Escaping the middle income trap – what’s holding back the Fragile Five?

By John Hawksworth

From the turn of the century until around 2012, the big story in macroeconomics was the shift in economic power to the BRICs and other large emerging economies such as Indonesia, Mexico, Turkey and South Africa. This story remains valid in parts, but the last couple of years have highlighted the growing pains facing some emerging economies. This was typified by Morgan Stanley’s introduction last year of a less bullish grouping of large emerging markets – the ‘Fragile Five’ of India, Indonesia, Brazil, Turkey and South Africa.

Our latest contribution to this debate is the PwC ESCAPE Index. This index combines 20 key indicators across five dimensions: economic growth and stability; social progress and cohesion; communications technology; political, legal and regulatory institutions; and environmental sustainability.

A particular objective of the index is to give an indication of how well different emerging markets are placed to escape the so-called ‘middle income trap’. As the chart below shows, Saudi Arabia, Malaysia, Chile and China seem to be the front-runners here based on 2013 data.

Escape index

Putting the Fragile Five under the microscope

The Fragile Five, however, generally score a lot less well on our ESCAPE index. Indonesia is the best of the bunch, but still only on a par with Mexico and Peru. Turkey, Brazil and India are near the bottom and South Africa fares even less well.

What’s holding them back? To answer this, we need to delve further into the details of the index, looking at results for each of the 20 component indicators.

The first conclusion from this analysis is that technology is not the problem. All of the Fragile Five have, for example, made great progress since 2000 in adopting new digital methods of communication, like smart phones and broadband internet.

Environmental sustainability is a long-term concern in some cases, ranging from the need to protect Amazonian rainforests in Brazil to worries about rising carbon intensity in India. But in terms of derailing economic development, the bigger concerns at present relate first to economic stability and second to political and social institutions.

We can make this more specific by identifying those indicators for each of the Fragile Five that are either below average and not improving between 2007 and 2013, or about average but declining since 2007, or both. The table below sums up the major weaknesses of each country on this basis.

Relative weaknesses of the Fragile Five based on PwC ESCAPE Index components

Country

Economic growth and stability

Political and social   institutions

Indonesia

Inflation*, relative trade openness*, current account deficit*

Corruption*, income inequality

Turkey

Current account deficit*

Political stability*, income inequality, low trust levels

Brazil

Inflation*, relative trade openness*, investment to GDP ratio*,   current account deficit*, government debt*

Low trust levels

India

Inflation*, current account deficit

Political stability*, corruption*, rule of law*, income inequality,   ease of doing business

South Africa

Relative trade openness*, unemployment*, investment to GDP ratio, GDP   growth per capita over previous ten years

Corruption*, political stability, ease of doing business, low trust   levels

Note: relative trade openness is the ratio of exports and imports to GDP, adjusted for the relative size of economies

*Both below average for all 42 countries in 2013 and getting worse in absolute terms between 2007 and 2013 (components without an asterisk qualify on only one of these two criteria).

Source: PwC analysis of ESCAPE index components for 2007 and 2013

On the economic side of the equation, most of these economies (except South Africa) have delivered relative strong GDP per capita growth performances over the decade to 2013. But this growth has pumped up inflation and trade deficits to levels that started to be of concern to financial market investors in 2013 and early 2014. Although these market concerns have eased somewhat in recent months, they could always flare up again.

For Brazil and South Africa, low investment to GDP ratios are also of concern here. But government debt to GDP ratios don’t look to be big worries yet, except perhaps for Brazil. This is in marked contrast to the fiscal vulnerability of Japan, the US and many EU economies.

Institutions - still a long way to go

The deeper problems, however, become apparent when we turn to political and social institutions. Research by academics such as Daron Acemoglu and James Robinson shows that these institutional factors can be critical to sustainable long-term growth. Where they are ‘extractive’, a small elite may get rich. But such countries are unlikely to graduate fully to the advanced economy club unless they reform their political, social and economic institutions to make them more inclusive and thereby provide the right incentives for innovation and entrepreneurship.

As the table shows, the Fragile Five have a long way to go on many key institutional measures, particularly in relation to corruption, political stability, income inequality and trust. Ease of doing business is also a major hurdle in India and South Africa in particular, based on World Bank analysis that we’ve incorporated into our index.

Interestingly, very little progress has been made by the Fragile Five on these institutional measures, even if we take the analysis back to 2000. This is in contrast to their generally strong performance on GDP growth, communications technology, rising education levels and increased average life expectancy over this period. Making deeper institutional reforms will take a long time, even if short term macroeconomic imbalances can be addressed.

Implications for business strategy

Our analysis has a number of high level messages for US and European businesses considering how to develop their emerging market strategies, although all of these would need careful tailoring to individual circumstances.

First, sustaining the growth rates of the 2000 to 2012 period in emerging markets like the Fragile Five will be difficult, given the combination of economic bottlenecks and institutional deficiencies.

Second, emerging markets vary greatly in their institutional strengths and weaknesses and need to be assessed in a nuanced way. There could also be major differences in institutional strengths between industry sectors within countries. Deep local knowledge that’s updated in real time is critical here.

Finally, don’t forget your ‘home’ markets in the US and Europe. These will remain significant players in the global economy for decades to come, with relatively high average incomes and relatively strong and stable political and economic institutions.

In short, by all means place some strategic wagers on emerging markets, but don’t bet the house.

John Hawksworth:
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