Gerrit Hugo van Heuvelen /
8-4-2012 /
Table of contents
Introduction
Traps and development, a short introduction
The Middle Income Trap
The classification of the Middle income country
GNI versus GDP
Searching for the optimal classification and thresholds
Methods
Testing the methods
In sample error of the Methods
Transition diagrams
Duration of middle income spells
Mean or median
The Lower Middle Income Trap (LMIT)
The Upper Middle Income Trap (UMIT)
Robustness
Conclusions
Discussion
References:
Iist of Tables
Table 1: classification
Table 2: World income development over time
Table 3: optimal thresholds
Table 4: Percentage of total (middle income) error when using the 1987-1996 sample
Table 5: Percentage of total (middle income) error when using the 2001-2010 sample
Table 6: optimal classification thresholds
Table 7: Percentage of total (middle income) in sample error when using the OWB benchmark
Table 8: Percentage of total (middle income) in sample error when using the RWB benchmark
Table 9: The percentage of countries misclassified by middle income classification
Table 10: LMIT definition obtained using the Kendall method with the WB benchmark
Table 11: The LMIT definitions obtained by the different methods and benchmarks (BM)
Table 12: Countries classified as stuck in the LMIT
Table 13: The UMIT definitions obtained by the different methods and benchmarks
Table 14: Countries classified as stuck in the UMIT
Appendix A: The WB classification distribution of all available countries
Appendix B: WB classification transition diagram for all countries on which data is available (215)
Appendix C: WB classification transition diagram for 124 sampled countries
Appendix D: In sample error when using the OWB benchmark
Appendix E: In sample error when using the RWB benchmark
Appendix F: Percentage of total (middle income) error when using the Weighted MSE optimal thresholds
Appendix G: The percentage of countries misclassified by middle income classification
Appendix H: List of countries that are included in the analysis
List of Figures
Figure 1: GDP versus GNI per capita from 1960 till 2010*
Figure 2: GDP versus GNI per capita from 1960 till 2010 excluding the seven notorious outlier countries *
Figure 3: The distribution of GDP and GNI per capita from 1960 till 2010
Figure 4: Official World Bank Classification
Figure 5: Spearman’s classification
Figure 6: Felipe’s classification
Figure 7: The Change of the Income classification structure*
Figure 8 :Classification of Albania (1=low income and 2=lower middle income)
Introduction
In the world we livethere are basically three groups of countries. There are rich countries with an gross national income(GNI) per capita of above in 2010. Then thereare poor countries that have and GNI per capita below in . Stuck in between these two categories there are also countries, we call them middle income countries (MIC).The countries that have been dubbed middle income countries have had a hard time moving up from this income group. A term was created to label theMIC that experienced difficulties in making the transition to the next income group. These countries were stuck in the so called middle income trap (MIT).
The exact definition of the MIT, however, is still ambiguous and often fails to provide a clear distinction between the countries that are stuck and those that avoid the trap. An aspect which of course is crucial. Often when asked what a middle income trap is many words follow but a satisfying answer is often not given. The person posing the question is often more puzzled after the answer than before posing his question.This is not strange as the MIT is one of the development topics on which there still a lot of debate. The term MIT is therefore still subject to a great deal of scepticism.
There are two main aspects of the middle income trap that have not yet been sufficientlyaddressed and thereby contribute to the scepticism. The first aspect that has not been sufficiently addressed is the development of a thorough theoretical framework for the middle income trap. The second aspect is a clear definition which separates the transition from the trap. Considering the fact that since 1987 more countries have been dubbed MIC the relevance of the MIT discussion is of increasing importance.[1] This paper is an attempt to tackle the second aspect. This paper searches to quantify a duration definition of the MIT that will enable individuals to distinguish between the time needed to make the transition and actually being stuck in the MIT. It must be stressed that in order for the discussion on the MIT to progress this distinction must be made.
Traps and development, a short introduction
Let us, as a starting point, use the notion of a low income (poverty) trap, that has been less debated and more generally accepted, in order to comprehend the phenomenon ‘trap’. The low income (or poverty) trap is based on the notion that poverty itself is a trap. In order to break out of this poverty trap capital is needed. However this capital cannot be accumulated because of, for example, disease, malnutrition, physical isolation and extreme poverty itself. Sachs (2005) in his book “The end of poverty” describes development as a ladder that has to be climbed. Individuals stuck in the poverty trap are, according to Sachs (2005), not even on this ladder. The poverty trap is in essence that the struggle for survival now is often more important than the future.[2] The notion of a trap therefore constitutes the inability or failure of individuals (countries) to take the necessary steps to break out of an undesirable circumstance they are stuck in.
