Regional convergence and trade liberalization under weak state capacity: evidence from Mexico.

• Author: Spruk, Rok

1. Introduction

   The importance of strong capacity of the state in enforcing contracts and providing the key public goods such as rule of law and education for economic development is well-recognized (Besley and Persson 2010, Cardenas 2010, Knutsen 2013, Acemoglu et. al. 2015, Dinecco 2017, Johnson and Koyama 2017). At the same time, there is strong evidence and consensus in the literature that regions within countries tend to experience conditional convergence of per capita income at the rate of about 2 percent per year (Gennaioli et. al. 2014, Ganong and Shoag 2017). The notion of regional convergence has gained its momentum and attracted considerable attention in recent years and this is especially true for developing countries such as Mexico (Diaz-Dapena et. al. 2019).

   The failure of poor regions to sustain high growth rates over time can intensify the vicious cycle of poverty trap by widening the regional per capita income gap. With respect to regional convergence, the literature emphasizes two distinct concepts of convergence (Barro and Sala-i-Martin, 2004). When initially poor regions grow faster over time than initially rich regions, the process is characterized by [beta]-convergence. Even though poor regions can sustain higher growth compared to rich counterparts, a substantial dispersion in the distribution of per capita income can persist over time. When dispersion of per capita income across regions falls over time, the process is characterized by [sigma]-convergence. Therefore, the presence of [beta]-convergence is a necessary but insufficient condition for o-convergence. A growing body of empirical research has presented multiple attempts to disentangle regional income disparities within single countries. (1) The evidence of both types of regional convergence has been confirmed for a growing number of countries starting from late 19th century onwards with the main emphasis on post-war period. (2)

   This paper presents an attempt to analyze the long-term patterns of regional convergence and divergence for a panel of 32 Mexican states for the period 1940-2010. (3) Compared to existing literature, we focus on long-term dynamics of per capita income distribution and paths of regional growth. To this end, a new regional dataset on real per capita GDP is constructed for the Mexican states using purchasing power parities and regional GDP deflator based on the historical intertemporal regional distribution of regional GDP per capita from a seminal contribution by German-Soto (2005).

   A simple model of convergence and poverty traps is constructed and tested on the reconstructed historical time-series for Mexican states. The evidence, based on decennial cycles, suggests that before the onset of 1980s, Mexican states and regions exhibit a strong and robust unconditional (absolute) output per capita convergence with no evidence of self-perpetuating poverty traps. The estimated convergence coefficient is robust to long-term unobserved state-specific effects and technology shocks over time with significant decline of regional income inequality. After the economic reforms carried out by De La Madrid and Salinas de Goltari administrations starting in early 1980s, Mexican regional convergence came to a halt with little evidence of absolute and conditional per capita output convergence since initially rich regions sustained higher growth compared initially poor counterparts. The absence of (un)conditional convergence in post-1980 period is further substantiated by rising regional Kuznets ratio and Gini coefficient since regional dispersion of per capita income rose substantially between US border and non-border regions. The evidence from within-regional estimated sigma coefficient uncovers significant divergence, driven by widening per capita income gap among Southern states compared to the rest of the country. Our sensitivity analysis underlines the absence of convergence and shows that the share of states exhibiting per capita income convergence declined markedly in post-1980 period. Our evidence on estimated regional growth disparities remains robust after the convergence coefficient is conditioned on spatial and intertemporal heterogeneity. These findings indeed suggest that Mexico's postwar regional growth pattern has created both "winners" and "losers" despite indicative evidence of regional convergence until 1980s.

   The paper contributes to the growing literature on regional income convergence in developing countries by providing a large dataset to exploit long-run patterns of economic growth across Mexican states with unobserved heterogeneity and deploying a plausible panel-data model of regional income convergence in the long-term perspective. The rest of the paper is organized as follows. Section 2 reviews the regional convergence response to trade liberalization in the context of weak state capacity. In Section 3, stylized facts from the literature on regional inequality and growth in Mexico are discussed. Section 4 presents a simple model of poverty traps where [beta]- and [sigma]-convergence are discussed in more detail. In Section 5, the data and methodology are presented. Section 6 discusses the results. Section 7 proceeds with robustness checks. Section 7 concludes.

