Journal Issue
Finance & Development, March 2007

Back in the Fast Lane: As members of the middle-income country club, East Asian nations may need to update their growth strategy

International Monetary Fund. External Relations Dept.
Published Date:
March 2007
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Indermit S. Gill and Homi Kharas

The Indonesian capital bustles at night.

IN 1997–98, a financial crisis brought three East Asian middle-income countries—Indonesia, Korea, and Thailand—to their knees. It also affected Malaysia and the Philippines, which had difficulty sustaining growth. Many predicted that the structural weaknesses that the crisis laid bare—corruption, cronyism, and nepotism—would condemn the region to stagnation, as they had in Latin America after its debt crisis in the mid-1980s. Emerging East Asia was expected to lose years of growth. Instead, its growth record since 1998 has been remarkable: GDP has almost doubled, growing by more than 9 percent a year, to reach $4 trillion in current dollar terms by 2005. Despite the setback in the 1990s, growth during the past 40 years has been consistent (see table).

Now, almost a decade later, Korea is a high-income country, and the other four are growing fast. China has joined the middle-income club. Once Vietnam achieves middle-income status, possibly as early as 2010, more than 95 percent of East Asians will inhabit a middle-income country.

Should East Asia expect to continue these high growth rates? The reality is that middle-income countries (those with per capita incomes of $826-$10,665) have grown less rapidly than either rich or poor countries. The per capita GDP of high-income countries rose by about 50 percent between 1980 and 2000, that of low-income countries increased more than 150 percent, and the income ratio between high- and low-income countries has been halved. In contrast, average real per capita incomes of middle-income countries grew by less than 20 percent over this period, widening the gap between them and high-income countries by about 20 percent. Middle-income countries, it is argued, are squeezed between low-wage competitors in poor countries, which dominate mature industries, and innovators in rich countries, which dominate industries undergoing rapid technological change.

This line of reasoning suggests that East Asian middle-income countries must update their strategies. What permits countries to grow fast from a per capita income of $1,000 to $10,000—the current challenge for most East Asian countries—is different and more difficult than what helped them grow from a per capita income of $100 to $1,000—the challenge they successfully faced in the past.

Economic research suggests that two opposing forces are at work. On the one hand, as countries get richer, they demand a greater variety of goods, many of which can be produced domestically. This creates a force toward sectoral diversification. On the other hand, countries get richer only if they specialize in what they do best. Which tendency dominates is an empirical question. Researchers have found that a switch to specialization happens during middle income and depends critically on the extent of economies of scale in production (see box).

What did the Asian leaders in the first wave do to successfully transit through middle-income stages of development? And what can today’s middle-income countries in East Asia do to ensure that they do not suffer the same fate as Latin America’s middle-income countries, which have struggled unsuccessfully to grow into rich countries? This article explores the challenges facing middle-income East Asia today.

Recognizing economies of scale

In addressing these questions, policymakers in the region can learn from recent advances in thinking about economic growth, industrial organization, international trade, and economic geography.

Renewed interest in economic growth since the late 1980s has been triggered by the observation that income levels across countries have not been converging in line with traditional economic theory. This theory predicted that efforts to accumulate physical and human capital, improve efficiency of production, and use the latest technologies would pay off in a narrowing of income gaps between developed and developing countries. Its fundamental implication was that, in seeking the highest possible returns, financial and human capital would move from places where they are abundant to where they are scarce, bringing with them the latest and best products, processes, and technologies.

How to get richer

Although economic development requires constant learning and adjustment, recent findings suggest that countries with per capita incomes between $1,000 and $10,000 should make several major changes in their strategy.

  • From diversification to specialization. Countries generally appear to diversify initially as they grow, but this trend is reversed after per capita incomes reach about $5,000-$8,000, after which countries begin to specialize. At what stage they reach this tipping point depends on their size and export orientation, but it implies that, in addition to worrying about the general investment climate, policymakers may also need to develop sector-specific strategies.

  • From investment to innovation. As firms in a country approach the technological frontier, regulatory policies that favored investment by incumbent firms should give way to regulations that encourage entry of new firms and exit of those whose products or technologies are obsolete. This switch has to be timed right and will be difficult to implement because of vested interests.

  • From basic to higher education. As countries exploit economies of scale, skill premiums will rise rapidly and policymakers must plan for an adequate supply of new graduates to mitigate the increase in income inequality. In such economies, knowledge spillovers are important and merit public subsidies for higher education.

