How China can avoid the middle income trap

Chinese leaders are usually quite sanguine about their country’s economic woes despite the fact the country is experiencing its slowest growth rate in years. Premier Li Keqiang is often playing the role of cheer-leader-in-chief, reassuring both domestic and international investors about the future prospects of the world’s second largest economy.

However, one of the country’s most senior financial officials seems to have embraced the role of the devil’s advocate, saying China has a 50 per cent chance of falling into the much-dreaded ‘middle income trap’. The person who made the comment is no one other than the finance minister of the People’s Republic, Lou Jiwei.

He is arguably the world’s second most powerful finance minister after the US Treasury Secretary, who was formally in charge of the country’s $US 600 billion sovereign wealth fund, China Investment Corporation.

The International Monetary Fund defines the middle-income trap as the phenomenon of hitherto rapidly growing economies stagnating at middle-income levels and failing to graduate into the ranks of high-income countries.  Miserable examples of several Latin American economies come immediately to mind, having failed to achieve high-income levels despite reaching middle-income status many decades ago.

On the other hand, several East Asian countries including South Korea and Taiwan have successfully dodged the middle-income trap and have graduated into the ranks of wealthy developed countries. The question of the century for development economists and policymakers is whether China can escape the middle-income trap?

The Chinese finance minister believes the chance of China making it is 50/50. Lou says the government needs to solve the problem of imbalance and market distortion in the economy within the next five to seven years while maintaining 6.5 to 7 per cent growth in order to avoid the middle-income trap.

The minister, who has the key responsibility of tackling the country’s debt problem, says the biggest problem for the economy is reducing leverage. China’s debt has quadrupled since 2007, according a recent McKinsey Study. The country’s total debt surged from $7 trillion in 2007 to $28 trillion by mid-2014.  China’s debt as a share of GDP is 282 per cent, larger than Germany and the US.  

In addition, the quality of Chinese corporate debt has gone from one of the best in the world to the most highly leveraged in just four years, according to Standard & Poor’s (China takes the corporate debt crown, June 17 2014).  

At the moment, the country’s credit expansion is still outpacing output, which means that overall leverage is still increasing.  According to analysis  by the Petersen Institute, the stock of total social financing at the end of 2014 was 123 trillion yuan or 193 per cent of GDP. It seems that Chinese authorities are unlikely to tighten credit further in the face of worsening economic growth prospects.

So how China reduces its debt levels under the current circumstances is anyone’s guess. Apart from the problem of tackling debt in the short to medium term, Lou is also concerned about bigger issues such as the country’s rapidly aging population; China’s population could shrink as much as 29 per cent between 2030 and 2070.  

The Minister lists five different areas of urgent reform to tackle the long-term problem of demographic decline in China. He starts with the problem of agriculture, one of the most sensitive areas in the country. In a remarkably liberal move, he has called for a reduction in subsidies for farmers, urging the country to import more farm goods from abroad.

“Many Chinese have this war mentality and believe the country’s food security will be endangered if war breaks out. However, we can still ensure food stock through turning grassland and wetlands into farmland,” he reportedly said at an economic forum in Beijing.

He says China needs surplus rural labourers to fill vacancies in manufacturing as well as services sectors.  This is an important point because the country has already reached the so-called ‘Lewis Turning Point’, which means it has more or less ran out of surplus rural labour.

As a result, wages for Chinese workers have been growing at double digits recently. For example, the 2013 wages of Chinese migrant workers increased 13.9 per cent from the previous year, nearly twice the growth rate of China’s GDP. Surprisingly, Chinese wages increased most dramatically around the time of the global financial crisis. Between 2009 and 2013, Chinese wages surged 5.7 per cent, 19.3 per cent, 21.2 per cent, 11.8 per cent and 13.9 per cent, according to data from China’s National Bureau of Statistics.

“We need to encourage more imports so we can transfer rural labourers to fill vacancies at industrial and services sectors. This is to ensure that wage increases stay below growth in productivity,” he said.

How China overcomes the middle-income trap is arguably one of the greatest problems for policymakers and development economists alike. China Spectator will return to the Minister’s remaining four prescriptions tomorrow. So stay tuned. 

Follow Peter Cai on Twitter: @peteryuancai

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