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From third world to first in class

Rapid economic growth is blurring the distinctions among developing, emerging and advanced countries, writes Jonathan Woetzel in Milken Institute Review.

When historians in the distant future look back at our era, the name Alfred Sauvy may appear in a footnote somewhere. Sauvy was a French demographer who coined the term “third world” in a magazine article in 1952, just as the Cold War was heating up. His point was that there were countries not aligned with the United States or the Soviet Union that had pressing economic needs, but whose voices were not being heard.

Sauvy deliberately categorized these countries as inferior: “tiers monde” (or third world) was an explicit play on “tiers état” (third estate), the ragged assembly of peasants and bourgeoisie under France’s ancien régime that was subservient to the monarchy (the first estate) and the nobility (the second). “The third world is ignored, exploited and mistrusted, just like the third estate,” Sauvy wrote. “The millennial cycle of life and death has become a cycle of misery.”

As a piece of editorial rhetoric based on the fetid geopolitical atmosphere of the time, Sauvy’s essay was on the mark. As prophecy about the course of economic progress, he could hardly have been more wrong.

“Third world” today is politically incorrect as a phrase and economically incorrect as a concept, for it fails to take into account one of the biggest stories of the past half-century: the spectacular economic development that has taken place across the globe. Since Sauvy’s essay, some (but not all) of the countries he referred to have enjoyed very rapid growth and huge leaps in living standards, including in health and education.

To cite just one metric: the number of people living in extreme poverty has fallen from more than half the global population in the 1950s, when his magazine piece was published, to just over 10 percent today, even as the total population of the world has tripled.

The changes have been so striking that we have reached a point where the very distinctions among “developing,” “emerging” and “advanced” countries have become blurred. Singapore is now the second most competitive economy in the world, according to the World Economic Forum’s 2018 Global Competitiveness Index, which also ranks Hong Kong, South Korea and Malaysia well ahead of Italy, a founding member of the G-7 club of “rich” countries. China has more billionaires than the United States and almost twice as many as the whole of Europe. Bombay’s stock exchange has a larger market capitalization than Frankfurt’s.

Not all nations have progressed as rapidly, of course. Infant mortality and poverty, as well as overdependence on richer nations for humanitarian aid, remain topics of our age. Overall, however, emerging economies (as we’ll call them in this article, for lack of a better term) have become the motor of economic growth and consumption for the global economy.

Led by China and India, they accounted for almost two-thirds of the world’s GDP growth and more than half of new consumption over the past 15 years. Financial markets sometimes have jitters about emerging markets in the short term, and the current fear of trade wars is casting a shadow. But in the longer term, the McKinsey Global Institute estimates that their growth will continue and that, by 2030, these economies’ share of consumption will exceed half the global total.

Far from being destined to live in misery, as Sauvy thought, the erstwhile third world has left the second world (the former Soviet bloc) behind in the dust and is racing to catch up to the first. Sauvy was also wrong about their voices not being heard. These days, the rising influence and commerce of China and others is a central topic in policy circles from Washington to Ouagadougou.

Who Wins, Who Loses?

This turn of fortune raises some important questions. First, how did these countries do it? Second, can they maintain their trajectory and pace of growth in an age of technological ferment and at a time when the nature of globalization itself is shifting? And third, what does the rise of emerging economies mean for policymakers, business leaders and investors (along with everybody else) around the world?

Lifting hundreds of millions out of poverty and into the consuming class is an incredible feat for humanity. And it has proved a boon to savvy investors. But it has also had unintended consequences on incomes and employment in some parts of the first world. That in turn has sparked a political back-lash, as disaffected populations take to the streets, donning yellow vests to burn cars and smash stores, or to elect leaders who rail against trade and immigration. Is the next phase of globalization destined to be a zero-sum game in which their good fortune is mirrored by our loss?

The Scorecard

Not all developing countries are equal in terms of growth over the past half-century. While much effort has been devoted to determining the prerequisites for development, economists continue to probe why incomes have so widely diverged. To put it succinctly, what is the secret sauce that make some countries develop faster than others?

In our research, we looked at the record of 71 developing economies since 1965 to identify those that grew faster and more sustainably than their peers. In all, we found 18 countries that outperformed — and quite a few others that could follow suit.

