Should businesses worry about middle income trap?

by: Prof. Yeah Kim Leng, Director of Economic Studies Program at Jeffrey Cheah In­stitute on Southeast Asia

Of the many challenges facing the Malaysian economy, the middle income trap has become an overarching theme in the country’s growth narrative. It will likely remain so until the nation is able to cross the high income threshold that is targeted by the year 2020.

Even when the country attains high-income status, there is no guarantee that it will not slip back. Venezuela was classified as high-income last year after more than 3 decades. Its relegation from high-income to upper-middle income this year exemplifies the difficulties many countries face in sustaining growth and raising income level.

In the World Bank’s income classification for this year, besides Venezuela, two other countries, Russia and Equatorial Guinea also dropped from high-income to upper-middle income category while none was elevated to high income compared to four in the previous year.

Myths and reality

The existence of a middle income trap continues to be widely debated as the term is not defined precisely. It is further compounded by the lack of consensus on how it should be measured, the choice of relative or absolute income levels, the thresholds to use as well as the length of time to constitute a trap.

Nevertheless, since it was first coined by World Bank economists in 2007, it has served as a useful concept to focus the attention of policy makers, country planners, business leaders and economists on the nature and the risks of the trap, particularly in finding ways to overcome the problem of slow growth.

Transitioning from low-income to middle-income appears to be relatively easy for some countries, including Malaysia, by leveraging on cheap labour, use of basic technology and capital and growing export markets for basic commodities and manufacturing products. The trap alludes to the inability of the middle-income country to compete with low-wage countries in labour-intensive industries and high-income nations in high value, skills and technology-intensive sectors.

Empirical evidence of the middle-income trap are mixed although growth slowdowns have been found to be more likely at middle-income levels. Other evidence point to the absence of a trap-like patterns for the majority of countries as well as the painfully slow process of convergence to high income.

A recent World Bank study points out that the ‘escapees’ have simply grown faster on account of rapid industrial transformation, low inflation, stronger exports, better quality education, or reduced inequality.

High income within Malaysia’s reach

According to World Bank’s classification, Malaysia transitioned from lower middle to upper middle income status in 1992. Its per capita gross national income (GNI) reached USD10,570 in 2015 or 15 percent short of the high income threshold of USD12,475.

Assuming there is no change in Malaysia’s inflation and exchange rates relative to the benchmark advanced economies, Malaysia’s GNI per capita in US dollars needs to increase by 3.4 percent annually to reach the high income threshold by 2020. This is certainly within reach as the country recorded an average 5.8 percent increase annually over the last five years. The challenge then is for businesses and the country as a whole to sustain the current growth momentum while keeping steady its inflation and exchange rate relative to the benchmark advanced countries so that the currency conversion does not result in a lower GNI per capita in US dollar terms.

Malaysia’s proximate, wider and deep sources of growth

The proximate growth sources refer to the availability of production factors such as land, labour and capital.

Current estimates of Malaysia’s growth potential based on the available production factors suggest the economy is capable of sustaining a gross domestic product (GDP) growth of four to five percent. Given the slower rate of population increase, a real per capita income growth of three to four percent is attainable over the next five years.

If the projection is realised, it will be close to three decades for the country to cross the high income threshold.

To increase the certainty as well as to strive for a faster convergence with the other high-income countries, government and business leaders will have to nurture both the wider and deep sources of growth. Opportunities to tap the wider sources of growth include international trade and investment expansion, financial deepening, effective government spending, services sector liberalisation and equitable income distribution.

Deep sources of growth that those that enable nations to achieve not only high-income but also fully-developed status. These are rooted in enduring and equitable social and political arrangements, human capital development, sound quality of institutions, good governance and leadership, and open and democratic societies, most of which are encapsulated in Vision 2020.

How firms can create and harness growth sources

Firms can create as well as harness the three types of inter-linked growth sources. When firms and organisations fully deploy, nurture, train and motivate its workforce, they help to maximise the nation’s proximate sources of growth as well as develop the wider and deep sources of growth. When firms innovate through technology adoption, diffusion and creation, they contribute to the country’s productivity gains as well as deepen its industrial base. Likewise, when the government in collaboration with the private sector promotes entrepreneurship, the new product lines or services offered will add to the country’s production capacity and innovation capability.

While the myth and reality of the middle-income trap will continue to dominate policy discussions and economic research agenda, the extent and dynamism of thriving businesses in all sectors of the economy will be the real gauge of the escape from slow or stagnant growth.

By Prof. Yeah Kim Leng | 8 Sept 2016

Professor Yeah Kim Leng is the Director of Economic Studies Program at Jeffrey Cheah In­stitute on Southeast Asia at Sunway University and Professor of Eco­nomics at Sunway University Business School. He is also an external member of Bank Negara Malaysia’s Monetary Policy Committee. The views expressed in this article are his own.

First appeared in the New Straits Times

Modified by Low Wai Sern