The Growing Divide Within Developing

Economies
PRINCETON When researchers at the McKinsey Global Institute (MGI) recently dug
into the details of Mexicos lagging economic performance, they made a remarkable
discovery: an unexpectedly large gap in productivity growth between large and small
firms. From 1999 to 2009, labor productivity had risen by a respectable 5.8% per year in
large firms with 500 or more employees. In small firms with ten or fewer employees, by
contrast, labor productivity growth had declined at an annual rate of 6.5%.
Moreover, the share of employment in these small firms, already at a high level, had
increased from 39% to 42% over this period. In view of the huge gulf separating what the
authors called the two Mexicos, it is no wonder that the economy performed so poorly
overall. As rapidly as the large, modern firms improved, through investments in
technology and skills, the economy was dragged down by its unproductive small firms.
This may seem like an anomaly, but it is in fact an increasingly common occurrence.
Look around the developing world, and you will see a bewildering fissure opening up
between economies leading and lagging sectors.
What is new is not that some firms and industries are substantially closer to the global
productivity frontier than others. Productive heterogeneity or what development
economists used to call economic dualism has always been a central feature of low-
income societies. What is new and distressing is that developing economies low-
productivity segments are not shrinking; on the contrary, in many cases, they are
expanding.
Typically, economic development occurs as workers and farmers move from traditional,
low-productivity sectors (such as agriculture and petty services) to modern factory work
and services. As this takes place, two things happen. First, the economys overall
productivity increases, because more of its labor force becomes employed in modern
sectors. Second, the productivity gap between the traditional and modern parts of the
economy shrinks, and dualism gradually diminishes. Agricultural productivity increases
during this process, owing to better farming techniques and a decline in the number of
farmers working the land.
This was the classic pattern of postwar development in the European periphery
countries like Spain and Portugal. It was also the mechanism that generated the Asian
growth miracles in South Korea, Taiwan, and eventually China (the most phenomenal
example of all).
One thing that all of these high-growth episodes had in common was rapid
industrialization. Expansion of modern manufacturing drove growth even in countries that
relied mostly on the domestic market, as Brazil, Mexico, and Turkey did until the 1980s.
It was structural change that mattered, not international trade per se.
Today, the picture is very different. Even in countries that are doing well, industrialization
is running out of steam much faster than it did in previous episodes of catch-up growth
a phenomenon that I have called premature deindustrialization. Though young people
are still flocking to the cities from the countryside, they end up not in factories but mostly
in informal, low-productivity services.
Indeed, structural change has become increasingly perverse: from manufacturing to
services (prematurely), tradable to non-tradable activities, organized sectors to
informality, modern to traditional firms, and medium-size and large firms to small
firms. Quantitative studies show that such patterns of structural change are exerting a
substantial drag on economic growth in Latin America, Africa, and in many Asian
countries.
There are two ways to close the gap between leading and lagging parts of the economy.
One is to enable small and microenterprises to grow, enter the formal economy, and
become more productive, all of which requires removing many barriers. The informal and
traditional parts of the economy are typically not well served by government services and
infrastructure, for example, and they are cut off from global markets, have little access to
finance, and are filled by workers and managers with low skills and education.
Even though many governments exert considerable effort to empower their small
enterprises, successful cases are rare. Support for small enterprises often serves social-
policy goals sustaining the incomes of the economys poorest and most excluded
workers instead of stimulating output and productivity growth.
The second strategy is to enlarge opportunities for modern, well-established firms so that
they can expand and employ the workers that would otherwise end up in less productive
parts of the economy. This may well be the more effective path.
Studies show that few successful businesses begin as small, informal firms; they are
started, instead, at a fairly large scale, by entrepreneurs who pick up their skills and
market knowledge in the more advanced parts of the economy. Enterprise surveys in
Africa by John Sutton of the London School of Economics indicate that it is often
entrepreneurs with experience in importing activities who found modern domestic firms.
Domestic subsidiaries of multinational firms or state-owned enterprises which are
repositories of skilled workers and managers are also a source of such firms.
The challenge is to create an economic environment in which there are incentives for
local talent and capital to invest in firms in the modern, tradable parts of the economy.
Sometimes, it is enough to remove certain of the more stifling government regulations
and restrictions. At other times, governments need more proactive strategies such as
tax incentives, special investment zones, or hyper-competitive currencies to raise the
profitability of such investments.
The details of appropriate policies will depend, as usual, on local constraints and
opportunities. But every government needs to ask itself whether it is doing enough to
support the expansion of capacity in the modern sectors that have the greatest potential
to absorb workers from the rest of the economy.