Industrial Game Over: Can Low-Income Countries Grow through Services Rather than Industry?

In a global economy with fewer opportunities to industrialize, low-income countries will need to embed the service sector in their vision for inclusive growth.

Amid a gloomy global economic outlook and crashing commodity prices, low-income countries ended 2015 with the slowest growth since 2009, and remain in serious need of new sources of inclusive growth. One major challenge to achieving higher living standards stems from the vast income and productivity gaps within these countries and in relation to the rest of the world.

Large-scale industrialization has traditionally been viewed as the main solution for bridging these gaps, as well as a strategic objective to create jobs and support future growth. Yet latecomers to development may have embarked on a path on which manufacturing—arguably the most promising sector—is expanding slowly in absolute terms, and often shrinking in relation to GDP. The questions are then: why do low-income countries struggle to industrialize? And could alternative sectors such as services replace manufacturing as engines of inclusive growth?

Growing out of the Traditional Economy

Let’s take a step back. While all economies are characterized by varying degrees of productivity and dynamism among sectors and businesses, the low-income countries feature tremendous structural gaps within their economies. Most of the workforce is employed in informal and traditional agricultural businesses, while manufacturing is limited and not fully organized and the dynamic services are largely confined to the cities. Also the modern and formal agricultural businesses are not as widespread as they could be.

To escape poverty, millions of workers need to move from low-productivity sectors and businesses, mainly agriculture, to high-productivity ones, where they will find better and more secure jobs. The reallocation of resources to modern and dynamic sectors can generate positive transformation and help low-income countries achieve inclusive growth.

However, economic transformation can lead to labor and capital being reallocated to more inefficient activities. Recent studies have found that from a macroeconomic perspective, structural transformation (i.e., intersectoral movement of resources) can be a drag on growth for long periods of time, and this is part of the reason why the growth dynamics of low- and middle-income countries have been so diverse. Such a pattern is illustrated in figure 1. Observing the breakdown (“decomposition”) of aggregate productivity growth in the sum of sectoral components and a component accounting for cross-sectoral labor reallocation, it can be noted that between the 1990s and the 2010s Asian and Eastern European countries benefited from the structural transformation of their economies, while Latin American and Sub-Saharan African countries had the opposite experience. Developing countries are therefore not necessarily transforming well over their growth paths.

Figure 1—Decomposition of aggregate productivity growth, 1990–2008

Figure 1

Source: Dabla-Norris et al. (2014)

CESEE: Central, Eastern and Southeastern Europe; CIS: Commonwealth of Independent States; LAC: Latin America and the Caribbean; MENA: Middle East and North Africa; SSA: Sub-Saharan Africa

Organized and modern manufacturing is commonly understood as the business where workers in informal or more traditional forms of agriculture should be reemployed. This is because, while manufacturing is not necessarily the most efficient sector in the economy, it can be a growth accelerator and engine of inclusive growth for at least three reasons. First, manufacturers in emerging economies can benefit from manufacturing technologies developed in more advanced countries, and can achieve fast productivity growth. Second, manufacturing can absorb unskilled labor—thus providing improved employment opportunities for agricultural workers in low-income countries. Finally, manufacturers can export their products, so their growth will not be confined by limited domestic demand. Tradability is key, because high productivity growth can quickly lead producers to lower their prices and shed labor and capital if they cannot scale up their sales in bigger markets.

Is Industrialization a Broken Engine?

Virtually all successful emerging economies in the past 30 years have industrialized by leveraging this potential. Manufacturing offers opportunities to diversify away from agricultural and other traditional products, and helps the country pull itself out of poverty. But is this growth trajectory still feasible for today’s developing countries?

In most countries, the share of jobs and GDP arising from manufacturing expands in the early stages of development, then peaks and starts shrinking as relative prices decline and the economy matures. As Dani Rodrik and others have recently argued, latecomers to development in Africa and Latin America are hitting the peak earlier in the process, and are starting to deindustrialize when manufacturing has exploited only part of its potential. Ghani and O’Connell, for example, explore this inverted-U relationship between the level of economic development and the industry’s share of total employment, in a panel of 100 countries. They show how, in recent times, jobs in industry have grown more slowly and shrunk earlier in the development process (figure 2). The engine of industrialization seems to be running out of steam.

