Samantha Stainburn

(Chicago Booth Review, 16 June 2014)

The globalization of trade is so established that it has lost the power to astound us. Fresh-cut flowers from Kenya are flown daily to Europe’s flower markets. North Americans eat Peruvian asparagus that took only a day to get from field to supermarket. Boeing puts together planes in Seattle using parts from 10 different countries—parts that were preassembled in Japan, Korea, Kansas, and South Carolina. Meanwhile, trading blocs such as the 28-country European Union and trade pacts such as the North American Free Trade Agreement lower tariffs and promote the movement of goods among trading partners.

Yet the global economy is not as integrated or efficient as is widely believed, according to A. Kerem Cosar, assistant professor of economics at Chicago Booth. Asparagus and aircraft parts may be easily shipped from one country to another, but getting goods from their point of origin to international shipping centers within the same country can be expensive—sometimes more expensive than shipping them to a foreign destination. Moreover, exporting goods across borders can incur costs that deter trade even when tariffs have been negotiated down.

“Building good ports and having policies that help exporters may be good, but at the end of the day, firms can’t all pile up close to the seaports in order to export,” says Cosar. “Internal infrastructure is key for your competitiveness as well, to get those goods out.”

China’s long road

Cosar cites the example of China, the world’s second-biggest economy. The country faces the South China Sea, the East China Sea, and the Yellow Sea on its southern and eastern coastlines, and borders Mongolia and Russia to the north, Central Asia to the west, and Vietnam to the south. Since 1978, when China began to open up to foreign trade and investment, the country’s exports have grown exponentially to $2.21 trillion-worth of goods in 2012, according to China’s National Bureau of Statistics.

China ships most of its exports from coastal ports. Just 17.4% of exports to its top 20 trading partners depart by air, and only 6.7% of all its exports travel overland to neighboring countries.

When China’s manufacturing renaissance got under way, congested roads and overloaded railways made transporting goods to seaports slow, unreliable, and expensive, so exporters moved to cities such as Shenzhen and Dongguan in the Pearl River Delta in the south, Suzhou and Shanghai on the east coast, and Dalian in the northeast, between the Bohai Sea and the Yellow Sea, to cut costs. Residents of China’s interior provinces, seeking work that paid more than farming, followed the companies to the coasts.

These days, some 163 million Chinese are long-distance migrants who leave their provinces each year to join companies that employ hundreds of thousands of workers making electronic components, auto parts, appliances, clothing, and more. It’s not uncommon for workers to spend 12 hours a day, six days a week on an assembly line, sewing sweatshirts, stamping metal into kitchen appliances, or screwing components into iPhones. They often leave their children behind in their home villages and live in crowded dormitories on factory property.

In a recent paper, Cosar teamed up with UCLA’s Pablo D. Fajgelbaum to study how international trade affects regional specialization, employment, and income in China. They used industry-level data from China’s 338 prefectures—regions that include several counties or a large city—between 1998 and 2007.

They find that distance from the coast has a sizeable effect on economic activity, particularly for industries that export a high percentage of goods. Firms located 275 miles inland in industries that export an average percentage of goods (20% of output) employed 17% fewer workers than firms in average-exporting industries located on the coast. Inland firms in heavily export-oriented industries, such as furniture manufacturing, which exports 40% of its output, employed 32% fewer workers than their counterparts on the coast.

The impact of poor infrastructure on economic activity in China is reflected in the researchers’ broader findings: when it’s expensive to transport export goods from the interior of a country to a port, export-oriented firms move closer to the ports to save money. Economic activity in these regions increase—the economic output of Guangdong Province on China’s southeast coast, for example, grew from $11 billion in 1978 to an estimated $1 trillion in 2013—and economic activity in the interior suffers.

This phenomenon depresses overall gains from trade as lagging regions drag down the national numbers, Cosar and Fajgelbaum note. At the same time, export-oriented manufacturers crowding into coastal regions force up real-estate rents and employee wages there. So poor infrastructure shrinks international trade gains even for firms that are able to locate close to gateways to foreign markets.

