Factors influencing growth and development

Several factors play a role in either promoting or constraining economic growth and development. These include:

Primary product dependency

Developing countries may become dependent on primary products derived directly from the land, including basic agricultural crops. Many land-rich countries in Africa and South America are endowed with plentiful primary resources, and while they may have a comparative advantage in the production of a few basic crops, the potential for economic development is likely to be limited.

Several problems are associated with reliance on primary production.

Falling terms of trade

Firstly, the terms of trade for primary commodities may worsen over time, so that the exporting country will have to produce increasing amounts of the commodity to enable them to import consumer goods.

Terms of trade refer to the relative price of exports in terms of imports, and are expressed as:

Index of export prices x 100
Index of import prices

For example, if the index of export prices rises at a slower rate than the index of import prices, the terms of trade will worsen (fall below 100) making it harder for the exporting country to earn enough export revenue to pay for its imports:

Index of export prices = 105 x 100  =  87.5
Index of import prices = 120

More significantly, long terms growth requires capital accumulation, but relying on exports of low value primary products means it is very difficult to import expensive capital goods – especially ‘strategic’ goods associated with transport and infrastructure.

The terms of trade issue was highlighted in the Prebisch-Singer hypothesis (1950), which suggests that developing countries will experience worsening terms of trade in relation to developed countries if they rely on exporting primary products.

This is largely because the income elasticity of demand for basic commodities and foodstuffs is low, or even negative, so that as the world economy grows primary producers will experience low levels of growth for their products. Also, the price elasticity of demand for commodities (at the beginning of the supply chain) is lower than for manufactured goods (at the end of the supply chain). This means that, as countries increase their output of commodities, the price is drive down, but there is no significant upward effect on demand - given the inelasticity of demand.

However, there have been recent spikes in the price of food and other commodities which casts some doubt on whether predictions of declining terms of trade for developing countries are entirely accurate. It is also argued that commodity prices are subject to long run supercycles which suggests that using data from just a few decades may give a misleading picture of long run trends in commodity prices.

Other sectors are not developed

An economy focusing on primary products may not allocate sufficient resources to other sectors, such as infrastructure or manufacturing. Other sectors may develop important linkages to education, which are not found with the agriculture sector. For example, the development of a more diverse economy increases the need for a variety of skills which can be transferred across the economy, such as skills related to business and management, and to design and engineering. In this respect, a reliance on agriculture is likely to lead to low levels of human capital development. This creates a future skills shortage which may limit future development. Even those who are educated and develop skills may emigrate in search of better paid non-agricultural work.

Low marginal productivity of agricultural workers

A fundamental and underlying problem of reliance on primary products is the low value of marginal productivity of labour, which means there may be high levels of underemployment which depress wages, and results in low levels of consumption.

The opportunity to add value by branding and other differentiation is difficult with primary products. It is possible to brand some products, such as ‘Kenyan coffee’, or ‘Egyptian cotton’, which does add value, but there are limits to what people will pay. Converting resources from agriculture to higher value industrial output is likely to significantly increase the marginal productivity of labour.

Dynamic price instability

Commodity prices are subject to supply shocks which can create dynamic price instability – also called the ‘cobweb effect’.  Price instability makes it difficult for producers to plan ahead and undertake expensive investment, which is seen as too risky.

Agriculture may experience protectionism

Many developed economies are members of trading blocs which erect barriers to protect their members agricultural sectors. For example, The basic tariff for importing sugar into the EU is €419 per tonne, although there is a reduced tariff on sugar from Australia, Brazil, Cuba and India. In addition, least developed countries can take advantage of the EU's Everything but Arms scheme which allows for tariff free access to raw sugar. [1] However, protectionism also includes non-tariff barriers which may also make it difficult to export to developed countries.

The level of savings

Saving and the savings ratio are highly significant in understanding economic growth, and development.

The Harrod-Domar model

Many early economic theories, including the Harrod-Domar model, regard saving as a necessary condition for economic growth and hence development.

