How to escape the middle income trap

 Economic development

Indermit Gill on what China and India must do to join the rich club

First invest, then infuse foreign technology and then innovate, says the World Bank’s chief economist

Illustration: Dan Williams

Aug 12th 2024

“TO GET RICH is glorious” is the maxim that inspired one of the most successful development strategies of the past 50 years. It’s an aspiration widely shared across developing countries—and for good reason. When countries become wealthier, the results can be glorious. Living standards rise. Poverty recedes. The propensity to pollute dwindles, as products and production methods improve.

That’s why a growing number of developing countries are setting national deadlines to become developed economies: China by 2035, Vietnam by 2045, India by 2047. In the absence of a miracle, their chances of success are slim—because of a distinctive affliction that strikes countries as they climb the income ladder. In the coming decades the fate of the world will depend on whether it can be cured.

In their drive for wealth, few countries get anywhere near the top. Economic growth in developing countries tends to level off during the middle-income stage. It’s what the World Bank calls “the middle-income trap”. This idea has been disputed over the past decade or so. Yet the latest evidence is compelling: since 1970 the average per-person income of middle-income countries has never risen above 10% of the level in America.

Since 1990 only 34 economies have managed to move up from middle- to high-income status—and more than a third of those were beneficiaries of either integration into the European Union or previously undiscovered oil. The number of people living in these economies is less than 250m—roughly the population of Pakistan.

Today middle-income countries (defined by the World Bank as having gross national income per person of between roughly $1,150 and $14,000) are home to about 6bn people and nearly two-thirds of those who struggle in extreme poverty. They produce about 40% of the world’s economic output and nearly two-thirds of its carbon emissions. In short, the global effort to end extreme poverty and spread prosperity and liveability will largely be won or lost in these countries.

Middle-income countries now face far heavier burdens than their predecessors did: ageing populations, geopolitical and trade frictions, and the need to speed up growth without fouling the environment. Yet most remain wedded to an approach out of the last century: policies focused heavily on attracting investment. That’s the equivalent of driving a car entirely in first gear: it will take forever to get to the destination. A few try to leapfrog to innovation. That’s the equivalent of shifting from first gear to fifth and stalling the car.

There is a better way. The World Bank proposes a sequenced, three-pronged plan.

Low-income countries are best served by a strategy focused mainly on attracting investment. Once they become lower-middle-income countries, they need a more sophisticated approach. Investment must be supplemented by the deliberate infusion of technology from abroad. That means acquiring modern technologies and business models and diffusing them domestically to enable enterprises to become global suppliers of goods and services.

Infusion requires an ever-larger talent pool: more engineers, scientists, managers and other highly skilled professionals. To expand the pool, skills must be sharpened across the workforce. One of the most self-defeating attributes of middle-income economies is their proclivity to sideline women by limiting their educational and economic opportunities. The payoff can be immense when such practices are halted. In America, for example, more than a third of the growth that occurred between 1960 and 2010 can be attributed to decreasing racial and gender discrimination in education and the workforce. Without these changes, America’s income per person would now be $50,000, not the $80,000 it is.

Once a country has mastered both investment and infusion, it is ready for the final push—towards global innovation. South Korea stands out in all three categories. In 1960 its per-person income stood at just $1,200. By the end of 2023 it had climbed to $33,000. No other country has managed to pull off a performance like that.

South Korea began with a simple set of policies to increase public investment and spur private investment. That morphed in the 1970s into an industrial policy that encouraged South Korean firms to adopt foreign technology and more cutting-edge production methods. Samsung, once a local trading company dealing in dried fish and noodles, began making televisions using technologies licensed from Japanese companies.

Samsung’s success fuelled demand for engineers, managers and other skilled professionals. The South Korean government did its bit to help the economy meet this demand. The education ministry, for instance, set targets and increased funding for public universities to help develop the new skills sought by domestic firms. The results are clear to see. Today Samsung is an innovation powerhouse—one of the world’s two largest smartphone manufacturers and its largest memory-chip manufacturer.

To make the transitions necessary to reach high-income status, governments in middle-income countries must enact competition policies that create a healthy balance between large corporations, mid-sized firms and startups. The benefits will be greatest when policymakers focus less on the size of the company and more on the value it brings to the economy, and when they encourage the upward mobility of all of their citizens instead of fixating on zero-sum policies to reduce income inequality.

