The “Middle Income Trap”:An Expanded Concept

Jiang Shixue

In recent years, Chinese academia has closely followed the concept of the “middle income trap”.However, when studying this issue, many scholars “expanded” this concept and raised some false arguments.This paper will clarify the definition of the “middle income trap”,point out the misunderstandings made by Chinese academia, and answer the most important question: Have Latin America and China fallen into the “middle income trap”?

What is the “middle income trap”?

International and Chinese academia have reached a consensus in terms of the origin of the “middle income trap”: it was first raised by the World Bank.In 2006, in its report on how East Asia should cope with global economic downturn, World Bank economists pointed out: “New strategies must be adopted at some point in time by middle income countries if they are to successfully become rich.The idea that middle income countries have to do something different if they are to prosper is consistent with the fact that middle income

Jiang Shixue is Professor and Deputy Director of the Institute of European Studies at the Chinese Academy of Social Sciences and also Vice President of the Chinese Association of Latin American Studies.countries have grown less rapidly than either rich or poor countries.”The economists also argued that middle income countries were squeezed between lower-salary, more competitive poor countries and innovative developed countries.But this report did not use the phrase “middle income trap”.

In 2007, the World Bank published a report entitledAn East Asian Renaissance: Ideas for Economic Growth, in which one of the subheadings was “Avoiding the Middle-income Trap”.This is the first mention of the “middle income trap” by the World Bank.The World Bank said that without economies of scale, middle income countries in East Asia would have to strive to maintain their unprecedented high speed of economic growth, but the development strategies based on accumulating factors of production would lead to deteriorating results.It is unavoidable, because marginal productivity will decline and for many decades, Latin America and the Middle East will remain middle income regions and be unable to get out of the trap.

In 2010, the World Bank published a report entitledRobust Recovery, Rising Risks.According to this report, economists believe that in the past few decades, many economies in Latin America and the Middle East have already fallen into the middle income trap.Stuck in this trap, the producing countries, with their high output and low costs, struggle to maintain their competitiveness when the cost of labor and capital is continuously rising.However, they can neither move up the value chain nor enter the fast-growing industrial and labor market based on knowledge and innovation.

Although World Bank economists have not clearly defined the “middle income trap” in the reports mentioned above, we can still come to the following conclusion: when becoming a middle income country, a nation’s labor costs will rise with the increase in per capita income.Its industrial structure, however,shows no remarkable improvement.As a result, it can compete neither with other developing countries, with lower labor costs,nor with developed countries, and thus ends up in a development dilemma.

We can learn more about the “middle income trap” from the interpretations of some foreign scholars.For example, Luis Abugattas-Majluf from Peru believes that the only way for Jordan to deal with “middle income trap” is to move towards technologyintensive production and higher labor productivity.Vikram Nehru from India says that to avoid the “middle income trap”,Indonesia must strengthen its manufacturing industry and reduce its overdependence on exporting primary products.Kenichi Ohno from Japan divides industrial development into four stages: first,simple manufacturing emerges under the guidance of foreign capital;second, supporting industries begin to develop and obtain foreign technologies through direct purchase or direct investment; third,domestic industries have mastered technologies and managerial expertise to manufacture high quality products; fourth, domestic industries are now able to focus on innovation and product designing.He points out that the “middle income trap” is a “glass ceiling” between stages two and three.

Eva Paus from the United States describes the “middle income trap” as follows: on the one hand, middle income countries have lost their low-cost competitiveness; on the other hand, they have yet to develop a fully fledged high-tech competitive edge.She makes the point that economic development is a part of economic and social transformation.In this development process, the production structure leans towards knowledge-based industry with more added value.In other words, middle income countries constantly face the challenge of guiding commodity production towards more knowledge intensive industries.She also argues that China has become a “fierce”competitor in the high and low end of technology intensive industry,hence many middle income countries are on the brink of falling into the “middle income trap”.

Of course, we by no means agree with Paus on blaming China for other countries’ falling into the “middle income trap”.However,from these works of foreign scholars, it is apparent that the concept of the “middle income trap” is relatively narrow.It does not refer to all of the problems and challenges a country encounters on its development path, but the dilemma it faces when labor costs rise but technological innovation remains backward.On February 16,2013, an article inThe Economistsaid: “Rich countries boast the best technologies; poor countries the lowest wages.Middle-income countries have neither.” Therefore, middle income countries have to compete against both high and low income economies.

However, in Chinese academia, the “middle income trap” is usually misinterpreted as the following three meanings: first, after reaching the middle income stage, some developing countries become stagnant in the development path, and are thus unable to move on to reach the high income stage.Second, after reaching the middle income stage, social and economic problems that accumulated in the low income stage begin to break out.Besides sluggish economic growth, these countries also face many challenges in poverty, agriculture, labor transfer, urbanization, income gap,polarization, financial instability, high inflation, lack of social integrity, corruption, drug abuse and social security.Third, the reason why some developing nations fall into the “middle income trap” is the failure of their original growth models.Unable to face challenges and systematic risks on the political, economic and social fronts, these governments have to rely heavily on foreign demand due to insufficient domestic demand.

