Cost competitiveness: A dangerous obsession

Konstantins Benkovskis, Julia Woerz

24 February 2015

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How can we reconcile real effective exchange rate (REER) appreciation – and hence an apparent deterioration in cost competitiveness – with rising world market shares – a clear sign of improved competitiveness? Catching-up in terms of prices while increasingly being able to sell goods and services at the world market has been observed for many emerging economies that are considered as being the most competitive nations worldwide. In contrast, other countries – and among them often peripheral EU members – have sometimes greatly improved their cost competitiveness, yet without a manifestation of increased competitiveness in the form of increased global market shares. So, maybe the focus on cost competitiveness prevalent in the European discussion on how to reduce external imbalances is delusive?

Clearly, a nation’s competitiveness is to be assessed on a much broader range of indicators than unit labour costs and real effective exchange rates.1 Composite indicators such as the World Economic Forum (WEF) or the International Institute for Management Development (IMD) competitiveness rankings take account of a wide range of underlying factors. However, they cannot be replicated or updated in between publication dates. Further, the results are available at the macroeconomic level only and cannot be broken down to different economic activities within countries. In order to meet the demand for a replicable, yet comprehensive indicator that can be applied to different entities – countries, regions, sectors – we propose a novel decomposition of market share growth that captures non-price factors like quality or taste (see Benkovskis and Wörz 2014a and b).

How to capture non-price factors statistically?

Given the lack of statistical data on consumers’ tastes and physical product quality, economic researchers have explored various routes to evaluate non-price factors indirectly. Khandelwal (2010) exploited price and quantity information to estimate quality, Hallak and Schott (2011) accounted for trade balances to decompose export prices into quality versus quality-adjusted price components. We follow this route and construct two indices using observed unit values of trade flows. We name the first index as “conventional relative export price (RXP)”. It is similar to a real effective exchange rate based on unit values (dollars per kg) and measures only price competitiveness. The second index is named “relative export price adjusted for quality and taste”. In contrast to the conventional RXP, it uses “dollars per unit of utility” instead of “dollars per kg” as a definition of price, thus taking into account also changes in non-price factors (see Benkovskis and Wörz 2013, 2014a for more details). Similar to real effective exchange rates, an increase in a relative export price denotes losses in competitiveness. The comparison of conventional relative export price and relative export price adjusted for quality and taste reflects the contribution of non-price factors to changes in export prices. As an example, let us briefly interpret the dynamics of both export price indicators for the US and China (see Figure 1).

Figure 1. Conventional relative export prices (RXP) and RXP adjusted for quality and taste (2000=100)

Source: BoL and OeNB calculations based on UN Comtrade.

The conventional relative export price shows a real depreciation for the US since 2002 and almost no changes in relative export unit values for China, thus indicating that price factors are unable to explain decline in the US export market shares and tremendous gains in market shares for China. This, however, is only one part of the story, as the relative export prices adjusted for quality and taste signals gradual losses of overall competitiveness for the US, and remarkable improvements for China. Taking into account non-price factors alters the evaluation of performance of the two countries. RXP indices uncover the decline in the relative quality of the US export products (and/or a lower valuation for US goods by global consumers). At the same time, the relative quality and consumer valuation of Chinese exports improved, which is in line with findings of Fu et al. (2012).

Let us stress here that we are looking at relative changes: the rising line for China indicates quality upgrading of Chinese exports, it cannot say anything about the absolute quality of Chinese export goods which is still likely to be lower than US export goods on average.

Figure 2 summarises the dynamics of price and non-price factors for EU and major non-EU countries since 2000. The horizontal axis denotes changes in price competitiveness as measured by the traditional export price index (positive values imply a loss in price competitiveness), while the vertical axis denotes the overall changes in the quality and taste adjusted index (positive values signal overall competitiveness losses).

Figure 2. Conventional RXP and RXP adjusted for quality and taste for EU and major non-EU countries in 2012

Source: BoL and OeNB calculations based on UN Comtrade.

Many of the countries that show losses in price competitiveness according to conventional export price indices have in fact improved their competitive position when we correct for changes in non-price factors (lower-right quadrant). Central and eastern European countries feature especially prominently in this group with remarkable improvements in non-price competitiveness observed for Poland, Romania, and the Czech Republic. As mentioned above, China shows particularly striking gains in overall competitiveness (correcting for non-price factors) despite its unchanged position in terms of price-competitiveness alone. In contrast, there is a group of (mostly advanced) economies that appear as more price-competitive but actually record deterioration in the quality and taste adjusted index (upper-left quadrant). These are France, the UK, the US, and Japan. The group of unambiguous losers in terms of competitiveness (upper right quadrant) is small and includes countries like Croatia, Italy, Greece, Russia, Canada but also Ireland.2 Countries like Germany, Austria, India, Slovakia, Turkey, and Chile have unambiguously improved their competitive position, in particular so when non-price factors are accounted for.