According to Rodrik, this manufacturing decline is mainly due to the adverse effects of trade and globalization on low- and middle-income countries in Africa and Latin America in two respects. First, these countries struggle in the international goods market because of a decline in the relative price of manufacturing in advanced economies, where technological progress has pushed up efficiency and reduced the need for expensive labor. Second, low transport costs and low trade barriers expose them to hyper-cheap production from East Asia, effectively reducing the scope for “import substitution” to expand the boost in manufacturing exports to the wider economy. This would suggest that today’s low-income countries will need to wait until East Asia becomes expensive before they industrialize.

A competing theory is that the low-income countries have subscribed to a trade system that is altogether unfavorable to them. On the one hand, to get access to international markets they are required to forgo protectionist policies that foster import substitution and screen nascent industries from foreign competition during their early development (see e.g., Ha-Joon Chang). On the other hand, trade barriers to advanced markets like the EU are set low for raw materials such as coffee beans and cocoa pods but high for the products obtained from processing of materials—in these examples, roasted coffee and chocolate. This means that the entry points to industrialization of commodity-dependent countries are essentially shut down.

Figure 2—Is Industrialization Running out of Steam?

Figure 2

Source: Ghani and O’Connell (2014) with World Bank data

Help Services

Both theories offer plausible explanations of why low-income countries struggle to industrialize. While more evidence on the causes of the problem is needed, it is increasingly clear that vast-scale industrialization has not featured in the development of most low-income countries. In contrast, the service sector has grown rapidly and absorbed lots of labor. Looking at Sub-Saharan Africa, for example, in the 15 years of this century . This pattern does not adequately represent how low-income countries grow and expand their productive capabilities, at least in that it does not capture the role of the variety and complexity of the products menu offered by these countries. Yet it can raise the question of how services can replace manufacturing as an engine of inclusive development. At least three routes can be identified.

First, there is a fringe of dynamic and tradable services that can boost the economy just as manufacturing does. Banking, customer services, and communications are examples of services which the ICT revolution has opened up to trade, and which can take low-income countries on a growth escalator, as the Indian boom has demonstrated. Crucially, investments in infrastructure, education, and human capital need to be made to facilitate development in these services. An alternative service attracting foreign demand with decent labor-absorption capacity is tourism.

Second, services are crucial inputs to manufacturing and there is evidence that their importance is growing. Hence cheap and efficient services such as transport and telecommunications can translate into stronger competitiveness of the tradable sector—both manufacturing and services.

Finally, the fact that manufacturing and services are becoming increasingly “blurred,” with services activities making up a higher share of manufacturing output, means that low-income countries could exploit a competitive edge on relevant service tasks. Moreover, these tasks can often be unbundled from merchandise production and traded along the global value chain. Logistics, marketing and post-sales services have been on the rise, not only in developed economies but also in developing ones. Furthermore, this trend could lead to a misinterpretation of statistics based on obsolete sector categories, effectively misleading our understanding of structural change.

In sum, the service sector offers new and interesting opportunities for growth, both through tradable services that plug directly into the global economy and through services that support competitiveness of manufacturing. In a global economy with fewer opportunities to industrialize, low-income countries will need to embed the service sector in their vision of inclusive growth and focus on the conditions that enable these opportunities.

Many thanks to my colleagues Joe Holden and Ignacio Fiestas for their helpful comments. This blog first appeared at: 


Are services and networks regulations the Achilles heel of Europe?

[this blogpost was firstly published on]

When badly designed, the regulation of service and network sectors risks creating barriers to the entry of new competitors or reducing the incentives of incumbents to compete, with detrimental effects on productivity and consumers’ welfare. These risks seem particularly tangible in many European countries as EU policy makers have made liberalisation in these sectors one of the structural reforms most often recommended to Member States to achieve sustainable growth in the long term. For example, the European Commission recommended reforms in one or more of these sectors for 14 out of 28 EU members in 2014 and 17 out of 27 in 2013. Targeted countries include growing economies like Germany and Austria and struggling ones like Greece and Italy. While these countries certainly start from very different regulatory conditions, is it true that the services and networks regulations are an Achilles heel for the whole Europe?

