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Why China will not fall into the middle-income trap

If highly industrialised China were to fall into the trap, it would imply that no other developing country would ever make it to developed economy status

China's economic growth after over three decades of dynamic expansion at double-digit rates has markedly come down in recent years. The growth deceleration has raised the spectre of the Chinese economy falling into the "middle-income trap" (MIT).

The concept of the so-called MIT has been widely discussed in recent years, but also widely misunderstood. It is simply about how a less developed economy (LDC) loses growth momentum after its initial easy phases of growth and stagnates, and is unable to graduate to become a developed economy. This LDC fails to make the critical transition from middle income to high income.

Early development economists had used the concept of "low-level equilibrium trap" to explain the phenomenon and argued that many LDCs' initial economic growth was not strong enough (due to low investment, low savings and hence low growth) such that any gross domestic product (GDP) growth would just be "eaten up" by their high population growth. That, however, may sound like a trite argument that a country remains poor because it is poor.

Naturally, many development economists took strong exception to this extreme argument, seeing it as purely a kind of "cumulative causation" with little explanatory power. MIT essentially operates on similar logic, as indeed any trap would imply little or no chance of moving forward towards a real economic take-off.

ONLY 13 MADE IT

At the empirical level, many LDCs in Latin America and South-east Asia started their economic development in the late 1950s. However, most of them failed to become high-income developed economies, either because their growth was based on the export of primary products or their industrialisation was trapped in prolonged import substitution, and they thereby failed to make the successful transition to export orientation. The Philippines is a case in point. It was the first country in South-east Asia to start industrialisation in the early 1950s, but it has since been languishing as a lower middle- income economy for half a century.


ST ILLUSTRATION : MANNY FRANCISCO

Accordingly, as reported by the World Bank, of the 101 or so middle-income economies in the 1960s, only about 13 of them (mostly relatively small economies) had become developed economies by 2008. In East Asia, it was Japan and the four "Little Dragons" of South Korea, Taiwan, Hong Kong and Singapore that had successfully overcome the MIT to become developed economies. They had precisely made the successful transition from import substitution to export orientation.

In 2006, a World Bank report entitled "An East Asian Renaissance", prepared for the 2006 World Bank and International Monetary Fund (IMF) meetings in Singapore, first introduced the concept of the "middle-income trap". This term has since been widely used in economic development discourse.

The concept of MIT is nonetheless full of conceptual and empirical difficulties. The World Bank used to categorise countries into low-income, lower-middle, upper-middle, and high-income, with the average income level of the high-income group being used as a benchmark for a "developed economy". Such categorisation and benchmarking are necessarily arbitrary. Furthermore, the per capita income level to benchmark a developed economy has changed several times over the years.

More serious for the MIT concept are its technical shortcomings. Economic growth is a long-term process full of ups and downs. For a country to be trapped at middle income implies that its growth has suddenly stagnated at a particular point or is predetermined to systematically slow down once it hits a particular income level. This is hard to explain and justify, especially since "being trapped" implies no exit.

WHERE IS CHINA NOW

China has been an intriguing case in the ongoing MIT debate. Whenever China's economic growth hits a hurdle, some commentators would project China to be moving towards the precipice of the MIT.

Chinese officials have also frequently discussed China's vulnerability to the MIT. Top economic officials such as Mr Liu He have often warned that China must step up its macroeconomic rebalancing to avert the MIT. More recently, Finance Minister Lou Jiwei was even more explicit, saying that China might face a "greater than 50 per cent chance" of falling into the MIT. Chinese officials use the phrase of MIT often as a political message to caution the Chinese people against the many potential obstacles and challenges that China is facing.

A useful starting point to discuss China and the MIT is to analyse China's available GDP numbers. China's per capita nominal GDP last year was about US$8,300 (S$11,200), compared with US$56,000 for the United States and US$53,000 for Singapore. In PPP (purchasing power parity) terms, China's per capita GDP for 2014 was US$13,000. This puts China in the upper range of the middle-income category.

For a country with such a huge population, it is always more difficult to achieve a quick jump in its per capita GDP, considering that China has already experienced over three decades of high growth. Accordingly, it is inherently more difficult for large economies like China, India and Indonesia to overcome the MIT.

The question of how long it will take China to become a "developed economy" obviously depends on, first, the internationally acceptable benchmark for a "developed economy", and then, the future growth potential of China's economy.

