Economic growth models provide a framework for thinking about how economic growth processes and income convergence take place, and how behind-the-border policy settings can influence the process. Traditional and modern economic growth theories suggest that we would expect to find lower-income economies growing faster than higher-income economies, thereby bringing about the convergence of per-capita incomes between economies over time.

Convergence in the neoclassical growth model is driven by capital flowing from places where it is abundant (high-income economies) to where it is scarce (low-income economies) to achieve the highest possible returns. In this way, economic integration can bring about growth and income convergence. However, empirical evidence suggests that capital flows from high-income to low-income economies are very modest and much less than predicted by the neoclassical growth model (Lucas 1990). Migration, trade and specialisation are other mechanisms that could drive growth and income convergence (see Sinn 2007; Frankel and Romer 1999).

Endogenous growth models emphasise the spill-over of ideas and technological knowledge as a key mechanism driving growth and income convergence. The transfer of scientific knowledge may occur through foreign direct investment (FDI) in low-income economies, bringing with it the skills of investors, or through international trade. Economies may ‘learn by exporting’ through interacting with foreign customers and learning how to meet higher product standards, or through technology embodied in imports. Keller (2004) surveys the literature on the extent of international technology diffusion and the channels through which technology is spread. He concludes that there is no evidence that international learning is inevitable, or that it is easier for relatively undeveloped economies. Evidence suggests that importing is associated with technological spill-overs, but evidence of benefits associated with exporting is weaker. The literature suggests that there can be spill-overs from FDI but they vary between economies, regions, sectors, and firm structures. Similar conclusions are drawn in the surveys by Greenaway and Kneller (2007) and Wagner (2007).

In addition to ‘static gains’ from trade (arising from economies exploiting their comparative advantage and economies of scale), there are also potential ‘dynamic gains’ from trade. Dynamic gains from trade refer to trade-related improvements in an economy’s productivity growth rate that arise from increased integration in the global economy. A recent OECD (2007) study identified three interconnected channels through which trade may increase productivity: by increasing investment; aiding technological diffusion; and promoting the competitive impetus to innovate. The empirical evidence on dynamic gains from trade is mixed. Research has not established a robust link between trade policy and long-run productivity growth rates. However, there is a strong correlation between increasing shares of trade in gross domestic product (GDP) and GDP growth.

Traditional and modern growth theories imply that there are potential benefits from ‘economic openness’ for all economies, not simply the lower-income economies, through specialisation, better allocation of skills and other resources, the dynamic interaction of learning, and the two-way spill-over of knowledge. Outward-orientation and strong growth performances have resulted in impressive economic growth in some low-income economies in the APEC region in recent years. Notable examples include China and Vietnam and, earlier, Korea and Singapore. However, progress across the APEC region has been patchy and evidence suggests that convergence mechanisms may not be operating as well as expected in some economies due to barriers at and behind the border. Furthermore, recent thinking suggests that what it takes to achieve growth at lower income levels may be different from what it takes to sustain growth at higher levels of income, and over the long term (World Bank 2007a; Rodrik 2003; Gill and Kharas 2007). This raises the question of not only how to lift performance in the slower-growing economies but also whether, and how, the recent impressive growth performances of some economies in the region can be sustained in the future.

Results from growth regressions suggest that deregulation in countries that start from a position of heavy regulation will result in improved economic performance. Djankov et al. (2005) found, after controlling for other factors, that economies with better regulations, as measured by the World Bank’s Ease of Doing Business indicator, grow faster. In particular, they concluded that improving from the worst quartile of business regulations to the best implies a 2.3 per cent increase in annual GDP growth. Improving from the worst quartile to the third quartile implies a 1.1 per cent increase in annual GDP growth. Erickson (2006) updated this work using the 2006 Ease of Doing Business data and an expanded sample of economies. Erickson was not able to reject the basic message of Djankov et al. that economies with better regulations grow faster, although his estimates of the gains were smaller (concluding that economies would achieve a 1.4 per cent growth increase from moving from the worst quartile to the best, and 0.6 per cent increase from moving from the worst quartile to the third quartile).

Alesina et al. (2005) show that the effect of product-market deregulation in OECD countries since the 1970s had significant effects on investment in utilities, transport and communications. By using indices of product-market regulation and by estimating the effects of these regulations on the rate of growth catch-up at the industry level in OECD economies, Nicoletti and Scarpetta (2003) show that product-market regulation tended to slow down catch-up growth in manufacturing and services. Their evidence also suggests that entry-limiting regulation may hinder the adoption of new technologies, possibly by reducing competitive pressures, technology spill-overs, or the entry of new high-technology firms.

Using a different approach, which captures general equilibrium adjustments and links various economies in the region, Dee (2005) evaluates the economic payoffs from structural policy reform in the East Asian region. This study includes nine APEC economies: China, Japan, Korea, Indonesia, Malaysia, Philippines, Singapore, Thailand and Australia. Dee examines the impact of three scenarios: a regional preferential trade agreement (including trade liberalisation and the elimination of regulations that discriminate against foreigners); the successful completion of the Doha round of World Trade Organisation (WTO) negotiations; and unilateral regulatory reform. Dee’s estimates show that preferential trade liberalisation and preferential reform of regulations would add US$16.6 billion per annum and US$2 billion per annum respectively to regional income. The successful completion of the Doha round would result in much larger gains of over US$30 billion per annum. However, by far the largest gains result from unilateral regulatory reform, which is estimated to result in gains of over US$100 billion per annum for the region.

On a cautionary note, the studies referred to in this section do need to be treated with some care given the difficulties in quantifying the extent of domestic regulatory restrictiveness, and hence measuring the gains from reforming. However, reviews of the evidence, such as the paper by Crafts (2006), suggest that the quality of regulation can impact significantly on productivity growth. Crafts also reviews other evidence of the effects of regulations on productivity and growth, including the transmission channels, and concludes that there is solid evidence that product-market regulation reduces productivity growth, particularly through creating barriers to entry, and this is more damaging in the context of new technological opportunities.

This review of international evidence suggests that in order to promote regional economic integration and productivity growth, it is appropriate that APEC promotes sound microeconomic structural policies, in addition to its traditional focus on trade and investment policies, and macroeconomic and financial policies. This is also supported by insights from the experiences of economies that have undertaken comprehensive or even partial structural reforms that suggest policy coherence is important. Policy coherence is achieved when economic policies support, or at least do not undermine, the effectiveness of other policies in attaining overall policy objectives, such as improved economic performance and higher standards of living. For example, openness to trade and FDI leads to opportunities, not guarantees, which may not be realised if structural policies do not support competition and efficiency. Similarly, gains from structural reforms increase significantly in an economy that can leverage global opportunities (APEC Policy Support Unit 2008).

Chile’s pro-competitive reform is an example of how policy can be designed to enhance the beneficial effects of trade policy reform. During the period after the late 1970s, Chile gradually removed high import tariffs and moved toward a low-level uniform import tariff (Corbo 1997). In order to avoid the negative impact of a uniform tariff on domestic competition, from the 1990s Chile introduced a more liberal investment regime and started to negotiate preferential trade agreements (PTAs) with many trade partners in a strategy of ‘additive regionalism’, thus allowing a significant number of foreign firms to fully compete with domestic producers.

In the next section we undertake a simple test of whether structural policies impact on income convergence in APEC economies by estimating a standard cross-economy convergence model for the region using a method along the lines of Baumol (1986) and Barro (1991).