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?

  • Just a couple of other points I would throw out there.
    Malaysia’s strategy relied very heavily on import substitution while South Korea’s revolved around creating export industries. Import substitution does nothing to bring in foreign exchange; it only stops outflows.
    Also, it doesn’t hurt that, at a very critical stage in its growth, South Korea’s Cold War protector (i.e. the US) allowed them to basically export at will while keeping their market almost completely closed to imports — which they still are to a large degree.

  • Skydaemon

    South Korea has a lot of focus and drive. Their companies also have scale and depth – including economies of scale. Part of this is because South Korea never cared about diversity. They bet it all on a half dozen gigantic mega-corps to run everything. It gives them the scale to get a foothold, but if one failed it would be a national crisis. And you better believe the gov’t would back those companies up all the way to the abyss with taxpayer financing, even if it had to put every person in Korea at risk to do so. If their bet had failed their entire country would’ve been wiped out with the companies.
    It’s also easier to get new products off the ground for their companies. They don’t need to fight to create markets from scratch always, they just roll out a new product to their own employee base and it throws it a few rungs up on the scale chart for small products (think something like a credit card).
    Then add cultural and business factors. Koreans believe very strongly in education. That’s partly because it really is a path to success there. Degrees really do get you promoted, unlike most of the rest of the world. Koreans make being educated into a really big deal. There is a strong black and white culture of winning and losing too. If you fail to score high enough on exams to get into a University then your life is a failure. Period. They don’t buy into the everyone is equal tripe at all. If you are equal you can prove it by passing the tests.
    Work ethic is also crazy there. 6 days a week, 16 hours days not uncommon at all. Not including the drinking after work. They’re not big on the work smarter not harder thing either. They’re more of the mindset where, if there are 10,000 possibilities, the way to test that is to try them all. If Koreans tell you you have a fault in a product, take their word for it, they’ve undoubtedly been testing the fault for days with documentation to back it up.
    Their biggest problems are a lack of consumer culture, and burn out of employees. It’s really easy to see how much potential they waste by burning people out to a point where they are just going through the motions. You really don’t have to look very hard to see that. In my experience, they are quite open to foreigners, and value developing skills in English (since it’s helpful for export oriented companies). Their managerial skills are pretty good as well. They’re well aware of managing motivations and such, and structure teams properly. They’re still wrapping their heads around the idea of highly paid employees though. And they haven’t learned to manage internal risk all that well. (The idea of separation of roles is a foreign concept over there. Even after you explain it they don’t understand.) If you want to see a Korean manager turn pale, tell him how much money you as a foreigner make.
    Take all that, and add top-notch infrastructure for things like the internet and so on. I’m not convinced they’ll completely shift into the first world until they learn to diversify. It’s simply very risky to depend on a few select companies for the health of your entire economy like that. They may not break for a while, but when they do, game over.
    Malaysia isn’t really a mid-sized firm at all. More like a lethargic government operation with mediocre status quo as the prevailing mantra. There’s no efficiency or any notable skill, there’s also no scale or depth. There’s zero marketing acumen.
    It seems more concerned with internal cultural problems than growing commerce (divisions between locals/chinese, islamic issues and so on). There’s also a culture of IP theft which is pretty prevalent You open a software co there, they’ll be selling burned copies of your stuff for $5 a cd at the local mall before the end of the week. They largely strike me as free riders, not leaders. It very much feels like a small town / strip mall kind of economy, with bootlegging thrown in.
    Even if you imported capital, equipment, innovation and good leadership, I don’t think they are culturally interested in commerce enough to suffer hardships to prevail. They don’t strike me as goal-oriented team players in the way koreans do.