Sources: Imbs and Wacziarg (2003), Aghion and Howitt (2005), and Romer(1994).
Consistent performance: East Asia has grown rapidly despite the 1997-98 crisis.(per capita GDP growth, 1966-2004; percent)
Region/countryGrowthNumber of years In which the rate was
Negative0–2 percentAbove 2 percent
East Asia and Pacific5.82334
Latin America and Caribbean1.5101514
Middle East and North Africa11.28139
South Asia2.611226
Sub-Saharan Africa0.214205
Sources: World Bank, World Development Indicators, and Global Development Finance central databases.

Data are from 1975 to 2004.

Sources: World Bank, World Development Indicators, and Global Development Finance central databases.

Data are from 1975 to 2004.

But this has not happened. With few exceptions—primarily East Asia’s strong performers—income gaps have widened. This does not mean the market has not worked at all: most countries have become richer and poverty has fallen. But both between and within countries, human and financial capital appear to move from places where they are scarce to where they are abundant. This makes good sense in a world of economies of scale in which factors of production tend to cluster in cities.

The main driver of economies of scale, in modern growth theory, is ideas. Unlike goods and factors, ideas can be used repeatedly, as well as by many people at the same time—that is, they are “nonrival.” And an idea, once formed, can be used as a starting point for new ideas. However, it requires effort to come up with useful ideas. And people can be prevented from using ideas to improve products or production processes through secrecy or enforcement of intellectual property rights, even if temporarily. Because of such “excludability,” knowledge confers on its creators some monopoly power and generates what economists call “economic rents.”

By bringing knowledge into formulations of economic growth, economists can recognize the centrality of ideas and increasing returns, but they must also recognize that ideas do not always flourish under perfect competition. Some competition can give firms an incentive to innovate, but too much can reduce the value firms get from each idea and thus reduce their effort to create new ideas. By the late 1980s, explanations of international trade routinely discussed imperfect competition to understand the rise of intra-industry trade. By the early 1990s, growth theorists had accepted the need to incorporate scale economies into aggregate formulations of the economy. By the mid-1990s, theorists had shown how these concepts could also be used to understand where economic activity became concentrated.

Insights for middle-income countries

How can modern growth economics help middle-income countries? At the risk of oversimplification, we classify the insights into two groups: the role of private enterprise in exploiting economies of scale, and the role of governments in ensuring a fair distribution of income. Both are needed to sustain rapid growth.

The formal recognition of economies of scale, which brings economic theory closer to the world of policymakers, has three implications for middle-income countries:

  • Trade can take place between all kinds of economies. Those with different factor endowments have more interindustry trade, and those with similar factor endowments can profitably engage in intra-industry trade. Both global and regional integration are important.

  • The market may underinvest in the creation, adaptation, or adoption of new ideas. The implication is that governments should, theoretically, subsidize higher education that will ensure that a country continues to acquire competitive advantages in some activities.

  • Large cities provide the ideal environment for activities that display increasing returns. Thus, as economies develop, policies to keep cities livable and friendly toward businesses become increasingly important.

Recognition of the distributional implications of economic growth also has three policy implications for middle-income countries:

  • Because cities are central for growth, middle-income countries should see urbanization as promoting development and strengthen the links between rural and urban factor and product markets.

  • In countries that aggressively exploit economies of scale, the demand for skilled labor rises and skill premiums increase. Inequality is likely to rise, both within urban areas and between cities and the countryside. The outcomes may not be egalitarian, but policymakers should at least try to provide equal access to education and other social services.

  • Modern growth theory predicts that there will be economic rents, and how they are distributed is vital for growth. If economic rents are reinvested in public infrastructure and social services, the foundations of economic growth are strengthened. If they are dissipated in ineffective cities, social strife, or corruption, they may even slow growth. Thus, governments must tax economic rents in ways that are least harmful to private interests and spend the proceeds in ways that best promote the public interest.

Growth centered on economies of scale encompasses both specialization and innovation, which are facilitated by integration. East Asian countries have retained their global trade, technology, and financial linkages while also deepening their regional ties to exploit unexhausted economies of scale. But specialization and innovation have led—through the rising importance of regional production networks and the growth of cities—to widening spatial and social disparities within countries. If left unaddressed, these disparities can slow growth as firms face rising costs, and social conflict will grow as economic disparities widen. Honest, well-informed, and effective governments that act in the public interest to facilitate sustainable agglomeration (that is, growth of cities) and investments in skills can ensure that economies of scale continue to be fruitfully exploited.

International integration has progressed …

East Asia integrated first with global trade markets, and its success with global integration is growing. Emerging East Asia (which excludes Japan) has increased its export market share to 20 percent, double its GDP share, and total merchandise trade has reached the same size as total GDP. These achievements are due in large part to open trade policies.

