Want to close the income gap? Boost productivity

Carl Dahlman, head of global development research at the OECD Development Center (right) at the “Innovating for development” sessions during the OECD Global Forum on Development in July 2014. Photo by: Julien Daniel / OECD / CC BY-NC-ND

Income levels in most developing and emerging countries will not catch up with advanced economies for many decades without renewed efforts to boost productivity, according to a recent report by the OECD Development Center.

“Many of the upper middle-income countries we expected would be catching up with advanced economies by the middle of the century will not do so at today’s growth rates,” Organization for Economic Development and Cooperation Secretary-General Angel Gurría noted in a press conference following the report’s launch in Paris last month. “Boosting productivity would help enhance growth and narrow the gap in living standards relative to the advanced economies more quickly.”

Indeed, while China, Kazakhstan and Panama are on track to reach OECD levels of average income by 2050, a number of middle-income countries — including Brazil, Colombia, Hungary, Mexico and South Africa — will take much longer at current growth rates. Diversification into higher value-added areas in agriculture, manufacturing and services along with economic reforms and a greater focus on innovation could help remedy this.

So what are the key emerging economic challenges identified in the report, and what actions, innovations or partnerships could be mobilized to remedy them? According to Gurría, it’s all about finding the right balance between, and pushing for fundamental structural reforms that will first make countries productive before becoming competitive in global markets.

After the press conference Devex sat down with Carl Dahlman, head of global development research at the OECD Development Center and lead author of the report, to learn more about how boosting productivity can help developing countries catch up with the advanced economies, and what role donors, aid implementers and the private sector should play.

Here are some highlights from our conversation:

Income levels in most developing and emerging countries won’t catch up with the advanced economies for many decades unless something is done about productivity. What are the key steps to be taken to remedy this and what are the key sectors of activity to effect this mind-shift toward productivity?

In the long-term, the only thing that is going to increase incomes is productivity … developing countries are far behind the global frontier and normally they need to accumulate more capital and also to improve [the] education of their labor force. But as the process of development continues, pretty soon the advantage of low-cost labor becomes more expensive, so they have to go and do other things. We’re interested in focusing on productivity, [because] that’s the only thing that’s going to give you higher income per capita. Having said that, one of the findings in the report that was really striking was just how low the productivity levels still were, even for middle-income countries.

So productivity had been stagnant?

Yes, in fact it had even gone backwards in countries like Mexico and Turkey. We were comparing them to the United States, but it was quite striking that the gap was getting bigger … The surprising thing was that some countries that had been middle income for a long time — Brazil, South Africa, Mexico — are not going to converge, assuming that the rates won’t change … It does drive the point home that they are countries that have been at a middle income level for many years and, somehow, have not been able to increase productivity.

And are there any notable exceptions?

Yes, there’s one big exception: Russia. It has officially become a high-income country, but it’s a very special case, mostly because of the windfalls from natural resources … However, if you look at the future sustainability of their growth, it’s not very good because it has specialized on these commodities and it doesn't have the flexibility to move into other areas … If the price of the commodities falls, Russia has a really big problem because it doesn't have sufficient resilience or flexibility. Having said that, if we had looked at India 20 years ago, it was growing at 5-6 percent, but then surprised everybody by subsequently growing at 8 percent [in the period] 2004 to 2010. So countries can change.

But how do they effect this change in practice?

It all depends on policy. Developing countries should be able to catch up because they are far behind the frontier and they don’t need to invent new things, it’s already been done. So you buy the capital goods, you get the foreign investment, you get the training, you license the technology, you get technical assistance. We know how to do it. Yet, what’s remarkable is that so few of them are really improving. That’s due to bad policies.

In what countries or sectors in particular?

Take labor in South Africa, for example. What's really shocking is that in the past 20 years the percentage of the population in the labor force has fallen. On top of that, more than 25 percent of people are unemployed. Why? Because you have very strict labor regulations … The problem is they create a labor “aristocracy” who get the benefits, but the rest of the population is left out. So South Africa is not competitive because labor costs are too high and because it has been boosted up artificially … These are the kinds of policies that create a problem.

