The riddle of middle-income countries

While Asia continues to set its pace as the world's fastest growing region, some Asian middle-income countries (MICs) are showing signs of economic slowdown and face stiff competition from lower-cost economies. The implications of this growth slowdown in MICs are of serious concern to economists and political decision-makers.
The threat of the 'middle-income trap' looms over policymakers from Malaysia to Mexico. It haunts countries that have escaped poverty but still await prosperity, threatening to turn their aspirations into disappointments, and their economic miracles into a mirage. Whether China, an epic example of convergence, will succumb to the trap is "the question on everyone's mind", say Barry Eichengreen of the University of California, Berkeley, et al. in a paper published in January, 2013.
The phenomenon of the middle-income trap is problematic because it has not been defined and has not been studied theoretically. The idea of a 'trap' implies that economies are stuck. Although it has no formal definition, the 'trap' is characterised by the inability of the middle-income countries to advance to high-income status. In contrast, low-income economies are said to be able to easily move up to middle-income status, and the high-income countries are likely to sustain prosperity. It is feared that mislabelling a slowdown as evidence of the middle-income trap leads policymakers to solve the wrong problem, perhaps prompting them to try building an information economy before a needed industrial or agricultural infrastructure is in place, or, digging in to protect established industries and cronies to the detriment of new businesses and sectors.
There is, however, a consistent narrative that underscores the idea of a middle-income trap and it goes something like this: Low-income country begins by development through low-wage manufacturing. Growth is driven by a shift in labour resources from low-productivity agriculture to higher-productivity manufacturing. Investment in the accumulation of capital relative to labour drives productivity improvements, both absolutely and relative to agriculture and mining. Rapid growth comes from both an increase in productivity and an increase in the quantity and quality of factors of production - investment in fixed and human capital; improvements in healthcare and diet, cuts in mortality rates and increases in population levels. At some stage, diminishing returns set in for capital, while population growth slows to a maintenance level. Since growth is now dependent solely on total factor productivity rather than increases in the factors  of production themselves, countries that lack the capability to improve productivity find growth potential limited by this constraint and remain stuck as middle-income countries. It means rapid factor accumulation plus higher productivity from the shift to manufacturing drive the initial growth phase out of low-income status. As economies mature, factor accumulation slows; and productivity gains become harder to achieve, 'trapping' countries which cannot make the transition to higher value-added manufacturing.
The first and very obvious shortcoming here is that this narrative essentially recognises only one path to development - that of industrialisation. But looking at the milieu of high-income economies today, it's obvious that there's more than one way. Of the East Asian economies to make the full transition to industrialisation, Korea and Japan have followed that road. Taiwan is more of a mixed economy, and Hong Kong and Singapore have thrived on services.
If we look at development policies, again there is considerable heterogeneity. Japan and Korea followed an almost socialist-style industrial policy, with Hong Kong's laissez faire economy diametrically opposite. Singapore's policies fall somewhere in between with an emphasis on pragmatism, and you could say that Taiwan's policy with respect to development to be one of benign neglect. Yet all these economies managed to make the leap to a high-income status. This suggests that it is the individual structure of the economies in question that matters - and it means that there's no single 'answer'. Malaysia's economy is pretty diverse. While export oriented manufacturing carried the initial brunt of development - from the 1980s onwards - it has continued to maintain a sizeable primary sector; and it now has a burgeoning services sector.
But how do we ensure that the gains in income will be shared equitably? That's the biggest worry --- the distributional issue between labour and capital. One way would be to impose capital gain taxes, but that would reduce business investment. Another option is to strengthen labour laws, but that introduces rigidities to the labour market. The third possibility is profit-sharing remuneration schemes, but it is difficult to figure out how to do this in the context of small and medium enterprises (SMEs) and non-listed companies. The fourth way is make everyone a capitalist - savings channelled into higher-yield securities rather than low-paying bank deposits - which has some promise as equity participation is still low. But this would not overcome the problem of initial endowments - rich get richer etc. - and inequality. Probably it will be needed to look at a combination of these measures.
Other things being equal, a middle-income country should grow faster than a rich country, since there is more opportunity to learn from the forerunner and catch up with it. This means that a middle-income country should close its gap relative to a rich country, unless its economy is really in a bad shape. But the real question is how fast the gap is closing. If the growth rate is only slightly higher than the rich world average, it could take literally decades for a country to graduate to the high-income status. Simply calling a country to be not in a middle-income trap because it eventually will get out of it - but perhaps after decades - does not seem to be a good idea.
Economic backwardness has its advantages. Late-comers to industrialisation can follow the path their forerunners broke before them and perhaps skip some steps along the way. As a result, poor countries can narrow the gap with the rich ones. But this happy principle of economic convergence does not always hold sway. Some poor countries fail to get going. Others make quick progress, and then lose their way. The first lot is sometimes described as victims of a 'poverty trap'. The second one is increasingly described as casualties of a 'middle-income trap'.
But is the 'middle-income trap' worthy of the name? Is there something especially treacherous about the levels of development that China is now approaching? Despite the term's popularity, the theory and evidence behind it are surprisingly thin. First, the theory: Rich countries boast the best technologies; poor countries the lowest wages. Middle-income countries have neither. Intuition suggests they must struggle to compete with countries above and below them. Poor countries also benefit from moving workers out of overmanned farms and into factories, where they are many times more productive. But a decade or two of fast growth will empty the fields of surplus workers, obliging countries to raise productivity within their factories if they are to make further progress. Their economies would seem to face a tricky jump from one growth model to another.
But intuition can mislead. Both pay and productivity exist along a continuum. Countries can remain 'competitive' at any level of wages and productivity, provided one stays in line with the other. The evolution from one growth model to another is also continuous. Factories do not wait until the last underemployed labourer has left the farm to begin improving the productivity of the workers who have already arrived. Moreover, as the urban workforce grows in size, a steady flow of new arrivals from the villages makes a smaller proportionate impact. China is a good example. Many worry that it has now exhausted its surplus labour and will slow sharply. But according to Louis Kuijs of the Royal Bank of Scotland, the movement of workers between agriculture, industry and services contributed only 1.4 percentage points of China's annual growth from 1995 to 2012.
So much for the theory, what about the evidence? The middle-income trap is rarely defined clearly enough to be tested. Some of its proponents argue that middle-income countries typically grow more slowly than richer and poorer economies. That is claptrap. If anything, they grow faster. Penn World Tables, which compare incomes across countries and over the time from 1950 to 2010 show economies with an income per head of $13,000-$14,000 (at purchasing-power parity) achieved per-person growth of almost 2.9 per cent over the next ten years on average. That is faster than the average for any other income level.
The key issue is not so much the 'trap' but whether the economy can be restructured to a more competitive model - raising competency and contestability. For the 'middle-income trap', the fact remains that the definition of 'middle income' comes from the World Bank, so for preciseness of the terminology, the trap should still refer to how slowly a country graduates to the next income group, as defined by World Bank, rather than its performance in relative terms.
The writer is a retired Professor
of Economics, BCS General
Education Cadre. Email:
[email protected]