Only a few middle-income countries have been able to graduate to high-income status, a phenomenon which has been labeled the “middle-income trap.” We discussed the data on economic convergence in a previous post (link) and now look at the possible explanations for the “middle-income trap.”
The literature on economic convergence and the “middle-income trap” is extensive, as this is a contentious debate in developmental economics. Most economists agree that many middle-income countries find themselves caught between low-wage poor countries that are competitive in mature industries and high-income rich countries that dominate the technologies that drive frontier industries. There is also agreement that for middle-income countries to continue to converge they need to improve institutions, governance and human capital. Moreover, it is widely accepted that savings-poor middle- income countries suffer from frequent economic slowdowns caused by unstable cross-border financial flows. Beyond this consensus, the debate broadly separates commentators into two camps with different policy recommendations:
- The institutionalists argue that countries are held back by weak institutions, which include rule of law, governance, public sector focus and efficiency, and transparency (democracy and press freedom). The problem for middle-income countries is that the reforms that are necessary to improve the institutional framework may be strongly opposed by entrenched interest groups. The quality of the institutional framework can be described in terms of whether institutions are “extractive” of “inclusive.” (Acemoglu and Robinson, Why Nations Fail). “Extractive” institutions empower the few at the expense of the public good, and the favored elites resist reforms with tooth and nail. Brazil and Argentina are countries which have stalled because of poor institutions that are structured to benefit narrow interest groups.
- The Structuralists argue that the key issue that middle-income countries face is the development of innovation capacity. Those middle-income countries that import all their technology or rely on multinational corporations eventually hit a wall (e.g. Malaysia and Mexico). The question is how does a country promote innovation? The institutionalists focus on guaranteeing strong intellectual property protection. The structuralist’s disagree and argue that strong and dirigiste governments are necessary to implement an industrial policy with incentives/subsidies to attract domestic capital and training programs to upgrade the skills of workers. In order for these interventionist policy initiatives to not turn into boondoggles for crony capitalists, companies must face the discipline of both domestic and international competition. Therefore, the structuralists argue for trade openness and export-driven growth.
On the surface, the arguments of the institutionalist seem more straight-forward and implementable. For this reason, the standard advice of the IMF and World Bank has relied heavily on promoting institutional reforms that improve governance and the delivery of quality public goods (justice, property rights, healthcare, education, infrastructure). Though these reforms are often blocked by entrenched interests, most newly-elected governments spout a ready-made agenda of improving justice, reducing regulation, cutting bureaucratic waste and improving public services. India’s president Modi famously promised at the beginning of his first administration that he would improve the country’s ranking in the World Bank’s “Ease of Doing Business” Index from the high 120s to the 50s, and it appears that he will achieve it. Brazil, which has made no progress on its “Ease of Doing Business” in 15 years and holds a miserable 124th position, now has a finance minister determined to address this. However, for those countries with more reasonable rankings (Malaysia,12; Thailand,21; Turkey,33; China, 31) those opportunities are more limited.
The structuralists argue that improving institutions is necessary but not sufficient, and only a stop-gap measure for middle-income countries with very poor governance, such as most Latin American countries. Chile is a warning for countries following this simple path: though at one point reaching the 25th position in the “Ease of Doing Business” rankings, it has fallen to 54th as the domestic consensus for reforms has softened in line with slowing GDP growth and growing social demands.
The nice thing about the arguments made by the structuralists is that they are solidly backed by empirical evidence. In effect, the structuralists look to the “Asian Tiger” model that has worked historically for Japan, Hong Kong, Singapore, Taiwan and Korea, and is now espoused by China and Vietnam.
The Asian Tiger model follows a few simple steps:
- Harness agricultural surplus and forced savings through financial institutions closely controlled by the government and seen to be at the service of nation-building.
- Manufacturing supported by state-driven industrial policy and credit.
- Exports supported by competitive currencies
- Capital controls to Foreign capital “hot money” flows seen as leading to financial instability
China’s “Made in China 2025” industrial plan to achieve competence in ten key high-tech frontier sectors is straight out of the structuralists game-plan. In fact, China has largely followed the “Asian Tiger” model for the past three decades of its accelerated development.
