Economic Research Forum (ERF)

Escaping the middle-income trap: lessons from East Asia’s experience

265
Many countries find themselves in the ‘middle-income trap’, facing a slowdown of economic growth because of weak innovation. This column draws on the experiences of East Asian countries to explore how businesses can upgrade their innovation capabilities and how policies can provide support for those efforts, thereby promoting renewed growth. There are important lessons for the MENA region.

In a nutshell

The experience of East Asian countries suggests the need for two kinds of upgrading in innovation capabilities to escape the middle-income trap.

In Korea and Taiwan, upgrading in the same industry and successive entry into promising new industries occurred over the course of industrial development.

Unless both of these kinds of upgrading are pursued, the chances for successful and sustained catch-up with the advanced countries are slim.

Many studies show middle-income countries getting caught in a trap between low-wage manufacturers and high-wage innovators: their wage rates are too high to compete with low-wage exporters; and their level of technological capability is too low to enable them to compete with advanced countries (Lee, 2013; World Bank, 2010).

A slowdown in economic growth is what ensues; and a key part of the solution lies in innovation (Lee and Kim, 2009). The experience of East Asian countries suggests the need for two kinds of upgrading in innovation capabilities.

The need for double upgrading

In the early days of their take-off, East Asian firms faced at least two important competitive disadvantages: first, their isolation from the major international sources of innovation; and second, their distance from advanced markets and the user-producer links that are essential to innovation.

‘Original equipment manufacturing ‘(OEM) has been one of the chief institutional mechanisms used to overcome these entry barriers and to enable technological learning to occur.

OEM is a specific form of subcontracting in which finished products are made to the precise specifications of a particular buyer, who then markets the products under their own brand name and through their own distribution channels. In Taiwan and Korea, OEM accounted for a significant share of electronics exports during the 1970s, 1980s and even the 1990s (Hobday, 2000).

While latecomer firms readily achieve an early stage of development through producing products designed by others (the so-called OEM model), they face uncertain long-term prospects, as potential technology suppliers refuse to sell designs or licences or switch production orders to other lower-wage sites or countries (Lee, 2005).

The fundamental reason for the unfolding of an ‘OEM crisis’ has to do with the rising wage rates that follow successful production and the difficulty that firms have when  upgrading into higher value-added segments to pay for higher wages. But upgrading requires acquisition of design capabilities. In the case of Korea, firms could find products to imitate, but no designs were forthcoming from incumbent producers since they were reluctant to transfer design technology to potential rivals.

In Taiwan, the crisis was so intense that foreign vendors switched their OEM orders to firms in other lower-wage economies, such as Malaysia. The Taiwanese firms then realised that they had to upgrade their design capability if they wanted to keep their customers.

Specifically, they had to design an ‘imitative’ product by themselves and to start to sell this product under their own brand name. But design capability is not easily acquired simply by continuing as a subcontractor or through networking with local producers. The case of Acer in Taiwan shows how difficult it is to move out of the OEM phase, and to move into ‘own brand manufacturing’ (Khan, 2002).

The Korean and Taiwanese cases reveal that upgrading in the same industry and successive entry into promising new industries occurred over the course of industrial development. My proposition is that unless both of these kinds of upgrading are pursued, the chances for successful and sustained catch-up are slim.

There are two issues involved here: one from the perspective of the latecomer; and the other from that of the frontrunner or incumbent firm.

Latecomers and frontrunners

First, from the latecomer perspective, it should be noted that while the current success with the OEM strategy tends to lead a consequent rise in wage rates, new, cheaper labour sites in ‘next-tier-down’ countries can emerge to replace a country’s position in global value chains. This condition forces firms to move up to higher value-added activities in the same industries.

Second, innovators in the frontrunner countries tend to generate new higher value-added industries. As innovations arise, established industries mature and may degrade into lower value-added activities, forcing firms to enter newly emerging industries and higher valued-added activities.

