It's easier to jump from a very poor country to a middle-income nation than it is to advance from that middle-income status to the ranks of the truly developed. China must make the leap

Jason Lee / Reuters China's Premier Wen Jiabao is shown on a screen speaking to delegates during the opening ceremony of the National People's Congress at the Great Hall of the People in Beijing on March 5, 2013

One of the great questions facing China is whether or not its economy can continue to produce the rapid gains in welfare for its giant population that the country has witnessed over the past 30 years. The answer is critical to the political and social stability in the nation. There is already quite a bit of grumbling among the working class that they aren’t enjoying the benefits of China’s economic ascent as much as they should be. The gap between rich and poor is worsening — according to one private study, it could be significantly wider than previous estimates. Growth has already drifted downward, in comparison with China’s recent history. In 2012, GDP increased at the slowest rate in more than a decade. If China encounters a prolonged period of slower growth, it could prove catastrophic.

The topic of growth and people’s welfare is at the center of this year’s National People’s Congress, taking place right now in Beijing. Wen Jiabao, in his final major speech as Premier before handing over the reins of government to a new crop of leaders, stressed the need to boost the incomes and spending power of the nation’s masses to put the country’s growth on a more sustainable path. “To expand individual consumption, we should enhance people’s ability to consume, keep their consumption expectations stable, boost their desire to consume, improve their consumption environment and make economic growth more consumption-driven,” Wen said.

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That’s all very nice. But we’ve heard it many times before. And in the end, a slowdown in China could well be inevitable. Making the transition from an investment-led to a consumption-led economy, as Wen preaches, will likely result in slower overall growth, at least while the shift is taking place. Demographics are working against China’s future performance as well. As a result of China’s controversial one-child policy, the population is aging quicker than it otherwise would have, which will drag on growth in coming years.

And then there is the possibility China could tumble into the “middle-income trap.” The problem in a nutshell is that countries can get stuck at a level of development in which its populace has been generally lifted out of poverty but hasn’t been elevated to the income levels of more advanced economies. That happens because it is easier to jump from a very poor country to a middle-income nation than it is to advance from that middle-income status to the ranks of the truly developed.

Why is that? When a country is really destitute, it can generate GDP growth and raise incomes simply by tossing its poor population and other resources into a modern economic system. Low wages attract investment in labor-intensive industries like apparel and electronics, which create lots of jobs, many of them requiring limited skills. That can quickly alleviate poverty and pump up growth. But such a strategy only takes a nation so far. As costs rise and these basic industries become less competitive, countries need to start developing their own intellectual property and improving the skills of the workforce to compete in high-technology industries. Middle-income countries literally get stuck in the middle — costs are too high to compete with lower-income economies, but they don’t possess the know-how and technology to compete with the truly advanced nations.

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Can the Middle Kingdom escape the middle-income trap?

History isn’t encouraging. Very few developing economies have managed to graduate into the high-income club in the past 50 years. Japan, Israel, South Korea and Singapore are among that select group. Most middle-income countries get trapped, at least for a while. A 2012 study from the Asian Development Bank figured that in 2010, 35 out of the 52 middle-income countries the author studied around the world were trapped. A January study by economists Barry Eichengreen of the University of California, Berkeley, Kwanho Shin at Korea University in Seoul and Donghyun Park at the Asian Development Bank in Manila determined that growth can slow down quite precipitously in countries that experience the trap.

Even more, the study showed that countries are vulnerable to the trap at more than one point in their development. “A number of countries appear to have experienced two slowdowns,” the report reads, one in the $10,000–$11,000 income per-person range (measured at 2005 purchasing-power-parity dollars) and another at $15,000–$16,000. With China’s 2010 GDP per capita at $7,129 (using the same data series as the report), a slowdown could be just a few years away. The authors go on to say:

We conclude that high growth in middle-income countries may decelerate in steps rather than at a single point in time. This implies that a larger group of countries is at risk of a growth slowdown and that middle-income countries may find themselves slowing down at lower income levels than implied by our earlier estimates.

Not everybody is so convinced such a trap exists. The Economist recently labeled the idea “claptrap,” explaining that “the theory and evidence behind it are surprisingly thin.” There are a host of analytical problems in defining and explaining the trap, from deciding what levels of income are “middle” and “high,” to figuring out what sort of slowdowns constitute being trapped. Whether you believe the phenomenon is widespread or not, however, there are clearly examples of nations that experienced high rates of growth only to stall once they reached middle-income status. I’ve detailed the sad case of Malaysia in the past.