Regional integration in East Asia is also well advanced and has accelerated since China’s accession to the World Trade Organization in 2001. Despite the 1997-98 crisis, regional trade has grown at about 10 percent a year over the past decade. More than half of East Asia’s imports come from within the region, resulting in increasingly efficient regional production networks. This trade—complementing, not substituting for, global trade—is dominated by intermediate imports of parts and components. Outside the region, trade is dominated by final goods. The two go hand in hand: intraregional trade provides a low-cost, high-quality supply chain; interregional trade provides a mass market in which economies of scale can be exploited. And East Asian exports have been growing fastest in sectors exhibiting scale economies (see Chart 1).

Chart 1.Star performance

Sources: Antweiler and Trefler (2002): Gill and Kharas (2007).

Note: A scale elasticity that is greater than one implies increasing returns to scale: unit costs of production of a good or service fall as more is produced. A scale elasticity equal to one implies constant returns to scale.

Most trade takes place between cities. In East Asia, cities are estimated to generate about three-fourths of annual output, and between one-half and two-thirds of exports. Often, output is concentrated in a single city: Bangkok has 40 percent of Thailand’s GDP; Manila, 30 percent of the Philippines’; in Vietnam, Ho Chi Minh City has 20 percent; and in China, Shanghai has 11 percent.

… but domestic integration is lagging

Despite successful global integration and increasing regional integration, many East Asian countries are falling behind in domestic integration.

Reversing this must start with cities, where most economic activity occurs. Spurred by fast economic growth, East Asia has begun to witness one of history’s largest rural-to-urban population shifts: 2 million new urbanites are expected every month for the next 20 years. This massive movement of people will put pressure on the region’s mega cities, those with more than 10 million inhabitants, especially their ability to provide clean air and water, green spaces, easy commutes, and low crime rates.

But the bulk of urban population growth will happen in cities with fewer than 500,000 people, which are generally less well managed, according to recent investment climate surveys. A poor business environment translates into a smaller tax base, and these smaller cities spend less per capita on key social services and on environmental cleanup, making them even less attractive places for investment.

The gap between income levels in smaller, interior cities and large coastal cities is also related to the poor domestic infrastructure connecting most cities to major ports. Although East Asia has some of the world’s most efficient seaports and air transport facilities, the internal logistics within countries are inadequate.

Growing inequality is pressuring East Asia’s social cohesion. Inequality in income levels, schooling, and access to basic services in much of the region has risen (see Chart 2). Poorer regions and rural areas are falling further behind their urban counterparts, and ethnic minorities are not participating in growth. More than three-fourths of the inequality of living standards is within countries.

Chart 2.Behind the averages

Source: Gill and Kharas (2007).

Note: A higher number for the Theil index indicates higher inequality in consumption levels.

Governments must come up with solutions to the problems of national distribution and local economic management and service delivery. But they are being sharply questioned by civil society groups because of a perception of widespread centralized corruption in some countries. Countries like Korea and Malaysia are trying to join Hong Kong SAR, Japan, and Singapore as places where corruption is severely sanctioned and opportunities for corruption are curbed by a rules-based government. China, Indonesia, and Vietnam have also launched aggressive national anticorruption programs and moved to prosecute high-ranking officials.

Much of the problem is now at the local level. East Asia has decentralized public expenditures on social services and infrastructure, which should, in the long run, lead to greater transparency and accountability of local public officials. But, while institutional checks and balances are maturing, decentralization could jeopardize control of corruption, threatening economic efficiency, aggravating social tensions, and worsening gaps in subnational economic performance. These changes may explain the deterioration in perception-based anticorruption indicators, which suggest that East Asia is falling behind in its efforts to fight corruption. They may be signaling that a greater emphasis is needed to ensure honest governments as these economies grapple with the middle-income development challenge.

A big push on the home front

Thus, the task ahead for East Asia is to complement global and regional integration with domestic integration. This requires ensuring vibrant cities that are well linked to the outside world but that remain linked domestically, strengthening social cohesion so that societies stay as strong as economies, and providing honest governments that efficiently reinvest the economic returns that accompany fast growth. The global trade and technology flows and regional networks that are powering East Asia’s growth provide adequate resources for meeting the challenge of domestic integration. If developing East Asia’s policymakers succeed in making this third integration as successful as the first two, they can, within a generation, eliminate poverty and lead their countries into the ranks of the rich, developed nations of the world. In doing so, they will also provide valuable lessons for middle-income countries around the world.

Indermit S. Gill is Economic Advisor in the East Asia and Pacific Regional Office at the World Bank, and Homi Kharas is a Visiting Fellow at the Wolfensohn Center for Development at Brookings Institution and formerly Chief Economist for East Asia and the Pacific at the World Bank.

This article is based on the authors’ An East Asian Renaissance: Ideas for Economic Growth (Washington: World Bank, 2007).


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