Trade Logistics in Landlocked and Resource Cursed Asian Countries

Trade Logistics in
Landlocked and
Resource Cursed
Asian Countries
Edited by
k a n k e su jaya n t h a k u m a r a n
n age sh sh u k l a
c h a r l e s h a rv i e
odb aya r e r de n e t so gt
Trade Logistics in Landlocked and Resource Cursed
Asian Countries
Kankesu Jayanthakumaran
Nagesh Shukla • Charles Harvie
Odbayar Erdenetsogt
Editors
Trade Logistics in
Landlocked and
Resource Cursed
Asian Countries
Editors
Kankesu Jayanthakumaran Nagesh Shukla
School of Accounting, Economics & School of Information, Systems and
Finance Modelling, Faculty of Engineering and
University of Wollongong Information Technology
Wollongong, NSW, Australia University of Technology Sydney
Sydney, NSW, Australia
Charles Harvie
School of Accounting, Economics & Odbayar Erdenetsogt
Finance UN House
University of Wollongong International Think Tank for LLDCs
Wollongong, NSW, Australia Ulaanbaatar, Mongolia
ISBN 978-981-13-6813-4 ISBN 978-981-13-6814-1 (eBook)

https://doi.org/10.1007/978-981-13-6814-1
© The Editor(s) (if applicable) and The Author(s), under exclusive licence to Springer
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Acknowledgement
As the editors of this book, our sincere thanks go to all of the contributors
of the book chapters, who throughout the last one year have ceaselessly
worked hand in hand to enable this book to materialise.
v
Contents
1 Introduction: Trade Logistics in Asian Countries That Are

Landlocked and Resource Cursed 1
Part I Economic Diversification 7
2 The Dutch Disease and Economic Diversification: Should

the Approach by Developing Countries Be Different? 9
Charles Harvie
3 Inclusion of Firm Heterogeneity in Resource Boom-Bust

Cycle Literature 47
Kankesu Jayanthakumaran, Mohammad Tariful Bari, and
Nelson Perera
4 Trade Facilitation in South Asia: Landlocked Countries’

Perspective 71
Ramesh Chandra Paudel
vii
viii Contents
5 The Determinants of FDI in Landlocked Developing

Countries in Central Asia 95
Nomintsetseg Ulzii-Ochir
Part II Country Studies: Laos PDR, Nepal and Mongolia 123
6 Modelling Trade Logistics Based on Multi-Method

Simulation Approach: Case-in-Point: Mongolia125
Nagesh Shukla and Arjun Radhakrishnan
7 Micro-, Small- and Medium-Sized Enterprises (MSMEs):

Challenges, Opportunities and Sustainability in East Asia155
Charles Harvie
8 Foreign Aid and Export Performance in a Landlocked

Country: Development Lessons from Nepal175
Kishor Sharma and Badri Prasad Bhattarai
9 Formation of Special Economic Zones in Mongolia193

Tsolmon Tsagaach
Index221
Notes on Contributors
Mohammad Tariful Bari is a senior assistant chief in the Planning

Commission, Bangladesh. He holds an MSc in Development Economics
from Hiroshima University, Japan, and a PhD in Economics from the
University of Wollongong, Australia. His research focuses on the micro-
economics of trade and development.
Badri Prasad Bhattarai is a learning adviser of Economics at Southern
Cross University, Sydney Campus, and holds a PhD in Economics from
the University of Western Sydney. Badri has worked at the University of
Western Sydney, Macquarie University, Central Queensland University,
Charles Sturt University and Charles Darwin University as a teaching aca-
demic for over 15 years.
Odbayar Erdenetsogt was elected as an executive director of the
International Think Tank for Landlocked Developing Countries (ITT for
LLDCs) in 2018 by all member states. Since 2012, he has performed as an
interim director. Under his supervision and leadership, the ITT for LLDCs
was legally established as the first-ever intergovernmental organisation at
the United Nations and produced several publications on LLDC-related
issues. Mr. Odbayar holds a BA and an MA in International Relations
from the University of Dresden, Germany (2006), majoring in Political
Science, Philosophy, Economics and Social History.
Charles Harvie is an associate professor in the School of Accounting,
Economics & Finance, University of Wollongong, Australia, and holds a
PhD in Economics from the University of Warwick, UK. His research
ix
x Notes on Contributors
focuses on the economies of East and Southeast Asia, and is published in

the form of books and scholarly academic journals.
Kankesu Jayanthakumaran is a senior lecturer at the University of
Wollongong, Australia. His research has focused on ‘trade facilitation and
performance’, an area in which he has written 34 peer-reviewed journal
articles and 5 book chapters, edited 2 books and authored 1:
Industrialization and Challenges in Asia, published in 2016. His current
research area is integrative trade and logistics in landlocked countries.
Ramesh Chandra Paudel is a visiting fellow at the Australian National
University and holds a PhD from there, too. Ramesh has worked as a con-
sultant at the World Bank, Asian Development Bank and other research
organisations. His research interests include, but are not limited to, eco-
nomic growth, international trade, liberalisation and reforms, develop-
ment financing, foreign direct investment, landlocked economies and
macroeconomics.
Nelson Perera is Head of the School of Accounting, Economics &
Finance at the University of Wollongong and holds a PhD in Economics
from La Trobe University, Australia. His research focuses on the monetary
policy, applied econometrics, business analytics and application of statistics
to the business area.
Arjun Radhakrishnan is a research assistant in the Faculty of Engineering
and Information Sciences, University of Wollongong, Australia. He is a
doctoral student at the university and his research focuses on supply chain
management and project management.
Kishor Sharma is Professor of Economics at Charles Darwin University,
Australia. He has written/edited 7 books, over 70 journal articles and
about 20 book chapters. He has been a consultant to the Asian
Development Bank and the United Nations Industrial Development
Organisation to help formulate trade and development policy in Asian
developing countries.
Nagesh Shukla is a senior lecturer in the School of Information, Systems
and Modelling, Faculty of Engineering and Information Technology at
University of Technology Sydney. He holds a PhD from the University of
Warwick, UK, and a bachelor’s degree (Manufacturing Engineering) from
the National Institute of Foundry and Forge Technology, India. His
research focuses on business data analytics and optimisation.
Notes on Contributors xi
Tsolmon Tsagaach is a senior lecturer in the Business School, National

University of Mongolia. He holds a MBA from La Trobe University,
Australia. He is a PhD student at the National University of Mongolia and
his research focuses on the regional economic integrations in Central and
Northeast Asia.
Nomintsetseg Ulzii-Ochir is a senior lecturer in the Business School,
National University of Mongolia, Mongolia, and holds a PhD in
International Trade from the University of Kangwon National University,
South Korea. Her research focuses on international trade, free trade agree-
ments and foreign direct investments.
Contributors
Mohammad Tariful Bari School of Accounting, Economics & Finance,

University of Wollongong, Wollongong, NSW, Australia
Badri Prasad Bhattarai SCU Sydney Campus, Southern Cross
University, Sydney, NSW, Australia
Odbayar Erdenetsogt UN House, International Think Tank for LLDCs,
Ulaanbaatar, Mongolia
Charles Harvie School of Accounting, Economics & Finance, University
of Wollongong, Wollongong, NSW, Australia
Kankesu Jayanthakumaran School of Accounting, Economics &
Finance, University of Wollongong, Wollongong, NSW, Australia
Ramesh Chandra Paudel Arndt Corden Department of Economics,
Crawford School of Public Policy, Australian National University,
Canberra, ACT, Australia
Nelson Perera School of Accounting, Economics & Finance, University
of Wollongong, Wollongong, NSW, Australia
Arjun Radhakrishnan Faculty of Engineering and Information Sciences,
University of Wollongong, Wollongong, NSW, Australia
Kishor Sharma CDU Business School and Northern Institute, Charles
Darwin University, Sydney, NSW, Australia
xii Notes on Contributors
Nagesh Shukla School of Information, Systems and Modelling, Faculty

of Engineering and Information Technology, University of Technology
Sydney, Sydney, NSW, Australia
Tsolmon Tsagaach Business School, National University of Mongolia,
Ulaanbaatar, Mongolia
Nomintsetseg Ulzii-Ochir Business School, National University of
Mongolia, Ulaanbaatar, Mongolia
List of Figures
Fig. 3.1 Dutch disease symptoms. (Source: Author constructed) 50

Fig. 3.2 Resource boom and cost of production. (Source: Author
constructed)62
Fig. 3.3 Resource boom and productivity. (Source: Author constructed) 63
Fig. 3.4 Exchange rate appreciation and exporters. (Source: Author
constructed)65
Fig. 3.5 Exchange rate pass-through and mark-up absorption.
(Source: Author constructed) 65
Fig. 4.1 South Asia’s trade share and growth of imports and exports
of goods, services (%). (Source: World Bank 2016b) 73
Fig. 5.1 FDI inflows to eight Central Asian LLDCs (millions of dollars),
1996–2016. (Source: Author’s compilation. UNCTAD (2018).
FDI database. [Online] Available from: http://unctadstat.
unctad.org/wds/ReportFolders/reportFolders.aspx)100
Fig. 5.2 FDI flow of the eight selected Central Asian LLDCs ($
millions). (Note: Author’s compilation) 103
Fig. 6.1 Overall methodology used for simulating a logistics system 133
Fig. 6.2 Rule-based shipment creation and delivery (where C1–C5
represent customer order amounts) 136
Fig. 6.3 Working process flow for transport agent 138
Fig. 6.4 Initial model graphical interface 140
Fig. 6.5 Snapshot of interface when the model is running 141
Fig. 6.6 Output statistics generated while the model is running 142
Fig. 6.7 Truck utilisation rates from the model 143
Fig. 6.8 Waiting time of trucks for products to be available at the
manufacturing plant 143
Fig. 6.9 Time duration when the order was in delivery 143
xiii
xiv List of Figures
Fig. 6.10 Delivery performance (order arrival duration—order lead time) 144
Fig. 7.1 Global and regional production networks and MSMEs. (LE
large enterprise, SME small and medium-sized enterprise.
Source: Abonyi, 2005) 169
Fig. 8.1 Agriculture, industry and service, value added % of GDP,
1965–2016. (Source: Based on WDI (2018) online database) 180
Fig. 8.2 Foreign aid and export performance, 1965–2015. (Source:
Estimated based on OECD (2018) online database and WDI
(2018) online database) 182
Fig. 8.3 Exports to and imports from India as % of total exports and
imports, 1975–2015. (Source: Based on data from Nepal Rastra
Bank (NRB) Quarterly Economic Bulletin, October 2017) 183
Fig. 8.4 Exports and imports as % of GDP, 1965–2015. (Source:
Estimated by the authors based on data from WDI (2018)
online database) 186
Image 9.1 Development plan schema of Altanbulag free zone. (Source:
Governor’s Office of Altanbulag Free Zone) 200
Image 9.2 Current map of Zamyn-Uud free zone. (Source: Governor’s
Office of Zamyn-Uud Free Zone) 201
Image 9.3 Development plan for cross-border free economic zone of
Zamyn-Uud and Erenhot. (Source: Governor’s Office of
Zamyn-Uud Free Zone) 203
Image 9.4 Asian highway routes through Mongolia. (Source: United
Nations ESCAP) 207
Image 9.5 Trans-Mongolian railway vs. Trans-Manchurian railway.
(Source: Governor’s Office of Altanbulag Free Zone) 208
Image 9.6 AH4 highway connecting China and Russia through Mongolia.
(Source: Governor’s Office of Tsagaannuur Free Zone) 215
List of Tables
Table 3.1 Early literature that establishes the Dutch disease concept 51
Table 3.2 Recent literature on the causal mechanism of the resource
curse54
Table 4.1 South Asia at a glance as of 2015 72
Table 4.2 South Asia’s institution and infrastructure quality (rank 138
countries in 2016) 78
Table 4.3 South Asia’s overall competitiveness indicators 79
Table 4.4 Doing business indicators for South Asian countries (rank
out of 190 countries), 2016 80
Table 4.5 Logistics performance index ranks (167 countries ranked) by
components for 2010–2016 82
Table 4.6 South Asia’s weighted average tariff rate (%) for all products
& open year 83
Table 4.7 Indicators of FDI regulations (average) 83
Table 4.8 Foreign equity ownership allowed in selected areas of
economy (%) 84
Table 4.9 Variables and expected signs with the data source 86
Table 4.10 Random effect estimation results, dependent variable
exports-log89
Table 4.11 Random effect estimation results, dependent variable
exports-log alternate specification 90
Table 5.1 Effect of selected variables on FDI 99
Table 5.2 FDI inflows to eight Central Asian LLDCs, to other country
groupings101
Table 5.3 FDI criteria (mining sector) 106
Table 5.4 Explanatory variables and data sources (eight countries) 111
Table 5.5 OLS estimation 113
xv
xvi List of Tables
Table 5.6 Regional corporate tax rate survey comparison (2006–2018) 115
Table 6.1 Demand parameters for five different demand profiles (cases) 135
Table 6.2 Parameters used in modelling the retailer agent 145
Table 6.3 Events used in modelling the retailer agent 145
Table 6.4 Parameters used in modelling the order agent 145
Table 6.5 Functions used in modelling the order agent 146
Table 6.6 Parameters and functions used in modelling the
manufacturer agent 147
Table 6.7 Datasets used for the manufacturer agent 148
Table 6.8 Cost parameters used in manufacturer agent 149
Table 6.9 Functions used in modelling the transport agent 150
Table 6.10 Parameters and functions used in modelling the shipment
agent150
Table 7.1 Significance of MSMEs in ASEAN economies, various years 157
Table 7.2 Factors impacting MSME size of a loan, duration of the loan
and cost of the loan 167
Table 7.3 MSME moving into and moving up production networks 169
Table 8.1 Distribution of population in rural and urban areas in Nepal,
1952/54178
Table 8.2 Composition of GDP (in percentage): 1961–62 to 2016–17 179
Table 8.3 Agricultural productivity (agriculture value added per
worker) in Nepal and other South Asian countries, 1991–
2015 and 2010 (US dollars) 180
Table 8.4 Total aid, bilateral and grants aid, 1960–2015 181
Table 8.5 Sectoral distribution of foreign aid as a percentage of total
aid (1975–2015) 182
Table 8.6 Export, import, total trade, inflation and exchange rate,
1965–2015183
Table 8.7 Exports and imports classified by major commodity groups,
1975–76 to 2016–17 184
Table 9.1 Main characteristics of Mongolia’s SEZs 198
List of Boxes
Box 3.1 Resource Sector Boom in Mongolia: 2007/08–2011/12 60

Box 3.2 Resource Boom and Non-mining Sector Productivity
Distribution in Mongolia: Kernel Density 2007/08–2011/12 64
Box 3.3 Kernal Density Estimation of the Productivity Distribution of
Exporters and Non-exporters: Mongolia 2007/08–2011/12 66
xvii
CHAPTER 1
Introduction: Trade Logistics in Asian

Countries That Are Landlocked
and Resource Cursed
1 Introduction
The purpose of this book is to provide a comprehensive picture of trade
facilitation in landlocked Asian countries. Globally there are 32 landlocked
developing countries, but we will only consider the 12 landlocked countries
in Asia, namely Afghanistan, Armenia, Azerbaijan, Kazakhstan, Kyrgyzstan,
Tajikistan, Turkmenistan, Uzbekistan, Bhutan, the Lao People’s Democratic
Republic (Lao PDR), Mongolia and Nepal. Since these countries have no
access to the sea, issues such as trade facilitation, foreign direct investment
(FDI), logistics, resource dependence and foreign aid present challenges to
policymakers as they seek to achieve economic development. Moreover, there
is an obvious lack of attention in literature to bottlenecks that must be elimi-
nated by having these countries diversify their sources and destinations for
regional and global trade, build and better manage transport and transit
arrangements, and also share their experience and knowledge; in response
K. Jayanthakumaran (*)
School of Accounting, Economics & Finance, University of Wollongong,
Wollongong, NSW, Australia
e-mail: kankesu@uow.edu.au
© The Author(s) 2019 1

K. Jayanthakumaran et al. (eds.), Trade Logistics in Landlocked and
Resource Cursed Asian Countries,
https://doi.org/10.1007/978-981-13-6814-1_1
2 K. JAYANTHAKUMARAN
to the acknowledged urgency of knowledge sharing an ‘International Think

Tank for Land-Locked Developing Countries’ (ITT for LLDCs) was formed
in Ulaanbaatar in July 2009 in association with a United Nations Development
Program (UNDP).
Central Asian countries such as Kazakhstan, Turkmenistan and
Uzbekistan suffer from bad governance, so they depend on exporting
resources while being subjected to symptoms of the resource curse.
Turkmenistan is among the top 15 gas producers worldwide, while
Azerbaijan and Kazakhstan export oil; Mongolia is gifted with abundant
natural resources such as copper, gold and coal, which attracted more
foreign investors during the resource boom during the late 2000s. Lao
PDR has natural resources such as tin, gold, gemstones and gypsum, but
it is still one of the least developed countries in Asia. Economic diversifi-
cation is one option for overcoming the resource curse problem, but for
this to be successful, better trade facilitation measures (TFMs) and foreign
investments are needed. South Asian landlocked countries such as
Afghanistan, Bhutan and Nepal are the least developed and also suffer
from backwardness in transport and transit arrangements, which is why
better trade facilitation measures, economic reforms and foreign aid are
necessary conditions for their growth.
Given this background and the complex nature of landlocked countries
in Asia, the studies presented in Part 1 form a thematic epistemological
contribution of those issues, while the new evidence we present covers a
wide range of possibilities; Part 2 focuses on the country studies that origi-
nate from the issues discussed in Part 1.
2 Part 1: Economic Diversification

Economic diversification is a necessary condition and a sufficient condition
to reduce volatility in resource-cursed Asian LLDCs. While there is a
consensus on adopting economic diversification, there is no consensus on
how to achieve economic diversification. Part 1 of this book sheds some
light on this issue by analysing the impact of the Dutch disease in a devel-
oping economy context (Chap. 2), exploring non-resource firm hetero-
geneity (Chap. 3), trade facilitation in South Asia (Chap. 4) and foreign
direct investment in Central Asia (Chap. 5).
In Chap. 2, Charles Harvie explores the impact of resource production
in a developing economy, the transmission mechanism of the Dutch dis-
ease and policy options to alleviate its potentially adverse effects. The
INTRODUCTION: TRADE LOGISTICS IN ASIAN COUNTRIES THAT ARE… 3
Dutch disease and the resources curse concepts are not the same, although
the former is seen often as being one explanation of the latter. The Dutch
disease refers to a resource windfall that contributes to an appreciation of
a country’s real exchange rate, which then exerts competitiveness pressure
on the country’s lagging non-resource tradables sector. Policymakers
may view the potential demise of non-resource tradables due to this, tra-
ditionally regarded as being the manufacturing sector, and associated de-
industrialisation as being of concern, arising from the importance of
certain characteristics and externalities derivable from this sector that are
of benefit to long-run growth and development. Thus, one could argue
for a protectionist approach by government, ranging from piecemeal to
strategic, of key existing and new manufacturing industries. Empirical evi-
dence on the existence of the resource curse remains sketchy and subject
to empirical methodological weaknesses. Policymakers need to be aware
that each resource-abundant country faces different economic circum-
stance requiring tailored policy packages and approaches best designed to
meet their individual economic, institutional and social circumstances.
In Chap. 3, Kankesu Jayanthakumaran, Mohammad Tariful Bari and
Nelson Perera combine the resource curse and firm heterogeneity litera-
ture to estimate how a resource boom will affect firms’ non-resource
intensive productivity. The cost of production for the non-resource sector
is high during a resource boom due to expensive domestic currency, vola-
tile commodity prices and rent-seeking activities stemming from economic
and political mismanagement. Thus the literature generally suggests that
economic diversification leads to long-term growth by generating spill-
over effects and increasing returns of scale, but effective economic diversi-
fication demands a greater understanding of how a group of firms behave
during a resource boom. It could be argued that while low-productivity
firms can improve their productivity with low cost options, highly produc-
tive firms actually experience a decline in productivity due to the high
cost of shifting to other opportunities, so the net effect is a stagnation of
aggregate productivity in the non-mining sector that is consistent with the
resource curse hypothesis.
In Chap. 4, Ramesh Chandra Paudel analyses the export performance
of landlocked South Asian countries such as Afghanistan, Bhutan and
Nepal by focusing on the scenario of South Asian intra-regional trade.
Ramesh revolves around research questions such as, why are South Asian
exports so poor, and what regional priorities are needed to improve the
trade performance in these regions; why do Afghanistan, Bhutan and
Nepal disadvantaged; and why is the intra-regional trade in South Asia so

poor? To answer these questions, Ramesh uses an econometric estimation
based on the gravity modelling technique where transport costs dominate
and reduce the volume of trade. The results suggest that being landlocked,
these countries have about a two and half percent trade disadvantage, but
they could trade about 10% more than other countries if they had a better
interaction with the trade facilitation index (TFI) and they could also
reduce trade costs by improving the TFM. These major TFMs are the
quality of governance, transparency, documentation processing time,
infrastructure, transit facilities and information and communication tech-
nology; this estimation suggests that improving the TFM would help to
reduce the trade costs and increase the volume of trade.
In Chap. 5, Nomintsetseg Ulzii-Ochir analyses foreign direct
investment (FDI) in landlocked Central Asian countries such as Armenia,
Azerbaijan, Kazakhstan, Kyrgyzstan, Mongolia, Tajikistan, Turkmenistan
and Uzbekistan, all of which have large mining resources. While FDI has
helped boost economies around the world, it has not eliminated the main
barriers and challenges faced by these landlocked countries in Central
Asia, so the pioneering purpose of her study is to empirically investigate
the determinants of FDI inflows such as market size, corporate tax rate,
import tariffs, trade openness, quality of infrastructure and political and
socio-economic stability for the mineral rich Central Asian economies
between 1996 and 2016. This study finds that a higher return on capital,
openness and good quality of infrastructure promotes FDI in LLDCs in
Central Asia, and, as expected, a decline in corruption had a positive
impact on FDI, whereas the quality of regulations and the degree of busi-
ness freedom had an insignificant impact on investment.
3 Part 2: Country Studies: Lao PDR, Nepal

and Mongolia
Given the complicated dynamics involved, the chapters in this section focus
mainly on the methods of economic diversification because economic
diversification strategies vary from country to country. The inability to
access seaports in Mongolia demands efficient trade logistics system. In Lao
PDR, the statistics for registered enterprises show that small enterprises
(1–19 employees) comprise about 99% of all enterprises, so this demands
an in-depth analysis of micro-, small- and medium-sized enterprises
(MSMEs), and since Nepal relies heavily on foreign aid, this resulted in a
INTRODUCTION: TRADE LOGISTICS IN ASIAN COUNTRIES THAT ARE… 5
dependency on developed nations and widening gaps in economic oppor-

tunities between rich and poor; this demanded an analysis of the sustain-
ability of foreign aid in Nepal. Like other LLDCs, Mongolia has not
eliminated the main barriers for inviting FDI, so this demands an analysis of
the effectiveness of currently operational special economic zones (SEZs)
such as Altanbulag, Zamyn UuD and Tsagaannuur. Thus part 2 shows the
trade logistics operations in Mongolia (Chap. 6), the MSMEs as a strategy
for Lao PDR (Chap. 7), foreign aid for trade in Nepal (Chap. 8) and SEZs
in Mongolia as economic diversification strategies (Chap. 9).
In Chap. 6, Nagesh Shukla and Arjun Radhakrishnan use process-
centric simulation models such as discrete-event simulation to under-
stand and improve trade logistics operations. These authors argue that
most of the research conducted in the area of trade logistics improve-
ment relies on the development of simplified flow diagrams, on-site
observations and brainstorming sessions that are complemented with
historic trade operations data, but these approaches have limited success
in comprehensively modelling important interactions and relationships
in trade logistics. The authors present a systematic methodology for
multi-method simulation modelling based on the Anylogic simulation
platform. They use a simulated case of Mongolian road-based trade
logistics to demonstrate how effective this proposed modelling approach
is because this methodology involves (i) capturing trade operations/
process details, (ii) utilising a range of quantitative datasets for time-
stamping the captured process details, (iii) encapsulating processes and
datasets in the simulation modelling platform, (iv) validating the result-
ing simulation models and (v) visualising and processing issue identifica-
tion for trade logistics.
In Chap. 7, Charles Harvie shows that MSMEs play a pivotal role in the
growth and development of virtually all developing countries in terms of
their contribution to business numbers, output, employment, exports,
entrepreneurial activity, poverty alleviation and economic empowerment.
This is no less so than for resource-abundant and landlocked countries in
the Asian region such as that of Lao PDR. By its very nature, the resource
sector tends to be relatively capital intensive and dominated by large state-
owned or foreign-owned multinational enterprises that generate relatively
few jobs. In this context, MSMEs have a critical role to play in generating
jobs, diversifying the economic base and spreading the economic benefits
of resource production in resource abundant economies. To achieve this
requires a new MSMEs growth and business strategy focusing on capacity
building through knowledge and skills acquisition, technology upgrading,

improved product quality and competitiveness, innovation and entrepre-
neurial activity. This will not be easy in a country such as Lao PDR, where
MSMEs are predominantly micro enterprises operating in the informal
sector and subject to severe resource constraints. They also face challenges
arising from the landlocked nature of the country and associated logistical
problems and additional costs of doing business, which can undermine
access to foreign markets, participation in regional value chains arising
from closer regional integration and attractiveness to foreign investment.
In Chap. 8, Kishor Sharma and Badri Prasad Bhattarai argue that
foreign aid has received a renewed emphasis since the mid-1990s, but this
time with a new agenda known as ‘aid for trade’. While foreign aid helps
to improve growth and export performance by addressing underdevelop-
ment, in reality its performance is lacklustre. As the debate continues, lit-
erature on the effectiveness of aid has been mushrooming, but there is no
consensus. In this chapter, the authors aim to shed light on this debate
using the experience of Nepal. Despite several decades of support from a
donor community, Nepal’s export performance has been lacklustre so it
obviously needs to implement a wide range of reforms otherwise any com-
mitment for more aid without fundamental reforms will be counterpro-
ductive in accelerating growth and improving export performance.
In Chap. 9, Tsolmon Tsagaach identifies locational choices and causes
for ineffective or non-beneficial SEZs in Mongolia. Non-beneficial SEZs
are associated with the landlocked nature due to borders with the People’s
Republic of China and Russia, high concentration of natural resources
offset by a lack of economic diversification and a middle-income nature
with a tendency to increase real wages. Of these four zones which the
government of Mongolia has established, Altanbulag SEZ is complete,
but the other zones are still in their infancy. Altanbulag SEZ has a loca-
tional advantage because it can access the markets in East Siberia, Buriat
and Irkutsk. The Russian government is promoting investment in order to
develop the Siberian regions and stop migration to the middle of Russia.
In brief, chapters of this book highlight the difficulties of economic
diversification due to the complex nature of landlocked countries.
PART I
Economic Diversification
CHAPTER 2
The Dutch Disease and Economic

Diversification: Should the Approach
by Developing Countries Be Different?
Charles Harvie
1 Introduction
It might be intuitively expected that resource-abundant countries pos-
sess economic advantages (other conditions being similar) over resource-
poor countries that enables them to achieve faster economic growth. This
expectation has, however, been widely questioned in the literature, with
empirical evidence suggesting that resource-abundant countries achieve
slower economic growth compared to less resource-abundant countries
over the long term. For example, between 1960 and 1990, the per capita
incomes of resource-poor countries grew 2–3 times faster than the per
capita income of resource-abundant countries, and the gap in growth rates
appears to have widened over time (see Sachs and Warner, 1999; Auty,
2001a). This counter-intuitive outcome has become the subject of intense
empirical, theoretical and policy research and underpins the so- called
resource curse puzzle.
C. Harvie (*)
e-mail: charvie@uow.edu.au

https://doi.org/10.1007/978-981-13-6814-1_2
10 C. HARVIE
Auty (1999) was the first to use the term “natural resource curse”1 to
describe a situation where resource-abundant countries achieved slower
rates of economic growth and well-being compared to resource-poor
countries, confirmed by empirical evidence provided by Sachs and Warner
(1995). A number of factors have been highlighted to explain this: politi-
cal conflict over the usage of resource revenues arising from vested inter-
ests (regional, ethnic or religious), sizeable inequality in the sharing of
benefits where a small group of privileged well-off individuals gain at the
expense of the poor, environmental pollution due to lax environmental
standards and/or a low capacity for environmental monitoring and
enforcement of standards, corruption and “rent seeking” behaviour by
economic agents, and weak government institutions unable or unwilling
to manage the resources effectively.
While a number of studies have found support for the “resource curse”
thesis and its effects on growth in resource-rich economies (see, e.g.
Nankani, 1979; Sachs and Warner, 1995, 1999, 2001; Auty, 1993,
2001a), more recent studies have even gone so far as to question its exis-
tence (e.g. Alexeev and Conrad, 2009; Stijns, 2005; Brunnschweiler,
2006). This has resulted in a reconsideration of hypotheses about the
impact of resource abundance on economic growth.
While the term “natural resource curse” is used to describe a number of
issues related to resource production, the term “Dutch disease”2 is also
widely conflated with it. It is, however, a more specific and technical eco-
nomic concept that refers to adverse effects arising from a resource boom
operating through a real exchange rate appreciation on various export and
import-competing industries, and is an important possible mechanism
though which the resource curse itself operates. The Dutch disease is
given particular emphasis in this chapter.
This chapter emphasises the impact of resource production in a devel-
oping economy, the transmission mechanism of the Dutch disease and
policy options to alleviate its effects, and proceeds as follows. Section 2
1
Also described as “the paradox of plenty”.
2
The term Dutch disease, first used by The Economist in 1977, is named after the experi-
ence of the Netherlands during the 1960s to 1980s arising from major discoveries of natural
gas in the Groningen gas field in 1959, which brought about a short-lived resource boom
that resulted in problems for other sectors of the economy. The term Dutch disease, there-
fore, refers to the existence of a causal relationship between the growth of a specific sector
(resources) and a decline in the growth of other (exporting and import competing) sectors
(e.g. agriculture and/or manufacturing).
THE DUTCH DISEASE AND ECONOMIC DIVERSIFICATION: SHOULD… 11
reviews the resource curse literature both theoretical and empirical. Section
3 conducts a brief review of the Dutch disease and its transmission process
in a resource-abundant economy. Section 4 looks at the implications of
resource production for long-run economic development with a particular
focus on developing economies. Section 5 looks at other aspects arising
from a resource boom. Section 6 discusses potential policies and mixture
of policies to reduce the adverse impact of the Dutch disease and maximise
economic development. Section 7 concludes.
2 The Resource Curse: An Overview3
2.1 An Overview
A number of potential explanations for the impact of the “resource curse”
on economic growth can be gleaned from the literature.4 The first is the
Prebisch-Singer hypothesis based on the contributions of Prebisch
(1950) and Singer (1950). This argues that the price of primary goods,
including resources, tends to decline relative to that of manufactured
goods5 and that the share of primary goods in gross domestic product
(GDP) will diminish with development due to technical progress in manu-
facturing. Deaton (1999) argues that a large majority of commodity
exporters focus on a rather narrow range of primary products, and so a
lack of diversification exposes them to price fluctuations that can generate
large swings in national incomes. Consequently, countries that are reliant
on the primary goods sector will tend to grow slower than economies
that rely on manufacturing industries. Prebisch recommended that in
order to address this deterioration in the terms of trade, developing coun-
tries should implement protective tariffs based on the infant industry argu-
ment with the aim of developing domestic manufacturing industries.6
3
For a more extensive review of the resource curse literature, see Frankel (2012) and van
der Ploeg (2011).
4
A more detailed discussion of these explanations can be found in Polterovich et al.
(2010).
5
Equivalent to a deterioration of the terms of trade for resource or commodity abundant
countries.
6
There are two major criticisms of the Prebisch-Singer (PS) hypothesis. First, the hypoth-
esis does not hold for all primary goods and for all periods (see Kellard and Wohar, 2006).
Second, only a few countries that have followed Prebisch’s advice have been successful.
12 C. HARVIE
Second, Innis (1954), Baldwin (1956), Hirshman (1977) and Auty and
Kiiski (2001) proposed an export-based theory of resource-driven
growth. This involves countries growing and developing by means of an
integrated economy based on exports of primary products. Innis (1954)
described this as a “staple theory of economic development” derived from
the historical experiences of developed and developing countries where
the primary resource sector influences positively or negatively economic
growth based upon linkages with other sectors. These linkages are deter-
mined by technologies related to resource extraction. The resource sector
could stimulate the development of industries that supplied its inputs
(backward linkages) and industries that processed the staple products prior
to export (forward linkages). Based on these and other linkages, the eco-
nomic base of the economy becomes diversified. A problem with this pro-
cess is that the diversification and growth of the economy will be retarded
if these linkages are weak such as in a situation where inputs into the
resource sector are imported and forward linkages fail to develop. The
resource sector remains dominant and the country falls into a staple trap.
Studies of resource-abundant countries suggest that the staple trap theory
has limited explanatory power as it does not take into account the role of
macroeconomic and political factors (see Findlay and Lundahl, 2001;
Abidin, 2001; Gylfason, 2001).
A third explanation of the resource curse relates to the “Dutch
Disease”.7 According to this a resource boom will cause a real exchange
rate appreciation that leads to a decline in the competitiveness of export-
ing and import competing industries (manufacturing, agriculture, inter-
nationally traded services) causing exports to decline and imports to
increase and non-resource tradables output to fall (especially manufactur-
ing) that can result in de-industrialisation. If the revenue from the resource
boom is mainly used for consumption instead of investment, the adverse
consequences are even higher (Burnside and Dollar, 2000; Sachs, 2007;
Cox and Harvie, 2010). If there are learning by doing effects or positive
externalities from human capital accumulation in the tradables sector but
less so in the resource extraction or non-tradables sectors, then the
resource boom may have a negative effect on long-run economic growth
(Corden and Neary, 1982; Krugman, 1987; Matsuyama, 1992; Auty,
2001a, b, Ch. 7).8
7
Discussed in more detail below.
8
Discussed in more detail below.
A fourth explanation is the “overshooting model” presented by

Rodriguez and Sachs (1999), where they argue that resource-abundant
economies tend to have higher, not lower levels of GDP per capita with
respect to resource-poor countries. They introduce a factor of production
which (such as oil) expands more slowly than labour and capital into a
Ramsey model and show that the economy demonstrates an overshoot-
ing effect. The economy surpasses its steady state level of income in finite
time and then comes back to its steady state, displaying negative rates of
growth. A shortcoming of the approach is that it does not explain why the
steady state is not moving fast enough to catch up with developed
economies.
A fifth explanation emphasises government policy and institutional fail-
ure and political economy aspects of a resource boom. Here, resource
revenue is diverted into rent-seeking activity9 and not into productive
investment due to lobbying, cronyism and corruption, resulting in unsuc-
cessful industrial policy projects that hamper economic growth, deterio-
rate human capital and exacerbate income inequality (Gelb, 1988; Auty,
1997, 2001b; Sachs and Warner, 1999; Auty and Gelb, 2001; Bulte et al.,
2003) and is further compounded when institutional quality is low. The
importance of low quality of institutions for resource-abundant countries
was analysed in Leamer et al. (1998), Sala-i-Martin and Subramanian
(2003), Gylfason (2004) and Stijns (2005), while Gylfason (2001) and
Suslova and Volchkova (2006) provide evidence and explanations of a
deterioration of human capital in resource-rich countries. Torvik (2002)
suggests that resource-abundant countries have a higher incidence of firms
engaging in rent-seeking activities, resulting in a smaller number engaging
in productive ventures. This is intensified in countries with low-quality
institutions. Low-quality institutions are less likely to draw entrepreneurs
into productive activity than are good institutions. Good institutions will
make an important contribution to addressing the resource curse, and this
represents a particular challenge to low-income developing economies.
Resource-abundant developing countries appear, therefore, to face an
important dilemma. Market failure requires government intervention but
9
Torvik (2002) found that resource-abundant economies with high resource rents tend to
have more rent-seeking activity by firms arising from perverse incentives for economic agent
behaviour, which results in fewer firms engaging in productive ventures. This is exacerbated
in countries with low-quality institutions, as they tend to attract less entrepreneurs into pro-
ductive activity compared to countries that have good institutions. Improving institutional
quality is, therefore, important in reducing adverse effects arising from the resource curse.
14 C. HARVIE
low-quality institutions results in government failure and inefficient usage

of resource revenue. Improving the quality of institutions is, therefore, an
important policy priority for low-income resource-abundant countries.
2.2 Resource Abundance and Economic Growth: A Review

of the Empirical Evidence
The discussion to this point suggests that resource abundance has the
potential to exert a negative impact on a country’s long-term economic
growth, but the empirical evidence on this issue indicates a lack of consen-
sus. Sachs and Warner (1995, 1997) found that natural resource abun-
dance exerted a negative impact on long-run economic growth and
emphasised the resource curse nature of resource abundance. Subsequent
empirical studies on the resource curse have been based on this seminal
contribution and typically assume the existence of an unconditional
resource curse, where resource abundance is correlated with measures of
economic development without accounting for other economic, social
and institutional factors that may affect this relationship. This approach
and the empirical results obtained from it have been questioned in the
literature. First, it cannot explain divergent growth experiences across
countries despite similar resource type and abundance (e.g. between
Botswana and Sierra Leone [diamonds], and between Norway and Nigeria
[oil]) (Bakwena et al., 2010). Second, several recent studies have provided
more plausible explanations of diverging growth performances focusing
on the role of institutional quality, and find that the natural resource curse
can be avoided, and long-term development fostered, if institutional qual-
ity is sufficiently high, as it is the main conduit through which natural
resource abundance affects economic growth (Mehlum et al., 2006;
Arezki and van der Ploeg, 2007; Boschini et al., 2007; Horvath and
Zeynalov, 2014; Humphreys et al., 2007).10 Third, some studies empha-
sise that the natural resource curse is more likely to occur for certain types
of natural resources than for others. Isham et al. (2005) argue that com-
modities extracted from a narrow geographic or economic base (“point
10
An interesting study by Brunnschweiler and Bulte (2008) shows that the quality of insti-
tutions is endogenous to natural resource richness and distinguish between resource depen-
dence (extent of country dependence on natural resource exports) and resource abundance
(a stock measure of resource wealth). They find no link between resource dependence and
growth, but resource abundance is associated with better institutions and more growth.
Their results do not provide support for the existence of the natural resource curse.
source” resources) are more susceptible to state capture than diffuse

resources. Their estimated results showed consistent negative impacts of
exports of point source resources on institutional quality, while institu-
tions positively affect growth. This suggested that export structure affects
growth through institutions (Isham et al., 2005), because point natural
resources such as oil are for economic and technical reasons more prone to
encourage rent-seeking behaviour and conflict (Boschini et al., 2007).
Although the more recent literature provides a richer analysis and has
greater potential to be more relevant to policy makers in the context of the
resource curse, methodological deficiencies exist in their empirical mea-
surement analysis such as for Sachs and Warner (1995, 1997). First, the
estimation methods used to measure the existence of the resource curse
tend to be cross-country ordinary least squares (OLS), but these results
are not robust when compared with panel instrumental variable estimation
techniques which allow for endogeneity among the explanatory variables
(see, e.g. Lederman and Maloney, 2002, 2007; Manzano and Rigobon,
2007). Differences in these results then arise since cross-country OLS esti-
mation fails to take into consideration endogeneity, heterogeneity and
omitted variables biases.11 These problems are prevalent in empirical
growth models which an instrumental panel estimator is capable of
addressing. Hence, a robust empirical examination of the conditional
resource curse hypothesis requires the use of panel data and an instrumen-
tal estimator.12 Second, the natural resource abundance indicator used in
more recent studies and based on Sachs and Warner’s (1995, 1997)
resource indicator, as represented by the share of primary exports (sum of
11
Many studies have employed cross-sectional data to investigate the long-term effect of
natural resources on growth (see Sachs and Warner, 1995; Leite and Weidmann, 1999; Tella
and Ades, 1999; Lederman and Maloney, 2003; Boschini et al., 2007; Sala-i-Martin and
Subramanian, 2013; Ding and Field, 2005; Mehlum et al., 2006; Brunnschweiler and Bulte,
2008; Arezki and van der Ploeg, 2007), but the application of cross-sectional data in growth
regressions suffers from omitted variable bias because of the correlation between initial
income and the omitted initial level of productivity (van der Ploeg, 2011; Lederman and
Maloney, 2007).
12
Panel regressions generally find a significant and positive effect of natural resources on
economic growth, while cross-sectional regressions generally result in negative but insignifi-
cant estimates. Tella and Ades (1999) used both cross-sectional and panel data and found
that the impact of natural resources on economic growth becomes insignificant when using
panel data. Lederman and Maloney (2003) find that using cross-sectional and panel data
produces different outcomes. Panel data has also been applied by Jensen and Wantchekon
(2004), Ilmi (2007), and Horvath and Zeynalov (2014).
16 C. HARVIE
exports of primary agriculture, fuels and metals, energy) in GDP or

exports, is problematic. This indicator only captures the lack of non-
resource sectors rather than indicating whether a country is resource-
based or not.13 If anything, the dominance of primary exports is an
indication of how specialised a country is and this may be related to the
structure of the economy rather than to the resource curse.
ther Evidence on the Resource Curse

O
Atkinson and Hamilton (2003) and Gylfason and Zoega (2006) propose
a different transmission channel and stress the role of investment. They
find that natural resources crowd out both physical and human capital,
resulting in a negative effect on long-term economic growth. Sala-i-Martin
and Subramanian (2013) emphasise that new oil discoveries tend to cause
real exchange rate appreciation that harms other export sectors of the
economy and growth.
On the other hand, Alexeev and Conrad (2009) find little evidence in
support of the natural resource curse. In fact, they find the opposite in
their examination of countries with large oil endowments, where such
countries exhibited higher not lesser income growth. Smith (2015) exam-
ined the impact of major natural resource discoveries since 1950 on GDP
per capita and, after applying various quasi-experimental methods such as
the synthetic control method, found that these discoveries are associated
with high growth in the long-run.
Another strand of the literature examines the impact of natural resources
on variables other than economic growth. Natural resource richness
might induce more corruption, increase political instability and the likeli-
hood of conflict, and hinder the functioning of democratic institutions
(see Tella and Ades, 1999; Barro, 1999; Ross, 2001; Jensen and
Wantchekon, 2004; Collier and Hoeffler, 2005).
13
Numerous resource curse studies using panel data apply the measurement of natural
resource richness based on that of Sachs and Warner (1995), such as Boschini et al. (2007),
Lederman and Maloney (2003), Isham et al. (2005), Brunnschweiler and Bulte (2008).
Leite and Weidmann (1999) and Mehlum et al. (2006) use the share of exports of primary
products to gross national product (GNP), Sala-i-Martin and Subramanian (2013) and
Jensen and Wantchekon (2004) use the percentage of fuel, mineral, and metal exports on
merchandise exports, Collier and Hoeffler (2005) employ the sum of resource rents as a
percentage of GDP. Papyrakis and Gerlagh (2004) use the share of mineral production in
GDP and Gylfason and Zoega (2006) employ the share of natural resource capital as a per-
centage of total capital.
Polterovich et al. (2010) compiled a statistical portrait of a “typical”

resource-abundant country aiming to establish basic stylised facts and rela-
tionships. Their empirical investigation showed that resource-abundant
countries experienced a number of growth inhibiting factors.14 First, they
generally have poorer quality institutions compared to other countries, an
issue picked up by other contributions in the literature. Second, resource-
rich countries suffer from the Dutch disease, resulting in higher and over-
valued real exchange rates that create obstacles for exports, especially
exports of high-tech goods. Third, many resource-abundant countries
keep domestic fuel prices at a low level with the aim of promoting growth,
but the potential benefits of this are offset by high-energy intensity and
distorted domestic prices. Fourth, resource-rich countries generally attain
a slower accumulation of human capital. Despite these problems they do
not find that they result in slower growth for resource-abundant countries
because, at the same time, they pursue good policies in some areas and
enjoy the advantages of having resource rent that can stimulate growth. In
particular, resource-abundant economies tend to have lower budget defi-
cits and inflation, higher investment/GDP ratios, higher inflows of for-
eign direct investment (FDI) as compared to GDP and have a more
equitable distribution of income. Hence, they conclude that resource-
abundant countries possess both growth enhancing and growth retarding
factors that can make resource abundance a blessing or a curse that requires
more in-depth analysis on a country by country basis.
This review of the empirical evidence on the relationship between
resource abundance and economic growth has failed to find unambiguous
results. Indeed, Havranek et al. (2016) report that approximately 40% of
empirical papers find a negative effect, 40% find no effect, and 20% find a
positive effect. They argue that overall support for the resource curse
hypothesis is weak across different methodologies. Their results also sug-
gest that three aspects are especially effective in explaining differences in
results across studies: (1) the interaction of natural resources with institu-
tional quality, (2) controlling for the level of investment activity and (3)
the need to distinguish between different types of natural resources when
looking at their economic consequences.
14
Their empirical analysis involved running cross country regressions but did not address
endogeneity concerns.
18 C. HARVIE
3 The Dutch Disease

