Chapter

IV Convergence and Divergence in Developing Countries

Author(s):
International Monetary Fund. Research Dept.
Published Date:
May 1993
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During the past two decades there have been wide disparities in the pace of economic growth among developing countries. Differences in the external environment account for some of these divergences, but domestic policies have been decisive. There is considerable evidence that macroeconomic stability and the removal of structural distortions boost growth by improving the incentives to save and invest, as well as the efficiency of investment. As more countries implement stabilization and structural reform policies, the medium-term prospects for the developing world appear brighter than they have been for some time.

Growth in Developing Countries

There have been significant variations in the growth performance of developing country regions since 1970, with growth in Asia notably higher than elsewhere (Table 9, Chart 20). These differences were especially marked during the 1980s, when per capita income increased at an average annual rate of nearly 5 percent in Asia but declined in other regions. There have also been significant variations within regions. In Africa, where growth was slowest in 1971–92, eight countries had average growth of 5 percent a year or higher.26 Similarly, in Asia growth in the four newly industrializing economies and in China, Malaysia, and Thailand was spectacular during the past decade but was low in countries such as Myanmar, Nepal, and the Philippines. The group of “successfully adjusting countries” identified in the October 1992 World Economic Outlook (Chapter IV), which included countries from all regions, had above-average growth since the implementation of reform policies started in earnest in the early 1980s.

Table 9.Developing Countries: Growth Performance(Annual percent change)
1971–921971–811982–921982–861987–92
All developing countries
Real GDP4.85.64.04.04.1
Real per capita GDP2.43.11.71.51.8
By region
Africa
Real GDP2.83.71.91.82.0
Real per capita GDP0.9–0.9–1.1–0.8
Asia
Real GDP6.35.96.76.96.6
Real per capita GDP4.44.04.84.94.7
Middle East and Europe
Real GDP4.46.02.92.23.4
Real per capita GDP1.02.6–0.6–1.2
Western Hemisphere
Real GDP3.75.91.61.61.6
Real per capita GDP1.33.2–0.5–0.8–0.2
By predominant export
Fuel
Real GDP4.26.12.31.23.3
Real per capita GDP1.12.8–0.6–2.00.6
Nonfuel
Real GDP5.15.54.75.04.4
Real per capita GDP2.93.32.62.92.3
By financial criteria
Net creditor
Real GDP5.16.73.51.55.2
Real per capita GDP1.12.8–0.5–2.10.9
Net debtor
Real GDP4.85.54.14.24.0
Real per capita GDP2.53.21.91.91.9
Successfully adjusting countries1
Real GDP5.65.55.75.75.6
Real per capita GDP3.53.43.73.53.8
Sustained adjustment
Real GDP6.56.56.46.36.5
Real per capita GDP4.54.54.54.34.8
Recent adjustment
Real GDP3.93.64.14.53.8
Real per capita GDP1.51.21.92.11.8

Chart 20.Developing Countries: Real GDP Growth1

(Annual percent change)

1Five-year centered moving average. Blue shaded area indicates staff projections.

Countries have differed in the degree of persistence of above- and below-average growth over time because of changes both in policies and in the external environment. Although the East Asian countries and China have sustained very strong performances recently, growth has been much more unstable in the developing countries of the Middle East and Europe, where many countries have been affected by large changes in the terms of trade, drought, and civil conflict, and in Latin America, where most countries experienced sharp fluctuations associated with the debt crisis.27 In Africa, countries such as Botswana have maintained their impressive growth rates throughout the past two decades, while in others there have been marked variations in growth, in part because of terms of trade fluctuations and other exogenous shocks, particularly drought.

It is also worth noting that, for most developing countries, there is little evidence of catching up to living standards prevailing in industrial countries, in the sense that countries with relatively low initial per capita income did not grow faster than countries with higher incomes.28 Catching up might have been expected for two reasons. First, higher potential returns to capital in the low-income countries, because of capital scarcity and lower capital-labor ratios, would attract international capital flows, leading to an increase in capital accumulation and growth. Second, because of the low-income countries’ larger technological gap compared with the more affluent countries, productivity might have been expected to grow particularly rapidly. That many developing countries have not caught up underlines the role that policies to encourage the accumulation of physical and human capital play in the development process. Those countries that have pursued such policies, including some in Asia and Latin America, have grown rapidly, and some are in the process of catching up with standards of living in the industrial countries.

Changes in the external environment, especially in the terms of trade and world interest rates, certainly contributed to the divergent performance among the developing countries, particularly in many of the relatively undiversified primary commodity exporters (Table 10). But in most countries the effects of these factors on long-run performance have been limited compared with the role of domestic policies. Even when external shocks were significant—as in the case of oil importing countries in 1973–74 and 1979–80, or for exporters of oil and other primary commodities from the mid-1980s—the policy response to these shocks played a key role in determining growth performance. Where governments maintained macroeconomic stability and eliminated structural rigidities, countries were able to weather external shocks well and to return quickly to a high-growth path.

Table 10.Developing Countries: Export and Import Unit Values and Terms of Trade(Annual percent change)
1971–921971–811982–921982–861987–92
All developing countries
Export unit values9.320.8–1.1–7.64.8
Import unit values6.812.11.7–1.74.6
Terms of trade3.08.6–2.4–5.90.6
By region
Africa
Export unit values9.021.3–2.0–7.52.9
Import unit values6.912.12.0–1.04.6
Terms of trade2.38.7–3.7–6.4–1.3
Asia
Export unit values6.912.61.5–2.75.1
Import unit values6.712.41.2–2.54.4
Terms of trade0.40.50.3–0.40.9
Middle East and Europe
Export unit values11.429.5–4.2–14.75.5
Import unit values6.711.72.0–1.44.9
Terms of trade5.016.9–5.7–13.61.3
Western Hemisphere
Export unit values7.517.0–1.2–6.03.0
Import unit values6.812.21.7–1.24.2
Terms of trade1.25.0–2.4–4.1–1.0
By predominant export
Fuel
Export unit values10.928.9–4.6–14.94.9
Import unit values6.410.52.40.54.1
Terms of trade4.416.8–6.7–15.11.0
Nonfuel
Export unit values6.612.11.3–2.04.2
Import unit values6.912.91.2–2.94.8
Terms of trade–0.1–0.50.41.1–0.2
Successfully adjusting countries
Export unit values7.414.31.0–4.25.3
Import unit values6.712.21.5–1.94.4
Terms of trade0.92.3–0.5–2.51.2
Sustained adjustment
Export unit values6.912.41.6–2.65.1
Import unit values6.812.41.5–1.84.2
Terms of trade0.20.20.2–1.01.2
Recent adjustment
Export unit values8.720.6–1.9–10.76.0
Import unit values6.311.31.5–2.54.9
Terms of trade2.79.2–3.5–8.50.9

