01 March 2015
Asia's economic catchup challenge

Asia's economic catchup challenge

Asia's miracle economies are experiencing great challenges catching up to the Western world, despite their rapid development.

Asia's miracle economies are experiencing great challenges catching up to the Western world, despite their rapid development.

Japan's very rapid development following the 1868 Meiji Restoration is evidence of the potential of all countries to catchup or converge to world leaders. Its GDP per capita had doubled by the eve of First World War in 1913, and doubled yet again by the beginning of Second World War 1939.

Indeed, Japan was the world's fastest growing economy during the period 1911-40. And despite exploitation by their Japanese colonial power, Korea and Taiwan also achieved high economic growth rates during this time, resulting in higher GDP per capita than other Asian developing economies.

The experience of Japan also demonstrates that new-found prosperity can be misused in military adventurism. Today, both China and India are making massive investments in their militaries, in tandem with their economic development. We can only hope these militaries will resist the temptation of similar adventurism.

But Japan's post-war resurgence showed that, even from the ashes of military defeat, economic catchup is still possible. And amazingly, this economic recovery was fostered by reconciliation and a partnership with Japan's former enemies, notably the US. (A similar story can be told about Western Europe's post-war revival.)

By 1989, just before Japan was about to experience a major financial crisis, its GDP per capita had almost caught up to that of the US. This lonely group of islands, sitting off the east coast of the Asian continent, seemed to have succeeded in achieving very high income status, and appeared to be a challenger to American global leadership.

And not only did Japan grow its GDP per capita, it transformed its economy from one based on agriculture and simple manufactures to a sophisticated industrial and service-based economy. Indeed, such structural transformation is a powerful driver of productivity growth, as labor and capital moves from low-productivity rural activities to higher-productivity urban activities.

But achieving full economic catchup can be a daunting challenge. Japan's bubble economy burst in the early 1990s. A sluggish response by the government led to two "lost decades" of stagnation. Its GDP per capita has slipped back to 30% below the US's. And Japan's world-beating automobile and electronics companies are now facing stiff competition from companies from Korea, Taiwan, China and elsewhere.

Catching up to the US and other world leaders now seems like a mission impossible. Japan is stuck in a stagnation trap.

Japan's experience demonstrates that the early phases of development can be easier than the later phases. As we climb the development ladder, the management and governance of our economies must become more sophisticated. It is now likely that Japan with its massive public debt, aging population, and political inability to change will slip even further behind the US and other world leaders.

In sharp contrast to Japan, the US has shown that not only is full catchup possible, but economic overtaking is also possible. In the decades before the First World War, the US overtook the UK in terms of GDP per capita, after the UK had been the world economic leader since the Industrial Revolution.

Elsewhere in Asia, other economies have followed Japan's economic catchup path, in a pattern of "flying geese". The next wave included Hong Kong, Korea, Singapore and Taiwan (New Industrialized Economies -- NIEs). Singapore, and also Macao, have not only leapt ahead of Japan. By some measures their GDP per capita now exceeds the US's. But despite the impressive performance of Hong Kong, Korea and Taiwan, based on present performance, there is little sign of them being able to achieve full economic catchup to the US.

In the next wave of fast developing Asian economies, there are the cases of Malaysia, the Philippines, China and India. Malaysia is caught in an "upper-middle-income trap", while the Philippines is a "lower-middle-income trap", according to an Asian Development Bank study.

This means that these countries achieved their upper- and lower-middle-income status some time ago, but they have not been able to break out of their respective groups (a similar fate has befallen Brazil and some other Latin American countries, along with many Middle East energy producing countries). The ADB study finds that Malaysia and the Philippines were only able to gain comparative advantage in electronics. In contrast, Korea, which has achieved high income status, developed a more diversified export basket basket by gaining comparative advantage in a significant number of sophisticated products.

The jury is still out regarding the ultimate catchup prospects of the hugely populous countries of China and India. At this stage, their GDPs per capita are still respectively around 20% and 10% that of the US. And they have a long road ahead of them in the economic catchup game.

What is the secret of economic catchup?

In mechanical terms, economic catchup is driven by fast economic growth. The ingredients of economic growth are well known -- private investment, public investment in infrastructure, the supply of labor, the human capital of that labor (thanks to education and health), and above all, the efficiency with which those resources are employed (in other words, productivity).

In the early stages of catchup, economic growth tends to be particularly fast, gradually slowing down as GDP per capita approaches the world leaders. One reason is that rapid progress can be achieved by absorbing knowledge and technology from overseas -- especially in the areas of public institutions, education, health, infrastructure, and basic industry.

Export-oriented development can be a powerful driver rapid development. It enables the exploitation of economies of scale, and exposes local industry to international competition and product quality standards.