The analogy of a ladder for developmentby Sachs (2005) is very misleading, as it implies a linear relationship for development. If only the individual (or country) would grab hold of the ladder then development itself will follow. However, if anything, the MITdiscussion has shown that there is a kink, a large kink, in this development ladder. After breaking the poverty trap and escaping the lower income classification development does not become any easier. In fact it might only become harder. The middle income trap is basically a concept for the notion that it is easier for a low-income country to become a middle income country than for a middle income country to become a high income country. Thereby implying that the development of a country is not a linear process. So why would the transition from low to middle income, theoretically speaking, be easier than the transition from middle to high income?
The basis of the answers lies in the fact that low income countries can basically use their current state, poverty and technological backwardness, to their advantage in order to grow quickly. In early stages developing countries primarily rely on subsistence employment.Subsistenceemployment is a synonym for an ‘unlimited’ supply of labour existing in this country relative to its capital and natural resources. Lewis (1959) called this subsistence sector the “unproductive sector” as individuals could switch to another sector without losing any productivity within the respective sector. In these early stages of development this relatively inefficient sector constitutes the largest share of employment and output. Therefore a country can quickly increase its productivity by reallocating labour from the subsistence sector (highly inefficient sector) to the other sectors (more efficient sectors) of the economy.[3] These more efficient sectors use (more) capital thereby quickly enhancing the productivity.
Late-developing countries also have the capacity to grow more rapidly than early developers. The catch up hypothesis asserts the idea that being backward in the level of productivity carries a potential for a rapid advance. Instead of inventing new technologies these countries can import know-how from abroad. They can therefore exploit the gains from these imported technologies by shifting workers from the subsistence sectors to manufacturing sectors. Thereby rapidly increasing their productivity.However this pool of underemployed (rural) labour will eventually be drained. At a certain point the share of manufacturing employment peaks and growth will start to depend more on raising the productivity in the service sector, generally speaking a more difficult process. As the country approaches the technological frontier it will have to make the transition from depending on imported technology to home grown innovation. Implying that the labour-intensive sectors are being replaced by a new set of industries that are in the way they produce more human capital, capital and knowledge intensive. This last transition is exceptionally difficult and explains why so few countries break into the high income class.[4]
However a side note should be made. Abramovitz (1986) stressed the idea that a country’s potential for rapid growth depends not only on the size of its technological gap but also on its social capabilities. Factors that enhance the diffusion of knowledge, the rate of structural change, the accumulation of capital, and the expansion of domestic demand are seen as social capabilities. The more developed the country’s social capabilities (e.g. education and institutions) the more likely it is for a country to catch up. Therefore escaping the low income group is a lot harder than the previous theoretical explanation gives credit to. Weak and harmful institutions, corruption, (civil) war, famine and natural disasters often prohibit a country from catching up despite its technological gap and surplus of cheap labour. It is therefore often difficultfor a country to escape the low income group. However when certain initial conditions are in place(i.e. the right social capabilities) a low income country often growths relatively quickly through the mechanism just described.
The Middle Income Trap
Kharas and Kholi (2011, 1) define the middle income trap as follows: “unable to compete with either low-wage economies or highly skilled advanced economies”. This is why the term trapped is used because these countries are ‘trapped’ in between. Basically what the countries did to achieve middle income status, usually some form of labour intensive production, becomes less competitive as wages start to rise. At the same time these countries are often not equipped with the needed know-how, capital and human capital needed to break into the markets of rich-country innovators and hence they are stuck. Kharas and Kholi (2011) use an analogy of golf to explain that even though not all countries fall into a “trap” all middle income countries are influenced by the presence of this trap.
“Both the poverty trap and the middle income trap can be best understood by analogy to golf. Not everyone falls into a “trap, ” but everyone’s play is influenced by the presence of traps. Successful economies avoid falling into traps or escape rapidly, while unsuccessful (or unlucky) economies can get stuck for many years. “
Ohno (2009) describes the middle income trap as an invisible glass ceiling that prohibits countries to move from the second to the third stage of development. In the second stage the country has just begun withthe initial stages of industrialization. It receives FDI and simple manufacturing production under foreign guidance is set up. At this stage the fact that wages are low is important for the foreign owned and controlled manufactures. Wages can therefore not increase greatly and most of the important tasks remain in the hands of foreigners. In the third stage management and technology is mastered by locals and domestic firms can produce high quality goods. Clearly there is a big gap between the second and third stage. In order to attain the third stage the country must “absorb technology”. This sounds wonderful but what does Ohno imply with this term?