Saving, Investment, and Productivity

The fast-growing developing countries—defined as the top one-third of countries ranked by GDP growth during 1971–92—share a number of characteristics that contrast with the middle- and low-growth countries (Table 11). The high-growth countries had markedly higher saving rates, particularly during the 1980s, when saving rates were nearly double those of the low-growth countries; higher investment rates; more efficient investment as measured by incremental capital-output ratios; and a higher proportion of investment financed by domestic saving. A large proportion of the foreign saving utilized by the high-growth countries was in the form of equity capital, including foreign direct investment and portfolio flows, rather than in the form of debt-generating capital flows.29

Table 11.Developing Countries: Characteristics of High-, Middle-, and Low-Growth Countries1(In percent a year or percent of GDP unless otherwise noted)
1971–921971–811982–921982–861987–922
All developing countries
Real GDP growth5.05.74.24.24.2
Real per capita GDP growth2.73.32.01.82.1
Total fixed investment21.721.721.721.821.7
Public investment12.111.912.411.813.0
Private investment9.69.89.310.08.6
Total saving22.623.122.121.323.0
Government final consumption11.911.512.312.212.3
Export volume growth6.96.87.05.78.0
Capital-output ratio33.23.23.73.93.5
High growth
Real GDP growth7.07.16.96.97.0
Real per capita GDP growth5.05.14.84.74.9
Total fixed investment23.822.225.625.325.9
Public investment11.810.812.811.913.8
Private investment12.011.312.813.412.1
Total saving27.326.528.126.529.6
Government final consumption11.911.412.412.712.1
Export volume growth9.18.89.47.610.9
Capital-output ratio2.52.42.93.12.4
Middle growth
Real GDP growth4.15.32.82.82.9
Real per capita GDP growth1.52.50.50.20.7
Total fixed investment20.521.319.619.619.5
Public investment12.712.912.612.113.1
Private Investment7.78.47.07.56.4
Total saving20.020.919.018.219.7
Government final consumption11.511.311.811.412.1
Export volume growth5.86.05.74.66.6
Capital-output ratio3.43.63.74.13.9
Low growth
Real GDP growth1.83.00.60.90.4
Real per capita GDP growth–0.50.7–1.6–1.4–1.8
Total fixed investment19.621.717.418.815.9
Public investment11.011.610.210.69.9
Private investment8.710.17.18.26.0
Total saving18.020.615.116.014.2
Government final consumption13.212.913.513.713.3
Export volume growth3.22.73.73.34.1
Capital-out put ratio4.94.66.66.05.1

Government policies played a key role in promoting growth, even though the direct involvement of government in the economy did not differ significantly across the three groups of countries. The ratio of government consumption expenditure to GDP was about the same in the three groups, although during the 1980s the ratio of public investment to GDP was markedly higher for the high-growth countries (with the ratio of private investment to GDP even higher). The most striking difference between groups of countries was in export performance—export growth of the high growth countries was more than double that of the low-growth countries. The benefits of an outward-oriented strategy, which in part explain this export performance, are discussed extensively in Chapter VI, which shows that countries pursuing such policies had a significantly better overall performance.

The sharp differences in economic performance can be summarized by using a basic growth accounting framework. During the 1970s, trend or potential output growth in the high-growth countries was nearly three times as high as in the lowgrowth countries (Table 12).30 Although the contribution of capital in the high-growth countries was twice that in the low-growth countries, the largest difference was in the contribution of total factor productivity, which can be interpreted broadly as an indicator of the efficiency of resource use. During 1971–91, for instance, productivity increases accounted for nearly one-fourth of the growth for the high-growth countries, around 15 percent for the middle-growth countries, and made no contribution for the low-growth countries. During the first half of the 1980s, all countries suffered a sharp decline in productivity, in part because of the dislocations caused by the sharp increase in oil prices in 197980, high international interest rates, and the debt crisis. But productivity growth remained positive for the high-growth countries in the early 1980s and then picked up substantially. For the low-growth countries, in contrast, there was a sharp drop in productivity in the early 1980s and further declines in the following five years.

Table 12.Developing Countries: Contributions to the Growth of Trend Output1(Annual percent change)
1971–911971–811982–911982–861987–91
All developing countries
Trend GDP5.26.04.24.14.3
Capital contribution2.53.12.02.31.7
Labor contribution1.31.61.31.31.2
Total factor productivity1.31.31.00.51.5
By region
Africa
Trend GDP3.44.52.32.22.3
Capital contribution1.92.91.01.60.5
Labor contribution1.31.41.51.41.5
Total factor productivity0.20.2–0.2–0.80.3
Asia
Trend GDP6.56.26.86.86.9
Capital contribution2.82.92.92.92.8
Labor contribution1.11.41.11.21.0
Total factor productivity2.61.92.92.63.1
Middle East and Europe
Trend GDP5.06.53.33.53.1
Capital contribution3.34.62.13.01.2
Labor contribution1.61.91.61.71.5
Total factor productivity–0.4–1.20.3
Western Hemisphere
Trend GDP4.06.21.61.12.0
Capital contribution1.93.01.01.20.7
Labor contribution1.52.01.31.41.3
Total factor productivity0.51.3–0.7–1.50.1
By growth
High growth
Trend GDP7.27.56.86.76.9
Capital contribution3.43.73.23.53.0
Labor contribution1.31.61.21.31.1
Total factor productivity2.52.22.31.92.8
Middle growth
Trend GDP4.25.52.92.63.2
Capital contribution2.13.01.21.51.0
Labor contribution1.51.81.31.41.3
Total factor productivity0.70.70.3–0.30.9
Low growth
Trend GDP2.23.40.81.00.6
Capital contribution1.21.90.61.10.2
Labor contribution0.91.01.11.01.1
Total factor productivity0.4–0.9–1.1–0.7

The achievements of the high-growth countries were attributable, in large part, to domestic policies that increased incentives to save, invest, and allocate capital and labor in the most efficient manner. Moreover, by reducing instability and uncertainty, the policies pursued by these countries encouraged innovation and the adoption of modern technology and enabled the private sector to respond speedily to market signals. The outward orientation of these policies, by increasing competition and exposing domestic producers to new products and ideas, further increased the efficiency of resource allocation.

