Can China Avoid the Middle Income Trap?

China stands at a crucial moment in its economic development. After years of unprecedented breakneck growth, in 2015 China’s $10 trillion-plus economy expanded at its slowest pace in decades. China’s leadership must now encourage new engines of growth that will secure the country’s rise into the ranks of the world’s advanced economies — or else risk stagnating in the middle-income range, a fate that has befallen many other developing countries.

This may explain why China’s ongoing lianghui, or the “Two Sessions” — an annual legislative confab that’s more like a cross between the U.S. State of the Union and the White House Correspondents Dinner — seems more sober than before. Although celebrities such as basketball star Yao Ming and business tycoons were still seen rubbing elbows with high-powered mandarins at the Chinese People’s Political Consultative Conference (CPPCC) that began on March 3, the ensuing National People’s Congress (NPC) a couple days later took on added significance as it focused heavily on the beleaguered economy. This year’s meeting marks the launch of the 13th Five-Year Plan, a comprehensive vision for China’s economic priorities through 2020. Amid China’s growing economic woes, the new plan aims to prevent the country from falling into the “middle income trap” that, over the past 50 years, few developing countries have managed to avoid. In the new Five-Year Plan, Chinese President Xi Jinping and his administration are essentially declaring that they, too, can join the shortlist of countries that have bucked this economic history. But to do so, China must stop propping up traditional industries with massive loans, create an economy based on innovation and services, and, with a prematurely aging population, leverage existing human capital to participate in the new economy.

As part of the 13th Five-Year Plan, Beijing rolled out a GDP target of 6.5 percent to 7 percent for 2016. While Beijing chose to set a range rather than the usual fixed target, the key is that it has set a growth floor for 2016. Though many remain skeptical that even 6.5 percent growth can be achieved, the target signifies that it’s full steam ahead toward one of Xi’s stated goals — to double the size of its economy by 2020 from 2010 levels. To achieve the goal, which is tantamount to a political mandate, growth has to average at least 6.5 percent through 2020. How that political mandate will be reconciled with economic reality is at the heart of the latest Five-Year Plan. It means the country must lay the groundwork to escape the middle-income trap.

Already considered an upper middle-income economy by the World Bank, China is heading into a potentially perilous development stage. According to economist Barry Eichengreen, after examining numerous middle-income countries, he found that fast-growing economies tend to decelerate significantly when they reach roughly $16,000 of GDP per capita. By Eichengreen’s calculations, using 2005 constant prices, China will reach about $15,000 per capita GDP this year, likely based on purchasing power parity, which implies that the trap lies just around the corner. That’s the risk with which the Five-Year Plan must grapple, and explains why more emphasis than usual has been placed on this plan, including an onslaught of peculiar, occasionally amusing propaganda that has imbued the plan with extraordinary prominence. The Chinese leadership realizes the country now confronts a crucial period that can determine whether it eludes the trap.

It is no easy task. The recent historical record is rife with failures and few successes. But the path has been trod before. South Korea, for example, managed to transition from roughly $14,000 per capita GDP to nearly $28,000 in just over a decade. In fact, since World War II, East Asian economies have experienced the greatest success in rising to the status of wealthy nations. The postwar performance of those economies has been so remarkable that it led economist Larry Summers to opine that “the dramatic modernization of the Asian economies ranks alongside the Renaissance and the Industrial Revolution as one of the most important developments in economic history.” Were China to join the list of exceptions to the middle-income trap, it would mark a stunning achievement.

But China must take several major steps to achieve that goal. First, the government must end its lending binges. Such practices, particularly its massive stimulus package in the wake of the 2008 global recession, have increased leverage risks, debt burdens, and nonperforming loans. The influx of easy money buoyed the economy through the recession but caused debt to balloon. According to some estimates, the country’s total debt level now stands at around 280 percent of its GDP. The longstanding mispricing and misallocation of state financing has created legacy problems, such as firms weighed down by debt, which will increasingly drag growth downward. These practices simply must end, even if it requires letting a number of state-owned firms fail and exit the market. Pricing capital correctly, deploying capital more efficiently, and reducing moral hazard in the financial system are central to ensuring that financing flows to the areas that most need it, particularly the private sector.

Second, to create new engines of growth, the economy must transform into a more innovation-driven and high value-added market. The services sector, which has grown robustly in recent years, is a source of dynamism — everything from a mobile app economy to digital healthcare, in which technology giant Tencent has invested heavily. Chinese Premier Li Keqiang has promoted “Internet-Plus,” an initiative aimed at creating a buoyant digital economy based on e-commerce and online services. In order to create 50 million new jobs by 2020, the five-year plan has hung its hope on services as a massive absorber of new employment — a key role as the country’s traditional industrial and manufacturing economy contracts and sheds massive overcapacity.

To foster entrepreneurship, China’s leaders must adopt a more hands-off approach rather than resort to the typical knee-jerk tendency to exert control. For example, China’s “Made in China 2025” plan, which aims to make the country a producer of high-value added goods, is meant to align with the innovation agenda in the five-year plan. But it is basically state-driven industrial policy. Such state-driven policy cannot predict or dictate innovation, which is usually a bottom-up, organic process. Beijing must create an environment that allows innovators to flourish, operate independently, and fail freely. An innovative economy requires legions of homegrown innovators, who will in turn demand that their intellectual property (IP) be protected from theft by domestic competitors. That will mean institutionalizing IP protection through more stringent enforcement of IP laws.

Third, with a rapidly aging population — a premature demographic transition due in large part to China’s strict population controls of the past 30 years — Beijing must do all it can to harness the country’s human capital to power its economy forward. Chinese universities are expected to graduate more than seven million college students in 2016 alone, a pool of human capital that has little interest in making widgets on assembly lines or pursuing a lifetime of bureaucratic service, the latter a career path once envied for its stability. But while Chinese policymakers have trumpeted entrepreneurship and risk-taking as an alternative for recent graduates, it is not clear whether many will actually pursue that path — a 2013 survey of Chinese engineering students showed that while many of them expressed interest in starting a business, only 3 percent planned to follow through.

Leveraging human capital for entrepreneurship and private enterprise extends beyond college graduates and encompasses another enormous demographic: the approximately 260 million rural-to-urban migrants who have poured into China’s cities over the past several decades in search of work. Official policy has previously denied most of these migrants formal urban status, making their existence in most cities tenuous. But Beijing now intends to allow 45 percent of the migrant population, most of whom are still officially registered as rural residents, to become permanent urban citizens by 2020, up from about 38 percent in 2015. This could lead to another large pool of as-yet untapped human potential that could expand the breadth of entrepreneurship and local innovation, especially in third- and fourth-tier cities where it is easier to acquire urban residency than in restrictive first-tier metropolises like Shanghai. It’s not that hard to envision; in the 1980s, some of the most innovative market experiments were initiated in rural China, not the coastal cities.

If Beijing hopes to show the world how a developing economy of its size can avoid the middle-income trap, it must curtail top-down control and harness bottom-up dynamism. Significant political capital will have to be expended to push through many of the reforms. It’s still too early to tell if the 13th Five-Year Plan will bring about the necessary changes. But if so, then Xi will have left for his successor, by 2022, a country on its way toward membership in the club of advanced economies.

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