Foresight - Thought Leadership

The convergence question

The idea of convergence is a powerful one for many emerging markets investors. But what is it? Why should it happen? What does history tell us about it?

10/12/2018

Nicholas Field

Nicholas Field

Global Emerging Market Equity Strategist, Emerging Market Equities

The idea of convergence is a powerful one for many emerging market investors. The idea that emerging countries will inevitably experience “catchup” economic growth to developed markets is a key part of their appeal.

We have written before about the tenuous link between economic growth and market performance1, but it is certainly a better backdrop for market performance to have years of strong growth, than not.

This note looks at convergence. What is it? Why should it happen in theory? Is it a sure thing? And what factors make it more likely or less likely in practice?

Convergence: the theory

The way we think about convergence has its origins in the Solow growth model proposed in 1956. This model of the economy suggests output depends on inputs of capital and labour, as well as a factor for technological advance, which represents the extra use a unit of labour can make of “better” capital. The output is used as consumption and savings. As the model assumes a closed single economy, hence no capital flows, the savings have to cover depreciation of the capital and new investments.

The implications of the Solow model are that there are two main engines of per capita growth: growth in the capital stock and improvements in technology. The growth of capital is assumed to suffer from diminishing returns. In the long run capital spend will equal depreciation, and growth can only come from an increase in technology. But economies can have “catch-up growth” if the technological growth has outstripped the capital growth for some reason, providing a boost to the returns to capital investment. A real world example would be the great depression followed by WW2, where there was plenty of technological advancement, but little capital was invested to take advantage of it. This allowed for considerable catch-up growth in the 1950s.

The Solow model has implications for emerging market convergence. If a poorer country receives access to technology from richer economies then there will be a gap between its old and new production capabilities, allowing for higher levels of investment and hence growth. This high return on capital should attract flows from abroad to provide the effective savings pool necessary to fund the capital growth.

This theory has been influential in how investors and policymakers think about growth and convergence. Whether its framework is realistic in the real world, however, depends on a lot of practical considerations and constraints. How has convergence worked in practice?

Convergence: the facts

Emerging countries have a very patchy record of achieving convergence. To show this we have a series of simple charts looking at the trend in GDP per capita in a country relative to that of the US. Everything is measured in current US dollars2. First up is Latin America.

Figure 1: Latin Per Capita GDP relative to USA

Source: World Bank (WDI). Data as at August 2018.

 

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1 https://www.schroders.com/en/uk/pensions/insights/thought-leadership/why-economic-growth-has-been-a-mirage-for-emerging-market-investors/
2 Our source is the World Bank database. We do not use PPP measures to convert currency rates, as many academic studies do. PPP is a somewhat theoretical construct and currencies rates have generally failed to converge to PPP rates over extended periods of time. The problem is that a basket of domestic goods will always be cheaper in a country with a small capital base and lower incomes. Using PPP rates tends to assume that the basket of goods will get more expensive as the economy grows – ie to some degree it assumes convergence within it.

 

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