In today’s Finshots, we dive into the middle-income trap and explore whether India can steer clear of it.

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The Story

India is a middle-income country. But don’t just take our word for it, the World Bank agrees.

You see, back in 2006, India was in the low-income bracket. But thanks to some solid economic growth, averaging 6-7% annually, the country’s per capita income (average income per person) started climbing. This prompted the World Bank to upgrade India to the lower-middle-income club in 2007. And we’ve been cruising in that lane ever since.

But India’s government doesn’t want to settle for just cruising along. It’s now keen to break out of this status quo. And it has set a rather ambitious target for itself. It wants to turn India into a fully developed nation by 2047, the 100th year of independence. That’s right, it’s dreaming big.

And to make this a reality, NITI (National Institution for Transforming India) Aayog recently rolled out a paper titled ‘Vision for Viksit Bharat @ 2047’. It’s a roadmap for transforming India into a tech-savvy, economically robust and inclusive society.

The goal is to boost India’s GDP (Gross Domestic Product) or the value of all the goods and services the country produces from the current $3 trillion to a whopping nine times that. And raise the per capita income per annum from about $2,400 today to $19,000.

But the real kicker in the document isn’t just these ambitious targets. The big highlight is that India must dodge the dreaded ‘middle-income trap’ to hit these growth goals.

How do we do that, you ask?

To figure that out, we first need to understand what the ‘middle-income trap’ is all about. You could think of it as a situation where a country hits a certain level of GDP per capita, but then gets stuck there. Growth slows down, and the country struggles to make a leap to the high-income status.

Sidebar: As of 2023, the World Bank classifies a country as high-income if its annual per capita income tops around $14,000.

But hold on Finshots. Hasn’t India's GDP been on a roll? I mean, we’ve climbed up to the 5th largest economy globally from the 17th spot in the early 1990s. So, doesn’t that mean our GDP per capita should be skyrocketing too? How can you say that it’s been stagnant?

Let’s explain.

The culprit here is income inequality. For context, as per an Oxfam India report, between 2012 and 2021, over 40% of the wealth generated in India ended up in the pockets of just 1% of the population. Meanwhile, only 3% of that wealth trickled down to the bottom 50%.

And this uneven distribution has actually been a dampener for GDP per capita growth, even though India’s overall GDP has been steadily climbing.

To get a grip on this, let’s dive into Thomas Piketty’s ideas from his book Capital in the 21st Century.

Piketty talks about two key variables — the rate of return on capital (r) and the rate of economic growth (g). Basically, r is what you earn from investments. Think stuff like stocks, real estate and savings. And g is how fast the overall economy is growing, usually tracked by GDP.

And here’s the crux of his idea. When r > g, the rich get richer faster than the economy grows.

Why?

Because the returns on their investments are growing quicker than most people’s wages.

In developed countries like the US, where the economy is stable and resources are fully used, wealthy folks see their investments soar while wages lag behind, widening the wealth gap.

In contrast, developing economies often face r < g. Here, the economy might grow faster than the returns on investments due to issues like underemployment and skill mismatches. And you’d think that this would help reduce inequality since work income grows faster than investment returns.

But despite this potential advantage, income inequality still rises. And this situation culminates into a ‘middle-income trap’.

Sounds a bit like India’s growth story, no?

And this might mean that India could find it hard to escape the middle-income trap. But it’s not like India is the first country to be staring at this predicament.

Take Brazil, for instance. Back in the early 2000s, Brazil seemed poised for greatness. Booming commodity prices and successful social programs lifted millions out of poverty. It looked like Brazil might swiftly transition from middle-income to high-income status.

Fast forward to 2024, and Brazil, despite a solid per capita income of around $10,000, still can’t shake off the middle-income trap. Income inequality remains a major issue. To put things into perspective, the top 10% hold over half the country’s wealth, while the rest see minimal gains. Add to that structural problems like corruption and the susceptibility to global commodity price swings, and it’s clear why Brazil’s growth stalled.

Now, we don’t want to get stuck like Brazil in this middle-income trap. So, how do we break free from it?

Dr. Rathin Roy, a former economic advisor to the Finance Commission, has a solution or rather some practical recommendations to prevent India from a situation like that.

And here’s pretty much a gist of what he said.

Even if India seems to be growing right now, this growth might be more illusion than reality. That’s because India’s current growth isn’t based on what all Indians consume. It’s more about what a few million or the small wealthy segment of Indians want to buy. Just think about it. While some Indians splurge on air conditioners, cars and fancy gadgets, the essentials for most are nutritious food, decent housing, clothing, healthcare and education.

So Dr. Roy suggests that India needs to focus on making these essentials affordable without relying heavily on subsidies. Subsidies are essentially a way of shifting money from the rich to the poor. Instead, India could look to produce these goods more cost-effectively over time, possibly reducing subsidies gradually.

You could take textiles as an example. India is less competitive compared to countries like Bangladesh and Vietnam in this segment because of higher wages. And that’s a product of shirts being made in west Gujarat or Tirupur, but with labour from UP, Bihar and West Bengal. So it’s obviously going to be expensive because wages here are higher. But why not produce these textiles in states like Bihar, UP, West Bengal, Chhattisgarh and Orissa or places from where people often migrate to the south or west for jobs?

The idea is to give a boost to people who already know how to make these goods, so they can head back to their home states and start production there. These states have the potential to do this with just a little bit of upgrading. Essentially, it’s about tapping into local skills and resources to get things rolling right where they are.

And this shift could tackle two big issues. First, it could help with unemployment since this type of manufacturing requires lots of hands-on work. Second, it could address regional inequalities by spreading economic opportunities more evenly.

Right now, India’s growth is more about what a few wealthy people consume rather than what everyone needs. While exports are starting to play a bigger role, our economy is still largely driven by consumption. And if we don’t start producing the essentials that the majority of Indians need, we might just end up stuck in the middle-income trap.

So yeah, inclusive growth is the secret sauce for moving forward and making the leap to a high-income country while sidestepping that pesky middle-income trap. And with India making strides through things like PLI (Production Linked Incentives) schemes and a push for local manufacturing and jobs, here’s hoping we can pull it off! Godspeed.

Until then…

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