Understanding what drives productivity growth isn’t limited to EM; boosting productivity growth is becoming increasingly important as the world faces rising costs from aging, debt, climate change, and security. This month’s detour from past GSM asset price discussions was motivated by our perception that many of the themes we’ve previously flagged seem better priced in – including a slower path for disinflation and more limited space for U.S. rate cuts – without any short-term catalysts for a meaningful repricing.
The productivity challenge
The conversation about what differentiates winning from lagging emerging economies began by noting that success stories in the emerging space – meaning countries that managed to sustain strong growth and rising living standards over multi-decade periods – are few and far between. This observation is important because it discredits common assumptions that the emerging world is bound to eventually catch-up with industrialized economies because of their younger populations, vast deposits of raw materials, the shift away from farming, and rising urbanization, among other factors. Barring a few exceptions, countries with high commodity export dependence delivered worse outcomes; rising urbanization ratios or levels show little relationship with long-term growth rates. Many of the most prosperous emerging economies, such as Taiwan and Korea, are commodity importers.
Speakers agreed that productivity – the efficiency with which an economy uses labor and capital – was the key to improving living standards. Certain conditions, moreover, tend to be associated with faster productivity growth. These include strong institutions that provide certainty for investment, property rights, and IP protection. Many of the countries behind the Iron Curtain and China enjoyed periods of rapid growth once they liberalized, moving from collective ownership to giving citizens property rights – a non-repeatable catalyst – allowing them to leverage previously “dead” capital.
Competitive conditions and openness incentivize companies to become more efficient. Larger firms can achieve economies of scale, have greater access to credit, and benefit from better technology – all contributing to faster productivity. Emerging markets are full of examples of failed attempts at picking winning sectors or companies, including many of today’s heavily indebted state-owned enterprises (“SOEs”) like Pemex and Eskom. Developing human and physical capital is critical too, though some pointed out that the quality of that investment and where it is allocated is what matters.
Industrialization, exports, and growth
Directing investment towards industrialization and exports is a path shared by many of the successful EM economies. Participants also noted the lackluster track record of other development models such as those relying on import substitution, public works, or investment in non-tradable activities. The appeal of an export-led growth model is compelling from both a development and productivity standpoint. Manufacturing is more scalable compared to services and they support a wide range of sectors such as logistics and transportation. Surplus labor from farming shifts to manufacturing, which if successful leads to a cycle of rising incomes and stronger domestic demand. Additionally, a competitive export-led model can help prevent economies from running into current account constraints, allowing them to sustain higher investment levels without building unsustainable debt burdens. Openness to foreign direct investment and technology also helps manufacturers in moving up the value chain and developing competitive local brands.
The paths of Korea, Taiwan, and China followed a similar path, initially focusing on light manufacturing – many of these activities since migrated to countries with more competitive labor costs, such as Bangladesh and Vietnam – and later transitioning to electronics and heavy industrial equipment. This process requires developing local know-how to manufacture more complex goods; unsurprisingly, historically growth in total factor productivity has moved closely with export swings.
Mexico, which is currently seen as a prime beneficiary of the reshuffling in supply chains and near-shoring, is a good example of the contrast between outcomes from an export-led and a more inward-looking approach to development. States in the northern part of the country are faster growing, more prosperous and open, having developed strong links to the U.S. through manufacturing, exports, investment, and technology transfer. Southern states rely more on agriculture and tourism. They also have a larger share of informal firms, which tend to be smaller, less productive and struggle to access credit; in fact, these relatively poorer states also receive a disproportionate share of remittances from workers living abroad (see Figure 1).
What's next for India?
The last part of the GSM discussion dealt with India, the world’s fastest growing large economy and EM darling. The country’s stock market delivered returns topping 9% per year in dollar terms over the past decade, far outpacing the MSCI EM index (3%). Speakers agreed that the Indian macro story remains compelling – Bloomberg consensus sees growth averaging 6.6% in the current and next fiscal years – and valuations reflect that optimism.
Policymakers continued to focus on incentivizing investment, primarily in infrastructure, power generation, and schemes like production-linked incentives (“PLIs”) to make manufacturing and exports more attractive – a break from the past, which deemphasized goods exports as a growth engine. The results of the ongoing general election vote, which will be known in early June, will likely hand PM Modi and his party a third five-year term, with positive implications for policy continuity. India also fits nicely as a beneficiary of global mega-trends, including the push towards supply-chain diversification and its standing as a non-aligned country at a time of rising tensions between the West and China (and like-minded nations).
In the context of the discussion on what drives productivity growth, some speakers questioned if India’s service-centric approach could deliver the prolonged cycles of rising productivity, incomes, and demand seen in other Asian economies that leveraged manufactured exports instead. While fiscal handouts to incentivize manufacturing are welcome, India is late to the game with a small manufacturing base and an export mix heavier on low value-add items like textiles. The shift to grow its manufacturing export pie also faces challenges from India’s limited trade openness (including relatively high tariffs and few trade agreements). India also trails countries like Korea, China, and Mexico in terms of economic complexity – a measure of accumulated productive knowledge necessary to manufacture higher value-added exports (see Figure 2). If India manages to deliver a rapid, sustainable improvement in living standards through services, it will make it an outlier among large EM success stories.
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