membership.
Post-Communist Economies, Vol. 19, No. 2, June 2007
importantly, these findings indicate that there are significant
reform complementarities
in the areas of financial depth, human capital investment,
infrastructure development,
governance, labour market flexibility and firm entry flexibility
that strengthen the link
between trade openness and economic growth. These results
suggest that the
advisability of trade liberalisation may depend on the level of
complementary reforms
present in a country at the time of the trade policy change.
Driven by the findings of Chang et al., this article analyses the
state of reforms
in Albania. The goal of this work is to question whether the
level of reforms in
Albania is sufficient for trade liberalisation to promote
economic growth. First, the
analysis presents simulation results of the growth effect of a
predetermined change
in trade openness given complementarities in six areas of
reform found significant
by Chang et al. The simulations highlight Albania’s (as well as
two comparator
countries’) potential gain in terms of economic growth given the
current level of

development in the complementary reform areas. The adequacy
of each reform
variable is also compared with the level predicted by Albania’s
per capita
income level, a measure of overall economic development.
Subsequently, we study
alternative reform proxies for the six complementary reform
areas mentioned above.
The goal here is to examine each reform area in more depth and
to highlight
those that may require additional improvement. The adequacy of
the additional
proxies is assessed by comparing their actual level in Albania
with the level that
would be expected given the country’s per capita income. Given
the intention to
highlight areas for further improvement, only those proxies that
are inadequate
given Albania’s per capita level of income are discussed more
extensively in this
article.
The article is organised as follows. First it reviews Albania’s
economic performance
during the transition years. Next it discusses reform
complementarities in the link
between trade openness and growth. Then it discusses the
empirical findings of Chang
et al. Following this it evaluates Albania’s state of reforms. The
final section concludes.
Albania’s Trade Performance during Transition
From the accession to power of the communist regime after
World War II until its first
democratic elections in 1992, Albania was one of the best

examples of autarchy
around the globe. In fact, aside from the alliances with the
Soviet Union and China
which ended in 1956 and 1978 respectively, Albania relied very
little on foreign trade.
As Kaplan (1994) vividly describes, ‘Albania’s was a primitive
service economy: little
was imported and there were no factories mass producing shoes
or clothes. A . . .
youth . . . begged me for gum: even in the poorest Third World
countries, children
sold gum: here there was none to sell’.
Eager to overcome more than 40 years of isolation, Albania
pursued a policy of
multilateral liberalisation right from the beginning of its
transition period. In 1992
Albania signed the Trade and Cooperation Agreement with the
EU, and in 1993 it
applied for WTO membership. Albania became a WTO member
in 2000 (World Bank
2004). In this process of global integration, Albanian tariff
rates, as depicted in
Figure 1, have steadily declined from 15% in 1996 to 7.3% in
2004. Albania now has
one of the most liberal trade regimes in its region (World Bank
2005c).
Furthermore, the negotiations for the SAA with the EU have
required Albania and
other SAA candidates to foster regional cooperation with each
other. As a
consequence, the simplification of commercial logistics through
the enhancement of
simpler and more transparent customs procedures has allowed
freer trade among the

226 Linda Kaltani
eight countries of South Eastern Europe (SEE-8).
2
Perhaps because of the pressure
from the EU, at the end of 2004 Albania had signed free trade
agreements with all the
other SEE-8 countries as well as Kosovo (EIU 2005). In
addition, the Albanian
government is also trying to sign a free trade agreement with
Turkey.
Figure 2 depicts the significant increase in Albania’s trade
openness since the
beginning of transition. Albania’s trade as a share of GDP has
climbed from 12% in
1991 to 73% in 2003. Although imports as a share of GDP are
clearly larger, the share
of exports to GDP has steadily increased since 1997. The
persistent current account
deficit has been financed to a large extent by remittance flows
from Albanians living
abroad, mainly in Greece and Italy. Korovilas (1999) has
estimated that remittances to
Albania may have been a lot larger than has been estimated by
the International
Monetary Fund, that they have allowed a situation of economic
stability without a
balance of payments crisis, and that they have provided the hard
currency to import
building materials and capital goods which were vital to
Albania’s economic recovery.

With the exception of 1997, Albania has made remarkable
progress in its
integration into the world economy, although from a very low
base. Since 2000 the
country’s openness seems to have peaked at around 73% of real
GDP. This may be a
converging point given the country’s structural characteristics.
However, it may still
be too early to make such an assessment given the possible
detrimental impact of the
past regional conflicts on Albania’s foreign trade. In a
comparative context, the rate of
growth of Albania’s openness, although significantly higher in
the 1990s, appears to
have tapered off since 2000 and has become similar to the rest
of the transition
countries and the SEE-8 (Figure 3). Nevertheless, convergence
of the growth rates of
trade openness would imply that the level of openness for
Albania is likely to remain
significantly below the rest of the SEE-8 countries.
In the aftermath of the communist experiment, many economists
questioned where
and to what extent trade should be redirected. Wang & Winters
(1991), Baldwin
(1993) and Collins & Rodrik (1991) concluded that high
integration potentials were
likely for the former communist countries vis-à-vis Western
European economies.
Jakab et al. (2001) have confirmed these earlier studies.
However, they have also
suggested that trade reorientation has been heterogeneous
among transition countries

Figure 1. International trade regime, 1996 – 2004.
2
The other seven SEE-8 countries are Bosnia and Herzegovina,
Bulgaria, Croatia, Macedonia, Moldova,
Romania and Serbia and Montenegro.
Reforms, Trade Openness and Growth in Albania 227
with those with more sophisticated product structures and more
FDI converging at a
faster rate. These findings would lead to the expectation of high
reorientation for
Albania’s trade that would continue into the future as the
country’s export structure
evolves into more high-technology products that would change
its trade relationship
with the EU away from one of centre to periphery.
Albania’s experience so far confirms the expectations of the
abovementioned
literature by displaying an almost complete reorientation of
trade toward the EU
(Figures 4 and 5). In 2004 more than 90% of Albania’s exports
went to the EU, with
Italy importing 74% of the total. The EU is also Albania’s
primary source of imports,
accounting for 70% of the total in early 2004. This is a
significant change from the pre-
1990 period when close to 50% of Albania’s exports and
imports where going to and
coming from other communist countries. Albania’s trade with
countries other than the

EU (i.e. transition countries as well as Turkey and China) has
steadily increased in
Figure 2. Albania’s trade as a share of GDP, 1991 – 2003.
Figure 3. Trade openness in transition countries.
228 Linda Kaltani
recent years. Trade is likely to increase at an even faster rate in
the future due to the
free trade agreements with the rest of the SEE-8 and the likely
agreement with Turkey.
Nevertheless, the growth rate of exports and imports with the
EU is still higher than
any other comparator group. It seems clear that Albania’s eyes
are on the EU both as a
trading partner in the short and medium run and as a full
member in the long run.
Albania’s composition of trade has also drastically changed
from the communist
years when the country was exporting very little and exports
were unprocessed
primary materials, fuels and minerals (Figure 6). Today
Albania’s main exports are
determined by its proximity to its trading partners and low
labour costs, and are mainly
manufactured goods in the form of textiles and footwear and re-
exports of semi-
finished goods. Like exports, the composition of imports has
become heavily skewed
toward the manufacturing sector (Figure 7). Albania’s reliance
on foreign

manufacturing products lies mainly in capital equipment and
building materials. In
addition, in the recent past (since 1999) the country has relied
less on foreign food
imports but more so for minerals and fuels; this is partly due to
the country’s continued
Figure 4. Albania’s sources of imports.
Figure 5. Albania’s destinations of exports.
electricity crises that reached unprecedented levels in 2001 – 02
and the last quarter of
2005.
With the exception of 1997, the year of the collapse of the
pyramid investment
schemes, Albania has experienced substantial economic growth
during the transition
period (Figure 8).
3
The high growth is greatly due to the reorientation of resour ces
to
more efficient uses, in part through trade liberalisation and the
ability of technological
know-how to enter the country (World Bank 2004).
4
Further trade integration with the

EU and neighbouring countries is likely to continue in the
future. For these reasons
and in light of the empirical findings of Chang et al., it is
informative to analyse
whether the complementary reforms that strengthen the link
between openness and
growth are in place and adequate in extent in Albania. Although
full EU membership
Figure 6. Albania’s composition of exports.
Figure 7. Albania’s composition of imports.
3
In the years leading to 1997 a large number of Albanians
invested big portions of their savings in fictitious
businesses promising exuberant returns. The whole set-up
collapsed when in early 1997 one of the companies
was unable or unwilling to pay back its customers, causing a
run that threw the country into unrest and near
civil war.
4
World Bank (2004) provides in-depth discussion of the sources
of growth in Albania.
230 Linda Kaltani
is still in the distant future, Albania needs to focus on removing
the impediments to
trade and to complete non-trade reforms so as to be able to take

full advantage of trade
openness in generating economic growth.
The Role of Policy Complementarities
After reviewing both the theoretical arguments for and against
trade liberalisation and
the findings of the empirical literature, Chang et al.
5
draw two conclusions from which
they build their work.
6
The first is that the average effect of trade opening on
economic growth is positive. The second is that behind this
positive average effect
there is considerable diversity regarding the aftermath of trade
liberalisation. This
raises the question whether the observed heterogeneity is
random or follows a
systematic pattern. The theoretical literature indicates that the
diverse growth response
to openness is not arbitrary but depends on a variety of
conditions related to the
structure of the economy and its institutions. Two simple
illustrations may serve to
convey this point. The first is taken from >Calderón, Loayza &
Schmidt-Hebbel
(2004). They allow the effect of trade openness on growth to
depend (non-linearly) on
the level of per capita GDP. Figure 9 shows their resul ts by
plotting the estimated
growth effect of a one-standard deviation increase in openness
as a function of per

capita GDP. The growth effect of openness is nearly zero for
low levels of per capita
GDP, increases at a decreasing rate as income rises, and reaches
a maximum only at
high levels of income. The conclusion would be that the growth
effect of openness
would be economically significant for middle and high-income
countries.
Finding that the growth effect of openness increases with
income in turn raises
another interesting question: what is it about overall
development (proxied by per
capita income) that makes a country take better advantage of
openness? Consider the
next illustration. Figure 10 plots changes in growth rates of per
capita GDP between
the 1980s and 1990s versus changes in the volume of trade (as a
ratio to GDP) between
those two decades for a worldwide sample of 82 countries. This
figure has four panels;
Figure 8. Albania’s real GDP per capita, 1980 – 2003.
5
This section and the next draw heavily on the work of Chang et
al. (2005).
6
See Chang et al. for an in-depth discussion of the arguments for
and against trade liberalisation and for the
most prominent empirical findings on this topic.