These are concerns shared by developing countries with poor domestic infrastructure that have opened up to international trade, such as Vietnam, where economic activity is concentrated near its ports, and Mexico, where economic activity has been highest along the US border.

Fortunately, infrastructure can be improved, Cosar notes. China has taken steps to better connect interior regions to the coast in recent years. In 2000, it launched a 20-year “go west” initiative, formally called the Western Development Strategy, to encourage companies to locate inland, enticing them with hundreds of billions of dollars’ worth of improvements to regional infrastructure and tax incentives. Between 2000 and 2012, China expanded its expressway network an average 16% a year, growing it to 75,000 kilometers of highways by 2012, KPMG reports. And China is undertaking one of the world’s biggest railway expansions, spending $1 trillion to add 120,000 kilometers of railway track by 2020.

Those kind of infrastructure investments make it more appealing for companies to invest in lagging interior regions. Among the companies that have moved production inland to take advantage of lower labor and land costs: computer manufacturers Intel, Dell, and Lenovo, which have opened factories in Chengdu, the capital of Sichuan Province, 1,500 miles from the eastern seaboard. Taiwan-based electronics firm Foxconn Technology Group, the Apple contractor known for its massive “factory cities,” has opened new factories in Chengdu and the inland provinces of Henan and Shanxi. And Unilever, maker of Dove soap and Lipton tea bags, has moved seven factories from Shanghai and Guangdong Province to Hefei
in Anhui Province, 250 miles west of Shanghai.

Ford built its first assembly plant in the southwest Chinese city of Chongqing, 700 long miles as the crow flies from the nearest major port, Guangzhou, in 2001. After that it opened a second assembly plant in Chongqing, and plans to open a third this year, as well as a transmission plant. Chongqing is already Ford’s second-largest manufacturing region after southeast Michigan, and employees in Chongqing will produce 870,000 Ford vehicles a year once the new factories are up and running. “Logistics and transportation infrastructure have reached a level such that it’s profitable for Ford to utilize land in the interior and incur the transportation costs of bringing those [cars and parts] to the large cities on the coast or to export [them] to other Asian countries from those cities,” Cosar observes. Ford declined to comment.

Turkish traffic

Nineteenth-century farmers in the US midwest only brought their grain to major markets when the weather allowed. During the spring, roads could be too muddy to navigate, a problem eventually solved by pavement and train tracks. As infrastructure developed, so did the American heartland and economy. Two hundred years later, how much of a boost can better infrastructure—and roads, in particular—provide to an economy in the era of global trade?

Consider Turkey, the world’s 17th largest economy and 22nd largest exporter by value. Turkey stretches 1,500 miles west to east between Europe and Asia, and 90% of its freight travels by road. Yet, until about ten years ago, Turkey had just one highway, connecting Istanbul, its main economic engine, with Ankara, its capital 300 miles to the east. Most of the country’s roads had a single lane in each direction, making for slow climbs and descents through the country’s mountainous interior, particularly during snowy winters, to get to the low-lying port cities on the Black Sea to the north, the Aegean and Marmara seas to the west, and the Mediterranean Sea to the south.

Adding to the delays, collisions were common, as motorists determined to overtake slow vehicles in front of them would drive into oncoming traffic to pass. Large logistics companies chose not to transport goods to and from certain areas with particularly congested roads because they could not guarantee the products would arrive on time. Independent truckers, whose vehicles were often older, overloaded, and more prone to break down, picked up the business.

In 2002, Turkey launched a major program to improve its infrastructure by upgrading dual-lane roads into four-lane expressways, with a safety divider in the middle. The amount of four-lane roads grew from 12% to 35% between 2003 and 2012. Cosar, who’s originally from Turkey, noticed the difference on a return trip. “What used to be an eight- or nine-hour drive from Istanbul to the Mediterranean seaside is now six or seven hours and much more pleasant,” he says. Even the Istanbul-Ankara route got an upgrade, with the opening of a motorway tunnel through Bolu Mountain in 2007, shaving 2.5 hours off the journey.

