China Research

A discussion forum on emerging markets, mainly China – from a macro, micro, institutional and corporate angle.

China Ahead of a “Middle-Income Trap”?

February 6, 2012

Chinese political authorities are concerned about their country which is feared to face a “middle-income trap”. The definition of such a trap is not clear but it could be understood as stagnation in the process of catching up to the rich countries and a significant decline in growth of per capita income.

To be more precise, what the Chinese authorities fear has not yet materialized. China is still a lower middle-income country following World Bank definition. The way to a high-income country passes via the upper middle-income country stage which China is expected to reach within the next few years. And it is there where in the past the majority of upper middle-income countries got trapped and failed to achieve the high-income status which starts at a level of about 12,200 US-$. Economic historians mark the 10,000 US $ per capita income level (PPP) as a junction from where economic growth tends to decline.

To discuss the reasons of such decline, it is beyond doubt, that in China, the average productivity of physical investment, often measured by its reciprocal, the incremental capital-output ratio ICOR, has declined. In 2009, the Chinese ICOR has been found to be twice as high as its average in the 1980s and 1990s. That, by itself, must not necessarily mean a waste of capital if high physical investment coincides with slow growth in the world economy because of a global crisis and if ICORs rise globally.  But as Chinese fixed-asset investment has increasingly gone into infrastructure, such investment, especially in remote regions, will not immediately pay off. Hence, the price to paid by China for possible (or likely) future returns of massive investment in infrastructure in a vast and geographically dispersed country, is that today much more physical capital is needed to achieve a specific level of growth than in the past.

Furthermore, other bottlenecks which were already identified as barriers against sustained double-digit growth rates some twenty years ago appear more binding than at that time. The quality and quantity of labor supply which is needed to match the rise in per capita- income in terms of skill content is no longer as elastic as it used to be. Physical bottlenecks such as energy availability and the use of the environment as a sink have become serious and the rise of income inequality to a Gini coefficient of close to 0.5 ( historically high for  a non-resource-rich economy in general and for China in particular) puts the normally high degree of social coherence and stability at risk. Disparities are present at any level, between coastal provinces and the Western and Central provinces, between rural and urban areas, and between the property and income positions of those working in profitable export industries and those confined to activities for the domestic market. Social security schemes lack sufficient coverage and discriminate against or even exclude thus those who are in most need of support (for instance, rural workers).

Finally, financial repression hampers an allocation of domestic funds to efficient investment. Such repression comprises barriers against investment abroad of domestic savings, upper caps on deposit rates for private savers, biases in domestic lending against private households and in favor of the corporate sector, in particular in favor of SOEs, and credit controls instead of the free play of interest rates. As a result, bond and equity markets are still in a state of infancy. Each of these bottlenecks can individually prevent China from fully exploiting its growth potential. Taken together, doubtlessly, they will slow down economic growth.

It seems, however, that the general question of China approaching a middle-income trap or not, is misplaced. The real issue is whether beyond the big cities or agglomerations like Beijing/Tianjin, Shanghai and Guangshou/Pearl River Delta which are already close to or within the high-income status, the rest of the country will be trapped. For the time being, China is separated in a number of “economies”. This is not a new phenomenon. Some twenty years ago, the ratio between income measured at PPP rates and income at current exchange rates, was measured between six in remote areas in the West and close to unity in the coastal cities.

The size of the difference is determined by the prices for non-tradables and the size of the non-tradable sector relative to the tradable sector. While in the coastal cities prices for non-tradables such as consumer services were close to international prices, they were far from international prices in the remote areas. In spite of sizable cross-country labor mobility through migrant workers, labor markets in China are still far from being integrated.

Large skill differentials play a role but also policy-rooted restrictions, such as the internal registration scheme (Hukou) which ties people to their traditional place of residence and forces migrant workers to live in an environment of illegality cut off from public services which normal citizens enjoy.   The Hukou system fragments Chinese labor markets and is responsible for some part of persistent income disparities over regions and people.  Nevertheless, the catching up process of backward areas is under way, no doubt. Growth rates in low-income provinces exceed those of higher-income provinces but if endowment differentials are taken into account, the catching up process must be expected to take much more time.

In other words, the superior endowment of higher-income provinces with technology, infrastructure, and skills protects these provinces against fiercer locational competition with lower income areas. While the latter provinces can still embark upon the catching up model of high investment ratios, the former provinces must raise their total factor productivity through innovations to better use of the existing capital stock. Actually, they do it. With labor supply getting tighter in the high-income provinces and with the low-income provinces impeded in their growth path by a relatively high share of employment in the agricultural sector, labor-saving investment in this sector will be important to release labor for other activities and for productivity improvement in the low-income provinces. Again, a reform of the Hukou scheme would be helpful.

As a result, the issue of a middle-income trap for China seems to be a problem of how fast lower-income provinces achieve the status of high income provinces. Estimates by Richard Herd from the OECD suggest that by 2020 13 instead of only 3 provinces (in 2015) will arrive at the high-income level and that it will be not earlier than 2030 that almost all of the 33 provinces will have followed. By that time, China will already be in the stage of becoming an aging economy. To defend the status of a high-income country after having achieved it, will then probably be a tougher task than to initially reach it.

