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Import Competition, Quality Upgrading and Exporting: Evidence from the Peruvian Apparel Industry PDF

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Import Competition, Quality Upgrading and Exporting: Evidence from the Peruvian Apparel Industry By Pamela Medina∗ This paper studies quality upgrading to escape competition from low-wage countries. Informed by Peruvian apparel man- ufacturers reaction to China’s WTO accession, I propose a new channel that does not rely on access to new inputs or markets. I introduce factor specificity in a multi-product firm model and show that a profitability loss due to competition in low-quality segments can induce firms to quality upgrade. With costly downsizing, firms reallocate idle factors across products and markets. Gains from this channel are large. Quality upgrading raised annual sales and employment by 17.5% and 18% relative to a counterfactual with no upgrade opportunities. JEL: F13, F14, O14, O24, O54. Keywords: Quality Upgrading, Import Competition. How can firms escape competition from low-wage countries? In an age of unprece- dented global market integration, this question has taken a central stage in the popular press as well as in the academic literature. Both the anecdotal and the scientific ev- idence indicate that quality upgrading is a way through which firms can avoid going head-to-head with foreign producers that pay an order of magnitude smaller wages. The existing literature has, broadly speaking, identified two mechanisms through which international trade integration leads to quality upgrading. First, firms have access to cheaper, more varied and higher quality inputs (Verhoogen, 2008; Fieler, ∗ Corresponding Author: Pamela Medina. UTSC and Rotman School of Management. University of Toronto. Email: [email protected]. I am especially grateful to Daniel Yi Xu, James Roberts, Allan Collard-Wexler, Rafael Dix-Carneiro and Duncan Thomas for their guidanceandsupport. Forhelpfulsuggestionsandcomments,IalsowanttothankPatrickAlexander, Peter Arcidiacono, Bernardo Blum, Lorenzo Caliendo, Jonathan Eaton, Rob Garlick, Paul Grieco, Ig Horstmann, Peter Morrow, Nina Pavcnik, Juan Carlos Suarez-Serrato, Dan Trefler, Eric Verhoogen, and many seminar participants. All errors remain my own. 1 Eslava and Xu, 2014; Bas and Strauss-Kahn, 2015). Second, access to larger markets complements the investment in new technologies (Bustos, 2011; Lileeva and Trefler, 2010; Aw, Roberts and Xu, 2011). In this paper, I present a new channel where trade-induced competition at the final good level alone leads firms to invest in quality upgrading and increase exports: within- firm factor reallocation. IdocumentthatwhenthePeruvianapparelindustrywashitby intense import competition following China’s accession to the WTO, firms responded by upgrading the quality of their products and exporting.1 These responses, on their own, account for about 30% of the sharp increase in exports between 2001-2012. Unlike traditional channels, this upgrading happened without Peruvian firms relying on the useofimportedinputsormakinginvestmentstoservetheChinesemarket, asevidenced by no significant change in the size or composition of firm-level employment, capital or investment. Rather, these within-firm responses occur alongside a decrease in firm- level prices and profits. Peruvian firms combined equipment that had been idled due to foreign competition with previously exported high-quality domestic cotton. This allowed them to produce high-quality varieties and differentiate themselves from the low-wage foreign competition. The empirical setting is ideal to study this channel for two reasons. First, unlike previousstudiesfocusedontradeliberalization,Icanisolatetheimpactofanexogenous increase on import competition. While China’s WTO accession meant it would receive and give MFN treatment, this did not immediately translate to a larger market for the Peruvian garment sector.2 Second, there is an observable measure of quality. Broadly, for basic garments, apparel quality is defined by its material quality. In Peru, the co- existence of high-quality Pima cotton and low-quality synthetic fabrics creates a clear hierarchy of material quality; the use of these materials is recorded in the data. In order to formalize the adjustment mechanism described above and to evaluate the extent to which it can explain the adjustment of the Peruvian apparel industry to Chinese competition, I develop a dynamic industry general equilibrium model that 1One standard deviation in Chinese import competition in the domestic market leads to a 