Seven economies achieved or exceeded real annual per capita GDP growth of 3.5 percent for the entire 50-year period. This threshold is the average growth rate required by low- and lower-middle-income economies to achieve upper-middle-income status (currently about $4,000 per capita per year, as defined by the World Bank) in a half-century. The seven are not exactly a big surprise. They are all Asian (China, Hong Kong, Indonesia, Malaysia, Singapore, South Korea and Thailand), and their rise has been the subject of countless studies over the past two decades.

The 11 other outperformers are less heralded. These more recently successful and more geographically diverse countries range across income levels: Azerbaijan, Belarus, Cambodia, Ethiopia, India, Kazakhstan, Laos, Myanmar, Turkmenistan, Uzbekistan and Vietnam. They all achieved real average annual per capita GDP growth of at least 5 percent between 1995 and 2016 — in other words, stronger growth but for a shorter period than the original seven. That 5 percent growth, 3.5 percentage points above the per capita GDP growth rate of the United States, was enough to lift them by one income bracket (low to lower-middle or lower-middle to upper-middle) as defined by the World Bank.

Most of these 18 countries have endured short-term volatility from time to time. But they have shown themselves to be resilient, exceeding the benchmark growth rate in at least three-fourths of the 50- and 20-year periods. Some countries, among them Brazil, Ghana and Poland, didn’t make the cut because their growth was unacceptably volatile, but our 18 outperformers managed to bounce back from setbacks speedily and become more stable.

For example, Indonesia, Malaysia, South Korea and Thailand were all hit by the 1997 Asian crisis but recovered to positive GDP per capita growth within a year or two. They learned the lessons of the dangers of foreign currency debt and inadequate foreign exchange reserves, which prepared them to withstand the 2008 global financial crisis reasonably well. That is not to say they are immune to shocks; rather, their track records suggest that they are better able to deal with them than many of their peers.

Recipe for the Secret Sauce

When we deconstructed the secret sauce, we found two essential ingredients. First, these countries implemented policies that, while varying in detail, shared some common characteristics that we define as a pro-growth agenda of stimulating productivity, income and demand. Those agendas included, for example:

  • steps to increase capital accumulation, such as mandates for retirement saving
  • efforts to boost government effectiveness
  • measures to encourage more competition in the domestic market

Successful countries implemented policies with pro-growth agendas of productivity, growth and demand

.

Capital accumulation contributed an average of 3.7 percentage points to the aggregate growth rate of the 50-year outperformers on our list and 5.1 percentage points to recent outperformers’ growth — which is substantially more than in the economies of both peer emerging economies and high-income countries, where capital accumulation accounted for about 1.7 percentage points of real GDP growth.

The productivity gains, generally linked to capital accumulation and honest, more efficient governance, are striking: more than two-thirds of the GDP growth in the outperforming countries over the past 30 years is attributable to a rapid rise in productivity that’s generally correlated with industrialization. These countries achieved annual average productivity growth of 4.1 percent, compared with just 0.8 percent for economies that have yet to reach “emerging” status.

When we decomposed total productivity growth in the most successful economies from 1965 to 2012 across 35 sectors (15 manufacturing sectors and 20 service sectors), we found that long-term growth was overwhelmingly driven by productivity growth within individual sectors rather than from the mix across sectors. In other words, success depended less on finding the right mix of sectors than on identifying sources of competitive advantage — and continuously driving productivity improvements within those sectors.

Competition is a key here. One of the essential ingredients we identified was the strong competitive dynamics within many of the outperforming economies, which enabled the rise of a generation of large companies that have driven productivity and GDP growth. These companies have been less studied in emerging economies than the policy measures that drove growth.

However, our analysis highlighted their often-underappreciated role: adjusted for the relative size of the economies, the 18 outperformers have twice as many publicly listed companies with annual revenues exceeding $500 million as other growth contenders. Small and medium-sized enterprises are often given pride of place in development theory, but we find that large enterprises are in fact the common denominator for the 18.

Here, the ratio of large-corporation revenue to GDP almost tripled in just 20 years, from 22 percent in 1995 to 64 percent in 2016 — far higher than the ratio in slower-growth peers and approaching high-income-country levels. Over the same period, the contribution of large-corporation value added to GDP also rose sharply, from 11 percent to 27 percent.