 

 

 

 

Rolf J. Langhammer
Professor & Vice-President of the Kiel Institute for the World Economy

 

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Russia – Stirred but not Shaken

As the March presidential elections approach, Russia is stirred but not shaken.  December demonstrations were the biggest in two decades, but still they gathered only tens of thousands of demonstrators in the capital city, even less elsewhere. There is no atmosphere of fear, but neither are there proper organizations or policy demands. Arab spring has again shown that social media can call many people to the streets, but it takes a split of elites to transform demonstrations into a political movement. The call for honest elections is a fundamental one, but there is not much else to unify the tens of aspiring leaders of the crowd. As a rule they are men in ripe age, scarred by two decades of mutual battles and proven inability to cooperate. The demonstrations will in all probability not evolve into a political movement offering an alternative to the Putin regime.

Therefore Russia is not really shaken. And if it were, we had better beware. At the time of the post-Soviet color revolutions Yegor Gaidar said that he did not wish one in Russia. The color, he feared, would be black and brown like in a cockroach: those of nationalism and reaction. Just before the demonstrations another friend of mine, also somebody with rich experience of high-level positions during the past twenty years, argued that Putin with his attempted power vertical is the only barrier between today’s Russia and a criminal state. This speaker is a ranking member of one of the unregistered opposition movements. His children have vowed not to return to Russia as long as the Putin regime remains.

Vladimir Putin is scarred as well. Twelve years ago he had an evident program though that was not easy to detect in the beginning. Russia had been dependent on outside finance, a nation to which conditions were dictated. Poor Yeltsin, Bill Clinton once noted, we keep tabling demands that he has little possibility of fulfilling. That had to go and it did, not least because soaring oil prices helped Russia to pay back debt, accumulate reserves and start financing the rest of the world. For a few years Russians were high on oil. Still money was cheaper abroad, and the 1998 crisis was repeated ten years later.

Russia also longed for stability, and for years the Putin regime helped deliver it. Inflation and unemployment went down, consumption, foreign travel and life satisfaction up. Putin was repeatedly voted the sexiest Russian man, not so much because of the muscles but because his regime facilitated sexy things. There was also a kind of political stability, maintained by thugs when deemed necessary.  Putin wished Russia and the world to function like a hierarchic bureaucracy. He had after all worked in one for sixteen years, and uses many pages of his dissertation to copy American organization science on how such a hierarchy should handle uncertainty.

But that is not the way the world or Russia actually functions. Not surprisingly Putin has grown frustrated and cynical. That is not a good starting point for a leader who should reinvent himself.

That Putin should do: politically, as there will be a real opposition; policy-wise, as Russia can no longer rely on those drivers of growth that just years ago made it one of the fastest growing major economies in the world.

Needed mental readjustment started in about 2006 when it was understood that Russia cannot rely on energy alone. It needs diversification and modernization. The readjustment continued a year ago when Putin tasked the leading economists to write a policy program for the post-elections. They did write, over 500 pages of program, with more than a thousand specialists contributing. In a little-noted speech just before Christmas Putin seemed to sign the basic message of the program. Russia’s future growth must be based on investment, and a major overhaul of investment climate is needed.

An authoritarian regime faces its biggest challenges when attempting partial democratization. That happened with Gorbachev’s perestroika. Putin is no Brezhnev but he risks becoming a Gorbachev – without Yeltsin as the alternative. The world and Europe in particular must pay great attention. The alternatives are several, and the most positive ones the least probable.

 

 

 

Pekka Sutela
Nonresident Senior Associate Carnegie Endowment, Washington D.C.  &  Visiting Professor at the School of International Affairs, Paris

 

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China Needs to Accelerate Institutional Improvements of its Financial System

Every year Linnaeus University conducts an institutional survey among roughly 25 well-known China experts from the U.S., Europe and Asia (and twice a year on the economic outlook for the forthcoming 18-24 months). Our latest survey was published shortly before Christmas.
Today, I would like to briefly comment on some of the latest survey results that concern China’s financial sector (gradings 10=very high/very good; 1=very low/very poor).

First. Transparency on financial markets is rated at 3.3 which has to be considered really low. By the way, insufficient transparency is often mentioned as one of the main reasons for the recent subprime crisis in the U.S. and to some extent for the European crisis. This fact should be taken seriously in China, too.

Second. Corporate accounting has an unsatisfactory rating as well (December 2011: 4.9). This is the same value as four years earlier. This could be an interesting analytical angle for both Chinese and foreign investors. Further progress is badly needed.

Third. The banking system now receives a grading of only 3.8 for its marketization efforts. This is exactly the same number we noted two years ago.

Forth. The stock market – on the other hand – shows a somewhat more favorable development since 2009 – i.e. from 3.7 to 4.5. However, 4.5 is not good enough either.

Fifth. The bond market is also characterized by a slight progress in marketization during the past two years – but only from 3.5 to 4.2.

Conclusion:
This very brief summary of my recent survey clearly indicates that the institutional conditions on and the marketization of Chinese financial markets are still strongly underperforming, with grading levels around 4 (which, however, means all the same that Chinese financial markets need an efficient financial regulation and supervision). I would define these shortcomings in terms of poor allocation of credit resources, insufficient competition, prioritizing of state-owned companies, low volumes for corporate bonds, weak conditions for corporate rating and investment plans, etc. There is a lot of literature (North, Tullock, Levine, etc.) that shows that improved institutions and financial systems favor long-term economic growth.
Making a positive interpretation out of this conclusion would mean that more ambitious improvements in financial institutional and market conditions could make an important contribution to China’s future potential growth.

 

Hubert Fromlet
Professor of International Economics
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