The Middle Income Trap and How India Must Avert It

While the Mahatyohar (Read: General Elections) of the Indian nation concluded with a staggering majority for the incumbent BJP, it was immediately followed by the official revelation of certain important economic indicators that were perhaps obscured in a mist of uncertainty during the election campaign. Nevertheless, the unemployment rate was revealed to be at a four-decade high of 6.1% while the GDP growth rate of 2019 Q1 has dropped to nearly 5.8% after a decline in the consumption expenditure for automobile and real estate, which explains the recent 0.2% reduction in the IMF growth projections for India as compared to its previous assessment in January. The growth concerns have put more interest rate cuts by the Reserve Bank of India on the radar, and have pushed its stance from neutral to accommodative. And while all these deviations can be credited to the global slowdown that is being projected for 2019 as a part of the generic economic cycle, for emerging nations like India this could indicate the end to an era of rapid economic convergence.

Recently, amidst the chaos of the Indian elections, Rathin Roy, Director of the National Institute of Public Finance and Policy, highlighted a bipartisan issue of long term stagnation that the Indian economy might soon have to confront. He identified that the long term growth of the nation is primarily spurred by what the top 10% income bracket of the population consumes. This was good enough to lift India to the group of lower-middle income nations back in 2008 when the per capita income rose above $1005 for the first time. But now, this group has become a major hindrance to reaching the upper-middle-income bracket that ranges from $3,956 to $12,235 per capita. In order to cross this threshold, the economy must witness a structural transformation of the non-luxury good industries, on which the majority of the Indian population depends. Roy states that while aspects like infrastructure, microfinance, etc. are being dealt with by the government’s PM Awas Yojana and PM Mudra Yojana schemes respectively, it is agriculture that clearly needs to undergo a proper revival to ameliorate the productivity of the most basic non-luxury good; foodgrain, for which we’re becoming increasingly dependent. Other aspects like technology and human capital development require immediate attention for escaping the Middle Income Trap that we’re heading into. 

The Middle Income Trap is an economic phenomenon that states how a poor nation makes significant progress on its way to becoming a middle-income nation but then finds it harder to take the shape of a fully developed, high-income nation. This phenomenon is more frequent than one would assume. Only 13 of the 101 nations deemed to be middle-income countries in the 1960’s had achieved high-income levels by 2011. The failure of the rest of the nations is primarily attributed to the rising domestic wages, failure to invest in human capital, lack of innovation and issues with macroeconomic stability. While the latter is comparatively under control and any recent macroeconomic discrepancies have been exogenous to the powers of the central bank, the remaining three are extremely crucial yet underrated issues in the Indian economy. 

Roy identifies that labour-intensive business investments are increasingly being channelled towards nations like Bangladesh, even though their wages are similar to those of East Indian states like Bihar, Jharkhand, etc. But there, the labour is scarce due to mass migrations towards the western states where minimum wages are much higher, a policy which had contributed to the early popularity the current PM Modi, during his tenure as the Chief Minister of the western state of Gujarat. Although it is difficult to revert such populist policies, the issue of high wages has the ability to resolve itself in time, as the nation’s demographic structure changes, with more people contributing to the labour supply. 

As for the development of human capital, the current share of education-related expenditure in India’s Union Budget is a mere 3%, much lower than the minimum 6% required for the basic functioning of the education system, let alone its restructuring. Innovation was encouraged through government initiatives like Startup India, which badly backfired as the government failed to encourage investors by perpetuating the regressive Angel Tax, which charged venture capitalists on any amount invested over and above the government’s faulty valuation of the startups. 

An observation similar to Rathin Roy’s was made in the Economic Survey of 2017-18, which identified the threat of a ‘Late Converger Stall’ that India will have to tackle on its way to the upper-middle-income status. Economic convergence, which is the process of developing economies catching up with the developed ones, is divided into phases. There have been early convergers like Japan and South Korea, who managed to take advantage of their cheap labour and efficient productivity in time, and then there are late convergers like India, who did not open their economy to global opportunities until the eleventh hour and must now bear the consequences. 

The Economic Survey identified the major headwinds that were absent for the early convergers and could now lead to a growth stall for the late convergers. Hyper globalisation repudiation due to a growing sentiment of protectionism was absent during the early convergers period, which gave Japan, China, and South Korea, an average export boost of over 15% during their convergence period. The global trade-to-GDP ratio is on a decline since 2011, which, from a policy perspective, means that the late convergers must now focus more on enhancing private investments to boost growth. Another factor identified by the survey was the thwarted structural transformation due to wrongly channelising resources from low productivity sectors to marginally more productive sectors rather than high productivity sectors. Sectors like finance, technology, and other professional services must be tapped for overcoming the stagnation. Additionally, climate-change-induced agricultural stress and regression of human capital are also some of the major issues that need to be addressed with greater urgency.

Although the middle-income trap can be avoided by both increasing domestic demand or by boosting exports, India can only prioritise the former because becoming an export-led economy would imply a current account surplus and capital account deficit, and that would curb the FDI to the nation, which is evidently undesirable for an Emerging Market Economy (EME). The policy mix of the politically right government has, for the most part, comprised economically left-leaning schemes combined with cleverly constructed, investment conducive foreign policy. But that is not enough. India is one of the prime investment destinations among its fellow EMEs, and we must fully take advantage of that before the preferences, as they inevitably will, shift to the African nations, for capital is faithful to none.


Riya Kaul

Studying economics at Delhi University. That's pretty much it.

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