Latent Trade Diversification and Its Relevance for Macroeconomic Stability

This paper examines the economic implications of a novel concept of trade diversification—latent diversification. In contrast to traditional measures, latent diversification accounts for potential movements of factors of production into activities where the country has previous exporting experience, hence presenting an additional margin through which countries can respond to shocks. The paper shows that the gap between traditional measures of diversification and latent diversification is sizeable and that latent diversification is in its own right an important determinant of macroeconomic stability. More diversified latent export baskets are associated with lower terms-of-trade volatility and, in turn, lower GDP per capita volatility, even after controlling for the degree of contemporaneous export diversification and other country characteristics.