Escaping the middle-income trap

by Michael Schuman | Time
August 10, 2010

I returned a few days ago from Kuala Lumpur, the capital of Malaysia, where the talk of the town – well, at least among economists — is the “middle-income trap.” What’s that, you ask? A developing nation gets “trapped” when it reaches a certain, relatively comfortable level of income but can’t seem to take that next big jump into the true big leagues of the world economy, with per capita wealth to match. Every go-go economy in Asia has confronted this “trap,” or is dealing with it now. Breaking out of it, however, is extremely difficult. The reason is that escaping the “trap” requires an entire overhaul of the economic growth model most often used by emerging economies.

Malaysia’s caught in the “trap” right now, and getting out if is going to be tough. Simply put, Malaysia needs to change what it has been doing economically for the past 40 years. How Malaysia got itself into the “trap,” and how it could escape from it, can provide us with some valuable lessons on development and, more specifically, how developing nations can graduate into becoming fully advanced economies.

The concept behind the “middle-income trap” is quite simple: It’s easier to rise from a low-income to a middle-income economy than it is to jump from a middle-income to a high-income economy. That’s because when you’re really poor, you can use your poverty to your advantage. Cheap wages makes a low-income economy competitive in labor-intensive manufacturing (apparel, shoes and toys, for example). Factories sprout up, creating jobs and increasing incomes. Every rapid-growth economy in Asia jumpstarted its famed gains in human welfare in this way, including Malaysia.

However, that growth model eventually runs out of steam. As incomes increase, so do costs, undermining the competitiveness of the old, low-tech manufacturing industries. Countries (like Malaysia) then move “up the value chain,” into exports of more technologically advanced products, like electronics. But even that’s not enough to avoid the “trap.” To get to that next level – that high-income level – an economy needs to do more than just make stuff by throwing people and money into factories. The economy has to innovate and use labor and capital more productively. That requires an entirely different way of doing business. Instead of just assembling products designed by others, with imported technology, companies must invest more heavily in R&D on their own and employ highly educated and skilled workers to turn those investments into new products and profits. It is a very, very hard shift to achieve. Thus the “trap.”

South Korea is probably the best current example of a developing economy making the leap into the realm of the most advanced. Companies like Samsung and LG are becoming true leaders in their fields. Taiwan isn’t far behind. China’s policymakers are fully aware that, with labor costs rising, it needs to follow suit. (More on See a stimulus report card at the one year mark)

Malaysia, though, is quite far from where it wants to be. That’s a bit surprising based on its remarkable recent history. Malaysia has been among the best performing economies in the world since World War II, one of only 13 to record an average growth rate of 7% over at least a 25-year period. The country has an amazing record of improving human welfare. In 1970, some 50% of Malaysians lived in absolute poverty; now less than 4% do. Yet Malaysians also feel that they’ve become somewhat stuck where they are. GDP growth has slowed up, from an annual average of 9.1% between 1990 and 1997 to 5.5% from 2000 and 2008. Meanwhile, other Asian economies have zipped by Malaysia. According to the World Bank, the per capita gross national income (GNI) of South Korea in 1970 was below that of Malaysia ($260 versus $380), but by 2009, South Korea’s was three times larger than Malaysia’s ($21,530 versus $6,760). Malaysia is getting “trapped” as a relatively prosperous but still middle-income nation.

Can Malaysia escape? The initial indications are not encouraging. The economy’s growth engine remains unchanged – export-oriented manufacturing backed by foreign investment. Its companies are just not innovating or adding much value to what they produce. You can find all of the ugly details in a very thorough study by the World Bank, released in April. Private investment has sunk precipitously, from more than a third of GDP in the mid-1990s to only some 10% today. Labor productivity is growing more slowly than in the 1990s. The “value-added” in manufacturing in Malaysia trails many of its neighbors – an indication that Malaysian factories are mainly assembling goods designed elsewhere. R&D spending remains frighteningly low, at about 0.6% of GDP (compared to 3.5% in South Korea). If Malaysia is going to break the “trap,” it has to reverse all of these trends.

