INDIVIDUAL SHORT PAPER

MIDLLE INCOME TRAP AND COMPETITIVENESS OF NATIONS

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INDIVIDUAL SHORT PAPER
MIDLLE INCOME TRAP AND COMPETITIVENESS OF NATIONS
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1. Introduction

This topic is related to the competitiveness of the manufacturing sector in
economies that receive a large amount of Foreign Direct Investment (FDI) and have
formed a sufficiently large base for producing and exporting manufactured products
among the middle-income countries. The challenges analysed here are quite different
from and pertinent to a much higher development level than those faced by typical lo
income countries in !ub-!aharan "frica and other regions# here enticing investors to
form an initial industrial base is the main policy ob$ective. %ast "sia&s middle income
economies# ith an aspiration to $oin the ran's of highly advanced countries# must
overcome the barriers that 'eep them in the middle stage of development.
In aggregate# middle-income countries have shon robust groth and made
progress in development# although performance varies among them. If history is a
reference# countries in this group are vulnerable to being caught in a so-called (middle-
income trap)# here they lose competitiveness compared to lo-income countries but
lac' the technological edge to catch up ith high-income countries. The challenge is to
redesign development strategies for them ith a focus on innovative# sustainable and
inclusive groth# gradually shifting to higher value added sectors.
*ompetitiveness depends on the difference beteen the to# not on the absolute
age level. +age increase should be a boon to or'ers# and there is no reason to fear it
as long as productivity is improving in tandem.
The challenge is to redesign development strategies for them ith a focus on
innovative# sustainable and inclusive groth# gradually shifting to higher value added
sectors. The ,nited -ations system is playing an important role in assisting middle-
income countries in their economic and social development# as is indicated by both the
replies of .overnments to a survey and the reports on specific programmes and initiatives
implemented by ,nited -ations agencies.
The fact that developing countries must acquire s'ill and technology# rather than
$ust offering factory space and cheap labour# can be stated in various ays. Four such
arguments are presented belo. It can be argued that the only ay for a country to remain
competitive is to improve labour productivity faster than age increase.
!ince the /012s# rapid groth has alloed a significant number of countries to
reach middle-income status3 yet# very fe have made the additional leap needed to
become high-income economies. 4ather# many developing countries have become caught
in hat has been called a middle-income trap# characteri5ed by a sharp deceleration in
groth and in the pace of productivity increases. Draing on the findings of a recently
released or'ing paper ("g6nor and *anuto 72/7)# as ell as a groing body of research
on groth slodons# this note provides an analytical characteri5ation of (middle-
income traps) as stable# lo-groth economic equilibria here talent is misallocated and
innovation stagnates.

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INDIVIDUAL SHORT PAPER
MIDLLE INCOME TRAP AND COMPETITIVENESS OF NATIONS
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2. Literture Re!ie"

%conomic history has shon that fe countries that have achieved middle-income
status continue to converge to the level of high-income countries. "s the policy#
institutional# and structural environment evolves# prior strategies and competencies no
longer remain effective at generating an equivalent rate of groth. Indeed# strategies
based on factor accumulation are li'ely to deteriorate as the marginal productivity of
capital declines# and rising ages ill reduce the international competitiveness of many
labor-intensive industries. Thus# the ne constraints on the economy become more
complex as domestic industries rely less on investment and more on innovation. "s this
process develops# experience has shon that middle-income countries can become
trapped 8 no longer able to effectively compete ith lo-age competitors in poor
countries and still lac'ing the innovative capabilities to rival high-income economies. "s
argued in a recent 7229 report by the +orld :an'# the ;middle-income trap& has become
a palpable challenge for several countries in %ast "sia in particular.
The (middle-income country trap) is a development stage that characteri5es
countries that are squee5ed beteen being lo-age producers and highly-s'illed# fast-
moving innovators. *ountries caught in this trap tend to gro sloer and often fall
behind. *ost advantages in labor intensive sectors# such as the manufactured exports
hich once drove groth# start to decline in comparison ith loer-age poor country
producers (.ill I and <haras =# 7229). "t the same time# they do not have the
institutions# capital mar'ets# trac' record# or critical mass of highly-s'illed people to
gro through ma$or innovations li'e rich countries. *aught beteen these to groups#
many are ithout a viable high-groth strategy. In addition# they are faced ith ne
challenges including distribution and social cohesion issues. Therefore# they are hard-
pressed to develop ne groth drivers (-ungsari and >eufac'# 7220).
