It’s become a middle-income world, but increasingly hard to join the club

Critical development gains over the past two decades have enabled half of the countries classified as low-income in the early 2000s to become middle-income.  Today, only 28 out of the 217 countries classified by the World Bank are considered low-income. The pathway to middle-income status for these countries appears more challenging, however, as some of the dynamics that helped so many climb the income ladder are now stalling. There are even elevated risks of some middle-income countries reverting to low-income status.

A range of factors explain this:

• The existing low-income countries are significantly poorer than those that managed to graduate.  Countries that sustained graduation from low-income status for ten or more years since 2000 started with 19 percent of their populations living below the national poverty line, on average. In contrast, as of 2019, low-income countries had more than 26 percent of their populations living below the national poverty line — a share that subsequently increased after COVID-19;
• Nearly two-thirds, or 17, of the 28 current low-income countries are also classified as fragile or conflict-affected situations (FCS). These situations take a huge toll on human capital, creating vicious cycles that lower people’s lifetime productivity and earnings and reduce socioeconomic mobility. The trend is expected to continue: on the current trajectory, by 2030 up to two-thirds of the world’s extreme poor will live in FCS countries;
• The effects of climate change on growth are becoming more pronounced. Impacts on labor productivity and agricultural output disproportionately hurt the poor, including people dependent on rain-fed agricultural, pastoral, forest, and coastal resources for their livelihoods. Without climate action, by 2030 more than 100 million people could be pushed into poverty by climate change impacts, and by 2050 as many as 143 million people could become climate migrants;
• The external environment poses multiple challenges. These include a slow global economic recovery from COVID-19, notably for trade and finance, limited fiscal space in donor countries possibly affecting aid flows, higher borrowing costs, and heightened global political tensions. COVID-related supply chain issues, coupled with Russia’s invasion of Ukraine, contributed to a surge in global inflation — particularly increasing food prices and food insecurity among low-income countries that rely on imported foods;
• Multiple crises have led to a generational setback in gender equality.  Gender gaps leave the full economic potential of countries untapped. Increasing female labor force participation to align with male rates, for example, could lead to an average 20 percent increase in per capita GDP;
• Global aging has led to a rising global ratio of dependents to workers. Demographic transition in middle- and high-income countries may translate into lower external demand for low-income countries. For example, rapid aging in China, accounting for 39 percent of global growth in 2016, points toward waning demand. Labor shortages in high-income countries could increase emigration of skilled workers from low-income countries; and,
• Public finances in low-income countries have deteriorated since the pandemic, limiting fiscal space to pursue development objectives.  Vulnerabilities have increased with rising debt-to-GDP ratios and global interest rates. As of January 2023, 50% of the 28 low-income countries are either at high risk of debt distress (nine) or in debt distress (five) — compared with 37% in 2018.

In contrast, before the onset of the COVID-19 crisis, rapid economic growth allowed 33 of the 66 countries categorized as low-income in 2001 to subsequently graduate. On average, one country graduated from low-income status every eight months from 2001 through 2020, compared with an average of one country graduating every 17 months from 1987 through 2000.

Various dynamics supported the rapid pace of graduation from 2001 through 2020. These include debt relief initiatives, such as the Heavily Indebted Poor Country Initiative, increased investment in human and physical capital, and improved economic policy frameworks. On the latter, for example, almost all World Governance Indicators are positively correlated with the number of years countries have maintained low-income country graduation.

Trade liberalization and globalization also supported income convergence, although impacts have been mixed. For example, unlike developing Asia, countries in Sub-Saharan Africa failed to invest revenues from commodity exports in infrastructure to facilitate a shift out of agriculture and into labor-intensive manufacturing. While not all targets were met by 2015, commitment in 2000 to the Millennium Development Goals contributed to critical gains, including the halving of poverty.

In parallel, aid architecture shifted, with the number of countries and multilateral institutions providing aid increasing from 47 in 2000 to 70 in 2019. Although a welcome trend, this contributed to more complex donor coordination and less predictability in aid flows, potentially reducing aid effectiveness. Aid to all developing countries have also steadily increased — led by private sector flows that increased from 36 percent of total flows in 2010 to nearly 50 percent in 2019. Nevertheless, for low-income countries, official aid flows continue to account for 90 percent of total flows.

In the face of cascading crises, deglobalization, and strained public finances, the above factors suggest two main approaches are needed to realize improved outcomes for low-income countries:

1. Enhancing efforts by donor and recipient countries to scale-up implementation of the aid effectiveness agenda — including improved coordination, recipient country ownership, and a focus on results — to help address key challenges, such as FCS, climate change adaptation, and debt.
2. Improving public financial management and the quality of public expenditures — aimed at: strengthening public service delivery, such as health, education, gender outcomes, and infrastructure; and, public sector governance, such as data reporting, oversight, accountability, and public investment management. This would strengthen competitiveness, facilitate investment, and support a country moving up the global value chain of production while shifting into more resilient and low-carbon activities.

This blog is based on a forthcoming paper on fiscal policy and low-income countries supported by the Korean Development Institute School of Public Policy and Management.