Part 2: DEVELOPING PROCESSING AND MANUFACTURING INDUSTRIES TO AVOID MIDDLE INCOME TRAP AND BECOME A HIGH INCOME ECONOMY

Communist Review - The middle income trap often occurs in developing economies when wages rise while price competitiveness declines, making it difficult for them to compete with technologically advanced economies or with economies of lower wage employment thatbring down the production costs. From the experiences of countries that have successfully moved from low income to high income during previous decades, Vietnam can draw useful lessons to avoid middle income trap.
 

Middle income trap and avoidance factor

The term middle-income trap refers to countries that have experienced rapid growth and thus quickly reached middle-income status, but then failed to overcome that income range to further catch up to the developed countries.It happens when a developed country gets stuck at that level or even becomes stagnant after reaching a gross domestic product (GDP) per capita between 1,000 USD to 12,000 USD according to World Bank standards ( WB).

Looking at the development of different countries over the past 60 years, it can be seen that some countries have succeeded in keeping the growth process moving from low-income to high-income economies (Japan, South Korea, Singapore) meanwhile, some other countries are still in the middle income level, unable to reach high income level (Malaysia, Thailand, Indonesia, Philippines). World Bank data indicates that in 1966, Japan was just a middle-income country, Singapore achieved GDP per capita of over 1,000 USD in 1971, South Korea and Malaysia both reached this threshold in 1977, Thailand in 1988 and Indonesia, Philippines in 1995. However, by 2019, GDP per capita of these countries is 40,248 USD (Japan), 65,233 USD (Singapore), 31,761 USD (South Korea), 11,414. USD (Malaysia), 7,808 USD (Thailand), 4,135 USD (Indonesia) and 3,485 USD (Philippines), respectively. Thus, among these countries, only Japan, South Korea and Singapore became high-income economies, the rest still get stuck  in middle income level.

The process from middle-income to high-income varies from country to country in terms of time and motivation for development. Research conducted by the Asian Development Bank (ADB) in 2017 demonstrates that the average time it takes for a country to progress from middle to high-income is about 30-40 years. If a country has not become a high-income economy for 40 years since reaching the middle-income threshold, it is considered to be  stuck in a middle-income trap. Considering each country  separately, some East Asian countries have greatly shortened the transition time. Japan and Singapore with GDP annual growth rate  of 6% - 8%/year takes only 20 years and South Korea takes 18 years with an average growth rate of 9% /year. Although Malaysia and South Korea had the same starting point, until now, after more than 40 years, Malaysia’s GDP per capita is approaching 12,000 USD with average growth rate of  6% / year.

To determine the engine of growth, looking at the GDP structure of countries in transition, it is obvious that there is a gradual decline of agriculture and an increase of industry - construction and services, especially the contribution of processing and manufacturing to GDP. World Bank data proves that South Korea's transition lasted from 1977 to 1995, during which time agriculture's share to GDP fell from 22% to 5%, industry – construction’s share increased from 28% to 36% (of which processing and manufacturing increased from 21% to 26%), services’s share increased from 39% to 49%. Singapore's transition lasted 20 years, from 1971 to 1991. During this period, agriculture's contribution to GDP fell from 3% to 0.2%, industry – construction’s share increased from 28%. to 33% (of which processing and manufacturing increased from 19% to 25%), services’s contribution decreased from 64% to 63%. It took Malaysia more than 40 years, from 1977 to 2019, to increase GDP per capita from 1,000 USD to 11,414 USD. It will possibly reach the highincome threshold in the next few years. During this period, the contribution of agriculture decreased from 28% to 7% while industry – construction’s share reached the highest level of 49% in 2004 and then gradually decreased back to 37% in 2019 (of which, processing and manufacturing increased from 20% to the highest level of 31% in the early 2000s and then gradually decreased to 21% in 2019), services’s share increased from 33% to 55%.