in each of them the country observations are separated
according to whether they
belong to the top one-third (diamonds) or bottom two-thirds
(squares) of a rank
distribution given by, in turn, each of the following criteria: a)
secondary enrolment
rates (a proxy for human capital investment); b) main telephone
lines per capita
(a proxy for public infrastructure); c) a subjective index of the
quality of governance;
Figure 10. Changes in growth rates of per capita GDP versus
changes in openness
between the 1990s and 1980s.
Figure 9. Growth effect of trade openness as a function of
overall development.
232 Linda Kaltani
and d) a de facto and de jure index of labour market flexibility.
Each criterion used for
ranking country observations is measured over the 1980s, the
initial period.
Dividing the country observations into top and bottom groups
makes it possible to
compare the corresponding slopes for the relationship between
changes in trade
volume ratios and changes in economic growth rates. In all
panels, the OLS line
described by the bottom observations is basically flat, implying

no relationship
between trade opening and growth improvements. However, for
the top observations,
the slope of the OLS line is positive and steeper than that for
the bottom group.
7
This is
quite a simple exercise, but it points to the heterogeneous
growth response to trade
opening which depends on specific country conditions, such as
educational
achievement, public infrastructure, governance and labour
flexibility.
In conclusion, it appears that the eventual success of openness
in terms of growth
performance—and all the good things that come with growth
such as employment and
poverty alleviation—depends on the economic and institutional
characteristics that
make economic agents, both workers and firms, able to adjust to
the new conditions
and opportunities presented by international competition. Will
firms be able to
increase productivity to make their products attractive in
foreign markets? Will the
creation of new firms and destruction of obsolete ones (the
Schumpeterian process of
‘creative destruction’) proceed smoothly, without large
dislocation of employment
and capital? Will workers be able to refocus their skills to be
employed in emerging
sectors? Will the financial system recognise and provide
resources for good

investment opportunities? Will public infrastructure in
telecommunications, roads and
ports support the process of transformation with inexpensive
costs and sufficient
availability? Will entrepreneurs direct their resources to
activities where the country
has a comparative advantage from a long-run perspective or will
they concentrate on
short-lived extractive sectors? Will firm owners choose a
technology that takes
advantage of the country’s abundant labour resources or will
they regard labour costs
and regulations as something to avoid? Finally, will economic
agents concentrate their
energies in productive activities or will they divert them to rent
seeking? The answers
to these questions will condition and determine the performance
of the economy in the
aftermath of liberalisation. They will depend on the progress the
economy can make in
educational achievement, financial development, public
infrastructure, good
governance and product and labour market flexibility.
Cross-Country Econometric Evidence
This section presents some cross-country empirical evidence
developed by Chang
et al. on how the growth effect of openness depends on a variety
of structural
characteristics, which at least in principle are subject to reform.
The panel data growth
regressions presented use a Generalised Method of Moments
(GMM) procedure that
controls for endogeneity and unobserved country-specific
factors in order to estimate

the growth effect of openness, as well as that of other policy
and non-policy variables.
In addition, and unlike previous studies mentioned, Chang et al.
allow for a
heterogeneous impact of openness on growth by interacting the
openness measure
with proxies of, respectively, educational investment, financial
depth, inflation
stabilisation, telecommunications infrastructure, governance,
labour market flexibility
and ease of firm entry and exit.
7
This is significantly so in the cases of educational investment,
public infrastructure and governance. Labour
market regulation is not a statistically significant criterion in
this simple example but becomes so once we use
more satisfactory econometric methods later in the article.
Chang et al. work with pooled cross-country and time series
data, focusing on
comparative information from within-country changes. The
sample consists of an
unbalanced panel dataset that comprises 82 countries. For each
of them, there are at
most eight observations, consisting of non-overlapping five-
year averages spanning
1960 – 2000.
The regression specification studying reform complementarities

is obtained by
interacting the openness measure with each of the control
variables in turn and can be
written as
yi;t 2 yi;t21 ¼ b0yi;t21 þ b
0
1cvi;t þ b2OPi;t þ b3cvi;t*OPi;t þ mt þ hi þ 1i;t ð1Þ
where the subscripts i and t represent country and time period,
respectively; y is the log
of GDP per capita, CV is a set of control variables, and OP
represents trade openness;
mt and hi denote unobserved time and country-specific effects
respectively; and 1 is
the regression residual. Openness is interacted with the control
variables one at a time
in order both to simplify the interpretation of the results and not
to overextend the
parameter requirements on the data.
Regression results are presented in Tables 1 and 2. Table 1
shows the results of the
basic regression with no interaction terms (column 1) and the
results of the regressions
where openness is interacted with time-varying variables
(columns 2 – 5). These
variables represent areas where economic reform has been most
active; they are
educational investment, financial depth, macroeconomic price
instability and public
infrastructure. Table 2 shows the regression results where
openness is interacted with
time-invariant variables. They represent institutional and
regulatory areas where
reform—often called ‘second generation’—has been most

sluggish. They are indices
of governance, labour market flexibility, firm entry flexibility
and firm exit flexibility.
These are treated as constant per country because their
underlying institutional
characteristics vary little over time and, partly reflecting this,
there are quite limited
data on their time dimension.
8
The basic regression (Table 1, column 1) shows results
consistent with the
previous empirical literature. Table 1 also shows the regression
results that consider
interaction effects between openness and time-varying variables
(columns 2 – 5). An
interesting pattern of reform compleme ntarity emerges: the
coefficient on the
interaction between the trade volume ratio and, in turn, the
secondary enrolment rate,
the private domestic credit ratio and the number of telephone
lines per capita is
positive and significant. This indicates that the growth effect of
an increase in
openness depends positively on the progress made in each of
these areas: more
openness results in a larger increase in economic growth when
investment in
education is stronger, financial markets are deeper and
telecommunications
infrastructure is more readily available. The shared explanation
for these results is
related to the competitiveness of domestic firms in international
markets: when
domestic firms find a better educated labour force and less

costly credit and
communications, they are able to compete with foreign firms
and expand their markets
effectively. The interaction between trade volumes and inflation
is not significant,
8
The ICRG governance index is available since the mid-1980s
and shows some time variation. Given that we
are forced to assume that its value was the same in the 1960s
and 1970s as in the mid-1980s, we make the
conservative assumption that its growth effect cannot be
estimated separately from that of the unobserved
fixed effect, as is the case with the other institutional variables
that are completely constant over time.
234 Linda Kaltani
possibly reflecting the fact that, for most inflation values,
relative price distortions are
not severe.
Table 2 shows the growth regression results when openness is
interacted with the
proxies of institutional and regulatory reform. Interestingly, as
in the results related to
time-varying variables, a pattern of complementarity emerges
other reforms: the estimated coefficients on the interaction
between the trade volume
ratio and, in turn, the proxies for governance, labour market

flexibility and firm entry
flexibility are positive and statistically significant. The
beneficial impact of an increase
Table 1. Economic growth and interaction between openness
and other economic
reforms
Interaction of openness with:
[1]
Benchmark:
no interactions
[2]
Human capital
investment
[3]
Financial
depth
[4]
Inflation
[5]
Public

infrastructure
Control variables:
Initial GDP per capita 23.1713** 23.2036** 23.2627**
23.2059** 23.3552**
(in logs) 0.18 0.21 0.17 0.18 0.23
Human capital
investment
1.1621** 20.8610** 1.2105** 1.1402** 1.2594**
(secondary enrolment, in logs) 0.15 0.42 0.16 0.16 0.17
Financial depth 1.0272** 0.9421** 0.0262 1.0071** 0.9234**
(private domestic
credit/GDP, in logs)
0.11 0.09 0.21 0.11 0.07
Inflation 20.4580** 20.4350** 20.4895** 20.3243 20.4364**
(deviation of inflation
rate from 23%, in logs)
0.08 0.07 0.07 0.21 0.07
Public infrastructure 1.5764** 1.5904** 1.6053** 1.6050**
0.6423**
(main telephone lines
per capita, in logs)

