Manufacturing innovation key to EM break out growth

EM countries hoping to dodge middle income trap need manufacturing and innovation

By Louis Kuijs, Oxford Economics | July 22, 2017

The concept of emerging markets is based broadly on the idea that the wealth of developing countries tends to converge over time with their developed peers. But, in fact, long-term growth and development has continued to vary enormously across emerging market (EM) economies.

Between 1992 and 2016, GDP per capita in China, South Korea and Poland caught up 20 to 25 percentage points relative to the US whereas South Africa, Russia and Saudi Arabia did not see any catch up on this metric.

There was some ‘convergence’ — poorer countries grew somewhat faster than richer ones, on average. But the huge variation in growth between countries at roughly the same level of development shows that convergence is conditional.

Among the structural factors that help explain such differences in growth performance, a sizeable manufacturing sector is central. Labour productivity tends to be higher in manufacturing than in agriculture and services. That provides a powerful engine of intra-sectoral productivity growth, in addition to that stemming from rural to urban re-allocation of labour between sectors. Other benefits include on-the-job training and economies of scale.

Some service sector activities also confer benefits such as economies of scale. But that is true mainly for the kind of tech companies that dominate Silicon Valley, of which few originate in EMs. India grew substantially in the last two decades while relying on exports of services rather than manufactured goods. However, that was from a low base. When India grows fast it faces supply-side bottlenecks and its ambitious growth aspirations depend on a stronger manufacturing sector.

But the productivity-related benefits of manufacturing are particularly pronounced compared to raw commodity production and export. Moreover, most raw commodity exporters have suffered from ‘Dutch disease’ symptoms such as unhelpful real exchange rate appreciation. And many commodity-oriented EMs have also been afflicted by the ‘natural resource curse’, with governments and business focusing on rent-seeking rather than raising competitiveness and productivity.

Not surprisingly, since the 18th century there are few examples of economies that got to high income status without a strong manufacturing sector. And we found that EMs with a relatively high share of manufacturing in GDP caught up significantly more with the US in 1992-2016 than others. While China, South Korea and Thailand benefited from a particularly large manufacturing sector, India, Brazil, Chile, Russia and Saudi Arabia were held back by a small one.

A sizeable manufacturing sector is necessary but not sufficient. Export orientation is also key. The imperative to sell manufactured products on foreign markets incentivises firms to be competitive while sales on international markets help reap economies of scale.

Indeed, we found that, other things being equal, EMs that export a larger fraction of manufacturing production have seen faster catch up. Malaysia and the Czech Republic benefited from the export-orientation of their manufacturing sector while in Argentina, Brazil, Saudi Arabia, Russia and Indonesia, trend growth has been held back by limited export orientation of the manufacturing sector.

Even export-oriented manufacturing is no guarantee for sustained catch-up to high income levels if it is largely based on foreign direct investment attracted by low wages. For the key benefits of manufacturing — productivity growth, scope for innovation, movement up the value chain and economies of scale — to accrue in full, the technology must be mastered domestically, evidenced by substantial research and development (R&D) and innovation.

To be sure, R&D and innovation are not conditions for sustained growth at modest levels of development. But, they become conditions for further catch-up in middle income countries (MICs), so that they can avoid the middle-income trap (MIT). Indeed, the degree to which technology is mastered has been an important factor in explaining the variation in catch-up among MICs in 1992-2016. And the problem is that, while some MICs now devote sizeable shares of GDP to R&D and engage in substantial innovation, others see remarkably little R&D and innovation.

China, Czech Republic, Russia, Singapore and South Korea rank high on our R&D and innovation indicators, relative to their level of development, while Chile, Mexico, Romania, Saudi Arabia and the United Arab Emirates rank particularly low. The scores of Argentina and the Philippines are mediocre.

When we put together the scores of countries on these three dimensions, China and the Czech Republic appear relatively well-positioned for further sustained growth and to avoid the MIT (Singapore and South Korea are also well placed but are already high income economies).

Malaysia and Thailand score well in terms of having a large, export-oriented manufacturing sector, while Mexico and Romania score OK on that metric. But all four of them score poorly on innovation and R&D, suggesting that technology is not sufficiently mastered domestically, putting them at risk of falling in the MIT.

Russia scores very well on innovation and R&D. But it has an unimpressive manufacturing sector, in part resulting from Dutch Disease and Resource Curse issues. As a result, the research output is not sufficiently leveraged towards economic development.

Our growth forecasts for 2017-26 show some continued convergence — other things equal, we expect countries with higher GDP per capita to grow slower. However, reflecting the above findings, the countries that we expect to grow relatively strongly in the coming decade, given their income level, generally score relatively well on export-oriented manufacturing and mastering of technology. Having said that, in the case of India and Indonesia, our relatively constructive long-run growth forecast is conditional on further implementation of key economic reforms.

We expect Brazil, Mexico, Argentina, South Africa, Russia and Saudi Arabia to continue to grow relatively slowly, trendwise, in 2017-26, consistent with relatively weak scores on the three criteria discussed here.

Chile caught up relatively well in 1992-2016 — in large part due to good policies and institutions. Nonetheless, we forecast its trend growth in 2017-26 to be on the low side, given its current income level, reflecting a small manufacturing sector and unimpressive scores on R&D and innovation.

Our conclusions are sobering, as they suggest that several major EMs may struggle to avoid the MIT. But it is what it is.

Source: https://www.ft.com/content/05f10e30-6199-11e7-8814-0ac7eb84e5f1