Want to beat the middle income trap? Follow 10 commandments of Dr. Duvvuri Subbarao

Monday, 14 October 2013 00:00 -     - {{hitsCtrl.values.hits}}

The 10 economic commandments Delivering the keynote address at the recently-concluded Silver Jubilee Convention of the Association of Professional Bankers, better known as APB, the former Governor of the Reserve Bank of India, Dr. Duvvuri Subbarao, left his audience with 10 suggestions which are in fact 10 Commandments. The theme of the Convention was ‘Beyond Growth: A Formula for Success’ and the theme of the keynote address on how to beat the middle income country trap was very apt to the Convention’s theme since it is an issue which Sri Lanka has to now tackle in its indefatigable march toward wealth and prosperity. Sri Lanka’s linear growth models Sri Lanka’s avowed goal, as it had been in the past, has been to attain continuous economic growth to elevate its economy from the current lower middle income country to higher middle income country in the next few years and from there, to a rich country within the next one and a half decades. As this writer has pointed out in previous articles in this series, these linear growth projections are fraught with unexpected impediments that will derail the country’s march on a pre-planned linear growth path (available at: http://www.ft.lk/2013/05/06/sri-lankas-linear-growth-projections-to-prosperity-in-a-non-linear-world/). For instance, for the country to attain this goal, it has to grow at a compound rate of 10% plus year after year. But the resource limitations within the country and market limitations outside the country are to work against it slowing down the growth and limiting the initial high growth only to a few successive years. The disappointed reality This is apparent in the growth attainments of the country in the past four years. Immediately after the end of the war, the real growth accelerated from 3.5% in 2009 to 8% in 2010. This growth rate further accelerated to 8.2% in 2011 filling everyone with the hope of having a growth decade of 8% plus. The Central Bank, as reported in its Annual report for 2010 (p 19), was so jubilant about this outcome that it raised its hope of increasing the growth rate to 9.5% by 2013 and remaining at that level in 2014 as well. But the actual realisations, badly hit by domestic as well as global impediments, were far from these accelerating linear growth projections: 6.4% in 2012 and a little above that in 2013 according to independent projections though the Central Bank still maintains that the country will grow at 7.5% this year despite the poor performance in the export sector and many of the leading corporates. Suggestions for avoiding the Middle Income Country Trap The Middle Income Country Trap is another impediment which is critically threatening high linear growth projections today. Given Sri Lanka’s low technology base, insignificant engagement in research and development, rising shortage of skilled labour, rising wage levels and limitations on global market access, this writer in a previous article speculated that the country will get snared in the middle income country trap even before it elevates itself to the higher middle income country status (available at: http://www.ft.lk/2012/01/23/will-sri-lanka-be-snared-in-a-lower-middle-income-trap-before-it-reaches-the-middle-income-trap-proper/). Now Dr. Subbarao has identified, based on Indian and East-Asian experience, 10 important requirements which the country has to fulfill if it wants to avoid the Middle Income Country Trap. Doubling per capita income in a shorter period Sri Lanka has been overly concerned with the ‘doubling of the per capita income’ in the next few years, a politically very attractive slogan of the day. In the past five decades, the country took a long period to double its per capita income and the Central Bank in a special box article in its Annual Report for 2010 (p 31) has highlighted these long periods: From 1960 to 1975, 15 years, from 1976 to 1991, 16 years and from 1992 to 2004, 13 years. But from 2005 to 2008, within just four years, the country managed to double its per capita income from $ 1,062 in 2005 to $ 2,014 in 2008. The Central Bank has attributed this to the growth rate of above 6% attained during this period supported by stable macroeconomic conditions. Thus, the next doubling will not take, the Bank has reasoned, 10 to 15 years as it had taken in the past but a shorter period. This shorter period was six years, making it possible for Sri Lanka to surpass the $ 4,000 mark by 2014. Money world vs real world What the Central Bank implies in its analysis is that with the doubling of per capita income, the real wellbeing of the people, on average, will also double. But an omission in this type of implication, as an impartial analyst should do, is the disregard of the fact that this doubling has taken place not in the real world but in the money world. The per capita income is calculated by estimating in local currency the market value of the total income of people which includes the increases in the prices and then, dividing it by the average exchange rate for the US dollar for international comparison. The impact of a high inflation on per capita income is to be automatically corrected by the depreciation of the currency to match the high local inflation. But if the currency is not depreciated and kept at an artificially high value, then, the per capita income in dollar terms too shows a higher value than what it should actually be. Over this period, the consumer price index has increased by 54% pushing up the