Macroeconomic Stability

A stable macroeconomic environment is a prerequisite for high rates of investment and strong productivity growth. Such an environment is characterized by low and predictable inflation, stable and sustainable fiscal balances, low but positive real interest rates, a competitive and relatively stable real exchange rate, and a balance of payments that is perceived as viable. The beneficial effects of stability on growth can be readily illustrated by the recovery of economic growth in several countries in Latin America in recent years, where an upturn in growth was preceded by the restoration of budget discipline and the reduction of inflation. The fast-growing countries of East Asia have generally maintained low inflation rates and for the most part have avoided balance of payments crises. When these countries have experienced such crises—as in Korea in 1980—they have moved swiftly to correct the underlying causes.

One of the major reasons for macroeconomic instability in the developing countries has been large fiscal deficits. These have been financed largely by lax monetary policies, with fairly direct effects on inflation. Even when budget deficits have been financed by running down foreign exchange reserves, the ensuing foreign exchange difficulties have invariably led to instability. In recent years, a substantial proportion of deficits in the middle-income developing countries have been financed by domestic borrowing, which has led to very high real interest rates that have further aggravated the fiscal position.31 In the late 1970s and early 1980s, external borrowing was often used to finance burgeoning fiscal deficits caused by high levels of public consumption or by public investments that failed to yield adequate returns. The resulting indebtedness and macroeconomic instability was compounded by capital flight.

The second major factor affecting macroeconomic stability is the exchange rate, which plays a dual role in economic policy. First, the stability of the nominal exchange rate can be used as a monetary anchor to reduce and stabilize inflation. Second, an appropriate level of the real exchange rate is crucial to the development of the domestic economy through the effects the real exchange rate has on incentives to export and on the ability of domestic producers to compete. These two aspects have often clashed in the developing countries—especially when an initial peg was set at the wrong level—because governments, in order to keep domestic inflation in check, have attempted to stabilize the nominal exchange rate with the result that the real exchange rate appreciated, eventually leading to external payments difficulties.

Macroeconomic instability reduces growth through several channels. First, by distorting price signals so that these no longer reflect underlying scarcities, it results in the misallocation of resources and reduced productivity. Second, macroeconomic instability increases uncertainty and reduces the rate of investment, as potential investors wait for uncertainty to dissipate before committing resources.32 Capital flight, which is likely to increase with macroeconomic instability, further reduces investment in the domestic economy. High and variable inflation, an important source of macroeconomic instability, further depresses investment, often by lowering real returns to saving. Large fiscal deficits may lead to the crowding out of private investment by raising real interest rates. High deficits, which result in rapid accumulation of public debt, may also signal higher taxes and lower public investment in the future.

The way that fiscal consolidation is undertaken has important implications for long-run growth. To reduce uncertainty, deficit reduction must be credible and sustainable. Increased taxes on income and investment may distort incentives and reduce growth. In many countries there is scope to reduce nonproductive government spending, such as military expenditures. In general, reductions in public investment, including expenditures on human capital, will reduce long-run growth prospects. However, the net effect of public investment depends both on the extent to which it is complementary to private investment and on the form of taxation used to finance it.33 Complementary and efficient public investment financed with consumption taxes is likely to lead to an increase in growth. In contrast, the effect of public investment is ambiguous when it is financed through taxes on income, profits, or capital.

As Table 13 illustrates, inflation and its variability and the variability of the real exchange rate have been considerably lower in high-growth countries than in other countries.34 There has also been a tendency for high-growth countries to keep their deficits in check by maintaining expenditures and revenues relatively stable in relation to GDP.35 For instance, between 1971–81 and 1982–92, the ratio of central government expenditure to GDP was unchanged at around 26 percent for the high-growth countries, but it increased from 24 percent to 31 percent for the low-growth countries without any corresponding increase in revenues. In those countries where there were pressures on government revenues, expenditure cuts were distributed evenly across government consumption and investment.36 In line with the relatively low fiscal deficits, the growth of broad money (adjusted for the growth in output) also tended to be lower. Many of the highgrowth countries, including Indonesia, Malaysia, and Thailand, have undertaken substantial financial sector reforms that have allowed them to finance their deficits by market borrowing, and to some extent the need to service debt obligations may have imposed, in general, some discipline on the public sector.

Table 13.Developing Countries: Indicators of Macroeconomic Stability1(Annual percent change unless otherwise noted)
1971–921971–811982–921982–861987–922
All developing countries
Consumer prices30.817.945.132.356.8
Consumer prices (median)10.311.29.49.69.2
Variability of price inflation3127.714.6156.727.5170.1
Real effective exchange rate–2.7–0.9–4.6–6.8–2.4
Variability of real effective exchange rate312.88.714.310.013.8
Budget deficit (percent of GDP)–3.9–3.2–4.6–5.1–4.2
Broad money41.628.356.341.170.1
High growth
Consumer prices9.89.99.77.511.5
Consumer prices (median)8.610.17.06.77.2
Variability of price inflation38.07.24.93.14.7
Real effective exchange rate–4.1–2.3–6.1–7.9–4.4
Variability of real effective exchange rate39.47.89.58.49.3
Budget deficit (percent of GDP)–2.6–1.6–3.6–4.0–3.3
Broad money22.922.922.821.823.7
Middle growth
Consumer prices43.720.871.047.893.1
Consumer prices (median)11.111.211.110.511.6
Variability of price inflation3154.816.3184.519.5199.2
Real effective exchange rate–2.1–0.4–4.0–5.7–2.2
Variability of real effective exchange rate312.38.713.910.312.4
Budget deficit (percent of GDP)–4.6–3.9–5.3–5.9–4.7
Broad money50.729.974.753.095.1
Low growth
Consumer prices60.034.790.068.5110.1
Consumer prices (median)12.212.212.211.912.4
Variability of price inflation3413.631.9544.2139.3597.3
Real effective exchange rate0.62.2–1.2–7.35.2
Variability of real effective exchange rate329.012.136.415.139.0
Budget deficit (percent of GDP)–5.4–5.4–5.4–5.4–5.3
Broad money76.440.3121.766.6181.3

