Structural change, productive development, and capital flows: does financial “bonanza” cause premature deindustrialization?

Abstract

Abstract Recent contributions to the literature on industrialization and development have confirmed that manufacturing continues to play a key role as a driver of economic development. As a corollary, these contributions highlight the importance of premature industrialization as a barrier to economic development and as one of the main sources of the middle-income trap. In this paper, we analyze the factors that may have hindered industrial development in the past four decades. In particular, we focus on the role of (non-Foreign Direct Investment) net capital inflows as a potential source of premature deindustrialization. We consider a sample of 36 developed and developing countries from 1980 to 2017, with major emphasis on the case of emerging and developing economies (EDEs) in the context of increasing financial integration. We show that periods of abundant capital inflows may have caused a significant contraction of manufacturing share to employment and GDP, as well as the decrease of the economic complexity index. We also show that the phenomena of “perverse” structural changes are significantly more relevant in EDE countries than in advanced ones and that they may similarly occur across EDE countries, regardless of structural differences in the way manufacturing contributed to their development. Based on such evidence, we conclude with some policy suggestions highlighting capital controls and external macroprudential measures taming international capital mobility as useful policy tools for promoting long-run productive development on top of strengthening (short-term) financial and macroeconomic stability.