World Data Lab

The following guest blog post is an adaptation of the author's Bachelor's thesis from the University of the West of England. For the complete thesis, please contact the author, Harry Woods. The author's opinions and insights are his own and do not represent the views of World Data Lab.

Water as a vital determinant of economic growth

The domination of neoclassical economics has solidified the use of a production function involving only inputs of labour, capital and technology when determining output. A more fruitful theory is the ecological production function, which considers the laws of thermodynamics. This approach suggests that the economy is an open system constrained by its finite resources. Energy and natural resources (flows) are manipulated by labour, capital and technology (funds), thus creating output and waste. I explore the relationship between finite resources, specifically water stress, and economic growth. Although most policy makers prioritise steady GDP growth, less focus is placed on sustainable growth, as policy makers, governments, firms and consumers assume that the supply of natural resources such as water is endless.

The European Environment Agency states that ‘water stress occurs when the demand for water exceeds the available amount during a certain period or when poor quality restricts use’. One-third of the largest groundwater systems are already in distress. Furthermore, by 2025, the number of individuals living in absolute water stress will rise to 1.8 billion, while two-thirds of the world’s population could be under water-stress conditions. It is clear that the lack of such a vital resource will have significant economic impacts. In my analysis, I study the channels through which water stress affects economic growth (Figure 1) and highlight whether the relationship is significant, and, if so, what policies can prevent such negative impacts.

The BRICs (Brazil, Russia, India, China and South Africa) were selected for analysis because they have a large percentage of water withdrawals and are projected to experience rapid future economic growth. I have chosen a recent period (1990-2018) because indicators for water stress have only been repeatedly recorded for a short period.

Water stress: A drag on growth

Interestingly, I found that an increase in water stress by 1 percentage point leads to the reduction in GDP per capita growth by 0.52 percentage points Ceteris Paribus. This result is significant at the 5% level. Although the magnitude of the coefficient is not substantial, it supports existing research which finds that water stress reduces economic growth by half a percentage point. Results for other variables included in the model can be seen in the complete research paper.

The road to sustainable growth

By studying the impact of climate change, countries can adapt and create policies that would help to maintain sustainable economic growth. This research places a particular focus on the impact of water stress on GDP per capita growth rates in the BRICs economies. Since this group of countries is expected to experience high future growth rates and increased water stress, this study helps to identify the relationship between the two phenomena. It highlights that water stress may dampen per capita growth rates in developing countries such as the BRICs.

The descriptive statistics suggest water stress in BRICs countries varied greatly throughout the 28 years. Although climate change is a concern, economic growth for all countries remains the top priority. Therefore, to ensure future growth, countries must adapt in order to manage water variability.

There are numerous policies that aim to achieve water stability; however, policy outcomes differ owing to the different definitions of water throughout the hydrological cycle (Damania, 2020). For instance, water at its source is a public good. However, for water to become a useful resource, it must pass through pipes, canals and reservoirs. As a result, water becomes a private good. At the same time, the United Nations defines water as a merit good, whereby it is a human right to have sufficient water at affordable prices. Conflicting objectives mean single policies often fail when trying to manage water effectively (Damania, 2020). A combination of policies is required to ensure future water stress doesn’t lead to efficiency losses highlighted in Figure 1.

Country-wide educational policies are simple but effective in changing behaviour from individuals through to the supply chains of major corporations. At the same time, countries must simultaneously address the issues of unsustainable agricultural and manufacturing processes. Investment in new technology is vital to develop the conservation and recycling of water. Furthermore, strong governance is needed to enable the efficient allocation of water resources throughout the population. Governments may set social minima which ensure agricultural and manufacturing businesses operate within sustainable standards and offer incentives for corporations that invest in water-efficient processes. The combination of these policies will aid the reduction of water stress within the BRICs nations but they require strong governments that are committed to country-wide investment and that uphold any regulations they set.

Most research ignores the influence of climate change when constructing growth models. The models that do, often focus on temporal changes and disregard water as a key factor of economic sustainability. Simply adding water stress as a determinant of GDP per capita growth provides a modern approach to growth models, thereby adding to an area of research that is fairly untouched. Furthermore, this study introduces water stress as the percentage of people with average water availability below 1700 m³. By using data from World Data Lab’s Water Scarcity Clock, a water-stress variable was constructed, so the direct effect of water stress on per capita growth rates could be analysed. Moreover, the use of data between 1990 and 2018 provides an up-to-date perspective on the contemporary relationship between water stress and economic growth. This research pinpoints the effects of water stress specifically on the BRICs growth rates and therefore provides evidence for the countries that are expected to experience dramatic changes in water stress.

To summarise, results highlight that, without the backing of multiple water-management policies, water stress would hinder economic growth. Although this effect may seem small in size, the exponential rise of climate change will almost certainly increase the magnitude of this relationship. The BRICs countries must combat the root causes of water stress in order to remain the future engine of the world economy.

Data and Models

Data for GDP per capita growth, Population Growth, Foreign Direct Investment (FDI) Inflows, Life Expectancy and Domestic Investment were collected from were collected from The World Bank’s ‘World Development Indicators’ database. In addition, data for calculating the Institutional Quality Index were collected from The World Bank’s World Governance Indicators database.

There are many theoretical and empirical models that examine the countless determinants of economic growth. All growth models share the aim of explaining causes of economic growth, yet they differ in the explanatory variables used owing to differences in the researchers’ preferences. It is therefore vital to ensure that variables included in this study’s model are particular to developing countries.

Both panel models are presented below:

Descriptive Statistics

Results from the descriptive statistics indicate that economic growth rates per head were very unstable. Although BRICs economies had an annual average growth rate of 3.14%, the coefficient of variation was 1.51 and growth ranged from a minimum of -14.6% and a maximum of 13.6%, which highlights a characteristic of most developing nations: unstable economic growth.

In the context of water stress, on average a third of the population in BRICs countries experienced water stress in the time period. Furthermore, over half of South Africa’s population experienced water stress, reaching a maximum of 56.7% in 2019. This highlights the extent to which individuals are exposed to water stress on a daily basis.

Substantial gains in both LE and human capital were achieved between 1990 and 2018. Average LE at birth increased from 53 to 76 years over this period. Average years of schooling rose substantially from a minimum of 2.96 years to a maximum of 12 years.

Based on a scale of -2.5 to 2.5, the average quality of institutions was -0.23, which suggests that the quality of institutions remained poor over time. However, the coefficient of variation of -1.59 implies that institutional quality varied greatly throughout the period. Finally, population growth, FDI inflows and domestic investment remained fairly stable over the period.

Harry Woods is an Economics BSc student graduating with a 1st class degree. He is interested in graduate opportunities within the sustainability, data, policy and finance sector. If you would like to read the complete dissertation, please contact him via email or LinkedIn.