18.6% averageincreaseinannualPeruvianexports(20.5%inhighqualityexports). Moreover,firmsare15% morelikelytoincreasetheirnumberofhigh-qualityproductsand4%morelikelytointroduceatleast one new high-quality product per year. 2Unlike imports originated in China, Peruvian manufacturing exports to China did not increase substantially, even one decade after China entered the WTO. 2 captures the main features of the data. In the model, firms can freely adjust the amount of labor they use in each period, but capital is specific to the firm and fixed over the short/medium run. However, in every period, firms can allocate both capital and labor to the production of varieties with different qualities. In this sense, the model departs from the assumption of constant marginal costs, resulting in pricing and production decisions that are no longer separable across products or markets. Each decision depends on the total production of the firm, as well as market conditions in each segment. As I demonstrate in the paper, these technological assumptions match the characteristics of the Peruvian apparel industry. In this setting, I show that foreign competition reduces the return on the firm’s fixed factor, in this case capital equipment, making it optimal for the firm to reallocate capi- talandlabortowardstheproductionofhigh-qualityvarietiesusinghigh-qualityinputs. More productive firms, which already sell many goods to many markets, intensify the production of their foreign high-quality segment (intensive margin of adjustment). In addition, surviving less productive firms start producing and exporting high-quality goods (extensive margin of adjustment). Relative to standard trade models, consumer welfare increases because foreign competition reduces price indices, and domestic firms decrease prices on other final goods as a response. Next, I estimate the structural model to: (i) quantify the importance of quality upgrading in industry sales, employment, and consumer welfare, and (ii) examine how policies that facilitate exports or quality upgrades compare with import tariffs. The estimation is not trivial. Given the lack of market segmentation, firm-level prices do not have closed-form solutions. Rather, they are the result of a non-linear system of equations. This system is embedded in the dynamic model and must be solved in all iterations, for all potential parameters and state-space values, a computationally demanding task. To circumvent this issue, I perform the estimation in two steps. First, Iestimateparametersassociatedwiththestaticprofitmaximizationforeverypotential product mix. Second, I estimate the dynamic multinomial choice model following Hotz and Miller (1993) and Arcidiacono and Miller (2011). When I estimate the model using the Peruvian data, I find that the ability of firms to switch to more profitable products and markets has far-reaching economic and social implications. I compare the baseline predictions of the empirical model with a case 3 where Peruvian firms had higher costs to upgrade and export. What if Peruvian firms faced higher cotton prices or sunk costs? Annual industry sales would have decreased by 4-18%, firm-level profits by 4-16%, and industry employment by as much as 8-18%. These effects are not trivial. In fact, they help explain why industries around the world were not immune from Chinese import competition. Theestimatedmodelalsocontributestotheongoingpublicdebateonthefulleffectof industry exposure to import competition from low-wage countries. Since import com- petition considerably affects employment, governments might worry about sustained unemployment. To limit unemployment, import tariffs are often proposed. In fact, while import tariffs of 15% could have expanded the Peruvian industry’s revenues and employment by 5%, the welfare cost is alarming. Import tariffs would have meant an annual 7% reduction in consumer welfare–equivalent to US$ 133 million per year. If Peru had implemented that measure in 2000, the welfare cost would have totaled US$ 349 million in present value terms over an 11 year period. In contrast, the model presents an alternative. Policies that decrease sunk costs of exporting high quality goods by 50% can achieve the same revenue and employment growth with no added cost to consumer surplus. In the counterfactual, the latter would imply 20% of the welfare cost of additional import tariffs. As mentioned above, this paper is part of the large body of literature on the effects of foreign competition on quality upgrading such as Verhoogen (2008); Fieler, Eslava and Xu (2014); Bustos (2011); Lileeva and Trefler (2010); Aw, Roberts and Xu (2011); Bas and Strauss-Kahn (2015). However, it departs from the existing trade literature in that it presents a mechanism where quality upgrading is not the