The Dutch disease is generally discussed concomitantly with that of the
resource curse. However, they are not the same thing as the Dutch disease
solely focuses upon the economic aspects arising from resource abun-
dance, production and exporting. The fundamental point of the Dutch
disease is that windfall gains arising through a natural resource discovery,
production and price increase exert adverse effects on an economy’s non-
resource tradables sector (exporting and import competing industries)
arising from a real appreciation of the home country’s currency.15 This can
then result in a structural change in production with a relative decline in
the share of non-resource tradables (e.g. manufacturing for a developed
economy and agriculture for a developing economy) in GDP. At the same
time, demand also tends to rise for some non-tradable industries (services
and construction) since resource booms often fuel a building boom. A
simple model of the Dutch disease capturing these aspects as well as pro-
viding a more complete analysis of the economic adjustment process is
now briefly discussed.
3.1 A Simple Dutch Disease Model and Transmission Process

The core Dutch disease model is that of Corden and Neary (1982), which
is the first systematic framework to analyse the structural impact of a
resource boom for a resource-abundant economy. The model consists of a
three-sector economy: a booming sector (resources), a lagging sector
(non-resource tradables, consisting of non-resource exporting and import-
competing industries (e.g. manufactured goods)) and a non-tradables sec-
tor (e.g. services, construction).16 Booming and lagging sector goods are
traded at exogenously determined world prices, while non-tradable goods
15
Although the Dutch disease is generally associated with mineral resources, it is also
equally applicable to the cases of an increase in domestic wealth from large sustained inflows
of foreign currency, such as from foreign aid, remittances and capital inflows (Auty 2001a,
b), as well as from a non-extractive export boom. For example, the displacement of an older
industry by a more technologically advanced industry.
16
The terminology booming, lagging and non-tradables sectors was used by Corden
(2012) and is retained in this chapter for ease of exposition. In reality, however, it is unreal-
istic to be able to simply categorise whole industries as being in either the lagging or non-
tradables sectors.
prices are determined endogenously by domestic supply and demand

conditions.
The model assumes that the output of all three sectors is only for final
consumption and is produced by internationally immobile capital and
labour. Capital is a factor specific to each sector while labour is perfectly
mobile across the three sectors. There are no commodity or factor market
distortions in the economy and the wage rate adjusts flexibly to ensure
that it is equalised across all three sectors and full employment is main-
tained at all times. Trade is always balanced as national output is always
equal to national expenditure. Booming sector output is wholly exported
and lagging sector production is a perfect substitute for tradable imports.
Monetary considerations are disregarded and only relative prices (mea-
sured by lagging sector prices to non-tradables prices) matter.
This simple framework can be used to analyse the economic transmis-
sion process and outcomes arising from a shock in the booming sector.
3.2 Dutch Disease Transmission Mechanism: Detailed Outcomes

A resource boom, arising from a discovery, increased production or rise in
the price of the resource, contracts the lagging sector economy through
two broad economic channels. First, a resource movement (or direct)
effect and, second, a spending (or indirect) effect. The direct effect, con-
sistent with the Corden and Neary (1982) model, arises where the boom-
ing sector draws in factors of production (specifically labour) from
non-resource sectors (lagging and non-tradables), and in the process
increases the cost of these factors (wages specifically) and the output of
these sectors falls. Rising wages impact both the lagging and non-tradable
sectors, but negatively impacts profits in the non-resource tradables sector
where prices are determined in international markets. This is the resource
movement effect.
Further issues not highlighted in the simple Corden and Neary model
can also be considered at this point, making the transmission process more
complex and dependent upon a number of factors: (1) the capital intensity
of the resource sector relative to non-resource sectors, (2) the capital
intensity of the lagging sector relative to the non-tradables sector (3)
how the price of capital changes relative to labour. If the resource sector is
relatively more capital intensive, as is generally the case, it will draw in rela-
tively more capital than labour and the return to capital will rise relative to
that of labour. If the lagging sector is relatively more capital intensive
20 C. HARVIE
than the non-tradables sector, this will then have a relatively larger impact
on the lagging sector (a bigger impact on its costs, decline in profits, loss
of capital and therefore production).
While the direct transmission mechanism (resource movement effect)
focuses primarily on the supply side consequences for the economy arising
from a resource boom, the indirect or spending effect from a resource
windfall will, irrespective of whether the private or public sectors are the
majority resource owners, result in additional spending (demand) on both
non-resource tradables and non-tradables. As the price of tradables is
determined in international markets they will not change and excess
demand will be met by higher imports and squeezed profits. The price of
non-tradables, being determined in domestic markets, will increase with
additional demand so that the relative price of non-tradables to tradables
will increase and this is equivalent to an appreciation of the real exchange
rate that results in a loss of competitiveness of the lagging sector, increased
demand for non-resource tradable imports, reduced non-resource trad-
able exports and an overall deterioration in the non-resource tradables
balance. Any excess demand thereafter will be met by additional supply as
labour is drawn into the non-tradables sector pushing up wages. The real
wage will rise when measured in terms of tradables but fall when measured
in terms of non-tradables. When measured in terms of an overall con-
sumption basket consisting of both tradables and non-tradables, the
change in the real wage is unclear, and will depend on the net impact of
the resource movement and spending effects and the composition of the
consumption basket.
The resource movement and spending effects combine to produce an
overall appreciation of the real exchange rate that results in a contraction
of both employment and output in the lagging sector when labour is in
fixed supply and the only mobile factor between sectors, a deterioration in
the non-resource trade balance as imports rise and exports decline, higher
wages and a squeeze on profits in the lagging sector. The increase in
domestic spending on tradables and non-tradables, however, is expansion-
ary. The resource movement effect raises non-tradable output, while the
spending effect reduces profitability and output in the lagging sector. The
latter development is a key characteristic of the Dutch disease effect and is
often referred to as “de-industrialisation”.
The above outcomes have been derived from the simple or “core”
Dutch disease model which is based on strong underlying assumptions.
Subsequent to this, numerous theoretical refinements to the core model
have been made, consisting of extending the scope of the analysis to allow
for monetary considerations, the presence of market rigidities, interna-
tional factor mobility, dynamic economic adjustment and knowledge
spillovers.17 Changing these underlying assumptions can result in differ-
ent outcomes from a resource windfall and negation of the Dutch disease.
If capital and labour are assumed to be perfectly mobile internationally, for
example, the real exchange rate is not affected by a resource sector export
boom, and there is no Dutch disease. Under perfect international factor
mobility, the supply of non-tradables expands to accommodate excess
demand by attaining more capital and workers from abroad without bid-
ding them away from the other sectors. With an infinitely elastic supply of
non-tradables there is no change in their price and the real exchange rate
does not change. The lagging sector can also benefit from higher domestic
demand and increasing production, taking advantage of internationally
mobile factors of production. Output of all three sectors can expand under
the assumption of perfect international capital and labour mobility.
Kojo (2014) has also de-bunked a number of myths relating to the
Dutch disease, arguing that many well-established arguments relating to
this lack well-grounded theory and empirical evidence. Hence, policy
makers need to take care when implementing policies based on Dutch
disease theory and the framework presented by Corden and Neary (1982).
He argues that the Dutch disease implies an absolute decline in produc-
tion by the lagging sector but this may not be the case. With a booming
sector (resources) in the economy it is likely that there will be a decline in
the relative share of the lagging sector in GDP but not necessarily an abso-
lute decline in production. The Dutch disease also implies that production
of the non-tradables sector will always increase. Again, this may not be the
case if the resource movement effect dominates the spending effect. In
this case labour would move towards the booming sector raising lagging
sector and non-tradable sector wages, squeeze profits and reduce output
in both. Kojo also argues that the Dutch disease need not have adverse
effects on long-run economic growth and productivity with the empirical
evidence on this being mixed at best. The argument for these adverse
effects is based on the belief that a country cannot become rich without
developing a manufacturing sector because of its “special” spillover or
other production-enhancing qualities that are critical for economy-wide
17
See, for example, Corden (1984), van Wijnbergen (1984), Bruno and Sachs (1982),
Buiter and Purvis (1983), Krugman (1987) and Matsuyama (1992).
22 C. HARVIE
knowledge accumulation and productivity growth in the long run. Other

sectors are assumed to not possess these special characteristics. When the
manufacturing sector declines it is very difficult to re-acquire these special
characteristics when the resource boom is over.
Empirical evidence on the existence of knowledge-spillovers from
manufacturing and exporting is, however, mixed. Kojo (2014) argues that
with the evolution of new technology, such as information and communi-
cation technology (ICT), the service sector is rapidly replacing traditional
export sectors as a new engine of growth and job creation. Exports in
ICT-intensive modern services have been growing in both poor and rich
countries, and are more technologically sophisticated than traditional
exports. Likewise, the mining sector has achieved advances in knowledge
and technological capabilities. In addition, acquisition of new ideas and
technology through trade is not just limited to export activity.
Improvements in domestic productivity and growth can also be achieved
through imports as a result of intensification of domestic competition and
access to intermediate inputs. Manufactured exports are not the sole
source of positive externalities.
he Dutch Disease and Developing Economies

T
Empirical evidence on the applicability of the Dutch disease to developing
countries is limited. However, the assumptions underlying the Dutch dis-
ease model do not align well with the features of developing countries,
which suggests that policy makers need to be cautious about policy imple-
mentation without taking into consideration the specific circumstances of
individual countries.
Full Employment
One of the core assumptions of the Dutch disease framework is that a
country is operating on its production possibility frontier, and therefore
has full employment of all factors of production. This is not likely to be the
case for many developing countries, where inefficient use of existing pro-
duction factors is endemic. In countries with underemployed labour, the
booming tradable sector can increase production by absorbing surplus
workers without bidding labour away from the other sectors. Similarly, the
non-tradable sector may be able to utilise underemployed labour without
raising wages and expand output to eliminate excess demand. A real appre-
ciation of the home currency is likely to be limited, and the Dutch disease
may not materialise. In countries where unemployment is related to a skills
mismatch in the local labour market, firms may choose to scale up produc-
tion by sourcing foreign skilled labour. In the absence of factor constraints,
there would be little impact on the real exchange rate and the structure of
the economy from a resource boom.
Competitive and Flexible Markets

Markets in developing countries are unlikely to be competitive and flexible
and respond only sluggishly to a resource boom and move in a direction
not predicted by the theory, influenced by market distortions, limited
absorptive capacity and other impediments that are often discussed in the
context of the resource curse. When market imperfections exist the Dutch
disease theory may be unable to predict the effect of a resource boom on
the economic structure of a developing economy. With administrative
price controls, subsidies on key inputs or import restrictions, domestic
prices will be unable to adjust quickly to reflect domestic market condi-
tions. Rigid labour market regulations and a skills mismatch make it dif-
ficult to reallocate workers across sectors. A lack of well-functioning
financial intermediation and a weak institutional and regulatory environ-
ment make it difficult for output supply to respond to increased domestic
demand. In addition, goods and services that could be exported or
imported may not be due to trade barriers, exchange controls, as well as
poor domestic trade logistics and facilitation. Under such circumstances in
a developing economy it is unclear how it will respond arising from a
resource boom.
Perfect Substitutability Assumption

Goods and services produced in developing countries are typically not
perfect substitutes for those traded on world markets, and local product
prices are influenced more by domestic rather than world markets. While
part of the increased demand would still go to imported foreign products,
producers of imperfect import substitutes, just like their non-tradable
counterparts, would also benefit from the spending effect of the boom.
Firms producing perfect import substitutes may lose from the real appre-
ciation, but others producing imperfect substitutes could expand. The
overall net impact on the tradable sector is, however, ambiguous.
No Intermediate Input Assumption

The introduction of intermediate inputs into the Dutch disease framework
makes the impact of a resource boom on an economy’s structure much
24 C. HARVIE
more complex to analyse compared to that of a standard trade model

based on comparative advantages of final goods. Developing countries
depend heavily on foreign intermediate goods and services for produc-
tion. While a resource boom leads to a real appreciation of the currency
and makes it more difficult to sell goods and services internationally,
exporters who rely heavily on imported contents benefit from cheaper
foreign intermediate inputs. If the resource windfall is entirely spent on
imports, it would have no impact on the domestic demand for non-
tradables and the real exchange rate, and the Dutch disease would not arise.
Studies have also revealed that many developing countries, including
those that are well resource endowed but poor, are participating in global
value chains, suggesting that a boom-induced real appreciation would
influence the structure of the economy in a more complex manner than
predicted by the simple Corden and Neary (1982) model. How a real
appreciation of the currency affects supply-chain trade in the context of
the Dutch disease framework has not been adequately developed at
this time.
Immobile Factors of Production

As identified previously the capital requirements to develop the resource
sector of a developing economy may be beyond its domestic capacity (sav-
ings), and, as a consequence, all or part may need to come from overseas
(capital inflows ensue). The impact of capital flows from within the domes-
tic economy to the resource sector now become unclear and will depend
upon the internal circumstances of the economy under investigation and
its ability to obtain and absorb overseas capital. Limited internal domestic
capital generation will increase reliance upon capital inflows mainly from
large multinational resource producing enterprises as well as from overseas
investors more generally. Large capital inflows from overseas will likely
appreciate the real exchange rate and put further competitiveness pressure
on the non-resource tradables (lagging) sector.
The resource sector is also likely to require a relatively highly skilled
workforce. For a developing economy this can be problematic but could
be overcome through an inflow of skilled migrants. There would then be
two opposing developments in operation. Inflows of foreign capital will
contribute to an appreciation of the domestic currency, although subse-
quent payments in the form of dividends and interest would weaken the
currency, while skilled worker remittances would also put downward pres-
sure on the currency.
4 De-industrialisation, Long-Run Growth

and Development Consequences from a Resource
Boom
4.1 A Resource Boom and Economic Growth
As discussed in the previous section, resource production has the potential
to result in overall economic benefits in the short run in terms of income,
wealth and national welfare, reflected in higher consumption of both trad-
ables and non-tradables with more of the former being supplied by higher
imports than before. Resource production generates economic rents to
both the public (through taxation) and private sectors (domestic and for-
eign), with the former enabling more expenditure than would have previ-
ously been possible on public spending on transport and logistics
(infrastructure), education and training as well as health, all of which have
the potential to enhance productivity, growth and the supply side of the
economy (Cox and Harvie, 2010; Ali and Harvie, 2013).
However, the direct (resource movement) and indirect (spending)
effects contribute towards a long-term change in the structure of the
economy, its productivity, economic development and growth where the
resource windfall is perceived to be permanent. While in principle the
changes in the structure of the economy should improve overall welfare
and reflect changes in demand arising from improved national income,
policy makers may be concerned with a decline in the lagging sector (non-
resource tradables sector18) and the de-industrialisation implications aris-
ing from this.
4.2 Is De-industrialisation Bad for Economic Growth?

The fundamental concern about the relative decline of the lagging sector
and de-industrialisation from a resource boom for policy makers arises
from the view that this sector possesses certain characteristics which are
beneficial to long-term growth, employment and development but which
are not as prevalent in the resources and non-tradables sectors (Kaldor
1981). If the lagging sector (manufacturing industries specifically) pos-
sesses specific long-term growth enhancing characteristics and qualities
18
Consisting of manufacturing industries for relatively developed resource producing
economies and agriculture related industries for low-income developing economies.
26 C. HARVIE
such as: increasing returns to scale, productivity enhancing activities,

attains interconnected activities within the lagging sector itself through
backward and forward linkages, generates linkages and externalities with
other sectors (agriculture and services) which raises their productivity,
achieves greater efficiency through specialisation and application of the
division of labour, generates learning by doing effects, achieves greater
innovation, has less volatile terms of trade, has positive externalities from
human capital accumulation, innovation and technological spillovers that
are more substantial compared to that of the other non-lagging sectors,
then this sector’s absolute or relative decline may have a strongly negative
impact on overall productivity, long-run growth and development and be
of concern to policy makers. Manufacturing industries are seen by many
contributors in the literature as playing this role and being a key engine of
growth (see Kaldor, 1966, 1981; Corden and Neary, 1982; Krugman,
1987; Matsuyama, 1992; Auty, 2001a; Rodrik, 2008).19,20
Trade theory would suggest that countries should specialise in indus-
tries in which they have a comparative advantage. For a resource-abundant
economy, the country could, in theory, be better off specialising in the
extraction of resources. According to Kaldor, however, a movement away
19
Important in this context is Kaldor’s first and second “growth laws”. According to
Kaldor (1966), an important stylised fact in the growth trajectory of developed economies in
the postwar period is the relationship between industrial growth and the performance of the
economy as a whole. Hence, his first growth law states that “manufacturing is the “engine of
growth””. The second law (also known as Verdoorn’s law) asserts that there is a positive
causal relationship between the growth of manufacturing output and labour productivity,
which runs primarily from the former to the latter and is derived from the existence of static
and dynamic increasing returns to scale in the industrial sector. Static returns relate mainly to
economies of scale internal to the firm, whereas dynamic returns refer to increasing produc-
tivity derived from learning by doing, ‘induced’ technological change and external econo-
mies in production. This also relates to Adam Smith’s idea that increasing productivity is
based on the division of labour, which in turn depends on an extension of the market for
manufactured goods.
20
Note that the exclusive importance of manufacturing to economic growth and produc-
tivity arising from knowledge spillovers and technological capabilities has been questioned in
the literature (see, e.g. Kojo, 2014; Lederman and Maloney, 2012), both in terms of the
empirical evidence on this issue as well as the capacity for development of new ideas and
technology associated in new sectors such as ICT and the resource sector itself. In addition,
ideas, knowledge and technology can be acquired through imports. Indeed, imports rather
than exports could be more important for productivity and economic growth through inten-
sification of domestic competition and access to intermediate inputs than exports.
from manufacturing can be detrimental as previously indicated and would

be difficult to rebuild as a source of growth once the natural resource was
depleted. If Dutch disease effects impact labour intensive industries (man-
ufacturing) more than capital intensive industries (resources), and increases
capital intensity in general, it could also result in an increase in unemploy-
ment (Ismail, 2010). When the natural resource begins to run out or there
is a downturn in resource prices, the short-run advantages of resource
production can be offset by the permanent costs of lagging behind in
terms of long-run economic development.
A further effect of the Dutch disease is a decline in overall investment.
Volatility in resource prices and by implication the real exchange rate can
discourage investment by non-resource (manufacturing) firms due to eco-
nomic uncertainty and loss of competitiveness operating in an economy
with an uncompetitive real exchange rate. Should this occur there is a
potential impact on growth and employment over the long-run. Hence,
overall, employment will expand in the resources sector, decline in the
non-resource tradables (lagging) sector and increase in the non-tradables
sector. A key issue is what will be the overall effect on employment and is
this effect on the structure of employment desirable, particularly in the
context of a developing economy.
If the non-resource tradables sector consists primarily of manufacturing
activity or relatively efficient agriculture production, this could raise ques-
tions about the sustainable growth of the economy, productivity, innova-
tion and externalities compared to that achievable with an expanded
non-tradables sector. Are the jobs in this sector of equivalent value to
those potentially lost in the manufacturing and agriculture sectors? Indeed,
jobs and output lost in the agriculture sector could also occur with lower
agriculture profits, lower farm incomes, increased poverty and substan-
tially increased income inequality (rural versus urban). These are particu-
larly important issues for developing countries heavily dependent on the
agriculture sector or urban jobs based on simple manufacturing.
In the case where the predominant non-resource tradable sector is agri-
culture, Dutch disease effects may result in less self-sufficiency in food
production and increased reliance on imported food. For many develop-
ing countries which are predominantly agrarian, the agriculture sector
makes a significant contribution to income and employment A decline in
agriculture production and declining exports may exacerbate rural poverty
outcomes, result in more migration to the urban economy and increase
28 C. HARVIE
regional income and social inequality (urban versus rural sectors) and gen-
erate internal political tensions and civil war.
To address Dutch disease and related de-industrialisation concerns, an
appropriate policy response is required, in both the short and long run,
but the nature and extent of this will depend on the characteristics, eco-
nomic structure and stage of economic development, including the land-
locked nature of the country under scrutiny. This is discussed in more
detail below.
5 Other Aspects of a Resource Boom

for Consideration
5.1 Volatility and the Transmission Mechanism

Resource production and related Dutch disease consequences result in an
economy having greater concentration and reliance on commodities that
tend to have higher price volatility than that of manufactured goods (Jacks
et al., 2009). Natural resource prices, and revenues, tend to be volatile
because of the low supply elasticity of resource production. If government
resource revenue and spending are closely related, then the latter will
become more volatile impacting both government consumption and capi-
tal (development) expenditure which will also impact GDP stability and
real exchange rate volatility. Revenue volatility could also have important
implications for growth enhancing public investment as well as the ability
of developing economies to meet debt repayments. Greater economic
instability could also have adverse implication for domestic private sector
investment as well as in attracting FDI, and consequently for productivity.
5.2 Over-Borrowing
Resource production, higher resource prices and potentially higher income
and future wealth can encourage governments in resource-abundant
economies to use this as collateral to extend their international borrowing
and external debt in order to proceed with major large development proj-
ects and higher public consumption expenditure, which can both contribute
to larger budget deficits. Should resource prices subsequently decline or
there is a decline in global demand for resources, this can result in a weak-
ening of resource revenue, unsustainable budget deficits and an
nsustainable external debt level. This may then lead to a crunch in gov-
u
ernment spending that can seriously damage long-term sustainable growth.
5.3 Government Weaknesses and Corruption

The ability to effectively utilise resource revenues for long-term growth is
an important issue. However, poor governance due to corruption, rent-
seeking behaviour of government officials, poor capacity of government
officials, poorly devised and targeted development strategies and eco-
nomic mismanagement, excessive government public consumption
expenditure and weak market institutions can seriously undermine eco-
nomic growth and development.
6 Policy Responses to the Dutch Disease

The Dutch disease represents one of the most important challenges facing
both developed and developing resource-abundant economies, in terms of
how best to address the economic consequences arising from it.21 This is
the focus of this section.
What should the government do to reduce or avoid the Dutch “dis-
ease” effect? The principal options are those proposed by Corden (2012),
Brahmbhatt et al. (2010), Polterovich et al. (2010), Cox and Harvie
(2010) and Kojo (2014).
6.1 Corden (2012)
Corden argues that there are three policy approaches to address issues aris-
ing from the Dutch disease. These being: (1) do nothing, (2) engage in
piecemeal protectionism and (3) operate a macro-stabilisation policy with
the objective of running a fiscal surplus, combined with lowering the
interest rate and possibly establishing a sovereign wealth fund (SWF). A
critical issue for Corden is whether firms and industries can be clearly
divided into those that belong to the non-tradable sector and those that
belong to the lagging sector, the latter being the losers from Dutch d
isease.
21
There is a clear divergence of views on how best to achieve this in the literature. Should
market forces and market determined prices be left to drive this or does this require explicit
government intervention and policy measures.
30 C. HARVIE
If such a clear distinction cannot be made, then the case for “doing noth-
ing” is strengthened.
6.2 Do Nothing
This approach would allow the Dutch disease to take its course and for
market forces to push the economy to its new long-run equilibrium. A
resources boom would inevitably appreciate the real exchange rate as dis-
cussed previously, with some industries (in the lagging sector) declining
and other industries (non-tradables) growing although some declines
would only be temporary if the boom itself was temporary. The best the
government can do according to this approach is to facilitate this adjust-
ment by implementing policies that will enhance the flexibility and adapt-
ability of the economy to change as well as reduce overall transition costs.
This will require improving labour force skills, remove bureaucratic obsta-
cles to labour mobility, temporarily assist losers, provide relevant informa-
tion, improve infrastructure and facilitate efficient institutions and
government.
This position is also proposed by Kojo (2014) who emphasises the need
for care in diagnosing the Dutch disease and in formulating policy pre-
scriptions based on the basic Corden and Neary (1982) analytical frame-
work, given its restrictive assumptions, as outlined previously, and
particularly in the context of developing economies. As with Corden’s
(2012) “do nothing” option he argues that countries experiencing a
resource boom or receiving large-scale foreign resource inflows should
focus on facilitating the economy’s adjustment to the new long-run equi-
librium and maximising the benefits from related foreign capital financial
inflows. Measures to stop a real appreciation or prevent a decline in par-
ticular industries would be costly and unlikely to succeed especially for
developing countries with weak institutions. Efforts should instead focus
on creating an enabling environment characterised by stability, flexibility
and competitiveness. Focusing on only fiscal policy in the context of a
resource boom is too narrow and should, instead, be more comprehensive
covering macroeconomic and structural policy measures and addressing
country-specific concerns regarding broader competitiveness and produc-
tivity growth, while safeguarding the economy from volatility of interna-
tional commodity and capital markets. Eliminating supply-side bottlenecks
(e.g. labour market rigidities, poor access to finance, complex administra-
tive procedures for business start-ups, cumbersome business licensing
requirements) can improve the economy’s flexibility and help facilitate the
supply response to increased demand and thereby speeding up the adjust-
ment process. Robust institutions including a strong rule of law, more
consistent enforcement of regulations, promoting free and fair competi-
tion and an enabling business environment, are critical to promote inno-
vation, entrepreneurship and productivity, and thereby increase the
country’s overall long-run competitiveness and export diversification.
Such measures aimed at building robust institutions, reducing adjustment
costs and boosting broader competitiveness would be preferred to those
aimed at protecting particular industries.
Focusing public outlays on areas that facilitate the economy’s supply
response, such as human capital and infrastructure, is important to enhance
the economy’s overall competitiveness (Cox and Harvie, 2010), while
being consistent with stabilisation objectives and being within the public
sector’s administrative capacity to minimise waste and leakages.
6.3 Piecemeal Intervention
Manufacturing industries are usually those selected for special assistance in
the form of subsidies or import tariffs arising from the effects of the Dutch
disease because of the presumption that they possess long-term growth
enhancing characteristics as discussed previously. An approach that is con-
sistent with the infant industry argument advocated by Prebisch (1950)
and Singer (1950) for developing economies.22
There are a number of arguments against piecemeal protection, similar
to that for the infant industry argument. First, how can a government or
official authority “pick winners” as compared with decisions of many pri-
vate sector entrepreneurs and managers? How can a government assess
which industries have good future prospects and justify assistance? Second,
choosing the wrong industries will be costly and irreversible. Third, such
protection involves discrimination that can result in propping up ineffi-
cient industries and strengthen the power of vested interest groups.
22
The infant industry argument argues that new industries with potential comparative
advantage should be protected and nurtured for a limited period of time using import pro-
tection to enable it to learn the skills necessary to be competitive in both the domestic and
international markets through acquisition of externalities associated with learning processes
so that the whole economy benefits from the initial protection; external benefits grow over
time; the costs of protection is an investment that can be offset against later gains; attainment
of economies of scale and lower unit costs enabling them to compete.
32 C. HARVIE
Fourth, protection can result in major resource misallocation more

broadly across the economy and increase the cost of protection. Fifth,
reduced manufactured imports will further appreciate the exchange rate
and intensify the Dutch disease effect. Sixth, protection of all manufactur-
ing industries would result in a substantial appreciation, which would
worsen the Dutch disease effects on other lagging non-manufacturing sec-
tor industries, notably agriculture, in developing economies. This could
have potentially adverse effects on rural income and poverty as well as
increase the urban-rural income divide. Finally, if protection was only
focused on selected manufacturing industries it would have adverse Dutch
disease effects on other, less protected, lagging sector industries, including
unprotected manufacturing, which would then likely lobby for protection
from the government.
In addition, the practical implementation of piecemeal protectionism
requires a clear distinction between non-tradable industries and Dutch
disease (real exchange rate) afflicted lagging sector industries. This may be
extremely difficult to do in practice and provides support for a do-
nothing strategy.
The discriminatory nature of the piecemeal approach which focuses on
protecting a few selected industries is likely to have adverse general equi-
librium effects on other Dutch disease afflicted industries. To avoid this
effect, it may be preferable to adopt a policy package that provides non-
discriminatory assistance for all Dutch disease afflicted industries and not
just the favoured few. This represents a third policy response identified by
Corden (2012).
6.4 Macroeconomic Stabilisation Program: Fiscal Surplus

Combined with a Lower Interest Rate
Corden’s (2012) third policy proposal to address the Dutch disease is one
involving the implementation of a particular macroeconomic policy pack-
age aimed at achieving approximate stabilisation of the real exchange rate
over time. The fiscal package requires the generation of a fiscal surplus
(government savings) with the aim of reducing domestic demand and
then offsetting this with an expansionary monetary policy involving a
reduction in the domestic interest rate to increase demand and maintain
internal balance. The domestic interest rate reduction leads to deprecia-
tion of the exchange rate resulting from net capital outflows. This reduces
the initial Dutch disease effect but would concurrently require politically
difficult tax and expenditure changes to achieve a fiscal surplus. This policy
package would not discriminate between industries in the lagging sector
but impact them uniformly, and, unlike piecemeal protectionism, result in
less domestic economy distortions.
I mportance of Fiscal Policy

Fiscal policy is traditionally the main tool with which to deal with the
negative effects of the Dutch disease, to ensure that the benefits from
resource production are sustainable, to assist in constraining the spending
effect which is the main channel of the negative transmission impact in a
low income economy and to smooth expenditure to reduce volatility
(Brahmbhatt et al. (2010). Key operational issues relating to fiscal policy
in this context are as follows: (1) the separation of spending from resource
revenues with the objective of generating budget surpluses aimed at con-
straining the spending effect and adverse Dutch disease consequences and
(2) identifying fiscal rules relating to how best to use the budget surplus
savings, including (a) how much of the resource revenue should be used
for current spending, (b) how much should be saved and (c) how much
should be invested (Davis et al., 2003).23
There are various types of funds that can be established from the
resource revenue to address these issues, including a stabilisation fund
(used to reduce macroeconomic volatility), a savings fund (used to con-
strain the spending effect) and an investment fund (focusing upon invest-
ment in future growth, income and development). It is important to
identify what the best institutional arrangements are to govern the usage
of resource revenue, with strict rules regarding payment into and use of
these funds. In this context, the establishment of a medium-term expendi-
ture framework is essential.
6.5 A Framework to Determine How Much of the Resource

Revenues Should Be Spent and How Much Invested
An appropriate fiscal policy for a resource endowed developing country
would be one that balances the need to achieve development objectives,
including the need to address social and poverty issues, while at the same
time constraining the spending effect and alleviating the Dutch disease.
23
Either in the form of a Future Fund (FF) and/or a sovereign wealth fund. Discussed in
more detail below.
34 C. HARVIE
van Wijnbergen (2008) used the “permanent income approach” to devise

a fiscal framework to provide a guide as to how much of the resource rev-
enues generated should be spent by government and how much should be
saved and invested (mainly abroad). This approach argues that the net
present value (NPV) of future resource revenue should be calculated and
then the permanent annual annuity value that would give the same NPV
calculated. This equates to the amount that the government should spend
annually. Revenue generated above this annual annuity value should then
be saved and invested overseas. When the resources are depleted the coun-
try can then draw on the accumulated financial assets to continue spending
the same constant annuity amount. However, Collier et al. (2009) argue
that the optimal fiscal rule for a developing country would need to be dif-
ferent, making it possible to save some of the resource revenues offshore
but involve saving less at the beginning and more at the end of the high
resource revenue period. This would allow more consumption spending
from the resource revenues early on compared to the pure van Wijnbergen
permanent income strategy. A key challenge for a developing country
would be to implement strict fiscal discipline and clear spending rules.
6.6 How Should Government Savings (Budget Surpluses)

Be Invested: Home or Abroad?
Governments of resource-abundant countries have a number of options
when it comes to using the savings generated from budget surpluses in
terms of investment and debt. First, the funds should be used to retire
existing international debt. Second, the funds can then be invested
domestically by establishing an FF.24 Third, the funds can be invested
overseas through a sovereign wealth fund.25,26 The issues involved in this
decision are quite complex but of considerable importance to the eco-
nomic growth and development of developing countries. If the objective
is to modify the Dutch disease effect of the resources boom it is also
24
An FF primarily focuses upon investing in the domestic economy.
25
A sovereign wealth fund is a government saving scheme, where income from resource
revenues is not spent but saved to give a future income stream (e.g. the Government Pension
Fund in Norway).
26
Adoption of any of these three options is consistent with Corden’s policy approach
aimed at addressing the adverse effects of the Dutch disease, where it is desirable that the
proceeds of the fiscal surplus are not used in a way that will increase aggregate demand for
domestic goods and services (spending effect).
important to identify the implications for the exchange rate from invest-
ing a given fiscal surplus at home rather than abroad.
6.7 Investing the Funds Domestically

One option for a resource-abundant economy is to invest government sav-
ings domestically in a mixture of asset/wealth accumulation and industrial
development policy. This would involve the establishment of an FF. If
domestic rates of return are quite independent of international rates for
equivalent investments, then domestic financial assets are not perfect sub-
stitutes for international assets. Domestic rates of return will fall when the
FF is used to buy domestic assets. If there is some degree of substitution
between financial assets then markets will wish to maintain a portfolio bal-
ance, so there will be some capital outflow to bring domestic returns closer
to the higher foreign returns. In domestic financial markets this outflow
will partially offset the inflow brought about by the FF. The net extra
funds available will also lead to an increase in private investment at home.
This will offset, at least partially, the reduction in aggregate demand result-
ing from the fiscal surplus. Thus, less monetary expansion (a lower interest
rate) will be required to maintain internal balance and hence there will be
less of an exchange rate depreciation brought about by monetary expan-
sion and a smaller modification of the appreciation that resulted initially
from the boom increasing the Dutch disease effects.
An alternative or complementary policy option is to establish an FF that
is primarily involved in investing in the home economy with the aim of
facilitating structural change, diversifying the economic base and enhanc-
ing the productivity and competitiveness of domestic firms. This can
involve expenditure on infrastructure (transport and logistics27), educa-
tion and training, health, business start-ups and entrepreneurship
(Polterovich et al., 2010; Cox and Harvie, 2010) as well as the ability to
absorb foreign technology and innovation. To be effective such a policy
requires good administration and a good coordination of government and
business efforts.
Other productivity related reforms should be considered such as those
relating to business regulations, reductions of red tape, reducing monopo-
listic barriers that discourage innovation, and promoting FDI (Kojo,
27
Building roads is usually one of the most effective poverty reducing investments involv-
ing local labour for developing economies.
36 C. HARVIE
2014). These are highly important issues in the context of low-income

developing countries, involving the adoption of an interventionist
approach over one that depended primarily on market forces. A further
option is to find an optimal mixture of investing in financial assets and
industrialisation policy.
6.8 Invest the Funds Overseas

It can be argued that budget surplus savings should not be used to finance
investment in the domestic economy, as it will simply increase domestic
demand, require relatively higher domestic interest rates, result in larger
capital inflows and a higher real exchange rate and a greater Dutch disease
effect. Corden (2012) argued instead that the resource proceeds should
go into a sovereign wealth fund (SWF) that only invests funds abroad.28
There are a number of advantages of operating a SWF (when combined
with a fiscal surplus and associated interest rate adjustment29). First, it is a
form of national savings that provides for any future adverse events, and
especially with the ending of a resource boom. Second, by investing
abroad rather than at home, the SWF gives the economy an internationally
diversified portfolio of financial assets and source of future income. Third,
it enables a country to maintain a lower real exchange rate through capital
flows and asset accumulation abroad and thereby reduces the Dutch dis-
ease effect while earning the country an interest income. While this strat-
egy may alleviate the Dutch disease effects by keeping the real exchange
lower than it otherwise would be, there is a question over the usage of
these funds in such a way from a developmental perspective. There is a
significant opportunity cost for a developing country in terms of lost
opportunity to build-up infrastructure and a universal social protection
system, which could be important from a political and development per-
spective (Polterovich et al., 2010). It would be hard to justify encouraging
investment to go overseas for a developing low-income economy where
28
A sovereign wealth fund (SWF) or sovereign investment fund is a government-owned
investment fund that invests in real and financial assets such as stocks, bonds, real estate, pre-
cious metals, or in alternative investments such as private equity funds or hedge funds that
are based overseas. SWFs receive their funds from revenues arising from resource exports or
from foreign-exchange reserves held by the central bank.
29
Corden’s (2012) preferred combination of policies to best address adverse outcomes
from the Dutch disease.
there was substantial poverty, a lack of domestic employment, a wide

income disparity and a lack of infrastructure and where the country may
be able to use effectively such revenues for domestic industrialisa-
tion purposes.
According to Corden (2012), if the objective of the fiscal surplus com-
bined with investment of the surplus is to moderate the Dutch disease
effect from a resource boom, it is better to invest abroad rather than at
home. Hence, a SWF should be preferred to that of an FF, but there is a
caveat. The decision between investing in the domestic economy (FF),
overseas (SWF) or a combination of both (FF/SWF) with the aim of ame-
liorating the Dutch disease effect depends on the degree of substitutability
between domestic and foreign assets. If domestic and foreign assets are
perfect substitutes, then a distinction between the FF and SWF erodes and
the case for the former will be weak, with all funds ending up being
invested overseas and equivalent to only having the latter. This is the case
since if foreign and domestic assets are perfect substitutes, then the FF
would have no effect on rates of return domestically in the same way as the
SWF has no effect on rates of return internationally. It would then not
matter whether the fiscal surpluses were invested abroad (through the
SWF) or at home (through the FF), as the outcome would be the same.
On the other hand, the less substitutable are foreign and domestic
assets, the greater the likelihood of establishing both an FF and SWF. If
foreign and domestic assets are not perfect substitutes, which is likely to be
the case for a developing economy, there remains a case for setting up a
SWF in addition to an FF, where a key objective is to moderate the real
appreciation effect of the resources boom. As the degree of substitutability
increases, however, the case for doing so is weakened (Corden, 2012).
Hence, a fiscal surplus associated with an “internal balance” monetary
policy will moderate the Dutch disease effect even when the funds made
available by the fiscal surplus go wholly to finance private invest-
ment at home.
7 Conclusions
This chapter has reviewed and analysed the so-called resource curse and
how this relates to the economic under-performance of resource-abundant
economies relative to resource-poor economies. The term is a generic one
drawing upon a number of explanatory variables, including political con-
flict, corruption and rent-seeking behaviour by economic agents, weak
38 C. HARVIE
government institutions and absorptive capacity, and economic factors

revolving around the Dutch disease.
The Dutch disease is focused solely on the economic aspects and out-
comes arising from resource abundance, production and exporting and is
often conflated with the resource curse, but the two are not the same. A
resource windfall will contribute to an appreciation of a country’s real
exchange rate and exert competitiveness pressure on its traditional but
lagging non-resource tradables sector. This is the core message of the
Dutch disease. There are critical policy issues arising from this for the
long-term growth and development strategy of a developing economy.
One strategy involves the adoption of a market-oriented approach that
involves acceptance of the long-run economic and structural consequences
arising from the resource windfall, and would aim to facilitate this process
by improving the flexibility and adaptability of the economy in order to
minimise the transition costs involved. This strategy would result in a rela-
tive decline of the non-resource tradables sector (manufacturing and agri-
culture for a low-income developing economy) but not necessarily an
absolute decline in output. The focus of government in this scenario is on
facilitation and not intervention in structural adjustment, and in providing
a stable macroeconomic environment (low inflation, low budget deficits
and a competitive exchange rate). It would also involve providing a
skilled workforce, a flexible and adaptable labour market, a supportive
and requisite legal and regulatory system, high-quality institutions, a busi-
ness conducive environment that encourages small business start-ups,
entrepreneurial and innovation activity, and, for developing economies in
Asia, encourage domestic firms to take advantage of closer economic inte-
gration through participation in regional and global value chains.
A second approach would see policy makers in developing countries
view the potential demise of the non-resource tradables sector (manufac-
turing and traditional agriculture) as being of major concern. A weak-
ened fledgling manufacturing sector and associated de-industrialisation
would be of concern due to the potential importance of certain charac-
teristics and externalities derivable from the sector that are of benefit to
the long-run growth and development of a developing economy. This
position would argue for a more interventionist approach by government
ranging from piecemeal to strategic protection of key existing and new
manufacturing industries. Such an approach raises concerns over the gov-
ernment’s ability to “pick winners”, resource misallocation and the
cost and effectiveness of such a strategy. In the case of a demise in
t raditional agriculture export activity, this could have severe implications

for the incomes of farmers and the rural sector as a whole. For many tra-
ditionally rural developing economies such a loss of income in the sector
would be fraught with both economic and political dangers, and intense
pressure for protectionist measures that would tend to further strengthen
the exchange rate and exacerbate these difficulties.
A third approach, highlighted by Corden (2012), would involve a more
general policy package aimed at addressing issues of competitiveness of the
non-resource tradables sector as a whole arising from Dutch disease
effects. This would involve a specific macroeconomic policy package aimed
at generating fiscal surpluses combined with a monetary policy aimed at
achieving internal balance. This would address concerns relating to the
spending effect. How best to utilise the savings from the fiscal surpluses
then becomes an important issue for developing countries. Such surpluses
could be invested domestically or internationally. The latter can occur
through the establishment of a SWF enabling the country to generate a
portfolio of foreign financial assets from which a future income stream can
be obtained, as well as contributing to a weaker real exchange rate that
would benefit the non-resource tradables sector. In the context of a low
income and underdeveloped economy, however, encouraging investment
to flow overseas may be difficult to justify both politically and socially. A
developing country with substantial poverty, inequality, underemploy-
ment and lacking in infrastructure and social protection programs, but
which has broad based economic potential, may prefer instead to allocate
fiscal surpluses to the domestic economy in terms of both current and
investment expenditure. The former to support social protection pro-
grams while the latter can emphasise investment in domestic and foreign
assets as well as industry policy programs in both the manufacturing and
agriculture sectors as well as on infrastructure. Such a strategy, however,
would imply a stronger exchange rate and a less competitive economy but
could be offset by improved domestic productivity arising from spending
on infrastructure and human capital development.
In addition to the economic challenges facing developing countries
from resource abundance, there are also many prevalent and challenging
non-economic factors that need to be addressed if tangible and sustainable
outcomes are to be achieved. In particular, policies need to address a num-
ber of governance-related issues. These include the need for greater trans-
parency and accountability in government; increasing the capacity of
government and market-supporting institutions; curbing corruption that
40 C. HARVIE
can result in misappropriation of resource funds and their misallocation to

pet projects, with little obvious benefit to the economy; and achieving a
more equitable, broad based and inclusive distribution of the benefits
through social investment in education, training and health.
As emphasised in this chapter, empirical evidence on the existence of a
resource curse remains sketchy and subject to empirical methodological
weaknesses, disparities in the measurement of resource abundance and dif-
ferent outcomes by type of resource produced. Each resource-abundant
country should be viewed as different, that there are many factors contrib-
uting to its economic growth, and that resource production alone is not
necessarily bad for its long-term growth. From the perspective of policy
there is no ideal one size fits all approach. Each resource-abundant coun-
try faces common yet different circumstance and challenges requiring tai-
lored policy packages and approaches designed to meet best their individual
economic, institutional and social situation.
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CHAPTER 3
Inclusion of Firm Heterogeneity in Resource

Boom-Bust Cycle Literature
Kankesu Jayanthakumaran, Mohammad Tariful Bari,

and Nelson Perera
1 Introduction
Neo-classical economists argue that a resource-rich country will out-
perform a country with low resources due to the given amount of nat-
ural capital, labour, physical capital, energy, materials, and other inputs
while advocating a positive association between natural resources (min-
erals) and economic development. The United States, for example, is
endowed with vast natural resources and, by exploiting its minerals, has
become a dominant nation. However, Post-World War II critics such as
Prebisch (1964) believe that the greater the concentration of primary
product exports (including minerals), the lower the economic growth,
and suggest adopting autarkic policies to promote the export of manu-
factured products rather than primary products. In the mid-to-late-
1980s, the Dutch disease in the Netherlands strengthened this
argument by post-war critics, as many authors found little or no eco-
nomic growth in many mineral-intensive countries over a longer period
K. Jayanthakumaran (*) • M. T. Bari • N. Perera

e-mail: kankesu@uow.edu.au; mtb975@uowmail.edu.au; nperera@uow.edu.au

https://doi.org/10.1007/978-981-13-6814-1_3
48 K. JAYANTHAKUMARAN ET AL.
and coined the term ‘resource curse’ (Auty, 1993). As discussed in

