Structural change for inclusive and sustainable industrial development

Structural change for inclusive and sustainable industrial development
Photo credit: Chris Kirchhoff | MediaClub South Africa

24 Apr 2018

This report from the United Nations Industrial Development Organization (UNIDO) highlights the importance of the manufacturing sector in economic development and, with a focus on structural change, discusses how industrial development can be harnessed for faster growth, greater inclusiveness and sustainability.

The concept of industrial structure is often elusive as income level, country-specific conditions, technological change and policies all play a role in structural change. Insights into the ebb and flow of different sectors and industries within the manufacturing sector along a country’s development path are crucial, as they give rise to new opportunities and challenges for the country in question.

The manufacturing sector has always been a key driver of economic growth for developing countries. At an early stage of development, manufacturing development can open a window for countries to pursue strong and inclusive growth. The competitive wage levels of low-income countries give them a distinct advantage in developing labour-intensive industries, which can generate a large number of formal jobs for both women and men. Successful development of labour-intensive industries sets the foundation for industrialization, as increased exports, revenues and consumption boost investments in education, infrastructure, and research and development. This can foster the development of higher valued and more technologically sophisticated industries. Such structural change ensures sustained and rapid industrial development, even after the loss of labour-cost advantage.

UNIDO’s research shows that the types of industries that emerge in the middle-income stage are likely to be more emissions- and material use-intensive and thus often increase the pressure on the environment, unless proper mitigation measures are introduced. The successful shift of the industrial structure from labour-intensive to capital-intensive industries increases productivity and generates higher wage jobs, which could help sustain industrial growth and lead to the creation of shared prosperity. Entering a high-income stage of development often slows down the growth of manufacturing relative to services, with the exception of technology-intensive industries. While the growth of manufacturing moderates, manufacturing activities gradually shift away from resource-intensive industries to high valued-added activities, and to a manufacturing sector that is less emissions-intensive.

Executive summary

Structural change is a central feature of economic development and as economies evolve, the manufacturing industry plays a key role. However, development is increasingly not only about raising income because the form growth takes also matters. Issues of inclusion (with as many as possible benefiting from the proceeds of growth) and sustainability (with growth minimizing the environmental impact) have become crucial. This report explores the role of the manufacturing industry in the twenty-first century in this context. Manufacturing offers the possibility of both job and income creation, but also poses challenges in terms of the effects this process has on natural resources and climate change.

Recent history demonstrates that experience with industrialization has been very uneven, both in terms of the spread of benefits between countries and their distribution within countries. The report highlights successful and unsuccessful experiences and considers their policy implications. The challenges discussed here are of central importance for most countries, especially for developing countries wishing to expand their industrial base and embark on a path of sustainable industrialization.

Manufacturing matters for the growth of developing countries

There is ample empirical evidence to show that the manufacturing sector plays an important role in growth, particularly when countries are at a relatively low-income level. Manufacturing offers the possibility of higher levels of productivity, more rapid productivity growth and greater technical change than agriculture, or below a certain income, many parts of services. In addition, it can create jobs that offer higher wages due to this higher level of productivity. Hence, there is usually an association between the growth of an economy and the size and growth of its manufacturing sector.

This relationship is typically stronger in low- and lower-middle-income economies than in middle- and high-income economies, since the productivity and employment effects of manufacturing relative to other sectors are expected to be higher at lower income levels. In addition, there is some evidence that this relationship may have weakened post-1990 in the more globalized world economy, where positive growth effects from manufacturing only operate in economies with relatively high levels of human capital.

In policy terms this means that governments of developing countries need to consider ways to encourage and support manufacturing activities and prevent a shift of resources from manufacturing to activities such as traditional agriculture or informal services, which offer less economic returns and have less potential for growth.

No unique path to development but understanding general patterns may inform policy

Cross-country analyses of the patterns of manufacturing development reveal both empirical regularities in these patterns and significant variations in country experiences due to country-specific factors. As per capita incomes rise, the share of the manufacturing sector in gross domestic product (GDP) typically follows an inverted U-shaped path peaking at a threshold level of income and declining as income rises further. This relationship has changed over time and the maximum share of manufacturing in GDP in today’s economies is at much lower levels of income per capita compared to the point at which the now industrialized countries reach their peak level of manufacturing activity.

Once the peak has been reached, the share of manufacturing tends to gradually decrease and the share of the services sector rises. There is no predetermined or unique path to development, and individual countries have specific features that influence the extent to which they may deviate from the general or average pattern. Nonetheless, establishing this general pattern can inform policy since it indicates how far the structure of an economy is from the ‘expected’ structure, given its income level, size and other characteristics.

