Sunday, 29 April 2012

China and the Middle Income Trap

An earlier post made the point that China, with a $7.2 trillion economy, no longer requires double-digit GDP growth to generate momentous amounts of economic growth - 6-7% will do just fine.  It isn't written in the stars, however, that the Middle Kingdom will enjoy that rate of growth over the medium to long-term.  One key threat to steady, sustained growth is the difficult transition to a mature economy, while avoiding the dreaded "middle-income trap" that has ensnared many fast-growing countries in the past.
China's economy has grown at 10% per year since the late 1970s by following a fairly simple formula: increasing inputs, especially labor and capital, and throwing them at an underdeveloped economy.  Moving hundreds of millions of people from the countryside into cities, and creating a modern industrial economy, required herculean capital expenditures.  Roads, railways, ports, buildings, dams, office towers, houses, apartments - constructing all of this architecture over the past three decades has been an amazing feat.  But half of China's population is now urban, and today's staggering levels of government spending cannot continue forever. 
However populous its citizenry, however vast its geography, China doesn't require infinite investment.  For the past 8 years, fixed asset investment has increased by a stunning 40% per year (1).  It now appears that some capital investment is motivated less by necessity and more by an effort to stimulate the economy.  This year, the government plans to build 5 million affordable apartment units, with a goal of reaching 36 million by 2015 (2), partly to keep growth from stalling.  Over the next decade or two, China must transition to an economy that's driven less by investment, savings and exports and more domestic demand.
There is reason for cautious optimism that China may be able to manage the transition.  First, the government fully understands the need to restructure the economy.  In fact, the government has been willing to limit unrestrained growth by raising interest rates and increasing banks' capital requirements, for example.  Second, several important market pressures are pushing in the same direction.  For example, wages and land prices, two key components of China's cost advantage, have increased sharply.  This will force labor to become more skilled and productive.  In addition, China's artificially low currency creates unwanted inflation and unhappy trading partners, but enables cheap exports; as it rises, it will increase consumption and decrease exports.
The transition requires increasing consumption even as investment as a percentage of GDP falls.  This will be tricky, but there is some low-hanging fruit.  For one, the country could put in place a more helpful social safety net, especially in the areas of health and education, so citizens spend more money instead of squirreling it away to guard against unforeseen developments.  This is helped by rising wages, which are a cost to employers, but income to employees.  With over $3 trillion in reserves, low deficits, and manageable overall debt, China also enjoys flexibility.  From today's relatively high interest rates, there is room to ease monetary policy, as well.
In a country as large, complex and fast-moving as China, it's difficult to make accurate predictions.  The country, to be sure, faces challenges.  Cutting unsustainably high asset investment while maintaining growth won't be easy, and there's a bubble in some areas of the property market.  However, the government has deftly managed the economy in the past, and is alert to the problems of the present and future.  Though this doesn't ensure success, there is hope that China can join neighbors Japan and Korea in the ranks of developed countries.  Let's hope the nickname "Middle" Kingdom continues to refer to geography, not income.
(2) Ibid

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