Burning Issues

[Burning Issue] Middle Income Trap and India

India has a nearly 34-year window of opportunity to leverage its human resources and realize its growth potential before a phase of demographic burden sets in. This period will coincide with another important part of India’s growth story: the pursuit of high-income status. Too many countries have failed to make the leap from the middle-income to high-income group, afflicted by a malady now commonly referred to as ‘the middle-income trap’.

What is the middle-income trap?

  • The “middle-income trap” is a theory of economic development in which a country lost its competitive edge in the export of manufactured goods because of rising wages.
  • The wages rise to the point that the growth potential of that country is exhausted before it attains the innovative capability needed to boost productivity and compete with developed countries.
  • The countries caught in the Middle Income Trap are unable to compete with low-income, low-wage economies in manufactured exports and with advanced economies in high-skill innovations.
  • The middle-income trap is associated with a relatively sustained growth slowdown with both direct effects (e.g. income losses) as well as indirect effects (e.g. social conflicts).
  • Fuelled by the global slowdown, many countries, particularly in South East Asia, Africa and Latin America currently face the predicament of the Middle-income trap.
  • This has impeded their transition from middle income to high income.

What is the basis for the categorization of countries?

World Bank has used the 2018 data of gross national income (GNI) per capita to categorize countries into the following four categories:

CategoryReal Per-Capita Income* (2016)
Low-Income Countries (LICs)Less than 5% of the US.
Lower Middle-Income Countries (LMICs)About 5-15% of the US
Upper Middle-Income Countries (UMICs)About 15-35% of the US.
High-Income Countries (HICs)All those above that line – including some above US’ level.

Why do Countries fall into the Middle Income Trap?

  • Inability to shift growth strategies: If a country cannot make a timely transition from resource-driven growth, with low-cost labor and capital, to productivity-driven growth, it might find itself trapped in the middle-income zone.
  • Lower export potential: Traditional exports cannot be as easily expanded as before because wages are higher and cost competitiveness declines. Middle-income countries also face varying levels of access to product and financial markets and diverse social, economic and environmental vulnerabilities.
  • Skewed income distribution & stagnation in middle-class population: Wealth inequality and the hierarchical distribution of income in developing countries is a downward drag on domestic demand, which results in stagnation. It slows down the upward mobility of families that are at lower levels, into the middle class that is prepared to pay more for quality and differentiated products.
  • Recurring boom-bust cycles & pro-cyclical lending: Many middle-income countries in Latin America have been through cycles of growth based on credit extended during commodity booms, followed by crisis, and then recovery. This stop–go cycle has prevented them from becoming advanced economies despite enjoying many periods of fast growth. This is in sharp contrast with successful countries in East Asia—Japan, Hong Kong, Taiwan, Singapore, and South Korea that have been able to sustain high growth over some 50 years.

India’s Case

  • In 1960, India was a low-income country with per capita income around 6% of the US. However India attained status of lower middle income in 2008 with per capita income of about 12% of the US.
  • But the growth has occurred with limited transfer of labor resources to high productivity and dynamic sectors, despite relatively modest agricultural growth.
  • Thus, the late converger stall risk remains for India too.

Why India might get caught in a middle-income trap?

(1) Backlash against globalization:

  • Hyper globalization (benefited the China, South Korea & Japan) led to a backlash in the advanced countries, as seen through increasing protectionism & lowering World Trade-GDP ratios since 2011.
  • This means that similar trading opportunities may no longer be available for the middle-income countries.

(2) Thwarted Structural Transformation:

  • The manufacturing sector is identified as a critically important sector for ensuring transformation. Successful development requires two kinds of structural transformations:
  • a shift of resources from low productivity to high productivity sectors; and
  • a larger share of resources devoted to sectors that have the potential for rapid productivity growth.
  • However, in late economies like India, ‘premature deindustrialization’ (tendency for manufacturing to peak at lower levels of activity and earlier in the development process) is a major cause of concern.
  • Also, there is a negative share of good growth over time along with weakening of the positive correlation between growth and good growth.
  • There are various outliers to the convergence process in this regard like India and China. China’s good growth persists and India’s share of the same declined.

