With long-term real GDP growth slowing in many major emerging markets (EMs), which EMs (excluding China) are better positioned to prevent growth from slowing further, or even to reverse that trend? And how could that play a role in our sovereign ratings?

Economic growth is, among other things, the outcome of fixed investment, and the GDP returns to that investment. To increase the level of fixed investment amid high global interest rates, EMs with a strong base of domestic savings, such as several in Asia, are better positioned to finance the investment needed to boost long-term growth prospects.

For EMs that have a weaker base of domestic savings, such as most of Latin America, boosting long-term growth prospects will depend more on their ability to increase the returns to investment through structural reforms. Otherwise, they will rely on now costlier foreign savings to finance an increase in investment.

The pace of long-term GDP growth plays an important role in our sovereign ratings directly in our assessment of economic resilience and indirectly in our assessment of other rating factors.

Chart 1

Slowing Population Growth And Lower Productivity Have Constrained Economic Growth

Slowing population growth in most EMs explains part of the decline in GDP growth. The annual increase in population in the median EM at the turn of the 21st century was 1.4%, the following decade it slowed to 1.2%, and today it's just under 1.0%.

Along with that, real GDP growth in per capita terms is also slowing--in the median EM it fell from 3.6% in the first decade of the century, to 3.2% the following decade, and it's been declining since (see chart 2). Slower real GDP per capita growth implies that productivity growth has eased more than population growth over the last decade.

Chart 2

There are many ways to define productivity. The broadest measure is output per worker. In the median EM, this measure of productivity growth slowed from 3.3% in the decade before the global financial crisis to 2.4% in the following 10 years.

However, there are some notable exceptions. Several EMs in Asia have seen an increase in average productivity growth over those two decades (see chart 3), and, as a result, average real GDP per capita growth for those EMs has also increased.

Chart 3

EMs With Lower Domestic Savings Will Rely On Improving Productivity To Prevent GDP From Slowing

Economies with a robust domestic savings base are better positioned to finance an adequate level of fixed investment. The main reason for this is domestic savings tend to be a more stable funding source in EMs than foreign savings.

Access to foreign savings can fluctuate significantly based on global interest rates and external financial conditions. While interest rates in the main advanced economies are high, EMs' access to foreign savings to fund investment can be more challenging, especially in economies where the return to investment tends to be low or uncertain, which lowers risk-adjusted returns.

The level of domestic savings varies significantly across EMs (see chart 4). In several Asian economies, these are above 30% of GDP (Vietnam, Indonesia, and India). In others, these are well below 25% of GDP (in several Latin American countries and in South Africa, for example).

Several factors influence the level of domestic savings, including confidence in the local currency, long-term inflation, and trust in the banking sector. Unsurprisingly, EMs with a history of banking sector crises, or currency devaluations, for example, tend to have low domestic savings.

Chart 4

What It Will Take To Return Long-Term Growth To Pre-Pandemic Averages

Taking into account the level of investment, its efficiency, and availability of domestic savings to finance future investment, we can get a good sense of which EMs are better positioned to boost long-term growth (see table). We can also identify, based on current conditions, which EMs require higher investment levels, higher investment efficiency, or both, to return long-term growth to pre-pandemic averages.

Thinking Of Productivity In Terms Of The Level And Efficiency Of Investment

Productivity can be broken down in several ways. One way is by calculating the returns to capital and labor, and then adding the GDP that is not accounted by those two factors of production (the residual), typically known as total factor productivity (TFP).

Several studies have documented a decline in TFP across EMs in the last decade as one of the main reasons for slowing economic growth. Some of the factors that have influenced lower TFP in EMs are lower marginal gains from technological changes, as well as less favorable global conditions that have affected returns in specific sectors, such as commodities, among other factors.

In this report we take a different approach, although it implicitly captures the decline in TFP. Arithmetically, GDP is the outcome of fixed investment (I) and the returns to that investment, also known as the incremental capital output ratio (ICOR). If we define productivity as GDP per worker, then I and ICOR explain most productivity growth. The only unexplained variable is the number of workers, which is driven largely by demographic factors.

If we assume that structural demographic trends will continue as broadly projected (implied by ongoing slowing population growth in most EMs), then understanding the trajectory of I and ICOR gives us a good idea of where productivity is heading.