money per capita income by more than a half. When the inflation is removed, the real per capita income of people has increased from Rs. 98,561 or $ 980 in 2005 to Rs. 117,109 or $ 1,081 in 2008. Since the rupee had a higher valuation against the dollar during this period and that valuation was partially adjusted in 2009, if one uses the adjusted rate, the per capita income in 2008 stood at around $ 1,018, an increase of only 4%. Thus, it is the money per capita income, not even useful for international comparison of real wellbeing, has doubled; the real wellbeing of the people as shown by that money income has increased only by a negligible fraction. What should have been targeted is the doubling of an indicator like the Purchasing Power Parity per capita income which better represents the wellbeing of the people. Disregard of middle income country trap issues This over-occupation in the doubling of money per capita income had prevented the Central Bank from addressing itself to the issues involved in the Middle Income Country Risk which Sri Lanka had been facing. In a second box article titled ‘Challenges in Increasing Per Capita Income Beyond $ 4,000,’ the current goal of Sri Lanka, published in the Central Bank Annual Report for 2012 (pp 12-3), the Bank has made a passing reference to these issues as a challenge. In this box article, it has identified some important solutions to push the per capita income beyond $ 4,000 and not necessarily to avoid the Middle Income Country Trap: introduction of technology, shift from labour intensive to capital intensive industries in view of falling unemployment rate and the consequential labour shortage, improving productivity, diversification of the economy to a broad based economic activities through the Five Hubs plus one strategy by adding tourism to the other five hubs already being pursued by the country, attraction of foreign direct investments and improving the skills base of the labour force. In this environment, the broad 10 Commandments suggested by Dr. Subbarao come in handy for Sri Lanka to introduce a broad policy measure to beat the Middle Income Country Trap. Be mindful of the bigger loss In the course of his presentation, Dr. Subbarao related a humorous story evoking laughter in the audience. He said that Sherlock Holmes, the famous detective in Sir Arthur Conan Doyle’s detective novels, had gone out of London with his friend and assistant Dr. Watson to spend a night out in a tent in the field. In the middle of the night, Holmes had awakened Watson and asked him what he had been seeing. Watson had replied first the sky, then to Holmes further insistence, stars, moon, flying bats, all pleasant experiences. Then the angry Holmes had asked Watson, “Haven’t you seen that our tent has been stolen?” Dr. Subbarao’s message was clear: Don’t get intoxicated in happy ending pleasant stories because you will fail to notice the major disasters that have hit you until someone else has pointed them to you. Advanced technology to join the rich country club The Middle Income Country Trap arises when a poor country moves up to become a middle income country but cannot become a rich country. It is relatively easy for a poor country to become a middle income country because of many advantages it is having: cheap labour, attraction of foreign direct investment with relatively low technology, widened market access for mass-produced goods, extension of trade concessions and concessionary lending by international lending agencies. But when it reaches the middle income level, it cannot compete with the poor countries anymore because it loses all these advantages. It cannot compete with rich countries too because it does not have the advanced technology and market access for its products. Hence, any solution to beat the Middle Income Country Trap should prepare the middle income country to overcome these impediments. Dr. Subbarao’s 10 Commandments are a compilation of the most important requirements which the emerging middle income countries like India, China and Sri Lanka should fulfil. 10 Commandments in five categories Dr. Subbarao’s 10 Comman-dments can be categorised under five broad headings: Development of physical and human infrastructure, economic reforms, managing the country’s finances, seamless integration to global markets and good governance practices. Under physical and human infrastructure category, Dr. Subbarao has listed three commandments: The development of physical infrastructure to facilitate efficient conduct of economic activities, the development of the skills base of the labour force to enable people to absorb high technology and improvement of higher education and focus on applied research to develop new technology, knowledge base and advanced scientific methods. Physical infrastructure Physical infrastructure is necessary but not sufficient to promote a country to rich country status. A country may have, thanks to modern engineering marvels, the most modern ports, airports, road networks and smart cities. They are necessary to facilitate future economic development. But without proper economic utilisation and managerial and marketing plans, such infrastructure facilities remain “white elephants” becoming an enormous burden for taxpayers to maintain them. For instance, Sri Lanka in the 1970s boasted of having the largest rice mill in Asia at Hasalaka without adequate water supply to mill paddy and the most modern sugar refinery at Kanthalai without planting sugarcane to feed it. Similarly, Viet Nam has been accused by Ruchir Sharma of ‘Breakout Nations’ fame of building 40 ports along