In 2010,The People’s Forumlisted 10 features of countries trapped in the “middle income trap”: slow or stagnant economic growth,political chaos, polarization, corruption, over-urbanization, lack of public services, unemployment, social unrest, lack of beliefs, financial instability.According to articles published in this magazine, Latin American countries have already fallen into the “middle income trap”.

In conclusion, in Chinese academia, the “middle income trap”seems to become a waste basket, into which you can throw any problems in the development path of middle income countries,especially in Latin America.

The “middle income trap” is not a “numbers game”

The World Bank’s definition of the “middle income trap” does not help us determine whether a country is caught in the trap.Some scholars, however, argue that since the World Bank defines high income countries as those with a per capita Gross National Income(GNI) of $12,196 or higher, and middle income countries, $996-$12,195, a country is regarded as caught in the “middle income trap”if its per capita GNI remains below $12,196 for a long time.

It is inappropriate to use per capita GNI as a quantitative indicator to determine whether a country has fallen into the “middle income trap”.

First, the term “for a long time” is very vague.Exactly how many years can be considered “a long time”? In the meantime, this judgment underestimates difficulties in the development path.According to US economist W.W.Rostow, economies are supposed to undergo five different stages: traditional society, preconditions for take-off,take-off, drive to maturity and age of high mass consumption.He believes that it takes about 60 years for an economy to transfer from the “take-off” period to real maturity.Apparently, it takes developing nations a long time to grow from the middle income to the high income stage.

Looking back at the history of the world economy, among the more than 100 developing countries, only a few stand out.It is unrealistic to expect all these countries to evolve from middle income to high income overnight.It is important to note that when the per capita GNI of developing countries goes up, so does that of developed countries and the “high income” threshold.More importantly, middle income and high income are relative concepts.One does not make sense without the other.Therefore, to some extent, some countries are always trying to catch up with some others.

Second, using per capita GNI to judge if a country is out of the“middle income trap” is nothing but a “numbers game”.As previously stated, in 2009, a country with a GNI higher than $12,196 was considered free from the “middle income trap”.In 2010, this figure increased to $12,276.In 2011, however, it increased further to$12,476.This means that for a developing country, the World Bank threshold rather than its own economic structural changes determine whether or not it is out of the trap.Moreover, the World Bank’s standard alters every year.A country may be out of the “middle income trap” one year only to fall back in it the next.This happens due to the false application of this “threshold”.

Here is another problem.Suppose in 2009, a country’s per capita GNI was $12,195 or $12,194 ($1 or $2 less than the World Bank standard), does this necessarily mean that this country was still in the“middle income trap”? If not, how close to the threshold does one’s GNI need to be in order to be considered out of the “trap”? We can’t even rule out the possibility that the authorities may commit fraud to raise their national or regional GNI.

Furthermore, per capita GNI, counted in US dollars, is vulnerable to exchange rate fluctuations.It is possible that, with dramatic exchange rate changes, a country’s per capita GNI could shift from the middle income to the high income level, or vice versa.Despite the shifts, this country may have seen no major improvement with regard to its industrial structure, competitiveness or technological innovation.

This may even lead to other ridiculous situations.For example, a country’s GNI is stuck in the “middle income trap” for a long time due to a number of factors.However, one day an earthquake strikes and many people lose their lives.Per capita GNI rises accordingly,reaching the threshold and leading this country out of the “middle income trap”.To think that this happens because of a natural disaster is preposterous.

Third, it takes a long time and a great deal of work for a highly populated country to reach the same per capita GNI as developed countries.For instance, China’s economic aggregate has to reach$16 trillion to become a high income country.Hence, it is going to be an uphill battle for China to increase its GDP from the current level of $6.6 trillion to reach this goal.In addition, the World Bank’s standard is very likely to go up with time.Does that mean that China will stay in the “middle income trap” in the long run?

How to understand Latin America falling into the “middle income trap”?

When Chinese academics study the “middle income trap”,Latin America is often used as a negative example.Some argue that although Brazil, Argentina, Mexico, Chile and Malaysia became middle income countries in the 1970s, by 2007 these countries were still struggling at the “development stage” with a per capita GDP of $3,000 to $5,000.And at the same time, only a few countries and regions, including Japan, South Korea and Singapore, have made it out of the “middle income trap”.Others believe that after a rapid development period in the 1960s and 1970s, Latin American nations ran into an economic standstill that has lasted more than 30 years.At their peak, these economies focused on exports rather than industrialization and encouraged the development of big companies.The over-expansion of cities caused huge income disparity.Soaring economies increased people’s expectations, which put great pressure on governments’ social security efforts.These economies ended up suffering damage from massive foreign debt, large financial deficits,raging inflation and recurring economic crises.