And focusing in on developing countries other than the fast-emerging ones such as the BRICS, we’ve heard a lot of talk about concepts such as diversification. What is your sense of the innovation in this area?

The key thing to improve productivity is to innovate. And by that we mean anything that is new to the local economy, to the sector, or even to the firm that has the innovation — to take advantage of knowledge that already exists. That’s the low-hanging fruit. It should be easy, but it’s not done that much. There are lots of imperfections in the information about that, or the ability of the firms to be able to get access to that.

And you’re also advocating for a larger role for the service sector?

Yes, that’s an important point … If you take a look at any high-income economy, they are at least 75 percent service sector and some economies are 90 percent service sector. Services are very important: high-value services such as finance, but also the press, the health sector, the education sector. When we look at the BRICS in the last decade, the biggest contribution to the growth has come from the service sector … As people get richer they can buy more material things, but what most money is spent on is the non-material, on services. The income of elasticity of demand of services is higher, so you buy more services.

Some countries are now finding themselves in a so-called middle-income trap — is there any particular nation that is a particular cause for concern in your eyes?

Generally speaking, Latin America 30 years ago was the continent that looked like it was catching up. Asia was not; Asia was a mess. And yet, [Latin America] still hasn’t really caught up. Some countries have caught up because of natural resource wealth, but the bulk of them have not. Brazil in the 1980s was really up-and-coming in a way that you could compare to South Korea, but it got stuck for two decades until they stabilized and after 2000 when they got the [macroeconomic situation] under control. South Africa is another country that was a middle income country 30 years ago, it’s still a middle income country and is not going to make it by 2050. And Mexico is another middle-income country that’s not going to make it by 2050 ... all big countries that are stuck. India was a low-income country that has just graduated so, given the potential India has, it still can do it all: it can put more labor from agriculture to industry, it can move to higher industry, it can develop more services. But this is all about policy and the political economy.

I wanted to touch on another point from your research: the question of whether donors should support private sector investment in the developing world? If so, how should it be done?

The private sector is what really moves the world. Let me just put it in context, the biggest global agents are the multinational companies. Two-thirds of world trade is done by multinationals, half of that is internal, half of that is external. Take a look at generational knowledge too: more than 50 percent of all the global R&D is done by the thousand biggest R&D multinationals … They go wherever it’s convenient for them looking for profits, but they can be a very powerful agent in development. At the same time you have domestic entrepreneurs of all sizes, even very small ones and you have medium and large ones.

Now, a big problem in many cases is that they are a really big cost and [imply] very big risks. Some of the investment that could be made is not made because of these big risks and what they may need sometimes is some support to offset this risk to get started. Whenever you start a new venture, a big problem is that once you do it you can get lots of imitators. There is very high cost to do it the first time, because things that you’re not aware of become a big constraint … and there is lots of cost for the innovator. So yes, it makes sense to try to offset some of these costs and there are now some programs to try to support the pioneer, particularly in the local context.

At the same time, you might want to try to get the "big boys" to think a bit more broadly ... Even a big company like General Electric is now finding that there’s a lot of good business to be done producing products that have been made specifically for developing countries. For example, it developed an electrical cardio machine that can be put on a bicycle and they [rolled it out] in India because people in the countryside couldn’t afford a big one and it had to be portable. They saw it was a really good money-making product — so there’s certainly money to be made here.

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    Richard Jones

    In his role as Editorial Director Richard oversees content for digital series, reports and events, leading a talented team of writers and editors, conducting high-level video interviews and moderating panels at events. Previously partnerships editor and an associate editor at Devex, Richard brings to bear 15 years of experience as an editor in institutional communications, public affairs and international development. Based in Barcelona, his development experience includes stints in the Dominican Republic, Argentina and Ecuador, as well as extensive work travel in Africa and Asia.