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There are reasons to worry about China too. China is hitting that stage where rising wages are making the country less competitive in the labor-intensive industries (apparel, electronics, shoes) that had once propelled its growth. These industries have not been decamping en masse for cheaper locales — some factories have moved internally, to cheaper parts of China — but, history tells us that it is only a matter of time before these plants shutter and move to where costs are lower. Unable to compete on costs, Chinese companies are forced to move “up the value chain,” into more advanced products and industries that command higher prices for their products. That means Chinese firms have to learn to innovate, improve product quality and build brands. It also requires they enhance their productivity and management expertise. There are many indications that China is heading in that direction. Look at the global success of Chinese companies like telecom equipment maker Huawei or PC giant Lenovo.

However, Eichengreen, Park and Shin, in their study, suggest that elements of the China growth story make it vulnerable to the middle-income trap. One indicator is that countries with especially high rates of growth when poorer are more likely to slow down at the middle-income level. China has been the fastest-growing major developing economy in the world for some time, so it clearly falls into this category. Another sign that a country might get stuck in the trap is a high level of investment relative to GDP — an indication that an “investment-led” growth model eventually runs out of steam. Check off China here too. With investment equivalent to nearly half national GDP, economists have worried about China’s dependence on high investment rates for many years. A third indicator is an overly cheap currency, which discourages companies that depend on low costs to improve their operations. Here, too, China likely qualifies. The controlled yuan has been a point of controversy for many a year. Here’s what the report says:

The new analysis again confirms that slowdowns are more likely in economies with high old age dependency ratios, high investment rates that may translate into low future returns on capital, and undervalued real exchange rates that provide a disincentive to move up the technology ladder. These patterns will presumably remind readers of current conditions and recent policies in China.

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Does that mean China is destined for the trap? Not so fast! There are other signs that China has some advantages that may help the country escape the trap — mainly, a healthy share of high-technology products in its exports, and a population with better education than other middle-income countries. Here’s more from Eichengreen, Park and Shin:

China has slightly higher average years of schooling at the secondary level than the median for our slowdown cases (3.17 years in China versus 2.72 years in our slowdown cases). It has a higher share of high-tech goods in exports (27.5 per cent in China versus 24.1 in our slowdown cases). In this sense China appears to be doing slightly better than average in moving up the technology ladder in order to avoid the middle-income trap.

Another recent report from economist Yiping Huang at Barclays backed up the case that China will dodge the trap. Here’s a tidbit of Huang’s reasoning:

We believe that China should be able to reach high-income status over the next decade or so by narrowing its technological gap with advanced economies … Science and technology have taken off much earlier in China relative to the experience of other emerging Asia economies. Moreover, the diffusion of existing technology should remain a powerful economic driver for some time to come.

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I’m not so convinced. Many of the more advanced products that China manufactures are, in fact, not very Chinese at all. Gadgets like iPads may register as Chinese exports, but they are really just assembled in the country, with the technology, designs and key components being developed elsewhere. In the end, very little value is actually added in China. Nor have some state-led initiatives to improve Chinese technology been all that successful. Look at the chaos in the targeted green-energy sector, like solar panels and wind turbines.

For me, the way to escape the middle-income trap is to successfully change a nation’s growth model. Look at the case of South Korea, for instance. It used a similar growth model to China in its earlier years — export-led, investment-led and government-directed. Over the years that model has (for the most part) morphed (helped along by the upheaval of the 1997 financial crisis). Government controls have receded. Banks have become stronger and allocate resources more efficiently. Companies, deprived of bottomless and effectively government-backed finance, were forced to become more innovative and profitable. Changes in the financial and corporate sectors unleashed entrepreneurship. The result: South Korea jumped out of the trap into the ranks of the developed world.

Can China do the same thing? Yiping Huang claims that China’s growth model is undergoing rapid change.

China is breaking away from its old growth model. Long-awaited structural improvements, including a narrowing of the current account surplus, a growing contribution of consumption to GDP and declining inequality, are already under way, but may be underappreciated by investors.

In my view, though, the old model in China is clinging on. Investment levels remain elevated, with some of it driven by higher levels of debt. The government still effectively directs lending through state banks. Private firms are under pressure from state-owned enterprises. Reforms are going to have to go much deeper. Will incoming President Xi Jinping and his new leadership team take such steps? If not, they may find themselves trapped.

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