Weekly economic briefing: The Economic Complexity Index: A roadmap for technological development

The Weekly Economic Briefing is written by two senior Deloitte Economists, David Rumbens from Deloitte Access Economics in Australia and Ian Stewart Deloitte’s Chief Economist in the UK. They provide a personal view on topical financial and economic issues. Subscribe to receive the Weekly Economic Briefing in your inbox!

In this week’s blog:

Australian economic briefing
UK economic briefing
International economic briefing

Australian economic briefing by David Rumbens

This section of the briefing provides a snapshot of key economic data and issues of relevance to Australia.

The Economic Complexity Index: A roadmap for technological development

The Economic Complexity Index (ECI) is a measure that allows us to compare the technological know-how of countries by analysing the technological complexity of products each country exports.

The ECI has a strong correlation with economic development and growth, particularly for developing countries. When we hold income constant, it is a useful indicator of growth as countries with higher ECIs tend to grow faster than countries with lower ECIs. The latest release of the ECI suggests that growth in emerging markets will continue to outpace that of advanced economies over the next decade.

In the latest ECI rankings, Australia is placed 77 out of 124 countries. The low ranking is largely because the majority of Australia’s goods exports are raw, unprocessed, and therefore low complexity materials (i.e. mining commodities). The ECI only considers tradeable goods so services exports, such as education, aren’t included. Therefore, Australia is an outlier when it comes to the ECI, performing much better than our level of export complexity would suggest.

What does the ECI say about our region?

If we follow the ECI through time, it lets us spot which countries are “moving up the value chain”. Since 1995, South Korea, Malaysia, China, Thailand, and the Philippines have all made sizeable improvements to their economic complexity, whereas the progress of Indonesia, Hong Kong, and India has been more piecemeal. While India is often heralded as the next China, its current level of export complexity is still below what China’s was over 20 years ago.

Chart: ECI rankings for selected countries in 1995 and 2015

Source: “The Atlas of Economic Complexity,” Center for International Development at Harvard University, http://www.atlas.cid.harvard.edu

The ECI can also be used to predict how quickly countries will grow: countries that are more technologically advanced than their income levels would suggest tend to grow faster than countries with the same ECI, but a greater level of wealth. From this perspective, India is well placed to benefit from catch-up growth: the 10 year GDP growth forecasts that are published based on the ECI predict that India will be among the fastest growing economies up to 2025, at an average rate of 7.7% per year.

Chart: Predicted average annual GDP growth rates to 2025 based on the ECI

Source: “The Atlas of Economic Complexity,” Center for International Development at Harvard University, http://www.atlas.cid.harvard.edu

How can we use the ECI to inform Australia’s technological development?

The ECI doesn’t just measure the complexity of an economy, it suggests development pathways too. As it is built on the notion of path-dependent development, where existing products enable the development of newer products, the ECI is published along with a collection of tailored maps called the “product space” that can help identify the opportunities and rewards available to each country. The product space is a network of products linked by similarity. Clusters of related products form wherever there are opportunities to leverage the same supply chain networks, expertise, and governance structures.

To identify the best avenues for development, we can look at the “opportunity gain” for each country, which is simply the product or group of products that would lead to a country getting the biggest increase in its ECI. At a high level, the industry groups that offer the greatest opportunity gain to Australia are machinery, electrical, and chemical manufacturing, but there would also be milder gains available from developments in manufacturing products using stone, glass, plastics, and rubbers (and very little gains for simple products like textiles).

Why these industries? Australia already exports a variety of raw materials that are involved in the manufacture of these products, so it’s a logical value-added progression. Given Australia’s high income level relative to its economic complexity, Australia could even leap-frog these simple types of manufacturing to focus on more advanced products.

However, that’s not to say that raw materials won’t be an important part of Australia’s export mix into the future. As Indonesia, India, and Pakistan increase the complexity of their export products (which already involve electrical and machinery manufacturing), they will be in need of many of the key raw materials that Australia can provide. Because of their growth potential, these countries offer excellent future trade partnerships for Australia.

