Why do emerging markets grow faster than developed markets, and when does this "catch-up" growth slow? What does this mean for CME?

The catch-up growth phenomenon is one of the most empirically robust patterns in development economics, and understanding it is essential for emerging market CME.

The Catch-Up Mechanism:

Why Catch-Up Growth Is Possible:

1. Capital deepening has high returns: Countries starting with low capital per worker can make large productivity gains by adding capital. The same investment that adds marginal value in the US may dramatically boost output in Vietnam or Indonesia.

1. Technology diffusion is easier than innovation: Adopting existing technologies (mobile phones, containerized shipping, modern factory design) is far cheaper and faster than inventing new ones. Emerging markets can leapfrog intermediate technology stages.

1. Labor reallocation: Moving workers from low-productivity agriculture to higher-productivity manufacturing and services produces large GDP gains. China's urbanization is a classic example.

1. Institutional improvements: Establishing property rights, rule of law, and educational systems boosts productive capacity significantly.

The Slowdown Mechanism:

As a country develops, each of these catch-up advantages diminishes:

1. Diminishing returns to capital: Adding the 20th factory has lower returns than adding the 1st
2. Exhausted technology frontier: Once you've adopted existing best practices, further gains require actual innovation
3. Reallocation complete: Most of the productivity gains from urbanization have been captured
4. Institutional completion: Further institutional improvements have smaller marginal effects

This is often called the "middle-income trap" — countries can reach middle-income status through catch-up but struggle to progress to high-income without developing their own innovation capacity.

Historical Examples:

Japan (1950-1990):

• 1950-1970: Real GDP growth ~9% (catch-up phase)
• 1970-1990: Real GDP growth ~4% (completion phase)
• 1990-2020: Real GDP growth ~1% (post-catch-up, demographic headwinds)

South Korea (1970-2010):

• 1970-1990: Real GDP growth ~9% (catch-up phase)
• 1990-2010: Real GDP growth ~5% (completion phase)
• 2010-2020: Real GDP growth ~3% (post-catch-up)

China (1990-2025):

• 1990-2010: Real GDP growth ~10% (intensive catch-up)
• 2010-2020: Real GDP growth ~7% (slowing catch-up)
• 2020-2025: Real GDP growth ~5% (transitioning to innovation phase)

The pattern is consistent: rapid initial growth followed by progressive slowdown as catch-up opportunities are exhausted.

Implications for CME:

1. Higher long-run equity returns in early-stage emerging markets: If rapid growth has not been priced in, investors can earn premium returns during the catch-up phase.

2. But growth must be unpriced to generate returns: If markets already expect the catch-up, expected returns are no higher than developed markets. Many emerging markets have disappointed investors because strong GDP growth did not translate to strong equity returns — growth was already priced.

3. Timing the slowdown: Catch-up slowdowns can be predicted roughly from development stage indicators (GDP per capita relative to frontier, urbanization rate, productivity gap).

4. Distinguish different EM phases:

• Early-stage EM (Bangladesh, Vietnam, Nigeria): Maximum catch-up potential, highest risk
• Mid-stage EM (Indonesia, Mexico, Turkey): Substantial catch-up remaining
• Advanced EM (China, Poland, Chile): Approaching completion, growth slowing
• Post-catch-up (Korea, Taiwan, Singapore): Now essentially developed

Example — Meridian Emerging Markets Fund:

Meridian's analyst builds CMEs for three EM allocations:

Vietnam (early-stage): Forecasts real GDP trend of 6% for next 10 years, but expects this to slow to 4% in the following decade as catch-up progresses.

Indonesia (mid-stage): Forecasts real GDP trend of 4.5% for next 10 years, slowing to 3.5% in the following decade.

Poland (advanced): Forecasts real GDP trend of 2.5% for next 10 years, with minimal further slowdown expected as the economy has nearly converged with EU peers.

Each of these trend growth estimates then feeds into equity and bond CME estimates, producing differentiated expected returns across the three markets.

Key Warning:

The catch-up pattern is not guaranteed. Countries can fail to catch up due to:

• Weak institutions
• Political instability
• Conflict
• Resource curse dynamics
• Policy mistakes

Argentina is a famous example of a country that appeared poised for catch-up in the early 20th century but failed to sustain it, actually regressing relative to peers.

Practice emerging market analysis in our CFA Level III question bank.