The Middle-Income Trap and China’s Future Prospects for Growth

By Ker Zheng

The Tufts Economics Society is hosting a lecture by Professor David Dapice about how nations grow fast for a while and then get stuck before becoming rich, and how that illuminates the shortcomings of standard development theory. The event will be happening on Wednesday April 4th at 6:00pm in Braker 001. Feel free to come check it out—it’s open to all Tufts students, and we’ll be serving Dave’s Fresh! This post is an interesting introduction to the middle-income trap, using China as a case study.

A few weeks ago the World Bank Group released a 400-page long report on China’s future economic prospects, termed “China 2030: Building a Modern, Harmonious, and Creative High-Income Society”. In the report economists analyze China’s current economic conditions as well as various risks that pose a threat to its economic growth. The report proposes a series of broad recommendations that should help China shift from a middle-income country to a high-income country, thus avoiding what is commonly termed the “middle-income trap”.

What is this so-called “middle-income trap”? Well, theories of economic convergence state that it is natural for low-income countries to grow faster than high-income countries, eventually allowing them to catch up in terms of per-capita income levels. Part of the reason is because an abundance of cheap labor in poorer countries and inward flows of advanced technology from advanced countries help propel rises in productivity and output. The middle-income trap occurs when developing economies, for some reason or another, run into difficulties after a certain point (say, when poorer countries approach the technology barrier) and growth in per-capita income levels stagnate, trapping these countries in the so-called middle-income category.

Below, The Economist plots per-capita income levels of various countries relative to the United States in 1960 and 2008, noting that the majority of middle-income level countries in 1960 still remained in the middle-income category in 2008.

Source: Economist Online (Mar. 27)

As we can see, the countries in the middle box, such as Malaysia and Brazil, have fallen into the middle-income trap while other countries in the top-middle box such as South Korea and Taiwan have successfully transitioned to high-income countries.

Now let’s take a look at China. Over the past two decades or so its economic growth has been propelled by low-cost manufacturing exports, which in large part has been financed by foreign direct investment, initially from neighboring Asian countries such as Singapore, Hong Kong, Taiwan, etc. (where Han Chinese diasporas are prominent), and later from advanced countries such as the US. For example, a company like Nike typically sends raw materials to China and uses its cheap labor (either through contract manufacturers or its own factories) to assemble products and re-export it back to the US. This phenomenon accelerated after China’s entry to the World Trade Organization in 2001, lowering tariffs and other trade barriers with WTO members.

However, this method of powering economic growth is unsustainable for a variety of different reasons. First of all, an export-led growth model is inherently dependent on demand from other countries. For example, the recent Global Financial Crisis severely hurt demand in advanced countries for China’s exports, a macroeconomic shock that was only deterred by a large Chinese stimulus package and surge in infrastructure and real estate construction. Unfortunately, this has resulted in an abundance of non-performing loans owned by Chinese state-owned banks and an expanding real estate bubble. Ideally, China’s economy should progress to an economy powered by domestic consumption like the US where its growth depends on factors within its own country as opposed to those of others.

Additionally, China’s growth model is dependent on cheap labor and the associated low-cost advantages it holds over other countries. This is unsustainable because Chinese laborers will expect to reap rewards from China’s recent economic growth, namely wage increases, a better social security system, better working conditions, etc. Many of China’s factories are worked by uneducated migrant workers from China’s rural areas and inland provinces. These workers oftentimes leave their children and elderly behind while they venture to advanced cities such as Guangzhou and Shenzhen to toil long hours in sweatshop factories, returning home only once a year for Chinese New Year. Wages are high in comparison to what they would make back at home on the farms, but low in comparison to those of urban residents. Recent developments have shown that a few of these laborers are no longer willing to leave home to work in these sweatshops. Protests and suicides at factories run by contract manufacturers such as Foxconn have drawn international attention to the plight of the factory workers and have pressured many companies to increase wages as well. Additionally, China’s labor force will reach its peak in 2015 and is expected to decline afterwards due to the one-child policy, another factor that will cause wages to rise. Many companies have or are considering shifting low-cost manufacturing to even cheaper countries such as Vietnam and other Southeast Asian economies.

Thus, as a country develops and loses its low-cost advantages, it is crucial that its economy becomes more innovative and technologically advanced, helping the country transition from an export-led, manufacturing-focused economy to a consumption-led, services-focused economy like the US. This allows for increases in productivity, which should be accompanied by wage increases. This is why one of the World Bank’s recommendations is to improve the Chinese education system at all levels, in order to increase the quality of the labor force. For example, South Korea, Taiwan, and Israel were some of the few countries who did in fact progress to high-income levels, and they are all examples of countries with highly-educated workforces. America’s biggest strength is its innovative services and products, which is accompanied by the fact that the US has the world’s best research universities and facilities and benefits heavily from government promotion of R&D.

Today, the Chinese education system is often criticized for its focus on rote memorization and for not promoting enough creative thinking. Additionally, the quality of the education system varies from region to region, with many rural children lacking the opportunities to attend senior high school, let alone university.  The goal of improving the education system is to spur innovation and R&D so that Chinese firms can produce higher-value products of their own rather than rely on imitating technology from other countries. Additionally, the World Bank Group recommends that the state release controls on various sectors of its economy, allowing the private sector to expand, inducing competitive pressures and spurring innovation. Along with improvements in infrastructure, rule of law, property rights, etc., this will allow China’s economy to move up the value chain and achieve a level of productivity high enough to accompany wage increases and, subsequently, overall rises in per-capita income levels. However, this presents a dilemma for authoritarian government leaders as the current regime must spur economic growth while still maintaining its power and control.

If you’re interested in learning more about various topics relating to economics at Tufts, as well as associated events planned by the Economics Society, sign up for the e-list by emailing with your preferred e-mail address and full name. Additionally, if you’re interested in learning more about the World Bank’s report on China, you can find the full document here.


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