2. Trade liberalization under weak state capacity: the Mexican case

   In the 1980s, Mexico embarked on the path of ambitious economic policy reforms that overhauled the previous inward-looking policies emphasizing import substitution and state-led industrialization. The key pillars of market-oriented economic policies of De la Madrid government administration in the period 1982-1988 included the encouragement of foreign direct investment, widespread privatization of state-run industries and a substantial tariff reduction. In January 1986, Mexico signed GATT agreement and embraced trade liberalization. Numerous scholars agree that trade liberalization is associated with higher rates of growth (Krueger 1998, Greenaway et. al. 2002, Cavalcanti Ferreira and Luiz Rossi 2003, Dollar and Kraay 2003, Winters 2004, Foster 2008). The general thrust of these studies is that trade liberalization fosters the economic specialization, improves productivity growth and reinforces both allocative and dynamic efficiency although the latter does not come automatically (Dijkstra 2000).

   One of the neglected facets of trade liberalization concerns the strength and weakness of state capacity. In particular, the notion that free markets function well of property rights are well defined and impartially enforced has become widely accepted (Demsetz 1964, Furubotn and Pejovich 1972, Leblang 1996, Besley and Ghatak 2010, Galiani and Schargrodsky 2011). Since gaining independence from Spain in the early 19th century, Mexico's institutional environment has been characterized by the distorted and unequal access to the rule of law. Kuchar (2016) provides several historical narratives and substantial evidence in support of the argument that the economic policies of trade liberalization and privatization of the De la Madrid administration were decidedly illiberal and further strengthened the directorship (i.e. rectoria) and control of the Mexican government over the economic activity. In particular, the privatization of the 1980s and 1990s culminated in a de facto protection and shielding of large state-funded corporations that went bust by 1970s. Haber et. al. (2008) show that trade liberalization in the 1980s did not produce the boom in investment trade and economic growth because Mexico changed its policies but did not fully liberalize its economy by maintaining a tax system that evolved under decades of the authoritarian rules. This implies that the macroeconomic stabilization policies along with the trade liberalization were carried out in the context of fragile state capacity under weak rule of law. Although the commitment of de la Madrid administration to macroeconomic stabilization had been undisputed, the stabilization policies were undermined by several constitutional reforms that promulgated state-led economic planning and government intervention in the particular economic sectors such as energy and telecommunications with exclusive public control.

   Furthermore, some scholars argue that the absence of the institutional environment that embeds the disregard of the rule of law is one of the chief causes of Mexico's underdevelopment (Katz 2014). Ill-defined property rights and the absence of an accessible low-cost enforcement of contracts for a significant fraction of the Mexican population coupled with the culture of rent-seeking, inefficient judiciary and costly bankruptcy law decidedly hinder economic transactions and restrain the financial development which feeds into lower total factor productivity and decreased economic growth. For instance, Ugalde (2014) argues that the economic reforms such as trade liberalization by the government administrations of de la Madrid and de Gotari were implemented without challenging the existing patronage framework. When the patronage networks hold substantial de facto economic power, the economic reforms that take place with the clientelistic patronage framework without effective and independent regulatory agencies, the deregulation, trade liberalization and privatization tend to benefit the existing business elites instead of the market in general. This implies that the economic reforms render the existing business and political elites entrenched insiders and further fuel the demand for political clientelism and the cooptation between both elites. Diaz Cayeros (2019) outlines the defining characteristics of the Mexican political and economic equilibrium of patronage framework that maintains the status quo bias such as the failure of land reform in facilitating asset formation among poor peasants, limited role of the stock market in firm-level capital formation, clientelistic regulatory framework that favors the...