In previous research we found that a sizeable, export-oriented manufacturing sector is key for unlocking sustained growth, while, to convincingly avoid the middle income trap, emerging markets must master technology, as shown by R&D and innovation. In growth accounting terms, vast differences in real growth across emerging markets in 1992-2018 were largely determined by variation in labour productivity growth.
This is primarily down to major disparity in capital deepening and total factor productivity (TFP) growth. Capital deepening stems from investment, the bulk of which has to be financed by domestic saving, explaining the important link between (gross domestic) saving and growth.
Empirical research by others confirms that TFP growth has been central to the transition to high income level; the most important drivers of TFP growth are R&D and human capital; and innovation and R&D are key to overcoming the middle income trap. This helps explain why Argentina, Brazil, Chile, Mexico and South Africa, middle income countries that don’t score high on innovation and R&D, saw poor (or negative) TFP growth in 2008-2017, in contrast to Japan, South Korea and Taiwan in earlier decades.
For sustained rapid growth, emerging markets will need solid saving. And to avoid the middle income trap, the upper middle income countries in particular need to make progress raising the involvement of companies and/or people in innovation and R&D. The disparity in catch up with the US in 1992-2018 across emerging market economies is massive. There is some “convergence” – poorer economies on average grow faster than less poor ones.
But the differences in catch up among middle income countries at broadly similar income levels in 1992 are striking. An economy can catch up towards US levels of income (GDP per capita) through faster real per capita growth or real exchange rate (RER) appreciation (rising relative prices). The vast differences in real per capita growth between economies are largely determined by variation in labour productivity growth. That is because differences in the trend evolution of the labour force as a share of the total population tend to be modest.
Exceptions include Malaysia and Turkey, where GDP per capita growth substantially outpaced labour productivity growth in 2008-17 because of favourable demographics, while in Argentina, the Czech Republic and Thailand the opposite happened. Labour productivity growth in our emerging markets averaged only 2.3% in 2008-17, after 3.3% in 1998-2007.
But the range is massive, with average gains below or close to zero in Mexico, Hungary, Russia and South Africa compared to 5.5% in India and 8% in China. What has differentiated the fastgrowing emerging markets from the others in recent decades is rapid capital deepening, largely financed by high national saving rates, and robust TFP growth. Russia scores high on innovation and R&D, but it is not channelled to economy, as indicated by its really poor TFP growth performance.
In the case of China, it is too early to say whether it will be able to avoid the middle income trap but its relatively high score on the innovation and R&D indicators would suggest it is reasonably well placed. Capital deepening obviously stems from investment. But how to finance it? Emerging markets can in principle rely on “imported” capital. However, in reality there are limits to this form of financing. These limits are visible when, as happened in 2018, at times of market pressure, the ones reliant on foreign financing – such as Turkey and, to a lesser degree, Indonesia and India – are forced to tighten macro policies to avoid a currency slump.
Looking ahead, in most individual emerging markets demographic factors will exert downward pressure on trend growth. Moreover, in rapidly growing middle income countries such as China and, later on, India, TFP growth is likely to moderate as catch up proceeds.
For emerging markets to show sustained rapid growth in the coming decades, they will need solid levels of domestic saving to finance substantial capital deepening without relying overly on foreign capital. And, to achieve solid TFP growth and avoid the middle income trap, the upper middle income countries in particular need to make progress in terms of “mastering technology”, raising the involvement of firms and/or people in innovation and R&D.
Louis Kuijs is head of Asia Economics at Oxford Economics