For more information on the Australian brief, please contact the co-authors, David Rumbens and Oscar Lane.

UK economic briefing by Ian Stewart

A personal view from Ian Stewart, Deloitte’s Chief Economist in the UK. Subscribe to and view previous Monday Briefings at: http://blogs.deloitte.co.uk/mondaybriefing/

  • Earlier this month I was on a panel with a former banker and an academic in Austria discussing the lessons of the financial crisis.
  • At one level the crisis was mind-boggingly complex, with obscure, linked financial structures blowing up, spreading risk through the system. At another level it was pretty simple.
  • Indeed, in many respects we knew the lesson of the financial crisis before the financial crisis. History has given us plenty of opportunities to learn. Taking just the 20 year period before 2008, the world witnessed deep financial crises in Russia and Asia, banking crises in Sweden and Finland, Black Monday, a general equity market crash in 1987 and the dotcom collapse of 2001.
  • The proximate causes varied – overvalued tech stocks getting their comeuppance in 2001, a reversal of inflows of foreign capital in Asia in 1997 and so on.
  • But the underlying drivers are the same: cheap money, excessive debt, too much risk taking and too little information. The failure of innovative and opaque financial structures, such as Collateralised Debt Obligations (CDOs) in 2008, often plays a role.
  • Underpinning it all is the very human desire not to miss the next few percent of gains in buoyant markets. In 2007 Citigroup’s then CEO, Chuck Prince, described the phenomenon in relation to the Citi’s commitment to leveraged buy-outs, “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
  • A year later, in 2008 the Paul McCulley, Chief Economist of PIMCO, a major investment management fund, put it  perfectly, “Human beings are not wired to buy low and sell high; rather, they are wired to buy that which is going up in price”. Every investors needs to remember those words.
  • None of this is new, and writers have long sought to understand it. The book I reach for is Charles Kindelberger’s classic, ‘Manias, Panics and Crashes’. It is testimony to its enduring relevance of the subject that it has never been out of print since it was first published in 1978 – and that has gone through five editions to cope with new financial crises.
  • Most financial crises are preceded by a sustained period of growth and stability. The years before the 2008 saw rising prosperity, low interest rates and low inflation. It was economic nirvana. Like most booms it generated its own self-justifying narrative, the so-called Great Moderation. This held that the world had entered a new era of prosperity, aided by good policy and globalisation, with risk better managed and distributed through the financial system.
  • But if financial booms and busts are such a staple of the liberal economic system and have such obvious causes, why don’t investors bet against them? If asset prices are set to collapse, there’s money to be made by ‘shorting’ the market. Why aren’t financial excesses offset by selling activity?
  • One problem is you can never be sure if an asset which has seen strong growth is about to crash or will carry on rising. Expensive things often get more expensive. Another problem relates to incentives, something that is powerfully illustrated by the career of the prominent 1990s UK fund manager, Tony Dye. Mr Dye famously refused to buy into internet stocks during the dotcom boom on the grounds they were overvalued. This led to the loss of clients. Mr Dye was sacked weeks before the bubble burst and his strategy paid off. Mr Dye was ultimately vindicated, but his career would have been smoother had he gone with the crowd and bought internet stocks.
  • Regulators face different challenges. They have to balance controlling financial excess against the benefits of dynamic financial markets. Successful economies have deep, sophisticated financial markets. Innovation require risk taking in the financial economy as much in the rest of the economy.
  • The often-made criticism of the financial sector in the wake of the crisis was that the failures outnumbered the successes. Paul Volcker, the former Chairman of the US Federal Reserve, asserted in 2009 that the ATM had been “the only useful innovation in banking for the past 20 years”. Yet in recent years the rash of innovations, from peer-to-peer lending, to mobile banking and cryptocurrencies, suggests that the appetite for financial innovation remains alive and well.
  • Perhaps the most important lesson from history is that when the financial system goes wrong the effects on the rest of the economy are severe. In other industries policymakers tend to let events take their course. Such a laissez-faire approach to the financial sector, whose health is vital to the whole economy, would be ruinous.
  • This lesson was well understood by policymakers in 2007-09. The Chairman of the US Federal Reserve at the time, Ben Bernanke, had a life-long interest in the Great Depression of the 1930s. He believed that disaster was caused by Fed inaction in the face of deflation. Bernanke told the monetary economist Milton Friedman in 2002 that the Fed had caused the Great Depression adding, “we’re very sorry… we won’t do it again”.
  • Mr Bernanke was true to his word. The aggressive and coordinated action of central banks and governments averted a 1930s style depression. The recovery has lacklustre, but compared with the human cost of the Great Depression the world got off lightly.
  • Good regulation can help mitigate and avert future financial crises. But to prevent all crises regulation would need to eliminate the risk taking necessary for growth. Unavoidably, the business of acting against financial excess will remain a matter of judgement. Regulation is an early line of defence, just as smoke alarms are the home. But we need institutions which can respond effectively to crises, just as we continue to need a fire service.
  • Yet for me the biggest lesson is not about institutions, it relates to the way we think. Group think is the hallmark of all financial crises. The antidote is informed scepticism and a willingness to question received wisdom.  That, perhaps, is a lesson for us all.