They should also seize opportunities arising from the need to tackle climate change—by producing and exporting electric vehicles, wind turbines, solar panels and so on. Middle-income countries should not be expected to immediately forgo the use of all fossil fuels in their quest for faster economic growth. But they should be expected to become more energy-efficient and cut emissions.

If they stick to the old approach, most developing countries will miss their target of reaching high-income status by the middle of this century. On current trends it will take China another 11 years to reach just one-quarter of America’s income per person. It will take Indonesia 69 years and India 75. By adopting a “3i” strategy—first investment, then infusion, then innovation—they can multiply their odds of getting there. The rest of the world would benefit, too, because policies that reward merit and efficiency enable growth that is quicker, kinder and cleaner. ■

Indermit Gill is chief economist and senior vice-president of the World Bank Group.

A bit of background on China and the middle income trap

 

PLANTING CHINA’S FLAG IN HONG KONG WAS A TERRIBLE MISTAKE

China imported its dynamism

project-syndicate.org
China’s economic success has long been something of a mystery, says Yasheng Huang. In their best-selling 2009 book Start-up Nation, Dan Senor and Saul Singer showed how a culture of informality and egalitarianism that is unafraid to challenge hierarchies helped to make Israel a global entrepreneurial success story. China, by contrast, is hierarchical, repressive and stifling of individual initiative, and lacks a culture of democracy, the rule of law, market-based finance or private property rights. And yet entrepreneurship seems to have flourished there too. How so?

THERE IS NO THIRD WAY

Some argue that it is because China found a “third way” that harnesses the efficiency of the market economy to the power of the state without having to rely on liberal institutions. They are mistaken. In my new book, The Rise and Fall of the EAST, I show that the answer to this conundrum has long been “hidden in plain sight”: Hong Kong. At least until very recently, it was the source of the rule of law and market finance for entrepreneurs in China. 

China in effect “outsourced” those functions to Hong Kong in the Deng Xiaoping era. Hong Kong was still a British colony in 1994, and between 1997 and 2019 it operated with relative autonomy from China, preserving its laissez-faire economy and market-orientated financial system, rule of law and secure property rights. Deng’s reforms linked China’s entrepreneurs with global venture capital and allowed some Chinese citizens and businesses to exit. China’s success, in short, had “less to do with creating efficient institutions than with providing access to efficient institutions elsewhere”. 

This is why Chinese high-tech companies, for example, have tended to register their assets outside China’s legal system. There are nine Chinese firms among the world’s top-20 biggest tech companies. Only three of them are fully domiciled domestically. The others all have domicile connections to establishments registered in Hong Kong or other overseas territories.

Since the imposition of the 2020 national security law, Hong Kong has been dragged away from the rule of law towards China’s “rule by law”. New safe harbours have emerged, such as Singapore, but they are hosting economic refugees more than performing Hong Kong’s historic role. It won’t be long before China feels the effect of its policies, which will strangle innovation-driven growth. China will “pay a steep price for getting basic economics so egregiously wrong”.

China and the Middle Income Trap

 We have to keep an eye on China; it may end up exporting deflation to the West which could have several negative impacts on us - but what about China?

China’s property crash is becoming more dangerous by the day

The country’s ticking time bomb economy is nearing the point of detonation

AMBROSE EVANS-PRITCHARD17 August 2023 • 7:21pm

Xi Jinping faces an invidious choice between hurling credit at his deformed economy or biting the bullet and risking a depression CREDIT: REUTERS/Tingshu Wang

China’s financial system is one step away from a full-blown crisis. Unless radical action is taken to stem contagion through the shadow banks and halt the contractionary slide in demand, China risks tipping into a classic liquidity trap.

Cai Fang, a rate-setter at the central bank, has called for a $550bn blast of helicopter money – or high-powered QE injected into the veins of the economy – in order to stop a deflationary psychology taking hold as frightened households retrench.

“The most urgent imperative now is to stimulate consumer spending. It is necessary to use all reasonable, legal, and economically viable channels to put money into people’s pockets,” he wrote on China Finance 40, the opinion forum of the elite.

This increasingly feels like the make-or-break moment faced by the US Treasury in 2008 after Lehman Brothers collapsed, or faced by the eurozone in 2012 when the doom-loop threatened to engulf Italy and Spain. 