How can Malaysia achieve that? The World Bank report has pages of recommendations. The basics include slicing apart the bureaucratic red tape that stifles competition and suppresses investment, bolstering the education system so it can churn out more top-notch graduates, and funneling more financial resources to start-ups and other potentially innovative firms. To its credit, the government of Malaysia is fully aware of what it needs to do. In March, Prime Minister Najib Razak introduced a reform program called the New Economic Model. You can read the initial report here. The NEM shows that Najib realizes that excessive government interference in the economy is dampening investor sentiment and holding back Malaysian industry. All eyes now are waiting for the more detailed policy recommendations for the NEM (though it is not clear when those might appear).

Yet I’m wondering if getting policy right is really enough. Of course, it would help, by setting in place better incentives for private businessmen to invest in innovative projects, and creating the tools they need to make those projects work. But I don’t think that’s the whole story. I’ve been musing on the differences between South Korea and Malaysia. Why has Korea jumped so far ahead? I think the reason is embedded in the different methods the two countries used to spur rapid growth.

Both countries relied exports to create rapid gains in income, but they did so differently. South Korea, from its earliest days of export-led development in the mid-1960s, had been determined to create homegrown, internationally competitive industries. Though Korean firms supplied big multinationals with components or even entire products, that was never enough – Korea wanted to manufacture its own products under its own brands. The effort was often a painful one – remember Hyundai’s first disastrous foray into the U.S. car market in the late 1980s and early 1990s – but Korea is where it is today because its private companies have been working on getting there for a very long time, backed in full by the financial sector and the government.

Malaysia, on the other hand, relied much, much more on foreign investment to drive industrialization. That’s not a bad thing – multinational companies provide an instant shot of capital, jobs, expertise and technology into a poor country. MNCs, however, aren’t going to develop Malaysian products; that has to take place in the labs and offices of Malaysia’s private businesses. But those businessmen have been content to squeeze profits from serving MNCs and maintaining their original, assembly-based business models.

In other words, what is needed for Malaysia to break from the “middle-income trap” is a greater national commitment to innovate on its own. Entrepreneurs and bankers have to be willing to take more risks to support inventive ventures and new technologies. Talented workers have to be willing to take jobs at home instead of Silicon Valley. The Malaysian private sector has to be more devoted to the country’s future. This is fuzzy stuff, outside of the realm of usual economics. But I fear the kind of commitment needed to escape the “trap” unfortunately can’t be created by government initiatives alone.

  1. #1 by ChinNA on Thursday, 12 August 2010 - 11:53 am

    Good point on the differences. That is the answer I have been looking for and it makes sense to me.

  2. #2 by HJ Angus on Thursday, 12 August 2010 - 12:24 pm

    The basic reason for the failure is that Korea does not have the NEP that was supposed to have ended 20 years ago.
    Instead rich Bumis here are not even prepared to give up their discount for luxury homes and people like Tony Pua even get a mailed bullet for voicing out a fairer policy.
    Unless Malaysians are prepared to vote out the Bankrupsi Negara regime, our economy is going nowhere but downwards.

  3. #3 by dagen on Thursday, 12 August 2010 - 12:28 pm

    Obviously the Schuman knows nothing about the RAMBUTAN TREE ECONOMIC PRINCIPLES.

    Principle XCVCXII says if you want jump, squat first. So in 2019, we will squat and come 2020 we will jump high.

    Confused Mr Schuman? Damned that mat salleh. He is good for nothing. Hoi Tun Tan Sri Dato Seri Dato Dr Prof Apapunboleh bin Similan(deleted)punok, explain the concept to him pls. in “RAMBUTAN TREE ECONOMIC PRINCIPLES FOR FOOLS” terms ok.

  4. #4 by Bigjoe on Thursday, 12 August 2010 - 12:56 pm

    Make our own tech products with the kind of labour force we have? You must be kidding.

  5. #5 by lkt-56 on Thursday, 12 August 2010 - 12:57 pm

    In short we need to inspire confidence of the local businessmen so that they feel comfortable to invest their capital. We also need to make our young and talented that they are wanted and we treasure their abilities to contribute towards a better Malaysia. Only the government of the day has the tools to make this happen. Therefore stop the sloganeering and start working really, really hard!

  6. #6 by yhsiew on Thursday, 12 August 2010 - 12:58 pm

    In the 1980s and 1990s, the GDP per capita of Malaysia was at par with countries like Hungary and Poland. Twenty years later, these countries have already been elevated to high income nations, yet Malaysia is still struggling in the middle income trap. Surely there is something wrong with our economy.