0.13 0.16 0.14 0.14 0.19
Openness:
Trade Openness (TO) 1.1959** 22.0421** 20.2553 1.3497**
3.2821**
(structure-adjusted
trade volume/GDP,
in logs)
0.16 0.59 0.28 0.28 0.48
Interactions:
TO * Human capital
investment
1.0031**
0.18
TO * Financial depth 0.4629**
0.08
TO * Inflation 20.0725
0.10
TO * Public
infrastructure
0.4970**

0.09
Period Shifts:
Intercept (base period:
1966 – 70)
26.6266** 33.8398** 30.5385** 26.8523** 24.3839**
—71 – 76 Period shift 20.2987* 20.2371 20.2168 20.2698
20.2973**
—76 – 80 Period shift 21.1300** 21.1488** 21.0385**
21.1052** 21.1850**
—81 – 85 Period shift 23.3327** 23.3847** 23.2966**
23.3011** 23.4343**
—86 – 90 Period shift 22.9064** 23.0726** 22.9450**
22.8904** 23.1684**
in trade openness on economic growth is larger when society
has a more efficient,
accountable and honest government and where the rule of law is
more respected.
Likewise, the positive growth effect of trade opening is stronger
when flexible labour
markets make it easier for domestic firms to transform and
adjust to changing
environments, particularly those in highly competitive foreign
markets. These results
also point out the importance of unrestricted firm renewal if
trade opening is to have a

positive growth impact, particularly regarding the firm entry
margin. The interaction
term between openness and firm exit flexibility is, however, not
significant; whether
this reflects data quality problems or a more substantial
difference with the opposite
margin of firm dynamics is unclear.
Albania’s State of Reforms in the Face of Increased Trade
Openness
The econometric analysis presented above can be used to assess
how well prepared a
country is to assume the challenges and opportunities of trade
openness. This can be
done by calculating the growth impact of a change in openness
given the country’s
level of progress in each area of complementary reform.
Moreover, the analysis can
serve to highlight the areas where further progress will allow
the country in question to
increase the positive growth impact of international trade
openness.
For this purpose, it is necessary to ascertain what the total
growth impact of a
change in openness is. This requires considering the regression
coefficients on both
the interaction term and the openness variable itself. Since the
total impact depends on
the values of the variables with which openness is interacted, it
will vary from country
to country. Specifically, from regression equation (1), the total
impact on growth is
given by the first derivative of the growth equation with respect
to the openness

variable then multiplied by a predetermined change in openness,
here denoted D
Openness:
D Growth ¼ ðb2 þ b3*Complementary ReformÞ*DOpenness
ð2Þ
Table 1. Continued
[1]
Benchmark:
no interactions
[2]
Human capital
investment
[3]
Financial
depth
[4]
Inflation
[5]
Public

infrastructure
—91 – 95 Period shift 23.6060** 23.8088** 23.6621**
23.6020** 23.9486**
—96 – 00 Period shift 24.3282** 24.6922** 24.4665**
24.3250** 24.8331**
Countries/observations 82/544 82/544 82/544 82/544 82/544
Specification tests ( p-values)
—Sargan test 0.42 0.42 0.37 0.39 0.47
—2nd. order correlation 0.15 0.14 0.15 0.14 0.14
Notes: Cross-country panel data consisting of non-overlapping
five-year averages spanning 1960 – 2000.
Dependent variable: Growth rate of real GDP per capita.
Estimation method: GMM-IV system estimator (Arellano &
Bover 1995; Blundell & Bond 1997).
Numbers below coefficients are the corresponding robust
standard errors. * (**) denotes statistical
significance at the 10 (5)% level.
Source: Chang et al. 2005.
236 Linda Kaltani
where the symbol D means change and b2 and b3 are the

estimated coefficients on
openness by itself and the interaction term. Here
‘complementary reforms’ are those
variables that have a significant interaction with openness in the
growth regression.
Clearly, the growth effect of a change in openness will be a
linear function of each
complementary reform. To scale the function at reasonable
values, the change in
openness is set equal to one standard deviation of the openness
measure used in the
regression analysis. Figure 11 plots (or simulates) the function
in expression (2) for
the full range of sample values of each of the six
complementary reforms: educational
Table 2. Economic growth and interaction between openness
and institutional/
regulatory reforms
1
[1]
Governance
[2]
Labour market
flexibility
[3]

Firm entry
flexibility
[4]
Firm exit
flexibility
Control variables:
Initial GDP per capita 23.4019** 24.0229** 23.0202**
23.2063**
(in logs) 0.33 0.24 0.21 0.18
Human capital investment 1.2845** 1.5146** 1.7603**
1.2424**
(secondary enrolment, in logs) 0.16 0.16 0.16 0.11
Financial depth 0.9632** 1.2870** 0.9063** 1.3196**
(private domestic
credit/GDP, in logs)
0.12 0.12 0.12 0.12
Inflation 20.3830** 20.3513** 20.5266** 20.2848**
(deviation of inflation rate
from 23%, in logs)
0.08 0.08 0.08 0.07
Public infrastructure 1.5912** 1.6379** 1.4037** 1.0532**
(main telephone lines

per capita, in logs)
0.17 0.12 0.14 0.13
Openness:
Trade Openness (TO) 0.0802 23.7359** 23.5333** 1.6581**
(structure 2 adjusted trade
volume/GDP, in logs)
0.33 0.64 0.69 0.27
Interactions:
TO * Governance 2.9617**
(governance: index from
ICRG, 0 – 1)
0.87
TO * Labour market flexibility 8.9986**
(labour: index from DB,
0.21 – 0.80)
1.36
TO * Firm entry flexibility 7.4593**
(entry: index from DB,
0.25 – 0.94)
1.31

TO * Firm exit flexibility 20.8598
(exit: index from DB, 0 – 1) 0.73
Period shifts:
Intercept (base period: 1966 – 70) 30.1810** 39.9023**
34.5819** 20.0764**
—71 – 76 Period shift 20.2943* 20.6062** 20.3485* 20.6757**
—76 – 80 Period shift 21.1737** 21.5945** 21.2628**
21.5267**
—81 – 85 Period shift 23.4484** 23.7077** 23.6949**
23.5881**
—86 – 90 Period shift 23.1087** 23.3740** 23.3734**
22.9243**
—91 – 95 Period shift 23.9498** 23.9600** 24.0722**
23.5820**
—96 – 00 Period shift 24.6800** 24.4676** 24.8611** 23.8035
investment, financial depth, telecommunications infrastructure,
governance, labour
market flexibility and firm entry flexibility. Therefore, the
range of the x-axis in each
panel varies and corresponds to that of each complementary
reform proxy. Moreover,
the proxies for educational investment, financial depth and
telecommunications
infrastructure are in log form, and thus their ranges may take on
negative and positive
values. Governance, labour market flexibility and firm entry
flexibility are captured by

indices spanning only the positive space.
Since for policy analysis the most current reform values are the
most relevant, the
range corresponding to the latest period (1996 – 2000) is
highlighted in bold.
9
This
bold line is reform-specific and thus varies from panel to panel,
but it has the common
feature of lying to the right of the all-period range since
reforms have advanced since
1960, and improvement is captured by movement to the right on
the x-axis of each
panel.
For all the reform variables in Figure 11 except the governance
index, the total
growth impact of openness changes from negative to positive as
progress occurs.
Therefore, in principle, for five out of the six complementary
reforms an increase in
openness could bring a reduction in economic growth if a given
complementary area is
not sufficiently advanced. In practice, given the current state of
reform progress
around the world (highlighted by the bold horizontal lines), this
concern is presently
relevant for half the complementary areas under consideration.
For educational
enrolment, financial development and governance, the results
indicate that they would
not cause growth to decline with increased openness given that
their current values

exceed the corresponding threshold below which trade
liberalisation would damage
growth (this would be any value to the left of each line’s
intersection with the x-axis in
Figure 11). However, regarding telecommunications
infrastructure, labour market
flexibility and firm entry flexibility, there are countries that
currently stand to lose
Table 2. Continued
[1]
Governance
[2]
Labour market
flexibility
[3]
Firm entry
flexibility
[4]
Firm exit
flexibility
Countries/observations 82/544 79/523 82/544 78/518

Specification tests ( p-values)
—Sargan test 0.37 n.a. 0.38 n.a.
—2nd. order correlation 0.12 0.28 0.13 0.25
Notes: Cross-country panel data consisting of non-overlapping
five-year averages spanning 1960 – 2000.
Dependent variable: Growth rate of real GDP per capita.
Estimation method: GMM-IV system estimator (Arellano &
Bover, 1995; Blundell & Bond 1998).
Numbers below coefficients are the corresponding robust
standard errors. * (**) denotes statistical
significance at the 10 (5)% level.
1
The measures of institutional and regulatory reform do not vary,
or vary little, over time. Their
direct impact on growth cannot be separated from that of the
country-specific effect; however, we
include them as an additional control.
Source: Chang et al. 2005.
9
Clearly, for time-invariant variables the bold line will cover the
whole range.
238 Linda Kaltani

from opening their markets. Focusing only on the reform
indicators used in this article
and taking a worldwide perspective, the implication would be
that the most urgent
reforms to ensure that trade promotes growth are related to
infrastructure, labour
markets and firm renewal, since their level in some countries is
so low as to cause a
negative growth effect. This is not to say, however, that
countries will not benefit more
from trade openness if they improve their educational
attainment, financial depth and
overall governance.
In addition to total growth effects (based on the coefficient
point estimates), Figure 11
shows two dotted lines which are the corresponding 90%
confidence bands
(constructed with the estimated coefficient standard errors) .
Finally, each plot
in Figure 11 identifies where Albania is located in 1996 – 2000
in terms of its
Figure 11. Growth effect of a change in one standard deviation
of openness for
various reform areas.
complementary-reform value and the corresponding growth
effect of openness. In
addition, two comparator countries are also identified. They are

