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While these aspirations are laudable, the questions now are if the high growth rate can be sustained or if the growth drivers in the initials stages will lose steam at some point of time –is it possible for Sri Lanka to fall into the middle income trap?
Speaking at the inauguration of the 25th Anniversary Convention of the Association of Professional Bankers (APB) Sri Lanka themed ‘Beyond Growth – A Formula for Success’ held last evening at The Kingsbury Hotel, Subbarao shared his views and check-list for economies to avoid the middle income trap and reach the high income level status.
What is the middle income trap?
In the last 65-70 years when looking at the developing history, as many as 100 countries have made the transition from low income to middle income but not have made the transition from mid to high income. The inability to move from mid to high income is what is known as the middle income trap, Subbarao explained. 
Essentially there are four questions about the middle income trap that countries need to focus on, he said: What causes the trap? At what per capital level does it manifest? Is it possible to avoid the trap? What can be done?
What causes the middle income trap?
“What causes it is, when countries start on the growth trajectory from very low income levels there is huge potential to grow.” The two key factors that drive growth from low to mid income are low cost labour and technology.
“There is a lot of labour in agriculture working much below productive levels. They move from primary sector to secondary and tertiary sectors and the transition happens. This is the first driver from poverty to middle level.” For the use of technology, countries can now skip several steps and see what advanced countries have evolved in to, take that technology and adapt it to local conditions.
However, very soon the potential of these drivers will be exhausted. As productivity improves, labour wages go up and in turn the competiveness of the sector is lost. On the technology front, economies can exhaust the leapfrog potential. Innovation is then a must for countries. “The inability to improve the productivity of labour and innovate technology is what puts countries in the middle income trap.
At what per capita income level does it manifest?
“People say the trap occurs at US$ 5,000-10,000 per capita income levels. Perhaps it can manifest at different income level for different countries,” Subbarao acknowledged.
Is it possible to avoid the trap?
Certainly, he said. The middle income trap is not inevitable. It is possible to avoid the trap by appropriate policies and more importantly, good governance.
What should be done to avoid the trap?
Subbarao noted that he had drawn up his own 10-point strategy for countries to avoid the middle income trap, drawing largely from his experience in India as well as experience in studying East Asian economies.
1. Strengthen infrastructure
“In India we are painfully aware of the infrastructure deficit,” he said. Commenting on the enormous power of infrastructure he noted that the World Bank estimates that if infrastructure is improved by 1%, annually, GDP will increase by 1%. Building infrastructure is quite difficult – and in fiscally constrained economies such as India and Sri Lanka, governments find it difficult to find the money necessary for infrastructure.
In India profit investment in infrastructure currently is at 3% of the GDP while estimates show that if India is to accelerate, public investment in infrastructure must improve this to 9-10% of the GDP in a five year period. “Here, private contribution is necessary,” Subbarao said. “Firstly, the financial sector, financial intermediation is necessary for private resources for some infrastructure. Then you need capacity to execute projects.” The play of PPP is important here.
2. Skill empowerment
There is a need to improve productivity in labour and for this skill empowerment is key. “In India we realised the skill care is no longer a handicap but a crisis. It is said that only 2% of India’s labour force is capable. It is difficult to do this. Governments by definition are poor teachers/administrators of skill development.” Will the private sector do it? The answer is a negative.
Subbarao explained that the private sector won’t because if they do invest in skills, there is no way they can hold the skills hostage. “Practical experience shows they won’t.” There again is a need for PPPs. India has been struggling with a skill development mission and the prime focus has been to bring partnership between private and public sector. The Indian Government has built some of the resources and handed them over for the public sector to run so that the skill levels will be improved and trainers will get trained, etc. In developing skills there is an incentive issues, he said – government does not have the comparative advantage and the private sector doesn’t have the incentive. “You need participation from both sides for this.”
3. Improvement of higher education and focus on applied research
Sri Lanka is ahead of all South Asian countries in primary education, in terms of enrolment, potential and achievement, etc. However, where the country falls behind is in higher education. Stressing that the quality of higher education is highly important to make the transition from mid to high income economies, he said: “We need to focus on the quality. We have focused on the quantity but compromised on the quality.” In China, the number of papers Chinese scholars produce indicates the upward movement of the knowledge hierarchy.