Even the simple circular flow model suggests that investment injected into the flow is largely determined by savings withdrawn from the flow – mainly because saving provides a flow of funds going into the financial system. Changes in the value of savings has two effects on investment:

  1. Firstly, the supply of savings can be seen as 'loanable funds' which financial institutions can lend out - more saving means more funds available for firms to borrow to invest in new technology or other capital assets.
  2. Secondly, an increase in the supply of any resource will reduce its price, other things remaining equal. Hence, an increase in savings reduces the interest rate on borrowing, which can then stimulate investment and capital accumulation.

Also, increases in savings will push down long-term interest rates, which will act as a stimulus to investment, and growth.

The Harrod-Domar model looks at the significance of two economic ratios - how many units of capital (K) are required to produce one unit of national output (or income, Y), called the capital/output ratio, and the amount of saving (S) as a proportion of income (Y), called the savings ratio. The two ratios can be used to explain an economies growth rate.

According to the Harrod-Domar model, the growth rate of an economy is found by dividing the savings rate by the capital output ratio:

  Growth rate   = Savings ratio
Capital output ratio

For example, if the savings ratio is 10%, and the capital output ratio is 4 (4 units of capital to produce one unit of output), then:

Savings ratio = 10 Growth rate   = 2.5%
Capital output ratio = 4

In this example, 2.5% growth per year may not be sufficient to increase the development of an economy. There are clearly two ways to increase growth:

Increase the savings rate, say to 20% - assuming nothing else changes, growth will now increase to:

Savings ratio = 20 Growth rate   = 5%
Capital output ratio = 4

Increase the efficiency with which capital is used, say, to a ratio of 2 (units of capital for every unit of output gained) - assuming nothing else changes, growth will also increase to:

Savings ratio = 10 Growth rate   = 5%
Capital output ratio = 2

Clearly, the most beneficial changes would be to increase the savings rate as well as increasing the efficiency of capital.

Several other economists have focused on the role of savings, including Rostow, who explored the factors creating a ‘take-off’ from traditional to industrialised economies. An adequate level of saving was a pre-condition for sustained economic growth.

A low rate of saving is clearly a significant constraint on economic growth and development and gives rise to the idea of a SAVINGS GAP.

This gap could be filled in several ways, including increasing inward flows of Foreign Direct Investment (FDI), preventing excessive capital flight, obtaining loans (say from the World Bank), encouraging foreign aid, or obtaining debt relief.

Foreign currency gap

Developing countries may suffer from foreign exchange shortages because of the relatively low value of their exports in relation to their imports, and worsening terms of trade. This can result in insufficient foreign exchange reserves to finance imports of to fund balance of payments deficits - the so-called ‘foreign currency gap’.

Developing countries in Africa and Latin America tend to have trade deficits - whereas those in Asia tend to have surpluses – resulting in a significant foreign exchange gap. [2]  This can be partly offset by remittances, and by foreign aid and debt relief. However, this can result in a dependency on external financing. [3] The problem can be exacerbated by ‘capital flight’ (see below).

The central banks of developing countries may put in place strict controls on the use of foreign currency, which can limit the importation of necessary goods from more developed countries. [4] 

Capital flight

Owners of private capital in developing countries may move their resources from one country to another in order to protect the value of their assets. Capital flight refers to the short-term outflows of private capital as a result of concerns regarding possible devaluation of the currency, inflation, political instability, or the threat of tightening capital controls by a government. Weak regulation of the financial system can also encourage capital flight. [5]

Capital flight also reduces potential revenue to a government from taxing capital gains and makes it less likely to be able to get cheap loans. While capital flight is a problem for less developed and emerging economies, African countries appear to have suffered the most. It has been estimated that between 1970 and 2010, African countries collectively lost some $1.3 trillion (in 2010 dollars) because of capital flight. [6]

Perhaps the single most important consequence of capital flight is the opportunity cost to the countries involved. For every $1 that flies out of a country there is $1 less available for domestic investment. Less investment means that potential growth suffers, with the consequential problems of unemployment, underemployment, and poverty. Research suggests that, on average, capital flight has cost African countries around 2.5% growth per year since 1970. The level of capital flight is uneven across African countries, with oil exporting countries, including Nigeria and Algeria experiencing some of the most dramatic amounts. [7]

Capital flight can be a significant constraint on the economic development of many countries.