Croatia and Ireland.
Both countries have performed like Albania or better in terms of
growth and
complementary reforms.
10
Given Albania’s state of reforms, a one standard deviation
change in trade
openness would lead to approximately a 0.9% increase in
growth in the regressions
with education, infrastructure and labour market flexibility,
while it would lead to a
0.2%, 0.7% and 0.7% increase in the regressions with financial
development,
governance and firm entry flexibility respectively.
Clearly, if Albania were to make progress in any of the six
reform indicators
by moving further to the right on the x-axis of each panel, the
effect on economic
growth would be even larger. Thus, although Albania can only
gain from trade
openness given its state of reforms (i.e. in all six panels
Albania’s impact on
economic growth is a positive value), it has a lot of room for
improvement in
each of these areas to get closer to the best practice countries
(those lying to the
extreme right of the x-axis).
One limitation of the empirical estimation, and consequently of
the simulations, is
the fact that the reform variables are proxies commonly used in
the economic literature
to capture development in areas such as human capital

investment, financial depth,
infrastructure development, governance, labour market
flexibility and firm entry
flexibility. As proxies they are typically highly correlated with
other variables that
describe the same reform area and are therefore very often
interchangeably used in the
literature.
11
The choice of proxies in the Chang et al. empirical estimation
was driven
by their wide availability both across countries and over time,
which, in turn,
guaranteed the largest possible sample from which to draw
conclusions on the role of
reform complementarities in the link between trade openness
and economic growth. It
is, however, conceivable that for some countries where reforms
have been uneven,
alternative proxies may portray a very different picture of the
state of development of a
particular reform area.
Driven by such considerations and recognising the general
pattern of high
cross-country correlations between variables capturing a
specific reform area, this
article questions whether Albania’s level of reforms, as
measured by various
proxies, is adequate for reform complementarities to ameliorate
the positive link
between trade liberalisation and economic growth. What we are
looking to find is
whether there are reform areas in Albania that are not as

advanced as the
regression proxies would suggest. These findings, in turn,
would question
Albania’s placement in Figure 11.
10
Croatia was picked as a regional comparator despite the fact
that its growth rate for 1996 – 2000 was 4.8%,
slightly lower than Albania’s, which amounted to 5%. Ireland
was picked as an example of a reformer around
the world. There was no country that scored higher than Albania
in terms of labour market flexibility and also
experienced higher growth.
11
For example, in the specific case of infrastructure development,
the economic literature interchangeably uses
roads, telephone lines or energy consumption. Other reform
areas display the same variety of choices. Here are
some cross-country correlations of the alternative variables that
are in the analysis below. The correlation
between education enrolment and education quality is 0.66. The
correlation between measures of energy
sector efficiency and telecommunications is 0.5. The correlation
between the quantity of credit and the quality
of the regulatory environment in the financial sector is 0.54.
The correlation between the composite

governance index and its sub-components ranges from 0.76 to
0.86. The correlation of the governance index
with other measures of governance such as, for instance, the
number of procedures required to enforce
contracts is 2 0.54.
240 Linda Kaltani
This exercise first compares Albania’s progress in each of the
six complementary
reforms used in the regressions with the level predicted by the
country’s per capita
income, which is the best available measure of overall
development. This makes it
possible to assess whether Albania is at a level of reform
progress adequate for its
development. Then alternative measures capturing the six
reform areas are plotted
against Albania’s per capita income. In those cases in which
Albania’s performance is
poor given its level of development, the graphical evidence
would highlight areas
where the country’s progress may have been uneven so as to
create potential
bottlenecks in the relationship between trade liberalisation and
economic growth.
Specifically, Figures 12 – 24 are scatter plots which display
GDP per capita on the x-
axis for the largest possible sample available and on the y-axis
have either the actual
reform proxies used by Chang et al. in their empirical analysis
or alternative variables

for these reform areas. The regression line described by each
scatter plot can provide a
prediction of Albania’s reform level given its income per capita.
This in turn makes it
possible to compare the actual level of the reform variable with
its prediction and to
conclude whether it is adequate. The discussion below will
emphasise only those cases
in which Albania’s performance is poor given its level of
development.
The sub-sections that follow discuss complementary reforms in
the areas of
educational achievement, financial development, public
infrastructure, governance,
labour and firm entry flexibility. The analysis starts with the
reform variables
considered in the cross-country estimation above in the most
current year available
(usually 2003); then it is extended to aspects that seem most
relevant for the case of
Albania as determined by experts’ advice and data availability.
12
Figure 12. Infrastructure vs. income level.
12
An initial analysis looked at telephones, electricity and water
for infrastructure development; school
enrolments, international educational assessment scores, teacher
– pupil ratios and expenditure on education
for human capital investment; availability of private credit,
legal rights, cost of collateral and creditor

information for financial development; corruption, rule of law,
quality of bureaucracy, accountability of public
officials, contract enforcement, property registration and
investor protection for governance; difficulty of
hiring and firing workers, rigidity of work hours and the size of
the informal sector for labour market
flexibility; number of procedures, duration, cost and minimum
capital for firm entry flexibility. Then, only
those proxies that appeared problematic given Albania’s level
of development and given comments from
experts are discussed below.
Infrastructure
The cross-country regression equations presented above use as a
proxy for
infrastructure the per capita number of main telephone lines.
This choice is driven
mainly by the need to have large data coverage in terms of both
countries and years.
The drawback of this variable is its inability to fully depict the
state of infrastructure in
a particular country since it fails to consider transport, energy
or roads, which are
equally vital to international trade.

Regarding telecommunications infrastructure, the simulation
exercise indicates
that, given its level in 1996 – 2000, Albania would gain from
increased trade openness.
In addition, Figure 12 plots countries’ measure of per capita
telephone lines against
their income per capita and shows that Albania’s
telecommunications infrastructure is
Figure 13. Electrical transmission and distribution losses vs.
income level.
Figure 14. Electricity constraints vs. income level.
242 Linda Kaltani
adequate for its level of development although far lower than
that of other SEE-8
countries.
When considering alternative proxies for infrastructure
development, it becomes
evident that the area that is most problematic for Albania’s
infrastructure is that of
energy. In fact, transmission and distribution losses, which are
due to technical faults
and energy theft, are very large for Albania although they have
demonstrated a
declining trend since the 63% peak in 1999. As Figure 13
demonstrates, Albania’s
energy losses are beyond what would be expected at its level of
development and are
lower only than Moldova among all transition countries.

Figure 15. Electricity services vs. income level.
Figure 16. Financial development vs. income level.
The effect of the electricity crisis on economic activities
becomes clearer in Figure
14; nearly 60% of Albanian businessmen interviewed in 2002
consider electricity
constraints to be large and a major obstacle to production. This
is the largest share
among all transition countries and is lower only than
Bangladesh in the world sample
available.
The crisis in the power sector has been driven by a combination
of factors. The rise
in the demand for electricity over the transition years has been
coupled with Albania’s
unpredictability of energy supply due to its exclusive reliance
on hydropower. To
these constraints one can also add vast losses in transmission
and distribution due to
theft and technical faults. Furthermore, financial constraints
(i.e. insufficient revenue
Figure 17. Credit information vs. income level.
Figure 18. Education vs. income level.
244 Linda Kaltani

collection) as well as a lack of connectivity to the rest of
Europe and limitations in the
distribution network have put a ceiling on the amount of
electricity that can be
imported at any particular time and forced KESH (Albanian
Energy Corporation) to
resort to load shedding. These difficulties, in turn, have forced
private individuals and
businesses to resort to expensive back-up generators and have
had a negative impact
on potential investment in Albania (UNDP 2004).
When businessmen are asked about the number of days during
which power cuts
were experienced, Albanians again reiterate their electricity
problems by counting
over 40 days with power cuts per year, significantly above the
rest of the SEE-8
countries (Figure 15). Although the most recent data for these
figures are from 2002
and 2003, the crisis in the power sector remains relevant today
and has escalated to
even higher levels. The weather conditions in the last quarter of
2005 led to a
Figure 19. Brain drain vs. income level.
Figure 20. Governance vs. income level.
widespread energy crisis (European Commission 2006). It is
still unclear how large an

effect this crisis will have on the economy, but the
repercussions are likely to be
substantial.
Financial Development
Based on the simulations of Figure 11, it can be deduced that,
given Albania’s level of
financial development, changes in trade openness would be
beneficial to economic
growth. However, the amount of private credit as a share of
GDP for Albania is the
lowest among the SEE-8 countries and is quite low given
Albania’s level of
development (see Figure 16).
Figure 21. Law and order vs. income level.
Figure 22. Enforcing contracts: number of procedures vs.
income level.
246 Linda Kaltani
It is important to note that Albania has made significant
progress in the past years,
and the growth rate of private credit has been substantial
although from a very low
base (World Bank 2006). Despite such progress, Albania still
lacks the rules and
regulations that would permit efficient functioning of the
financial sector. There is in
fact concern that the credit market may be put at risk by new,
increased competition in
the face of poor regulations (EIU 2005). An illustration of this

