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.