# **BOX 1: WHAT’S THE MIDDLE-INCOME TRAP?**

The “middle-income country trap” is a development stage that characterizes countries that are squeezed between being low-wage producers and highly-skilled, fast-moving innovators. Countries caught in this trap tend to grow slower and often fall behind. Cost advantages in labour-intensive sectors, such as the manufactured exports which once drove growth, start to decline in comparison with lower-wage poor country producers (Gill I and Kharas H, 2007). At the same time, they do not have the institutions, capital markets, track record, or critical mass of highly-skilled people to grow through major innovations like rich countries. Caught between these two groups, many are without a viable high-growth strategy. In addition, they are faced with new challenges including distribution and social cohesion issues. Therefore, they are hard-pressed to develop new growth drivers (Nungsari and Zeufack, 2009).

Productivity slowdown has been a sound characterization of middle income traps. Over time in a country’s development process, there emerges diminishing marginal returns to cheap labor and technology imitation; this could be offset if government act early to move from an imitation based economy to innovation based production cycle (see Agénor, P-R and O Canuto 2012). The East Asian experience has illustrated that such policies are central to fostering technological learning, attracting talented individuals into research and development activities, and encouraging the build-up of national and international knowledge networks. Recently, the broader debate over China's innovative prowess and potential development path has intensified. Some observers regard Chinese firms’ ability to stay close to the world technology frontier and to improve upon and adapt existing innovation as key to the country’s continued growth (Breznitz and Murphree 2011) where the globalization of services is increasingly an important components of China’s growth (see Roach, Stephen 2013).Only one (South Korea) of the seven countries which were middle-income by 1975 managed to reach high-income status by 2005. Brazil and South Africa, which had double the per-capita income of South Korea in 1975, have remained at the same level since then. It faced periods of negative growth, which cancelled all earlier progress.

Evidence of the middle-income trap can also be found in the dynamics of occupations and wages across countries. The integration of the world’s labor markets creates big gains for rich and poor countries alike. For example, blueprints of products flow from California to China, while manufacturing goods flow in the opposite direction (see Kharas et at, 2010). The middle-income countries benefit less from globalization (Eeckhout and Jovanovic, 2007). They are not technologically-savvy enough to compete with rich countries and are not cheap enough to compete with China, Vietnam and other dynamic low-income countries. Thanks to communications and transportation technologies, managers, engineers and designers — larger in number in rich countries — have access to a pool of cheap labor in poor countries. This makes them more productive as they can produce more with the same resources. The higher wages that accrue to high-skilled individuals represent the gains to rich countries of an integrated global labor market.

Poor countries also gain. They produce better and more, thanks to the technology, design and managerial skills brought in from rich countries. The wages of their unskilled rise and this represents their gains from globalization. However, middle-income countries (lower middle-income to upper middle-income) gain almost nothing from globalization as they are likely to experience “the smallest change in factor-price ratio” or no significanthange in the ratio of skilled to unskilled wages (Udomsaph and Zeufack, 2009). Escaping the middleincome country trap is an uphill battle. The move from being a middle-income country (MIC) to being a highincome country (HIC) requires a break from the past in some significant structural shift. Apart from policies that no longer work to elevate them to a high-income economy, many “trapped MICs” tend to make two common mistakes: either they cling on too long to past successful policies or they exit prematurely from the industries that could have served as the basis for their specialization process ( _The Growth Report_ , 2008). Timing is key. Most MICs fail to anticipate the transition and the new demands that come with it. For example, most MICs hold on to a labour-intensive strategy for too long. They artificially maintain non competitive firms through a battery of subsidies, continuing to pile up fi scal incentives with no consideration of the take-up rate or efficiency, and continue to make FDI volumes the key performance indicator for competitiveness (Nungsari and Zeufack, 2009). The second common mistake is a premature shift away from assembly manufacturing before ensuring an adequate supply of high-quality and competitive human capital to support the transition to higher value-added sectors.

_Source_ **:** Nungsari and Zeufack (2009) and Kharas et. al. (2010).

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