Cross-country analysis suggests that an increase in the inflation rate by 10 percentage points a year reduces the growth of the capital stock by around 0.30 percentage point, and the rate of productivity growth by about 0.15 percentage point.37 A sustained reduction in fiscal deficits of 1 percentage point of GDP is typically associated with an increase in growth of up to 0.25 percentage point. These large effects underscore the importance of macroeconomic stability, although the evidence indicates that some of the effects may be nonlinear. For instance, variations in inflation do not significantly affect growth as long as annual inflation is in single digits, but higher rates significantly reduce growth through adverse effects on capital accumulation and productivity.

Structural Distortions and Government Intervention

Although the above indicators of macroeconomic stability have a significant effect on growth, they explain only a part of the total cross-sectional variation in growth among countries. Structural policies also influence growth—as shown, for instance, by the evidence from the CFA franc zone in Africa, where many of the countries have grown slowly since the early 1970s despite relative macroeconomic stability, and from India, which grew steadily but moderately while pursuing cautious macroeconomic policies since the early 1950s. Such results may be the consequence of government interventions in the form of barriers to trade, subsidies, and exchange and interest rate controls that lead to price and trade distortions and reduce incentives to save and invest. In such an environment, resources will remain in low-productivity activities, bottlenecks will become persistent, and growth will be impeded.38

Two indicators of price distortions are particularly noteworthy: the foreign exchange premium in the parallel (or black) market, and indices of trade intervention. The parallel market premium is an indicator of the distortions created by exchange restrictions and an overvalued currency. This situation encourages capital flight and distorts incentives—both for exporters, who tend to underinvoice exports, and for importers, who may overinvoice imports. The outflow of capital may thereby increase the scarcity of foreign exchange, which may induce governments to impose further restrictions on trade and capital flows.

Another area of distortion is in the financial sector. There is increasing evidence that government policies toward financial institutions have had an important effect on long-term growth. To encourage capital investment, governments often keep real interest rates artificially low and even negative for prolonged periods of time. This reduces incentives for domestic saving, encourages capital flight, and leads to misallocation of capital to nonproductive sectors. Similarly, when credit to particular sectors is subsidized, it often results in excessively capitalintensive projects. Policies that adversely affect the efficiency of financial intermediaries, including excessive restrictions on entry, hamper resource allocation and productivity growth.39

Cross-sectional empirical evidence shows a clear link between structural distortions and growth performance. Countries with above-average growth have had relatively fewer trade restrictions and, as shown in Table 14, lower black market premiums. High-growth countries not only have had fewer distortions, but also have gradually reduced them over time.40 The high-growth countries have tended to have positive but relatively low real interest rates, while the other two groups have had either large negative real interest rates or large positive real interest rates.41 High positive real interest rates were due, in part, to large fiscal deficits and may have reflected default risk premiums, while large negative real interest rates typically reflected interest rate controls coupled with high inflation. A composite index of distortions that combines the different measures of distortions to provide one indicator again shows a clear difference between high-growth and low-growth countries.42

Table 14.Developing Countries: Black Market Premiums and Growth
Black Market Premiums1
Average Annual GrowthLowMediumHigh
1971–81
Less than 0 percent9.111.1
0–2 percent4.58.718.5
2–4 percent13.626.140.7
4–6 percent27.334.829.6
Greater than 6 percent45.530.4
1982–86
Less than 0 percent9.117.429.6
0–2 percent18.247.833.3
2–4 percent27.321.711.1
4–6 percent36.413.014.8
Greater than 6 percent9.111.1
1971–86
Less than 0 percent3.7
0–2 percent13.613.048.1
2–4 percent27.330.429.6
4–6 percent22.739.118.5
Greater than 6 percent36.417.4
Total number of countries222327

It is often suggested that some types of direct intervention in industry, particularly the manipulation of financial incentives to favor certain sectors or firms, may be beneficial. Although there may be costs imposed by the distortions associated with these interventions, it is argued, there can be significant benefits in terms of structural transformation and positive external effects, especially in the early phases of development. In this regard the experience of East Asian countries is often emphasized. However, the experience of these countries also suggests that, while there were many instances in which government intervention was beneficial in facilitating the development of high-tech “strategic” industries and in the formation of managerial and technical expertise, policymakers in these countries were not always successful in their attempts to pick the winners.43

Box 4.Economic Reforms, Growth, and Trade in China

The early stages of China’s reforms, beginning in 1978, dealt chiefly with the agricultural and foreign trade sectors.1 Rural reforms increased agricultural productivity sharply and released surplus labor to rural nonstate enterprises, many of which developed an external orientation. External reforms were designed both to boost exports and to encourage foreign direct investment and the adoption of new technology. The rules governing foreign investment were liberalized, and significant tax incentives were granted, initially in four special economic zones (SEZs) and later in other open economic zones.2 Since 1978, China’s complex exchange and trade system has been gradually liberalized. The role of the foreign trade plan was reduced, transactions were increasingly allowed at a market-oriented exchange rate, and the foreign trade corporations (FTCs) were decentralized, with most FTCs becoming responsible for their own economic performance by 1988. From the mid-1980s, market-oriented reform began to be applied to the urban industrial sectors, with particular emphasis on state-owned enterprises. These enterprises were gradully exposed to market forces, investment decisions were made more decentralized, and enterprises were allowed to retain profits and became liable for taxation. Simultaneous reform of the financial sector saw the breakup of the old monobank system and the growth of nonbank financial institutions.

