Growing Beyond the Low-Cost Advantage. Yiping Huang

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       Middle-income trap and lessons from international experience

      Many countries experience a growth slowdown after achieving middle-income status. Some 18 countries globally have been “middle income” for the past 50 years, including 12 in Latin America and three in Asia—Malaysia, the Philippines, and Thailand. At their current pace of growth, many will remain trapped for years to come. On the other hand, 14 economies have escaped the trap since 1965, including five in Asia—Hong Kong, China; Japan; the Republic of Korea; Singapore; and Taipei,China. These Asian economies completed the transition from low to high income within 3 to 4 decades.

      Avoiding the middle-income trap requires continuous industrial upgrading through innovation and moving from a low-cost to a high-value economy. Low-income countries possess a large pool of surplus labor that limits wage increases when urban industrial and service sectors expand. Firms employ low-level, established technologies that are easily imported and mastered locally, and compete on low cost. Upon reaching middle income, the pool of surplus labor shrinks and—as it approaches the Lewis turning point—wages rise rapidly. Countries must upgrade industry and services through innovation to improve labor productivity—moving from a low-cost to a high-value economy. If they fail to do so, the economy becomes trapped: no longer able to compete with low-income countries but unable to compete with high-income countries.

      Moving from a low-cost to a high-value economy requires a critical mass of firms with strong incentives for innovation. It also requires the government to create a conducive environment. This environment should have the following key elements: (i) macroeconomic, political, and social stability; (ii) adequate public investment in infrastructure and human capital; (iii) a well-functioning market system that provides price signals, encourages competition, protects investors, and promotes trade; and (iv) a well designed industrial policy. The East Asia miracle economies possessed most of these characteristics during their take-off periods. Conversely, macroeconomic instability, debt crisis, high-income inequality, social tension, and political instability caused many Latin American countries to remain caught in the middle-income trap.

       Sustaining the PRC’s long-term growth: Challenges and risks

      The PRC faces the following critical challenges—which, if not addressed effectively—could hamper its long-term growth and increase the risk of getting caught in the middle-income trap.

      Large technology and productivity gaps with advanced countries. Despite significant advances over the past 3 decades, the PRC’s productivity and technology gaps with advanced countries remain large. In 2009, its industrial labor productivity was about 10% of the level of the United States. Although the PRC is the world’s largest high-tech exporter, a very high proportion of these products are processed—with low domestic value added. While it is considered the world’s factory, the PRC is largely an assembler with few internationally known brands. Innovation and industrial upgrading require a critical mass of productive and innovative enterprises. However, its private enterprises, although growing strongly, remain small in size with limited innovation resources. In contrast, state-owned enterprises (SOEs) are far larger with access to more innovative resources—but they are less efficient and have weaker incentives to advance.

      Rising wages. The PRC’s low-cost advantage is likely to erode gradually in the coming years. Real wage growth in the industrial sector now exceeds labor productivity gains and there are labor shortages in coastal areas in recent years. Many believe the PRC is approaching the so-called “Lewis turning point”, in which a decline in rural surplus labor leads to tightening labor markets and rising wages—a process that may occur over a decade or so. Labor supply will also be affected by population aging and an end to the demographic dividend. Rising labor costs mean the PRC’s growth needs to be driven increasingly by productivity improvements through innovation and upgrading—moving from a low-cost to a high-value economy.

      Imbalances in the sources of growth. On the demand side, growth has relied too much on investment and net exports, with private consumption weak—in 2009, the latter comprised just 35% of gross domestic product (GDP). On the supply side, services remain underdeveloped at about 43% of GDP—compared with an average of 48% for lower-middle-income countries, 60% for upper-middle-income countries, and over 70% for high-income countries. Imbalances are often associated with rapid structural transformation. But in the PRC, incomplete reform is also a major contributing factor. Over-reliance on net exports makes the economy vulnerable to external fluctuations and shocks, especially in the face of weak demand from advanced markets. Over-investment could lead to poor asset quality, which in turn could undermine the performance of banks and the stability of the financial system.

      Rising income inequality. The PRC’s rapid growth has been accompanied by rising income inequality. The Gini coefficient of per capita consumption expenditure increased from about 30 in the early 1980s to 43.4 in 2008, which is among the highest in Asia. Technical progress, globalization and market-oriented reform are among the key drivers of PRC’s rapid growth, but they have also had significant distributional consequences, including a rising skills premium, falling labor income share, and growing spatial inequality. Unequal access to opportunity—due to weaknesses in governance—is also a major contributing factor. High inequality can retard growth as low-income households contribute little to effective demand and are unable to invest in their human capital through improved health and education. Beyond direct economic effects, inequality has the potential to generate social unrest, which can derail the growth process.

      Resource constraints and environmental degradation. The PRC’s rapid growth has created significant pressure on its natural resources and the environment. Rising demand and pollution are leading to water shortages, projected to reach 10% of water requirements by 2030 if nothing is done. Primary energy consumption could double in 25 years and oil import dependence could reach 85%, making the PRC vulnerable to external shocks if it continues its current energy use pattern. Thus, energy supply and security could also constrain the country’s future growth. Furthermore, the PRC’s coal-based energy system is damaging the local environment and contributing to global warming and climate change.

      A challenging external economic environment. As the world’s second largest economy, the PRC exerts an increasingly large impact on many of its key trading partners and the world economy in general. Authorities need to consider these impacts when deciding on economic policy to help create a stable and harmonious external economic environment. In particular, the PRC will continue to face the following issues, among others: (i) with the current slow pace of global recovery and the ongoing eurozone debt crisis, external demand may be unable to contribute to growth as much as in the past; (ii) the PRC’s trade balance with its trading partners will continue to generate tension; (iii) pressure on the PRC to reduce its carbon dioxide emissions will only intensify; and (iv) calls to do more to protect intellectual property rights will continue.

       Policy options to avoid the middle-income trap

      To avoid the middle-income trap, the PRC needs a development strategy that allows it to grow beyond low-cost advantage and move from a low-cost to a high-value economy. This strategy should include the following agenda: (i) stepping up innovation and industrial upgrading by strengthening enterprise incentives for innovation, building an environment conducive for innovation, investing in human capital, and moving toward a knowledge-based economy; (ii) deepening structural reform, in particular reforms of enterprises, labor and land markets, the financial sector, and the fiscal system; (iii) developing services and scaling up urbanization; (iv) reducing income inequality to make growth more inclusive; (v) maintaining macroeconomic and СКАЧАТЬ