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Beating the Middle-Income Trapin Southeast AsiaWilliam T. Wilson, PhD


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Photo on the Cover thinkstockphotos.com

This paper, in its entirety, can be found at:http://report.heritage.org/sr156

The Heritage Foundation214 Massachusetts Avenue, NEWashington, DC 20002(202) 546-4400 | heritage.org

Nothing written here is to be construed as necessarily reecting the views of The Heritage Foundationor as an attempt to aid or hinder the passage of any bill before Congress.

About the Author

William T. Wilson, PhD, is a senior research fellow in the Asian Studies Center, of the Kathryn and Shelby Cullom Davis Institute for National Security and Foreign Policy, at The Heritage Foundation.
http://www.heritage.org/http://www.heritage.org/


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SPECIAL REPORT | NO. 156 AUGUST 27, 2014

Abstract: Since 2000, Southeast Asia has had some of the fastest growing economies in the world. Indonesias economyhas enjoyed 6 percent annual growthbut will its lack of infrastructure and its commodity dependence soonreveal some cracks in its economy? The remarkable growth in the Philippines will not last unless domesticinvestment is elevated. Thailands growth has stalled amid political turmoil, and it is currently in a classiccredit bubble. Vietnam still generates impressive growth, but it has a banking problem, high ination, andubiquitous corruption. Are these four countries in danger of becoming ensnared in the classic middle-incometrap (MIT)the oft-observed slowdown in growth that occurs once developing countries reach middle-income

levels? This Heritage Foundation Special Report explores these countries MIT risksand explains how theycan avoid, or escape, this trap.

I n the 14 years of the new millennium, Southeast Asia has had some of the fastest growing econo-mies in the world. Indonesias economy has beencruising at 6 percent annual growthbut will itslack of infrastructure and its commodity depen-

dence soon reveal some cracks in its economy? Theremarkable growth in the Philippines will not lastunless domestic investment is elevated. Thailandsgrowth has stalled amidst political turmoil, and itis currently in a classic credit bubble. Vietnam stillgenerates impressive growth, but it has a bankingproblem, high ination, and ubiquitous corruption.

Are these countries entering the classic middle-income trap (MIT)? The MIT is generally dened asthe slowdown in growth that occurs once develop-ing countries reach middle-income levels. It is con-

structive to examine Southeast Asia, as it is the partof the emerging world that has most notably deedMIT tendencies. While only 13 developing countriesavoided the middle-income trap since 1960, ve ofthem were in East Asia. 1

According to the World Bank, there are cur-rently 145 emerging or developing economies in the world. If history holds, relatively few of these econo-mies are destined to become high-income and willbecome ensnared in the powerful MIT. The WorldBank explains that after exceeding the poverty trapof $1,000 gross domestic product (GDP) per capita,many emerging market countries head rapidly tothe middle income take off stage of $3,000 per cap-ita GDP, but as they reach the middle-income range,they experience long-term economic stagnation. 2

Beating the Middle-Income Trapin Southeast AsiaWilliam T. Wilson, PhD


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BEATING THE MIDDLE-INCOME TRAP IN SOUTHEAST ASI A

While the causes of the MIT are multifaceted,there does appear to be one consistent cause amongmany of them. As developing countries hit theirearly growth spurt and wages rise, manufacturersoften nd themselves unable to compete in exportmarkets with lower-cost producers elsewhere. Yet,they still nd themselves behind the advanced econ-omies in their ability to produce higher-value prod-ucts. The biggest challenge, then, is moving fromresource-driven growth that depends on cheap laborand capital to growth based on high productivity .

Recent history is littered with examples of seem-ingly extraordinary rates of economic growth that were not what they seemed. During the rst twodecades after World War II, for example, it was a

widely held belief that the Soviet Union was out-pacing the United States in economic growth. Someeconomists at the time had even come to admire theCommunist model of central planning. Unfortu-nately for the Soviets, the relatively rapid growth inoutput could be fully explained by the rapid growthin their factor inputs: a rapid expansion in their laborforce, signicant increases in educational levels, andabove all, massive investments in physical capital.

Economic growth that is based exclusively on fac-tor accumulations, rather than on growth in outputper unit of input or productivity, is inevitably subject

to diminishing returns. It was simply not possible forthe Soviet economy to sustain the high rates of growthin labor force participation, education levels, and itsphysical capital stock that had prevailed in the earlypostwar years. The result was a slowdown in produc-tivity growth. 3 Without the sustenance of productivitygrowth, Soviet economic growth eventually faltered.

Productivity growth is the most important gaugeof an economys long-run health. Nothing is morecritical in determining living standards over thelong run than improvements in the efficiency with which an economy combines its inputs of capital and

labor. Most economists focus on labor productivity, which is an incomplete gauge of efficiency becauserms can boost output per man-hour by investingmore and equipping workers with better machin-ery. A better gauge of an economys use of resourcesis total factor productivity (TFP), which assessesthe efficiency with which both capital and labor areused. Once a nations labor force stops growing andan increasing capital stock causes the return onnew investment to decline, TFP becomes the mainsource of economic growth.

The illusion of sustainable growth was not onlylimited to the command economies. The unusuallyrapid and protracted growth in the then newly indus-trialized economies (NIEs) of East Asia (Hong Kong,Singapore, South Korea, and Taiwan) from the 1960suntil the 1980s led to the widespread belief that pro-ductivity growth in these economies, especially intheir manufacturing sectors, had been extraordinari-ly high. But seminal research 4 showed that the NIEseconomic growth was mainly due to factor accumula-tion and the sectoral reallocation of resources.

