The Empirical Economics Letters, 7(5): (May 2008) ISSN 1681 8997

How Important is Water Endowment for Trade in Agricultural Products?

Gairuzazmi M. Ghani
Department of Economics, KENMS, International Islamic University Malaysia P.O. Box 10, 50728 Kuala Lumpur, Malaysia Email: gairuzazm@iiu.edu.my
Abstract: Water is an important input for the production of agricultural products. Hence, following the Heckscher-Ohlin model and the virtual water hypothesis, relatively water abundant countries will have comparative advantage in agricultural products. We show that water endowment does play a role in determining agricultural products comparative advantage, especially for net importing countries. Keyword: Virtual Water, Trade Patterns, Agricultural Trade, and Hecksher-Ohlin. JEL Classification Number: Q17, Q25, and F18.

1.

Introduction

We show that water endowment plays a role in determining comparative advantage in agricultural products, especially for net importing countries. Across sectors, agriculture is the most intensive water user, accounting for more than 70 percent of global fresh water withdrawal1. Water endowment across countries also differs, hence, following the Heckscher-Ohlin (HO) model; water endowment is important in explaining comparative advantage in agricultural products. Furthermore, the virtual water (VW) hypothesis shows that a country can reduce its water withdrawal substantially by importing the embedded water in the agricultural products instead of producing them domestically. Virtual water is thus an alternative water source, next to domestic water sources. At the global level, trade also save water if exporters use water more efficiently than importers, or when exporters cultivates under rain-fed conditions, while importers rely on irrigated agriculture. The importance of water in the agricultural sector, the potential global water saving because of trade and the differences in water endowment across countries, justify the studys objective in examining the importance of water endowment in determining comparative advantage in agricultural products. 2. Trade in Agricultural Products and Water Endowment Background

Even though water is an important factor of production for agricultural products, the literature on international trade has not examines the importance of water directly. The
1

Withdrawal is the gross amount of water extracted from any sources either permanently or temporarily for agriculture, domestic or industrial use.

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exceptions are Hakimian (2003) and Sayan (2003). They show that water endowment is important in determining the direction of trade in agricultural products for the Middle East and North African countries. However, the results from Hakimian (2003) are sensitive to the definition of water used. On a related literature, Leamer (1984) who study the sources of international comparative advantage across industries, and, Peterson and Valluru (2000) who study the effect of government policy interventions on agricultural comparative advantage, indirectly test the importance of water endowment by embedding water in the type of lands. Meanwhile the literature on virtual water (see Hoekstra, 2007) measure water used in the production of different products, but not the direction of trade or the importance water in determining comparative advantage in agricultural products. 2.1. Importance of Water for Agriculture Agricultural sector accounted for about 70% of global fresh water withdrawals in 2000. This is in contrast to the industrial sector, which accounted for 20% of withdrawals, and household use which accounted for 10%. For developing countries, on average, agricultural sector accounted for 81% of water withdrawals, but it only accounted for 45% of withdrawal for developed countries. The difference is because the share of agricultural sector in developed countries is small compared to developing countries. In term of output, agricultural sector accounted for 15.4% of GDP in developing countries, while it accounted for 1.7% of GDP in developed countries2. The disproportionate share of water use by agricultural sector and the output from agricultural sector further highlight the intensity of water used for agricultural production. The intensity of water usage can be further demonstrated at the disaggregated product level. It takes between 500 to 4,000 liters of crop water to produce one kilogram of cereal (Fraiture et al., 2004). About 1-2 m3 of water are needed to produce 1 kg of grain3, 16 m3 of water are needed for 1 kg of beef and 105 kg of water to produce 1 kg of potatoes (Chapagain & Hoekstra, 2003). 2.2. VW and HO VW is the volume of water required to produce a commodity or service. Allan (1993) introduced the concept when studying the option of importing virtual water as a partial solution to problems of water scarcity in the Middle East. Virtual water import, which come along with food imports, provide a tool to release the pressure on the scarcely available domestic water resources in the region as the importation of agricultural products indirectly import water. Meanwhile, following the HO model, trade in goods is an indirect way of trading factors of production. The HO model is based on two essential premises: (i)
2 3

