What exactly is the middle-income trap and how do economies fall into it? When a country escapes poverty levels by ascending from a primarily agrarian economy to middle income status it faces a higher probability of a major economic slowdown. This phenomenon inhibits the economy from taking the next steps towards high income status thereby creating what is known as the middle-income trap. In China’s case they have moved out of the mainly agrarian system of a few decades ago into a more industrialized middle-income level economy which has shown dramatic growth rates in recent years. Now they are faced with declining growth, and risk being unable to accelerate up to the next level.
China’s odds of escaping the trap are not good:
Escaping an agrarian economy is an easier endeavor than moving upward from the middle-income level. History has shown that high flying growth rates have a tendency to revert to a global average (about 2%) after a period of time. China’s large economy has needed growth in the 7% + range to propel itself to middle income levels. As this rate reverts back towards 2% the economy will lose the steam needed for the quantum leap to high income status. Globalization has enabled rich country technology to be supplied to poorer, emerging market countries that have cheaper labor forces. Competition from other emerging markets, particularly in manufacturing, will make the leap more difficult for China. Further, China has the necessity of importing oil for its energy needs risking its growth requirement at the hands of global crude oil supply, demand, and price fluctuations. There’s some question that China’s infrastructure is ready to handle the massive increase in transportation and communication services needed for the push to higher income status.
China’s risk factors align with victims of the middle-income trap:
- High GDP growth:
Research has shown that ultra high levels of GDP growth are more susceptible to declines over the long run owing to government stimulus in the short run. China’s ultra high growth over the last decade or so faces the side effects of this stimulus such as excess capacity, uneven distribution of resources, and financial problems including high bad debt levels.
- High old-age dependency ratio:
China’s population has an old-age percentage which corresponds to other countries at the middle-income level (about 14 seniors for every 100 working adults). In the next decade this percentage is expected to double putting it on a par with developed countries such as the United States, Canada, and Australia. Compounding this problem will be the increased requirement of better social safety nets which will consume capital and resources and pull back on overall growth rates. Rising old-age dependency ratios usually translate into lower savings rates and a declining labor force participation rate, particularly for skilled and/or experienced employees.
- High investment share of GDP:
To generate the high growth rates of the past decade China has had to apply a very high percentage of its GDP towards investment – nearly twice the middle-income norm. Ultra high investment rates can lead to lower future returns and greater risk of interim capital losses—all of which can inhibit growth.
- Undervalued currency:
An undervalued currency has a tendency to support exports which would assist growth. However, researchers say that an undervalued currency is associated with countries being stuck near the bottom of the technological ladder with little incentive to move up as technology is usually acquired from richer countries that have higher valued currencies. China apparently does not have an undervalued currency at the current time, although this is particularly difficult to gauge.
- Low secondary education attainment:
Countries that lack high levels of secondary education in the population generally also have an untrained labor force. As the activities of manufacturing, construction, and services become more and more sophisticated owing to technology the better educated workforce will be in position to leverage growth. China’s workforce is slightly behind the middle-income country norm, but the more recent generations are showing signs of bringing better education to the workplace.
- Low high-tech share of exports
Researchers argue that countries with a lower percentage of high-tech exports face a greater likelihood of a slowdown. Growth is enhanced when an economy can transit from producing labor-intensive products to knowledge-intensive products which bring higher value to the marketplace.
Can China escape the middle-income trap? Former Finance Minister, Lou Jiwei, gives it no better than a 50-50 chance. To increase those odds China needs to look for improvement in four major dimensions: Institutional quality, innovation, human capital, and information and communication infrastructure.
Sources: China and the Middle-Income Trap, by Daniel Rohr, CFA, Morningstar News, morningstar.com