Demographic factors and demographic transition

Demographic factors, including the age distribution of the population, birth rates and death rates, can impact upon the likelihood of economic development. In the case of a high birth and death rates, the age of the population is skewed towards a younger average age, with increasing dependency rates. For example, the average number of births per woman in sub-Saharan Africa is 5.1 – which has fallen but is still much higher than for developed countries. [8]

Declining infant mortality has contributed to the growing number of under-14 dependents, which averages around 42% of the population, for sub-Saharan Africa.

With a high birth rates and low death rate, the issue is slightly different, but dependency will increase as more of the population are below and above the working age population. The high youth population could also represent an opportunity for Africa in terms of a ‘demographic dividend’. This means that as the ‘age wave’ of young people enter the working population, there will be fewer dependents in relation to those working.

This is part of a large shift referred to as ‘demographic transition’ where countries with high birth and death rates experience falling death and falling infant mortality rates, supported with better healthcare and education.

Demographic transition is clearly one factor that can contribute to positive growth rates in the future.

Debt

The debt levels of many developing countries create a significant drag on growth.

A high debt level means that debt diverts funds from consumption or investment to repaying debt. High debt levels mean that interest rates are driven up, increasing the cost of servicing debt.

According to the World Bank, there are currently (2021) 37 heavily indebted poor countries (HIPC), with 31 in Africa. [9]  The IMF-World Bank initiative, launched in 1996, aimed at reducing debt burdens to a sustainable level. Debt relief increases the likelihood that debt is manageable and that by reducing debt repayments low-income countries can allocate more of their national income to merit and public goods. [10] Before the debt relief began, many low-income countries were spending more on debt repayments than on health and education combined.

Access to credit and banking

Trade credit is a vital source of funding for business as it eases any cash flow problems that may exist. However, fully developed credit markets are often absent in poorer developing countries.

With borrowers having poor or no credit rating, interest rates tend to be very high. This means that good ‘quality’ borrowers are deterred from seeking credit in the first place.

The same is true for banking and bank services, which may not be developed or sophisticated. However, banks in poorer developing countries tend to be less well-regulated than those in developed countries, which makes them more likely to fail, and reduces the efficiency with which they operate.

Research suggests that inefficient regulation is partly the result of regulatory capture and concerns that prudential regulation will drive investors away. [11]

The financial crisis forced many banks in developing countries to improve their capital adequacy but, as a recent World Bank report indicates, banks often fall short in disclosing necessary information to assist regulators. [12]

Other studies have indicated that banking is much less available to the average citizen in a developing country. This increases the costs of having a bank account, given the additional cost of travel and time taken. [13]

Infrastructure

Many developing countries have poorly developed infrastructure, including inferior roads and rail networks, and a lack of airports. Many are land locked and rely on road networks for valuable supplies.

Infrastructure projects are extremely costly and usually relate to public and quasi-public goods, such as roads, bridges, tunnels, docks, and airport infrastructure. These projects are likely to be too expensive for private firms to build on their own, hence public money is commonly used - either on its own, or in tandem with private finance.

Infrastructure creates a range of positive externalities, including reduced business costs, savings in travelling time, and increase in tourism revenue.

Given the low levels of public revenue in many developing countries it is no surprise that joint projects with other countries is increasingly common, especially in Africa, where China has an increasing interest in investment. Indeed, since 2010, one third of Africa's power grid and energy infrastructure has been financed and constructed by state-owned Chinese companies. [14]

Education and skills

Education is regarded as a merit good and is typically under consumed. In the case of education (and healthcare) the state provides a large share of supply and funds state education and healthcare. However, because of low rates of tax collection, public sector funding is often constrained, with educational spending per head significantly less than in developed countries.

