Making sense of economic diversification

In recent months, Nigerians have seen and heard expressions of both pain and hope on the need to diversify the country’s economy. On close examination however, it appears clear that the general understanding of the supposedly mono-product economy is somewhat fuzzy. Apparent solutions being suggested further magnify our weak understanding of what the real issues are.

To offer some clarity, it is important to note that economic diversification can be evaluated and pursued along three main dimensions: national output, government revenues, and exports.

Output diversification describes how productive activities within a country are distributed among various sectors. A largely agrarian economy may be as ‘non-diversified’ as a mineral resource rich economy. Both will depend on about the same type of economic activity (extraction) and both will be subject to swings in global commodity prices. To the extent that a significant number of Nigerians are employed outside any one major sector, with the exception of agriculture, it is safe to say that from an output perspective, the Nigerian economy is diversified. However, further diversification is possible and need to be pursued as a matter of deliberate policy.

Next is diversification of government revenues. It is possible that due to the fiscal regimes that govern the exploitation of valuable mineral resources, revenue that accrues to a government becomes concentrated in the production of a few commodities. Such concentration gets more pronounced as commodity prices rise. It presents even more serious dangers when the prices of such commodities are determined outside the domestic economy. We refer to such risks as external shocks.

An economy with a robust productive base, with significant activity across sectors and in which the government implements a broad-based tax strategy with efficient tax assessment and collection systems is, in combination, the surest way to address the lack of diversification of government revenues. A strong productive base and high employment levels tend to reduce the dependence of governments on commodity-price related revenues.

A third dimension of diversification has to do with the export base. This can be pursued along two dimensions: product diversity and process complexity. Again, it is possible for a country’s exports to be ‘well diversified’ across various products such as hydrocarbon resources (i.e. crude oil, gas and coal), agricultural produce and solid minerals and yet the country lacks any significant complexity in processing or transformation of these base resources into finished goods. The export base of such a country can still rightly be considered diversified. A consequence of such diversification however is the constant exposure of the export base to external shocks.

One unintended consequence of a diversified but low-complexity economy is that dependence on importation of finished goods and intermediate inputs will remain very high. This puts the exchange rate under constant pressure. In a related measure, if such a country has a large and growing population, import demand will need to grow steadily to cater for local consumption. However, the combined growth in the volumes and prices of export commodities may become insufficient to cope with the rapidly expanding import bill.

In modern economies, the vital need of most emerging market countries is to upgrade their export base to include increasing proportions of higher-skill manufacturing and high-technology industries. Malaysia, for example increased the share of manufacturing in its GDP from 6% in the early 1970s to over 70% by 2014. This was achieved through a focus on certain target industries including high-tech electronics.

Costa Rica, in 1994, made a deliberate policy decision to upgrade its export base toward high-skilled modern technology sectors. With a medium to long-term strategy, concrete incentives, and the right operating environment, the Latin American country of only 3.5 million people became the place to be for a number of global leaders in technology. By 2008, Intel, the global leader in computer chips announced plans to set up a semi-conductor plant in the country. Within a few years, Microsoft, Cisco and some smaller technology firms followed suit. At various times, Intel accounted for between 5 and 10% of Costa Rica’s GDP and a larger fraction of its export base. While the initial chip-making plant was closed a few years ago, Intel and other technology firms continue to maintain significant operational presence in Costa Rica.

The cases of Malaysia and Costa Rica demonstrate that a shift towards agriculture and solid minerals is necessary but grossly insufficient to reposition our economy and firmly stabilize our currency. Unless such shift is combined with transformation or processing of those outputs, Nigeria will continue to produce low-value items that earn limited foreign exchange. On the other hand, less resource-endowed countries that process such inputs into finished goods will be the real gainers in a world where knowledge and its effective application in industry is an increasingly vital source of competitive advantage.

As it is, from an export perspective, Nigeria is a Quadrant 1 economy (marked by low-diversification and low complexity). A mere export diversification strategy, even if successful will only move the country to a Quadrant 2 economy (marked by high diversification and low complexity). With the nation’s diversified natural resource-base, large population, and broad demographics, a move to Quadrant 3 (low diversification, high complexity) will also be sub-optimal. Such a strategy may create rapid growth without shared prosperity.

Hence, the most optimal path to true economic development will be a guided diagonal flight towards a Quadrant 4 economy (which is marked by high diversification and high complexity). A move to Quadrant 4 will have important implications (benefits and burdens) for the country’s economy. It will help stabilize our foreign exchange situation, raise employment levels, improve income generation, and reduce poverty levels and economic inequality. A well diversified economy with sizable quantum of complex production will export more output, especially of higher value products. It will also import less of finished goods. Such an economy will create larger opportunities for both semi-skilled and higher skilled jobs in different sectors.

Important burdens of a quadrant 4 economy include increased pressure on the country’s educational system to fit the needs of a truly emerging economy. Also the pressure on infrastructure and social amenities would be immense. Making the transition will also imply the need to strengthen vital agencies of government to attract, promote and retain critical investment in target sectors. Very importantly, political leaders at all levels will also have to learn to see beyond the question of ‘what’s in it for me?’ which is a factor that impedes the flow of investments into, and the ease of doing business in the country.

With significant diversification and upgrade of Nigeria’s export base, diversification of government revenues would be largely addressed, and diversification of economic output and employment within the country’s boundaries would be greatly enhanced.

David Adeoye

David Adeoye is a financial analyst and certified Energy Risk Professional (ERP). He leads the financial advisory services team at MBC Financial Services based in Lagos.