The lower- middle income nation trap

Economic convergence—or the process of poorer countries growing faster than richer countries and closing the gap in standards of living—started in the 1980s and gathered pace between 1998 and 2007 into what came to be called “convergence with a vengeance’’. But it suddenly seems to be stalling after the global financial crisis of 2007. The possibility of such a “Late Converger Stall”, as the latest Economic Survey (2017-18) calls it, can derail India’s best-laid plans of economic development and prevent it from entering the league of an upper middle-income nation in the medium term.

With a per capita income of $6,538 in purchasing power parity terms, which is 12% of the U.S. per capita income, India continues to be categorised as a lower-middle income country and needs to get to anywhere between 15% to 35% in terms of per capita income to join the ranks of upper-middle income countries. In fact, India’s per capita income needs to grow at 6.5% every year till the mid-to-late 2020s to achieve upper-middle income status, if it isn’t tripped by any external factors.

These possible headwinds to India’s growth trajectory include the backlash against globalisation, which has reduced exporting opportunities, the difficulties in transferring resources from low productivity to higher productivity sectors (also described as structural transformation), the challenge of upgrading human capital to the demands of a technology-intensive workplace, and coping with climate change-induced agricultural stress.

Before attempting any analysis of such a theory, it is important to put the whole issue in the context of a slowdown in global growth after the global financial crisis and its impact on the process of convergence. Global growth, for instance, declined from 4.3% in the 10-year period before the global financial meltdown to 2.9% in the next 10 years; advanced nations slid from 3.6% to 1.4%; upper-middle nations from 4.5% to3.3%, and lower middle income countries 4.9% to 4.2%.

Low global growth coupled with the rise of automation and artificial intelligence and robotics in the workplace also meant large-scale unemployment, stagnating wages for the middle class, rising inequality, and overall deterioration in the standard of living in developed countries. Calls for protectionism have echoed across the globe with most countries closing their borders to the free movement of people and goods.  This backlash against globalisation means that developing countries, which came late to the convergence party, will find a very different trading environment from the earlier era of rapid globalisation, which allowed countries like Japan, Korea and China to post average export growth of more than 15% for more than 30 years. It also implies that trading opportunities available to early convergers, specifically the ability to export at double-digit growth rates for three or four decades consistently, may no longer be available, says the survey.

The transition to a middle-income nation also calls for certain structural transformations. Allocating resources from low productivity to high productivity sectors and devoting a larger share of resources to sectors with potential for rapid productivity are instances of such structural transformations. Yet, in many countries the shift happens from the informal, low productivity sectors to ones that are only marginally less informal or slightly more productive, resulting in what is called “thwarted structural transformation” of the economy. That is why the survey warns of premature industrialisation—the tendency for manufacturing to peak at lower levels of activity and earlier in the development process—unlike richer countries, which attained earlier and higher levels of peak manufacturing in their development process.

Sectors such as manufacturing, finance, telecommunications, and professional services rather than hotels, restaurants, transport etc are sectors with high levels of productivity and have the potential for unconditional convergence. For China, the average share of this good growth—in these high-growth areas— as a percentage of total growth is 53% while that of India’s was 37%, which further slid to 32% after the great financial crisis.

The early convergence countries had another benefit.  Educated but relatively unskilled labour could be easily employed in factories or in other manufacturing jobs, thereby allowing the migration from agriculture to industry. But those arriving at the party late are doubly challenged; not just they have failed to provide even basic education but also because “technology will increasingly favour skilled human capital, where the requisite skills will include adaptability and the ability to run continually”. As the survey argues, that growth itself will be based less on comparative advantage and more on some absolute human capital attainment.

The true magnitude of India’s human capital challenge is enormous. The Annual Survey of Education (ASER) shows that nearly 40% to 50% of children in rural India from grades three to eight, between the ages of five and 16, cannot meet the fairly basic learning standard—read a simple story in a local language or do simple subtraction. If technology going forward is going to be even more human capital-intensive as the current trend suggests, the wedge between the opportunities offered to the future labour force and capabilities to take advantage of them will widen even more and countries like India may find it difficult to join the ranks of the middle-income nations.

Agriculture too could come back to haunt the structural transformation fortunes of late convergers because of the adverse impact of climate change on farm productivity. An analysis by the Economic Survey shows that if there is a rise in temperature and reduced monsoons because of climate change, Indian farmers could be poorer by 20% to 25% in non-irrigated areas. Any fall in agricultural productivity not only means that the many people will go hungry in rural areas, but also those who move from the farm to more modern sectors.

While India is susceptible to all these risks, the biggest challenge as a late converger is that resources (especially labour) will move from low productivity, informal sectors to other sectors that are marginally less formal and only marginally more productive. That is something that India must avoid.