A Note on the Middle Income Trap

In the last couple of years, a number of China political observers have commented on the dangers to China of the middle income trap.  The fear is that the Chinese economy will fall into the trap. Since economic growth is the remaining claim to legitimacy for CCP, a substantial slowdown from real growth rates of 6 to 15 per cent per year, which obtained in the last forty years, will be disturbing to the harmony that keeps CCP in power. 

In what follows I am not making direct claims for or against the middle income trap in China, only describing the concept. 

What does the middle income trap mean? 

Most models of national development posit a growth track that demands -

- increased savings, so savings can be used for investment;

- an abundant low wage population;

- transfer of low wage, low productivity workers into higher productivity jobs in factories;

- promotion of exports; and

- a progression to higher levels of productivity, eventually approaching the GDP per person levels of the most developed countries. 

Only a few countries – notably, the Asian Tigers – Singapore, South Korea, Taiwan, Hong Kong – have made that transition.  More countries have begun the transition and after a couple of decades, found themselves stuck – unable to significantly increase GDP per person.  That list is longer – Mexico, Philippines, Malaysia, Indonesia, Turkey. The World Bank has identified 37 countries that are prisoners of the middle income trap.  These countries have achieved middle-income country status, but seem unable to pass that barrier, or trap. 

It is important to note that the middle income trap does not mean people are starving, or in poor health.  It does not mean that economies are failing, only that GDP/person is failing to grow much.  National economies are stuck, not declining.   But notably, economic performance is the remaining claim to legitimacy for CCP, now that Marxism-Leninism is discredited (except for Mr. Xi) and nationalism is a dangerous ally.  If nothing else, the middle income trap may be just reversion to the mean of GDP growth.  But that alone is scary for a government whose claim to legitimacy is growth. 

Reasons for the middle income trap include the need to transition institutional arrangements, from those that worked well when the country was emerging from poverty to those needed for higher quality growth – one can imagine changes in rules about finance, banking, savings, property ownership, transfers of ownership, control of bribery and corruption.  With increasing sophistication of work come demands for increasing sophistication of education – workers in finance need different training than workers on factory assembly lines.   Also, changes in cultural features – attitudes to education, health care, family connectedness.   Acemoglu and Robinson Why Nations Fail boil most of the necessary changes down to institutional change – rules, regulations, laws, customs built in to culture. 

Is there evidence for the middle income trap in China?  Here are some things that keep Chinese macroeconomists up at night.

 Scott Rozelle, education and health researcher in rural China, defines part of the problem, not mentioned in glowing reviews of Chinese economic power.  In decades of research across many Chinese provinces, he finds that iron deficiency anemia was present in 40% of students in fourth and fifth grade in at least four rural provinces; in Guizhou and other southern provinces, 50% of children suffered from at least one type of intestinal parasite; and nearsightedly was common in schoolchildren, but went unaddressed in many rural areas.   Health care and education in rural areas is now significantly better than twenty years ago, but problems persist for much of the rural population.   The health problems are definitely treatable; but they persist, nevertheless.   Rozelle has found that 15% to 20% of rural kids do not do not complete middle high school.  That is a fearful statistic for future growth.   Many of those same kids are affected by poor quality or poisonous drinking water, or rice laden with heavy metals, or air that is even more poisonous.  China has been a leader in flashy environmental projects – wind, solar, dam construction.  Not so much in the unflashy, dirty job of cleaning air, water, land, or ensuring food quality.  Spending on those items will make no contribution to exports or factory technology or even short term health.  For local officials, what’s the point?

For those rural kids, China now has much less ability to build on exports to fuel internal growth.  The rural school children who don’t go to high school are not going to swing investment deals in London, and other countries in Asia and Africa are now lower cost producers of commodity and low-end  products.  That part of the growth path is now less available in China for the 800,000,000 or so who are not middle class and living in Beijing or Shanghai or Hangzhou.  How will they flourish?

That is one side of the problem.  Another side is the ability of superior Chinese scientists and engineers to continue with indigenous innovation.   In one sense, this is not a problem – what is not invented can be stolen, as in the past.  But innovation is no longer an individual working in his garage, but coordinated lab work and bench work and computer work, and collaboration with people outside China is vital.  The Great Firewall, in all its manifestations, inhibits that.  On a project basis, that may not be much of a problem.  In addition to theft, direct internet access to western journals and scientific reports in readily available within scientific and engineering schools and labs.  The firewall, which is eminently adjustable locally, does not affect them.  On another level, however, those same scientists and engineers can find themselves unable to participate in the events of the world in which they have an interest – conferences and symposia and simply news of family and friends outside China.  Sometimes, these sophisticated workers find the daily restrictions and requirements – writing paeans to Xi Jinping Thought, as is a current requirement -  to be just too stupid, and they leave.  They don’t want their kids to write such paeans, either.

When we look at the macroeconomic picture of China is all its glory and warts, we come down to the Acemoglu and Robinson prescription – institutional change.  The change required is not small.  It is systemic, and at the heart of the Chinese model for the last forty years – financial repression and investment in infrastructure and real estate.  Interest on savings in banks was held low, so loans to SOE and other factories and real estate developers could be held low as well.  The hukou kept peasants out of cities, keeping social overhead capital for poor people – primary and secondary education, health care, low income housing, pensions – mostly out of government budgets.  But changing the model means changing the relative shares of income in the economy – poor people and farmers and ordinary savers need to get a larger share of total income, and lots of vested interests in government and SOE and banks need to get a smaller share.  The reluctance to share in China is no less than it is on Wall Street, hence the political conundrum.  Social spending in China on education and health care and pensions needs to go up significantly, as China ages and education needs are greater and pensions, long a source of misspent and stolen funds and poor accounting, become a bigger factor in people’s lives. 

Truthfully, when reform began in 1978, China did need every piece of infrastructure that it could build – trains, planes, airports, ports, expressways, housing, factories, offices.  Now, what was needed is built, and far more.  The return to GDP from more construction is less and less.  That contributor to GDP growth is no more.  But building more stuff is the only lever that officials have right now to goose short term GDP. 

Finally, the world is no longer cooperating with China.  For forty years, in the US and Europe, policy makers were willing to accept some job losses in return for low priced consumer goods.  Now, in 2019, governments are less willing to trade jobs and technology for low priced shirts and televisions.   That is one threat facing China.  Another is the economic construct of a secular stagnation, a  general slowdown in all the advanced economies attributable to ageing populations (which don’t buy as much), greater income disparities (since the wealthy don’t simply buy more food or shirts or televisions), greater savings in advanced economies (due to risks of recession or simple job loss), and even greater flexibility in wages and prices, which we normally think of as a good economic outcome (flexibility can increase savings and decrease spending because incomes can now fall as well as rise).  In general, there is more savings than the world can profitably use, and investment levels remain anemic.  This is certainly not good for China exports or profitable Chinese infrastructure investments overseas. 

There is no guarantee that GDP/person will fail to grow in China.  But the threat is there, as evidenced by the paper by Barry Eichengreen, Donghyun Park, Kwanho Shin in 2013 - Growth Slowdowns Redux: New Evidence on the Middle-Income Trap.  Their conclusion - We also find that slowdowns are less likely in countries where the population has a relatively high level of secondary and tertiary education and where high-technology products account for a relatively large share of exports, consistent with our earlier emphasis of the importance of moving up the technology ladder in order to avoid the middle-income trap.

That is what CCP theoreticians and macroeconomists are thinking about. 



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