Otaviano Canuto
Since the 1950s, rapid growth has allowed a significant number of countries to reach middle-income status; yet, very few have made the additional leap needed to become high-income economies. Rather, many developing countries have become caught in what has been called a “middle-income trap”, characterized by a sharp deceleration in growth and in the pace of productivity increases.
An examination of the successful experiences in overcoming that trap suggests a number of public policies that governments can pursue, such as improving access to advanced infrastructure, strengthening the appropriability of returns from innovation, and reforming labor markets to reduce rigidity—all implemented within a context where technological learning and R&D are central to enhancing innovation. Such policies not only explain why some economies—particularly in East Asia— were able to avoid the middle-income trap, but are also instructive for other developing countries seeking to move up the income ladder and reach high-income status.
In the post-war era, many countries have managed to fairly rapidly reach middle-income status, but few have gone on to become high-income economies. Rather, after an initial period of rapid ascent, many countries have experienced a sharp slowdown in growth and in the pace of productivity increases, falling into what has been called a “middle-income trap.” To be sure, the World Bank has recently estimated that of 101 middle-income economies in 1960, only 13 became high income by 2008—Equatorial Guinea, Greece, Hong Kong SAR (China), Ireland, Israel, Japan, Mauritius, Portugal, Puerto Rico, Republic of Korea, Singapore, Spain, and Taiwan (China).
“In the post-war era, many countries have managed to fairly rapidly reach middle-income status, but few have gone on to become high-income economies.”
– Otaviano Canuto
By contrast, although many countries in Latin America and the Middle East reached middle-income status as early as the 1960s and 1970s, a great majority of them have remained there ever since. In Latin America, for instance, income per capita relative to the United States has fallen almost continuously in the region during the period from 1960 to 2005, especially after the debt crises of the early 1980s. Likewise, economic growth in many Middle Eastern and North African countries has waned and given way to high unemployment, as evidenced most recently by the social and political upheavals that took place during the Arab Spring of 2011. Middle-income countries elsewhere have expressed fears that they could follow a similar path.
Climbing and getting stuck in the middle of the income ladder
The evolution of countries from low- to middle-income levels has been reasonably similar wherever it has happened. Typically, a large pool of unskilled labor is transferred from subsistence-level occupations to more modern activities that do not demand much upgrading of these workers’ skills, but nonetheless employ higher levels of capital and embedded technology. Such technology is available from more-advanced countries and is often easy to adjust to local circumstances. The effect of the labor transfer is an extraordinary increase of GDP values beyond what could be explained by the augmented use of labor, capital and other physical factors of production.
This growth pattern tends to eventually slow down, either when the pool of transferable unskilled labor is exhausted or if the expansion of labor-absorbing modern activities peaks before the pool is empty. Beyond that point, growth toward high-income levels will require an increasing share of the population occupied in activities that are more technologically sophisticated, human capital-based, and intensive in design and organizational capabilities. In that context, an institutional setting supportive of innovation and complex chains of market transactions becomes 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. A local and idiosyncratic process of skill acquisition is essential. It no longer suffices to transfer and adapt technology blueprints and organizational capabilities from abroad. Education of the labor force and access to advanced infrastructure – which facilitate the circulation of ideas and promote knowledge networks – are obvious requisites. However, government efforts to provide them will not get a country very far if they are not accompanied by institutions that reward innovations in products and processes and that allow complex chains of market transactions to take place at low costs. Local people’s investment in innovative skill acquisition and organizational capacity building only materializes if appropriable private returns are commensurate.
Are there lessons of wide applicability from successful stories of ascent?
As mentioned earlier, only 13 countries were able to transition from middle- to high- income status since the 1960’s. Five of them – Ireland, Portugal, Spain, Greece and Puerto Rico – constitute a special case, with their ascent inextricably associated to their absorption by existing high-income country spaces. Equatorial Guinea also has the singular experience of a very small country that is extremely well endowed with natural resources. On the other hand, like Israel and Mauritius, the five East Asian economies in that select group – Japan, the Republic of Korea, Singapore, Hong Kong SAR (China) and Taiwan (China) – provide a reference of broader reach for autonomous efforts to transit steadily from the bottom of the income ladder to the top.
Taiwan
First, of the East Asian economies that were able to escape the middle-income trap, all have succeeded in developing advanced infrastructure networks, particularly in the form of high speed communications and broadband technology. Due equally to the liberalization of telecommunication networks and the related reforms to regulatory frameworks, a number of countries in the region have been able to develop and enhance the availability of information and communications services. To be sure, previous research on regional competitiveness underscores the importance of broadband telecommunications technologies and interactive multimedia. For countries with large export-oriented information equipment industries, such as Japan, South Korea, and Taiwan (China), a drive to enhance international competitiveness perpetuated the development of broadband and multimedia industries in domestic markets. Likewise, other economies in the region that were able to escape the middle-income trap, such as Singapore and Hong Kong (China), have developed their advanced infrastructure networks in order to enhance their role as regional headquarters for major foreign multimedia companies.
Another key factor underlying the success of the East Asian economies that were able to transition from middle- to high-income status has been their ability to push the technological frontier and move from imitating and importing foreign technologies, to innovating technologies of their own. Underpinning this home-grown innovation has been strong intellectual property rights protections. According to the World Bank’s Doing Business Database, intellectual property rights in in economies such as Hong Kong (China), Korea, Singapore, and Taiwan (China) rival those in place in Japan, US, and other high income countries.
As a result of a well functioning system of intellectual property rights protections, many countries in the region have become global leaders in patenting their own technologies. Using the number of patents issued by the United States Patent and Trademark Office as a measure, economies in the region have generated patents per 100,000 people at around the same rate as the advanced economies. In particular, Taiwan (China) now generates nearly as many as patents as the best performing developed economies, such as Japan and the United States, with Hong Kong (China), Korea, and Singapore not far behind. Supporting this innovation has been a commitment to investments that spur the upgrading of skills and directing public funds to R&D efforts. According to the UNESCO database on R&D expenditures, Korea, Singapore, and Taiwan (China) now devote resources to R&D spending as a proportion of GDP comparable to the levels in the United States and other highly-innovative developed economies
Last, flexible labor markets and open economic policies have allowed for the reallocation of labor across sectors within the most successful economies in the region. Countries in the region have relied extensively on international trade to accelerate their labor transfer by inserting themselves into the labor-intensive segments of global value chains. Such a transfer was facilitated by advances in information and communication technologies, and by decreasing transport costs and lowering international trade barriers. Labor market flexibility has facilitated the new labor transition, now increasingly toward innovative occupations.
Conclusion
The features of East Asia’s experience in transiting from middle- to high-income status provide important lessons for other countries that are attempting to follow suit. The middle-income trap is not an ineluctable outcome; it can be avoided if governments act accordingly. Doing so requires implementing public policies aimed at improving access to advanced infrastructure, strengthening the appropriability of returns from innovation, and reforming labor markets to reduce rigidities. These policies are central to fostering technological learning, attracting talented individuals into R&D activities, and encouraging the buildup of national and international knowledge networks.
Originally published at Capital Finance International, winter 2012-2013