result of exogenous positive productivity shocks, demand shifters or other comparative advantage forces. In the model, there is an additional incentive that induces firms to escape competition: reallocate productive factors within the firm. In this sense, the paper is closer to the industrial organization literature (Aghion et al., 2005), as well as recent empirical trade work by Khandelwal (2010) and Amiti and Khandelwal (2013), who link competition and innovation. In particular, the results of the paper are consistent with Khandelwal (2010) work on quality ladders. One way to think about this is that given Peru’s rela- tively easy access to higher quality inputs, the Peruvian industry has a shorter quality ladder than other countries. In this sense, one contribution of this paper is to provide 4 evidence and the mechanism that underpins the firm’s incentives (costs and benefits) to move up the quality ladder. In doing so, this paper is able to match this mecha- nism to the empirical observation of heterogeneous impacts of low-wage competition on manufacturing employment and output, not only across industries within a country, but also within an industry, across countries. This paper is also related to old literature on the presence of fixed production factors and their implication for trade models. With a fixed factor, firms no longer consider their production decisions to each market as separate choices: instead they optimize theentireproductionbundle. Thedeparturefromtrademodelswithconstantmarginal costs allows this framework to explain empirical regularities, such as the correlation between domestic and export sales (Blum, Claro and Horstmann, 2013), increasing marginal costs of production (Ahn and McQuoid, 2015), and the interdependence of production of products at the firm level (Bernard, Redding and Schott, 2010). More broadly, the paper speaks to the literature on product diversification, the search for niche markets, and even industry diversification as a more efficient firm-level response to import competition. While here, factors are used in the production of goods, the mechanism could account for cases where they are used to produce different outcomes. As in Bloom, Draca and Van Reenen (2015a,b), labor could be used for the production of goods or the “production” of innovation. Finally, due to the structural estimation of the model, I am able to quantify welfare and perform counterfactual policy exercises. In this sense, the paper also adds to the ongoing literature and public debate on welfare effects of import competition on developing countries, with a particular emphasis on Latin America, as in Goldberg and Pavcnik (2007); Verhoogen (2008); Topalova (2010); Iacovone, Rauch and Winters (2013); Pavcnik (2002). The remainder of this paper is organized as follows. Section I describes the data. In Section II, I present the key facts about the Peruvian apparel industry that guide the reduced-form evidence in Section III, and the theoretical model detailed in Section IV. I then structurally estimate the model in Section V, and evaluate the impact of relevant policies in Section VI. Section VII concludes. 5 I. Data This analysis is based on firm-level production and trade data that covers the 2000- 2012 period. Appendix A.A offers a more detailed description of the data. Briefly, my primary sources are the Peruvian Economic Survey (EEA) and the Peruvian Cus- toms Data (PCD). The EEA provides information for each firm on total revenue, wage bill, intermediate inputs, as well as investment and capital stock. The PCD provides information for every firm-level export and import transaction, on shipment values, quantity, destination, commercial description, as well as duties and rebates. Impor- tantly, PCD classifies each product at the 10-digit Harmonized Tariff Schedule (HTS), a fact that will ultimately allow me to determine the quality of the good. I select firms engaged in the production of apparel, either classified under CIIU (Clasificaci´on Industrial Internacional Uniforme) rev.4. Codes 1410 and 1430, or firms classified elsewhere but exporting apparel products under Chapters 61 and 62 of the HTS code. II. The Peruvian Apparel Industry: Key Facts 2000-2012 In this section, I present some key facts on the Peruvian apparel industry that inform the modeling of the production process, as well as the focus on quality upgrading and exporting as within-firm responses to import competition. A. Sequential Production Process Garment manufacturing is, in principle, a sequential assembly-oriented production process. Broadly, it goes through the following array of tasks.3 The process begins with a specific amount of fabric, which is spread and cut to product specifications (i.e., pants, t-shirts or shirts). Seamstresses put these pieces together, garments are washed, and add-ons such as buttons and labels are included. Clothes are inspected for quality, and finally, goods are packed and shipped. While the process is relatively labor intensive, materials represent the largest per-unit cost share. This production sequence is independent of the type of clothing manufactured. That is, to produce a t-shirt or a pair of pants, a firm can use the same assembly line. This 3Exceptions include knitted products and garments made with fur or leather. 