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When Will China Become a Developed Market?

China's transition from a country of middle-income earners to a nation of high-income earners would mean it was no longer an emerging market

Daniel Rohr, CFA 20 October, 2017 | 4:39PM

Shanghai, China          

China became a middle-income country in 2011, which means that gross national income is between $1,000 and $12,615 per head, according to the World Bank. A country earns developed market status when gross national income per head is above a certain level. 

But is China country, which is the world’s second largest economy, in danger of falling into what economists call “the middle-income trap”? China is hoping to double GDP from its current level.

China is far from the first country to endure slowing economic growth following its ascent from agrarian poverty to middle-income status. In fact, newly minted middle-income countries are disproportionately likely to experience slowdowns.

Worryingly, China shares some of the traits common to countries that have fallen into the trap, including unusually rapid prior growth, a high investment share of GDP, and an aging population. Yet, on other dimensions that tend to predict large slowdowns, including an undervalued currency and limited high-tech exports, China appears low risk. While Morningstar analysts do not think China is especially likely to fall into the middle-income trap, the odds of escape are not great either.

Ever since Chinese GDP growth began to slow from last decade's double-digit pace, investors have argued over the country's long-term prospects. At various times in the past several years, bulls and bears have each glimpsed apparent victory, only for a reversal of China's credit cycle to hand narrative momentum to the other side. The long-term outlook remains unsettled and the debate continues.

Perhaps no question matters more to investors globally. Over the past 10 years, China has been the single largest contributor to global GDP growth, accounting for nearly one third of the world total. Meanwhile, China has become the world's biggest buyer of everything from cars to oral hygiene products.

The bullish side of the debate often points to China's remaining potential for catch-up growth, which would portend slower, albeit robust growth for many years to come, something close to 5% to 6%. Bulls note that Chinese GDP per capita of $15,535 is still only about one fourth that of the United States at $57,467. Within China, there is ample scope for catch-up too. Interior provinces like Guizhou where incomes average $9,534 are far less developed than their coastal counterparts such as Jiangsu where incomes average $27,414.

Bears fret about the consequences of repeated stimulus and stalled reforms. Credit-fuelled spending may enable 6%-plus GDP growth in the near-term, but only by adding to the twin burdens of bad debt and excess capacity that will reduce growth in the long-term. Meanwhile, the sort of structural reforms that propelled growth in prior decades have been lacking as the Communist Party has prioritised stability and control.  

Why China’s Economy Has Slowed

Whether the bulls or bears prove right will depend greatly on Chinese productivity growth; this has struggled in recent years, dragging down the country’s GDP. Productivity gains have been shrinking mainly because the four sources of comparably "easy" productivity growth are drying up. 

  • China is no longer a technologically backward country with ample opportunities to boost productivity by copying more sophisticated foreigners. 
  • Having urbanised and industrialised at a pace possibly unprecedented in human history, the scope for increasing productivity by moving ever more farmers to factories or storefronts is narrowing. 
  • Decades of rapid capital accumulation have left China with far fewer high-return projects than were available at the dawn of the reform era. 
  • China's "demographic dividend" has been spent: after nearly doubling in size since 1980, the country's working-age population is now shrinking, reducing the savings available to fund productivity enhancing investments.

Looking ahead, productivity and therefore GDP growth are likely to come under further pressure as each of these prior sources of outsize productivity gains approaches exhaustion. 

The ways in which China boosted productivity are hardly novel, even if the pace at which it did was exceptional. Nor is China the first country to endure faltering productivity and slowing GDP growth following its ascent from agrarian poverty to middle-income status. 

Lessons from Other Middle-Income Countries

In fact, middle-income countries like China are disproportionately likely to experience growth slowdowns - roughly 50% more likely than their low-income counterparts according to the International Monetary Fund. More ominous is the tendency for growth to utterly stagnate among newly minted middle-income countries.

Stagnating growth explains why comparably few middle-income countries ultimately become high income countries. Among the 96 countries categorised as low- or middle income in 1960, only 12 non-OPEC countries eventually graduated to high-income status. This is the leap China aims to make, which would involve more than doubling GDP per capita from today's level.

Worryingly for China, the historical record suggests that it may be getting harder for middle-income countries to ascend to high-income status. Of the 12 non-oil middle-to-high country transitions since 1960, only four have occurred since 1990: Taiwan, Ireland, Spain, and South Korea.

Why have more countries graduated from low-to-middle status and fewer made the grade from middle-to-high income status?

Globalisation might explain both phenomena. A combination of technological progress and falling barriers to trade and investment may have made it easier for poor countries to achieve middle-income status, but harder for middle-income countries to ascend to high-income status.

Information technology is only half the story. From the perspective of a multinational manufacturing firm, pairing rich country know-how with poor country labour might sound great in theory, but makes little practical sense if rich country tariffs block exports from poor countries. Without concurrent trade and investment liberalisation, it seems likely globe-spanning supply chains would have been far slower to develop. 

China's ascension to the World Trade Organisation in 2001 triggered a similar boost to its own inbound foreign direct investment and exports. Meanwhile, newly plentiful job opportunities in export-oriented sectors reinvigorated growth in China's industrial employment. In the five years prior to joining the WTO, Chinese industrial employment was essentially flat. In the five years after, it rose by 27 million people or 16%.

Middle-Income Countries Stuck in the Middle

But the same forces that have ignited growth among low-income countries like China over the past couple of decades - modern communications technology, highly mobile capital, and freely flowing trade - have pressured growth among middle-income countries like Malaysia and Thailand by subjecting them to increased competition from countries with cheaper labour.

In effect, globalisation can trap middle-income countries between low-income countries with a competitive advantage in labour-intensive industries and high-income countries with a competitive advantage in knowledge-intensive industries.

For China, the risk is that growth falters amid stiffer competition from poorer countries like Bangladesh, India, and Vietnam that now seek to follow in its footsteps. 

The historical experience of countries that have fallen into the middle-income trap may offer clues about the road ahead of China, including a sense of how sharply growth slows once a country achieves middle-income status, the causes of slowing growth, and any attributes that influence the size of the slowdown. China's recent experience would seem to fit the historical pattern.

Looking ahead, productivity growth is likely to falter further as sources of "easy" productivity gains, such as technological imitation and industrialisation, approach exhaustion. The question is whether Chinese productivity growth slips towards the 0.6% growth that has historically characterised slowdowns among newly minted middle-income countries.

China’s Way Out of the Middle-Income Trap

China carries some of the markers historically associated with the middle-income trap, including rapid GDP growth, a high investment share of GDP, and an ageing population. Yet on other factors that tend to predict slowdowns, including an undervalued currency and limited high-tech exports, China appears comparably low risk. 

On balance, while we would not regard China to be at especially high risk of falling into the middle-income trap, the odds of escape are not that great either - former Finance Minister Lou Jiwei in a 2015 speech at China's Tsinghua University pegged the country's chances at 50-50.

For China to improve its odds of escape, it must tap new sources of productivity growth. Academic research consistently finds that the few countries that make the leap to high-income status tend to perform well on four key dimensions: institutional quality, innovation, human capital, and information and communication infrastructure.

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About Author

Daniel Rohr, CFA  is a senior equity analyst at Morningstar.