  • Twofish

    You can also pull in Mexico and Latin America into the mix. People forget the “Mexican miracle” of the 1960’s and 1970’s.
    One thing that makes China very different from Malaysia and South Korea is that China is big. Both Malaysia and South Korea are roughly the size of a single Chinese province. So one thing that the central government has to deal with is the fact that some provinces will be moving into upper incomes while other provinces are still in developing stage.
    China’s bigness helps it in these situations, because you can have different provinces and different localities try very different things, and then whatever works gets copied. In the case of South Korea and Malaysia, you have to decide on one economic policy, whereas with China, you can have six different policies and just see what works.
    The other thing about China is that it has Hong Kong that’s already made the jump to high-income economy. There’s also Taiwan, which without getting into whether or not it’s “part of China or not” is something of a model to see what’s possible.

  • gregorylent

    climate, a bigger role than we can easily measure …

  • outcast

    I’d like to point out that more than a few of South Korea’s economic policies closely mirrors Japan’s. For a long time this is what people used to say about Japan (remember the “Japanese Threat” from the 80’s?), and at one point, IIRC, it had the highest GDP per capita income in the world. Then came the bursting of their asset price bubble. Because the government and it’s people refused to change to match changing realities, leading to a fantastically long period of relative economic stagnation that continues to this day, as well as a shrinking population.
    While Korea hasn’t reached that point quite yet, there is a good probability that will happen in the next 20 years. Of course that’s something of a crystalball statement, but Japan’s experience casts a long shadow over other nations that chose its development path (over regulated, closed off, highly patriachal) and that is something I don’t think we should ignore.

  • Jack S.

    The TIME blog seems remarkably poorly researched. You can’t compare apples and oranges.
    He could look at the recent statement made by the “father” of modern Malaysia, Dr. Mahathir Mohamad, on Malay political dominance
    I’m no Korean expert but those I do know, get out of bed in the morning to leave the Japanese in their dust.
    And when it comes to China – what China? There are so many “China’s” I can throw up to support or negate any argument!
    As for innovation; so Mr. Schuman would have me believe that Australia is rich because its innovative? How about Brunei, or the oil rich Middle East?

  • anon this time

    Korea benefitted mightily from postwar investment from the U.S. and from Japan. The things that people most often knock them for – the amazing level of nationalism and insularity – were helpful too, as their chaebol protectionism helped incubate lots of home grown talent, and time to make mistakes when the neighborhood was not as competitive as it is today.
    I agree Korea is a fantastic success story, and that they deserve a lot more respect, but despite that, they are still very much a bronze medalist in Northeast Asia, and the gap between Korea and the big two is widening. My money is not on Korea catching up with Japan or China, but on another Asian country closing the gap on Korea in the next two decades. I am also curious how Korea will handle increased trade competition with China, and if relations between the two nations stay somewhat solid.
    To the poster who mentioned Malaysia and the Islamic influence, that is something that is largely recent and came about after the spectacular growth had already tapered off. Malaysia isn’t really an “everyone is equal” country at all, and they also do really well at the sort of standardized testing that Koreans constantly congratulate themselves on. It’s too bad Malaysia is losing ground to religious fundamentalists and such, but then there have always been echoes of that, they just have gotten a strong foothold and grown since the long time Prime Minister stepped down.
    I’d like to see China make more of an overt effort to support the Chinese diaspora in Malaysia, which would greatly benefit what is generally a well-run country where many more people are comfortable speaking English than in Korea, and the climate is a lot less hostile.

  • Inst

    Re: South Korea,
    South Korea is most commonly compared with Taiwan, which went a more American-style route to success with heavier emphasis on SMEs. Comparing the two countries, South Korea has better conglomerates with global brand recognition, while Taiwan has higher living standards.
    Recently, however, Taiwan has been growing at a breathneck 8 or 9% speed due to, I’m told, tighter integration with the Chinese economy than South Korea’s 6 or 7% growth rate.

