Productivity growth is Asia's path to success

It is generally acknowledged that the key to avoiding Asia’s three growth traps is productivity growth, or more precisely “total factor productivity growth”. In a recent speech, Janet Yellen, the Chair of the Federal Reserve Board, stated that, “The most important factor determining continued advances in living standards is productivity growth.”

I could not agree more.

Take the example of the Malthusian trap. Malthus’s dismal prophecy did not materialise because dramatically high productivity growth in the agricultural sector in the 18th century enabled countries to feed vastly increasing populations and hence sustain growth. For instance, when the potato, a plant native to the Americas, was introduced into Ireland, a field of potatoes could feed two or three times as many people as a similar field of grain, so the introduction of the potato resulted in a significant rise in Ireland’s agricultural productivity.

Likewise, in the modern world, higher productivity enables an economy to grow even with a smaller working-age population, and hence to avoid the demographic trap. If a country can maintain a decent productivity growth even after it has exploited imported technology and an under-utilised labour force, that country is likely to succeed in growing its way out of the middle-income trap.

Discussion of the myth of Asian miracles also highlights the importance of total factor productivity. Well before the Asian currency crisis of 1997-1998, Paul Krugman argued that the rapid growth of the Newly Industrialised Economies (NIEs), or Asian tigers was not sustainable because their high growth was not sufficiently supported by total factor productivity. History vindicated his assessment: The Asian currency crisis was in part an inevitable transition toward more sustainable and balanced growth.

In the period preceding the Asian currency crisis, the economic growth of NIEs could be explained relatively more by expansion of inputs, such as demographic bonus and investment boom, rather than by total factor productivity growth.

After the Great Financial Crisis, economic growth appears to be more balanced, but it may have also lost some strength, with total factor productivity growth generally lower than it was in the 1990s. 

This is a bit disturbing because population ageing is about to accelerate in some countries, with stronger demographic headwinds therefore to be expected. Remember that once a country falls into demographic onus, it needs to offset negative demographic forces with higher growth in total factor productivity just to maintain per-capita growth, and hence living standards. This is exactly why total factor productivity growth is the crucial issue for a number of Asian economies.

The next question then is, how do we raise total factor productivity growth? The answer may be a pessimistic one if we think that productivity growth is only exogenously determined. If this is the case, all we can do is hope that some exogenous shock, or just pure luck, will raise productivity. We would have to admit that there is an element of truth in this explanation if we look at the history of prosperous cities, as highlighted by Enrico Moretti, an expert in urban economics. 

For instance, the reason why Seattle, Washington, became a high-tech industry hub depended to a large extent on the fact that the founders of Microsoft had grown up there and wanted to relocate their company to a place familiar to them. Similar stories can be found for other US high-tech cities. If these cases provide a complete explanation of productivity growth, all we can do is wait and hope for a genius like Bill Gates or Steve Jobs to be born by chance in our country.

Fortunately, however, economic literature is much more hopeful in this respect: productivity is largely endogenous.

 

How to raise productivity

In the economic literature, there is a long list of factors that are thought to have a positive impact on productivity growth. I do not intend to go through all of them but, instead, I would like to focus on three things that I think are of particular importance.

The first is human capital. Measuring human capital is a difficult task, but one of the simplest indicators often used is the number of school years. In Chart 7, the greater the number of years spent in school, the darker the shade of the country. In Asia, there are a number of dark areas, such as Japan, South Korea, Malaysia and Sri Lanka. As you would expect, Hong Kong and Singapore also belong to this group, although it is not shown clearly on this map. One may get the impression that Asia as a whole is not as dark as North America or Europe, and is more or less similar to South America. This would indicate that there remains significant potential for further accumulation of human capital in the region.

At the same time, there are some interesting figures relating to US universities, which are generally acknowledged as providing the highest standard of education, attracting talented people from all over the world. If you look at the data for US university students by their country of origin, you can see that students from Asian countries dominate, as shown in Chart 8. Those students returning to their home countries will no doubt have a profound impact on the human capital there. It is well known that Bangalore, the IT hub of India, benefited from returnees from Silicon Valley. Moretti’s study shows that innovative, highly skilled workers contribute not only directly to the higher quality of human capital, but they also have a positive effect on the skills of those around them – a sort of positive externality. 

It is also encouraging to see that an increasing number of Asian universities have become recognised as top-tier at a global level. According to some recent university rankings, more than 10 universities in Asia are among the best 100. Remember that the success of Bangalore also lies in the fact that local IT firms were able to recruit many highly skilled graduates from nearby universities.

