The challenge is to escape the middle income trap

The challenge is to escape the middle income trap
The Financial Express, June 24, 2009, Page 2

There is much cause for celebration in India today: a successful democratic election, growth rates for 2009 and 2010 averaging 5 percentage points more than the world, and a stock market up 77% in the last three months. For a country that graduated from low income status only in 2007, these are heady statistics.

For the first time in many years, a single party emerged as a clear winner in national elections. The size of the Congress Party victory has raised hopes that, despite India’s complex coalition politics, serious reform is possible. If growth can be sustained or even accelerated to reach its potential, India could be transformed into an affluent country within one generation. The prize is huge: the elimination of poverty in one of the world’s largest countries, and an economy that could be one of three largest in the world at market exchange rates-a global economic leader.

But the challenges are also enormous. Few countries have grown from low income to affluent in a single generation. Most have floundered and seen growth slow considerably when they reach middle income. Only a handful of East Asian economies have sustained rapid growth once they reached middle income. The great challenge for the new Indian government is whether it can lay the policy and institutional foundations that will allow the country to become affluent. The temptation will be to move cautiously. After all, cautious reforms generated India’s current economic success, and caution in financial reform insulated India from the recent global turmoil. With a solid mandate in hand, why risk political capital on an accelerated reform agenda?

The answer lies in a hard-nosed look at what happened to Brazil, Morocco, the Philippines, South Africa, and Syria in the past. Only Brazil and Morocco from this group had higher per capita incomes in 2005 than in 1975 in constant dollars. In Brazil, this was due entirely to a commodities boom that started in 2005 (its 2004 per capita income was lower than in 1975), and in Morocco the annualized growth over 30 years was less than 0.1 percent a year.What is striking about these examples is that all the countries grew rapidly in the previous decade, 1965-75, and were considered development success stories in 1975, much as India is today. Brazil had grown by 10 percent per year per capita, more than doubling incomes during these years.

But each of these countries got caught in a middle income trap. That occurs when countries cannot compete with low-wage, low-income economies in manufacturing exports or with advanced economies in skill-intensive innovative activities. Without an identified growth strategy, middle income countries can stagnate, at best showing short spurts of growth offset by periods of decline. That is the risk for India today-if it becomes complacent about growth because of its recent success, just when sustained growth is becoming harder to achieve.

But India can avoid a middle income trap if it plans far enough in advance and start to implement institutional reforms to achieve the transformation from poor to advanced economies. History offers some lessons on the needed transformations. The first transformation is to shift from accumulating factors of production to using resources more efficiently in the modern economy. In India this shift towards efficiency can happen only if cities develop properly. Urbanisation is happening fast, with millions moving out of the countryside every year. Today, just the fact of urbanisation is enough to yield growth. But eventually growth will depend on cities becoming more efficient-delivering what is known in the jargon as “agglomeration” benefits. Poorly managed cities, with crime, congestion, and squalor, do not deliver such benefits. Instead, they choke the growth process.

The second transformation is to move beyond basic education for all to a broader concept that also includes skills for a knowledge economy-with broad-based tertiary education, research institutes, and firms with in-house technological capabilities. Despite India’s vaunted institutes of technology and management, and its space and nuclear programs, the knowledge establishment is very thin and highly skewed towards the public sector. India needs more scientists and engineers in the private sector, using their talents to commercialise products. India has two universities in the Shanghai Top 500 global ranking; China has 22. India spends only 0.25% of GDP on R&D devoted to civilian applications. Three-quarters of its total R&D spending is in the public sector. It now needs to produce and deploy skilled workers.

The third transformation is from a centralised to a decentralised administrative system. India already has problems implementing national policies-witness the difficulties in resolving infrastructure bottlenecks despite innumerable plans. As the economy grows more complex, decisions will need to be speeded up. Local administrative cadres need professionalisation. As a recent Administrative Reform commission noted: “It is ironic that there has been no sincere attempt to restructure the civil service although more than six hundred committees and commissions have looked into different aspects.”

Each of these changes is massive and intergenerational. Leaving them untouched and hoping that growth or the passage of time will solve the problem will not work. They require leadership with a focus on sustained implementation. The leadership must be far-sighted enough to realise that, even if gains are not apparent by the time of the next election, reforms must be initiated for the sake of the country’s future.

The Congress Party has the chance to provide that leadership. If it can steer India clear of the middle income trap, more than one billion potential middle class Indians stand to benefit from the rewards of this decisive leadership long into the future.

—The writer is a senior fellow at Brookings Institution and was a member of Centennial Group team that prepared the India 2039 Study