America and Europe acted in time, after a string of errors. 

It is far from clear that Xi Jinping has recognised the destructive mechanisms at work in China, or that economists in the West are alert to the global dangers through multiple channels of transmission, starting with an exchange rate shock. 

The yuan has fallen to a sixteen-year low against the dollar. The East Asian currency bloc is falling in tandem, pushing the euro trade-weighted index to a record high. 

The effect is to bludgeon a eurozone economy already in a deep industrial recession. The cheaper the yuan, the greater the tsunami of Chinese electric vehicles, machinery, or wind turbines, heading for Europe.  

Westerners emerged from the pandemic with windfall savings, thanks to furlough schemes. 

The Chinese endured draconian lockdowns for three years with far less support. The damage has undermined the finances of millions of small family businesses. A large chunk of the population has slashed spending in order to rebuild depleted savings. 

It is the immediate reason why the post-pandemic rebound has already fizzled and why the economy has tipped into deflation. 

The deeper reason is the painful unwinding of the great Communist debt bubble, an episode uncannily similar to the debt woes of the late Qing dynasty. 

The giant developer Country Garden, with total liabilities of $200bn, is days away from default after missing payments on dollar loans issued in Hong Kong. 

Ting Lu and Jing Wang from Nomura estimate that the company has already received payment for a million properties that have yet to be built. 

Like other developers relying on China’s “pre-sale” model it depends on a constant flow of new buyers to cover old debts.

The buyers have dried up. The CRIC Research Centre says sales in July by the top-100 developers were just 30pc of levels three years ago. 

“We believe the Chinese economy is faced with an imminent downward spiral with the worst yet to come,” they said, warning that half-hearted tinkering by the authorities so far will not stop a wave of defaults and chain-reaction through the economy.

“In our view, Beijing should play the role of lender of last resort to support major developers and financial institutions in trouble, and should play the role of spender of last resort to boost aggregate demand,” it said.

China’s $60 trillion property edifice is by far the largest asset class in the world. 

It accounts for half of the world’s entire property sales, an astonishing figure given that China’s workforce is already contracting and net migration from the countryside has stopped.

The developers have debts of $5 trillion. By comparison, this is six times greater than America’s $800bn subprime property debt on the eve of the Lehman crisis. 

They rely heavily on the $3 trillion “trust” segment of the shadow banking nexus known, which has no lender of last resort. These trusts are starting to blow up. The $140bn Zhongzhi Empire is the most disturbing casualty so far. 

The property bubble is the Ponzi scheme that keeps China’s local governments afloat. 

They rely on property for 38pc of total revenue, mostly from land sales. These sales have collapsed. The finance ministry says local government income fell 21pc in the first half of 2023. 

This must lead to a severe fiscal squeeze unless Beijing comes to the rescue with a huge stimulus package stimulus. The signs are that Xi Jinping is still reluctant to do so. 

His allies have published a media note entitled “Clarifying the Eight Misconceptions about Expanding Domestic Demand”.

Xi faces an invidious choice. Hurling credit at the deformed Chinese economy every time the sugar rush fades and the economy slows is what has led to this colossal mess, but biting the bullet risks an economic depression and a crisis of legitimacy for the Communist Party. 

His immediate reflex is to silence unpleasant statistics. Youth unemployment data has been suspended after the rate jumped to a record 21pc.

A Beijing professor thinks the rate is nearer 46pc once you include those “lying flat”, the Chinese term for dropping out, living at home, and sponging off grandparents (four per child) to while away the day with friends in coffee shops. 

The Party’s first mistake was to ignore warnings by premier Li Keqiang a decade ago that China risked falling into the middle income trap if it clung too long to a catch-up model of state-led construction.

The second mistake was to launch a political purge against business bosses and turn away from Deng Xiaoping’s outward-looking economics, the motor force of China’s revival. 

The third was to revert to economic Leninism, thinking that 2008 was a systemic crisis of US-led capitalism and a validation of Party control over credit. 

The fourth was to pick a fight with the liberal West before China was close to economic parity.

The evidence is in. The growth rate of total factor productivity has fallen to the levels of mature economies before China is mature. 

