How Economic Fitness Can Improve Industrial and Sovereign Development Funds Policies 

By | April 11, 2023

The idea that industrial policy is back in vogue has become something of a cliché in recent years. Joseph Stiglitz, the Nobel Prize winning economist, and Justin Lin, a former Chief Economist of the World Bank, were onto the trend early, arguing in 2015, “today, the relevance and pertinence of industrial policies are acknowledged by mainstream economists and political leaders from all sides of the ideological spectrum.” Since then, this view has gained credence, with the Financial Times recently declaring “industrial policy is so hot right now.” Others have linked the revival of industrial policies to the anticipated post-pandemic trends, such as deglobalization and “reshoring,” the Green Revolution, and geopolitical rivalries between the world’s major economies.  

Interestingly, we observe the parallel rise of Sovereign Development Funds (SDFs) within the broader community of global Sovereign Wealth Funds (SWFs). The traditional SWF model, which still accounts for the majority of the sovereign-investor asset pool, emphasizes offshore investments in global capital markets in pursuit of inter-generational capital growth and a steady stream of investment income. In contrast, SDFs invest domestically in sectors and industries that are positioned for growth over the medium to long term and can contribute to diversification, employment, and economic development. Since the Global Financial Crisis in 2008, there has been a steady increase in the number of newly established SDFs worldwide, as well as the assets they manage as a whole, while traditional SWFs are also increasingly interested in, or being pushed towards, domestic allocations.  

Industrial Policy and SDFs: the shared identification problem 

In two recent papers, published through the Stanford Research Initiative on Long-Term Investing and the Golub Center for Finance and Policy at MIT, we explore the links between industrial policy, SDFs and an emerging set of diagnostic tools emerging from the literature on Economic Fitness. While the precise role, mandate, and focus of SDFs often remains elusive, we argue that the binding raison d’etre of all SDFs is to invest public resources to address market failures and political constraints that impede the natural emergence of new areas of economic activities. The increasing popularity of SDFs is a complementary development to emergent intellectual and policy trends that emphasize the need to remove market failures through development-finance institutions and industrial policy.  

Further parallels between SDFs and industrial policy can be identified. In line with industrial policy, SDFs typically organize their portfolios in a vertical manner. Of course, SDFs and investment performance benefit from an environment characterized by supportive horizontal policies – strong institutions, appropriate exchange-rate and macroeconomic policies, broad-based tax incentives, reduced regulatory burdens, and enabling infrastructure. However, their own mandates and capital allocation are typically vertically defined and organized.  

Herein lies a set of practical policy challenges that SDFs share with industrial policy. First, they must identify why private capital is not allocated at a sufficient scale to target sectors. Which market failures result in underinvestment in areas that would otherwise contribute to sustained economic development? How would SDF investments overcome such market failures? Second, policymakers face the dynamic and evolving challenge of defining the strategic focus areas of the SDF by identifying target industries, sectors, projects and businesses. Finding the “right” sectors to target is hard enough as a static exercise. Periodically updating and upgrading policies in a dynamic setting is all the more challenging. Finally, policymakers need an empirically grounded process through which to monitor, assess, and ultimately demonstrate value around the achievement of developmental objectives.  

These challenges place a premium on analytical tools and frameworks that assist the process of identifying areas of emergent economic activity that are poised for growth and/or will contribute to sustainable diversification. Our research proposes a solution in this regard: the application of Economic Fitness tools at various levels of SDF decision making, ranging from the strategic to portfolio – and even investment-level decisions.  

Understanding Economic Fitness 

In our MIT paper, we argue that Economic Fitness (and the closely related literature on Economic Complexity, pioneered by Hausmann and co-authors) expands on insights from Endogenous Growth Theory, Network Economics, and Economic Geography to model the process of economic growth through an emphasis on dynamically evolving “productive capabilities.” The concept of capabilities embeds a multitude of factors – natural endowments, human and physical capital, soft and hard infrastructure – that make the production of specific goods and services on a competitive basis possible. Productive capabilities are modelled as being situated in a complex network-based structure, characterized by non-linearities and externalities.  

An important corollary of this network structure is the connection between productive capabilities, such that the cultivation of one set of capabilities enables or catalyzes the emergence of adjacent ones. Here we note a clear market failure, which establishes a role for SDFs. Private investors do not fully capture the broader social benefits from expanding the network of productive capabilities. Hence, aggregate private investment in capability-enhancing activities may be below the level or in different areas of economic activity than what is socially or strategically optimal. The cultivation of feasible capabilities, located near the existing, but constantly evolving, capability endowment can deliver such positive externalities.  