?roductivity slodon has been a sound characteri5ation of middle-income
traps. @ver time in a country&s development process# there emerges diminishing
marginal returns to cheap labor and technology imitation3 this could be offset if
government act early to move from an imitation based economy to innovation based
production cycle (see "g6nor# ?-4 and @ *anuto 72/7). The %ast "sian experience has
illustrated that such policies are central to fostering technological learning# attracting
talented individuals into research and development activities# and encouraging the build-
up of national and international 'noledge netor's. 4ecently# the broader debate over
*hinaAs innovative proess and potential development path has intensified. !ome
observers regard *hinese firms& ability to stay close to the orld technology frontier and
to improve upon and adapt existing innovation as 'ey to the country&s continued groth
(:re5nit5 and Burphree 72//) here the globali5ation of services is increasingly an
important components of *hina&s groth (see 4oach# !tephen 72/C).@nly one (!outh
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<orea) of the seven countries hich ere middle-income by /091 managed to reach
high-income status by 7221.
:ra5il and !outh "frica# hich had double the per-capita income of !outh <orea
in /091# have remained at the same level since then. It faced periods of negative groth#
hich cancelled all earlier progress.
%vidence of the middle-income trap can also be found in the dynamics of
occupations and ages across countries. The integration of the orld&s labor mar'ets
creates big gains for rich and poor countries ali'e. For example# blueprints of products
flo from *alifornia to *hina# hile manufacturing goods flo in the opposite direction
(see <haras et at# 72/2). The middle-income countries benefit less from globali5ation
(%ec'hout and Dovanovic# 7229). They are not technologically-savvy enough to compete
ith rich countries and are not cheap enough to compete ith *hina# Eietnam and other
dynamic lo-income countries. Than's to communications and transportation
technologies# managers# engineers and designers F larger in number in rich countries F
have access to a pool of cheap labor in poor countries. This ma'es them more productive
as they can produce more ith the same resources. The higher ages that accrue to high-
s'illed individuals represent the gains to rich countries of an integrated global labor
mar'et.
?oor countries also gain. They produce better and more# than's to the technology#
design and managerial s'ills brought in from rich countries. The ages of their uns'illed
rise and this represents their gains from globali5ation. =oever# middle-income countries
(loer middle-income to upper middle-income) gain almost nothing from globali5ation
as they are li'ely to experience (the smallest change in factor-price ratio) or no
significant change in the ratio of s'illed to uns'illed ages (,domsaph and >eufac'#
7220). %scaping the middle-income country trap is an uphill battle. The move from being
a middle-income country (BI*) to being a high-income country (=I*) requires a brea'
from the past in some significant structural shift. "part from policies that no longer or'
to elevate them to a high-income economy# many (trapped BI*s) tend to ma'e to
common mista'esG either they cling on too long to past successful policies or they exit
prematurely from the industries that could have served as the basis for their speciali5ation
process (The .roth 4eport# 722H). Timing is 'ey. Bost BI*s fail to anticipate the
transition and the ne demands that come ith it. For example# most BI*s hold on to a
labour-intensive strategy for too long. They artificially maintain noncompetitive firms
through a battery of subsidies# continuing to pile up fiscal incentives ith no
consideration of the ta'e-up rate or efficiency# and continue to ma'e FDI volumes the
'ey performance indicator for competitiveness (-ungsari and >eufac'# 7220).
The second common mista'e is a premature shift aay from assembly
manufacturing before ensuring an adequate supply of high-quality and competitive
human capital to support the transition to higher value-added sectors.
