In a recent paper modestly titled Why We Are Bullish On China, Morgan Stanley, the global investment bank, makes a strong case for why China will achieve high-income status (gross domestic product, or GDP, per capita greater than $12,500) within 10 years, from its current upper middle-income status of $8,100. The paper by Chetan Ahya and others begins with these words: “China’s shift from low-income to middle-income status has been the largest and most rapid economic transition in world economic history. Yet, throughout this journey doubts have been raised about its sustainability".

The paper’s argument is anchored on two pillars (1) that Chinese economic activity will shift towards higher value activities and (2) that policymakers will handle the debt cycle well enough so as not to create a financial shock to the system. The authors state that “alongside this rise in per capita incomes, there will also continue to be significant structural changes in the economy. To continue its journey towards a high-income society, China will need to move up the value chain in economic activities, shutting down capacities in old, redundant industries while fostering the development of new, high value-added economic activities in sectors such as high-end manufacturing, healthcare, education and environmental services. Consumption and services will come to dominate the economic landscape".

The Chinese economy has been gradually shifting from an investment bias to a consumption-oriented one. For the first time, the service sector contribution to GDP has crossed 50% and will likely register 53% this year. Private sector consumption is expected to increase from $4.4 trillion today (39% of GDP) to $9.7 trillion (47% of GDP) in the next 10 years. This shift towards consumption will be driven by an increase in per capita income, an ageing population and a shift towards more “consumer experience" rather than consumer goods.

For manufacturing, the shift from low value-added to high value has already begun. Import content in manufacturing has been declining steadily and products termed high-value have crossed 50% of the export bucket. The Made in China 2025 plan forms part of a three-stage blueprint to boost manufacturing competitiveness—the goals are to be a strong manufacturer by 2025, a medium-level player by 2035 and a leader in innovation by 2045.

The underlying “magic" that enables economies to grow from low income to middle income and from there to high income is captured in an economic term called “Total Factor Productivity (TFP)". TFP is a measure of the total growth in output that is beyond simply the increase in inputs into the system. In arcane economic terms, it is measured by something called the Solow residual—named after the Nobel Prize winning growth economist Robert Solow. In simple English, it is that which allows blood to be squeezed out of (the labour and capital) stone.

In an article written six years ago called “Escaping The Middle-Income Trap", Berkeley economist Barry Eichengreen showed that structural growth pick-ups and slowdowns are almost always because of an increase/decrease in TFP. Eichengreen accurately predicted that the TFP drop in China caused by over-allocation to investments would cause a fall in growth rate, and that this growth would only be rebalanced if the economy were to shift towards consumption and higher value-added manufacturing. That is the juncture at which China stands today. While the Morgan Stanley case is well argued, there is nothing inevitable about China’s ascendancy to high-income. It will require an improvement in TFP caused by a shift towards consumption and higher value-added manufacturing and the prevention of a debt accident.

At $1,750 per capita GDP, India is classified as a lower middle-income country (per capita GDP between $1,026 and $4,035). It achieved that status in 2007 and is likely to remain a middle-income country for many more years. Brazil, Mexico and South Africa have remained middle-income countries for over 25 years now. Russia has yo-yoed in and out of middle income over the last 10 years. Countries are often “trapped" because of excessive dependence on a resource economy (Brazil, South Africa, Russia) or inadequate innovation, reform and competitiveness (Mexico). China has risked getting trapped in the past because of a misallocation of capital to the investment economy.

India is still in a phase of growth when openness to trade, efficiency, ease-of-doing business and labour cost advantage are the critical determinants to growth. Change in female labour force participation alone can be a major source of growth in this phase.

However, we would do well to prepare for a time in the not-too-distant future when we will need to account for a declining TFP when these advantages begin to erode. By that time, we will need competitive product and factor markets, a well-developed financial market (including corporate bonds) that allocates capital efficiently and, most importantly, a trained workforce that is part of an innovation economy.

The intervening years must be used to fix our poor learning outcomes in primary education and to create the environment for innovation, design and development. Given the low odds, escaping the trap requires meticulous long-range thinking and we would do well to begin now.

P.S. “The best way to predict the future is to create it," said Peter Drucker.

Narayan Ramachandran is chairman, InKlude Labs. Read Narayan’s previous columns at www.livemint.com/avisiblehand

Comments are welcome at narayan@livemint.com

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