Access to Finance, Product Innovation, and Middle-Income Growth Traps

After experiencing an initial period of rapid growth, many developing countries have fallen into the middle- income “trap”—stuck between low-wage, low-technology markets and high-income, innovation-based developed economies. As previous literature has demonstrated (Agénor and Canuto 2012), public policies aimed at improving access to advanced information and telecommunications (ITC) infrastructure, protecting intellectual property rights, and reforming labor markets to reduce rigidities can help developing countries avoid such low-growth equilibria. As a complement to these policies, which create an enabling environment for learning and innovation, this note draws on more recent work (Agé- nor and Canuto 2014) that emphasizes the role of access to finance in supporting the innovative activities that in turn can help countries climb the ladder to high-income status. In particular, this note argues that inadequate access to finance has an adverse effect on innovation, directly, through the financing of fewer research and development (R&D) projects, and also indirectly, as fewer individuals may choose to invest in the skills necessary to work in R&D fields. These dual effects highlight the need for public policies aimed at alleviating credit market imperfections to promote the production of ideas and increase the incentives for workers to invest in higher skills. An empirical comparison of countries in East Asia that were able to escape the middle-income trap with less successful counterparts in Latin America provides a poignant example of how access to finance influences innovation outputs and long-term economic growth.