Chap. 2, resource curse means that countries with an abundance of
natural resources such as fuels and minerals tend to have lower eco-
nomic growth, less democracy, and poor development experiences than
countries with a scarcity of natural resources. Most empirical studies
carried out on resource-rich countries found an inverse association
between mineral and oil resource abundance and economic growth
after controlling for the usual determinants of growth, although a few
studies attempted to prove the opposite. Overall, the empirical evi-
dence on this is highly sketchy and by no means unambiguous.
The connection between natural resources and growth does not
necessarily imply cause and effect, and there are still disagreements
over the reliability of the methodologies used and appropriateness of
the time horizons (Davis and Tilton, 2005; Badeeb et al., 2017). In
fact, most of the literature on resource-intensive countries is macro
oriented and only provides very vague suggestions for diversifying
economies. For example, after studying 21 African states, Alemu
(2016: 13) concluded that ‘countries seeking to diversify must create suf-
ficient levels of human and physical capital as well as an adequate infra-
structure, and above all conducive macroeconomic policies and strong
government institutions to support export diversification and structural
change in the economy’. Knowing the productivity of different group of
firms (firm heterogeneity) during resource boom and bust cycles is an
essential condition for economic diversification but in macro studies
firms are treated as homogeneous. The application of firm heteroge-
neity studies in countries experiencing Dutch disease symptoms may
provide more insight into the effect of shocks (boom and bust cycles)
on the economy and provide concrete suggestions for strengthening
marginal firms further.
This chapter intends to show how important firm heterogeneity
studies are in resource-intensive countries, so it is structured as fol-
lows: Sect. 2 describes the origin of the Dutch disease and the resource
curse hypothesis. Section 3 discusses the causal mechanism that under-
pins the resource curse hypothesis. Section 4 provides economic diver-
sification as a means of overcoming the resource curse. Section 5
analyses the necessity of firm heterogenic analysis to promote economic
diversification. Section 6 provides a roadmap for interpreting the chap-
ter’s main empirical findings.
INCLUSION OF FIRM HETEROGENEITY IN RESOURCE BOOM-BUST CYCLE… 49
2 Origin of the Resource Curse Hypothesis

The resource curse hypothesis is associated with resource dependence1
and accommodates non-renewable natural resources that may only be
extracted but not produced, such as oil, gas, and other minerals. Here the
extraction process is generally capital intensive and creates few jobs per
unit of capital invested. This sort of natural resource is also located in
poorer countries, and since they remain poor over time, it sparks a debate
on the role of natural resources in the economy. Economists have debated
the role of natural resources in an economy from two opposite perspec-
tives, one optimistic and the other pessimistic. Prior to the early 1960s the
optimistic view prevailed, so it was argued that natural resources would
enable poor countries to transition to become a developed country via
industrial take-off (Rostow, 1960). Countries such as the United States,
Canada, and Australia provide evidence of this successful transition. This
conventional view was challenged by so-called structuralists, who consid-
ered that primary products (including mining) were subject to a down-
ward relative price to that of manufactured goods (i.e. declining terms of
trade) over the long term and income instability in the short term, and this
causes primary producing countries to become poor (Prebisch, 1964).
The Soviet Union, Nigeria, and Venezuela are good examples of countries
with abundant natural resources but which remained underdeveloped.2
This conventional view was strongly challenged after natural gas
upswinged at Groningen in the Netherlands in the early 1980s; it was
quickly observed here that the gas sector adversely affected tradable
non- resource commodities (Corden and Neary, 1982). The term
‘Dutch disease’ was frequently used then because the Netherlands’
tradable non-resource commodities were adversely affected by the
upswing of natural gas. The adverse effects on the production and
export of tradable non-resource sectors occurred due to an increase
in the domestic and export income of the natural gas sector. This
expanding gas sector demanded workers and materials, and paid higher
1
Resource abundance, measured by natural resource capital per capita, may not be resource
dependent when measured by the ratio of natural resource exports in gross domestic product
(Badeeb et al., 2017).
2
One can argue that non-economic factors are also at play here. Poor institutions, gover-
nance, corruption, lack of skill development, and exploitation by resource-producing multi-
national enterprises are also important factors.
wages than that in other sectors.3 Furthermore, gas exports raised the
value of the local currency (the guilder) and caused non-resource trad-
able sectors such as manufacturing to become internationally uncom-
petitive. In brief, the shrinkage of non-resource tradable commodities
occurred due to higher production costs and an appreciation of the real
exchange rate (Fig. 3.1).
Based on these premises, a disproportionate investment and resource
mobility occurs that favours the mining sector at the expense of the
tradable manufacturing sector. Shifting resources away from non-
resource tradables such as manufacturing to the resource sector such as
minerals, in the light of comparative advantage, is not necessarily a
bad policy, but if the minerals receive declining terms of trade, then,
without a viable manufacturing sector, economic growth becomes
unsustainable. The expanding mining sector demand workers and
materials, and raise the value of the local currency and cause manufac-
turing to become internationally uncompetitive. The potential decline
in the non-resource tradables, especially manufacturing, will have
implications for de-industrialisation. Post- World War II literature
argues that ignoring the manufacturing sector will lower the growth
rate by limiting backward and forward linkages (Hirshman, 1958) and
reducing the learning-induced growth of manufacturing (Prebisch,
1964). However, the increased globalisation brought additional oppor-
tunities such as modern services and high-tech firms, which can substi-
tute de-industrialisation (Table 3.1).
Fig. 3.1 Dutch disease symptoms. (Source: Author constructed)
3
Iscan (2015) used the general equilibrium analysis to study the changing share of employ-
ment due to changes in windfall revenue and sectoral productivity in Canada during
1960–2008, and found an overall decline in the share of employment in the manufacturing
sector (1.14 percent per annum). In the 2000s, when the Canadian terms of trade improved
drastically, this effect was very strong.
Table 3.1 Early literature that establishes the Dutch disease concept
Authors Sample Main findings
Prebisch Both centre and Productivity increases more rapidly in the centre
(1964) periphery (industrialised) but not in the commodity-
dependent peripheries (developing countries)
Corden Theoretical model The concept of Dutch disease is established in a
and Neary small open economy model. Authors primarily
(1982) focus on the resource movement effect, changing
relative prices, and an appreciation via this process
Gelb Six countries—Algeria, Oil mismanagement has left the sample countries
(1988) Ecuador, Indonesia, worse off after the end of the first and second oil
Nigeria, Trinidad and booms
Tobago, and Venezuela
Auty Six ore exporters—Peru, Natural mineral resources can harm the
(1993) Bolivia, Chile, Jamaica, developing economies to the extent that benefit
Zambia, and Papua New can become a curse. By emphasising sustaining
Guinea development, the author suggests resource-
conserving technology and economic
diversification
Sachs and Resource and non- Found evidence for a negative relation between
Warner resource countries: natural resource intensity and growth
(1995) Sub-Saharan Africa, However, subsequent empirical evidence from
Middle-Eastern other studies found mixed results. The debate is
countries, and Asia ongoing
Source: Author constructed
The Dutch disease model has been scrutinised even more since then
and used as a source of resource curse hypothesis. By studying r esource-rich
oil economies, Gelb (1988) argued that the costs that are incurred from
oil windfalls offset the future benefits associated with that windfall and
actually build a foundation for the resource curse hypothesis. However, it
was Auty (1993) who coined the term ‘resource curse’ to demonstrate
why resource-rich nations experience lower growth relative to countries
without natural resources. Auty’s conclusion was also based on an analysis
of industrial policies of resource-rich oil-producing countries. In fact, Auty
argued that their industrial policies failed due to the volatile nature of
revenues from minerals and the repatriation of mineral income by foreign-
owned mining companies. Since then many authors have used cross
sectional studies and quantitative techniques in an attempt to provide evi-
dence for an inverse association between natural resources and economic
growth. Of them Sachs and Warner (1999) were the first, and they
obtained support for the existence of an inverse association between

natural resources and economic growth. More recent studies tend to chal-
lenge the assumptions and estimations of Sachs, Warner, and others (Van
der Ploeg, 2011). This is discussed in detail in Chap. 1.
3 Causal Mechanisms of the Resource Curse

Post-Dutch disease empirical literature shows that countries that are rich
in resources tend to underperform (e.g. Gelb, 1988; Sachs and Warner,
1999; Papyrakis and Gerlagh, 2004; Van der Ploeg, 2011; Kim and Lin,
2015; Parlee, 2015); this literature further shows why they underperform
using the causal mechanism of growth. Badeeb et al. (2017) surveyed the
literature on the resource curse and summarised the causal mechanisms as
the Dutch disease symptom, volatility in commodity prices, economic mis-
management, and rent seeking and corruption. Papyrakis and Gerlagh
(2004) show corruption, investment, openness, and terms of trade and
schooling as the causal mechanisms. The causal mechanism has been
examined using case studies (Gelb, 1988), cross-section analyses (Sachs
and Warner, 1999), heterogeneous panel co-integration in a sample of
countries (Kim and Lin, 2015), cross-country, pooled panels of nations
and sectoral analyses (Van der Ploeg, 2011), single-country studies (Parlee,
2015), disaggregated sectoral data for manufacturing (Ismail, 2010), and
disaggregated data for all sectors (Kuralbayeva and Stefanski, 2013).
Kuralbayeva and Stefanski (2013) used the growth accounting exercise
to argue that the low aggregate productivity of some resource-intensive
countries is not due to a resource-induced decline in highly productive
manufacturing (traded). Rather it stemmed from their small manufactur-
ing sector that quite often reveals relatively high productivity. Through
the self-selection process, windfall incomes from the resource-intensive
sector stimulate unskilled workers to shift from the manufacturing sector
to the resource sector and other non-manufacturing sectors, while skilled
workers continuously remain in the manufacturing sector and make this
sector productive.
Badeeb et al. (2017) surveyed literature and concluded that resource
dependence inversely affects growth, but these studies are weak, so they
must be dealt with properly in order to obtain a strong conclusion. Badeeb
et al. (2017) claimed that post-2000 studies considered an inverse impact of
natural resource wealth on growth by their choice of time, countries, and
variables by ignoring endogeneity and the time-sensitivity of the resource
curse. Several recent empirical literature addressed endogeneity using

instrumental variables (Brunnschweiler and Bulte, 2008; Van der Ploeg,
2011) and also corrected for time sensitivity by avoiding shocks (James, 2015).
If we hypothetically agree that natural resources harm growth, then we
need to ask why there are so many countries worse off by having an abun-
dance of natural resources? A natural resource windfall induces adverse
effects such as rising real wages and exchange rates, de-industrialisation,
and bad growth prospects, but these adverse effects are only severe in vola-
tile countries. The adverse effects include volatility in commodity prices,
economic mismanagement (bad institutions), rent seeking, and corrup-
tion among others. These volatilities are expounded below.
Volatility in Commodity Prices
Primary commodity prices are subject to volatility apart from any long-
term price trend in global markets, and this volatility hinders planning for
economic development and adversely affects economic growth (Prebisch,
1964). Volatility arises not only from low incomes and the price elasticity
of commodities as suggested by structuralists, but there is also less invest-
ment in physical capital and ‘learning-by-doing’ due to a rise in the
exchange rate due to symptoms of the Dutch disease (Van der Ploeg,
2011). Boom and bust cycles of natural resource revenue induce resource-
rich countries to increase their foreign borrowings during a boom and
then incur a debt crisis during the bust (Van der Ploeg, 2011). The drastic
fall of export earnings and government revenue from the natural resource
sector will bring uncertainty in government planning and reduce public-
and private-sector efficiency (Davis and Tilton, 2005).
Economic Mismanagement
A sudden resource windfall leads policymakers to become over confident

and induces a false sense of security. A massive resource rent encourages
policymakers to invest in unimportant projects and make hasty decisions
that are difficult to finance when the resource revenue disappears.
Choosing weak projects due to excessive parliamentary power, inefficient
coordination between government agencies, a lack of transparency in pub-
lic procurement, politically motivated awarding of contracts, and ineffi-
cient infrastructure projects in terms of time and costs can cause the fiscal
position to deteriorate (Li et al., 2017) (Table 3.2).
Table 3.2 Recent literature on the causal mechanism of the resource curse
Authors Periods Sample Main findings
Gylfason 1980–1997 65 Resource- Education is inversely related to natural

(2001) rich nations resource dependence
Papyrakis and 1975–1996 Panel of 103 A natural-resource-abundant economy
Gerlagh countries suffers from corruption, low investment,
(2004) protectionist measures, deteriorating
terms of trade, and low educational
standards. The negative indirect effects
on economic growth outweigh the
positive direct effects
Davis and Literature Mineral deposits provide opportunities
Tilton (2005) survey for developing countries. Some countries
use this wisely to promote development.
Some countries misuse this opportunity
and do harm to their development
Bhattacharyya 1980–2004 Panel of 124 If democratic institutions are weak then
and Hodler countries resource rents increase corruption. The
(2010) results hold when there is control for the
effects of income, time varying common
shocks, regional fixed effects, and various
additional covariates
Van der Ploeg Literature A resource boom induces an appreciation
(2011) survey of the real exchange rate and
deindustrialisation. Countries with bad
institutions, lack of rule of law,
corruption, presidential democracies, and
an underdeveloped financial system suffer
more in terms of growth
Arezki and 1992–2005 Panel of 30 An increase in oil rents can be associated
Bruckner oil-exporting with an increase in corruption and lower
(2011) countries political rights. There is a significant
effect of oil rents on corruption in
countries where there is a high share of
state participation in oil production.
Political elite to reduce political rights in
the presence of oil windfalls to evade
redistribution and conflict
(continued)
Table 3.2 (continued)

Authors Periods Sample Main findings
Melitz and Pre and Canadian The share of low-productivity plants

Trefler (2012) post manufacturing declined and the share of high-
NAFTA in firms productivity plants rose mainly due to
1989 the reallocation mechanisms across
plants. Also, a decline in the entry rates
of plants with productivity near or below
the median where low-productivity
plants made the cost cut and joined the
team in the earlier period but not in the
later period
Kuralbayeva 1989–2008 184 countries, Resource-induced structural
and Stefanski 75 of which are transformation is in favour of improving
(2013) oil rich manufacturing sector productivity and
not in favour of improving non-
manufacturing sector productivity. The
explanation for the resource curse lies
outside the economic structure but more
in terms of political nature
Andersen and 1800–2006 53 countries Oil wealth became a hindrance to
Ross (2014) democratic transitions after the 1970s.
After the 1970s, governments of
developing countries attempted to own
the oil rents that were previously used by
foreign-owned firms
Iscan (2015) 1960–2008 Canada Both windfall income and productivity
growth lead to a decline in employment
in the manufacturing sector
Badeeb et al. Literature Resource dependence negatively affects
(2017) survey growth. Future research should address
endogeneity of dependence measures
and expand the years of study and range
of empirical methodologies
Li et al. (2017) 2014–2025 Mongolia Using a dynamic general equilibrium
model for Mongolia, it was found that
rapid fiscal outlays will increase
macroeconomic vulnerabilities

Van der Ploeg (2011) mentioned that the Netherlands expanded

public employment and consumption, provided generous unemploy-
ment and disability benefits, raised the minimum wage, and imple-
mented protective labour market regulation soon after the discovery of
natural gas and following the oil price shocks in the 1980s. This may
not be sustainable during a resource bust. Another example of eco-
nomic mismanagement is where neo-Marxist policy makers in develop-
ing countries advocate continuous (regardless of a resource boom or
bust) state-led industrialisation strategies using protectionist policies;
this has partially resulted in an appreciation of the real exchange rate
and shrinkage of the non-resource tradable sector. Protectionism is to
blame for this downfall. Another example is from Gylfason (2001),
who argues that a dependence on natural resources raises resource-
based real wages relative to non-resource based and reduces the incen-
tive for accumulating human capital.4
Rent Seeking and Corruption
A sudden resource windfall is often controlled by powerful groups that

include elites, and this group has the capacity to execute income disparity.
Conflict between domestic stakeholders such as politicians and citizens
often arises as a result of a resource revenue bonanza. Politicians and their
immediate circles may have benefitted from a mining windfall due to rent
seeking and this may lead them to believe that mining windfalls generate
adequate private returns but lower social returns, while the lack of invest-
ment in infrastructure and sustainable economic development often has
detrimental future social benefits.
Resource windfalls magnify the already existing weak political system
and institutional quality. This tends to create autocratic leaders who remain
in power for longer terms, often without holding elections. Resource
dependence of these vulnerable countries encourages elites and cronies to
advocate protectionism and exclusive licences to exploit resources in order
to obtain wealth and political power, and political power leads to corrup-
tion. Studies indicate that corruption is associated with high state partici-
pation (Arezki and Bruckner, 2011) and non-democratic regimes
4
There is also evidence that government spending on education (supply side) and school
enrolment at all levels (demand side) are inversely related to natural-resource dependence
(Gylfason, 2001).
(Bhattacharyya and Hodler, 2010); studies also show a weakening of gov-

ernment democratic accountability (Andersen and Ross, 2014) as resource-
rich countries rely on resource rents, but do not tax revenue (Ross, 2001).
4 Economic Diversification

During the post-World War II period it was believed that a country which
depends on a few commodities for its export earnings is vulnerable to
fluctuations in the export market (Love, 1979). As MacBean (1966)
pointed out, ‘it is always risky to put all one’s eggs in a single basket’. To
keep export proceeds stable, a country can either choose to export stable
industrial products or export a number of products (export diversifica-
tion5) whose fluctuations off-set each other. Export diversification not
only offsets fluctuations in export earnings, but also leads to long-term
growth that accommodates increasing returns to scale and spill-over in
line with endogenous growth theory.
The terminology for economic diversification is slightly different but it
accommodates export diversification as a core. Economic diversifica-
tion may be defined as the process whereby an increasing range of eco-
nomic outputs is produced in the light of comparative advantage, and it
can also explain the term used for the diversity of economic activities or
markets. Theoretically, there are two types of arguments for economic
diversification: the first is a structure of preferences where patterns of con-
sumption change as income from a diversified sector grows, while the sec-
ond says that having more sectors makes it easier to diversify idiosyncratic
risk. Empirically, adding to the variety of goods produced will have a posi-
tive impact on productivity and diversified export growth (Barro and Sala-
i-Martin, 2004). Imbs and Wacziarg (2003) show there is a monotonic
relationship between income and economic diversification, whereas Cadot
et al. (2007) show that economic diversification is positively associated
with per capita income and total factor productivity growth.
Trade facilitation is a vehicle for export diversification and may be defined
as any policy that reduces the transactional costs of international trade.
Trade facilitation may be considered a policy prescription to promote the
5
Most studies on export diversification used the Herfindahl–Hirschman index of export
values across a given range of products and sectors to capture and measure export diversifica-
tion. This measure captures the intensive margin (existing products) and extensive margin
(new products), but export diversification is often linked to the extensive margin because a
shift in export composition is expected.
intensive margin (existing products) and extensive margin (new products)

with the potential to stimulate growth in existing trade flows. Since the
intensive margin is about existing products, export diversification is par-
ticularly concerned with the extensive margin. Existing findings that trade
facilitation to stimulate growth does not account for their potential to
promote export diversification prompted Dennis and Shepherd (2011) to
suggest utilising export diversification in terms of trade growth at the
extensive margin (new products) by ignoring the intensive margin
(existing products).
Identifying the behaviour of a group of firms (with firm heterogeneity)
will provide a greater insight into the intensive and extensive margins.
Firm heterogeneity means a group of firms in an industry can be much
larger, more profitable, and more productive than another group of firms.
Melitz and Trefler (2012) observed that the share of low-productivity
plants declined and the share of high-productivity plants rose mainly
due to the reallocation mechanisms across plants in Canada after the
Canada-US Free Trade Agreement of 1989. This conclusion provides in-
depth knowledge about firms and provides policy implications and an
advancement of macro-level studies. Melitz and Trefler (2012: 114) refer
to this advancement as ‘empirical confirmation of the gains from trade pre-
dicted by models with heterogeneous firms represents one of the truly signifi-
cant advances in the field of international economics’.
To explain firm heterogeneity further, we focused on within-sector
diversity and individual firms that self-select based on productivity distribu-
tion. Firms with the lowest productivity cannot produce for any market so
they drop out, whereas high-productivity firms can serve the domestic
market and at least one overseas market. In fact, the more high-productivity
firms that a country has, the greater the range of products that it exports
to overseas markets. In other words, new exporters should satisfy the
required threshold level of productivity (productivity cut-offs). The level
of trade cost and market entry cost (firms that enter multiple markets pay
multiple entry costs) determines the productivity cut-offs. New exporters
may find it difficult to export due to export costs, import country tariffs,
and transport charges. Lower trade costs mean lower productivity cut-offs
and, in such circumstances, the export bundle will be higher. Conversely,
the higher the market entry costs, the higher will be the productivity cut-
offs, and in such circumstances, it is harmful for domestic firms to access
overseas markets (Helpman et al., 2008). This argument can also be
extended to between-sector diversity based on a shift in comparative
advantage. Existing findings that used firm heterogeneous models indicate

that trade and market entry costs inversely impact on the range of export
products, so larger countries trade in a wider range of goods, whereas the
growth in import variety leads to gains in national welfare (Dennis and
Shepherd, 2011).
A group of firms will react differently when exchange rates change, so
if a home currency appreciates, some firms will exit and the exports of
surviving firms will decrease and local sales will increase; these changes in
domestic sales and exports determine the net effect on productivity (Fung,
2008). Exporters face the adverse consequences of exchange rate appre-
ciation mainly due to increases in the marginal cost of exporting—increases
which are partly passed on through prices and partly absorbed into export-
ers’ mark-ups. Firm heterogeneous models predict that exchange rate
pass-through and mark-up absorption will vary with firm productivity.
Berman et al. (2012) utilised total factor productivity across French
firms at unit value to conclude that less productive exporters displayed
greater exchange rate pass-through whereas high-performance firms par-
tially absorbed exchange rate movements in their mark-up. When a cur-
rency appreciates the ability of exporters to raise prices diminishes and
therefore the mark-up of high-performing firms decreases, so the reduced
profitability of high-performing exporters means they have little incentive
to invest in productivity-enhancing technology. By way of contrast, Cook
(2014) utilised the imports of US firms at transaction prices and con-
cluded that the pass-through for higher-price exporters (lower-productive
firms) was lower, so when their currency appreciated, it raised the marginal
cost of exporters selling overseas. According to Cook, a higher-price
exporter (lower-productivity firm) has a lower pass-through because they
cannot raise their prices relative to lower-price exporters (higher-
productivity firm).
5 Firm Heterogenetic Analysis

One can find similarity in the recent argument that resource dependence
inversely affects growth and therefore a resource-dependent country
should promote economic diversification to enhance growth. If a resource
bonanza is invested within a sector or between sectors, there will be
higher growth in productivity and exports in other sectors that will even-
tually support the economy during an economic bust. However, Warner
(2015), in a resource-dependent cross-country study, claims there is lack
of proof that resource booms left the anticipated productivity transforma-

tion behind in other sectors. According to Warner, the policies in place
may not promote long-term development outside the resource-intensive
sectors because rent-seeking elites absorb windfall profits and leave no
room for export diversification.
Box 3.1: Resource Sector Boom in Mongolia: 2007/08–2011/12
100 Mineral export share in overall exports and 250 Real Wage Index (2010 Price)
Gross Domestic Product
80
Percentage of Mineral Export in Total Export 200 National average
Percentage of Mineral Export in GDP Mining & quarring
60 150 Manufacturing
40 100
20
50
0
0
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2016
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
The percentage share of mineral exports in GDP increased from
27 to 41 while the percentage of mineral exports in total exports
increased from 60 to 89. The percentage of exports in GDP and
overall exports has tended to fall since then.
A mining boom coincided during this period and the export
value index (162 in 2004 to 1077 in 2014) disproportionately
increased relative to the export volume index (117 in 2004 to
321 in 2015). An improvement in the terms of trade was evident
during this period and this can be further associated with an
extraordinary rise in the real effective exchange rate (REER) index.
The REER index increased from 97 to 141 during the same period.
The real wage rate (RWR) for the manufacturing sector fell signifi-
cantly relative to the national average during the boom, while min-
ing and quarrying was far above the national average. Both the
RWR and REER were not favourable for the non-resource trad-
ables sector to grow and negatively impacted non-resource trad-
able sector exports.
A shifting of resources away from the manufacturing sector into

the production of mining sector was evidenced. The investment
share in mining and quarrying increased from 23 percent in 2009 to
62 percent in 2011 and decreased to 23 percent in 2016. Alternatively,
investment in the manufacturing sector declined from 7 percent to 1
percent during this same period. Mining investment has focused on
two large development projects at Oyu Tolgi (OT) and Tavan Tolgoi
(TT) based on the premise that this capital-intensive mining sector
would generate export earnings. These premises have led to a dis-
proportionate investment and resource mobility to the resource sec-
tor at the expense of the non-resource tradables sector.
Since 2013, Mongolia has experienced an economic slowdown
due to a reduction in coal exports when the People Republic of
China slowed down and the exchange rate depreciated. The high
dependency on resource-intensive sectors makes Mongolia vulnera-
ble to possible ‘Dutch disease symptoms’ such as higher real wages,
higher real exchange rates, and slower manufacturing.
Li et al. (2017) used Mongolian data and stated that it is not only the
lack of policies that is important, but also the timing of investments. By
studying productivity transformation using a structural model-based
approach and by simulating public investment strategies on key fiscal and
growth variables, it was argued that quick fiscal spending led to macroeco-
nomic vulnerability, so in order to enhance long-term sustainable growth,
Mongolia should moderate its infrastructure investment and optimise
investment efficiency in a sustainable way. Thus, to promote non-resource
sectors in resource-intensive countries, governments should use prudent
fiscal policies and careful planning and monitoring on a long-term basis.
Fiscal strategies are discussed in Chap. 2.
The issue is that most of the literature on resource boom and bust
cycles only address the macro perspective; this means there is no literature
on firm heterogeneity theories that provide more insight into the effect
that shocks have on the economy. Since a resource boom raises the cost of
production for the non-resource sector in unusual ways compared to nor-
mal circumstances, firm heterogeneity studies will provide a different
insight into firm behaviour. The dynamics of a group of firms during
resource boom and bust cycles might give some insight into the effect that
the resource curse has on production and exporting, but there are no such
studies in the literature. Most of the literature on the resource curse sug-
gests economic diversification as a remedy but how to actually diversify the
economy is not well articulated. With regard to economic diversification,
it is important to recognise the survival of weaker high-cost and stronger
better-performing firms during a resource boom and nurture their future
potential (Fig. 3.2).
Resource-intensive countries experience large increases in the cost of
non-tradable resources and an appreciation of their exchange rate, both of
which add to the cost of production; they also face high volatility in resource
prices. A high volatility of prices in international markets leads to greater
uncertainty in the production process and adds an additional cost, while
further costs can be added due to economic mismanagement, rent seeking,
corruption, and lower-quality institutions. Therefore, the overall cost of
production and trade costs tend to increase mainly in the non-resource sec-
tor tradables during a resource boom. This cost is obviously more than the
existing trade and market entry costs that firms usually face in non-resource
countries, because in these circumstances there should be a higher produc-
tivity cut-off and domestic firms would find it difficult to access overseas
markets. This means that analysing firm heterogeneity relative to non-
resource-intensive countries requires a different treatment (Fig. 3.3).
Fig. 3.2 Resource boom and cost of production. (Source: Author constructed)
Fig. 3.3 Resource boom and productivity. (Source: Author constructed)
Melitz (2003) argues that in a non-resource-intensive country, lower-

productivity firms (high cost) contract and the lowest-productivity firms
(highest cost) exit, so if lower-productivity firms are to survive, they must
adopt low-cost options to improve their productivity (König, Lorenz and
Zilibotti, 2016). Firms do adopt various ways to achieve low-cost options,
one of which is to shed unskilled labour, while skilled workers remain via
self-selection (Kuralbayeva and Stefanski, 2013); another way is to move
away from their badly performing products and specialise in their better-
performing products. Lower-productivity firms that operate in non-
resource sectors in resource-intensive countries may go through similar
experiences and this can be captured by analysing firm heterogeneity.
We assume that high-productivity firms specialise in high technology, so
they tend to use high-cost options in updating technology, whereas non-
resource-intensive firms would not upgrade their technology during a
resource boom because investment in these sectors would have higher
opportunity costs than investing in mining or other related sectors. Note also
that developing countries that are resource intensive cannot compete with
technologically advanced products where the cost of production and trade
relative to technologically advanced countries has unequivocally increased.
Our overall concern is the net effect of low- and high-performing firms
because technologically advanced high-productivity firms generate relatively
more spill-overs than low-productivity firms, and, therefore, any decline in
high-productivity firms tends to reduce spill-overs that will eventually affect
the productivity growth of the overall economy in the long run. This find-
ing is similar to macro studies where the authors show that resource depen-
dence inversely affects growth in the long run (Badeeb et al., 2017).
Box 3.2: Resource Boom and Non-mining Sector Productivity

Distribution in Mongolia: Kernel Density 2007/08–2011/12
Kernel density was constructed using two World Bank Enterprise

Surveys for 2009 and 2013. The estimates are of the labour produc-
tivity distributions (constant 2010 prices) of the sample firms in the
entire non-mining, manufacturing, and service sectors between
2007–08 and 2011–12. To control for the industry and year effect,
each firm was assigned a value measured by the difference of its log
productivity from the median productivity of the industry-year
group to which the firm belongs.
Firms that were at the left (less efficient) of the distribution in
2007–08 increased their productivity in 2011–12 by either exiting
some of the products/markets or gaining efficiency by imitating
other firms. However, the upper side of the distribution (high-
productivity firms with high technology) showed their productivity
declined because of their inability to upgrade their technology in the
wake of exceptionally increased production and trade costs. The net
of these two effects left the whole distribution with changes where
medium-productivity firms dominated in 2011–12.
With regard to exporters and non-exporters in the non-resource sector in

resource-intensive countries, both experience higher costs at home due to
trade costs and market entry costs that are incurred by the volatility of prices
and political and economic uncertainty. However, exporters tend to be
affected more than non-exporters mainly because they face increased exchange
rates, which they can either pass on to consumers in importing countries or by
reducing their profit margins. If there is no product differentiation in devel-
oping countries, then non-resource-intensive exporters will respond to an
increased exchange rate by either exiting the market or reducing their exports.
Since there are entry barriers for new exporters due to the high cost of pro-
duction, there appears to be very little difference between exporters and non-
exporters in these circumstances (Figs. 3.4 and 3.5).
Since less-developed resource-intensive countries do not pass through
the high costs resulting from domestic exchange rate appreciation, it is
worth considering the Berman et al. (2012) model, which shows that less-
productive exporters restructure their products and destinations with
available low-cost options in order to survive, while high-productivity
firms tend to exit because they have little incentive to invest in productivity-
enhancing technology. Mayer et al. (2014) raised a similar argument on
the basis of multi-product French firms to argue there would be a down-
ward shift in the distribution of mark-ups across all products in the wake
of tougher competition in overseas markets because firms tend to reduce
Fig. 3.4 Exchange rate appreciation and exporters. (Source: Author constructed)
Fig. 3.5 Exchange rate pass-through and mark-up absorption. (Source: Author
constructed)
the range, destination, and mix of their products to remain profitable.

With these facts in mind, it could be argued that an appreciation of the
exchange rate due to a resource boom could also generate similar effects
for the productivity of a group of firms. This argument could be gener-
alised as follows: The net effect is where firms with lower productivity tend
to increase their productivity using low-cost options, while firms with
higher productivity experience a decrease in productivity because it is dif-
ficult to upgrade their technology due to the increased cost of production.
Box 3.3: Kernal Density Estimation of the Productivity Distribution

of Exporters and Non-exporters: Mongolia 2007/08–2011/12
Exporters (b) Non-exporters

.4
.4
.1 .2 .3
.1 .2 .3
Density
Density
0
0
-4 -2 0 2 4 -2 0 2 4 6
prod prod
Exporters2007-08 Exporters2011-12 Non-exporters2007-08 Non-exporters2011-12
(c) Exporters vs. Non-exporters (2007-08 (d) Exporters vs. Non-exporters (2011-12
.3
.4
.1 .2 .3
.2
Density
Density
.1 0
-4 -2 0 2 4 -2 0 2 4 6
prod prod
Exporters2007-08 Non-exporters2007-08 Exporters2011-12 Non-exporters2011-12
The data used here has been obtained from two World Bank
Enterprise Surveys of 2009 and 2013. The estimates are of the
labour productivity distributions (constant 2010 prices) of the sam-
ple firms of exporters and non-exporters between 2007–08 and
2011–12. To control for the industry and year effect, each firm was
assigned a value measured by the difference of its log productivity
from the median productivity of the industry-year group to which
the firm belongs.
Panels ‘a’ and ‘b’ show the productivity distribution of exporters

and non-exporters where the bottom quartile of the productivity dis-
tribution of exporters and non-exporters improved during this period,
although the top quartile experienced a decline in productivity. Panels
‘c’ and ‘d’ show that the productivity distribution of exporters was
higher than that of non-exporters during both periods. However, the
variation was lower in 2011–12 relative to 2007–2008, a result con-
firming that exporters were adversely affected more by increased costs
than non-exporters.
6 Conclusions
The existing macro perspective resource curse literature does tend to agree
that resource booms raise the costs of production and trade via expensive
non-tradable, expensive domestic currency, volatile commodity prices,
and rent-seeking activities due to economic and political mismanagement.
This is eventually reflected in lower productivity and lower growth of
resource-intensive nations. In order to grow, one can suggest economic
diversification because it leads to sustainable growth by generating spill-
over effects and increasing returns of scale, and economic diversification
demands strong firms operating in a range of sectors that understand firm
dynamics during resource boom-bust cycles. This chapter has combined
the concept of a resource curse with literature on firm heterogeneity to
reveal how a resource boom affects firms.
Literature on the macro perspective of a resource curse on trade assumes
that firms are homogenous and therefore make the same choices with the
same alternatives, but in reality, they behave differently during resource
booms. Lower-productivity exporting firms (high-cost firms) tend to
reduce the range, destination, and mix of their products to remain profit-
able and find low-cost options to survive, whereas higher-productivity
exporting firms (technologically advanced) tend to leave the export mar-
ket because they face high opportunity costs due to the difficulties of
upgrading their technology due to the increased costs of production and
trade during a resource boom. The net effect is a stagnation of aggregate
productivity in the non-mining sector that is consistent with the resource
curse hypothesis.
The firm heterogeneity approach has not been widely tested in the
resource curse literature mainly due to the lack of survey data, but improv-
ing the panel data set of World Bank surveys could fill this gap. This
approach will provide specific policy implications and regulations for
firms to defend themselves, and this will eventually be reflected in a
nation’s growth.
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CHAPTER 4
Trade Facilitation in South Asia: Landlocked

Countries’ Perspective
Ramesh Chandra Paudel
1 Introduction
South Asia, the densest region in the world and the southern region of
the Asian continent, comprises eight countries, namely Afghanistan,
Bangladesh, Bhutan, India, the Maldives, Nepal, Pakistan and Sri Lanka.
The geography of South Asia is located within the boundary of the Indian
Ocean in the South, the People’s Republic of China in the North, and in
between West Asia, Central Asia, East Asia and Southeast Asia. All these
eight countries have an economic cooperation organisation, the South
Asian Association for Regional Cooperation (SAARC), established in 1985.
South Asia covers about 4.8 million square kilometres of land area,
which covers almost 3.7 per cent of the world’s land. The total population
of South Asia is about 1.749 billion, almost one-fourth of the world’s
population as of 2015, making it both the most populous and the most
densely populated geographical region in the world. Economy wise, South
Asia produces about US$2.7 trillion, which is just 4 per cent of the world’s
R. C. Paudel (*)
Arndt Corden Department of Economics, Crawford School of Public Policy,
Australian National University, Canberra, ACT, Australia
e-mail: u4472609@alumni.anu.edu.au

https://doi.org/10.1007/978-981-13-6814-1_4
72 R. C. PAUDEL
gross domestic product (GDP) for one-fourth of the population of the

world. In terms of international trade, the region has merely 2 per cent of
the world’s merchandised exports, and 3 per cent of the world’s merchan-
dise imports. It seems that the region is not really benefiting from the era
of globalisation. As a consequence of this fact, the region’s average per
capita GDP remains only US$1542, far below the world average of
US$10058 in 2015 (Table 4.1). These facts show the poor performance
of South Asian economies despite the advantage of the demographic div-
idend of working age population and the large size of the regional market.
Figure 4.1 presents South Asia’s trade share in her GDP and the growth
of exports and imports of goods and services. The trade share gradually
increased over the period of 1960–2014, and at a faster pace since the
mid-1990s. As seen in the figure, the growth of imports and exports is not
impressive, and the region is achieving a 1960s level of trade growth,
which requires urgent attention from policy makers in the region.
The key message from this discussion is that about one-fourth of the
population of the world exports just 2 per cent of the world’s exports, and
imports just 3 per cent of world’s imports, and all the countries in the
region are far behind in matching their trade with their GDP. This leads to
many questions as to why the trade situation in South Asia is so deprived.
Does trade facilitation play a role? If so, which component is the most
Table 4.1 South Asia at a glance as of 2015

Country Land Population GDP US$ Merchandise Merchandise
(sq. km) million million exports US$ imports US$
million million
Afghanistan 652,860 33 19,331 470 557

Bangladesh 130,170 161 195,079 32,379 3946
Bhutan 38,117 1 2058 585 117
India 2,973,190 1311 2,095,398 267,147 39,198
Maldives 300 0 3435 240 187
Nepal 147,181 29 21,195 720 638
Pakistan 770,880 189 271,050 22,188 4422
Sri Lanka 62,710 21 82,316 10,470 1905
South Asia’s 3.68 24 4 2 3
share (%) in
world
World 1.3E+08 7347 73,891,889 16,482,000 1,672,500
Source: World Bank (2016b)

TRADE FACILITATION IN SOUTH ASIA: LANDLOCKED COUNTRIES… 73
(%)
60
50
40
30
20
10
0
-101961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 2013
-20
Trade as a share of GDP Growth of Exports Growth of Imports
Fig. 4.1 South Asia’s trade share and growth of imports and exports of goods,
services (%). (Source: World Bank 2016b)
important in boosting the trade performance of the region? Why is region

unable to benefit from globalisation and policy reform, leaving trade
growth at the 1960s level?
Panagariya (2007) describes the possible reason for poor trade perfor-
mance of the South Asian region as the trend of intra-regional trade in
South Asia since the end of British rule. He argues that ‘the world markets
were relatively closed for South Asia and the region was relatively open
within in the beginning, but later the two trade regimes exchanged
places—the world markets opened up while South Asian borders became
progressively closed’. This situation might have played a crucial role in the
poor performance of international trade in the region.
This study is crucial in many respects, particularly for three reasons. It
aims to make a thorough analysis of the export performance of South
Asian landlocked countries, namely Afghanistan, Bhutan and Nepal,
touching on the scenario of South Asian intra-regional trade. Second, this
study revolves around the following pivotal research questions: Why are
the landlocked countries of the region, namely Afghanistan, Bhutan and
Nepal, are peculiar in the region? Why is South Asian intra-regional trade
so poor? Third, this study attempts to analyse the impact of trade facilita-
tion on controlling trade costs and export performance so that a good
policy inference can be made.
This study is structured as follows. Section 2 discusses the relationship
between trade and trade facilitation in South Asia. Section 3 analyses the
74 R. C. PAUDEL
various indicators of trade competitiveness within the context. I discuss

the research methodology in Sect. 4 before concluding in Sect. 5.
2 Trade Facilitation in South Asia
2.1 Concept of Trade Facilitation

Trade facilitation refers to lubricating international trade via varieties of
improvements in policy, implementation process and logistics. In a broad
sense, trade facilitation is defined as the set of policies aiming at reducing
the costs of exports and imports by improving efficiency at each stage of
the international trade chain as stated in Portugal-Perez and Wilson (2012).
Arvis et al. (2016), in a report quoting the consensus on trade facilita-
tion agreement at the ministerial conference of the members of the WTO
in Bali, Indonesia, on December 7, 2013, describe trade facilitation as a
bundle of commitments on publishing and making available information
for traders and adopting modern approaches to improve customs, includ-
ing border management, with a special focus on improving the opera-
tional standards of customs agencies, reducing risk and improving
clearance post-audit. The main focuses are improvement in transparency
of new legislation, appeals against administrative decisions and advance
rulings, cooperation between government agencies, for example to imple-
ment the national single window system, and improving the guidelines for
streamlining international transit procedures. Also, this report suggests
that the benefits of trade facilitation will be fully realised only if countries
are prepared to go beyond it, such as by adopting the regional integrated
framework like that of the European Union (EU).
The International Trade Center (2013) defines trade facilitation as an
effective way to reduce trade costs via better border and customs manage-
ment, improving infrastructure, preparing open and competitive markets
in the logistics and service sectors, and harmonising regional standards
that help to improve competitiveness, which helps to enhance export per-
formance, creating more employment that ultimately contributes signifi-
cantly to the reduction of poverty.
Grainger (2011) argues that with falling tariff levels, the non-tariff
area and trade facilitation, in particular, are receiving growing attention
among international trade economists. Because of this scenario, trade
facilitation has become a subject of substance within a wide range of
international organisations including the United Nations (UN), the
World Customs Organization (WCO), the World Bank and recently

the Asian Development Bank, connecting this issue with economic
development, supply chain security and sector-specific issues such as
international transport and logistics. Gradually, transit issues have also
been able to draw the attention of stakeholders. The author also defines
trade facilitation as fundamentally an operations-focused topic that
deserves to be approached from a bottom-up perspective that not only
provides a strong case for an interdisciplinary research agenda, but also
calls into question whether current institutions related to trade facilita-
tion have been designed appropriately so that the crucial aspects of inter-
national trade are addressed on time.
Grainger (2008) states that trade facilitation is the simplification, har-
monisation, standardisation and modernisation of trade procedures by
reducing trade costs which are associated with customs, infrastructure,
transit, information and so on with the combined effort of the public
and private sector. Iwanow and Kirkpatrick (2007), using 5-year data for
78 countries in the standard augmented gravity modelling framework,
analyse quantitatively the impact of trade facilitation on international
trade and find that a 10 per cent improvement in trade facilitation
increases export performance by 5 per cent if trade facilitation is fol-
lowed by improvements in the quality of transportation and communi-
cation infrastructure.
Engman (2005) examines the link between trade facilitation and trade
flows and argues that improved and simplified customs procedures would
have a significant positive impact on trade flows, improving cross-bor-
der movement of goods, and would have a positive effect on the ability
of a country to attract foreign direct investment and better integrate in
international production supply chains. In this context, Wilson et al.
(2005), using panel data for 75 countries covering the short period of
2000–2001, suggest that improving trade facilitation contributes sub-
stantially to international trade. The paper is particularly focused on the
case of Organization for Economic Cooperation and Development
(OECD) countries’ trade performance, and suggests that the level of the
trade facilitation can be enhanced through improving the quality of ports
and other infrastructure, customs administration, and other series of reg-
ulatory and service reforms.
Based on the above discussion on the literature, we can say that trade
facilitation is not limited to any administrative documentation require-
ment, but includes any measure that eases a trade procedure and reduces
76 R. C. PAUDEL
the transaction costs to improve trade performance. These measures

include (a) formalities, procedures and number of documents; (b) physical
movement of goods through improvements in services (transparent, pre-
dictable, uniform), the legal framework, and the transport and communi-
cations infrastructure, as well as the use of modern information
technology tools by services providers and users; and (c) timely discussion
and dissemination of trade-related information to all concerned stakehold-
ers (government, services providers and the trading community), ideally
through an established consultation mechanism.
2.2 Trade Facilitation and South Asia