Governments in the outperformers worked with the private sector to define the development agenda, and they actively cleared the way for growth with business-friendly regulatory flexibility. The firms that come out of this environment are battle-hardened — they have often survived tough knocks at home — which helps explain why they are making inroads in global markets so rapidly against U.S. and European incumbents.

Bigger is Better

Big businesses in emerging economies now play a disproportionately large role on the global stage. While they accounted for only about 25 percent of the total revenue and net income of all large public companies globally in 2016, they contributed about 40 percent of the revenue growth and net income growth from 2005 to 2016. More than 120 of these companies have joined the Fortune Global 500 list since 2000.

When we examined the track record of these companies more closely, we found that more than half that reached the top quintile in terms of generating profits between 2001 and 2005 had been kicked off their perch within a decade. That’s a high churn rate, reflecting the difficulty of reaching the top and constructing barriers against newcomers. By comparison, 62 percent of incumbents in high-income economies, on average, remained in the top quintile for the same decade. In the United States, 68 percent stayed put, and in the United Kingdom, the figure was 76 percent.

One of the biggest surprises came from a survey we conducted of companies in seven economies, both emerging and advanced. It showed just how competitive these emerging economies have become. The top performers innovate more aggressively than their advanced-economy rivals: 56 percent of their revenue comes from new products and services, compared with 48 percent for firms in advanced economies. These firms also invest almost twice as much as their advanced-economy peers, when measured as the ratio of capital spending to depreciation. And they are nimbler as they do so: on average, they make important investment decisions six to eight weeks faster, which amounts to 30-40 percent less time.

These firms can also be good investments, as we discuss in more detail below. Between 2014 and 2016, the top quartile of companies in the best-performing economies generated a total average return to shareholders of 23 percent, compared with 15 percent for top-quartile firms in high-income countries.

Some readers may by now be complaining, as some in Washington and other capitals do, that the competitive edge we are seeing in these countries and companies has been unfairly gained. It is indeed true that some governments do support young companies in various ways, with the goal of helping them grow. However, our research also found that where governments aid up-and-comers, the support is generally targeted and time-bound. The broader aim, it seems, is to make companies, and the economy overall, more competitive — not to nurture powerful interests seeking rents. Countries where support was given but productivity growth stagnated did not achieve sustainable growth.

The Times They Are A Changin'

Could what we once knew as the third world end up at the top of the heap? Will the strong growth trajectory we have seen among outperforming economies continue? And what about other emerging economies that are poised to break into the ranks of out-performers?

In our research, we identified several countries that have adopted significant elements of the pro-growth agenda as well as spawning a new generation of firms that are global competitors. Some, including Bangladesh, Bolivia, the Philippines and Rwanda, are already achieving per-capita growth that exceeds 3.5 percent over a period of several years. Others, including Kenya, Mozambique, Paraguay, Senegal and Tanzania, are posting significant improvements in key productivity, income and demand drivers, although their per capita growth rate has not yet reached a consistent 3.5 percent. Two other countries, Côte d’Ivoire and the Dominican Republic, have hit the growth target, but lag on some of the policy elements.

We also found that if all the emerging economies we looked at were able to match the productivity growth performance of the ones we tagged as outperformers, the boost to global GDP growth by 2030 would amount to $11 trillion — the equivalent of adding another China. That aspirational scenario would also lift another 200 million people out of poverty.

The broader aim with government support for growth has been to make young companies, and the economy overall, more competitive.

Yet, to paraphrase the mutual fund ads, past performance is not a reliable guide for future growth. Four seismic shifts are currently taking place in the global economy that seem poised to change conditions for all economies, emerging and advanced alike, and what worked for emerging economies in 1990 may not work today. Conversely, new opportunities beckon, putting a premium on agility and adaptability, not just at the firm level, but also at the level of national economies. The four shifts are

  • the rapid march of technological progress
  • the emerging “superstar” phenomenon, which is exacerbating inequalities
  • the rapidly changing dynamics of China’s economy
  • the evolving nature of globalization itself.

