Sri Lanka’s Middle-Income Transition: Thinking Beyond the “Optics”, to the “Mechanics”

‘The middle-income transition’ – a challenge that dozens of countries are grappling with and, as of late, is increasingly being spoken about in Sri Lanka as well. A recent business forum (by LBR-LBO) was one of the first private sector forums to initiate a discussion on this in the country, and this article captures some thoughts that were presented in my opening presentation. This article takes an initial look at what this “middle income transition” (or “middle-income trap” as sometimes referred to) means and puts forward some ideas drawn from the increasing body of literature on the subject. It explores what factors contribute to economies ending up in this “trap” as well as some of the ingredients that help get out of it. It does not particularly put forward any policy prescriptions for Sri Lanka but in exploring the ideas drawn from that literature, a reader will notice that there is a lot of resonance with Sri Lanka, Sri Lanka’s current context and the challenges it faces.


Middle-Income Transition: Why Does Growth Slow?


In the post-world war era, the 1950s onwards, many economies managed to rapidly reach middle-income status but few went on to become high-income. A very comprehensive study led by the World Bank estimated that out of 101 middle-income countries in 1960, only 13 had graduated to high-income status by 2008. It is argued that this was essentially due to a slowdown in productivity growth, and therefore getting out of that situation also depended on productivity growth. The estimates showed that around 85% of the slowdown in output experienced by those countries was explained by a slowdown of growth in Total Factor Productivity (TFP), and not merely a slowdown in returns to physical capital.


Why does this slowdown occur? We have what economists call a ‘Lewis-type development model’. It simply means that factors and advantages of a country which had helped to generate high growth during the initial phases of rapid development disappear when middle- and upper-middle income levels are reached. For instance, cost advantages in manufacturing that once drove high growth rates start to decline. The economy gets squeezed between low-wage producers on the one hand and high-skilled fast-moving innovators on the other. So, economies in this transition or trap get squeezed between these two and do not have the critical ingredients to edge out of it. Relate this to Sri Lanka – low wage economies like Bangladesh or Vietnam squeezing from one end and another like Malaysia, which is more innovation-driven, squeezing from the other. In such a situation what becomes critical for an economy is to be able to unleash new sources of growth to maintain a sustained increase in per capita income – not just 8% over 2 years but 8% plus over a much longer period.


Busy streets of downtown Seoul. South Korea was one of the handful of countries that succesfully breached middle-income and became a developed country in a relatively short period of time. (Photo: Anushka Wijesinha, 2013)

A busy street in downtown Seoul. South Korea was one of the handful of countries that succesfully breached middle-income and became a developed country in a relatively short period of time. (Photo: Anushka Wijesinha, 2013)


Middle-Income Transition: The “Optics”


The “optics” of this challenge refers to what we see in the headlines, the pronouncements and the press releases – by a Central Bank of a country or by donors – who announce that a country has reached or breached a certain GNI per capita threshold. The “optics” certainly do matter and provide a powerful signal domestically and internationally. Yet, it is first important to understand what this entails and ask the question – “what are these thresholds of lower-income, middle-income, and high-income?”. Different institutions have different ways of looking at it. The leading indicator many refer to is composed by the World Bank using the World Bank Atlas Method. Table 1 indicates at which GNI per capita income levels that the transitions happen. But you will notice some differences, for instance, between the ADB and World Bank’s classifications. You will also notice that each year the World Bank would revise the thresholds, in keeping with global price levels. So for instance, if a country’s economic authorities announce in 2010/11 that the economy is going to reach middle-income status and go beyond the US$ 3,975 per capita to become upper middle-income, in two years time that goal-post will shift because the threshold to breach lower middle-income to upper middle-income has been revised. So in Sri Lanka, for instance, as it stands now we have to breach US$ 4,085 to reach upper middle-income, not US$ 3,975 that we thought of before.


Table 1



Organizations like the ADB Institute (ADBI) analyze from the perspective of the number of years that a country is in middle income. Beyond a certain threshold numbers of years in that group, and an economy is said to be in a trap. It is very relative and historic. For example, it could be that country A is in a middle income trap today, if A has been in that group longer than the historical experience of a set of countries. According to the ADBI literature, a country is in a lower middle-income trap if it has been in that category/group for 28 years and in the upper middle-income trap if it has been in that group for 14 years. Going by this, Sri Lanka should only worry about being stuck in the middle income category/group if it is still there in 2053!


So, codifying the “trap” is not easy and can be contentious. This is probably why Nobel Prize winning economist Michael Spence prefers to call it “the middle income transition” rather than focus on the specific thresholds of a “trap”. His idea of a middle income transition refers to “that part of the growth process when a country’s per capita income gets into the range of US$ 5,000-10,000”.


Meanwhile, the IMF looks at the classification slightly differently – it is based on a set of criteria. In January 2010, Sri Lanka was graduated by the IMF out of what it calls the ‘Poverty Reduction and Growth Trust’ set of countries – essentially the low income category – into “middle income emerging market” status. In Sri Lanka’s reclassification, the IMF indicated the combination of factors it considered – firstly, the World Bank’s classification, but also whether there has been no declining trend in GNI per capita over the previous 5 years, whether the country can access international debt capital markets, and whether the country faces serious short-term vulnerabilities on the macro front.


