Traditional development economics view structural transformation as a crucial factor in the course of development. Under this view, the movement of labor from agriculture and other primary sectors to modern industry was the key to drive economic growth. Growth has been associated with the expansion of industrial activities. Due to globalization, world markets had a great demand for manufactured exports from developing countries.
Recent economic thinking on policy reforms view structural transformation and industrial development as automatic processes that happen once macroeconomic stability and well-functioning markets are achieved. Economic policies favoring some economic activities over others are not welcome and still frowned upon.
However, the growth of manufacturing activities in low-income economies is filled with lots of externalities and spillovers. Therefore, this paper argues that industrial development (non-traditional manufactures) is the one responsible for economic growth and development. The following empirical regularities stress the importance of industrial development as a stimulus for economic growth:
1. Economic development requires diversification, not specialization
In contrast to the principle of comparative advantage, the key to economic development is product diversification – not specialization. Producing a wider range of goods is an important part of economic development. Imbs and Wacziarg (2003) examined the patterns of sectoral concentration in a large cross-section of countries, as well as within countries over time. They discovered that as incomes increase, economies become less concentrated and more diversified. At higher levels of income, further growth is associated with increased specialization. The same authors tested the robustness of these results and they found that the regularity they had identified was a very strong one. It can be observed both cross-sectionally and across industries.
2. Rapidly growing countries are those with large manufacturing sectors
In 1965, the manufacturing industries of East Asia and Latin America were of roughly similar size, about 25% of GDP. By 1980, the share of manufacturing in East Asia rose to 35% of GDP, while that of Latin America did not experience growth. The manufacturing share of Latin America declined since then. The bigger manufacturing share of East Asia is an important structural difference between these two regions.
3. Growth accelerations are associated with structural changes in the direction of manufacturing
Johnson, Ostry, and Subramanian (2006) studied the cases of sustained growth accelerations identified by Hausmann Pritchett, and Rodrik (2005) and found that almost all such cases took place amidst a rapid increase in the share of manufactures in total exports (Prasad, Rajan, and Subramanian 2006). Furthermore, Jones and Olken (2005) discovered that upbreaks were associated with increased manufacturing employment, while down-breaks were connected with declines in manufacturing employment. “Regime shifts therefore see broad moves into and out of manufacturing rather than intra-manufacturing reallocation.” All of these studies show a rise in the share of trade (imports and exports) in GDP during growth accelerations.
4. Specialization patterns are not pinned down by factor endowments
Research suggests that factor endowments and policy are both important in shaping production structure. The reason why countries like China and India have done so well is not just because of their labor endowment advantage but because of their diversification into more high-level, technically-demanding activities. Hausmann, Hwang, and Rodrik (2006) used a quantitative index, EXPY[1], to illustrate this point. They discovered that EXPY is highly correlated with per-capita income. This means that rich countries export goods that other rich countries export. However, EXPY is not well explained by factor endowments and other economic fundamentals. There is also a weakly positive partial correlation between EXPY and the stock of human capital, and no partial correlation with the index of institutional quality. These results imply that while productive capacity and human capital endowment determine the sophistication of a country’s exports at a point in time, policy also matters.
5. Countries that promote exports of more “sophisticated” goods grow faster
In contrast to the view that comparative advantage drives economic growth, research indicates that there is a robust and significant positive relationship between the initial levels of a country’s EXPY and the consequent rate of economic growth experienced by that country. Data from the 1960s also suggest that countries that experience a rise in EXPY subsequently grow more rapidly (Hausmann, Hwang, and Rodrik 2006). The evidence firmly supports the idea that industrial upgrading is a primary indicator of economic performance.
6. There is “unconditional” convergence at the level of individual products
Productivity level convergence with rich countries is an important influence for economic growth. Producing sophisticated goods presents a positive challenge, a greater room for countries to catch up technologically and enlarge their productivity improvements. In addition, Hwang (forthcoming) noted that it is essential for a country to produce what rich countries are producing because when a country starts to produce that good, its productivity converges to its frontier unconditionally and automatically, regardless of the characteristics of that country. For this to happen, a country must overcome coordination and learning externalities that block investment and entrepreneurship in new activities to let new industries take off.
7. Some specialization patterns are more conducive to others in promoting industrial upgrading
A country that focuses on manufacturing is likely to enjoy opportunities and growth because specialization based on manufactured goods presents a better platform for moving on to new economic activities with unexploited productivity potential. Hausmann and Klinger (2006) observed that a country is better off producing goods that require assets that can be used in a wide range of goods; doing so encourages structural transformation and diversification. The product space is uneven as some economic activities require highly specific assets that do not allow jumps to other activities, while others require assets that permit such jumps. Moving to manufacturing is beneficial not just because it pulls resources into higher productivity activities, but also because it makes future structural change easier.