The Product Market Regulation (PMR) indicators of the OECD can be used to track reform progress across time and jurisdictions and compare services and networks regulations with a number of other policy settings that influence competition in product markets. We can therefore determine if the results for individual countries share an EU-wide pattern involving the areas of interest.

In practice, the indicators are compiled through the assessment of many detailed regulatory practices that could restrict competition while not necessarily being helpful for the purposes of the regulation. For instance, in domains like professional services the regulation aims at guaranteeing the quality of suppliers but it is sometimes implemented in ways that arbitrarily limit their number, thus hampering competition. The indicators are produced for 18 categories or sub-components, among which two are of interest here: ‘barriers to services sectors’ (i.e. entry barriers in professional services, freight transport services and retail distribution) and ‘barriers to network sectors’ (i.e. entry barriers in gas, electricity, water, rail, air passenger transport, road freight transport, telecoms). The indicators range on a scale from 0 to 6 where low figures point to less restrictive regulations and high figures to more restrictive ones. The 18 categories are aggregated in 7 components and 3 pillars.

To rank regulations at EU level, we simply average the indicators from 20 EU countries for which data are available for 2013. In addition, we capture heterogeneity across countries through the standard deviation. These new indexes are shown in Table 1 below. As it can be seen, barriers in the services sectors receive an aggregate 3.48 points, the highest on the board and also much higher than the overall PMR index, as low as 1.30 points. Barriers to networks sectors also seem high (2.33). Interestingly, services regulations also seem more restrictive than the administrative burdens for corporations (1.62 points) and the license and permits system (2.77), two other targets in the reforms’ agenda. Looking at indicators heterogeneity, it can be seen that barriers in the service sectors and barriers in network sectors have a standard deviation of 0.71 and 0.42 respectively, i.e. the 6th and the 14th highest among the 18 categories. These dispersions do not look particularly high, especially if compared to the magnitude of these indicators with respect to the other categories. Thus, it seems that barriers in service and network sectors are consistently high in EU countries. However, it should be stressed here that homogeneity of the scores is no guarantee of homogeneity of the rules. The OECD Economic Survey of the European Union offers a discussion on the matter.

Table 1 – Product Market Regulation in EU countries

 Product Market Regulation in the EU

Source: based on OECD.

A further confirmation of the above comes from the regulation scores of the EU countries whose overall regulatory stance is more conducive to competition, i.e. Austria, Denmark, Germany, the Netherlands and the United Kingdom (PMR index below 1.25). As it can be seen from Table 2 below, these regulations look slightly less restrictive than the EU average and yet obtain higher scores with respect to the country-specific PMR index – at least one point – and are regularly ranked among the 5 most restrictive of the 18 categories, with the only exception of barriers in network sectors in the United Kingdom. This suggests that national services regulations are restrictive from the point of view of the countries that have better regulations in general.

Table 2 – Barriers in the services and networks sectors in selected EU countries

 Services and networks regulation in best regulated countries

Source: based on OECD

Four releases of the PMR indicators also allow tracing reform paths since 1998. As way of comparison, indicators for barriers to services and to networks, administrative burdens for corporations and the PMR index for EU countries are shown in Figure 1. To guarantee comparability the indicators are averaged across all EU countries for which data is reported in all vintages (16 countries). The displayed trends suggest that, in aggregate, product market regulations have become considerably more competition-friendly during the past 15 years: the average PMR index fell from 2.16 to 1.31, while indicators for networks regulation and administrative burden dropped by 1.90 and 1.16 respectively. Only reforms in service sectors seem to have stagnated over the considered period. But was the reform process homogeneous across countries? In fact, while it is true all countries improved their overall regulatory stance and, in particular, substantially liberalized the network sectors, reforms in the services seem to have had divergent outcomes across Europe. The United Kingdom is the country that moved more clearly towards more pro-competitive rules, with a drop of about 1.5 points. Reform efforts are also noticeable in Denmark and Greece (–1 and – 0.9). However, in 9 countries the change was well below one point and can be considered marginal with respect to the ample room for improvement. For instance, in Germany and Finland the score remained broadly stable. Even more surprising is the outcome of 4 countries – Belgium, Ireland, Hungary and Czech Republic – where in fact the score deteriorated between 1998 and 2013 (up to + 1.4).

Figure 1 – Reform progress in services and networks

 Reforms in services and networks

Source: based on OECD.

