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Finance & Economy

What could derail a middle class China?

Chinese Yuan

Chinese Yuan

Every investor knows about the middle income trap.That’s when countries hit a certain income level, say around $15,000 annually per head, and growth ceases to impress.

The economy moves slower. It goes through bouts of recessions, some steeper than others. Middle class economies contract.  Poorer economies on route to middle classdom, expand.

China is far from a middle income economy. Per capita income is under $8,000 a year in most cities. But in Shanghai, Hong Kong, Guangzhou and Beijing, the China view looks more like that of middle class Eastern European nations like the Czech Republic than an emerging market where most people still earn just a few hundred dollars a month.

Cities like Hong Kong, in particular, are more like Tokyo and New York than they are anything that resembles a developing economy. Hong Kong has been rich for some time, and now that magic is spilling deep into mainland China, starting from the coast, and now inching into second tier cities nationwide.

For sure, China’s eastern seaboard cities have hit or are hitting the middle income trap. Their economies are growing slower, but are still humming along as upwardly mobile Chinese drive demand for housing and consumer goods in those hot urban centres.

As China becomes “middle class” by World Bank standards, what does that mean for China?

In their last instalment on the Chinese economy, titled “Beyond the Miracle,” Barclays Capital analysts in Hong Kong led by Yiping Huang wrote that China will avoid the middle-income trap. However, they did not underestimate the risks facing China’s economy in the coming years.

It’s one thing to be middle income. It’s another thing to move out of that middle income and into the coveted high income class of Western Europe, the United States and Japan.

The experience of countries that failed to make the jump to high-income status suggest that their inability to innovate and upgrade can be attributed to three broad factors:

  1. Macroeconomic, political and social instability;
  2. Persistent inefficient allocation of resources;
  3. Insufficient support to physical infrastructure and human capital development.

A long list of risk factors

The Chinese economy faces a long list of risk factors, such as worsening corruption and worsening income inequality, particularly in those cities. These, and other risk factors, could easily disrupt China’s growth trajectory as much as a shift away from exports to domestic consumption is doing so now.

Yiping Huang said that they think policy reforms and economic forces should be able to discuss many of these issues. For instance, with help of rapid increase in wage rates, expected interest rate liberalisation and further reforms, China is probably close to a turning point when income distribution switches from deterioration to improvement.

Similarly, the government recently stepped up its efforts to crack down on corruption. An implicit acceptance of social media as a monitoring mechanism for government officials is particularly encouraging, although in itself this will be insufficient to eradicate corruption.

And, finally, the protection of intellectual property rights has improved much, and that should help local entrepreneurs and foreign entities set up shop in China without the fear that they are days away from having their intellectual property ripped off.

After joining the WTO in late 2001, China set up a nationwide court system for dealing with intellectual property right issues. International experience also suggests that such protection can strengthen much when indigenous intellectual property rights become dominant.

So what could derail a middle income China?

1. Environmental Degradation

One of the major consequences of China’s rapid economic growth during the past few decades is serious and widespread degradation of the environment, writes Yiping in “Beyond the Miracle”, Barclays’ 25 page report on China’s long term growth prospects. According to one count, 16 out of the world’s 20 most polluted cities are in China.

The press has been loaded with stories this year alone about China’s horrible air quality.

Air pollution may be relatively easy to discuss, considering the experiences of major cities such as New York, London and Tokyo dealing with similar problems during their postwar periods. But other environmental damage could be much more difficult to reverse.

For instance, water shortages have already led to a rapid drop of underground water table levels in Northern China. Underground water supplies in about two-thirds of China’s cities are also considered seriously polluted.

These problems, if not tackled quickly, are likely to reduce life quality, hamper productivity, drive away investment and, eventually, dim China’s growth outlook.

2. Increasing Cost of State-Owned-Enterprises

The government runs China, and the SOEs are not only massive in size, but costly and slow to innovate, if they innovate at all.

The SOEs have evolved into an important lobby group within the government apparatus and are obstacles to further reforms. The state sector is generally profitable, thanks to implicit input subsidies and monopoly power, not necessarily its own competitiveness. In relative terms versus the private sector, the SOEs suck in more resources but churn out less in output.

This is a significant limiting factor in the non-state sector’s growth potential. It is best demonstrated by credit allocation in the banking sector in municipal development projects that have been wasteful, either through corruption of local officials, or by building housing developments where there is no demand.

SOEs may also contribute to fiscal risks, as both the state sector and local governments continue to face soft budget constraints, and become a source of social tension.

3. Financial Crisis

This is what the hard landing crowd has waited for.

The financial risks are already on the rise in China, reflected in “excessive borrowing” by heavy industries and local governments. The rapid growth of the shadow banking sector also suggests that further delaying financial reform is no longer an option.

International experience also suggests that liberalisation of currency be accompanied by significant increases in financial instability. It remains an open question if China’s banks and its financial system more generally could withstand the shocks likely brought about by financial liberalisation and opening.

Implications for the rest of the world

“In our view, the government’s ability to control and alleviate risks in these three areas – environmental damage, the SOEs and financial shocks – will determine China’s chance of maintaining its growth sustainability,” says Yiping. “If the above risks explode, China’s growth could collapse, at least in the short term, with devastating implications for the rest of the world.”

About Political Atheist

Living in South East Asia (Vietnam & Cambodia). At the ending/starting point of the more than 1000 year old SIlk Road.


5 thoughts on “What could derail a middle class China?

  1. Reblogged this on Oyia Brown.


    Posted by OyiaBrown | February 27, 2013, 10:57 pm


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