Spence, Michael (2011).

The Next Convergence: The Future of Economic Growth in a

Multispeed World (Kindle Locations 1723-1736). Farrar, Straus and Giroux. Kindle Edition.

16. The Middle-Income Transition

Most countries that grow to middle-income levels slow down, and some even stop growing. The
exceptions are relatively few: Japan, Korea, Taiwan, Hong Kong, and Singapore. Here we
explore some of the challenges associated with making this transition. It is important. China is
entering the middle-income transition now. Brazil is successfully restarting its growth as a
middle-income country. India is about ten to fifteen years from entering the same process. Russia
is a middle-income country in which it is at present unclear whether the structural dynamics of
sustained growth have been initiated. Much in the global economy will depend on the success of
these upcoming navigations. Middle-income transition refers to that part of the growth process
that occurs when a country’s per capita income gets into the range of $5,000 to $10,000. At this
point, the industries that drove the growth in the early period start to become globally
uncompetitive due to rising wages. These labor-intensive sectors move to lower-wage countries
and are replaced by a new set of industries that are more capital-, human capital–, and
knowledge-intensive in the way they create value. This transition turns out to be very
problematic. There is a very strong tendency to try to hold on to the known successes. And it is
hard for policy makers to sit idly by while competition shrinks known sources of employment.
The techniques for resisting the structural evolution are many: subsidies, increasing protection in
the form of tariffs, management of the exchange rate so as to keep the cost of exports down, and
the like. There are potentially powerful domestic interests that create pressure in this direction.

[Figure]

As a result, there is a tendency for growth to stall at this point. The graph above illustrates this
effect, and also two of the exceptions— Korea and Taiwan. In both these cases, policies were
adapted to promote rather than impede the microeconomic structural transformation. Similar
exceptions are the city-states Singapore and Hong Kong (before its formal reconnection with the
PRC). Though not shown on the graph, Japan also maintained high growth through the middle-
income transition. In talking about structural change earlier, I spoke about my trip to Korea as it
was entering the middle-income transition. There was universal concern about the loss of growth
momentum. High-quality, labor-intensive manufacturing was migrating to lower-cost countries
like China. Jobs and industries were threatened. The press framed the issue in terms of what was
needed to protect the competitiveness of the declining industries and their employment. This was
perfectly natural. What was more unusual is that the government saw that the structural
transformation was inevitable if incomes were going to continue to rise. It therefore dramatically
shifted the focus of policy and public-sector investment away from targeting labor-intensive
export sectors and toward education, applied research, and attracting talent back from abroad. It
withdrew from much of its earlier industry-level planning and support and turned the dynamics
over much more to the private sector. Korean companies, stalwarts of the low-cost
manufacturing era, invested in developing global brands. They became powerhouses in research.
Samsung, a manufacturer of household appliances, astonished Western observers by announcing
its intention to develop and make semiconductor memory chips. This was viewed as lunacy in
the West. But ten years after the announcement, Samsung produced the first working 256-
megabit memory device, a major milestone in the semiconductor industry. The external skeptics
have quieted down. As you can see from the graph shown here, South Korea continued to grow
and is now very close to advanced-country income levels. What is not visible in the graph is that
it is a very different economy than it was twenty-five years ago. It may be the most advanced
country in the world in terms of broadband Internet connectivity and use, for example. What
happens in the middle-income transition is a combination of positive and negative forces. As
incomes rise, labor-intensive processing industries with relatively low value added become
internationally uncompetitive relative to other countries in a less advanced state. They are
replaced by higher-value-added industries and functions within industries, both upstream in the
value-added chain in product development and more capital-intensive parts of manufacturing,
and in the downstream part with marketing, global reach, and brand building. Service industries
grow in size and employment to serve a growing and shifting pattern of domestic demand as the
middle class grows in size and consumption. The new emerging economy is more capital-,
human capital–, and knowledge-intensive. The pattern of importing knowledge and technology
starts to shift from importing technology to developing and exporting it, part of the journey to
advanced-country status. The key inputs to this process are education, investment in research,
and urbanization. The government stops targeting specific labor-intensive and export-oriented
sectors for development. It stands back to let the market forces take over. It becomes less hands-
on at the microeconomic level. This transition is more than a little scary and requires a leap of
faith. What is disappearing is highly visible, while what is hoped will appear is much less so.

There is also a structural change on the demand side in the middle-income transition. At about
this point, a middle class appears and grows. With higher incomes, they buy more, and they buy
different things, more closely matched to the production side of the economy. Therefore, an
important part of the supply side of the economy grows and shifts its focus to domestic demand.
Exports also shift to high-value-added activity and continue to be a driver of growth. But the
domestic market, with its rising incomes, starts to assume a more prominent role in determining
the structural evolution and patterns of growth of the economy. In short, more growth is
traceable to the domestic-economy demand than is true at earlier stages. The more advanced
parts of the complex Chinese economy are now at the middle-income transition stage,
particularly in the wealthier coastal areas. The critical question for the future of the country and
the global economy is whether the mandatory economic restructuring that has characterized the
past thirty years of sustained high growth will continue and shift in a way that supports the
microeconomic evolution of the economy. Without it, growth will begin to slow. Thus far,
China’s economy and its policy makers have been flexible and have accommodated the
structural change. Indeed, policy makers in China appear to understand very well that continued
growth requires more rapid structural transformation. But there is some dissent. As profit
margins shrink in the labor-intensive manufacturing sector, pressure builds to protect the known
source of employment growth, the pattern that worked so well in the past. I will come back to
China’s structural challenges in Part IV, when I discuss the prospects for sustaining