ADB Identifies the Keys to Economic Progress

Get your investment priorities right. That is the message which emerges from a detailed study by the Asian Development Bank of the ways for countries to transform themselves from low to lower-middle, upper middle and finally high income. Those priorities change over time but none in itself is self-sufficient.

The good news is that most of Asia has already moved out of the low-income bracket – much though that may surprise hundreds of millions in India, Bangladesh and Pakistan for example. The main reason is that the ADB, like other such institutions, using a fixed Purchasing Power Parity measure of income which is absolute, not relative. Thus we are told that the Netherlands reached lower-middle income status in 1829 while Argentina get there in the late 19th century.

Yet at the time those were among the top two or three most prosperous societies in the world. So it is a measure of Asian progress that almost all countries are now at least at the level of the richest 150 years ago. But it may be scant comfort to Mumbai slum dwellers or Bangladeshi farmers to know that they have now reached the income levels of Argentinians more than a century ago.

Categorization is also at times problematic. Thus by some measures Malaysia, Kazakhstan and Turkmenistan are high-income (manly thanks to oil and gas) but are treated as Middle Income by the World Bank.

So what are the most important factors that lead countries up through the income rungs, absolute and relative? For those in the low- and lower-middle brackets, by far the most crucial issue is standard of education. Thus of major Asian countries today, India has most to gain from raising the number of school years. Raising educational scores (as judged by maths and science tests) could double Indian income levels over 30 years. Philippines and Thailand would also benefit exceptionally from raising their educational sights.

However, for those with already high levels of education such as Kazakhstan, they need to find other avenues to progress further.

For the lower income countries, human capital is first priority, but it also needs to be accompanied by physical capital – the roads, transport and communications systems needed to spur output and trade. These physical investments become even more important as countries climb the middle-income ranks, as China has shown with infrastructure and housing spending making possible a boom in car and consumer durables production and bringing outlying areas to play a larger role in the national economy.

Clearly, the inference from the ADB is that in Southeast Asia the Philippines and Indonesia stand out as in need of both human and physical capital investment to speed income gains while Thailand needs to focus on education. Bizarrely, however, as noted elsewhere in the ADB report, much of the region, including the Philippines and Thailand, (but not India and Indonesia) exports capital even though returns to domestic investment should be higher. The problem seems to lie in the longer term nature of investment in human capital and infrastructure.

For those already at the top of the middle-income range and moving into the high bracket, the biggest gains need to come not from a greater quantity of investment but in raising Total Factor Productivity – the output per unit of invested capital. The conclusion here is very clear. Those such as South Korea which made the most difficult transition – to the highest level – showed TFP contributing 1.2 percentage points to income growth compared with just 0.4 percent for those stuck in the upper middle range.

The report identified several factors contributing to TFP growth: research and development spending; access to foreign investment bringing new skills and increasing the complexity of production skills; scope for entrepreneurship, and allowing creative destruction of older industries. Infrastructure investment also needed to keep up with technological change. The report noted that income convergence in the European Union had primarily been the result of TFP growth rather than high investment.

China scored highly on R&D. human capital, patent applications and industrial complexity though by implication the size and power of its public sector and aversion to closing factories could hold it back.

For China, as for some other countries such as Korea, Taiwan, Japan and Thailand, rapidly aging populations increase the importance of TFP in maintaining growth in the face of static or declining work forces. Meanwhile the country in Asia nearest to high income seems unlikely to make that jump while entrepreneurship, competition and access to capital are hobbled by race-based politics and commercial structures.