Thursday, February 10, 2011

Escaping the middle-income trap

I returned a few days ago from Kuala Lumpur, the capital of Malaysia, where the talk of the town – well, at least among economists -- is the “middle-income trap.” What's that, you ask? A developing nation gets “trapped” when it reaches a certain, relatively comfortable level of income but can't seem to take that next big jump into the true big leagues of the world economy, with per capita wealth to match. Every go-go economy in Asia has confronted this “trap,” or is dealing with it now. Breaking out of it, however, is extremely difficult. The reason is that escaping the “trap” requires an entire overhaul of the economic growth model most often used by emerging economies.

Malaysia's caught in the “trap” right now, and getting out if is going to be tough. Simply put, Malaysia needs to change what it has been doing economically for the past 40 years. How Malaysia got itself into the “trap,” and how it could escape from it, can provide us with some valuable lessons on development and, more specifically, how developing nations can graduate into becoming fully advanced economies.

The concept behind the “middle-income trap” is quite simple: It's easier to rise from a low-income to a middle-income economy than it is to jump from a middle-income to a high-income economy. That's because when you're really poor, you can use your poverty to your advantage. Cheap wages makes a low-income economy competitive in labor-intensive manufacturing (apparel, shoes and toys, for example). Factories sprout up, creating jobs and increasing incomes. Every rapid-growth economy in Asia jumpstarted its famed gains in human welfare in this way, including Malaysia.

However, that growth model eventually runs out of steam. As incomes increase, so do costs, undermining the competitiveness of the old, low-tech manufacturing industries. Countries (like Malaysia) then move “up the value chain,” into exports of more technologically advanced products, like electronics. But even that's not enough to avoid the “trap.” To get to that next level – that high-income level – an economy needs to do more than just make stuff by throwing people and money into factories. The economy has to innovate and use labor and capital more productively. That requires an entirely different way of doing business. Instead of just assembling products designed by others, with imported technology, companies must invest more heavily in R&D on their own and employ highly educated and skilled workers to turn those investments into new products and profits. It is a very, very hard shift to achieve. Thus the “trap.”

South Korea is probably the best current example of a developing economy making the leap into the realm of the most advanced. Companies like Samsung and LG are becoming true leaders in their fields. Taiwan isn't far behind. China's policymakers are fully aware that, with labor costs rising, it needs to follow suit.


Malaysia, though, is quite far from where it wants to be. That's a bit surprising based on its remarkable recent history. Malaysia has been among the best performing economies in the world since World War II, one of only 13 to record an average growth rate of 7% over at least a 25-year period. The country has an amazing record of improving human welfare. In 1970, some 50% of Malaysians lived in absolute poverty; now less than 4% do. Yet Malaysians also feel that they've become somewhat stuck where they are. GDP growth has slowed up, from an annual average of 9.1% between 1990 and 1997 to 5.5% from 2000 and 2008. Meanwhile, other Asian economies have zipped by Malaysia. According to the World Bank, the per capita gross national income (GNI) of South Korea in 1970 was below that of Malaysia ($260 versus $380), but by 2009, South Korea's was three times larger than Malaysia's ($21,530 versus $6,760).  Malaysia is getting “trapped” as a relatively prosperous but still middle-income nation.

Can Malaysia escape? The initial indications are not encouraging. The economy's growth engine remains unchanged – export-oriented manufacturing backed by foreign investment. Its companies are just not innovating or adding much value to what they produce. You can find all of the ugly details in a very thorough study by the World Bank, released in April. Private investment has sunk precipitously, from more than a third of GDP in the mid-1990s to only some 10% today. Labor productivity is growing more slowly than in the 1990s. The “value-added” in manufacturing in Malaysia trails many of its neighbors – an indication that Malaysian factories are mainly assembling goods designed elsewhere. R&D spending remains frighteningly low, at about 0.6% of GDP (compared to 3.5% in South Korea). If Malaysia is going to break the “trap,” it has to reverse all of these trends.

How can Malaysia achieve that? The World Bank report has pages of recommendations. The basics include slicing apart the bureaucratic red tape that stifles competition and suppresses investment, bolstering the education system so it can churn out more top-notch graduates, and funneling more financial resources to start-ups and other potentially innovative firms. To its credit, the government of Malaysia is fully aware of what it needs to do. In March, Prime Minister Najib Razak introduced a reform program called the New Economic Model. You can read the initial report here. The NEM shows that Najib realizes that excessive government interference in the economy is dampening investor sentiment and holding back Malaysian industry. All eyes now are waiting for the more detailed policy recommendations for the NEM (though it is not clear when those might appear).

Yet I'm wondering if getting policy right is really enough. Of course, it would help, by setting in place better incentives for private businessmen to invest in innovative projects, and creating the tools they need to make those projects work. But I don't think that's the whole story. I've been musing on the differences between South Korea and Malaysia. Why has Korea jumped so far ahead? I think the reason is embedded in the different methods the two countries used to spur rapid growth.

Both countries relied exports to create rapid gains in income, but they did so differently. South Korea, from its earliest days of export-led development in the mid-1960s, had been determined to create homegrown, internationally competitive industries. Though Korean firms supplied big multinationals with components or even entire products, that was never enough – Korea wanted to manufacture its own products under its own brands. The effort was often a painful one – remember Hyundai's first disastrous foray into the U.S. car market in the late 1980s and early 1990s – but Korea is where it is today because its private companies have been working on getting there for a very long time, backed in full by the financial sector and the government.