regulatory weakness
can be found in World Bank (2005a) which, based on La Porta
et al. (1998), develops
measures on credit information sharing and the legal rights of
borrowers and lenders.
As depicted in Figure 17, the lack of information through public
and private registries
that keep track of borrowers’ credit histories earns Albania a
very low score on the
Doing Business credit information index. The lack of creditor
history creates a
situation of credit rationing due to imperfect information:
lenders cannot verify
Figure 23. Labour market flexibility vs. income level.
Figure 24. Firm entry flexibility vs. income level.
potential borrowers’ credit worthiness and either provide a
smaller loan than the
borrower demands at the quoted interest rate (Jaffee & Russell
1976) or impose a
higher interest rate on larger loans (Jaffee & Stiglitz 1990).
Imperfect information can
be particularly burdensome for small firms that would have
difficulty getting funding
from non-bank sources and thus would be forced either to resort
to the informal sector
or to contract their business activities (Walsh 1998).
The lack of integration of the financial sector in people’s lives
is also highlighted

by the fact that although Albania receives among the largest per
capita remittances in
the world, these mainly occur in cash and, even when not used
for household
consumption, do not enter the banking system where they could
be efficiently
channelled to large-scale, high-return investments (IMF 2006).
This is part of a larger
pattern of a cash-based society with the highest level of
currency outside the banking
system in the SEE-8 countries. Recently, however, as part of an
effort to increase the
use of the financial system by its citizens, the government has
started to pay public
sector salaries into the banking system (EIU 2005).
Educational Achievement
The simulation results in Figure 11 indicate that Albania’s level
of secondary school
enrolment is adequate to ensure a positive growth effect of
openness. Figure 18 also
suggests that Albania’s quantity of education is broadly in line
with the level predicted
by its level of per capita income.
A fairly similar conclusion can be given regarding the quality of
education in
Albania. Albania participated in the 2000 Programme for
International Student
Assessment (PISA), which evaluates how far students in the last
years of secondary
school have acquired essential knowledge and skills in the areas
of reading,
mathematical and scientific literacy. Although Albanian
students performed worse

than their peers in other transition countries, the scores were
consistent with what
would be predicted given Albania’s level of development.
Despite such findings, it is
clear that Albania needs to invest more in education and human
capital development in
order to better face the potential competition from the more
skilled labour present in
its neighbourhood (World Bank 2006).
Whether Albania’s students will be able to perform well in the
future is uncertain.
One indicator of concern comes from statistics from UNICEF
which indicate that
expenditure on education by the Albanian government was 2.6%
of GDP in 2002, the
lowest of the SEE-8 and higher only than Georgia and Armenia
among all transition
countries (UNICEF 2003). Although it is possible that
reductions in government
spending on education are caused by a reduction in
inefficiencies in the budget, there
is evidence that the cost of schooling has become a reason for
children to drop out of
school as transport costs due to school closures have become a
significant family
burden, and drastic cuts have occurred in teacher training and
school maintenance
(Hertz, Meurs & Satarkulova 2005).
Another area of concern that seems to be emerging from the
BEEPS (2002) data is
the widespread impact of the brain drain phenomenon on
Albania’s businesses. On a
scale of 1 – 5 Albania’s firms rate the impact of the departure of
skilled workers to

foreign countries on the survival of their business at 3.2, which
is the highest rating
among the transition countries and matched only by Macedonia
among the SEE-8
countries (Figure 19). The critical impact of the brain drain on
the Albanian economy
is also highlighted by UNDP (2006), which points out that
during 1990 – 2005 more
than 50% of Albania’s scientists and researchers left the
country, and nearly 50% of
248 Linda Kaltani
those were under the age of 40. Moreover, the report points out
that there is evidence
that nearly 60% of highly educated Albanians abroad are not
working in their field of
expertise, warranting concerns not just of ‘brain drain’ but
‘brain waste’.
Although mass emigration has served as a safety valve on the
Albanian labour
market during the transition years and has significantly
contributed to Albania’s
economy through large amounts of remittances, it has also
restricted Albania’s pool of
qualified human resources. This vicious circle can be quite
detrimental to the country
as educated individuals leave to find opportunities abroad and
the government, in turn,
finds it not worthwhile to invest in educating its citizens better,
as possibly highlighted
by the lower share of education expenditure in GDP.

Governance
The governance indicator used in the regressions is a composite
index from Political
Risk Services (2003). The components used, which are based on
subjective opinions
of domestic and international experts, measure the prevalence of
the rule of law,
democratic accountability of state actions, absence of
corruption and the efficiency of
the bureaucracy. By looking at the simulations, one can deduce
that Albania’s level of
governance would allow a positive effect of trade openness on
growth. However,
Albania’s level of governance is below what would be predicted
by its level of
economic development and is the lowest among the SEE-8
countries (Figure 20).
Clearly there is a lot of room for improvement which would
strengthen the positive
impact of trade liberalisation on growth.
It can also be helpful to look at each individual component
making up the
governance index in order to pinpoint the areas that are most
problematic given
Albania’s level of development. It appears that, although
corruption seems to be
widespread within the political system, the area of governance
where Albania is most
lagging behind is law and order (Figure 21).
13
The indicator measuring law and order
assesses both the strength and impartiality of the legal system

and popular observance
of the law. In this particular area of governance Albania is
lagging behind not only the
SEE-8 countries but also all the transition countries. This seems
to indicate that the
legal system has failed to generate trust—partly because the
courts are not
independent enough and partly due to the legacy of the
communist years—and has
thus contributed to a widespread tendency for citizens to ignore
the laws of the country
(Broadman et al. 2004).
The weakness of the courts and legal institutions can be
particularly detrimental to
potential investment and business relations if contract
enforcement is lengthy and
unpredictable. For instance, as depicted in Figure 22, in
instances of contract
enforcement of overdue debt, the number of procedures
mandated by law or court that
demand interaction between the parties or between them and the
judge or a court
administrator are excessive in the case of Albania (only Serbia
and Montenegro has
more procedures than Albania among the SEE-8 countries). A
large number of
procedural steps has the potential to increase the length of a
court case, impose more
regulation and complexity on dispute resolution, imply higher
costs, and fuel more
corruption and bribe extraction.
The failure of contract enforcement, in turn, forces firms to
avoid local courts
as much as possible and affects their willingness to acquire new

(potentially more
13
The idea here is that there is an expected negative link between
the level of corruption and a country’s
economic performance. However, this view has been countered
by arguments that corruption may not
necessarily be inconsistent with the level of development; see
Kaufmann (1997) for a discussion.
profit-generating) clients and suppliers due to the fear of being
cheated and not being
protected by the judicial system, thus leading to lost
opportunities to trade (Broadman
et al. 2004). Evidence from the BEEPS data, in fact, confirms
that firms rely on mutual
trust and long-lasting relations in their business and tend to
structure transactions in
ways that minimise contractual risk (i.e. prepayment, non-use of
credit). Moreover,
what makes the bottleneck in the legal system and its associated
institutions an ever
more pressing issue is the underdevelopment of alternative
resolution channels such as
mediation or arbitration (Broadman et al. 2004). In the case of
Albania, improving
governance has become a major priority as it is a precondition
for the country’s
negotiations on the SAA. Therefore, Albania has a lot to gain
from improved

institutions both in terms of economic growth and a European
future (European
Commission 2006).
Labour and Firm Flexibility
The measure used to capture labour market flexibility is a de
jure index presented in
the Doing Business database (World Bank 2005a) which
captures three aspects of
labour market conditions: difficulty of hiring workers, difficulty
of dismissing workers
and rigidity of working hours. The firm entry flexibility index
is derived from Doing
Business and Index of Economic Freedom (Heritage Foundation
2003). It measures de
facto and de jure challenges of establishing a new business
which come in the form of
the associated time and cost as well as the number and leniency
of the application for
entry procedures.
14
The regression results show that labour and firm entry
flexibility are the areas of
reform that are most important to the positive relationship
growth. In the case of Albania the simulations imply a positive
impact on economic
growth given the level of regulations on labour and firm entry
in the country. In
addition, the overall indices of labour and firm entry flexibility
are both satisfactory
given the country’s level of per capita income (Figures 23 and
24). Albania also fares

quite well relative to neighbouring countries. Thus, given its
level of reforms in these
areas, Albania is likely to benefit significantly from trade
openness. This conclusion
holds true even when individual components making up the
indices or alternative
regulation proxies (for instance, the extent of the informal
sector) are taken into
consideration.
In the case of the labour market flexibility index, it appears that
in Albania it is
quite easy to hire workers without much regulation on the use of
term contracts or a
minimum wage. The component that evaluates the ability of
firms to shed workers
looks at whether firms are required by law to notify and
possibly get permission
from trade unions or the labour ministry. Albania’s regulations
again do not appear
stringent in this category. The last component of the labour
flexibility index looks at
the rigidity of hours and measures whether night or weekend
work is allowed and
whether the days of vacation provided meet a minimum
criterion. In this category
Albania performs slightly worse that its level of income would
predict but
the difference does not appear to be substantial and is similar to
other transition
countries.
As for the firm entry flexibility index, it seems that the number
of procedures that a
start-up would have to comply with in Albania is close to what
would be predicted by

