Can China Escape The Middle Income Trap?

A “middle-income trap” is looming large for China and this, along with a variety of other factors, may well impede its uplift to a high-income country. The first set of impediments come from China’s own system of political and economic governance, along with declining productivity levels and other external obstacles, including the imminent threat of global recession due to Russia’s Ukraine invasion and trade and economic sanctions of the US and the West on China.


The middle-income trap (MIT) usually refers to countries that have experienced rapid growth and thus reached the status of a middle-income country in a very short period but have not been able to catch up with the group of high-income countries. The debate that started in 2011 with a slowdown in China’s rapid growth as discussed in a working paper of the Asian Development Bank (ADB), titled “The People’s Republic of China in the Middle-Income Trap?”, is again gaining attention after the Covid-19 pandemic and other structural problems and external shocks which have hindered China’s miracle growth episodes of the past.


China's economy stands at a key juncture. The country’s per capita GDP doubled to an estimated US$12,000 this year from US$5,600 in 2011 – a level close to the World Bank’s defined threshold for a high-income country. Economists generally consider it to be a middle-income country. Those living in middle-income countries typically can satisfy their daily spending needs but have limited disposable income. To become an advanced economy, China must shift its growth model from a strategy “driven by inputs” to an approach “driven by technological innovation” – a process that is still in progress.


The increase in China's per capita GDP and remarkable improvement in the living standards of a population of 1.4 billion represents one of the quickest economic success stories in history. But the decline in Chinese economic activity increases its financial instability and slows the much-needed reorientation of the Chinese economy. It is a risk that is amplified by the fact that China’s historic development process is navigating the trickiest of all transitions where it faces the ‘middle-income trap’, in which a country’s economy becomes stuck and never shifts into a higher gear. “Common prosperity” has been portrayed as an effort to reduce income inequality and reassert core Communist Party values. In reality, it risks leaving the country stuck at middle-income status.


China’s gross domestic product expanded at a 0.4% annual rate of growth in the April-June quarter of 2022, the worst since the first quarter of 2020 when it shrank by 6.9% as the Covid-19 pandemic erupted in Wuhan. Economists polled by the Wall Street Journal had forecast China’s economy to grow 0.9% in 2022. Even if the declining Chinese growth is attributed to disruptions caused by Covid-19 and the Ukraine war, which may be short term shocks, the long-term picture is also not heartening.


Oxford Economics downgraded China’s growth forecast to 3.2% in 2022, from 4% previously after the April-June quarter’s slowdown. It said, “Though the authorities continue to fine tune policy to reduce supply-side disruptions caused by (Covid-19 lockdowns, demand is unlikely to recover sufficiently as long as risk of restrictions remain.” It added, “while containing real estate leverage is beneficial to a sustainable, albeit slower, long-term growth, the process will be bumpy, and the risk of a hard landing in real estate is likely to haunt the economy for some time.” It has forecast 4.5% average growth for China over the next decade; however, some other estimates have predicted an average growth of about 3%.


China now realises that its business-as-usual approach will not help realise its goal to break out of the MIT and becoming a high income country by 2025. Chinese authorities have been attempting to address the structural issues including industrial overcapacity, local debt mountains and shadow banking, the property bubble, and have been stimulating innovation. The Chinese government’s key policies aim to help rebalance the Chinese economy, wean it off its mostly export-driven model, encourage cutting-edge technology, tap into the massive home market, and make the nation more self-sufficient. However, many of these initiatives are failing.

In the 2012 report, there was consensus between the World Bank and China’s state researchers that institutional reforms and technological innovation were both needed to move the country’s economy forward. The primary policy suggestion, therefore, was to “rethink the role of the state and the private sector to encourage increased competition in the economy”.


Nevertheless, China’s authoritarian regime and unilateralism, military expansionism, violation of human rights and lack of credibility of its tech companies have created an adverse business environment leading to several distortions and limitations to its journey to high income country. Xi Jinping has become the ultimate and overarching authority on business operations and politics in China. This has led to concerns among companies and states dealing with China. Fundamentally, the Xi Jinping regime now faces its biggest challenge as the ‘middle-income trap’.


While an ageing population and lack of skilled workers has created a demand-supply mismatch in the labour market, the remarkable presence of state-owned enterprises is throttling competition. The foreign companies are also losing their fascination with the Chinese economy due to a lack of patent protection and forced technology transfer, as well as the vulnerability of China-centric supply chains. The US-China Trade dispute has opened the door for other nations and as many as 50 companies have moved production out of China, according to the Nikkei Asian Review. The main reason for this exodus of investors is a bid to avoid the punitive tariff introduced by the US government. Manufacturers like Apple have therefore started shifting their production, though on a trial scale, to India and Vietnam.  The golden days of the dragon as the go-to hub manufacturing for the West seem to be over for good.


The colossal Chinese economy is currently bleeding and the more it will bleed, the more its competitors will take advantage. Companies like Samsung, Nike and Adidas have shifted production to Vietnam. Samsung has downsized its manufacturing units in Shenzhen and Tianjin and had shifted production to Vietnam because of the volatility of the Chinese government and tariffs. Similarly, South Korean conglomerate Lotte, also moved its supply chain subtly out of China after being forcefully sanctioned by the Beijing government.


If foreign companies continue to leave China, as they are doing gradually, then new investment in China may stagnate, which will negatively affect China to ascend to the status of a high-income economy.


In the present scenario, it seems almost impossible that China would catch up with the high-income countries any sooner. It needs, first of all, to earn credibility as a democratic and law-abiding country and, second, to remove all distortions in the economy. Only this could help China have the sanctions removed and regain growth momentum again. The present scenario indicates that China would take more time than countries like South Korea and Japan to transition from a middle-income country to a high-income one.


European governments and corporations alike must think long and hard about their commercial and policy approach to China. Europe has been slow to look to other Asian countries as major investment and trade partners in its focus on China. It’s only recently that with serious issues, such as human rights abuses, the Taiwan Straights Crisis and industrial espionage, all raising alarm bells for policy makers, that there has been a marked shift away from China. But still Western supply chains are embedded in the country and it will take significant resolve to ensure that Western demands are met, or a concerted effort to disentangle our economies from China may be needed.