    In the 1990s, an expert once predicted that if Malaysia continued to rely on manufacturing for its economic expansion, in the end its GDP per capita would not exceed US$5,000. He added that the country must also explore the service sector to improve its per capita income.

    Twenty years later, what the expert said had really come true. If we convert US$5,000 (twenty years ago) to today’s money, it would probably be at around US$7,700 after taking inflation into account.

    The government must seriously look at the service sector to see how it can bring more revenues to the country, after all, many developed countries have a very large service sector contributing to national income.

  7. #7 by k1980 on Thursday, 12 August 2010 - 1:07 pm


    Thought wawasan 2020 has been pushed forward to 2050 by Dollah. 30 more years to wallow in the mud while other countries surge ahead.

  8. #8 by cseng on Thursday, 12 August 2010 - 1:17 pm

    Don’t we have Proton to take on the word? If not, we still got this fat Sime Darby. Not to forget our Ace – Petronas.

    No problemo! We got wawasan 2020! Just wait few more years, we will be there. What needed is a ‘strong goment’, right? Mr. Mel_a_yu?

  9. #9 by raven77 on Thursday, 12 August 2010 - 1:40 pm

    Innovate???? IN UMNO land???

    The moment you innovate, invent or come up with an original project, all these fellas at MOF, JKR, PM’ s Department, will change the cover and hijack the project…so what for innovate here..

    Better innovate in UK, US, Ozzieland or Kiwi land where they are HONEST and DONT CHEAT..

    As long as BN is in power…Malaysia will remain a third world nation. No one in their right minds would develop or innovate anhything in Malaysia…

  10. #10 by cseng on Thursday, 12 August 2010 - 1:59 pm

    Let’s be proud! Be very proud!

    We got national car!, otherwise you could be driving Honda, Toyota and Mercedes. Look at Thailand’s automobile industry, what is the point try to be ‘Detroit of asia’ if you don’t have national car, right?

    We have race-based politic to get where we are today! otherwise you could have to struggle to compete with Korea, Singapore and Taiwan to stay on top. What for you scarify to lift standard of living for all?, without making yourself billionaires first, right?

    We got so many talents! We even ‘push’ them to help Singapore, Australia, NZ and other. Depending how you define talent? If you don’t vote BN, or b’coz of you, I could not make my billions thru political dominance (with the illusions of race supremacy and 30% policy) those are talents to dispense.

  11. #11 by boh-liao on Thursday, 12 August 2010 - 3:55 pm

    Many yers ago, MMK established Cyberjaya 2 b d Silicon Valley here
    Ppl really got excited n now we hv valleys with shapely lovelies with silicone
    At dat time, MMK forgot 2 introduce science in English
    Silicon, silicone in BM, sama mah, silly
    Meanwhile, Cyberjaya still waiting 2 transform in2 a Silicon Valley, must outsource lah

  12. #12 by dagen on Thursday, 12 August 2010 - 4:11 pm

    And dr mamak then actually went on a roadshow round the globe telling the world all about the malaysian miracle. OMG!

  13. #13 by Bunch of Suckers on Thursday, 12 August 2010 - 4:20 pm

    Don’t we have Proton to take on the word? If not, we still got this fat Sime Darby. Not to forget our Ace – Petronas.

    Our Proton is useless without any foreign demands! Its sales in foreign nations are marginally low, in fact, pushed out competitive markets globally. It’s not quality & price of the vehicles; it is probably due to our big mouth Mamathir….

    Couple of weeks ago, Sime Darby proclaimed a huge loss. Convincingly, it was due poor managements and intense corruption practices!

    Only our Petronas makes it marginally gains due to high petrol prices selling in the global markets. The profits have been sucking out by those BN/UMNO cronies and cohorts without much savings leaving behind!

    Our national Airline MAS is struggling in the commercial aviation markets competitively after reporting heaps of losses with recent changes in its minor managerial divisions!

    What else is profitable and that can take on any foreign competitors globally? Precisely and presumably NONE, nothing! Only our extraordinary “RAMBUTAN TREE ECONOMIC PRINCIPLES with 30% of shares, which imposed on any foreign investments, be owned by our sucky BN/UMNO government for transferring to those suckers squatting and dreaming under the Rambutan Trees, hoping to get rich without struggling and suffering.

