The Myth of Malaysia’s Middle Income Trap

Source: http://econsmalaysia.blogspot.com/2011/08/myth-of-malaysias-middle-income-trap.html

MONDAY, AUGUST 15, 2011

The Myth of Malaysia’s Middle Income Trap

It’s a stylised fact and almost universally accepted that Malaysia is caught in a middle income trap. But a funny thing happened when I went looking for the evidence – it’ incredibly hard to find. And thinking about the issue made me more convinced that the whole idea is about as real as Hogwarts.

Taken at face value was does the term mean? Simply that a middle-income country stays a middle income country, and doesn’t make the leap into high income status. There’s also the notion of a poverty trap for countries; that low-income countries are unable or unwilling to make the necessary structural changes to achieve a growth “take-off” and start on the long road of development.

I hadn’t the time to try and track down the antecedents of both ideas, though they appear to have originated in the 1950s and 1960s (concurrent with the advent of development and growth economics) and formed the basis of large scale foreign aid to low income countries by the likes of the World Bank. In fact you could say that the whole raison d’être of development institutions such as the World Bank and the Asian Development Bank is that countries need “help” – especially large scale, expensive “help” – to get going. I don’t want to get sidetracked into that particular debate, so I’ll just concentrate on Malaysia’s particular “problem”.

The reason why I haven’t been able to fully track these ideas down is that, despite a decent literature search, there’s an incredible lack of academic papers on the “trap” condition itself, as opposed to how to get out of one. That doesn’t make sense to me – where I’ve been able to find references, the idea of a “trap” is taken as a given, with lots of advice to aspiring countries on what to do to get out of one. There’s hardly anything empirical on what middle or low income “traps” actually are, much less if they actually exist. How you can define a policy path based on a particular problem, yet almost completely ignore the conditions and particularities of the problem itself, is beyond me.

There is however a consistent narrative that underscores the idea of a middle income trap and it goes something like this:

1. Low income country begins by development through low wage manufacturing;
2. Growth is driven by a shift in labour resources from low productivity agriculture to higher productivity manufacturing;
3. Investment in the accumulation of capital relative to labour drives productivity improvements, both absolutely and relative to agriculture and mining;
4. Rapid growth comes from both an increase in productivity and an increase in the quantity and quality of factors of production (investment in fixed and human capital; improvements in healthcare and diet cuts mortality rates and increases population levels);
5. At some stage, diminishing returns sets in for capital, while population growth slows to a maintenance level;
6. Since growth is now dependent solely on total factor productivity, rather than increases in the factors of production themselves, countries that lack the capability to improve productivity find growth potential limited by this constraint and remain stuck as middle income countries.

This narrative seems to describe Malaysia pretty well – we’ve nowhere near matched the record of development posted by the likes of Singapore or Korea for instance. There’s no doubt as well that manufacturing – especially export-oriented manufacturing – appears to have hit a wall:

But there’s a number of ways I can pull this argument apart. Let’s take the obvious first – for a middle income country to remain a middle income country, growth has to have stalled relative to the high income target. Here’s the raw data (GNI per capita; RM ‘000; 1970-2010):

Apart from three identifiable recessions (1985-87, 1996-2001, 2009-2010), growth has been steady, if not spectacular. The World Bank’s definition of high income only came into being around 1987 (click here for the data and history of the World Bank’s income definitions) – here’s the chart above as a ratio to that definition (GNI per capita in USD; ratio to World Bank High Income Level; 1987-2010):

You’ll notice that there’s a lot of movement here – the 1997 financial crisis caused a massive loss in relative welfare, as did this past recession, though not quite to the same degree. It took nearly five years for Malaysia to make up the ground lost in 1997, something which we’ve almost achieved in a year this time. The 2001 recession on the other hand was a mere speed bump.

