Navigating the Road to Riches

Otaviano Canuto

A switchover of global growth engines is taking place. Developing economies as a whole are now the source of more than half of global GDP growth. As a result, concern has naturally shifted to a new question: Are there risks that some or many of these developing countries could fall prey to the “middle-income trap”?

The “middle-income trap” has captured many developing countries: they succeeded in evolving from low per capita income levels, but then appeared to stall, losing momentum along the route toward the higher income levels of advanced economies. Such a trap may well characterize the experience of most of Latin America since the 1980’s, and in recent years, middle-income countries elsewhere have expressed fears that they could follow a similar path. Does moving up the income ladder get harder the higher one climbs?

In most cases of successful evolution from low- to middle-income status, the underlying development process is broadly similar. Typically, there is a large pool of unskilled labor that is transferred from subsistence-level occupations to more modern manufacturing or service activities that do not require much upgrading of these workers’ skills, but nonetheless employ higher levels of capital and embedded technology.

The associated technology is available from richer countries and easy to adapt to local circumstances. The gross effect of such a transfer – usually occurring in tandem with urbanization – is a substantial increase in “total factor productivity,” leading to GDP growth that goes beyond what can be explained by the expansion of labor, capital, and other physical factors of production.

Reaping the gains from such “low-hanging fruit” in terms of growth opportunities sooner or later faces limits, after which growth may slow, trapping the economy at middle-income levels. The turning point in this transition occurs either when the pool of transferrable unskilled labor is exhausted, or, in some cases, when the expansion of labor-absorbing modern activities peaks before the pool is empty.

Beyond this point, raising total factor productivity and maintaining rapid GDP growth depends on an economy’s ability to move up on manufacturing, service, or agriculture value chains, toward activities requiring technological sophistication, high-quality human capital, and intangible assets such as design and organizational capabilities. Furthermore, an institutional setting supportive of innovation and complex chains of market transactions is essential.

Instead of mastering existing standardized technologies, the challenge becomes the creation of domestic capabilities and institutions, which cannot be simply bought or copied from abroad. Provision of education and appropriate infrastructure is a minimum condition.

Today’s middle-income countries in Latin America saw the transfer of labor from subsistence-level employment slow well before they had exhausted their labor surpluses, as macroeconomic mismanagement and an inward-looking orientation until the 1990’s established early limits to that labor-transfer process. Nevertheless, some enclaves have been established in high positions on global value chains (for example, Brazil’s technology-intensive agriculture, sophisticated deep-sea oil-drilling capabilities, and aircraft industry).

By contrast, Asian developing countries have relied extensively on international trade to accelerate their labor transfer by inserting themselves into the labor-intensive segments of global value chains. This has been facilitated by advances in information and communication technologies, and by decreasing transport costs and lower international trade barriers.

The path from low to middle income per capita, and then to high-income status, corresponds to the increase in the share of the population that has moved from subsistence activities to simple modern tasks, and then to sophisticated ones. International trade has opened that path, but institutional change, high-quality education, and local creation of intangible assets are also essential for sustaining progress over the long run. South Korea is a prime example of a country that exploited these opportunities to move all the way up the income ladder.

As for maintaining high growth in developing countries, the remaining pool of rural-subsistence and urban-underemployed labor in low- and middle-income countries constitutes a still-untapped source for increases in total factor productivity via occupational change. For this to succeed at the global level, middle-income countries that have already started the process must overcome the obstacles on the road to higher income, thereby creating demand and opening supply opportunities for the primary labor transfer in developing countries farther down the income ladder.

Natural-resource-rich middle-income countries face a road of their own, one made wider by the apparent long-term increase in commodities prices that has accompanied the shifts in composition of global GDP. Unlike manufacturing, natural-resource use is to a large extent idiosyncratic, which creates scope for local creation of capabilities in sophisticated upstream activities, with the corresponding challenge to do so in a sustainable fashion.

While most country that evolve from low- to middle-income status have followed a fairly common route, their next stages point to a more diverse set of experiences in terms of institutional change and accumulation of intangible assets. Given advanced economies’ poor growth prospects, the world economy’s dynamics nowadays will depend on how successful country-specific steps up the income ladder turn out to be.

First appeared as Navigating the Road to Riches, Project Syndicate, July 2011