(3) Human Capital Regression:

  • Human capital frontier for the new structural transformation has shifted further away making the transformation costlier.
  • This is because the new advances in technology not only require skilled human capital, but also demands them to learn continually.
  • As opposed to these requirements, there is a wider educational attainment gap and skill deficit between lower income countries and advanced economies.
  • If this gap persists or widens, the kind of transformation enjoyed by the early convergers might prove more difficult for late convergers.
  • This gap is highly stark for India given its absolute Learning Poverty Count between 40-50% and Learning Poverty Gap is about 25% for reading and a little lower for math.

(4) Climate change-induced Agricultural Stress:

  • Agricultural productivity is crucial both for feeding people and for ensuring human capital moves from agriculture to modern sectors.
  • The agricultural growth rates of richer countries have been consistently greater than for developing countries in each time period.
  • With climate change, weather extremities have become a recurrent phenomenon. This is, in particular, a threat to India where agriculture is heavily dependent on precipitation.
  • Fall in private consumption, muted rise in fixed investment and sluggish exports have led to a slowdown in the economy and increase India’s vulnerability to the middle-income trap.
Learning Poverty Count- measures the number of children who do not meet the basic learning benchmark. Learning Poverty Gap- Takes into account how far each student is from the benchmark.

Avoiding the Middle Income Trap

  • In 1960, India was a low-income country with per capita income around 6% of the US. However, India attained the status of lower middle income in 2008 with per capita income of about 12% of the US.
  • But, the growth has occurred with limited transfer of labor resources to high productivity and dynamic sectors, despite relatively modest agricultural growth.
  • Thus, the risk of getting trapped in a middle-income zone remains.
  • To avoid becoming trapped without a viable high-growth strategy, India needs to:

(1) Transitioning from diversification to specialization in production:

  • Specialization allowed the middle-income Asian countries to reap economies of scale and offset the cost of disadvantages associated with higher wages (E.g. Electronics industry in South Korea).
  • High levels of investment in new technologies and innovation-conducive policies are two overarching requirements to ensure specialized production.
  • Developing good social-safety nets and skill-retraining programs can ease the restructuring process that accompanies specialization.

(2) Shifting to productivity-led growth:

  • Total factor-productivity growth requires major changes in education, from primary & secondary schooling to tertiary education so that workers adept new skills as per the demands of the markets.
  • Creating such knowledge economy requires long term planning and investment.
  • Middle-income countries need better access to technologies, research, and innovation, and also better management practices.
  • That requires redesigning development strategies and gradually shifting to higher-value-added sectors with a focus on innovative, sustainable and inclusive growth.

(3) Opportunities for professional talent:

  • To attract and retain a critical mass of professional talent that is becoming more internationally mobile, India must develop safe & livable cities that provide attractive lifestyles to professionals.

(4) Addressing barriers to effective competition:

  • There is a need to address rigidities that can arise from bankruptcy laws, stringent tax regulations, limited enforcement of IP regulations, imperfect information, discrimination etc.

(5) Decentralized economic management:

  • Greater powers should be vested in local governments, address the insufficiency of judges in lower courts, etc. to ensure speedier decision making.

(6) Sustaining macroeconomic stability:

  • Flexible fiscal framework that limited deficits and debt, and a flexible exchange rate mechanism backed up by a credible inflation-targeting monetary policy could help sustain long periods of growth.
  • Effective restructuring, regulating, and supervising of the financial sector must be ensured so that the present NPA crisis can be effectively handled.

(7) Changing orientation of social programs:

  • Social programs should target the middle class as well as poorer sections of society.
  • Ramping up domestic demand is also important—an expanding middle class can use its increasing purchasing power to buy high-quality, innovative products and help drive growth.
  • Inequality is a barrier to the broadening of the demand base in an economy.
  • This could be achieved through initiatives like low-cost housing for first-time homebuyers in cities, programs to ensure that recent graduates get suitable employment opportunities, etc.

Way forward

  • Rapidly improving human capital–– healthy individuals, including all women, with the basic education to continually learn and adapt––will be key to sustaining India’s dynamic growth trajectory.
  • Rapidly improving agricultural productivity––against the headwinds of climate change and water scarcity––will be another key to achieving good growth and hence sustainable growth.
  • And, of course, the hyper globalization backlash in advanced countries, over which India has little control, must recede to create a favorable external climate to sustain rapid growth.
  • There is no Late Converger Stall, as yet, but it would be wise to act to head it off.
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