Economic growth in the emerging economies, in general, and in the BRIC, in particular, has slowed down significantly, while for now headline inflation remains quite elevated – China excepted. This points to rising supply constraints and suggests that the growth slowdown is in part structural. Labour markets in Brazil and Russia, for instance, are very tight. While all BRIC economies are in need of productivity-enhancing reform, measures necessary to tackle these constraints vary.
Hausmann et al. have proposed a framework for the identification of the so-called (most) binding constraint(s) limiting economic growth, called growth diagnostics. Cross-country regression analysis may help identify the factors that constrain economic growth, whether they be low human capital, weak institutions or insufficient capital accumulation. Each country faces a unique set of economic, socio-political etc, conditions, however, and cross-country research singles out the factors that on average support higher economic growth.
The growth diagnostic strategy, on the other hand, seeks to identify the “the most binding constraints on economic activity, and hence the set of policies that, once targeted on these constraints at any point in time, is likely to provide the biggest bang for the reform buck”. More specifically, Hausmann et al. (2008) propose a decision tree that helps identify the causes of low private investment. The underlying assumption is that it is the level of private investment that in large measure determines future output growth. This framework can be heuristically applied to the BRIC economies.
Brazil undoubtedly suffers from a high cost of finance. This is, however, not due to bad international finance, for external borrowing costs are very low, but due to a combination of low domestic savings and, arguably, poor financial intermediation. Poor intermediation, in turn, can be attributed to banks’ high reserve requirements and a legal framework that makes it difficult for lenders to recover their losses. Raising domestic (public) savings through a longer-term fiscal adjustment should therefore help address the dearth of domestic savings and lessen the need for high reserve requirements.
China does not suffer from low private investment and the Hausmannian framework does hence not seem to be applicable here. If anything, it would be desirable to reduce domestic savings through greater fiscal outlays and social expenditure as well as, potentially, by raising the cost capital (aka financial and interest-rate reform) and by forcing SOEs to pay dividends to the government. Financial reform would also help boost household income and potentially reduce the propensity to save. This would help wean the economy off potentially excessive investment and all the risks this entails. China could nonetheless introduce reforms aimed at raising the productivity of investment. This would help it maintain high growth in spite of the anticipated reduction in domestic investment and rise in consumption.
To the extent that India suffers from low private investment, this can be attributed to low social returns. Interest rates have not historically been very high (in real terms) and governance or market failures would appear to be somewhat less important growth constraints as far as low appropriability is concerned than low social returns and, more specifically, a low level of human capital and a bad infrastructure. Illiteracy is very high and the infrastructure is notoriously poor. Admittedly, market failure is likely the second most important binding constraint in India. India should therefore focus on specific bottlenecks in the energy and infrastructure area as well as reduce market inefficiencies (e.g. accelerated approval of large investment projects, land acquisition law, restrictive labour laws).
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| Source: IMF |
To the extent that India suffers from low private investment, this can be attributed to low social returns. Interest rates have not historically been very high (in real terms) and governance or market failures would appear to be somewhat less important growth constraints as far as low appropriability is concerned than low social returns and, more specifically, a low level of human capital and a bad infrastructure. Illiteracy is very high and the infrastructure is notoriously poor. Admittedly, market failure is likely the second most important binding constraint in India. India should therefore focus on specific bottlenecks in the energy and infrastructure area as well as reduce market inefficiencies (e.g. accelerated approval of large investment projects, land acquisition law, restrictive labour laws).
Last but not least, the relatively low level of private investment in Russia seems to be primarily due to micro-risks and governance failures and ultimately low appropriability. The cost of finance does not appear to be unduly high and Russia has been running current account surpluses for many years, suggesting excess savings. A poor geography and an at best average-quality infrastructure represent important constraints. But compared to the issues of property risk and corruption, these constraints are arguably less “binding”. Structural reforms aimed at boosting private-sector investment will therefore be key to raise medium-term economic growth. A more efficient state would also help boost the productivity of public investment. But state reform is difficult. WTO accession offers a welcome opportunity to implement structural reforms aimed at making the business environment more predictable, strengthen the rule of law and limit corruption.