How to avoid middle-income traps? Evidence from Malaysia

Aaron Flaaen, Ejaz Ghani, Saurabh Mishra, 22 July 2013

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Many developing countries have successfully made the transition from low-income to middle-income status, thanks to rapid economic growth, but have subsequently got stuck in a middle-income trap. A great deal of research has been done on what explains much faster growth in the developing world than in the developed world (Acemoglu et al 2011, Baldwin 2011, Commission on Growth and Development 2008, Rodrik 2013, UNIDO 2011). But little is known about why so few countries succeed in making the transition from middle-income to high-income status (The Economist 2013). This is a worrying trend and an issue of major concern, especially because the majority of poor people now live not in low-income but in middle-income countries (Chandy and Gertz 2011, Sumner and Kanbur 2011). So what is a middle-income trap? What should policymakers do about it?

We examine these questions in the context of Malaysia, whose structural transformation from low to middle income has made it one of the most prominent manufacturing exporters’ in the world. However, in a competitive global economy, like many other middle-income economies, it is sandwiched between low-wage economies on one side and more innovative advanced economies on the other.

What is a middle-income trap?

The middle-income trap is a development stage that characterises countries that are squeezed between low-wage producers and highly skilled and fast-moving innovators. Cost advantages in manufactured exports that once drove growth start to decline in comparison with other lower-wage countries. Caught between these two groups, many middle-income countries are without a viable high-growth strategy. They are faced with new challenges, including social cohesion, a large pool of young people in search of jobs, as well as millions who still live in misery and poverty, particularly in lagging regions.

As global, institutional, and structural environments evolve, prior strategies no longer remain effective at generating an equivalent rate of economic growth. Transition becomes more difficult when the status quo prevails, and the emerging competitive sectors do not have a seat at the table. Many middle-income countries tend to make two common mistakes: either they cling to past successful policies for too long, or they exit prematurely from the industries that could have served as the basis for their specialisation process (Agénor and Canuto 2012; Aiyar et al. 2013;s Eichengreen, Park, and Shin 2013; Felipe 2012; Gill and Kharas 2007; Nungsari and Zeufack 2009; OECD 2007). Timing and smooth transition are the two keys to success.

What might be the new growth drivers?

The world is experiencing a third industrial revolution, with the globalisation of services being at the forefront (Blinder 2006, Ghani 2010). Due in part to lower transport costs, services are now characterised by growing tradability and a potential new source of growth. The number of services that can be transported digitally is constantly expanding – education, health, insurance, audits, call centers, and many more. The list of modern services that can be traded is exploding, and productivity growth in services is increasing at a much faster pace than in manufacturing.

Figure 1 compares output per worker in Malaysia in agriculture, manufacturing and services sectors during the past two decades. Although all three sectors have experienced an upward trend, productivity growth in the manufacturing sector trumps the other two sectors. Good infrastructure, sound institutions, global integration, and skills have benefitted the manufacturing sector. Its strategic location and historical role as a regional hub for commercial interactions with the West has given Malaysia a long history of international trade in manufacturing. However, the record for Malaysian services exports has been less successful.

Figure 1. Malaysian output per worker: Major sectors, 1987–2007

Source: growth accounting calculations as explained in text.

Figure 2 compares the sectoral contribution to total labour productivity growth in Malaysia, with China, India, Korea, and the US. For the two east Asian countries and India, the results broadly agree with popular perceptions of the regions: there is a dominant contribution of the industrial sector in both Korea and China, while India relies mostly on services for overall productivity growth. As a high-income country with a large services sector, the US also records high contributions from services along with minimal benefits from reallocating labour among the sectors. Malaysia appears to fit somewhere between India, the US, and the east Asian countries.

Figure 2. International comparisons, shares of sector contributions to output per worker, 1990–2007

Source: Authors calculations from data in Bosworth and Maertens (2010).

Figure 3 compares the export of modern and traditional services from Malaysia with other countries. Brazil, China, India, Singapore, and Thailand have all experienced a much faster decadal growth in export of modern services (and traditional services) compared to the US. The exception is Malaysia, which experienced a slower growth in modern service export compared to the US.

Figure 3. Modern and traditional services export growth, 2000–2009

Source: IMF Balance of Payments 2009.