The country is no longer on the same trajectory as Japan, Taiwan, and Korea at a comparable point of development. The nail in the coffin is an 87pc fall in foreign direct investment last quarter, the lowest level since records began in the 1990s. That is Xi’s legacy.

Capital Economics thinks China’s (true) trend growth will drop to 2.8pc over the late 2020s. If so, China will not surpass the US this decade, and will then fall back as the demographic decline gathers pace.  

China denies vehemently that it is succumbing to ‘Japanification’. 

In my view, it will be lucky to do as well as Japan. It has the same pathologies of boom-bust deflation and vanishing workers, but is further blighted by totalitarian leaders with a deep fear of the free market. 

Unlike Japan, it has angered the West and must now contend with strategic reshoring and a hi-tech blockade.

Joe Biden calls China’s economy a “ticking time bomb”. 

My presumption is that Xi Jinping will not let it detonate on his watch. At some point he will blink and take drastic action to shore up the property market and the shadow banks, putting off the day of reckoning for another cycle. 

If he does not, the global financial system is in for a dangerous denouement this winter.

Must-read on middle income trap

If I'd read this before your mock, put it here and you had read it & digested, it could have added 4-5 marks to your Paper 3 essay(s). I have highlighted one absolutely critical paragraph (even my son realised this was crucial), and put a line at the bottom of the part that is important - below the ******* it becomes an analysis of statsistical application, which is not so important:

Mixed-income myths - The Economist October 7th 2017

The middle-income trap has little evidence going for it
Countries that are neither rich nor poor can hold their own against rivals at both extremes

EVERY FEW YEARS Foreign Affairs, a magazine about international relations, provokes a fracas in a neighbouring discipline, international economics. In 1994 it published an essay by Paul Krugman, “The Myth of Asia’s Miracle”, which re-examined the source of the tigers’ success. Then, after the Asian financial crisis, it came up with “The Capital Myth” by Jagdish Bhagwati, which re-examined the case for free capital flows, the source of the tigers’ humiliation. In 2004 it offered “Globalisation’s Missing Middle” by Geoffrey Garrett, then at the University of California, Los Angeles. This essay is cited much less often than the other two, but in a roundabout way it has been equally influential. It argued that middle-ranked countries were in a bind, unable to compete either with the cutting-edge technology of rich nations or the cut-throat prices of poor ones. “Middle-income countries”, it said, “have not done nearly as well under globalised markets as either richer or poorer countries.”

To prove his point, Mr Garrett ranked the world’s economies by GDP per person in 1980, dividing them into three groups: top, middle and bottom. He then compared their growth by that measure over the subsequent two decades, finding that the middle-ranked economies grew more slowly than either the top or bottom ones. Three years later Homi Kharas and Indermit Gill of the World Bank cited Mr Garrett’s essay in a book about East Asia’s growth prospects. They invented the term “middle-income trap”, which subsequently took on a life of its own.

The trap can be interpreted in a variety of ways, which may be one reason why so many people believe in it. Some confuse the trap with the simple logic of catch-up growth. According to that logic, poorer countries can grow faster than richer ones because imitation is easier than innovation and because capital earns higher returns when it is scarce. By the same logic, a country’s growth will naturally slow down as the gap with the leading economies narrows and the scope for catch-up growth diminishes. All else equal, then, middle-income countries should grow more slowly than poorer ones. But Mr Garrett was making a bolder argument: that middle-income countries tend to grow more slowly than both poorer and richer economies. 

The notion of a trap resonated widely with policymakers, note Messrs Kharas and Gill, especially in countries where growth had lost its lustre. Najib Razak, Malaysia’s prime minister, began talking about it in 2009. Trap-talk also spread to Vietnam’s leaders in 2009 and appeared in South Africa’s National Development Plan in 2012.

By far the most prominent trap-watcher is China, one of the few middle-income economies that is more than middle-sized. In 2015 Lou Jiwei, then China’s finance minister, said that his country had a 50% chance of falling into the trap in the next five to ten years. The same fear haunts Liu He, an influential economic adviser to Xi Jinping, China’s president. Mr Liu was one of the driving forces behind a report entitled “China 2030”, published in 2012 by his Development Research Centre (DRC) and the World Bank. The report featured a chart that has perhaps done more than any other to spread the idea of a middle-income trap (see chart). It showed that of 101 countries which counted as middle-income in 1960, only 13 had achieved high-income status by 2008. The rest spent the intervening 50 years trapped in mediocrity or worse.