Where Are Investment Dynamics The Most Favorable?

We can then look at where the investment level and the efficiency of investment are the most favorable across EMs. Broadly speaking, fixed investment as a share of GDP seems to have peaked in most major EMs around 2012 (see chart 5). In the median EM, fixed investment as a share of GDP fell from 25% then to about 23% now. That said, the significant variations across countries partly explain the differences in GDP growth in recent years.

Chart 5

In some EMs, such as Peru, Colombia, and Malaysia, the decline in fixed investment as a share of GDP has been very large, roughly 5 percentage points of GDP from its peak over the last decade to its current level. In these countries, if the level of investment does not increase to where it was before the pandemic, investment efficiency (ICOR) would have to improve to return to those GDP growth levels.

In other EMs, such as Vietnam and India, fixed investment is now higher than its average in the decade before the pandemic, and well above 30% of GDP (see chart 6). In these countries, as long as fixed investment remains relatively stable, maintaining the long-term growth rates observed over the last decade does not require improving the efficiency of investment (ICOR).

Chart 6

The GDP returns to fixed investment vary significantly across EMs. EM Asian economies have historically had among the highest returns to fixed investment, while Latin American ones have had the lowest (see chart 7). In fact, in the pre-pandemic decade, the median Latin American economy would have had to invest twice the amount than the median in EM Asia to get the same GDP growth outcome.

Several factors explain variations in fixed investment efficiency, such as institutional and regulatory frameworks, macroeconomic stability, adequate infrastructure, and human capital.

Chart 7

Long-Term Growth And Sovereign Ratings

A country's long-term growth performance is important to the sovereign ratings. Our methodology for rating sovereigns is based on an assessment of the following factors: institutional, economic, external, fiscal (including debt), and monetary. Each of the five factors is assessed on a scale from '1' (the strongest) to '3' or '4' (neutral) to '6' (the weakest).

Our economic assessment is anchored by a sovereign's level of per capita GDP. We then compare long-term GDP growth performance with that of peers at a similar level of development. If growth is, in our view, materially below or above the peer average, we can adjust the economic assessment, which has an impact on the rating.

We apply this growth adjustment to one-third of the 137 sovereigns that we currently rate, with about 20% of them with below-average growth and 14% with above-average growth (see chart 8).

The prevalence of an analytical adjustment for GDP growth varies from region to region. Asia-Pacific has the highest share of sovereigns with a positive adjustment to our economic assessment, at 43% of the 21 rated sovereigns in the region. The Latin American and Caribbean region has the highest share of sovereigns with a negative adjustment for poor economic growth--at 45% of the 29 rated sovereigns.

Chart 8

GDP growth also has an indirect impact on other rating factors. For example, poor GDP growth may dampen income and limit job creation, thus creating potential social problems that could spill over into political tensions. That, in turn, could affect our institutional assessment of a sovereign.

Good long-term economic growth may support the development of domestic capital markets and reduce dependence on foreign savings, thereby facilitating better debt management and containing external vulnerabilities (potentially affecting our debt and external assessments). A stronger and deeper financial system could also increase the effectiveness of a central bank's monetary policy by extending the reach of its transmission mechanism toward a larger segment of the economy.

As personal incomes rise with economic growth, more people save more money through the financial system, in banks and in other investments in financial markets. That, in turn, creates a growing pool of financial savings that's available for both the government and the private sector to meet their own funding needs.

To the extent that the government and the private sector rely more on domestic funding in the local currency, they reduce their dependence on foreign funding (typically in foreign currency). As a result, they can curtail the potential currency mismatches between their revenues and their debt.

Moreover, the growth of domestic capital markets makes it easier to create a long-term bond market based on fixed interest rates, thus reducing interest rate risk for borrowers. Stronger domestic capital markets based on a high rate of domestic savings help mitigate both the interest rate and currency risk of sovereign debt. Reduced vulnerability to sudden shocks can be a positive rating factor.

Finally, long-term economic growth can indirectly affect public finances and a sovereign's fiscal assessment. For example, good and sustainable economic growth can boost tax revenues and the government's fiscal balance, thereby affecting the sovereign's debt burden. Conversely, sovereigns with poor economic growth face a more difficult policy trade-off between running large fiscal deficits (due to weak revenues) or pursuing spending austerity to stabilize public finances.