Growth Diagnostics: Theory and Practice
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1 Growth Diagnostics: Theory and Practice Leonardo Garrido PREM-ED October 1 st, 2011
2 Outline Growth Diagnostics Foundations Principles of differential diagnosis Inclusive Growth vs Growth Diagnostics Going down the tree
3 The (in)famous GD tree Not the investment Ratio to GDP! HRV tree is just an organizational framework Risk of GD to become a mechanical exercise In HRV parlance: A mindbook not a cookbook Returns to economic activity Low growth rate of private investment per unit of labor Cost and access to finance While the approach comes with a decision tree, which probably accounts for its good reception in policy circles, it is different from just checking a series of boxes--which is what is often done Dani Rodrik Low social returns Problems of private appropriability Low domestic savings / access to international sources of finance Local sources of finance Poor geography Government Market Human Capital Bad Infrastructure Macro (financial, monetary, fiscal) Micro (taxes, property rights, corruption) Information ( selfdiscovery ) Coordination Low competition High risk / High cost
4 The (most relevant) Steady State Equation in GD k k t t c = σ ( c )( r ( a, θ, x )(1 τ ) ρ) t = t t t t t t ct -Derived from a dynamic optimization (optimal control) exercise. -More specifically, it is obtained as the result of a Ramsey-type optimal growth model that introduces wedges to economic activity k / k c / c r x a θ τ ρ = Growth rate of investment per unit of labor = Growth rate of consumption per unit of labor = Rate of return to economic activity = Input to production function = Factor productivity = Externality in production of inputs = Tax rate = Discount rate Low returns? Appropriability? Finance?
5 But that equation does not help much to know how to undertake a GD either, does it? Dani Rodrik: The language of growth diagnostics and of removing binding constraints is becoming so commonplace in multilateral agencies and donor organizations these days that I sometimes wonder whether we have not unleashed something out to the real world before its time. The trouble is that what I see being implemented in practice is often the rhetoric and not the substance. That is because: The framework cannot be applied mechanically Requires an inquisitive, detective's mind-set Need to balance economic theory and evidence To look for a series of clues that will identify the most likely suspect. There is an element of craft in doing the diagnostics right, but it is a craft solidly based on economic science
6 Basic principles of a country differential diagnosis If a constraint is binding, then 1. High shadow price of the constraint 2. Movements in the constraint should produce significant movements in the objective function (e.g. GDP, or income of a specific group of individuals) 3. Agents in the economy should be attempting to overcome or bypass the constraint 4. Camels and Hippos: Agents less intensive in that constraint should be more likely to survive and thrive, and vice versa
7 1. The (shadow) price of the constraint is high. Relative scarcity of a factor. Look at prices (interest rates, wages, etc.) Estimate prices using regressions Example: Mincerian regressions In other cases no market: Infrastructure: congestion as the price to pay Non-market valuation techniques, either based on revealed or in stated preferences. Ex: Hedonic prices, ICAs stated preferences
8 2. Movements in the constraint should produce movements in growth A constant cannot explain a change Differences Between time periods (look at trend breaks) Between regions (why are some prosperous and some lagging?) Between groups of firms differently affected by the potential constraint
9 3. Agents in the economy are engaging in efforts to overcome/by-pass the constraint. Examples: Border controls smuggling Poor financial intermediation growth occurs within business groups (conglomerates) Industry specific public goods binding growth in sectors less sensitive to specific inputs or unusual level of cooperation among successful producers. Property rights and contracting binding Mafia
10 4. Camels vs. hippos The surviving sector (camels) are those least intensive or least dependent on in the binding constraint ( water in a desert ) In a good investment climate ( environment with water ) the economy, and the thought comparative advantages, may look differently (hippos) What do analysis of camels and hippos reveal about potential constraints? Are successful groups particularly connected to the political system? Any missing factors within the successful industry? The importance of analyzing hippos? Example: Informal ICAs
