How Can Emerging Markets Avoid The Middle-Income Trap?

By Brent Radcliffe | October 20, 2011 AAA
How Can Emerging Markets Avoid The Middle-Income Trap?

Developing countries experience such rapid growth for several reasons. First, they invest in imported technology that allows them to be more productive. This is more or less copying the know-how of developed economies, skipping over the painful process of reinventing the wheel. Second, their labor costs are lower relative to developed countries, allowing them to produce labor-intensive goods more cheaply. Third, they are able to tap into a population working in inefficient or non-industrial sectors of the economy, such as agriculture. Fourth, they operate export-dominated economies that emphasize capital-intensive growth.

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At some point, emerging markets will have picked all of the low hanging fruit that has provided them with such consistently high GDP and productivity growth rates. The "easy wins" will be exhausted as rural labor sources are utilized and investment in more urban factories leads to saturation. As the supply of migrant or cheap labor declines, high levels of demand will increase wage rates. This will reduce the competitive advantage enjoyed by many export-driven industries. This is especially the case in industries dominated by high volume orders with low costs. (For related reading, see What Is An Emerging Market Economy?)

Strategies to Work With
Luckily for emerging economies, a wealth of historical perspective can provide some potential strategies to keep growth alive:

  • Investment in infrastructure, such as roads, should continue in order to connect industrial centers to more far-flung internal markets.
  • Regulatory institutions protecting companies that innovate must be developed, signaling to firms that creating products and services able to be patented is a viable investment.
  • Investments in education a wider proportion of the population, as well as the development of higher education institutions linked to science and industry will help develop the next generation of entrepreneurs.
  • Monetary policy will eventually have to allow currencies to fluctuate with market conditions more, as an emphasis on keeping exchange rates artificially low distorts the economy and pushes capital to the same industries as before.
  • Businesses and consumers will have to be given greater access to credit, which will help develop a domestic market.
  • Emphasize the development of industries outside of commodities.
  • Governments will have to loosen the top-down approach to directing the use of capital and development of industries, allowing smaller operations to flourish and limiting continued investment in industries with low returns.
  • Domestic markets will have to be open to a level of international competition, removing implicit government protection on businesses that cannot compete or use capital efficiently.
  • Encourage institutions that fight corruption.

The End of Fast Growth
Slowing economic growth is more likely to stem from maturation than from lack of capital investment or access to labor. In order to navigate out of the doldrums of the middle-income trap, emerging markets must pursue structural and financial reforms in order to transition to high-income, innovation-driven economies. The development of strong financial institutions and markets will be the key to overcoming the decline in GDP growth that accompanies an aging economy, as these will improve the way in which capital is employed by sending money to where it will be most productively used.

Many emerging markets have been fueled not only by high demand for exports, but also by high savings rates from their populations. This has provided a cheap source of development capital, and has allowed some countries, such as India and China, to bypass international capital markets for bond sales. Based on 2010 numbers, gross national savings, calculated as gross national income (GNI) less consumption plus net transfers, is higher in the BRIC economies - Brazil (15%), Russia (28%), India (28%), and China (51%) - than it is in the United States (10%). (For related reading, see Should You Invest In Emerging Markets?)

Making the Jump
In order to make the jump from savings to consumption, countries need to encourage the development of domestic industries providing products and services for the home population. Aggregate demand, which is a measurement of demand for a country's goods and services, will need to increase as a function of emerging market GDP. Household consumption as a percentage of GDP (2010) is lower in Brazil (64%), Russia (51%), India (63%) and China (38%) than it is in the United States (71% in 2009). A reliance on commodity exports has depressed Brazil and Russia's household consumption as a percentage, but high savings rates are hurting China. According to the IMF's World Economic Outlook report, emerging and developing economies are projected to have real GDP above 6% through 2016, with developing Asian economies growing above 8%. China is expected to grow above 9%.

The Bottom Line
There is no singular cure-all for emerging markets suffering from slowed growth. Some need to increase consumption (China) while others need to reduce consumption and increase saving (Brazil). Regulations will take time to come into their full effect, and most importantly the business environment needs to provide the resources to start new businesses quickly and let them fold if they are no longer competitive. It is possible that competition for capital, whether from international or domestic sources, will be the driving force that pushes emerging markets into the next level.

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