Stuck in the Middle- Indian Economy

7/28/2019 Stuck in the Middle- Indian Economy

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Stuck in the middle' is never a good

ending to a story. Especially when it

comes to economics, we like clearstories of good and evil. "The Soviet

Union collapsed because it banned

private enterprise", or "the US is the

world's biggest economy, because it

encourages innovation", are the kindsof stories we like.Less compelling is an economy which grew strongly, then stopped growing, well before it became

rich. A country which just runs out of steam altogether somehow seems less interesting.

Yet that's the real danger that the International Monetary Fund (IMF) points to, in its regional

economic outlook for Asia which it released last week. It pointed out that the fast-growing

economies of Asia - from China to India to Vietnam to Malaysia - faced the risk of falling into a

'middle-income trap'.

Which means that average incomes in these countries, which till now had been growing rapidly, will

stop growing beyond a point - a point that is well short of incomes in the developed West.

Effectively these countries could become 'middle class', and stay that way.

Falling into the Trap

The idea of a 'middle-income trap' is not new. Before Asia, the countries believed to have suffered

most from the middle-income trap phenomenon were the hitherto fast-growing economies of Latin

America, during their famous 'lost decade' of the 1980s, when growth stalled, industrial production

stagnated and unemployment and inflation both remained high.


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"The lesson from what happened in Latin America is that you cannot get complacent about

growth," says Shekhar Aiyar, a co-author of an IMF paper ("Growth Slowdowns and the Middle-Income Trap") on which the IMF outlook was based. "Just because you are seeing fast growth

doesn't mean it will last." The bottomline: just because you made the transition from a low-income

economy to a middle-income one, don't expect to easily clear the next hurdle, from a middle- to

high-income economy.

Growth Slowdowns

Indeed, as the research shows, once a country reaches the middle-income stage (defined as

anything between $2,000 and $15,000 per annum per person in what are called 'international

dollars' which enable cross-country comparisons), the stakes and risks actually go up. Middleincome

economies are far more prone to slowdowns in growth than either low- or high-income economies.

The effects of a middle-income trap were there for all to see after the Asian crisis of 1997.

The IMF report points out that while the Asian Tiger economies - Taiwan, Singapore, South Korea

and Hong Kong - reached high-income levels, "the experience of several other Asian middle-income

economies (MIEs) has been more mixed, reflecting in part the transitory but large effect on living

standards of the Asian crisis of the late 1990s.

Malaysia has been more success- ful than Indonesia, with Thailand falling in between, but in all

three cases convergence to living standards in advanced economies stalled for a decade after the

Asian crisis, regaining momentum only in recent years."

But what causes such growth slowdowns and middle-income traps? The IMF paper and report

identify a number of causes - none of which are surprising - from infrastructure to weak institutions,

to less-than-favourable macroeconomic conditions.

But the broad, overall cause, says the research, is a collapse in the growth of productivity - the

ability for a given amount of labour and capital to produce ever-increasing amounts of output. Such


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productivity is driven by, along with technological innovations, a range of other factors from higher

education and skill levels (more skilled workers are more productive), and also the state of

institutions and infrastructure.

People Issues

"The main idea behind a middleincome trap is getting caught in low productivity growth," says

Jehangir Aziz, India chief economist at JP Morgan. "The initial surge in productivity which drove

growth begins to recede, causing growth to slow down, and is not boosted later.

Importantly, there is little push from within the economy to reinvent itself" Another major factoraffecting middle-income countries in Asia is demography and slowing population growth.

As the population begins to age, new additions to the workforce begin to slow. This pushes wages

up, making the country less able to compete purely on labour costs alone.

"At this point you need a completely new production structure driven by technology and

innovation," points out Pronab Sen, former chief statistician of India and currently chairman of theNational Statistical Commission. Countries such as South Korea or Taiwan made that transition to

high-tech manufacturing, from competing purely on labour costs. It's less clear whether countries

like China, India, or Malaysia can do so.

The India story

India is less at risk from an ageing population, at least for now - indeed over the next decade or so, itis one of the few countries whose average population will actually get younger, thus providing a

potential demographic dividend. But the IMF research identifies a set of other factors - among them

re infrastructure weaknesses and macroeconomic problems, as potential causes of a growth

slowdown in India.

"Infrastructure is not much of a factor behind growth slowdowns in high income economies," points

out Aiyar. "Neither is it a major constraint in low-income economies," he says pointing to other,

more pressing problems such as even basic institutions, and a functioning state. "But it is an

important factor affecting growth in middle-income economies."


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The broader picture that emerges from the research is one of different factors affecting growth

at different stages. For low-income countries, just maintaining minimum law and order and afunctioning state is a major achievement.

Beyond this, for a country to move to middle-income status, and beyond, a much larger set of

conditions needs to be fulfilled - everything from allowing entrepreneurs to flourish, to ensuring

adequate credit and well-functioning infrastructure. As Aiyar points out the idea can even be applied

to individual states within India. "A good example is Bihar under Nitish Kumar," he says.

"His most immediate priority was to put in place a functioning state and that led to an immediate

burst of growth. But to sustain that, Bihar needs to focus on building other aspects of its economy

such as infrastructure." While India does not face a 'demographic time-bomb' like China, there is

hardly any room for complacency on this front either.

While the decreasing age of India's population might make us believe that there isn't much to be

worried about, when it comes to supplying

labour to feed demand, skill shortages in a number of sectors have already pushed wages up.

This makes the picture more complicated and puts the emphasis on education and even health.

"That's clearly a risk that we will face in the years ahead," says Aziz, referring to the lack of an

adequately skilled workforce.

Cautious Optimism

Interestingly, though, Aziz is sceptical that the term 'middle-income' fits India at all. The country has

a per capita income of about $3,600 (in 'international dollars'), technically bringing it within the

ambit of the IMF's definition. "It's difficult to apply the definition of 'middleincome' to a country

where around 300 million live on less than a dollar a day," he argues.

But his argument goes deeper. "The very idea of a 'trap' suggests a situation from which a country

cannot extricate itself. If India does face serious economic problems, there will be pressure fromwithin for change," he says.


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In fact, he points to the experience of the last few years. "For three years we had a policy freeze, but

we continued to coast along since we had reasonable growth. There was no urgency to fix problems.

But only when we ended up with a 5-6% growth rate, did the government move with urgency to fix

outstanding policy problems.

The impact of this will play out in the months ahead," Aziz adds Scaling It Up Middle-income trap or

not, India will eventually have to deal with the problem of how to move to a higher growth path.

This isn't merely a problem of numbers. Sen points to the example of largescale labour-intensive

manufacturing in the textiles sector. "We are nowhere when compared with a country like

Bangladesh when it comes to scale of factories," he says.

India, he points out, has moved to a segment in the textiles sector which is focused on more

highvalue garments, vacating the basic garments space to its neighbour to the East and countries

like Vietnam. "The problem is that the segment we operate in faces a limit to demand beyond a

point. That limit is not there in basic garments."

While Bangladesh's textile manufacturing model comes with its own set of critical problems -witness the over 900 deaths from fires in two textile factories in a span of two weeks - the concern

for India is whether it can create an environment where large-scale labour-intensive manufacturing

facilities can be built.

Ironically, while China has built factories of enormous scale, that country's main concern is whether,

over the next decade or two, it can find enough workers, cheaply enough, to staff them. India seems

to have exactly the opposite problem.

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Stuck in the Middle- Indian Economy