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Indian Economy and the “Middle Income Trap”

Posted in Finance Articles, Total Reads: 2772 , Published on June 08, 2014

The Indian economy after registering a growth of more than 9% since 2005-06 is now able to register growth of mere 5%. Now that we are aiming to make India a super power till 2020, will this growth rate of 5 % take us there is a big question. In this article I would like to present that why India faces the risk of falling in “Middle Income trap”.

image:ddpavumba, freedigitalphotos.net


Year Growth Rate (%)

2006-07- 9.6

2007-08- 9.3

2008-09*- 6.7

2009-10*- 8.6

2010-11- 9.3

2011-12- 6.2

2012-13- 5.0

2013-14**- 4.9

(*The figures of 2008-09 and 2009-10 are not comparable due to spillover effects of the Euro Crises

** Estimated)


So now, what is “Middle Income Trap”? The middle income trap is situation in economy, wherein a country which attains a certain income (due to given advantages) will get stuck at that level. It is phenomenon in which the hitherto rapidly growing economies now face the risk of having a stagnant middle income level and hence fails to graduate in the ranks of high income countries. This means that average income in these countries, which till now had been growing rapidly, will stop growing beyond a certain level which is well short of income in the developed West. The phenomenon has been observed in many Latin American countries like Peru, Mexico and Brazil. In case of India, we can find that till 2006-07 growth rates were steadily increasing and had reached the level of 9.6% in 2006-07, after which it is steadily decreasing thus registering the growth rate of mere 4.9% in 2013-14.

This is in direct contrast to the popular belief is that once the country has achieved a pace in growth rate it can sustain the same and can reach the income level of developed countries.

Naturally the question arises as to why this happens? In the growing rate phase the high growth scored by country is mainly because of adoption of well known technologies and managerial practices often borrowed from the western countries. Workers start moving from subsistence farming to commercial farming and further to manufacturing sector. Due to this there is remarkable increase in growth rate achieved along with increase in wages and living standards. But after certain level it becomes harder to further increase or sustain this level of growth which was basically achieved by piggybacking on the advances made abroad or to simply say on borrowed technology without own local innovation , entrepreneurship and investment.

This phenomenon though contrary to our belief has infact being observed in many economies. Japan is a classic example. The average growth rates have been 10% in the 1960s, 5% in the 1970s, and 4% in the 1980s though after that we see some sort of revival but again the growth rate has fallen down drastically to (-)0.6% and 2 % in 2011 and 2012.

Other reasons as to why country faces middle income trap are slow manufacturing growth, limited industrial diversification and poor labor market conditions. In case of India, the Index of Industrial Production for February 2014 contracted 1.9% year on tear basis. On detailed analysis we can see that manufacturing which constitutes 75 per cent of the index has declined by 3.7 % thus showing the signs of declining manufacturing growth. Though this in itself is a matter of concern, the spillover effects have a much larger impact on economy. Low growth of manufacturing sector implies low employment, low research and development investment and low exports. Due to this the country lacks innovation and hence has to rely on imports.

The ageing population also plays an important role. As population ages there is a rise in labor cost thus making a country less competitive in export market. Here begins the time when the country must begin to reinvent itself through technology and innovation. As for India the risk of ageing population does not exist but the real risk for India is that of unskilled labor without any technical education and low capacity of manufacturing sector to absorb the existing labor force. Also it must be understood that only on basis of labor and capital we cannot have ever increasing growth rate because both face diminishing marginal returns.

If ever it happens that India falls in Middle Income Trap the consequences would be disastrous. Firstly, unable to compete with low wage competitors around the world on one hand and with advance economies due to lack of technology and innovation on the other hand, the exports would enormously fall behind. Secondly, the per capita income will always be at a middle level as there will be no much growth employment. Thirdly, the skilled human capital will flow out of India due to decreasing job opportunities.

So what should be done to make sure that India does not fall in this trap? Firstly, Skill development should be stressed for. This can be done by revisiting our universities and making them more research oriented. Universities should stress on skill development and not just theoretical education. The universities can act as research centers for industries and hence enhance innovative thinking and tacit knowledge among the masses.

Secondly, the policies should be directed in such a way that productivity of labor and capital is enhanced. What we need to increase is the marginal productivity of labor by increasing their skills. Thirdly, there should be increased stress on innovation i.e. original research for which we need young minds in field of research and development. If must be understood that the concept on economic development has drastically changed and is no more seen as capital driven but is known to be knowledge driven. Considering the need for innovation the Government of India has also introduced Innovation in Science Pursuit for Inspired Research (INSPIRE) Programme.

Considering the huge long lasting impact the Middle Income Trap can have on Indian economy, it will be a real brainstorming for the new 2014 government to balance funds for innovation and reduce fiscal deficit so as to prevent India from falling in middle income trap."

The article has been authored by Swaraj Chhallani, Institute of Chartered Accountants of India.

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