By  Era Dabla-Norris and Kalpana Kochar

(Version in Español)

The era of remarkable growth in many emerging market economies fueled by cheap money and high commodity prices may very well be coming to an end.

The slowdown reflects not just inadequate global demand, but also structural factors that are rendering previous growth engines less effective, and the fact that economic “good times” reduced the incentives to implement further reforms to enhance productivity. With the end of the period of favorable global financing and trade conditions, the time is nigh for governments to make strong efforts to increase productivity—the essential foundation of sustainable growth and rising living standards.

Wanted: A Second Generation of Reforms

Governments should focus on the next wave of structural policy reforms to increase competition and improve how markets function. In most emerging market economies, improvements in productivity growth will be linked to their ability to “climb the technology ladder,” that is to move away from reliance on cheap, low-margin goods to more value-added manufactured goods potentially offering higher profits.

This will mean implementing reforms that encourage resources to relocate from lower productivity activities, for example, agriculture, toward higher value-added manufacturing activities as well as more modern services activities such as transportation, distribution, and information and communication technology.

Here are some examples of reforms that are likely to have the highest payoffs for emerging market economies:

Real sector reform

  • Improve the business environment. Reforms should focus on reducing administrative burdens, simplifying regulations, strengthening competition, and cutting red-tape. Heavy regulation often discourages international participation in the domestic economy, which limits a country from benefiting from knowledge transfers from abroad.
  • Remove labor market distortions and rigidities. Rigid hiring and firing and employment protection regulations tend to encourage the proliferation of small, informal and generally less productive firms.  They also give rise to distortions including labor markets with protected “insiders” and vulnerable “outsiders.” Reforms should encourage firms to move away from the informal sector to the formal sector and from low productivity to high productivity sectors and new activities, while providing a safety net to protect workers during the process of adjustment.
  • Liberalize foreign direct investment. Regulations limiting foreign direct investment can hinder the adoption of technologies by reducing competition, preventing technology transfers between countries, and hampering the entry of new firms. Dismantling these barriers can create productivity gains for the economy as a whole.

Financial sector reform

  • Ease financial restrictions. Removing interest rate ceilings and controls on credit, and introducing stronger regulatory and supervisory frameworks to curb unsound financial market practices will allow capital to flow to where it will get the highest return while minimizing systemic risks.
  • Develop local capital markets. Improvements such as developing local capital markets, in particular local currency bond markets, can increase the availability of financing for long-term and innovative investments.

Governments should also invest in people’s skills. The Organization for Economic Cooperation and Development’s scores that measure performance in reading, mathematics, and science show large gaps between emerging and advanced economies, suggesting a significant payoff from investing in higher education.

Infrastructure should not be neglected. Despite impressive progress in some areas such as telecommunications, many emerging market economies have deficient transportation and communications networks and little capacity to generate their own energy. Reforming the regulatory environment for infrastructure, and promoting public-private partnerships would help attract private investment to help fix some of these problems. Better infrastructure, for example roads, railways, ports and airports, can improve firms’ability to connect to domestic and foreign markets, and increase competitiveness and efficiency which would have a significant impact on productivity and growth.

Reform will not be easy

While most emerging market economies know what reforms they need to enact, implementing them will not be easy.

Policymakers will have to contend with resistance from vested interests that have grown rich and powerful from the status quo. Moreover, adopting reforms while the economy is experiencing lower growth and the government has less money to spend on reforms will be more difficult. A weak fiscal position makes it harder to find the resources needed to provide adequate compensation for those who stand to lose from structural reforms. Governments with limited political capital may opt to “spend” it  to reduce government debt and deficits rather than to  reform the way the economy works.

Ultimately though, how different emerging market economies reconcile competing interests to implement necessary reforms will determine their prospects.