6 is because labor and machinery are specialized to tasks instead of a specific garment. Besides, the fabric requirement for a product does not vary with the type of fabric used. For example, a t-shirt requires the same amount of either fabric, regardless of whether it is cotton or man-made fabric. B. Quality is in the Materials In the garment industry, final good quality directly reflects material quality. Since firms use the same method, labor and capital to produce various types of clothes, quality differentiation depends only on materials. I use this feature to construct an observed measure of product quality. To do that, it is fundamental to have a ranking of material quality and information on the material used for each garment. My empirical set-up and data provides these requirements. First, in Peru, there is a clear hierarchy on the quality of materials used by gar- ment producers. Peruvian-grown natural fibers are notorious for their high quality. In particular, Peru’s most important cotton varieties, Pima and Tangu¨is, are among the highest quality in the world. Besides having higher staple length and uniformity than other cotton varieties,4 they feature superior strength and dyeing properties compared to synthetic and man-made fabrics. Thus, Peruvian cotton fabric is higher quality material than other cotton, synthetic, or man-made fibers. Second, the data specifies the material used in every exported garment. At the 10- digit HTS level, all apparel products are classified by type, targeted consumer, and broad material type. For instance, HTS 6105100051 groups “Shirts, made of cotton, with neck and front opening, solid color including white, for men”. Unfortunately, even with this level of detail, HTS codes do not differentiate among types of cotton. To deal with this issue, I use information collected on the PCD about the commercial descriptionoftheproduct. Thisincludescharacteristicssuchasbrand,size,andspecific type of fabric used, as in “LACOSTE, Men Polo Shirt, 100% Pima Cotton, R03-12E, receives drawback.” Thus, I define the observed quality measure as follows. A garment is high-quality if it is uses fabrics containing 50% or more of Pima or Tangu¨is cotton fibers. Conversely, 4Pima has extra-long 1-3/8” staple length, similar to Egyptian cotton. Tangu¨is has long staple, similartoAmbardcottonfromSudan,Giza47and68fromEgypt,andAlcalafromtheUnitedStates. Both are higher quality than Upland, the largest US cotton crop. 7 it is low-quality if it is produced using other mixed-cotton varieties, synthetic or man- made cloth.5 C. Rising Chinese Import Competition Import competition intensified for the Peruvian apparel industry after China’s acces- sion to the WTO. Figure 1 shows this large influx of Chinese clothes in the Peruvian market. They not only entered the country in large quantities, but at half the price of Peruvian and other imported garments. 600 20 World China 500 16 Apparel Imports(in US$ Millions)340000 Unit Price(in US$)128 200 All Apparel Imports 100 4 Peruvian FOB Exports Apparel Imports from China 0 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 0 2000 2002 2004 2006 2008 2010 2012 (a)ValueofPeruvianImports (b)UnitValues Figure 1. : Chinese Import Competition Source: Peruvian Customs Data and Peruvian Tax Authority (SUNAT). Note: (1) I approximate domestic unit prices with FOB unit values of Peruvian exports. Not consid- ering duties and fees, FOB unit values reflect production costs and mark-ups. In less than ten years, the value of Chinese imported apparel quintupled, surpass- ing those of any other country. Immediately, China became the main competitor of Peruvian manufacturers. As a consequence, the domestic share of Peruvian manu- facturers declined over time. Value share of Peruvian firms in the domestic market decreased from 88% to 70% between 2000 and 2011. Yet, considering the low value of Chinese clothes, China was supplying more than 50% of clothing units to Peruvians by 2011. The situation was no different in Peruvian’s most important export destinations. Chinese import competition also increased in the United States and other developed countries with the end of the Multi-Fiber Agreement in 2005. 