Wednesday, 4 June 2014

Is the middle-income trap real?

Arisyi Fariza Raz
The Jakarta Post
4 June 2014

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In the first quarter of this year, Indonesia’s economy grew annually by 5.2 percent, much lower compared to 5.7 percent in the previous quarter. Given the current economic situation, the government became less optimistic by aiming this year’s growth at 5.5 percent. 

Bank Indonesia (BI), the central bank, gave an even more conservative opinion by predicting this year’s growth to be around 5.1-5.5 percent.

In the short run, this slowing growth rate may be partially caused by contractionary monetary and fiscal policies implemented by the central bank and the government in anticipating several internal and external short-run economic shocks. 

On top of that, however, there are some structural factors, such as productivity, competitiveness and knowledge that may affect economic performance in the longer term.

These structural factors may not have an immediate impact, but they have long-run implications for the economy, risking it to become a victim of the middle-income trap.

According to development economics theory, the middle-income trap is referred to as a phenomenon in which rapidly growing economies stagnate at middle-income levels for many years, thus falling to reach the high-income level.

When discussing Indonesia’s risk of becoming trapped as a middle-income country, an International Monetary Fund (IMF) working paper written by Sehkhar Aiyar et al. (2013) provides some quite revealing facts. The study shows that Indonesia’s growth trajectory has performed relatively poorly compared to its regional peers.

In fact, even though on regional average East Asian economies have performed better than Latin American economies, Indonesia’s trajectory was below its Latin American counterparts.

The paper also points out that inadequate transportation and communication infrastructure are among the main variables that put Indonesia at higher risk of facing a growth slowdown. 

It further suggests that Indonesia’s trade category, even though still lagging behind other East Asian middle-income economies, still could serve as a buffer against growth slowdowns.

Despite this growth buffer, this issue still may pose a serious threat to the economy. As mentioned above, the middle-income trap is a structural economic issue that can have long-term implications for the economy. Therefore, immediate policy actions have to be undertaken to address this issue.

Apparently, infrastructure investment should become one of the primary focuses of the government’s policy. However, on top of infrastructure investment, the government should also improve the quality of education at all levels.

According to endogenous growth theorists such as Lucas (1988) and Romer (1986; 1990), education or knowledge is one of the essential inputs for long-term economic growth since it provides positive externalities that can offset the diminishing returns effect of other inputs, i.e. capital and labor.

Practically, the availability of education or knowledge provides more resourceful human capital with better productivity. As productivity increases, the cost of producing an additional unit becomes relatively cheaper, thus improving competitiveness in the market.

In other words, the availability of capable human capital will make Indonesia’s market more competitive. Accordingly, it will also attract investment, including in infrastructure, which can help the economy to avoid the middle-income trap.

Regarding the importance of education, the Organization for Economic Cooperation and Development (OECD) has raised the argument regarding improvements in elementary and secondary education in Indonesia. Through its country note published in 2013, the OECD points out that Indonesia should focus its policy on widening access to education, particularly for low-income households.

Indeed, the government is doing something to deal with this issue. The School Operational Assistance (BOS) and the Social Safety Net (JPS) are among the policies that are being implemented to enhance elementary and secondary education participation rates in the country.

However, these policy actions are still insufficient. The government needs to be more aggressive to promote the country’s educational development since its performance is still very poor even by regional standards. This is reflected in data published by the OECD that show that in 2008 the lowest quintile of the population aged 5 years and upward did not even have elementary education.

In addition to elementary and secondary education, tertiary education is also important because it helps economic development through innovation. A report by Asian Development Bank Institute (ADBI) in 2013 argues that the role of innovation on economic development can be two-fold. First, it contributes economic development through product innovation as the result of research and development activities. 

Second, it also creates process innovation that improves the process production of existing products.

In other words, this suggests that tertiary education in Indonesia needs to be promoted because it can trigger innovations that can be beneficial to economic development.

Unfortunately, this ADBI report also shows some unsatisfactory data by revealing that Indonesian graduates in industrial fields (such as engineering, manufacturing and physics) accounted for only 16 percent of all graduates.

This figure is in stark contrast to South Korea, a country that succeeded in escaping the middle-income trap and the joining high-income group in the 1990s. During that time, graduates in industry fields accounted for 35 percent of all university graduates.

Concretely, tertiary education in Indonesia can be improved by giving more scholarships to university students, encouraging high quality research through incentives and coordinating cooperation between researchers and the private sector and industries. 

Through these actions, education is expected to be able to deliver in its role as the source of innovation, which, eventually, creates economic growth.

In short, the availability of education or knowledge will create qualified human capital, which emphasizes product and process innovations as well as increased industrial capability. Then, positive externalities, which are the by-product of education and knowledge, will act as a more sustainable growth engine that will help the economy escape the middle-income trap.

The writer is an economist and is a graduate of the University of Manchester, the UK.

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