In the context of poor intra-regional trade, some studies express their
concerns about the poor trade performance within the region. Baysan
et al. (2006) and Weerahewa (2009) document that political rifts within
the region have resulted in neglecting intra-regional trade facilitation. The
lack of confidence in market potential and trading opportunities is also a
factor, though to a lesser extent. These studies indicate that improving just
the customs clearance systems would enhance the intra-regional
substantially.
As the previous sub-section documents, the impact of trade facilitation
is seen directly in trade costs and trade performance. In regard to trade
costs, Duval and Utoktham (2011) state that South Asia is a unique case
because of its higher intra-regional trade costs structure. A notable point
is that South Asia has similar trade costs for inter-regional and intra-
regional trade, which has caused a stagnant intra-regional trade rate.
Banik and Gilbert (2008) explain the situation as follows. The lack of
infrastructure, both physical and services related, measured by usage rate
of digital services, government regulations, port inefficiency with higher
shipping turnaround time, and corrupt practices with poor quality of gov-
ernance, has contributed to high trade costs in South Asia, and this situa-
tion is responsible for poor trade performance in the region. Wilson et al.
(2005) describe that the highest export gain from improvement in all
trade facilitation measures is almost 20 per cent in South Asia.
Consumer Unity & Trust Society (CUTS International) have published
several works covering the different aspects of trade facilitation in the
South Asian context. For example, George (2011) and Ahmed (2006)
describe that port logistics, digitisation and clearance capacities at LCSs;
harmonisation of product codes and standards, customs notification and

information sources; and administrative transparency are the crucial issues
of trade facilitation in the region. They also indicate that South Asia has
failed to benefit from earlier reforms because of these missing links.
Transport infrastructure and facilities are fundamentals for intra-regional
trade and are of a significantly lower standard in the region.
Hence, the direct impact of trade facilitation is replicated in two ways:
first, as a part of trade costs minimisation, and second in trade maximisa-
tion. Considering these facts, following the acceleration of economic lib-
eralisation policies in the region in the 1990s, the SAARC) Preferential
Trade Agreement also came into existence. This indicates that the trade
facilitation needs eventually caught the attention of policymakers. In the
early 2000s, significant improvements were made across all the regional
countries in digitising many documentation processes and dissemination
of trade regulations.
2.3 Literature Gap
The literature suggests a gap in the context of the South Asian region. As
can be seen in the previous sub-section, not many studies have been done
in the regional context, and the literature is unable to present a solid
empirical analysis using the regional data to ascertain the role of trade
facilitation in regional trade. In this study, I aim to bridge this gap by con-
ducting an empirical analysis employing the state of the art technique in
the primary data from the region to estimate the impact of trade facilita-
tion in two scopes: cost minimisation and trade maximisation.
At present, the global economy is currently undergoing major shifts—
the global-, region- and country-specific crises following the global finan-
cial crisis. In recent years, the eurozone has experienced political economic
struggle. The exit of the United Kingdom from the EU and the beginning
of the Trump era in the United States show the symptom of a kind of
reversal on policy shift more towards protectionism. Alongside these
socio-political economic events, South Asia as a region will experience
multi-dimensional negative effects of these scenarios in the future in terms
of investment, governance and international trade. These issues are more
crucial for landlocked developing countries in the region. These coun-
tries (Afghanistan, Bhutan and Nepal) are in a difficult position in terms of
their trade performance and must face the additional burden of the many
78 R. C. PAUDEL
transit issues that compel them to be doubly disadvantaged. In the global

perspective, these countries are not only landlocked but also located in a
comparatively trade-inefficient region.
3 South Asia’s Infrastructure and Policy

in Global Competitiveness
The quality of infrastructure is one of the major determinants of trade

facilitation. South Asian countries are ranked poorly in the Global
Competitiveness Index published by the World Economic Forum. For
the year 2016–2017, a total of 138 countries’ status in terms of different
infrastructure components have been ranked. The larger the number, the
poorer the strength of the infrastructure.
Table 4.2 shows that the overall rank of India stands at 39th out of 138
countries, and best in the region. India’s rail quality and institution quality
are remarkably high among the countries in the region. The ranks of
Bangladesh and Pakistan are recorded above 100th, indicating very poor in
those infrastructures despite being larger economies in the region. Sri
Lanka stands in the second position for these infrastructure indexes in
the region with the rank of top 50 in the quality of road and rail transport.
The meagre quality of ports—dry ports stand 136th rank out of 138,
despite being the main windows of trade—of Nepal indicates lots more to
improve for smooth international trade. Bhutan is not visibly different in
this case, while we do not have the data for Afghanistan.
Table 4.2 South Asia’s institution and infrastructure quality (rank 138 countries
in 2016)
Country Overall Institutions Quality of Quality Quality Quality Quality
rank overall of roads of rail of ports of air
infrastructure transport
Afghanistan NA NA NA NA NA NA NA
Bangladesh 106 125 120 113 72 89 115
Bhutan 97 95 78 80 NAP 134 104
India 39 42 51 51 23 48 63
Maldives NA NA NA NA NA NA NA
Nepal 98 100 124 118 NAP 136 131
Pakistan 122 111 93 77 53 84 91
Sri Lanka 71 57 55 43 43 60 58
Source: World Economic Forum (2016)

Note: NA refers data not available, NAP refers to not applicable
3.1 Competitiveness and Logistic Performance Index (LPI)

Table 4.3 presents an overall picture of competitiveness indicators for the
138 and 140 countries that are ranked by the World Economic Forum
(2016), for the years 2016–17 and 2015–16 respectively. These indicators
are prepared with a thorough analysis of infrastructure and other competi-
tiveness pillars, and countries are ranked indicating the smaller value has
the better competitiveness. In both periods, India stands as the best per-
former in the region, followed by Sri Lanka, which seems to lose some
ground from the previous year unlike India. The rest of the countries have
improved slightly in 2016–17 compared to that of 2015–16. The indica-
tors show Pakistan as being the least competitive in both periods. Bhutan
and Nepal also both perform poorly in these data.
Table 4.4 shows the rank of South Asian countries in the context of
doing business indicators, which is prepared by analysing various pillars of
the business. These pillars are related to the business environment that
directly impacts the business of international trade, particularly exports. As
shown in the table, all South Asian countries are ranked in 11 pillars. In
most of the cases, these countries are ranked out of top 100th position
among 190 countries, indicating these remain in the lower half of the
sample. This situation reflects, overall, the poor trade performance of
the region.
There are some positive signs in the scope of the international trade in
the region as the silver light in the dark cloud, i.e., Afghanistan stands on
42nd position in starting a business in the world while it is ranked in the
second last in protecting minority investors. Bangladesh, on the other
Table 4.3 South Asia’s overall competitiveness indicators

Country Rank (out of 138) Rank (out of 140)
2016–2017 2015–2016
Afghanistan NA NA
Bangladesh 106 107
Bhutan 97 105
India 39 55
Maldives NA NA
Nepal 98 100
Pakistan 122 126
Sri Lanka 71 68
Source: World Economic Forum (2016)

Note: NA refers to data not available, NAP refers to not applicable
80
R. C. PAUDEL
Table 4.4 Doing business indicators for South Asian countries (rank out of 190 countries), 2016
Indicators Afghanistan Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka
Ease of doing business 183 176 73 130 135 107 144 110
Starting a business 42 122 94 155 65 109 141 74
Dealing with construction permits 186 138 97 185 62 123 150 88
Getting electricity 159 187 54 26 145 131 170 86
Registering property 186 185 51 138 172 72 169 155
Getting credit 101 157 82 44 133 139 82 118
Protecting minority investors 189 70 114 13 123 63 27 42
Paying taxes 163 151 19 172 134 142 156 158
Trading across borders 175 173 26 143 147 69 172 90
Enforcing contracts 189 47 172 105 152 157 163
Resolving insolvency 159 151 169 136 135 89 85 75
Source: World Bank (2017)

hand, stands as the best performer in this pillar when compared to other
pillars in the same context. Bhutan has been able to stand in top 50 ranked
in three pillars and stands above 100th position only in two pillars. In fact,
Bhutan’s indicators seem to be the best in the region. Nepal has top 100th
rank in four pillars.
Table 4.5 presents the rank for the logistics performance index. This
index is prepared ranking 167 countries for the period of 2010–2016. In
this ranking, India stands at the top of the region, securing top 42nd posi-
tion for overall LPI rank, while Afghanistan stands the lowest (160th posi-
tion) in the region.
3.2 Policy and Regulations Context

The policy and regulation set-up explains how the region has adopted the
liberalisation and reform process, which is said to be an indispensable
lubricant for international trade in this era of globalisation. For this pur-
pose, Table 4.6 presents South Asia’s weighted average tariff rate in per-
centage for all products and each country’s graduating year into an open
country based on the Sachs and Warner index of trade liberalisation.
Sri Lanka has been the best performer as an early starter of the reform
process, while Bhutan and India have shown rapid progress in reducing
tariff rates. Bangladesh, Nepal and Pakistan seem to be making slow prog-
ress in reducing tariff rates, but their level is not high enough to restrict
the international trade significantly.
The foreign direct investment (FDI) regulation indicates how a coun-
try looks in terms of the foreign capital. Different aspects explain FDI
regulation. Table 4.7 presents some key areas in which Bangladesh permits
foreign equity, on average, up to 97 per cent, while Sri Lanka permits only
up to 74 per cent. Afghanistan has the lowest number of procedures to
start a business with foreign equity, and India seems to be the most tradi-
tional in this regard.
Further, looking at the foreign equity ownership situation in the
region, Table 4.8 presents the FDI allowed in the major business areas. In
this case, Bangladesh is the only country in the region that provides
no restrictions in all selected areas. Nepal does not permit electricity trans-
mission but permits 100 per cent in the rest of the areas in the table. India
has the most restrictions in the telecommunication and financial ser-
vices sectors.
82
R. C. PAUDEL
Table 4.5 Logistics performance index ranks (167 countries ranked) by components for 2010–2016
Country LPI Rank Customs Infrastructure International Logistics Tracking and Timeliness
shipments competence tracing
Afghanistan 160 146 163 152 156 165 154

Bangladesh 91 104 105 77 93 99 86
Bhutan 140 134 153 122 124 141 150
India 42 46 45 38 38 42 45
Maldives 100 83 85 118 98 102 130
Nepal 136 151 133 129 147 116 119
Pakistan 69 66 70 62 73 74 75
Sri Lanka 86 79 123 103 67 82 87
Source: Arvis et al. (2016)

Table 4.6 South Asia’s weighted average tariff rate (%) for all products & open
year
Country 2000 2005 2010 2015 Open year
Afghanistan NA NA NA 7.02 –
Bangladesh 18.1 22.7 10.16 11.89 1996
Bhutan NA 21.51 13.05 2.82 –
India 23.28 13.87 6.07 6.4 2001
Maldives 18.98 20.5 19.71 19.73 2001
Nepal 16.44 14.33 11.84 11.72 1991
Pakistan 22.29 12.22 10 9.53 2001
Sri Lanka 6.63 7.27 6.8 5.25 1977
South Asia 13.53 13.37 8.29 8.21 –
Source: World Bank (2016b); the last column is based on Paudel (2014) which describes the Sachs and
Warner index of trade liberalisation
Table 4.7 Indicators of FDI regulations (average)

Country Investing Starting a business with Arbitrating and mediating disputes
across sectors foreign investment
Foreign Number of Number Length of Length of

equity procedures of days arbitration recognition and
ownership proceedings enforcement
permitted % (days) proceedings (days)
Afghanistan 87 6 9 NA NA
Bangladesh 97 10 45 278 836
Bhutan NA NA NA NA NA
India 81 15 35 569 1654
Maldives NA NA NA NA NA
Nepal 80 10 84 NA NA
Pakistan 93 13 36 479 5610
Sri Lanka 74 7 47 NA NA
Source: World Bank Group (2010)

84
R. C. PAUDEL
Table 4.8 Foreign equity ownership allowed in selected areas of economy (%)
Countries Electricity Transport Telecommunications Financial Services
Transmission Distribution Freight International Fixed-line Fixed- Wireless Wireless Banking Life Health
by road air transport infrastructure line infrastructure services insurance insurance
services
Afghanistan 49 49 100 100 49 100 100 100 100 100 100

Bangladesh 100 100 100 100 100 100 100 100 100 100 100
Bhutan NA NA NA NA NA NA NA NA NA NA NA
India 100 100 100 49 74 74 74 74 74 26 26
Maldives NA NA NA NA NA NA NA NA NA NA NA
Nepal 0 100 100 100 100 100 100 100 100 100 100
Pakistan 100 100 100 49 100 100 100 100 49 100 100
Sri Lanka 0 49 40 49 100 100 100 100 100 100 100
Source: World Bank Group (2010)

4 Methodology
4.1 Econometric Analysis
The gravity model, as proposed in Tinbergen (1962), is a standard frame-
work for estimating the patterns of bilateral trade flows among the coun-
tries, and has become a work horse among the international trade
economists in recent decades. Also, this model is widely used to investi-
gate the impacts of various economic variables on trade flows, for example
by Anderson and Van Wincoop (2003), Baldwin and Taglioni (2006) and
Silva and Tenreyro (2006). Therefore, we use an augmented gravity model
specification to identify the impact of trade facilitation index (TFI) on
trade costs and trade volume.
Many previous studies have estimated the gravity equations using a
pooled ordinary least square estimation, a fixed effect estimation (FE) or
a random effect (RE) estimation. One important assumption made is that
the country-specific effects (fixed effects) are uncorrelated with all regres-
sors, although this assumption has been rejected in most empirical works.
Therefore, among these three methods, FE is the preferred one to reduce
the bias caused by this assumption. However, as a drawback of FE, we can-
not estimate the coefficients of time-invariant variables, which are the
main variables in the gravity modelling framework. In this study, the main
variables of interest, such as distance for trade costs, proximity and com-
mon language, are time-invariant. This situation leads us to limit the RE
estimation technique.
Against this background, one general question may be related to the
potential endogeniety issue caused by the possible reverse causality from
GDP to exports in the trade analysis. However, the exports in this study
are measured at the country level and the GDP is measured as a product
of the trading partners level, so there is minimal risk of reverse causality.
Thus, the endogeniety in this case is likely not powerful enough to impact
on the credibility of the results.
4.2 Model and Data

We use two models, that is, the cost model as in Eq. (4.1) and the export
trade model as in Eq. (4.2)
LCOSTi , j = α + β1 LDISTi , j + β 2 TFI i + β 3 CONTIG i , j +

(4.1)
β 4 COMLANG i , j + β 5SAARC j + ε i , j ……..
86 R. C. PAUDEL
Where α is a constant term, subscript i refers to exporter, j refers to

trading partner and L denotes the natural log. The βs are the coefficients
of individual explanatory variables. The last term, ε i , j , is the stochastic
error term and is assumed to have a normal distribution.
LEXPORTi , j = ∂ + γ 1LGDPSi , j + γ 2 LPOPSi , j + γ 3 LDISTi , j + γ 4 TFI i +

(4.2)
γ 5CONTIG i , j + γ 6COMLANG i , j + γ 7SAARC j + i , j ……..
The details of the variables with the expected signs are given in Table 4.9.
As in Eq. (4.1) the dependent variable is the cost at current value in
US$. The dependent variable for Eq. (4.2) is the exports, also measured in
US$. Mirror exports (the imports into other countries from the South
Asian countries) are used as these better capture the real situation of exports
for two reasons: first, the general assumption that imports are recorded
more accurately than the export, and second, underreporting of exports is
generally a common phenomenon in developing countries. The exports
are measured based on Standard International Trade Classification (SITC)
classification revision 3 for non-oil products.
Table 4.9 Variables and expected signs with the data source
Variables Descriptions Expected sign
COST Exports costs in US$, collected from World Bank Dependent variable
(2016a) in Eq. (4.1)
DIST Distance between business cities of exporters and (+) in Eq. (4.1) and
partners measured in kilometres in log, collected (−) in Eq. (4.2)
from the Centre d’Etudes Prospectives et
d’Informations Internationales-CEPII (2016)
TFI Trade facilitation index as developed in South Asia (−) in Eq. (4.1) and
Watch on Trade, Economics and Environment- (+) in Eq. (4.2)
SAWTEE (2018)
CONTIG Border dummy, 1 if trading partner is border, 0 (−) in Eq. (4.1) and
otherwise, collected from CEPII (2016) (+) in Eq. (4.2)
COMLANG Language dummy, 1 if have common official (−) in Eq. (4.1) and
language, 0 otherwise, collected from CEPII (2016) (+) in Eq. (4.2)
SAARC Regional dummy, 1 if the partner is in South Asian (−) in Eq. (4.1) and
region, 0 otherwise (+) in Eq. (4.2)
EXPORT Exports value measured in US$, collected from Dependent variable
World Bank (2016c) in Eq. (4.2)
GDPS Products of exporter’s and trading partner’s GDP, (+)
collected from World Bank (2016b)
POPS Products of exporter’s and trading partner’s (+)
population, collected from World Bank (2016b)
The three explanatory variables—products of the GDP of exporters

and their partners—GDPS, products of the population of the exporters
and their partners—POPS and distance—DIS to measure the distance
between the most populated cities between the exporters and importers
are the standard gravity variables and are explained widely in the literature,
and thus do not require further discussion here. The widely-used variables
in gravity models, such as, proximity—CONTIG, common language—
COMLANG are dummies. Similarly, SAARC is also a dummy variable
that represents whether the importer is also in the South Asian region.
TFI is used to identify the overall impact of trade facilitation on trade
costs and volume. We expect that the impact of TFI would be negative for
the first equation as TFI contributes to lowering the cost. On the other
hand, this impact would be positive for the second equation as it smooths
the business procedures.
The main data sources for this study are WITS-Comtrade for exports
flows, World Bank (2016c), and the World Development Indicators,
World Bank (2016b) for GDPS and POPS. The other variables such as
the data for distance, common language and border are collected from
the CEPII (2016) gravity data set. The data for trade costs are collected
from the World Bank (2016b). Finally, the data to construct TFI are the
primary data collected from the Survey as discussed in the previ-
ous chapter.
4.3 Results and Robustness Check

We estimated the costs equation at first and got the same results as in the
Eq. (4.3). The reported values in parentheses are p-value, and the coeffi-
cients are reported with the independent variables. This result suggests
that distance causes cost to increase, that is, on average, a 1 per cent
increase in the distance results in an increase in cost of 19 per cent, hold-
ing other variables constant.
The most important message, as we want to analyse the impact of the
TFI, is that a one-index point increase in TFI, on average, results in a
decline of trade costs of more than 1.30 per cent. In addition to this, bor-
der, common language and SAARC as partner have a negative impact on
trade costs, but only the border is statistically significant at a 5 per cent
level of significance. This implies that the focus of the policy makers
should be on trade facilitation, which has a larger impact on trade costs
88 R. C. PAUDEL
reduction than border. We have estimated the results by altering the

variables for robustness; the results for the estimation of the major vari-
ables, particularly TFI, remain valid.
LCOST = 4.49 + 0.19LDIST − 1.31TFI − 0.36CONTIG − 0.04COMLANG − 0.02SAARC

( 0.00∗∗∗ ) ( 0.00∗∗∗ ) ( 0.03∗∗ ) ( 0.00∗∗ ) ( 0.48 ) ( 0.82 )
(4.3)
For the robustness check of our estimation, we present the estimation

results in the form of Eq. (4.4), where we introduce a dummy for land-
locked countries and an interaction term of this dummy and TFI. The
result reveals one important message, that is, the landlocked countries in
the region (Bhutan and Nepal) with TFI get better benefits than other
countries as the interaction term is statistically highly significant, meaning
that the landlocked countries with better TFI can more substantially
reduce trade costs than other non-landlocked countries in the region.
LCOST = 1.97 + 0.21LDIST + 4.22 TFI − 0.41CONTIG − 0.11COMLANG

( 0.00∗∗∗ ) ( 0.00∗∗∗ ) ( 0.03∗∗ ) ( 0.00∗∗∗ ) ( 0.046∗∗ )
∗
+ 0.02SAARC + 1.17LLOCK − 2.96 LLOCK TFI
( 0.819 ) ( 0.00∗∗∗ ) ( 0.009∗∗∗ ) (4.4)
Table 4.10 presents the estimated results for exports volume from
South Asia in and outside the region. For the main variable of interest,
TFI, the results suggest that a one-index point increase in the TFI causes
exports to increase by about 12 per cent.
The other gravity variables, such as GDP and population of the trading
countries and distance, have significant results with their expected signs.
Most importantly, having a common official language seems more impor-
tant than the proximity (contiguity) for exports. This result is of particular
interest because the border can somewhat reduce cost, but the trade has
not been realised as explained in our database. Policy makers should think
about the infrastructure connectivity in the border areas of South Asian
countries for better trade performance in the long un within the regional
integration perspective.
The results of Column 2 suggest that the efficiency component has a
negative impact on trade, which implies that there is a lot to improve in
the efficiency areas. The information and communication component has
a positive but not statistically significant effect. The most important com-
ponent of the TFI is the quality of governance; however, transparency and
infrastructure are also statistically significant. The results for the variable
Table 4.10 Random effect estimation results, dependent variable exports-log

Variables (1) (2) (3)
Product of exporter & importers’ 0.966*** 0.910*** 0.912***

GDP (log) (0.055) (0.054) (0.051)
Product of exporter & importers’ 0.247*** 0.136** 0.208***
populations (log) (0.053) (0.064) (0.049)
Distance between business cities (log) −0.428*** −0.494*** −0.577***
(0.146) (0.140) (0.136)
Contiguity (dummy) −0.095 0.392 0.253
(0.553) (0.528) (0.510)
Common official language (dummy) 0.988*** 0.469* 0.825***
(0.267) (0.272) (0.246)
SAARC (dummy for South Asian partner) 1.595*** 1.471*** 1.383***
(0.438) (0.421) (0.405)
Trade facilitation index 11.805***
(2.206)
Transparency component 40.004***
(13.495)
Governance component 51.600***
(16.736)
Efficiency component −15.784***
(4.888)
Trade infrastructure component 20.601**
(9.690)
Information & communication component 6.317
(9.232)
Landlockedness of exporter (dummy) −2.413***
(0.203)
Observations 635 635 635
R-squared 0.690 0.710 0.720
Note: ***, ** and * indicate 1 per cent, 5 per cent and 10 per cent level of statistical significance, respec-
tively. The figures in parentheses are robust standard errors
landlockedness suggest that being a landlocked country in the region

gives a country about a 2.5 per cent trade disadvantage.
We estimate three different sets of equations to confirm our estima-
tion results for the main variable of interest remain consistent. The main
variable of interest, TFI, is statistically highly significant and has the
expected sign in all estimations, suggesting our estimation results are
robust (Table 4.11). Importantly, the results suggest that the landlocked
90 R. C. PAUDEL
Table 4.11 Random effect estimation results, dependent variable exports-log

alternate specification
(1) (2)
Product of exporter & importers’ GDP (log) 0.933*** 0.896***

(0.132) (0.051)
Product of exporter & importers’ populations (log) 0.271* 0.198***
(0.165) (0.052)
Distance between business cities (log) −0.675*** −0.829***
(0.218) (0.122)
Contiguity (dummy) 0.324 0.692
(0.380) (0.506)
Common official language (dummy) 0.990** 0.934***
(0.497) (0.254)
Trade facilitation index 11.986*** −8.058*
(4.367) (4.181)
Landlockedness of exporter (dummy) −6.328***
(2.014)
Landlockedness *TFI 10.130*
(5.342)
Observations 635 635
R-squared 0.66 0.71
Note: ***, ** and * indicate 1 per cent, 5 per cent and 10 per cent level of statistical significance, respec-
tively. The figures in parentheses are robust standard errors
countries in the region can trade about 10 per cent more than other
countries if they have better interaction with the TFI.
These findings are consistent with the studies in the context of the
South Asian region, predicting a significant upward shift in trade volume
even from modest reforms. For example, Wilson and Otsuki (2007) sug-
gest that if the South Asian countries raise their capacity halfway to East
Asia’s average, their trade will rise by an estimated $2.6 billion, approxi-
mately 60 per cent of the total intra-regional trade. Further, they suggest
that if South Asia and the rest of the world raised their levels of trade
facilitation halfway to the East Asian average, the gains for the region will
be an estimated $36 billion. Out of these gains, about 87 per cent of the
total gains for South Asia would be generated from South Asia’s own
efforts (leaving the rest of the world unchanged).
De (2011) in an econometric analysis finds that a 10 per cent fall in
transaction costs at borders has the effect of increasing a South Asian
country’s exports by about 2 per cent. The analysis also explains that
the implementation of online filing of customs documents (as a mea-
sure of trade facilitation) at the borders is a statistically significant
determinant of trade flows as well as the transit reforms to the land-
locked countries.
5 Conclusions
A brief review of the trends and patterns of South Asian exports is docu-
mented in this study. Then, trade competitiveness, logistic performance
index, infrastructure and policy context of the region are widely discussed
while analysing the South Asian trade scenario before attempting to
address the questions: Why is South Asian export performance so poor?
What should be the regional priorities to improve the trade performance
in the region? Why are the landlocked countries of the region, namely
Afghanistan, Bhutan and Nepal, peculiar in the region? Why is South
Asian intra-regional trade so poor?
To answer these questions, an econometric estimation is conducted
within the standard gravity modelling framework. First, we detect that
South Asia’s situation is not satisfactory when comparing the popula-
tion and size of the economy with the rest of the world. Second, the
situation of the landlocked countries in the region has a severe disad-
vantage due to their geographical constraints, and there needs to be
more focus on improving trade facilitation to compensate for these
constraints.
The findings show that transport costs, proxied by the distance, play a
significant negative role in regional export performance. This being said,
improving the TFI would contribute to reducing the trade costs signifi-
cantly (a one-index point increase in TFI, on average, results in a decline
in trade costs by more than 1.30 per cent) and it will help to increase the
trade volume, on average, by 12 per cent. In addition, the results suggest
that being a landlocked country in the region—namely Afghanistan,
Bhutan and Nepal—has about a 2.5 per cent trade disadvantage. These
countries can trade about 10 per cent more than other countries if they
have better interaction with the TFI. Overall, the countries in the region
need to improve their quality of governance with a special focus on trans-
parency and infrastructure.
92 R. C. PAUDEL
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CHAPTER 5
The Determinants of FDI in Landlocked

Developing Countries in Central Asia
Nomintsetseg Ulzii-Ochir
1 Introduction
Foreign direct investment (FDI) helps accelerate development and
reduce poverty through employment, transfer of technologies and busi-
ness processes, knowledge of export markets, and transfers of capital. FDI
can also play a pivotal role in providing infrastructure, such as transport,
utilities, and telecommunications, where there is insufficient local factor
endowment (UNCTAD, 2009).
The growth of FDI around the world has been significant in the past
two decades. Between 1996 and 2016, worldwide FDI inflows increased
more than six times. For instance, the total inward FDI of the world has
been estimated as $363.5 billion in 1996, but as $2.4 trillion in 2016.1
However, landlocked developing countries2 (LLDCs) perform more
1
World Bank. (2018). World Development Indicators, [Online] Available from: https://
datacatalog.worldbank.org/dataset/world-development-indicators
2
According to the United Nations Conference on Trade and Development (UNCTAD), 32
countries belong to the group of LLDCs: 16 are located in Africa, 12 in Asia, 2 in Latin
America, and 2 in Central and Eastern Europe. LLDCs face special trade and development
challenges arising from their lack of territorial access to the sea and geographical remoteness
from international markets.
N. Ulzii-Ochir (*)
Business School, National University of Mongolia, Ulaanbaatar, Mongolia
https://doi.org/10.1007/978-981-13-6814-1_5
96 N. ULZII-OCHIR
poorly as hosts for FDI than do other types of developing countries.

LLDCs’ total inward FDI flows amounted to just $35 billion between
1996 and 2006, accounting for 1.4% of total world FDI inflow. During
these years, FDI flows to developing and developed countries accounted
for 34.6% and 60% of total world FDI inflow, respectively. In 2016, the
combined stock of FDI in LLDCs was $330 billion, or less than 4% (3.7%)
of the total stock in developing economies ($8.7 trillion). These statistics
confirm that LLDCs are the weakest bloc of countries attracting sufficient
FDI flows among types of developing and developed nations.
A key factor influencing the ability of LLDCs to capitalize on future
growth opportunities in the world market is their capacity to secure significant
long-term investments. FDI has become the most important component of
development finance for LLDCs (UNCTAD, 2017. World Investment
Report). However, foreign investment is governed by a number of factors,
including a variety of institutional and regulatory arrangements that cover a
broad spectrum of issues. Based on these indicators, this study aims to identify
the determining factors that attract FDI inflows into LLDCs in Central Asia.
Indeed, there is a lack of empirical studies on the determining factors of
FDI in Central Asian LLDCs. Therefore, it is critical to evaluate FDI
determinants of Central Asian LLDCs based on previous conceptual
studies. In doing so, this study conducts empirical analyses, using the
ordinary least square (OLS) method on a panel of eight Central Asian
mineral-resource-rich LLDCs (Armenia, Azerbaijan, Kazakhstan, the
Kyrgyz Republic, Mongolia, Tajikistan, Turkmenistan, and Uzbekistan)
for the period 1996–2016.
Analyzing FDI flows to LLDCs in Central Asia is important for sev-
eral reasons. First, this study tries to shed light on the inflow of FDI to
eight Central Asian countries, which have a unique geopolitical context.3
Since FDI accelerates economic growth and development, it is impera-
tive to determine the reason behind the sluggish FDI growth in these
regions. In other words, the focus should be on both unique geographi-
cal location and shared socio-economic characteristics of countries with
mining resource endowments. Second, insufficient empirical analysis has
been carried out investigating the importance of FDI determinants in
LLDCs in Central Asia. To the best of my knowledge, the United
Nations Conference on Trade and Development (UNCTAD) has con-
ducted several studies but they do not include empirical findings of
3
A landlocked country is defined as “one that does not have open access to the sea”
(Raballand, 2003, p. 521).
THE DETERMINANTS OF FDI IN LANDLOCKED DEVELOPING COUNTRIES… 97
single-country studies such as for Kazakhstan and Uzbekistan. Third,

econometric analysis could help elucidate the key factors that can be used
by countries wishing to attract more foreign investment and can provide
proper indications for policy implications for those countries.
The rest of this chapter is organized as follows. Section 2 reviews the
existing literature related to FDI flows to Central Asian LLDs. Section 3
describes general trends and patterns of FDI into Central Asian LLDCs.
Section 4 illustrates the model specifications. Section 5 presents the
description of the variables and the data set. Section 6 discusses the empir-
ical results. Section 7 provides the conclusion and recommendations.
2 Literature Review

A number of studies have been conducted to investigate the determinants of
FDI to different regions. Recent regional studies on FDI determinants
include those of Ang (2008) and Duanmu and Guney (2009), while
Thangamani et al. (2011) analyze FDI flows to Asia, such as Malaysia, China,
and Southeast Asia; Bellak et al. (2009) focus on Central and Eastern
European countries; Deichmann et al. (2003) investigate Eurasian transition
́
economies; and Botric and Skuflic (2006) explore the case of Southeast
European countries. Moreover, Ramirez (2006) and Montero (2008) evalu-
ate FDI flows to Latin America; and Morisset (2000), Asiedu (2002, 2006),
Fedderke and Romm (2006), Lemi and Asefa (2003), and Rjoub et al.
(2017) examine FDI flows to Africa, including Sub-Saharan Africa and South
Africa. Mottaleb and Kaliappa (2010) investigate the factors of FDI in devel-
oping countries. Most of these empirical analyses on the determinants of FDI
employ panel data analysis to identify country characteristics that attract or
deter FDI, such as market size, labor cost, and political instability.
Nevertheless, it should be noted that there has been hardly any research
of an empirical nature addressing FDI flows to mineral-resource-rich LLDCs
in Central Asia. Previous studies on the determinants of FDI into LLDCs in
Central Asia lack empirical analysis and have not closely investigated the fac-
tors affecting FDI in Central Asian LLDCs or on some single countries only.
For instance, Lee et al. (2015) study the relationship between FDI and
economic growth in Kazakhstan. Recently, Metaxas and Kechagia (2016)
studied the impact of FDI in Uzbekistan. While research in this broad area
has been quite extensive, most studies are generally based on conceptual
issues. UNCTAD (2003, 2009) has undertaken several works that cover
98 N. ULZII-OCHIR
FDI in LLDCs. These studies aim to describe recent trends in FDI to

LLDCs, and the changes that have taken place in relevant areas of the regu-
latory legal framework, but have not obtained empirical findings.
Table 5.1 represents the effects of some variables that have been broadly
used in the previous literature. Most empirical studies on the determinants
of FDI have investigated a number of variables, such as gross domestic
product (GDP) per capita, trade openness, labor cost, quality of infra-
structure, political stability, and domestic macro policies, as noted earlier.
Surprisingly, studies that identify the availability of natural resources as
significant are rare. This may be because few of the studies focus explicitly
on FDI in natural resources, or because there are few or no cross-country
indicators that measure the availability of natural resources as a whole. To
date, Nomintsetseg and Sohn (2011) have contributed to the existing litera-
ture on FDI determinants by newly investigating 40 countries with natural
resources. The variable is designed to test whether countries richer in min-
eral or metal resources attract more investment and is measured by the total
export product divided by GDP. Nomintsetseg and Sohn (2011) find a sig-
nificant negative effect on FDI and mineral resources. Thereafter, Rjoub
et al. (2017) empirically test the natural resource endowments of LLDCs in
Sub-Saharan Africa on FDI flows and find a negative relationship with FDI.
Noticeably, the results in the literature are ambiguous in defining the
relationship between FDI and other explanatory variables. The purpose of
the present research is not to establish which results are inconclusive.
Rather, it seeks to evaluate the extent to which the variables are included
in the existing works and to analyze the impact on FDI to LLDCs in
Central Asia.
3 FDI in Central Asian LLDCs: Stylized Facts

Along with deepening international economic and financial integration,
attracting FDI inflows is a significant factor influencing capital flows to
LLDCs in Central Asia. In addition, FDI inflows intensely affect a host
country’s economic growth, macroeconomic stability, infrastructure, and
government policy. According to the UNCTAD, FDI to LLDCs stabilized
in 2016 but remains insignificant. In 2016, total FDI flows to selected
countries in Central Asia were estimated at $15.3 billion compared to
$18.7 billion in 2014. FDI inflows to selected countries peaked in 2011 at
about $26.6 billion (see Fig. 5.1).
Table 5.1 Effect of selected variables on FDI

Determinants of FDI Positive Negative Insignificant
Real GDP per capita Schneider and Frey Edwards (1990) Loree and Guisinger
(1985) Jaspersen et al. (1995)
Tsai (1994) (2000) Wei (2000)
Lipsey (1999) Hausmann and
Rjoub et al. (2017) Fernandez-Arias (2000)
Asiedu (2002)
Infrastructure quality Wheeler and Mody Asiedu (2002)
(1992)
Kumar (1994)
Loree and
Guisinger (1995)
Trade openness Edwards (1990)
Gastanaga et al.
(1998)
Hausmann and
Fernandez-Arias
(2000)
Asiedu (2002)
Rjoub et al. (2017)
Corporate tax rates/ Loree and Guisinger Wheeler and Mody
profits (1995) (1992)
Otto (1998) Lipsey (1999)
Gastanaga et al. Saidu (2007)
(1998)
Wei (2000)
Penney et al. (2007)
Rjoub et al. (2017)
Import tariff rates Loree and Guisinger Wheeler and Mody
(1995) (1992)
Otto (1998) Lipsey (1999)
Gastanaga et al. Saidu (2007)
(1998)
Wei (2000)
Penney et al. (2007)
Quality of Lucas (1990) Schneider and Frey Loree and Guisinger
governance (political (1985) (1995)
instability, etc.) Edwards (1990) Jaspersen et al. (2000)
Asiedu (2002) Hausmann and
Rjoub et al. (2017) Fernandez-Arias (2000)
Natural resource Rjoub et al. (2017) Nomintsetseg and
Sohn (2011)
Note: Author’s compilation

100 N. ULZII-OCHIR
30000
25000
20000
15000
10000
5000
Fig. 5.1 FDI inflows to eight Central Asian LLDCs (millions of dollars),
1996–2016. (Source: Author’s compilation. UNCTAD (2018). FDI database.
[Online] Available from: http://unctadstat.unctad.org/wds/ReportFolders/
reportFolders.aspx)
The total share of FDI flows to selected Central Asian LLDCs accounted
for less than 1% (0.8%) of world inflows in 2016 (see Table 5.2). FDI to
LLDCs in Central Asia continue to focus on natural resources, with invest-
ment shifting toward such economic activities as infrastructure and manu-
facturing, helping to mitigate these countries’ geographical disadvantage
(UNCTAD, 2017. World Investment Report). Many of these Central Asian
LLDCs are trying to improve their investment climate significantly, but
there are still obstacles to attracting more investment. For instance, the
Global Foreign Direct Investment Country Attractiveness Index shows
that Kazakhstan ranked 55th and Azerbaijan 64th out of 109 countries in
2017.4 Undoubtedly, such rankings indicate that these countries further
need to consider improving their attraction of inward FDI.
The dynamics of overall FDI inflows diverged across selected host
economies (Fig. 5.1). FDI grew in transition economies, especially
Kazakhstan, where it more than doubled to $9 billion on the back of proj-
ects in oil and gas as well as mining during 2008. In addition, Azerbaijan
and Turkmenistan are the top FDI recipient countries. For instance, FDI
inflows to Azerbaijan grew by 11% to $4.5 billion. In Turkmenistan, the
flow of FDI grew marginally to $4.5 billion. Most of the FDI inflows
4
GFICA Index—A Global Foreign Direct Investment Country Attractiveness Index.
[Online] Available from: http://www.fdiattractiveness.com/ranking-2017/
Table 5.2 FDI inflows to eight Central Asian LLDCs, to other country groupings
Country FDI inflows ($ Percentage of total FDI stock as FDI inflows as a FDI inflows Annual average Annual average
groupings million, 2016) world (%, 2016) a % of GDP share of gross fixed per capita of FDI inflows growth rate of
(2016) capital formation (2016, $) ($ million, FDI inflows (%,
(%, 2015) 1996–2016) 1996–2016)
World 1,746,423 100.0 35.1 9.6 236 1,222,220 7.5

Developed 1,032,373 55.4 38.2 11.8 984 729,064 7.4
economies
Developing 646,030 42.4 30.2 8.2 107 447,582 7.4
economies
LDCs 37,944 2.4 33.4 17.9 39 24,052 13.9
LLDCs 24,326 1.4 49.4 12.8 50 17,541 9.8
LLDCs (CA-8) 15,325 0.8 67.9 18.3 85 11,851 11.2
Source: Author’s compilation. UNCTAD (2018), FDI database. [Online] Available from: http://unctadstat.unctad.org/wds/ReportFolders/reportFolders.aspx
THE DETERMINANTS OF FDI IN LANDLOCKED DEVELOPING COUNTRIES…
101
102 N. ULZII-OCHIR
c ontinue to focus on natural gas-related activities, such as the expansion of

the Galkynysh gas field (UNCTAD, 2017. World Investment Report). FDI
rebounded in Armenia, reaching $338 million. However, the performance
is still low in comparison that in with 2008.
Among the selected eight countries, Mongolia recorded negative (−$4
billion) FDI owing to various factors, including policy and judiciary uncer-
tainty, low commodity prices, and profit taking from mature projects
(UNCTAD, 2017. World Investment Report). FDI flows to Kyrgyzstan,
Tajikistan, and Uzbekistan have remained inconsistent since mid-2008
owing to their economic liberalization and high levels of corruption.
Furthermore, the unstable political and financial conditions in Uzbekistan
reduced its attractiveness to Western investors (Metaxas and Kechagia,
2016). Uzbekistan, along with Tajikistan and the Kyrgyz Republic, ranks
last in terms of FDI stock and predicted FDI inflow (Kenisarin and
Andrew-Speed, 2008) (Fig. 5.2).
In these countries, however, FDI inflows continue to be the most
important source of GDP growth, gross capital formation and technology,
and new innovation. Furthermore, knowledge and management skills
through investment are recognized as major sources of economic develop-
ment for these countries.
4 Model Specification

This section derives the econometric model specifications. The economet-
ric model utilized in this research is the standard gravity model. To date,
the gravity model not only has been utilized in international trade but
also has been applied to determinants of FDI across countries and regions.
The traditional gravity model using cross-sectional data has been improved
in the framework of panel estimations.
In order to examine the determinants of FDI for mineral-resource-rich
LLDCs in Central Asia, the present study employs panel data analysis,
which is considered a powerful research technique that can be used to
measure the effect of any variables of interest over a period of time (time-
series) and across countries (cross-sectional panel).
The data set of this research consists of observations from a sample of
eight Central Asian LLDCs out of a total of 32 LLDCs based on the
unique characteristics of those countries, such as mineral resource abun-
dance and geographical destination. Panel data for a 20-year period
(1996–2016) are constructed. There is some rationale for concentrating
on the period between 1996 and 2016. The first is that the mid-1990s
0
500
1000
1500
2000
2500
3000
3500
4000
4500
5000
-5000
-4000
-3000
-2000
-1000
0
1000
2000
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4000
5000
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0
2000
4000
6000
8000
10000
12000
14000
16000
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1000
1996 1996 1996 1996
1997 1997 1997 1997
1998 1998 1998 1998
1999 1999 1999 1999
2000 2000 2000 2000
2001 2001 2001 2001
2002 2002 2002 2002
2003 2003 2003 2003
2004 2004 2004 2004
2005 2005 2005 2005
2006 2006 2006 2006
2007 2007
Armenia
2007
Mongolia
2007
Kazakhstan
2008 2008 2008 2008
Turkmenistan
2009 2009 2009 2009
2010 2010 2010 2010
(Note: Author’s compilation)

2011 2011 2011 2011
2012 2012 2012 2012
2013 2013 2013 2013
2014 2014 2014 2014
2015 2015 2015 2015
2016 2016 2016 2016
0
100
200
300
400
500
600
700
800
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0
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0
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-2000
0
2000
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1996 1996 1996

1997 1996
1997 1997 1997
1998 1998 1998
1999 1998
1999 1999 1999
2000 2000
2001 2000 2000
2001 2001 2001
2002 2002 2002
2003 2002
2003 2003 2003
2004 2004 2004
2005 2004
2005 2005 2005
2006 2006 2006
2007 2006
Uzbekistan
2007 Tajikistan 2007
2008 2007
Azerbaijan
2008 2008
2009 2009 2008 2009
2010 2010 2009 2010
2011 2011 2010 2011
2011
The Kyrgyz Republic
2012 2012 2012

2013 2013 2012 2013

2014 2014 2013 2014
2015 2015 2014 2015
2016 2016 2015 2016
Fig. 5.2 FDI flow of the eight selected Central Asian LLDCs ($ millions).
103
104 N. ULZII-OCHIR
ushered in a period of unprecedented exploration of the world’s mineral

resources; a number of mining corporations have unprecedented access to
a larger portion of the earth’s surface than before. The second reason is
related to the collapse of the socialist system in the world, which led to
increased foreign capital flows to those new transition economies at that
time. The third reason is that foreign investment flow data are available
until 2016 in the UNCTAD’s statistical database for all countries.
This research employs OLS estimation. A number of similar studies
utilize OLS in their analysis to predict the relationship between the inflow
of FDI and other dependent variables (e.g., Asiedu, 2002, 2006).
The dependent variable, FDI, is the fundamental estimation in this
analysis. It is expressed in log form, as Eq. (5.1) below shows.
ln ( FDI )it = β 0 + β1 ln ( GDP )it + β 2 OPEN it + β 3 INFRA it

+ β 4 TARIFFit + β 5 CTAX it + β 6 POLINSTABit
+ β 7 CORR it + β8 GOVEFFit + β 9 REGQUAL it
+ β10 BUSFR it + β11 INFL it + uit (5.1)
where FDI is the dependent variable and denotes the aggregate flow of
FDI. GDP is expressed as GDP per capita and it shows market size, INFRA
is the quality of infrastructure, TARIFF is the tariff rate, CTAX is the cor-
porate tax rate, POLINSTAB is political instability, CORR represents the
level of corruption, GOVEFF denotes government effectiveness,
REGQUAL is the regulatory quality, BUSFR is business freedom, and
INFL is the inflation rate. i and t denote country or cross section and time,
respectively. uit denotes an error term.
5 Description of Variables and Data

The determinants of FDI identified as significant vary depending on the
country, sector, year, and type of investment studies.5 Many studies have
been unable to meet the econometric identification challenge. However,
Hornberger et al. (2011) presents interesting results. The authors col-
lected a set of 30 empirical studies focusing on developing and transition
economies, and that have been conducted since 2000. The studies differ
5
There are four different types of FDI (UNCTAD, 2005): natural resource-seeking FDI,
market-seeking FDI, efficiency-seeking FDI, and strategic-asset FDI.
in geographic coverage; some focus on transition economies in Eastern

Europe and Asia, some on Africa or Latin America only, and some on
single countries. Regardless of geographic focus, a majority of the studies
reveal that the size and growth potential of markets is significantly associ-
ated with FDI inflows. In addition to market size, institutional and regula-
tory quality, trade openness, infrastructure quality, labor quality and costs,
cultural links, and natural resource endowments are found as major deter-
minants of FDI in those countries.
Asiedu (2002) considers differentiating two types of FDI in determining
the factors that affect FDI. One is market-seeking FDI and the other is non-
market-seeking FDI. The focal point of market-seeking FDI is to serve
domestic markets. As a result of this type of FDI, goods are produced in the
host market and sold in the local market. For non-market-seeking FDI,
goods are produced in the host country but sold abroad. Non-market-seeking
FDI comprises natural-resource-based investments and other export-oriented
investments, such as parts and components of automobiles. Therefore, it can
be said that demand-side factors of the host country are less relevant.
As stated earlier, the countries included in the sample are mineral-
resource-abundant Central Asian countries and FDI to these countries is
mainly concentrated in mining resources. This shows that FDI to the coun-
tries in the sample is less likely to be market seeking. Therefore, the selection
of explanatory variables is mostly related to non-market-seeking FDI and all
independent variables have been utilized in the previous literature.
Therefore, the choices of explanatory variables in the study are based on a
number of previous conceptual and empirical studies in the literature and are
defined in Table 5.3. As noted earlier, the eight selected Central Asian LLDCs
in the study are mineral-resource-rich countries and flow of FDI is mostly in
their mining sector. In general, more than 60 factors may affect a mining
firm’s decision to invest in one country over another. The best compiled and
most advanced research on the determinants of foreign investment in this sec-
tor was conducted by Otto (1998) and Otto et al. (2007). Otto divides the
investment criteria into nine principal categories, as shown Table 5.3, which
also includes additional criteria identified by Morisset (2000), Kasatuka and
Minnit (2006), Penney et al. (2007), and Tole and Koop (2011).
As employed in the existing literature, the dependent variable is net
FDI expressed in millions of US dollars at current prices. Some authors
choose the ratio of net FDI flows to GDP because of data availability, par-
ticularly for Sub-Saharan African countries. In my case, FDI data for
Central Asian LLDCs are available in most cases.
106 N. ULZII-OCHIR
Table 5.3 FDI criteria (mining sector)

