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Institutions key to sidestepping middle-income trap

GUO JINXING | 2019-08-01
(Chinese Social Sciences Today)
As the Chinese economy has slowed down from high gear to medium-high rates, academics at home and abroad have been wondering whether the country can avoid the middle-income trap. Photo: CHINA DAILY

During the more than half a century after World War II, many countries in Latin America and Southeast Asia grew rapidly for a period of time, but they then began stagnating at middle-income levels, failing to graduate into the ranks of high-income countries. The phenomenon was first summed up as the “middle-income trap” in a research report released by the World Bank. 
According to the World Bank’s criterion of classification, China had already stepped into the middle-income stage in 2010. Thereafter the Chinese economy entered what would become a new normal, with growth slowing down from high gear to medium-high rates, provoking academics to reflect on whether China would get stuck in the middle-income trap. 
From such perspectives as declining capital return, diminishing demographic dividend, imbalanced regional development, inadequate human capital accumulation and weak independent innovation ability, scholars have probed into the challenges facing China if it wants to avoid the trap. 
Studies show that institutions are fundamental to a country’s long-term economic growth. Exploiting institutional dividends to inject vitality into growth can provide important assurances for escaping the middle-income trap. 
Institutions matter 
American economist and Nobel laureate Douglas C. North (1920–2015) defined institutions as the humanly devised constraints, formal and informal, that structure political, economic and social interaction. 
Based on general economic theories, growth manifests in the continued increase of per-capita income, relying on the investment of human and material capital as well as technological advances in the broad sense. In other words, it is a result of improvements in economic efficiency caused by various factors. 
However, due to decreasing marginal returns of capital, sustained growth can only depend on technological progress made through innovation. Factor investments and technological advances alike are simply the immediate reasons for economic growth. The speed and direction of factor investments and technological advances are determined by incentives and constraints facing economic entities; and economic entities decide on the incentives and constraints through institutional arrangements. 
The formation of the middle-income trap is concerned directly with institutions. After entering the middle-income stage, a country’s comparative and late-mover advantages will change markedly with the increase of income levels. 
Rising labor costs will deprive middle-income economies of their original edge in low-end manufacturing, throwing them into fierce competition with low-income countries. Meanwhile, while climbing up to the high end of the industrial and value chains, they are squeezed by high-income nations that already have a hold on abundant patents and advanced technologies. It is thus necessary to manage the pressure from growing costs through technological and industrial upgrading. 
When it comes to changes in the late-mover advantage, the source of technological progress shifts from resource reallocation to innovation, and adaptive innovation based on learning and imitation should be abandoned in favor of independent, creativity-based innovation. 
Transforming into a model of industrial upgrading and technological advancement is crucial for the economy to grow from high speed to high quality, but that cannot be realized automatically. It entails not only the support of extensive hardware and software infrastructure and public goods, such as road and communication infrastructure, education and medical care, and a legal system and uniform market, but social issues resulting from economic restructuring should also be addressed, including income inequality, regional imbalance, trade friction, poverty and unemployment. 
Only when a country is equipped with an institutional framework suited to economic development can the above requirements be met to realize the transformation of the development model and continuous economic growth, thereby avoiding the middle-income trap. However, most developing countries are weak precisely in their institutions. It is the poor quality of their institutions that have mired some economies in the middle-income trap. 
Institutional quality means to what extent the rules set by institutions can provide appropriate incentives and constraints to dampen opportunistic behaviors of diverse entities and align their cost-benefits with those of the entire society. 
In practice, some research institutes have adopted various indicators and collected subjective and objective data from countries around the world to quantify their institutional quality. 
Empirical evidence reveals that many developing countries did base their economic takeoff on some special advantages, such as the endowment of certain natural resources, favorable terms of trade or international environment, and the inflow of global capital. 
