Can China make it to the top of the ladder?

Author: Peter Drysdale, East Asia Forum

China’s GDP or output per head climbed towards US$8000 last year, making it a comfortable member of the middle-income club of emerging nations. The remarkable achievement of lifting the bulk of its people out of poverty since it opened up its economy in the late 1970s is a cause for celebration, not only in China but around the world where China’s new prosperity has brought additional prosperity and impetus to global growth.

Residents walk past a replica of Tiananmen Gate in Yinchuan in northwestern China's Ningxia Hui autonomous region on 8 October 2015.  (Photo: AAP)

China’s output per head in current prices in 2014 was, of course, still way behind that of Japan (US$34,000), the United States (US$54,000) or Australia (US$61,000) but many millions of people in China can already aspire to incomes up there with the richest in the world.

So far so remarkably good: China has enjoyed a faster transition to middle income than any country before it, despite the massive size of the country.

Yet many in the West are increasingly anxious about China’s future growth and, over the past few months, punters on the Chinese stock market also seem to have been infected with the jitters.

Does the shift of Chinese economic growth from rates of more than 10 per cent over almost three decades to much lower rates, currently around 7 per cent, signal that growth momentum has collapsed? There’s a whole literature which warns that middle-income countries like China face major hurdles in the transition from middle to higher incomes.

Over the past half century or so, many countries have committed to promoting economic development and catching up to the income and productivity levels achieved in advanced industrial economies. China’s ambition, as Deng Xiaoping put it at the time, to achieve the living standards of the lower-income members of the OECD, defined its opening and reform at the end of the 1970s. The emerging economies have been the great hope for global growth. But the remarkable fact is that only 13 of 101 countries across the world that have made it to middle-income status have been able to complete the transition from lower- or middle-income levels to high-income levels since 1960, and catch up to the technological frontier. This is the so-called ‘middle-income trap’.

There are many problems that China will have to deal with on the way through middle to higher levels of income. David Dollar points to the strong empirical relationship between the quality of institutions (as measured by the World Governance Indicators’ Rule of Law index) and economic growth. But the relationship between institutional quality and year-by-year economic growth is clearly complex, he argues, and cannot easily explain periods of strong growth followed by periods of much lower growth. Rather, the issue on which to focus might properly be the quality of institutions relative to the level of development.

Today, the sustainability of Chinese growth is at the front of everybody’s mind. And the challenges facing Chinese policymakers have never appeared more real. The fact that many countries have failed to graduate into high-income status after reaching a stage of development that is similar to that in China now is cause to question. With Chinese growth visibly and persistently slowing, it’s understandable that the international market has become bearish on China.

In our lead essay this week Yiping Huang observes that ‘whether China makes the transition to high-income status is probably one of the most important economic questions facing the world today. Success can lift the living standards of 1.4 billion people. Failure may lead to economic and social instability in China and the world could lose one-third of its global economic growth engine’.

The good news, Huang argues, is that China’s growth model is already changing, evidenced by a narrowing current account surplus, rising shares of consumption and services in the economy, an improving income distribution and higher wage shares in income. There’s still quite a way to go. So far, the positive changes have been mainly triggered by changes in the labour market.

At the core of the task ahead will be China’s steady-handed delivery of its factor markets: the financial reform agenda, continuing reform of the labour market, reform of the land market and the energy market.

Financial reform is the critical first step. Financial repression results in an enormous misallocation of capital. It favours particular regions, privileges state-owned enterprises, shields the banking sector from the need to build risk-management capacity and starves the more dynamic private sector of competitive funding. The next and complementary step is capital account liberalisation that links investment in domestic and international capital markets.

‘China still needs to make huge efforts to foster its innovation capability’, Huang says. ‘It must strengthen its research and education base, including training for more than 300 million migrant workers. China also needs to reform its financial system, including liberalising the interest rate and developing new channels of financial intermediation in order to provide better financial services to innovation activities. And it must construct new legal and political institutions that are conducive to technological innovation. This includes protection of intellectual property rights and liberalisation of entry in many sectors. And while China is unlikely to move to the Western-style democracy any time soon, certain political changes are necessary to ensure the free flow of information, to maintain order and to resolve social conflict’.

Whether authoritarian institutions are better for economic growth than democratic ones has long been a central puzzle for students of economic development. As per Dollar’s argument, this could depend on the stage of a country’s development. When we look at the history, in countries that have a per capita income below US$8000, authoritarian institutions may not hamper, and could assist, higher growth. But at higher levels of income, democratic countries are likely to see higher growth than authoritarian ones.

Political legitimacy with China’s new middle class may well depend importantly on success in this next phase of economic reform. The Chinese leadership still looks to have the stomach for the huge new economic reforms that are needed to lead the country from middle to higher incomes. How they manage the political change that appears to be their inevitable complement will be the hard test.

Peter Drysdale is Editor of the East Asia Forum.