Malaysia, on the other hand, relied much, much more on foreign investment to drive industrialization. That's not a bad thing – multinational companies provide an instant shot of capital, jobs, expertise and technology into a poor country. MNCs, however, aren't going to develop Malaysian products; that has to take place in the labs and offices of Malaysia's private businesses. But those businessmen have been content to squeeze profits from serving MNCs and maintaining their original, assembly-based business models.

In other words, what is needed for Malaysia to break from the “middle-income trap” is a greater national commitment to innovate on its own. Entrepreneurs and bankers have to be willing to take more risks to support inventive ventures and new technologies. Talented workers have to be willing to take jobs at home instead of Silicon Valley. The Malaysian private sector has to be more devoted to the country's future. This is fuzzy stuff, outside of the realm of usual economics. But I fear the kind of commitment needed to escape the “trap” unfortunately can't be created by government initiatives alone.

Wednesday, February 9, 2011

Avoiding the Middle Income Trap

New York Times, 25 October 2010

GYEONGJU, SOUTH KOREA — The past is not an infallible guide to the future, but a reading of how economies have developed suggests that China needs to get ready for a slowdown in economic growth in the coming years.

And that same history lesson could have Beijing praying that it can follow in the footsteps of vibrant South Korea, not stagnant Japan.

The gathering of finance officials from the Group of 20 major economies last weekend was aimed at securing short-term economic growth and currency stability. But the opulence of the resort where the Group of 20 met was a vivid illustration of how South Korea has avoided the so-called middle income trap and continued to push living standards closer to those of rich economies.

For decades, many countries in Latin America and the Middle East have failed in this task. In Asia, the Philippines is a prominent example.

“Many countries make it from low income to middle income, but very few actually make that second leap to high-income,” said Ardo Hansson, a World Bank economist in Beijing. “They seem to get stuck in a trap where your costs are escalating and you lose competitiveness.”

Not so South Korea. When war on the divided peninsula came to a halt in 1953, the south was poorer than the north. By 1997, though, the South Korean per capita gross domestic product (at purchasing power parity exchange rates) had reached 57 percent of the average of the Organization for Economic Cooperation and Development, a group of free-market democracies which Seoul joined in 1996.

The 1997-98 Asian financial meltdown set back many countries across the region. Investment, vital to sustaining medium-term economic growth, has still not recovered to precrisis levels in Malaysia, the Philippines and Thailand.

South Korea, though, after nearly defaulting on its debts at the end of 1997, pulled itself together and resumed its march up the value chain.

The key reason is that Seoul embarked on far-reaching market changes. In particular, the government reduced the power of the chaebol, the sprawling debt-heavy conglomerates whose links to the state created the impression that they were too big to fail.

But many did fail as South Korea injected more competition into the economy, liberalized imports and deregulated the financial sector, which was a captive source of financing for the chaebol.
“They really changed the rules of the game for the large corporations,” said Randall Jones, who heads the O.E.C.D.’s South Korea desk. “It became clear that being big and being close to government was not enough to keep you alive.”

Since the crisis, the South Korean economy has grown more than twice as fast as the O.E.C.D. average, propelling per capita gross domestic product to 83 percent of the group average by 2008.

“Korea is a success story because of what they’ve been able to do during the past decade, and it’s the wave of reform back in 1997-98 that gave them that second wind,” Mr. Jones said.

The lessons for Beijing seem evident. The chaebol can be likened to China’s state-owned enterprises, which generally enjoy cozy monopolies and favorable financing from state-owned banks that are themselves cosseted.

Beijing needs to emphasize the efficiency of investment, not its scale. It must foster innovation and make it easier for more productive private companies to enter sectors like finance and logistics.

“Part of it is just making sure that you are creating new sources of growth all the time,” said Mr. Hansson of the World Bank.

A particular lesson from South Korea is that investing in human capital is critical to avoiding the middle income trap.

“Korea, 50 years ago, already had very high levels of educational attainment,” Mr. Hansson said. “There has to be some sense in which making that final leap really depends upon widespread access to high-quality education.”

Emulating South Korea would help China to improve the structure of its economy and actually benefit from the loss of momentum that history suggests is looming.

According to data compiled by Angus Maddison, an economic historian, and cited by Morgan Stanley, about 40 economies have attained a per capita gross domestic product level of $7,000 over the past century or so.

Remarkably, the average economic growth rate of 31 of those 40 economies was 2.8 percentage points less in the decade after the $7,000 inflection point was reached than in the preceding decade.

Japan and South Korea reached the $7,000 mark around 1969 and 1988, respectively, whereupon their annual average economic growth rates decelerated in the following decade by 4.1 and 2.4 percentage points, respectively, Morgan Stanley calculates.

China’s per capita gross domestic product is less than $4,000 at market exchange rates, but Morgan Stanley said China had reached Mr. Maddison’s magic number, which is based on purchasing power, in 2008.
“If history is a guide and the law of gravity applies to China, China’s economic growth is set to slow,” Morgan Stanley said in a report.

China’s slowdown might be gentler given its continental-size economy and the potential for catch-up in the poorer interior. But the development experience of its neighbors, including Taiwan, is a benchmark too powerful to ignore.

Morgan Stanley has penciled in average economic growth for China of 8 percent a year between 2010 and 2020, down from 10.3 percent between 2000 and 2009.

Slower, though, can mean a better balance. In Japan and South Korea, consumption and labor income rose sharply as a share of gross domestic product in the decade after the growth rate peaked, while their service sectors expanded strongly.

China’s new five-year plan proclaims the same goals.

“China is not unique,” said Steven Zhang, a Morgan Stanley economist in Shanghai. “It will follow the pattern of Korea and Japan and, after the inflection point, consumption will take off and investment will decline.”