All four economies had experienced sizableincreases in their labor force participation, leadingto natural increases in output per capita, or averageliving standards. In particular, however, they had been

rapidly accumulating capital, leading to more capi-tal per worker, and in turn, higher labor productivity.Unlike the command economies of the Communist era,however, factor accumulation in the four NIEs con-tributed substantially to growth because these econo-mies on the whole allowed the increasing amounts oflabor and capital to move from the less productivesectors to the more productive ones. It is this factoraccumulation, combined with eventual gains in pro-ductivity, which allowed them to escape the MIT.

Japans dismal rate of economic growth over thepast two decades is largely the result of lackluster

productivity increases. (According to the Confer-ence Board, TFP growth averaged only 0.5 percentbetween 2000 and 2013. 5 ) As its postWorld WarII rate of factor accumulation began slowing down,particularly capital accumulation, so did its overallrate of growth.

Part of the jump in Americas labor productiv-ity during the new economy era of the late 1990sreected a sharp rise in domestic investment as ashare of GDP (that is, capital accumulation). As thisinvestment share returned to historically normallevels last decade, so did U.S. real GDP growth.

This Special Report explores the root causes ofthe MIT and offers policy recommendations on howdeveloping countries can avoid it. The MIT issue ismost critical today because there are now 55 devel-oping countries in the upper-middle-income range with combined populations of over two billion. 6 This Special Report focuses on four nations in Southeast AsiaIndonesia, the Philippines, Thailand, and Vietnambecause these have been some of the fast-est growing since the turn of the millennium, and atleast for now, appear resistant to the MIT. 7


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The Determinants of

Middle-Income TrapsProtracted economic slowdowns that pull emerg-ing economies into the MIT can be generated bya host of factors. This Special Report examines abroad range of factors that have been consistentlyshown to impact TFP and, consequently, economicgrowth. In a similar methodology used by Shekhar

Aiyar and his colleagues, 8 13 explanatory variablesare grouped into six categories: (1) macroeconomicfundamentals, (2) demographics, (3) institutions, (4)trade structure, (5) infrastructure, and (6) wars andcivil conicts.

Macroeconomic Fundamentals. This sec-tion examines credit growth, government size, andinvestment freedom. While slower growth is hardlyprima facie evidence of an MIT (it could simply bea cyclical downturn), real GDP seems a logical placeto check rst. Charts 2, 3, 4, and 5 show three-yearmoving averages of annual real GDP growth. Thesmoothing of the data takes out some of the under-lying economic turbulence from the crisis and post-crisis period to better ascertain a trend.

n Indonesias economy has remained robust andresilient, setting an impressive pace of approxi-mately 6 percent during the past ve years andalso growing at a 6 percent pace during the 20082009 crisis.

n Since 2000, the Philippines has experienced aclear acceleration in growth, averaging almost 6percent growth over the past three years.

n Since the middle of the past decade, Thailand has witnessed a marked deceleration in growth. Aftergrowing at 5 to 6 percent during much of the pastdecade, it has dropped to a three-year movingaverage of approximately 3 percent.

n Vietnam has had remarkable growth over thepast two decades, although it has leveled off clos-er to the 5 percent range in recent years.

1. Credit Growth. It is well known that loosecredit has played a big role in driving Chinesegrowth in recent years, but the rest of Asia couldalso have a debt problem, says Frederic Neumannof HSBC. 9

Bank credit as a share of GDP in Asia (exclud-ing Japan) is now running at much higher levels

than during the 19971998 Asian nancial crisis.Since then, this ratio has risen from 110 percent toover 140 percenta steep rise that has seemed to gounnoticed. Some believe that a major crisis in Asia isavoidable today given that much of this debt is nowdenominated in local currencies and that exchangerates are generally exible, unlike the situation dur-ing the 19971998 crisis. Nevertheless, given theirheavy debt levels, many nations in Asia will be vul-nerable should there be a sharp rise in global inter-est rates.

A major reason why Asia managed to rebound

quickly from the 2008 crisis and maintain stronggrowth afterwards can be explained by the precipi-tous rise in leverage that helped offset recessionaryconditions in the West. In fact, according to Neu-mann of HSBC, there are mounting signs of a risingcredit intensity of GDP growth in Asia: While lend-ing growth slowed in many Asian markets over thepast year, it slowed by less than GDP growth slowed(especially when factoring in soaring bond issuance).In short, more and more debt is needed to generateone percentage point of GDP growth. 10 If the most

Vietnam Philippines Indonesia Thailand

$3,620

$4,380$4,730

$9,280

CHART 1

Source: International Monetary Fund, World Economic OutlookDatabase, October 2013, https://www.imf.org/external/pubs/ft/weo/2013/02/weodata/index.aspx (accessed July 1, 2014).

GDP PER CAPITA, 2011, IN U.S. DOLLARS

Reaching Middle IncomeThese four Southeast Asiannations have GDP per capitaabove $3,000, putting them in thecategory of middle income.

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recent nancial crisis has demonstrated anything,it is the difficulty of resuscitating economic growth

after a debt binge. Aggregate gures can hide important country-

by-country differences. At a steady 40 to 50 percentof GDP, both Indonesia and the Philippines seemedto have managed their growth in domestic creditover this most recent cycle relatively well. Vietnamand Thailand, however, are different stories. While

Vietnams domestic banking credit share of GDP hasnally leveled off in recent years, the banking sys-tem is riddled with bad loans and most certainly willrequire a large-scale bailout, which could negativelyimpact the economy for years to come. Thailand is

in an even worse situation, in which rapid domesticcredit growth since the middle of the past decadehas fueled consumer debt and spending.