To summarize, the OECD PMR indicators suggest that:

  • barriers in service and network sectors seem to be restrictive of competition throughout the EU in 2013, while in particular looking restrictive from the point of view of the countries whose overall regulatory stance is more conducive to competition;
  • networks regulations were substantially improved in all EU countries during the 1998-2013 period, following a widespread enhancement in product market regulation;
  • services regulations were only marginally improved in 9 EU countries, substantially improved in 3 countries and worsened in 4 countries over the same period.

Notwithstanding the macroscopic nature of the analysis and the focus on long-term patterns, some considerations can be drawn from the results. First, regulation in network and service sectors is an area where rules seem to have a large space for improvement. The EU rightly suggests national governments to prioritize country-specific problems but should also assess the options to tackle EU-wide competition issues as a whole. For example, according to the OECD the EU framework in network sectors like telecoms and energy should foster more cooperation between national regulators. In professional services a complex overlap of heterogeneous provisions across the EU makes it hard for operators to compete in different markets. Thus, forcing the recognition of common standards looks like a warranted intervention.

Second, it seems that services reforms are not always implemented with the intention of making the sector more competitive. In comparison with other regulatory domains, this observation seems to be peculiar of these industries. Perhaps the reasons are connected with political economy’s considerations: governments may worry that pro-competitive rules are in conflict with other objectives, or their liberalizations may raise the opposition of incumbents.

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Mind the widening gap between the euro area and the UK/US

by Marco Antonielli, Silvia Carrieri, Carlos De Sousa and Michele Peruzzi

[this blog first appeared here]

In these charts of the week we show how the euro area (EA) is lagging behind its two major advanced economy counterparts in a few key macroeconomic variables. Without blaming responsibility or drawing causality from any particular policy measure, these simple metrics only intend to show the relative under-performance of the EA vis-à-vis the UK and US. The data range from 1999 to the first quarter of 2014.

Two of the most striking charts relate to the Unemployment Rate and to GDP per person employed, a measure of labour productivity.

Unemployment rate


GDP per person employed


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IMF forecasts euro area inflation to stay well below 2% target for years to come

by Marco Antonielli and Carlos De Sousa

[this article previously appeared on the Bruegel’s blog]

In the April 2014 update of the World Economic Outlook (WEO) released this week, the International Monetary Fund (IMF) forecasts a fall in the average inflation for the euro area to 0.9% in 2014, down from 1.3% in 2013. For 2015 and 2016, inflation is expected to remain well below the 2% policy rate, at approximately 1.2% and 1.3%. While the fall in inflation for 2014 was largely anticipated in recent estimates released by Eurostat, the IMF forecasts might be taken as further support for the claim that inflation will be lower than 2% in the medium term. Indeed, the IMF forecasts usually display a strong mean-reverting behaviour, i.e. a speedy convergence to the long term inflation rate, which in case of the euro area is anchored at below but close to 2%. This trend is quite apparent when we check the realized inflation against each year’s April forecasts from the IMF. This time however, the IMF recognizes that given the bleak outlook for the euro area real economy, if the ECB continues with its relatively hawkish monetary policy approach it will take 5 years for inflation to converge to just 1.5%.

Average euro area Inflation percent change in different vintages of IMF WEO

inflationSource: IMF WEOs

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Transatlantic trade, butterflies and earthquakes

How TTIP fits in the evolving global trade landscape

[this article firstly appeared on the Bruegel blog]

European Union and United States heads’ of state are meeting this week to reinforce among other things the political will to conclude the transatlantic trade talks termed the Transatlantic Trade and Investment Partnership (TTIP). The agreement is meant to bring down the remaining tariffs on goods and unnecessary regulatory barriers that undermine the transatlantic trade and investment potential. According to an independent study, an ambitious deal could boost overall EU exports by 6% (or €220 billion) and overall US exports by 8% (or €240 billion). The sectors that are expected to benefit the most are largely in manufacturing, namely metal products (+12% in EU exports), processed food (+9%), chemicals (+9%), other manufactured goods (+6%), and other transport equipment (+6%). The study’s estimates incorporate trade creation and trade diversion, as well as dynamic effects in third countries.