A surge in inflation in the late 1980s led to a twoyear hiatus in reform, but the process began to regain momentum in the course of 1991, with a further sharp quickening in 1992. Significant liberalization in the trade and exchange systems in 1991 was followed in 1992 by steps toward an integrated foreign exchange market. There has also been an extension of liberalization to new inland regions, reinforcing their growth potential. Foreign participation in new areas of economic activity (notably in the tertiary sector) was allowed in 1992, and steps were taken toward adopting international standards and practices in areas such as accounting, copyright law, and patent protection. Domestic reforms, which have included a major liberalization of prices and a sharp reduction in mandatory planning, have also focused on the enterprise sector, where the policy objectives include the elimination of price distortions and soft budget constraints. The social security and housing systems are being overhauled to ensure an adequate social safety net. The prospects for reform in the financial sector are being bolstered by promoting money markets and interbank markets, while trading in enterprise shares is growing rapidly on the stock exchanges.

Domestic and external reforms in China have played a complementary role, leading to a dramatic increase in growth (see table). The domestic reforms contributed to a sharp increase in savings and investment, with the investment-GDP ratio rising to 34 percent in the 1980s and an increasing amount being directed to the fast-growing manufacturing sector.3 The external reforms have been accompanied by a dramatic expansion in foreign direct investment, a major part of it coming from Hong Kong and Taiwan Province of China, and by a rapid growth in exports. The opening up of the economy contributed to the acceleration in growth because the development of many key manufacturing industries hinged on imports of technologically advanced machinery and equipment, and export earnings were an important source of financing for these imports.4

China: Exports and Growth(Annual average, in percent)
1978–821982–861986–901990–92
Growth of real GDP7.011.97.510.3
Growth of export volume16.16.513.212.7
Share in world exports1.01.41.82.1

Exports increased more than six-fold between 1978 and 1991, China’s share in world exports more than doubled, and its rank among world exporters advanced from thirty-second to thirteenth. Regional trade also boomed, as the share of China’s total exports going to other Asian countries rose from 39 percent in 1985 to 57 percent in 1991. One of the largest and fastest-growing export categories, referred to as “products exported after inward processing,” reflects processing in the open economic zones and involves enterprises set up and operated primarily by investors from Hong Kong and Taiwan.5 In contrast to the rest of the Chinese economy, whose exports are dominated by basic manufactures and primary products, exports from these zones largely consist of machinery and electronics and textiles and garments. The growth of these exports illustrates the importance of economic liberalization and foreign investment in the zones in the development of the Chinese economy through the 1980s. The share of inward processing industries in China’s total exports and imports increased sharply toward the end of the decade, rising from 8½ percent and 4½ percent, respectively, in 1985 to 17 percent and 16 percent in 1990. The open economic zones have been a major recipient of foreign direct investment, new technologies, managerial skills, and labor training. Many foreign investors, particularly those from countries with labor shortages, are attracted by the relatively low wages.

The marked rise in economic activity in 1991–92, however, has led to a renewed risk of overheating that, if not contained, could lead to macroeconomic instability and could jeopardize the reform process. A key to containing fiscal and monetary pressure would be an improved performance by the state enterprise sector, whose losses were compensated by budgetary subsidies, amounting to 2½ percent of GNP in the past, and bank credit of a similar magnitude. Sustained domestic demand restraint should help the Chinese economy to achieve a soft landing from its current very high rates of expansion while maintaining a sound external position. Greater efforts to preserve macroeconomic stability will ensure that the full benefits of China’s trade reforms will be realized.

1 See Michael W. Bell and Kalpana Kochhar, “China: An Evolving Market Economy—A Review of Reform Experience,” IMF Working Paper 92/89 (November 1992).2 Open economic zones are areas that were opened up by the authorities to external trade and investment; these include mainly the SEZs, open coastal cities, and several other types of economic development zones.3 See World Bank, China: Between Plan and Market, World Bank Country Study (Washington, 1990).4 See Nicholas R. Lardy, Foreign Trade and Economic Reform in China, 1978–1990 (Cambridge and New York: Cambridge University Press, 1992).5 See Adi Brender, “China’s Foreign Trade Behavior in the 1980s: An Empirical Analysis,” IMF Working Paper 92/5 (January 1992).

In Korea, for example, the government actively intervened in the early process of industrialization and pursued an export-oriented strategy, but the extent to which the interventions successfully favored particular sectors is subject to considerable debate. Some maintain that the motivation for the interventions, including tax and tariff exemptions and subsidized credits, was to maintain rough neutrality between incentives provided to different sectors and that the interventions did not result in large price distortions.44 Together with competitive labor markets and Korea’s comparative advantage in laborintensive manufacturing activities, the interventions led to a rapid expansion of labor-intensive exports. Others have suggested that such interventions, especially the heavy and chemical industry promotion drive in the mid-1970s, promoted industries that were subsequently able to compete in world markets but at the expense of other sectors. The degree of distortion is difficult to assess. What is not disputed is that the heavy and chemical industry drive culminated in serious macroeconomic imbalances in the early 1980s, which led to a marked shift in these policies and reforms. There is also some evidence that tariffs and subsidized credit may have had negative effects on labor productivity and technological progress in some of the favored sectors, although tax incentives had a strong positive effect.45 The negative relationship between trade protection and productivity growth highlights the difficulties in targeting the right industries and the inefficiencies that can arise from reduced competition.

In Thailand, the push for capital-intensive, largescale, import-substituting industries in the 1970s also had mixed results. These policies contributed to macroeconomic imbalances, but they also helped to develop infrastructure, as well as technical and managerial structures, that were essential for the subsequent expansion in the 1980s. In Indonesia, sectoral policies entailing public investment in infrastructure and agricultural services were successful in promoting agricultural development, but interventions in the industrial and financial sectors did not always yield the desired results.

