The middle-income trap

The Economist Blog
Apr 5th 2011

AS A brief follow-up to this morning's post on Chinese wage growth, let me draw your attention to a new working paper by Barry Eichengreen, Donghyun Park, and Kwanho Shin. Here's the abstract:

Using international data starting in 1957, we construct a sample of cases where fast-growing economies slow down. The evidence suggests that rapidly growing economies slow down significantly, in the sense that the growth rate downshifts by at least 2 percentage points, when their per capita incomes reach around $17,000 US in year-2005 constant international prices, a level that China should achieve by or soon after 2015. Among our more provocative findings is that growth slowdowns are more likely in countries that maintain undervalued real exchange rates.

The reason for the slowdown?

Growth slowdowns, in a nutshell, are productivity growth slowdowns...85 per cent of the slowdown in the rate of growth of output is explained by the slowdown in the rate of TFP growth...The intuition for this is straightforward. Slowdowns coincide with the point in the growth process where it is no longer possible to boost productivity by shifting additional workers from agriculture to industry and where the gains from importing foreign technology diminish. But the sharpness and extent of the fall in TFP growth from unusually high levels of 3-plus per cent to virtually zero is striking.

So at around $17,000 per capita output, countries run into two constraints. First, the sectoral shift from agriculture to industry has nearly run its course and a larger portion of the population is working in the slower-productivity-growth service sector. And second, the scope for rapid catch-up growth due to adoption of technology is limited by the fact that the economy is now much closer to the technology frontier.

Why should an undervalued currency make a slowdown more likely?

It may be that countries that rely on undervalued exchange rates to boost economic growth are more vulnerable to external shocks resulting in sustained slowdowns. It may be that real undervaluation works as a mechanism for boosting growth during the early stages of development when a country relies on shifting labor from agriculture to export-oriented manufacturing but not in subsequent stages when growth becomes more innovation intensive, but governments are reluctant to abandon the earlier policy strategy, leaving the economy increasingly susceptible to slowing down. It could be that real undervaluation allows imbalances and excesses in export-oriented manufacturing build up, as in Korea in the 1990s, through that channel making a sustained deterioration in subsequent growth performance more likely.

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http://www.economist.com/blogs/freeexchange