Avoiding the middle income trap in China

I have been thinking quite a bit about China and its confrontation with the middle income trap. As I have said in a recent post, it isn’t at all clear whether China will be able to avoid the middle income trap – the phenomenon that economic growth starts to fall rapidly in some countries once they reach GDP per capita levels somewhere around $10,000 to $15,000.

That there is a clear risk of a middle income trap can be seen in the chart below. It shows the regression coefficient between economic growth and starting GDP per capita for a set of 89 countries. For low income and high income countries, the regression coefficient is negative, meaning that countries with lower GDP per capita have higher growth rates. This is what one would expect since these poorer countries start from a lower base and can increase growth by reducing inefficiencies in the economy.

However, the chart also shows that for GDP per capita between $317 and $1,808 in 1960 Dollars ($2,738 and $15,601 in 2019 Dollars), the coefficient turns positive, meaning that countries with lower GDP per capita subsequently have lower economic growth. This is the middle income trap when some countries stop catching up with high income countries.

The empirical connection between starting GDP per capita and future growth

Source: Feng et al. (2019). Note: The horizontal axis is the natural logarithm of 1960 GDP per capita, the vertical axis is the regression coefficient with future real GDP growth.

Despite years of research, it is unknown which factors drive the transition from middle income to high income and which factors trap some countries in middle income status. Take Mexico and Poland, for example. Both Mexico and Poland are middle income countries that border on a large highly developed economy (The United States in the case of Mexico and the European Union or Eurozone in the case of Poland). Both countries are linked to these large developed economies with free-trade agreements enabling them to import and export goods freely. Both countries compete with lower labour costs for foreign direct investments. Yet, between 1980 and 2019, Mexico’s GDP per capita growth was a mere 0.8% per year, while Poland’s was 2.5% per year. As Homi Kharas and Indermit Gill point out:

“In the early 1980s, after the oil price shock, Mexicans were 50% richer than Poles. Today, Poles are 50% richer than Mexicans.”

It seems as if Mexico is a victim of the middle income trap while Poland is not. While there seems to be no universal driver or set of factors that can push a country into the middle income trap, there are a few cases that illustrate the potential pitfalls.

Faced with a declining labour cost advantage, some middle income countries try to encourage investments in high-tech industries even though they lack the crucial infrastructure to support such industries. They are lacking a suitably educated workforce, required investment capital and a stable legal system. On the other hand, they may be bogged down by corruption and high regulatory barriers that scare off foreign investors. Another observation is that countries that successfully migrate from middle income to high income status seem to do this based on a specialisation of the economy in some niche areas. Just think of South Korea and Japan that specialised in the machinery, electric and automotive industry. Similarly, Poland and other successful Central European countries specialised in becoming suppliers to the automotive and machinery industry in Europe. Mexico, on the other hand still has an export sector mostly focused on agricultural products and natural resources.

Jungsuk Kim and Jungsoo Park from the Asian Development Bank point out that countries that successfully transition from middle income to high income status manage to create positive factor productivity growth while countries that remain trapped in middle income status have negative factor productivity growth.

To turn this around, and focus on China as the most important middle income country in the world right now, this seems to imply that China needs to stimulate its productivity growth by increasing its educated and highly skilled workforce, reduce regulatory barriers and focus on high-tech industries where the country can catch up with the West or even leapfrog Western competitors.

In some sense, China is on a good path here since the country is educating more students in STEM fields (Science, Technology, Engineering and Mathematics) than any other country in the world, it is increasingly opening some of its industries to Western investors (e.g. the automotive industry, banking or the pharmaceutical industry) and its Made in China 2025 strategy focuses on developing capabilities in crucial high-tech industries like AI, robotics, and electric vehicles. These are promising developments and the right steps to foster continued strong growth.

On the other hand, we know that countries trapped in middle income status often suffer from a lack of creative destruction. Unlike high-tech countries like Germany, Switzerland or the United States, they do not have a large number of privately owned small- and mid-cap companies that are developing new technologies and are hotbeds of innovation. Instead, a large part of the economy is in the hands of unproductive zombie companies or conglomerates that have domestic monopolies and no incentive to innovate. The keiretsu system of company cross-holdings in Japan and the accompanying zombie banks have contributed to decades of minuscule growth there. Meanwhile, state capture by an elite class of industrialists has destroyed the competitiveness of many industries in countries like Brazil or South Africa.

Unfortunately, in China the state-owned enterprises (SOE) control large parts of the economy. These SOE are controlled by party members and suffer from extremely low productivity. If they aren’t opened up to private and international competition in the future, China risks being dragged down by these millstones of the economy. But with the economic slowdown in China due to the trade war with the United States and now the Coronavirus pandemic, the Chinese government relies heavily on these SOEs to boost industrial output. And this means that these SOE become relatively more important in the Chinese economy not less. The result has been a continued decline in Chinese productivity growth in recent years. So far, the situation is not too bad and productivity growth remains positive, but the trend is certainly not China’s friend here.

Chinese productivity growth

Source: University of Groningen.