Arno Fontaine, economist at BSI Economics, answers three questions about the middle-income trap.
What difficulties arise when developing countries move upmarket?
Arno Fontaine: Initially, developing countries (BRICS and LDCs[1]) opted for economic models based on specialization in labor-intensive sectors at low cost, in order to attract foreign capital and benefit from technology transfers.
This was the case, for example, in China from the 1990s and 2000s, and especially from 2001 onwards with its accession to the World Trade Organization. The productivity gains generated during this period were extremely high, and the country gradually opened up to foreign investors. Economic catch-up then began, with growth driven by investment, exports, and intensive production, thanks to very cheap labor.
However, once this catch-up phase was over, developing countries sought to adapt their model. Several factors explain this desire for transformation: an aging population, the introduction of social protection for employees, rising wages, better development of education, a desire to better protect the environment, etc.
Developing countries are thus seeking to move upmarket by rebalancing their initial model in order to strengthen domestic demand (e.g., the 2015 development plan, Made in China 2025) and accelerate income growth. This is one of the last steps in the climb to being considered a developed economy, where the goal is to compete with advanced countries on high value-added and high-end products.
Why is this transition between the two models problematic?
Moving upmarket in industry and services is proving more complicated than expected for emerging countries due to several limitations: the financial system remains underdeveloped and loan guarantees are more restricted, regional heterogeneity with low-cost manufacturing persists in outlying areas, the education system remains underdeveloped, particularly in rural areas, etc. While developing countries benefited from foreign technology transfers when they were catching up, increasing their productivity, moving upmarket limits this phenomenon.
This deadlock is commonly referred to as the middle-income trap, which still affects a number of developing countries today (China, India, Indonesia, Brazil, South Africa, etc.). This is a situation in which countries that have rapidly moved from low-income to middle-income status[2] are unable to catch up with high-income countries. As labor costs rise, countries gradually lose their price competitiveness advantage, leading to a slowdown (or even a decline) in their exports. At the same time, the middle class has not fully emerged and domestic demand is unable to provide more significant support for the country’s growth.
Another factor is exacerbating the middle-income trap: the social and ecological transition that has gradually been introduced in emerging countries is actually weighing on growth, as the economic model does not have the capacity to absorb the advances that have been introduced.
What impact has the Covid crisis had on this change of model?
The Covid-19 crisis has inevitably exacerbated the problems associated with this middle-income trap in emerging countries. Beyond the recessions it has caused, weighing on economic activity as well as countries’ budgets and debt, the crisis has had significant social consequences in countries that do not have the same individual social protections as developed economies.
According to World Bank figures, the crisis has mainly affected the poorest social classes, particularly in emerging countries: in 2021, the poorest quintile of the planet suffered an average income loss of 6.7% compared to pre-pandemic levels (compared to 2.6% for the richest quintile). While the wealthiest populations have recovered nearly half of their initial losses during the pandemic, income losses continue to widen for the most vulnerable populations, particularly in Sub-Saharan Africa and Latin America. It is also in low-income countries that extreme poverty has increased the most during the crisis.
The Covid-19 crisis has, for example, posed a number of problems in education, which has proved to be very unequal across territories and regions, leading to significant gaps for the most disadvantaged children and the most isolated areas. Inequalities within emerging countries have increased significantly, with populations losing their previously acquired sources of income, leading to a K-shaped recovery (meaning a rapid recovery for certain sectors/individuals/countries while others continue to deteriorate).
Finally, developing countries have had less room for maneuver to mitigate the impact of the crisis and slower access to vaccines. By exacerbating the structural problems of these countries, the Covid crisis is making it much more difficult to escape the middle-income trap: as a result of the crisis, the World Bank downgraded Indonesia from an upper-middle-income country to a lower-middle-income country in June 2021, highlighting the difficulties developing economies face in moving up the income ladder in a sustainable manner while still grappling with major structural challenges.
[1] BRICS: Brazil, Russia, India, China, South Africa; LDCs: Least Developed Countries, a category comprising the least developed countries on the planet.
[2] According to the World Bank classification, an economy moves from the low-income to middle-income category if its GNI (Gross National Income) per capita exceeds USD 1,036 (current prices). It becomes a developed economy if its GNI per capita exceeds USD 12,535.
