I am fascinated by the “Middle-Income Trap,” particularly as it applies to China. The Middle Income Trap is used to describe a developing economy that stalls out after a period of rapid growth before it becomes a developed economy.  My shorthand view of it is that it is relatively easy to go from being an extremely undeveloped country to becoming an emerging market company simply through dint of super low wages. The much tougher thing to do is to go from an emerging market economy to a developed one because doing that requires way more than being just a low cost provider of labor.

It is not yet clear to me whether China will be able to make the big leap to developed nation status or not.  I wrote about this early last year in Will China Escape The Middle Income Trap?:

To me, the most important question is whether China will have what it takes to surmount the middle income trap.

I was on a panel this past weekend at the Wharton China Forum 2012 and while there I had the opportunity to listen to a great lecture by world-renowned economist, Augusto Lopez-Claros. I asked Professor Lopez-Claros whether he thought China would be one of the rare countries that breaks through the middle income trap and his answer was a resounding “it’s possible.” He then went on to note how only five countries have really done that and become developed: South Korea, Japan, Singapore, Hong Kong and Chile. I’m not even sure Singapore and Hong Kong are even large enough to count. I am not prepared to say that China will not be able to burst through the middle income trap, but I will say that I think those who just assume that it will are ignoring all sorts of things.

Will China ever become a developed country? If you think it will, what do you think China has that that will enable it to do so? Conversely, if you think it will not, please explain why you think that.

The Wall Street Journal’s Real Time China Blog just came out with a post, entitled, Four Ways Asia Can Avoid the ‘Middle-Income Trap’ setting out what Asia’s emerging economies  (“defined by the International Monetary Fund as China, India, Indonesia, Malaysia, the Philippines, Thailand and Vietnam) must do to avoid getting “trapped.” The post is based on an IMF report that came out earlier this week in which IMF economists suggest four ways to avoid that”:

  • Invest in infrastructure. IMF analysis suggests that subpar infrastructure is a key factor that can check an emerging economy’s growth. India, the Philippines and Thailand are particularly exposed in this area and should focus on building new and upgrading existing public transit systems, freight channels, ports and energy infrastructure.
  • Guard against excessive capital inflows. Money flows from abroad can energize an economy and give domestic consumption a boost, but can send an economy south if investors retreat in a hurry. Policy makers should have macro-prudential controls in place to mitigate potential rapid outflows, the IMF said.
  • Boost spending on research and development and post-secondary education. Both are needed to foster the innovation that’s a hallmark of advanced economies. Malaysia and Thailand have the highest college enrollment rates among emerging Asian economies, but China is rapidly catching up, according to IMF data. China far outstrips other developing Asian countries on R&D, with 2009 spending at more than 1.5% of GDP.
  • Get more women into the workforce and raise the retirement age. Aging populations are a problem in much of Asia. Governments can take steps to reduce “dependency ratios” by raising the age when workers are eligible for pensions and encouraging girls to enter university and vocational training.

It is an interesting list, but I wonder how predictive it really is.  If it is accurate, my sense is that China will do quite well over the next 50 years.  But is it accurate?  Are these four things really enough? And is China doing a good job with the above four things?  What about economic reform?  What about rule of law? What about IP protection? What about innovation?  What do you think?

I don’t think so.  Just my view.

Read an article in Forbes entitled, “What Could Derail A Middle Class China?” This article starts out by asking what could prevent China from becoming a developed country and then sets out what usually prevents countries from reaching “high-income status”:

The experience of countries that failed to make the jump to high-income status suggest that their inability to innovate and upgrade can be attributed to three broad factors: (1) macroeconomic, political and social instability; (2) persistent inefficient allocation of resources; and (3) insufficient support to physical infrastructure and human capital development.

Though I agree with the above, I completely disagree with the way the article applies (or really fails to apply) these factors to China.  The article lists the following three things as most likely to derail China’s path to riches:

1. Environmental Degradation.  “These problems, if not tackled quickly, are likely to reduce life quality, hamper productivity, drive away investment and, eventually, dim China’s growth outlook.”

2. Increasing Cost of State-Owned-Enterprises.  “SOEs may also contribute to fiscal risks, as both the state sector and local governments continue to face soft budget constraints, and become a source of social tension.”

3. Financial Crisis.  “It remains an open question if China’s banks and its financial system more generally could withstand the shocks likely brought about by financial liberalization and opening.”

