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2. What Matters for Growth of Productivity, Employment, and Capital?

Author(s):
Pritha Mitra, Amr Hosny, Gohar Minasyan, Mark Fischer, and Gohar Abajyan
Published Date:
March 2016
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The above supply-side drivers of growth have long been examined,6 but what are the underlying determinants of these drivers? For example, technological progress can raise productivity, as can better managerial practices. But which factor has a larger impact? Honing in on the factors that have the strongest influence on each driver of growth (this chapter), and assessing how developed these factors are in the Middle East and Central Asia and what policy reforms are needed to enhance them (next chapter), can help identify how to raise the region’s growth potential.

Our empirical analysis points to eight factors with the most robust links to the supply side drivers of growth:

  • A competitive business environment has the strongest relationship with productivity (Figure 4) and is founded on an environment where the government delivers basic services efficiently, promotes the rule of law, reduces corruption and fraud, and streamlines business regulations.
  • Worker talent carries almost equal weight as the competitive business environment in influencing productivity. While both the quantity and quality of education (in other words, human capital) are important elements of worker talent, there is also a third component: diaspora support. Large and successful diasporas can convey knowledge and expertise of global opportunities and local particulars and pull together the financial resources needed to act on new opportunities.
  • Modern production methods are also an important influence on productivity, but have half the impact of the competitive business environment or worker talent. They include technologies and management techniques that help firms efficiently use energy, capital, and worker talent, and institute policies that encourage innovation.
  • Financial market development is the cornerstone for raising physical capital (Figure 4). By facilitating access to funds and ensuring adequate protection of investors’ legal rights, developed financial markets foster greater investment activity.
  • Public infrastructure also plays a significant role in the creation of physical capital, especially in EMDCs. By definition, it directly adds to the stock of physical capital. Indirectly, it promotes private capital accumulation through the provision of more affordable and reliable production inputs (especially for electricity).
  • Openness, in the form of better trade integration with other countries, supports growth in both physical capital and employment by stimulating economic activity, though the impact of openness on capital and employment is smaller than that of other factors (Figure 4). In addition, greater openness to foreign investment (such as taking part in globally integrated manufacturing chains) is also linked to employment growth.
  • Labor market efficiency has the strongest relationship to employment growth (Figure 4) through greater flexibility in wage setting, as well as hiring and firing policies in an environment providing adequate worker protection.

Figure 4.Relevance of Key Factors to the Drivers of Growth

Sources: IMF, World Economic Outlook; ILO, Global Employment Trends; World Bank, Doing Business Report; World Economic Forum, Global Competitiveness Report (2014); and IMF staff estimates. Mitra and others (forthcoming) provides additional details.

Note: Calculated as the ratio of contributions of a given significant factor relative to the total for all significant factors. Contributions are calculated by multiplying the regression coefficients by weighted average factor values for each subregion.

Although not explicitly measured in our study, security and political stability underpin the success of all these factors in raising growth. This is a serious challenge for the Middle East and Central Asia, where geopolitical shocks and intensifying regional conflicts have substantial and often long-lasting spillovers across the region (Figure 5).

Figure 5.Political Risk

Sources: PRS Group, International Country Risk Guide; and IMF staff calculations.

These eight key factors are identified with cross-country regressions. For each of the long-term drivers—productivity, physical capital, and employment—a pooled ordinary least squares approach is used to regress its potential or long-term growth rate7 on the latest macroeconomic and structural data (Annex 1 provides details). In addition to traditional growth determinants, including each driver’s own past lagged level to account for convergence, a new set of technological and sociopolitical factors are included.8,9 The cross-section on which the regression is applied covers more than a hundred advanced and emerging and developing countries and pulls data from several databases, such as the Fraser Institute’s Economic Freedom of the World Index, International Financial Statistics, the International Labor Organization, the PRS Group, World Bank Doing Business, World Bank Education Statistics, the World Economic Forum’s Global Competitiveness Report, the World Economic Outlook, and the World Governance Indicators.

Several important findings pertain to the identified factors. In the area of productivity growth, this study examines and finds significance for diaspora support and places modern production methods as the third-most important influence, behind only a competitive business environment and worker talent. This paper also highlights the importance of affordable and easily available financial services and the importance of property and legal rights in supporting physical capital growth (Herrala and Ariss 2013 discuss the importance of removing financial constraints; Bayraktara and Fofackb 2011 illustrate the importance of the quality of governance for capital accumulation in MENAP and Sub-Saharan countries; and the World Bank’s Global Financial Development Report 2014 highlights the critical role of financial inclusion). Instead, most studies focus on the influence of financial market depth (measured as the ratio of banking credit to GDP; Levin 1997, 2004; Khan and Senhadji 2000) on capital accumulation. The influence of openness on employment growth, especially with large emerging markets, is also a key finding.

The other factors found to influence the drivers of potential growth are broadly consistent with the literature:

  • The importance of worker talent and a competitive business environment are consistent with results from previous studies. Cubeddu and others (2014) find that investing in human capital (a major part of worker talent) can significantly improve emerging markets’ medium-term growth prospects. Dabla-Norris and others (2013) identify a competitive business environment, strong institutions, and openness to foreign investment and trade to be most influential on emerging market productivity growth. Loko and Diouf (2009) focus on Maghreb countries, where human capital, trade openness, and the business environment are most important. Similarly, Christiansen and others (2013) find financial and trade liberalization matter most for growth, especially in middle income countries. Mitra and Pouvelle (2012) emphasize the importance of institutional and infrastructure quality, market efficiency, and higher education for productivity in Emerging Europe.
  • The importance of public infrastructure and openness for growth in physical capital reinforces previous studies. IMF (2014a) finds that raising infrastructure investments in MENAP and CCA countries can significantly boost growth. Chong-Hyun and Chang-Jin (2000) suggest raising trade openness had a significant positive impact on Korea’s capital accumulation during 1965–95.
  • As expected, labor market efficiency is most strongly linked to employment growth. Stockhammer and Klär (2008) find that labor market institutions have a strong influence on medium-term unemployment. Baccaro and Rei (2007) also underline the importance for long-term employment of labor market institutions, such as wage flexibility and hiring and firing practices on unemployment rates in OECD countries. The employment-creating effects of trade and investment openness are elaborated in Baldwin (1994).

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