As economies grow and reach what is known as ‘middle-income’, they run the risk of getting caught in a slow-growth middle-income trap. When markets are all hoping that these middle-income countries will be the growth engines for the world, the question of the middle-income trap is imperative.
Once low-income countries achieve growth ‘take-off’, they tend to grow very quickly into middle-income economies. In financial terminology, they become emerging markets.
Some countries have been skilled or lucky enough to grow quickly through middle-income and rapidly become high-income. Such robust and sustained growth has earned some of these economies the epithet ‘Asian Tigers’, including South Korea and Taiwan (see chart 1). Other countries have been less successful, storming into middle-income with rapid growth but then slowing down sharply on achieving that level.
In many cases, the growth of income per capita has slowed down to less than half of its earlier pace. Latin America has been particularly susceptible to the middle-income trap. Brazil, Mexico and Peru have all spent decades stuck in the trap, with flat or even declining real GDP per capita.
One may well think that income traps are not unique to middle-income countries. After all, some high-income countries appear to have slowed down markedly as well. Two decades ago Japan was the first high-income country to experience a sharp slowdown in trend growth. Following the financial crisis in 2008, almost all advanced economies have experienced a multi-year slowdown in growth.
Nonetheless, economists at the IMF have found that middle-income countries are, historically, half-again as likely to suffer a marked growth slowdown than either low-income or high income countries (chart 2). That probability could narrow if high-income countries continue to experience lower trend growth over the next five years as well – this would generate a much higher incidence of growth slowdowns than seen in the historical data.
What makes the difference between a country falling into the middle-income trap as Peru did, or avoiding it completely like Taiwan? Why do some countries like Malaysia and Thailand appear to plot a course somewhere between the two? The IMF has identified a number of factors that can explain the difference. Some of these are surprising but most are in line with what you would expect. Strong institutions with a clear rule of law and lack of overbearing government involvement are key to avoiding a middle-income trap. High quality and sufficient physical infrastructure such as roads and telecoms are clearly important for businesses to continue to expand.
A robust structure of trade without too much reliance on a limited range of export products also helps. Investment growth has a somewhat surprising impact on the risk of getting caught in a middle-income trap. You might expect that a high rate of investment in machinery and buildings would increase the rate of growth of an economy.
This is the story of China’s fantastic growth experience over the last fifteen years, so surely high investment must be a driver of growth? The IMF agrees that investment booms are good for growth for a while, but such booms often end up as busts. And those busts can have severe, long-lasting effects that can lead to a substantial and prolonged growth slowdown. There can be too much of a good thing.
Demographics are also a big challenge for a number of middle-income countries in Asia, notably China and Thailand. Dependency ratios are likely to rise, meaning that there will be more old people or children for each person of working age. The challenge for such countries is to get rich before they get old, otherwise the costs of supporting the retired population will be a drag on the rest of the economy.
Overall, the challenge for most middle-income economies is to manage the transition from technology absorption (copying and implementing technology from other countries) to innovation (generating ideas and technology domestically).
When countries are far from the technological frontier of the most advanced economies (to coin a phrase from the economist Phillipe Aghion), they often have quite protected industries and dominant state-owned enterprises that are good at copying and implementing existing technology from other countries. This brings strong initial benefits to growth but these effects eventually diminish. A point is reached when innovation is needed but protectionism and dominant firms are a major impediment to innovation. The transition is made more difficult by the political influence accrued by those protected industries and dominant firms.
The biggest middle-income country of all, China, is a complex mix of strengths and weaknesses for avoiding the middle-income trap. There is strong rule of law but the government is still too large a part of the economy. There is plenty of effort to encourage domestic innovation, but dominant state-owned enterprises are likely to limit the effectiveness of these efforts.
There is abundant investment in public infrastructure like roads and telecoms, but overall there has been a two-decade long investment boom. In this light, the news that Chinese Premier Wen Jiabao is investigating the effects of slowing the Chinese economy to 7% growth next year may actually be good news. Tighter policy to restrict the investment boom may mean slower growth next year, but if it reduces the risk of a crash the price will be well worth it.
Get this policy right, and the Middle Kingdom might not stay middle-income for longer than necessary.
