Back in the Fast Lane

The Indonesian capital bustles at night.

As members N 1997-98, a financial crisis brought The per capita GDP of high-income countries three East Asian middle-income rose by about 50 percent between 1980 and of the middle- countries—Indonesia, Korea, and Thai- 2000, that of low-income countries increased income Iland—to their knees. It also affected more than 150 percent, and the income ratio Malaysia and the Philippines, which had dif- between high- and low-income countries has country club, ficulty sustaining growth. Many predicted that been halved. In contrast, average real per cap- East Asian the structural weaknesses that the crisis laid ita incomes of middle-income countries grew bare—corruption, cronyism, and nepotism— by less than 20 percent over this period, wid- nations may would condemn the region to stagnation, as ening the gap between them and high-income need to update they had in Latin America after its debt cri- countries by about 20 percent. Middle-income sis in the mid-1980s. Emerging East Asia was countries, it is argued, are squeezed between their growth expected to lose years of growth. Instead, its low-wage competitors in poor countries, which strategy growth record since 1998 has been remark- dominate mature industries, and innovators able: GDP has almost doubled, growing by in rich countries, which dominate industries more than 9 percent a year, to reach $4 trillion undergoing rapid technological change. Indermit S. Gill in current dollar terms by 2005. Despite the This line of reasoning suggests that East setback in the 1990s, growth during the past Asian middle-income countries must update and Homi Kharas 40 years has been consistent (see table). their strategies. What permits countries to Now, almost a decade later, Korea is a high- grow fast from a per capita income of $1,000 income country, and the other four are grow- to $10,000—the current challenge for most ing fast. China has joined the middle-income East Asian countries—is different and more club. Once Vietnam achieves middle-income difficult than what helped them grow from status, possibly as early as 2010, more than a per capita income of $100 to $1,000—the 95 percent of East Asians will inhabit a middle- challenge they successfully faced in the past. income country. Economic research suggests that two oppos- Should East Asia expect to continue these ing forces are at work. On the one hand, as high growth rates? The reality is that middle- countries get richer, they demand a greater vari- income countries (those with per capita ety of goods, many of which can be produced incomes of $826-$ 10,665) have grown less domestically. This creates a force toward sec- rapidly than either rich or poor countries. toral diversification. On the other hand, coun-

38 Rnance & Development March 2007 ©International Monetary Fund. Not for Redistribution tries get richer only if they specialize in what they do best. Which tendency dominates is an empirical question. Researchers have Consistent performance found that a switch to specialization happens during middle East Asia has grown rapidly despite the 1997-98 crisis. income and depends critically on the extent of economies of (per capita GDP growth, 1966-2004; percent) scale in production (see box). Region/country Growth Number of years in which the rate was What did the Asian leaders in the first wave do to success- 0-2 Above fully transit through middle-income stages of development? Negative percent 2 percent East Asia and Pacific 5.8 2 3 34 And what can today's middle-income countries in East Asia China 7.0 3 3 33 do to ensure that they do not suffer the same fate as Latin Indonesia 4.0 4 3 32 America's middle-income countries, which have struggled Thailand 4.8 3 5 31 unsuccessfully to grow into rich countries? This article Philippines 1.3 6 21 12 Malaysia 4.0 5 3 31 explores the challenges facing middle-income East Asia today. Latin America and Caribbean 1.5 10 15 14 Middle East and North Africa1 1.2 8 13 9 Recognizing economies of scale South Asia 2.6 1 12 26 In addressing these questions, policymakers in the region Sub-Saharan Africa 0.2 14 20 5 OECD 2.5 0 18 21 can learn from recent advances in thinking about economic Sources: World Bank, World Development Indicators, and Global Development growth, industrial organization, international trade, and eco- Finance central databases. nomic geography. 'Data are from 1975 to 2004. Renewed interest in economic growth since the late 1980s has been triggered by the observation that income levels across countries have not been converging in line with tradi- move from places where they are abundant to where they are tional economic theory. This theory predicted that efforts to scarce, bringing with them the latest and best products, pro- accumulate physical and human capital, improve efficiency of cesses, and technologies. production, and use the latest technologies would pay off in a But this has not happened. With few exceptions—primarily narrowing of income gaps between developed and developing East Asia's strong performers—income gaps have widened. countries. Its fundamental implication was that, in seeking the This does not mean the market has not worked at all: most highest possible returns, financial and human capital would countries have become richer and poverty has fallen. But both between and within countries, human and financial capital appear to move from places where they are scarce to How to get richer where they are abundant. This makes good sense in a world Although economic development requires constant learning of economies of scale in which factors of production tend to and adjustment, recent findings suggest that countries with cluster in cities. per capita incomes between $1,000 and $10,000 should make The main driver of economies of scale, in modern growth several major changes in their strategy. theory, is ideas. Unlike goods and factors, ideas can be used • From diversification to specialization. Countries gener- repeatedly, as well as by many people at the same time—that ally appear to diversify initially as they grow, but this trend is is, they are "nonrival." And an idea, once formed, can be used reversed after per capita incomes reach about $5,000-$8,000, as a starting point for new ideas. However, it requires effort to after which countries begin to specialize. At what stage they come up with useful ideas. And people can be prevented from reach this tipping point depends on their size and export ori- using ideas to improve products or production processes entation, but it implies that, in addition to worrying about through secrecy or enforcement of intellectual property the general investment climate, policymakers may also need rights, even if temporarily. Because of such "excludability," to develop sector-specific strategies. knowledge confers on its creators some monopoly power and • From investment to innovation. As firms in a country generates what economists call "economic rents." approach the technological frontier, regulatory policies that By bringing knowledge into formulations of economic favored investment by incumbent firms should give way growth, economists can recognize the centrality of ideas and to regulations that encourage entry of new firms and exit increasing returns, but they must also recognize that ideas do of those whose products or technologies are obsolete. This not always flourish under perfect competition. Some compe- switch has to be timed right and will be difficult to imple- tition can give firms an incentive to innovate, but too much ment because of vested interests. can reduce the value firms get from each idea and thus reduce • From basic to higher education. As countries exploit their effort to create new ideas. By the late 1980s, explana- economies of scale, skill premiums will rise rapidly and policymakers must plan for an adequate supply of new graduates tions of international trade routinely discussed imperfect to mitigate the increase in income inequality. In such econo- competition to understand the rise of intra-industry trade. mies, knowledge spillovers are important and merit public By the early 1990s, growth theorists had accepted the need subsidies for higher education. to incorporate scale economies into aggregate formulations of the economy. By the mid-1990s, theorists had shown how Sources: Imbs and Wacziarg (2003), Aghion and Howitt (2005), and Romer(1994). these concepts could also be used to understand where economic activity became concentrated.