I minimize all three of these. Both Environmental degradation and the cost of SOEs can be overcome and even if that does not happen, I do not see those failures as enough to prevent China from becoming a wealthy nation. Any financial crisis will have a short-term impact.

No, at this point, what I see holding China back from developed status are far more systemic.  I simply have doubts as to whether China can innovate enough to move from a country based on heavy industry for others to a country that innovates sufficiently to develop big time products/services/ideas so as to make China a 21st century economic powerhouse. I also am skeptical of its ability/desire to substantially improve the living standards of more than half of its poorest 900 million.

For more on China’s chances of escaping the Middle Income Trap, check out the following:

What do you think?

Orville Schell and Peter Schiff contend that China’s brand of state-directed capitalism has the resilience to come out on top of the global market.  Ian Bremmer and Minxin Pei put their money on the American model despite its faltering in recent years.

Where do you stand?

Intelligence Squared U.S., in partnership with Slate, promises provocative, insightful discussion of this timely question as Schell and Schiff square off against Bremmer and Pei to debate whether “China Does Capitalism Better than America.”  ABC News’s John Donovan will be moderating the March 13th event at NYU’s Skirball Center, and a live audience will vote to determine the winning team.

A word of warning for anyone staunchly embedded on one side of the Chinese vs. American capitalism debate: according to its mission statement, Intelligence Squared aims to “to transcend the toxically emotional and the reflexively ideological; and to encourage recognition that the opposing side has intellectually respectable views.” It was also voted one of Forbes’s “Top Five Podcasts to Change Your Mind.”

Attend in-person or tune in via live stream – then let us know what you thought.

Though this upcoming discussion sounds fascinating, I actually think framing the issue as a face-off between China’s state supported capitalism versus the US’s more freewheeling version is the wrong question. To me, the most important question is whether China will have what it takes to surmount the middle income trap.

I was on a panel this past weekend at the Wharton China Forum 2012 and while there I had the opportunity to listen to a great lecture by world-renowned economist, Augusto Lopez-Claros. I asked Professor Lopez-Claros whether he thought China would be one of the rare countries that breaks through the middle income trap and his answer was a resounding “it’s possible.” He then went on to note how only five countries have really done that and become developed: South Korea, Japan, Singapore, Hong Kong and Chile. I’m not even sure Singapore and Hong Kong are even large enough to count. I am not prepared to say that China will not be able to burst through the middle income trap, but I will say that I think those who just assume that it will are ignoring all sorts of things.

Will China ever become a developed country? If you think it will, what do you think China has that that will enable it to do so? Conversely, if you think it will not, please explain why you think that.

I just learned a new term today that I know I will be using frequently in the future. The term is “middle income trap” and it crystallizes some of my previously discombobulated thoughts I have had regarding economic development. Let me explain.

This new term (for me) comes from a post by Michael Schuman on Time Magazine’s Curious Capitalist blog, entitled, “Escaping the middle-income trap.”  The post focuses on how Malaysia’s economic growth has been so consistently strong since World War II, yet has been slowing over the last few years and of how Malaysia just cannot seem to break into the league of developed nations. Schuman defines this “trap,” as follows:

I returned a few days ago from Kuala Lumpur, the capital of Malaysia, where the talk of the town – well, at least among economists — is the “middle-income trap.” What’s that, you ask? A developing nation gets “trapped” when it reaches a certain, relatively comfortable level of income but can’t seem to take that next big jump into the true big leagues of the world economy, with per capita wealth to match. Every go-go economy in Asia has confronted this “trap,” or is dealing with it now. Breaking out of it, however, is extremely difficult. The reason is that escaping the “trap” requires an entire overhaul of the economic growth model most often used by emerging economies.

The concept behind the “middle-income trap” is quite simple: It’s easier to rise from a low-income to a middle-income economy than it is to jump from a middle-income to a high-income economy. That’s because when you’re really poor, you can use your poverty to your advantage. Cheap wages makes a low-income economy competitive in labor-intensive manufacturing (apparel, shoes and toys, for example). Factories sprout up, creating jobs and increasing incomes. Every rapid-growth economy in Asia jumpstarted its famed gains in human welfare in this way, including Malaysia.

