Escaping the Middle-Income Trap: Innovate or Perish

We analyze the reasons for the middle-income trap in Latin America, where countries have been at the middle-income level for decades, and draw out lessons for Asia. The middle-income trap captures a situation where a middle-income country can no longer compete internationally in standardized, labor-intensive goods because wages are relatively too high, but it also cannot compete in higher value-added activities on a broad enough scale because productivity is relatively too low. The result is slow growth, stagnant or falling wages, and a growing informal economy.

Insufficient development of domestic innovation capabilities is at the heart of the middle-income trap. In Latin America, it is the result of a market-led strategy which generated dismal productivity growth, rapid de-industrialization, a decline in export sophistication in many countries, poor innovation performance, and underinvestment in the requisite social capabilities. Globalization provides a challenging context for middle-income countries to narrow the capabilities gap because they have less time to do so with more players competing in the innovation space and with technological innovation changing faster. A comprehensive innovation-focused strategy with strategic active policies is the only way to escape the middle-income trap. The nature of the production structure, already existing elements of an innovation ecosystem, and the possibilities for creating political coalitions in support of a systemic advancement of innovation capabilities are critical factors conditioning the escape from the middle-income trap.

WORKING PAPER NO: 685