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#. Midd$e%Inco&e Tr'( P(t nd Pre(ent

In the postar era# many countries have managed to fairly rapidly reach middle-
income status# but fe have gone on to become high-income economies. 4ather# after an
initial period of rapid ascent# many countries have experienced a sharp slodon in
groth and productivity# falling into hat has been called a (middle-income trap.) To be
sure# the +orld :an' (72/7) estimates that of /2/ middle-income economies in /0I2#
only /C became high-income by 722HF%quatorial .uinea# .reece# =ong <ong !"4
(*hina)# Ireland# Israel# Dapan# Bauritius# ?ortugal# ?uerto 4ico# the 4epublic of <orea#
!ingapore# !pain# and Taian# *hina (figure /).
:y contrast# although many countries in Jatin "merica and the Biddle %ast
reached middle-income status as early as the /0I2s and /092s# a great ma$ority of them
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have remained there ever since. In Jatin "merica# for instance# income per capita relative
to the ,nited !tates fell almost continuously from /0I2 to 7221# especially after the debt
crises of the early /0H2s. Ji'eise# economic groth in many Biddle %astern and -orth
"frican countries has aned and given ay to high unemployment# as evidenced most
recently by the social and political upheavals that too' place during the "rab !pring of
72//.
). *eco&in+ (tuc, in t-e Midd$e
Formal evidence on groth slodon and middle-income traps has suggested
that at per capita incomes of about ,!K/I#922 in 7221 constant international prices# the
groth rate of per capita gross domestic product (.D?) typically slos from 1.I to 7./
percent# or by an average of C.1 percentage points. ,sing regression and standard groth
accounting techniques# this analysis (%ichengreen# ?ar'# and !hin 72//) argues that
groth slodons are essentially productivity groth slodons# hereby H1 percent
of the slodon in the rate of output groth can be explained by a slodon in the rate
of total factor productivity grothFmuch more than by any slodon in physical
capital accumulation. Therefore# middle-income traps are not simply the natural
implication of decreasing marginal returns to investment in physical capital# as a simple
neoclassical groth model ould suggest. " common explanation of groth slodons
is based on a Jeis-type development process (*anuto 72//3 %ichengreen# ?ar'# and
!hin 72//3 and +orld :an' 72/7). In that perspective# factors and advantages that
generate high groth during an initial phase of rapid development disappear hen middle
and upper-middle-income levels are reached# thereby requiring ne sources of groth to
maintain sustained increases in per capita income.
During an initial phase of development# lo-income countries can compete in
international mar'ets by producing labor-intensive# lo-cost products using technologies
imported from abroad. These countries can achieve large productivity gains initially
through a reallocation of labor from the lo-productivity agricultural sectors to high-
productivity manufacturing sectors or to modern services. =oever# once these countries
reach middle-income levels# the pool of underemployed rural or'ers drains and ages
begin to rise# thereby eroding competitiveness. ?roductivity groth from sectorial
reallocation and technology catch-up are eventually exhausted# hile rising ages ma'e
labor-intensive exports less competitive on orld mar'ets precisely at the time hen
other lo-income countries become engaged in a phase of rapid groth. "ccordingly#
groth slodons coincide ith the point in the groth process here it is no longer
possible to boost productivity by shifting additional or'ers from agriculture to industry
and here the gains from importing foreign technology diminish significantly (figure 7).
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Fi+ure 2 . *eco&in+ Stuc, in t-e Midd$e%Inco&e Tr'
/. A!oidin+ t-e Midd$e%Inco&e Tr' nd Mo!in+ U' t-e Inco&e Ldder
:uilding on the model described above# there are a number of public policies that
developing countries can employ to avoid or escape from middle-income groth traps.
!uch measures include developing advanced infrastructure in the form of high-speed
communications netor's# improving the enforcement of property rights through patent
protections# and reforming labor mar'ets to ensure that rigidities do not prevent the
efficient firing and hiring of employees.
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Fundamentally# these policies attract more high-ability or'ers into the design
sector3 improve productivity and ages in that sector# and increase a country&s capacity
for innovation.