Note: Modern services include exports in telecommunications, computer and information services, other business services, financial services, insurance, royalties, and license fees. Traditional services include travel, transportation, construction and personal, cultural, and recreational services exports.

A large gap in productivity exists between manufacturing and services in Malaysia, and this gap has only accelerated in recent years. However, this gap is not the inevitable consequence of a country’s economic evolution. There is no intrinsic characteristic of manufacturing that translates into inevitable productivity growth. Rather, in the current global environment, ‘industrial versus nonindustrial’ is no longer the appropriate distinction for designating high-productivity/low-productivity production. The key designation is ‘modern versus traditional’ activities. Therefore, rather than advocate for a particular sector as the source of stronger growth in Malaysia, there is a stronger need for broad structural transformation; that is, moving to higher productivity production in both goods and services.

What should policymakers do?

Over the past several decades, Malaysia has leveraged the three channels of globalisation – trade, capital, and economic management – to expand its tradable sector, and has consequently become one of the most sophisticated exporters of manufacturing goods in the world. The services sector in Malaysia has yet to modernise and contribute substantively to economic growth. What steps can be taken to advance this sector to enable Malaysia to proceed on the path to high-income status?

Malaysia’s economic strategy to become a high-income economy by the year 2020 is strongly supported by the Economic Transformation Program, Strategic Reform Initiatives, and Government Transformation Program. Public investments through the Economic Transformation Program are expected to accelerate in the future, as the implementation of large infrastructure and investment projects gather momentum and are funded by government-linked companies. Furthermore, these investments have also bolstered private manufacturing, services, and mining sectors in targeted growth corridors. The Economic Transformation Program has made great strides in liberalising crucial manufacturing and services activities to pull in a skilled labour pool and relax restrictions on capital mobility. But more can be done:

Policymakers should promote entrepreneurship and innovation to begin reaping the benefits of information networks and skilled labour before the gains from cheap labour and knowledge spillovers are exhausted.

Rapidly expanding the secondary and then tertiary education system will be critical in producing graduates with the skills that employers require. Highly skilled workers and professionals are an indispensable ingredient of high, valued-added, modern services and manufacturing. The “skills crisis” is a well-known shortcoming of the Malaysian economy.

  • Attracting highly productive foreign firms to locate production in Malaysia is another area on which policy makers should focus.

Apart from the direct benefits of high wages, imported capital equipment, and substantial tax revenues, the spillovers between these firms and the broader economy are well documented. More can be done, including allowing foreign-owned firms – particularly in the services sector – to gain from network externalities and collateral benefits of foreign direct investment to stimulate further growth, and promoting venture capital investments for small domestic startup firms seeking to scale to global markets.

  • Developing the services sector holds the greatest promise.

In particular, providing access to learning and training opportunities to build social entrepreneurs and product innovations will be crucial. The promise of the globalisation of services means that Malaysia should utilise the market space provided by internet and communication technologies to foster business innovations for the global economy. In this respect, the interaction of spatial transformations linked to such structural changes will be paramount.

The range of modern services that can be digitised and traded globally is constantly expanding. India has been a pioneer, but many other emerging markets are finding it easier to generate productivity growth in services than in industry. This does not happen automatically. Although the same set of general non-distortionary policies is as important for modern services as for goods, specific strategies for services matter, like market integration and the technological changes in information networks. Services expansion provides an alternative growth escalator for emerging markets like Malaysia to escape the middle-income trap.

Conclusions

Malaysia and other countries facing the middle-income conundrum will need to expand their ‘modern’ sectors. This will work, in practice, when traditional sectors with low productivity shed labour and high productivity modern sectors (be they in goods or services) grow and hire more labour. Both processes are needed if a country is to climb out of the middle-income trap. But this process of structural reform can be tricky: structural reforms can be slow and complex, or fast and easy, depending on the ownership of the programme, implementation capabilities, and a macroeconomic stance that provides fiscal and political space to implement the program.

Editor’s note: this is a summary of a World Bank Working PRE Paper on Malaysia by Flaaen et al, 2013. Views expressed here are those of the authors and not necessarily of the institution they may be associated with.

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Topics: Development
Tags: Malaysia, middle-income gap, productivity

Graduate student in the Economics Department, University of Michigan
Ejaz Ghani
Lead Economist in Economic Policy and Debt, PREM Network, World Bank
Economic consultant at the World Bank and IMF

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