Could the rising credit intensity of Asian eco-nomic growth be a normal sign, a byproduct of theregion reaching greater economic maturity? Notnecessarily, according to Neumann. In order forSoutheast Asia to continue growing at healthy rates,it needs continuous improvements in productivity, which is less likely to happen if investment efficiencydeclines in the ood of easy credit.

Moreover, because global interest rates remainlow, the leverage is continuing to increase. And with

the Bank of Japan joining the Western central banksin aggressive quantitative easing, this trend towardgreater leverage in the region is likely to continue.

2. Government Size. Growth of government isoften a sign that a growth slowdown is only a ques-tion of time, particularly if the growth in spendingis viewed as permanent. The Heritage Foundationemploys the Fiscal Freedom and GovernmentSpending categories in the Index of Economic Free-dom 11 to measure government size. Fiscal freedom cap-tures the burden of taxes by measuring the overall taxburden from all forms of taxation as a percentage of

total GDP. Government spending must eventually benanced by higher taxation (including the inationtax), which leaves fewer resources for the private sector.

n Both Indonesia and the Philippines have madereasonable improvements in limiting govern-ment size in recent years.

n Indonesias public debt is only 24 percent of GDP.In the Philippines, public debt is approximately50 percent of GDP.

%

%

%

%

%

%

%

%Indonesia Philippines Thailand Vietnam

CHART 2

Source: World Bank, GDP Growth (Annual %), http://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG(accessed July 1, 2014).

PERCENTAGE CHANGE IN REAL GDP, THREE-YEAR MOVING AVERAGE

Economic Growth for Middle-Income Nations in Southeast Asia

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n Thailands public nances are relatively respect-able; public debt is 45 percent of GDP. (It was 24percent of GDP in 2008.)

n Vietnam has not improved its relative standingsince 2005, and its public debt is above 50 per-cent of GDP. Public expenditures are a sizable 31percent of GDP.

3. Domestic Investment. Investment providesa stimulus to economic development, and the rateof investment reects the infusion of requisite capi-tal to support the development process. High ratesof domestic investment are necessary conditionsfor middle-income countries to maintain elevat-ed growth levels. A rate of 30 percent of GDP is notuncommon among healthy developing economies. 12

Indonesia comes out on top in this category, withgross investments share of the economy exceeding30 percent for four consecutive years. If this high

rate of investment were combined with falling GDPgrowth rates, it would be a concern because it mightimply declining returns on capital (but GDP growthrates have accelerated, not slowed down). There is,however, one possible caveat: Indonesia runs a rela-tively large current account decit because domes-tic spending exceeds domestic savings. As witnessedduring the 19971998 emerging-market crisis, aight of foreign capital easily could destabilize

the economy.The Philippines rate of domestic investment

runs a full 10 percent of GDP below that of Indone-sia and has been generally at since 2000. With a percapita GDP of only $4,700, this should be some causefor concern. The Philippines marginal product oflabor would receive a considerable boost if capitalformation was much stronger.

Vietnams domestic investment has been strongfor some time although it has signicantly leveledoff in recent years. In the 2014 Index of Economic

%

%

100%

%

%

East Asia and Pacic(Developing Nations Only)

Thailand

Vietnam

PhilippinesIndonesia

CHART 3

Sources: Financial Times , Beyond BRICs Blog, HSBC: Asias Worrying Debt-Led Growth, February 21,2013, http://blogs.ft.com/beyond-brics/2013/02/21/hsbc-asias-worrying-debt-driven-growth/(accessed April 17, 2014), and World Bank, Domestic Credit Provided by Financial Sector (% of GDP),http://data.worldbank.org/indicator/FS.AST.DOMS.GD.ZS (accessed April 17, 2014).

Bank Credit at Dangerous Levels in AsiaTotal combined bank credit for developing nations in Asia is at 141 percent of GDP and rising.Thailand and Vietnam both have bank credit levels exceeding 100 percent of GDP.

BANK CREDIT AS PERCENTAGE OF GDP

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Freedom , Vietnam is ranked as one of the lowest ininvestment freedom throughout the world. 13

Thailand, Southeast Asias traditional manufac-turing hub, has witnessed strong investment trendsin recent years. However, as reported in the Financial

Times , more than $15 billion of planned foreign anddomestic investment in Thailand is on hold becauseof political turmoil. [T]he backlog highlights theeconomic damage Thailand is suffering from theongoing crisis that is paralyzing government andplaying out as foreign investors from Japan and elsewhere outsource production to cheaper neighboringstates. 14 Continued political turmoil in Thailand isdestined to dramatically slow domestic investment(particularly foreign direct investment) and tourism.

Demographics With the right set of economic policies, a favor-

able demographic prole can be a boon to a nationsrate of growth. This section examines the depen-dence ratio, urbanization, and the female labor par-ticipation rate.

4. The Dependence Ratio. Recently, most econ-omists have come to the view that the changing agestructure of the population, rather than populationgrowth itself, can signicantly alter economic devel-opment. The source of population growth and itstiming are the critical factors.

Unlike working-age individuals, the young andold tend to consume more output than they gener-ate. As a consequence, the value of output per capitatends to be boosted when the population of working-age individuals is relatively large, and tends to be

depressed when a relatively large part of the popula-tion consists of young and elderly dependents.

Developing countries that are entering theirdemographic transition have a unique chanceto convert their population dividend into highergrowth from this demographic dividend. Unfor-tunately, this demographic shift creates only one window of opportunity. Low fertility rates even-tually lead to a rising proportion of older people,raising the dependence ratio as the working pop-ulation goes from caring for children to caringfor parents and grandparents. If a country acts

wisely before and during this transition, a special window opens up for faster economic growth andhuman development.