The link between education, human capital development and economic growth has been studied in great detail. The main conclusion is that education, and knowledge, is not subject to diminishing returns, as with real capital, or even constant returns, but does experience increasing returns. Unlike private goods, there is significant non-rivalry in consumption - if I know something, it does not take away what you know. Indeed, it is likely that sharing knowledge creates beneficial feedback effects on all those involved directly and indirectly.

Knowledge and skills provide a 'premium' to those countries that allocate resources to it, getting much more back than they spend on it. This is especially true with embracing new technology - something well understood by emerging economies.

For example, Singapore allocates over twice as much to education as a proportion of GDP compared with many developed economies:

Singapore 28.84%

Norway 17.27%

New Zealand 16.55%

Ireland 13.21%

United Kingdom 12.92%

Germany 11.04%

Italy 8.16%

[source: macro trends https://www.macrotrends.net/countries/SGP/singapore/education-spending [2014 data]

Absence of property rights

Property rights are an important feature of advanced economies. The ability of individuals and organisations to own private property is important because private ownership encourages individuals to work hard without the risk of theft. Development is constrained in those countries where the right to own property is limited, or absent. For example, if it is not possible to own land there may be little incentive to improve the quality and fertility of the land.

Non-economic factors

There are many other non-economic factors that both stimulate development, when present, or constrain it, when absent.

Such factors include:

Political stability, corruption, and conflict

A stable political environment, with good governance of institutions and corporations, and an absence of war and conflict creates several important benefits in terms of economic growth and development, including:

  1. Business and consumer confidence
  2. Increased domestic investment
  3. Increased FDI
  4. Reduced capital flight
  5. Higher savings ratios

Endnotes and sources

[1] Ragus - https://www.ragus.co.uk/tariffs-on-sugars-explained/

[2] Unctad - https://stats.unctad.org/handbook/EconomicTrends/CurrentAccount.html]

[3] Encyclopedia-UIA  http://encyclopedia.uia.org/en/problem/134506

 [4] Researchgate - https://www.researchgate.net/publication/273447083

[5] Isabella Massa,/a> 2014 Capital flight and the financial system , ODI - Overseas Development Institute,

[6] Cairn Info - hhttps://ww.cairn.info/revue-d-economie-du-developpement-2014-HS02-page-99.html

[7] Ndikumana, Léonc, 2014 Capital Flight and Tax Havens: Impact on Investment and Growth in Africa  Revue d'économie du développement, vol. 22, no. HS02, , pp. 99- 124. https:///ww.cairn.info/revue-d-economie-du-developpement-2014-HS02-page-99.html

[8] World Bank https://blogs.worldbank.org/africacan/7-facts-about-population-in-sub-saharan-africa

[9] World Bank  https://www.worldbank.org/en/topic/debt/brief/hipc

[10] IMF - https://www.imf.org/en/About/Factsheets/Sheets/2016/08/01/16/11/Debt-Relief-Under-the-Heavily-Indebted-Poor-Countries-Initiative

[11] Brownbridge, M, Kirkpatrick, C, 2002 Financial Regulation and Supervision in Developing Countries, An overview of the Issues, in Development Policy Review].

[12] World Bank https://www.worldbank.org/en/news/press-release/2019/11/06/greater-information-disclosure-and-supervisory-capacity-needed-in-developing-countries-to-improve-banking-systems

[13] Ignacio Mas (2011) WHY ARE BANKS SO SCARCE IN DEVELOPING COUNTRIES? A REGULATORY AND INFRASTRUCTURE PERSPECTIVE, Critical Review, 23:1-2, 135-145, DOI: 10.1080/08913811.2011.574476

[14]  Shirley Ze Yu, April 2021, https://blogs.lse.ac.uk/africaatlse/2021/04/02/why-substantial-chinese-fdi-is-flowing-into-africa-foreign-direct-investment LSE Blog