The growing literature on Economic Fitness, summarized in our MIT paper, has also resulted in a highly applied and practical database, developed by the International Finance Corporation (IFC) in partnership with the Enrico Fermi Research Center. Economic Fitness indicators can be used to identify which sectors and industries to target based on an existing capability network. Economic Fitness characterizes an economy’s level of diversification and its ability to produce complex products based on observed patterns in export data. The assumption, which enjoys strong empirical support, is that the structure of exports proxies the existence of productive capabilities. The “fittest” economies are not only specialized in complex productive activities but are also diversified: they are able to produce the largest bundles of products, ranging from the simplest to the most complex, using the largest set of productive capabilities.  

Table 1: The Economic Fitness Toolkit 

Economic Fitness Indicator  Description and Applications 
Sector Fitness Profile 

 

Provides a snapshot visualization of the sectors a country is currently competitive in, which sectors ranked in terms of their sophistication and complexity 
Product Progression Network 

 

Maps the network-based pathways to higher Economic Fitness experienced by other countries, reflecting the ability of the Economic Fitness framework to identify, with a high degree of statistical significance, which products are connected through a causal relationship 
Progression Probability  Represents the feasibility (as a probability) of cultivating competitiveness in a specific sector over a five-year horizon, given existing productive capabilities 
Complexity of Industry  Assesses the level and nature of productive capabilities required to competitively export a product 
Complexity Gain  A probabilistic expression of the expectation that success in one sector will unlock opportunities to upgrade to related products/sectors/industries in the future – that is, to enable the creation of new markets 

In recent years, Economic Fitness indicators have been successfully integrated into the formulation of World Bank strategy and IFC investment project evaluations. This holds valuable lessons for how SDFs’ strategic focus and investment decisions can be improved. For example, the indicators described in the table below provide mappings of the existing capability network (including changes to it over time), as well as signals around which areas are best positioned for growth and the cultivation of overall or sector-specific fitness.  

The emphasis on capabilities described above permits a reinterpretation of sector-specific or vertical policies, including the strategic allocation of SDFs into target sectors. Hidalgo notes that capability-centric complexity and fitness “methods grew together with a revival of industrial policy” and “help characterize detailed economic structures and provide a quantitative base for industrial policy efforts.” We argue that this toolkit can be gainfully employed in narrowing and dynamically adjusting the strategic focus of SDFs while also aiding more granular decisions at the portfolio and investment-specific levels. 

Applications of Economic Fitness by SDFs 

We argue that Economic Fitness-based investment- or portfolio-level screening tools would be straightforward to implement, and several tailor-made indicators could be updated annually or semi-annually. Such tools could be integrated with the investment analysis and evaluation process much like ESG and “impact-investment” indicators are today: either on its own or as part of a weighted scorecard for specific investments or at the portfolio level.  

Granular tools, such as the Progression Probability and the Complexity of Industry indictors (see Table 1), can be used to assess the probability of success of investments in specific sectors. Likewise, Complexity Gain data can help assess how investments contribute to Economic Fitness through greater diversification and/or upgrading to more complex economic activities. At this level of analysis, the Economic Fitness toolkit would be primarily used by the SDF’s Executive, Investment Committee, and investment teams, although more aggregated summaries of the portfolio’s Economic Fitness scores can facilitate consistent and systematic discussions between the Executive and the Board.  

More ambitious applications of Economic Fitness by SDFs pertain to longer-term strategic considerations. Economic Fitness creates an empirically grounded identification mechanism based on the exploitation of existing productive capabilities and the cultivation of new capabilities that create new markets or raise the complexity of production. Beyond general sector-strategy identification, our papers outline three possible strategic applications of Economic Fitness by SDFs: first, distinguishing between commercial and developmental investment opportunities (see below); second, assessing the role SDFs can play in importing scarce productive capabilities through targeted cross-border investments; and third, assessing when investments need to be updated, upgraded, and refocused.  

Of relevance to these slow-moving strategic decisions are interactions between “feasibility” and “complexity gain.” The former refers to the modelled and computed probability of success (over a five-year horizon) of cultivating a new area of economic activity, given the existing productive capabilities present in an economy. The latter refers to the extent to which such success would add to the economy’s productive capabilities, thus enabling feasible expansions into new areas of economic activity over time over time.  

Earlier, we argued that the raison d’etre of SDFs is linked to the removal of constraints to growth, which generally involves correcting market failures. If investment opportunities reside in the high-feasibility/high-complexity-gain (top-right) quadrant, the policy question should be: how can the SDF’s deployment of capital, including co-investments with private investors, help resolve a market failure that is preventing or suppressing spontaneous investments in high-feasibility areas? This is most likely the most productive area where there are initial investment opportunities for a newly established SDF.  