The 20th century has provided numerousexamples of how demographic transitions can givedeveloping countries an opportunity to acceler-ate development. Japans economic miracle in theearly postwar period was highly correlated with theshrinkage in its dependence ratio. The same is trueof the remarkable economic ascendancy of the fourtiger nations (South Korea, Taiwan, Singapore, and

Indonesia Philippines Thailand Vietnam

CHART 4

Source: Terry Miller, Anthony B. Kim, and Kim R. Holmes, 2014 Index of Economic Freedom (Washington, D.C.:The Heritage Foundation and Dow Jones & Company, Inc., 2014), http://www.heritage.org/index.

AVERAGE GOVERNMENT SIZE SCORES

IN THEINDEX OF ECONOMIC FREEDOM

Measuring Government Size

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Hong Kong). In 1950, women of the tiger nations hadan average of six children; today, they have fewerthan two. As a result, between 1965 and 1990, the working-age population increased four times fasterthan the number of young and elderly dependents. 15

Conversely, when this window closes, holding

everything else equal, a natural economic slowdownis likely as the elderly place an increasing economicburden on the working-age population. For example,Chinas recent economic slowdown (from 10 percentto 7.5 percent) has partially been attributed to thefact that the working-age population peaked in 2011and is now declining.

Since 2000, Vietnam has experienced by far thelargest demographic dividend, with its dependen-cy ratio falling an enormous 20 percentage points(from 61 percent to 41 percent). This gave Vietnama one-time enormous potential lift in growth. The

Philippines also witnessed a sharp drop of 9.4 per-cent points.

Indonesia and Thailand experienced more mod-est drops in their dependence ratios, with declines of2.2 percent and 5.7 percent, respectively. Current-ly, at 39 percent, Thailand has the most favorabledemographic ratio, while the Philippines has the worst, at 62 percent.

More important, how will these dependenceratios change over the next 15 years (20152030)?Thailand has clearly exhausted its demographic

dividend, and with the working-age populationcurrently growing 0.4 percent per year, Thailandsdependence ratio is expected to rise approximately11 percent. What the demographic dividend gave, itnow takes away.

Vietnam has also experienced a sharp drop in the

growth rate of its working-age population (from 2.9percent to 1.3 percent from 2000 to 2012), but itsdependency ratio is expected to drop by only 2 per-cent by 2030.

Both Indonesia and the Philippines fare better, with their dependence ratios continuing to declinemodestly in the coming years. At 2.2 percent, thePhilippines currently has the fastest growth of thefour countries in working-age population.

5. Urbanization. In the earlier stages, a goodshare of economic growth for many developingeconomies emanates from the TFP gains derived

from urbanization. As labor switches from low-productivity sectors (such as agriculture) to higher-productivity sectors (such as manufacturing andmodern services), the TFP can provide a boost in percapita income. This sectoral shift in labor is onereason why developing economies can grow muchfaster than their developed counterparts. Accordingto the World Bank, a portion of Chinas rapid TFPgrowth over the past two decades has been the resultof very rapid urbanization, which has now surpassed50 percent. 16

%

%

%

%

%

%


CHART 5

Source: World Bank, Gross Capital Formation (% of GDP),http://data.worldbank.org/indicator/NE.GDI.TOTL.ZS (accessed July 1, 2014).

Gross Capital Formation as Percentage of GDP

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At some point, however, this process natural lybegins to slow down as the country becomes increas-ingly urbanized. Much work in the past suggeststhat many growth slowdowns are declines in TFPbrought on by diminishing returns to urbanization. 17

n Since 2000, Indonesia and Vietnam have achievedthe largest gains in urbanization (9.4 percent and7.3 percent, respectively).

n Indonesia and the Philippines are already 50 per-cent urban.

n Only one-third of the population in Thailand and Vietnam is urban, meaning that the TFP couldsignicantly increase growth in the comingdecades if both countries continue to urbanize.

A more precise way of looking at the potentialsectoral shift is to compare the employment distri-bution by sector. These four Association of South-

east Asian Nations (ASEAN) countries still haveconsiderable employment in agriculture. In fact,in Thailand and Vietnam, agriculture is the larg-est employer.

6. Female Participation Rate. The female workparticipation rate in some Asian countries is low byglobal standards, and higher female participation isa key to offsetting Asias declining demographics.

n The female work participation rate is only 50 per-

cent in Indonesia and the Philippines (the aver-age for developing Asia is 63 percent). These par-ticipation rates should gradually rise, providingfaster growth in the workforce.

n Thailands female work participation rate isalmost two-thirds, while Vietnams is over 70percent, leaving much less room to raise partici-pation rates.

%

%

%

%

%

%

Thailand

Vietnam

Philippines

Indonesia

ACTUAL PROJECTED

CHART 6

Sources: World Bank, Age Dependency Ratio (% of Working-Age Population),http://data.worldbank.org/indicator/SP.POP.DPND (accessed July 2, 2014), and World Bank, PopulationEstimates and Projections, http://datatopics.worldbank.org/hnp/popestimates (accessed July 2, 2014).

RATIO OF NON-WORKING-AGE POPULATION TO WORKING-AGE POPULATION

Dependency Ratios

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InstitutionsMany economists studying economic develop-

ment have come to the conclusion that institutions which shape the incentives of a societyare a fun-damental determinant of economic performanceand long-run economic growth. 18 It is only naturalthat middle-income countries encounter barriersto growth as factor accumulation eventually slowsdown and the economy experiences diminishingreturns. To break through this barrier and avoid the

MIT, developing countries will have to improve theirinstitutions. Good institutions provide the incen-tives for hard work, the acquisition of human capital,and in turn, better technology and innovation.