  14. #14 by boh-liao on Thursday, 12 August 2010 - 4:41 pm

    We hv Proton, founded in 1983, d pride of M’sia n MMK

    China has Geely Automobile Holdings ???? which began manufacturing in 1986
    MMK must hv tot: Cars fr China, where got standard 1, compared 2 my Proton

    Ford said on 3.8.2010 it has completed d sale of Volvo Cars 2 Geely Holding Group 4 US $1.8 billion

  15. #15 by Jeffrey on Thursday, 12 August 2010 - 4:53 pm

    Time’s Michael Schuman knows his stuff. Although he omits mentioning the obvious elephant in the room – ie our race based NEP, the Rentier or Rent Seeking culture and few other ‘obvious’ things- his concluding statement here sums up all – “Talented workers have to be willing to take jobs at home instead of Silicon Valley”. Which is another way of asking what is there in Silicon Valley that is absent here or what is present here and absent in Silicon Valley? No point drawing a list : it will be too long. As Michael said “this is fuzzy stuff, outside of the realm of usual economics. But I fear the kind of commitment needed to escape the “trap” unfortunately can’t be created by government initiatives alone.”

    It is just about everything. Obviously human capital is key but in a Globalised World in which such skilled and knowledge based people can move, and are wanted everywhere, can we provide the kind of environment and policies to such people that competes as good if not better than other places to attract these people to come in or at least prevent them from leaving? Get real!

    It would take more than providing a few cosmopolitan places to hang out in Bangsar or Sri Hartamas where one could take booze and ogle at SWTs. Even then that’s KL : what about in Shah Alam or Cyber Jaya???

    It is the mindset fostered by values around. Is merit appreciated? Is promotion based on merit, skin colour or creed? But that’s not all. Take an average Malaysian with any brain and skill. If he does not migrate he’d probably try to horn his knowledge/skill – not for building and creating value in a certain product or service of which could be proud but how to make money fastest by the shortest route leveraging on connections and other advantages.

    The guy that falls under the “privileged group” and have privileged connections will leverage on these assets. – something, “hey you need me, I know the right ropes to the top to cut off the rest, besides national policy requires me to get a slice of the action; don’t worry about not having seed money, the banks can finance, if not bonds can be issued securitised against “letters of support”. Here this guy scours around for businesses and assets that others have built up. Just take over an orchard of full grown Rambutan tree and reap the ripe Rambutans. Orchard owners have to sell. With this licence and that restrictions and national policy and all that, the Orchard owner can’t develop and expand here, and he is soon persuaded to hand over his plot, take his money and go to other pastures – India, China or anywhere else where there’s comparative advantage.

    The guy outside the privileged group is also not that underprivileged since he knows members of the privileged group. He provides the know how, the plans the financing to structure the deal and to make the difference, skimming the profits once its packaged nicely for the flip either to another party or Bursa Malaysia.

    What’s the point of coming out with a unique idea and slog at it when one has to get this approval or that approval from this Ministry or that regulatory authority – and some official from that Ministry or regulatory authority leaks and gives your plans to his crony who makes the next application, approved, whilst yours just kept in cold storage if not an explicit rejection?

    Soon everyone learns that it pays to talk glib and bullsh*t eloquently about things (eg some IT or whatever field) that ‘sounds’ right and intelligent – even though one knows not too much about it- but just enough to get the numbers dressed up, and cultivating the right connections, commercialise and flip the idea for a quick profit. Who has time to wait and seep comfortable tea on a titanic that has hit iceberg?

    One can’t nurture value mindset and skills if everyone who is mobile is not given an assurance of a stable future and no sooner he too embraces a rent seeking, quick flip attitude in what he does and sells. I am generalizing of course, as in all discussions of such nature.

  16. #16 by tunglang on Thursday, 12 August 2010 - 6:26 pm

    The whole Malaysian System rots from education, to financing, to incentives, to licensing, to the day you die.

    Unless you are the smart, ‘hard working’ Bumi taking advantage of the advantages of NEP, you and I are just never going to make the leap in normal, controlled circumstances.