Unfortunately, the future of the Asian Tiger model is unclear. The worse-kept secret about the success of the Asian Tigers is that, either because they were small (Hong Kong, Singapore) or key American strategic geopolitical allies (Japan, Taiwan, Korea) they were allowed to flout the rules, as Washington looked the other way on intellectual property theft and industrial subsidies. Until recently China was also given some leeway, but those days are gone because Washington now sees China as a key strategic rival. The “Trump Doctrine,” which is likely to remain after he leaves office, is that the U.S. will no longer tolerate interventionist policies, particularly if they affect American companies.
Moreover, structuralist policies have a bad name in many countries where attempts to implement them in the past were undermined by incompetence and corruption. For example, Brazil has a tradition of subsidizing and protecting sectors but it has done this without weeding out the underperformers or demanding export competitiveness. The consequence is that in Brazil and many other countries these policies are deeply associated with crony capitalism. Ibid for “financial institutions at the service of nation building,” In most countries these policies are seen as mainly benefiting politicians and their cronies.
Also, for structuralist policies to function countries need strong governments that can pursue initiatives over the long term and stable economies which facilitate long-term planning by public officials and firms. Unfortunately, these are rare attributes. In Latin America we see the opposite of this, with brusque changes of policies with every incoming government and economies prone to repetitive boom-to-bust cycles.
The Case of Emerging Markets
The table below shows the countries that are considered middle-income on the basis of having per capita incomes between 10% and 50% of the per capita income of the United States. EM countries of significance to investors are highlighted in bold and make up the majority of EM countries of importance to investors.
The low-income EM countries (India, Indonesia, Vietnam, Nigeria) should face fewer challenges to high relative growth and convergence simply because of demographic dividends and technology leapfrogging.
In terms of EM countries, which ones are likely to be middle-income trapped? A few comments on the main countries in EM.
China
China’s future growth path is debatable, with strong views on both sides. On the one hand, the country is assiduously following the path of the Asian Tigers with a keen focus on innovation and human capital. Also, it still benefits from urbanization and the development of backward geographies. On the other hand, rising tensions with the U.S. are leading to trade and technological decoupling which will be a burden. Moreover, a massive debt build-up to finance increasingly unproductive investments is unsustainable. My guess is that, if a financial crisis can be avoided, China’s growth will stabilize around the 3-4% level, still well above expected U.S. growth of 2%
South-East Asian
Thailand and Malaysia are dependent on export, which is a negative in a de-globalizing world. Moreover, they suffer increased competition from new low-cost producers but have very limited innovation capacity of their own.
Europe, Middle-East and Africa
The Eastern European countries have mostly been strong convergers, and Poland is no exception. They still benefit from relatively low costs and opportunities to integrate with Western Europe and have the human capital to participate in high-tech innovation.
Russia’s situation is different, as is it increasingly isolationist. Bad demographics, weak institutions and an overbearing state sector are additional challenges.
Turkey suffers from political and financial instability, a significant brain drain and weakening transparency (democratic and press freedoms).
South Africa appears to be in prolonged decline, with weakening institutions.
Latin America
The region has poor institutions, and political and economic instability, characterized by frequent policy changes and boom-to-bust economies. Innovation capacity is lacking, with the exception of some tech savvy which should be strongly supported by governments. For Latin America, those countries able to improve institutions and business conditions have some upside. Today, it seems Brazil and Colombia are best positioned for this. Mexico is exceptionally placed to take advantage of the current global trade environment but faces declining governance and institutions.
For further reading on convergence and the middle-income trap:
“Convergence Success and the Middle-Income Yrap,” byJong-Wha Lee, ERBD, April 2018 (ERBD)
“Growth Slowdowns and the Middle-Income Trap,” by Shekk Aariyar ; Romain A Duval ; Damien Puy ; Yiqun Wu ; Longmei Zhang, IMF, March 2013 (Link)
“Middle-Income Traps A Conceptual and Empirical Survey,” by Fernando Gabriel Im and David Rosenblatt, The World Bank, September 2013 (Link)
“Avoiding Middle-Income Growth Traps,” by Pierre-Richard Agénor, Otaviano Canuto, and Michael Jelenic, World Bank, November 2012. (Link)