Against these backdrops, Asian has made larger contributions to the development of science.

For instance, the share of Asian-born Nobel Prize winners in scientific fields doubled to more than 10 per cent after the turn of the millennium. These truly top academic scholars have influenced the development of human capital in their own countries in various forms as exemplified by Professor Amartya Sen himself in front of us.

The second key to higher productivity is a market-friendly business environment. For example, a critical precondition for market functioning such as property rights protection, or the rule of law more generally, is an indispensable ingredient for an innovative environment, which in turn is the basis for productivity growth. I firmly believe, as many economists do, that healthy competition and appropriate incentives are essential for a well-functioning market mechanism, through which sustainable and robust economic growth is made possible.

On this score, deregulation is to be strongly encouraged as well. I think that Asian economies are making steady progress in this regard, although I also believe that much more needs to be done.

While the importance of market mechanisms cannot be exaggerated, it does not mean that we can turn a blind eye to income inequality. As a matter of fact, some academics argue that inclusiveness is conducive to economic growth in the long run.  Furthermore, a recent empirical study shows that lower inequality is correlated with faster and longer economic growth. Chart 9 compares inequality in income across countries. According to Thomas Piketty, inequality in the United States is alarmingly high and hence coloured in dark red in this chart. Compared with the United States, inequality in Asia is generally low, albeit with some exceptions.

The third element which plays an important role in raising productivity is a strong financial sector. I am completely convinced by arguments for creative destruction as a source of Nobel prizes in the areas of physics, chemistry, physiology or medicine and economic sciences.

As pointed out by Joseph Schumpeter, financial inter-mediation is an important catalyst to support innovative entrepreneurs and value creators generally. A modern example of this can be found in venture capitalists, who provide not only financial resources, but also business advice for growth-oriented companies. Of course, the role of financial inter-mediation is not limited to supporting start-ups. As a matter of fact, the seamless availability of a wide range of financial functions would best serve innovation-led economic growth.

In the Asian context, channelling the region’s abundant savings to the vast demand for infrastructure is also an important challenge in which I myself was deeply involved when I was president of the Asian Development Bank. Developing bond markets has been one of the successful initiatives in terms of intra-regional matching between savings and investment. 

Bond markets in Asia, especially those denominated in local currencies, have grown significantly since the mid-2000s, thanks to the efforts of the relevant financial authorities and other bodies. At the end of 2013, outstanding bond issuances amounted to US$3.5 trillion, which is about five times the figure for 2005.

Turning to retail financial services, inclusiveness, which I mentioned a little while ago, is again an important issue. We should note that a significant number of people in Asia still do not have their own bank accounts. Less than half the population in India has a bank account.

China fares better, with the proportion of account holders being two-thirds of the population, but that is still far from the situation in advanced economies where almost everybody has access to a bank account. I believe that the Asian financial landscape, and therefore the prospects for further strong economic growth, will be completely different once the issue of limited availability of banking services is addressed.

 

Conclusion

I have emphasised that productivity growth is crucial to sustaining

hitherto robust economic growth in Asia. Among many other things, in my view, the continued accumulation of human capital, market-friendly institutional set-ups and strong financial sectors, all play an important role in productivity growth. We have seen many positive developments in this respect in Asia, but much more needs to be done.

What I have discussed today could be broadly categorised as structural reforms. Generally speaking, structural reforms are always and everywhere difficult to implement in the face of vested interests. Depending partly on where you are in the business cycle, there is often a strong temptation to defer them to a later date. This is because of concerns about short-term negative impacts on the economy. Despite all those downsides, however, I still believe that there is no better time than now to put necessary reforms in motion. Short-term negative impacts are often overstated. They should not be used as an excuse to oppose reforms. If structural reforms are well designed, they will increase rather than decrease current demand, because they improve the prospects of future profits for businesses and hence permanent income for households. 

That’s all from me tonight. Once I have completed my assignment to talk about growth in Asia, I need to put on my central bank governor’s cap again. If I may use Professor Lucas’s quote again with a slight modification, “Once one starts to think about deflation or inflation, it is hard to think about anything else.” Therefore, please give me your comments and questions before I put my central banker’s cap back on.

 

This is the second and final part of the speech Bank of Japan Governor Kuroda delivered for 

the Amartya Sen Lecture in Bangkok on Tuesday.