its level of income. The same can be said of the costs associated
with starting a
14
See O’Driscoll et al. 2003.
250 Linda Kaltani
business, the days it takes to complete a procedure, and the
overall level of regulation
of the start-up process by the government.
Therefore, it appears that when it comes to the ability of the
private sector to
reinvent itself by either adjusting the demand for labour or
changing the number of
firms in the market, Albania’s businessmen are able to compete
with the rest of the
transition countries and with their SEE-8 counterparts.
Conclusions
This article is based on new evidence by Chang et al. (2005) on
the positive link
between trade openness and economic growth and the important
role of certain reform
complementarities in this relationship. These reform
complementarities are
educational investment, financial depth, public infrastructure,
governance, labour
market flexibility and firm entry flexibility. The goal of the
article is to investigate
whether Albania’s level of complementary reforms can enhance
the link between trade

openness and economic growth. Since the collapse of the
communist regime in 1992
Albania has been writing a new history for itself and has been
slowly integrating with
the rest of Europe after decades of isolation. If Albania is to
benefit from the
opportunities offered by global integration, it is important to
focus on non-trade
reforms and to analyse their adequacy to foster a positive link
between trade openness
and economic performance.
The article first reviews Albania’s trade and output performance
in the years of
transition, highlighting the country’s continued efforts to
liberalise its trade regime, its
reorientation of trade towards the EU and the drastic change in
the composition of both
imports and exports to reflect its revealed comparative
advantage. Subsequently, the
article simulates the growth-producing effect of Albania’s
reforms in light of a pre-
established change in trade liberalisation and places such
performance in a context by
comparing it with two other European economies. The main
conclusion of the exercise
is that, despite being much lower than the comparator
countries’, Albania’s reforms
would be conducive to positive economic growth in the event of
a change in trade
openness. Furthermore, the level of each reform proxy is
compared with that predicted
by Albania’s per capita income, which is used as a broad
measure of overall
development and provides a way of gauging whether reforms
have progressed at the

same pace as the performance of the overall economy. This
exercise makes it possible
to highlight certain reform areas that seem inadequate given
Albania’s level of per
capita income. Finally, to arrive at a thorough assessment of the
progress of each
reform area, other reform proxies are compared with the level
predicted by Albania’s
per capita income.
The overall exercise highlights three areas of reform that are
crucial for Albania’s
link between trade openness and economic growth. First, in the
area of infrastructure,
the energy sector comes at the top in terms of its needs for
further reform. Second,
Albania’s level of financial development remains inadequate
despite recent rapid
progress. In this context, of vital importance is the creation of
credit information
agencies that would streamline the assessment of the
creditworthiness of potential
borrowers. Finally, the issue of governance is particularly
important for Albania both
for its link to economic outcomes and its crucial role in the
continuation of
negotiations between Albania and the EU. Within this broad
realm, improvement in
the indicators of law and order, which capture aspects of the
judicial system and the
business climate, are found to be particularly crucial.

Although Albania’s much-desired reintegration with the world
has been successful in
generating higher trade, there is significant room for the
country to improve its ability to
benefit from its trade liberalisation by lowering the non-trade
policy and institutional
barriers that make it difficult for Albanian firms to compete
abroad. Despite the fact that
this article has focused on the areas that seem most in need of
further improvements, it
may be useful to reiterate that the empirical findings on which
this work is based are clear
in indicating that any reform progress will always be beneficial
to economic growth.
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Oxford Development Studies, Vol. 30, No. 3, 2002
Trade Policy, Equipment Investment and Growth in
India

KUNAL SEN
ABSTRACT The relationship between trade policy and
economic performance is one of the
oldest controversies in economic development. In this paper, we
examine an alternative
mechanism through which trade reforms may impact on
economic growth to those commonly
discussed in the literature. This mechanism builds on the link
between equipment investment
and growth that has been observed in cross-country data. We
argue that that in countries
which have had highly restrictive trade policies with respect to
capital goods, liberalization
measures that speciŽ cally target capital goods imports may
bring about a fall in the relative
price of capital goods, leading to an increase in the rate of
investment in equipment.
Quantifying the link between trade policy, equipment
investment and economic growth in the
Indian case, we Ž nd strong support for this mechanism.
1. Introduction
The relationship between trade policy and economic
performance is one of the oldest
controversies in economic development. In recent years, there
has been a revival of
interest in the debate on trade and growth due in part to current
widespread trade
liberalization in developing countries and in part to
developments in economic theory–
most notably, the endogenous growth theories pioneered by
Romer (1986) and Lucas
(1988). The endogenous growth theories identify several

mechanisms by which trade
reforms may have a sustained impact on economic growth. First,
trade liberalization
increases the variety of goods, and raises productivity by
providing higher quality
intermediate and capital goods. Second, trade liberalization
leads to the exploitation of
scale economies as Ž rms in the reforming economy expand into
world markets. Finally,
trade reforms may lead to greater technological progress in the
reforming economy as
Ž rms are able increasingly to capture new ideas being
generated in the rest of the world.
While the endogenous growth theories provide new and
important insights on the
dynamic effects of trade on growth, the theoretical literature
does not yield an unam-
biguous conclusion on whether trade reforms have a positive
impact on economic
growth (Rodrik, 1988; Tybout, 1992). Furthermore, systematic
attempts at
quantiŽ cation have failed to single out trade policy as a major
factor in economic
growth (Rodrik, 1992). Both the ambiguity in the theoretical
literature and the weak
empirical evidence have led trade liberalization sceptics to
argue that “the effect of trade
Kunal Sen, School of Development Studies, University of East
Anglia, Norwich NR4 7TJ, UK.
This paper has beneŽ ted considerably from the helpful and
detailed comments received from the Editors of the
journal, the late George Peters and Sanjaya Lall. The usual
disclaimer applies.

ISSN 1360-0818 print/ISSN 1469-9966 online/02/030317-15 Ó
2002 International Development Centre, Oxford
DOI: 10.1080/1360081022000012725
318 K. Sen
liberalisation on growth is, at best, very tenuous, and at worst,
doubtful” (Edwards,
1998, p. 383).
A separate line of enquiry in the growth literature has explored
the link between
equipment (or machinery) investment and economic growth,
arguing that equipment
investment is strongly and robustly correlated with long-run
growth rates in cross-coun-
try data (De Long & Summers, 1991, 1992, 1993). In particular,
for developing
countries, the magnitude of the estimated returns to equipment
investment is extremely
high–well over 50%–and much higher than the estimated returns
to investment in
structures (Temple, 1998). Furthermore, there is a strong
negative relationship be-
tween the relative price of equipment and economic growth
(Jones, 1994). Thus,
policies that decrease the relative price of equipment will
encourage the accumulation
of equipment capital, leading to favourable effects on economic
growth in developing
countries.
In this paper, we propose an alternative mechanism by which
trade policy may

impact on economic growth to those that have been discussed in
the endogenous
growth literature. This mechanism builds on the link between
equipment investment
and growth observed in cross-country data. We argue that in
countries which have had
highly restrictive trade policies with respect to capital goods,
liberalization measures
that speciŽ cally target capital goods imports may bring about a
fall in the relative price
of capital goods, leading to an increase in the rate of investment
in equipment. This
provides a simple mechanism by which trade policy can have an
unambiguous positive
and sustained impact on economic growth. We attempt to
quantify the link between
trade policy, equipment investment and economic growth by
examining the Indian
case.
As is well known, since independence India has had one of the
most highly
restrictive trade regimes with respect to capital goods in the
world. Since 1977–78,
there has been a slow but steady liberalization of capital and
intermediate goods
imports, culminating in the comprehensive reforms of 1991. In
this paper, we examine
whether trade reforms enacted since the late 1970s have had an
appreciable positive
impact on the rate of equipment investment and whether this has
contributed to higher
economic growth in India.
The rest of the paper is divided into six sections. In the next
section, we provide a

brief overview of trade policies in India since independence. In
Section 3, we set the
stage for the empirical analysis by attempting to identify
patterns in investment
behaviour in India during the period of our study. Section 4
presents the conceptual
framework and Section 5 the empirical results. In Section 6, we
examine an alternative
explanation of the observed rise in the equipment investment
rate in the post-1991
period: the role of domestic deregulation of industrial policy.
Section 7 concludes.
2. Trade Policy in India
The import and exchange rate regime that Indian policy-makers
followed since inde-
pendence was aimed at the comprehensive, direct control over
foreign exchange
utilization, with an overwhelming reliance on quotas rather than
tariffs (Bhagwati &
Srinivasan, 1975). The allocation of import licences re ected
two major criteria: (1)
“essentiality”; and (2) “indigenous non-availability”. Thus,
imports, in terms of both
magnitude and composition, were permitted only if the Ž rm in
question certiŽ ed to the
government that they were “essential” (as inputs or equipment
for production). At the
same time, the government had to clear the imports from the
viewpoint of indigenous
availability: if it could be shown that there was domestic
production of the goods