  • Falen

    “Japan threat in the 80s, look at what happened to Japan now!” is like saying “Runner A (japan) tried to sprint past runner B(US) but tripped, therefore Runner C (China) will trip if he tries to sprint past runner B.” Simply silly.
    I really wish people would stop raising the Japan stagnation as if it is the unavoidable future for countries with “export growth model”, like South Korea. Only Japan stagnated and others continues to prospered, leads me to believe Japan’s circumstance was only in part due to the economic model and the other uniquely Japanese characteristics were probably more relevant. This is even not considering all the very lively conspiracy theories in Japan, such as “the Plaza Accord was the American plot to destroy Japanese economy.”
    Digressing, China has the advantage of very very large scale. “Quantity has a quality all its own”, because, in my opinion, efficiency becomes inherent with scale even without deliberate effort for qualitative improvement.
    I know this is debatable, but the converse is almost certainly true that efficiency is extremely difficult with small scale. Taiwan’s SMEs are the perfect example of this, who often struggle with competitive yet small domestic market. Profitable firms who are leader(let alone others) in their respective market reaches a ceiling and remain trapped in a “family run” state of affair forever because they have trouble introducing new technologies and practices. The small scale can not justify the investment. Therefore, the small domestic market can not organically foster internationally competitive enterprise and need to be either 1) totally export-driven(Hon Hai/Foxconn) 2) be state driven (TSMC). This leads to a somewhat tragic situation where products designed by reputable Taiwan brand (Asus, Acer, HTC) in fact do not design with Taiwan consumers in mind, and relegate domestic market to bottom rung of their product line-up.
    I guess Malaysia is likely to suffer from this problem as well, given the population is not much bigger than Taiwan. China on the other hand enjoys massive scale. This means that the choices for many Chinese firms, when searching for solutions, are often simple : “get the biggest gun you can find”, which often translate somewhat into competitiveness.

  • I think China will eventually stagnate at the point at which countries like Malaysia and Thailand have. I do not see anything that would lead me to believe China will be able to get past countries like those. I think the great dichotomy between China’s rich and poor and its urban and rural, will be what holds it back.

  • kiers

    It is certainly not an easy debate. Different “High Income” countries are so for DIFFERENT reasons. Geopolitics, Natural Resources (it’s NOT all innovation), culture, climate, government leadership are enough reasons for differentiation. For eg. Taiwan made itself into a “high end” gateway/entry portal for investment into china, besides innovating with HTC, TSMC, Asus etc. It could be argued it took advantage of US backing as a “base” against China. Japan, and S. Korea, and Singapore too have implicit hard line underlying US Military support. So these countries could get past “National Defense” spending ballooning out of control and occupying all their energy. Peace is the major prerequisite to study and higher skillls and growth and trade. Saudi Arabia is another beneficiary of US Peace Umbrella, Iran on the other hand (whatever the merits) is NOT. SO let’s not get carried away with national attributes, cultural arguments etc. It requires the confluence of many many things to go right. Having Pax Americana in your favor is a big component.
    Let’s not forget that a lot of the SE Asia “tigers” were waylaid by the 1999 Currency crisis led by hedge funds which ceded supremacy to China, with active complicity of western states’ financial markets.

  • jemz

    if we discuss about “middle income trap” topic, we must throw south american experience into our subject of debate. It’s not just about the lack of economy innovation (that happened in Malaysia), but also the political stability, and corruption. In my opinion, Brazil and Argentina fail to tackle it’s economy problem and struggle to broke the bottleneck because they have many political problems and high government corruption, despite they have big size in territory and population (if we say that “big size” can help China escaping the trap)

  • Jeremiahliang

    Out of numerous obstacles, one of Malaysia’s key problem is the government’s perpetual subsidy of Proton. We could have become a major car maker by scaling up into the ASEAN market if Proton was allowed to go bust or compete without protection.

    Low quality of skilled workforce is due to the rote-based and mixed language education system that has hampered creativity, innovation and depth of intellectual enquiry.

    Finally, the fact of religious oppression within the national religion whereby all Malays are defined as Muslims and laws against conversion out of Islam has also contributed to a constrained intellectual life.

    The internet and its growing popularity of alternative media may be the last hope for Malaysia to redeem itself from the middle income/mediocre intellectual syndrome.