In East Asia, examples of upgrading in the same industries are numerous. For example, semiconductor firms in Korea and Taiwan started from integrated circuit packaging or testing (low value-added activities), then moved to integrated circuit fabrication and eventually to integrated circuit design (highest valued-added).

Likewise, in Taiwan and Korea, there are many cases of successive entry into higher value-added activities. For example, the Tatung company in Taiwan has made successive entries into new activities since the 1960s, starting with black and white TVs in 1964, colour TVs in 1969, video recorders and personal computers in the mid-1980s, hard disk drives in the mid-1980s, TV chips/ASICs in the late 1980s, and workstation clones in 1989 (Khan, 2002).

The Samsung group in Korea is well known for its successive entrance into new industries during its 60-year history. Samsung started with involvement in light manufacturing industries, such as textiles, but then entered consumer electronics, followed by semiconductors, telecommunications equipment and flat-panel displays.

The question that naturally arises from these success stories is how to make double upgrading happen. Upgrading and structural transformation do not occur automatically even if a country is open to trade and foreign direct investment.

Rather, they always involve deliberate learning and risk-taking by companies and public institutions, combined with the open windows of opportunity. The market mechanism serves not as a triggering factor but as a facilitating factor that stimulates risk-taking and rewards the successful actors.

Policy tools for the double upgrading

The fundamental requirement for upgrading in a firm is to establish and initiate its own in-house research and development (R&D) centre. Independent R&D efforts are required because foreign firms would become increasingly reluctant to grant technology licences to the rising latecomer firms, especially when the latter attempt to enter the skill-intensive markets dominated by the advanced countries.

With the establishment of in-house R&D centres, firms may then explore diverse channels of learning and access to foreign knowledge. Arranging access to foreign knowledge and trying new modes of learning are critical because isolated in-house R&D efforts are often insufficient to build indigenous R&D capabilities.

Alternative modes of learning are diverse, including co-development contracts with foreign R&D specialist firms and/or with public R&D institutes, gaining mastery of the existing literature, setting up overseas R&D outposts and initiating international mergers and acquisitions. These alternatives will be elaborated in a forthcoming ERF policy brief.

Policy space under the WTO

Policies to support private sector initiatives are vital. Developing countries should not take the restriction on industrial policies set by the World Trade Organization (WTO) as an excuse for not trying industrial policy because there is still space for such policies under the WTO rule (Lee et al, 2014). Although subsidies on exports are prohibited, those on production are ‘green light subsidies’ or have not been prohibited unless they are deemed as specific and causing adverse effects on other member countries.

Moreover, the WTO’s agreement on subsidies and countervailing measures (SCM) does not prevent governments from subsidising activities (particularly through regional, technological and environmental policies), provided that they have sufficient ingenuity to present such subsidies as WTO compatible. In general, developing countries may attempt to take advantage of the fact that many rules in the WTO SCM have loopholes or room for flexible interpretation, as the term ‘yellow light’ for certain types of subsidies suggests.

Especially, for the upper-middle-income countries for which innovation is one of the most binding factor for economic growth beyond the middle-income trap, it should be noted that several policy to cultivate innovation capabilities, such as R&D subsidies, have not been restricted (or classified as green light subsidies).

In general, developing countries may be able to use some ‘non-specific’ subsidies because these subsidies are not prohibited by the WTO. In other words, when subsidies are not limited to ‘certain enterprises or industries’ but are available on the basis of ‘objective criteria or conditions,’ they are regarded as not specific.

Further reading

Hobday, Michael (2000) ‘East versus Southeast Asian Innovation Systems: Comparing OEM- and TNC-led Growth in Electronics’, in Technology, Learning and Innovationedited by Linsu Kim and Richard Nelson, Cambridge University Press.

Khan, Haider (2002) ‘Innovation and Growth: A Schumpeterian Model of Innovation Applied to Taiwan’, Oxford Development Studies 30(3): 289-306.