Source: World Development Indicators CD-ROM and Pacific Institute. www.worldwater.org 1 m3 = 1000 kg

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countries factor endowments varies, and (ii) resources intensity for production varies for different products. Applying the HO model to water resource yields similar results to that of the virtual water hypothesis. Given that production of agricultural products is water intensive, both the HO model and the VW hypothesis predict a specialization pattern that is based on imports of agricultural products from relatively water abundant to relatively water scare countries. 3. Comparative Advantage in Agricultural Products (HO Model)

To justify the empirical approach in explaining comparative advantage patterns, we follow Leamer (1984) by considering the standard HO theory. Assuming Leontieff technology, the system of equations that relate factor supplies to factor demands is given as:
K = a K 1Y1 + a K 2Y2 L = a L1Y1 + a L 2Y2

(1) (2)

where K and L are the amounts of factors, available in a country. These factors varies by countries and are not mobile internationally. Y1 and Y2 denote the quantity of the two products produced in the country. aK1, aK2, aL1, and aL1, are the factor intensities determined by the production technologies of each products, and they represent the units of factors required to produce a unit of output. Equations (1) and (2) can be generalized to a model with multiple products and factors of production as long as the latter do not exceed the number of products, or as long as the model is just identified or under-identified. Hence:
Y = A 1V

(3)

where Y is the vector of outputs, V is the vector of endowments and A is the vector of factor intensities. A is invertable as long as the production technologies are different across sectors so that the ratios of factor intensities across sectors are not identical. Consequently, world production is given by:
YW = A 1VW

(4)

where YW is the vector of world outputs and VW is the vector of world endowments. Assuming identical homothetic preference, a country consumption levels (C) is:
C = sYW

(5)

where s is the countrys consumption share. Under balanced trade, from (3), (4) and (5), the vector of net exports is the product of the inverse of the vector of factor intensities across product clusters and the difference between each countrys vector of endowments and the worlds vector of endowments, i.e.:
NX = Y C = A 1 (V sVW )

(6)

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A country with balanced trade will export the services of its abundant factors and import the services of its scarce factors. However, the balanced trade assumption for a single year can be relaxed when panel data is used. Deardorff (1994) points out that the model holds in multiple periods as long as trade is balanced over all periods together. 4. Empirical Approach To examine the importance of water endowment in determining comparative advantage we estimate the following model, for product cluster i (cereal, animals and tropical agricultural).
NX
jt

= j + A 1V jt + jt

(7)

where NX is the net export of product cluster i by country j at time t, A is the factor intensities matrix, V is the matrix of country-specific relative factor endowments and is the individual country effect. We use the cluster shares of the sum of the absolute value of net exports (NXij) as a proxy for net export (see Leamer et al, 1999):
NX ij = nx ij

nxij
i

(8)

where nxij is the net export of product cluster i from country j. The variable NXij ranges from 1 to +1 where a positive value mean that the country has a comparative advantage and hence exporting the product, while a negative value mean that the country is a net importer of the products. We divide the product cluster into (i) raw materials, (ii) forestry, (iii) tropical agriculture, (iv) animals, (v) cereal, (vi) labor intensive, (vii) capital intensive, (viii) machine, (ix) chemical (see Leamer, 1984; Xu, 2001). Only the results for agricultural products i.e cereal, animals and tropical agricultural products are reported. To measure relative endowment (adjusted for openness) we follow Spilimbergo et al. (1999), where adjusted relative endowment (REjf) is: E jf RE jf = ln * (9) Ef And
E pop X + M jf j gdp j j * Ef = X +M pop j gdp j j

(10)

