To transition to a more mature and sustained growth path and to stay competitive, Asean countries would need to deepen labour, capital and product market reforms.

By some measures, the goal of Asean nations to forge a single market and production base that stitches together 10 countries into a coherent, integrated whole of sizeable scale has had a good headstart. Many more multinational companies now have a regional approach to strategy in Asean, even as they await the formal creation of the Asean Economic Community (AEC) by the end of 2015.

Asean's recent performance has been impressive. The region has grown 5.5 per cent annually since the 2008 global financial crisis and drawn in significant foreign direct investment (FDI) and portfolio flows. In 2013, FDI inflows reached a peak of US$125 billion, 9 per cent of the global total.

While Asean's 10 countries and 625 million people are at different stages of development, millions have already joined the middle class, who are now driving consumption and investment. The region is fast becoming a major economic force in Asia and a driver of global growth.

This dramatic economic progress has come about through steady macroeconomic management, economic reform and liberalisation, along with investment, innovation and favourable demography. The Organisation for Economic Co-operation and Development projects Asean to continue growing at 5.5 per cent into 2018. Yet these high growth rates cannot be taken for granted. While necessary, prudent macroeconomic management, openness and improved governance do not provide sufficient conditions for sustained economic dynamism and growth. To keep up the growth momentum, Asean economies will need to invest in productivity growth.

 

Beyond Economic Catch-up

Productivity provides a simple but powerful indicator of the ability of a country, sector or company to optimally use its resources to drive growth. Labour productivity measures output per employed worker or number of hours worked. In the medium term, it is productivity growth that is the most important driver of prosperity.

Among advanced economies, slow labour productivity growth has been leading to a downward spiral of lower output, investment and wages. This may be a result of capital productivity growth outpacing that of labour productivity, leading to more automation and suppressed wage growth. According to new data released by The Conference Board, a think tank, average labour productivity growth in mature economies slowed to 0.6 per cent last year, down from 0.8 per cent in 2013.

For now, Asean is plugging in one of the highest labour productivity growth rates in the world. The Asean average in 2014 was 4.3 per cent, led by Myanmar (6.1 per cent), Indonesia (5.9 per cent) and the Philippines (5.6 per cent). Still, the strong numbers are largely a result of catch-up growth. Asean economies have had plenty of scope to quickly grow by adopting the technologies, processes and strategies developed and deployed by the advanced economies.

To transition to a more mature and sustained growth path, however, Asean countries would need to deepen reform in labour, capital and product markets if growth and competitiveness are to continue.

What would drive productivity growth for Asean? It will come about through raising worker productivity and by closing gaps in technology, infrastructure, education and financing. These, in turn, require a range of reforms, including encouraging structural transformation, raising literacy rates, removing barriers to trade and investment, and scaling up infrastructure investment.

These reforms are ongoing in Asean. Beyond macroeconomic fundamentals, what else will drive productivity growth'

 

Structural Transformation

First, structural change. Economists have observed that in emerging economies, productivity levels vary significantly across different economic activities. These productivity levels tend to converge within economies over the course of economic development. Such heterogeneity means that not all firms or industries are equally behind the global technology frontier.

Those that are a part of global production networks, for instance, are usually better placed to absorb ideas and blueprints, and reap productivity gains. There is economic evidence to suggest that once a country starts to export something, it moves up the value chain in that product, regardless of domestic policies or institutions. In other words, such industries experience automatic convergence with the global productivity frontier.

For Asean economies, this means sustained growth requires more than just conventional macroeconomic and openness policies. It requires policies that foster economic diversification and structural change from low-productivity activities (such as agriculture and informal sectors) to tradable higher productivity activities. It requires pulling the economy's resources into those sectors that almost guarantee productivity gains, what the Harvard economist Dani Rodrik calls the automatic "escalator up".

Strikingly, data suggests that once an economy starts producing electric generators, or motor vehicles, labour productivity in that industry is placed on an automatic upward trajectory. The trick is to gain a foothold into these automatic-productivity industries and to expand domestic employment in them. Economies that grow rapidly are those that are able to push their resources into the escalator sectors. Those that grow in a sustained manner are those that can achieve this on an ongoing basis.

Export-driven manufacturing has provided Asean economies with the archetypal escalator industries, given its scope for technology transfer and ability to absorb surplus rural labour. But it is worthwhile to note that productivity growth is not uniform across manufacturing industries. It is fastest in machinery and equipment, and slowest in textiles. Even within manufacturing, some of the escalators move faster than others.

 

Integrate, and Reap

Free trade and economic integration hold the second key to productivity growth. While Asean trade is largely tariff-free, non-tariff barriers remain sticky, particularly affecting services, and presenting obstacles to investment.

Intra-regional trade in Asean should intensify with further integration and the launch of the AEC. Closer economic integration within Asean provides three mutually reinforcing benefits. One, it strengthens the region's overall productivity. A more integrated Asean would allow companies to draw on the varied competitive advantages across the region, thereby raising the value proposition it is able to offer global firms. Collectively, Asean would be able to offer a more compelling portfolio of options for companies to restructure and compete.

Two, sectoral cooperation across national boundaries will allow weaker economies to learn and absorb technology from more advanced member states, thus raising the region's human and capital stock. The regional integration efforts that succeeded in anchoring the automotive sector in Asean is a case in point.

Three, a more integrated Asean would be better able to cope with change. For all its potential, Asean's growth will still depend on developments in the global economy. Significant global risks remain, particularly volatile financial markets and pressures that could arise from large movements among key currencies.

Cooperating at the regional level has helped Asean countries to defend against these risks and create a financial safety net, including the renewal of bilateral swap agreements, doubling the resources of the Chiang Mai Initiative Multilateralisation, and strengthening the Asean+3 Macroeconomic Research Office.

An Asean with more of such trade, industrial and financial links will prove more resilient to risks and change. Equally, a more integrated Asean whose fruits of growth are more evenly shared across its populace would be able to better respond to and drive change.

 

Spurring Innovation

Encouraging homegrown innovation is the third element important in accelerating convergence. Innovation requires talent, funding and a risk-taking appetite. No less important are protection of intellectual property rights and a level playing field.

Given Asean's relatively strong growth and increasingly sophisticated exports, it is surprising to find the region's total factor productivity growth falling starkly behind South Korea and Taiwan's. This may partly reflect the wide scope for improvement in which inputs such as technology and innovation are used in Asean countries. Closing infrastructure gaps is the fourth factor that will drive productivity growth. Asean needs to raise US$1 trillion by 2020 to meet its infrastructure needs, according to the Asian Development Bank. If kept productive, infrastructure investment can raise potential output and be self-financing. Most countries in Asean have the fiscal scope to step up infrastructure investment.

In two generations, Asean has moved from poverty to prosperity. By pursuing sound macro-prudential policies, economic reform and liberalisation, innovation and investment, the region has made huge strides, and may yet provide a model of development for other emerging regions.

The next stage is for Asean to sustain its growth dynamism through productivity growth. It is on a steady course to realise that goal if the drivers outlined above are pursued consistently.

The article is contributed by Tham Sai Choy , Chairman of KPMG's Asia Pacific region and Managing Partner at KPMG in Singapore. The views expressed are his own.