Lee, Keun (2005) ‘Making a Technological Catch-up: Barriers and Opportunities’, Asian Journal of Technology Innovation 13(2): 97-131.

Lee, Keun (2013) Schumpeterian Analysis of Economic Catch-up: Knowledge, Path-creation and Middle Income Trap, Cambridge University Press.

Lee, Keun, and Byung-Yeon Kim (2009) ‘Both Institutions and Policies Matter but Differently at Different Income Groups of Countries: Determinants of Long Run Economic Growth Revisited’, World Development 37(3): 533-49.

Lee, Keun, Wonkyu Shin and Hochul Shin (2014) ‘How Large or Small is the Policy Space? WTO Regime and Industrial Policy’, Seoul Journal of Economics3.

World Bank (2010) ‘Exploring the Middle-Income-Trap’, World Bank East Asia Pacific Economic Update: Robust Recovery, Rising Risks, Vol. 2.

 

Most read

Fair competition is needed to empower women economically in the Arab world

The participation rates of women in the labour market in Arab countries are the lowest in the world. This column argues that remedying the under-representation of women in the labour force is a social and economic imperative for the region. There are three dimensions for action to realise the potential of Arab women: amending laws and regulations; instilling fair competition in markets; and promoting the digital economy.

Arab countries are caught in an inequality trap

Conventional wisdom, based mainly on surveyed household income distribution statistics, suggests that inequality is generally low in Arab countries. At the same time, little attention has been devoted to social inequalities, whether in terms of outcomes or opportunities. This column introduces a forthcoming report, which offers a different narrative: based on the largest research project on the subject to date and covering 12 Arab countries, the authors argue that the region is caught in an inequality trap.

Recession without impact: why Lebanese elites delay reform

The survival of Lebanon’s political elites is highly dependent on the wellbeing of the economy. Why then do they delay necessary reform to avoid crisis? This column examines the role of politically connected firms in delaying much-needed economic stabilisation policies.

Competition laws: a key role for economic growth in MENA

Competition policy lacks the attention it deserves in the countries of the Middle East and North Africa (MENA), a region characterised by monopolies and lack of market contestability. As this column explains, there are many questions about the extent of anti-competitive barriers facing new market entrants in the region. What’s more, MENA’s weak overall performance on competition is likely to be hindering economic growth and the path towards structural transformation.

The Egyptian economy is still not creating good jobs

Growth in Egypt has recovered substantially since the downturn following the global financial crisis and the political instability following the 2011 revolution – but what has happened to jobs? This column reports the results on employment conditions from just released data in the 2018 wave of the Egypt Labor Market Panel Survey.

How Egyptian households cope with shocks: new evidence

Managing risks and reducing vulnerability to economic, social, environmental and health shocks enhances the wellbeing of households and encourages investment in human capital. This column explores the nature of shocks experienced by Egyptian households as well as the coping mechanisms that they use. It also examines the relationship between such risks and job formality and health status.

The future of Egypt’s population: opportunities and challenges

Egypt’s potential labour supply depends on the growth and changing composition of its working-age population. This column reports the latest data on labour supply and fertility rates, concluding that the country has a window of opportunity with reduced demographic pressures to try to address longstanding structural challenges for the labour market.

Egypt’s labour market: facts and prospects

An ERF policy conference on the Egyptian labour market in late October 2019 focused on gender and economic vulnerability. This column summarises the key takeaways from the event.

An appeal for Sudan’s future

Sudan today is on a knife-edge: it can evolve toward peace and democracy – or spiral into instability and violence. As this Project Syndicate column argues, vital and timely international assistance can make the difference between success and failure for the new government.

Domestic demand and competition: a new development paradigm for MENA

A lack of competition in domestic and regional markets is holding back development in the Middle East and North Africa. This column argues that the region and the international community must ensure that barriers to market entry and exit are eliminated, and that independent regulatory bodies at the national and regional levels help to promote domestic demand as the main engine for sustainable and inclusive growth.