Can China Become a High-Income Economy?

The IMF thinks so, but some challenging reforms will be needed if China is to avoid the middle-income trap.

By Christopher Ernest Barber

April 11, 2014

In the Asia-Pacific, the inevitability of China’s economic rise has been a reality for a number of years. Already we are witnessing the changingpolitical dynamics of the shifting economic balance of power. New Zealand’s economy, for example, now relies heavily on Chinese markets. As a result, the Defence Minister Jonathan Coleman visitedBeijing in November 2013 in order “to balance” out New Zealand’s diplomacy; maintaining a “path” between the U.S. and China. The purpose of the visit was to emphasize to the Chinese government that New Zealand would not take sides in disputes such as China’s Air Defence Identification Zone in the East China Sea, preferring to utilize “international processes” to resolve issues.

For a nation that traditionally takes great comfort in its network of Western allies and friends, such a move would have been unthinkable were it not for China’s newfound significance in the region. In years to come, other pragmatic nations who wish to benefit from China’s economic affluence will also find themselves displaying comparable degrees of neutralitytowards China’s foreign policy initiatives. If one is inclined to view the current situation between China and the U.S. as a “struggle for mastery” in Asia, then China’s future economic mastery over the region is likely to make the projection of a few U.S. warships in terms of its pivot to Asia, a largely symbolic exercise. Of course, the foregoing sentiments and those of many other pundits are dramatic reductions of the future dynamics of Asia-Pacific politics that need to be qualified for a future date.

In the meantime, China keeps growing.

Already it has moved up in the World Bank’s statistical estimation: into the upper-middle income bracket (those economies with a 2012 GNI of $4,086-$12,615 per capita) in the same territory as Brazil, South Africa and Turkey. However, whereas these nations are ostensibly stuck in the middle-income trap, without the capital, technology, or labour conditions to converge further, China is tipped to move into the exclusive high-income club of nations (those with a 2012 GNI of $12,616 per capita). In a recent working paper, the IMF has appraised the dragon economy’s prospects of achieving fully developed status as being entirely within its grasp—albeit with a number of important caveats.

Of these, China first and foremost needs to rein in its borrowing and put an end to excessive investment in the construction and manufacturing sectors. Vast capital accumulation is no longer a feasible policy and economic growth needs to be carefully managed with the mantra being slow and steady. In addition, the IMF proscribes a reformist agenda for China’s financial and services sector. Unsurprisingly, it suggests that China deregulate these sectors in order to allow for greater competition as well as reforming the hukou system that places restrictions on the movement of rural and urban populations.

The Chinese authorities are well aware that reform is needed and that there is little margin for error. If China does make the necessary reforms, it will transform into a high-income economy by 2030—barring global economic crisis. However, if China fails to control the economy, then it will face an economic crisis and the very real prospect of stagnating in the middle-income bracket. The next few years will be an exercise in economic brinkmanship for China, testing the agility of the government.

In recent years, China has started to experience lower returns on its huge investment. All the while, its reliance on credit has increased alarmingly. As the IMF’s working paper notes, China’s growth model “may be running out of steam.” To maintain momentum while making the necessary reforms, the IMF’s deputy Asia-Pacific director Markus Rodlauer arguesthat China needs to redirect focus towards more sustainable “consumer orientated” sectors with “environmentally friendly and inclusive growth.” Chinese authorities have already started to move economic growth in that direction. Thetwelfth five-year plan highlights the shift in thinking away from labor intensive industries towards technology and innovation as well as an emphasis on the domestic economy.

One of the most important determinants in China’s economic future is demographics. By 2025, the Chinese economy will no longer be able to rely on surplus labor (i.e. cheap labor) filing out of the central and western provinces into the manufacturing hubs of the eastern seaboard. Its population is slowly declining and with the ready supply of surplus labor will dry up. As surplus labor disappears, China will eventually encounter what is commonly referred to as the Lewis Turning Point. Named after economist Arthur Lewis, this is the point at which an economy fully absorbs surplus labor. With a scarcity of surplus labor there is a systematic shift in capital accumulation: cheap labor is replaced by higher wages for workers; at the same time, there is less return on investment and less profit in general. From that point, China can expect more modest economic growth figures in line with those of advanced economies.

Much like Japan, South Korea and the Asian Tigers that transitioned in the 1980s from labor-intensive industries towards more efficient, technological production processes, the question is whether China’s economy will transform in a similar manner. The key is for China to transition from a middle-income country to a high-income country in time to accommodate the changing dynamics brought on by the Lewis Turning Point. Failure to do so essentially means that China will hit the glass ceiling of the upper-middle income bracket and no longer be in the same position to converge to a high-income economy. The specter of the middle-income trap, in which nations are unable to converge further due to a lack of economic dynamism is a fearful prospect for an aspiring nation such as China.

For the Chinese authorities therefore, the transition from labor-intensive industries towards an innovative exporting economy with a developed domestic consumer sector is the overriding economic strategy of the future.

If China’s economy successfully makes this transition then the IMF envisages two scenarios. The first scenario is modeled on Korea’s convergence pattern in the 1990s, in which case China’s output growth would average seven per cent until 2030. The second scenario, which is more realistic, follows the tendencies of standard convergence patterns in which China’s output growth would average six per cent until 2030. This scenario would make China’s per capita GDP forty per cent of the United States by 2030, sufficient to make it into the world’s largest economy and a prosperous one at that.

From a global point of view, the prospect of China converging towards the echelons of a high-income economy will invariably shape the future economic order for the Asia-Pacific region. For one, high-income status will remove the future comparative advantage of “Made in China” products: it will no longer be possible to produce them as cheaply as low-income economies with surplus labor such as Vietnam. More crucially, however, the convergence of China towards high-income status opens the door for China’s trading partners. As incomes rise in China and the consumer sector opens up, countries that have free trade agreements with it will benefit from an even more lucrative market. This fact is not lost on many nations. As the New Zealand government report “Opening Doors to China” shows, the number of Chinese earning between 100,000 and 200,000 RMB ($16,500 to $33,000) will increase to 28 percent by 2015 (compared to 6 percent in 2010) and those earning more than 200,000 RMB will double to 4 percent in the same year. The numbers in this report perhaps go some way to explaining the true significance of the New Zealand Defence Minister’s visit to Beijing in November 2013. China’s prosperity is a reality and with developing economic power comes emerging economies of power that remap the geopolitical terrain and the status quo. After all, China’s economic endgame will alter the global balance of power and transition its socialist society into the realm of capitalism’s elite. Increasingly, more countries in the region will come to rely on the Chinese economy, not just as a source of manufactured goods but also as a wealthy market in its own right.

The impact of this will invariably play out in the future political dynamics of the region, placing an even bigger question mark on how China will direct its foreign policy in line with its increased economic impact on the Asia-Pacific region. That is not to say that China will struggle to dominate the Asia-Pacific as is sometimes crudely suggested, but rather it emphasizes the fact that pragmatism and flexibility will be a far more important factor in Asia-Pacific politics for nations straddling between the two potentates of China and the U.S.

Christopher Ernest Barber is a doctoral candidate at the University of Auckland, specializing in the history of international arbitration and the development of globalization, commerce, and trade. Follow him on Twitter@C_E_Barber