Avoiding the middle-income trap

In order to transition to true prosperity, middle-income countries need to invest heavily in human capital and improve the quality of education

More than 100 developing countries have successfully made the transition from low-income to middle-income status. Unfortunately, most of them have got stuck in the middle-income trap. When middle-income countries are just about to get their first whiff of prosperity, they revert to a slow growth trajectory. The frequency of such slow growth episodes has increased in middle-income countries. The impact of the recent global downturn is being felt more acutely in middle-income countries. The large number of countries, including China and India, getting caught in the middle-income trap is a worrying trend, as a large share of poor and near-poor people still live in middle-income countries.

What is a middle-income trap?

A great deal of research has been done on why low-income countries grow faster than advanced countries. In the early stages of economic development, the share of agriculture in both output and employment is overwhelmingly large. Subsequently, as industrialisation proceeds, the share of the non-agricultural sectors increases. This process of structural transformation is associated with a faster pace of economic growth and growth convergence between developing and developed economies. But little is known about why most countries get stuck in the middle-income trap. 

Most middle-income countries have traditionally relied on exports of manufactures to achieve higher growth rates. But the cost advantage that once drove their growth begins to decline, as they get sandwiched between more competitive low-income countries on the one hand, and highly-skilled and more innovative advanced economies on the other. Caught between these two groups, many middle-income countries are left without a viable high-growth strategy. 

Prior growth strategies are no longer effective in coming out of the middle-income trap. Changes in globalisation, technology and trade generate new growth-drivers. Policy-makers, in once fast-growing economies, often find it difficult to make the transition toward new growth-drivers. When the status quo prevails, the newly emerging competitive sectors fail to take off. Most middle-income countries tend to make two common mistakes: Either they cling to past successful policies for too long, or they exit prematurely from industries that could have served as the basis for their specialisation process. Timing and smooth transition are the two keys to coming out of the middle-income trap.

What might be the new growth-drivers?

Strengthening the digital economy holds the greatest promise for bolstering economic growth. But this requires skills that are a combination of technological knowhow, and problem-solving and critical-thinking capabilities

For more than 200 years, it was argued that economic growth is associated with the manufacturing sector. Services were considered as menial, low-skilled, and low-innovation. But today, with changes in trade and global value chains, the digital economy is the most dynamic sector. The trade in services is growing a lot faster than trade in goods, and services are creating value far beyond what national accounts measure. Global value chains are becoming more knowledge-intensive, and low-skill labour is becoming less important as a factor of production. Globalisation is in the midst of a major transformation and understanding how the landscape is shifting will help policy-makers and business leaders to take advantage of new growth-drivers.

Services now account for more than 75 per cent of the global economy. Some service subsectors, such as transportation, telecommunication, finance, and business services, have recorded rates of productivity growth that are much higher than the top-performing manufacturing subsectors. It is not surprising that services are expanding rapidly in the upper-middle-income developing countries. Their economies increasingly resemble those of rich countries, where services have long dominated economic growth. 

Services can be divided into two broad categories: Modern services and traditional services. Modern services, which are information communication technology (ICT)-intensive, can be unbundled, disembodied, and splintered in a value chain just like goods. In the past, the service trade was limited because it required closer proximity and face-to-face interaction between the buyer and the seller. Recent innovations in ICT have rendered several previously non-tradable services tradable. The cost of transporting services that could be digitised has fallen dramatically and services do not have to confront customs. They can be electronically transported internationally through satellite and telecom networks.

The world has experienced a new industrial revolution, with the globalisation of modern services being at the forefront. Globalisation of services provides many opportunities for developing countries to find niches, where they can be successful. Taking advantage of these opportunities requires a government that energetically takes steps to accelerate new growth-drivers, through a variety of active policies. 

What should policymakers do?

Policymakers need to think about the long-term drivers of growth now, before the gains from cheap labour are exhausted. The best insurance against the risk of slipping into the middle-income trap is to invest heavily in human infrastructure and improve the quality of education. Developing the digital economy holds the greatest promise. 

The skills needed for a digital economy are different. New jobs will require specific skills — a combination of technological knowhow, problem-solving and critical-thinking skills, as well as soft skills such as perseverance, collaboration and empathy. Investing in human capital is the magic wand, since the biggest asset of most middle-income countries is a young population. Economies with relatively high cognitive skills benefit from having a critical mass of students likely to become innovators tomorrow.

It is important to also get the institutions right, both economic and political, to guide the economic reform agenda that has a shared vision and aimed at promoting both faster and more inclusive growth. Policy-makers need to resist powerful incumbent interest groups that block policy reforms. Future growth will be driven by shifting resources from incumbents in the manufacturing sector, to new entrants in the digital economy. This process needs to be well governed, and be more inclusive, green, and resilient. The recent downturn in growth in both China and India is a gentle reminder that nobody is immune to the middle-income trap.

The writer is lead economist, World Bank