Decomposition of changes in export market shares

Although the relative export prices indices help to understand whether the price and non-price factors contribute positively or negatively to overall competitiveness, the magnitude of these effects remains unclear. It can be assessed through a decomposition of changes in export market shares into various components, including the contribution of price and non-price factors (see Benkovskis and Wörz 2014b for details). Figure 3 shows the example of such a complete decomposition that presents the cumulative changes in export market shares for the Czech Republic and the UK since 1996. Five different factors can be separated: the role of entering new markets (extensive margin of export growth), changes in the number of competitors (changes in variety from the consumer’s point of view), shifts in global demand patterns, and price as well as non-price factors.

Figure 3. Decomposition of cumulative changes in export market shares (%)

Source: BoL and OeNB calculations based on UN Comtrade.

The Czech Republic performed successfully on external markets, as its global market share increased by more than 60% since 1996 despite an evident erosion of its price competitiveness related to nominal catching-up. Hence, the major drivers of this export success were non-price factors: interpreted as an increase in relative quality and taste. Other factors did not play a significant role apart from the small positive contribution arising from shifts in global demand. The analysis reveals for the UK that declining export market shares arose from a combination of increasing relative unit values and a relative deterioration in the quality or consumers’ valuation of British export goods.

Conclusions

Relying solely on price factors (REERs) in the assessment of a country's competitiveness may lead to wrong policy conclusions as this reduces the policy focus to pure price competitiveness and rules out any change in a country's competitive position due to other factors such as enhanced quality or better labelling of its export products. Putting the focus on such factors, our analysis suggests that the role of the exchange rate in explaining China's competitive position may have been overstated and the dominant role in boosting China's presence in the global market belongs among others to improvements in non-price factors.

Our results may also indirectly indicate the importance of the globalisation and outsourcing process. The nice clustering – developed countries losing and emerging countries gaining non-price competitiveness – can be partially attributed to the outsourcing of higher-quality goods production from developed to emerging countries. The Czech Republic is a well-known ‘final-assembly’ destination for the German car industry that may partially explain the positive contribution of non-price factors in its exports whereby the increase in relative quality is likely to have been imported via intermediates to some extent. This would support the finding of Koopman et al. (2014) who report that a significant share of domestic value added returns home to advanced countries via imports from emerging countries for Western EU, the US, and Japan. This requires shifting the focus of the analysis to from trade flows to value added when assessing the external performance of countries.

References

Benkovskis K and J Wörz (2013), "Non‐Price Competitiveness of Exports from Emerging Countries”, ECB Working Paper No. 1612, November.

Benkovskis K and J Wörz (2014a), “Lower import prices = 100% welfare gains? Not necessarily: don't forget the impact of consumer taste and product quality”, VoxEU.org, 15 July.

Benkovskis K and J Wörz (2014b), “What Drives the Market Share Changes? Price versus Non‐Price Factors”, ECB Working Paper No. 1640, February.

Christodoulopoulou S and O Tkačevs (2014), “Measuring the Effectiveness of Cost and Price Competitiveness in External Rebalancing of Euro Area Countries. What Do Alternative HCIs Tell Us?”, ECB Working Paper No. 1736, September.

Fu X, R Kaplinsky, and J Zhang (2012), “The Impact of China on Low and Middle income Countries, Export Prices in Industrial-Country Markets”, World Development, 40(8), 1483–1496.

Hallak JC and PK Schott (2011), “Estimating Cross-Country Differences in Product Quality”, Quarterly Journal of Economics, 126(1), 417–474.

Khandelwal A (2010), “The Long and Short (of) Quality Ladders”, Review of Economic Studies, 77(4), 1450–1476.

Koopman R, Z Wang, and S-J Wei (2014), “Tracing Value-Added and Double Counting in Gross Exports”, The American Economic Review, 104(2), 459–494.

Footnotes

1 Christodoulopoulou and Tkačevs (2014) show that the ability of various REER indicators to explain trade flows is rather low.

2 This somewhat surprising result may be owed to the time period chosen. Since Ireland has certainly recorded large gains in particular in non-price competitiveness before the 2000s, it is possible that our results simply reflect a consolidation of Irelands relative position.

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Topics:  Exchange rates International trade

Tags:  real effective exhange rate, cost competivenss, relative export prices

Adviser in the Monetary Policy Department, Bank of Latvia; Assistant Professor, Stockholm School of Economics in Riga

Head of the Central, Eastern and Southeastern European Analysis Unit in the Economic Analysis and Research Department, Oesterreichische Nationalbank

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