In Singapore, industrial policy, through fiscal incentives and direct government investment in firms, was relatively successful. The promoted industries were more broadly defined than the specific industries targeted in other countries such as Korea. Moreover, the incentives affected the sectoral composition of investment and output only to a limited extent. Given the large share of foreign direct investment in total investment, the selection of industries was ultimately made by multinational firms on the basis of their own assessment of profitability. As regards direct investment, the so-called government-linked companies in Singapore, in contrast to state-owned companies in other countries, were run on a commercial basis, and the government did not interfere with business decisions or provide subsidies to nonprofitable companies.

In general, although selective industrial policies have left a mark on East Asian development, they did not play a consistently positive role. These policies varied greatly in intensity across countries and over time, as well as in the extent to which they achieved their objectives. Where government interventions succeeded, it was in the context of a stable macroeconomic environment and an outwardoriented trade strategy, and the interventions sought to complement the market rather than replace it.46 (See Box 4 on reforms in China.)

Institutions and Human Capital

The experience of high-growth countries underscores the importance of strong institutions, especially those responsible for macroeconomic policy formulation and implementation. In many fastgrowing countries, the viability and credibility of these institutions were reinforced by strong social support for growth, which, in turn, was nurtured by the wide distribution of the fruits of growth. For instance, in addition to strong economic growth performance, East Asian countries have made outstanding progress, compared with other developing countries, in reducing absolute and relative poverty.

Education and the formation of human capital are necessary to build institutions and raise productivity growth. Investment in education leads to the acquisition of skills that improve efficiency through the better use of existing technologies. Education also helps technological progress by shortening the “imitation” lag between the development and use of new technologies.47 Technological progress, in turn, speeds up the accumulation of human capital through positive externalities and learning by doing. Indeed, one of the main obstacles preventing the poorest developing countries from catching up in living standards is the lack of investment in human capital, not just a shortage of physical capital.

In this regard also, the experience of East Asian countries—with some of the highest per capita expenditures on education—is instructive. Unlike in many other developing countries, these expenditures, incurred substantially by private households, were used to acquire primary and secondary education and vocational skills. The sharp increase in literacy in these countries surpassed the increase in most other countries. For instance, both Korea and India had a literacy rate of roughly 30 percent in the mid-1950s; by 1991 Korea’s literacy rate had increased to over 95 percent, while India’s had increased to only about 45 percent. Between 1960 and 1991, college enrollment in Korea increased fourteen-fold, far surpassing the increase elsewhere and making it second only to the United States in the number of students as a share of the total population.

The cross-sectional evidence suggests that growth in productivity as well as the accumulation of physical capital are strongly correlated with the level of human capital. For instance, the level of secondary school enrollment, which may be interpreted as a proxy for the stock of human capital, is strongly correlated with subsequent growth.48

Medium-Term Prospects

The medium-term prospects for developing countries are encouraging, perhaps more so than they have been in decades. This assessment is based primarily on the fact that increasing numbers of countries are pursuing policies to achieve macroeconomic stability and the reduction of structural distortions.49 On the assumption that these efforts continue and, in particular, that developing countries with IMF-supported adjustment programs implement the policies underlying the programs, output is projected to grow at an average rate of 5¾ percent in 1995–98—considerably faster than in 1982–92—while growth performances across different regions would tend to converge (Table 15).50 Much of this improvement can be traced to a marked pickup in the countries that had previously been experiencing debt-servicing difficulties.

Table 15.Developing Countries: Growth and Investment(Annual percent change and percent of GDP)
1982–871988–921993–941995–98
All developing countries
Real GDP4.44.75.15.9
Investment ratio24.125.826.727.6
Africa
Real GDP1.82.43.34.4
Investment ratio22.220.922.223.5
Asia
Real GDP7.36.86.67.0
Investment ratio28.330.930.730.9
Middle East and Europe
Real GDP3.04.04.44.4
Investment ratio22.719.920.621.0
Western Hemisphere
Real GDP1.81.62.54.8
Investment ratio19.020.722.424.6

Real output growth in Asia is projected to average 7 percent in 1995–98, fueled in part by continued increases in intraregional trade, further modernization of financial systems, and increases in infrastructure investment. In the Western Hemisphere, major reforms in the areas of trade, foreign investment, and financial and labor markets, together with the declining debt overhang, are projected to boost growth markedly in the medium term. As in other regions, the medium-term outlook depends crucially on the assumption that the region continues to ensure macroeconomic stability and to sustain the momentum of reform.

For the developing countries in the Middle East and Europe, medium-term growth is expected to average around 4¼ percent, somewhat higher than in the recent past. Several countries are likely to benefit from improvements in both the rate and efficiency of investment, owing to significant financial sector liberalization and exchange market reforms. Moreover, several countries have embarked on fiscal consolidation programs that will enhance the credibility of government policies, improve financial stability, and spur economic growth. For the oil exporting countries in the region, there are considerable uncertainties about the medium-term balance between global supply and demand for petroleum (Box 5).

Although growth in Africa is projected to increase somewhat in the medium term, these projections are subject to a wider margin of uncertainty than for other regions. Despite considerable progress in some countries, many obstacles to stronger growth remain to be tackled, including inadequate infrastructure, weak administrative capacity, rigidities stemming from official controls, poorly designed tax and expenditure policies, and social and political instability. Comprehensive policy initiatives, such as those associated with the IMF’s SAF and ESAF arrangements (with complementary assistance from the World Bank), are being implemented to create the conditions for sustained growth and progress toward external viability. Continuing weakness in commodity prices and serious debt problems in several countries, however, may hamper these efforts. To change prospects decisively, reform policies would have to be accompanied by political stability, institution building, greater investment in education, and increased financial and technical assistance.

Previous issues of the World Economic Outlook have emphasized the risks to the projections for the developing countries if the assumed policies are not implemented. The possible consequences of policy slippages in countries with IMF programs are examined in Annex II, where it is assumed that fiscal imbalances would persist and that structural reforms are not implemented as steadfastly as assumed in the baseline projections. The consequences of policy slippages would, of course, depend on the number of countries affected, on the degree of slippage, and on the impact on capital flows.

