Can Asia keep growing through middle income?

Authors: Indermit Gill, World Bank, and Homi Kharas, Brookings Institution

About a decade ago we observed that there was no easily communicable growth strategy we could recommend to policymakers in the middle income economies in Asia.

At that time, the China export juggernaut was accelerating. With wage levels that had already risen as a result of a successful transition from low-income to middle-income status, many East Asian economies were becoming uncompetitive with China in labour-intensive manufacturing. Economic policymakers began to wonder where the growth their countries needed to graduate from middle income status to high income status might come from.

Female Chinese workers sew clothes at a garment factory in Huaibei city, east China's Anhui province, 1 June 2015. Studies suggest that one-quarter of Chinese growth over the past three decades has been the result of its demography. (Photo: AAP)

In describing the problem, we coined the term ‘middle income trap’.  To us, the middle income trap was as much the absence of a satisfactory theory that could inform development policy in middle-income economies as the articulation of a development phenomenon. It was a trap of ignorance about the nature of economic growth in middle income countries: mainstream economics addressed the problem in high income economies, and development theory attempted to understand the growth problem in low income countries. Since three out of four people in the world lived neither in advanced economies nor low income countries, this was not a small gap.

To our surprise, the phrase ‘middle income trap’ immediately became popular among policymakers and development specialists. In East Asia, the Great Recession of 2008 rocked the confidence of economic policymakers and triggered a big debate on what to do next. By mid-2009, Malaysian policymakers, including Prime Minister Najib, had started to use the phrase in speeches and even launched a National Economic Advisory Council to elaborate a plan on how to escape the trap. In China, from 2010 onwards, officials in charge of the preparation of the 12th Five Year Plan 2011–2016, including Liu He, started to debate whether China was becoming vulnerable to the middle income trap.

Ten years have passed, and there is growing discussion about whether the middle income trap exists and, if so, what its characteristics are and how countries might ‘escape’ it and reach high income levels. So what have we learnt since?

The importance of trade liberalisation for growth in middle income countries remains vital; countries and firms that have joined global value chains have seen productivity growth. Countries that are competitive in sectors where economies of scale are present are the most likely to experience substantial gains from opening up.

Successful middle income countries are also likely to be ones that encourage innovation. Openness to trade plays a big role in increasing competition and thereby inducing innovation and technological transfer. So too do new capital investments, as well as research and development: these are also likely to lead to the diffusion of more advanced technologies.

The quality of financial markets and capital market liberalisation are also likely to be important for middle income countries. We recommended that middle income countries move towards more flexible exchange rates, while developing local financial markets to provide firms more opportunities to hedge foreign exchange risk. As it happens, middle income countries have been moving steadily in this direction, restoring monetary policy as an instrument of macroeconomic management.

And we emphasised the role that dealing with urbanisation and agglomeration, tackling inequality and rooting out corruption might play in a successful economic strategy for middle income countries.

But in hindsight, there are other areas we did not emphasise, but should have.  There are three issues to which leaders in middle income countries ought to pay attention.

One of these is the impact of demographic shifts. Some studies suggest that a whole one-quarter of China’s growth over the past three decades has been the result of its demography. And many middle countries, like Nigeria or India, are hoping that a generation of young people entering the labour force will provide them a demographic dividend; others worry that the dividend has now run its course. The danger for all middle income countries is that of growing old before they get rich.

Another task that faces middle income countries is to foster a climate of entrepreneurship. This is subtly different from the issue of innovation. A balanced set of skills — including but not restricted to the traditional science and technology skills favoured by some middle-income countries — is needed to produce a generation of entrepreneurs that will turn ideas into new businesses. China already faces this imperative.

The role of external commitments and regionalism also deserves attention. Regional institutions can help to secure the long-term economic trajectory of middle-income countries by pre-committing countries to liberalising reform. In a world in which the WTO process has stalled, these external commitments are likely to be regional in nature. This might help several middle income countries in a region to escape the trap together, and it is for this reason that we are optimistic about the poorer countries in ASEAN such as Cambodia, Laos and Myanmar.

There is no doubt that the ‘middle income trap’ has captured the imagination of policymakers around the region. Although the idea itself is still being sorted out, what is clear is that middle income countries will have to think hard about the changes they need to make if they are to make the transition to high income.

Indermit Gill is director for development policy in the Office of the Chief Economist of the World Bank. Homi Kharas is a senior fellow and deputy director for the Global Economy and Development Program at the Brookings Institution, Washington DC.