June 29, 2011 11:24 pm

China can yet avoid a middle-income trap

By George Magnus
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The Chinese Communist party will celebrate its 90th anniversary on July 1 with a pride that testifies to the pragmatism it has shown since Deng Xiaoping determined to lift the nation out of poverty some 30 years ago, and set a course to make China what it is today. But the party also faces three huge challenges that should make us wonder what the country will be like when the centenary comes round.


First, China will this decade make the transition from a borderline to a fully fledged middle-income country, with per capita income rising more than three times to about $13,000. This will be a quite different experience from the trebling of per capita income that has occurred since Deng, because richer, more complex economies need high-quality institutions, especially in the legal arena, to sustain human development. This is far more important than national output, steel production or any other metric.


In their absence, countries get stuck in a middle-income trap – as evidenced by Argentina, Venezuela and the former Soviet Union. The Fraser Institute ranks China’s institutional quality 82nd in a group of 141 countries. While it scores well in size and efficiency of government, it is weak in other areas, particularly regarding the rule of law and neutral legal institutions. The problem with reform in this area is that it clashes directly with the primacy of the CCP party over both the state and the judiciary.


Second, China is in the throes of a leadership change which, while carefully orchestrated, is exposing political and ideological struggles, not least for membership of the State Council. The revival of Maoism by some of the “princelings”, the revolutionaries’ children, is significant.


Uncertainty is already apparent in foreign and domestic policies that sometimes reflect an assertiveness that derives from economic power, and sometimes a latent sense of insecurity that speaks to angst about both the party’s own legitimacy and rising social tensions. The escalation of the latter has resulted in a sharp crackdown on human rights activists and lawyers. Meanwhile, internal rivalries lie behind an intrusion of the military, state-owned enterprises and regional party elites into many areas of policymaking that is heightening political uncertainty.


In the international security arena, a more truculent China has already emerged over the past two years. Posturing to Japan, South Korea and the US, complex relations with North Korea and Iran, and the courting of Pakistan – plus, to India’s chagrin, the construction of naval facilities – all have a sharper edge nowadays and point to tensions that detract from a crucial domestic agenda.

Third, China is at a crucial economic juncture. It has to attend to rising inflation in goods and property prices, rooted in the sharp rise in recourse to credit, sometimes of questionable quality, to finance high investment and growth. The political will to attack the underlying causes of inflation is weak, however, and there is no desire to use market mechanisms to set interest rates and the appropriate price of capital.


China must also press on with rebalancing; that is, the move away from an investment-centric growth model to one based on consumption and services. This is a complex task, liable to lead to pronounced economic volatility – and it is also intensely political. It entails redistributing power from those who have benefited to date – companies, coastal regions, the military and provincial party elites – to those left behind, including consumers, migrant workers and the countryside, on which 780m citizens still depend for their livelihoods.


In line with the Chinese proverb about crossing the river by feeling the stones, economic and financial policies change slowly. But, contrary to recent assuring statements from Wen Jiabao in this column, inflation is not yet beaten, and there is little evidence that successful rebalancing is occurring. If anything, investment is holding up too well, while households are compromised by rising inflation and financial repression. More than 40 per cent of household wealth is held as bank deposits, on which the real interest rate stands currently at -2.3 per cent.


Incremental change, however, will not substitute for institutional change and this is the CCP’s greatest challenge for the coming years. It has pulled China out of poverty with unprecedented speed and success by being smart and flexible. But in steering it to become a middle-income nation, it will need far more of the latter quality if, in aspiring to high-income status and global leadership, it is not to fall at what we might call a Bric wall.


The writer is senior economic adviser at UBS and author of Uprising: will emerging markets shape or shake the world economy?


Copyright The Financial Times Limited 2011.