Category Specific criteria
1. Geological Geological potential for target minerals

Ability to apply geological assessment techniques
Quality of mineral titles system (cadastre)
2. Political Consistent and constant mineral policy
High level of transparency
Low level of corruption
Adoption of international agreements related to mining
National security and political stability
Internal and external conflicts
3. Investment promotion Trade liberalization
Privatization program
Image-building effort to attract investment
Import–export policies
Existence of prior priority projects
4. Regulatory Stability of exploration/mining terms (security of tenure)
Modern mineral legislation
Efficient regulatory institutions/administrative procedures
5. Fiscal Ability to predetermine tax liability (predictability)
Stability of the fiscal regime
Method and level of tax levies
6. Financial Realistic foreign exchange regulations
Ability to raise external financing
Permitted external accounts
7. Environmental and social Ability to predetermine environment-related obligations
Stringent environmental regulations
Ability to gain the support of local stakeholders
8. Operational Majority management control held by investors
Right to transfer ownership
Quality of infrastructure
9. Profit Projected measures of profitability
Note: Author’s compilation based on previous works by the authors
5.1 Description of Explanatory Variables
DP Per Capita
G
In general, FDI tends to flow into countries that pay higher return on capital.
However, constructing an appropriate measure for the return on investment
is problematic, especially for developing countries. The reason is that most of
those countries do not have well-functioning capital markets (Asiedu, 2002).
Many scholars (Schneider and Frey, 1985; Tsai, 1994; Loree and Guisinger,
1995; Lipsey, 1999; Hausmann and Fernandez-Arias, 2000; Wei, 2000;
Asiedu, 2002; Rjoub et al., 2017) employ GDP or GDP per capita instead of
return on capital by assuming that capital-scarce countries tend to be poor. By
and large, GDP is defined as the value of all markets and is the most compre-
hensive method of estimating a country’s economic output. Therefore, this
study uses GDP per capita as proxy for return on capital and captures better
prospects for FDI in the mineral-resource-abundant Central Asian LLDCs.
In the previous literature, the relationship between FDI and GDP per
capita showed ambiguous findings. Some scholars, for example, Schneider
and Frey (1985), Tsai (1994), Lipsey (1999), and Rjoub et al. (2017),
find that higher GDP leads to greater investment flows, while other schol-
ars, such as Loree and Guisinger (1995), Wei (2000), Hausmann and
Fernandez-Arias (2000), and Asiedu (2002), find negative and insignifi-
cant results.
Infrastructure Quality/Development
Well-developed infrastructure increases the productivity of investments
and therefore, accelerates FDI inflows. Following the previous empirical
studies, the number of telephones per 100 people is used to measure of
quality of infrastructure. A good measure of infrastructure develop-
ment should consider both the availability and reliability of infrastruc-
ture (Asiedu, 2002, 2006). Generally, most multinationals tend to be
attracted to countries that have good road and rail infrastructure.
Unfortunately, there are no definitive global statistics available on road
and train networks for the period in this study. This necessitates the use
of fixed telephone subscriptions per 100 people as a proxy of host infra-
structure quality. It may be noted that originally, Tole and Koop (2011)
use data pertaining to the percentage of a country’s population subscrib-
ing to telephone services. The authors derive the variable from Estache
and Goicoechea (2005).
Trade Openness
The openness to trade variable is often utilized to examine the significance
of an economy’s trade liberalization/openness on investment. This variable
is estimated as the sum of exports and imports divided by real GDP, and is
expressed in terms of constant price. The trade openness variable is used to
explore how trade openness can affect the decision-making process of mul-
tinational corporations (Tole and Koop, 2011). This ratio is also often inter-
preted as a measure of trade restrictions. Investors in mining sectors are
attracted to countries with more liberalized trade.
108 N. ULZII-OCHIR
orporate Tax Rates

C
Many researchers reveal that a higher corporate tax rate can reduce the
profit margin of investing corporations and discourage investment flows.
The investment inflows to the eight Central Asian countries in the sample
are mostly in the mining sector. Profits on foreign investments could be
directly reduced owing to the amount of tax imposed by the government.
Therefore, mining corporations pay careful attention to fiscal systems.
Otto (1998) clarifies that mining corporations are not in the business of
mineral production per se; rather they are solely driven by the need to
make profits. Similarly, Penney et al. (2007) highlight the fact that mining
exploration is a high-cost activity, and the profitability of a project can be
significantly influenced by a government’s fiscal regime. Saidu (2007) esti-
mates the tax burden and tax climate on mining operations in Nigeria and
Indonesia. Surprisingly, he finds that an attractive tax regime does not
necessarily have a significant effect in sustaining or attracting FDI in min-
ing. However, tax incentives work well toward increasing the level of
investment.
Inflation Rate
The rate of inflation is one of the critical determinants in affecting foreign
investment inflow. Many authors believe that a high rate of inflation indi-
cates an unstable economic situation and inefficient government policies,
especially monetary and fiscal policies (Macpherson, 2013). A high infla-
tion rate tends to lead to distortions in economic activities, which in turn
reduce the inflow of capital. A high inflation rate also leads to increased
costs and lower profits for foreign investors owing to higher prices.
However, a low and stable inflation rate is a predictor of overall economic
stability. A lower rate of inflation accelerates investments and reduces
uncertainty for businesses.
Indeed, several studies in the literature on the impact of inflation rate
on FDI and economic development reveal mixed and controversial results.
One study is by Omankhanlen (2011), who examine the impact of infla-
tion on FDI in Nigeria. The results show that inflation might not have a
negative effect on FDI, provided that it does not exceed a certain thresh-
old. The study recommends that the government should ensure that infla-
tion does not exceed the current threshold of inflation rate so that it would
not negatively influence FDI inflows in to the country (Omankhanlen,
2011; Khamis et al., 2015).
Quality of Governance
The host country’s quality of governance, such as regulatory quality, polit-
ical instability, government effectiveness, and corruption level, are critical
factors in attracting FDI flows. This is especially relevant for investments
in Central Asian mineral-resource-rich countries. In order to measure gov-
ernance quality, Kaufmann, Kraay, and Zoido-Lobatόn (KKZL) indexes
provide the most useful aggregate scale. KKZL units range from −2.5 to
2.5, with higher values corresponding to better outcomes. However, no
observations are reported for the years 1997, 1999, and 2001, which
necessitates the use of the average mean for the purposes of the study. The
existing empirical literature shows ambiguous results on the relationship
between political instability and FDI flows. For example, Hausmann and
Fernandez-Arias (2000) and Jaspersen et al. (2000) find no evidence of a
relationship between FDI and political stability, while Schneider and Frey
(1985) find negative results. Loree and Guisinger (1995) find a negative
effect in 1982 but no impact in 1977. Using Barro and Lee’s (1993) mea-
sure of political instability, Asiedu (2002) finds a negative impact on
FDI. Gani (2007) finds strong confirmation that the rule of law, control
of corruption, regulatory quality, government effectiveness, and political
stability are positively correlated with FDI.
I mport Tariff Rate

The selected eight economies are mostly recipients of FDI from mining
investing corporations. Mining corporations are likely to invest in coun-
tries imposing lower tariffs owing to lower cost of their imported premises
and facilities, such as drills, cranes, and other gear for mining operations.
Therefore, the tariff rate could be negatively related to countries’ higher
tariffs. Previous empirical literature shows inconsistent results on the effect
of import tariffs on FDI. For instance, Loree and Guisinger (1995),
Gastanaga et al. (1998), and Wei (2000) find a negative relationship, while
Wheeler and Mody (1992) and Lipsey (1999) reveal an insignificant effect.
Business Freedom
Business freedom is an overall indicator of the efficiency of government
regulation of business, and is one of the economic freedom indexes. In
this study, a business freedom index is employed in order to consider how
foreign investors make decisions depends on the speed and ease with which
they start, operate, and close their businesses in a new market. The index
shows that burdensome, redundant rules are the most harmful barriers to
110 N. ULZII-OCHIR
enterprises. Therefore, it is expected that firms are likely to invest in coun-

tries where it is easier to access and quit the market. The business freedom
score for each country is a number between 0 and 100, with 100 equaling
the freest business environment.6 The score is based on ten factors,7 all
weighted equally, using data from the World Bank’s “Doing Business” study.
5.2 Data Description
In order to evaluate the investment factors in selected countries, it is better
to utilize the data on FDI inflows in the mining sector as an independent
variable. However, there is a lack of data on FDI inflows in the mining sector
for those countries. These limitations exist in terms of availability, quality,
and quantity. In other words, there is no detailed and comprehensive inter-
national data source in the mining sector. Some of the data are available only
in an individual country’s native language and are held by national banks,
investment promotion agencies, as well as the National Statistical Offices of
individual countries. In addition, it is impossible to obtain yearly data.
Therefore, FDI data are taken from the UNCTAD’s FDI, database assum-
ing that FDI flows are mostly in the mining sector for the sample countries.
The data for the explanatory variables are obtained from various sources,
such as Penn World Tables, World Development Indicators, World Governance
Indicators (KKZL indexes),8 The Heritage Foundation, KPMG’s Corporate
and Indirect Tax Rate Survey, and the International Monetary Fund.
Summary statistics of the variables and data are reported in Table 5.4.
6
Business freedom index, [Online] Available from: https://www.heritage.org/index/
business-freedom
7
The factors are starting a business (procedures, time, cost, minimum capital), obtaining a
business (procedures, time, cost), and closing a business (time, cost, recovery rate).
8
KKZL indexes describe various aspects of the political and governance structures of a
broad cross-section of countries, including measures of political instability, rule of law, graft,
regulatory burden, voice and political freedom, and government effectiveness. Using an
unobserved components model, the KKZL indexes have been estimated by employing 31
different qualitative indicators from 13 different sources, including BERI, DRI/McGraw
Hill, the Heritage Foundation, the World Bank, the World Economic Forum, and the
Economist Intelligence Unit. Thus, they are in a sense meta-indexes, encompassing many of
the various measures used in previous studies. Aggregate indicators drawn from a variety of
sources should provide more precise measures of governance than individual indicators do.
A further advantage is that these measures are available for an unusually large sample of
countries (between 145 and 158). Thus, I contend that the KKZL indexes are superior to
other indexes used in empirical studies thus far.
Table 5.4 Explanatory variables and data sources (eight countries)
Variables Description Data sources
1. GDP Log of GDP per capita World Bank, (2018) World Development Indicators
2. Tariff rate Applied, simple mean World Bank, (2018) World Development Indicators
3. Trade openness Degree of trade openness total trade volume Penn World Tables—Version 7.0
divided by real GDP per capita (constant price)
4. Corporate tax rate Corporate tax rate KPMG’s Corporate and Indirect Tax Rate Survey
5. Quality of infrastructure Fixed telephone subscriptions (per 100 people)a World Bank, (2018) World Development Indicators
6. Regulatory quality Units ranging from −2.5 to 2.5, with higher World Governance Indicators
values corresponding to better outcomes
7. Political instability Units ranging from −2.5 to 2.5, with higher World Governance Indicators
8. Corruption levelb Units ranging from −2.5 to 2.5, with higher World Governance Indicators
9. Government effectiveness Units ranging from −2.5 to 2.5, with higher World Governance Indicators
10. Inflation rate Inflation, average consumer prices, Index International Monetary Fund, World Economic
Outlook database
11. Business freedom Business freedom index. Economic Freedom Index of the Heritage
Units ranging from 0 to 100, where 100 Foundation
represents the maximum freedom
Notes
a
Fixed telephone subscriptions refer to the sum of the active number of analogue fixed telephone lines, voice-over-IP (VoIP) subscriptions, fixed wireless local
loop (WLL) subscriptions, ISDN voice-channel equivalents, and fixed public payphones
b
There is another official source, Transparency International (TI), which estimates the Corruption Perception Index. However, while TI published its first report
in 1995, the years before 1998 were not analyzed, because the country samples for these years were limited. In particular, TI excludes a number of mineral-
exporting countries that are known to display relatively high levels of corruption. Therefore, the KKZL indexes are employed for the purposes of this study
111
112 N. ULZII-OCHIR
6 Empirical Results

There are five different sets of results reported in Table 5.5. The overall
estimates of parameters for the determinants of FDI in selected countries
seem to be relatively good, with values (e.g., adjusted R-squared) ranging
between 0.5825 and 0.6501. Both R-squared and adjusted R-squared
become higher when other explanatory variables are added step by step in
the model. Like other studies, this study employs OLS for all estimations.
The analysis begins with determinant variables that are a benchmark for
the model. The results are reported in Table 5.5. The estimated coefficient
for the GDP per capita (proxy for return on investment) result is consis-
tent with the previous theoretical predictions about FDI. The coefficient
is positive and statistically significant at the 1% level for all models, indicat-
ing that foreign investors are likely to invest if strong economic conditions
exist in the host economy.
The result also shows that FDI inflow increases with a high degree of
openness to international trade and quality/development of infrastructure.
As noted in the description of explanatory variables Sect. 5.1, the degree of
trade openness also plays a large role in the increased amount of investment.
The estimated coefficients of trade openness are found to be significantly
strong and positive. In the literature discussing FDI, openness to trade is a
potential factor that attracts FDI to an economy. Tole and Koop (2011)
indicate that investors in gold mining are attracted to countries with more
open trade. The variable fixed telephone subscriptions per 100 people, as a
proxy of the host country’s infrastructure quality, is found to be statistically
significant and with a positive sign for almost all estimations. This result sug-
gests that owning a telephone (representing quality of infrastructure) is one
of the pivotal decisive factors for firms considering investments in a host
country. The results are consistent with previous studies.
Next, the import tariff rate is included in the estimation. Recall that
investments in mineral-resource-rich countries are sensitive to import tar-
iffs owing to the need for mining equipment, machines, and other tools
that differ from those in other sectors. Therefore, it should be clarified
whether or not imports of mining equipment are exempt from tariffs/
duties. In the analysis, the estimated coefficient for tariff rates is consis-
tently negative but not statistically significant, which shows that FDI is
somehow negatively affected by a higher tariff rate in the recipient coun-
tries. In practice, investors pay serious attention to tariff rates when they
attempt to install their own equipment and tools in a host country.
Table 5.5 OLS estimation

Dependent variable: log of FDI flow
Variable name (1) (2) (3) (4) (5)
GDP per capita 1.000*** 1.160*** 1.065*** 1.026*** 0.883***

(0.097) (0.119) (0.128) (0.133) (0.146)
Trade openness 1.609*** 0.907** 0.876** 1.091** 1.586***
(0.377) (0.416) (0.428) (0.441) (0.493)
Quality of infrastructure 1.235*** 0.701*** 0.731*** 0.458 0.613**
(0.196) (0.237) (0.235) (0.281) (0.289)
Tariff rate −0.433 −0.340 −0.208 −0.031
(0.286) (0.290) (0.290) (0.299)
Corporate tax rate 0.939*** 0.751*** 0.993*** 0.981***
(0.241) (0.274) (0.294) (0.292)
Political instability 0.332** 0.302* 0.473***
(0.164) (0.168) (0.182)
Level of corruption −0.443 −1.291*** −1.321***
(0.288) (0.454) (0.449)
Government effectiveness 1.326** 1.125*
(0.572) (0.579)
Regulatory quality −0.244 −0.058
(0.281) (0.348)
Business freedom 0.052
(0.470)
Inflation rate 0.276**
(0.123)
R-squared 0.5902 0.6380 0.6481 0.6628 0.6743
Adjusted R-squared 0.5825 0.6262 0.6319 0.6425 0.6501
Number of observations 164 160 160 160 160
Note: P-values are in parentheses

*** Significant at the 0.01 level
** Significant at the 0.05 level
* Significant at the 0.10 level
Corporate tax is another important factor that is utilized to capture the

extent of investments, especially for mineral-resource-rich countries.
The mining sector is usually subject to a range of taxation instruments,
including indirect taxes, direct taxes, and quasi-taxes (Mélanie et al.,
2005). Among these, corporate tax rates can be considered one of the
most substantial tools supporting mining investment projects. In other
words, effective tax rates have a large impact on particular investment
decisions. Surprisingly, the corporate tax rate estimated coefficients show
114 N. ULZII-OCHIR
positive and statistically significant results for all models. These results are
inconsistent with other scholars’ findings. A possible explanation for this is
linked to the fact that average corporate tax rates among selected LLDCs
in Central Asia tend to be less than those in other regions. From the
KPMG report, it can be observed that LLDCs’ average corporate tax rate
in recent years is not as high as the global and other regional averages
(Table 5.6). Thus, the results show that effective or lower tax rates tend to
be attractive to countries.
Using the specification in Column 2 in Table 5.5 as my benchmark
model, I test for robustness by including measures of governance quality
and economic variables (political instability, level of corruption, government
effectiveness, regulatory quality, business freedom, and inflation rate).
Initially, a strongly significant and negative relationship is expected for
the variable political instability. A stable political environment reduces the
risk to companies of regulations changing without warning, and of licenses
being revoked. A stable political environment also increases security of
tenure and investors’ confidence in an economy. Furthermore, companies
are concerned with the safety and security of their employees, equipment,
and tenements. Where violence is endemic, companies need to increase
their spending on security measures for land holdings, mining equipment,
and staff, which in turn increases operating costs.
Unusually, the estimated coefficient for political instability is found to
be positive and statistically significant in this analysis. This means that
more politically unstable and unsafe countries can attract larger invest-
ments in selected economies. The possible explanation matches the argu-
ment of Lucas (1990) and Kim (2010), who find that politically unstable
countries attract capital flows from developed countries with high political
stability. In addition, these authors find that FDI inward performance
could be positively correlated with the corruption level of governments
and negatively correlated with the level of democracy.
As expected, the level of corruption is found to be strongly significant
and negatively associated with inward FDI in resource-rich countries. Like
political instability, the corruption level could be a significant factor in
attracting FDI. For instance, La Porta et al. (1999) reveal that a country
with a higher level of government corruption and lower political rights has
higher FDI inward performance.
Regulatory quality and business freedom are not as sensitive to FDI in
the estimated model. The reason is that, in general, mining sector investors
favor policies that are outcome based rather than process based, because the
Table 5.6 Regional corporate tax rate survey comparison (2006–2018)
Average (location) 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Africa 30.73 30.52 28.75 28.83 28.49 28.64 29.07 28.37 27.85 28.17 28.06 28.21 28.26
Americas 29.97 29.27 28.84 28.82 28.28 29.31 28.67 28.35 27.77 27.61 27.81 28.29 27.89
Asia 28.99 28.34 26.24 25.37 23.72 22.91 22.72 22.13 22.00 21.98 21.41 21.04 21.21
EU 24.83 23.97 23.17 23.11 22.93 22.70 22.51 22.75 22.39 22.15 22.09 21.33 21.29
Europe 23.70 22.99 21.95 21.64 21.46 20.83 20.44 20.60 20.42 20.05 19.97 19.53 19.48
Global 27.55 26.96 25.66 25.32 24.65 24.52 24.38 24.15 23.85 23.74 23.58 24.04 24.00
L. America 29.07 28.30 27.96 27.96 27.52 28.88 28.30 27.96 27.31 27.16 27.38 27.98 27.95
N. America 38.05 38.05 36.75 36.50 35.50 34.00 33.00 33.00 33.25 33.25 33.25 33.25 26.75
Oceania 30.60 30.20 29.60 29.20 29.00 28.60 28.60 27.00 27.00 27.00 27.00 28.43 28.43
OECD 27.67 27.00 25.99 25.64 25.70 25.42 25.18 25.32 24.98 24.77 24.69 23.95 23.50
S. America 29.07 28.30 27.96 27.96 27.52 28.88 28.30 27.96 27.31 27.16 27.38 27.98 27.95
LLDCs-8 18.81 18.81 18.81 18.43 18.43 18.43 18.43 18.43 18.43 18.43 18.43 18.43 18.43
Source: Author’s compilation from KPMG’s Corporate and Indirect Tax Rate Survey. [Online] Available from: https://home.kpmg.com/xx/en/home.html
115
116 N. ULZII-OCHIR
former help investors to find the least expensive way of achieving a specific
outcome and reward innovative companies. High-quality policies provide a
strong foundation for other governance measures and support investment
in the mining sector over the medium-to-long term. The results of govern-
ment effectiveness show a positive and significant effect at the 5% and 10%
levels in Columns 4 and 5 in Table 5.5, respectively. The results indicate that
host countries are likely to receive more FDI if public services are of high
quality and there is efficient policy formulation and implementation.
As noted in the description of explanatory variables’ section, the rate of
inflation is an important determinant in influencing foreign investment. A
high rate of inflation indicates an unstable economic situation and inefficient
government policies, especially monetary and fiscal policy (Macpherson,
2013), which tends to lead to distortions in economic activities and to
increased costs and lower profits for foreign investors owing to higher prices.
By contrast, a low and stable inflation rate indicates overall economic stability.
Interestingly, the estimated coefficient for inflation gives inconsistent
results with the existing literature. Indeed, several studies on the impact of
the inflation rate on FDI and economic development reveal mixed and con-
troversial results. Omankhanlen (2011) examines the impact of inflation on
FDI in Nigeria and shows that inflation might not have a negative effect on
FDI if it does not exceed a certain threshold. Omankhanlen (2011) recom-
mends that the government should ensure that inflation does not exceed the
current threshold of inflation rate so that it would not negatively influence
FDI inflows into the country (Omankhanlen, 2011; Khamis et al., 2015).
7 Conclusion
The purpose of the study is to shed some light on why mineral-resource-
rich LLDCs in Central Asia are less attractive than other regions for for-
eign investors and what the main factors limiting FDI are. It does so by
drawing out the main findings from the theoretical and empirical litera-
ture. Many studies have been conducted to evaluate FDI determinants
across the world. However, there is a lack of empirical studies investigating
the determinants of FDI in LLDCs in the Central Asian region. Similar to
the existing literature, this study finds that a higher return on capital,
openness, and good quality of infrastructure promotes FDI in LLDCs in
Central Asia. As expected, a decline in corruption has a positive effect on
FDI, while regulatory quality and degree of business freedom have insig-
nificant impacts on investment.
Furthermore, the results are surprising and unusual compared to the

results in other studies. However, these results might be possible or reliable
in practice. Remarkably, the governance indicators show positive evidence.
Specifically, the result for political instability presents consistent positive
effects—suggesting that an unstable political situation encourages the flow
of FDI and generates more investment in LLDCs in Central Asia.
Nonetheless, political instability threatens investment; investors sometimes
consider political instability as a good sign. Many historical cases show these
kinds of examples, especially in developing and mineral- resource-rich
regions of the world. Roughly speaking, politically unstable countries are
likely to have a weak and inefficient decision-making process, which would
eventually attract investors trying to seize opportunities. Several studies also
find that politically unstable countries attract capital flows from developed
countries with high political stability. Another important and interesting
finding is that, all else being equal, corporate tax rate and inflation rate are
positively related to FDI. The corporate tax rates of selected economies in
the study are relatively lower than those of other regional economies.
Therefore, an effective and flexible tax rate is able to accumulate investment
flows. The final notable result is the inflation rate and FDI relationship.
Many researchers reveal a negative relationship between inflation and FDI;
inflation itself could have a positive effect on FDI. This finding means that
the government should ensure inflation does not exceed the current or
recent threshold so that it does not negatively influence FDI inflows.
The results show that political instability, a high corporate tax rate, and
a high inflation rate do not always lead to less FDI flow. However, this
finding does not mean that countries should promote an unstable political
and economic situation in order to accelerate and boost investment flows
in their countries. In this case, I suggest that host countries need to pay
more attention to how to improve the quality of governance and eco-
nomic situation by attracting foreign investment.
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PART II
Country Studies: Laos PDR, Nepal

and Mongolia
Chapter 6
Modelling Trade Logistics Based on Multi-

Method Simulation Approach: Case-in-Point:
Mongolia
Nagesh Shukla and Arjun Radhakrishnan
1 Introduction
Historically, landlocked countries have been pessimistic about creating
an export-oriented economy and associated development strategies. With
stringent trade policies and complex border problems often cited, most of
these nations remain poor, requiring so much improvement in infrastruc-
ture development. Mongolia, being a large nation without any direct
access to a sea, shares its border with China and Russia. Although China
and Russia are considered huge economies, Mongolia’s trade exchange
with either country has been very limited, resulting in low revenue
N. Shukla (*)
School of Information, Systems and Modelling, Faculty of Engineering and
Information Technology, University of Technology Sydney,
e-mail: Nagesh.Shukla@uts.edu.au
A. Radhakrishnan
Faculty of Engineering and Information Sciences, University of Wollongong,
e-mail: ar425@uowmail.edu.au

https://doi.org/10.1007/978-981-13-6814-1_6
126 N. Shukla and A. Radhakrishnan
eneration for Mongolia. While China is the major export destination for
g
Mongolia, with 64.5% of overall exports of products such as minerals,
apparels or livestock, a large portion of the rich mineral deposits of this
East Asian nation still remains unexploited (Lv & Li, 2009). Even with
such abundant choices, the available transportation and logistics in
Mongolia have not excelled, a major hurdle in carrying out trade with
global partners. Everything from road conditions to political will has
been identified as a reason for such a calamitous logistics system in the
country (Pomfret, 2011).
Improvements in talks with neighbouring countries (Association of
Southeast Asian Nations [ASEAN] and the Northeast Asia region) have
played a crucial role in developing the idea of a better logistics system to
support industrial development in the nation (Opasanon & Kitthamkesorn,
2016). Other nations in the region have started to identify Mongolia’s
geo-political location as advantageous for trade and its abundant mineral
resources as potential resources for trading. Although developments in
transportation and infrastructure have not been rapid, they have not
been slow either in essentially improving the trading situation in the coun-
try. This has urged major firms willing to trade across borders to enhance
production and improve talks within themselves and with governments of
the Northeast Asian nations (Jazairy, Lenhardt, & von Haartman, 2017;
Opasanon & Kitthamkesorn, 2016). An improved and well-organised
logistics system is one that ensures smooth transportation of goods deliv-
ered on time at a lower cost. Trade logistics, a relatively new concept that
welcomes changes in policies for smoothening the logistics process, has
become the aim of developing countries, Mongolia included. This calls for
improvement in many soft capabilities of governments and officials by
being open to negotiations and trade talks, ignoring the political rifts
existing in the region.
The constraints that still exist in trade logistics in Mongolia had little
effect on the efforts put in by firms to develop logistics strategies that
support their trade activities. Whilst there is improvement in the logistics
activities in the country, understanding the real-time challenges remains a
major hurdle (Pomfret, 2011). An easy way to identify bottlenecks and
improve efficiency of a logistics system in a complex environment is by
developing a software model encapsulating the same characteristics as
those of the real world system. As a result, practitioners and researchers
have identified that building a process model could provide a comprehen-
sive overview of the major logistics networks, which could be useful in
Modelling Trade Logistics Based on Multi-Method Simulation… 127
identifying and capturing inefficient and/or less value adding process

steps/tasks in the overall logistics system. Although many soft capabilities
such as government policies and political issues may still not be largely
captured in a process model, the suitability and sufficiency of using
models that use real-time data have been well-established (Fleischmann
et al., 1997).
The aim of the proposed logistics delivery model is to improve the
effectiveness and efficiency of delivery of goods from the manufacturer to
the customers. Effective utilisation of trucks and the manufacturer/ware-
house capacities have always been a challenge for firms in Mongolia owing
to a lack of proven methodology. Without sufficient access to advanced
technology in process management, identifying bottlenecks and rectifying
issues are always risky, time-consuming and error prone due to excessive
human interventions. As for this chapter, the Anylogic process modelling
software is utilised to develop and simulate the logistics delivery process.
A simple but powerful tool, Anylogic is easy to understand and easy to
modify as per user requirements.
In this chapter, we have identified some of the challenges that trade
logistics in Mongolia faces as discussed in the relevant literature and
thereby potentially include them in the modelling process. Complete
details on the implementation of the software, including the parameters
and their descriptions, are explained in different sections of this chapter.
Furthermore, as an ultimate purpose of the study, we concluded our chap-
ter with the results and suggestions that would help improve the system in
consideration.
2 Literature Review

There has been significant growth in the volume of trade and transporta-
tion in Asia in the past two decades. The rise of more efficient production
networks and improved regional economic integration in the Northeast
Asian region have provided a major stimulus to trade and investment
flows across borders. The emergence of China as an economic superpower
has helped countries in Northeast and Southeast Asia to conduct increased
trading opportunities, thereby leading to higher revenue generation. Such
countries that lie near China have been supplying products that are
deemed necessary as additional supplies for China. Such activities have
helped both the exporting and the importing countries in their trade
activities (Warr, 2010). Even when trading partnerships are established,
countries still found it difficult to transport and deliver products in a timely

manner. The countries that find logistics the hardest to implement and
expensive to remain efficient are those countries without a seaport (Warr,
2010). Subsequently countries with nearest seaports being located in
another country find themselves entrapped in series of bilateral talks and
conduct trade at the mercy of the neighbouring nation (Sun, Fang, & Li,
2017). Such countries, known as landlocked countries, have very limited
options of transportation, which occur predominantly through roads or
rails. While it appears simple, landlocked countries often have very limited
infrastructure in roads and rail owing to their poor economic condition
(Opasanon & Kitthamkesorn, 2016). Mongolia is one such nation that
has found itself in a similar situation.
A study conducted by the World Bank and Policy Research Corporation
(2003) has identified that only 2.2% of the total roads in Mongolia are
paved, shedding light on the dismal state of its infrastructure and economic
development. Furthermore, only 1.2 square kilometres out of an area of
1000 square kilometres has rail facilities. Although this result may seem
dated, it cannot be ignored as infrastructure development has not been
rapid in this country (Opasanon & Kitthamkesorn, 2016). Truckers, for
instance, have reportedly lost several hours in reduced speed due to poor
roads. More importantly, it has been reported that there are high costs in
terms of time and money associated with trade in Mongolia (Pomfret,
2011; Ulzii-Ochir & Vorshilov, 2016). Increasing the cost of local produce
in foreign markets has clearly placed small- and medium-sized enter-
prises in Mongolia out of competition. In addition, such firms find it dif-
ficult to take advantage of trade opportunities due to their inability to
compete in a market that requires so much investment with little returns on
those investments made. Besides, Mongolia has shown to have a lack of
export penetration like many other landlocked countries, which makes it
vulnerable to demand and policy shocks (Biggs, 2007). The literature sug-
gests that delays associated with trade are primarily happening at border-
crossing points between countries, adding further to delays related to
geographical features and low road density. In Mongolia, a survey con-
ducted by the International Exhibition Logistics Associates suggests
that there is a delay of at least a few days to a few weeks at the Mongolia-
China Border. In addition, some managers have indicated that the trucks
sometimes get stopped intermittently, which adds to the overall time taken
for delivery. Evidence of bribery and corruption at the borders is quite
common, which adds to the transaction costs of conducting business

(Jazairy et al., 2017; Opasanon & Kitthamkesorn, 2016; Pomfret, 2011).
Delays lead to excess costs in terms of inventory and storage.
Subsequently, when the goods are perishable, delays could even affect the
quality of the product due to spoilage (Hanaoka & Regmi, 2011).
Measurements of performance and subsequent delays have evidently
resulted in Mongolia being ranked 73 among 180 countries in a survey
that was conducted to identify the ease of doing business in these regions
(Arvis et al., 2016). While this survey did not suggest that Mongolia is
among the poorest performers, the country’s position is not encouraging
as there are still many improvements required. Behar and Venables (2011)
outlined in their study on logistics in landlocked countries that the cost of
transportation to and from a landlocked country is much higher (15–20%)
than that in a country with seaports. Further to this, governments of
countries through which landlocked nations have to transport their goods
to the seaports levy undue taxes for goods transported, adding to the
cost-related challenges faced by countries. Lim et al. (2017), in a study to
identify the key factors in developing transit trade corridors in East Asia,
has found that the safety and security of the resources transported as well
as the performances of government agencies and political concerns at
national borders have a significant impact in ensuring smooth cross-
border trade. The stricter and less safe the borders are, tougher it would
be to conduct business.
An important additional challenge to trade faced by landlocked coun-
tries is uncertainty. Limited research has been done in the area of uncer-
tainty in trade logistics. Christ and Ferrantino (2011) suggest that
uncertainty in costs and time is becoming more crucial and needs to be
treated with great care and attention. Uncertainty arises when factors
known as soft factors enter into the picture. Similar to the findings of Lim
et al. (2017), this article also mentioned factors such as regulations, mar-
ket structure, administrative barriers and corruption as some of the major
hurdles in supply chain and logistics that add to uncertainty that might
even pull traders out of business. The susceptibility of destruction of road
facilities has been one identified reason that limits smooth operations,
leading to uncertainty in delivering goods on time, especially in the sup-
ply chain of a multi-national or large domestic firm. Unavailability of
alternative routes has added to the uncertainty with regard to road infra-
structure (Christ & Ferrantino, 2011; Jazairy et al., 2017).
As the extent of transportation- and logistics-related activities

increases, this uncertainty also tends to amplify. For instance, if multi-
modal transportation modes are used without proper attention to the
existing infrastructure conditions, there would be uncertainty with
regard to time and cost. Practitioners have commented that uncertainty
in ports is extremely high, and it affects the whole system (IFC 2008).
Landlocked countries that only have dry ports find that uncertainties
associated with a dry port are even higher. The agencies, both govern-
ment and firms, therefore are forced to improve warehouse capacities
with anti-theft facilities. In the absence of such facilities, the goods
remain in trucks, which might be susceptible to theft, adding to the
uncertainty of goods security. Inclusion of insurance to compensate for
thefts adds to the hefty costs, which is already being paid by firms in
logistics. This could further undermine profitability and viability
particularly for small firms. The focus, therefore, should be on reducing
uncertainty.
Trade logistics have been a concept that academicians and managers
alike have tried to address particularly in the case of developing nations
(Arvis et al., 2016). It requires active participation from government
agencies as well, implying that cooperation is mandatory for logistics
across borders. But research suggests that often government policies in
the case of trade logistics lack stability, transparency and consistency
(Christ & Ferrantino, 2011; Lv & Li, 2009). A major area in which gov-
ernment agencies tend to fail is in the standardisation of processes.
Reportedly, developing countries have remained poor with limited devel-
opment in trade and economics due to poor policy coordination between
the centre and the subsidiary agencies. A case study report by (Jazairy
et al., 2017) found that standardisation within the process, such as that of
standardising product packaging, barcoding of logistics information, con-
tainer unitisation for loading and unloading, transportation and storage,
could effectively reduce uncertainty, minimise logistics cost and promote
overall efficiency. From the same case study, it was argued that customer
satisfaction could only be achieved if factors such as communications, trust
and culture system compliance are satisfactory in addition to work stan-
dardisation. This in fact implies that successful trade logistics is possible
only if all the parties develop a good relationship among themselves. A bad
relationship could even result in failure in completing the logistics process
(Havenga, Van Eeden, & Pienaar, 2013; Pomfret, 2011).
Relationships across borders have often been attributed to cultural

differences between the parties involved. In case of Mongolia, although
cultural differences are not reported, cultural distance with China can-
not be ignored (Opasanon & Kitthamkesorn, 2016). With Tianjin
(China) being a major destination for Mongolian exports to both China
and subsequently to other countries, it is crucial that Mongolia maintain
a healthy relationship with China. In addition to hard factors such as
contracts, system compliance and standardisation, what also matters are
soft factors such as trust and proper communication (Arvis et al., 2016;
Jazairy et al., 2017). It is important to have transparent communication
channels so that there are limited chances of conflicts between the par-
ties involved. Additionally, trust is often considered a logistics perfor-
mance enhancement that, when coupled with proper communication
channels, generates excellent results (Khabbazi et al., 2013). A lack of
such attributes could be the reason for delays at borders in the case
of Mongolia.
A good logistics system can help in fulfilling consumer expectation,
reducing inventory costs and insuring against regional price fluctuations
for more-developed consumer markets such as Mongolia (Hanaoka &
Regmi, 2011). This reduces the gap between expectation and reality in
terms of cost and time for the customers. The requirement for any cus-
tomer would be to receive an order on time and in full. In a logistics sys-
tem in which they are the end users, they would be keen to keep track of
their deliveries and the expected expenditure for the entire process. Until
now, firms in Mongolia have not been well supported by the overall pro-
cesses involved in cross-border logistics, which could provide a clear pic-
ture of the process that could in effect translate into customer satisfaction
at the other end of the supply chain. Thus, there is an increased need for
an overhaul concerning the logistics operations conducted in developing
nations such as Mongolia.
An encouraging trend that has emerged among the global firms is the
usage of information technology and the internet. Technology has
improved in various business applications such as e-sales, e-marketing, and
monitoring vendors and enterprise management associated with strategic
planning and warehouse accounting (Golicic & Mentzer, 2006). A recent
report from the European Central Bank (2017) suggested that Mongolian
firms involved in trading operations need more help from the finance insti-
tutions in the country.
Limited research in the field of trade logistics in landlocked countries is

a major drawback once a process model-based approach is planned to be
undertaken. Although a simulation model with organisation and logistic
attributes and parameters could be developed, soft factors as mentioned
previously in this world would still be largely missing, which could still be
problematic while implementing the system (Khabbazi et al., 2013).
This chapter aims to reduce the gap between customer expectations
and logistics efficiency in the Mongolian context.
3 Modelling Methodology
3.1 Agent Framework
The model used for the proposed solution uses an integrated agent-
based modelling methodology where delivery logistics processes are sim-
ulated through a set of agents. The proposed integrated model employs
discrete event models for simulating processes and agent-based models
for the distributed agents involved in the logistics delivery system.
Figure 6.1 illustrates the conceptual overview of the overall approach
used for modelling logistics delivery problem in the Mongolian context.
The methodology starts when orders are generated by the retailers in
the logistics process. The orders, considered as agents, contain details of
customers or retailers to whom the final product needs to be delivered.
The subsequent stage involves a manufacturer agent who receives the
orders and creates shipments based on pre-defined rules. Depending on
the availability of the product as inventory at the manufacturer’s location,
the incoming orders can be fulfilled directly or, if the inventory is low,
then the order can be manufactured (based on processing time per unit
product). Further, based on the transportation capacity, the order could
either be split or delivered in full by the available transport option (truck
or rail). Orders are batched to create shipments based on the proximity of
customer locations to which the order must be delivered. This step is fol-
lowed by the processing of the shipment according to the needs of the
customers (quantity, lead time).
The next step involves a transport agent, specifically either trucks or
railways. An intriguing concept that is quite common in the field of logis-
tics is the concept of full truck load (FTL). A full truck load means a
transport system would be ensured to be filled before its despatch which
could ultimately aid in cost reduction. Much attention is given to the
Fig. 6.1 Overall methodology used for simulating a logistics system

c oncept of truck load, where the shipments to be delivered are filled in full
by the transport provider (in case of our model, it is referred to as trans-
port agent).
A statistics generation (or performance calculation) step is also used
such that overall system performance can be monitored. These are
designed to provide results based on the inputs provided and the varia-
tions included in both the expected quantity and the number of trucks
available.
3.2 Agents
There are six agents used in this process, each serving its own specific tasks
while also interacting with other agents.
Retailer Agent
Retailer agents generate orders intermittently using a uniform time distri-
bution. The orders generated by retailers or customers could be of differ-
ent quantities and lead times, and have to be delivered to different
locations. These details are contained in the orders the retailer agent gen-
erates. The entire process thus starts with the demand generated by a
retailer agent and ends once the requirement is delivered to the retailer in
full and potentially on time (ideal case). The parameters used by the
retailer agent determine the movement of transport and subsequent deliv-
ery. The parameters used by the agent are as follows:
(i) Name of the retailer

(ii) Location of the retailer in the form of latitude and longitude
The details of each retailer and their location are stored in the database.
On the other hand, the parameters used in generating the orders are
as follows:
(i) Lead time for processing and delivery

(ii) Amount of products required
(iii) Customer location as specified in the database (to be discussed later)
Orders are generated on a case-by-case basis, where the amount is dis-

tributed uniformly between 100 and 550 units and the lead time is distrib-
uted normally and truncated while varying the minimum and maximum
Table 6.1 Demand parameters for five different demand profiles (cases)
Case 0
Lead time Order amount
Minimum Maximum Mean Std. dev. Minimum Maximum
1 80 20 8 100 200
Case 1
1 80 30 8 150 250
Case 2
1 80 40 8 200 300
Case 3
1 80 50 8 250 350
Case 4
1 80 60 8 400 500
Case 5
1 80 70 8 450 550
values for each case from 0 to 20 hours, as illustrated in Table 6.1. These
parameter values are assumed to illustrate the working of the proposed
model. A user can change these values appropriately to simulate any spe-
cific scenario.
Order Agent
The orders generated by the retailer agents are considered as agents and
referred to as “order agents”. The parameters for order agents could vary
depending on the conditions invoked in the modelling process, as indi-
cated in Table 6.1. The lead time and order amount associated with the
process are stored in the order agent, which is subsequently used for creat-
ing shipments and their processing.
In addition, there is an option of invoking priority (a variable used by
the agent) for orders as well as to allocate waiting time for the product.
This is crucial as orders are processed in subsequent stages.
Manufacturer Agent
A manufacturer agent conducts two major functions:
(i) Rule-based shipment processing, where shipments are created from

orders using two rules depending on
• The truck capacity, whether it can hold the shipment wholly or
partially; and,
• Proximity of customer locations.
Figure 6.2 illustrates the rule-based shipment processing process.

