4 February 2016.

Part II: Lurking the Middle-Income Trap

Further to the challenges of over-capacity and old economy inefficiencies, China faces a classical competitiveness dilemma. The middle-income trap occurs after a growth period that sees salary increases exceed productivity gains. Today we are at a point were Portugal has more affordable factory workers than China. Whether China has reached the Lewis turning point is debatable; what is clear is that the Middle Kingdom never aimed for the honor of being the perennial low cost producer to the world. At the same time, it is not yet an innovator, the mark of advanced economies. Being stranded in no-man’s land between low-cost and higher value-added can be a long-lasting affair.

Brazil, the joke goes, was the country of the future in the 1960’s and so it shall always be. Besides city-states like Singapore, just Korea and Japan have made it through the middle-income glass ceiling since World War II, which today is reckoned at about USD 17,000 per capita.

In search for a new economic model

China’s GDP per capita is about USD 8,000 in nominal terms and USD 13,000 in purchasing power parity terms so the moment of truth is closing up. The country needs to steer to a new economic model or risk getting stuck in the trap. By no means is this a done deal as last year China’s finance minister Lou Jiwei famously set chances at 50-50. Reducing over-capacity and monopolistic positions to increase the efficiency of the old economy will provide the conditions for a new economy based on innovation and services.

Will these reforms address over-savings, over-investment and under-consumption, which many foreign pundits deem so worrisome and even unsolvable?

Under-consumption as a joker for future growth

China’s consumption as a percentage of GDP is basically only half of that of the US. To economists, the problem is less about under-consumption and more one of investment in productivity increases. Liberalization and reform of SOEs will go both ways since SOEs are big savers who hand no dividends to their owners, the state, and pay little for their assets (spectrum allocation, mining rights). Moreover as the Averch–Johnson effect posits, price-regulated firms have perverse incentives to over-invest. At the household end, high savings rates could quickly fall. The young Chinese are spendthrift, a chasm away from their prodigal parents. An under-consumption problem is a wonderful one to have for China; a joker for future growth than can easily be played.

The key problem for an increasingly productive new economy is not consumption, but a rather one of inequality. Its impact on the political system via populist policies or even revolution lay behind the middle-income trap.

In the 1970’s industrialization and growth rates pointed to a nation about to break through the middle-income trap; not Korea but Iran. Social unrest and then revolution truncated what should have been a textbook economic miracle. Countries like Brazil, Venezuela or some in Southern Europe have not gone the revolution route. Nevertheless populist routes of different degrees have been chosen. These all are characterized by preempting strife by paying dearly to buy off trouble. For instance, workers and government employees are given benefits beyond the country’s means and productivity. Ensuing debt levels are unbearable and competiveness slides.

Inequality has dramatically increased
On the other hand we have an Asian model based on a social contract of sorts. General Park’s South Korea, LDP-dominated Japan and Lee Kuan Yew’s Singapore delivered growth on the back of authoritarian leadership. The passage through the middle-income trap is always a rocky one. Inequality in China has dramatically increased even though the country has lifted more people out of poverty than any nation in economic history – a fair bargain? Capital accumulation and its deployment processes dictate inequality, which is only addressable and reversible at advanced economy stages; for emerging economies inequality is an unavoidable and painful rite of passage. Countries stay poor not just on account of wage inflation above productivity gains; the more profound cause is the social unrest and its narratives, which destroy growth foundations one generation at a time. Strong leadership that keeps social pressures for a quick inequality fix at bay while steering the ship to a new economic model is generally wanting. In this sense we can be sure that China’s top team has drawn lessons from Latin America’s populisms and the Arab Spring.

A new financial crisis?

The fundamental old economy challenges of the middle-income trap, SOE inefficiencies, monopoly positions and reform, as well as over-capacity will be aggressively targeted in the 13th Five-Year Plan, the roadmap for development starting this year. In the next part we will dissect the aim of the plan: China’s new economy. Also meriting examination is whether the excessive leverage at non-financial firms, nearly 150 per cent of GDP and so double the US ratio and triple Germany’s, could drag down the old economy, and with it the world. That is, a financial crisis before China’s new economy emerges.

Part three of this article will be published on 10 February 2016.

Picture: Tomas Casas i Klett