Yet TTIP negotiators need not to forget that in an integrated world economy a multitude of unpredictable factors can alter the intended consequences of the agreement. To contextualise the ongoing TTIP negotiations in the larger global trade scenario and show its relevance for TTIP’s prospects, in this blog I illustrate how world trade patterns have changed in the past two decades and highlight current trends. If TTIP negotiators cannot predict whether the flap of a butterfly in Chinese factories will provoke a hurricane in transatlantic trade, they can look at how an earthquake in China has shaped trade to date and try to think how future earthquakes could be accounted for. I focus on merchandise trade, as this is the area that TTIP’s impact would be most apparent.

Changing trade patterns: the world upside down

The past twenty years witnessed dramatic changes in global trade shares. The first one of them is the increased relevance of merchandise trade. According to World Bank data, the percentage of imports plus exports over GDP increased from 46% to 66% for the EU and from 18% to 24% in the US over the 1995-2008 period (Figure 1). Noticeably, intra-EU trade increased less than extra-EU trade did. The crisis produced a major shock: world trade to GDP fell by 10 points in one year, but then reversed in 2010 and 2011. However, the data does not allow predicting if we are entering a phase of slow or negative trade to GDP growth.


 Source: The World Bank

Relevant intra-regional trade patterns also radically changed in the 1995-2012 period, albeit in the opposite direction, and underlying trends were not hugely affected by the crisis. The year 1995 is an interesting reference as it marked a transition point for world trade, with the completion of both the Uruguay Round and NAFTA.  According to UNCTAD data, the EU-US share of world merchandise trade (excluding intra-EU trade) almost halved from 8.5% in 2001 to 4.4% in 2012 (Figure 2). Noticeably, bilateral EU-US trade also became less significant for the two partners, falling sharply to 15% of total extra-EU trade and 17% of US trade in 2012 (Figure 2) as both partners diversified their export and import destinations.

Figure 2 TTIP

 Source: The World Bank

But trade patterns were affected everywhere: by way of comparison, we consider intra-group trade between partners in two other supra-regional agreements currently under negotiation, i.e. the Trans-Pacific Partnership (TPP) and the Regional Comprehensive Economic Partnership, also known as ASEAN + 6 (Figure 3). The observed change is startling: trade between the TPP partners – comprising the US, Canada, Mexico, Japan, and other eight countries in the Pacific area – fell from 25% of world trade in 2000 to 13.6% in 2012, while trade between ASEAN + 6 countries – comprising China, India, Japan, Australia, New Zealand, South Korea and ten countries in the South-East Asian region – increased from 9.3% in 1998 to 15% in 2010. These figures suggest that the dominating trade groups in the Nineties saw their influence on the global scene declining to make way for the rise of the Asia-Pacific region. The prospects of continued high growth in Asian countries suggest that the trade relations could further strengthen in their influence: the global trade landscape seems to have suddenly turned on its head. While the economic balance between the Western World and Asia might be reassuming the pre-industrial revolution trends, the speed of this adjustment so far has undoubtedly been extraordinary.


Source: UNCTAD, Bruegel computations

How do changing trade patterns affect TTIP?

Despite its declining relevance for the two partners and for the world, transatlantic trade still amounted to $648 bn in 2012, or 4.4% of extra-EU global trade, which as a base level is likely to result in far-reaching impact of the negotiations. Yet shifting trade patterns worldwide indicate a change in the composition of the goods bilaterally traded between the EU and the US, which must be reflected in the TTIP negotiations. Indeed the past fifteen years also witnessed a critical shift: China’s accession to the WTO twinned with increased possibilities of slicing up the manufacturing production processes boosted the relocation of the low-value added intermediate goods production from the EU and the US to lower-cost Asia, in particular China. Figure 4 shows the steady rise in bilateral trade of the TTIP partner’s vis-à-vis China.


In turn, European and American companies refocused their domestic industrial capacities to high-value high-tech products and activities like product design and R&D. Arguably, today’s transatlantic trade in final goods incorporates inputs from many other countries. To grasp the relevance of these shifts for the ongoing bilateral trade negotiations, one can imagine that had the two partners agreed to tear down regulatory barriers in the year 2000, as was being attempted, the savings from the costs of multiple regulations would have partly offset for the huge labour cost savings from relocating to China. Thus, benefits would have been a lower drop in the bilateral trade share relative to extra-EU global trade, and retaining of more manufacturing employment at home. Perhaps in the past political capital has been expended in favour of the owners of capital and technology as opposed to interests of labour. Nonetheless, the fall in manufacturing employment in the EU and the US could not have been avoided. Today, cutting unnecessary regulatory costs through TTIP can be seen as a competitiveness-boosting measure that benefits business while also protecting labour’s interests.

