Emerging Economies

FAYETTEVILLE, Ark. — An unprecedented number of emerging countries are struggling to make the transition to market economies. University of Arkansas researcher Raja Kali has determined a pattern of development in these economies, whether the country is in Asia, Latin America or Eastern Europe. His model will appear in the next issue of the journal Economics of Transition.

"Examination of any emerging nations during the past century shows distinct similarities in the growth process," said Kali, assistant professor of economics in the Walton College of Business. "This model will shed some light on the growth processes in emerging and transition economies and, perhaps, facilitate the transition process."

Kali found that the early stages of economic development are marked by kinship and relationship. This relational contracting usually occurs when formal institutions and laws regulating contracts are weak or non-existent. People choose to do business with others to whom they have some tie, whether it is geographic, ethnic or personal.

"Co-incident with the widespread use of relational contracts, the industrial landscape of emerging economies is dominated by large, diversified organizations — often referred to as business groups," Kali explained.

Diversified business groups are similar in different countries. Often emerging from a family business, they have financial interlinkages, trade ties and personnel exchanges. Although they cover diverse industries, they usually are not integrated like a conglomerate, but they are not independent subsidiaries, either. For example, India’s House of Tata includes firms in industries such as steel, watches, trucks, tea and computer software and Chile’s Grupo Luksic has interests in banks, hotels, mining, beer and pasta.

These groups arise when the legal, financial and educational infrastructure of a country does not support the efficient function of a market economy. If a country has a corrupt, slow or unreliable legal system that does not support or enforce contracts, diversified business groups make doing business safer. They can also be a solution to labor market problems. For example, in India and Argentina, where laws make it difficult to fire people, workers can be moved around between group members as company needs dictate.

Business groups can also develop their own distribution channels, thus overcoming the inadequate communications infrastructure often found in developing countries. And they may compensate for weaknesses in financial institutions, serving as venture capitalists to fund potentially risky projects that banks and other financial institutions cannot support.

However, diversified business groups also present problems for emerging economies. Because they are inherently rigid, they do not adjust easily to changes in the economic environment. And because the can operate as monopolies, they can have a negative effect on other companies seeking to enter a market.

"Firms are often hesitant to experiment with firms outside the network even when outside firms have more favorable offers," Kali explained. "Persisting with a high-priced supplier because of the trust that was developed can generate inefficiencies as new entrants have difficulty in competing. These rigidities may have serious macroeconomic implications and may explain some of the problems in emerging economies."

As emerging economies continue to develop, relational contracting gradually becomes arms-length contracting. At this stage, relational and arms-length contracts are complementary and business groups expand in size and strength. But eventually the emerging countries develop the soft infrastructure of legal, financial and education institutions that are an important prerequisite to establishing a market economy.

At this stage, as explicit contracting becomes more reliable the economy crosses a threshold. Business groups become less significant and shrink in size, scope and strength. According to Kali, this transition process is often accompanied by rapid growth, which then slows or stops altogether.

"Some of the most significant economics lessons of the past decade have been learned from the grand experiment of entire economies trying to move from a system with more government intervention to a more market-driven system," Kali said. "Economies don't function in a vacuum. While emerging countries may seem very different, they have some of the same problems and go through the same phases as their economies emerge."