Trade Policy in India 319
demanded, then imports were not permitted (regardless of cost
and quality consider-
ations).
Nearly all imports were subject to discretionary import
licensing or were “canalized”
by government monopoly trading organizations. The only
exceptions were commodi-
ties listed in the Open General Licence (OGL) category. Capi tal
goods were divided
into a restricted category and the OGL category. While import
licences were required
for restricted capital goods, those in the OGL category could be
imported without a
licence subject to several conditions. Intermediate goods were
also classiŽ ed into the
banned, restricted and limited permissible categories plus an
OGL category. As the
names suggest, the Ž rst three lists were in order of import
licensing stringency. OGL
imports of intermediate goods were also governed by the “actual
user” condition. The
import of consumer goods was, however, banned (except those
that were considered
“essential” and could only be imported by the designated
government canalizing
agencies).
Beginning with the export—import policy of 1977–78, there
was a slow but
sustained relaxation of import controls. Several capital goods
that were not allowed to
be imported without an import licence were shifted to the OGL
category. The number

of capital goods on the OGL list increased from 79 in 1976 to
1170 in April 1988.
These changes were made with the intention of allowing
domestic industries to
modernize. Moreover, during the 1980s the import licensing of
capital goods in the
restricted list was administered with less stringency (Pursell,
1992). As a consequence,
the import penetration ratio in the capital goods sector increased
from 11% in 1976–77
to 18% in 1985–86 (Goldar & Renganathan, 1990). In the case
of intermediate goods
too, there was a steady shift of items from the restricted and
limited permissible
categories to the OGL category. However, in practice a capital
or an intermediate good
was placed in the OGL list only if it was not domestically
produced. Thus, import
liberalization during this period may have led to some degree of
competition to
established producers of intermediate and capital goods in India
(though in several
instances, the goods that were allowed to be imported were
imperfect substitutes of
domestically produced goods). On the other hand, there was an
increase in tariff rates
across all commodities and, in particular, on capital goods. By
1987/88, the unweighted
average of tariffs on manufactured goods was 147%, with most
tariff lines for manufac-
turing clustered around a range of 140–160%.
The pace of the trade reforms–in particular, the shift from
quantitative import
controls to a protective system based on tariffs–initiated in the
mid-1970s was consid-

erably quickened by the government (led by Rajiv Gandhi) that
came into power in
November 1985. Restrictions on the import of capital goods
were further eased to
encourage technological modernization. Also, beginning in the
mid-1980s, there was a
renewed emphasis on export promotion. The number and value
of incentives offered to
exporters were increased and their administration streaml ined.
The allotment of REP
licences–tradable import entitlements awarded to exporters on a
product-speciŽ c basis–
became increasingly generous (Agrawal et al., 1995). Finally,
the duty exemption
scheme for imported inputs was extended to cover all imported
inputs for both direct
and indirect exporters.
In 1991, as a part of the comprehensive economic reform
programme, there was a
signiŽ cant liberalization of the trade regime with respect to
capital goods. Import
licensing was virtually abolished with respect to most
machinery and equipment and
manufactured intermediate goods (Ahluwalia, 1999). There was
also a signiŽ cant cut
in tariff rates, with the peak rate reduced from 300 to 150% and
the peak duty on
capital goods cut to 80%.1 Import-weighted custom duty rates
fell from an average of
320 K. Sen
97% in 1990–91 to 29% in 1995–96. There was, however, little

change in trade policy
with respect to consumer goods which remained in the
“negative” (banned) list.
The reforms of the trade regime in 1991 coincided with an
equally signiŽ cant set of
reforms in industrial policy. Prior to 1991, there was a system
of industrial licensing of
private industry in place which governed almost all aspects of Ž
rm behaviour in the
industrial sector, controlling not only entry into an industry and
expansion of capacity,
but also technology, output mix, capacity location and import
content. In 1991,
previous piecemeal efforts towards liberalization of controls
were consolidated in a
comprehensive wave of domestic deregulation. Industrial
licensing was abolished alto-
gether, except for a list of environmentally sensitive industries.
Along with this came the
removal of restrictions on large business groups to merge or
expand, and the opening
up of several industries, previously reserved for the public
sector, to the private sector.
Since the 1991 reforms encompassed both the domestic
deregulation of private industry
and trade reforms that facilitated the purchase of low -cost
imported capital goods, this
implies that any changes in India’s growth performance in the
post-1991 period cannot
be directly attributed to one set of reforms. This important issue
will need to be dealt
with in the empirical sections that follow.
3. Investment Behaviour in India: Trends and Patterns

In this section, we present a brief overview of investment
behaviour in India over the
period 1955/56–1998/99, highlighting the key features of the
data. We begin with a
graph of GDP growth (Figure 1). As expected of an economy
where climactic factors
play an important role in determining total output, growth
shows a great deal of
variation from year to year. There is, however, a clear rise in
the trend rate of growth
of output in the 1980s and 1990s as compared with the earlier
period–the average
annual growth rate in 1981/82–1998/99 was 5.6%, while that for
the period 1955/56–
1980/81 was 3.6%. There has also been an increase in gross Ž
xed capital formation
(GFCF) as a ratio of GDP since the 1980s, with a signiŽ cant
acceleration in the 1990s
(Figure 2). The increase in the GFCF-to-GDP ratio in this
period can clearly be
attributed to a rapid increase in the ratio of equipment
investment to GDP, particularly
since 1991. In contrast, the ratio of structures investment to
GDP has been stagnant
since the mid-1970s.
The increase in Ž xed investment as a ratio of GDP since the
1980s cannot have
resulted from an increase in public Ž xed investment, since this
had been falling as a
ratio of GDP (both in the aggregate and in each of the
components) since the
mid-1980s (Figure 3). The rise must be attributed to the sharp
increase in private Ž xed
investment since the mid-1980s (Figure 4). The ratio of private
Ž xed investment to

GDP increased from 9.1% in 1981/82–85/86 to 14.9% in
1991/92–98/99. This was
primarily due to a sharp rise in the rate of private equipment
investment, with the
private investment in buildings and structures showing no signs
of buoyancy.
One possible explanation of the sharp rise in private equipment
investment could be
the fall in the relative price of equipment. The latter has shown
a negative trend since
the late 1970s, in contrast to the relative price of construction
investment, which
showed a signiŽ cant increase in the 1980s.
This suggests a clear upward trend in the series as a ratio of
GDP since the 1980s,
driven by a spectacular increase in private equipment
investment. At the same time,
there was an increase in the average annual growth rate of
output and a fall in the
relative price of equipment. In the econometric analysis, we
shall explore more rigor-
Figure 1. Growth of GDP.
ously whether the behaviour of these three series–the relative
price of equipment, the
rate of equipment investment and the growth rate of output–can
be causally linked.
4. The Analytical Framework

The argument that trade policy can positively affect economic
growth via an increase
in equipment investment is based on three behavioural
relationships. These are: (i) the
link between equipment investment and economic growth; (ii)
the link between the
relative price of equipment and the rate of equipment
investment; and (iii) the link
between trade policy and the relative price of equipment. We
discuss each in turn:
4.1 The Link Between Equipment Investment and Economic
Growth
There is now a vast number of cross-country studies of the
determinants of economic
growth using a wide range of explanatory variables. While the
factors found to be
important in explaining economic growth have differed from
study to study, Levine &
Renelt (1992) found that the signiŽ cance of the investment rate
in explaining economic
growth remains robust to different speciŽ cations. There seems
to be little doubt that
the investment rate is a crucial determinant of economic growth,
if not the key
determinant. Furthermore, the new growth literature has argued
that among the three
components of total investment–investment in equipment,
investment in construction
and investment in inventories–the most important for growth is
(De Long & Summers, 1991, 1992, 1993; Temple, 1998). This
view argues that the

322 K. Sen
Figure 2. Investment in Ž xed capital and its components, as a
percentage of GDP.
social return to equipment investment is higher than that for
other types of investment.
The reasons are not very clear, though as De Long & Summers
argue (1991, p. 447),
“historical accounts of economic growth invariably assign a
central role to mechaniza-
tion”. It could be that the role of external economies may be
greater for equipment
investment than for buildings and construction investment,
possibly due to the greater
amount of research and development expenditure in the
machinery sector.
To assess the impact of equipment investment on the growth
rate of output, we use
a simple empirical formulation similar to that used by De Long
and Summers. We take
the growth rate of output to be a linear function of the rates of
equipment and buildings
construction investment. However, in our context, it would be
useful to keep the rate
of private equipment investment separate from the rate of public
in the output growth equation. This is for two reasons. First, the
rate of return on
private equipment investment may be different from that on
public equipment invest-
ment. Second, our purpose in the next stage of the analysis is to
explain the behaviour

of equipment investment, and it can be argued that public
investment is, in great part,
exogenously determined and in uenced more by political and
institutional variables
than by economic variables. Thus, the determinants of public
investment may be quite
different from those of private investment.
The Ž nal speciŽ cation is as follows:2
GY 5 a1PVRE 1 a2PBRE 1 a3RS, (1)
Figure 3. Public Ž xed investment and its components, as a
percentage of GDP.
where GY is the growth rate of GDP, PVRE is the ratio of
private sector investment in
equipment to GDP, PBRE is the ratio of public sector
investment in equipment to
GDP and RS is the ratio of investment (both private and public)
in structures to GDP.
4.2 The Link Between the Relative Price of Equipment and the
Rate of Equipment Investment
Since we are interested in examining the relationship between
the relative price of
equipment and the rate of equipment investment, we conŽ ne
our empirical analysis for
this section to the determinants of private equipment investment
(as we have argued
earlier, public investment may be taken to be exogenously

