Will China get stuck in the "middle income trap"?
The advantages and disadvantages of scale
Quora: Are the latest troubles in China’s stock market, devaluation of the Yuan and general slowdown of the economy symptoms of the inability of the Chinese economy to move beyond the “middle income trap” or rather the bursting of bubbles in the Chinese economy?
China has a very good chance of breaking out of the “middle-income trap” and I discuss why below. But it isn’t 100% guaranteed and I discuss below the major risk that China faces that could prevent it from breaking out.
China’s per capita GDP is $7-8k, or $12-13k on a PPP-adjusted basis. The World Bank classifies it as an “upper middle income” country, alongside countries like South Africa and Colombia. There are parts of China that would already be classified as “high income” while its poorest provinces would be classified as “lower middle income” somewhere between Guatemala and Thailand.
One way to answer this question is to consider the cases of countries that have gotten stuck in the “middle income trap” and the ones that broke out and compare and contrast with China.
The archetypal “middle income trap” countries are certain Latin American and Southeast Asian countries. These countries started poor and underwent some degree of industrialization, often funded with (dollar-denominated) debt. At the beginning of their modernization drives, growth was rapid but hit a wall after two or three decades after some sort of financial crisis (Latin American debt crisis, 1997 Asian financial crisis) from which some are still recovering from.
In the modern era, there are actually only a handful of countries/economies that have broken out of the “middle income trap” and the most relevant examples (as it relates to China) are Taiwan and South Korea. Both of these economies started out dirt poor after World War II, industrialized rapidly through the 60s and 70s and then busted out and became “high income” countries in the 90s and 2000s. I write more about their respective stories here.
You can certainly draw parallels between China and the archetypal “middle income trap” countries. For example, China has taken on a serious amount of debt to fund their most recent stage of growth, similar to the Latin American countries that were helping recycle petrollars in the 70s. Despite this parallel, there are still some significant differences. For example, China’s debt is largely domestic in nature. While this certainly does not prevent financial crises (see Michael Pettis for more on this), it does mitigate the risk of an external shock (which is exactly what happened when those cheap funding sources disappeared after oil prices collapsed). External shocks are bad because they often come out of nowhere, leading to significant disruption with no time to prepare.
There are other noticeable differences between China and the “middle income trap” countries. For example, very few companies in “middle income trap” countries are truly globally competitive. Take Malaysia for instance. Looking at a list of its top companies, you’ll notice that it is dominated by companies in real estate, banking, telecommunications ... i.e. mainly protected domestic industries that require licenses and regulatory approvals. In other words, their largest companies do not make products or services at a price point that make sense to other countries.
Meanwhile, China is the world’s largest exporter and has countless companies that are emerging (if not already) global leaders from telecom equipment to online gaming/messaging to drones. And it is not from having the cheapest labor — China’s per-hour labor costs already exceed many of the “middle income trap” countries — but from having the best combination of productivity and cost. I recently made a trip to Shenzhen and I can say that the amount of innovation coming out of China is staggering and will only accelerate. Chinese companies are extremely (some would use the word “frighteningly”) competitive.
China’s economic development path is much more similar to South Korea and Taiwan. They all kicked off their modernization drives by reforming the agricultural sector (e.g. successful land reform programs) ... had tightly controlled financial sectors which allowed them to concentrate scarce capital/resources ... industrialized with a heavy emphasis on producing goods for export etc. Interestingly, they all had authoritarian de facto one-party governments for the first three decades of their modernization drives.
At the same time China is also very different from South Korea and Taiwan. The most obvious difference is size and this is both a negative and a (potential) positive. On the negative side, China cannot “export its way to becoming a rich country”. While South Korea and Taiwan (and Japan, for that matter) could rely heavily on an export-led strategy until they reached high-income status, China’s population – which is nearly 7x higher than those three countries combined – means that the world (and principally the U.S.) cannot absorb all of those exports without triggering a serious trade war. In fact, one of the underlying reasons for the 2008 Global Financial Crisis was that the U.S. economy had just about reached its limit absorbing higher and higher trade deficits (and more specifically its corollary: job losses).
But China’s scale can also be an advantage. As it has shown already, its scale means that China is the largest market in the world for things like automobiles, smartphones and online games. For markets where it is not #1, it will probably get there soon. I remember being absolutely shocked when I learned that the #1 beer brand in the world was not Budweiser or Heinekin ... it was this (Tsingtao was #2, and two other Chinese brands were in the Top 10). And there are a lot of other Chinese brands that most of the world has never heard of that are the largest in their space. This home market advantage is one of Michael Porter’s four major factor conditions that leads to competitive (and ultimately wealthy) nations. While scale by itself is not the only factor to building competitive companies, it certainly helps.
I can also see a scenario where China gets stuck. And if it does in fact get stuck, the main driver will be income/wealth inequality.
Wealth creation can be zero-sum / rent-seeking (the “bad way”) or mutually beneficial to society (the “good way”). Countries get rich by making sure their entrepreneurial energy is focused on efforts that are not only beneficial for themselves, but also beneficial to society. In China I think this type of activity is best represented by private sector companies such as Alibaba and Tencent and the massive export/industrial zones in and around the Pearl and Yangtze River Deltas. I like to joke that Jack Ma did more to put a dent in income inequality than any government handout ever could. In my experience, entrepreneurs who made money the “good way” also are more likely to re-invest back into the country instead of siphoning their ill-gotten proceeds offshore.
However during the last cycle too much wealth creation happened the bad way. For example, much of China’s real estate development over the last 15 or so years was characterized by land that was formerly own by the public transferring into the private hands. This process was notably rife with corruption via the transfer process of assets from society into the hands of the relatively (and often politically connected) few.
Another example are state-owned enterprises that get the benefit of operating in protected industries (e.g. banking, telecom, energy) with access to low, subsidized (mainly by the household) financing. They do not need to be ruthlessly efficient, so employees get paid relatively high salaries and never worry about losing their jobs, without necessarily having to provide better products or services. Again, this situation effectively means wealth is transferring from the people (who have no choice but to use these services) to the SOEs and its employees, who are (unsurprisingly) disproportionately members of the CCP.
Too much zero-sum activity will pretty much guarantee that you end up in the “middle income trap”. This is what happened to the Latin American and Southeast Asian countries that got stuck. Their most motivated entrepreneurs figured out that the best way to get wealthy was to get involved in rent-seeking activity ... and after they became wealthy, they used their wealth to buy political influence to make sure that their situations could continue. And at that point it becomes a vicious cycle — not to pick on Malaysia, but Google “Jho Low 1MDB” and you will know what I am talking about.
A little corruption is inevitable. But too much and the country can get overwhelmed by it.
I think China is close to that critical point and this is the main risk it faces on its path towards becoming rich. Over the past generation, the lives of the 1% have improved disproportionately (not dissimilar to here in the U.S. by the way). If this trend continues, China runs an increasing risk of getting stuck (or worse).
That said, the current administration looks like it is taking relatively bold steps to address this. Some are cynical about the true motives behind the anti-corruption measures but one cannot argue with the impact (just look at sales of expensive liquors and certain luxury items, which were notably correlated to many of these zero-sum activities). And more significantly, the country has taken fairly drastic steps to cut down on loans and investment-driven activity, which effectively limits the opportunity set for further corruption and zero-sum wealth transfers. Hopefully, some of these motivated individuals will decide to direct their energy at enlarging the pie instead of just trying to go for the largest piece.
If that happens, I am pretty certain that China will become rich.
This was originally published in Quora in September 2015.