DEC releases study on relationship between trade, competitiveness and knowledge

Dubai Economic Council (DEC) has recently prepared a study on the relationship between trade, competitiveness and knowledge. This study is part of a research effort undertaken by the Economic Policy Research Center, the operational arm of the Council, which addresses various issues of interest to the present and future of Dubai's economy.

Dubai’s authorities issued a new strategic plan for sustainable development in the emirate entitled Dubai Plan 2021. It identifies a number of policy goals in six areas: society development, quality of life, urban planning, human capital, economic development, and government management. On the economic front, the strategy is articulated along the development of world-class business centers for trade, logistics, finance, and tourism.

Sustainable economic growth is expected to be driven by the diversification of the productive base and the expansion of value-added activities to be achieved as the result of policies destined to further innovation and increase productivity. These policies are anticipated to enhance the local economy resilience and allow it to better absorb internal and external shocks.

While the quest for efficiency and international competitiveness is an important goal in most economies, the observed rate of success is appallingly low. The cases of Hong Kong and Singapore are the exception and not the norm. Empirical evidence indicates that the first stage of economic development tends to be a smooth ride in most small open economies: as a result of the exploitation of their resource base and the progressive integration to the global economy –both in trade and financial markets emerging economies are able to reap the benefits of catching up with more developed economies. However, once countries reach the "middle-income status", achieving higher productivity levels becomes increasingly difficult. Few countries are able to keep the edge of their international competitiveness and continue to grow on a sustainable basis (e.g., Republic of Korea). Most middle-income countries do not follow this pattern. Instead, they have bursts of growth followed by periods of stagnation or even decline, or are stuck at low growth rates. Instead of steadily moving up over time, they fall into "the middle-income trap" whereby they subsequently stagnate and fail to grow to advanced-country levels.

At the root of the middle-income trap is a problem of low-productivity growth. Countries caught in the trap become unable to compete with low-income, low-wage economies in manufactured exports and, at the same time, unable to compete with advanced economies in high-skill innovations. Such countries cannot make a timely transition from resource-driven growth, with low-cost labor, to productivity-driven growth.

The Dubai Plan 2021 precisely attempts to deal with this challenge of transforming the engine of economic growth of the emirate. It is certainly true that when measured by income levels, Dubai ranks as a high-income economy. However, when looking at average labor productivity the emirate is far from developed economies and its performance is similar to that of "upper middle-income countries".

In middle-income countries, traditional exports cannot be as easily expanded as in the initial stage of development because business opportunities are used up, wages are higher and cost competitiveness declines. Export growth depends on introducing new processes and finding new markets, not just on expanding sales of the same product to existing markets. To do this, innovation and product differentiation to meet the needs of the market become an important objective of middle-income countries.

To avoid becoming trapped without a viable high-growth strategy, middle-income countries need to develop modern and more agile institutions for property rights, capital markets, successful venture capital, competition, and a critical mass of highly skilled people to grow through innovations as affluent countries do.

Evidence indicates that some East Asian countries, like South Korea, have successfully managed three critical transitions to avoid the middle-income trap. These transitions are (i) from diversification to specialization in production; (ii) from physical accumulation of factors to productivity-led growth; and (iii) from centralized to decentralized economic management.

Among the most important macroeconomic determinants of competitiveness is the exchange rate, i.e., the relative price between domestic and foreign currencies. There are several ways in which the exchange rate influences competitiveness. First and foremost, it affects the profitability of exporting activities: an appreciated exchange rate gives incentives to national produces to serve local markets and disregard foreign trade as an attractive market. Second, the exchange rate influences the competitiveness by affecting the production costs of local producers: a depreciated exchange rate makes purchases of imported inputs expensive, including raw and intermediate materials, capital goods and imported technology. However, a depreciated real exchange rate could also promote the competitiveness of exporting industries that are intensive in the use of domestic inputs. Third, permanent changes in exchange rates affects the local demand for different types of goods thus affecting economic activity in the short run and sustained growth in the long term. Fourth, exchange rate movements require domestic investors to adjust their portfolios of foreign and domestic assets and hedge risk: continuous and unpredictable movements in the exchange rate tend to induce speculation on the part of investors and distract resources from more productive investments.

Macroeconomic determinants are also important. The cost of capital plays a key role in both investment levels at the plant level and technology adoption (since most technology is embedded in capital investments). In most industries –particularly those less advanced from a technological viewpoint labor costs also play a key role in determining profitability and competitiveness.

Dubai has based its successful economic record on a particular strategy which combines both macroeconomic policies and micro economic conditions. On the macroeconomic front, the most salient policies determining competitiveness are the fixed nominal exchange rate (US dollar) and an open capital account, allowing domestic investors ample access to foreign capital in the form of FDI and portfolio investments.

On the microeconomic front, several factors determine productivity gains. One issue is the long-standing government’s policy of maintaining energy costs disconnected from and well below international levels, thus inducing relatively high usage of both hydrocarbons and electricity.

Source:WAM