World Development Report 2024: The Middle-Income Trap

Openness in goods and product markets is critical for firms in middle-income countries seeking to absorb and infuse global knowledge. And yet openness to trade and foreign investment works two ways. Although openness provides firms with access to larger markets, international value chains, technology, and know-how, it also exposes domestic firms to competition with international firms closer to the technology frontier. Firms can either scale up or be eased out.

Upgrading by trading

A key part of contestability is trade openness. Because the firms in middle-income countries most able to adopt global technologies are often large incumbents (see chapter 4), these incumbents will be more likely to compete by enhancing products and processes to the extent that markets are globally connected.

Knowledge acquired from the global economy holds the key to the economic catch-up of middle-income countries. Countries that have experienced sustained high growth have rapidly absorbed know-how (knowledge that is not easily transmittable), technology, and, more generally, knowledge from the rest of the world. Middle-income countries far from the knowledge frontier should act quickly and furiously to infuse knowledge. The World Bank Productivity Project highlights that roughly half of overall productivity growth is driven by incumbent firms adopting new technologies, products, and processes. Yet middle-income countries face an “innovation paradox”—returns on infusion are believed to be high in middle-income countries, and yet firms in these countries appear to invest little.

The incentives for and ability of middle-income country firms to absorb knowledge can be enhanced by government policies that support upgrading the capabilities of firms. For this, industrial policy will need to connect global and local firms and support adoption of modern organizational models. Because knowledge is often embodied in machinery and equipment, for many countries purchasing equipment from a foreign-owned company is an important way to acquire knowledge. In fact, 45 percent of firms in Asia and 29 percent in Africa, on average, are doing so. Technology licensing is also important for infusion, as seen in Korea (see chapter 2). However, licensing increases with proximity to the technology frontier, with most firms unable to license foreign technologies, possibly reflecting weak human capabilities in using these technologies (chapter 8), as well as weak institutions protecting intellectual property. Less than 10 percent of firms in middle-income countries such as the Arab Republic of Egypt, India, and Tunisia use licensed technology. And even in other countries that are more economically advanced, such as Croatia and Türkiye, only 20 percent of firms engage in licensing (figure 7.10). Of considerable concern is that rising geopolitical tensions and protectionism can potentially worsen the diffusion of knowledge to middle-income countries.

In view of the positive effects associated with deploying advanced technologies, a government can help firms by using industrial policy to make it easier for them to license technologies. Countries can use infusion incentives, such as Korea’s temporary subsidies for the adoption of foreign technology, while pursuing more general policies such as investing in upgrading domestic skills (chapter 8) and protecting intellectual property. Market contestability also promotes faster foreign technology adoption at a lower cost to consumers.

Government policies to open markets and facilitate economic integration can also help domestic firms connect with multinational corporations (MNCs), thereby introducing a country’s firms to foreign production techniques, overseas markets, and international supply chains. The gains from such connections are evident in Poland. After Poland joined the European Union, the benefits to direct suppliers in sectors that use research and development (R&D) more intensively spread to the broader economy through positive vertical spillovers, while positive horizontal spillovers were boosted as domestic firms accumulated intangible assets such as licenses and patents. In Costa Rica, domestic firms increased productivity by 4 percent and expanded their workforce by 26 percent within four years of joining an MNC supply chain. Supplying MNCs also led to improvements in domestic firms’ production processes, supported by capacity building from the MNCs.

Domestic rules can encourage sharing technology with MNCs, such as licensing agreements and the ability of local suppliers to acquire competitive or licensed technologies (box 7.2). Local conditions and institutions also matter, such as national innovation systems and training programs, access to financing, and contestable domestic markets. For example, the success of Norwegian FDI for salmon farming in Chile stemmed in large part from the favorable local business conditions.

Increased participation in global value chains also promotes diversification and sophistication and magnifies the gains of traditional trade. Exporting transmits knowledge back to the domestic economy through value chain links and learning by exporting. And long-term supply relationships between exporters and foreign buyers can promote upgrading in product quality and management practices. However, mixed results have emerged from promoting specific industries or sectors through tax breaks, direct subsidies, import tariff exemptions, cheap credit, dedicated infrastructure, or the bundling of all of these in export zones.

Box 7.2 Technology for market access

Quid pro quo policies mandate that multinational firms entering the domestic market establish direct partnerships with local firms through joint ventures. The objective is to amplify the positive spillovers from multinational firms to domestic ones, solidify their connections, and facilitate knowledge transfers. Despite the potential, little is known about the impacts of such policies.

