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

79 Pages·2017·0.92 MB·English

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