As a country's development approaches world leaders, and the scope for "copycat development" diminishes, innovation and creativity must then become engines of growth. And as the services sector becomes the dominant sector of the economy, global mindsets and cross cultural skills become important for competing on global markets.

But digging behind the mechanical story of economic growth is a deeper story of institutions and politics. What is required for successful economic development are "inclusive economic institutions", as argued by Daren Acemoglu and James A. Robinson in their celebrated book, "Why Nations Fail".

Inclusive economic institutions "allow and encourage participation by the great mass of people in economic activities that make best use of their talents and skills and that enable individuals to make the choices they wish. To be inclusive, economic institutions must feature secure private property, an unbiased system of law, and a provision of public services that provides a level playing field in which people can exchange and contract; it also must permit the entry of new businesses and allow people to choose their careers."

In short, "inclusive economic institutions require secure property rights and economic opportunities not just for the elite, but for a broad cross-section of society". And behind inclusive economic institutions are inclusive political institutions.

The enemy of economic development is "extractive political institutions" which "concentrate power in the hands of a narrow elite and place few constraints on the exercise of this power". This elite then usually structures economic institutions in order to extract resources from the rest of society.

The Philippines has been a country dominated by a relatively small group of families which have stacked the political and economic system in such a way that the vast majority of the country's population is excluded from opportunity and hope. This country has long been considered the "sick man" of Asia. Thanks in part to their command of the English language, ordinary Filipinos have been able to seek opportunity overseas. At least 10% of Filipinos now live overseas, with large numbers suffering unsavory conditions in the Middle East.

The Philippine economy is now virtually kept afloat by vast sums of migrants' remittances, which amounted to $28 billion or 10% of GDP in 2014 according to the World Bank. These remittances have become a key driver of the now fast-growing Philippine economy, as they finance residential construction, and consumption. They also finance investment in education and training for potential future emigrants. In short, migration is financing migration. And with Philippine mindsets geared up to emigration, rather than domestic politics, there is less pressure on the government (and elites) to implement the necessary reforms to develop the economy.

As Acemoglu and Robinson argue, "fear of creative destruction is often at the root of the opposition to inclusive economic and political institutions". Indeed, the fear of Philippine elites that they might lose their privileges holds back reform in that country. The fear of creative destruction is most evident in the case of North Korea where a narrow communist elite in Pyongyang dominates the country, totally impoverishing and abusing the human rights of millions of people.

So what is the origin of the inclusive economic institutions in Asia's success stories -- Japan, Hong Kong, South Korea, Singapore and Taiwan -- that enabled them to develop so rapidly? They all had a great incentive to build strong economies in the immediate postwar period, as they faced threatening neighborhoods surrounded by communist regimes in China, North Korea and the USSR, and instability in Southeast Asia. They were also dependent on imports to supply their energy and other natural resources -- this meant that export-oriented growth was necessary to finance imports. Of critical importance was the sympathetic financial aid and open markets provided by the US.

Japan's early success provided a model to the other four economies. And in turn, their success inspired other Asian countries, especially China when Deng Xiaoping took over the leadership in the late 1970s.

Ian Buchanan, Chairman of the Australia Committee of the Pacific Economic Cooperation Council, has strongly argued that these geopolitical factors were the driving force behind the rise of Japan and the Asian NIEs. And with the subsequent waning of these geopolitical factors, prospects for these economies are now greatly diminished.

In this context, the permanence of inclusive economic institutions cannot be taken for granted. The fear of creative destruction by corporate and government elites has been behind stagnation in Japan. This has been a key factor behind Japan's inability to achieve full catchup to the US economy. In Korea, the domestic economy and politics are dominated by an elite associated with the "chaebol", enormous conglomerates like Samsung and LG, which will likely inhibit the full catchup potential of the country.

Similarly, Communist Party elites in China fear the creative destruction that would result from deep reform of China's grossly inefficient state-owned enterprise and banking sectors. President Xi Jinping's anti-corruption drive has been an impressive effort to clean up China's politics. But regrettably, he seems to be mainly targeting political enemies, and not his corrupt friends. At this stage, there is little sign of reforms to ensure that market will play a "decisive" role in allocating resources, as promised in the Third Plenum in 2013.

Some 70 years after Japan began its post-war recovery, democracy and inclusive politics still have very shallow roots in Asia. Political and economic institutions remain dominated by entrenched elites, and new players have great difficulty breaking through. And as the gap between rich and poor continues to widen in Asia, there seems very little prospect of this changing.

In sum, it seems most likely that Asian politics will hold the region back from realizing its full economic and human potential and achieving real success in the Asian Century.


John West
Executive Director
Asian Century Institute
Tags: asia, economic convergence, economic catchup, why nations fail, Daren Acemoglu and James A. Robinson, middle income trap

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