For many years, the World Bank had simply used the per capita nominal GDP level of US$10,000 as a convenient cut-off point to denote a "high-income economy", which is a proxy for being a "developed economy". In this sense, China today with its per capita income of US$8,300 is quite near the threshold of a developed economy, and likely to get there around 2020.

However, the cut-off point for a "developed economy" has recently been raised to about US$16,000. Using 2015 as a starting point to extrapolate, it will take China's economy about six years to reach this US$16,000 level, assuming a 7 per cent growth; or about 10 years with a continuing 6 per cent growth. In any case, China would certainly become a "developed economy" well before 2030.

UNDERSTANDING CHINA'S GROWTH POTENTIAL

For a formal discussion of whether China can overcome the MIT, one needs to properly analyse its present state of economic growth as well as its future growth potential.

After over three decades of double-digit rates of hyper-growth, China's economy in recent years has significantly slowed down, and this growth deceleration is set to continue. But the country's present economic slowdown has been much sensationalised by international media.

First, China's so-called "slowdown" has actually been quite moderate - "slow" only in China's own historical growth context. China's 7.4 per cent growth in 2014 was regionally and globally the highest among major economies. Even its 6.9 per cent growth last year was still higher than that of its neighbouring economies.

Economic growth means increases in GDP based on the compound interest rate principle. With a bigger base, the 6.9 per cent growth of 2015 actually generated more GDP than the 7.4 per cent growth in 2014! This explains why President Xi Jinping readily embraced China's present economic slowdown as a "New Normal".

The Chinese government is currently doing its utmost to moderate the growth deceleration with all its available monetary and fiscal tools. Premier Li Keqiang has repeatedly affirmed that China has the means to maintain reasonable economic growth while at the same time carrying out the necessary structural reforms.

CULTIVATING NEW SOURCES OF GROWTH

To maintain its reasonably strong growth in future, China will have to cultivate its new sources of growth associated with (1) innovation and technological progress, and (2) accelerating industrial restructuring.

China's past dynamic growth had indeed been fuelled by significant technological progress associated with simple technology transfer from imported machines and the initial phases of economic reform by marketisation. But China today has already exhausted such easy sources of technological progress, and is no longer picking low-hanging fruit. Its future productivity gains will have to come from its own technological development.

Indeed, China has already rapidly expanded its R&D activities, which reached 2.1 per cent of GDP in 2014, compared with 2.8 per cent for the US. In total terms, China's R&D spending is actually quite high, being the world's second-largest after the US. Not surprisingly, China has for several years in a row topped the world in filing the largest number of patents and inventions - some 2.7 million applications were registered in 2015 alone.

China is already home to the world's largest stock of science and technology personnel, with over 3.5 million engaged in full-time R&D activities. With nearly eight million new university graduates every year joining the ranks and a vast industrial base that is becoming increasingly sophisticated, China is admittedly on track to develop a viable technological base that will eventually generate new sources of productivity increases to support its future growth.

In the meantime, the government has also stepped up its industrial restructuring efforts. Recently, it unveiled a bold "Made in China 2025" Master Plan (reportedly similar to Germany's "Industry 4" plan for its Fourth Industrial Revolution) to promote "intensive manufacturing". This is aimed at fundamentally transforming China's manufacturing sector from being a global giant in terms of volume and output to a leading manufacturing power in a quality and high-tech sense. The key slogan is to upgrade China's manufacturing industries from "Made in China" to "Created in China". The focus is on 10 crucial sectors, including information technology, robotics, large aircraft, new materials and biotech.

Suffice it to say that all these new investments and action plans are calculated to create a powerful new engine of growth that will propel China's next phase of economic growth not just to overcome the MIT, but also to cross the threshold of a developed economy well before 2030.

To conclude, China does present a sharp contrast to the many developing countries that had fallen into the MIT. Apart from its stellar growth record, China has already developed a huge and balanced industrial structure along with a strong and growing technological foundation. Its manufacturing exports are dynamic and competitive while its superb infrastructure is of First World standard.

If the highly industrialised China should still fall into the MIT, it would simply be mind-boggling, implying that no other developing country would henceforth ever make it to a developed economy - quite an implausible supposition.


The writer is a professorial fellow at the East Asian Institute, National University of Singapore.

A version of this article appeared in the print edition of The Straits Times on April 23, 2016, with the headline 'Why China will not fall into the middle-income trap'. Print Edition | Subscribe