4. Create an environment for structural transformation to take place
Subbarao said: “The middle income trap is the consequence of losing competitiveness in some sectors. The solution therefore lies in an early structure for the transformation to take place so that sunset industries go in the direction of the sunset and there are new sunrise industries coming up – that creative disruption must take place.” This has been the hallmark of developmental advance everywhere in advanced technologies, he reflected. The issue however is that political economy is against structural transformation. Especially in democracies, to stand by and see certain industries losing competiveness and millions losing their jobs is not something that they can stomach. While it is easier to hang on to the sunset industries and not let sunrise industries raise their head, controlling them with subsidies, tariffs, exchange controls; inevitably the transition must take place. “At the middle income level, political interests must work for structural transformation. This must be allowed to take place.”
5. Regulate, but do so efficiently
He noted that structural adjustments involve the public sector yielding to the private sector. However in sectors such as infrastructure monopolies or oligopolies have been set up, therefore governments must yield to this. When this happens it is possible that consumer interests get compromised. “Public sector must regulate the private sector, governing the markets to protect the consumers.”
Regulation is not discussed only in the financial sector but in other sectors as well, he commented. The criticism against regulations is that it imposes additional costs. The struggle for regulators therefore is to regulate but do so efficiently in a manner that benefits always exceed the costs, he noted.
6. Manage financial sector development
There is virtually no country in the world that has moved from low income to middle income without a quality financial sector, Subbarao said. The reason the accelerated growth rate in India dropped before the global financial crisis was an unacknowledged consequence of the improvement of the quality of financial integration.
“There could be a question that if financial sector development is important for growth, is more of it better? The answer is no,” he said. “In fact, one of the problems for the world has been getting carried away in the euphoria of financial sector development. “After the crisis we know that for every real sector problem, there is a financial sector solution which is wrong. The growth of the development effort has to be the real economy and the financial sector.”
7. Manage public finances responsibly
Sri Lanka has made credible fiscal consolidation in South Asia. It is important that governments are responsible in fiscal management and that the financial sector is the stakeholder in the economy though the government is accountable for fiscal decisions.
8. Manage globalisation intelligently
Globalisation is a double-edged sword, Subbarao said – with potential rewards but with challenges, with positivity and negativity attached. Politically, the negative side of globalisation is always in mind whereas the positivity – such as the years before crisis countries such as India and Sri Lanka reached out to the world, opened it up, globalising and integrating, he reminded.
The negativity was the impact of crisis. “Globalisation is a very powerful force; whatever happens enabling the world impacting every country. For countries to move up from middle income to high income, they must manage globalisation; especially in the financial sector it is important to reach to a sizeable level to global institutions; together or individually. Banks must consolidate.”
9. Provide good governance
Subbarao said: “Good governance is at the heart of everything, including avoiding middle income trap.” It is the ability to see long term, prioritising against short term compulsions. Governance must be recognised at regional and provincial levels as well, he added.
10. Don’t make banking boring
Among the causes for crisis was that the banking sector was too flamboyant, too exciting. There was huge growth in investment banking and such that it got out of controls. The remedy, as some see it (and projected in a research), is to make the financial sector less glamorous, less flamboyant, less attractive and more boring. Ina way this was seen in the period before great depression, after which the banking was heavily regulated and far less adventures and less lucrative. Just before crisis financial sector once again became exciting and glamorous.
“I disagree,” Subbarao said. “That must be for the advanced economies but for countries aspiring to go higher, we must make banking attractive and innovative. We need financial inclusion and we need to take banking to every household in the country.”
Is the middle income trap a destiny?
Certainly not; the important thing is to be aware of the trap and impose appropriate polices and implement them, Subbarao assured.
“When an economy grows as Sri Lanka’s has, several factors are looked at such as peace dividends, effective investments, improved productivity, demographic advantages, good governance, etc. One of the commonly missed factors is the financial sector – the improvement and quality of the financial sector,” he said.
As Sri Lanka pursuits the goal of achieving per capita income of US$ 4,000 by 2016 and moving beyond that afterwards, the financial sector will have to play a viable and more important role, Subbarao reminded.
Pix by Upul Abayasekera