0. Midd$e Inco&e Tr'( nd t-e A(in E1'erience
@nly /C countries ere able to transition from middle- to high-income status since
the /0I2s. @f these countries# five ere from %ast "siaF=ong <ong !"4 (*hina)#
Dapan# <orea# Taian# *hina# and !ingapore F four of hich comprise the so called
("sian Tigers) of the late 72th century. .iven their success# it is instructive to reflect on
their experience to dra lessons for other middle-income countries see'ing to move into
high-income status. Interestingly# many of the public policies highlighted above as ell
as a larger frameor' for innovation based on technological learning and public sector
support of 4LD investments can be extrapolated from the %ast "sian success story. The
best practices of these countries are particularly valuable for high groth emerging
mar'ets# such as *hina and other large middle-income countries# hich are already
shoing signs of sloing.
The %ast "sian economies that ere able to escape the middle-income trap# all
have succeeded in developing advanced infrastructure netor's# particularly in the form
of high-speed communications and broadband technology. Due equally to the
liberali5ation of telecommunications netor's and related regulatory frameor' reforms#
a number of countries in the region have been able to develop and enhance the
availability of information and communications services (.ill and <haras 7229).
To be sure# previous research on regional competitiveness underscores the
importance of broadband telecommunications technologies and interactive multimedia.
For countries ith large export-oriented information equipment industries# such as Dapan#
<orea# and Taian# *hina# a drive to enhance international competitiveness perpetuated
the development of broadband and multimedia industries in domestic mar'ets. Ji'eise#
other economies in the region that ere able to escape the middle-income trap# such as
!ingapore and =ong <ong (*hina)# developed their advanced infrastructure netor's to
enhance their role as regional headquarters for ma$or foreign multimedia companies
(Jangdale /009).
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2. Ho" to A!oid t-e Midd$e%Inco&e 3ro"t- Tr'
To avoid the Biddle-Income Trap# it is critical for a country to sustain high
rates of economic groth. This tas' is complicated by the fact that the transformation of
"sian economies from rural to urban-based is expected to ta'e place ithin 12 years#
hile this transformation too' over /22 years in advanced economies (see "i5enman et
al. 72/7). The economic transitions are occurring much more rapidly than those in the
past (see Felipe# 72/7). 4ecent evidence also finds that Balaysia# the ?hilippines and
*hina ill face a larger ris' of groth slodon stemming from institutions3 hile
Eietnam# India# and Indonesia are most at ris' of a slodon arising from a lac' of
transport and communications infrastructure (see "iyer et al. 72/C).
?revious studies of groth slodons in fast-groing middle-income countries
identify to modes of slodonsG one in the K/2#222-K//#222 range and another at
K/1#222 - K/I#222 (see %ichengreen et al. 72/7 and 72/C). " groth slodon is less
li'ely to occur in countries ith more diversified economic production accompanied by a
s'illed population set and high-technology production to avoid the middle-income trap
(see "iyer et al. 72/C and %ichengreen et al. 72/C).
The continued advancement of emerging mar'ets ill influence the future global
competitive landscape in a number of ays. First# domestic mar'ets in emerging
economies ill assume far greater significance. "s a result of rapid groth# developing
"sia&s middle-class population more than tripled from 1I1 million to /.0 billion from
/002 to to 722H ("D: 72/2). !econd# the steady rise of intra-regional trade is li'ely to
further gro in prominence (%rnst L Moung 72/C# "D: 7220) ith higher anticipated
flos of people# goods# services# and technologies. Third# corporations in emerging
economies are gaining ground in global mar'ets hile also developing ne products and
services tailored to the needs of developing country customers.
*ompetitiveness is no longer associated only ith exchange rates# industrial
policies# labor costs# and natural resource endoments. Today# it also includes or'force
s'ills# management of ho s'ills are used and government&s ability to formulate and
implement education# training# and s'ills-based policies.
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Developing "sia therefore needs a robust and mar'et driven s'ills development
system that contributes to competitiveness. Talent and s'ills are crucial to
competitiveness of industries.
"nother important indicator is the .lobal *ompetitiveness Index (.*I).
"ccording to +orld %conomic Forum# hich releases the annual global competitiveness
report# in its 72/C-72/N publication the competitiveness of /NH economies ere evaluated
providing insights into the main drivers of productivity and prosperity across the orld.
