22 October 2016
If China succeeds in structural rebalancing efforts, its economy will move to a higher level. Photo: Bloomberg
If China succeeds in structural rebalancing efforts, its economy will move to a higher level. Photo: Bloomberg

Why China can avoid the middle income trap

Although China’s official data is still showing an economic expansion rate of more than 7 percent a year, which remains an envy of the world, the growth engine is starting to falter.

Since the early 2000s, marginal returns on investment have been falling, with no signs of revival, according to our research.

Meanwhile, there are pessimistic predictions on China succumbing to a disease that afflicted many other developing economies over the years: the middle income trap. Many other promising development stories – such as Brazil or Argentina at some stage over the past century – have seen growth falter and their per capita incomes stagnate.

The recent growth slowdown seems to suggest that China might follow the same fate. According to the World Bank, the Middle Kingdom’s per capita gross national income (GNI), which defines development categories in the World Bank framework, was only a little over US$6,500 in 2013 a year. That puts China in the upper middle income bracket, which ranges from US$4,100 to US$12,700.

Experience shows that many countries failed to graduate to the high income category. As China’s growth rate decelerates, debt burden climbs and the backlog of structural reforms lengthens, the risk is there for the country to follow others into the middle income trap.

Still, there is a very good chance it will be able to avoid that.

It is true that China is facing cyclical headwinds that may continue to grow slowly for a while. But there are some crucial factors that will likely help China avoid the middle income trap.

First, the current growth slowdown is a policy choice for the sake of implementing structural reforms. This means that Beijing has the financial resources and policy capability to push growth faster if it wants to.

Second, the country’s sheer size makes a difference. Despite its impressive economic development over 35 years, the interior parts of the country remain at poor-country levels while the coastal cities’ incomes have reached advanced-country levels. This disparity offers the prospect of high investment returns for many years to come as the poor regions catch up.

The third differentiating factor is demographics. There is little doubt that an ageing population and declining growth of the labor force restrain growth. But often ignored is China’s population dynamics.

A substantial reservoir of underemployed workers remains in the rural areas that can be redeployed into more productive jobs in the cities. The leadership clearly recognizes this and, therefore, aims at encouraging more urbanization.

Even if the labor force shrinks, the average level of education is rising. The current retiring workers were mainly educated during the Cultural Revolution, which severely restricted higher education and disrupted even basic schooling.

By contrast, China is now churning out almost 8 million university graduates a year, with many of its high-school graduates in first-tier cities exhibiting high educational proficiency. So, human capital is improving to keep productivity gains to offset the disadvantage of the shrinking of the labor force.

Most importantly, China retains an impressive capacity for reform, which will create an environment for developing efficient governance and retooling of the economy through structural adjustments.

It is easy to point finger at China and lament the progress on a number of fronts, such as state-owned enterprise, household registration, or financial reforms.

But compared to many other developing and developed economies in recent years, Beijing has started to implement an impressive array of new policies – ranging from the anti-corruption campaign, to the curtailment of shadow banking and liberalization of the capital account.

Granted, progress to date will not be enough to pull the economy out of its doldrums. More will have to be done. But when putting Beijing’s capacity of further reform against that of the other governments, China seems to retain powerful levers to bring economic change.

Experience underscores this point. In the 1990s, China undertook a major overhaul of state-owned enterprises, restructured the country’s banks, and oversaw its entry to the World Trade Organization. These structural changes delivered another decade of spectacular growth, which was sustained even beyond the collapse of global trade in the wake of the Great Recession in the West.

This is not to ignore the risks to China’s growth in the current cycle. Along with structural rebalancing is the risk of policy mistakes weaning the economy off its growth course and plunging the system into a financial crisis. But these are cyclical issues that any transitional economy inevitably faces after a long period of rapid growth.

The real question is not whether the economic imbalances exist, but whether the country retains its ability to deal with their inevitable unwinding. What makes China different is the potential for catch-up in backward areas, improvement in human capital, and the government’s willingness to reform.

If the structural rebalancing process is implemented properly, China will likely be able to graduate from the middle-income class to a sustainable high-income group.

Opinions here are of the author’s and do not necessarily reflect those of BNPP IP.

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Senior economist of BNP Paribas Investment Partners (Asia) Ltd. and author of “China’s Impossible Trinity – The Structural Challenges to the Chinese Dream”

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