Cosar and Banu Demir of Bilkent University in Ankara have quantified the impact of that investment program. The researchers estimate that every $1 spent on upgrading the old roads generated an additional 10¢–15¢ in export revenues. The improvements particularly aided time-sensitive industries such as furniture, chemicals, communications equipment, electrical machinery, and office and computing machinery. They posted bigger increases in exports and employment than industries where fast delivery is less important to consumers, such as luggage and tobacco products.

While the road-improvement scheme was designed to relieve congestion caused by a growing economy and increasing urban population, it’s clear why exporters benefited from the new highways. Even as the number of vehicles on the road doubled, the average travel speed for freight-carrying vehicles increased. Traffic-related fatalities per vehicle-kilometer dropped 40% from 2004 to 2011, likely contributing to increased speed. According to World Bank data, between 2007 and 2012, the median time it took to transport goods from their point of origin to ports and airports in Turkey decreased by 12 to 48 hours. Cosar speculates that higher-quality roads also lowered costs for exporters by reducing wear and tear on vehicles and causing a drop in their freight-insurance expenses as accidents decreased. After the roads were improved, logistics companies expanded scheduled freight services to more cities. The total volume of freight carried by all trucks in Turkey increased 29% between 2004 and 2012, from 157,000 million ton-kilometers to 203,072 million ton-kilometers.

Turkey has been closely watched by officials in countries such as Colombia, Brazil, and Ecuador. In mountainous Colombia, where it takes some 10 hours to drive 270 miles from Bogotá to the port city of Medellín, officials are attempting to attract $20 billion in private investment over the next five years to fund road improvements, which President Juan Manuel Santos has called a top priority.

Windmills without borders

Research suggests traffic and other problems involved in transporting goods from factories to ships or aircraft can be a significant drag on international trade, but there are also limits to what infrastructure investments could accomplish. Cosar has found that there’s another thing that makes it difficult for goods to leave the country: costs incurred at the border. Cosar and two coauthors spotted the phenomenon in a study of European wind turbines.

Along with Paul L.E. Grieco of Pennsylvania State University and Felix Tintelnot in the University of Chicago’s economics department, Cosar looked at wind-turbine manufacturers in Denmark and Germany in 1995 and 1996. The researchers were interested in studying the effects of national borders on market segmentation, and the data on the wind-turbine industry in the two countries included the location of all manufacturers and wind farms, which were scattered throughout each country. This allowed them to account for actual shipping distances and separate the impact of distance from the impact of the border on costs.

Also, Denmark and Germany both belong to the EU, which created a single market in 1992. Members strove to eliminate import or export restrictions by lowering nontariff barriers. In both countries, wind-farm operators are paid above-market rates, bumped up by government subsidies, for the electricity they generate and provide to the electric grid. Operators are free to buy whatever turbines maximize their profits, regardless of where in the EU they are manufactured. In this setting, formal barriers to trade are not creating border costs.

The researchers focused on the years 1995 and 1996 because national price subsidies for electricity generation had been in place for several years and the industry was stable. Subsequent years saw a wave of mergers and acquisitions, including a cross-border acquisition that would have complicated analysis of the border effect. Utility companies later became significant buyers of turbines, making purchases from the same manufacturer for different sites, further blurring the picture.

Pushed by high fuel prices, and because EU countries formally committed to protecting the
environment under the Maastricht Treaty, EU countries have moved away from fuel oil, coal, and
nuclear power while increasing wind, gas, solar, and other renewable power over the past two decades. A total of 117 GW of wind energy capacity is now installed in the EU, up from 2.5 GW in 1995, according to the European Wind Energy Association.

Typically, EU wind-farm owners secure permits for their operation, and manufacturers bid to provide turbines, quoting a price that includes transporting three 100- to 150-foot blades and the 50- to 75-ton box that contains the generator and gearbox, on a massive platform trailer. The turbine is then assembled on site. The farther away from a wind farm a turbine is manufactured, the more it costs to transport, so the researchers expected German wind-farm owners located close to the border would buy turbines from nearby Danish companies rather than from more distant German companies, and vice versa.

In fact, manufacturers tended to sell their turbines domestically, even if there were closer wind farms just over a border, the researchers find. The top five German manufacturers produced 60% of the turbines purchased in Germany but only 2% of those purchased in Denmark. Similarly, Danish manufacturers captured 93% of the Danish market but only 32% of the German market.