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Ejf is the endowment of country j in factor f, popj is the population in country j, X is exports, M is imports and gdp is gross domestic products. In addition to water, we also include the three traditional factors endowment, namely land, labor, and capital. The data are of 10 year interval for the period 1970-2000. Data sources are reported in Appendix A. Suspecting non-linearity we estimate (7) in two steps, firstly we use Logit model where NXjt is equal to 1 for net exporting countries and 0 for net importing countries. Then we estimate the fixed and random effects model on the group of net exporting and net importing countries. Table 1 reports the results for the Logit model. Table 2 and 3 report the fixed and random effects results for the net exporters and net importers respectively4. Table 1 show that relative water endowment is statistically significant at conventional level in explaining the probability of being a net exporter or importer for animal products; however it is not significant for cereal and tropical agriculture. The second stage of regressions (Table 2 and 3) shows that for the net exporters, relative water endowment is not significant; however, for the net importers the coefficient for water endowment is significant. The results mean that for the net importers, countries which have relatively small amount of water import relatively more agricultural products; however the implication cannot be extended to exporting countries. For the exporting countries, water endowment is not a statistically significant factor in explaining trade in agricultural products. This may be the case because agricultural products require a certain minimum amount of water; after the requirement is fulfilled the excess water does not provide any advantage to the country. The exporting countries have the minimum required level of water; hence the determination of comparative advantage does not depend on water endowment but the other factors. Table 1: Random Effect Logit Model Water Land Capital Labor No. of .Observations No. of .Groups 2 Cereal 0.308 1.539** -0.193 -1.526** 289 91 15.79** Animal 0.529** 1.269** -1.141** -0.412 290 92 20.54** Tropical 0.472 -0.487 -0.988** 1.162 290 92 11.62**

Notes: Dependant Variable is probability of being a net exporter. ** denotes significance at 5% level.

Only the coefficient for water endowment is elaborated as the objective of the paper is on the importance of water.

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Table 2: Fixed and Random Effects for Net Exporter Cereal Fixed Random -0.105 -0.009 0.024 0.039** -0.023 -0.012 0.092 -0.025 104 104 48 48 0.104 0.152 7.81* Animal Fixed Random 0.003 -0.005 -0.059** -0.008 0.010 0.011* 0.045 -0.007) 162 162 64 64 0.065 0.163 6.83 Tropical Fixed Random -0.006 0.003 -0.026 -0.034** -0.052** -0.031** 0.018 0.048** 174 174 64 64 0.345 0.161 34.14**

Water Land Capital Labor N.Obs N.Groups R-squarea Chi-squareb

Notes: a for fixed effect R2 and R2 is overall for random effects. .b Chi square from Hausman test. ** denotes significant at 5% level and * denotes significant at 10% level

Table 3: Fixed and Random Effects for Net Importer Cereal Fixed Random 0.097** 0.013** -0.019 0.012** -0.005 0.014** -0.078** -0.037** 186 186 74 74 0.273 0.298 24.74** Animal Fixed Random 0.037** 0.003 -0.019 0.002 -0.024** -0.003 0.012 -0.002 128 128 50 50 0.085 0.069 5.81 Tropical Fixed Random 0.049** 0.003 0.006 0.003 -0.014 0.001 -0.025* -0.008 116 116 45 45 0.254 0.013 20.37**

Water Land Capital Labor N.Obs N.Groups R-squarea Chi-squareb

Notes: a for fixed effect R2, and R2 is overall for random effects. b Chi square from Hausman test. ** denotes significant at 5% level and * denotes significant at 10% level.

5. Conclusion Water is important in the production of agricultural products. Following the HO model and the virtual water hypothesis, relatively water abundant countries will have comparative advantage in agricultural products. We show that results of the two models support especially for net importing countries. For animal products water endowment does explain the probability of being a net exporter or importer.