Two recent studies have examined a policy implemented in 1978 in China that required international automakers wishing to enter the Chinese market to establish joint ventures with domestic firms for production facilities.a The policy facilitated the transmission of knowledge between foreign and domestic firms through workers. The research indicates that the likelihood of workers transitioning from a joint venture to a domestic firm was 18 percentage points higher than a benchmark in which worker movements were random. Domestic firms affiliated with multinationals through a joint venture shared, on average, 12 common suppliers, or nearly seven more than the suppliers shared between unaffiliated domestic firms and multinationals. The enhanced network explains about 65 percent of knowledge spillover via joint venturing. Finally, this policy contributed to an enhancement in product quality, measured as a 3.8 percent reduction in defects per car model for affiliated domestic firms.

Improving firms’ capabilities—including through exporter training, country promotion, and market research—has been shown to increase exports by reducing fixed costs and enabling firms to initiate exports, explore new international markets, or introduce new products. Openness to trade also matters. For example, in Pakistan increases in upstream markets’ tariff duties reduced the productivity of firms in the downstream markets. In Peru, firms that were helped to enhance their capabilities in the early 2000s experienced a 17 percent higher export growth rate than firms that did not participate. The higher rate was driven primarily by expansion in the number of countries served and the variety of products traded. Direct support programs to encourage the integration of small firms with large ones have been shown to increase the export capabilities of small firms (box 7.3). But to ensure that the benefits are durable, complementary measures to facilitate technology absorption are also needed.

The integration of economic principles in industrial policy design and implementation is essential for infusion for three reasons. First, assessing the need for industrial policy to address identified market failures, as well as the opportunity costs of state support, is important. Second, ensuring that design and implementation foster contestability and merit will mitigate the risks of market distortions and favoritism. And, third, monitoring and evaluating the direct intended impact, as well as market and spillover effects, will maximize effectiveness. The European Union uses these principles in its state aid control framework, and they are now being used and implemented in different ways in various countries, including Chile, Colombia, Moldova, and the Philippines.

Box 7.3 Supplier development programs to connect small firms with large firms

Chile’s Supplier Development Program establishes two-way connections between potential suppliers that are small and medium enterprises (SMEs) and their large firm customers. In such connections, SMEs benefit from higher sales and employment, resulting in a lower likelihood of exit, while large buying firms enjoy higher sales and bolster their export capabilities. The program provides the government with a subsidy to execute projects sponsored by large firms, on the condition that SMEs act as suppliers for these larger companies. The program also subsidizes activities to enhance SMEs’ technical capabilities, such as providing professional advice and facilitating technology transfers. In the agribusiness sector, supplier firms saw a 16 percent increase in sales and an 8 percent increase in employment within one year after the program was approved. And the large firm customers enjoyed a 19 percent increase in sales and a 3 percent gain in the probability of becoming an exporter.a

In the early 2000s, Costa Rica’s new PROPYME program began promoting innovation among Costa Rican SMEs by facilitating their connections with research units. These units were associated with local or foreign universities or private research centers with no university affiliation. Together, they collaborate on projects geared toward technology development, innovation, growth of human capital, or technology transfer. In addition to fostering these partnerships, the government is financing up to 80 percent of the projects’ total cost. PROPYME resulted in a substantial 19 percentage point increase in labor demand and a 9.6 percentage point boost in the probability of SMEs engaging in exporting.b

Upgrading to ward off foreign competitors

Trade openness improves access to larger markets, international value chains, technology, and know-how. But it also exposes domestic firms to competition from international firms closer to the technology frontier. Such competition forces domestic leaders to upgrade to “escape” competition and puts pressure on laggards to quit, especially when domestic markets are threatened by imports. Such competition can induce a reallocation of resources toward firms that are more productive. It can also incentivize innovation by well-positioned incumbents and upgrading of product quality, including by introducing greater variety.