Nevertheless, the policy-slippage scenario suggests that average inflation in 1995–98 would be about 30 percentage points higher than in the baseline case, with a particularly sharp rise in the Western Hemisphere and in the most heavily indebted countries. Investment ratios would be somewhat lower than the baseline, and total factor productivity growth in 1995–98 would fall from 3 percent to 1½ percent for the net debtor countries. The annual average growth of potential output would fall from 4¾ percent to about 3¼ percent for the program countries as a group, and actual growth would decline at least as much. Although growth in the developing countries would still be 5 percent a year in the medium term, relatively large divergences would persist between the stronger performers and those experiencing policy slippages.

Box 5.Oil Demand and Supply in the Medium Term

Global oil demand is expected to grow by an average of about 1¾ percent a year until 1995, and by about 1 percent a year between 1995 and 2000.1 A key determinant of world oil demand in the medium term will be GDP growth and energy policies in the major industrial countries. Total demand for oil by industrial countries reached a peak of 42.2 million barrels a day (mbd) in 1978, fell significantly in the early 1980s, and then picked up with the sharp decline in oil prices in 1985 (see chart on oil prices). In the medium term, demand growth is likely to be lower if excise taxes on fuels are increased to reduce oil imports, to increase government revenues, or to curb carbon emissions. Even without tax increases, the oil intensity of output is expected to fall in the medium term. The share of oil in electric power generation, for example, was 15 percent in 1990, but is expected to drop to 12½percent by 2005.

In the former Soviet Union, oil demand has been falling sharply with the collapse of economic activity. Oil demand is likely to increase as output grows in the medium term, but the energy intensity of output is expected to decline as subsidies are removed and energy is used more efficiently. In developing countries such as India, in contrast, stronger economic growth is likely to increase the demand for oil in the medium term, and the oil intensity of output is expected to rise in response to buoyant population growth, urbanization, and industrialization. Although China is currently a small net exporter of oil—production and consumption in 1991 were 2.8 and 2.5 mbd, respectively—the likelihood of continued high output growth implies that China will be a net importer of oil in the medium term. Given China’s large population, there is a potential for a substantial increase in oil demand, which could have a major influence on world oil prices.

The share of non-OPEC output in total world oil supply has declined steadily since 1985 (see chart on oil supply), in part because of the decline in oil prices and the higher cost of production compared with the OPEC countries. Non-OPEC output is expected to peak in 1997 at around 43 mbd. In the short run, U.S. oil output will decline as a result of the slump in drilling activity since 1986, and in the medium term as resources are depleted. North Sea oil production is likely to rise in the short run but to decline after the late 1990s, while oil output could increase in Canada (from the Hibernia oil field and the Beaufort Sea). In Latin America, Mexico appears to have significant oil reserves, but the extent to which they can be exploited will depend on investment and foreign capital. In the non-OPEC Middle East, Yemen, Oman, and Syria are each capable of producing up to about 1 mbd. Non-OPEC oil production elsewhere in Asia and Africa is expected to stagnate, although China may have some undiscovered reserves in its northwest region, which is being opened to foreign exploration, and oil production in India could increase as a result of changed government policies in the oil sector. Oil output in countries of the former Soviet Union has fallen since the late 1980s and is expected to fall further until the mid-1990s. A recovery of oil output in the former Soviet Union—which is the major uncertainty with regard to the medium-term outlook for non-OPEC oil production—will depend on the resolution of political and economic uncertainties, substantial inflows of direct foreign investment, and introduction of better technology and improved management.

World Crude Oil Prices1

(In U.S. dollars a barrel)

Sources: Petroleum Market Intelligence (New York), other oil industry sources, and Commodities Division of the IMF Research Department.

1Data from 1984 are the unweighted average spot market prices of U.K. Brent, Dubai, and Alaska North Slope crude oil, representing light, medium, and heavier crude oil, respectively, in three different regions. Estimated average prices for earlier years are broadly comparable with the data after 1984. Blue shaded area indicates staff projections.

2 Crude oil prices deflated by the export price of manufactures of industrial countries.

The share of OPEC in world oil supply—which fell following the two oil price increases in the 1970s—has been increasing since mid-1980, and this trend is expected to continue. OPEC production is likely to increase about 6 percent in 1993 and 1994, with most of the increase coming from countries in the Middle East. Over the medium to long term, Saudi Arabia, Kuwait, the Islamic Republic of Iran, Iraq, and the United Arab Emirates—countries in the region with the greatest reserves of oil—are expected to dominate world supply. OPEC production in 1992 is estimated to have been 26.6 mbd, but estimates of capacity for 1997–98 range from 31 mbd to 36 mbd, with Saudi Arabia accounting for about 11 mbd, the Islamic Republic of Iran about 5 mbd, and the United Arab Emirates and Kuwait about 3 mbd each. Oil output in Iraq could be as high as 5 mbd. Among the other members of OPEC, Venezuela is expected to increase capacity to about 3.5 mbd in the medium term.

In the short run, oil prices will largely be determined by the ability of OPEC countries to influence supply. Prices may fall with the return of Iraq to the international oil market unless production is reduced in other countries. Although constant real oil prices in the medium term are assumed in the IMF medium-term projections, there is the possibility of substantial downward pressure on oil prices from lower oil demand growth—reflecting increased energy efficiency, environmental policies, and higher energy taxescombined with possible increased production capacity among major OPEC countries (to 35 mbd, for example). This downward pressure may be partially offset by higher oil demand growth if prices remain low or if OPEC is better able to control production as its total share in world supply increases.

Share in World Oil Supply1

(In percent)

Source: International Energy Agency (IEA).

1Blue shaded area indicates IEA projections, which are based on economic projections that are broadly comparable with the World Economic Outlook medium-term projections; see Energy Policies of IEA Countries: 1991 Review (Paris: OECD and IEA, 1992).

A sustained fall in the price of oil of 10 percent, stemming from a rise in production, would have a positive, but small, impact on oil importing countries as a whole. There would, however, be substantial adverse effects on countries where oil production accounts for a large share of GDP, becuase the increase in oil output would not offset the fall in prices, owing to inelastic oil demand. Real income would therefore fall, which would tend to reduce domestic absorption and output in the non-oil sector.2

1 The projections discussed in this box are from Energy Policies of IEA Countries: 1991 Review (Paris: OECD and International Energy Agency, 1992); OECD Economic Out look (Paris, December 1992); and staff projections based on oil industry forecasts. The economic assumptions underlying these projections are broadly consistent with the medium-term projections discussed in Annex II.2 Work is in progress to include the net creditor countries, many of whom are oil exporters, in a new version of the IMF’s Net Debtor Developing Country Model used to prepare alterative scenarios.