7. Property Rights. The institutional environ-ment is determined by the legal and administrationframework within which individuals, rms, andgovernments interact to generate wealth. Propertyrights provide an assessment of the ability of individuals to accumulate private property, secured byclear laws that are fully enforced by the state.

During the late 1990s, Indonesia, Thailand, andthe Philippines all had property rights ratings at orabove the world average (approximately 50 of a pos-sible 100). Contrary to conventional wisdom, how-ever, the late 1990s (after the Asian nancial crisis) were not a stellar time for improvement in thesecountries institutions, and property rights ratingsdeclined or did not improve. According to the 2014

Index of Economic Freedom :

n

While property rights are generally respected inIndonesia, their enforcement is inefficient anduneven. Corruption remains endemic.

n In the Philippines, corruption and cronyism are widespread in business and government. Delaysand uncertainty negatively affect property rights.

n Thailand has an independent judiciary that isgenerally effective in enforcing property and con-tractual rights but remains vulnerable to politi-cal interference.

%

%

%

%

%

%

%

%

CHART 7

Source: World Bank, Urban Population (% of Total),http://data.worldbank.org/indicator/SP.URB.TOTL.IN.ZS/countries (accessed July 2, 2014).

PERCENTAGE OF POPULATIONLIVING IN URBAN AREAS

Urban Populations

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Thailand

Vietnam

Philippines

Indonesia

%

%

%

%

%Indonesia Philippines Thailand Vietnam

39% 32% 38% 48%

48% 53% 48% 31%

13%15%

14%

21%

CHART 8

Note: Figures have been rounded.Source: Central Intelligence Agency, World Factbook: East andSoutheast Asia, https://www.cia.gov/library/publications/the-world-factbook/wfbExt/region_eas.html (accessed July 7, 2014).

Share of Laborby Industry, 2013

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n Vietnam has serious institutional problems that will eventually hamper growth. The judiciaryis subservient to the ruling Communist Party, which controls courts at all levels. Private prop-erty rights are not strongly respected.

8. Regulation. The proxy for regulation is TheHeritage Foundations Business Freedom categoryin the Index of Economic Freedom . Business freedomis an individuals right to establish and run an enter-prise without undue interference from the state.Burdensome and redundant regulations are themost common barriers to the free conduct of entre-preneurial activity.

n Ranking below the global average of 64, Indo-nesias overall regulatory efficiency is weak.

Launching a business takes longer than a monthand the regulations concerning the creation andtermination of employment relationships arerelatively costly.

n The Philippines has cut the time needed to deal with licensing requirements, but the governmentsubsidizes state-owned and state-controlled cor-porations in the power, food, health care, andagricultural industries.

n Business freedom has been relatively high andstable in Thailand. No minimum capital isrequired to start a business, but state-ownedenterprises (SOEs) account for more than 40 per-cent of GDP.

n In Vietnam, launching a business takes 10 pro-cedures on average, and no minimum capitalis required. The government inuences pricesthrough SOEs and controls bank interest rates.

Trade Structure9. Commodity Intensity and the Resource

Curse. Between early 2003 and mid-2008, oil pricesclimbed by 330 percent in dollar terms, with met-als and minerals making similar advances. The realprice of agricultural products was broadly stable,

especially in the developing countries early on, butthen rose sharply from 2006 to 2008 (during whichtime global food prices doubled).

While commodity booms are often accompaniedby a temporary lift in economic growth for commod-ity exporters, economic dependence on commoditieshas generally been associated with slow growth andeconomic development over the longer term. Thisso-cal led resource curse, which has been thoroughlyexplored by the academic literature, 19 is thought to work through a number of important channels. One


CHART 9


PROPERTY RIGHTS SCORES IN

THEINDEX OF ECONOMIC FREEDOM

Measuring Property Rights

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is a tendency for the commodity boom-bust cycle toaccentuate both changes in government spendingand economic cycles, which can discourage long-runeconomic development.

Another is a tendency for exchange-rate appre-

ciations associated with commodity booms (the so-called Dutch disease) to weaken the competitivenessof the non-commodity sectors of the economy.

Lastly, but perhaps most important, is a tenden-cy for countries that enjoy high commodity reve-nues to waste their windfalls and not invest them in wealth-generating investments or activities. Com-modity endowments are well known to lead to rent-seeking behavior and corruption. There is a veryhigh correlation between resource dependenceand corruption.

The resource curse is not a signicant issue for

Southeast Asia and the Pacic region. Rapid indus-trialization had made the region the least dependenton commodity exports of any major emerging-mar-ket region (representing just 20 percent of mer-chandise exports, down from almost 60 percent asrecently as 1985).

As one of the worlds largest suppliers of miner-als and agricultural products, Indonesia is an Asianexception. Commodities are 55 percent of totalexports, and 13 percent of GDP. Declining commod-ity prices over the past two years have led to deterio-

ration in Indonesias current account, which helpedlead to a signicant exit from Indonesian assets.

On the plus side, lower commodity prices shouldincrease the relative protability of manufacturingand help Indonesia develop its industrial base. 20

Infrastructure10. Power Consumption. Any developing coun-

try looking to build a manufacturing base or increaseits rate of urbanization should have an electricitygrid to match its current needs or ambitions.

n According to the World Banks 2014 Ease of Doing Business , Indonesia continues to be straightjack-eted by electrical power infrastructure problems, while the Philippines is just as bad, with per cap-ita electricity consumption barely growing over

the past decade.

n Thailands large manufacturing sector consumesmuch electricity, while Vietnams per capita con-sumption has risen surprisingly almost fourfoldover the past decade.