Beyond the low-hanging fruit opportunities situated in the “sweet spot” of the top-right quadrant, SDFs confront trade-offs. For example, the bottom-right quadrant that combines high feasibility with lower complexity gains should be regarded as primarily the domain of private-sector investors (or commercially orientated sovereign or public investor), as it is less likely to result in positive externalities that promote diversification and development. The existence of market failures that may suppress private capital deployment into feasible sectors may be better addressed through institutional changes and horizontal policies such as broad tax incentives. The bottom-left quadrant of low-feasibility, low-complexity activities are best avoided by the SDFs and may be a domain that is best suited for impact investors, the deployment of critical aid, and philanthropic capital. Policymakers can still use the Economic Fitness framework to ensure that SDFs and indeed other industrial policies are not biasing the allocation of overall investment (public and private) towards this relatively unproductive quadrant. 

Figure 1: A Stylized SDF Opportunity Set Based on Feasibility and Complexity Gain  

Over time, the top-left quadrant in Figure 1 is the most intriguing area for an established SDF to evaluate and also where SDFs in commodity-dependent economies can add considerable value. These are typically areas of activity that are not highly feasible. The productive capabilities required to make investments in this domain succeed are absent in the local economy, making private investment unlikely to happen. This is a likely state of affairs in undiversified, resource-dominant economies (home to the overwhelming majority of SWFs and SDFs worldwide).  

Yet, if patient capital could be deployed in these domains and the requisite productive capabilities could be imported or aggressively cultivated alongside the investment, success in these areas could unlock significant complexity gains, bringing with them diversification, employment and the catalyzing of adjacent industries that would not “naturally” emerge through private-sector investments alone. In that sense, the SDF’s investment would capture positive externalities to the national economy that are not appropriately priced in the market. Below we explore how cross-border strategic investments by SDFs can target the transfer of knowledge, technology, and know-how, particularly if those are the productive capabilities missing in the local market to make high-complexity gain activities imminently feasible.  

Conclusion 

The revival of enthusiasm around industrial policy and the emergence of new development-finance institutions such as SDFs can be linked the belief that absent the guiding or coordinating hand of the state, markets do not always provide the clear price signals, incentives, and coordination mechanisms required to catalyze sustained economic growth. Market failures such as missing markets, coordination failures, information asymmetries, and funding gaps provide a rationale for policy interventions, particularly through industrial policy and public-sector investment, not least by SDFs.  

While this basic rationale for an SDF (and industrial policy) is by now well understood, the funds and their political owners face several practical challenges in designing and executing policy. First, they face the challenge of identifying target sectors and industries that are poised for growth but not receiving the desired level of private capital investment. Second, given their dual mandates, SDFs need to distinguish between and untangle the commercial and developmental benefits in both their overall investment portfolio and at the level of specific investments. Third, they need to continually update and refresh their analysis, as economic growth and development is a complex, evolving process, and scarce public resources need to be allocated where they will have the greatest impact (successful industrial policy is always temporary in nature, as an industry that indefinitely requires vast public investment, subsidies and other support measures has not truly emerged). Finally, SDFs benefit from robust, quantitative measures that enable them to monitor and ultimately report contributions to developmental objectives.  

In two recent papers, we show how a framework and set of analytical tools contained in the World Bank’s Economic Fitness database can help meet these challenges, which are specific to SDFs but also hold valuable lessons more generally for the design and execution of industrial and development policies. Economic Fitness should be understood in the context of the recent literature’s emphasis on disaggregated productive capabilities, empirically identified through a fine-grained analysis of the composition of exports, mapped into a network structure. Existing productive capabilities – a concept that encompasses all the traditional factors of production such as land, capital, and labor, as well as more elusive notions of productivity, technology, and institutions – help explain what goods and services an economy already excels at. More importantly, the identification of productive capabilities through a network-based analysis of exports provides robust signals around the prospects for growth, diversification and increasing Economic Fitness.  

Beyond the contextualization and high-level overview of Economic Fitness, our main contribution is to show how its analytical tools can be applied to improve policymaking and development strategies. We conclude that Economic Fitness provides robust and practical signals to SDFs and their government owners regarding sectors, industries and investments that are poised for growth. The framework provides tools for assessing how SDF investments are likely to contribute to a country’s Economic Fitness, which is the ultimate driver of sustainable, long-term growth and diversification prospects.  

 

Khalid Alsweilem is a Visiting Scholar at the Center of Sustainable Development and Global Competition (SDGC) and at Stanford Long-Term Investing Initiative (SLTI).  

Masud Z. Cader is the Lead of Country Analytics for the International Finance Corporation, the private sector arm of the World Bank Group. 

Malan Rietveld is a Research Fellow at the Departments of Economics at the University of Stellenbosch.  

 

This post was adapted from their paper, “Productive Capabilities, Economic Fitness and the Role of Sovereign Development Funds,” available on SSRN 

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