Structural change and mid-income trap--under which conditions can China succeed in moving towards higher income status?

• Author: Wagner, Helmut
• Position: Report

1. China's Recent Development Success

   China's development during the last three decades has been very successful and admirable. China was a very poor country in 1978 when it decided to reform its country towards a modern, more efficient economy. China's per capita GDP in purchasing power parity (PPP) terms was then lower than India's per capita GDP. It was only in 1992 that China overtook India in terms of GDP per capita. Since then, the country developed in an astonishingly quick and positive way. (3) The following summarizes progress from 1990 until 2014: (4)

   * Real income (on a PPP basis) increased by more than 14 times.

   * Real income per capita (on a PPP basis) increased nearly twelve-fold.

   * Poverty headcount ratio declined significantly from 60.73 per cent in 1990 to 6.26 per cent in 2011.

   * Number of poor at $1.25 a day (on a PPP basis) was reduced from 689 million to 84 million during the same period.

   * In 2014, China represented 16.48 per cent of global GDP--more than four times as much as it did in 1990--making China the worldwide No. 1.

   * Exports of goods increased by almost 2677 per cent from 1992-2014.

   * Annual FDI flows to China grew from $2bn in 1985 to (an estimated) $127bn in 2013.

   * The secondary gross school enrollment ratio rose from 37.77 per cent in 1990 to 88.98 per cent in 2012.

   This shows: China is on its way to regaining its old strength. According to a study by Maddison, China was the world's largest economy in 1820, accounting for an estimated 32.9 per cent of global GDP. By 1952, China's share of global GDP had fallen to 5.2 per cent and by 1978 to 4.9 per cent. (5) Since then, China has started to reform and restructure its economy and to catch-up so that it has regained global economic power, and in 2014 it succeeded in becoming again the world's largest economy (see above).

   Therefore, China has succeeded in developing from a very poor country in the 1970s/80s to a relatively rich mid-income country or Emerging Market Economy (EME) within an astonishingly short period of time. Of course, China can be proud of having reached this. Indeed many countries which were as poor as China was 30 years ago would be more than content with this development. But China is still 'hungry' and wants more, since it regards itself not as being any emerging economy country. China has a great history/past. It was in former times one of the richest countries in the world, not only absolutely but also in per capita measures. And it wants to reach this level again.

   There are at least two understandings of a positive or successful future development for China, namely:

   1. A rise in absolute wealth (or eradication of poverty) = a modest goal

   2. Catching-up to Advanced Market Economies (AMEs) such as the USA in output/income per capita = an ambitious goal

   China aims at reaching the ambitious goal b), and it wants to reach it as soon as possible. But, in order to reach b), a country has to overcome the mid-income range significantly and durably. That implies, in order not to stay caught in (or fall back to) the so-called 'mid-income trap' (MIT) (6), it has to undertake sustainable reforms. (7) According to the empirical literature, there are several factors of success (for escaping or avoiding the MIT). Eichengreen et al. (2013) show that growth slowdowns are less likely in countries with a high share of population with secondary and tertiary education and where high-technology products account for a large share of exports. Aiyar et al. (2013) identify several determinants such as institutions, demography, infrastructure, the macroeconomic environment, output structure and trade structure (among others).

2. The Challenge of Overcoming the Mid-Income Trap

   Surpassing the mid-income range (MIR) or, catching up to advanced countries in income per capita, is a very ambitious goal, since many or most former developing countries which had reached a development level which is comparable to China's current development level, have failed to overcome this range and have stayed caught in this trap. In other words, they have not succeeded in significantly and quickly catching up to the advanced countries in terms of income per capita. (8)

   A good example in that respect is Turkey which has been a dynamic, fast-growing economy over the last decade and is often regarded to be a success story. However, seen over a longer perspective, its development has rather been disappointing, and even its most recent development success has not been comparable with China's over the last few decades. Another example is Latin America, in particular Brazil (see Figure 1 for per capita GDP developments).

