How India can escape the middle income trap

Middle-income countries have for long been relying on investment-led, foreign capital-led strategies to grow which may not work anymore.

The World Bank believes that middle-income countries tend to stagnate after years of rapid growth on the path to being higher-income economies. Whether such a trap exists is still being debated, but its latest World Development Report is devoted to it and a new playbook for escaping it.

The list of over 100 countries includes two of the world’s largest economies, China and India, proving maybe that size doesn’t matter, though China is on the cusp of exiting the group. The report has some good insights on growth dynamics and can also be a reality check for India in the light of its targets (developed economy by 2047 or a $5 trillion economy in the next three years).

3i approach to escape

In brief, middle-income countries have for long been relying on investment-led, foreign capital-led strategies to grow which may not work anymore. What is required now is the infusion of new, modern technologies and business models along with investment. For graduating to high-income, additionally, innovation will be needed. A business-as-usual strategy, it says, could take a country like India 75 years to reach only a quarter of USA’s per capita.

At current per capita levels of $2,540, even upper middle-income status is some years away. But the Bank’s point is really about the need to rethink strategy given the time remaining and the formidable challenges of the present day - aging populations, exploding debt, a hostile geopolitical and trade environment and roadblocks from environmental impact. Technology and reform underlie its 3i strategy of investment, infusion and innovation.

For countries seeking to move up to upper middle-income, it suggests an infusion led investment strategy, by which it means the adoption of new global technologies and business models that get infused into the larger economy. What this requires are more technology transfers, technology licensing and state polices that help local industry absorb technology and scale up. This would enable a large section of domestic industry to become global producers of a range of sophisticated products.

The Economic Complexity index which specifically tracks country and product complexity capabilities, currently ranks India at 42, while South Korea and China have leaped to the top in less than three decades.

Fast growth, but per capita income lags

India’s case has not really been stagnant growth but of a growth that did not sufficiently increase per capita incomes. But strategies were investment-led and capital-led. While overall growth rates went up, employment and incomes did not keep pace, perhaps due to some long standing structural issues.

Its main economic sectors, agriculture and industry have been underperforming for long. Agriculture’s share in GDP has declined over the years more due to low productivity than a designed shift. The yields per hectare of rice and wheat, two of its largest crops are about 50 percent lower than that of China, which also has a similar average farm land size. But the sector continues to ‘employ’ over 240 million people, which really is disguised unemployment given the low output and low incomes. Given its size, the number of people dependent on it and the crucial issues of food security and food inflation, agriculture looks an obvious candidate for infusion strategy, because even a small increase in yields could lead to significantly higher output and incomes.

Skills shortage influences employment structure

The other structural issue is the nature of industry and labour. The labour force has a huge skills problem- about 25 percent of the 509 million labour force is not literate or formally schooled, while another 52 percent are educated only up to Standard 11 and 12. Infusion of technology and know-how require an appropriately skilled labour force which makes the task extremely difficult.

The employment structure is marked by a high level of informality- about 55 percent of labour force is self-employed or working on own account, largely in agriculture and trading, while about 22 percent is employed on a casual basis. As per ILO data, industry (which includes manufacturing, utilities, mining) employed about 70 million people while construction employed almost an equal amount at 68 million. But less than half of industrial jobs were regular while construction jobs were almost entirely casual employment. With such a large level of informality, not unsurprisingly, job generation and incomes have not increased.

The low Labour Force participation Rate (LFPR) is yet another issue. A workforce of 509 million translates to a LFPR of 58 percent (with female LFPR even lower at 37 percent). While low LFPR is not uncommon, for a population of the size of 1,400 million it implies that a large section, especially women, does not participate in the economy. China in contrast has a LFPR of 67 percent and a women’s LFPR of 61 percent. The challenge for job creation then goes beyond incentivising industries to incentivising the creation of the right jobs especially for women.

The government looks up to industry to generate jobs but as the report points out, its own role in encouraging infusion and innovation is important. The report specifically refers to India’s size-based small-scale industry reservation policy from the 1960s as a classic example of misallocation of resources and discouragement of innovation. If technology absorption instead of size had been the criteria, incentives could perhaps have had better outcomes. Likewise in agriculture investments in research, extension or market infrastructure could have better chances of raising productivity and rural incomes than input subsidies.