Ultimately, to deliver a deal that is more welfare-improving, TTIP negotiators will need to focus on means to enhance long-term competitiveness of the two partners rather than bargain concessions that will be bear little fruit in the global trade arena.

Special thanks to Suparna Karmakar for her useful comments.

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Are capital markets the only friend of innovation?

While Twitter grew through venture capital, other innovative firms might profit from better credit – by Marco Antonielli and Carlo Altomonte

[this article firstly appeared on the Bruegel blog]

Intangible assets are the key to growth in the knowledge economy, but innovative entrepreneurs can find it hard to secure the financing to kick-start their projects. The role of capital and credit markets in procuring funds for innovation is therefore crucial. Twitter is a case in point: financial support offered by early seed investors and venture capitalists in its first years permitted young entrepreneurs to grow a company around the simple idea of a microblogging platform. Started in 2006, after only seven years the microblogging platform went public last November. This is all the more impressive given that Twitter’s most valuable assets are not buildings or equipment, but patents and software or even more ethereal resources such as the interface design, customers data and its 2,000 employees’ human capital. Twitter’s stock market performance since it floated is an indication that these assets are crucial in the knowledge economy [1]. It is probably no coincidence that Twitter was born in the US: the US capital markets, arguably the most developed in the world, make it a favourable location to start up innovative companies.

Twitter’s story is telling on the merits of the capital markets for innovation, but could credit markets also play a role? In principle, innovative entrepreneurs benefit from the progress made by banks in monitoring borrowers: risky projects become easier to track while less-tangible forms of capital are increasingly used as collateral. Thus, a developed credit market should also be a friend of innovation. It is then interesting to see how capital and credit markets compare in supporting innovation in different countries.

Intangible assets and the capital market

The economic literature suggests that innovative firms might find it hard to raise external financing for intangible assets [2]. Adverse selection and moral hazard become more acute when firms are younger, projects are inherently riskier, and investment returns cannot be easily appropriated. A general case in favour of development of financial systems is made the literature: improvements in the monitoring of borrowers and the diversification and management of risk can mitigate these potential market imperfections. These factors then play out differently in the capital and credit markets. We start out with the capital market, because its relationship with innovation is the most commonly made in the literature.

Quantitatively speaking, the depth of the capital market is a proxy for its stage of financial development. Thus, in order to assess the extent to which the relationship between long-term depth in capital markets and investment in intangible assets holds, we matched stock market capitalisation to GDP from the World Bank Global Financial Development Database, with investment in intangible investments estimated by the INTAN-Invest project [3]. The data covers the US and selected EU countries plus Norway, and spans 1995 to 2010. Figure 1 shows investment in intangible assets as a share of GDP relative to stock market capitalisation to GDP, in each case as country averages during three periods (1995-2000; 2001-07; 2008-10). These mid-term snapshots help with the potential countercyclical behaviour of productivity-enhancing investments (see Aghion et al, 2010).

Figure 1

Figure 1


Although we observe a positive correlation between the two variables, this could be driven by external factors, such as GDP per capita. There are also other reasons why the apparent relationship might be strong: for example that early-seed investment and venture capital help young innovative firms, for which intangible assets are most important, to raise capital and eventually enter the stock markets, thus increasing the size of the market overall relative to countries in which these segments are not well developed. The observed relationship thus would not be driven by the pure effect of financial development on investment in intangible assets in all incumbent firms, but rather by a compositional effect by which, in financially developed markets, young innovative companies, which rely more heavily on intangible assets, are relatively more numerous. Europe’s lack of young leading innovators is now well documented and can explain the gap relative to the US. However, venture capital would not be sufficient to explain the observed relationship, because it is highly developed in the US but quite homogenously limited throughout Europe.

