Unlocking the truth of the middle-income trap

Developing nations like Indonesia, Thailand and Malaysia have helped keep the world economy humming in recent years – but are they now stuck in the middle-income trap?

Lowy Interpreter

With Europe stagnating, America in a limp recovery and Japan still mired in its lost decades, world growth has been sustained over the past two years by the performance of the emerging countries, which accounted for half of world growth. This has occurred despite confident predictions that these countries could 'decouple' from weakness in the advanced economies and go it alone.

So far so good on that front. But the pessimists are finding new reasons for doubting that emerging economies can continue to grow at a good pace.

It's true that slow growth in advanced countries has taken away the traditional export-oriented growth option. Emerging countries have had to rely on domestic demand. But this switch has been achieved. China, India and the ASEAN countries have not relied on net exports (the blue segments in this IMF graph) to help their growth; imports have grown faster than exports.

Even with this concern assuaged, the pessimists can still find plenty to fret about.

The most wide-ranging but nebulous anxiety relates to the 'middle-income trap', the observation that many countries have moved out of abject poverty into modest living standards, but few have made the extra step, breaking through to high living standards in the way Japan did in the decades after World War II and Singapore, Hong Kong, Taiwan and Korea have done more recently. Chapter 3 of the IMF's recent Asia report finds support for this view, identifying the Asian middle-income countries as being more vulnerable to episodes of sustained slowing.

But if the middle-income trap relies on some intrinsic dynamic of the growth process which causes growth to run out of puff at the income levels reached by Indonesia, Malaysia and Thailand, then the Asian evidence is weak or non-existent.

The IMF's analysis is based on two types of slowing. First, the countries caught up in the 1997 Asian crisis took a decade to recover from this searing experience. Then there is the more recent experience of India and China, both shifting from a period of unsustainably high growth to slower but still rapid growth.

None of these episodes seems either intrinsic to the growth process or similar to the chronic failed promise found more typically in Latin America (for example, Mexico and Brazil). Having identified Indonesia, Malaysia and Thailand as candidates for 'middle-income trap' status, the IMF's growth forecasts for these countries (found in the same document) are uniformly around 5 per cent, safely above any trap.

If the discussion of the middle-income trap is intended as a salutary reminder to the region's policy-makers that economic growth requires vigorous and continuing reform, then the importance of the message cannot be denied. The essence of the development process is the progressive replacement of inefficient practices by more productive ones.

These transitions are not easy or inevitable: labour has to be shifted to new jobs and techniques; vested interests have to be circumvented; government maladministration has to be reformed.

But the middle-income trap is an unconvincing threat in the Asian context. Anyone observing the myriad opportunities to correct inefficiencies, smooth the production process through better infrastructure and reap the obvious potential for transformational productive change will see the glass as half full rather than half empty.

The refutation of the middle-income trap hypothesis is apparent in countries like Indonesia which, despite the painfully obvious deficiencies of policy, governance, productive techniques and infrastructure, is growing at a steady 6 per cent a year. The same document gives the game way when it records (Graph 1.25) that the return on assets in Indonesia is over twice the rate in any of the advanced countries. The issue is not whether Indonesia is falling into a middle-income trap, but rather why it doesn't take the available opportunity to grow at 8 per cent rather than 6 per cent.

Of course, reaching such higher potential would require the solution to stubborn problems, mainly political rather than economic. Even the current growth rate is not assured, since it is always subject to the risk of financial crisis or serious policy errors. But to base the case for better policy-making on the threat of the middle-income trap risks being ignored through irrelevance.

Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.