Slow and queasy

The evidence in the chart and Mr Garrett’s essay was suggestive but hardly systematic. However, it was buttressed by a more rigorous pair of studies by Barry Eichengreen of the University of California, Berkeley, Donghyun Park of the Asian Development Bank and Kwanho Shin of Korea University, which reached similar conclusions. They looked for fast-growing economies that subsequently suffered sustained slowdowns (defining fast growth as at least 3.5% per person, and a slowdown as a two-percentage-point drop in growth, both averaged over seven years). Their research indicated that these slowdowns seemed to cluster at GDP levels of $11,000 and $15,000 per person (converted into dollars at purchasing-power parity). 

Perhaps the most sophisticated analysis was published by Shekhar Aiyar and his colleagues at the IMF in 2013. They sought to distinguish between growth traps and the natural slowdown that any country can expect as it converges with leading economies. To do this, they first calculated an expected growth path for each country, based on its income per person as well as its human and physical capital. Second, they looked for countries that were growing faster or slower than expected, resulting in positive or negative growth gaps. Third, they looked for unusually severe and sustained slowdowns, when these growth gaps widened sharply. They found that middle-income countries were more likely to suffer such setbacks, no matter how middle income was defined.

The combined weight of this economic evidence and policymakers’ intuition is hard to ignore, and seems to justify scepticism about the growth prospects of China, Malaysia, Thailand and many other emerging economies. But neither the intuition nor the number-crunching is as convincing as it looks.

Intuitively, it seems to make sense that middle-income countries will be squeezed between higher-tech and lower-wage rivals on either side. But those rivals rely on high technology or low wages for a reason. Rich economies need advanced technologies and skills to offset high wages. Poor countries, for their part, need low wages to offset low levels of technology and skill. The obvious conclusion is that middle-income countries can and do compete with both, combining middling wages with middling levels of skill, technology and productivity.

To be sure, those average levels mask huge variations. Most economies have a mix of impressive leading firms and unsophisticated stragglers. The productivity of the top quarter of American firms is at least 4.86 times that of the bottom quarter, according to a study by Eric Bartelsman, Jonathan Haskel and Ralf Martin published by the Centre for Economic Policy Research. In developing countries the gaps are even bigger. Indeed, middle-income countries are often more accurately described as mixed-income economies.

Shaping the mix are at least four possible sources of growth in GDP per person. The first is moving workers from overmanned fields to more productive factories (structural transformation). The second is adding more capital such as machinery per worker (capital-deepening). The third is augmenting capital or labour by making it more sophisticated, perhaps by adopting techniques that a firm, industry or country has not previously embraced (technological diffusion). The final source of growth derives from advances in technology that introduce something new to the world at large (technological innovation).

Economists find it helpful to keep these sources of growth separate in their minds. The mistake is to think they remain separate between countries. In reality, in most countries several of these forces are at work simultaneously, at different paces and in varying proportions. Countries do not wait until the last surplus farm worker has left the fields to begin capital-deepening. Nor do they wait until the returns to brute capital accumulation have been exhausted before they start to increase the sophistication of their production techniques. So development does not proceed in discrete stages that require a nationwide leap from one stage to the next. It is more like a long-distance race, with a leading pack and many stragglers, in which the result is an average of everyone’s finishing times. The more stragglers in the race, the more room for improvement.

Positive splits

The statistical work by Messrs Eichengreen, Park and Shin shows that middle-income countries do suffer slowdowns. But since it looks only at countries with an income per person of over $10,000, it cannot say whether they are more vulnerable to such setbacks than poor countries. That was not a question the authors ever intended to answer. When their method is extended to countries further down the income scale, it turns out that slowdowns among poorer economies are at least as prevalent as among middle-income ones.

Countries in the middle do slow more often than rich countries, but that is partly because rich economies rarely grow fast enough (3.5% per person over seven years) to be eligible for a slowdown as the paper defines it. Nor is such a slowdown sufficient to trap an economy. Hong Kong, Singapore, South Korea and Taiwan have all endured at least one, and none of them is trapped in middle income. Growth in China’s GDP per person has also slowed, to about 7.6% over the past seven years, against more than 10% over the previous seven. That qualifies as a sharp slowdown by the authors’ definition. But China is not trapped; it is still growing faster than most countries, rich or poor.

