Macro Matters: Is the current slowdown cyclical or structural?

If the slowdown is a warning that India is in danger of being caught in a middle-income trap, where does that leave investors?

Published: Jul 11, 2019
Image: Shutterstock

The consensus is that the current slowdown in the economy is cyclical and it's a matter of time before we see a recovery. The government, the Reserve Bank of India and the markets believe the recovery will come in the second half of the current fiscal year. But what if there are other, more structural, reasons for the downturn? What if the reason for the downturn is that the economy is getting caught in a ‘middle-income trap'? This warning has been sounded by no less than a member of the Prime Minister's economic advisory council -- Rathin Roy, director of the National Institute of Public Finance and Policy.

What is the ‘middle-income trap'? The Asian Development Bank defines it as a ‘phenomenon where rapidly growing economies stagnate at middle-income levels and fail to transition to a high-income economy.' The forces that have propelled economic growth for the economy no longer work as well as they used to. As a result, growth loses momentum.

There has been extensive discussion about the middle-income trap and the World Bank, the International Monetary Fund (IMF) and the Asian Development Bank (ADB) have all chimed in at some point in time. The crux of the argument is that while the movement of surplus labour from low-productivity agriculture to other, more productive sectors of the economy such as manufacturing, is usually the key engine driving an economy from the low to the middle income category, accompanied by an increase in capital, the engine of growth has to change when an economy progresses to the high-income stage. The determinants of growth differ at various stages.

Only a few countries in East Asia have made a successful transition to high-income status and of these Singapore and Hong Kong are city-states. In contrast, Latin American countries such as Argentina and Brazil are held up as examples of economies that have failed to make it to high-income status.

Most accounts of the middle-income trap say the key to avoid it is to improve productivity and innovation. The ADB's Asian Development Outlook, 2017, for instance, explained why Latin American countries have been stuck in the trap. It said, ‘The relatively low growth of productivity in Latin America and the Caribbean has several facets. Estimates indicate significant inefficiency in the allocation of resources, including the expansion of low-productivity services and the presence of very small and often informal firms that drag down measures of economic efficiency. In the formal sector, there appear to be inefficiencies even in manufacturing for lack of large and highly productive companies and the persistence of less efficient smaller firms.' The parallels with India are ominous.

The report says the way forward for middle-income economies is to encourage innovation and technological progress, upgrade human capital quality, and invest in information and communication technology (ICT) and other advanced infrastructure.

But Rathin Roy's middle-income trap for India is rather different. His contention is that India's growth has depended on catering to the needs of the richest 100 million of its population and demand from this segment is now plateauing. As the incomes of the rich have grown they are now going in for foreign education for their kids, foreign holidays and luxury imports. And since there doesn't seem to be any chance of export-led growth, India will either have to find new sources of domestic demand by going down the income pyramid or see growth faltering.

At the root of the problem is increasing inequality. A research paper by French economist Thomas Piketty had pointed out that the richest 10 percent of Indians had hogged two-thirds of the entire growth in national income between 1980 and 2014. In spite of overall economic growth going up after 1980, the poorer half of the population saw a reduction in their income growth rates, while the next 40 percent saw only a negligible increase. The biggest gainers have been the top 1 percent. These findings correspond with Rathin Roy's argument that it is the top 100 million who drive India's growth.

Marriner Eccles, a celebrated former head of the US Federal Reserve, put the argument succinctly. He wrote of the Great Depression, ‘a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations. But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants.' These words could very well apply to the prolonged slump in investment that we have seen in India. Lower consumption demand will in turn affect investment demand.

It's no wonder then that a working paper from the ADB Institute by Chinese economists Chen Wang and Jiajun Lang in 2017 said, ‘Fighting inequality and improving income distribution are a must if a country does not wish to fall into the MIT (Middle Income Trap).' But while inequality limits domestic demand, surely, with growth, more and more of the next ten million or so will also increase their consumption?

The answer is: it depends on jobs. India is still at the stage of development where a large part of its population hasn't yet made the transition from agriculture to industry. A recent government report has found very high levels of unemployment among the youth. If they don't have jobs, what will they consume? And even the jobs being created, for instance in the construction sector and in services, are low productivity no-hope jobs. Indeed, former chief economic adviser Arvind Subramanian had published a paper that showed several states in India were facing premature de-industrialization. It's not a sustainable growth model.

The 2018 Economic Survey said that India could face a ‘Late Convergence Stall', meaning that the process of catching up with the advanced economies, aka convergence, could stop. It said, ‘The possibility of such a “Late Converger Stall” arises because of four possible headwinds in the post-Global Financial Crisis era that were largely absent for the early convergers such as Japan and Korea. These headwinds include: the backlash against globalization which reduces exporting opportunities, the difficulties of transferring resources from low productivity to higher productivity sectors (structural transformation), the challenge of upgrading human capital to the demands of a technology-intensive workplace, and coping with climate change-induced agricultural stress. India has so far defied these headwinds but can continue to do so only if the challenges are decisively addressed.'

If the slowdown is indeed structural rather than cyclical, it will take years to address and there is no guarantee we will escape the middle-income trap. Where does that leave investors?

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