Confronting the Middle Income Trap: Policy Lessons from a Trans-regional Comparison

Eva Paus, guest blogger

The middle income trap is a new concept that strikes fear into the hearts of development practitioners. Analysts generally agree that the absence of broad-based upgrading towards more knowledge-intensive activities is at the heart of the middle income trap. But they differ in their explanation of the trap.  Some see it as a typical problem for middle income countries in the process of accumulating technological capabilities and emphasize internal causes (e.g. Eichengreen, Park and Shin 2011, Asian Development Bank 2011).  Others, including this author and her collaborators in a project on the middle income trap, argue that middle income countries have always faced the challenge of how to move from commodity production to more knowledge-intensive activities. But it is the current globalization context that is turning this challenge into a possible trap.

The high road to economic development involves a process of structural change where production shifts increasingly towards activities with greater value added and knowledge-intensity. The failure of Washington Consensus policies to engender such structural transformation has become ever more apparent in recent years, as competition in international markets has intensified, and China has become a powerful competitor in low-tech goods and high-tech goods. In 2000, 19.6% of world imports of low-tech goods came from China, compared to only 6.7% of high-tech goods. By 2009, the shares had risen to 29.2% and 21.5%, respectively. Middle income countries now find themselves between a rock and a hard place.  They are increasingly unable to compete with producers in low wage countries in the export of standardized products, but they have not developed the capabilities to compete, on a broad basis, in the exports of skill and knowledge-intensive goods and services. They now run the risk of being trapped, of being pushed onto the low road of change, where declining wages, not rising productivity, form the basis for competitiveness and growth.

Our recent study on the middle income trap suggests valuable policy lessons for governments seeking to avoid or escape from the middle income trap.*  Our working group developed an analytical framework that shifts the focus from growth to upgrading, and thus to learning processes, policy interventions, and the interactions among social and firm-level capabilities in the context of path dependency and location and time-specific contingencies. Merging structuralist, evolutionary and global value chain analysis, this capabilities-based approach links the macro-economic context with micro-economic behavior and meso-economic conditions contingent upon path dependency and global circumstances.

We used the capabilities-based approach to analyze upgrading processes and outcomes in five small latecomers: Chile, the Dominican Republic, Jordan, Ireland, and Singapore. We focused on small countries because most middle income countries are small and do not have the advantages of size and bargaining power of large latecomers like Brazil, India, and China, and thus tend to be more open to trade and investment. We chose countries that narrowed the income gap with high-income countries under a liberal foreign trade and investment regime, the dominant policy regime today, and which have been considered success stories in their own regions, and sometimes beyond. Finally, we chose countries from different parts of the world to explore the importance of location and time for upgrading experiences.

The country studies suggest five important lessons. First, they show that income convergence does not necessarily imply capability convergence and broad-based upgrading. In at least three of the cases (Chile, the DR, Jordan), an assessment of development success based on capability advancement differs significantly from an assessment based on growth. Second, the country studies demonstrate that strategic, proactive and coherent government policies for the advancement of social and firm-level capabilities, at different stages of development, were a critical determinant of upgrading, both at the country level and in the development of ‘pockets of excellence.’  Far from being a relic of import substitution, industrial policies are critical for upgrading under liberal trade and FDI policies.

Third, the trans-regional comparison demonstrates the peril of neglecting the development of local firm capabilities. Small countries are more prone to rely on foreign direct investment (FDI) for upgrading. Indeed, in all five countries, governments envisioned FDI to play a key role in the country’s development. But the case studies demonstrate that production by TNC affiliates in the host country does not automatically contribute to increasing local firm capabilities, and that, in the context of changing national and global conditions, TNCs may be more likely to relocate to other countries than to upgrade in the host country.

Fourth, while substantial fiscal resources are needed in support of the expansion of social capabilities, local firm upgrading and TNC movements up the value chain, the fiscal space is not necessarily the binding constraint. Ireland benefited from EU Structural Funds. Singapore combined forced savings via the retirement scheme with incentives to increase savings voluntarily in the private sector. Chile has taken advantage of the copper price boom to extract additional revenue to support the current expansion of R&D. And Jordan has been receiving grants equivalent to 25% of GDP. With a tax ratio of 13%, the Dominican Republic was the only country in our sample where the fiscal space was severely restricted.

Fifth, macroeconomic variables have to provide a coherent incentive structure that supports a broad focus on upgrading and innovation. The combination of macroeconomic stability and incentives towards upgrading worked very well in the case of Singapore, but not in the other countries. In Jordan, the long-time fixed exchange rate vis-à-vis the US dollar (since 1995) has constituted a serious obstacle to upgrading. In Chile, since the crisis of the early 1980s, successive governments have privileged nominal macroeconomic stability and, in the last decade in particular, permitted exchange rate appreciation to the detriment of local producers.  And in Ireland, low interest rates (the result of joining the Euro Zone) together with weak regulation of the banking system and populist policies favored short-term profit-making in the real estate and financial sectors over long-term development of innovation-based activities.

In sum, the comparative case studies suggest that the best shot at an escape from the middle income trap is a shift in the analytical focus from growth to capability-accumulation and a shift in the policy focus from the current faith in a market-led process of upgrading to an embrace of a proactive state to support the synergistic advancement of social and firm-level capabilities.  Effective states may be hard to build, but they have become essential in the current process of China-dominated globalization.

*The studies are published as a special issue in Studies in Comparative International Development, June 2012.

Eva Paus is a Professor of economics and the Carol Hoffmann Collins Director of the McCulloch Center for Global Initiatives at Mount Holyoke College.

The Triple Crisis blog invites your comments. Please share your thoughts below.