Asia and the middle-income trap

Friday, 2 August 2013 00:00 -     - {{hitsCtrl.values.hits}}

Will Asian emerging markets follow Latin America and the Middle East into the middle-income trap? Having enjoyed fast catch-up growth, will they now get stuck, unable to graduate to high-income levels? These are live policy and research questions, most recently brought up in the IMF’s Spring Regional Outlook for Asia and the Pacific. This IMF report identifies middle-income countries in East and South Asia as those with per-capita incomes of US$ 2,000-15,000. Its reading of the evidence is that there is indeed a middle-income trap, and Asian countries need to reform policies and institutions to get out of it. Let’s probe deeper. Most of the evidence on the middle-income trap comes from Latin America and the Middle East. These are regions abundant in land and natural resources. They have had growth spurts during commodity booms, often followed by growth crashes when commodity prices plummet. In Latin America, from the 1950s to the 1970s, extra growth came from import-substitution policies that favoured urban, import-competing manufacturing industries. However, the inefficiencies these policies bred caused growth to taper off, come to a halt and even end up in macroeconomic crises. In contrast, much of East and South Asia is abundant in labour. The East Asian Tigers started their catch-up growth by putting armies of initially unskilled labour to work. They shifted rapidly from agriculture to export-oriented manufacturing. Then they moved up the value chain in ‘flying-geese’ pattern. From the 1980s and ’90s, they inserted themselves in global value chains (GVCs). Growth has been higher and more sustainable, with benefits more widely shared, than in Latin America and the Middle East. Until the 1980s, South Asia, unlike East Asia, had Latin American-style import-substitution policies that restricted growth – and without a commodities bonanza. But then the sub-continent opened up and integrated with the global economy. Growth rates shot up accordingly. The comparative lesson is clear: labour abundance has helped ‘globalising Asia’ to achieve faster catch-up growth, particularly with export-oriented industrialisation in East Asia. That puts the region in a better starting position than Latin America and the Middle East to avoid the middle-income trap. Now let’s differentiate middle-income Asia. There are eight countries that stand out in East and South Asia: the ASEAN-5 (Malaysia, Thailand, Indonesia, Philippines and Vietnam), China, India and Sri Lanka. But they are at very different levels of development. So let’s first divide them into ‘high middle-income’ and ‘low middle-income’ brackets. Malaysia is at the top of the high middle-income bracket. Indonesia, Philippines, Vietnam, India and Sri Lanka are in the low middle-income bracket. China and Thailand are roughly in the middle with per-capita incomes of about US$ 8,000. Now let’s make a further subdivision, this time within China and India. Both have vast sub-continental reach, with sub-regions that differ widely in terms of economic development. The 10 coastal provinces of China are clearly in the high middle-income bracket, close to Malaysia. But the interior provinces are low middle-income. The more advanced Indian states, mainly in the south and the west, are low middle-income, but India’s ‘cow belt’ in the north-centre, and its northern and eastern states, are low-income. Much of India, like Pakistan, Bangladesh, Nepal, Cambodia, Laos and Myanmar – not to mention East Timor, Papua New Guinea and North Korea – has yet to escape the low-income trap. This twofold differentiation of middle-income Asia is important, for it affects conclusions on policy and institutional reforms to get out of growth traps. So far, only five Asian countries have escaped the middle-income trap: Japan, South Korea, Taiwan, Hong Kong and Singapore. What do the rest need to do to follow them? To answer this question, it is useful to go back to the World Bank’s landmark report, The East Asian Miracle, published in 1993. It analysed the catch-up growth of the East Asian Tigers, but some of its conclusions are relevant to the middle-income trap. Its foremost conclusion was that it is vital to ‘get the basics right’: macroeconomic stability, relatively low distortions to domestic competition, openness to external trade, flexible labour markets, and investment in hard infrastructure as well as education. Pace the ‘revisionist’ school of thought, these “horizontal”, economy-wide policies are far more important than ‘vertical’ industrial policies to promote favoured sectors and national champions. Getting the basics right must still be the top priority for low-income Asia – including the less developed states in India. These countries and regions should be in the business of catch-up growth, which comes from maximum mobilisation of capital and labour inputs, and large productivity gains from efficient resource reallocation. This is what Paul Krugman calls growth through ‘perspiration’. At the other extreme, high-income Asia, from Japan down to Singapore, has to rely on ‘output-led,’ productivity- and innovation-based growth. This is what Prof. Krugman calls growth through ‘inspiration’. Getting the basics right is still important – note that Japan is hurtling in the opposite direction with wildly profligate fiscal and monetary policies. But this has to be complemented with more sophisticated structural and institutional reforms. These ‘second-generation’ reforms have to go beyond liberalisation of product markets to encompass deregulation of factor markets (for land, labour and capital). They must also include opening up of services sectors, upgrading ‘soft infrastructure’ (such as higher education and skills), and improving the quality of public administration, regulatory agencies and judicial systems. What about middle-income countries ‘in between’? They need a mix of getting the basics right and second-generation reforms. But the balance should differ as between high middle-income and low middle-income countries. High middle-income countries need to crack on with structural and institutional reforms for productivity-based growth. This applies to Malaysia, Thailand and China (especially its coastal provinces). Reforms to the Bumiputera policy and government-linked companies in Malaysia, the financial sector, state-owned enterprises and the hukou system (that restricts labour movement) in China, and property rights and the rule of law in all three countries, come to mind. Low middle-income countries still have to go farther with getting the basics right, just as they have more room for catch-up growth. But they must also embark on the simpler, less institutionally demanding second-generation reforms. That applies to India (especially its more advanced states), Sri Lanka, Indonesia, Philippines and Vietnam. The middle-income trap is also as much about politics as it is about economics. Second-generation reforms are politically more sensitive than first-generation reforms, for they get closer to the heart of vested interests and political systems. That is why factor-market deregulation generally lags far behind product-market liberalisation. To make middle-income trap issues more concrete, let’s look at one policy cluster: trade and global value chains (GVCs).  The latter fragment production across borders. Simultaneously, trade in parts and components, and complex logistics systems, knit production networks together to serve global markets. Trade in GVCs is the fastest growing part of international trade, and a critical driver of productivity, growth and employment in both developed and developing countries.  East Asia, alongside NAFTA and the EU, is a production hub for GVCs. How can GVCs help countries to escape growth traps? For low-income and low middle-income countries, the challenge is to insert themselves into labour-intensive segments of GVCs, particularly in manufacturing. This is a proven recipe for fast catch-up growth. It applies to South Asia, the poorer ASEAN countries and the interior provinces of China. High-income and high middle-income countries need to specialise in more capital-, knowledge- and skill-intensive segments of GVCs, in manufacturing and increasingly in services. Finally, what policies best ensure gains from GVCs? First, get the basics right with macroeconomic stability, competitive product markets, low levels of red tape, and openness to trade and foreign direct investment (FDI). Second, focus on taking down more complex regulatory barriers, especially in services, FDI and border administration. And third, avoid industrial policy of the ‘picking winners’ variety. Discriminatory policies, e.g. local-content and technology-transfer requirements, FDI and public-procurement restrictions, lax intellectual-property protection, trade-distorting subsidies, disrupt the seamless cross-border flow of goods and services that is the essence of GVCs. (The author is Visiting Associate Professor at the Lee Kuan Yew School of Public Policy, National University of Singapore.)