“…… Internalize skill and knowledge by accumulating industrial human capital, locals must replace foreigners in all areas of production including management, technology, design, factory operation, logistics, quality control and marketing. As foreign dependency is reduced internal value rises dramatically”
Basically the locals must master the skills needed to produce high quality goods and start replacing foreigners at all levels. Clearly more value will be added by the locals and productivity will therefore increase drastically allowing wages to increase. As long as wages rise faster than productivity the country will be losing its competitive edge. However if wages rise due to higher productivity the country will remain competitive. The absorption of technology, that according to Ohno is needed to break the “glass ceiling”, will take years if not decades to attain. In the mean while rising wages due to labour shortageswithout an increase in productivity can deteriorate the countries competitive advantage as a low cost manufacturer.
The previous definitions and explanations of the MIT describe the problem that middle income countries face when making an transition to high income status. However they do not provide us with a way to distinguish between countries that are stuck and countries that avoided the MIT. There is,nevertheless, one feature that all factors required to move past the middle income stagehave in common and that is that they take a long time to develop. However a distinction should be made between the transition which by definition takes a long time, as the factors needed to make the transition take time to acquire, and actually being stuck in the MIT. Kharas and Kholi (2011) hint on a duration based definition for the MIT with the golf analogy. Felipe (2012) pursues the quest to quantify the MIT duration definition. Felipe (2012) defines countries that have middle income spells that last longer than the median duration of the non-censored middle income spells of countries that escaped as stuck in the MIT. The paper by Felipe (2012) is, to my knowledge, the only paper that tries to quantity theMIT duration definition.
The classification of the Middle income country
The World Bank classifies countries into income groups since 1989 when it started with classifying the countries beginning with the year 1987. The World Bank uses thresholds to classify countries as low (L), lower middle (LM), upper middle (UM), and High(H) income using the current GNI per capita (Atlas methodology).[5] The initial thresholds were set for the different income groups by taking into account both summary measures of wellbeing (e.g infant mortality and poverty incidence) on one hand and economic variables (e.g GNI per capita (Atlas method)) on the other hand. The thresholds have since then been corrected for international inflation (average inflation of Japan, Euro Zone, United Kingdomand the United States) so that the thresholds remain constant over time in real terms. The classification is therefore absolute, implying for example that at an certain point in time all country can be classified as high income countries.
In order define the MIT this paper looks at the evolution of the middle income groups over a longer period of time. However since the middle income trap is a relatively recent notion going too far back in time would make little sense. The period after 1950 is in many ways not comparable economically to the period before this. Growth of certain countries starting with Japan and Brazil has been unprecedented historically. Growing at least 7% per annumfor a period longer than 25 years.[6] It is partly because of these growth miracles that the notion of MIThas come into being. Before this time period countries like the Netherlands, the first lower middleincome country, took 116 years to achieve the upper middle income status.[7]Also around 1950 the US starts setting the stage as the dominant and leading economic power.
As stated before the goal of this paper is to formalize theMIT. In order to do that development has to be put into a time perspective. The Maddison’s GDP per capita estimates are the longest estimates of GDP per capita available. In line with Felipe(2012) the data is expanded till 2010 using IMF growth rates of GDP per capita (in local currency) measured in constant prices. There is however no official World Bank income classification before 1987. Therefore a time independent classification scheme must be developed for the period before this.
GNI versus GDP
The WB uses GNI per capita to classify countries into income groups. The author of this paper uses GDP per capita instead of GNI as it enables the author to research a significantly longer timespan and a greater amount of countries. Thereby increasing both the length and scope of the sample. Therefore before proceeding it important to know if GDP per capita can be used as an substitute for GNI per capita.
GDP is a location based measure of the income of a country. It corresponds to the value added created by foreign and local owned factors of production within a certain geographical location. GNI is ownership based. It constitutes the total value added produced by nationals irrespective of where they live. Generally speaking GNI and GDP are closely related to each other. Therefore substituting one for the other will not lead to great discrepancies. However to confirm this fact GNI and GDP have been compared.