Economic Diversification in Africa: How and Why It Matters

For decades, economic diversification has been a policy priority for low- and middle-income economies. In the words of former managing director of the International Monetary Fund (IMF), Christine Lagarde, “We know that economic diversification is good for growth. Diversification is also tremendously important for resilience.” Unfortunately, this goal continues to elude many African countries. In fact, the continent is home to eight of the world’s fifteen least economically diversified countries. This reality weakens the foundation of their economic transfomation and slows their pace of progress. It also makes these countries particularly vulnerable to sudden external shocks, as the pandemic-induced disruption of tourism and oil-dependent economies has illustrated. Given the importance of diversifying African economies, it is critical to recognize how various dimensions of diversification can have different implications for the menu of policy options. Closely associated with the process of structural transformation from lower to higher productivity sectors, economic diversification has three evident dimensions. The first relates to the expansion of economic sectors that contribute to employment and production or gross domestic product (GDP) diversification, and the second is associated with international trade or exports diversification. This paper, however, focuses on a third dimension that the economics literature pays scant attention to: fiscal diversification. This fiscal element involves expanding government revenue sources and public expenditure targets and can therefore play a central role in helping to catalyze broader economic transformation through the expansion of activity in specific industries and sectors. It is also critical that policymakers effectively measure the extent to which this objective is being achieved. Both the expansion of existing economic sectors and the creation of new ones may diversify an economy. But these processes are vastly different in practice and will garner distinct outcomes. Of the main tools used by economists to measure diversification, the Theil Index differentiates between the respective contributions of new economic sectors and existing ones to overall diversification. Another tool widely used by development practitioners—the Public Expenditure and Financial Accountability (PEFA) framework—has significant potential for evaluating fiscal diversification but would need to capture more information on government revenue collection and spending and link them to policy objectives. Yet not all dimensions and measurements of economic diversification are equally applicable for all African countries. Important structural differences—many of which are on full display in Africa—have implications for how these countries pursue the policy objective of economic diversification. In the economics literature, national income correlates closely with economic diversification: low-income countries are generally undiversified but diversify as they transition to middle income. Another central factor is natural resource dependence: resource-rich countries tend to be less diversified than their counterparts. The quality of governance is also a factor but unlike its link with economic growth, its exact link with economic diversification remains underexplored and inconclusive in the literature. Beyond the relationship between national-level structural characteristics and economic diversification, it is important to account for subnational differences within countries, which can sometimes be stark. Interregional inequality is especially pronounced among Africa’s eastern and western coastal countries, where more diversified islands and productive coastal areas contrast with huge swaths of inland areas used mainly for subsistence farming. Within other African countries, economically diverse and productive areas, or growth poles, are clustered around the national capital, while the hinterlands predominantly engage in subsistence agriculture. Therefore, African countries’ challenges of economic diversification may be more acute at the subnational level and necessitate different policy responses. This spatial and subnational dimension of economic diversification merits further research. Overall, the policy strategies for diversifying any economy depend on identifying—with the country’s structural characteristics in mind—the specific dimension of economic diversification desired.