Vietnam has become a middle-income country since 2008. After more than 10 years, Vietnam's economic restructuring has occurred more slowly than its predecessors, its development roadmap has not obtained an early-stage breakthrough such as Japan, South Korea and Singapore. From 2010 to 2019, the contribution of agriculture in Vietnam's GDP decreased from 18.3% to 13.9%, industry – construction’s share increased from 32.1% to 34.4% (of which, processing and manufacturing increased from 12.9% to 16.4%), services increased from 36.9% to 41.6%. The average growth rate of Vietnam in the first 10 years was 6%, lower than the average of 10 first years of its predecessors (Japan: 7%, South Korea: 8.9%, Singapore: 8.8%).

The growth pathway for each country shows the difference between countries that do not get in the middle income trap and the ones that are stuck in the trap. Although the average growth rate of these countries do not differ greatly from one to the other (only 6% - 8%), successful economies such as Japan, South Korea and Singapore have achieved continuous rapid growth in the first few years, creating a strong momentum for the following years. Meanwhile, countries that are currently stuck in middle income trap did not make a strong breakthrough in the early stages. After they reach the middle income threshold, their growth shows signs of decline, prolonging the transition to high income threshold. Korea and Malaysia have a similar starting point in 1977. In the first few years after becoming  middle-income economies, the two countries had similar growth pathways. But from 1984 onwards, the two countries followed two completely different directions. While South Korea grew rapidly, gradually narrowed the gap with Japan, Singapore and outstripped other countries, Malaysia did not make a breakthrough like South Korea with slower growth and it took more years to reach to the same level of income. During the 10 year period  from 1985 to 1995, South Korea's GDP per capita increased fivefold while Malaysia only doubled. By comparing the measures and policies that these two countries implemented during this period, latecomer economies can draw useful lessons to avoid the middle income trap.

In the period 1960 - 1990, South Korea and Malaysia both used the 5-year plans as the basis for issuing economic development and industrialization policies in the medium term. South Korea's first plan started in 1962 - 1966. It spent 30 years with a series of 7 plans and ended with the seventh plan from 1992 to 1996. The first three plans have lift South Korea from a low income economy to a middle income level and the next four plans have made it a high-income country. Malaysia's series of planning started in 1966 and continue to date. The most recent plan is the 12^thone for the period 2021 - 2025. Entering the third phase (1976-1980), Malaysia has become a middle-income country. After implementing 10 plans, Malaysia finally became a high-income economy.

Until the 1960s, South Korea remained one of the poor, backward agricultural economies, ravaged by war and caught in a vicious cycle of poverty. The share of agriculture in GDP accounts for 36%, GDP per capita is at 158 ​​USD. After President Park Chung Hee took power in 1961, he was determined to move the country toward economic autonomy and developed five-year plans with ambitious goals and strong policies to achieve the set goals. Similarly, Malaysia in the early 1960s was also an agricultural country with the agricultural share accounting for 43.7% of GDP and the per capita income reaching 235 USD.

Despite having the same level of development and facing similar issues such as poverty and underdevelopment, each country has chosen its own problem solving approach. South Korea has a clear orientation in defining development priorities by focusing on  industries, specially on the foundation industries (electrification, oil refining, synthetic fiber...) and then on technology and skill intensive industries and and by accessing to the supply chain and the value chain (fertilizers used in agriculture; iron, steel, chemicals in shipbuilding, machinery, equipment and semiconductors in electronics...). For its part, Malaysia has a clear focus on social issues throughout the period of its plan implementation (poverty reduction, social justice, balanced development among ethnic groups...). Although Malaysian Government implements several policies to support domestic industries such as the Subcontractor Development Program, the Domestic Automotive industry Development Program (Proton, Perodua), these policies are not systematically executed as in South Korea and are not clearly defined in the overall goals of the 5-year plans. In contrast, for South Korea, the lack of including social issues in the development goals of the 5-year plans does not mean that the country does not pay attention to solving these problems. In fact, it chose industrial development as the starting point. Through the development of industries, social problems were solved by creating more jobs, increasing income for workers and the whole society, ensuring fair development among regions and localities.