its coast with no ships visiting them. Hence, infrastructure is important but decisions to build infrastructure should be made after carefully undertaking cost-benefit analyses and proper prioritising in order to avoid waste of scarce resources. These decisions should be made by experts and not by politicians. If not what would happen is, as the one time Soviet leader Nikita Khrushchev put it “building bridges where there are no rivers” for which “politicians are famous”. Human infrastructure A skilled labour force is a must if a country is to join the rich country club. While the educational institutions have to train the labour force, higher education and research institutions will have to build the knowledge base through research and development for that labour force to use. The government sector or the private sector alone cannot do this. Dr. Subbarao has suggested that both these sectors should work together to attain this goal. He did not give a practical measure to do it but what is necessary is to have a proper incentive structure for the private sector to spend money on that and reap the benefit as well. Economic reforms Under economic reforms, Dr. Subbarao has categorised two commandments: Creating an environment for structural transformation and introducing an efficient regulatory mechanism. An economy is like a human body with billions of cells where old cells die in order to pave way for new cells to be born. If old cells do not die, it is a cancerous situation where the undying old cells will cripple the body into eventual death. Similarly, Dr. Subbarao pointed out that in the structural transformation old industries which have served their purpose known as ‘sunset industries’ should be weeded to pave way for new industries known as ‘sunrise industries’. These are hard and bold economic decisions which a nation should make but if it fails to make those decisions, it should give up the hope of joining the rich country club as well. Flamboyant lending Under managing the country’s finances, Dr. Subbarao referred to the need for managing the financial sector as well as the public finance sector. A quality financial sector which provides flamboyant financial facilities is a must for any country to channel savings into productive investment sectors, Dr. Subbarao reasoned out. What he meant by flamboyant financial facilities is active and productive participation in lending by financial institutions, a proposition contrary to what Nobel Laureate Paul Krugman propagated in order to avoid financial crises. According to Krugman, crises occur because financial institutions go out of the way to take risks; so he suggested that instead of being flamboyant, they should be boring. Dr. Subbarao disagreed saying that ‘boring financial institutions’ will not help an economy to make big pushes. In the view of this writer, Dr. Subbarao has overestimated the capacity of financial institutions in taking high risks without damaging the interests of depositors and outside stakeholders. So, while financial institutions should in fact grant quality loans actively, there should be a healthy bank regulatory system to show them their limits. Responsible public finances In the public finance management, Dr. Subbarao has drawn attention to the need for managing fiscal affairs of a country responsibly. This is where, many countries, including developed nations, have erred. The belief of fiscal authorities that they can continue to borrow and finance profligate government expenditure programs to cater to what is known as ‘the gallery’ of a nation without damaging the long-term health of an economy has driven many countries to their limit; the latest being the sudden and embarrassing ‘Federal Government Shutdown’ in USA, the outcome of such profligate expenditure programs in the past. A country which manages its public finances responsibly like modern Singapore will not live to regret it one day. Resources available to any country are limited and it is necessary, whether it is public finance or private finance, such resources should be managed prudently and responsibly. Dr. Subbarao left an important message to Sri Lanka’s fiscal authorities who are deeply immersed in a debt recycling crisis but take pleasure in announcing that they have reduced the debt/GDP ratio by a few notches without disciplining the overall consumption expenditure of the budget. Dr. Subbarao has also emphasised on the need for countries to get integrated to global markets seamlessly to create wealth and prosperity continuously. Governance in a new dimension It is under the category of good governance where Dr. Subbarao has hit the nail on its head. In his words as reported by Daily FT in its issue on 9 October 2013: “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.” Dr. Subbarao has drawn attention to a new dimension of governance here: The action which can bring immense damage to an economy by the short-sighted economic policies of a government which is bent on winning only elections ignoring the long term implications. The answer to this was reported to have been given by Singapore’s first Finance Minister Dr. Goh Keng Swee. Justifying the tough economic policies the country had been adopting, he has said that if future politicians want to incur vote catching expenditure programs, they should bring money for that from their homes and not out of taxpayers’ money or central banks’ printed money. Should Sri Lanka listen to it at this crucial hour of its economic development? (W.A. Wijewardena can be reached at waw1949@gmail.com.)

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