A similar problem bedevils the paper by Mr Aiyar and his IMF colleagues. To see why, suppose a miracle economy were to grow much faster than an economist would expect, given its level of income, schooling and capital. Imagine its growth were then to moderate to a more normal pace. That might count as a severe slowdown by the authors’ definition (since the country’s highly positive growth gap has dropped to zero), even though the economy was still converging on high income at a normal pace.

Or suppose a country were rapidly to increase its investment in schooling and physical capital to avoid the middle-income trap. If the strategy were successful, it might result in steady growth. But with the method used by the IMF paper, that constant growth could nonetheless count as a severe slowdown because, other things being equal, their model expects improved education and deeper capital to raise the pace of growth, not merely shore it up.

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Neither of these papers, then, proves the existence of a middle-income trap as commonly understood. Indeed, Mr Eichengreen has said that his line of research was intended to explore different questions. But what about the DRC’s and World Bank’s “killer” China 2030 chart?

Its criteria for middle income are idiosyncratic. They include any country with a GDP per person between 5.2% and 42.75% of America’s, measured at purchasing-power parity. The good news is that eight countries on the chart (including Turkey, Malaysia, Oman and Poland) have since escaped the middle-income bracket thanks to better data or further growth. Ten others, the Slovak Republic among them, have also crossed that threshold but were not included on the chart because either the data or the countries themselves did not exist in 1960.

But the chart contains a more fundamental flaw. Its criteria for middle-income are too broad to be useful. By its definition, a country with a GDP of just $590 per person (at 1990 prices) counted as middle income in 1960. That includes countries like China in the middle of its Great Famine. At the other extreme, a country with a GDP per person of $13,300 in 2008 also counted as middle income. This upper threshold for 2008 is more than 2,000% higher than the lower one for 1960. No wonder so many countries remained stuck in between them.

One of them was China. Its GDP per person increased tenfold between 1960 and 2008, despite the famine and the Cultural Revolution. But because it started that period above $590 and ended it below $13,300, it remained confined to the middle square of the China 2030 grid.

One of the World Bank staff involved in the China 2030 report has subsequently co-written a paper investigating the middle-income trap more closely. It found no “evidence for [unusual] stagnation at any particular middle-income level”. More recently, research by Xuehui Han of the Asian Development Bank and Shang-Jin Wei of Columbia, and separately by Lant Pritchett and Larry Summers of Harvard, has also cast doubt on the trap. Another Harvard economist, Robert Barro, the doyen of empirical growth studies, thinks that “this idea is a myth.” The transition from middle to upper income is certainly “challenging”, he writes. But it is no more challenging than the transition from low to middle.

Messrs Kharas and Gill are themselves agnostic about the precise definition and empirical salience of the term they invented. They introduced it “with modesty, because we had not rigorously established its prevalence”, they wrote ten years later. Since some middle-income countries have undeniably stagnated, barriers to their growth clearly exist. As Messrs Kharas and Gill see it, what matters is whether these threats take a distinctive “middle-income” form, not whether they are more common or severe than the dangers facing other economies.

Trappist agnosticism

The duo came up with the term chiefly because the economics profession seemed to offer no clear or convincing growth recipe for middle-income countries. Partly as a result, policymakers often felt caught between two stools: either they clung on to old growth strategies (such as low-end manufacturing) for too long, or they embraced sophisticated models (such as the “knowledge economy”) too soon. The middle-income trap is really a middle-income dilemma.

What about Mr Garrett’s original finding in Foreign Affairs, which helped inform the thinking of Messrs Kharas and Gill? An effort to replicate that exercise, with newer data covering the same 20 years, shows a much narrower gap between middle- and high-income growth for the period from 1980 to 2000. And that gap all but disappears if the countries are divided into three groups of equal size, rather than Mr Garrett’s somewhat arbitrary 25-45-30% split.

More importantly, middle-income countries, even by his definition, grew faster than their high-income counterparts over the two decades from 1990 to 2010, as well as from 1995 to 2015. It seems that in the 1990s and 2000s middle-income countries were quite capable of competing with cutting-edge economies. So what tripped them up in the 1980s? Part of the answer may lie with America’s Federal Reserve.