In terms of trends over the period 1970-2013 in different regions, a significant relocation of manufacturing value added has been observed from wealthier countries (the United States and Western Europe) to Asia, in particular China. The share of manufacturing in GDP (at constant prices) over this period dropped in Western Europe, Latin America and sub-Saharan Africa, and has been constant in the United States (at 13 percent). On the other hand, its share in Asia (excluding China) has increased from 16 percent to 20 percent while in China it has risen four-fold from 9 percent to 36 percent. Within the developing country group, the share of manufacturing in total economic activity rose from around 15 percent to over 20 percent over this period. In 2014, China contributed over 18 percent of world manufacturing value added, and was the second largest manufacturing producer behind the United States.

Patterns can also be established for change within manufacturing as the sector expands at different levels of income. Industries within manufacturing can be classified as ‘early’, ‘middle’ or ‘late’ depending on the level of income (at constant prices) at which an industry’s share in GDP reaches its peak. Early industries are mostly those that are relatively labour-intensive and/or domestic-oriented (typically food and beverages, tobacco, textiles, wearing apparel, wood products, publishing, furniture, and non-metallic minerals). Middle industries include those that process natural resources (typically coke and refined petroleum, paper, basic metals and fabricated metals). Late industries tend to be more knowledge- and capital-intensive (typically rubber and plastics, motor vehicles, chemicals, machinery and equipment, electrical machinery and apparatus and precision instruments).

There are country differences from this general pattern, and at low income levels in particular, there can be considerable variation between countries as evidenced by differing experiences in the development of textiles and wearing apparel. Once the manufacturing sector has accumulated experience and incomes have risen, the differences in performance between countries at the same income level decrease. However, as countries approach the end of the upper-middle-income stage (at around $15,000 GDP per capita in terms of PPP in 2005 constant prices), they again exhibit bigger differences in performance, as they face the challenge of competing in more sophisticated and technology-intensive goods.

Overall, the aggregate share of world manufacturing employment in total world employment (including both developed and developing countries) has barely changed since 1970. Rather, a major reallocation of the share of manufacturing in total employment has occurred, rising from below 10 percent to around 14 percent in the developing country group, whilst it has fallen significantly in developed countries.

Although there are sufficient regularities in the data to identify a ‘normal’ development pattern and path of structural change as income grows, countries may deviate from this path because of their specific characteristics. Small countries (defined here by a population size below 12.5 million) tend to develop labour-intensive industries earlier than large countries, although they decline fairly rapidly once these industries reach their peak levels of output relative to other industries. At high income levels, the growth of industries between small and large countries tends to vary far more, as small countries must specialize more than larger ones. Due to agglomeration effects, high levels of population density tend to be associated with relatively high levels of manufacturing.

On the other hand, countries with large levels of natural resources have lower than expected levels of manufacturing for their income level. Similarly, countries with high labour costs and poor governance have lower levels of manufacturing than expected. Whilst there may be a few developing countries that have significant potential in high productivity activities, such as tourism services or mineral processing, a need for most countries will eventually arise to develop some form of manufacturing. The policy challenge is to ensure that given the country’s size and natural resource endowment, its actual level of manufacturing activity is not significantly below what might be expected. This requires ensuring that adequate support for manufacturing and key aspects of the investment climate, like high quality infrastructure, training activities and a stable macro-economic environment, are in place.

There is a need for industrial policy

There are different ways to support industry, and the precise choice of instruments matters less than the way in which they are applied. Current thinking highlights the need to focus on the key constraints to new investments. These constraints are to be identified by a dialogue between government (through the agency that implements industrial policy) and the productive sector (private or public enterprises). Instruments are to be used flexibly so that where one is ineffective, it should be replaced by another or terminated. Support for a given instrument should be linked to performance and the achievement of targets, and be of a temporary nature. In practice, governments are ‘doomed to choose’ in the sense that as resources are limited priorities for support need to be set if interventions are to be effective.

Manufacturing offers the potential for higher wages and stable employment. The links between employment growth and output growth have weakened in recent decades in part because of the skills bias inherent in new technologies created in higher income economies. Overall, the expectation is that innovation increases employment since even if innovation in processes results in labour-shedding, innovation in products creates new markets and expands output. Whilst the spread of industrial robots may create a labour-displacing effect in the long run, this has not as yet emerged as a major problem in middle- and lower-income economies.

Interventions to support sustainable green growth will be increasingly important in the future to offset the negative effects of a growing rate of production on the environment. Governments can play a key role in getting prices to incorporate the negative consequences of resource use on the environment and in funding research and development (R&D) in environmentally supportive technology and its dissemination, so that increasingly, environmental considerations will need to be an important aspect of industrial policy.

This report has been prepared by Nobuya Haraguchi, UNIDO staff member, and John Weiss, Emeritus Professor at University of Bradford.

Download: Structural Change for Inclusive and Sustainable Industrial Development (PDF)