Trade liberalization and volatility: Evidence from Indian firms

• Date: 01 November 2019
• DOI: http://doi.org/10.1111/roie.12429
• Published date: 01 November 2019
• Author: Asha Sundaram

Rev Int Econ. 2019;27:1409–1426. wileyonlinelibrary.com/journal/roie

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INTRODUCTION

As developing countries have liberalized trade beginning in the 1980s and as advanced economies

trade more with developing countries, the debate on the benefits of trade liberalization for the domes-

tic economy continues to rage in the literature. One concern is that increased international exposure

might be associated with increased volatility. Di Giovanni and Levchenko (2009) show that more open

industries experience greater output growth volatility. Bergin, Feenstra, and Hanson (2009, 2011) find

that employment in the offshoring industry in Mexico is significantly more volatile than the corre-

sponding industry in the United States. More recently, Caselli, Koren, Lisicky, and Tenreyro (2015)

have argued the opposite. They look at aggregate GDP and argue that trade openness can lower vola-

tility by reducing exposure to domestic shocks and allowing countries to diversify sources of demand

and supply across markets.

Despite the contention, the literature concedes that isolating the link between greater trade

exposure and volatility is an important exercise. Volatility has implications for workers, given that

it may be associated with greater job and income uncertainty, emphasizing the need for policies like

Received: 4 September 2018

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Revised: 28 June 2019

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Accepted: 1 July 2019

DOI: 10.1111/roie.12429

ORIGINAL ARTICLE

Trade liberalization and volatility: Evidence from

Indian firms

AshaSundaram

Department of Economics,University of

Auckland, Auckland, New Zealand

Correspondence

Asha Sundaram, Department of

Economics, University of Auckland,

12 Grafton Road, Auckland 1010,

New Zealand.

Email: a.sundaram@auckland.ac.nz

Abstract

I look at the impact of trade liberalization on sales growth

volatility of firms. Exploiting India’s externally imposed

trade reform to identify trade liberalization effects, I find

that while a fall in the tariff on the final product produced

by the firm is associated with an increase in volatility in

Indian manufacturing firms, a fall in the tariff on intermedi-

ate inputs is associated with a decrease in volatility, with

the latter effect dominating the former. I hence propose an

additional channel for gains from trade liberalization to the

ones documented in the literature.

JEL CLASSIFICATION

F13, F14, O14

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SUNDARAM

unemployment insurance and adjustment assistance. Volatility in output can also affect price vola-

tility, resulting in greater uncertainty in the macroeconomic climate. This can in turn lead to lower

investments in capital, including human capital. Additionally, price volatility can also adversely affect

household welfare (Bellemare, Barrett, & Just, 2013).

In this study, I look at the impact of trade liberalization on volatility in sales growth at the firm

level using India’s externally imposed trade reform to identify trade liberalization effects. The litera-

ture on trade and volatility has largely focused on aggregate analyses at the level of the industry or the

macro economy, though studies like Kurz and Senses (2016) and Buch, Döpke, and Strotmann (2009)

utilize firm level data to provide insights into this relationship at a more micro level.1

However, estab-

lishing a relationship between trade and volatility at the firm level is challenging for two main reasons.

First, unobserved firm‐specific factors that determine trading status of a firm can also affect volatility.

For instance, firms that experience greater volatility in their supply of raw materials from domestic

sources might choose to import from abroad. Similarly, firms that face greater volatility for their final

product in the domestic market might wish to diversify into foreign markets. Alternatively, technology

shocks may make output less volatile, but also increase participation by firms in global markets.

Second, trade can affect output growth volatility via various potential channels and parsing these

out can be difficult. Whether trade liberalization increases or decreases volatility may depend on

the channel. Trade can lead to specialization and a less diversified production portfolio, increasing

volatility (Di Giovanni & Levchenko, 2009). Alternatively, trade liberalization may incentivize firms

to innovate and invest in better technology to deter entry by foreign competitors (Aghion, Burgess,

Redding, & Zilibotti, 2008). Better production technology might lower volatility by stabilizing the

production process. Finally, trade liberalization might affect volatility through the transmission of cost

shocks. On the one hand, greater import competition may be associated with more elastic demand, do

that cost or wage shocks translate into greater volatility (Hasan, Mitra, & Ramaswamy, 2007).2

On the

other hand, trade might allow firms to import input varieties from a wider range of countries to tide

over shocks in input availability, lowering volatility (Caselli et al., 2015). Hence, the relationship be-

tween trade liberalization and volatility is, a priori, ambiguous and ultimately, an empirical question.3

In this study, I tackle both these challenges. To tackle the first challenge, I exploit India’s trade

liberalization episode in the 1990s, characterized by a fall in tariffs across sectors, as a natural experi-

ment to study the impact of trade liberalization on volatility of sales growth (henceforth, volatility) of

Indian manufacturing firms. I argue that the tariff reform was exogenous to Indian firms since it was

imposed as a part of an IMF restructuring package following a balance‐of‐payments crisis, and hence

allows me to estimate the impact of greater trade exposure on volatility. To my knowledge, this is the

first study to explore a causal relationship between trade liberalization and firm volatility.

Further, I am able to tease out some of the channels via which trade affects volatility. I exploit data

on sales for every product that a firm produces to examine within‐firm changes in the firm’s product

portfolio from trade liberalization as a channel (channel one). I utilize data on capital stock (net fixed

assets) to examine the impact of trade on volatility operating through investments in better technology

(channel two). Lastly, data on raw material expenditure allows me to consider the impact of both the

tariff on the final product produced by the firm (output tariff), and the tar iff on intermediate inputs

used in the production of the final product (input tariff) on firm volatility through the transmission of

cost shocks (channel three).

The empirical analysis employs data from India at the firm and product level for Indian manu-

facturing firms over a 15‐year period between 1989 and 2003, spanning India’s trade liberalization.4

I relate changes in the output and input tariff over time at the industry level to changes in volatility of

sales growth of firms. Baseline estimates indicate that a 10 percentage point decrease in the output

tariff is associated with a 1.2% increase in volatility, while a 10 percentage point decrease in the input