Technological progress. First, the technological shifts. Smartphones, the mobile internet, e-commerce and cloud-based services are now ubiquitous — and have opened the door to more mobility and convenience globally, as well as to greater competition. Moreover, it’s not all happening in Silicon Valley. India alone has more than half a billion Internet subscribers, and Indians downloaded 12 billion apps in 2018. Kenya has taken a global lead in providing financial services to the poor and unbanked, thanks to some fast footwork by a telecom company whose technology enables digital payments by phone. China’s Tencent and Alibaba are blazing trails in digital services and e-commerce.

Now comes the next wave of innovation in the form of advanced automation and artificial intelligence. An explosion in algorithmic capabilities, computing capacity and data volume is enabling beyond-human machine competencies and a new generation of system-level innovation.

These technologies still have limitations, and deployment can be complex. Nonetheless, massive productivity gains across sectors are already visible, with AI in functions such as sales and marketing (e.g., “next product to buy” personalization), supply chain logistics, and preventive maintenance.

It's no surprise to find that companies from China, India, Japan and South Korea have made the biggest gains.

For the global economy, AI adoption could be a boon. A simulation we conducted showed that AI could raise global GDP by as much as $13 trillion by 2030, which translates to an additional 1.2 percent GDP growth per year.

For now, China and the United States are responsible for the most AI-related research activities and investment, with Europe coming a distant third. India may not be far behind. It produces around 1.7 million graduates a year with STEM degrees — more than the total number of STEM graduates produced by all G-7 countries.

The "superstar" phenomenon. As disproportionately large rewards go to the winners, those falling behind face disproportionately large losses. The net effect of this phenomenon, which can be found not only in companies, but in sectors and even cities, is an increasingly uneven distribution of wealth and income that could in turn create negative feedback loops.

Our analysis of nearly 6,000 of the world’s largest public and private firms shows that the top 10 percent — the superstars — capture 80 percent of profits. These aren’t just the first-world incumbents of yore; they come from all sectors of the global economy and all regions. Indeed, their geographic diversity has increased over the past 20 years.

U.S. and Chinese tech companies that didn’t exist 20 years ago — among them Alibaba, Facebook and Tencent — are on the list alongside old-school brands such as Coca-Cola and Nestlé. American companies account for 38 percent of these leaders, down from 45 percent in the 1990s but still the largest contingent. It’s no surprise to find that companies from China, India, Japan and South Korea have made the biggest gains and now account for 22 percent of the total, up from 7 percent in the 1990s.

These top-decile firms capture 1.6 times more economic profit today compared to 20 years ago, with larger revenues and higher profit margins than in the past. By contrast, the bottom decile destroys more value (i.e., loses more money) than the top 10 percent creates.

The skew is greater still when looking at the top 1 percent. The world’s 58 largest value-creating firms account for 6 percent of all economic profit. They have 20 times more sales, 4 times more profit (based on net income margin) and 5 times more R&D investment than the median for firms with annual sales above $1 billion.

China’s growing economy. The third seismic shift we see is taking place in China, and in its relationship with the world. By 2017, China accounted for 15 percent of world GDP. According to the IMF, it overtook the United States to become the world’s largest economy in terms of purchasing power in 2014. (In terms of GDP at current exchange rates, China’s economy is still just two-thirds the size of the U.S. economy.)

Behind these headline numbers lies a less-noticed shift: over the past decade, even as its economy has grown, China’s exposure to the world, as measured by the magnitude of flows of trade, technology and capital relative to its GDP, has declined. At the same time, the world’s exposure to China has increased. For the first time in history, emerging economies contribute more than half of global trade flows, with trade between China and other developing countries being the fastest-growing component.

South-south trade (trade that doesn’t involve traditional first-world economies) has risen from 8 percent of global trade in 1995 to 20 percent in 2016. By contrast, north-north trade (trade among high-income economies) has dropped from 55 percent of the total in 1995 to 33 percent today. If this trend continues, other emerging markets could benefit from increased investment and increased transfer of know-how from China — and China could become an increasingly important destination for their labor-intensive imports.

Globalization’s evolution. The fourth shift is in part related to the first three: globalization itself is morphing, becoming more data- and services-driven even as global value chains are shifting along with the balance of power. Long global supply chains are starting to make way for shorter, localized production of goods near consumer markets. China and other developing countries are consuming more of what they produce and exporting a smaller share.