determined). We model the
rate of equipment investment by the private sector as follows:
PVRE 5 b0 1 b1RPE 1 b2RPS 1 b3FINT 1 b4RINT 1 b5PBRI 1
b6DUM91
1 b7PVRE( 2 1), (2)
where RPE is the relative price of equipment (price de ator for
as a ratio of the GDP de ator), RPS is the relative price of
structures investment (price
de ator for structures investment as a ratio of the GDP de ator),
FINT is Ž nancial
deepening, RINT is the real interest rate (the bank lending rate
minus the in ation
324 K. Sen
Figure 4. Private Ž xed investment and its compone nts, as a
percentage of GDP.
rate), PBRI is total public investment as a ratio of GDP and
DUM91 is a dummy
variable for the 1991 reforms (value of one from 1991 onwards,
zero otherwise).
We would expect from theory that the sign of the coefŽ cient
for the relative price of
equipment, b1, will be negative–an increase in the latter will
decrease the rate of
equipment investment in the economy. The sign for the coefŽ
cient for the relative price
of structures, b2, cannot be determined a priori and will depend
on whether construc-

tion capital is a complement or substitute for equipment capital.
Financial deepening
is expected to have a positive impact on equipment investment.
Financial deepening
can increase both the volume and efŽ ciency of investment. The
“debt accumulation”
hypothesis of Gurley & Shaw (1955), formalized more recently
by Bencivenga & Smith
(1991), argues that the spread of organized Ž nance can help
overcome indivisibilities in
investment through the mobilization of otherwise unproductive
resources. Moreover,
Ž nancial intermediaries and markets play an important role in
selecting the most
promising Ž rms and households for lending purposes and thus
contributing to the more
efŽ cient use of capital (Levine, 1997). Financial intermediaries
may also enhance the
quality of investment by identifying entrepreneurs with the best
chances of successfully
initiating new activities (King & Levine, 1993). In the Indian
case, Bell & Rousseau
(2001) found conclusive evidence of the positive impact of Ž
nancial deepening on gross
Figure 5. Relative prices of structures and equipment.
domestic Ž xed investment in the post-1950 period. Following
Bell and Rousseau, we
use the ratio of real bank credit to the private sector as a ra tio
of GDP as our preferred
measure of Ž nancial deepening (FINT).3

An increase in the real interest rate is expected to have a
negative effect on the rate
of equipment investment via an increase in the cost of capital.
Public investment may
affect private investment via both supply and demand. On the
supply side, the private
sector relies on public investment for most of the infrastructure,
because this is either
a natural or a legal monopoly of the government. Public
infrastructural investment can
affect private equipment investment by in uencing its rate of
return–poor roads, an
erratic supply of electricity or inadequate communication
facilities can negatively affect
the amount of output that it is possible to obtain from a given
amount of investment.
Thus, public investment in infrastructure and private investment
should be comple-
mentary (Blejer & Khan, 1984). On the demand side, the
relationship is ambiguous. If
there is some slack in the economy one would expect a change
in public investment to
push private investment in the same direction. Otherwise, some
private investment may
be “crowded out” (Athukorala, 1998).
We also add a post-1991 period dummy (DUM91) to capture the
effect of the 1991
deregulation of industrial policy which may have had a positive
effect on the private
investment rate over and above the effect of trade reforms on
the latter working
through the relative price of capital goods. Finally, we include
the one-period lagged
private equipment investment rate to capture the high degree of

persistence in the
latter.
326 K. Sen
Table 1. Summary data of variables used in econometric
analysisa,b
Years GY PVRE PBRE RS PBRI RPE RPS FINT RINT RER
1955/56–60/61 3.98 4.61 2.12 8.86 6.42 0.74 0.90 0.09 0.63
8.38
1961/62–65/66 2.84 5.05 2.78 9.64 8.47 0.81 0.88 0.11 2 0.13
6.64
1966/67–70/71 2.28 4.67 2.46 10.06 7.07 0.89 0.87 0.15 2 1.12
7.51
1971/72–75/76 4.66 4.06 2.38 11.20 7.03 0.89 0.81 0.13 1.73
7.38
1976/77–80/81 3.08 4.68 2.68 9.89 7.23 0.92 0.89 0.16 0.60
8.44
1981/82–85/86 4.69 4.50 3.22 9.99 7.66 0.96 0.91 0.18 3.75
9.39
1986/87–90/91 6.30 7.60 5.03 7.73 9.27 0.91 1.36 0.25 8.02
10.28
1991/92–98/99 5.77 10.53 4.18 7.57 7.47 0.86 1.40 0.24 7.58
14.09
SD: 0.033 0.026 0.011 0.013 0.012 0.089 0.236 0.061 0.055
2.56

a All variables in percentages except RER, RPE and RPS.
b Annual averages, except Ž nal row which contains standard
deviation of variables over period 1955/56–1998/99.
4.3 The Link Between Trade Policy and the Relative Price of
Equipment
Machinery is a key tradable commodity and its relative price
will be greatly in uenced
by trade policy. In addition, the relative price of machinery
would be affected by the
real exchange rate as movements in the latter would lead to
change in the price of
tradables relative to that of non-tradables. We choose a very
simple speciŽ cation for the
relative price of equipment, modelling it as a function of trade
policy and the real
exchange rate. As is evident from the discussion in Section 2,
the most important shifts
in Indian trade policy occurred in the years 1977, 1985 and
1991. We use dummies to
capture the changes in the trade regime in these 3 years. We
also add a time-trend to
the speciŽ cation to capture the upward drift in the relative
price series, is evident from
Figure 5.
RPE 5 c0 1 c1TIME 1 c2DUM77 1 c3DUM85 1 c4DUM91 1
c5RER, (3)
where TIME is the time-trend, DUM77 is a dummy variable for
the 1977 reforms
(value of one from 1977 onwards, zero otherwise), DUM85 is a
dummy variable for the
1985 reforms (value of one from 1985 onwards, zero otherwise),

DUM91 is a dummy
variable for the 1991 reforms (value of one from 1991 onwards,
zero otherwise) and
RER is the real exchange rate (equal to eP*/P, where e is the
nominal exchange rate, P*
is the foreign price level and P is the domestic price level).4
5. Results
We estimate equations (1), (2) and (3) using ordinary least
squares (OLS) regression.
Our period of analysis is 1955/56–1998/99. A summary of the
data used in the
regressions is provided in Table 1.
There is a possibility that equation (1) would be subject to
simultaneity bias if we
used current equipment and structures investment rates as
explanatory variables in the
regression. This is because positive and signiŽ cant coefŽ cients
on the rates of private
equipment investment and structures investment could imply
that higher investment
rates are the result of economic growth, not the other way
around. Therefore, we use
one-period lagged investment rates in the Ž nal estimation. We
also include dummy
variables for the years 1965 and 1979 (denoted DUM65 and
DUM79, respectively) to
Table 2. Regression results

1. GY 5 0.544*PVRE( 2 1) 1 0.189*RS( 2 1) 2 0.084*DUM65 2
0.10DUM79
(3.29)*** (1.73)* (3.04)*** (3.56)***
R2 5 0.41 SE 5 0.027 SERCOR 2 c2(1) 5 3.10 NORM 2 c2 (2) 5
0.68
2. PVRE 5 0.072 2 0.084*RPE 1 0.174*FINT 1 0.017*DUM91 1
0.490*PVRE( 2 1)
(5.34)*** (5.14)*** (5.73)*** (3.60)*** (5.13)***
R2 5 0.92 SE 5 0.007 SERCOR 2 c2(1) 5 3.10 NORM 2 c2(2) 5
1.44
3. RPE 5 0.707 1 0.011*TIME 2 0.049*DUM77 2 0.13*DUM85
2 0.13*DUM91
(26.07)*** (5.77)*** (1.30) (3.97)*** (3.47)***
(3.47)***R2 5 0.62 SE 5 0.058 SERCOR 2 c2 (1) 5 2.65 NORM
2 c2 (2) 5 0.78
Notes: t-Ratios of regression coefŽ cients are given in
parentheses. Approximate critical values for the t-ratios are
as follows: 10% 5 1.66 (*), 5% 5 2.04 (**) and 1% 5 2.75 (***);
R2 5 R-squared; SE 5 standard error of
regression; SERCOR 5 Lagrange multiplier test of residual
serial correlation; and NORM 5 Jarque-Bera test for
the normality of residuals.
capture the large dips in the growth rate of output in these 2
years (due to a negative
weather shock in 1965 and an oil price shock in 1979). The
rates of public equipment
investment (PBRE) for equation (1) and total public investment
(PBRI), the relative
price of structures (RPS) and the real interest rate (RINT) for

equation (2) consistently
had statistically insigniŽ cant coefŽ cients in the experimental
runs and were dropped in
the Ž nal speciŽ cation.5 Similarly, in our initial estimate of
equation (3), the coefŽ cient
for the real exchange rate failed to attain statistical signiŽ cance
at the 10% level and was
omitted.6 The Ž nal results are presented in Table 2.
As the estimates indicate, the explanatory power of the
regressions is high and they
perform well by all diagnostic statistics. While both the coefŽ
cients of PVRE and RPS
are statistically signiŽ cant (at the 1% and 10% level,
respectively), we found that an
increase in the rate of private equipment investment has a far
stronger positive impact
on the growth of output than an increase in the rate of
construction investment–the
coefŽ cient on the former is more than double that of the latter.
This is consistent with
what has been observed in the cross-country studies.7In the case
of private equipment
investment, the relative price of equipment plays a decisive role
in its determination–its
coefŽ cient is negative and highly signiŽ cant. Financial
deepening has also been a key
determinant of the private equipment investment rate in India.
In addition, the dummy
for the post-1991 period indicates a clear increase in equipment
investment associated
with that period. This provides some support for the argument
that the deregulation of
industrial policy in 1991 played an important role in the
observed increase in equip-
ment investment in the post-1991 period (see Section 3) and

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