However, that growth model eventually runs out of steam. As incomes increase, so do costs, undermining the competitiveness of the old, low-tech manufacturing industries. Countries (like Malaysia) then move “up the value chain,” into exports of more technologically advanced products, like electronics. But even that’s not enough to avoid the “trap.” To get to that next level – that high-income level – an economy needs to do more than just make stuff by throwing people and money into factories. The economy has to innovate and use labor and capital more productively. That requires an entirely different way of doing business. Instead of just assembling products designed by others, with imported technology, companies must invest more heavily in R&D on their own and employ highly educated and skilled workers to turn those investments into new products and profits. It is a very, very hard shift to achieve. Thus the “trap.”

Schuman sees South Korea as “probably the best current example of a developing economy making the leap into the realm of the most advanced.” Schuman sees Malaysia as a long way from making that same leap:    

Malaysia, though, is quite far from where it wants to be. That’s a bit surprising based on its remarkable recent history. Malaysia has been among the best performing economies in the world since World War II, one of only 13 to record an average growth rate of 7% over at least a 25-year period. The country has an amazing record of improving human welfare. In 1970, some 50% of Malaysians lived in absolute poverty; now less than 4% do. Yet Malaysians also feel that they’ve become somewhat stuck where they are. GDP growth has slowed up, from an annual average of 9.1% between 1990 and 1997 to 5.5% from 2000 and 2008. Meanwhile, other Asian economies have zipped by Malaysia. According to the World Bank, the per capita gross national income (GNI) of South Korea in 1970 was below that of Malaysia ($260 versus $380), but by 2009, South Korea’s was almost three times larger than Malaysia’s ($21,530 versus $6,760). Malaysia is getting “trapped” as a relatively prosperous but still middle-income nation.

Schuman does not see Malaysia making the leap.  Its companies are not innovating. Its private investment is declining and it spends almost nothing on R&D. “If Malaysia is going to break the “trap,” it has to reverse all of these trends.”

So what has made Korea so different from Malaysia?  

Why has Korea jumped so far ahead? I think the reason is embedded in the different methods the two countries used to spur rapid growth.

Both countries relied exports to create rapid gains in income, but they did so differently. South Korea, from its earliest days of export-led development in the mid-1960s, had been determined to create homegrown, internationally competitive industries. Though Korean firms supplied big multinationals with components or even entire products, that was never enough – Korea wanted to manufacture its own products under its own brands. The effort was often a painful one – remember Hyundai’s first disastrous foray into the U.S. car market in the late 1980s and early 1990s – but Korea is where it is today because its private companies have been working on getting there for a very long time, backed in full by the financial sector and the government.

Malaysia, on the other hand, relied much, much more on foreign investment to drive industrialization. That’s not a bad thing – multinational companies provide an instant shot of capital, jobs, expertise and technology into a poor country. MNCs, however, aren’t going to develop Malaysian products; that has to take place in the labs and offices of Malaysia’s private businesses. But those businessmen have been content to squeeze profits from serving MNCs and maintaining their original, assembly-based business models.

I have for years viewed Korea as THE success story of Asia. In fact, whenever people tout China and act as though democracy is wholly incompatible with growth, I respond with Korea. You can see me making this point in this Commonwealth Club of San Francisco video of a “Doing Business in China” panel. Korea was at one time the second poorest country in the world, second only to Niger. Now, Seoul is more dynamic than Tokyo and Korea just continues to grow both economically and in terms of its political freedoms. Why is that? And why are countries like Malaysia and Thailand stuck in the middle ground?  And what about China and Vietnam, will they be able to make “the leap? 

Japan and Korea are important because they have spending power. Vietnam and Cambodia are important because they have very low wages. China is the most interesting because just three or four years ago, companies were going to China because of its low wages, but now, companies are going there to make money (mostly on the Coast) and going there to make things (more and more inland).  

Where do Malaysia or Thailand fit into all this?  

Malaysia and Thailand remind me a bit of the mid-size law firm. I can understand hiring the big firm for the big deal or the big case requiring a massive number of associates or legions of highly specialized partners. And I can understand hiring a highly efficient and focused small firm. But I rarely understand hiring the mid-sized firm, which usually tries to price itself along the same lines as the big firms, but without the corresponding depth or expertise. Why bother? And nothing against either Malaysia or Thailand, but I think many businesses have asked themselves this very question.

What do you think?