As emerging economies build more comprehensive domestic supply chains, they are reducing their reliance on imported intermediate inputs. One consequence is that goods-producing value chains have become less trade-intensive, even as cross-border services are growing briskly and generating more economic value than trade statistics capture.

Trade based on labor costs has been declining and now makes up only 20 percent of goods trade. Some of these shifts are not yet captured in trade statistics, since these do not track soaring cross-border flows of free digital services, including email, real-time mapping and social media. Indeed, even as trade in physical goods and cross-border financial flows lost momentum following the 2008 global financial crisis, data flows have risen sharply and are helping to drive global GDP.

Cross-border data volume grew by 148 times between 2005 and 2017, to more than 700 terabytes per second (the entire U.S. Library of Congress contains less than 700 terabytes of data), and are projected to grow another nine-fold in the next five years as digital flows supporting commerce, video, search and communications continue to surge.

Through a Glass Darkly

How will these shifts play out? You don’t need superpowers to figure out that the changes outlined above are long-term ones. Their effects will be profound even if, as yet, they are not entirely clear.

From a political standpoint, we can already see repercussions, as Washington reconfigures its rhetoric and relationships with the rest of the world, starting with China. In Europe, Brexit and the yellow vests in France are both manifestations of public disgruntlement with how the world is changing.

Should we expect another “Thucydides Trap” — the prospect that when one great power threatens to displace another, war is almost always the result? Harvard’s Graham Allison, for one, thinks that can be avoided. Whatever the new geopolitical tensions that may arise, all countries in the erstwhile first world will need to adjust to the shifting power balance. Their big challenge will be to rekindle growth as they do so.

One thing is certain: the cycle of misery Sauvy predicted back in 1952 was spectacularly off the mark.

Normally, they would be the ones to adopt automation and AI faster since their labor costs are higher, and thus be quicker to reap the productivity gains from adoption. But public fears of job losses could slow that adoption. And, as we have seen, productivity growth has stalled in advanced economies, even as China has become a formidable innovation machine that is already a leader in AI research.

For companies, global competition seems sure to become more intense as emerging-economy firms make deeper inroads into markets everywhere, not just at home. This could lead to a plethora of protectionist measures and increased complexity in supply chains. But the shifting value chains will create new opportunities. As noted, one of our main findings is that cross-border services are growing considerably faster than cross-border trade of physical goods. Automation could enable many companies to bring production closer to their key markets.

Still, low-cost, labor-intensive manufacturing does seem to have a future: China itself is outsourcing such manufacturing as it moves to more R&D-intensive production. In many outperformers, there is plenty of room for manufacturing to grow, both in terms of value-added share and employment.

For investors, these are interesting times. When emerging economies embrace pro-growth policies, we see that certain businesses benefit disproportionately — typically, those operating in sectors that are most open to international trade and can achieve minimum efficient scale rapidly. Size matters, because large, publicly listed firms in outperforming emerging economies increased their net income four to five percentage points faster annually than firms in other emerging economies from 1995 to 2016.

At the same time, the increased churn and dynamism among top emerging-economy companies makes picking winners especially difficult. Investors may want to use both a telescope and a microscope — a telescope to search broadly for economies with pro-growth agendas and the industries that will benefit, and a microscope to look narrowly for companies with the winning attributes that can benefit disproportionately from economic growth.

Alfred Sauvy died in October 1990 just as his “second world” was imploding. The Berlin Wall had already come down, and within a few months the Soviet Union would collapse. Would he relish the way events have unfolded since?

We cannot know. But one thing is certain: the cycle of misery he predicted for the countries he categorized as third world back in 1952 was spectacularly off the mark.

Other demographers, including Sweden’s Hans Rosling, have expounded views more recently that are far rosier and more accurate thus far. As Rosling has noted, most of the third world is on the same trajectory toward health and prosperity as the first world once was, the difference being that many emerging economies are moving twice as fast. If Sauvy ends up as a footnote for future historians, Rosling’s analysis is likely to be the main thesis.

This article appeared first in Milken Institute Review.

About the author(s)

Jonathan Woetzel is a director of the McKinsey Global Institute, the business and economics research arm of McKinsey & Company.