    Of course, some of us will just take the Ali Baba way out, but that too will create a crutch-relying mentality in the long run as there is absence of incentive to compete. Thus the venom of complacency spreads to those relying, enjoying the benefits and doing nothing but spoilt under the roting system, Bumis as well as non-Bumis with Ali Baba connections.

    We are now in the throes of big shake up of global realities, but will the leadership and the privileged group sincerely take the challenge to CHANGE for the better future of every Malaysian?

    Time is not on our side. Neither is our misconstrued pride and given privileges of by gone eras. Today is a globalised world of no boundaries for the strong and competitive, not for the day-dreaming Katak Di Bawah Tempurong in Bolehland!

  17. #17 by dagen on Thursday, 12 August 2010 - 6:39 pm

    Cheese, pizza, pasta and burgers were unknown to most people my age (and older) when they were of school going age. Nonetheless they have little problem migrating and assimilating to new environment. Kids today are quite quite used to such stuff. And they have facebook friends from all over. So speaking of mobility, these kids will in future be super mobile. And since I cant see umno supressing its vulgar desire to exhibit its ketuanan in public, I can certainly see the country losing most if not all its talents in the future. Even bright malay boys and girls would want to leave. Believe me. Is this how the Rahman legacy is going to materialise? End of the nation? At least pakatan is here. We have a choice. The possibility to change things for the better.

    Vote pakatan. Kick umno.

  18. #18 by Loh on Thursday, 12 August 2010 - 8:42 pm

    I am happy that it is confirmed that NEP causes this country to be in low income trap. But the majority of those who suffer the low income inconveniences thought that it is worthwhile to feel proud that some Muslims who claimed to be Malays are fabulously rich; Mamahthir’s family might be richer than Li Ka Seng, if Thaksin’s type of having his drivers and maids holding the wealth in trust are properly accounted. They do not realize that the vanity causes them to be poor in order that UMNOputras are rich. Somehow Mamakthir’s was able to imprint in Malays mindset that the collective ownership of Malays equity share in the corporate sector is equivalent to Malays having automatically a share in them. The billions in Mamathir’s account for are only for his family, and Mamakthir has not said that he is about to distribute his wealth to Malays. Malays keep producing huge families and the poor are hoping that their children would become UMNOputras. For them corruption through NEP has to be preserved to keep their hope burning.

    The indigenous Malays might still be able to enjoy government handouts in the name of helping the poor without resorting to NEP for as long as they needed Tongkat if the UMNOputras are not given the convenience of NEP to plunder the land, and if Mamakthir has not invited some three million Muslims to become NEWMalays and to share what ought to be enjoyed by indigenous low income citizens. Mamakthir had wasted billions of Petronas funds in addition to putting some into private purse, and UMNOputras have made this country close to bankrupt. The status of Malaysia at the brink of bankruptcy was declared by a cabinet minister. That Mamakthir was able to destroy the country was supported by three million UMNO members for 22 years. When UMNO Malays could be so easily fooled, there is nothing 40% non-Malays could do to help.

    Over the past 40 years, more than two million Malaysians who refused to be discriminated have left. More are leaving. It is nice to know that NEP causes so much trouble to condemn the majority race to low income status. That is justice.

  19. #19 by limkamput on Thursday, 12 August 2010 - 9:56 pm

    Hello, pseudo economists, middle or high income is the result of right economic policies consistently and prudently applied over time. You can’t wish for high income from middle income. There is no prescription off the shelf. How may time do I have to tell you fellows.

  20. #20 by waterfrontcoolie on Thursday, 12 August 2010 - 11:57 pm

    Proton has proven TDM had failed to create the platform based on RACE to leap forward. Proton was meant to prove KAMI BOLEH!But with all the artificially created economic advantages given to it. It naturally failed miserably. what does it prove? To compete in the international scenario, you can’t depend on Jaguh Kampong!! No matter what colour of his skin, he must be taken based on his brain. Even Honda or BYD [in China] employed the Italians to design their cars. Geely [ as noted above] turned into a huge company because it dares to take the quantum leap. Proton has been hiding behind the skirt of the Gomen to make profit; how would it compete outside Malaysia? toady Thailand exported over 1.5 million units annually. What’s Proton’s? After nearly 30 years of hiding behind APs and high duty, Proton has failed to compete; would it survive if under WTO , we have to iopen up our market? My prediction is, we will end up competing with Cambodia in ASEAN within the next 10 years!