This suggests that there are costs at the Danish-German border that make it more expensive for manufacturers to sell turbines and consumers to buy turbines across the border rather than within national boundaries. Among them, manufacturers face one-time entry costs, Cosar observes. These range from developing and installing technology to connect turbines to the foreign electricity grid to obtaining certification for turbines in the foreign country to hiring and managing a country-specific sales team. Manufacturers also have to pay to acquire local permits and to do business with unfamiliar officials. Once established across the border, a company faces yet more costs—associated with writing and enforcing international contracts, visiting foreign locations for maintenance, and dealing with a different currency, language, and culture. Consumers may anticipate having to spend more to settle a dispute with a foreign supplier because it involves slightly different legal systems, Cosar says.

Cosar and his colleagues estimate that the postentry costs of selling turbines across the national border are 85% higher than the costs of selling across an internal provincial or state border for the German firms. “The level of integration between Denmark and Germany is supposed to be deeper than between Canada and the United States, but even there [in this integrated market], we found that the border creates huge friction,” Cosar says.

What would happen if Germany and Denmark were to remove all residual barriers to trade, including language, cultural, and administrative differences, so that the impact of the national border would be reduced to that of a state border? The researchers performed this thought experiment to show what removing barriers might accomplish, estimating that if all frictions could be removed, German firms’ share of the Danish market would increase from 3% to 19% and Danish firms’ share of the German market would grow from 32% to 42%. At the same time, Danish firms’ share of their home market would shrink 16% while German companies’ share of the German market would drop 8%.

However, because there are more wind farms in Germany than in Denmark, Danish firms would make higher profits in the larger German market that would outweigh their losses at home. That means eliminating national border costs would be, overall, good for Danish firms. All German companies would suffer losses, however, as the increased competition would outweigh the gains German firms would make as a result of better access to the Danish market. But wind-farm owners in both countries would benefit, as consumer surplus would rise by 9% in both places.

The work provides food for thought for pro-trade policymakers in countries that have already inked trade agreements, as it suggests they may want to investigate how internal policies might be hindering international trade. Danish policymakers, for example, might want to revisit Denmark’s decision not to adopt the euro. Companies from eurozone countries doing business in Denmark pay costs when they convert their currency to Danish kroner.

“When there are no tariffs and an open border, what remains are residual, nontariff barriers, such as technical and regulatory differences,” Cosar says. “As our wind-turbine paper shows, it seems to have a big impact.”

Viewing trade as a domestic issue

Cosar is keen to increase awareness that barriers to international trade are internal as well as external.

Domestic policymakers aren’t typically focused on how internal regulations or state- or provincial-level investments impact foreign trade, he notes. “When people legislate things like what tests a car should pass in order to be sold in the US market, they do not have in mind, ‘Let’s shut out Japanese car producers or German car producers.’ But the results may create an entry barrier to foreign producers,” he says, adding that a new trade agreement being negotiated between the US and EU, the Transatlantic Trade and Investment Partnership, does aim to reduce such barriers. And poor roads that add the equivalent of a few hundred dollars to the cost of driving a container of goods from a factory to a port may motivate an exporter to set up shop in another country.

Cosar has started new research on the market-share differences of big car producers in different countries. “There’s a huge home bias—given similar price and quality of the car, people seem to buy domestic,” he says. He’s investigating whether policy- or border-related costs are behind this phenomenon.

Domestic policy decisions designed to increase international trade can greatly impact life inside a country, creating new sets of winners and losers. Improving infrastructure may lead to interior regions gaining factories that would have otherwise invested in coastal regions, for example. “In the short run there are definitely losers,” when barriers at national borders are removed, Cosar says, referring to companies that chug along in a limited market but do not have the ability to compete in a larger one.

But he believes consumers and producers benefit from more openness in the long run—and from greater efforts on the part of individual nations to promote global trade.

“More competitiveness induces more innovation,” he says. “If you can sell your goods in a larger market, you are more likely to be willing to incur costly innovations.”

Read this article at Chicago Booth Review.