Figure 6.2 shows customer orders, with the size of the ellipse depicting
the quantity ordered. In the model developed, the orders are sent to the
manufacturer, who processes the orders and creates shipments. The rules
for creating this shipment are as discussed earlier. For instance, if we
assume C1 and C2 locations are within a 100-kilometre radius, orders
being delivered to these locations can be combined to create shipments
utilising the full transport (truck or rail) capacities. In this process, large
orders may be split appropriately into multiple shipments. This process is
also presented in Fig. 6.2. This is to make sure the transport capacities are
Fig. 6.2 Rule-based shipment creation and delivery (where C1–C5 represent
customer order amounts)
fully utilised. The manufacturer agent considers this shipment request and
processes it further for fulfilling the order in the next stage. Another
instance that could be noted is the customer order location represented by
C5. Assuming it is a large order, it can appropriately fill the truck capacity,
and then the shipment (in this case having one order only) is transported
only to the location C5.
(ii) Manufacturing stage batching operation: If the required number of

products to fulfil the shipments/orders is not available in the inven-
tory, then these are manufactured and later appropriately batched
for delivery. As per step (i) above, the orders are converted to ship-
ments and processed at the manufacturer agent.
Manufacturing agent is mainly involved in processing of orders. The

following parameters are defined:
(i) Transport agent capacity

(ii) Name of retailer/customer
(iii) Retailer/customer location in the form of latitude and longitude
(iv) Cost parameters that are utilised in calculating the cost of the pro-
cess involved:
(a) Manufacturing set-up cost— the constant cost of setting up
for the process
(b) Manufacturing cost per item—cost of manufacturing a unit
product that is updated whenever a product is produced
(c) Holding cost per item per day—these costs are associated with
storing inventory that remains unsold at the manufac-
turer locations
(d) Shortage cost per item per day—the cost allocated due to
shortage of finished products for dispatch
These cost parameters are used to calculate overall manufacturing costs,

inventory holding costs and shortage costs.
Transport Agent
The transport agent is the carrier of finished products from the manufac-
turer’s warehouse location to the customer/retail location. Trucks and
railways are used as transport agents in this set-up. Optimal utilisation of

trucks and timely delivery of products could be achieved only by rightfully
managing this agent, especially with regard to full load and delivery in full
on time to the retailer. This agent uses a cyclic loop logic to carry out this
function (see Fig. 6.3).
Based on the shipment (which is a group of order(s)) message (sent by
the manufacturer agent), the transport agent loads the required number
of products and travels towards the customer location before unloading
Fig. 6.3 Working process flow for transport agent

the goods at the customer location(s) and then finally returns to the man-
ufacturing warehouse location for the next delivery. Based on customer
locations, shipments are delivered to customers one by one. See Fig. 6.3
for details.
Shipment Agent
The shipment agent stores a set of order agents (to fill truck/rail capacity
based on customer proximity). Figure 6.2 illustrates the variations in ship-
ments that are created because of the rules applied at the manufacturing
location. One point to be noted is concerning the priority of the ship-
ments to be delivered. Delivery of the finished goods would follow the
priority given to the products (if initially set).
3.3 Software Implementation
The software used for developing this model was Anylogic. The Anylogic
software has multi-method modelling capabilities and has the unique abil-
ity to use Geographic Information System (GIS) maps within the simula-
tion models in a Java-based architecture, enabling the integration of
multiple levels of simulation modelling. This integration is critical to iden-
tifying breakthroughs associated with complex logistics systems.
Integrating diverse types of data with multi-method simulation can
advance our understanding of logistics systems to deliver higher value in
improvement analysis. It enables the use of multiple methods such as sys-
tem dynamics, agent-based and discrete event simulation models within
one modelling language and it also provides a Java-based programming
environment to implement new concepts and techniques. It is envisaged
that the logistics simulation model will interact with the changes in policy
reforms to provide a scenario-based analysis of the performance of logis-
tics systems. Broad performance objectives, including throughput, deliv-
ery time, wait time and resources required, can be used to evaluate cost
and benefits of the policy-level reforms and their impact on the operation
of logistics systems.
A map including the road/rail network of Mongolia using Open Street
Map Classic (OSM Classic) has been used (see Fig. 6.4). Note: Open
Street Map Classic (OSM Classic) is a collaborative project to create a free
editable map of the world with limited restrictions on the use or availabil-
ity of the map (Source: Wikipedia). The manufacturer locations can also
be identified in the frame as a red icon with the icon of a truck on top of
Fig. 6.4 Initial model graphical interface
it (in red circle). Input to this model is provided through two range tabs,
namely number of trucks (zero and 100) and production rate of the man-
ufacturing plant (50–1000 products produced per hour). One could
develop different scenarios by varying these inputs, which would aid in
clearly understanding the model capabilities.
The values of the cost parameters (e.g. manufacturing, inventory hold-
ing, shortage) are updated once the model is run, which is instrumental in
identifying the associated costs and extent of improvements that need to
be included. Here, manufacturing cost represents the cost of products
manufactured. The inventory cost represents the cost of holding the
inventory for other shipments to be sorted and batched. Shortage cost
represents the cost compensated for shortage in the inventory. A scenario-
based evaluation of the process could effectively provide a glimpse of bet-
ter utilisation and optimisation opportunities in terms of both time and
cost for the organisation.
The initial simulation is based on the default settings. The simulation
(see Fig. 6.5) shows movement of trucks (transport agents) through the
road network to the destination specified in the development stage of the
Fig. 6.5 Snapshot of interface when the model is running
model (in red circle). The change in the values of the cost parameters are
also shown (in red rectangle).
In addition to the virtual representation of truck movements, the statis-
tics bar shows four different statistical outputs generated during the simu-
lation of the model (see Fig. 6.6).
Figure 6.6 provides a snapshot of the outputs generated following the
simulation of the logistics network. The outputs required to be displayed
by the system can be chosen in the programme settings. For the current
model, the outputs generated are as follows:
(i) Truck utilisation—representing the utilisation rate of the truck

fleet at the manufacturing firm
(ii) Waiting time for product—representing the waiting time for
orders to be manufactured at the manufacturing plant
(iii) Order in delivery—representing the overall time taken by the
orders to be fulfilled (including production, ordering, deliv-
ery in full)
(iv) Delivery performances—representing the delivery performance
of the logistics system (i.e. delivery in full and on time)
In all these four outputs, the horizontal axes represent time taken.
The four outputs are discussed briefly in subsequent paragraphs.
Fig. 6.6 Output statistics generated while the model is running
Transport agent utilisation shows the percentage utilisation of trucks

involved in delivering the products. In Fig. 6.7, the percentage utilisa-
tion is 95%.
Waiting time for the product provides a time-related assessment of how
effective the manufacturing process is. It essentially indicates the delay
associated with the production/availability of the product before batching
in the shipment-processing stage of the manufacturer agent (refer to
Fig. 6.1). In Fig. 6.8, the percentage of orders is plotted against waiting
time, which in the default set-up indicates that 15% of the orders have
typically a waiting period of 40 hours.
Order in delivery indicates the overall time a product was in the system.
It gives the percentage of orders in the system against the total time it is
available in the system. In Fig. 6.9, approximately 17% of the orders had a
total time in system of around 120 hours.
Delivery performance shows the continuous performance of the manu-
facturing firms, which consists of various “agents” in the system through-
out the operation, starting from when the order was received until its
delivery. As indicated in Fig. 6.10, delivery performance is the difference
between expected lead time and delivery time.
Fig. 6.7 Truck utilisation

rates from the model
Fig. 6.8 Waiting time of trucks for products to be available at the manufacturing
plant
Fig. 6.9 Time duration

when the order was in
delivery
Fig. 6.10 Delivery performance (order arrival duration—order lead time)
4 Model Parameterisation

The model uses several parameters associated with the different agents
involved. The details of each of those parameters are discussed in
this section.
4.1 Agent Attribute Values

The agent attribute values are reported separately for each of the agents.
The details of parameters, variables, functions and collections are
given below.
Retailer
In the modelling process, the retailer agent represents a group of custom-
ers. The relevant parameters and events used for modelling the retailer
agent in the system are illustrated in Tables 6.2 and 6.3.
Order Agent
The order agent represents the orders generated by the retailer agent. The
relevant parameters and events used for modelling the order agent are
illustrated in Tables 6.4 and 6.5.
Table 6.2 Parameters used in modelling the retailer agent

No. Name Description Type
Parameters
1 Name Name of the retailers/customers as per the database String
2 Latitude Location of customer Double
3 Longitude Location of customer Double
Note: Column type represents the type of variables used

String type is used for character variables. Integer and double are used for numerical variables
Table 6.3 Events used in modelling the retailer agent

No. Name Description Trigger Mode First Recurrence
type occurrence time (days)
time
(hours)
Events
1 Demand Generates demand on a Timeout Cyclic 0 Uniform
case-by-case basis where the distribution
amount is distributed
uniformly between values of
100 and 550. A case
programme methodology is
utilised, which includes five
different cases. Lead time is
distributed normally
Table 6.4 Parameters used in modelling the order agent

No. Name Description Type Default
value
Parameters
1 Lead time Lead time is the amount of time that passes Double _
between the commencement and the end of a
process
2 Amount Amount of item requested by customer Integer
3 Customer Customer or retailer who generates demand String
Table 6.5 Functions used in modelling the order agent

value
Functions
1 ToString Returns value for each of the parameters used in the String
order agent
Manufacturer Agent
The manufacturer agent represents the key processes carried out in this
logistics delivery system. The relevant parameters, functions, datasets and
events used for modelling the manufacturer agent is illustrated in Tables
6.6, 6.7 and 6.8.
Transport Agent
The transport agent represents the transport system (trucks and railways)
used in this logistics delivery system. The relevant functions used for mod-
elling the transport agent is illustrated in Table 6.9.
Shipment Agent
Shipment agents represent the processed orders. The relevant parameters
and functions used for modelling the shipment agent is illustrated in
Table 6.10.
4.2 Datasets Used
A model that illustrates a real-life scenario requires external datasets that
would essentially provide relevant data associated with the situation. The
model developed requires data for the road and rail systems—information
about routes, type of roads, normal traffic and distance between manufac-
turing and delivery points of the firms of interest in Mongolia. An applica-
tion that supported this need was OSM Classic. OSM Classic provides an
open view of road/ rail network shape files with the inclusion of street
views that make retailer locations accurate to a fair extent. OSM Classic
provides Geographic Information System data. GIS is a system designed
to capture, store, manipulate, analyse, manage, and present all types of
geographical data. Hence the geography of Mongolia and the topography
of the route to other ports were available and gave us sufficient idea
regarding the challenges faced in this regard.
Table 6.6 Parameters and functions used in modelling the manufacturer agent

value
Parameters
1 Truck capacity Capacity as pre-defined for the transport Integer 300
agent
2 Name Name of the retailers/customers as per String
the database
3 Latitude Location of customer Double
4 Longitude Location of customer Double
5 S Lower threshold value for inventory or Integer 20
re-ordering point
6 S Upper threshold value for inventory or Integer 80
re-ordering point
7 Manufacturing Cost of setting up for the process Double 50
set-up cost
8 Manufacturing Cost of production per item Double 5
cost per item
9 Holding cost per Amount required to keep items in Double 0.75
item inventory
10 Shortage cost per Amount required to compensate for the Double 4
item lack of availability of an item
No. Name Description Type Agent
Functions
1 Waiting time Calculates overall time waited for products to be Double Order
produced
2 Get_priority Function to simulate higher priority for higher Double Order
amount + lower delivery time (70 is average
speed)
3 Getorder_ Function that returns a value if amount of Integer Order
Split products is greater than truck capacity
4 Check_ Function to check if amount is between 250 and Boolean
Amount_ truck capacity
Order
5 Waiting for Function that calculates amount of time waiting Integer Order
trucks for trucks to be available and returns if priority
needs to be given
6 Packing Function used for packaging. It looks at the Just Order
previous orders waiting to be processed in the action
queue and identifies orders for packaging (based
on customer proximity and truck capacities)
(continued)

No. Name Description Time Trigger Mode First
Std. occurrence
time
Parameters
1 Updating Calculate orders waiting Model Timeout Cyclic 1 hour
backlog time
2 checkPriority_ Checks priority for each Model Timeout Cyclic 1 day
dayEnd order waiting for trucks. time
If an order is waiting for
more than a day
Force the order to be
picked up by next
available truck
Table 6.7 Datasets used for the manufacturer agent

No. Name Description Horizontal axis Samples limit Updating
value
Datasets
1 Dataset Set of samples used in Time 100 Not updated
the process automatically
5 Numerical Model Visualisation

The integrated logistics delivery system presented in this chapter encapsu-
lates the challenges faced in the landlocked countries and has effectively
developed a multi-method methodology that could be used in the
Mongolian context. It has taken into account the types of logistics aspects
such as manufacturing, retail, as well as distribution of a particular product
type. In addition, this model has also incorporated the transportation type
used as well as the time required for order production and delivery by the
manufacturing firm. Apart from the maps used to depict directions of the
routes used in Mongolia, this study has also utilised evidences from litera-
ture indicating the general characteristics of the Northeast Asia region.
Those characteristics include size of roads, average delay at borders and
average time taken to move from one location to another. The flexibility
associated with the model helps users to vary inputs and generate simula-
tion results thereby providing ample opportunities to develop strategies
Table 6.8 Cost parameters used in manufacturer agent
No. Name Description Time Horizontal axis value Update Recurrence
Std.
Cost parameters
1 Holding cost Number of products (every hour) × holding costs Model Continuous duration Auto 1 hour
(/hour) time of time in hours
inventory_Manuf ×
(HoldingCostPerItemPerDay/24)
2 Manufacturing Kicks in after each order is processed Continuous duration Do not
cost Variable cost (per item) × amount + of time in hours update
Set-up costs: assuming it is per order automatically
(ManufacturingCostPerItem × order_agent_
process.amount) + ManufacturingSetupCost
3 Shortage cost Cost of non-availability of item in the inventory Continuous duration
(amount_WaitingToBeProducted × of time in hours
ShortageCostPerItemPerDay)
Modelling Trade Logistics Based on Multi-Method Simulation…
149
Table 6.9 Functions used in modelling the transport agent

No. Name Description Type Default value
Functions
1 ToString Returns value of shipment after each iteration String _
Table 6.10 Parameters and functions used in modelling the shipment agent

No. Name Description Type
Parameters
1 Destination Destination of shipment as indicated by retailer location Retailer
2 Leadtime Latency between order request and delivery Double
Function
1 toString Returns value of above parameters after each iteration and Not
updates it to collection orders Applicable
aimed at improving the time taken for transportation, delivery in full as

well as lowering the costs associated with the business depending on the
estimated results.
A major advantage of this model is in effectively utilising transport
capacity. The process is designed to make use of trucks effectively,
thereby minimising underutilised capacities. If there are less than full
truck load orders, then these are combined to make them near-full truck
loads. A common problem in real-world logistics systems is the concept
of full truck load, a problem easily rectified in this current process by
batching the finished products based on truck capacity as well as cus-
tomer location. The customer also benefits due to reduced time con-
straints on each shipment.
Excessive loss in terms of time and costs associated with logistics
remains a challenge that has yet to be fully resolved. This model is designed
to make proper utilisation of truck capacity, which could save the cost of
multiple trips to the same location. The manufacturing process is so
designed that it creates delays only when there is an absence of products in
the inventory. If the manufacturer can make sure products in the right
amount are available in the inventory, the time required for completing
the process could also be saved. Once the products are manufactured and
transported, the waiting time for customers to receive the shipment in full
capacity is reduced by effectively combining both customer locations and
order amounts. Additionally, this model can be used as a supporting tool

for forecasting events. Since simulations could indicate the optimal num-
ber of trucks and production capacity required for satisfactory opera-
tions as well as better control over a shipment due to consolidated
shipments, strategies can be easily developed using data obtained as a result.
Further, the model can be effectively used for capacity planning, such
as warehouse planning. As the firm becomes more aware of its logistical
capabilities, it would be easy to identify the number of excess products
that might have to be stored as the system waits for the next set of trans-
port agents to a particular location.
With continuous improvements imminent in logistics delivery sys-
tems in developing countries, this model could assist in assessing the
impact of the process change that has occurred. Monitoring the delivery
performance during a process change could determine the extent of
improvement, thereby measuring the impact this change has had on the
system. A process change could range from an update in the machinery to
an acquisition/merger to improve businesses.
6 Conclusions and Future Research

The above discussion has indicated the relevance of a logistics delivery
process model. Process models are effective methodologies for creating
scenarios that best relate to real-life situations. As businesses today are
heavily reliant on planning and strategy development, a process model
could be a useful tool to provide data on resource utilisation and capac-
ity forecasting, which in turn enhances the competitiveness of Mongolian
firms. Improved competition drives innovation and performance.
Therefore, firms participating in trade logistics can utilise and better
develop efficient logistics systems to improve their manufacturing and
export. A problem faced by developing and landlocked countries like
Mongolia in trade logistics is the lower volumes of export (Biggs,
2007). Excessive involvement of public entities has often been a factor
for corruption—in this case, the cross-border trade. An enhanced sup-
ply chain would increase the volume of goods transported, thereby
reducing the power exercised by governments, thereby improving cross-
border transportation.
For developing nations, such models could be crucial so that the pro-
cess runs optimally with available resources such as trucks and an organisa-
tion’s capabilities. For Mongolia, which has many untapped natural
resources, improvements in logistics and processes associated with it could

be crucial not just for organisations within the country but for the govern-
ment as well. Governments have the opportunity to increase the country’s
revenue by enhancing the gap between exports and imports. As exports
increase, the revenue generated will improve substantially. For a country
that is still categorised as a poor nation, exporting its reserves could be the
best way of improving the economy. Nations such as Mongolia could fol-
low some of the successful models such as that of Switzerland, where they
have been excellent in border policies with neighbouring nations, to gain
momentum in trade. Although the circumstances for Switzerland and
Mongolia are quite different in terms of political treaties, one could argue
that good trade negotiations could do wonders to improve the trade
from Mongolia to other nations and vice versa. Since border delays
remain a major challenge for Mongolia, even a highly optimal process
model would not yield the best results due to uncertainties related to
time and cost associated with these administrative issues that are out of
the control of firms.
Additionally, as poor infrastructure persists, transportation through
roads could be a major hurdle. A solution to this problem could be the
improvement in rail tracks and utilising intermodal transportation tech-
niques so that there is comparatively less delay associated with transporta-
tion. Meanwhile, better utilisation of available railways is still a better
option than relying just on road transportation. An encouraging develop-
ment in this direction has been the bilateral agreement between China and
Mongolia along the Silk Road Economic Belt, which is likely to improve
transportation in this region.
While there is growth in technology and trade relationships, there still
is a responsibility on the government’s part to build healthy relationships
with neighbouring countries. Mongolia should make the best use of the
economic growth of China by creating an opportunity of smooth trade
across the borders. A logistics delivery system can be successful only if
trust and communication is clear and well preserved.
Future research in this area should therefore be focusing on trade logis-
tics identifying best practices in manufacturing and logistics when applied
especially to landlocked developing countries. More research needs to be
done on the efficiency and effectiveness of government bodies in their
effort to improve border performances so that simulation models can be
put into practice in a real-life scenario. A quantitative approach using
rocess models where such soft factors which can determine non-value
p
adding delays in borders could be developed and collated so that policy
makers could identify the bottlenecks and generate risk-free solutions that
timely can cost effectively be implemented. A firm could remain competi-
tive only when its development, both internal and external, is aligned with
the changes happening globally.
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CHAPTER 7
Micro-, Small- and Medium-Sized

Enterprises (MSMEs): Challenges,
Opportunities and Sustainability in East Asia
Charles Harvie
1 Introduction and Context

The potential contribution of micro-, small- and medium-sized enter-
prises (MSMEs) to sustainable, broad-based and inclusive growth in both
developed and developing economies is widely recognised in both the
academic and policy literature. MSMEs contribute significantly to employ-
ment, output, exports, poverty alleviation, economic empowerment and
the wider distribution of wealth1 (Harvie, 2002, 2008; Harvie and Lee,
2002, 2005; Asasen et al., 2003). Despite this they face many difficulties,
most of which stem from their small size and limited resources and capac-
ity. Intensification of competition in domestic and international markets
arising from the process of globalisation, regional economic integra-
tion, domestic reforms and competition from large domestic and
1
See Davis, Haltiwanger and Schuh (1993) and Hallberg (2000) for a useful critique on
the contribution of small- and medium-sized enterprises (SMEs) in these areas.
C. Harvie (*)
e-mail: charvie@uow.edu.au

https://doi.org/10.1007/978-981-13-6814-1_7
156 C. HARVIE
ultinational enterprises combine to create a challenging market environ-

m
ment. This, in conjunction with severe capacity constraints relating to
knowledge, entrepreneurial and labour force skills, innovation potential,
ability to effectively utilise and adapt technology, identification of market
opportunities, limited information and networks and a less than support-
ive business environment, has resulted in many MSMEs performing
poorly, struggling to survive and not achieve their full potential. Their
inability to grow and expand is exemplified by the so-called missing mid-
dle phenomenon, whereby many developing economies in Asia have a
large number of micro-sized enterprises and a small number of large
enterprises, but little in between. A critical challenge for policy makers is
to identify not only how to improve the survival prospects of MSMEs but
also how to bring their growth and employment generation potential to
full fruition. These challenges are intensified when an MSME is located in
a landlocked country, where logistics and transport cost issues can make
participation in regional and global markets much more difficult.
In this context, the remainder of the chapter proceeds as follows: Sect. 2
provides an overview of the role, significance and contribution of the
MSME sector to economies in Southeast Asia. Section 3 identifies MSME
challenges and opportunities that have arisen from the process of globalisa-
tion and regional economic integration, and key capacity constraints.
Section 4 focuses upon recent research results relating to MSME access to
finance and participation in regional and global value chains. Finally, Sect. 5
provides a summary of the major conclusions from this chapter.
2 Importance of MSMEs to Regional Economies

MSMEs play a pivotal role in both developed and developing economies
from a number of perspectives. These include business numbers, employ-
ment generation, output, export growth, fostering entrepreneurship,
sources of product innovation, suppliers of products and services to large
domestic and multinational enterprises, poverty alleviation, economic
empowerment and inclusion, and the wider distribution of wealth (see
Harvie, 2002, 2008, 2015; Harvie and Lee, 2002, 2005; Asasen et al.,
2003). Table 7.1 provides a summary of this contribution for the ASEAN2
economies.3 The contribution to business numbers is sizeable, around
2
Association of Southeast Asian Nations.
3
See also Harvie (2015).
MICRO-, SMALL- AND MEDIUM-SIZED ENTERPRISES (MSMES):… 157
Table 7.1 Significance of MSMEs in ASEAN economies, various years

Country Share of total Share of total Share of GDP Share of total
establishments employment exports
Share (%) Year Share (%) Year Share Year Share (%) Year
(%)
Brunei 98.2 2010 58.0 2008 23.0 2008 – –

Dar.
Cambodia 99.8 2011 72.9 2011 – – – –
Indonesia 99.9 2011 97.2 2011 58.0 2011 16.4 2011
Lao PDR 99.9a 2006 81.4 2006 – – – –
Malaysia 97.3 2011 57.4 2012 32.7 2012 19.0 2010
Myanmar 88.8b – – – – – – –
Philippines 99.6 2011 61.0 2011 36.0 2006 10.0 2010
Singapore 99.4 2012 68.0 2012 45.0 2012 – –
Thailand 99.8 2012 76.7 2011 37.0 2011 29.9 2011
Vietnam 97.5 2011 51.7 2011 – – – –
Note: aAsian Development Bank (2013), bRegistered numbers

Source: Various country reports, ERIA (2014)
99% plus for most economies, and mainly in the form of micro enterprises.
The employment contribution of MSMEs is generally between 60% and
70% of the total with a major exception being that of Indonesia at around
97%. The gross domestic product (GDP) contribution is between 20% and
60%, with Indonesia at the upper end of the spectrum. The export contri-
bution is again quite variable at between 10% and 30% of the total. It is
quite noticeable that despite their dominance in terms of business num-
bers their contribution to other macroeconomic variables falls off quite
sharply, suggesting that they are engaged in low-value-adding, low-
productivity activities, and that many of them are in the informal sector
with limited potential for growth and employment generation. Their low
participation in direct export activity suggests an inability to take advan-
tage of market opportunities from regional integration due to a number of
factors. A lack of competitiveness in their products, a lack of knowledge
and expertise in exporting, high costs of exporting, behind the border
issues arising from administrative and customs costs of exporting and poor
logistics, as well as uncompetitive and poor-quality products. For a land-
locked country such as Lao PDR, this is compounded by logistical and
transport issues and costs that make it difficult to gain access to interna-
tional markets and to be price competitive.
158 C. HARVIE
This presents many challenges to policy makers and to the success of

ASEAN, where a vibrant MSME sector is critical in supporting closer
regional integration and attaining a successful outcome for the ASEAN
Economic Community (AEC). Encouraging and promoting competitive
and innovative MSMEs is necessary to achieve greater economic growth
and social development towards more inclusive and broad-based integra-
tion of the ASEAN region (Asasen et al., 2003; ERIA, 2014), as well as
developing further production networks across the region more generally
to which MSMEs make an important contribution.4
3 Globalisation and Regionalisation:

Opportunities, Challenges and Capacity Building
for MSMEs
3.1 MSME Opportunities
Globalisation and regional economic integration have exerted positive
aspects on SME development. Factors encouraging the growth of MSMEs
include the following: the rise of niche markets and the importance of
product customisation; technological advances that have resulted in dis-
continuities in production, product fragmentation, subcontracting oppor-
tunities and the rise of production networks (OECD, 2007; OECD
et al., 2014); reduced product life cycles that have made flexible pro-
duction more important than volume of production as a source of com-
petitiveness; opportunities arising from global retail sourcing (the
so-called putting out system); the increased importance of the services
sector (dominated by SMEs) due to rising affluence in developing and
post-industrial societies, as well as in low-income developing economies;
their ability to utilise and commercialise knowledge, skills and i nnovation
as core sources of competitiveness, value creation and value addition in a
knowledge-driven economy (Acs and Audretsch, 1990; OECD, 2000a);
4
The ASEAN Economic Community (AEC) started in December 2015 and represents a
major milestone in the attainment of regional economic integration in the context of the ten
ASEAN member countries. The AEC forms a market of over 622 million people valued at
US$2.6 trillion (in 2014), making it the third largest economy in Asia and the seventh largest
in the world. It aims to achieve the free flow of goods, services, investment, and freer flow of
capital, equitable economic development, and reduced poverty and socioeconomic dispari-
ties by 2020.
their greater flexibility to respond to rapidly changing customer demands

and technology; advances in information and communications technology
(ICT) and innovative utilisation of e-commerce to expand market out-
reach, networks, access to information and participation in value chains
(OECD, 2000c); participation in clustering (horizontal and vertical) and
networking that can facilitate access to knowledge-sharing spillovers and
skilled labour (Porter, 1990, 1998; OECD, 2000b) as well as achieve
economies of scale and scope which would be impossible in isolation; flex-
ibility in technology development, adaptation and application; and rec-
ognition by policymakers both at the national level and international
regional levels (Asia-Pacific Economic Cooperation, ASEAN, Asian
Development Bank etc.) of the important role that SMEs can play in
inclusive economic development, particularly in terms of employment
generation, empowerment and poverty alleviation.
In the above context, improving trade facilitation measures such as
reducing time delays and costs involved in trade, improving the quality of
port infrastructure and telecommunication services and providing more
access to finance to both exporters and importers with the aim of increas-
ing merchandise trade are of particular concern for MSMEs interested in
accessing international markets. Trade facilitation measures are particu-
larly important for landlocked countries in the region, such as Lao PDR,
where improvements to transportation (infrastructure), logistics, customs
regulations and administration measures are critical to reducing time
delays and the cost of delivering products to overseas markets beyond
those at a country’s border. Access to port facilities in another country can
be vital but beyond domestic control, but can be essential for domestic
firm participation in regional production networks.5
Despite these potentially favourable developments, MSMEs in
Southeast Asia face many challenges to their survival and growth.
3.2 MSME Challenges
MSMEs face challenges on a number of fronts from increased competi-
tion, adapting to rapidly changing market demand, technological change
5
In this context, China’s so-called Belt and Road initiative, which is a development strat-
egy involving infrastructure development (via road, rail and port facilities) and investments
in countries across Europe, Asia and Africa, has the aim of enhancing regional connectivity
and could be very important. This could potentially carry benefits for many developing
economies involved in this initiative, and in particular for landlocked countries such as Laos.
160 C. HARVIE
and capacity constraints relating to knowledge, innovation and creativity.

For many MSMEs, however, their potential is often not fully realised due
to a number of factors related to their small scale and limited capacity.
These include the following: a lack of resources (finance, technology,
entrepreneurial and labour force skills, market access and market informa-
tion); a lack of economies of scale and scope; higher transaction costs
relative to larger enterprises (e.g. transportation costs); high costs in
accessing and utilising ICT and skill deficiencies in the utilisation of
ICT; entrepreneurial, managerial, accounting and marketing skill
deficiencies; difficulty achieving accreditation for product quality; a
lack of networks that can contribute to lack of information, know-how,
and experience of domestic and international markets; a lack of informa-
tion on market opportunities; increased market competition and con-
centration from large domestic and multinational enterprises caused by
globalisation and economic integration; an inability to compete against
larger firms in terms of research and development (R&D) expenditure
and innovation (product, process and organisation); being subject to con-
siderable “churning” and instability; geographical isolation putting
them at a competitive disadvantage.
They also lack skills in dealing with customers, both in the domestic
market and in the export market. They have limited knowledge about
language and culture as well as legal and bureaucratic issues involved in
exporting. They may experience a lack of business infrastructure sup-
port and face discrimination in some countries relative to large firms.
3.3 Key Areas of MSME Capacity Building

There are a number of key areas where MSME capacity building is
required, and these are as follows.
3.4 Access to Finance6
MSME financing has been, and remains, an intractable problem, not least
because financial resources are typically in short supply in almost all devel-
oping economies. Many financial support measures for MSMEs have lim-
ited outreach at disparate cost. In addition, capital markets can be far from
adequate for MSME debt (bonds) and equity (shares) financing. Higher
6
For a more comprehensive discussion of this issue, see Harvie et al. (2015).
transaction costs, perceived risk, lack of MSME transparency, greater like-

lihood of failure, lack of credit rating agencies and a lack of bank expertise
in the evaluation of MSME loans, render it unprofitable for commercial
banks to focus on such enterprises as their main debt clientele. In addition,
most MSMEs do not have a bankable business plan, which could increase
stringent bank demands for quality collateral. Banks see MSMEs as carry-
ing greater risk, especially where there is a lack of credit-rating agencies
(Harvie et al., 2015). Proper financial reporting and information disclo-
sure is another difficult issue to resolve for many MSMEs. Consequently,
MSMEs experience a financing gap7 and borrow on less favourable terms
and for a shorter duration. Most MSMEs tend to be restricted to internal
finance sources, such as personal savings, borrowing from friends and rela-
tives, and internal profits. This puts a severe constraint on their capacity to
grow and take advantage of market opportunities (Harvie et al., 2015).
These problems are more intense in developing countries where many
micro firms, which make up the majority of enterprises, operate as infor-
mal enterprises and are excluded from accessing finance from formal finan-
cial sources such as banks.
3.5 Connectivity to Markets
In the context of rapid trade liberalisation within the East Asian region,
MSMEs need to develop capacities to take advantage of opportunities aris-
ing from a more open regional and global trading system. The internet is
regarded as being of particular importance in this regard, as is the need to
identify appropriate partners for joint ventures or strategic alliances, to
harmonise standards and professional qualifications (including investment
laws and taxation procedures) and to protect intellectual property rights.
Reductions in tariffs may not benefit MSMEs as their contribution to
direct exports has remained quite static or declined (e.g. in ASEAN).
More emphasis is required by governments to address nontariff barriers
and to improve trade facilitation measures (customs procedures, mobility
of business people, standards of labelling requirements, access to finance,
recognition of professional qualifications, consumer protection (particu-
larly regarding online transactions) and intellectual property rights) if
MSMEs are to benefit from trade expansion and enhance their exporting
7
Occurs where MSME demand for credit is greater than the supply of credit to them
(Harvie et al., 2015).
162 C. HARVIE
capacity and outreach. For landlocked countries like Laos it is also impor-
tant to add to this list the need to address domestic infrastructure and
logistic concerns as well as access to ports in neighbouring economies to
access markets further afield. Without this they will experience time delays
and additional costs in exporting which will make these high cost locations
for both domestic and foreign investment and unattractive for participa-
tion in regional and global production networks.
Greater participation by MSMEs in trade has the potential to generate
a number of benefits including economies of scale and additional revenues
(APEC, 2002), and the acquisition of new skills, new technology and new
marketing techniques. Exporting firms tend to apply knowledge and tech-
nologies at a faster rate and more innovatively than non-exporters, and
have greater efficiency and productivity. MSME exporters assist skill and
technology applications by spreading these over many small buyers and
speeding up a multiplier effect, which extends the gains over the entire
economy and not just firms that export. They are more flexible and envi-
ronmentally responsive firms and achieve higher growth rates and long-
term improvements in productivity and employment levels. Exporting has
a positive effect on living standards, as competition drives firms to invest
in staff development, which in turn improves productivity, wages and
working conditions. Exporting also encourages cultural diversity and the
building of relationships and reputations with other countries.
3.6 Access to Technology
In a knowledge-based economy, applications of ICT can be a great leveller
for MSMEs. However, when MSMEs have limited access to, or understand-
ing of, these technologies, their prospects of acquiring and utilising them for
their benefit is reduced. In terms of the internet, e-commerce use amongst
small businesses tends to lag well behind their larger counterparts in most
economies (OECD, 2000c; Hall, 2000). However, many small businesses
view e-commerce as providing cost savings and growth potential. The gap
relative to larger enterprises is closing, but further action by national gov-
ernments will be required in terms of improved infrastructure, cost and ICT
training, as well as information relating to business opportunities that
e-commerce can generate. Enhancing the role and participation of small
businesses in the global marketplace through e-commerce will be of critical
importance and particularly in the context of participation in regional and
global production networks. E-commerce presents small businesses with the
opportunity to compensate for traditional weaknesses, in areas such as access

to new export markets and competing with larger firms. It can provide
global opportunities by enabling the flow of ideas across national boundar-
ies, improving the flow of information and linking increased numbers of
buyers and sellers. This provides opportunities for greater numbers of trad-
ing partners dealing in goods and, increasingly, in services. Studies suggest
that small businesses with higher levels of e-commerce capabilities are more
likely to identify using e-commerce to reach international markets as an
important benefit. Hence, the desire to export for many SMEs may have a
fundamental influence on promoting the rapid development of more
advanced e-commerce capabilities. For many small businesses (e.g. in the
Asia-Pacific region), integrating the development of e-commerce into their
future strategies for accessing international markets is seen as crucial.
E-commerce also has the potential to lead to cost savings and efficiency
gains. Raising the awareness, as well as the understanding, of the benefits
from e-commerce will be important in increasing its uptake by small busi-
ness. To incorporate the technology into their operations, small businesses
need to find ways to deal with high set-up costs as well as lack of adequate
infrastructure and ICT skills. If these can be overcome MSMEs will play an
important part in the ICT-driven economy, and at least as much for more
traditional forms of commerce. In this regard, the role of the government is
likely to be crucial. This role includes the development of telecommunica-
tions infrastructure, addressing legal and liability concerns, ensuring that
fair taxation practices are applied to e-commerce, addressing security issues,
and raising the awareness of the business benefits of e-commerce, including
the potential for export growth. All of these are pertinent in the context of
overcoming challenges facing landlocked developing countries.
3.7 Access to Skilled Human Resources

In economies driven by knowledge and innovation, access to skilled
human resources is critical, to enable effective utilisation of new and rap-
idly changing technology, and to facilitate innovation. Human resource
development for MSMEs requires a comprehensive approach including (i)
social structures and systems, such as broad educational reforms, (ii)
encouragement of entrepreneurship, the acquisition of business skills and
encouragement of innovation in society, (iii) mechanisms for developing
self-learning, and ongoing training and enhancement of human resources
and (iv) supportive governmental programs. Among micro- and small-
164 C. HARVIE
sized enterprises, a shortage of skills in information technology and associ-

ated costs are major hindrances to business growth. Consequently, staff
training in ICT as well as in related and supporting skills is required to be
successful in entering export markets. Improved ICT skills can enable effi-
cient management of a business, workload sharing and the development of
more market opportunities including exports. Other desired exporting
skills include language and cultural expertise, as well as legal and logistical
knowledge. Again, the role of government will be critical, but this can be
effectively achieved in the context of strategic cooperation and collabora-
tion across countries, as emphasised by ASEAN member countries.
3.8 Accessing Information
Accurate and timely information on, for example, market opportunities,
financial assistance and access to technology is crucial for MSMEs to com-
pete and grow in a global market environment. This is an important role
that the government and relevant business organisations can play.
In addition to these key areas of capacity building, there is also the need
to encourage the development of business networks—including the devel-
opment of strategic alliances and joint ventures both domestically and
internationally—with the objective of enhancing the innovative capac-
ity of MSMEs.
3.9 Inter-firm Networking and Clustering

Entrepreneurs who develop and maintain ties and strategic alliances with
other entrepreneurs tend to outperform those who do not. There is now
a large amount of literature, and numerous case studies, on the emergence
of competitive industries and the revitalisation of domestic regions pushed
and driven largely by networks and clusters of MSMEs. This process has
taken place in both developed and developing countries. It has often been
induced and facilitated by support policy, but there are also significant
instances of spontaneous development (Asasen et al., 2003).
A related issue in the promotion of inter-firm linkages is not whether to
assist MSMEs to invest in ICT-based facilities and services, but how best
to encourage MSMEs to make the most cost-effective use of these new
technologies. In fact, ICTs are now a prerequisite for participation in the
growing number of cross-country production networks and global supply
chains. They are also indispensable for tapping e-commerce opportunities,
which have expanded tremendously in size and scope.
3.10 Knowledge Acquisition and Innovation

Recent studies have shown that despite the fact that a very small fraction of
total business R&D in developed economies is accounted for by MSMEs,
they contribute greatly to the innovation system by introducing, in particular,
new products and adapting existing products to the needs of their customers
(OECD, 2000a). Small firms account for a disproportionate share of new
product innovations, despite their low R&D expenditures (Acs and
Audretsch, 1990). In addition, they have also been innovative in terms of
improved designs and product processes, and in the adoption of new tech-
nologies. Investment in innovative activities has increased by MSMEs and is
increasing at a faster rate than that for large firms. Scherer (1988) has sug-
gested that SMEs possess a number of advantages relative to large firms when
it comes to innovative activity. For many developed and developing econo-
mies, their future international competitiveness will also depend on their abil-
ity to develop a capacity in knowledge-intensive firms, many of which will be
MSMEs, based upon the experience of the high-income OECD economies.
3.11 Entrepreneurship Education and Training

Among the constraints faced by MSMEs in developing and emerging mar-
ket economies is the lack of a sustained track record in entrepreneurship
development. Extensive capacity building in business skills and opera-
tional capabilities are required by MSMEs for a fuller exploitation of the
new market opportunities from global value chains and new technologies,
including e-commerce. Such capacity enhancement needs to be comple-
mented by ancillary development (by the public and/or semi-public sec-
tor) of hard and soft infrastructure prerequisites, which are of high quality,
accessible and affordable. Such development and the related policy issues
are generally of a longer-term nature.
4 Results from Two Studies on MSMEs

This section provides results obtained from two recent studies focusing
upon aspects of particular importance to the development, sustainability
and growth of the MSME sector. These relate to the following:
(a) MSME access to finance: Case study 1

(b) MSME participation in regional production networks (global
value chains): Case study 2
166 C. HARVIE
4.1 MSME Access to Finance: Case Study 1

As identified previously, access to finance is probably the most important
issue to affect the start-up, development, growth and sustainability of
MSMEs. A study of eight East Asian economies8 conducted by Harvie,
Narjoko and Oum (2015) for ERIA explored the issue of firm character-
istics that allow MSMEs to receive favourable/unfavourable conditions
from financial institutions in terms of (1) size of a loan, (2) duration (time
period) of a loan and (3) cost of the loan.
Key findings from this study are summarised in Table 7.2. Stage of
country development (and related financial market development) and
owner’s wealth consistently favourably affected the conditions of finance
offered to MSMEs. Hence, MSMEs located in more developed econo-
mies with wealthy owners tend to get larger loans of a longer duration
and at a lower interest rate cost. Share of foreign ownership, firm size,
business plans and cash flow are also important in determining the size
and conditions of loans. Larger MSMEs, with foreign ownership, a busi-
ness plan and good cash flow tend to have access to larger loans of a
shorter duration and at a lower interest rate. MSMEs with a high profit
margin tend to borrow less, which is consistent with the pecking order
hypothesis. More mature MSMEs have easier access to longer-term
finance, and a sound track record of sales growth can reduce the interest
cost of their loans. The possession of collateral is beneficial for an MSME
when it wishes to obtain longer-term finance while the preparation of
financial statements assists MSMEs in attaining larger loans. Where the
legal system of a country does not adequately protect property rights,
lacks a bankruptcy law, is weak in terms of disclosure and transparency
in terms of firm operations, there is likely to be a restriction on the extent
of credit offered and the cost of credit higher to MSMEs as they are seen
as being more risky and likely to go bankrupt. MSMEs in countries at a
lower stage of economic development tend to obtain much smaller loans
8
The research methodology adopted a structured survey of MSMEs conducted in eight
East Asian countries (Cambodia, China, Indonesia, Laos, Malaysia, the Philippines, Thailand
and Vietnam). The survey collected information on MSME characteristics, sources and usage
of finance. A usable sample of 1055 MSMEs was obtained containing information on the
basic characteristics of the sample of firms (size, age, ownership type, cost and input struc-
ture, performance (e.g. participation in production networks, sales, sales growth, profit rate),
sources of finance and usage, innovation capability and managerial background). For more
details, see Harvie et al. (2015).
Table 7.2 Factors impacting MSME size of a loan, duration of the loan and cost
of the loana
Loan size Loan duration Loan cost
Foreign ownership (+) Foreign ownership (−)

Firm size (+) Owner has multiple Firm size (−)
businesses (+)
Stage of development (+) Stage of development (−) Stage of development
(−)
Owner’s wealth (+) Owner’s wealth (+) Owner’s wealth (−)
Financial stability (cash flow) (+) Firm age (+) Financial stability (cash
flow) (−)
Financial transparency (financial Collateral (+) Sales growth (−)
statement) (+)
Business plan (+) Garment sector (−) Business plan (−)
Profit margin (−)
a
All the variables listed under the three outcome headings of loan size, loan duration and loan cost were
found to be statistically significantly related, either positively or negatively, with each of these three
outcomes
Source: Derived from Harvie, Narjoko and Oum (2015, pp. 125–131)
if at all, be of a longer duration if successful, and have a higher loan cost.