Low value-added trap and internal forces of domestic industries

Besides the middle income trap concept, the term “the low value added trap” is also taken up to talk about the economic development situation of a country. The United Nations Conference on Trade and Development (UNCTAD) describes a country caught in a low value-added trap as one that mainly attracts foreign direct investment (FDI) from enterprises that do not have intention to form linkages with the domestic economy, does not create spillover effects and set short-term goals. Those enterprises are underperforming in all aspects: investment, productivity, and skill development. They invest mainly in labor-intensive industries that compete on price instead of quality and on-time delivery and often see labor as a cost factor rather than a resource that needs to be developed.

This concept of UNCTAD is only assessed from one sided basis of FDI sector while a country trapped in low value added can be caused not only by the FDI sector but also for other reasons. It is heavily dependent on the self-reliance and resilience of the domestic private sector to mature, become independent, master the economy and be competitive in the global market, gradually get rid of dependency on external resources. In terms of nature, the low value added trap is also a manifestation of the middle income trap. It happens when a country fails to build a strong domestic industrial base (domestic private sector), its growth mainly relies on external resources (FDI sector). And when domestic advantages are no longer available (low labor costs, attractive tax incentives...), FDI enterprises will move to countries with more advantages and lower manufacturing costs (This is called a flying geese paradigm by economists), leading to deindustrialization, making domestic business incapable to competing against other technologically advanced economies or lower wages economies.

In the period 1951-1989, the newly industrialized economies (NIEs) such as South Korea, Singapore, the territories of Taiwan, Hong Kong (China) and ASEAN-4 countries (namely Malaysia, Thailand, Indonesia, and the Philippines) have all attracted a large amount of investment from Japanese enterprises with a total FDI in NIEs of 19,919 million USD and in ASEAN of 17,531 million USD⁽¹⁾. After about two or three decades, these NIEs have built their own strong, independent domestic industries and even could compete directly with Japanese businesses while the ASEAN-4 countries still depends on FDI enterprises in most industries. In the 1980s, while Japanese businesses in NIEs economies could achieve localization rates above 50%, in ASEAN-4, the domestic purchasing rate of Japanese companies was only 42%, mainly from FDI enterprises. In NIEs economies, the majority of Japanese FDI enterprises were able to withdraw Japanese experts and leave factories for people in the host country to manage and operate. On the contrary, ASEAN-4 countries so far depend on the middle and senior Japanese leaders. This difference shows the leading role of processing and manufacturing industries and the importance of enterprise capacity as well as domestic human resources in industry duringthe process of national industrialization and modernization to avoid the middle income trap.

Right from the opening of the economy, Vietnam has become an attractive destination for foreign investors. In recent years, it has always led the ASEAN countries in attracting foreign investment. By the end of 2019, the country has attracted nearly 40,000 projects with a total registered capital of over 363.3 billion USD. In terms of percentage (%) of GDP or per capita, FDI in Vietnam has surpassed China, India and most of the ASEAN countries. Among FDI projects in Vietnam, there are many high value projects of the most powerful multinational corporations in many fields. However, most of the FDI inflows to Vietnam are focused on market exploitation sectors such as real estate businesses or labor-intensive manufacturing with low added value such as textiles, leather and footwear, rubber products, plastics, food and beverages, furniture and wood, paper... According to the World Bank report (2018), many investors often assume that low labor and energy costs and attractive tax incentives are the main reasons for investing in Vietnam, while very few FDI firms believe that high skill labor or  competitive domestic supply chain are strengths of Vietnam. The report also pointed out that in order to avoid middle income or low value-added trap and become a high-income country, Vietnam needs to build a new generation FDI attraction strategy combined with strategies and national development planning to form supply chains and industry clusters. Vietnam needs to focus on industries and stages that create high added value, use eco-friendly technologies and consume less energy, attract projects and investors to develop sustainably by focusing on quality and socio-economic efficiency, ensuring security  and national defense and building lasting relationship with domestic businesses.