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©International Monetary Fund. Not for Redistribution Insights for middle-income countries and between cities and the countryside. The outcomes may How can modern growth economics help middle-income not be egalitarian, but policymakers should at least try to countries? At the risk of oversimplification, we classify the provide equal access to education and other social services. insights into two groups: the role of private enterprise in • Modern growth theory predicts that there will be eco- exploiting economies of scale, and the role of governments nomic rents, and how they are distributed is vital for growth. in ensuring a fair distribution of income. Both are needed to If economic rents are reinvested in public infrastructure sustain rapid growth. and social services, the foundations of economic growth The formal recognition of economies of scale, which are strengthened. If they are dissipated in ineffective cities, brings economic theory closer to the world of policymakers, social strife, or corruption, they may even slow growth. Thus, has three implications for middle-income countries: governments must tax economic rents in ways that are least • Trade can take place between all kinds of economies. harmful to private interests and spend the proceeds in ways Those with different factor endowments have more inter- that best promote the public interest. industry trade, and those with similar factor endowments Growth centered on economies of scale encompasses can profitably engage in intra-industry trade. Both global both specialization and innovation, which are facilitated by and regional integration are important. integration. East Asian countries have retained their global • The market may underinvest in the creation, adaptation, trade, technology, and financial linkages while also deepen- or adoption of new ideas. The implication is that govern- ing their regional ties to exploit unexhausted economies of ments should, theoretically, subsidize higher education that scale. But specialization and innovation have led—through will ensure that a country continues to acquire competitive the rising importance of regional production networks and advantages in some activities. the growth of cities—to widening spatial and social dispari- • Large cities provide the ideal environment for activities ties within countries. If left unaddressed, these disparities can that display increasing returns. Thus, as economies develop, slow growth as firms face rising costs, and social conflict will policies to keep cities livable and friendly toward businesses grow as economic disparities widen. Honest, well-informed, become increasingly important. and effective governments that act in the public interest to Recognition of the distributional implications of economic facilitate sustainable agglomeration (that is, growth of cities) growth also has three policy implications for middle-income and investments in skills can ensure that economies of scale countries: continue to be fruitfully exploited. • Because cities are central for growth, middle-income countries should see urbanization as promoting development International integration has progressed . . . and strengthen the links between rural and urban factor and East Asia integrated first with global trade markets, and its product markets. success with global integration is growing. Emerging East Asia • In countries that aggressively exploit economies of (which excludes Japan) has increased its export market share scale, the demand for skilled labor rises and skill premiums to 20 percent, double its GDP share, and total merchandise increase. Inequality is likely to rise, both within urban areas trade has reached the same size as total GDP. These achieve- ments are due in large part to open trade policies. Regional integration in East Asia is also well advanced and has accelerated since China's accession to the World Trade Chart 1 Organization in 2001. Despite the 1997-98 crisis, regional Star performance trade has grown at about 10 percent a year over the past East Asia's exports have grown the most in sectors exhibiting decade. More than half of East Asia's imports come from economies of scale. within the region, resulting in increasingly efficient regional (change in export share. 1994-2004; percent) production networks. This trade—complementing, not sub- stituting for, global trade—is dominated by intermediate imports of parts and components. Outside the region, trade is dominated by final goods. The two go hand in hand: intra- regional trade provides a low-cost, high-quality supply chain; interregional trade provides a mass market in which economies of scale can be exploited. And East Asian exports have been growing fastest in sectors exhibiting scale economies (see Chart 1). Most trade takes place between cities. In East Asia, cities are estimated to generate about three-fourths of annual output, and between one-half and two-thirds of exports. Often, out-

Sources: Antweiler and Trefler (2002): Gill and Kharas (2007). put is concentrated in a single city: Bangkok has 40 percent Note: A scale elasticity that is greater than one implies increasing returns to scale; unit costs of Thailand's GDP; Manila, 30 percent of the Philippines'; in of production of a good or service fall as more is produced. A scale elasticity equal to one implies constant returns to scale. Vietnam, Ho Chi Minh City has 20 percent; and in China, Shanghai has 11 percent.

