China must face up to the constraints on its growth

Cary Huang says problems such as overcapacity and bad debt need to be fixed to sidestep the middle-income trap for the next economic leap

PUBLISHED : Friday, 15 May, 2015, 12:35pm
UPDATED : Friday, 15 May, 2015, 12:35pm

The recent deceleration in China's economic growth has raised serious questions over whether the world's second-largest economy is settling into a protracted period of subdued growth, better known as the "middle income trap". Lou Jiwei , the finance minister, reinforced such fears recently by saying that the country had a 50 per cent chance of heading for the miserable fate in the next five to 10 years.

While the slowdown is a structural inevitability, China is especially vulnerable because its decades-long rapid growth has been based on cheap labour and state-led investment. With a quasi-capitalistic economy, it is more challenging to move to a higher-income bracket, as its East Asian peers, Japan, Singapore, Taiwan and South Korea, have done in the past.

The term "middle income trap" is probably most readily applicable to several Latin American economies that have failed to achieve high-income levels despite reaching middle-income status many decades ago. The World Bank defines middle-income nations as those with a per capita income of between US$1,006 and US$12,275. China's per capita gross domestic product stood at US$7,575 last year.

History suggests that high-speed growth tends to be extremely short-lived; just nine years on average. But, from 1980 to 2012, China's GDP growth averaged 10 per cent per annum. However, the economy has slowed considerably in the first quarter of this year, to just 7 per cent, firmly marking the end of the high-growth heyday.

Economics suggests that countries with especially high growth rates when incomes are very low are more likely to slow down when they reach the middle-income level. China falls into this category.

Another key determinant of China's economic future is demographics. The nation's growth has been largely built on a plentiful supply of cheap labour. But the labour-intensive economy has recently reached the "Lewis turning point", moving from a period of unlimited supply to a new era of labour shortages and rising wages.

Yet another indicator that China might get stuck in the middle-income trap is its overreliance on capital investment to fuel growth. The proportion of capital investment to GDP reached an unprecedented 50 per cent in recent decades. During the periods of rapid industrialisation between the 1950s and 1970s, capital investment in Japan, Singapore, Taiwan and South Korea was equivalent to about 30 per cent of GDP. China's state-led investment model has resulted in overcapacity in many sectors and accumulated bad debt for state banks.

China's economy is no longer factor-driven, and is now driven by efficiency, in which it produces more advanced products and services on the back of major improvements in productivity.

The next stage of development will be to create an innovation-driven economy, which requires tackling a string of problems, such as overcapacity, deflation, the asset bubble and local government debt. It also requires solutions to social crises due to widespread corruption and the widening of the wealth gap, which are all constraining growth.

A scenario where a previously fast-growing economy falls back into stagnation is the last thing China's leaders want to see. But, in its transition towards a more affluent society, fundamental reform of the one-party system will decide whether China can succeed in navigating the currents to reach the status of a high-value-added economy based on productivity and innovation.

Cary Huang is the Post's Beijing bureau chief