China’s accession to the World Trade Organization (WTO) is a clear and compelling example of how market leaders in different countries have responded to competition in domestic markets. China’s overall exports grew from US$62 billion in 1990 to US$1.2 trillion in 2007, a staggering average increase of about 20 percent a year. China entered the WTO in 2001. By 2009, it had become the world’s largest exporter and by 2010 the second-largest economy in the world. How have firms responded to rising competition? In 12 European countries, imports from China increased the innovative activity of European firms that survived the competition, while reducing employment and lowering overall chances of firm survival. In heavily exposed sectors, low-tech firms suffered declines in jobs and survival rates, while high-tech ones remained relatively safe. In Argentina, there was a positive association between competition and technology upgrading. In Peru, higher exposure to foreign competition translated into higher value, quantity, and product shares of high-quality exports.

Evidence from Chile and Mexico highlight the following:

• In Chile, as imports of Chinese products rose at an average pace of 27 percent each year from 2001 to 2007, Chilean firms that were market leaders increased their product innovation by 15 percent and product quality by 22 percent. The laggards scaled back their process innovation by 11 percent and product innovation by 13 percent.

• In Mexico, firms making a “peripheral” product (one of small importance in the firm’s total sales) were more likely to pull it off the market if it faced strong competition. However, products that were core to a firm’s business (those with large shares of total output) were less vulnerable. Larger plants and “core” products benefited from expanded access to cheaper imported intermediates, helping firms improve the competitiveness of core products. Furthermore, Mexican firms that faced competition from Chinese imports used existing information technologies to increase productivity, while firms that did not face competition as intense did not, even if they acquired the same technology.

Learning by moving

Connecting with the world by means of trade is a basic requirement for incentivizing incumbents to upgrade, thereby sustaining growth at the middle-income level. But so is the free movement of ideas and people. Together, the movement of ideas, along with goods, services, capital, and people, are critical for advancing technology diffusion.

Middle-income countries should not restrict the movement of their highly skilled individuals. Their emigration can be an opportunity for the origin country rather than a loss. The extent to which this can happen depends on how strongly emigrants remain connected to the origin countries—or even return—and on emigrants’ ability to accumulate knowledge about modern production processes and technologies in their destination countries (box 7.4). This is particularly relevant in conflict-affected countries such as Ukraine that have experienced a large outflow of highly skilled individuals. Origin countries can also create a conducive environment for knowledge transfer involving the diaspora by creating conditions such as political stability, institutional quality, and a favorable investment climate. In addition, origin countries can leverage immigrants’ earnings for economic growth by enabling a safe, efficient flow of remittances.

Some countries have adopted measures to facilitate engagement with their diaspora and foster collaboration on R&D. For example, in 2019 the Academy of Sciences of Albania created NanoAlb, a virtual center to coordinate nanoscience and nanotechnology research in institutions located in Albania as well as Israel, Italy, Kosovo, Montenegro, North Macedonia, Spain, the United Kingdom, and the United States. By engaging the Albanian diaspora in those countries, NanoAlb is able to deliver a variety of products, engage in R&D activities, and offer classes in applications of nanotechnology. The center also disseminates knowledge to society at large and provides educational activities for young students.

Convincing highly skilled emigrants to return home has been a priority for countries such as China, where the Thousand Talents program brings back researchers for permanent employment or short-term visits. However, policies to bring such migrants back can have mixed results. R&D workers are highly mobile and respond to monetary incentives as well as research support and the proximity of other researchers. Reducing the tax rates for returning R&D workers may lead to an increase in the number of inventors through both the retention of domestic inventors and the immigration of foreign inventors, although it may also reduce knowledge spillovers and productivity in the countries from which they are returning. Regardless of the specific policies used, turning brain drain into brain gain remains an imperative in countries’ talent agendas.

Box 7.4 Turning brain drain into brain gain

A highly skilled migrant who moves to a high-income country but cannot find a job—or must work as a cab driver—cannot gain new skills, whereas one who works using his or her skills (as a manager, professional, or technician) is more likely to do so. figure B7.4.1 measures the potential of origin countries to realize gains from knowledge spillovers from their diaspora. To quantify this potential for each origin country, the figure measures the extent to which tertiary-educated workers migrate to high-income countries and the share of tertiary-educated migrants who succeed by working in “good” occupations in the destination country. Countries in the upper right of the figure have the greatest potential because their diaspora is large and successful. To leverage this potential, they should promote knowledge exchange and connections between the diaspora and local industry leaders and investors. Other countries send fewer highly skilled emigrants to advanced countries (lower values on the x-axis), or their migrants are less successful (lower values on the y-axis). Although these features can complicate knowledge transfers, a small number of skilled and successful emigrants may nevertheless be sufficient to transmit ideas or knowledge back to their sending communities.