We need to think twice before using Latin America as a prototype of the “middle income trap”.

First, it is not true that all of these economies ran into a standstill after they became middle income countries.In the 1980s, these economies, suffering from the blows of debt and economic crises,registered low or even negative growth rates, but this only lasted less than 10 years.Since 1990, Latin American nations began to recover.They have maintained positive growth since then, apart from in 2009, the year of the global financial meltdown.Their growth rate can be as high as 6%.

Second, it is not only Latin American nations that have experienced economic slowdown, poverty, income disparity, weakening social cohesion, rampant corruption, drug abuse and deteriorating social security, so have other developing countries and even some high income countries.

Third, when discussing the “Latin America syndrome”, “Latin Americanization”, the “Latin America trap” and the “Latin America phenomenon”, all kinds of problems these countries encounter in the course of socioeconomic development are considered “symptoms”.These problems are thought to be reasons why these countries can’t cross the “$1,000 threshold”; negative examples of “failed modernization”; the inevitable consequences of “neoliberal reforms”and evidence that these nations are in the “middle income trap”.This is not the way to conduct research.

We certainly cannot ignore the following two facts: labor costs in Latin American countries have continued to rise, thus bringing negative effects.In the 1980s and 1990s, for example, US multinationals moved a huge number of factories from Mexico to China or other Asian developing countries.For another, most Latin American countries remain over-dependent on exporting primary products.As was predicted in the 1970s by former Venezuelan Oil Minister Juan Pablo Perez Alfonzo: “Ten years from now, 20 years from now, you will see.Oil will bring us ruin.”

In conclusion, if we have to say that Latin America has fallen into the trap, we must also make it clear that this trap is a result of rising labor costs and overdependence on exporting primary products, instead of everything that goes wrong in its socioeconomic development.

Will China fall into the “middle income trap”?

The rapid development of the Chinese economy inevitably drives up labor costs.Ernst & Young published a report in September 2012,pointing out that since the beginning of 2007, China’s labor costs had more than doubled.Some Chinese economists, however, had already asserted several years ago that China had reached the “Lewis turning point”.

Soaring wages put an end to the abundant supply of cheap labor.As a result, multinationals begin to transfer their production to countries with lower costs.According to an article inThe Financial Times, a Cambodian worker’s monthly wage is $110 to $130, whereas that of a Chinese worker can be as high as $400.Another article inThe Wall Street Journalsaid that China’s average wage had risen from$0.6 per hour in 2000 to $2.5 per hour in 2012.Therefore, the cost of many products will be lower if they are produced in Mexico instead of China.

Reports said that Adidas terminated its contracts with 10 OEM factories in China.Experts believe that this was related to rising labor costs.For example, at Tongling Donglong the average wage of 2,000 workers increased from 1,100 RMB in 2007 to 2,000 RMB in 2012.The escalating cost will surely erode Adidas’ profit margin.

It is important to add that while rising wages put China at risk of falling into the “middle income trap”, i.e.the loss of its global competitive edge and the degrading of its industrial structure, many other factors determine if China will fall into the “middle income trap”, among which the most important is whether or not China will change its development mode.

According toThe Twelfth Five-year Plan for National Economic and Social Development of the People’s Republic of China, the strategic adjustment of the economic structure is the major goal in accelerating the change of the growth model, and scientific and technological progress and innovation is an important supporting factor.In the Report to the 18th National Congress of the Communist Party of China, it is also clearly stated that we must transform the mode of economic development, promote innovation-driven development and carry out strategic adjustment of the economic structure.We must strive to remove major structural barriers to sustained and sound economic development, with a focus on improving the demand mix and the industrial structure, promoting balanced development between regions and advancing urbanization.

Conclusion

The “middle income trap” is a narrow concept, referring to the situation that a middle income country, due to rising labor costs and a lack of technological innovation in its industrial structure,loses its competitiveness in world trade and runs into a development dilemma.In other words, the “middle income trap” does not equal all the problems a developing nation (or a middle income country)encounters in the course of its socioeconomic development or modernization, or the fact that a nation constantly fails to climb up the rankings to become a high income country.To some extent,it is completely false to judge whether a country is in or out of the“middle income trap” by finding out if its per capita GNI has reached$12,196.

Although we refuse to use per capita GNI for high income as the indicator of getting out of the “middle income trap”, it does not for a second mean that we are oblivious towards challenges encountered by Latin America and other developing countries.What Latin America went through shows that the rising per capita income shifts the consumption model, increases environmental pressures, expands the income gap, triggers social problems, raises people’s political awareness, adds to governing complications and improves connections with the outside world.Therefore, we must admit that the only thing worth learning from the concept of the“middle income trap” is that it is urgent and necessary to transform the development mode, optimize the growth model and step up technological innovation.

With the soaring cost of labor, China is at increasing risk of falling into the “middle income trap”.Hence, it must accelerate the change of its economic growth model, and, through technological progress and innovation, speed up the strategic adjustment of its economic structure.