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References Allan, J.A., 1993, Fortunately there are Substitutes for Water Otherwise our HydroPolitical Futures would be Impossible, In Priorities for Water Resources Allocation and Management, London, United Kingdom, pp. 1326. Baier, S., Dwyer, G. and Tamura, R., 2006, How Important are Capital and Total Factor Productivity for Economic Growth, Economic Inquiry, 44, 23-49. Chapagain and Hoekstra, A.Y., 2003, Virtual Water Trade: A Quantification of Virtual Water Flows between Nations in Relation to International Trade of Livestock and Livestock Products, Virtual water trade Proceedings of the International Expert Meeting on Virtual Water Trade Ed. A.Y. Hoekstra. Fraiture, C., Cai, X., Amarasinghe, U., Rosegrant, M. and Molden, D., 2004, Does International Cereal Trade Save Water? The Impact of Virtual Water Trade on Global Water Use, International Water Management Institute. Hakimian, H., 2003, Water Scarcity and Food Imports: An Empirical Investigation of the 'Virtual Water' Hypothesis in the MENA Region, Review of Middle East Economics & Finance, 1, Article 1. Leamer, E.E., 1984, The Sources of International Comparative Advantage, MIT Press, Cambridge, MA. Leamer, E.E., Hugo Maul, H., Rodriguez, S., and Schott, P., 1999, Does Natural Resource Abundance Increase Latin American Income Inequality? Journal of Development Economics, 59, 3-42. Peterson, E.W.F., and Valluru, S.R.K., 2000, Agricultural Comparative Advantage and Government Policy Interventions, Journal of Agricultural Economics, 51, 371-87. Sayan, S., 2003, H-O for H2O: Can the Hecksher-Ohlin Framework Explain the Role of Free Trade in Distributing Scarce Water Resources Around the Middle East? Review of Middle East Economics & Finance, 1, Article 2. World Bank., 2003, World Development Indicators CD-ROM.

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Appendix A: Data Sources Variable Description Import and Export Value 1. Raw Materials (SITC 27, 28, 32, 34, 35 and 68) 2. Forest Products (SITC 24, 25, .63 and 64) 3. Tropical Agriculture (SITC 5, 6, 7, 11 and 23) 4. Animal Products (SITC 0 to 3, 21, 29, 43, and 94) 5 Cereals, Oil, Textile Fibers, Tobaco and others (SITC 4, 8, 9, 12, 22, 26, 41, and 42) 6. Labor Intensive (SITC 66, 82 . to 85, 89, 91, 93 and 96) 7. Capital Intensive (SITC 61, 62, 65, 67, 69 and 81) 8. Machinery (SITC 71 to 79, 87, 88 and 95) 9. Chemicals (SITC 51 to 59) Water Endowment Natural renewable water resourcesthe sum of internal and external renewable water resources. It corresponds to the maximum theoretical amount of water available for a country on an average year on a long reference period. Capital Labor Arable Land

Source UN COMTRADE.

World Resource Institute

Baier, Dwyer, and Tamura (2006). Baier, Dwyer, and Tamura (2006) World Development Indicators

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Appendix B: List of Countries

Algeria Angola Argentina Australia Austria Bangladesh Belize Benin Bolivia Botswana Brazil Burkina Faso Burundi Cameroon Canada Central African Republic Chad Chile Colombia Congo Costa Rica Denmark Dominican Republic Ecuador Egypt El Salvador Ethiopia Finland France Germany Ghana Greece Guatemala Haiti Honduras Hong Kong India Indonesia Ireland Israel Italy Ivory Coast Jamaica Japan Jordan Kenya South Korea Liberia Madagascar Malawi Malaysia Mali Mauritania Mauritius Mexico Mozambique Nepal Netherlands New Zealand Nicaragua Niger Nigeria Norway Pakistan Panama Papua New Guinea Paraguay Peru Philippines Portugal Rwanda South Africa Senegal Sierra Leone Singapore Somalia Spain Sri Lanka Sudan Sweden Switzerland Syria Tanzania Thailand Togo Trinidad and Tobago Tunisia Turkey Uganda United Kingdom USA Uruguay Venezuela Zaire Zambia Zimbabwe