4. 5-t S-ou$d Po$ic6 M,er( Do7
?olicyma'ers should promote entrepreneurship and innovation to begin reaping
the benefits of information netor's and s'illed labor before the gains from cheap labor
and 'noledge spillovers are exhausted. 4apidly expanding the secondary and then
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tertiary education system ill be critical in producing graduates ith the s'ills that
employers require.
=ighly s'illed or'ers and professionals are an indispensable ingredient of high
valued added# modern services and manufacturing. The (s'ills crisis) is a ell-'non
shortcoming of the middle-income economy. The response O-ot enough good peopleO is
a common complaint among business oners in those countries. "ttracting highly
productive foreign firms to locate production in developing countries is another area that
policyma'ers should devote their focus. "part from the direct benefits of high ages#
imported capital equipment# and substantial tax revenues# the spillovers beteen these
firms and the broader economy are ell-documented. The current degree of restrictions
on foreign-oned firms 8 particularly in the services sector 8 might be hindering the
potential for FDI to stimulate further groth.
Developing the services sector holds the greatest promise for high impact reform.
In particular# providing access to learning and training opportunities to build social
entrepreneurs and product innovations ill be crucial. The promise of service
globali5ation means that middle-income countries should utili5e the mar'et space
provided by the Internet to foster business and technological innovations for the global
economy. In this respect# the interaction of spatial transformations ill be paramount.
The range of modern services that can be digiti5ed and traded globally is constantly
expanding. India has been a pioneer# but many other emerging mar'ets are finding it
easier to generate productivity groth in services than in industry. This does not happen
automatically.
"lthough the same set of general non-distortionary policies is as important for
modern services as for goods# specific strategies for services matter li'e mar'et
integration and the technological changes in information netor's. !ervices expansion
provides an alternative groth escalator for emerging mar'ets li'e Balaysia. The
globali5ation of service has $ust begun. The moderni5ation of services is a promising ay
out of the middle-income trap.


8. Conc$u(ion
Talent and s'ills are crucial to competitiveness of industries. !'ills development
serving clusters of different but interrelated industries can increase efficiency and
sectorial competitiveness. !'ills credentials developed and endorsed by industry are
crucial for successful transition from school to or'.
The rise of technology in manufacturing requires (gray collar) or ('noledge
or'ers) for higher value-added product that enable economies to avoid the middle-
income trap. "dvanced s'ills are indispensable for a high-productivity economy hile
medium-s'ills or'ers are 'eys for groth of labor-intensive sectors. Developing s'ills
for the service sector is important for "sia to improve competitiveness in 'noledge-
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intensive services such as financial intermediation computer and information services#
legal and technical support# and business services.
The features of %ast "sia&s experience in transitioning from middle-to-high-
income status provide important lessons for other countries that are attempting to follo
suit. The middle-income trap is not an unavoidable outcome3 it can be avoided if
governments act early rather than late# hen the benefits of cheap labor and the gains
from imitating foreign technology are all exhausted and decisively to promote innovation.
Doing so requires timely implementation of public policies aimed at improving access to
advanced infrastructure# enhancing the protection of property rights# and reforming labor
mar'ets. These policies are central to fostering technological learning# attracting talented
individuals into 4LD activities# and encouraging the buildup of national and international
'noledge netor's.
4%F%4%-*%!
"sian Development :an' ("D:). 7220. <ey Indicators for "sia and the ?acific
7220. Banila.
International Bonetary Fund (IBF). 72/2. +orld %conomic @utloo' Database.
"vailableG httpGPP.imf.orgPexternalPpubsPftPeoP72/2P27PeodataPindex.aspx
!uggested *itation Dagannathan# !.# L .eronimo# D. (72/C). !'ills for
competitiveness# $obs# and employability in developing "sia-?acifc. BanilaG
"sian Development :an'.
+orld :an'. 72/C. +orld Development 4eportG Dobs. "vailableG
httpGPPsiteresources.orldban'.orgP%QT-+D472/CP4esourcesPH71H27N-
/C720129N9/07PH7I270C-/C77II1HHC/N9P+D4R72/CR4eport.pdf
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