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Will China Avoid the "Middle-Income Trap"?

With the exception of last year, the acceleration of China's economy had been slowing, leading economists to suggest the future depends on overall productivity.

Karen Liu
    Feb 11, 2018 5:30 AM  PT
Will China Avoid the

Official figures released three weeks ago showed that the growth of China's gross domestic product (GDP) hit 6.9 percent in 2017, the first year-over-year acceleration for the economy since 2010. The annual growth beat the government's 2017 target of around 6.5 percent and quickened from 6.7 percent in 2016, the weakest pace in 26 years.

These figures might suggest the growth momentum in the economy was weakening these years, especially since 2010, despite the fact the last four-decade reform and opening-up has witnessed China's remarkable economic development with double-digit growth rates. Concerns are raised whether China will face the risk of economic stagnation as it attempts to become a rich nation.

In other words, will China fall into the so-called "middle-income trap"?

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(Source: World Bank)


Middle-income trap, first put forward by the World Bank in a 2006 report on the development of East Asian economies, described the scenario that a developing country, who has experienced rapid growth, and thus reached the status of a middle-income country in a very short period of time, is unable to generate further economic momentum and reach developed (high-income) status.

According to a report by the World Bank in 2013, only 13 out of 101 middle-income economies in 1960 had become high-income economies by 2011. The remaining countries - primarily located in Latin America and Asia - were "caught" in the middle-income range for more than half a century. 

By World Bank's definition, China is currently an upper middle-income country. Thus China's economic downturn since 2010 gained the attention from policymakers and researchers.

For example, Lou Jiwei, the former Chinese finance minister, sparked a debate two years ago saying China had a 50/50 chance of sliding into the middle-income trap. But in a recent interview, he said that advances in reforms in the past two years had convinced him to change his mind.

This article, based on the paper by Glawe and Wagner (2017), will introduce the measurement of a middle-income trap and determine whether China is, or will be, "trapped", and then analyze the potential triggering factors that either accelerate or impede growth.

Measuring the Trap

In literature, the measurements of a middle-income trap vary across studies, but mainly refer to a period that is longer than 40 to 50 years. The thresholds of the middle-income range are identified as the per capita income relative to a developed country (frequently the U.S.). The World Bank (2013) defines the range as 4.5%-45% of US per capita income (other studies in literature would define different ranges like 20%-55% or 10%-50%) and classifies countries that were within this range between 1960 and 2011 as middle-income-trap countries (the shaded area of the following figure).

Obviously, by this definition, China is among these countries. As Glawe and Wagner estimated, China's GDP per capita will grow around 6.4% per annum and that of the US around 1.5% each year between 2011 and 2030. In this scenario, they optimistically predicted China would leave the middle-income range in 2022. But if the growth rate drops to 3-4%, China will not avoid the "trap."

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(Source: Glawe and Wagner, 2016)


Although the above statement on whether China is stuck in a "trap" depends on a specific measurement, and academia hasn't reached a consensus, the economic slowdown is an indisputable fact that calls for attention.

The basic economic theory says the total production in a country depends on total factor productivity, capital input, and labor input. The transition for China from low to middle income is input-driven based on an abundant labor supply reallocated from unproductive agricultural sector to more productive industrial sectors and the fast build-up of capital through high rates of investment. That makes China one of the most investment heavy economies in the world.

However, the initial growth drivers become exhausted once China has reached the middle-income range. The working population tends to decline because of an old-age boom and a low fertility rate. Also, the pace of investment is unlikely to continue because it might lead to a growing number of unprofitable projects, a higher proportion of non-performing bank loans or defaults, and a greater risk of a credit crunch.

In addition to the domestic problems, international competitiveness is eroded. Middle-income countries are squeezed between the low-wage poor-country competitors that dominate in mature industries and the rich-country innovators that dominate in industries undergoing rapid technological change.

Keys to Avoiding the "Trap"

Sustained growth toward the high-income level must be increasingly characterized by a series of continuing triggering factors. Glawe and Wagner (2017) concluded the key to maintaining fast economic growth in the future was a much greater reliance on the real economy/production side, in particular, total factor productivity, human capital, and the export structure.

Pointed by many researchers, the productivity in privately owned enterprises is relatively higher than in state-owned enterprises. The enforcement of reform and an opening-up policy gradually reallocates the production to the private sector and thus, increases the total factor productivity of the whole economy.

But in recent years, China has also been going through structural change characterized by a transition from the manufacturing sector to the service sector. The service sector is not as productive as the manufacturing sector.

This reform of deindustrialization might decrease the total factor productivity as a whole. As suggested by Glawe and Wagner, future reforms should also focus on improving productivity in the service sector. Also, more attention should be paid to human capital and education, including narrowing a rural-urban human capital gap to lift up the effective labor productivity. And China should continue to be on a track of steadily improving export sophistication.

In conclusion, since China is already an upper-middle-income country, whether it will be stuck in, or escape from, the "trap" deeply depends on the rigorous forecast of growth prospects.

Different models tell different stories. But one thing is certain: improving total factor productivity growth will provide China the potential to further catch up to high-income countries and to avoid a middle-income trap.

 

References:

1. Glawe, L. and H. Wagner. 2016. The Middle-Income Trap: Definitions, Theories and Countries Concerned—A Literature Survey. Comparative Economic Studies 58(4): 507–538.


2. Glawe, L. and H. Wagner. 2017a. The People's Republic of China in the Middle-Income Trap? ADBI Working Paper No. 749. Tokyo: Asian Development Bank Institute (ADBI).

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