Diversification and Development

This paper explores the relationship between output volatility and economic development. We develop a methodology to assess countries’ extent of sectoral diversification. The productive structure of a country tends to be risky when the country (i) specializes in highly volatile sectors, (ii) has high sectoral concentration, and/or (iii) specializes in sectors highly affected by country-specific fluctuations. Within the context of a portfolio choice model, we derive the implied mean-variance frontiers both for individual countries and for the world, and compute countries’ distances to each. We find that as countries develop, they move from riskier sectors to safer ones. In addition, sectoral concentration declines with development at early stages, whereas at later stages the relation flattens out and tends to reverse slowly. The concentration index we construct is robust to the arbitrariness of sectoral classification. Finally, poor countries are typically inside their mean-variance frontier, that is, they could achieve the same level of productivity at lower risk by modifying their sectoral composition. Existing theories linking volatility and development are not consistent with all of our findings. We propose new directions for future theoretical work. (O11, O14, E32, G10) An important theme in the growth and development literature is the relationship between risk, diversification, and economic development. In a seminal paper, Lucas (1988) observes that developed countries tend to exhibit stable growth rates over long periods of time, whereas poorer countries are prone to experience sharp fluctuations in growth rates. This relationship is illustrated in Figure 1, which plots the standard deviation of annual growth rates against the level of real GDP per capita for a large cross section of countries.