Old trap for a new mule: A study on the role of financial systems in escaping the middle-income trap

Abstract

The middle-income trap has been in developmental discussions for the better part of the last decade since the inability of most Latin American countries to break out of it. There is renewed interest in the concept since the realisation that one of the biggest economies in the world, i.e., China could be caught in it. While there is abundant literature on the part that social infrastructure and human capital development plays, the effect of financial systems is relatively ignored. This paper seeks to fill this gap by understanding the role of financial system variables in escaping the middle-income trap. By taking a sample of thirteen countries and using two classification techniques—Naive Bayes and random forest, it is concluded that both bank-based measures and market-based measures have an impact on income levels. These results have strong implications on understanding how to break out of the trap for policymakers.