 

OUR REVIEW OF LAST WEEK’S NEWS

The FTSE 100 ended the week up 1.3% at 7,311. Political events continued to dominate news flow in Europe, the US and Asia. So-called ‘safe haven’ assets, such as gold, the Japanese Yen and Swiss franc posted gains after North Korea further escalated geopolitical tensions.

International economic briefing by Ian Stewart

Economics and business

  • Exit polls last night suggested Angela Merkel was on course for a fourth term as Germany’s chancellor, though the victory appears to be tempered by a poor showing by her coalition partners, the SPD, and a strong performance by the anti-immigration AfD
  • The Federal Reserve announced it will start to unwind its quantitative easing programme after 10 years of asset purchases
  •  The Bank for International Settlements warned that higher interest rates could derail global growth
  • The OECD forecasts global growth will rise from 3.1% in 2016 to 3.5% this year and 3.7% in 2018
  • Euro area consumer confidence hit a 16-year high
  • The UK’s credit rating was cut one notch to Aa2 by Moody’s, over stressed public finances and Brexit risks
  • UK supermarket, Costcutter, became the first in the world to offer its customers the option pay through ‘vein recognition’
  • As part of a crackdown on illegal immigration UK banks will have to carry out immigration checks on 70 million current accounts from January
  • German car giant, Mercedes-Benz, announced it is to invest $1bn in electric car manufacturing in the US
  • Uber’s London licence was revoked by Transport for London, citing a “lack of corporate responsibility”

Brexit and European politics

  • Theresa May addressed EU leaders in Florence and proposed a two-year Brexit transition period after March 2019, with continued contribution to EU budgets
  • The Prime Minister outlined her opposition to an “off the shelf” Brexit agreement, such as membership of the European Free Trade Association or a Canada-style deal
  • Michel Barnier, the EU’s chief negotiator, said that Theresa May’s speech was “constructive”
  • Theresa May also announced plans for a “seamless transition” to a post-Brexit trade deal between the UK and Canada
  • Applications for citizenship to the UK from the EU have more than tripled in the year to June, compared to the same period in 2015
  • Research from the CBI has found that 91% of London businesses leaders believe the City remains a great base for business, despite Brexit risks
  • Spanish police arrested 13 people in the region of Catalonia for the alleged involvement in planning a vote to secede from Spain
  • The number of tourists visiting the UK rose to over four million in July for the first time ever, with visitors attracted by a weaker pound
  • The BBC reports the UK has reached an agreement with the US to develop a special relationship for collaboration over science
  • 35% of euro area firms expected in August to cut their investment in the UK as a result of Brexit, and “quite quickly”, according to a survey from UBS
  • The UK government said it will develop a distinct regulatory system from the EU for financial services, in order to maintain its competitive advantage

And finally…

  • Researchers in Israel claim that sending a happy face emoticon in the text of a work email is likely to make the sender look less competent to the recipient. They also suggest a smiley could make the reader less likely to share information in their reply – Demoticons

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