11. The Internet. The Internet has revolution-ized communication, making obtaining informationeasy, quick, and cheap. Rising Internet penetrationrates would seem a necessary condition in avoiding


CHART 10


AVERAGE REGULATORY EFFICIENCY SCORES

IN THEINDEX OF ECONOMIC FREEDOM

Measuring Regulatory Efficiency

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the MIT. According to the International Telecom-munications Union, high-income countries had anInternet penetration of 76 percent in 2012. 21

n In early 2000, Vietnam had almost no Internetusers; by 2012, four in 10 Vietnamese were online.

n The Philippines witnessed an explosion in Inter-net usage that began ve years ago and has nowsurpassed the emerging-market average of18 percent.

n Like the rest of its infrastructure, Indonesia haspoor Internet penetration (15 per 100).

n For a country with a relatively high per capitaincome and decent physical infrastructure, Thai-land has poor Internet penetration.

12. Education. A rapid expansion of the secondaryschool system may not be enough to allow a develop-ing country to escape the MIT. Increasing the share ofthe population with a tertiary education may be nec-

essary.22

This necessity is consistent with the impor-tance of moving up the technology ladder. Slowdownsare less likely in countries where high-tech productsaccount for a large share of exports. Broad-basedgrowth in tertiary education was precisely how theRepublic of Korea achieved its successful transitionfrom middle-income to high-income status.

n Vietnam and Indonesia have made moderateprogress since 2000, but should probably focuson increasing the adult share of secondary educa-tion over the next decade.

n The Philippines tertiary education has at-linedover the past 15 years, foreboding an economythat is destined to copy and service the worldfor some time to come.

n If they are able to regain political stability in thecoming years, Thailands manufacturers, such asthe auto-parts makers, might be able to innovateand create new and better products in the com-ing years.

CHART 11

Source: World Bank, Electric Power Consumption (kWh perCapita), http://data.worldbank.org/indicator/EG.USE.ELEC.KH.PC (accessed July 2, 2014).

IN KILOWATT-HOURS PER CAPITA

Electrical Power Consumption

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Thailand

Vietnam

Philippines

Indonesia

CHART 12

Source: World Bank, Internet Users (Per 100 People),http://data.worldbank.org/indicator/IT.NET.USER.P2(accessed July 2, 2014).

NUMBER OF INTERNET USERSPER 100 PEOPLE

Internet Usage

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Thailand

VietnamPhilippines

Indonesia


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13. War and Civil Strife. After socialism, noth-ing has negatively impacted productivity and growthmore than war and civil strife throughout the emerg-ing world. When normally productive inputs (peopleand capital) are distracted from normally produc-tive activities, economic growth is a big casualty.

Indonesia, Vietnam, and the Philippines havebeen largely devoid of any signicant civil discord inrecent years. Thailand is an entirely different story.In the past, Thailands economy has always tendedto bounce back vigorously from military coups andcivil strife. This time could be different. 23

To outside observers, it appears that the Thaisfaith in their national institutions is crumbling. Thegovernment that the army installed after the 2006

coup mismanaged the economy. The courts havedissolved several of former Prime Minister ThaksinShinawatras proxy governments. In short, Tha is areleft with no one to trust.

The economy is quickly deteriorating and the eco-nomic slowdown has been broad-based. Hotel andight bookings to Bangkok have plummeted as the weeks of turmoil have stretched into months. Morethan $15 billion in foreign investment is on hold. Thelonger the infrastructure projects and measures toimprove productivity among Thailands rapidly agingpopulation are held up, the more Thailand risks losing

out to some of its regional neighbors. Moreover, con-sumer spending this time would be unlikely to reboundrapidly because of the household debt. As if things werenot bad enough, the May 2014 military coup could leadto economic sanctions against Thailand.

Mothers Milk:Total Factor Productivity 24

As discussed, total factor productivity ultimatelydetermines a countrys living standard over the longrun. All middle-income nations at some point reachdiminishing returns from their labor and capital

inputs. Increasing the efficiency of these inputs atthis stage then becomes critical.

Chart 14 shows how the four ASEAN nationsfared over two different periods.

The rst period coincides with the Southeast Asian nancial crisis, and TFP growth rates plum-meted more or less across the board in 1998. (Indo-nesias fell 18 percent that year.) TFP does not neces-sarily have to fall during economic slowdowns, butthe crisis had become destructive to the nancialsystem over this period.

The 20072011 period is more suitable to focuson for two reasons. First, Southeast Asia emerged

from the 2008 global crisis relatively unscathed, andsecond, it provides a picture of conditions under thecurrent business cycle.

Three factors are immediately apparent: (1) TFPgrowth is anemic, considering that these nations arein their catch-up phase with a per capita GDP of$3,000 to $12,000. Labor and capital accumulationsremain the primary economic engines, and TFP hasnot recently been a major contributor to GDP growth.(2) Both Thailand and Vietnam had declining TFPrates in recent years, implying declining efficiencyof inputs. (3) While Indonesia and the Philippines

have positive rates, they are low compared to otherfast-growing emerging economies. India and China,for example, have maintained TFP rates in excess of3 percent for over a decade.

Middle-Income-Trap StatusesThailand: Already Trapped. At the time

of publication, the political turmoil in Thailandshows no sign of subsiding, and it has already heav-ily impacted foreign direct investment and eco-nomic growth.

%

%

%

%

%

%

%

CHART 13

Source: World Bank, School Enrollment, Tertiary (% Gross),http://data.worldbank.org/indicator/SE.TER.ENRR (accessedJuly 2, 2014).

GROSS ENROLLMENT RATIO

Tertiary School Enrollment

heritage.orgSR 156

Thailand

Vietnam

PhilippinesIndonesia


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Data on Thailands TFP growth are not avail-able for the past two years but it might very wellhave been negative given the political disruptionsand slowing growth. Thailand is now enteringits dividend decit as the fertility rate has fall-en to an average of 1.6 children per womanfromseven in the 1970s. Much of the texti le industry hasmigrated to countries with lower wages, such asthe Phil ippines.

