The implications of China’s middle-income trap

Three decades ago, China’s annual economic output was about $433 billion in current dollar terms, making the economy about the size of Austria or South Africa today.

It is now comfortably the world’s second largest economy – with gross domestic product in current dollars of $17.7 billion – and in the post-financial crisis era has easily been the single largest contributor to global GDP growth.

Between the beginning of 2010 and the end of 2020, China’s economy grew by about $11.6 billion in current dollars. That is equivalent to adding about six and a half Russia, almost four Great Britain or India, almost three Germany, more than two Japanese or more than 50 Greece. It’s like adding an Indonesia every year for a decade.

Let’s put aside disagreements about the accuracy of Chinese economic data using current dollars, etc. The point of this number is to show that China has clearly been THE essential engine of global economic growth for the past decade plus.

Why are we going over this again? Well, a few weeks ago we wrote about the IMF’s Article IV report on China. FT Alphaville then spoke to Sonali Jain-Chandra, the IMF’s China mission chief, to dig a little deeper into some of the issues (such as the ongoing horrors of the property market) and find out what we should be thinking about that isn’t hitting the mark not necessarily the headlines.

Our biggest takeaway was that the IMF has turned much gloomier on China’s long-term growth potential, having marked down its forecasts for 2024-28 by more than a percentage pointwhich declines to just 3.4 percent by 2028. Here’s a chart showing the latest projections versus those the IMF put out in its last Article IV report just a year ago, and the one from 2021.

Column chart of the IMF chainsaw its long-term Chinese economic forecasts (%) showing middle-income trap ahoi

As Jain-Chandra pointed out, some of this was inevitable. But it is also a consequence of political choices – and with the right policy, the decline can be mitigated. Here is her view:

When the Chinese economy approaches the limit, it is natural that growth will slow down from the 8-10 percent growth seen in recent decades. A decline was therefore inevitable, but that does not mean that higher than expected growth is not within reach. Indeed, our analysis shows that China has the potential to grow faster than our current forecast over the medium term if it adopts a comprehensive set of reforms aimed at boosting productivity and countering a declining labor force.”

A separate “selected cases” report published after Article IV provides more meat on the bone. The main problems are well known. A rapidly aging population means much lower labor force growth in the coming years, and productivity growth has already fallen sharply as the simple gains from investment in technology and skills have largely been achieved.

But there are some idiosyncratic problems that are increasingly weighing on China’s economic potential, according to the IMF:

What is unique in the case of China is the added pressure of diminishing returns on investment-led growth, as excessive investment – ​​fueled by record domestic savings – has been channeled towards relatively less productive SOEs, activities such as real estate, which are less growth-promoting in the longer term, and to further increase China’s already relatively large public capital stock. This pattern of investment in China has accelerated the decline in overall productivity, and thus potential growth.

Basically, it appears that China has now fallen into a classic middle-income trap, a term coined by the World Bank in 2006 to describe the phenomenon of emerging economies that never, well, actually emerge.

On the one hand, almost all the countries that have managed to free themselves from the middle-income trap are in Asia: South Korea, Taiwan, Hong Kong and Singapore, for example. On the other hand, the current global economic environment is radically different today. Globalization is booming, for example.

If China’s economy continues to decelerate, the implications are . . . not good.

Based on the World Bank’s data – via the St Louis Fed’s FRED database – China accounted for more than one in three dollars of economic growth in the period 2010-2020. It is likely to require indirect credit for much more, thanks to the negative effect in countries such as Brazil and Australia. What could possibly replace it? Let’s just say we remain skeptical that India will prove the answer.

The IMF is not the only institution concerned about the global implications of a secular slowdown in China’s growth. In October last year, FTAV highlighted how the BlackRock Investment Institute was also quietly alarmed by the long-term outlook for China and what it could mean for the rest of the world.

While the relaxation of Covid-induced lockdowns has improved China’s economic outlook in the short term, BlackRock’s Alex Brazier and Serena Jiang reckon China’s potential growth rate could fall to just 3 percent by the end of the decade.

In the past, when countries faced a downturn, they could still count on Chinese consumers and companies to buy up their cars, chemicals, machinery, fuel – even as consumers at home tightened their belts. And they could count on China to continue to supply an abundance of cheap products as China’s rapidly growing working population enabled it to keep production costs low. Not so anymore. Recession is now threatening the US, UK and Europe. But this time, China will not come to its own, or anyone else’s, rescue.

It now looks like the US and Europe can escape recessions (fingers x’d). But the long-term fallout from halting Chinese growth could still be overwhelming.

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