   [FIGURE 1 OMITTED]

   To sum up, over a long period of time, countries like Turkey and Brazil have disappointed as they have not succeeded in durably overcoming the mid-income trap. But also most other emerging market countries have not been successful. In a joint study by the World Bank and the Development Research of the State Council, P. R. China (2013), it has been shown that only 13 of the 101 middle-income economies in 1960 overcame the mid-income trap by 2008.

   South Korea is a typical example of a country that has managed the successful transition from an upper middle-income country which it became in the second half of the 1980s to a high-income economy in 2000. (9) Besides South Korea, the other members of the so-called "Four Asian Tigers" (namely Hong Kong, Singapore and Taiwan) experienced exceptionally high growth rates as well, transforming their economic status to high-income countries.

   How about China? China has so far only reached the lower bottom of the so called mid-income range or 'trap' (here understood as a range of $10,000 to $17,000 PPP per capita as displayed in Figure 2). (10)

   [FIGURE 2 OMITTED]

   In PPP, China's 2014 per capita GDP was about 23.60 per cent of the US-level; in absolute terms $12,880. (11)

   [FIGURE 3 OMITTED]

   As shown in figure 3, this is a level nearly comparable to Latin American countries as Brazil; however, this is only a little more than one quarter of Germany, slightly more than a third of South Korea, and one half of Eastern European (post-communist) EU-countries (12).

   That is, history has shown that many EMEs have failed in steadily overcoming the MIR. However, some have succeeded. Why?

   And: Is China going to succeed, too? What preconditions are required?

3. The Role of Structural Change in Reaching and in Overcoming the Mid-Income Trap

   China has reached its mid-income status by mainly fostering industrialization (esp. heavy industry) over the past decades. The question is how long focusing mainly on industrialization can effectively be extended and when it is time to 'rebalance'. 'Rebalancing' is currently the magic word in China. It implies that an intelligent strategy of structural reforms is needed to overcome the 'structural transformation barrier' and to catch-up to the advanced economies and thus converge to a high-income status.

   Here it has to be recognized that the transition path (from X to Y) in Figure 2 is accompanied and is influenced by frequent (economic and socio-political) structural changes. One major structural change I will focus on is the 'natural' consecutive transition from dominance of agriculture to manufacturing towards services ('tertiarization').

   This structural change is a common feature of development (in all countries).

   There are three common explanations for this process: (13)

   1. Income elasticity of demand for services,

   2. Baumol's cost disease,

   3. The costs of industrialization that force countries/governments to foster tertiarization.

      With respect to a): Because of a high income elasticity of services demand, a country with a rising income level will show a higher private demand for services (see Kongsamut, Rebelo and Xie, 2001). With respect to b), Baumol and Bowen (1965, 1966) previously described that some sectors of the economy are exposed to an increase in labor costs because they do not benefit from increased efficiency. Sectors such as health care or other public services tend to suffer from this cost disease. With respect to c): There are significant negative side-effects of industrialization (such as rising income disequilibria, and other undesired distortionary effects) which tend to induce governments to take counter-measures favoring tertiarization. (14) Success in overcoming the MIR depends upon how EMEs manage this structural change.

      However, one has to recognize that there is no standard model of the transition path associated with the structural change process. Nonetheless, economic modelling of EMEs has to take into account the impact of structural change on the transition path from X to Y (in Figure 2), and the country-specific dynamic interrelationship between economic and political/social development relevant for the specifics of the transition process in a country.

      Moreover, there is no standard model of how to politically steer the transition path either. The optimal or appropriate way to politically steer the transition path in a country is dependent upon the politico-economic system and the corresponding optimal speed and optimal sequence of economic and political liberalization/deregulation measures of and in this specific country.

      Last but not least, one should mention that within China there currently seem to be two types of this structural change:

   1. In the East: beginning de-industrialization

   2. In the West: beginning industrialization

      This was apparently planned or intended a long time ago as a consecutive, step-by-step development of the country (going back to a strategy developed in the 1980s by Deng Xiaoping).

      In retrospect, China has chosen a clever way to quickly approach the MIR by slowing down structural change and thus retarding the de-industrialization process. The relevant question is: is this also the best/most clever way to steadily overcome the MIR?

      China has...