China’s Middle Income Trap Story and Why it’s Just a Story

There is an interesting and very topical debate going on on the viability of China’s system of “state capitalism”. Intelligence Squared will be hosting a debate entitled, “China Does Capitalism Better Than America“, where Orville Schell and Peter Schiff will be arguing “For” and Ian Bremmer and Minxin Pei will be “Against.” The China Law Blog than picked up this dialogue by focusing on the significance of, what has become known as, The Middle Income Trap, a follow up to a piece covering this subject in The Economist.

Despite many good points and observations being made on this subject of the “middle income trap”, I tend to still view it predominantly as just a moniker that the media at large has adopted to address the malaise they are perceiving about China’s economy. A few years back, no one mentioned it because China was roaring forward. But now that there is uncertainty, this has become a convenient label to address this issue, namely, can China continue to grow, or will it stagnate?

From a macro perspective, this issue is raised from two different view points:

• Insider – The China perspective: Wen Jiabao has used this issue early (even before 2007) to alarm people at large and to prod the various factions in the government into continuing economic reforms.
• Outsider – The Pundit vision: Western media use alarmist speculations to look good and sell newspapers. Their main contribution to the process is to heighten awareness of the issue within China.

In practical terms, what is the answer? Can China continue to grow, or will it stagnate? The answer of course is speculative in nature because it could go either way, in other words, it is reasonable to expect that China will screw it up, that it will stagnate. But it is not probable. The reasons for this are numerous and complicated because they require one to delve deep into the fabric of China’s society and understand how it got to where it is today.

Some of the arguments can be identified as listed below:

Why China should continue to grow healthy and strong:

• The Chinese people are they key: they are enterprising by nature and they have a long way to go before they reach a level of wealth approaching that of the West.
• The Chinese economy will thrive if it is sustainable.
• Statistics that feed speculation are unreliable. There are indications that the consumer contribution of the economic data is higher than statistics indicate (After all statistics come from official data, but a lot of money is “under the radar”. One example is payroll.) so that the “25% consumption” statistic could be wrong: real numbers might be much higher.
• Economic reforms have allowed the growth of a private sector which now accounts for more than 70% of the economy and 90% of new jobs generated.
• The CCP does not care about economic control, it cares about political control. Political control is not incompatible with economic growth.
• Social unrest is the big challenge, but it can be addressed by control over graft and corruption. And control over corruption is a major objective of the CCP. Proven ways to achieve this are (i) Strengthening the legal system (which China has done over the last 30 years – although there is still a long way to go); (ii) Democratizing the grass-root level of the government process – which is where most of the socially destabilizing social unrest comes from (China has made progress in this direction); (iii) Enabling a free press, which will root out social problems before they become incendiary; (iv) Doing a better job managing the SOEs.

Reasons why China could stagnate:

• China’s phenomenal past growth is due to the fact that China started from a very low point. It is easy to grow at 10% average rate when you start low.
• Most of the “low hanging fruit” of economic success has been harvested. Future growth will be harder, it will require more contentious reforms.
• The financial tools that enabled China to pump money into the system without much discipline are still in place, but they are running out of steam. Even though China’s economy is huge, China’s past financial “cheating” will not work as a long term solution. China has to make their financial system sustainable, and that requires making hard decisions that the CCP may not be willing to make.
• The current model of the Chinese economy is not really sustainable. Officially, c. 25% of the economy is Consumer driven; the rest is divided by Exports (unstable because reliant on health of other nations) and government driven (not sustainable). It will be (more) sustainable if a greater part of it (i.e. 50% or more, vs current estimates of 25%) is generated by consumers. To achieve this kind of growth in the next few years seems very hard to do.
• The CCP does not want a free market and it is distracted by the 2008 global financial crisis (GFC) which suggest that the capitalist model may not work.
• Lack of resolve on the part of the CCP will maintain a status quo on reform, and a status quo will cause stagnation.
• The CCP is worried about social unrest. But it may not have the stomach to push through the controversial tough solutions that are needed. Some of the leadership may not be convinced that aggressive reforms are the way to go, and so see reforms as a weakening of the CCP.
• The SOEs are badly managed. They are coddled by the state which makes them bloated and inefficient. One example: they are given too much financial credit – which they invest in real estate. Three problems with that: not fair (private sector cannot compete); not real market driven (i.e. When you have plenty of money, and that money is not really yours, you are quite happy to pay high prices.); and it is unsustainable in the long run.

The reason this topic attracts so much attention is that, in this closely knit world of ours, China’s economy is important and it affects all nations. It is also difficult for Westerners to understand. If you were to transpose China’s economic conditions to the USA, the market forces would be unleashed and China would be booming for the next 50 years. But, although that simplistic approach may explain the fundamental reasons for optimism, it is unrealistic because it ignores China’s unique historical, cultural and social background. The solution has to be a Chinese solution. The most qualified people to address this challenge are in the leadership of the CCP. They are the ones that have guided China to where it is today, and they are the ones who will determine how to take China further tomorrow.

In my opinion there are reasons to be optimistic. China’s leaders are focused on China’s success. Unlike the leaders of some other nations, they are professional, which means they spend their whole life studying the challenge and finding appropriate, timely solutions to it. They are also meritocratic in their own way, and those that make it to the top are highly respected. Over the last 30+ years I have observed China getting itself out of very challenging situations. I have studied China’s leaders carefully and met some of them. Most of them were impressive. I have also had the opportunity to meet the up-and-coming Xi Jinping recently and to listen to what he has to say: all this reinforces my optimism that China will thrive. Sure, it will have problems, but China reminds me of a large aircraft carrier in the ocean, it is difficult to slow it once it is going full speed ahead, and at the same time it takes time to make it change its course.

Michael De Clercq- CPG CEO and Founder