Much of Thailands growth over the past decade was the result of a credit bubble. Thailands consum-

ers are paying the price, with household debt at theend of 2013 hitting a record at 82.3 percent of GDP,compared with 77.3 percent a year earlier, and 45percent a decade ago. 25 An inevitable period of dele- veraging will be protracted and painful.

On the bright side, Thailand is an exporter ofhigh-tech products such as integrated circuitsand cars. A large share of its workforce remainsemployed in agriculture, meaning that it can stillreap a sectoral TFP gain. If it is able to nally resolveits political divide (unlikely anytime soon), it couldcontinue climbing the technological ladder, resusci-

tating the economy. Vietnam: An MIT Candidate. Like Thailands,

Vietnams growth was elevated by a credit bubble. Itis likely that much of the banking system will needto be bailed out by the state. Vietnamese authori-ties have made only slow progress in reforming thestates involvement in the economy. Like China, ithas many SOEs. Its initial public offerings of someSOEs in the rst quarter of 2014 went poorly, attract-ing little attention from foreign investors. Its enor-mous demographic dividend over the past decade,

which helped elevate labor force participation andeconomic growth, is quickly dissipating; corruptionis stiing; and it has high structural ination. Viet-nam will have to attract much more direct invest-ment, while improving its transparency.

On the plus side, it is urbanizing fast and build-ing its secondary education infrastructure. It is alsoa large exporter.

The Philippines: Shaky But Improving. Overthe past few years, the Philippines has become oneof the worlds fastest growing economies. It seems to

be moving in the opposite direction of an MIT. Thegovernment has recently made signicant efforts tocombat corruption, and the level of corporate trans-parency has improved. While agriculture is stilla signicant sector, the electronics, apparel, andshipbuilding sectors are growing rapidly. Domesticinvestments share of the economy needs to be elevated in the coming years.

Indonesia: Reasonably Solid. Indonesiasincreasingly modern and diversied economysailed through the recent economic crisis. It lookedsolid on most fundamentals, particularly on credit

growth and foreign direct investment. The countrymust, however, improve its overall infrastructure(both physical and cyber) and continue to diversifyits economy.

ConclusionThe middle-income trap has become the scourge

of the developing world. Thailand, Vietnam, thePhilippines, and Indonesia would be wise to taketheir cues from the success of the Asian economiesthat were able to transition from middle-income

CHART 14

Source: Conference Board, Total EconomyDatabase, Growth Accounting and TotalFactor Productivity, 19902013,https://www.conference-board.org/data/economydatabase/ (accessed July 2, 2014).

AVERAGE ANNUAL PERCENTAGECHANGE, 19972006 AND 20072011

Total Factor Productivity

heritage.orgSR 156

Indonesia

9706

0711 9706 0711 9706

0711

9706

0711

Philippines Thailand Vietnam


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status to high-income status based on their abilityto increase productivity by allowing, to the greatestextent possible, the market to allocate assets. Thesuccessful countries also pushed their technologicalboundaries and moved from imitating and import-ing foreign technologies to innovating technologiesof their own.

Strong protection of intellectual property rights was a major factor in elevating TFP in the success-ful East Asian economies of South Korea, Taiwan,Hong Kong, and Singapore. According to the WorldBanks Doing Business database, intellectual prop-erty rights in these economies rival those in place inJapan, the U.S., and other high-income countries. 26

Thailand, Vietnam, the Philippines, and Indo-

nesia are currently suffering from low TFP growth,and Thailand and Vietnam are likely in credit bub-bles. As former chairman of the Council of Econom-ic Advisers Herb Stein put it in his Steins law: Ifsomething cannot go on forever, it will stop. Allfour countries should focus on improving their fun-damentals, such as protecting property rights andlimiting the size and scope of government. Thereare other measures that could be used to combatthe MIT, such as reforming labor markets to ensurethat rigidities do not prevent the efficient ring andhiring of employees.

Avoiding ination is obviously a necessity. A longperiod of solid economic growth can be wiped outby one bad bout of ination. Central Bank indepen-dence is critical.

As economist Chris Hartwell points out, open-ness to trade is crucial to escaping the MIT. In fact,openness to trade only grows more important asdiminishing returns to technology set in, because

trade restrictions shrink the market for produc-ers in a particular country in the domestic market;restrictions often bring a whole host of other dis-tortions with them (including the creation of trade-licensing bureaucracies); a country that closes itselfoff to trade often pursues other growth-dampeningpolicies as well. 27 Passage of a truly liberalizing

Trans-Pacic Partnership would increase trade andinvestment throughout Asia. At one time, developing economies looked to the

United States and other OECD nations as economicmodels to emulate. Now, with their reckless scalpolicies, heightened business regulation, and too-big-to-fail policies that punish the good and rewardthe bad at taxpayer expense, emulating the rich clubis not such a good idea.

Bottom line: The middle-income trap is avoid-able if caught early; it can be escaped with the properpolicies.


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1. For example, of 101 middle-income economies in 1960, only 13 became high-income by 2008. Those countries were Equatorial Guinea,Greece, Hong Kong, Ireland, Israel, Japan, Mauritius, Portugal, Puerto Rico, the Republic of Korea, Singapore, Spain, and Taiwan.

2. The World Bank, How We Classify Countries, http://data.worldbank.org/about/country-classications (accessed May 30, 2014). According tothe World Bank, as long as a country stays in the GDP-per-capita range of $1,036 to $12,615, it is considered a middle-income developing nation.

