How China can avoid the middle-income trap

Concern about the "middle-income trap" has grabbed public attention again. Recently, Minister of Finance Lou Jiwei said at Tsinghua University that China had a "50-50 chance" of sliding into the middle-income trap in the next five to 10 years. However, many inaccurate versions of his speech are circulating on the internet, causing widespread concern, and it is important to have a complete and proper understanding of his views.

In fact, Lou made reference to two scenarios in his speech. In the first, he said that if China forged ahead with structural adjustments, the economy could grow 6.5 per cent to 7 per cent in the mid-term - a more upbeat outlook. However, it is the second - the middle-income trap scenario - that raised more interest online, although his speech was focused much more on the first. His analysis is based on the success of China's economy and institutional foundations, while looking at the risks and problems. The conclusion was practical; whether China can avoid the middle-income trap will depend on whether comprehensive reforms can change the growth model, making the country a highly competitive innovator.

The concept of the middle-income trap was first put forward by the World Bank in its 2006 report on the development of East Asian economies. According to the concept, in many middle-income economies, growth slows and they are unable to move up to become high-income economies.

Japan and the four Asian tigers are among a few examples that have become high-income economies. Most Latin American countries have fallen into the trap. And many other countries are still caught in the poverty trap; their economies have never taken off.

Why is it so difficult to avoid the middle-income trap? When a country attains a certain income, its labour-intensive export sectors - the traditional growth drivers - lose competitiveness because of rising labour costs. It must transform its growth model and build four pillars for an innovative economy - competition and "creative destruction"; top-notch research universities; a dynamic labour market system; and, a financial system comprising venture capital, private equity and securities markets. But that's easier said than done.

China's per capita GDP has reached the middle-to-upper levels after 30 years of reform and opening up. But this has made it easier to fall into the middle-income trap. Some claim China has already solved the problem but it is too early to say that. China's economy has a foundation to grow, but it also faces unique difficulties. It has the institutional framework for a market economy, and attaches importance to opening up to the outside world. Yet, its newly transformed economy retains remnants of the planned economy. It takes time to adapt to a knowledge-based economic system, with the rule of law at its heart, and China's system needs to be improved, especially in copyright protection, labour mobility and land transfer.

Worse, because of previous policy errors, the population is ageing before getting richer, while the labour force is shrinking. As Lou said, other countries have had two or three decades to evolve; China has only five to 10 years.

Time and tide wait for no man, and China must respond quickly. Urbanisation must be speeded up, to release the agricultural population. Urban areas need renewal to make it easier for modern enterprises to survive. To this end, investment in rural education and infrastructure must increase. The household registration system, the social security system and the rural land use system must be reformed. Labour, capital and land markets must be built during the process of urban-rural integration. There must also be strong urban and land management systems, plus a healthy local fiscal system. All these were mapped out during the third and fourth plenary sessions. Only by deepening reforms can China avoid the middle-income trap.

Implementation is key. Of the hundreds of different reforms being undertaken, financial reforms have been the most gratifying. Liberalisation of interest and exchange rates, as well as the opening of capital accounts, have been forging ahead. However, many other reforms have shown little progress, including for the household registration system. Social insurance reform is also moving slowly, with administrative monopolies and regulatory barriers still in place.

It is becoming more urgent to coordinate and speed up various reforms. Meanwhile, plans for state-owned enterprise reform have yet to come about. This risks seriously weakening the effects of financial reforms. Sacrificing some short-term interests is necessary.

China is not doomed to fall into the middle-income trap, or automatically be protected. Planning for the 13th five-year plan is about to begin. It is time to review the experiences of the 12th plan to create an innovative and more efficient economy.