A Model of Growth through Industrial Development
The growth model presented here revolves around the idea that growth is driven through learning and enhanced capabilities accumulating in the industrial sector. It recognizes that a traditional developing economy has 1) an importables sector, 2) a non-traditional exportables sector, 3) a traditional exportables sector, and 4) a non-tradable sector. The evolution of the level of productivity of importables and non-traditional exportables (modern part of the economy) is the main driver of economic growth. It is assumed that productivity increases more rapidly as the size of the modern sector increases. In this model, the aggregate of output in the modern sector drives productivity growth. This acknowledges that domestic market oriented industry generates learning spillovers for exportables, just as exportable production may improve productivity elsewhere in the economy.
Two types of trade policies are considered: import tariffs on importables and export subsidies on non-traditional exportables. Labor is assumed to be mobile across all four sectors. This generates a common wage rate in the economy, which is equal to the value of the marginal labor productivity in each sector. In addition, the difference between domestic expenditures and domestic income is expected to be covered by net resource transfers from abroad. Since national income is simply the sum of value added in the economy and it is assumed that neither of the exportables is consumed at home, total expenditure becomes the sum of consumption of importables and non-tradables.
When policy intervention is absent, the output of the modern sector will be too low and the economy’s growth rate will also be low. Policies should be implemented to subsidize importables and non-traditional exportable production.
Import liberalization ends up stimulating the production of exportables (Lerner symmetry theorem). However, it works at cross purposes with the need to generate new learning and it is inefficient in producing the desirable export response when only non-traditional exportables generate learning spillovers.
It is important to stress that the fundamental rationale of the Lerner Symmetry theorem is a general equilibrium. With import liberalization, the resources released by import competing activities have to be deployed elsewhere in the economy. If liberalization only stimulates traditional exports rather than non-traditional products, there may only be significant export growth but little overall economic growth. Under this case, import liberalization will reduce employment and output in the import-competing sector without encouraging growth in non-traditional exports. Productivity growth and economic growth will slow down as traditional exports swallow up all the resources released by the import competing activities. On the other hand, if import liberalization is accompanied by macroeconomic policies that allow the trade deficit to get larger, the export response will be sluggish and growth will be slow.
Import liberalization have produced adverse results especially in Latin America in the 1980s because these reforms deteriorated the industrial base of economies and reduced productive dynamism. They crowded the import-competing sectors without stimulating new non-traditional exportables. On the other hand, Asian countries provided non-traditional export activities direct inducements and subsidies. The focus was on targeted new exportables, rather than on import liberalization, significant import liberalization was undertaken only after growth had reached a substantial momentum.
The export subsidy has no effect on production and employment in the import-competing sector, while it directly stimulates non-traditional exportables. Since non-traditional output increases while importables output is unchanged, the rate of productivity growth is permanently higher.
Economic growth needs strategic policies that are directed to new economic activities. The trickledown effects of import liberalization are not enough to produce the desired effects. In addition, an appreciated currency and a volatile real exchange rate implied by turbulence in financial markets are not favorable to the expansion of new exportable activities. Conversely, an “undervalued” currency can be more useful to an economy in promoting industrialization than industrial policy.
A strict inflation targeting regime is not suitable to the needs of industrial development and growth. In such monetary regimes, the central bank does not have a competitiveness target, and the level of the exchange rate becomes an issue only to the extent that it affects inflation. Long stretches of overvaluation and substantial currency volatility over the medium term become usual consequences. To date, inflation targeting has focused at consequences for inflation and output volatility, rather than longer-term growth (see IMF 2006). The framework presented here proposes that there are costs—in terms of foregone growth over the longer term—for introducing financial and monetary concerns in exchange rate policy.
Concluding Remarks
A robust industrial policy is needed; what is important is to target it at new exportables and a helpful exchange-rate policy that encourages production of tradables across the board. A stable and competitive exchange rate is also needed; without it, it is almost impossible to encourage investment and entrepreneurship in tradables of any kind. However, exchange rate policies cannot be powerful in promoting diversification without more directly targeted industrial policies. A cheap domestic currency helps both traditional exporters and non-traditional ones. The combination of these two types of policies is the secret of the success of high-growth economies.
As a final note, industrial policy must be viewed not as a government effort to select particular sectors and subsidize them through a range of instruments. As noted by Rodrik (2004), industrial policy must be seen as a process whereby the state and the private sector examine sources of problems in new economic activities and formulate solutions to them. It requires the government to build the public-private institutional arrangements whereby information on profitable activities and useful instruments of intervention can be drawn but it doesn’t require it to determine the activities to be promoted or on the instruments to be deployed.
Source:
Rodrik, Dani, “Industrial Development: Stylized Facts and Policies” paper prepared for UN-DESA (2006).
[1] EXPY is the weighted average of income levels of different commodities of different countries, where the weights are the share of each commodity in that country’s total exports. Income levels, PRODY, are the weighted average of the incomes of the countries exporting each traded commodity, where the weights are the revealed comparative advantage of each country in that commodity.
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