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.”