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©International Monetary Fund. Not for Redistribution . . . but domestic integration is lagging a rules-based government. China, Indonesia, and Vietnam Despite successful global integration and increasing regional have also launched aggressive national anticorruption pro- integration, many East Asian countries are falling behind in grams and moved to prosecute high-ranking officials. domestic integration. Much of the problem is now at the local level. East Asia Reversing this must start with cities, where most economic has decentralized public expenditures on social services and activity occurs. Spurred by fast economic growth, East Asia infrastructure, which should, in the long run, lead to greater has begun to witness one of history's largest rural-to-urban transparency and accountability of local public officials. But, population shifts: 2 million new urbanites are expected every while institutional checks and balances are maturing, decen- month for the next 20 years. This massive movement of peo- tralization could jeopardize control of corruption, threat- ple will put pressure on the region's mega cities, those with ening economic efficiency, aggravating social tensions, and more than 10 million inhabitants, especially their ability to worsening gaps in subnational economic performance. These provide clean air and water, green spaces, easy commutes, changes may explain the deterioration in perception-based and low crime rates. anticorruption indicators, which suggest that East Asia is But the bulk of urban population growth will happen in falling behind in its efforts to fight corruption. They may be cities with fewer than 500,000 people, which are generally less signaling that a greater emphasis is needed to ensure honest well managed, according to recent investment climate sur- governments as these economies grapple with the middle- veys. A poor business environment translates into a smaller income development challenge. tax base, and these smaller cities spend less per capita on key social services and on environmental cleanup, making them A big push on the home front even less attractive places for investment. Thus, the task ahead for East Asia is to complement global The gap between income levels in smaller, interior cities and regional integration with domestic integration. This and large coastal cities is also related to the poor domes- requires ensuring vibrant cities that are well linked to the out- tic infrastructure connecting most cities to major ports. side world but that remain linked domestically, strengthening Although East Asia has some of the world's most efficient social cohesion so that societies stay as strong as economies, seaports and air transport facilities, the internal logistics and providing honest governments that efficiently reinvest within countries are inadequate. the economic returns that accompany fast growth. The global Growing inequality is pressuring East Asia's social cohe- trade and technology flows and regional networks that are sion. Inequality in income levels, schooling, and access to powering East Asia's growth provide adequate resources for basic services in much of the region has risen (see Chart 2). meeting the challenge of domestic integration. If developing Poorer regions and rural areas are falling further behind their East Asia's policymakers succeed in making this third inte- urban counterparts, and ethnic minorities are not participat- gration as successful as the first two, they can, within a gen- ing in growth. More than three-fourths of the inequality of eration, eliminate poverty and lead their countries into the living standards is within countries. ranks of the rich, developed nations of the world. In doing Governments must come up with solutions to the problems so, they will also provide valuable lessons for middle-income of national distribution and local economic management countries around the world. • and service delivery. But they are being sharply questioned by civil society groups because of a perception of wide- Indermit S. Gill is Economic Advisor in the East Asia and spread centralized corruption in some countries. Countries Pacific Regional Office at the World Bank, and Homi Kliaras like Korea and Malaysia are trying to join Hong Kong SAR, is a Visiting Fellow at the Wolfensohn Center for Development Japan, and Singapore as places where corruption is severely at Brookings Institution and formerly Chief Economist for East sanctioned and opportunities for corruption are curbed by Asia and the Pacific at the World Bank.

This article is basal on the authors' An East Asian Renaissance: Ideas for Chart 2 Economic Growth (Washington: World Bank, 2007). Behind the averages References: Inequality has been rising in East Asia despite regional Aghion, Philippe, anil Peter Hewitt, 2005, "Growth with Quality- economic convergence. Improving Innovations: An Integrated Framework," in Handbook of (Theil inequality index, percent) Economic Growth, Volume I A, ed. by Philippe Aghion and Steven Durlauf (Amsterdam; Boston: Elsevier; North-Holland), pp. 67-110. Antweiler, Werner, and Daniel Trefler, 2002, "Increasing Returns and All That: A View from Trade," American Economic Review, Vol. 92 (March), pp. 93-119. Imbs, lean, and Romain Wacziarg, 2003, "Stages of Diversification," American Economic Review, Vol. 93 (March), pp. 63-86. Source: Gill and Kharas (2007). Note: A higher number for the Theil index indicates higher inequality in consumption levels Romer, Paul, 1994, "The Origins of Endogenous Growth," The Journal of Economic Perspectives, Vol. S (Winter), pp. 3-22.

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