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From issue: Free Trade and Market Access (Winter 2011)

AQ Feature

Latin America's Middle Income Trap

Eva Paus

Economic success has left many countries unable to compete with either low-wage exporters or high-tech producers.

Latin America’s recent economic success carries with it the risk of complacency among the region’s policymakers. Economic growth during 2003–2007 was the highest in the region since the adoption of neoliberal policies in the early 1980s. Most of South America seems to be well on the road to recovery from the global financial crisis, while countries like Brazil appear bound for global economic status. But when the region’s economies are examined within the larger global context, the urgent need for action becomes clear.

Many Latin American countries today are caught in a middle-income trap. On the one hand, they can no longer compete with low-wage countries in standardized products. On the other, they cannot compete with countries with greater capabilities in more technology-intensive goods and services. The reason: many governments have never developed the policies and institutional environment to make the leap to high-tech or industrial economic development—what is often referred to as industrial policy.

In the last 60 years, Latin America’s economic strategy has swung—broadly—from import substitution industrialization (ISI) to neoliberalism. Under ISI, governments understood that economic activities differ in their potential for creating sustained growth, and that they need to provide an incentive structure that allows private producers to accumulate the technological capabilities required to compete in activities with increasing returns. Governments also understood they had to adopt policies to support and coordinate the development of complementary social capabilities.

But overconfidence in the abilities of governments as well as the lack of built-in performance requirements for protected industries resulted in persistent and widespread inefficiencies and widely divergent productivity within and across sectors of the region’s economies. In the neoliberal period, governments substituted competitiveness policies for industrial policies, assuming that market forces would generate sustained growth.

The benefits of trade liberalization, foreign investment and good governance are not automatic. If local industries and producers have not reached a certain threshold in their own capacity, then they will not be able to take advantage of the opportunities offered by international markets and foreign investment. This is where government policy comes in. Well-structured, transparent and predictable interactions between government institutions and private-sector organizations provide the institutional architecture to implement successful, pro-growth industrial policies.

Falling Short in Global Comparisons

The accumulation of technological capabilities is at the heart of the development process. Technological capabilities refer to the resources and organizational abilities needed to generate and manage technological change. In a changing national and global context, accumulating those capabilities is the key to sustained productivity growth and high-end economic development.

The results of 25 years of neoliberal policies in Latin America speak volumes about the current state of technological capabilities in the region. Latin American economies grew at an average annual rate of 2.7 percent between 1980 and 2008. That is half the rate of growth during the import-substitution period and substantially lower than in any other developing country group. Productivity growth has fared even worse. Labor productivity grew at an annual rate of 0.2 percent compared to 2.5 percent during the prior period.1 To be sure, economic growth for most of the 2000s was considerably higher (though still lower than in other developing country groups). But that was primarily the result of the commodity price boom and remittances from Latin Americans living in the United States.

The set of reforms adopted in the late 1980s and early 1990s, including the lowering of tariff barriers, reduction of public subsidies, elimination of price controls, and  freeing of interest rates (the so-called Washington Consensus), led to the de-industrialization of Latin American economies. The share of manufacturing as a percentage of GDP declined from 27 percent in 1980 to 17.9 percent in 2009, which puts it roughly at the same level as the Eurozone (18.1 percent), and substantially below developing East Asia and Pacific (31.4 percent).2 South American countries reverted to comparative advantages in natural resources with a few new ones like natural gas and soybeans added to the old ones like copper and iron ore. Central American countries, and to some extent Mexico, developed specializations in low-skill, labor-intensive, assembly-based production, facilitated by privileged access to the U.S. market through special provisions of the U.S. tariff schedule and broad tariff-free access through the Caribbean Basin Initiative and, in the case of Mexico, the North American Free Trade Agreement (NAFTA).

At the same time, other developing countries performed much better over the last 25 years, most importantly China—both in terms of economic growth and the development of comparative advantages in more technology-intensive activities. With an investment ratio double that of Latin America and a strategy of controlled market liberalization, deliberate expansion of technological capabilities, and strategic incorporation of foreign investors, China has become competitive in both technology-intensive and labor-intensive products. Given the difference in technological capabilities between China and Latin America, the region’s bilateral trade deficit with China skyrocketed from $863 million in 2000 to $32 billion in 2009. Only Brazil, Chile and Peru had a significant trade surplus with China in 2009, based on their exports of iron ore, copper and soybeans.

Industrial Policies under Import Substitution: All Carrots, No Sticks

The industrial policies of the ISI period have been maligned by the proponents of neoliberalism. But it is important to distinguish the economic and development logic of the strategy from the detrimental ways some of the policies were carried out. Industrial policies under ISI were based on the acceptance of three central premises: (1) what a country exports matters for productivity and economic growth; (2) technological learning takes time and is cumulative; and (3) the accumulation of broad-based technological capabilities requires proactive government policies and the development of human resources, particularly through education.

Under ISI, upgrading production meant creating policies and an environment that would foster industrial activities. Industrial production promises longer-term development benefits than natural resource extraction and primary production. It offers greater potential for technological learning and spillover effects into other areas of the economy for increasing returns and higher value-added production. And manufactured products enjoy higher income elasticities of demand in international markets.