11 Growth Diagnostics vs. IG Analytics Growth Diagnostics emphasize: Analysis of constraints to private capital formation as starting point Constraints from the perspective of a representative firm Human Capital seen from the perspective of a firm Inclusive Growth Analytics emphasize: The individual/economic actor as starting point worker or firm owner Disaggregated analysis constraints depending on self/wage employed, size of firm, sector, formal/informal, Sector Dynamics Analysis, Employability Analysis and Business Environment Analysis Human Capital central in many dimensions
12 Human Capital in IG Analysis Study of demographic trends To analyze dynamics of the population and labor force To ascertain expected changes in participation rates Dynamics of Output, Poverty and Employment Growth decomposition in employment and productivity changes Poverty Growth links Profile of the Economic Actors Analysis of selected labor groups: Employed vs unemployed (and underemployed); Agricultural, Informal, Self employed vs Modern Employees; Rural vs Urban + Poor vs non poor (i.e. Poor Rural vs Poor Urban); Selected Economic Activities Human Capital Constraints from the Perspective of the Firms Returns to Education Estimating labor demand, probability of participation and probability of getting good jobs Analysis of labor market regulations
13 Going Down the tree (not a proper expression) Understanding social, political and economic factors that fundamentally affect the way economic actors interact and that determine long term socio-economic outcomes PREM ED Basic Questons And proceed with the diagnostic exercise Not mechanically. This is not a check list. Constraints are dynamic and interact with one another
14 Basic questions to ask within an Inclusive growth analytical exercise 1. What was growth performance in the past? 2. What are the aggregate demand sources of economic growth? 3. What sectors have led economic growth? 4. What has been the role of TFP versus factor accumulation? 5. What has been the path of investment and the capital stock? 6. Is economic growth sustainable? (BOP, Fiscal accounts) 7. What has been the return on capital? 8. What are the main demographic and labor force trends? 9. What has been the productivity performance across firms? 10. What percentage of industries account for TFP gains in the period? 11. What characterizes the firms and industries experiencing negative TFP growth? 12. What is the macroeconomic policy environment? 13. What are obstacles to the expansion of exports? 14. What is the microeconomic policy environment? 15. What is the state of technology adoption? 16. Is government the problem? 17. What is the expected contribution of reform to economic growth? Carry on a GD exercise
15 Going down the tree : Hypotheses for low investment and growth There is no reason to think that the investment ratio (to GDP) is correlated to countries per capita income. That ratio depends on the aggregation of technology mix by individual firms In GD, a low investment country is not a country with low ratio of investment to GDP. Instead, is a country where the growth rate of capita formation per capita (equal, in the steady state, to the growth rate of per capita private consumption) is low. Social returns Returns to economic activity Private appropriability Low returns to investment? International sources of finance Cost of finance Local sources of finance Investment / worker, logs (curr US$) Investment / GDP (current US$) Cross Country Per Capita GDP vs Ratio of Investment to GDP (Avg. 2000s) Liberia Sub Saharan Africa Per Capita GDP, logs (Current US$) Cross Country Per Capita GDP vs Investment per worker (Avg. 2000s) Liberia Sub Saharan Africa Per Capita GDP, logs (Current US$) Poor geography Human Capital Bad Infrastructure Macro Government Micro Information Market Coordination Domestic savings Financial sector intermediation
16 Look for evidence for low capital formation Perpetual inventory method for computing capital stock at macro level Anecdotal evidence Savings-Investment constraint
17 Look at Social Returns to Economic Activity Low social returns to economic activity (for given appropriability of such returns) can be associated with lack of complementary factors of production which are necessary for undertaking entrepreneurial ventures: Human Capital, from the point of view of the firm? Poor geography? (Landlocked, Land, Water availability?...) Infrastructure? IS THERE A DEMAND FOR THESE?