A further explanation could be that listed companies face fewer constraints than companies that rely on credit. Because creditors prefer tangible assets, which are easier to seize, access to equity financing might help listed companies to acquire intangible assets. Empirical research has shown that innovative firms tend to have lower levels of the debt/capital ratio. This is confirmed by Bruegel’s Triggers of Competitiveness, which demonstrates that firms with rapidly increasing productivity are those with low debt/capital ratios.

Capital v. credit markets: how do they compare in supporting innovation?

The different appetite for intangibles in capital and credit markets suggests that the tangible versus intangible assets aspect is the key to identifying possible dissimilarities, especially for European countries. Thus, in Figure 2 we report the same plots as Figure 1, with the intangibles over tangibles investment ratio on the vertical axis. The observed relationship is positive, suggesting that a developed capital market might underpin more investment in intangible assets relative to tangible assets. This would not be an obvious conclusion for credit markets, because creditors prefer tangible assets. To further investigate this, in Figure 3 we draw the same plots of Figure 2 using bank private credit to GDP from the same World Bank database on the horizontal axis.

Figure 2

Figure 2

Quite surprisingly, the figures seem to support the view that higher provision of credit to the economy is linked to investment in intangible assets [4]. The reasons for such a relationship can be found in the factors underpinning the expansion of credit to the economy. A first factor is the improvement of risk management, which eases the evaluation of innovative projects. Second is the increase in monitoring activity, which helps banks to follow new projects with limited or no track records. A third and final factor is the reduction in contracting costs, which constrain the spread of more complex financial contracts. The link between these three factors and investment in intangible assets has been found by recent economic research.

Figure 3

Figure 3

Intangible assets and financial markets during the crisis

How did the crisis affect the relationship between financial markets and the level of investment in intangible assets? Figure 3 lends some support to the hypothesis that credit markets became less efficient in supporting innovative investment: this seems apparent from the higher dispersion observed around the fitted lines in the crisis panel with respect to pre-crisis panels. To clarify this result, Table 1 displays coefficient and the Root Mean Squared Error (a measure of dispersion around the supposed relationship) for each period’s regression: lower effects and wider dispersion point to a weaker link between investments in intangible assets and credit markets [5]. The varying response of credit markets to the crisis can be detected by comparing countries with similar performances before the crisis but very different performances after the crisis (for example, one could look at the before-after for Portugal and Ireland). The records of the stock markets – also displayed in Table 1 – show a less precise relationship but a stronger effect. The general result seems particularly sensitive to data from the US and UK: if these countries are omitted, the equity/intangibles relationship looks much more similar for the periods under consideration.

Table 1

Credit market Stock market
Coefficient Root MSE Coefficient Root MSE
1995-2000 0.0029 0.166 1995-2000 0.0042 0.148
2001-2007 0.0028 0.199 2001-2007 0.0066 0.199
2008-2010 0.0021 0.275 2008-2010 0.0098 0.274

Policy implications

No matter how difficult it is to develop intangible assets, it has become clear that they are the key to growth in the knowledge economy. Together with the crucial support of capital, one surprising source of support might be the credit market. The crisis has possibly altered this link, not only by drying up credit but also by making credit markets less efficient in supporting innovation. This is especially bad news for Europe, which already lags behind the US in terms of the development of its capital markets and is, conversely, heavily dependent on its credit markets. What could be done? While healing the European banking sector remains a priority for the economy as a whole, governments should go beyond the usual innovation subsidies and encourage intangible-collateralised debt, or support public-private partnerships to act as venture capital funds.



[1] On the other hand, the stock market euphoria for tech companies, as exemplified by the super-expensive acquisition of Whatsapp by Facebook, is raising concern about a bubble.

[2] To describe the diverse forms of cumulated spending in knowledge creation, economists use the concept of intangible assets: together with software and R&D spending – part of the so-called computerised information and innovative property components – intangible assets also include expenditure on firm-specific human capital and organisational know-how, under the heading economic competencies.

[3] The investment data covers the market sector (NACE sectors A through K, excluding real estate, plus sector O).

[4] In the figure, the US stands out as an outlier, possibly owing to the way private credit is computed by the World Bank, which might leave securitised products aside. The fitted lines are calculated without US data.

[5] Results and interpretation are robust if the UK, which might be seen as an outlier, is excluded.

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Competition policy trends in South Korea

Economists often talk about a strong correlation between market development and enforcement of competition policy rules…

Read the rest of the blog at: Bruegel blog