Botswana, Cape Verde, Congo, The Gambia, Guinea-Bissau, Kenya, Mauritius, and Tunisia.

The correlation between individual country average growth rates in the 1971–81 period and in the 1982–92 period were as follows: for all developing countries, 0.34; Africa, 0.31; Asia, 0.59; Middle East and Europe, 0.37; and Western Hemisphere, 0.21.

See N.G. Mankiw, David Romer, and D.N. Weil, “A Contribution to the Empirics of Economic Growth,” Quarterly Journal of Economics, Vol. 107 (May 1992), pp. 407–37; and Malcolm Knight, Norman Loayza, and Delano Villanueva, “Testing the Neoclassical Theory of Economic Growth: A Panel Data Approach,” IMF Working Paper 92/106 (December 1992).

Korea is the main exception, where, until the 1970s, over a third of the investment was financed by foreign borrowing.

Potential GDP is approximated by a three-year moving average of real GDP. The contributions of capital and labor are derived by multiplying their respective growth rates by the estimated share of each factor in output. Total factor productivity is calculated as the residual after taking account of the contributions of capital and labor.

Pablo E. Guidotti and Manmohan S. Kumar, Domestic Public Debt of Externally Indebted Countries, Occasional Paper 80 (IMF, June 1991).

For a discussion of the relationship between macroeconomic stability and long-term growth, see Jacob A. Frenkel and Mohsin S. Khan, “Adjustment Policies and Economic Development,” American Journal of Agricultural Economics, Proceedings of the ASSA 1989 Winter Meeting (August 1990).

Mohsin S. Khan and Manmohan S. Kumar, “Convergence, and Public and Private Investment,” IMF Working Paper (forthcoming, 1993).

Inflation and its variability are highly correlated across countries, making it difficult to disentangle the effect on growth of the level of inflation from that of uncertainty about inflation.

Although fiscal deficits and growth may be expected to be endogenously determined over short periods and both may be influenced by external factors, over longer periods it is reasonable to view deficits as being determined mainly by government policy. See, for instance, Stanley Fischer, “Growth, Macroeconomics, and Development,” NBER Working Paper 3702 (Cambridge, Massachusetts: National Bureau of Economic Research, May 1991).

See “Fiscal Adjustment in Developing Countries,” Annex V in the May 1992 World Economic Outlook.

These results are based on a sample of 50 developing countries over the period 1970–91. Given the cross-sectional nature of the analysis, these results should, of course, be regarded as illustrative, rather than indicating precise elasticities. See also Fischer, “Growth, Macroeconomics, and Development”; and José De Gregorio, “The Effects of Inflation on Economic Growth: Lessons from Latin America,” European Economic Review, Vol. 36 (April 1992), pp. 417–25.

As noted in the October 1992 World Economic Outlook, in recent years many developing countries have undertaken major structural reforms that have improved the medium-term outlook considerably. In India, for instance, the process of reform initiated in mid-1991 has so far led to the dismantling of most industrial licensing, the opening up to the private sector of many industries previously reserved for the public sector, liberalization of foreign investment, the first stages of financial sector reform, and major trade liberalization. Price reforms have included the decontrol of many previously administered prices and increased flexibility in setting a number of important prices. Most recently, the dual exchange rate system has been unified, with the exchange rate now being determined through a system of managed floating.

Empirical evidence suggests that financial development, proxied by the ratio of private sector bank credit to GDP, generally leads to improved growth performance through its effect on the efficiency of investment. See José De Gregorio and Pablo Guidotti, “Financial Development and Economic Growth,” IMF Working Paper 92/101 (December 1992).

See Vinod Thomas and Yan Wang, “Government Policies and Productivity Growth: Is East Asia an Exception?” Working Paper, Office of the Vice President, East Asia and Pacific Region (Washington: World Bank, forthcoming, 1993).

See October 1992 World Economic Outlook, Chapter IV, “The Experience of Successfully Adjusting Developing Countries.”

See Vinod Thomas and Yan Wang, “Government Policies and Productivity Growth.”

Note that, in contrast to the debate about government intervention in industry, there is a consensus that land reforms in countries such as Korea and China have been extremely important in laying the foundations for spectacular growth performance. These reforms, by improving incentives, sharply increased growth of output and productivity in agriculture and freed up resources for industrial development. Lack of agricultural reforms in countries such as the Philippines has been a serious impediment to structural transformation and sustained growth.

Anne O. Krueger, “Asian Trade and Growth Lessons,” American Economic Review, Papers and Proceedings, Vol. 80 (May 1990), pp. 108–12.

Jong-Wha Lee, “Government Intervention and Productivity Growth in Korean Manufacturing industries,” IMF Working Paper (forthcoming, 1993).

Cross-sectional evidence also supports the view that, even where high rates of investment in particular sectors (such as machinery and equipment) yield high increases in productivity, the benefits are likely to be low unless policy interventions are market conforming. See Bradford J. De Long and Lawrence H. Summers, “Equipment Investment and Economic Growth,” Quarterly Journal of Economics, Vol. 106 (May 1991), pp. 445–502.

R.E. Lucas, Jr., “On the Mechanics of Economic Development,” Journal of Monetary Economics, Vol. 22 (July 1988), pp. 3–42.

See Robert J. Barro, “Economic Growth in a Cross-Section of Countries,” Quarterly Journal of Economics, Vol. 106 (May 1991), pp. 407–43.

These include countries such as Argentina, China, Egypt, India, Kenya, Malawi, Mexico, Tanzania, Tunisia, and Uganda; the structural reforms undertaken by these countries were examined in the October 1992 World Economic Outlook (Chapter IV).

A detailed assessment of the medium-term outlook for developing countries is provided in Annex II.

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