Economic transformation: A must for economic development

Published in Ceylon Today on 12th, Oct. 2014
By Priyanga Dunusinghe

It is widely accepted that poverty reduction and economic growth cannot be sustained without economic transformation and productivity change but, despite this obvious point, the policy makers has traditionally paid relatively little attention to these long-term determinants of development.

What is economic transformation?

Economic transformation involves moving labour from low to higher productive activities. This includes between sectors (from agriculture to manufacturing) and within sectors (for example, from subsistence farming to high-value crops) productive factor reallocations. Following Arthur Lewis (1954) seminal work, economists argue that moving resources from low productive sectors to high productive sector is essential for economic growth and development. According to Lewis model (1954), developing countries are characterized by a dual economy nature; (a), labour scarce urban sector specialized in manufacturing activities and (b) labour abundant rural economy specialized in agricultural activities. Economic transformation (moving labour from rural agriculture to urban manufacturing sector) helps accelerate economic growth through two channels; (a) an increase in labourproductivity because resources are now employed in more productive sectors compared to previously employed sectors and (2) an increase in investment around urban centers because urban industrialists could hire any number of workers without raising wages thereby allowing industrialists to increase their profits and in turn re-investingthe surplus thus created thereby witnessing rapid industrialization around urban centers. On that basis, Lewis argues that developing countries could accelerate economic growth by facilitating the economic transformation. This model received a wide acceptance in 1950-60s although its popularity faded away until recently.

Economic Transformation in the economy

At the time of independence, Sri Lanka was predominantly agricultural economy. Agriculture sector accounted from nearly 41 per cent of the country’s output while well over two-third of total workforce engaged in the sector. However, over the years, the relative share of agriculture output in the GDP declined rapidly although similar pattern did not witnessed with respect to the share of labour engaged in the sector. For instance, by 2013, agriculture accounted for 12 per cent of the GDP while it employed nearly 30 per cent of the total workforce.  It is relatively easy for anyone to understand that labour productivity is lowest in the agriculture sector given 30 per cent of total workforce just contributes 12 per cent of the total output of the country. It reflects that a significant share of labour force is still under-utilized or employed unproductively in the agriculture sector thereby witnessing higher level of under-employment and wide-spread poverty among people who engage in agriculture activities. At the same time, it is important to note that national averages hides a lot with respect to the structure of provincial economies. Other than in the Western province, a significant share of the workforce employs in the agriculture sector thereby reflecting that economic transformation has mostly taken place around the Western Province. For instance, the share of workforce in the agriculture sector in the Western, Central, North Central, and Uva provinces is 7 per cent, 41per cent, 54per cent and 57 per centrespectively.

As discussed above, not only the between sectors economic transformation, but also the within sector economic transformation is crucial for productivity improvement and economic growth. A recent study carried out by Asian Development Bank (2014) found that Sri Lankan economy slowly witnesses creative destruction indicating that within-sector economic transformation is weak.

“The country performs averagely in the provision of the knowledge-skill base and appropriate institutions, but challenges remain in its sluggish creative destruction, driven by the rigid labour market and the poor quality of its financial institutions” (ADB, 2014).

It implies that a large amount of resources are trapped unproductively due to a number of reasons. Some firms find it difficult to expand while some unproductive firms stay in business using various assistances offered by the government. This is equally applied for the agriculture sector as well. Farmers wanting to expand their farm land as well as those who want to more out of agriculture find it difficult to do so because there are a number of distortions in the land market. These distortions force some people to engage in farming whether they like or not. These factors together with existing taxes and subsidy schemes discourage the process of economic transformation thereby holding back resources in unproductive sectors. As highlighted in previous articles, a protective trade regime encourages unproductive businesses to stay in the business thereby holding back required economic transformation in the economy.  Certain fiscal policy elements could also discourage structural transformation if such decisions are taken purely based on political economy considerations rather than on economic logic.

Sri Lanka witnessed a decline in the public sector share in total workforce since economic liberalization in 1970s. However, this trend was reversed by the present government by recruiting a large number of unemployed youth for the public service and re-taking some of the privatized state-owned commercial entities. Absorption of unemployed youth into public sector made several positive externalities, while, it also led to some labour market distortion. One among them is that it reversed the process of labour moving from low productive sectors to high productive sectors thereby not witnessing positive contribution to economic development. It is quite obvious that many newly recruited youth are underemployed in the public sector thereby holding up some productive resources untapped in the economy.

What is structural transformation important?

In recent years, economists have found renewed interest in structural transformation models because many cross-country evidences suggest that rapid and sustained economic growth is not feasible unless the economy witnessed rapid economic transformation along with higher level of investment in fundamentals. According to Rodrick (2013), investment in fundamentals mainly refers to investment in human capital, physical capital, and institutions. Rodrik (2013) conceptualizes, based on Lewis’ two-sector growth model, a matrix showing the interaction between structural transformation and investment in fundaments. The author identifies four possible scenarios with respect to economic growth;

(1) No growth:economies witnessing low level of economic transformation and low investment in fundamentals.

(2)   Slow growth: economies witnessing low economic transformation and sufficiently high investment in fundamentals

(3)    Episodic growth:economies witnessing high level of economic transformation but low investment on fundaments.

(4)    Rapid and sustained growth:higher level of economic transformation and investment in fundamentals. 

Rapid and sustained economic growth requires continuous process of creative destruction where unproductive businesses go out of business while new players emerging in the markets. This process makes sure that economic agents employ resources efficiently.

Conclusion

As argued previously, it is widely accepted that poverty reduction and economic growth cannot be sustained without economic transformation and productivity change but, despite this obvious point, the policy makers has traditionally paid relatively little attention to these long-term determinants of development.As the data clearly show economic transformation witnessed by the economy so far largely confines to the Western province. Economic transformation within-sectors and provinces other than the Western remain relatively low. Hence, it is imperative that policy makers pay sufficient attention in devising policy instruments for moving this large stock of resources (both labour and capital) employed unproductively into more productive sectors. It is important that political and economic institutions provide right set of incentives so that economic agents employ their resources in productive sectors.