Avoiding the middle-income trap

The rapid economic growth of so-called emerging markets is one of the leading storylines of our age. Arguably, it is the most important economic development affecting the world's population in the first decade of the 21st century. Rapid economic growth has lifted millions out of poverty. It has accounted for the vast majority of global growth in a period when the advanced countries have struggled economically and financially.

For some time now the question on everyone's minds has been how long this rapid growth can continue, both for emerging markets in general and for the group's largest and most economically dynamic member, [People's Republic of] China, in particular. Attempts to answer that question have given rise to a literature on what is variously referred to as 'growth slowdowns' and 'the middle-income trap' (Agenor, Canuto and Jelenic 2012; Gill and Kharas 2007). At the time of writing, Google identifies more than 7,000 page references to the first term and nearly 400,000 to the second.

In an earlier paper (Eichengreen, Park and Shin 2012), we analysed historical experience with growth slowdowns as a way of shedding light on future prospects. We considered post-1956 cases of fast-growing countries: Where GDP per capita had been growing for seven or more years at an average annual rate of 3.5%; and where growth then slowed significantly (that is, where the growth rate of GDP per capita stepped down by at least two percentage points between successive seven year periods).

We found considerable dispersion in the per capita income at which slowdowns occurred, but: When the slowdown began, the mean GDP per capita was $16,540 in 2005 constant US dollars at purchasing power parity, the median $15,085. Growth of per capita income slowed on average from 5.6% to 2.1% per annum. By comparison, China's per capita GDP in constant 2005 purchasing-power-parity dollars was $8,511 in 2007, when the data in our source, Penn World Tables 6.3, ended.

In analysing the correlates of growth slowdowns, we found that slowdowns were positively associated with high growth in the earlier period (suggestive of mean reversion), with unfavourable demographics (high old-age dependency ratios), with very high investment ratios (as if growth fuelled by brute-force capital formation eventually becomes unsustainable), and with an undervalued exchange rate (as if countries with undervalued currencies have less incentive to move up the technological ladder out of unskilled-labour-intensive, low-value-added sectors and thus find it more difficult to sustain rapid growth). These results were suggestive, and they were suggestive for China in particular.

New research

We have now revisited these questions (Eichengreen, Park, and Shin 2013), updating and extending our previous results. There are several reasons for doing so. Concern about slowdowns and therefore the literature on this subject have continued to grow. China's growth rate has meanwhile decelerated from more than 10% in 2010 to less than 8% in 2012, meeting our slowdown threshold, although how much of this change is cyclical and how much is secular remains to be seen. For what it is worth, the IMF's forecasts for the rate of growth of gross domestic product at constant prices have Chinese growth accelerating to more than 8.2% in 2013 and remaining above 8.5% for a string of subsequent years. Others, in contrast, suggest that the current deceleration in China is likely to be permanent and that, if anything, more is coming.

In addition, we now have more and better data. Our earlier data ended in 2007, the last year covered by what was then the most recent release of the Penn World Tables. Now, courtesy of Penn World Tables 7.1, we have data through to 2010. This allows us to identify a number of growth slowdowns after the turn of the century that did not show up in our earlier data set. The new release also revises earlier estimates of per capita GDP for a number of countries - not least for China, whose 2010 per capita GDP at 2005 PPP prices is now estimated to have been only $7,129. In some cases where previously erratic series on the growth of GDP per capita have been smoothed, what appeared to be slowdowns no longer qualify. In other cases where once smooth series are now more volatile, episodes not previously identified as slowdowns can now be added to the list.

Our new results are broadly consistent with what we found before, albeit with some important differences. We still find that slowdowns are still most likely when per capita GDP in year-2005 constant dollars reaches the $15,000 range, the distribution of slowdowns is no longer as obviously uni-modal. The new data point to the existence of two modes, one around $15,000 and another around $11,000. We also find increasing the share of the population with at least a secondary level of education (secondary, university and higher) reduces the probability of a slowdown, other things being equal. We do not find the same thing for education in general, holding constant the share of graduates of secondary schools and universities; 'high quality' human capital matters more than 'low quality' human capital for avoiding growth slowdowns, or so it would appear. Slowdowns are less likely in countries where high-tech products account for a large share of exports. This is consistent with our earlier emphasis of the importance of moving up the technology ladder in order to avoid the middle income trap.

Implications for China

China has slightly higher average years of schooling at the secondary level than the median for our slowdown cases (3.17 years in China versus 2.72 years in our slowdown cases). It has a higher share of high-tech goods in exports (27.5% in China versus 24.1 in our slowdown cases). In this sense China appears to be doing slightly better than average in moving up the technology ladder in order to avoid the middle-income trap.

Our finding that high quality human capital reduces the probability of a slowdown seems intuitive. Skilled workers are needed to move up the value chain from low value-added industries and activities. High quality human capital is especially important for modern high value-added activities like business services. The Asian Development Bank (2012) finds that the underdevelopment of the service sector in China and other Asian emerging markets is attributable partly to the dominance of traditional low value-added services. It identifies shortages of appropriate human capital as an important explanation for the weakness of modern high value-added services.

Even emerging markets that have achieved rapid improvement in overall education attainment can suffer from shortages of specific kinds of skilled workers. The Asian Development Bank (2008) warns that such shortages are sufficiently prevalent to pose a risk to growth in China and other parts of emerging Asia. Surveys of employers in China and emerging Asia regularly identify shortages of qualified staff as a top business concern. Lack of high quality human capital helps to explain why Malaysia and Thailand have become synonymous with the middle income trap. The rapid expansion of secondary and then tertiary education helps to explain Korea's successful transition from middle- to high-income status.

Whether China can avoid the middle-income trap will presumably depend, in part, on whether it develops an education system that successfully produces graduates with skills that employers require.