These results confirm the difficulties faced by MSMEs in poorer develop-
ing economies such as Laos.
4.2 MSME Participation in Regional Production Networks

(Global Value Chains): Case Study 2
Since the early 1990s, international production/value chain networks
have developed rapidly in the global economy, involving many developed
and developing countries and are particularly dense and sophisticated in
East and Southeast Asia (Yuhua and Bayhaqi, 2013; Yuhua, 2014). They
have been driven by intensification of global competition (focused on cost,
quality and delivery), the adoption of new global business models based
upon global markets, global sourcing, flexible production, a focus on core
business, subcontracting and outsourcing, knowledge creation, commer-
cialisation and innovation, rapid technological change and production dis-
continuities, and advances in information and communications technology
(ICT). They have also been facilitated by regional, sub-regional and bilat-
eral free trade agreements (FTAs) (Ando and Kimura, 2005a, b).
168 C. HARVIE
The process of globalisation and increased regional integration have

provided a strong impetus for the expansion of value chains, and presented
new market opportunities for enterprises, in particular MSMEs, most able
to respond flexibly and adaptively to rapidly changing regional and global
demand (OECD, 1997; Wignaraja, 2013). A critical issue for policymak-
ers is how best to ensure that enterprises in their jurisdiction fully partici-
pate in the business and value creation opportunities that present
themselves (APEC, 2002; Asasen et al., 2003).
A summary of the results obtained from a study of MSMEs (Harvie,
Narjoko and Oum, 2015) concerned with key factors impacting their abil-
ity to participate in regional production networks, as well as factors
enabling them to participate in higher-value-adding tiers of a production
network (see Fig. 7.1), is summarised in Table 7.3.9
Table 7.3 indicates that firm (labour) productivity is a key determinant
of MSMEs “moving into” production networks, and is a robust finding
from the study. Foreign ownership share is an important factor for the suc-
cessful participation of MSMEs in production networks, implying that
MSMEs able to exploit firm specific assets or knowledge from their foreign
partners can improve their competitiveness and successful performance in
production networks. Better access to finance at a lower interest rate as
well as ability to service their debts enhances MSME participation in pro-
duction networks. Attaining international product standards is important
as well as activities relating to process, business and technology innovation.
Findings on these innovation activities confirms the importance of having
the necessary technology and know-how to be invited to participate in,
as well as better surviving in, production networks. MSME entrepreneur
attitudes to risk taking and a greater willingness to adopt a new business
strategy are also significant for participation in a production network.
Once in a production network a critical issue is what then needs to be
done to engage in higher-tier, higher-value-adding parts of a production
network. Table 7.3 again summarises some key findings from Harvie et al.
(2015) on this issue. The larger the size of an MSME the greater the
chance of its participation in higher-value-adding activities in a network.
9
The data used in this study was obtained by means of a structured questionnaire survey
conducted in seven ASEAN countries (Thailand, Indonesia, Malaysia, Philippines, Vietnam,
Cambodia and Lao PDR) and China. Some 780 usable MSME samples were obtained. The
questionnaire aimed at collecting information on SME characteristics, and the perceptions of
their managers of the factors that constrain MSME growth.
Original product
manufacturer
----------------------------------------------------------------------------------------------
1st Tier
Supplier (LE) Supplier (MSME) Supplier (LE) Suppliers
-------------------------------------------------------------------------------------------------------
2nd Tier
Suppliers
Supplier (LE) Supplier (MSME) Supplier (LE)
-------------------------------------------------------------------------------------------------------
3rd Tier
Supplier (MSME) Supplier (MSME) Supplier (LE) Suppliers
-------------------------------------------------------------------------------------------------------
4th Tier
Supplier (MSME) Supplier (MSME) Suppliers
-------------------------------------------------------------------------------------------------------
Fig. 7.1 Global and regional production networks and MSMEs. (LE large enter-
prise, SME small and medium-sized enterprise. Source: Abonyi, 2005)
Table 7.3 MSME moving into and moving up production networksa

Moving into … Moving up …
Labour productivity Labour productivity

Foreign ownership share Foreign ownership share
Financial stability and cost of credit
Meeting international standards
Introduced ICT Introduced ICT
Established a new division
Acquired new machinery
Improved existing machinery
Acquired production knowledge Acquired production knowledge
Recently introducing new products
Positive attitude towards risk
Willingness to adopt a new business strategy Willingness to adopt a new strategy
Size
a
All the variables listed under the two outcome headings of participation in a production network and
participation in a higher tier of a production network were found to be statistically significantly related,
either positively or negatively, with each of these two outcomes
Note: “Moving into” refers to the participation of an MSME in a production network, while “Moving
up” refers to an MSME engaging in a higher-tier value-adding activity in a production network
Source: Harvie, Narjoko and Oum (2015, pp. 57–74)
170 C. HARVIE
This could reflect the need to take advantage of economies of scale and
scope to remain competitive in a network. Resource constrained MSMEs
will have difficulty in moving into higher tiers in a value chain, presenting
a major challenge to a landlocked country such as Laos, which is domi-
nated by many informal micro enterprises. Foreign ownership involve-
ment also remains important for MSMEs to attain higher-tier involvement
in a production network, as well as improvements in labour productivity.
The fact that foreign ownership and labour productivity remain important
after production network participation in order to move into higher-value
chain activity, indicates the need for continuous learning and technology
updating even after an MSME has established a position in a production
network. This is confirmed by an ongoing need to acquire production
knowledge. As for the case of gaining access to a production network,
ongoing usage of ICT is important to achieve higher–value-adding contri-
butions to the network.
5 Conclusions
MSMEs represent an integral part of many developing and developed
economies. They make significant contributions to economies from many
perspectives—business numbers, output, employment, exports, entrepre-
neurial activity, poverty alleviation and economic empowerment.
Globalisation and closer regional economic integration, especially in East
and Southeast Asia, have presented local MSMEs with many challenges
that threaten their survival but also opportunities that could ensure their
survival and sustainability. MSMEs face many capacity constraints, com-
pounded if they are in the informal sector, arising from difficulties in
accessing finance, technology and skilled labour, which also results in inad-
equate innovative activity, entrepreneurial deficiencies and limited connec-
tivity to domestic and international markets. These capacity constraints
can result in a “missing middle”, where micro- and small firms fail to
mature into medium-sized enterprises. Medium-sized enterprises contrib-
ute disproportionately to output, employment and exports relative to their
contribution to business numbers. They also have a greater capacity to
engage in higher-value-adding activity in production networks. Addressing
these issues is of importance to regional leaders and policymakers.
Access to finance is important for the establishment, growth and sur-
vival of MSMEs, but many struggle to attain this. Case study 1 drew upon
empirical evidence to suggest that foreign ownership involvement, own-
ers’ wealth, stage of economic development, financial stability, transpar-

ency, collateral, sales growth, business plans and the profit margin of
MSMEs exert an important influence on the size and terms of their bor-
rowing. A number of these factors suggest that it is particularly difficult for
micro and start-up enterprises to obtain loans. This suggests that for
MSMEs located in the major landlocked economy in ASEAN, Laos, access
to finance presents a major challenge. As most of these MSMEs are micro
enterprises based in the informal sector, without access to finance their
prospects for growth, employment generation and participation in pro-
duction networks is highly problematic. The latter implies that they will
not be able to participate fully in the benefits arising from closer regional
and global integration.
Participation in regional production networks presents interesting
opportunities and challenges for MSMEs. Case study 2 provided empirical
evidence to suggest that “moving into” such a network is enhanced with
improvements in productivity, foreign ownership share, financial stability,
innovation activity (product, business and technical) and positive entre-
preneur attitudes. On the other hand, “moving up” to higher-tier value-
adding activity requires ongoing improvements in competitiveness
(productivity, foreign ownership involvement, achieving economies of
scale), innovation activity, particularly in terms of ICT usage, ongoing
knowledge acquisition and improved entrepreneurial capacity. For a land-
locked country such as Laos the ability of its MSMEs to engage in
higher-value-adding activity in a production network will be very chal-
lenging to achieve based on these requirements. If access to production
networks can be achieved it is most likely that Lao MSMEs will be con-
fined to lower-tier value-adding activity, which will constrain the country’s
growth and development prospects.
An added dimension not often discussed in the literature are the
additional challenges faced by MSMEs located in landlocked develop-
ing countries such as Laos. Exporting MSMEs face obstacles relating to
delivery of their products to overseas markets arising from behind the
border, at the border and beyond the border problems. Behind the
border problems relate to poor transport infrastructure and logistics
that can result in time delays and additional cost in exporting. At the
border, issues relate to customs and bureaucratic regulations and
requirements. Beyond the border, problems relate to the distribution
and transportation of products to ports in other countries for on-ship-
ping to more distant markets overseas. These make it extremely difficult
172 C. HARVIE
for MSMEs in landlocked countries to be competitive, to participate in

regional and global production networks and be attractive to foreign
investment. Moves towards comprehensive integration and attainment
of an open, dynamic and resilient AEC by 2020, however, have the
potential to address a number of these concerns at the border and
secure access to ports in neighbouring partner countries for a land-
locked country such as of Laos. Issues relating to poor infrastructure
and access to domestic, regional and global markets both behind and
beyond the border could, however, be addressed through effective par-
ticipation in China’s belt and road initiative aimed at linking markets
from Africa, to Europe and Asia.
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CHAPTER 8
Foreign Aid and Export Performance

in a Landlocked Country: Development
Lessons from Nepal
Kishor Sharma and Badri Prasad Bhattarai
1 Introduction
In the wake of growing threats to international security and peace result-
ing from development failure in many developing countries, foreign aid
has received a renewed emphasis since the mid-1990s, but this time with
a new agenda widely known as ‘aid for trade’.1 The proponents of aid
argue that aid helps improve growth and export performance by address-
ing underdevelopment (Hansen & Tarp 2001; Dalgaard et al. 2004;
1
Aid for trade is about helping poor developing countries to build trade capacity and trade
infrastructure to facilitate growth.
K. Sharma (*)
CDU Business School and Northern Institute, Charles Darwin University,
e-mail: kishor.sharma@cdu.edu.au
B. P. Bhattarai
SCU Sydney Campus, Southern Cross University, Sydney, NSW, Australia
e-mail: Badri.Bhattarai@scu.edu.au

https://doi.org/10.1007/978-981-13-6814-1_8
176 K. SHARMA AND B. P. BHATTARAI
Sachs 2005), while the opponents point to the evidence of lacklustre per-
formance (Easterly 2001; Rajan & Subramanian 2005). As the debate
continues, the literature on aid effectiveness has been mushrooming, but
there is no consensus. Our aim in this chapter is to shed light on this
debate using the experience of Nepal.
Located between India in the East, West and South, and China in the
North, Nepal’s strategic position has attracted unusually high attention
from the donor community, especially during the Cold War period,
although aid inflow to Nepal and the nature of projects funded by bilat-
eral donors varied with the intensity of the Cold War. By the early 1990s,
aid flows to Nepal had reached 10% of the gross national product as against
only 3% on average for low-income countries (Sharma 2015). Despite
this, its export performance shows continuous deterioration from about
24% of GDP in 2000 to about 11% by 2015, making poverty alleviation
a major development challenge. Naturally, this raises the question as to
why aid has failed to accelerate growth and improve export performance
and thereby help reduce poverty, which were the roots of conflict that
erupted in the early 1990s.
With the end of World War II and the establishment of the Bretton
Woods institutions, Nepal attracted foreign aid mainly for capital-
intensive projects for developing its infrastructure (roads, electricity, hos-
pitals, schools). By the 1970s, foreign aid to Nepal contributed about 95%
of its development budget. As aid inflows increased, this perpetuated cor-
rupt behaviour and created a moral hazard, which significantly under-
mined its institutions, delayed much needed reforms for private sector
development, and prevented the ruling elite from embarking on institu-
tional reforms. Bias in the aid programmes towards urban development
led to deterioration in the rural-based agriculture sector, namely agri-
culture, and the gap between the rural and urban sectors continued, lead-
ing to a rise in poverty and inequality, particularly in rural areas. As the
negative consequences of past aid programmes became clear to the donor
community in the mid-1980s, they began linking aid to ‘policy reforms’
and ‘trade facilitation’. Trade is pro-poor because it creates employment
opportunities linking aid to trade, and trade facilitation is good for growth.
This view has led to ‘aid for trade’, a popular development agenda in
recent times. The aim of this chapter is to shed light on this debate using
Nepal’s experience.
The chapter is organised as follows. Following this brief introduction,
section two sets the scene by presenting a quick overview of the Nepalese
FOREIGN AID AND EXPORT PERFORMANCE IN A LANDLOCKED COUNTRY… 177
economy and discussing trends and patterns of aid inflows to Nepal, while
section three examines Nepal’s export performance. Section four discusses
key challenges. The chapter concludes with policy remarks in section five.
2 An Overview of the Nepalese Economy

and Trends and Patterns of Aid Inflows
2.1 The Economy
Located between India and China, Nepal is a landlocked country. The
closest seaport is in India, which is about 600 miles away, while accessing
international market through China is difficult mainly due to high moun-
tains, which are covered with snow in the winter months. Clearly, these
two factors have always influenced Nepal’s trade policy regime. Any
attempt to establish trading relationships with the rest of the world
through standard trade policy instruments is likely to be constrained by
the unofficial movements of goods and services across the open border
with India.
About 85% of Nepal’s total population live in rural areas (Table 8.1)
and rely on agriculture, which is the backbone of the economy. The share
of agriculture in the Nepalese GDP was as high as 63% by the early 1960s,
and fell to about 30% of GDP by 2016–17 with the rise in the share of the
services sector brought about by the structural changes in the economy
(Table 8.2). As the share of agriculture in GDP declined, its contribution
to export earnings also fell to about 10% by 2016–17 from the pick of 70%
in 1960s to export earnings, although the share of agriculture was as high
as 67% and 70% respectively until the mid-1970s. This significant decline
in contribution of agriculture is appears to be partly due to rapid increase
in population (which grew at the rate of 2.5% pa in the past three decades)
and partly due to poor agricultural productivity performance (see Tables
8.2 and 8.3). By 2015, Nepal had the lowest agricultural productivity
among the South Asian countries (Table 8.3).
Despite several decades of attempts to industrialise the economy,
Nepalese manufacturing is in its infancy, contributing less than 6% to GDP
by 2016–17 (Table 8.2). Following the liberalisation of the trade and
investment regime in the mid-1980s, export-oriented manufacturing grew
rapidly until the mid-1990s mainly to take advantage of Nepal’s Most
Favoured Nations (MFN) and the generalised systems of preferences quo-
tas. However, since then it has experienced a significant decline mainly due
178
Table 8.1 Distribution of population in rural and urban areas in Nepal, 1952/54
1952/54 1961 1971 1981 1991 2010 2016
K. SHARMA AND B. P. BHATTARAI
Urban 238,275 338,183 463,909 958,702 1,697,710 4,545,832 5,505,277

Rural 8,018,350 9,074,813 11,092,074 14,064,137 16,793,387 22,477,305 23,477,494
Total Population 8,256,625 9,412,2996 11,555,983 15,022,839 18,491,097 27,023,137 28,982,771
Urban % Total 2.9 3.6 4.1 6.4 9.2 16.8 19.0
Source: CBS (1991a), for data until 1991 and World Development Indicators (2018) for 2010 and 2016
Table 8.2 Composition of GDP (in percentage): 1961–62 to 2016–17
Sectors 1961–62 1964–65 1974–75 1984–85 1994–95 2004–05 2011–12 2016–17
Agriculture 63.85 65.22 67.21 54.06 39.10 34.71 34.80 29.37

Manufacturing 0.85 1.48 3.13 4.15 8.90 7.92 6.30 5.67
Services 35.30 33.30 29.67 41.79 48.0 57.37 58.90 64.96
Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Source: The author’s calculations based on data from Economic Survey (various issues) and CBS, National Accounts of Nepal 2016/17
FOREIGN AID AND EXPORT PERFORMANCE IN A LANDLOCKED COUNTRY…
179
to the eruption of civil war in the mid-1990s, which lasted for nearly a
decade, causing massive damage to its institutions and infrastructure
(Sharma 2006). The abolition of the Multifiber Arrangement in 2005
also appears to have contributed to the contraction of its export-oriented
manufacturing industries, particularly readymade garment exports.
Over the years, the urban-based services sector has grown rapidly over
10% pa, but it employs less than one quarter of the economically active
workforce. By 2015, its share in GDP reached over 50% (see Fig. 8.1).
Tourism—in which Nepal has an inherited comparative advantage due to
its natural beauty—remains undeveloped and its contribution to the econ-
omy is very small. In fact, it has experienced a significant decline since the
eruption of civil conflict, as reflected by a fall in foreign exchange earn-
ings from tourism—from 4% of GDP in the early 1990s to about 1% by
the mid-2000s.
Table 8.3 Agricultural productivity (agriculture value added per worker) in

Nepal and other South Asian countries, 1991–2015 and 2010 (US dollars)
Year NPL IND PAK LKA BGD
1991 4.13 7.69 15.27 11.83 4.08

1995 3.89 8.32 16.42 13.68 3.95
2000 4.52 9.13 17.09 12.11 4.34
2005 4.76 9.63 17.86 14.44 6.08
2010 5.12 12.40 17.07 18.30 7.28
2015 5.44 15.21 18.12 25.97 8.88
Source: WDI online database
80
60
40
20
0
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
Agriculture, value added (% of GDP) Industry, value added (% of GDP)

Services, etc., value added (% of GDP)
Fig. 8.1 Agriculture, industry and service, value added % of GDP, 1965–2016.
(Source: Based on WDI (2018) online database)
2.2 Trends and Patterns of Aid Inflows

As noted earlier, Nepal is one of the highest recipients of foreign aid in
South Asia. The share of foreign aid in Nepal’s GDP increased from
about 2% in the late 1960s to over 10% by the end of the 1990s (Table 8.4).
This unprecedented growth in aid inflows was largely brought about by
Nepal’s strategic position (located between India in the East, West and
South, and China in the North) as tension between the US and China rose
sharply during the Cold War period. A global increase in development
assistance since the 1970s also appears to have contributed to a rise in aid
flows to Nepal. However, the end of the Cold War, together with a global
decline in development assistance and the eruption of civil war in the
country, led to decline in aid since the late 1990s—from 10% of GDP by
the end of the 1990s to about 7% by the mid-2000s (Table 8.4).
A large proportion of development assistance to Nepal has gone into
social services (such as education, hospitals, water supply) and the transport,
power and communications sectors. The third largest recipient of aid has
been the agriculture sector (Table 8.5). Investments in these sectors are sup-
posed to be boosting production and productivity. Unfortunately, due to
poor governance and institutions these investments had little impact on
increasing export-oriented output. In addition, urban-biased develop-
ment strategy facilitated the development of import substitution industries
and service-related sectors in urban centres, discouraging private sector
investment in agriculture, which is the backbone of the Nepalese economy.
As shown in Fig. 8.2, despite significant aid flow into Nepal, the share
of export in GDP remains very low.
Table 8.4 Total aid, bilateral and grants aid, 1960–2015

Year Total aid (% of GDP) Bilateral aid (% of total Grants aid (% of total aid)
aid)
1960–69 1.86 96.65 99.89

1970–79 3.87 68.24 71.38
1980–89 10.10 54.65 64.17
1990–99 10.25 60.87 67.68
2000–09 6.84 71.82 81.52
2010–15 6.53 68.57 90.13
1960–15 6.57 70.75 77.52
Source: Estimated by the authors based on data from OECD (2018) online database
Table 8.5 Sectoral distribution of foreign aid as a percentage of total aid

(1975–2015)
Year/average Agriculture Industry and Transport, power Social Others
commerce and communication services
1975–1980 18.88 9.45 57.68 13.66 0.4

1981–1985 30.5 7.64 42.96 18.3 0.76
1986–1990 24.56 9.64 46.78 18.02 1.04
1991–1995 29.08 8.56 42.56 19.44 0.38
1996–2000 19.5 1.14 51.94 27.4 0.188
2001–2005 14.18 1.376 40.78 41.6 2.052
2006–2009 13.89 1.0 41.30 43.50 0.31
2010–2015 14.07 1.15 41.5 42.28 1.03
1975–2015 22.9 6.5 47.4 22.7 0.9
Source: Estimated by the authors based on data from CBS (1991b, 2001, 2015)
30
25
Exports % of GDP
20
15
10
5
y = 1.6569x + 6.1802
R² = 0.2799
0
0 1 2 3 4 5 6 7 8 9
Foreign aid % of GDP
Fig. 8.2 Foreign aid and export performance, 1965–2015. (Source: Estimated
based on OECD (2018) online database and WDI (2018) online database)
3 Nepal’s Trade Performance

In this section we document Nepal’s trade performance, with a special
focus on export performance. Due to Nepal’s landlocked position and
proximity to India, India has been a major market for Nepalese exports and
most of its imports originate from India (see Fig. 8.3). While this trend
gradually shifted for a short while in the late 1980s, partly due to preferen-
tial market access granted to Nepalese exports into developed countries’
markets and partly due to Nepalese government policy to diversify its
90
80
70
60
50
40
30
20
10
0
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
exports to India (% of total exports) Imports from India (% of total imports)
Fig. 8.3 Exports to and imports from India as % of total exports and imports,
1975–2015. (Source: Based on data from Nepal Rastra Bank (NRB) Quarterly
Economic Bulletin, October 2017)
Table 8.6 Export, import, total trade, inflation and exchange rate, 1965–2015
Time Exports % of Imports % of Trade % of Inflation Exchange rate
GDP GDP GDP Rate with US $
1965–1970 6.51 9.28 15.78 7.85 8.94

1970–1975 6.16 9.94 16.09 11.28 10.41
1975–1980 10.89 15.34 26.23 8.58 12.02
1980–1985 11.41 19.65 31.06 9.16 14.47
1985–1990 11.34 21.26 32.60 12.05 23.52
1990–1995 16.73 27.55 44.28 10.61 43.21
1995–2000 23.85 33.98 57.83 6.48 61.98
2000–2005 18.42 30.28 48.70 5.46 74.18
2005–2010 12.61 32.81 45.42 9.63 71.86
2010–2015 10.40 37.10 47.49 8.91 87.57
Source: Estimated based on WDI (2018) online database
market for exports, Indian market dependency remains very high for
Nepal’s trade transactions and has in fact increased since the early 1990s.
Appendix 1 compares Nepal’s trade and investment performance with
neighbouring South Asian countries.
As shown in Table 8.6, there has been a gradual rise in shares of exports
and imports in GDP with significant fluctuations in some periods. The
share of total trade in GDP rose from 31% in the 1980s to nearly 58% in the
late 1990s and then fell to 47% by 2015 mainly due to political instability
184
Table 8.7 Exports and imports classified by major commodity groups, 1975–76 to 2016–17
In millions of rupees 1975/76 1986/87 1991/92 1996/97 2001/02 2006/07 2011/12 2016/17
Export 1185.8 2991.4 13,706.5 22,636.5 46,944.8 59,383.1 74,261 70,117.2

Food and live animals 804 703.7 1941.6 2661.7 5094.2 7055.8 15,930.3 16,421.3
Tobacco & beverages 4 3.5 13.7 14.9 145.7 23.2 101.8 478.3
Crude materials & inedibles 226.3 491.1 437.4 663.5 624.5 1368 2587 2218.3
Mineral fuels & lubricants 1.7 0.2 0 1.4 1.6 0 0 1
Animal & vegetable oils & fats 1.8 117.1 160.3 312.6 7421.4 4454.9 331.7 106.9
Chemicals & drugs 9.3 2 19.6 1353.4 3308.3 4091.6 2737.3 4618.1
Classified by materials 104.7 1009.5 7557.2 11,028.6 17,394.9 30,412.2 39,008.9 32,666
Machinery & transport equipment 3.7 2.6 0.3 59.6 364.9 1240.9 277.5 399.7
Miscellaneous manufactured articles 23 661.5 3576.4 6540.3 12,589.3 10,736.5 13,284 3204.9
Not classified 7.3 0.2 0 0.5 0 0 2.5 2.7
Imports 1981.7 10,905.2 31,940 93,553.4 107,389 194,695 461,668 773,599
Food and live animals 291.1 1028.9 2947.5 5400.5 6333.2 12,895.9 40,783.4 109,757
Tobacco & beverages 42.4 144 288.3 590.7 717.1 957.9 3081.9 6413.3
Crude materials & inedibles 88.7 657.2 3415.7 5487.1 6734.1 8829.3 17,773.2 33,391.9
Mineral fuels & lubricants 211.7 929.5 3644.7 7160.3 15,200.8 36,362 102,771 84,088.2
Animal & vegetable oils & fats 7.4 175.9 801.8 2327.6 7887.5 12,137.6 17,918.4 21,153.3
Chemicals & drugs 190.1 1287.6 4615.3 8504.2 12,380.9 26,995.9 49,017.3 103,962
Classified by materials 545.9 3226.8 8599.9 44,741.9 32,889.1 48,145.3 114,782 163,132
Machinery & transport equipment 413.4 2784.1 5892.5 13,794.9 19,513.8 36,357.4 82,413.6 189,764
Miscellaneous manufactured articles 168.4 663.9 1547.6 4016.4 5670.3 11,755 32,972.2 45,864.2
Not classified 22.6 7.3 186.7 1529.8 62.1 258.3 155.1 16,074.2
Source: Computed by the authors from CBS (2014, 2016), NRB Economic Review (2005), and NRB Bulletin April (2003)
and trade tension with India. However, throughout the 1980s the export/
GDP ratio remained almost unchanged. It increased only after the trade
liberalisation of the early 1990s, when India significantly opened it econ-
omy. Thus, the export/GDP ratio increased to over 17% in the first half of
the 1990s and to over 23% in the second half of the 1990s, from 11% in the
1980s. The growth of exports in the 1990s was mainly driven by growth in
manufactured exports. However, export growth has fallen significantly
since the early 2000s, while growth in imports has continued. This appears
to be due to numerous factors, including the Maoist violence and frequent
strikes across the country led by political parties.
Nepalese exports are characterised by a very high level of market con-
centration. Over 85% of total exports from Nepal go to three countries:
the United States, Germany and India. This makes exports subject to a
high degree of volatility. For example, increased dependence on the
Indian market, particularly since 1996 following the new trade treaty, has
elevated risks arising from Indian policy shifts. Thus, the recent slowdown
in exports is not only caused by domestic instability but also by excessive
concentration in a few limited markets (IMF 2002). Over the years, the
composition of Nepal’s trade has changed dramatically (Table 8.7).
Nepal’s exports are still dominated by primary products, namely food and
live animal products. In recent years, there has been some increase in exports
of miscellaneous manufactured goods, although exports fell significantly in
2016–17. Nepalese imports are dominated by mineral fuels and lubricants,
miscellaneous manufactured goods, and machinery and transport equip-
ment. Clearly, despite attracting huge aid inflows over the years, Nepal has
not reaped the benefits from international trade mainly due to weak institu-
tions and infrastructure. Nepal’s landlocked position and open border with
India also appear to have contributed to its lacklustre trade performance. In
the next section, we discuss some of these challenges in detail.
4 Challenges for Export Promotion

Despite opening up the economy and significant aid flows into the coun-
try, Nepal’s agriculture, manufacturing and export sectors continue to
perform poorly, and Nepal remains one of the least attractive places for
trade and investment.2 One of the most alarming aspects is that Nepal’s
trade deficit has been increasing since the early 2000s, as can be seen in
Fig. 8.4. Its exports of merchandise goods have been declining despite
significant aid inflows to the agriculture and infrastructure sectors, and
2
This section draws heavily on Sharma (2015).
45
40
35
30
25
20
15
10
5
0
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
Exports of goods and services (% of GDP) Imports of goods and services (% of GDP)
Fig. 8.4 Exports and imports as % of GDP, 1965–2015. (Source: Estimated by

the authors based on data from WDI (2018) online database)
trade and investment liberalisation. High aid inflows in the presence of

weak institutions have led to misallocation of resources and prevented
bureaucrats from introducing bold reforms which are crucial for creating
appropriate incentives for trade and investment. This appears to have
impacted on aid effectiveness, resulting in lacklustre export performance
(Sharma 2006). Nepal’s landlocked position and open border with India
also appear to have contributed to lacklustre export performance, while its
imports have been surging, leading to a sharp rise in total trade (exports
and imports of merchandise goods) as percentage of GDP.
Nepal’s key challenges for export promotion are discussed below.
4.1 Challenges Relating to Transit, Customs and Cross-Border

Infrastructure
Due to Nepal’s landlocked position and open border with India, traders
not only face the challenges of distance but also those related to transit.
These include frequent checks by border security officers and police, time-
consuming customs formalities, shortages of containers at the borders and
a long delay at the port, which obviously add to the cost of international
trade. According to a rough estimate by the Federation of Nepalese
Chambers of Commerce and Industry, transit costs associated with
overseas imports are as high as 20% of the value of goods. This is attributed
by the high costs of transport, damage and pilferage (while goods are in
transit), time-consuming customs formalities, and numerous fees and
charges, both official and unofficial. Time-consuming customs formali-

ties are also caused by lack of computer networks and modern equipment
at customs. For instance, Nepalese customs are not connected to the Indian
customs through computer networks, causing delays at customs points on
either side. Consequently, customs clearance remains a highly document-
intensive and time-consuming formality, and it can take up to 3 days to get
a green signal from customs officers. Often, payment of unofficial fees is
unavoidable to reduce clearance times. Traders often face delays at Nepalese
customs due to the lack of well-trained staff and modern devices (such as
X-ray machines, weighing bridges, cranes and container scanners), and this
has occurred despite significant aid inflows over the years.
4.2 Industrial Relations and Quality Issues

Flexibility in factors markets is extremely important for business enterprises.
Unfortunately, in Nepal there is very limited flexibility with regard to hiring
and firing an employee. Given this environment, with a few exceptions, the
private sector is increasingly involved in non-exporting services rather than
in labour-intensive manufacturing for exports, where Nepal has an intrinsic
comparative advantage. The Labour Act (1992) covers all organised sec-
tors employing 10 or more people, guarantees a permanent position for a
worker who has been employed 240 days in the company, and stipulates
minimum wages. The variations in minimum wages between skill levels are
so small that this discourages skill formation and upgrading. In this climate,
firms have limited choice in altering labour requirements. Under the current
Labour Act, employing people on contract is not allowed and firing a worker
is extremely difficult and often linked to political pressure. In terms of labour
market flexibility, Nepal ranks 150 out of 184 countries according to the
Doing Business Index (World Bank 2014). To promote employment-
intensive growth, Nepal needs to amend the 1992 Labour Act, and at the
same time improve the rule of law and address the infrastructure bottleneck.
Here again, aid inflows have failed to make an impact through policy reforms.
Nepal lacks both quality products and reputation in export markets, which
are important for improving market access. Inability to meet international
standards and technical requirements has led to poor reputation of its prod-
ucts in the world market. This, together with delays in transit (which result in
greater uncertainty in meeting deadlines), has contributed to lacklustre export
performance. The capacity to provide evidence of high-quality products and
their consistent supply are essential to ensure the sustainability of its tradi-
tional agricultural exports, particularly honey, dry ginger and herbal medicines.
4.3 Smuggling and Governance Issues

While it is true that both Nepal and India have significantly liberalised their
trade regimes since the early 1990s and the extent of unauthorised trade
has significantly reduced, a substantial amount of smuggling takes place
even today, depending on price variations caused by the tariff structure
and the government subsidy programmes. For instance, smuggled imported
fertiliser and kerosene oil, which are subsidised in Nepal for farmers and
vulnerable households, often find their way to bordering Indian towns,
putting pressure on the Nepalese fiscal position. Similarly, since 2012 the
smuggling of gold from Nepal to India has been on the rise in response to
an increase in Indian import tariffs on gold, creating a lucrative environ-
ment for gold smuggling, as mentioned earlier. Given Nepal’s landlocked
position and open border with India, both countries should perhaps con-
sider having a common trade policy to avoid rent-seeking behaviour.
Good governance is extremely important for creating an appropriate
business environment for export promotion. However, the business com-
munity often faces delays in meeting official formalities, which are not
only time consuming but also very costly, mainly due to the unwillingness
of Nepalese bureaucrats to reform the system.
5 Conclusion
In the wake of growing threats to international security and peace resulting
from development failure in many developing countries, foreign aid has
received a renewed emphasis since the mid-1990s, but this time with a new
agenda widely known as ‘aid for trade’. The proponents of aid argue that
aid helps improve growth and export performance, while the opponents
point to the evidence of lacklustre performance. As the debate continues,
the literature on aid effectiveness has been mushrooming but no consensus
has been reached. Our aim in this chapter is to undertake a case study of the
role of foreign aid in the export performance of Nepal—a landlocked coun-
try located between India in the East, West and South, and China in the
North. Despite several decades of support from the donor community and
policy liberalisation, Nepal has recorded lacklustre export performance per-
haps partly due to poor governance and partly due to transit- and customs-
related problems caused by its landlocked position. Obviously, Nepal needs
to embark on a wide range of reforms. Donors’ commitment to giving
more aid without fundamental reforms will be counterproductive in accel-
erating growth and improving its export performance.
Appendix 1: Nepal’s Trade Performance in Comparison with Some South Asian
Countries, 1970–2015
1970s 1980s 1991–1995 1996–2000 2001–2005 2006–2010 2011–2015
Bangladesh
Trade (% of GDP) 18.3 18.8 20.8 27.4 29.0 39.0 44.8
Exports of goods and services (% of GDP) 5.4 5.1 7.6 10.9 12.1 16.5 18.9
Tariff rate, applied, simple mean, all Na 105.4 84.9 22.2 19.0 14.2 12.8
products (%)
Total debt service (% of exports of goods, 24.3 27.0 22.4 12.6 9.2 6.2 5.8
services and primary income)
Foreign direct investment, net inflows (% of 0.0 0.0 0.0 0.2 0.4 1.0 1.3
GDP)
Taxes on international trade (% of revenue) Na Na Na 31.1 29.7 27.2 22.2
India
Trade (% of GDP) 11.3 13.8 18.3 23.4 30.4 47.2 52.8
Tariff rate, applied, simple mean, all Na Na 81.6 56.4 29.6 11.1 10.0
products (%)
GDP)
Taxes on international trade (% of revenue) 17.7 25.6 24.4 22.4 15.9 14.0 14.1
Nepal
Trade (% of GDP) 20.9 32.0 38.9 59.7 50.5 44.9 46.5
FOREIGN AID AND EXPORT PERFORMANCE IN A LANDLOCKED COUNTRY…
Tariff rate, applied, simple mean, all Na Na 20.9 16.7 14.7 12.7 12.0
products (%)
189
(continued)
1970s 1980s 1991–1995 1996–2000 2001–2005 2006–2010 2011–2015
190
GDP)
Taxes on international trade (% of revenue) Na Na 25.2 23.7 18.9 15.5 16.6
Pakistan
Trade (% of GDP) 29.5 34.3 37.3 35.5 30.4 34.3 32.6
Tariff rate, applied, simple mean, all Na 25.8 24.3 Na 10.5 9.9 7.8
products (%)
GDP)
Taxes on international trade (% of revenue) 34.4 30.4 Na 17.9 9.8 10.6 7.6
Sri Lanka
Trade (% of GDP) 63.5 66.1 73.0 79.6 80.1 65.2 51.1
Tariff rate, applied, simple mean, all Na 25.8 24.0 9.3 10.6 9.3 7.8
products (%)
GDP)
Taxes on international trade (% of revenue) Na 26.0 22.2 15.6 12.6 15.1 17.4
Source: Estimated based on WDI online database

References
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Central Bureau of Statistics (CBS) 1991b, Statistical Year Book of Nepal:
Government of Nepal.
Central Bureau of Statistics (CBS) 2001, Statistical Year Book of Nepal:
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Nepal: Government of Nepal.
Central Bureau of Statistics (CBS) 2016/2017, National Account of Nepal:
Government of Nepal
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Growth”, The Economic Journal, 496: 191–216
Easterly, W 2001, “Can Institutions Resolve Ethnic Conflict?”, Economic
Development and Cultural Change, 49: 697–706
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New York, Penguin Press.
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worldbank.org/data/reports.aspx?source=world-development-indicators
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bank.org/data/reports.aspx?source=world-development-indicators
CHAPTER 9
Formation of Special Economic Zones

in Mongolia
Tsolmon Tsagaach
1 Introduction
Special Economic Zones (SEZs) allow the creation of an enclave, isolated
from the domestic economy, within which export-oriented manufacturing
activities can operate freely. Foreign investors within SEZs enjoy preferen-
tial treatment with respect to taxation, infrastructure, import controls and
industrial regulations, and process intermediate imports to export. The
expectation of the host country is to provide important motivations for
the industrialisation process in the form of linkages through which skills
and technology are transferred. Many high-performing Asian countries
utilised this strategy in the early stage of development and achieved their
developmental goals (Jayanthakumaran, 2003).
Linnemann, Dijck and Verbruggen (1987) suggest that SEZ strategies
could only be advocated for those countries that are poorly endowed with
natural resources. Warr (1990) concludes that as industrial development
proceeds and the surplus labour is absorbed, interest in SEZs tends to
wane. Mongolia is characterised as being landlocked, with abundant nat-
ural resources, and as being in the middle-income category. Mongolian
T. Tsagaach (*)
Business School, National University of Mongolia, Ulaanbaatar, Mongolia
e-mail: tsolmon_ts@num.edu.mn

https://doi.org/10.1007/978-981-13-6814-1_9
194 T. TSAGAACH
SEZs are located at the borders of the People’s Republic of China (PRC)
and Russia and different from the traditional SEZs. Further, Mongolia is
currently in the process of economic diversification and is expected to
utilise SEZs to promote more manufacturing production. However,
Mongolia tends to fall into the middle-income category and is therefore
experiencing a rise in real wages.
This chapter intends to show the challenges and opportunities of estab-
lishing SEZs in Mongolia. The rest of the chapter is organised as follows.
Section 2 shows the Mongolian background. Section 3 describes the
development of SEZs in Mongolia. Section 4 analyses the advantages and
disadvantages. Section 5 concludes.
2 Mongolian Background

Mongolia, despite having a vast amount of land and valuable natural
resources, is still struggling to maintain its economic stability. And much
of this can be attributed to the landlocked, low-income and sparsely pop-
ulated nature of the country. Recent economic problems and aid from the
IMF have shown that the Mongolian economy is overly dependent on the
mining sector, and this could be its most vulnerable side when it comes to
the fluctuations in price and demands of mineral resources.
Besides mining, Mongolia possesses no reliable income generators in its
manufacturing and service sectors. According to the National Statistics
Office of Mongolia, as of end of 2017 almost 90% of the country’s
exports come from the mining sector and 73% of total investments went
into the mining industry. Also, it accounts for 74% of manufacturing out-
put and 22% of GDP.
The Government of Mongolia (GoM) has been trying to develop the
country’s manufacturing industry for a long time in the process of eco-
nomic diversification. It approved various policies and regulations with the
intention to facilitate development of national enterprises and imple-
mented many projects towards Small and Medium Enterprises develop-
ment, export manufacturing, import substitution, industrial parks and
SEZs. However, the results are not encouraging. Many economists point
out that the instability in government policies is to be blamed in these
under-performing or unsuccessful approaches to developing the industry.
It should be noted that in 2011 and 2012 FDI inflow reached an all-
time record level and foreign investors were willing to put their money in
FORMATION OF SPECIAL ECONOMIC ZONES IN MONGOLIA 195
big projects in Mongolia. However, the downturn started with the

introduction of “Strategic Entities Foreign Investment Law” and the
announcement by some members of Mongolian Parliament to increase
the government’s share of the Oyu Tolgoi project from 34% to 51%. This
news was not received well by the international community and potential
investors who felt uncertain. As a result, even though GoM ruled out
these intentions to stabilise the situation, almost all investment activities in
Mongolia froze. Since then, for the last 5–6 years inward FDI has plum-
meted dramatically and prices of mineral products have fluctuated signifi-
cantly. GoM looked for assistance from the IMF during hardship.
These circumstances led to one inevitable conclusion: that not being
dependent on only one sector and developing a competitive manufacturing
industry is only possible when there is a very stable legal and business envi-
ronment. This is where the concept of the Special Economic Zone kicks in.
3 SEZs Development in Mongolia

Mongolian Parliament initiated the first legal act for establishment of
SEZs in 1995 under the title “Concepts for Establishment of Free
Economic Zones”. Following this decree, in 2002 “The Law of Free
Zones” was passed in order to establish the first provisions for the forma-
tion of SEZs. “The Law of Free zones” has experienced minor amend-
ments around six times in 2003, 2011, 2012, 2014 (two times) and 2015.
Amendments prior to 2015 were minor and not adequate to address the
emerging issues. Therefore, a sweeping change was introduced in 2015
which let the existing laws on the legal status of Altanbulag, Zamyn-Uud
and Tsagaannuur expire.1 The 2015 act intended to improve the adminis-
trative arrangements on several grounds: regulation of land ownership and
usage for domestic and foreign individuals; electronic one-window service
for tenants; some additional concessions on value-added tax; excepting
visa requirements for foreign visitors; and promoting fair competition
within the zones. The new act further introduced some new concepts into
the zones, for instance development of cross-border free zones, legalising
private and public partnership for establishment of zones, permission to
run gambling activities and formation of an investors’ board (Law of Free
Zone, 2015).
1
The new law has 9 chapters and 26 provisions in total, compared to the 2002 law which
had only 3 chapters and 18 provisions.
196 T. TSAGAACH
The 2015 amendment states that the purposes for establishing SEZs
shall be promoting exports and imports by individuals and businesses,
developing export-oriented production, developing new industries of
trade and services, developing tourism, attracting investment, increasing
transit and logistics, introducing and adopting new technologies, facilitat-
ing trade, accelerating regional development, and sustaining economic
growth, by creating favourable regulatory and investment environments
in the region.
According to the 2015 amendment, the tax regime for the zones will
be as follows:
• No customs, VAT and special tax if goods are imported from abroad.
• No tax for goods for which taxes have already been paid, and based
on transaction documents tax payback is allowed.
• Domestic goods from customs territory will be exempted from VAT.
• Goods purchased by visitors, valued at no more than ₮3 million, will
be exempted from customs and value-added taxes when entering
customs territory from the zones.
• Other goods except above-mentioned goods will be eligible to pay
customs and other taxes as stated in corresponding laws.
• No taxes when goods exported from the zones to abroad.
• Products and services produced in the zones will be exempted from
value-added tax.
• Revenue generated by $500,000 or more of investment into the
zones’ infrastructure development will have a corporate tax cut equal
to 50% of the investment.
• Revenue generated by $300,000 or more of investment into ware-
houses, loading facilities, hotels, tourism complex, export promoting
and import substituting industries will have a corporate tax cut equal
to 50% of the investment.
• Losses by financial statements can be transferred to next 5 years of
active production.
• Manufacturing based on IT and high technology will be freed from
corporate tax in the first 5 years of active production.
• New buildings in the zones will be fully exempted from real estate tax.
• Trade, tourism and hotel businesses will be freed from land fee 100%
in the first 5 years and 50% in the next 3 years.
• Businesses operating in infrastructure development of the zones

will be freed from land fee 100% in the first 10 years.
As noted, 2015 amendment is very comprehensive. However, when it

comes to the actual implementation of these laws and policies in a real
environment there are plenty of issues and uncertainties to address. Usually
these issues arise in various types of administrative policies and activities.
For example, when a foreign company enters the zone under a “free zone
regime” from the Customs Office, they are required to have modern sur-
veillance and electronic systems in place and have to provide all kinds of
information about goods, inventory, production costs, in and out of zone
sales, and remaining goods after processing and so on. However, all these
requirements are not yet detailed for the action.
Furthermore, the company will face uncertainties in hiring, firing and
social insurance policies. When a foreign company hires a domestic worker,
disagreement over salary structure could arise between them since no clear
rules on social insurance payments are provided in the zones. Administrative
rules and regulations on foreign investments transactions, currency
exchange, construction permits and terms of preferential tax regimes are
still not quite clear within the proposed zones.
Even though the implementation stages are fruitless, Mongolia is
embracing a free trade policy and has been trying to open its markets to
foreign investment. Thus, in order to improve export capacity, increase
foreign investment flows and acquire the latest technology, the govern-
ment decided to establish three SEZs in different areas of Mongolia.
Zamyn-Uud SEZ is located at the biggest trade port between Mongolia
and China. Altanbulag SEZ, on the other hand, is located on the northern
border of Mongolia, which is the main port for entering Russia.
Tsagaannuur is located at the crossroads of four countries (China,
Kazakhstan, Mongolia and Russia). Their main characteristics are pro-
vided in Table 9.1.
The government is expecting the following possible outcomes from
successfully established SEZs: projected tax revenues, revenues from
granting concessions, licences, production-sharing agreements, job cre-
ation, introduction of new technologies and management know-how, and
backward and forward linkages with other local firms, eventually leading
to the formation of clusters and increased incomes.
198 T. TSAGAACH
Table 9.1 Main characteristics of Mongolia’s SEZs

Zone Type of zone Location Objectives Targeted sectors
Altanbulag FTZ (Trade Mongolia– Important transport International trade

Facilitation & Russia border corridor connecting between Russia,
Logistics) China, Mongolia and China and
Russia Mongolia
25 km from Access to third- Becoming a link
Sukhbaatar country markets between Asia and
City Europe
335 km from Developing into a Hotels, resorts and
Ulaanbaatar major trade, industry, auto service
commerce and service centres
centre in northern Auto parts or
Mongolia construction
material sectors
Zamyn-Uud Free Mongolia– Creation of a major Foreign trade,
economic China border commercial, industrial manufacturing,
zone (Trade and tourism centre tourism, resorts,
Facilitation & Increase of economic casinos and
Logistics) welfare, jobs and warehousing
business opportunities
for residents of
Dornogovi and
Omnogovi aimags
Benefiting from the
transport corridor
linking Russia and
China
South of To become main
Zamyn-Uud gateway of Mongolia
City to China and
North-East Asian
markets
To support and
improve
competitiveness of
Mongolia in the field
of non-traditional
industry
(continued)
Zone Type of zone Location Objectives Targeted sectors
Tsagaannuur FTZ (Trade 68 km away Accelerate International trade

Facilitation & from the development of between China,
Logistics) centre of western Mongolia Kazakhstan,
Bayan-Olgii through foreign and Mongolia and
province local investments Russia
About Create more jobs and Heavy and light
1720 km away business opportunities industries, hotels,
from for local residents resorts, service
Ulaanbaatar industries
3.1 Altanbulag Free Zone

The Altanbulag zone was established on paper in 2002 but launched
officially in 2014 after several unsuccessful attempts to start its operation.
Even though it was designed to operate permanently except in the winter
season, its operation has been sporadic since its opening day. The zone
occupies 500 hectares of land, sufficient for up to 20,000 people. Benefits
expected from this zone are increased FDI, improved export capacity, rise
of foreign currencies reserve, more job opportunities, specialisation of
workforce and impact on regional economy.
Out of four zones which GoM initially tried to establish, Altanbulag is
fully funded by GoM on infrastructure development. However, inconsis-
tent funding from the GoM has delayed infrastructure building and it is
not finished as of today. According to the Governor’s Office of the
Altanbulag SEZ, it has not received any funding from government since
2012 and its completion of infrastructure development is at only 21%.
And it should be noted that this zone is considered a more complete zone
in terms of infrastructure development compared to the other two zones.
The GoM allowed foreign investors to complete the infrastructure via
international bids. However, a lack of interested entities and their desire to
have full control of the zone were not favoured by government. As calcu-
lated by the initial development plan, total investment for the zones stands
at US$51.6 million but the zone received only US$10.6 million
(Governor’s Office of Altanbulag Free Zone, 2018) (Image 9.1).
According to the Governor’s Office of the zone, there are 105 regis-
tered entities in the zone. Around 55 companies invested US$3.3 million
200 T. TSAGAACH
Image 9.1 Development plan schema of Altanbulag free zone. (Source:

Governor’s Office of Altanbulag Free Zone)
in the zone, mostly for fences, feasibility studies and some warehouses (80
containers). Out of 105 entities, 23 have buildings, 32 have fences and 15
are actively operating. For the last 10 years, the zone collected US$420,000
as a land fee by allowing bids on land ownership. Between 2015 and 2018,
goods valued at US$3.9 million entered the zone and US$2.9 million
worth of goods was sold. Activities in wood processing, furniture, con-
struction material, auto parts and tourism industries are showing some
signs of increase.
3.2 Zamyn-Uud Free Zone

