A quarterly magazine of the IMF

March 2006, Volume 43, Number 1

Getting Out of the Rut
Danny Leipziger and Roberto Zagha

Applying growth diagnostics at the World Bank

Not all distortions are borne equal. Effective growth strategies tackle the one or two most "binding constraint(s)" as they emerge over time. This is the central lesson from the World Bank's review of growth experiences of the 1990s (World Bank, 2005). But applying this lesson is easier said than done. The growth diagnostics framework proposed by Harvard's Ricardo Hausmann, Dani Rodrik, and Andrés Velasco (see "Getting the Diagnosis Right" on page 12) offers an appealing way forward because of its focus on the basic foundations of sustained growth—capital accumulation and entrepreneurship—its intuitive economic logic, and its ability to rank reforms according to their impact on growth. This approach helps differentiate reforms essential for growth from those that are merely desirable because of efficiency gains. The distinction is important because, in addition to growth, governments have many other welfare improving objectives—from protecting the environment to creating a more responsive public administration—all of which are important, but not necessarily related to growth.

To explore the potential of the growth diagnostics framework and clarify its strengths and limitations, Hausmann, Rodrik, and Velasco agreed to work with World Bank economists, with Professor Barry Eichen-green (University of California, Berkeley) serving as an independent check. During 2005, Bank economists applied the method to 12 pilot studies (Armenia, the Baltic countries, Bangladesh, Bolivia, Brazil, Cambodia, Egypt, India, Madagascar, Morocco, Tanzania, and Thailand), subjected the results to review and discussion, and in some cases changed their analysis and policy recommendations as a result. However, the framework was not applied with the same rigor and depth in all the pilot studies. Many unresolved issues remain, and it is, therefore, too early to make a definitive assessment. But we have already learned some preliminary lessons.

First, the identification of binding constraints to growth is "disciplined art" more than science, as Nobel Prize Laureate Mike Spence put it recently. The growth diagnostics approach provides a framework for formulating hypotheses on what may be constraining growth. But it provides neither the hypotheses nor the empirical tools for testing them—both these tasks rely on the creativity of the analyst and his or her ability to formulate hypotheses and create plausible "stories" that can then be verified empirically. As in all art, talent needs to be complemented with practice, and the framework's potential will be realized only through repeated use. The approach is much more open-ended than growth regressions, for example, which are commonly used to justify reform priorities and determine which policies have the highest growth payoff. Growth regressions generate results independent of the analyst applying them and the possible stories that he or she can formulate. In a similar fashion, investment climate assessments benchmark variables believed to influence private investment independent of who is carrying out the analysis. But the objectivity of these approaches comes at the cost of a formulaic approach to reform strategies and a loss of analytic accuracy.

Second, growth diagnostics require in-depth knowledge of the economy being analyzed. Assume, for example, an economy in which social rates of return to private investment are high but private investment is low. Identifying whether the gap is the result of macroeconomic instability, poor enforcement of property rights, political risks, or some other reason requires in-depth knowledge of the economy and the ability to rank, if not quantify, interventions. Since cross-country evidence is often inconclusive and since country-specific models are useful mainly in terms of calibrating the direction of change rather than assessing the absolute impact of an intervention, it is often country experience that matters most in growth diagnostics. The same reform measure can yield highly varying outcomes depending on country circumstances.

Third, the search for binding constraints to growth leads to the formulation of hypotheses that challenge conventional wisdom and highlights the complexity of growth processes. A case in point is Bolivia. The conventional wisdom is that political instability has made appropriation risk (the likelihood of being denied economic returns on a private investment, for instance through expropriation) the binding constraint to Bolivia's growth. Appropriation risk, however, is embedded in institutions that are unlikely to change significantly in a short time, and it was not an issue during the mid-1990s when finance was readily available and the economy was growing. If appropriation risk is indeed the main constraint, rates of return on investment that are actually realized should be high (to compensate for expected negative returns in the event of expropriation), and investment should be high in sectors such as services and small and medium-sized enterprises, in which the risk of expropriation is not an issue. Evidence to support this hypothesis is not available, however. An alternative hypothesis is that Bolivia's growth has suffered from insufficient investments in "self-discovery"—finding the goods and services in which Bolivia can become competitive and that will generate new opportunities for employment and income growth. Despite significant reforms since the mid-1980s, the economy has registered neither growth nor significant diversification. In fact, Bolivia's per capita income is now at the same level as in 1950. Needless to say, the inability to establish a firm basis for development has accentuated political instability and social conflict.

