Without big reforms, China risks middle income trap

PUBLISHED : Tuesday, 18 October, 2011, 12:00am
UPDATED : Tuesday, 18 October, 2011, 12:00am

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Speaking in Delhi yesterday, Haruhiko Kuroda, the boss of the Asian Development Bank, said that if Asian countries don't raise their game, they may never reach developed economy status.

Kuroda's warning follows a similar alarm call last month from World Bank president Robert Zoellick, who said that unless China overhauls its economy, it risks getting caught in the 'middle income trap' in which growth rates collapse long before the population attains rich-country levels of wealth.

These warnings are based largely on the bitter lessons of history. In the 1960s and '70s, economists predicted great things for fast-growing Latin American economies like Brazil and Argentina, forecasting they would reach developed status within a decade or two.

They never made it. In the 1980s their growth evaporated amid the Latin American debt crisis. Today, incomes in the big Latin American economies are still less than half those enjoyed by the developed world. Typically, gross domestic product per capita falls between US$10,000 and US$15,000 in purchasing power parity terms, compared to US$30,000 to US$40,000 in Western Europe or North America.

The worry now is that Asia's developing economies, and especially China, may fall into a similar trap.

Economists argue that China has found it easy to generate high growth rates over the last 30 years, simply by playing catch-up with the rest of the world.

The country has made huge gains in productivity by moving underemployed peasant farmers into coastal cities to work in factories making goods for export.

And those factories have not even needed to develop their own manufacturing technologies. They have been able to boost productivity by simply buying off the shelf from more advanced economies.

But sooner or later China will exhaust these easy gains. The proportion of the labour force employed in manufacturing will reach its optimum level, and the productivity gains to be made from buying in foreign technology will diminish.

At that point, growth rates will inevitably slow. And if China fails to make the switch from relying on imported technologies to indigenous innovation, and from an export-and-investment-driven economic model to one relying primarily on domestic consumption, growth may stall altogether.

At first glance, there doesn't appear to be much immediate cause for concern. After all, Japan, Taiwan and Korea never fell into the middle income trap, so it looks likely China could escape it too. And in any case, it may be years yet before China reaches the crunch point.

In an ADB working paper published in June, economists Barry Eichengreen, Donghyun Park and Kwanho Shin examined past slowdowns and determined that the downshift in growth rates was most likely to happen when GDP per capita reached around US$15,000 a year in purchasing power parity terms.

China is still a long way from that threshold. Extrapolating from World Bank figures, GDP per capita is likely to be around US$7,500 this year. At current growth rates, it will not top US$15,000 until the end of this decade (see chart).

Unfortunately, however, Eichengreen and his colleagues warned that China may find itself entering the middle income trap danger zone at a lower income level than other economies.

They found that productivity gains from the invest-and-export growth model typically start to evaporate once 23 per cent of an economy's workforce is employed in the manufacturing sector, a proportion they believe China is likely to hit in the next three years.

On top of that, they discovered that countries are more likely to suffer a marked growth slowdown if they have undervalued currencies - possibly because their economies tend to be unbalanced - and most likely to escape the middle income trap if domestic consumption makes up around 60 per cent of GDP.

China scores poorly on both counts, with a currency undervalued by 46 per cent on the ADB researchers' measure, and with domestic consumption contributing just 48 per cent of economic output.

As a result, it looks as if the warnings of Kuroda and others are justified. China's transition to developed economy status is not assured. Without far-reaching economic reforms in the next few years, it could easily suffer the fate of so many Latin American countries and fall into the middle income trap.

 

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