Latin America’s missing middles

Once the world’s most prosperous emerging-market region, Latin America is in danger of being overtaken by its peers, owing to its sluggish and unevenly distributed growth. To break that pattern and make growth more dynamic and inclusive, Latin American economies must fill two “missing middles”: a lack of medium-size firms that can foster competition, and too few middle-class consumers whose spending could create much-needed demand. Harnessing the power of new digital technologies will be crucial to meeting both imperatives.

Despite reform initiatives and poverty reduction, the region’s economies are struggling. GDP growth in the region averaged just 2.8 percent per year between 2000 and 2016, well below the 4.8 percent average rate in 56 other emerging economies. Moreover, labor-force expansion accounted for 72 percent of Latin America’s growth over that period. As fertility rates fall, the region will need to increase productivity to compensate.

Although Latin America is home to some highly productive global companies, it lacks the backbone of midsize firms that drive innovation and competition—and create productive, well-paying jobs—in more vibrant economies. The region has fewer large- and medium-size firms (with more than $50 million in annual revenue) than Turkey, India, South Africa, and many high-performing Asian emerging-market economies; and those it does have are far less productive than its large businesses. Compounding the problem, many Latin American economies have a long tail of small, often informal companies that collectively employ millions, but that hold back growth because of their low productivity.

Because weak productivity keeps wages low, Latin America also has too few upwardly mobile consumers whose rising disposable income could help drive demand and investment on a sustainable basis. In addition, high indirect taxes further reduce people’s purchasing power by making consumer goods more expensive. In Brazil, for example, value-added tax represents 40 percent of the total tax burden, compared with an OECD average of 32 percent. And the region’s trade barriers keep local prices, including for food, above global levels; for example, cars in Brazil retail for more than double the price in the United States.

Worse, economically vulnerable groups have limited ability to borrow and save. Less than half of the population in Mexico and Colombia has access to a bank account, and the lack of consumer credit across the region significantly affects consumption patterns. As a result, the bottom 90 percent of Latin American households account for just 64 percent of domestic consumption—the lowest share of any region in the world. Today, more than 150 million people in Latin America (over 60 percent of them in Brazil, Colombia, and Mexico) live on $5-11 per day. They are thus unable to afford more than basic necessities and are at risk of falling back into poverty.

The dearth of middle-class consumers limits demand and growth opportunities for domestic businesses, which provide the majority of jobs in a modern economy. It also delays the development of more complex or differentiated goods and services, which are typically characterized by higher value added and productivity.

This equilibrium of weak productivity, low levels of innovation, and limited product differentiation explains Latin America’s sluggish investment and growth rates. Yet the region has the chance to revitalize its economies by using new digital technologies to raise productivity and develop the missing middles. For this to happen, though, firms and policymakers must keep three priorities in mind.

First, they need to create a competitive business environment in which digital technologies can thrive, innovation is rewarded, and opportunities are created for all. Digital tools can help midsize firms to narrow the productivity gap with larger companies, and develop products for the vulnerable classes by cutting fixed design and start-up costs.

Second, digital-based business models can raise employees’ productivity, skills, and wages, and integrate workers in remote communities with the rest of the economy. Such business models also offer new opportunities for young people to improve their skills and even compete for jobs with peers in advanced economies.

Third, governments can actively embrace digital platforms to become more efficient and provide better, cheaper public services. Public-sector institutions will need to adapt and shift their focus from protecting and regulating the status quo to cutting red tape, encouraging fresh investment, and experimenting with new methods of service delivery.

Such changes could provide a powerful boost to productivity and growth. If Latin America’s economies can fill in and strengthen their missing middles, GDP per capita in the region could increase by more than $1,000 per year, generating a $1 trillion incremental boost to GDP by 2030.

The good news is that digital technologies are already starting to restore Latin America’s economic luster. Digital entrepreneurship is on the rise, with new platforms and applications in e-commerce and digital finance emerging across the region. And several Latin American digital startups have already achieved valuations of over $1 billion, while creating new, more productive jobs. These include Mercado Libre, a digital marketplace based in Argentina with a valuation of more than $30 billion and more than 200 million users; São Paulo-based Nubank, which heads a cohort of financial technology companies in the region; and Rappi, a Colombian online delivery firm that now operates in countries from Argentina to Uruguay, and which recently added Japan’s SoftBank as a core investor.

Decades of weak growth in Latin America have left large parts of the population economically vulnerable. But by taking advantage of digital disruption, the region has a golden opportunity to nurture faster growth that benefits everyone.