China’s economic performance during the last three and a half decades has been spectacular. However, as a new generation of leaders assumes office, there are increasing concerns about its ability to sustain this record over the next 10 years. To do so, it is usually said that China needs to draw lessons from other countries on how to avoid the “middle-income trap”. However, there are no ready-made lessons that China can adopt. Instead, it will have to rely on home-grown solutions to attain convergence to advanced economy living standards. Over the medium-term, China faces a number of challenges, but it is hard to imagine that the “China Dream” can be realized without successfully negotiating two powerful forces income inequality and population aging.
Let us begin by reconsidering the middle-income trap. If we take US per capita income as a benchmark, four distinct groups emerge in the post-war era. The first group is the advanced economies, whose per capita income has converged with one another and toward that of the United States. The second is largely Eastern European and Latin American countries, who started at a broadly similar level as those in the first group, but fell away and only partly recovered. The third is those few economies that managed to break away from the low income group and made significant headway in converging to US per capita income, principally Korea and Taiwan Province of China. The final group consists of low and middle income countries that have only started to converge in the last decade, and includes China.
Two broad lessons emerge from these experiences. First, political stability and good governance are necessary conditions for convergence. Indeed, poor governance in Latin American countries manifested in corruption and high income inequalityand political instability in Eastern European countries are widely cited as impediments to their development. Second, the few economies that managed to break away and converge toward advanced standards did so on the basis of high levels of investment and a matching rapid pick up in exports. So far, China has done very well with respect to the first lesson and has internalized the second, with investment and exports already the two main engines of its traditional growth model.
However, this can no longer work. The dramatic rise in inequality over the last two decades has contributed to some recent deterioration in public perceptions of governance. In terms of the drivers of China’s growth, exports will not be as buoyant as external demand remains sluggish in the wake of the global crisis, input costs rise, and gains in global market share slow with the increasing size of the Chinese economy. And at close to half of output, China’s investment level is already about 10 percent of GDP higher than that of other Asian economies prior to the Asian crisis. According to a recent IMF paper, this elevated level of investment is in part made possible through financial controls that result in a hidden transfer from households and SMEs to large corporates and banks of 4 percent of GDP per year. Damagingly, this resource transfer suppresses household incomes and consumption and reduces the efficiency of capital allocation, both of which limit China’s medium-term growth potential. Going forward, tightening labor market conditions due to population aging and rising wages will necessitate faster productivity growth if China is to remain competitive. So as China’s new leaders attempt to prolong the economy’s growth momentum over the next decade, among the strongest headwinds they will have to confront are inequality and demographic change. Let us take a closer look at these two phenomena.
Since the reform and opening up period, China has made remarkable strides in lifting people’s incomes and reducing poverty. However, while absolute poverty has been substantially reduced, it has come at the cost of raising relative inequality, dampening this remarkable achievement and leaving China among the most unequal economies in the world. As a result, China’s growth has been less inclusive than in many other developing regions, particularly Latin America.