Focus on Manufacturing for Economic Development

manufacturingIntroduction:

Developing countries have been experiencing rapid economic growth over the last decade that is mostly fueled by the strong performance of the agriculture sector, which in turn was mainly due to the higher yield and area expansion of smallholder farmers. However, there is a limit as to how much this strong performance of the economy can continue if the country continues to rely on the agriculture sector. To be able to sustain the strong economic performance of the last decade and achieve economic growth, countries need a structural change towards manufacturing. This raises a couple of questions: why manufacturing and what kind of manufacturing?

Why Manufacturing?

Much recent literature has demonstrated that economic development requires structural change from low productivity activities to high productivity activities. It also suggests that the industrial sector in general and the manufacturing sector in particular is the engine of economic growth. In fact, virtually all cases of high, rapid, and sustained economic growth in modern economic development have been associated with industrialisation, particularly growth in manufacturing production[1].

But these assertions require grounding in empirical regularities and theoretical justifications. Policy makers need to provide stylized facts regarding the correlation between the manufacturing sector and economic growth.

Empirical reasons (stylized facts)

There is an empirical correlation between the degree of industrialization and per capita income in developing countries.

One of the most prominent empirical regularities is that countries with a higher manufacturing share in GDP grow faster.  Of course one may object that, this evidence, based on a cross section data, may be a result of the fact that some countries have conducive economic policies and endowments that enable establishment of manufacturing and high growth. i.e., it may not be the case that manufacturing contributes to the faster growth, rather it may be the case that there is something else the countries have got that encourages manufacturing. This takes us to the second empirical regularity. The data shows that the experience of sustained fast growth in developing countries are associated with an increase in the share of manufacturing exports in the total exports and an increase in employment in the manufacturing sector.

A combination of the above two empirical observations suggests that manufacturing is a key sector for countries to experience sustained high growth. The next question then is whether manufacturing can be brought about by policy or countries are doomed to specialize in their comparative advantage. In other words, do the countries with higher share of manufacturing in their economy achieve that because they have a conducive endowment structure (e.g. abundance of labour) or do they achieve that because they have made conscious policy decisions that are conducive for the development of manufacturing?

A look at the data suggests that the latter is closer to the reality. Specifically, empirical regularities show that countries that grow fast are those that produce (especially export) goods more sophisticated than what their comparative advantage shows. In other words, a conscious policy to promote technological upgrading dictates whether a country engages in the production of a manufacturing good that facilitates its growth rate. Part of the reason why countries that produce goods more sophisticated than their comparative advantage grow faster is because that entails catching up to a higher level technology (i.e., getting closer to the technological frontier).

These empirical regularities suggest that a transition to manufacturing is likely to provide a boost to the economic fortunes of the country. One might wonder about the channels through which manufacturing provides such a growth boost. The following is a brief discussion regarding the theoretical rationale for it.

Theoretical reasons[2]

First, there is substantial data that shows that in developing countries the productivity of labor in the industrial (manufacturing) sector is much higher than the agriculture and service sectors. As a result, shifting labor away from agriculture/service towards the industrial sector provides a positive static shift effect. i.e., the country’s GDP will be much higher for a given amount of labor and hours worked. This static shift effect is known in the literature as a structural change bonus.

Second, the data also shows that in developing countries the productivity of labour tends to grow much faster in the manufacturing sector than in the agriculture and service sectors. In other words, a country where more workers are engaged in the manufacturing sector will grow faster due to the dynamism of the sector.

Third, the manufacturing sector tends to have stronger Linkage and spillover effects. There are evidences in the literature that the industrial sector provides a stronger demand for the products of other sectors (backward linkage) and supplies more inputs to other sectors (forward linkage). In addition, the manufacturing sector has traditionally been the sector where most new products and processes get developed. In other words, most sectors adopt new technologies and processes that originate from the manufacturing sector. To put it in an economic jargon, the manufacturing sector has stronger spillover effects (knowledge externalities).

Fourth, the manufacturing sector usually requires lumpy investments. This characteristic of the industry has two implications. The first implication is that production in the sector offers economies of scale, i.e. increased productivity as more is produced. The large-scale production that results from the effect of economies of scale will further provide opportunities for learning by doing. In other words, production in the industrial (manufacturing) sector provides both static gain (economies of scale) and dynamic gain (growth of productivity through learning by doing). The second implication of lumpy investment in the sector is that the sector provides more opportunities for capital accumulation.

Finally, there is the effect of Engel’s Law: as per capita incomes rise, the share of agricultural expenditures (as a share of total expenditures) declines and the share on manufactured goods increases. One consequence of this observation is that the expanding world market that results from economic growth provides a much larger market for manufacturing goods than agricultural commodities. As a result, countries that produce manufacturing goods are better positioned to benefit from this growth in the global economy.

What Kind of Manufacturing?

The above discussion has illustrated the benefit of transitioning to the manufacturing sector as a source of high and sustained growth. In addition, it shows that policy plays a role on whether a country achieves the suggested structural transformation or not. If policy is going to play such a role, then we have to identify what kind of manufacturing is likely to succeed in the country and therefore needs the support of the government.

When deciding which manufacturing sub sectors a country wants to trasit to it needs to take in to account two factors: Comparative advantage and linkages.

Comparative advantage is dictated by the type of productive asstes that are abundant in the country. In the case of developing countries cheap labor and land are the basis for our comparative advantage. The manufacturing goods that rely on these inputs are agro related food and non-food processing as well as as other light manufacturing such as textile and leather.

Whether producing a specific manufacturing commodity, that relies on cheap labor and agricultural commodities, will lead to rapid transformation compared to encouraging other relatively similar manufacturing goods depends on the degree of sectoral linkages it produces. If the production of the specific manufacturing good encourages stronger backward and forward linkages with the other sectors of the economy, then encouraging its production will lead to faster and sustainable growth.

Comparative advantage is one of the main criteria for encouraging the production of a specific manufacturing good. Ethiopia has an abundance of land, with potential to produce agricultural products as an input to agro processing manufacturing subsector. Comparative advantage, however, is not automatically translated into competitive advantage. Whether a country successfully industrializes or not depends on the availability of the right type and quantity of raw materials on long term and sustainable basis. In other words, the performance of the agricultural sector in terms of providing quality inputs at a competitive price and in suffient quantity is a fundamental issue for the success of the manufacturing sector.

[1] Szirmai(2009)

[2] Most of the discussion regarding theoretical justifications provided below relies on Szirmai(2009)

Keshav C Das

New Delhi, October, 31, 2016

 

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