18 Is there macro stability? Fiscal Sector and Debt External Sector Monetary and Banking Sectors Real Sector IMF, Article IV, an excellent source of information Low returns to investment? Returns to economic activity Cost of finance Social returns Private appropriability International sources of finance Local sources of finance Poor geography Human Capital Bad Infrastructure Macro Government Micro Information Market Coordination Domestic savings Financial sector intermediation
19 Micro : Poor countries will always look bad There will be always issues such as corruption, the business environment, and the lack of respect ofproperty rights LICs always at bottom in surveys such as Doing Business, Transparency, Governance, etc The question is: Are these issues binding? Can productive activities occur even in an unfriendly business environment? Lack of level playing field? Low returns to investment? Returns to economic activity Cost of finance Social returns Private appropriability International sources of finance Local sources of finance Poor geography Human Capital Bad Infrastructure Macro Government Micro Information Market Coordination Domestic savings Financial sector intermediation
20 Market : Information (Self-discovery) Self-Discovery: The process of identifying industries with potential but as of yet unrealized comparative advantage Are private entrepreneurs discouraged from undertaking activities due to fears that new entrants will reduce (by entry, imitation) their expected benefits? In absence of detailed production data, use export data Export sophistication Export diversification Product space Low returns to investment? Returns to economic activity Cost of finance Social returns Private appropriability International sources of finance Local sources of finance Poor geography Human Capital Bad Infrastructure Macro Government Micro Information Market Coordination Domestic savings Financial sector intermediation
21 Market : Coordination. Is there a role for industrial policy? What if the country was successful in diversifying towards higher income value products? What you export matters An empirically contended, controversial idea Or: Agriculture for development instead product / export sophistication Not picking winners Industrial policy as a discovery process Government and firms o learn about underlying costs and opportunities and engage in strategic coordination. Carrots-and-stick Incentives and performance requirements Not picking winners, but knowing when to let losers go. Government embedded in private sector (not in bed with private sector) Low returns to investment? Returns to economic activity Cost of finance Social returns Private appropriability International sources of finance Local sources of finance Poor geography Human Capital Bad Infrastructure Macro Government Micro Information Market Coordination Domestic savings Financial sector intermediation
22 How do we assess whether a country is liquidity constrained? Misleading to rely on the popular measure of the amount of credit to the private sector as a share of GDP Low quantity of credit to the private sector is not necessarily a signal of scarcity of the factor Quantity of finance may be low because of scarce supply, in which case the country is considered liquidity-constrained (e.g. Brazil, ) But it may be low because of low demand, in which case the economy is not liquidity constrained, it is a case of low returns (e.g. Zambia, ) Low returns to investment? Returns to economic activity Cost of finance Social returns Private appropriability International sources of finance Local sources of finance Poor geography Human Capital Bad Infrastructure Macro Government Micro Information Market Coordination Domestic savings Financial sector intermediation
23 Why is a country liquidity constrained? Inadequate access to savings Both access to foreign borrowing and domestic savings must be limited High spreads on foreign borrowing due to high country risk and low credit ratings Domestic capital controls Poverty traps High tax burden Important to understand who is not saving: firms or households Inefficient process of financial intermediation Low returns to investment? Returns to economic activity Cost of finance Social returns Private appropriability International sources of finance Local sources of finance Poor geography Human Capital Bad Infrastructure Macro Government Micro Information Market Coordination Domestic savings Financial sector intermediation
24 Cost of finance: What measures do we use? Look at the real interest rate Low quantity and high price indicate scarcity of supply relative to demand Look at international comparisons and the distance of the price from the mean If the price signal is an outlier and is several standard deviations outside the expected range it is difficult to reject the hypothesis Look at investment by sector investment may be adequate at the aggregate level but it may be concentrated in one sector or a few sectors Investment allocation tells us about the type of growth process occurring in the country and the likelihood that growth will be broad based and inclusive
25 Objective data Look at objective data over time and cross-country: Average real lending rates as a proxy of real cost of capital time series data Benchmark to comparators Bank s lending rates by maturity and by borrower The range tells us a lot about the costs faced by different types of firms Investigate the reasons for the change in the cost of capital Is it due to changes in inflation? Is it due to changes in deposit rates? Is it due to changes in risk premiums? Benchmark deposit rates and risk premiums What are the determinants of deposit rates and risk premiums?
26 Subjective data Use firm survey data to see what are the perceptions about the cost and access to capital Match perceptions with reality, find out: The percentage of firms complaining about the cost and access to finance as a severe constraint to firms growth The percentage of firms that did not apply for a loan because of the high cost of capital The percentage of firms that either obtained a loan or did not need a loan Distinguish between loans of different maturity Access to long-term financing is typically a big problem Even when the cost of capital is high, and the credit to the private sector is low, if the majority of firms do not need loans to expand operations then the country may not be liquidity constrained
27 Inefficient process of financial intermediation Difficulty assessing credit risk May lead to very high risk premiums for the majority of firms, especially small firms High collateral requirements Reasons Poor corporate governance Lack of transparency in business operations Weakness in the bankruptcy and debt recovery framework
28 Inefficient process of financial intermediation Issues with access to capital Underdeveloped capital markets The financial system may be dominated by a few banks, the stock market may be illiquid, commercial bond market may not exist, and pension funds may be small Banks may offer a limited range of products People may not be using the banking system due to lack of trust Financial system misallocates resources Could result in high opportunity costs and possibly high fiscal costs Banks may lend for consumption but not for productive projects Banks may lend to the elite and well-connected, and for this exclusive group, private cost of capital may be low, while for the majority of individuals access to capital may be very limited
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