Middle-Income Transition: The “Mechanics”



As has become evident from the preceding discussion above, the definitions of middle-income (the “optics” of the thresholds, etc.) are clearly in debate. Even if one really thinks of the development process, it is a continuum rather than an event that takes place in discrete “jumps” through thresholds. Therefore, the argument being made here is that we should not get too preoccupied with the “optics”, but rather focus on the “mechanics” of dealing with the challenges that arise. The question to focus on is – “what are the drivers of sustained high growth?”.


Reviewing the literature on the international experience of middle income transitions reveal the answers to this question – the “mechanics” of the middle-income transition challenge. The three key factors that determined the trajectory of countries that did or didn’t breach the lower to upper middle income or upper middle to high income categories can be put down as: 1) better talent, 2) better products, and 3) better institutions.


The “Mechanics”: Better Talent


As the middle income transition involves losing initial labour cost advantages, a country needs to go beyond. Better talent would mean higher productivity of labour – not just getting workers to work more but ensuring that those workers are getting better at what they do. Striving for higher productivity of labour is especially important for a country like Sri Lanka whose demographic dividend is waning. Basic skills are adequate in a country’s labour force if it is in the business of producing final goods – basic or light manufacturing. But in the middle income transition what matters is to shift from this to advanced skills and innovation- and knowledge-driven activities like design. In Sri Lanka’s apparel industry, companies like Brandix, MAS and Hirdaramani can attest to this. Better talent would mean a stronger focus on higher education and training. When you look at countries like South Korea, Taiwan, Singapore and others that breached the middle income trap, these were key pillars of their success.


The “Mechanics”: Better Products



The second element of ‘better products’ refer to producing innovation-driven products that are globally competitive and not easily imitated. It requires a combined focus on of Information Communication Technologies (ICTs) and Research and Development (R&D). When looking at countries in East Asia that successfully breached the middle income trap, they moved from ‘importing and imitating’ to innovating technologies of their own. A major part of this came from investment in what is called ‘advanced infrastructure’ like high-speed broadband and satellite connectivity, beyond the connective infrastructure like ports, roads, and railways. Governments in these countries also focused on investment in R&D through a combination of investment directly in national R&D centres and fiscal incentives like tax breaks to stimulate innovation. Another element was strong Intellectual Property (IP) protection. During the middle income transition of East Asian economies, IP protection helped stimulate a lot of local innovation and even generate patents at the same rate as advanced economies.


The “Mechanics”: Better Institutions


The third element is ‘better institutions’. Some argue that in the early stages of development sophisticated institutions are not necessary. Policy formulation would be fairly simple; the development trajectory is less complex and more linear as the country develops steadily beyond being agriculture-based. But for sustained growth towards high income, a country needs to move beyond ‘crude institutions’ as they are no longer fit-for-purpose. In his work on how institutions matter for growth, Dani Rodrik notes that these new institutions – ‘high quality institutions’ – are required for high quality growth. Often, people assume that countries in East Asia, with strong state roles in the economy skipped through this process or decided to ignore them. But even countries like South Korea, Taiwan, Hong Kong and Singapore did battle the institutional challenges, overcame strong political and bureaucratic forces to unleash new waves of dynamism. We may think that concepts like ‘good governance’ and ‘better dialogue between government and business’ are just cosmetic ‘feel good’ factors, but as has been very clearly shown in countries that breached the middle income transition, these ideals mattered greatly to their core economic performance, especially in realizing the potential of their private sectors.


A Known Recipe: Time for Everyone to Focus


We must bear in mind that middle income challenges do not manifest overnight and do not come by surprise. Looking at what countries like Korea did 15 years before they became high-income provide instructive lessons. But the recipe to tackle the challenge is not really an enigma. Many forums that are being held in Colombo have argued along similar lines. What is the recipe? Invest in higher levels of human capital, invest in advanced infrastructure, innovation and R&D, build institutions that promote dynamism and help unleash private sector potential not institutions that promote political capture and stagnation. In fact, IPS’s latest Sri Lanka: State of the Economy 2013 report – themed ‘The Transition to Middle-Income Economy’ – emphasizes many of the very same issues.


While the recipe may be clear, getting there requires work and focus. As is clear from other countries, it requires a long-term view of economic strategy. A strategy that keeps evolving as needs change and as we learn what is working and what is not. All of us must look at the 88 (out of 101) countries that hadn’t been able to breach middle-income status as well as look at the experience of the 13 countries that did make it, to distill the key lessons. This is not just a task for a government, but rather all of us. We must all look beyond the “optics” of being a middle income economy – the headline numbers and target thresholds – and focus on the mechanics of getting there.


The article is based on the author’s presentation at the 14th LBR-LBO CFO Forum on ‘Middle-Income Economy Challenges’. IPS Project Intern Thamali Ranasinghe assisted in preparing this article.


The latest edition of the IPS State of the Economy 2013 report is available for purchase at IPS and all leading bookstores.