December 4, 2012

The Middle-Income Trap Looms in China

A top Chinese official lays out what his country needs to do to break into the ranks of high-income nations.

Sharon Kahn
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China’s breakneck, double-digit growth rate is decelerating. That's hardly a secret, but Liu Shijin, vice minister of the Development Research Center of the State Council of China, says that the government’s reaction to crucial challenges in the next two years will be key. Policy moves by newly installed leadership can determine whether China falls into “the middle-class trap” — in which salaries increase to the point where a country can no longer compete on the basis of cost — or joins the elite ranks of high-income countries.

“China’s economy is nearing a new balancing point,” Liu told a sold-out crowd attending the annual N.T. Wang Distinguished Speakers lecture, co-sponsored by Columbia University’s Weatherhead East Asian Institute and the Chazen Institute of International Business.

The stakes for China are high: In a worse-case scenario, the country faces upheaval if the state fails to deliver on the so-called “prosperity compact,” in which the populace accepts the government as long as incomes keep rising. To avoid disruption, China must evolve from an export- and resource-driven emerging market into a modern domestic- and services-focused economy sparked by innovation rather than cheap labor. It’s up to the government, Liu argued, to create a launching pad for its citizens to enter the ranks of high-income countries.

“China is not like the United States,” he said. “Americans doubt the government. Chinese may gripe, but they look to the government to support growth.”

Why Slowdown is Inevitable

Liu outlined a joint project that his group conducted with The World Bank, which resulted in the prescriptive report “China 2030: Building a Modern, Harmonious and Creative High Income Society.” The research detected a well-worn path industrializing countries have trod in the past. As Robert B. Zoellick, World Bank Group President noted in September 2011 when he introduced the seminal report: “After they have reached upper-middle-income status, middle-income countries can no longer rely on growth models that have worked while they were poor. If they do, they can be squeezed on both ends: by competition from low-income, low-wage economies as well as by competition from upper-income countries through innovation and technological change.”

Liu pointed out that quite a few countries have initiated industrialization and realized an early-stage economic take-off. But “few were able to successfully cope with the risks and challenges and eventually become true high-income economies,” he said.

Examples of countries stuck in the middle income trap, Liu said, include Mexico, Brazil, Argentina, and the Philippines, each of whose per capita GDP stalled between $4,000 to $5,000 (expressed in 1990 dollars). Soviet and Eastern Europe nations managed a higher plateau, but the per capita cut-off for unsuccessful nations seems to be under $7,000. Although growth continued in these countries, in each case the pace was cut by half or more. Incomes failed to rise and the basic structure of the marketplaces in those countries have not changed.

More successful countries (including Germany, Japan, and the Asian tiger economies of Hong Kong, Singapore, South Korea, and Taiwan) were able to delay dramatic deceleration until per capita GDP neared the $11,000 mark. Their growth rates declined, too, but kept to a more moderate pace that allowed individual incomes to continue to rise. Over time, these economies became more diverse, adopted more market-driven international standards, and built companies around innovative R&D structures.

China’s Place in the World

Liu is fairly confident China can join the ranks of the countries that transitioned successfully. (In July, the World Bank reclassified China as an upper-middle-income economy rather than an emerging market.) “China reached per capita GDP of $7,864 in 2010. Its growth path is similar to that of the catch-up economies in East Asia, and falling into the middle-income trap is unlikely,” he said.

Still, Liu suspects growth will slow substantially around 2015, plus or minus two years, when per capital GDP reaches the $11,000 inflection point. He presented a chart that posits China's trajectory:

Those growth percentages assume that China both takes advantage of its considerable potential and implements crucial reforms. If it achieves those goals, China’s GDP will reach or exceed that of the United States, making it the largest economy in the world. And its per capita GDP will continue to grow significantly, moving all the country's citizens toward high-income status.

The World Bank report recommended six pillars of reform that could catapult China to high-income status. Part two of this series examines those reforms.

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