Nonetheless, once they reached the middle-income status, they usually faced economic stagnation and even consequent social disorder when the advantages changed or were insufficient to sustain growth, thus falling into the trap. Only a handful of middle-income economies with high institutional quality could, through constant institutional and policy adjustments, resolve or mitigate a variety of economic and social contradictions and problems stemming from rising income levels, declaring themselves as the exemplary few who have overcome the middle-income trap. 
Improving adaptive efficiency
The income level of a country has a great bearing on its industrial structure, technological type, growth model and relevant software and hardware infrastructure, as well as accompanying social problems. 
This is why the policies and strategies that were effective in the economic takeoff phase might pose hindrances to development in the middle-income stage. Hence there are no changeless, perfect institutions that fit different development stages and historical contexts. 
Instead, since the problems to be solved are ever-changing, only flexible institutions adaptable to the development stage of a country are truly efficient and proper for sustainable economic growth. 
State capacity and rule of law are the two dimensions that enhance the adaptive efficiency of institutions. North dubbed them as the “fundamental political dilemma.” 
For one thing, only when a state is strong enough can it furnish the infrastructure and public goods needed for development, including a stable social order and the definition, protection and implementation of property rights, which are the basic conditions for market mechanisms to function. For another, rule of law is essential to establishing indispensable and effective rules and procedures for the state and the government to play out their functions. 
When economic and social contradictions, conflicts and problems change, these rules and procedures can act as the basis for the proper adjustment to state and government functions and strong state capacities, guaranteeing that they can demonstrate adaptive efficiency and provide effective solutions. 
It is worth noting that in most advanced capitalist countries, the enhancement of state capacities and the improvement of rule of law are historically synchronous. Economists normally pay attention only to the key role played by the improvement of rule of law in long-term development, while casting doubts over the role of state capacities. 
The experiences of developed nations, particularly East Asian countries, suggest that strong state capacities have played a vital role in their economic takeoff, which is still of referential value to many low-income countries in Southeast Asia, South Asia and Africa. Meanwhile, backward rule of law in many middle-income countries has led to serious economic and social crises, a bitter lesson that cannot be ignored. 
Exploring institutional dividends 
In different historical periods, demographic dividends brought by changes in the population structure and technological benefits from late-mover advantages have contributed greatly to China’s economic growth. For a long time to come, institutional dividends will also play this role. 
A series of data sets measuring economic and social institutions show that China’s institutional quality has improved remarkably over the past four decades, but there is still a big gap with some developed countries and East Asian economies that have successfully sidestepped the middle-income trap. 
Take the Worldwide Governance Indicators compiled by the World Bank in 2017 as an example. China ranked 100th in overall rating among the 173 economies, roughly at a comparable level to Vietnam in Southeast Asia, Morocco in Africa and the Dominican Republic in Latin America. 
In the six dimensions of governance, namely “Voice and Accountability, Political Stability and Absence of Violence, Government Effectiveness, Regulatory Quality, Rule of Law and Control of Corruption,” China obtained high scores in Government Effectiveness and Regulatory Quality, which represent state capacities, but scored low in Rule of Law. Hence enhancing rule of law is significant to improving the overall quality of institutions in China. 
Based on the experiences of countries around the world, efforts can be made in the following aspects to improve institutional quality. The first is to foster a universal compliance with the constitution. The constitution is the fundamental institution for regulating a country, setting rules fundamental to the establishment and alteration of other institutions. The respect and compliance of all members of society with the constitution provides a basis for the operation and improvement of institutions, thereby enhancing the adaptive efficiency of institutions. 
Moreover, it is important to effectively integrate top-level design with extensive public participation. Institutions regulate behaviors of all entities and involve their vital interests, so effective institutional changes necessitate not only guidance and promotion by decision-makers, but also the building of effective communication mechanisms to represent public interests and opinion. 
In addition, income and wealth should be distributed more fairly to create a social environment that can advance institutional improvement. 
Guo Jinxing is an associate professor and deputy director of the Institute of Economics at Nankai University. 
edited by CHEN MIRONG