There is no easy escape from the middle-income trap

Net FDI into India fell to $3 billion in the five months through August, compared with $18 billion in the same period a year earlier, the Reserve Bank of India reported last week.
Net FDI into India fell to $3 billion in the five months through August, compared with $18 billion in the same period a year earlier, the Reserve Bank of India reported last week.

Summary

  • Optimism over how many more countries will make the leap to rich-world status is scarce for good reason

No semi-final play-offs happen and no trophies are awarded to the winners. More than 1 billion people compete over decades. It is the most difficult endurance and entrepreneurial challenge of our times. Last week, one of its chief referees was in New Delhi to speak about it, but few reporters were in the audience. Graduating from middle income to developed world status is the greatest prize in development economics. Only a handful of East Asian and Central European countries have made the transition so far, along with a few fortunate resource-rich countries.

World Bank chief economist Indermit Gill’s assessment was worrying. The developing world has a much harder task ahead of it than countries such as South Korea and Taiwan did. “There’s no reason to believe that the next couple of decades will be better than the last two for global development," said Gill, who is also the co-author of a book that 15 years ago coined the term ‘middle-income trap’. “Middle income economies have to grow in a shrinking space." For economies as large as India, that is bad news. It turns out that getting from $1,000 per capita to $10,000 is much more of a multifaceted challenge than getting from $100 to $1,000, which relies on using low labour costs and putting more people to work.

And the economic backdrop has rarely looked less promising. The trade environment is much more protectionist than before, while many large US and UK retailers have gone bankrupt. A New Delhi-based exporter told me recently that rather than haggle with the new owners of retailers, often private equity funds that have bought distressed assets, exiting the business seemed a preferable option. Even large and mid-sized MNCs are losing heart: Foreign direct investment (FDI) is plummeting in tandem with global trade. Net FDI into India fell to $3 billion in the five months through August, compared with $18 billion in the same period a year earlier, the Reserve Bank of India reported last week. China has seen an even steeper fall as the country turns inward. In a recent blog co-authored by Gill and M. Ayhan Kose, they observed: “Global trade is expected to grow less than 2% this year—not even half the annual average that prevailed in the 2000s. At the end of 2022, the total volume of global FDI inflows was down by almost 40% from the 2007 peak." By contrast, in the first seven years of the 2000s ahead of the great financial crisis, trade grew by more than 10%.

But the problems are still wider. As Gill put it in a tweet this month: “Too much public debt. Too little private investment. And the slowest recovery in global trade in the past five decades." Private investment is not proving much help in providing the financing needed by developing countries for green transitions. They also have higher foreign and fiscal debt than before.

In a telling moment, Indonesia, one of the countries seeking to escape the middle-income trap, was forced last week to hike its benchmark rate to 6% to keep in step with the Fed’s higher rates, even though its inflation rate at 2.3% is at the bottom end of its central bank’s target band. The reason it did so was that the rupiah was under pressure, despite having, along with China, the highest real interest rates compared with our Asian peers. India now has public debt at 83% of GDP and combined fiscal debt (states and Centre) in double digits, among the highest fiscal deficits in Asia. No wonder even leading contenders in the growth stakes such as China, India and Turkey now look as if they are stuck in a middle-income trap. Turkey’s revolving door of finance ministers over the past few years resembled a soap opera. India’s demonetization was a first for a large economy not experiencing runaway inflation. Now, Beijing’s abrupt sacking of senior ministers, which started with the disappearance of its foreign minister months ago and then its defence minister and finally the dismissal of the finance and defence minister and culminated with a change in finance minister on Tuesday (which was telegraphed in late September) raises big questions about the country’s governance. A former White House official quipped that it seems like an Agatha Christie novel, but it alarmingly harks back to Mao Zedong’s era.

Even with steady economic management, however, there is no easy way to escape the trap. East Asian economies such as Taiwan and South Korea had energetic bureaucracies fine-tuning industrial and trade policy, while their education systems (including the primary level, crucially) churned out just what their economies needed to jump hurdles in the way of becoming developed. If improving school education matters, so does boosting the speed and predictability of bureaucratic and judicial decision-making. India still struggles in these mission-critical areas, as seen in everything from our Annual Status of Education Reports to the mind-numbing revising of revisions of rules governing the import of computers.

Governments seeking to transition their nations to developed-world status need to resist crafty lobbyists (usually influential donors to political parties) and the urge for fiscal populism that democracies with deep disparities demand, while improving education and R&D. This is perhaps why many middle-income countries’ growth rates start slowing after they achieve merely a fraction of the US per capita income. Compared to East Asia’s track record, India looks “downright mediocre," Gill said last week. Sadly, so does most of the developing world.

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