03 January 2016
China Garden

Asia's economic traps

Most Asian economies are being stalked by low-income traps, middle-income traps, and even high-income stagnation traps, writes John West.

The world is wondering if the Chinese economy will fall into a "middle income trap", according to distinguished US economist Barry Eichengreen. After successfully transitioning from low-income to middle-income status, could China fail to maintain sufficient economic growth to achieve high-income status?

In other words, could it get stuck at a middle income level like Brazil and some other Latin American countries have done? Countries caught in middle-income traps find themselves squeezed between countries that compete on the basis of low wages and costs (like Cambodia and Vietnam), and those that compete on the basis high-skills and innovation capacities (such as Japan and Korea).

But while economic commentators are obsessed with speculating about China's future, economic traps of all sorts are lurking everywhere in Asia, stalking all economies, both rich and poor.

In fact, only the micro-economies of Hong Kong, Macao and Singapore have managed to climb the development ladder sufficiently to match the dizzying heights of leading Western economies like the US, Germany and Switzerland. And there is little prospect of any other Asian economy achieving such success, notwithstanding economists' insightful analysis of conditional economic convergence.

First of all celebrate we should celebrate the fact that virtually all Asian economies have escaped the "poverty trap", that vicious cycle of poverty breeding poverty. And thankfully Burma/Myanmar may finally be on the verge of breaking out of its longstanding poverty trap.

The once-seemingly desperate cases of Bangladesh, Cambodia and Vietnam have managed to attract sizable flows of foreign investment for the garments industry. True, this is a low-skill and low value-added industry. It is also true that these industries are riddled with human and labor rights abuses. And governments have provided massive incentives to secure such foreign investment.

But the garments industry in these countries has created many jobs, notably for women. And extreme poverty has fallen markedly.

In India and the Philippines, there have been other paths out of the poverty trap. Financial remittances from overseas migrants have enabled many families to survive, send their kids to school, and sometimes start a small business. And English language facility has enabled the development of competitive IT-based industries.

All these economies may have escaped the wretchedness of the poverty trap. But vast swathes of their populations still live in near-poverty, and sizable chunks of their populations are yet to break out of poverty. And they all risk getting stuck in a low-income, low-skills trap.

What do they need to do to decisively break into middle income status?

The prescription is simple. Substantial investments in infrastructure and basic education, more open markets, and cleaning up some of the corruption in their governments. However, the evidence shows that it is proving more difficult to implement the necessary reforms, than it was to first ignite the development engine. All too often, vested interests from rigid social structures block the necessary change.

But without such reforms, these countries will never attract high quality foreign or domestic investment. And wallowing in a low-income, low-skills trap would mean skilled labor draining away to more attractive countries, and successful companies (especially in the case of India) taking more interest in international than domestic markets.

Countries like Malaysia and Thailand were propelled into the middle income group by successful policies. Basic education, infrastructure, openness to foreign investment, and political stability. But breaking out, and moving towards high-income status requires much much more. High income means higher value-added, more skills, greater technological capacity, and innovation capabilities.

But neither Malaysia nor Thailand have made the necessary leap. Both are mired in middle-income traps.

Their education systems are totally inadequate for middle income countries. Both are suffering from skills crises. Neither have developed the necessary institutions for generating local innovation. And both have done a poor job offering economic opportunity to all citizens. Malaysia's talented but frustrated Chinese are leaving the country in increasing numbers. While in both cases, the exploitation of low-skilled immigrants undermines the quest for progress.

Moreover, appalling politics is undermining deeply the prospects for both countries, as evidenced by the 2014 military coup in Thailand and the corruption scandal presently engulfing Malaysia.

As countries develop, populations demand a say in their destiny and also demand clean governance. But in both cases, corrupt entrenched elites refuse to allow governance to mature in tandem with their economies. Political instability is the result, which is undermining the economy, just at the time when high quality governance is necessary to foster economic sophistication. The tragedy of Malaysia is palpable. In 1980, it had a similar level of development to Korea, a country which went on to achieve high-income status.

Japan and Korea are the poster children of Asian economic development. Japan was the first to achieve high-income status, and even appeared to be challenging the US juggernaut in the 1980s. But following a financial crisis two decades ago, it has fallen into a high-income stagnation trap. Today, GDP per capita and labour productivity are some 30% lower than the OECD's leading economies. And the likelihood is for it to keep slipping backward. For its part, Korea seems to be following Japan's path.

There are very many angles to the Japan/Korea syndrome. As Asia's first-mover economies, they implemented export-oriented growth strategies, but not free trade. A combination of protectionism and competing on world markets enabled their manufacturing sectors to become very competitive and productive.

But since their services and agricultural sectors didn't export to world markets, they became highly inefficient behind walls of protection. In Japan's case, services sector productivity is only 50% that of the manufacturing sector, while in Korea it is even lower. Inefficient services sectors are an enormous drain on the whole economy, especially since they typically account for the three-quarters of modern, advanced economies. And their agricultural sectors are even more inefficient, imposing great costs on both consumers and the economy.

Both Japan and Korea have been clinging onto the interventionist policies and institutions which were successful in the past. But these policies are no longer appropriate at a stage where all sectors need to work for the economy, and where entrepreneurship and innovation must become key drivers of the economy. And the vested interests that benefit from these policies and institutions maintain roadblocks to reform and change.

Another angle to Japan's stagnation these past two decades is demographics. In the early 1990s, Japan still had an annual "potential growth rate" of over 3%. But with the working age population declining since 1995, potential growth has slipped down to 0.5% according to the Bank of Japan. For its part, Korea will see its working age population start declining in the next couple of years, which means the start of the demographic slippery slope.

There is much that both Japan and Korea could do cope with poor demographics -- like opening up to immigration, encouraging seniors to work longer, and giving more opportunity to women and youth, both of whom suffer miserably in these Confucian societies. But neither country is tackling population aging with sufficient vigor, with the inevitable consequence of economic stagnation.

Where does all this leave China and its possible middle income trap?

China is such a vast and diverse country that it faces the challenges of all three income traps. Some parts of its vast hinterland like Guizhou and Yunnan have more in common with Cambodia and Vietnam than Shanghai, and need decisive action to escape a low-income/low skills trap. The quality of education in rural areas is still very low, and inadequate for its modern industry.

Then there are vast numbers of second- and third-tier cities in the middle, while a few cities like Guangzhou and Shanghai have more in common with high income countries. But even here, China’s services sector has low productivity due to regulatory, infrastructure and human capital bottlenecks.

Overall, the Chinese government has proved itself very capable of providing the hard infrastructure that can drive economic development. But it is much less adept at providing soft infrastructure, notably rule of law and freedom of expression, which are necessary to achieve high income status.

The current anti-corruption campaign is evidence of that, where the Communist Party decides who is and is not corrupt, and the media and civil society are not allowed to play a role. And the government has not been able to prevent the great divergences between the country’s different regions despite all of its talk of inclusive growth.

In short, notwithstanding the splendid analysis of conditional convergence theorists, it is difficult to see China (or any other Asian economy) converging to the levels of development of the US, Germany or Switzerland in terms of GDP per capita.

As a distinguished China expert once said to me:

"China will never become a democratic, advanced economy like the US. The open and free-wheeling nature of America is not China and will never be China."

"Moreover, the Chinese Communist Party will do its utmost to stay in power by continuing to ramp up repression, as it is doing now. The ultimate demise of the Party, one day or another, will be a bloody affair, and will only usher in a period of political and economic instability, rather than lay the foundations for democratic prosperity."
Tags: asia, middle income trap, low income/low skills traps, stagnation traps

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