5See Appendix A.B for an extensive list of HTS codes for every apparel type. 8 D. Export Boom and Quality Change While Peruvian apparel production was traditionally destined for the domestic mar- ket, beginning in the early 2000s, exports became the largest source of growth for this industry. Figure 2a shows the export increase after 2001. At the same time Peruvian producers lost a considerable share of the domestic market, they managed to increase their shares in their most important foreign markets. The rise was such that, between 2000 and 2008, the share of exports in industry sales rose from 56% to 71%. 500 1800 40 Synthetic 1600 30 Cotton 400 1400 20 Imports(in US$ Millions) 230000 11802000000 (in US$ Millions)Exports Export Growth %-11000 600 -20 100 400 -30 PERU 200 -40 0 1994CHINA 1996 1998 2000 2002 2004 2006 2008 2010 2012 0 2000/2001 2001/2002 2002/2003 2003/2004 2004/2005 2005/2006 2006/2007 2007/2008 2008/2009 2009/2010 2010/2011 2011/2012 (a)PeruvianExportsvsChineseImports (b)ExportGrowthDecomposition Figure 2. : High-Quality Export Boom Source: Peruvian Customs Data and Peruvian Tax Authority (SUNAT). Most of the growth in Figure 2a is due to the increase in exports of one type of garment: Peruvian high-quality cotton apparel. Figure 2b shows that while export growth was evenly distributed between high- and low-quality apparel before 2001, it has been predominantly driven by high-quality cotton garment exports since then. Except for the 2008 financial crisis episode, Peru not only exports more, but exports more high-quality clothing. Moreover, as firms export more of these higher quality products, they also shift their product-mix towards these goods. During the 2000s, 38% of non-cotton exporters will likely include at least one cotton product over the next year and 9.8% will become only-cotton exporter. Meanwhile, only 5% of cotton exporters will drop cotton altogether to sell synthetic apparel only. 9 III. Within-Firm Responses: Quality-Upgrading and Exporting Large exposure to firm-level import competition has a positive effect on export- ing and quality upgrading, consistent with patterns shown in Section II. This section draws on micro-data from PCD and EEA to estimate firm-level strategies after an im- port competition shock. I proceed in two steps. First, I describe the firm-level import competition measure. Second, I estimate the impact of this measure on firm perfor- mance. Domestic Chinese import competition increase firm-level exports, number of exported products and introduction of new products. Yet, the effect is only significant for high-quality goods. Even though the uptick in high-quality exports increases total exports, total sales are not affected, suggesting a negative adjustment in the domestic market. Moreover, the effect is heterogeneous and stronger for larger firms. A. Measuring Firm-Level Import Competition Import competition affects firms differently because each firm produces a distinct bundle of goods. Firms that produce garments that are also sold by Chinese firms face fiercer competition. Meanwhile, firms selling clothing not otherwise produced in China arelessaffected. Thus, firm-levelexposuretoimportcompetitionisdeterminedbyhow directly a firm’s products compete with Chinese clothes, and their relative importance to the firm’s product mix. Denote Chinese import penetration in country k on product n at time t as ChPenk . nt Import penetration refers to the share of imports originated in China on total imports of country k by product. Products are defined by 10-digit HTS codes. Then, a firm j in period t selling a set of products N faces the following exposure to Chinese import jt competition in the Peruvian market: (cid:88) x (1) DComp = jnt0ChPenPeru jt x nt n∈Njt jt0 where xjnt is the share of product n in the overall exports of firm j at time t. Due xjt to endogeneity concerns, export shares are set to the ones observed the first time the firm appears in the data.6 In addition, a similar measure is constructed for the foreign 6Similar measures have been used in the empirical literature by Iacovone, Rauch and Winters 10

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Peruvian garment sector.2 Second, there is an observable measure of quality. Broadly, for basic garments .. Import competition intensified for the Peruvian apparel industry after China's acces- sion to the WTO. Figure 1 Rust, John. 1997. “Using randomization to break the curse of dimensionality.
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Most books are stored in the elastic cloud where traffic is expensive. For this reason, we have a limit on daily download.