But looking at the ratio above, there’s one thing you don’t see – stagnation. At almost no point, save in the early 1990s, could you reasonably point to and say “TRAP!” In fact, the recent record is actually pretty good, as we’ve almost covered a third of the distance to the high income threshold in the past decade alone. More formally, ADF and PP tests strongly reject the hypothesis that the ratio is stationary in levels.

Another way of looking at the same thing using different data is through the Penn World Tables, which has a few indicators measuring per capita GDP as a ratio to US per capita GDP (index levels; US=100; 1960-2007; G-K method;PWT ver6.3):

The picture here’s slightly different, but the conclusion’s the same – Malaysia’s per capita income is still gaining ground on that of developed economies. There’s only a few periods (pre-1968; 1980-86; 1997-2001) where you could say that Malaysia’s economy was “trapped” – otherwise, we’ve made continually progress. Again, formal tests point to non-stationarity.

Digression: It was interesting to look at the experience of the NIEs in this context – we’ve always been treated as poorer cousins to them, despite starting off on nearly the same footing. So I can’t resist inserting the following (log ratios to US GDP per capita; US=100):

Singapore and Hong Kong started off richer than Malaysia and maintained their lead. We started better off than Korea and Taiwan, but ended up behind because of two factors – poor growth pre-1970 and losing a lot of ground in the 1985-87 recession. More research required here obviously…and now back to the topic at hand.

The past, as they say, is prologue. Just because growth has rather inconveniently not stalled as per the “trap” hypothesis, doesn’t mean it can’t happen in the future. But even here, there’s more than enough grounds for rejecting it.

Recall the narrative of the middle income trap above – rapid factor accumulation plus higher productivity from the shift to manufacturing drive the initial growth phase out of low income status. As economies mature, factor accumulation slows and productivity gains become harder to achieve, “trapping” countries who can’t make the transition to higher value added manufacturing.

The first and very obvious shortcoming here is that this narrative essentially recognises only one path to development – that of industrialisation. But looking at the milieu of high income economies today, it’s obvious that there’s more than one way to skin this particular cat. Of the East Asian economies to make the full transition to industrialisation, I think it’s fair to say that only Korea and Japan have followed that road. Taiwan’s more of a mixed economy, and Hong Kong and Singapore have thrived on services. Europe’s experience is similar – for every Germany, there’s a Norway or Switzerland.

If we look at development policies, again there’s considerable heterogeneity. Japan and Korea followed an almost socialist style industrial policy, with Hong Kong’s laissez faire economy diametrically opposite. Singapore’s policies falls somewhere in between with an emphasis on pragmatism, and you could say that Taiwan’s policy with respect to development to be one of benign neglect. Yet all these economies managed to make the leap to high income status. This suggests that there’s the individual structure of the economies in question matters – and means that there’s no single “answer”.

Malaysia’s economy, need I point out, is pretty diverse. While export oriented manufacturing carried the initial brunt of development (from the 1980s onwards), we’ve continued to maintain a sizeable primary sector and now have a burgeoning services sector:

Focusing development efforts and investment on the latter (where measured productivity can be higher than in manufacturing) is likely to produce greater benefits than trying to counteract a trap that doesn’t exist.

Lastly, and the biggest reason why I reject the notion of Malaysia’s middle income trap, is that we’re not past the factor accumulation stage. Malaysia’s demographics are highly supportive of future per capita income growth. Birth rates have already fallen below replacement levels, yet we have a big cohort in the school years that will raise the ratio of the labour force to the population. Any investment made to raise productive capacity or factor productivity will produce considerable dividends down the road. We’re about to experience a baby-boomer induced economic growth phase on par with that experienced by developed economies in the post-WWII era.

Mark my words: fifty years from now, people will look back and see these next 2-3 decades as Malaysia’s golden era. While the ETP and NEM will probably get the credit, this is a structural transformation that’s been years in the making.

Technical Notes:

1. GDP and GNI data from the Economic Planning Unit of the PM’s Dept.
2. World Bank income data from the World Bank
3. International per capita GDP data from the Penn World Tables