Another case where conventional wisdom has been challenged thanks to the growth diagnostics framework is that of aid-dependent countries in Africa experiencing an acceleration of growth after stabilizing and opening their economies to trade and private investment. One possible, conventional, explanation is that the reforms resulted in higher growth. An alternative hypothesis is that the reforms were backed by significant aid inflows, which were responsible for raising growth, but that such growth is unsustainable in the medium and long term in the absence of further structural changes. In Tanzania, this hypothesis is made plausible by the fact that both private investment and nontraditional exports have remained sluggish in spite of economic growth, which suggests that structural transformation and diversification have yet to take place.

Fourth, the growth diagnostics framework applies to stagnant as well as rapidly growing economies. But can the method really be applied to a rapidly growing economy? Conceptually, the question relates to the increase in the growth rate. Asking whether a zero growth rate can be increased is no different from asking whether a positive rate can be increased. Accordingly, the method is as valuable for slow-growing economies as it is for rapidly growing ones.

Take the cases of India and Bangladesh. India has well-known and widespread infrastructure shortcomings. And yet the economy has been growing at a rapid pace. Can these facts be reconciled? The answer is yes. Growth, it turns out, has been concentrated in sectors that are not "infrastructure-intensive." India's fastest growth has been taking place in skills-intensive segments of the service and manufacturing sectors that are either less dependent on public infrastructure (for instance, software and pharmaceuticals) or operate on a scale large enough to justify captive infrastructure (for instance, steel and petrochemicals). In contrast, small and labor-intensive industries have grown at a much slower pace. In Bangladesh, about half the country's economic activity is concentrated in Dhaka despite congestion, infrastructure overuse, and plain pollution, suggesting that something that is holding back growth elsewhere in Bangladesh is being provided in the capital. Whether this something is access to government, infrastructure, access to information and marketing networks, or another scarce factor has yet to be determined. As these examples demonstrate, empirical hypotheses will often need to be tested using indirect evidence, such as the nature of growth or variations in growth across time and geography.

Fifth, even though the framework focuses on short-run constraints, it does not ignore constraints that will emerge in the long run. In any growth process, as one constraint is lifted, another will emerge, and then another, and then yet another. Whereas empirical evidence can be found to identify today's constraint, it is much more difficult to find empirical evidence on what tomorrow's constraint will be. As Rodrik recently said: "What is required to sustain growth should not be confused with what is required to initiate it" (Hausmann, 2004). The process of adapting policies to changing circumstances without losing sight of the ultimate aim is what has made success stories of China, Korea, and Vietnam over the past three decades. In all three countries, future bottlenecks to growth—whether caused by a lack of human capital, infrastructure, expertise or innovation—were identified early, and the government acted to remedy emerging constraints.

Customization is key

The growth diagnostics framework brings numerous insights to the analysis of growth in developing countries and helps us test the strength of empirical evidence supporting specific policy and institutional reforms. That said, it remains a challenging and difficult approach. Behind the intuitive, methodic, and judicious use of price and other signals in the economy lies the enormously hard task of organizing and interpreting such signals. And, as the examples above show, a more generalized application of the method will require better data than those currently available if we are to correctly confirm or reject hypotheses. Moreover, as the World Bank's "Lessons of the 1990s" exercise demonstrated, customization is key to good policy advice. Effective policymaking takes into account those policies and institutions that work and those that do not. Creative policymaking enables economies to overcome their deficiencies and generate economic growth. If that were not so difficult, we would have many more success stories.