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Economy

Time to talk about the high income trap

     The middle income trap is a disease that has afflicted a number of developing economies over the years. After breakneck economic expansion, growth suddenly begins to stagnate when per capita income reaches a level the World Bank defines as middle income -- on average $6,900. As old economic drivers, like the development of light manufacturing or commodity exports, become exhausted, they need to be replaced by new ones. Policy paralysis, however, often prevents the adjustments needed to propel the economy to the next level.

     Some economies in Latin America are often cited as prime examples. Brazil, for instance, grew as rapidly in the late 1950s and 1960s as some of the Asian tiger economies; but its expansion subsequently fizzled. In Mexico, per capita income peaked in the early 1980s, taking over two decades to recoup lost ground. By contrast, South Korea, Taiwan, Hong Kong and Singapore have gone through similar growth shocks over the years, but quickly bounced back to attain high income status.

     An even more dramatic picture emerges when we compare per capita incomes with that in the U.S. In 1982, Mexico's average income reached nearly 45% of that across the northern border. Today, the share is a mere 30%. Per capita income in Brazil is 23% of that in the U.S., up just a couple of percentage points since the 1970s. Meanwhile, in Singapore and Hong Kong -- admittedly more manageable economies given their small sizes -- per capita income now comfortably exceeds that in the U.S. Taiwan (80%) and South Korea (nearly 70%) have also delivered impressive achievements over the years.     

     The debate -- much of it in academic circles -- centers on whether some less-developed Asian economies might experience a similar growth jolt as their incomes climb into the middle range. Malaysia -- close to graduating to the top bracket -- and Thailand are facing structural challenges that, if not properly addressed, will curtail growth in the coming years. China, too, has reached the critical threshold, although fears that it might fall into the middle income trap appear overdone. Other economies, from the Philippines to Vietnam and Indonesia to India, should still have many years of catch-up growth left before facing the middle income hurdle.

Affluent, but in limbo

What is missing in the discussion, however, is the risk of a high income trap. Similar to Brazil and Mexico over past decades, a number of rich economies have recently seen their per capita incomes stall relative to the U.S. This might seem like a nice problem to have: Once the broad development goals have been achieved, why worry about being stuck in relative affluence? We will return to the question in a moment. Suffice it to say that a high income trap is as much a risk as being stuck in middle income.

     Japan serves as a poster child. Per capita income in the country has essentially not changed over the past 20 years. It is easy to regard Japan as different, mired in its unique problems, ranging from changing demographics to deflation. But that would be a mistake. The malaise gripping Japan may well come to afflict others in the region that have attained high income status. Further afield, economies such as Italy and, to a limited degree, France have encountered similar challenges, with their per capita income barely rising since the turn of the millennium, though not in quite as spectacular fashion as Japan.

     To gauge the risks of others falling into a high income trap, it is worth taking a look at Japan. The parallels of the country's boom to others in the region are only too obvious -- an export-led surge in manufacturing. Of greater interest is what came thereafter. The property bust in the early 1990s was addressed through unprecedented monetary and fiscal easing, with little focus on restructuring an overextended financial sector and giant companies that hampered competition, especially in services. A sharp demographic turn, with the labor force shrinking since 1997, added to the challenges.

     Over time, policy paralysis started to set in and economic stagnation became a way of life. In the early 2000s, the administration of Junichiro Koizumi bravely tried to tackle some of Japan's most pressing problems, such as getting banks to finally begin repairing their balance sheets. But far-reaching changes ultimately stalled. For example, the country's dismal growth performance is often blamed on demographics. But rather than serve as an excuse for inaction, this should have spurred labor market liberalization to release workers from Japan's excessively staffed companies. Also, why is it only now that policies are being put into place to encourage greater participation of women in the workforce?

     The temptation in Japan, as elsewhere, is to delay the tough choices and rely on monetary and fiscal easing to tide the economy over until better days arrive. This is not always a result of vested interests prodding politicians to make decisions that are ultimately inimical to a country's long-term interests. Complacency can also play a role: The electorate at large may not feel the urgency of required action, preferring to stick with the status quo, even if this becomes unsustainable over time. This is where decisive political leadership is required, something that is even harder to deliver when progress grinds to a halt and the economic pie stops expanding.

Japan not alone

What, then, of others in Asia? In South Korea, Taiwan, Singapore and Hong Kong, populations are starting to age rapidly, even if the latter two have more room to replenish their pool of workers through immigration. South Korea and Taiwan also remain driven by manufacturing exports, where outsized gains may be harder to sustain. Singapore and Hong Kong, by contrast, have largely managed to shift to services. What they all have in common with Japan, however, is a sharp buildup in private leverage and a vibrant real estate sector. Here, a slump could expose similar problems that Japan once faced.

     In the end, however, it is not whether imbalances exist that could lead economies to stumble. These invariably emerge over time. The real question is whether reforms are put into place to address vulnerabilities. At heart, therefore, the high income trap -- just like its middle income counterpart -- reflects policy paralysis. While development is never assured, neither is stagnation inevitable. Monetary and fiscal easing only help to address cyclical downturns. Structural growth problems require far-reaching reforms that nurture new sources of growth. These, admittedly, get harder to identify once countries climb up the income ladder. And it is best to begin the work before stagnation sets in.

     Singapore has perhaps made the greatest progress in this regard, even if much remains to be done. The government is, for example, actively encouraging faster productivity growth through various fiscal incentives, such as tax breaks on employee training. The exact recipe differs from one economy to the next, but services -- outside of finance and real estate -- will have to play a critical role in driving growth everywhere. This may require pruning privileges of local companies in some economies and exposing them to greater foreign competition. Leverage, too, cannot serve as a lasting driver of growth. Whether governments can move nimbly and avoid the mistakes that Japan made will determine whether they can steer clear of the high income trap themselves.

     Why does any of this matter? After all, as any visitor to Japan can attest, the majority of the population continues to live in respectable affluence. For one, challenges have begun to emerge at the fringes of society, such as among the elderly and in rural areas. More broadly, it is only thanks to a giant buildup in government debt and extraordinary easing measures by the Bank of Japan that the economy putters along. These strategies, however, are not sustainable and, as a result, continued prosperity is hardly assured. As other economies in Asia push into higher income brackets, they will do well to heed the lesson of inaction. Japan, after all, is not that different.

Frederic Neumann is co-head of Asian economic research at HSBC.

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