Middle income trap the way out – The Financial Express

Muhammad Mahmood | Published: February 05, 2022 20:37:27

All least developed countries aim to become middle income countries and many have succeeded like Bangladesh, which achieved the status of a lower middle income country in 2015 and now officially will graduate to become a developing country in 2026. Bangladesh also aspires to become a high middle income country in 2031 and a developed country by 2041.

Only a few like South Korea and Singapore have managed to gain the status as high income countries while countries like Malaysia, Argentina, Uruguay and South Africa have become stuck in the upper middle income trap. And countries like India and Indonesia seem have entered into the lower middle income trap. Overall, most of the middle income trapped countries are located in Asia and Latin America. It is estimated that half of the world's population by 2025 will live in Asian middle income countries. Many of these middle income trapped countries also suffer from persistent pockets of poverty and remain vulnerable to sudden changes in income.

The term middle-income trap (MIT) usually refers to countries that have experienced rapid growth and thus quickly reached middle-income status, but then failed to overcome that income range to further catch up with the developed countries. The MIT is a narrative of growth stagnation. Therefore, the MIT is also characterised by reform stagnation.

Equally, low income countries can also face the prospect of getting trapped into a low income trap or otherwise described as the "poverty trap". In a low income country it is difficult to escape poverty. But poverty trap is not merely the absence of economic means. It is created due to a combination of factors such as the lack of employment, access to education and health care etc.

The MIT was mentioned in a World Bank study titled "An East Asian Renaissance: Ideas for Economic Growth" published in 2007. The report suggested that Medium-income countries have lower growth trends when compared to rich and poor countries.

It is generally postulated that countries at the initial stages of growth start with an agrarian base. From there on, a country over time transits to an industrial economy with the help of surplus extracted from the agriculture sector, then onto a predominantly services oriented economy.

As a result output increases which contributes to rising per capita income. Therefore, the growth process enables a country to move from low income to lower middle income to upper middle income and finally to a high income country.

Many economists, in particular Dani Rodrik expressed concerns over premature de-industrialisation of developing economies where a growing services sector bypasses manufacturing sector with industrialisation peaking at a relatively small share of GDP around 20 per cent or even below. Such a transition path would further distort the long term structural adjustment process causing very slow growth to economic stagnation. It is generally agreed that growth slowdowns are primarily productivity slowdowns.

In fact, some growth models do suggest that the existence of low productivity equilibrium in middle income countries is characterised by low shares of highly skilled workers in highly skilled activities. Many countries also fail to put in place active policies for firms to move their resources from protected domestic to globally competitive export sectors and to upgrade skills of workers working in those sectors.

Economic transformation process implies an increase in productivity of available resources, with the transition to middle income status generally characterised by the movement of resources between activities. Transitioning to high income status leads to levelling out productivity across firms within sectors. This in turn leads further resource reallocation resulting in most productivity growth taking place within certain sectors.

The growth process does not have an automated impetus propelled by time. Empirically, growth performances of countries around the world by and large demonstrate that they remain in a specific income group for extended periods, some even may regress from a lower middle income country into a low income country if the required level of growth momentum can not be maintained.

Overall, it appears developing countries experience great difficulties in their transition from the middle income to the high income. Most empirical studies on the MIT use either the absolute approach or the relative approach.

The absolute threshold approach tends to interpret the MIT as a growth slowdown and it is generally suggested that growth slowdowns typically occur at two different per capita ranges, namely between US$10,000 and US$11,000 and between US$15,000 and US$16,000 range. Out of 101 middle income countries in 1960, only 13 countries became high-income countries by 2019 based on per capita income relative to the US.

The relative threshold considers the MIT as a failed catching up process relative to a developed country like the US or Japan. There are a number of ways in which this can be measured such as the Catch-Up Index (CUI) or like the World Bank which considers a country experiencing the MIT if it stays within the range of about 5 percent to 45 percent of the US per capita income.

The notion of MIT has gained currency in recent years and because it is a very easy to interpret the concept makes it very useful in public policy discussions. In fact, the MIT has provided a theoretical construct to understand why so many countries seem to stagnate at the middle income level. But such a theoretical construct does not provide us with a uniform policy prescription for avoiding the MIT. It is not a destiny but an obstacle that needs to be overcome.

The MIT has shown us that middle income status does not mean that economic growth trajectory gets easier to deal with, if anything, it appears more difficult. Various arguments have been put forward to explain the existence and persistence of the MIT. These arguments include diminishing return to capital, exhaustion of cheap labour and imitation gains, poor quality of human capital, distorted incentives and misallocation of resources, lack of advanced infrastructure, capital, inadequate contract enforcement.

Furthermore, middle income countries also find the transition to next level doubly challenging because the institutional arrangements that helped them to achieve the middle income status created vested interests who benefit from the status quo. If these vested interests are not shoved aside, these countries will fall into the trap and stagnate.

At the heart of it all, the MIT is a governance failure, an inability to take realistically achievable goals of growth and development. Therefore, avoiding the trap can take a careful preparation for implementation of policies and programmes over a required period of time because there is no quick fix for the MIT.

There is no uniform policy prescription for avoiding the MIT. Therefore, addressing the challenges posed by the MIT will require different policies for different countries around the world but underneath there are a number of commonalities standing in the way of becoming a high income country.

Middle income status can be considered as a signal for a successful trajectory for moving the country ahead. That will require to accelerate productive investment and a complex set of skills development, fostering innovation and most importantly of institution development because institutions suited to growth and development differ at different stages of development.

Therefore, the key problem for many countries looking to move forward to achieve high income status is the ability to generate the political will to make needed reforms. Vested interests will strongly oppose any change that threaten their economic power.

Meanwhile, shifting comparative advantage resulting from advances in manufacturing technologies further add to middle income countries' woes along with increasing concerns over wage competitiveness. The new manufacturing technologies have already enabled the sports apparel company Adidas using the 3D technology to re-shore its production from Vietnam to its home country, Germany.

New strategies may require for countries like Bangladesh rebalancing towards domestic demand while export orientation remains in place and levelling the playing field for all firms domestic or foreign. Also, these countries face challenges of altering the course to reflect their shifting comparative advantage in the face of resistance from vested interests that have grown rich and powerful from the status quo.

Bangladesh is the only country so far that has bucked the trend in South Asia by continually increasing the manufacturing share of GDP as measured by the widely used measure of "share of value added by manufacturing" in GDP over the last two decades.

But Bangladesh still remains a capital scarce country. To face the challenges of emerging manufacturing technologies, Bangladesh will have to boost the productivity of its abundant labour force with investment in productivity enhancing skills development, efficient infrastructure, machinery and technology supported by a well functioning and efficient financial system. Also, openness to trade and investment will remain the key instruments to foster innovation to achieve competitive advantage.

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Middle income trap the way out - The Financial Express