The decision to establish the zone was made by Mongolian Parliament in
2004 (Resolution No.17) and 900 hundred hectares of land was granted
to its possession. The Governor’s Office of the zone was established in
2004 under the Ministry of Industry and trade but, in 2008, it was shifted
under the jurisdiction of the Vice Prime Minister. In 2012 authority over
the zone was held by the Ministry of Economic Development and since
Image 9.2 Current map of Zamyn-Uud free zone. (Source: Governor’s Office
of Zamyn-Uud Free Zone)
2015 it has been operating under the supervision of the Vice Prime
Minister (Image 9.2).
Like Altanbulag free zone, the Zamyn-Uud free zone has a long his-
tory of unsuccessful attempts at infrastructure development and investment
attraction. In the beginning, the GoM favoured foreign know-how and
was willing to hand control of the zone to the experienced companies
which could run the zone. Using international bids and tenders, the gov-
ernment found the companies (one from the British Virgin Islands and
one from the USA) and signed long-term contracts with them after accept-
ing their proposals.
However, no works are done by the British one and the contract was
terminated in 2006. A management service agreement with the US com-
pany was also terminated after one year when the company was not able to
deposit the required amount (US$10 million). After these failed attempts
to utilise strategic investors, the government developed several plans
before it finally approved the current master plan in 2011.
In 2010, The Ministry of Finance of Mongolia and EXIM bank of
China reached an agreement to grant a soft loan to an “Infrastructure
202 T. TSAGAACH
improvement project of Zamyn-Uud Free Zone”. The total cost of this

project was US$58.8 million and US$50 million was funded by EXIM
bank, while GoM provided the remaining US$8.8 million. Within the
framework of the project four basic establishments were completed: water
supply, sewerage, power grids, roads and communication (Bilgee, 2018).
However, these facilities are not sufficient to fully operate the zone. To
illustrate, the length of the paved roads is only 13.5 km and consists of a
main street road (6.9 km), district street roads (6.9 km) and a road con-
necting the zone to the border port (1.25 km) as published on the zone’s
website. It is safe to say that these sets of works are only the first stage of
the infrastructure development. For this reason, along with unclear legal
regulations, there are no significant investment or construction activities
in the zone by tenant companies. GoM is trying to finance the second
phase of the infrastructure development through long-term loans from
other countries such as India and China.
After 5 rounds of the project selection procedure (public bids for land
possession or use in the zone) 35 companies were selected to operate in
the zone. Yet only 14 of them signed an investment agreement with the
zone. Letters sent to those 21 companies received no reply. As a conse-
quence, the zone was forced to invalidate the operation rights of those
companies. Then the next project selection bid was announced for the
sixth time in June 2018.
According to some of the tenants in the zone, business entities, who
signed the investment contract, are still unsure about the legal stances of
the zone. Though the new law has granted more freedom to free zones in
legislating their own rules and acts in favour of the investors and tenants,
the Governor’s Office of the zone is lagging in issuing the necessary poli-
cies and regulations. This inactivity could be caused by a possible estab-
lishment of the “Cross-border economic cooperation zone of Zamyn-Uud
and Erenhot” after a memorandum of understanding has been signed
between two governments.
During a visit to Mongolia in 2014, Chinese President Xi Jinping called
for a joint economic zone and agreed with the Mongolian President to
conduct feasibility studies on economic and social benefits for both sides.
To fulfil this task, a working group, assigned by the Prime Minister of
Mongolia, was formed to identify possibilities to establish cross-border
free economic zones between Mongolia and China relying upon Zamyn-
Uud and Erlian port.
Furthermore, the Governor’s Office of the zone was appointed by the
State Secretary of the Ministry of Industry to announce a bid on developing
a “Feasibility study and Risk assessment” of the joint free zone in early 2016.
As a result, two companies were selected to do the jobs and the studies were
submitted to the Governor’s Office in April, 2016. Moreover, an MOU was
signed between the Governor’s Office and Mayor’s Office of Erenhot on
“Accelerating the development of the cross-border economic zone of
Zamyn-Uud and Erenhot” in September of 2016 (Image 9.3).
Image 9.3 Development plan for cross-border free economic zone of Zamyn-
Uud and Erenhot. (Source: Governor’s Office of Zamyn-Uud Free Zone)
204 T. TSAGAACH
The joint zone is planned to occupy 9 square km and the length of the
border with Zamyn-Uud free zone is expected to be around 2 km. It is
divided into three sectors (Lixin, 2015):
1. Finance and trade

2. Manufacturing and processing
3. Tourism
Despite these efforts, the joint zone development process is stalling and
progressing at entirely different speeds on each side. On the Mongolian
side, unacceptably slow development of Zamyn-Uud zone (according to
the governor of the zone; to launch the zone officially it still lacks US$1.0
million to finish two projects) is contributing to doubts about Mongolia’s
ability to perform its responsibilities after the joint zone starts operating.
On Chinese side, it has only started establishing SEZ at the Mongolia—
China border since 2014 with the intention to have a joint free zone with
Mongolia. However, according to the administration of Erenhot, as of
today, thermal, electrical, communication, pure water and sewerage net-
works of the zone have been completed and seven plants worth $126 mil-
lion are expected to be finished in 2019.
The Zamyn-Uud zone has not commenced officially yet. The
Governor’s Office is citing many reasons including a budget shortage,
delayed construction work and the lack of business activities from tenant
companies. However, the governor of the zone has been stressing the
importance of launching the zone on a small scale (in a selected area of a
few hectares) with involvement from business entities which are waiting to
start their operations.
3.3 Tsagaannuur Free Zone

Tsagaannuur free zone is the least developed zone among the three SEZs
of Mongolia. The zone was established in 2005 with the purpose of accel-
erating regional development of western Mongolia through foreign and
local investments and benefiting from international trade between China,
Kazakhstan, Russia and Mongolia. As stated in the master plan of the
zone, its target areas are the western part of Mongolia, Altai Krai of the
Russian Federation, Xinjiang Uyghur Autonomous Region of the PRC
and the eastern side of Kazakhstan. The zone possesses 708.4 hectares of
land. It is located 60 km from Ulgii city (centre of Bayan-Ulgii province),
28 km from the Russian border, 212 km from the Chinese border and
190 km from the border of Kazakhstan (through Russian territory). The
Asian Highway 32 (AH-32) and the Asian Highway 4 (AH-4) go right
across the zone. The zone is established on the base of a former logistics
centre which was responsible for distributing goods imported from the
former Soviet Union to the five western provinces of Mongolia. Moreover,
this logistics centre was used as a port to export commodities collected
from livestock in these provinces.
Manufacturing, trade and service, banking, tourism and gambling
activities are permitted to operate in the zone. Selling and serving alcohol,
sale of cigarettes and running professional medical services businesses are
required to get a licence from the governor of the zone. As of June, 2018,
four companies have signed a contract to operate in the zone and they
possess 116.2 hectares of land according to the Governor’s Office of the
zone. These companies are planning to open businesses such as a logistics
centre, gas plant, data centre, housing project, warehousing, trade, ser-
vices and shopping centres.
4 Advantages and Disadvantages

After specifying the advantages and disadvantages, to understand further,
face-to-face, open-ended (unstructured) interviews were conducted in
each zone. Interviewees were selected from a pool of tenants, administra-
tors and potential tenants. Having all three zones not operating at full
scale makes finding suitable participants challenging. For Altanbulag free
zone, prior connections with the zone’s tenants made it easier to find the
right respondent. For Zamyn-Uud, the interviewee is a new tenant and
had contacted me for advice on the future of the zone. For Tsagaannuur,
conversation with the administration was more important than with the
actual tenants since the zone hasn’t started operating.
Interview questions are as follows after assessing their poten-
tial outcomes:
1. Brief introduction
2. What do you think is hindering the process of making the zone
operate effectively?
3. What hindrances did your company face or encounter to start and
run the business within and outside of the zone?
4. What issues occurred in terms of legal regulations?
206 T. TSAGAACH
5. What made it hard for your company in terms of aspects of the busi-
ness environment?
6. Does the zone present any opportunities to gain investments
from abroad?
7. Did you lose or make money after operating in the zone? How?
8. Will the company remain in the zone? If not, why?
9. What would you recommend for improvement or development
of the zone?
Depending on the zone and the interviewees the questions asked dif-
fered for each zone. The durations of the interviews ranged from 1 hour
up to 3 hours. Notes were collected.2
4.1 Altanbulag Free Zone
Advantages
–– Altanbulag free zone is located beside the biggest port (Altanbulag

port) entering Russia. Most of the goods being exchanged with
Russia go through this port. With the right incentives and basic
infrastructure, it is highly possible to attract a significant flow of its
track to the zone. This locational advantage allows the zone to sell
and serve customers from East Siberia, Buriat and Irkutsk with
products from Mongolia and China. Recent studies presented in
Greater Tumen Initiative (GTI) policy dialogue showed that the
Russian government is putting more effort into developing the
Siberian regions and stopping migrations to the centre of the
country. Thus, the government of Russia is investing more in pub-
lic infrastructure and living conditions and is making its markets
more open (Stepan, 2018). As illustrated in Customs Yearly
Bulletin, there are many businesses and individuals who are
engaged in re-export business transactions between China and
Russia (Mongolian Customs, 2017). The zone could be very ben-
eficial for them considering the market opportunities.
–– The zone’s location is right on the path of the Asian Highway 3
(AH-3) which would run from Ulan-Ude, Russia through
Mongolia, China and Thailand to Kengtung, Myanmar after its
2
Notes from interviews with Itgel Tsolmon, Tumur-Ochir. B and Shinebayar. G.
completion. AH3 is one of the roads which connects Asia with

Europe, initiated by Belt and Road Initiative. And Mongolia,
Russia and China have agreed to make this road a first priority
among the 32 projects planned within the framework of the
“Economic Corridor” initiative according to the President’s
Office of Mongolia. To get the full benefit of this road the zone
needs to have state-of-the-art infrastructure and to build a highly
efficient logistics centre (Image 9.4).
–– With the improved road conditions, the zone could benefit from
a dramatic increase in transit transportation which can go
through the Trans-Mongolian railway or AH-3 highway. The
Trans-Mongolian railway is 1339 km shorter than the Trans-
Manchurian railway to get from Beijing to Moscow as calculated
by the Mongolian Railway Company. However, this advantage
could be materialised only when there are fully restructured rail-
ways and highways since the existing railways and highways are
not up to international standards. The efforts to pave the AH-3
roads in Mongolia using joint investments was introduced to
Russia and China recently (Image 9.5).
Image 9.4 Asian highway routes through Mongolia. (Source: United Nations
ESCAP)
208 T. TSAGAACH
–– The last, and possibly most important, advantage is financial sup-

port from GoM even though its inconsistency is preventing the
zone operating at full capacity. As the first operational free zone in
Mongolia, Altanbulag offers many perks and privileges for its ten-
ants. Besides its higher-than-usual tax concessions, land incen-
tives, and special and preferential regimes, the zone gives the
tenants an opportunity to amend their own inputs to the zone’s
policies and rules based on their experiences obtained from the
activities occurring within the zone. On the other hand, GoM can
benefit by using the zone as an experimental laboratory for devel-
oping and testing new policies and strategies.
Disadvantages
–– No basic infrastructure prevailed. Intra-zone roads are still not

paved. This makes running any warehouse or logistics operations
implausible. Moreover, intra-zone movement of goods will be
inefficient and time consuming due to this irrationality. Also, the
absence of a heating system makes the zone seasonal. And since
there are a small number of tenants, the zone’s water supply and
Image 9.5 Trans-Mongolian railway vs. Trans-Manchurian railway. (Source:

Governor’s Office of Altanbulag Free Zone)
sewerage system can’t be turned on due to economic inefficiency.

Though electricity grids are built, it will not have enough capacity
when the zone operates at full scale.
–– Lack of commitment from the government in implementation.
Budget scarceness caused by change in importance of SEZs in gov-
ernment policy direction, incompetent administrations with politi-
cal interests, no consequences for irresponsibility (Tsolmon, 2016).
–– No increase in trade turnover through the zone because of Russian
and Mongolian customs inability to control the illegal transactions
of goods through Altanbulag port. If both Customs Offices could
conduct strict control on customs procedure many of these com-
panies and individuals would prefer to obtain their goods through
the zone because of the tax-reducing advantage. As of 2017, trade
turnover via Altanbulag free zone equals only less than 2% of the
total transaction value of Altanbulag port.
–– According to some tenants of the zone, one of the reasons that
the zone is not doing well could be blamed on the unwillingness
of the Russian government to give preferential access to the goods
going through the zone. Goods entering the zone from Russia are
treated in the same way as goods entering the Mongolian border
port. Furthermore, before the 30-day visiting grant there was one
incidence in which people from Irkutsk, who were coming to par-
ticipate in the launching ceremony of Altanbulag free zone, could
not get a visa to enter Mongolia in 2014, as told by the former
management of the zone.
–– Uncertainty is prevails in rules and regulations.
Outcome of the Interview

Interview questions focused on reasons for inactivity of the zone, difficul-
ties they faced in starting and running business, aspects of legal and
business environments of the zone, foreign investment opportunities,

profit and loss, their future plans, and recommendations for improvement
of the zone.
The interviewee pointed out three main reasons for unsuccessful opera-
tion of the zone:
1. Lack of required infrastructure development. Non-completion of

the roads, sewerage, electricity and heating facilities harmed the day-
to-day activities.
210 T. TSAGAACH
2. No interconnection between government and its related institu-

tions. There is no trade turnover because government is not easing
or facilitating the business environment to attract domestic or for-
eign businesses. The interviewee said his company engaged in re-
exports of outdoor shoes between China and Russia. After he got
the goods from China he declared them to the customs office of the
zone under the free zone regime to benefit from the tax conces-
sions. However, the customs office did not approve his request and
tried to get taxes from the goods. He went to the Governor’s Office
of the zone and they gave him an assurance letter proving his com-
pany is from the free zone. Only after presenting the letter did he
receive the preferential conditions allowed for the free zones. After
this incident the Governor’s Office requested all the tenants to get
their business licences re-printed with the words “Free Zone” after
the original names of their companies.
3. Not enough support from Russia for the zone. The interviewee said
that after several re-export transactions with a Russian partner their
business relationship comes to an end because of difficulties the
Russian side has been facing. A significant level of tariff or non-tariff
barriers from Russia made the trade unprofitable for both sides.
However, now the situation is improving in the right direction.
Thus, he wants to restore business with the Russian partner.
The interviewee did not express any big concerns over issues he faced
when he started or in running the business within the zone, except the
infrastructure problem. He was familiar with the new law and some of the
new regulations decreed under it. He even explained how some businesses
are exploiting these regulations’ weaknesses. Overall, he admitted that
legal regulations are still incomplete and uncertain in some ways. Also, it
should be noted that he was totally content with the fact that rules and
regulations of the zone are not complete. And he said it will be more the
Mongolian way if it can be finalised after or during the operation of the
zone. This shows that issues stemming from uncertainty might not be a
big problem for Mongolian tenants. However, he understands that it will
be a real hindrance to foreign companies and investors.
On the topic of foreign investment opportunities, he suggested that the
zone should go after some big foreign companies and offer them very
generous terms to bring them into the zone. If the zone can do that many
companies will follow these big companies. As an example, he suggested

that the big chain store from Russia, Absolute, could be the instigator.
The interviewee had earned a small profit during the above-mentioned
re-export transactions. But the profit was not so important for him, as he
mentions future benefits. He seemed not to care very much about any
losses he might experience. Even after I mentioned the land fee, time value
and opportunity costs, he told me that he believes in the success of the
zone and that the land will be a fortune for his descendants. He also said
that 70–80% of all tenants have the same thought as him and that is why
they pay their land fee every year even though there are no activities
in the zone.
The interviewee talked about the latest development in the completion
of the zone’s infrastructure, especially rumours about new budget distri-
bution and recent visits by high-ranking officers from government. And
he has quite a positive attitude towards the development direction of the
zone. On the recommendation for the zone, he suggested to complete
infrastructure and attraction of big trade turnover and more foreign busi-
ness participation.
In brief, the zone is still in the establishment stage and this problem is
holding back the zone from reaching its full potential. Also, the zone is
incompetent in terms of rules and regulations regarding business and legal
environments and these issues are not a hindrance for Mongolian tenants
but rather for foreigners. Most of the tenants are confident about the
prosperity of the zone and will keep paying the land fee even though they
are losing some money.
4.2 Zamyn-Uud Free Zone
Advantages
–– The main strength of this zone lies in its location. Approximately

70% of all trade transactions with China goes through Zamyn-
Uud port, which is the biggest port in Mongolia (1 km from the
zone). Completed infrastructure coupled with a favourable tax
environment can attract a significant share of the flows going
through the Zamyn-Uud port.
–– The Mongolian part of the AH-3 highway and Trans-Mongolian
railway give the zone a key advantage in logistics and transport
212 T. TSAGAACH
activities. A major portion of exports and imports of minerals,

consumer and industrial products transacts through the Zamyn-
Uud port. In peak periods, the port frequently handles excessive
loads and there is a long line of declarants in the port’s customs
office. The zone can benefit from its simplified regimes of customs
procedures by directing a certain percentage of these loads to its
territory.
–– Within the framework of the “Economic Corridor between
Russia, Mongolia and China” project, GoM is planning to develop
a new network of railways across East Mongolia (CAREC, 2009).
One of the high-priority roads is a parallel railroad to the existing
railway from “Sainshand” city to Zamyn-Uud port. This road will
reduce the loads of the main railway and will speed up the trans-
port of goods significantly. It will be beneficial to the zone in
terms of logistics and warehousing capabilities.
–– The above-mentioned “Sainshand” city has great potential to be a
successful industrial park. Mineral processing plants, such as a
coke plant, copper processing plant, metallurgy plant and thermal
plant, are planned in the park development (Ministry of Economic
Development, 2013). Thus, the opportunities in many areas,
especially in logistics, transportation and warehousing services,
will be presented to the zone.
–– Finally, the reliefs and exemptions in tax and land fees in use are at
full scale. These concessions and cuts have been identified based in
the results of many studies and practices from other countries’ free
zones. And it should be noted that the level of preferences is rela-
tively high compared to other zones used in the research.
Disadvantages
–– Being located near the city of Erlian in China has been a blessing
and a curse at the same time. Due to better infrastructure and fully
engaged local government, Erlian has been preventing the Zamyn-
Uud zone from attracting trade and investment to the zone. Since
the beginning of the 1990s this city, along with Beijing, has been
the biggest source of imports for Mongolian companies and indi-
viduals. In the beginning the city was a small countryside town at
the border of China. After Mongolia embraced the open eco-
nomic policy, the city received a huge demand in export products
to Mongolia in various sectors. As a result, the city attracted many

investors and manufacturers, which contributed to the develop-
ment of the city. Simplified customs procedure, low tax rates,
loosened legal requirements and close proximity to the Zamyn-
Uud port have been the main reasons that Mongolians do busi-
ness in the city. The city has started establishing the SEZ within
itself since 2014 and it signals big trouble for the Mongolian rival
free zone, Zamyn-Uud zone, unless the joint economic zone
materialises (Asian Development Bank, 2009).
–– Not enough support from government and lack of decent infra-
structure. As stated earlier, the zone had been suffering from sev-
eral incidents of misconduct in regard to management and
planning. After these mishaps the zone had not received any sup-
port in planning or financing from the government until the soft
loan agreement from the Chinese government. Even today the
infrastructure of the zone is not sufficient to run a business effi-
ciently within the zone. Very basic facilities have been finished in
2017 and the second stage of infrastructure development has not
been carried out yet.
–– Poor development plans and incomplete feasibility studies.
According to the USAID report “Assessment of Mongolia’s Free
Trade Zone Program and Site Evaluation”, two major recommen-
dations were emphasised in order to make the SEZ programme
successful and competitive, and to align it with international stan-
dards. First, it noted that the government had not conducted an
economic cost-benefit analysis for the establishment of the
SEZ. Second, no full commercial feasibility study for the SEZ had
been conducted, including market assessment, market planning,
infrastructure requirements, implementation planning, and busi-
ness and financial modelling (Ceron, 2004). Though government
developed a master plan after this report, it has not been imple-
mented in effective ways since. Thus, this again calls into question
the credibility of the plan.

The interviewed tenant is a co-owner of a logistics company which has
recently been selected to operate in the zone. Questions are focused on
benefits from the zone, legal and operational environment factors, uncer-
tainties, and the future of the zone.
214 T. TSAGAACH
The interviewee is looking for a profit from offering transport and

warehousing services to trading companies who conduct business between
China and Mongolia. He believes the business will be booming when the
zone launches officially because of its tax advantages in importing and
exporting products via the zone. The tenant has not started any construc-
tion activities and has paid the land fee without any concessions. He also
plans to conduct re-export business between China and Russia in con-
struction materials.
According to the tenant, like the Altanbulag zone, rules and regula-
tions within the zone are unclear or not legislated yet. There is no detailed
information specified on housing, infrastructure and uncertain circum-
stances on living conditions and social services. Also, there is insufficient
information on hiring and firing foreign workers and outsourcing from
abroad. The interviewee has indicated that there is a lack of intra-zone
roads and therefore it is not yet plausible to conduct logistics business
inside the zone.
The interviewee is pessimistic about the future of the zone. The joint
economic zone with China has affected the decision to hold starting of the
necessary construction facilities. In his view, it will be more beneficial if his
company operates within the joint zone rather than Zamyn-Uud zone in
isolation. However, he believes that government procedures are slow on
the progress of the joint zone development process.
4.3 Tsagaannuur SEZ
Advantages
–– A cheap, fast way to transport goods between Northwest China

and Russia through the AH-4. The Mongolian part of AH-4 is
under construction. After completion of the AH-4 pavement, the
zone can be a logistics centre for connecting Russia and China. The
AH-4, along with the AH-32, can boost the market potential and
trade turnover in western Mongolia (Batbold, 2007). The zone
could operate as a main trading hub for this region (Image 9.6).
–– Establishing a joint economic zone with Russia, China and
Kazakhstan could accelerate the zone’s development and increase
trade potentials significantly. Even a joint economic zone of four
countries is possible in terms of location and important highways.
Image 9.6 AH4 highway connecting China and Russia through Mongolia.
(Source: Governor’s Office of Tsagaannuur Free Zone)
Although the chances are very slim, the concept of “One zone,
four markets” is quite appealing.
–– The region is located in the High Mountains of Altai, which could
be transitioned into a core area of tourism. Therefore, it is
necessary to develop an infrastructure suited for tourism industry
(hotels, camps and tour operators).
Disadvantages
–– The biggest issue is the lack of support from the government. To

attract foreign investment, the zone needs basic infrastructure
which could only be financed by the state budget. Chinese and
Russian investors are interested in operating in the zone. Proposed
plants are a flour plant, meat processing, wood processing and a
plant for livestock feeds. However, they are waiting for the com-
pletion of the facilities of the zone.
–– Uncertainties and unstable environment for foreign investments.
Specifically, Chinese investors complain about lack of clarity and
continuity of the government policy towards investment and
financial sectors.
–– The political situation is not conducive in Xinjiang Uyghur
Autonomous Region of China.
216 T. TSAGAACH
–– The feasibility study is outdated. It has not been updated since

2009 and no additional studies have been conducted to improve
the master plan of the zone.

We interviewed an acting director of the Governor’s Office who has been
working for the zone since 2005. Questions focused more on the difficul-
ties they are facing in opening the zone, government assistance and financ-
ing, chances to attract foreign investments, and the future of the zone.
According to him, lack of cooperation with customs officers put up a bar-
rier to opening the zone. Though the Vice Prime Minister requested the
Head of the Customs Office in Bayan-Ulgii province, the customs officers
haven’t started working in the zone, citing poor working conditions and
lack of surveillance systems. This shows that there is no cohesiveness
between government agencies. Companies interested in selling their prod-
ucts inside the zone are complaining and leaving the zone.
Even some potential investors are losing their interest in investing in
the zone due to indecisiveness of the government policies towards the
zone. Without the basic infrastructure the zone will not be able to attract
large companies and investors. Moreover, the new development plan has
not been approved by the government. However, the director has a
positive attitude towards the future of the zone. He stated that with the
necessary funds and assistance from the government fundamental facilities
will be finished soon. And then by relying on the Asian highways and
Economic Corridor projects the zone would prosper in trade, manufac-
turing and service industries.
5 Conclusions
The 2015 amendment makes the SEZs more powerful. It improved on
land ownership, foreign hiring, service quality, and tax and visa conces-
sions, and went forward in promoting fair competition. However, there
are problems of implementation. Lack of detailed regulations down to the
lower levels of administration is still the biggest hurdle for investors, espe-
cially foreign investors. Hiring, firing and social insurance policies are cre-
ating uncertainties and disputes between employers and employees. Thus,
in order to solve these issues GoM needs to give the authority to legislate
own rules and regulations independently in favour of the investors and
tenants. Then the Governor’s Office of the zone can operate freely and
fast without waiting for government approvals and permissions. On the

other hand, the GoM can use the zones as the testing ground for its new
policies and regulations.
Lack of funding from GoM put up a barrier for infrastructural develop-
ment. Unsuccessful attempts to attract foreign investments along with
inconsistent funding from government are the main reasons for: 21% of
budget Altanbulag free zone; only first stage of infrastructure for Zamyn-
Uud free zone; and $480,000 of $8 million for Tsagaannuur free zone.
Without competitive infrastructure it will be a constant struggle to attract
foreign businesses and investments. To solve this, GoM needs to fully
commit to zone development and must distribute a significant share of the
revenue from the mining sector into the zones’ infrastructure as a public
investment.
Traditional SEZs are located near the coastalline to facilitate import
and export. Mongolian SEZs are located at the borders of the People’s
Republic of China (PRC) and Russia. This limits the investors. However,
AH-3, AH-4, AH-32 highways, Economic Corridor and Silk Road
(OBOR) initiatives could allow Mongolian free zones to benefit from
their strategic locations which are connecting Europe and Asia through
railways and paved roads. However, to be able to attain these benefits the
zones have to develop a strong base of logistics and warehousing capacities.
The renovation of existing railways and highways which are already
included in Asian Highways is of utmost important.
As mentioned before, the master plans and feasibility studies are out-
dated and uncompetitive. Starting without decent cost-benefit analysis
and complete development plans has been the main reason for failures and
inactivity among zones. Market assessment, market planning, infrastruc-
ture requirements, implementation planning, and business and financial
modelling need to be redefined. More participation from the private sec-
tor in planning and running of zones is to be expected. To achieve these
goals, the capability of the zone administration needs to be better.
Incompetent personnel and complete lack of responsibility contributed
greatly to the poor development of the zones.
Mongolia is currently in the process of economic diversification from
mining and is expected to utilise SEZs to promote more manufactur-
ing industry. Due to the instability of government policy and the inefficient,
bureaucratic system of public service, investors have been holding back their
funds and sending their investments out of the country. With the right
approach to the business environment, the administration of the zones can
218 T. TSAGAACH
attract investors back into the country and promote the manufacturing sec-
tor in efficient ways. This effort has been reflected in the tax regimes of the
zones through deduction of a substantial tax amount for manufacturing
activities (Aggarwal, 2014). However, it should be stressed that Mongolia
tends to fall into the middle-income category and therefore a rise in real
wages could cause some difficulties in attracting cost-conscious industries.
Moreover, attracting investment to SEZs has become more and more dif-
ficult as the traditional SEZ model is no longer effective. Investors are
looking for more than mere assembly activities, and newly defined SEZs are
offering multi-use developments including industrial, commercial, residen-
tial and even tourism activities (Farole and Akinci, 2011).
Even though there are some advantages in the location of the zones,
there are also some disadvantages in certain ways. To name a few, high
transport cost (Tsagaannuur), weather conditions (Altanbulag) and rival
port cities (Zamyn-Uud) are creating problems for Mongolian free zones.
To overcome this, GoM is experimenting with the concept of joint free
zone development with China (Erenhot) and Kazakhstan (Khorgas). The
joint zone will provide many benefits and rewards for both sides as it is
giving new market and investment opportunities. However, competing in
this kind of zone requires more resources and capabilities from GoM and
tenants from Mongolia. Without clear advantages and well-defined strat-
egy, it will be very difficult to compete with these big countries and the
zone could become an isolated enclave for partner countries such as
Mongolia (Baissac, 2011).
References
ADB, (2009). Development of Regional Cooperation Programs for Mongolia and
the People’s Republic of China [online] Ulaanbaatar: ADB, p. 9–18. Available at:
https://www.carecprogram.org/uploads/Development-of-Regional-
Cooperation-Programs-for-Mongolia-and-the-Peoples-Republic-of-China.pdf
Aggarwal, A. (2014). Many levels – Various zones: Which type suits best at given
development stage. In: Expert Hearing: Special Economic Zones in a regional
and global context – Economic significance and impact. Shanghai: Deutsche
Gesellschaft für Internationale Zusammenarbeit (GIZ) GmbH, pp. 15–21.
Baissac, C. (2011). Brief History of SEZs and Overview of Policy Debates, In:
T. Farole, ed., Special Economic Zones in Africa, The World Bank., pp. 23–60.
Batbold, Z. (2007). NEA Integrated Transport Network: Mongolia’s involve-
ment. In: Transportation and Trade Roundtable, Toyama: Northeast Asia
Economic Forum, p. 11. Available at: https://neaef.org/public/neaef/files/
documents/publications_pdf/young_leaders/2nd/z_batbold%20.pdf
Bilgee, D. (2018). Zamyn Uud Free Zone’s legal environment and opportunities for
export, import and investment.
CAREC. (2009). Country Progress Report on the Implementation Action Plan for
the Transport and Trade Facilitation Strategy. [online] Ulaanbaatar: CAREC,
pp. 4–9. Available at: https://www.carecprogram.org/uploads/Progress-
Report-TTF-Action-Plan.pdf
Ceron, J. (2004). Assessment of Mongolia’s Free Trade Zone Program and Site
Evaluation. [online] Ulaanbaatar: USAID, pp. 7–41. Available at: http://
forum.mn/res_mat/trade_zone_eng.pdf
Farole, T. and Akinci, G. (2011). Special Economic Zones: Progress, Emerging
Challenges, and Future Directions, Washington: The International Bank for
Reconstruction and Development/The World Bank, pp. 8–23.
Governor’s Office of Altanbulag Free Zone. (2018). Introduction of Altanbulag
Free Zone. [online] Available at: http://altanbulag.gov.mn/backend/f/
A9QnvGphov.pdf
Jayanthakumaran, K. (2003), Benefit-cost appraisals of export processing zones: a
survey of the literature, Development Policy Review, 21(1), 51–65.
Law of Free Zone as amended in 2015, c.9. Available at: https://www.legalinfo.
mn/law/details/10930
Linnemann, H., (ed.), van Dijck, P. and Verbruggen, H. (1987), Export-oriented
industrialization in developing countries, Singapour University Press, Manila.
Lixin, Y. (2015). One Belt One Road and Cross-border economic cooperation zone of
China and Mongolia.
Mongolian Customs. (2017). Customs Yearly Bulletin. Ulaanbaatar: Mongolian
Customs, ch. 2–8.
Ministry of Economic Development, (2013). Developing Mining-based
Infrastructure. Ulaanbaatar: Ministry of Economic Development
Stepan, Z. (2018). Industrial parks in the Russian regions. In: GTI Policy Dialogue
on Industrial Parks, Changchun: Greater Tumen Initiative, pp. 22–24
Tsolmon, Ts. (2016). The Implications of Successful SEZs in Northeast Asia:
Opportunities for Developing SEZs in Mongolia, The Northeast Asian Economic
Review, 4(2), pp. 77–88.
Warr, P. (1990), ‘Export processing zones’, in C. Milner (ed.), Export Promotion
Strategies, Wheatsheaf, New York, 130–161.
Index
A Border management, 74
Abundant natural resources, 193 Border port, 202
Accounting, 160 Borders, 128
Accreditation for product quality, 160 Business entities, 202
Afghanistan, 78, 81 Business freedom, 109, 110
Aid for trade, 175 Business numbers, 156
Aid inflows, 176, 181
Altanbulag zone, 199
Anylogic process modelling, 127 C
Anylogic simulation platform, 5 Capital-intensive, 176
Asian Development Bank, 75 Central Asia, 4
Asian Highway 3 (AH-3), 206 Central Asian countries, 2
Asian Highway 4 (AH-4), 205 China, 127
Asian Highway 32 (AH-32), 205 Churning, 160
Association of Southeast Asian Nations Civil conflict, 180
(ASEAN), 126, 158 Civil war, 180
Attractiveness Index, 100 Clearance post-audit, 74
Clustering, 159
Commodity prices, 102
B Communication infrastructure, 75
Belt and Road Initiative (BRI), 207 Comparative, 187
Best practices, 152 Comparative advantage, 50
Bhutan, 91 Container unitisation, 130
Booming sector, 18 Corporate tax rate, 108
Border delays, 152 Corruption, 52, 102

https://doi.org/10.1007/978-981-13-6814-1
222 INDEX
Cross-border movement, 75 F
Cross-border trade, 129 FDI determinants, 96, 116
Customisation, 158 Firm heterogeneity, 48
Customs, 74, 187 Firm productivity, 59
clearance systems, 76 Foreign aid, 6, 175, 188
formalities, 187 Foreign direct investment (FDI), 4, 95
Foreign equity ownership, 81
Foreign investment inflow, 108
D Foreign ownership, 170
Delivery performances, 141
Demographic dividend, 72
Dependence, 185 G
Developing countries, 39 Gas sector, 49
Digitisation, 76 Geographical isolation, 160
Direct effect, 19 Geographic Information System (GIS)
Discrimination, 160 data, 146
Doing Business Index, 187 Global Competitiveness Index, 78
Domestic instability, 185 Globalisation, 81
Domestic reforms, 155 Global retail sourcing, 158
Donor community, 176 Global value chains, 24
Dutch disease, 2 Good governance, 188
symptoms, 50 Government regulation, 109
Gravity equations, 85
The gravity model, 85, 102
E Greater flexibility, 159
e-commerce, 159, 162
Economic Corridor, 207, 212, 216
Economic diversification, 2, 57, 217 H
Economic growth, 16 Harmonisation, 77
Economic liberalization, 102 High costs in accessing and utilising
Economic mismanagement, 29, ICT, 160
53–56 Higher-price exporters, 59
Economies of scale and scope, 160 Higher transaction costs, 160
Employment generation, 156 Higher-value-adding, 168
Endogeneity, 53, 85 High-productivity plants, 58
Engine of growth, 26
Entrepreneurial, 160
Entrepreneurship development, 165 I
Exchange rate pass-through, 59 ICT-driven economy, 163
Export diversification, 57 Import substitution, 194
Export performance, 3 Inability to compete against larger
Extensive margin, 58 firms, 160
INDEX 223
Income inequality, 27 Lack of information, 160

Increased market competition, 160 Lack of networks, 160
Industrialisation, 193 Lack of resources, 160
Infant industry argument, 31 Lacks a bankruptcy law, 166
Inflation rate, 117 Lack skills, 160
Information technology, 76, 131 Lagging sector, 18, 19
Infrastructure, 36 Landlocked, 193, 194
development, 107, 197 Landlocked countries, 1, 91, 125, 156
indexes, 78 Landlocked developing countries
Innovation, 158 (LLDCs), 77, 96
Instability, 160 Lao People’s Democratic Republic
Institutional reforms, 176 (PDR), 2, 157
Integrated agent-based modelling, 132 The Law of Free Zones, 195
Intensive margin, 58 Lead times, 134
International Exhibition Logistics Legal system, 166
Associates, 128 Level of corruption, 114
International Think Tank for Land- Liberalisation, 81
Locked Developing Countries Liberalized trade, 107
(ITT for LLDCs), 2 Limited knowledge about language
International transit, 74 and culture, 160
Interventionist approach, 36 Linkages, 50, 193
Intra-regional trade, 73, 76 LLDCs in Central Asia, 96
Intra-zone roads, 208 Logistics centre, 205
Inventory, 140 Logistics delivery model, 127
Inventory cost, 140 Logistics delivery systems, 151
Inward FDI flows, 96 Logistics performance index, 81
Logistics process, 126
Logistics strategies, 126
J Logistics system, 126
Java-based programming, 139 Low cost options, 63
Lower-price exporters, 59
Low-productivity plants, 58
K
KKZL indexes, 110
Knowledge, 158 M
Knowledge-based economy, 162 Managerial, 160
Knowledge-spillovers, 22 Manufactured exports, 22
Manufacturing, 11
Market dependency, 183
L Market entry cost, 58
Labour market, 23 Marketing skill deficiencies, 160
Lack of business infrastructure, 160 Market-seeking FDI, 105
Lack of competitiveness, 157 Method, 96
224 INDEX
Micro-, small- and medium-sized Origin of the resource curse

enterprises (MSMEs), 4, 155, 156 hypothesis, 49–52
Middle-income category, 193 Overshooting model, 13
Mineral-resource-abundant, 105 Oyu Tolgoi, 195
Mineral-resource-rich countries, 113
Mineral resources, 104
Minimum wages, 187 P
Mining sector, 22 Panel data analysis, 97
Misallocation, 32 Pass through, 65
Missing middle, 156 Pick winners, 38
Mongolia, 2, 126 Piecemeal protectionism, 32
Multifiber Arrangement, 180 Political instability, 109, 114, 183
Port logistics, 76
Positive externalities, 22
N Poverty, 32
National Statistics of Office of Poverty alleviation, 176
Mongolia, 194 Prebisch, R., 11
Natural resource curse, 10 Prebisch-Singer hypothesis, 11
Natural resources crowd out, 16 Preferential Trade Agreement, 77
Nepal, 4, 81, 91, 177, 181 Primary goods, 11
Networking, 159 Primary products, 11
Niche markets, 158 Process-centric simulation models, 5
Non-democratic regimes, 56 Process model, 126
Non-exporters, 64 Process of globalisation, 155, 168
Non-market-seeking FDI, 105 Product differentiation, 64
Non-resource firm heterogeneity, 2 Production capacity, 151
Non-resource tradables sector, 3, 18 Production networks, 127, 158, 168
Non-tradables sector, 19, 27 Productivity, 3
Northeast Asian region, 127 Productivity cut-off, 62
Product life cycles, 158
Property rights, 166
O Protectionism, 29, 77
Oil resource abundance, 48
Oil windfalls, 51
Open border, 186 R
Open Street Map, 139 Ramsey model, 13
Optimal number of trucks, 151 Real appreciation, 24, 30
Order agents, 135, 139 Real exchange rate appreciation, 12
Order in delivery, 141 Recognition by policymakers, 159
Ordinary least square (OLS), Regional economic integration, 127,
96 155, 158
INDEX 225
Regional production networks, 165 Stabilisation, 31

Rent seeking, 52 Strategic Entities Foreign Investment
activity, 13 Law (SEFIL), 195
behaviour, 15 Supply chain, 129
Resource abundance, 10, 14
Resource-abundant countries, 9
Resource bonanza, 59 T
Resource boom, 61 Tariff structure, 188
Resource dependence, 49, 52 Technology and know-how, 168
Resource dependent, 59 Technology development, 159
Resource-driven growth, 12 Telecommunications infrastructure,
Resource misallocation, 38 163
Resource mobility, 50 Tourism, 180
Resource movement, 20, 25 Tradable non-resource sectors, 49
Road conditions, 126 Trade competitiveness, 91
Road infrastructure, 129 Trade costs, 58, 73
Rural-based agriculture sector, 176 Trade facilitation, 1
Russia, 217 Trade facilitation measures, 159
Trade flows, 75
Trade logistics, 129, 151
S Trade openness, 107
Seaports, 129, 177 Trade performance, 182
Self-selection, 63 Trade theory, 26
Services sector, 158 Trade volume, 90
Shipment agent, 139 Traditional SEZ model, 218
Simulation models, 139 Transaction costs, 76
Simulating processes, 132 Transaction costs at borders, 90
Skills, 158 Transit costs, 186
Small- and medium- sized enterprises, Transition economies, 100
128 Transit trade corridors, 129
Smuggling, 188 Transit transportation, 207
South Asia, 71, 90 Trans-Mongolian railway, 207, 211
South Asian Association for Regional Transport, 129
Cooperation (SAARC), 87 agent, 132, 137
Southeast Asia, 156 capacity, 150
Sovereign wealth fund (SWF), 36 cost, 218
Special economic zones (SEZs), 5 Transportation and infrastructure, 126
Spending effect, 33 Truck load, 132
Spillovers, 21 Truck utilisation, 141
226 INDEX
Tsagaannuur free zone, 204 in resource prices, 27
U W
Underdevelopment, 175 Wages, 19
Undue taxes, 129 Waiting time for product, 141
United Nations (UN), 74 Windfall incomes, 52
Urban-biased development strategy, 181 World Bank, 75, 128
World Customs Organization (WCO),
75
V
Van Wijnbergen, S., 34
Volatility Z
in commodity prices, 53 Zamyn-Uud free zone, 201

Trade Logistics in Landlocked and Resource Cursed Asian Countries

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Trade Logistics in

ISBN 978-981-13-6813-4 ISBN 978-981-13-6814-1 (eBook)

1 Introduction: Trade Logistics in Asian Countries That Are

Part I Economic Diversification 7

2 The Dutch Disease and Economic Diversification: Should

3 Inclusion of Firm Heterogeneity in Resource Boom-Bust

4 Trade Facilitation in South Asia: Landlocked Countries’

5 The Determinants of FDI in Landlocked Developing

Part II Country Studies: Laos PDR, Nepal and Mongolia 123

6 Modelling Trade Logistics Based on Multi-­Method

7 Micro-, Small- and Medium-Sized Enterprises (MSMEs):

8 Foreign Aid and Export Performance in a Landlocked

9 Formation of Special Economic Zones in Mongolia193

Mohammad Tariful Bari is a senior assistant chief in the Planning

focuses on the economies of East and Southeast Asia, and is published in

Tsolmon Tsagaach is a senior lecturer in the Business School, National

Mohammad Tariful Bari School of Accounting, Economics & Finance,

Nagesh Shukla School of Information, Systems and Modelling, Faculty

Fig. 3.1 Dutch disease symptoms. (Source: Author constructed) 50

Box 3.1 Resource Sector Boom in Mongolia: 2007/08–2011/12 60

Introduction: Trade Logistics in Asian

© The Author(s) 2019 1

to the acknowledged urgency of knowledge sharing an ‘International Think

2 Part 1: Economic Diversification

Nepal disadvantaged; and why is the intra-regional trade in South Asia so

3 Part 2: Country Studies: Lao PDR, Nepal

dependency on developed nations and widening gaps in economic oppor-

building through knowledge and skills acquisition, technology upgrading,

The Dutch Disease and Economic

© The Author(s) 2019 9

2 The Resource Curse: An Overview3

A fourth explanation is the “overshooting model” presented by

low-quality institutions results in government failure and inefficient usage

2.2 Resource Abundance and Economic Growth: A Review

source” resources) are more susceptible to state capture than diffuse

exports of primary agriculture, fuels and metals, energy) in GDP or

 ther Evidence on the Resource Curse

Polterovich et al. (2010) compiled a statistical portrait of a “typical”

3 The Dutch Disease

3.1 A Simple Dutch Disease Model and Transmission Process

prices are determined endogenously by domestic supply and demand

3.2 Dutch Disease Transmission Mechanism: Detailed Outcomes

knowledge accumulation and productivity growth in the long run. Other

 he Dutch Disease and Developing Economies

Competitive and Flexible Markets

Perfect Substitutability Assumption

No Intermediate Input Assumption

more complex to analyse compared to that of a standard trade model

Immobile Factors of Production

4 De-industrialisation, Long-Run Growth

4.2 Is De-industrialisation Bad for Economic Growth?

such as: increasing returns to scale, productivity enhancing activities,

from manufacturing can be detrimental as previously indicated and would

5 Other Aspects of a Resource Boom

5.1 Volatility and the Transmission Mechanism

5.3 Government Weaknesses and Corruption

6 Policy Responses to the Dutch Disease

Fourth, protection can result in major resource misallocation more

6.4 Macroeconomic Stabilisation Program: Fiscal Surplus

I mportance of Fiscal Policy

6.5 A Framework to Determine How Much of the Resource

van Wijnbergen (2008) used the “permanent income approach” to devise

6.6 How Should Government Savings (Budget Surpluses)

6.7 Investing the Funds Domestically

1 Introduction: Trade Logistics in Asian Countries That Are

Part I Economic Diversification 7

2 The Dutch Disease and Economic Diversification: Should

3 Inclusion of Firm Heterogeneity in Resource Boom-Bust

4 Trade Facilitation in South Asia: Landlocked Countries’

5 The Determinants of FDI in Landlocked Developing

Part II Country Studies: Laos PDR, Nepal and Mongolia 123

6 Modelling Trade Logistics Based on Multi-Method

7 Micro-, Small- and Medium-Sized Enterprises (MSMEs):

8 Foreign Aid and Export Performance in a Landlocked

9 Formation of Special Economic Zones in Mongolia193

Fig. 3.1 Dutch disease symptoms. (Source: Author constructed) 50

Box 3.1 Resource Sector Boom in Mongolia: 2007/08–2011/12 60

ther Evidence on the Resource Curse

he Dutch Disease and Developing Economies

I mportance of Fiscal Policy

t raditional agriculture export activity, this could have severe implications

Gylfason 1980–1997 65 Resource- Education is inversely related to natural

Melitz (2003) argues that in a non-resource-intensive country, lower-