Economic historian Barry Eichengreen has shown how countries that have experienced rapid economic growth during their escape from the clutches of mass poverty tend to falter in their subsequent move to mass prosperity. His research suggests that the most common point when inertia sets in, is when average incomes are either around $11,000 or $15,000 a year. This is the famous middle income trap. Fewer countries emerge from it than enter it.

The International Monetary Fund (IMF) estimates that average incomes in China will be $10,098 this year. Eichengreen based his estimates on constant prices in terms of 2005 US dollars while the IMF data is based on current prices, but the broad lesson is the same. China has entered challenging territory. This should serve as background for two important events. First, there are signs that the Chinese financial system is facing immense stress. Second, India has overtaken China as the fastest growing major economy in the world. Both these events have profound implications for the rest of the world.

The usual belief among economists is that economic growth in the initial phases is predominantly driven by the use of more inputs. The labour force is growing. Investment rates are high. Then the need for productivity growth kicks in. The transition from one phase to the other—from using more inputs to using them more productively—is not an easy one. The countries of East Asia painfully realised this in 1997. South Korea had a per capita income of $13,137 in the year before the Asian financial crisis.

China is now struggling with a similar challenge that South Korea and its Asian peers faced more than two decades ago—how to best switch the economic growth model from input intensity to productivity growth. The basic facts are clear. The Chinese labour force seems to have peaked. The investment rate is already unsustainably high. The inputs game is drawing to a close.

China has responded to its challenges through stimulus measures that have created massive financial stress. The true fiscal deficit, which includes subnational borrowing as well as money raised off balance sheet, is perhaps close to 10% of Chinese gross domestic product.

The credit booms directed by the government have raised the risk of a financial meltdown. Some China bears are convinced that a Minsky Moment is just around the corner. The point to remember is that much of this is connected to the challenge of changing the growth model to escape the middle income trap. It is not just a question of financial engineering.

Where does India stand in all this? India has been growing faster than China in the past couple of years. That is likely to continue as the Chinese economy continues to lose momentum. Yet, there is a lot of catching up to do.

The Indian average income in 2019 will be broadly similar to the Chinese average income in 2006. What this means is that India is now 13 years behind China in terms of living standards. There is a similar gap when it comes to the size of the economy. The first gap deals with living standards of the average citizen, while the second gap can influence our global strategic heft. There is a third gap that is wider, for social development indicators such as health and education.

How fast the income gap can be closed, or at least narrowed, is not a question that can be easily answered. It depends on whether India can improve its economic trajectory even while China slows down.

In the two decades before its structural slowdown began in 2013, China expanded its economy at double digits in nine years while it grew in excess of 9% for another six years. India had one year of double digit growth and three years of 9%-plus growth in the same period.

China has on average been growing around two percentage points faster than India since the early 1990s. The two Asian giants began at more or less the same level. China moved ahead very rapidly. India now has a chance to close the gap. A lot depends on the respective policy responses in the two countries. Can China change its growth model without a financial shock? Can India accelerate its growth rate over the next two decades?

The Chinese Communist Party has historically been obsessed with avoiding a political collapse of the sort the Soviet Union saw in 1991. It may perhaps now have reason to worry more about the sort of financial meltdown that many Asian countries saw in 1997, or even the long stagnation that Japan encountered after its financial bubble burst in 1989, at the very end of its economic miracle.

However, it would be unrealistic to dismiss the possibility that China will extricate itself from the middle income trap. Remember that this is the same country that has had the most spectacular economic boom in human history as well as the most astonishing development story ever. Twenty years of bearish forecasts about the coming collapse of China have not materialized—as yet.

The China slowdown is an opportunity for India to close the gap. The first condition for that will be policy reforms to sustain higher economic growth.

Niranjan Rajadhyaksha is research director and senior fellow at IDFC Institute. Read Niranjan’s previous Mint columns at www.livemint.com/cafeeconomics

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