Asia and the Middle-Income Trap: How exclusion hinders growth and innovation

TODO Yasuyuki
Faculty Fellow, RIETI

In general, the lower the income level of a country is, the higher is its economic growth rate, due to benefits from backwardness. It is relatively easy for less developed countries to imitate technologies of developed countries because there is much room for learning. In addition, since less developed countries have not accumulated much capital, returns from capital investment are high.

This "convergence hypothesis" fits well the experiences of the currently developed economies of East Asia (namely, Japan, Singapore, Hong Kong, Taiwan, and South Korea). When these economies reached a gross domestic product (GDP) per capita of about $5,000, their respective growth rate was in excess of 6%. As they become more developed, their growth rates then settled to about 2%, which is standard for developed countries.

On the other hand, many other countries that managed to grow into middle-income countries, with GDP per capita of about $5,000-$10,000, subsequently stagnated and did not become fully developed. This phenomenon is called the middle-income trap. For example, many Latin American countries attained GDP per capita of about $5,000 in the 1980s, but then were caught in the middle-income trap.

Let's look at the experiences of emerging economies in Asia. As the figure shows, India, Malaysia, Thailand, and Indonesia have raised their income standards gradually, but have only been able to achieve growth of 2%-4% once their GDP per capita reached around $5,000-$10,000. (The major exception is China.) Clearly, these countries are taking a different route from that of the developed economies of East Asia and may have fallen into the middle-income trap.

Figure: Real GDP per Capita and its Growth Rate
Figure: Real GDP per Capita and its Growth Rate
Changes in 5 periods: 1960-70, 1970-80, 1980-90, 1990-2000, 2000-10, 2010-13
*PPP = Purchasing Power Parity

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There are several conceivable reasons for this, but this article focuses on social capital as an important factor. Social capital refers to networks of people who share the same norms and values. Professor Yasuyuki Sawada of the University of Tokyo called these networks kizuna (or "strong ties" in Japanese) in his article published in Nihon Keizai Shimbun in December 2012.

The idea that strong ties within a community or organization lead to economic growth and social development has been argued by many researchers, including Professor Robert Putnam of Harvard University (Putnam, 1993). On the other hand, strong ties do not necessarily bring about economic development (Olson, 1984; Hayami and Godo, 2005), as recent empirical evidence has revealed some negative aspects of strong ties.

In Europe, for example, the more important people feel about their family and friends, the lower is the economic growth rate in the region (Beugelsdijk and Smulders, 2003). Spanish firms have lower profits if they trust their suppliers too much (Villena et al., 2011). In prewar Germany, the Nazi Party's penetration rate was higher in those areas with highly developed community organizations and strong ties (Satyanath et al., 2013). The negative effect of strong ties may come from that strong ties within a community or organization tend to exclude outsiders, preventing outside knowledge and stimuli from getting in.

Thus, for an economy or society to develop, it is important to foster strong ties within communities or organizations and at the same time maintain ties with "outsiders" and not exclude them. The result is that people build diversified networks, and new knowledge brought in by outsiders is assimilated into the community or organization and spurs innovation.

According to a study that examined the performance of German researchers, those who usually work with the same collaborators but occasionally conduct research with those from other organizations and fields achieve the best performance (Rost, 2011). The popular Japanese singers' group, AKB48, exchanges members with its five sister groups in other regions in Japan and in other countries, such as SKE48 in Nagoya and SNH48 in Shanghai. This exchange has helped each group to develop new innovations and maintain their popularity.

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Given this perspective, the middle-income trap may occur due to ties that are too strong. In emerging economies which have achieved a certain level of income through their diversified networks, domestic ties may become too strong, to the point of excluding outsiders, so that they cannot learn technology and knowledge from developed countries. The result is a vicious cycle in which the economy stagnates, causing the society to become more closed and attempt to protect its domestic rents.

A good example of this is the Latin American countries that, for many years after World War II, restricted imports of industrial products in order to protect their domestic industries. As a result, their economies grew by a certain amount in the 1950s and 1960s, but domestic firms that had become used to protectionism started to lose their competitiveness in the 1970s and 1980s. Even then, these countries were unable to change to open-market policies, and stagnation set in for a long period.

The middle-income countries of Asia have achieved a higher rate of growth than their Latin American counterparts thanks to open-market policies, but there have been signs of a protectionist movement recently.

Indonesia, for example, has forbidden the export of unprocessed minerals such as nickel to protect domestic industries. Malaysia's former Prime Minister Mahathir bin Mohamad, who went on to become the chairman of the national automaker Proton, has refused any partnership with foreign firms and sought government protection for his company. The recent political coup in Thailand is rooted in the fact that the administration of former Prime Minister Thaksin Shinawatra had implemented overly protective measures for farmers.

If the emerging countries of Asia become more closed, they will repeat the mistakes of Latin America and will certainly fall into the middle-income trap. To escape this fate, they must take the opposite route and actively build networks beyond their borders.

They can actively learn from foreign technology through networks with foreign countries. For example, in the recent construction of subways in Jakarta, Indonesia, local firms have partnered with Japanese firms so that state-of-art technologies in subway construction are being transferred from the Japanese firms to the Indonesian partners. In China, the government is encouraging local firms and universities to partner with foreign firms to conduct collaborative research and development. This will help them transition from simple one-way imitation to domestic innovation so that they can catch up with the developed countries.

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The vicious cycle of being closed and stagnation due to ties that are too strong is found not just in the middle-income trap but also in the economic stagnation of Japan over the past 20 years.

Such regulated sectors as agriculture, childcare, universities, health, nursing care, and small- and medium-sized enterprises have become closed and have begun to stagnate. As the government sets their regulation in stone to protect vested interests, the stagnation becomes a quagmire. Breaking free will require deregulating the regulated industries and joining free trade agreements to build networks with outsiders, particularly with businesses and foreign interests, in order to spur innovation.

The vicious cycle is also very pronounced in local economies. A comparison of regional growth rates in Japan shows that growth rates are not higher in those regions with low income levels (Seya et al., 2012). Particularly in the last decade, the income gap between regions has not shrunk. Just as in those countries that have fallen into the middle-income trap, regional economies of Japan have become more closed, so the technologies and knowledge of regions with high productivity, such as Tokyo, have not spread to the regional economies. Forming networks with outsiders is therefore also essential to regional development.

To give an example, the town of Kamikatsu in Tokushima prefecture has successfully used the production of tsumamono (leaves and twigs used as decoration for Japanese foods) to revitalize its economy. This was an innovation of Tomoji Yokoishi, an agricultural advisor from outside the town. The town of Minakami in Gunma prefecture has attracted more tourists by offering rafting and bungee jumping activities with help from a New Zealander.

In brief, strong ties in a community are a double-edged sword as far as growth is concerned. Community ties can be a strength if the community accepts outsiders and builds AKB-like international networks. To do this, it is necessary for the national government and municipalities to provide supports for networking, including encouraging a supply of risk money in local economies, industry-academic partnerships, collaborative research between enterprises, the migration of workers from mega cities to local cities, internationalization of Japanese firms, and foreign investment flows to Japan.

Diversified networks help economies and societies to develop, whether they are in a middle-income country or a regional economy of Japan. It is hoped that the governments of Asia and Japan will implement policies to build networks with outsiders on every level so that their economies will continue to grow.

>> Original text in Japanese

* Translated by RIETI with some additional information.

August 27, 2014 Nihon Keizai Shimbun

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September 24, 2014