China's race to avoid the middle income trap

When its GDP per capita hit almost $US7500 in 2014, China entered the middle income stage of economic development. Relatively few countries that have made middle income status in the past three or four decades have graduated to high-income status, or achieved per capita incomes over $US16,000.

Now the Chinese economic slowdown has raised questions about whether China will be able to continue its steady economic growth to avoid this middle income trap in the coming decade.

Whether China makes the transition to high income status is probably one of the most important economic questions facing the world today. Success can lift the living standards of 1.4 billion people. Failure may lead to economic and social instability in China and the world could lose one-third of its global economic growth engine.

Economists are divided on the subject. While some predict that China will join the high-income club by around 2020, others argue that the prevailing pattern of regression to the mean in cross-country growth rates should create substantial doubt about extrapolative forecasts of China’s growth, and anticipate that there is a significant risk of a major growth slowdown in the next decade.

There are currently two economic cycles leading to slower growth in China’s economy. The first is a typical shorter-term macroeconomic cycle. Following recent aggressive monetary and fiscal policy expansion, the macroeconomic cycle may bottom-out during the second or the third quarter of 2015. But this will likely be temporary and short-lived. The longer-term structural transition is likely to continue to push trend growth lower until new leading industries are well established to take the economy to the next level.

Some new industries are already forming, such as online shopping, express delivery, large machinery equipment and heavy trucks. But these are not yet ready to replace leading industries of the past, particularly in the labour-intensive manufacturing export sector and the heavy industry investment goods producers. And it will take more than a couple of years before they can begin to do so.

More worrying than the growth slowdown is weakening productivity, which underlines the unsustainability of China’s current model. Continuing strong economic growth requires a transformation of the current growth model. Often characterised by strong growth with serious structural imbalances, the current model has its root in China’s transition strategy, with its two dual-track approaches. The first dual-track is between state-owned enterprises and non-SOEs, while the second is between product and factor markets. The continuous protection of SOEs ensured social and economic stability during the early stage of reform but also had negative social, financial and fiscal consequences.

The need for SOE protection also gave rise to the second dual-track approach: factor market distortions. While depressing input costs, these distortions -- including financial repression and energy price setting -- are akin to subsidies to producers, investors and exporters but taxes on households. They explain why economic growth may been extraordinarily rapid but was also associated with growing structural imbalances, including the continuous rise in the GDP shares of exports and of investment, a falling consumption share, income inequality and waste of resources. Transforming the growth model requires completing the transition to a market economy and abandoning factor market distortions. And this in turn requires successful reform of the SOEs.

The good news is that China’s growth model is already changing, as evidenced by a narrowing current account surplus, rising shares of consumption and services in the economy and an improving income distribution. But so far, this has been mainly triggered by changes in the labour market as China reaches the so-called Lewis turning point, from a surplus to shortage of labour. The liberalisation of financial markets, the land market and energy policy are now critical for this transformation to continue.

The real challenge of the middle income trap is an economy’s ability to develop new competitive industries and companies after reaching the middle-income level. Countries that fail to do that would be stuck in the middle-income range, unable to compete with either more advanced economies (because of lower efficiency) or less developed economies (because of higher costs).

Although most of China’s industries have been built on low-cost products produced with foreign technology, compared to most countries at similar stage of development, China’s innovation and upgrading capability is already quite high. Its share of research and development in GDP already exceeded 1 per cent -- a benchmark at which most economies’ innovation takes off -- at a much lower income level than the average of the developing world. China is already one of the leading owners of patents globally, although most of the patents are at the lower end of the technological ladder.

But China still needs to make huge efforts to foster its innovation capability. It must strengthen its research and education base, including training for more than 300 million migrant workers. China also needs to reform its financial system, including liberalising the interest rate and developing new channels of financial intermediation in order to provide better financial services to innovation activities. And it must construct new legal and political institutions that are conducive to technological innovation. This includes protection of intellectual property rights and liberalisation of entry in many sectors.

While China is unlikely to move to the western-style democracy any time soon, certain political changes are necessary to ensure the free flow of information, to maintain order and to resolve social conflict.

With these reforms, China can hope to rise to high income status and continue on its path to becoming the largest economy in the world. But there are some very high hurdles to negotiate on the way.

Yiping Huang is a professor of economics at the National School of Development, Peking University, and the editor of the China Economic Journal.

This article originally appeared on East Asia Forum and is republished with permission.