3. Mark Harrison, Trends in Soviet Labour Productivity, 192885: War, Postwar Recovery, and Slowdown, European Review of Economic History ,Vol. 2, No. 2 (1998), pp. 171200, http://wrap.warwick.ac.uk/215/ (accessed May 30, 2014).

4. Alwyn Young, Lessons from the East Asian NICS: A Contrarian View, National Bureau of Economic Research Working Paper No. 4482,October 1993.

5. The Conference Board, Total Economy Database, January 2014, http://www.conference-board.org /data/economydatabase/(accessed April 15, 2014).

6. The World Bank denes the upper-middle range as $4,036 to $12,475.

7. Issues surrounding economic growth in India and China will be examined in a future paper.

8. Shekhar Aiyar, Romain Duval, Damien Puy, Yiqun Wu, and Longmei Zhang, Growth Slowdowns and the Middle-Income Trap, InternationalMonetary Fund Working Paper , March 2013.

9. HSBC: Asias Worrying Debt-Led Growth, Financial Times , Beyond BRICs blog, February 21, 2013,http://blogs.ft.com/beyond-brics/2013/02/21/hsbc-asias-worrying-debt-driven-growth/ (accessed April 17, 2014).

10. Ibid.

11. Terry Miller, Kim R. Holmes, and Anthony B. Kim, 2014 Index of Economic Freedom (Washington, DC: The Heritage Foundation and Dow Jones& Company, Inc., 2014), http://www.heritage.org/index.

12. As mentioned, factor accumulations, including domestic investment, will eventually hit diminishing returns unless the middle-income countrycan manage to innovate and stave off these diminishing returns to capital.

13. Vietnam was ranked 169th in the world in the 2014 Index of Economic Freedom .

14. Michael Peel, Thailand Political Turmoil Imperils Foreign and Domestic Investment, Financial Times , March 9, 2014,http://www.ft.com/cms/s/0/6a2c75f4-a5e7-11e3-9818-00144feab7de.html#axzz2zBLu7zqU (accessed April 17, 2014).

15. George Magnus, The Age of Aging: How Demographics Are Changing the Global Economy and Our World (Hoboken, NJ: Wiley, 2008), p. 17.

16. The World Bank, Data: Indicators, http://data.worldbank.org/indicator (accessed May 30, 2014).

17. Barry Eichengreen, Donghyun Park, and Kwanho Shin, When Fast Growing Economies Slow Down: International Evidence and Implicationsfor China, National Bureau of Economic Research Working Paper No. 16919, March 2011, http://www.nber.org/papers/w16919(accessed May 30, 2014) .

18. For a recent review of how institutions impact economic growth, see Chris Hartwell, The Growth Elixir: Escaping the Middle Income Trap inEmerging Markets, Institute for Emerging Market Studies, November 2013, http://iems.skolkovo.ru/en/research-platforms/publications/183-the-growth-elixir (accessed July 16, 2014).

19. For an excellent review of the resource curse, see Andrew Rosser, The Political Economy of the Resource Curse: A Literature Survey, Instituteof Development Studies Working Paper No. 268, April 2006, http://www.ids.ac.uk/les/WP268.pdf (accessed May 29, 2014).

20. I. Made Sentana, Falling Commodity Prices a Blessing in Disguise for IndonesiaWorld Bank, The Wall Street Journal , Real Time Economicsblog, March 18, 2014,http://blogs.wsj.com/economics/2014/03/18/falling-commodity-prices-a-blessing-in-disguise-for-indonesia-world-bank/?KEYWORDS=falling+commodity+prices+a+blessing+in+disguise+for+indonesi (accessed May 29, 2014).

21. ITU, Statistics: Development , http://www.itu.int/en/ITU-D/Statistics/Pages/stat/default.aspx (accessed April 5, 2014).

22. The World Bank denes tertiary education as universities and institutions that teach specic capacities of higher learning, such as colleges,technical training institutes, community colleges, nursing schools, research laboratories, centers of excellence, and distance learning centers .

23. The civil strife and increasing violence in Thailand stems from a long power struggle between supporters and opponents of ThaksinShinawatra, the prime minister who was removed from power in 2006.

24. TFP is also referred to as multi-factor productivity.

25. Thais Brace for Recession as Crisis Drags On, The Star , April 14, 2014,http://www.thestar.com.my/Business/Business-News/2014/04/14/Thais-brace-for-recession-as-crisis-continues/ (accessed May 29, 2014).

26. Doing Business Database, World Bank and International Finance Corporation, http://www.doingbusiness.org/ (accessed April 15, 2014).

27. Hartwell, The Growth Elixir.

Endnotes
http://blogs.wsj.com/economics/2014/03/18/falling-commodity-prices-a-blessing-in-disguise-for-indonesia-world-bank/?KEYWORDS=falling+commodity+prices+a+blessing+in+disguise+for+indonesi%20(accessedhttp://blogs.wsj.com/economics/2014/03/18/falling-commodity-prices-a-blessing-in-disguise-for-indonesia-world-bank/?KEYWORDS=falling+commodity+prices+a+blessing+in+disguise+for+indonesi%20(accessedhttp://blogs.wsj.com/economics/2014/03/18/falling-commodity-prices-a-blessing-in-disguise-for-indonesia-world-bank/?KEYWORDS=falling+commodity+prices+a+blessing+in+disguise+for+indonesi%20(accessedhttp://blogs.wsj.com/economics/2014/03/18/falling-commodity-prices-a-blessing-in-disguise-for-indonesia-world-bank/?KEYWORDS=falling+commodity+prices+a+blessing+in+disguise+for+indonesi%20(accessed


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