Tariffs and non-tariff barriers were expected to provide the space needed for local producers to learn by doing and to develop the needed capabilities to become internationally competitive. Governments adopted policies that supported the development of capacities across different sectors (horizontal policies) as well as policies that channeled resources to specific sectors that were thought to have large potential spillover effects (vertical policies).

At the same time, government investment in human capital—in higher education and vocational training—increased considerably, and there were incipient efforts to promote science and technology. Development banks provided long-term financing for local investors. And to ensure that foreign investment would generate backward linkages and spillovers in technology, larger countries like Brazil and Mexico adopted technology transfer requirements and stipulated that foreign investors had to buy a certain percentage of inputs domestically (domestic content requirements).

It is well known where industrial policies under ISI went awry in Latin America. The Asian Tiger governments combined public support to companies with performance requirements, which often meant that firms had to export a growing share of their output during the learning process. Latin American governments provided only the carrots without the sticks. They did not use disciplining mechanisms to ensure that firms would turn public support to help them learn to become internationally competitive. The public coddling created widespread inefficiencies.

Some East Asian governments formed deliberative committees to bring companies together with public officials to explore possible new comparative advantages. In Latin America, by contrast, there was little consultation between governments and the private sector. The lack of serious coordination produced many projects with no foreseeable comparative advantage.  At the same time, though, the state initiated the production of strategic intermediate goods (e.g., steel in Brazil) that the private sector would have avoided given the  large initial capital layouts and long gestation periods...

 

ENDNOTES:

1.  The data are based on Palma (2010)
2.  World Bank. World Development Indicators.
3.  See Schneider (2009) for an excellent discussion of the dynamic legacies of Brazil’s multinational corporations.
4.  ECLAC 2010, 95
5.  Abugattas and PaulsPaus, 2010
6.  ECLAC 2004, 117.
7.  Schneider 2010
8.  Meléndez and Perry 2010
9.  Paus 2005
10. Perez Caldentey 2010
11. Agosin, Larrain, Grau (2009)
12. Agosin, Larrain, Grau (2009)
13. Coutinho 2010
14. Based on Perez and Primi (2009)

REFERENCES:

Abugattas, Luis and Eva Paus. “The Impact of China on Latin America and the Middle East and North Africa: New Center-Periphery Relations,” Paper presented at the International Congress of Latin American Studies Association, Toronto, October 2010.

Agosin, Manuel, Christian Larraín and Nicolás Grau. 2009. “Industrial Policy in Chile,” Working Paper 294, Department of Economics, University of Chile.

Coutinho, Luciano. 2010. “Challenges for Industrial Policy, Innovation and Competitiveness in Brazil,” Woodrow Wilson International Center for Scholars, July.

ECLAC. 2010. Time for Equality: Closing Gaps, Opening Trails. Santiago: ECLAC.

Cooper Ramo, Joshua. 2004. “The Beijing Consensus,” The Foreign Policy Centre, London.

Gallagher, Kevin and Mehdi Shafaeddin. 2010. “Reform and Development in China and Mexico,” in Shahrukh Khan and Jens Christiansen. eds. Towards New Developmentalism. Market as Means Rather than Master. London and New York: Routledge, 177-202.

Hausmann, Ricardo and Dani Rodrik. 2006. “Doomed to Choose: Industrial Policy as Predicament,” http://ksghome.harvard.edu/~rodrik/doomed.pdf

Lall, Sanjaya. 2005. “Rethinking Industrial Strategy: The Role of the State in the Face of Globalization,” in Kevin Gallagher. Ed. Putting Development First. London and New York: Zed Books, 33-68.

Meléndez, Marcela and Guillermo Perry. 2010. “Industrial Policies in Colombia,” Inter-American Development Bank, IDB Working Paper Series No. IDB-WP-126.

Palma, José Gabriel. 2010. “Why Has Productivity Growth Stagnated in Most Latin Latin American Countries Since the Neo-liberal Reforms? The economic consequences of a rentier-dominated power structure and a narcissistic ideology,” Cambridge University, Cambridge Working Papers in Economics 1030.

Paus, Eva. 2005. Foreign Investment, Development and Globalization. Can Costa Rica Become Ireland? New York and London: Palgrave Macmillan.

Peres, Wilson and Annalisa Primi. 2009. “Theory and Practice of Industrial Policy: Evidence from the Latin American Experience” Serie Desarrollo Productivo 187, CEPAL, Santiago.

Pérez Caldentey, Esteban. 2010. “Natural Resource Specialization and the Middle Income Trap: An Analyis of the Case of Chile,” Paper presented at the International Congress of the Latin American Studies Association, Toronto, Ocoter 2010.

Rodrik, Dani. 2007.  One Economics, Many Recipes. Globalization, Institutions and Economic Growth. Princeton: Princeton University Press.

Schneider, Ben Ross. 2010. “Business-Government Interactions in Policy Councils in Latin America: Cheap Talk, Expensive Exchanges, or Collaborative Learning?” Inter-American Development Bank, IDB Working Paper Series No. IDB-WP-167.

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