  21. #21 by monsterball on Friday, 13 August 2010 - 5:31 am

    Clean….Efficient…Trustworthy…was Mahathir’ slogan.
    If he can live with that for 22 years as a PM who lies and steal Malaysians savings{EPF} by the billions…this man has no conscience nor dignity.
    All he projected with his nose held high up…is successfully recruited a band of robbers and thieves to continue his mission to buy up the country.
    Tunku Abdul Rahman or Mahathir….Muslims must clearly choose.
    Father of Independence or Father of all Crooks?
    Do not be like him…answering..”I FORGOT”….14 times…questioned by Royal Commissioners consisting of 3 respected retired Judges..within 1/2 Lingam case.
    All 3 recommended Mahathir should be arrested…nothing done…all forgotten.
    For part of that… UMNO B planned to oust Pak Lah to save Mahathir.
    Corrupted to core it is….UMNO B party.

  22. #22 by monsterball on Friday, 13 August 2010 - 6:13 am

    Dirty…inefficient and cannot be trusted are Mahathir’s legacy to UMNO B…with his to divide and rule …race and religion dirty politics.
    “I Malaysia” ‘People First.Performance Now” totally bunkum from the start.. when UMNO B is a racist party..and the performances are all double standards.
    Mahathir’s legacy.. is too deeply rooted.
    If Najib really mean what he says..he should put Mahathir in jail…as his first duty as PM…and declare 13th GE..and he would get at least 99% voters support.
    No.. .this is a band of robbers and thieves…all have strings of crooked reputations that must protect each other or all will be arrested….sooner or later.
    Pak Lah”s “I am People’s PM”…and so he was..sadly.. with no balls…talking alot…totally irresponsible..and quite stupid too.
    Add all have more than 30 years being cheated and bluffed by UMNO B crooks.
    Are UMNO B members really that stupid…and cannot see..these crooks do cheat all Malaysians…including their EPF money and their natural wealth from oil?
    Giving some back to selected Malays loyal to UMNO B. Are all these Muslims.. your relations?
    How can UMNO B have so many half past sixes members that cannot understand simple explanations?
    Oh I see….UMNO B guys are told they own the country and all others are tenants by Mahathir and they believe that?
    If so…why need Malays PERKASA?
    You need no defend your rights from MINORITIES?
    But the fact is the so call minorities is now a vast majority of all races including Muslims against UMNO B members…..making Najib keep thinking how to stay as the little napoleons be officially elected as PM.
    He will never be ELECTED by the people… as our PM.
    He knows that too well.

  23. #23 by dagen on Friday, 13 August 2010 - 8:28 am

    Heard that stupid aman damai song aired over a chinese radio station this morning. Oh boy. That is so umno. So last centuary. Replaying old records. In the middle of raps and hip hops and pop songs you suddenly get a revolting piece of aman damai, the creation of RTM. I just went “WTF was that?”

    Aman damai could better be achieved if RTM had some malay boys and girls singing some lee home’s songs or bad boy gary chow’s pieces. Certainly not that super yucky rtm aman damai whatever!

  24. #24 by tsn on Friday, 13 August 2010 - 10:23 am

    Human stock quality at works.

    Right economic policies, good implementation of policies all are by creature so call “human”.

    China economy is speeding at Ferrari speed.

  25. #25 by PoliticoKat on Friday, 13 August 2010 - 11:46 am

    “Entrepreneurs and bankers have to be willing to take more risks to support inventive ventures and new technologies. ”

    We do take risk and we do innovate. Just look at New Zealand. We have a Malaysian, a Prof Swee Tan, who has discovered a new way avenue to treat cancer. We just don’t do any of it Malaysia

    “Talented workers have to be willing to take jobs at home instead of Silicon Valley.”

    A delicate way to phrase it… given the work environment, you will need to club them on the head and drag them “home”.

  26. #26 by johnnypok on Saturday, 14 August 2010 - 2:57 am

    The single most destructive factor is NEP
    Parents of bumis tell their children “Don’t worry about your future”
    Non-bumis constantly remind their children to study hard, work hard, save money, and DON’T EXPECT THE GOVERNMENT TO HELP YOU.
    5 generations down the road, the “malas” bumis become EXTINCT

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