Typical street scene in Santa Ana, El Salvador. (Photo: iStock)
IMF Survey: Closing the Gap: IMF Examines What Makes Growth Sustained
May 21, 2008
- Sustained growth is more important for development than short spurts
- What sustains growth is critical for assisting poor countries
- Factors aiding durable growth include macroeconomic stability, exports, democratic institutions, and more equal income distribution
Understanding the variables that contribute to sustained growth is critical for helping poor countries close the income gap with rich countries.
Working in a car plant in South Africa: trade liberalization seems to help sustain growth. (Photo: DPA)
IMF working paper
Closing this gap requires long periods of relatively fast growth in developing countries. While growth surges are relatively common in the developing world—even in such regions as sub-Saharan Africa that have fared poorly in recent decades—what really sets poor-performing regions apart is that their growth spells tend to end relatively quickly, and often with periods of negative growth rather than "soft landings."
The question of how to forestall the end of growth spells is thus critical, especially for the large number of developing countries now enjoying strong growth. This is the issue explored in a our recent working paper "What Makes Growth Sustained?".
Assessing what's right
Previous research has sought to explain the differences in long-term growth between countries, for example, between the rapid growth episodes in Asia and the stagnation in sub-Saharan Africa and Latin America. But it ignored the lack of persistence of growth—why some growth episodes end more quickly and abruptly or why some downturns are relatively protracted.
We look at what a country is doing while it is still growing, focusing on the determinants of the length of growth spells, using duration analysis techniques. This has advantages over just looking at the causes of "turning points" or decelerations, since we actually use the information about "what a country is doing right" during a growth spell.
Key points
The issue: What are the social, political, and economic factors that contribute to sustaining economic growth in poor and emerging-market countries?
The evidence: The main variables that seem to sustain growth include more equal income distribution, democratic institutions, openness to trade and foreign investment, and an export structure favoring manufacturing and relatively sophisticated exports underpinned by a competitive exchange rate.
Policy considerations: Sustaining economic growth in poor and emerging-market countries is an overriding concern for policymakers seeking to accelerate development and reduce poverty. The evidence highlighted in the paper suggests key policies that may be useful in achieving these objectives.
Main findings
Our main findings confirm some earlier results, mainly that external shocks and macroeconomic volatility are negatively associated with the length of growth spells and that good political institutions help prolong growth episodes. We also find that trade liberalization seems to help not only in starting growth but also in sustaining it, especially when combined with competitive exchange rates, current account surpluses, and an external capital structure favoring foreign direct investment.
And we find that a high share of manufacturing in exports—an indicator of the sophistication of export products—tends to prolong growth, perhaps by building constituencies for reforms that themselves are conducive to sustaining growth. Most strikingly, we find that the duration of growth is strongly related to income distribution, specifically, more equal—and arguably therefore more cohesive—societies tend to enjoy more durable growth.
Our specific findings are as follows:
• External shocks. Changes in a country's terms of trade and in external (U.S.) interest rates affect the duration of growth. A 1-percent improvement in terms of trade will reduce the probability of a growth downturn by 2-3 percent, while a 1-percentage-point rise in U.S. interest rates could raise the probability that a growth spell will end in the next year by 25-50 percent.
• Political and economic institutions. Democratic institutions are strongly associated with durable growth, supporting the well-established link between long-run growth and political institutions. Economic institutions—such as protection of the rights of investors and entrepreneurs, or property rights more generally—also appear to matter but estimates are imprecise and not always statistically significant. This could be driven by to data limitations (data on economic institutions is only available for a relatively short period).
• Inequality and fractionalization. Income inequality is strongly associated with the duration of growth spells, and the effect appears to be economically highly significant. Measures of ethnic, linguistic, or religious heterogeneity appear to be less significant determinants of the duration of growth spells.
• Social indicators. While there is some (inconclusive) evidence that indicators of primary education help to sustain the duration of growth spells, there is greater evidence that health indicators—especially for child mortality—matter. An increase in infant mortality by one death per 100, for example, is estimated to raise the risk that a growth spell will end by about 10 percent a year.
• Globalization. Trade liberalization and growth duration are strongly linked. Countries with liberal trade appear to enjoy a 70-80 percent reduction in the risk of a break in growth. The effects of financial integration on growth are less clearcut (perhaps reflecting the impact of higher foreign debt on the volatility of growth), but foreign direct investment flows seem clearly to have a substantial protective effect on growth. An increase in FDI liabilities of 1 percent of GDP in recipient countries is associated with a 4-7 percent reduction in the probability of a growth downturn.
• Current account, competitiveness, and exports. Running a current account surplus during a growth spell seems to increase the sustainability of growth, while currency overvaluation seems to undermine growth duration. The link between growth spells and export structure—measured by the degree of export sophistication and/or the share of manufacturing exports—is also strong. What seems to matter is not so much the share of manufacturing at the start of a growth spell, but whether manufacturing exports rise as a share of total exports during the growth spell. A 1-percentage-point rise in manufacturing exports, for example, is estimated to reduce the risk of an end in growth by 2-4 percent.
• Macroeconomic stability. Two indicators of macroeconomic instability—inflation and exchange rate depreciation—are significant risk factors for ending growth spells. A 1-percentage point increase in inflation, for example, raises the likelihood of an end to growth by 1-4 percent, while a 1-percentage point increase in currency depreciation leads to a 2-6 percent increase in risk. These effects, moreover, are present even at moderate rates of inflation, underscoring the need for countries to avoid (even moderate) degrees of nominal instability if they are to reap the benefits of growth spells.
In sum
Our findings seem consistent with several themes prominent in the literature on economic development in the past 20 years. These include the view that less equal and cohesive societies experience lower or more volatile growth, perhaps because social conflict breeds populist policies or because it leads to weaker institutions and a reduced capacity for managing external shocks.
Our findings also support the notion that export orientation may help growth by building constituencies in favor of better institutions and the idea that sophisticated export or production structures matter for future growth because they favor innovation and allow economies to react more flexibly to shocks. Exploring, differentiating, and testing these channels are challenges for future work.
Comments on this article should be sent to imfsurvey@imf.org