In order for the FDI sector to support more to the Vietnamese economy in the process of industrialization, modernization and economic restructuring in the direction of improving productivity and values, narrowing the gap with developed countries, Vietnam needs to change its approach to FDI attraction that must be based on dynamic competitive advantages (workers' skills, creative capacity and natural environment and favorable business environment) instead of the previous static, unsustainable competitive advantages (natural resources, unskilled labor and attractive incentives).

Specifically, Vietnam must focus on attracting FDI of investors who can: 1-Create higher wage jobs (higher output/labor); 2-Promote skills development, technology transfer, research and development in the country; 3-Encourage the more efficient use of resources (including not only energy, but also land, water sources, raw materials,...); 4-Create opportunities for domestic enterprises and investors to cooperate with foreign enterprises in global value chains without overwhelming domestic investors and small and medium enterprises; 5-Enhance the competitiveness of Vietnamese enterprises at home as well as abroad (by improving supply chain, logistics,...).

Policy implications

The above analysis indicates that the shift from middle-income to high-income countries cannot ignore processing and manufacturing industries. Along the path, domestic industrial enterprises are the main factors promoting sustainable economic development, helping Vietnam avoid the middle income trap and low value-added trap. FDI in processing and manufacturing industries is the driving force. However, domestic industrial enterprises are a solid foundation to help a country escape the middle income trap. Therefore, it needs to build a selective FDI attraction strategy and avoid low-tech FDI to directly compete with domestic industrial enterprises in order to avoid low value-added trap; to build and develop strong domestic industrial enterprises which are closely linked with the FDI sector so that they could grow strong and take the lead in the national supply chain.

Experience from South Korea, Malaysia and its predecessors reveals that there are many different ways to progress from middle to high income economy. Whether that path is long or short depends on how the country determines the right goals for each medium term and concentrates its resources and policies to achieve the set goals. South Korea has moved up to high income in a relatively short period of time because they have clearly defined their industrialization goals through seven five-year plans and all their social resources and policies are mobilized to achieve the set goals. Industrial development policy should be placed in a broader context, including policies that directly affect industrial enterprises and indirect policies that have a great influence on the development of industry in general and industrial enterprises in particular. To determine the right goals, it is necessary to have a coordination mechanism between the State and enterprises to have consensus between government agencies and between the State and the private sector. Therefore, it is indispensable to formulate and maintain a policy dialogue mechanism with industrial enterprises, supervise and evaluate the improvement of Vietnam's policy quality and industrial competitiveness compared to other countries in the region and in the world.

In order to attract high-value FDI, it is required to address a number of challenges and barriers in terms of mechanisms and policies throughout the entire investment cycle of enterprises and change the current approach to FDI. Firstly, it is compulsory to target investors who are involved in highly skilled labor, technology that uses resources economically instead of relying on low labor costs, low cost of infrastructure services. There should have uniform guidelines on investor selection from the central to local levels to attract investments for business development purposes. It is necessary to continue to effectively connect domestic enterprises with FDI enterprises, strengthen the capacity of domestic enterprises to participate in the supply chain of FDI enterprises (prolong the deadline of the supporting industry development program). Secondly, investment promotion should be proactive and targeted to attract investors that the economy wants instead of passively waiting for investors to come. Thirdly, investment marketing tools should be approached by industry, by value chain to attract investors based on long-term competitive advantage instead of using traditional marketing tools based on high incentives to attracts investors based on short-term cost advantage. It is needful to support and create the most favorable conditions for production and business activities of existing foreign investors instead of holding ineffective investment promotion events because current investors are the “ambassadors”, which are the most objective and effective channels to promote the policies and business environment in Vietnam. Fourthly, investor incentives should be based on their domestic efficiency, value added, post-investment performance rather than on the amount of registered capital and their scale./.

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(1) See: S. Urata: “Japanese Foreign Direct Investment and Its Effect on Foreign”, In T. Ito, & AO Krueger: Trade and Protectionism, NBER-EASE Volume 2, pp. 273 - 304, University of Chicago Press, 1993

This article was published in the Communist Review No. 952 (October 2020)