GLOBAL

The real problem investors in China need to worry about is not inflation or debt. It’s known as the "middle-income trap," and it may be hitting China now.

When will China overtake the United States as the world’s largest economy? That question is getting a lot of attention right now.

At current growth rates, the Chinese economy will catch the US economy around 2016 if you measure purchasing-power parity (which corrects for price differences among different economies), according to the International Monetary Fund. Or in 2020 at the official exchange rate, according to The Economist.

China now has a gross domestic product of $5.7 trillion at the official exchange rate, or $10.1 trillion using purchasing power parity. America’s GDP is $14.7 trillion.

But an important question for China and the global economy is when, or actually whether, China will catch South Korea. Not in GDP, of course. China’s GDP has long since passed South Korea’s $1.5 trillion (purchasing-power parity) economy on that scale.

However, in terms of per-capita GDP, China lags well behind. Its GDP per person is $7,600. South Korea’s, at $30,000, is closer to the $47,200 per capita US GDP than to China’s.

Understanding the Middle-Income Trap
Why is this important? Because of something economists call the “middle income-trap.” Developing economies showing fast rates of growth tend to slow down once they hit a per capita GDP of $7,000—about where China is now.

More than 40 economies have reached that $7,000 per capita GDP level over the past 100 years or so, according to the work of the late economic historian Angus Maddison. Of those, 31, or more than 75%, have shown a drop in their economic growth rate in the decade after they hit $7,000. The average drop in growth was 2.8 percentage points.

For some countries, this drop in growth was temporary. Growth reaccelerates once the economy works through the transition from the export-driven, manufacturing-heavy model that typically fuels fast early growth.

South Korea, for example:

  • hit the $7,000 mark in 1988;
  • nearly defaulted on its debts in 1997, as a result of the Asian currency crisis;
  • and then, after reforming its economy, took off again in after the crisis.

Since the end of 1997, the South Korean economy has grown more than twice as fast as that of the average developed economy in the Organization for Economic Co-operation and Development (OECD).

On the other hand, some economies that have reached the ranks of middle-income countries have stagnated for a decade or two. That was the fate of many Latin American economies that boomed in the 1960s and 1970s, only to stagnate during the 1970s and 1980s. Only recently have the economies of countries such as Peru, Chile, and Brazil reaccelerated.

China’s economy has, on all evidence, hit this crux.

To hugely oversimplify, as a country rises to middle-income status, it converts cheap agricultural labor into more-expensive manufacturing labor. In addition, it makes massive investment in fixed assets—infrastructure, factories, and housing—fueling the growth of the domestic manufacturing sector. At the same time, it supplies infrastructure for future—potentially more efficient—growth.

The larger scale of the manufacturing sector, plus that supply of cheap labor, leads to rapid growth in exports that, combined with domestic growth from a combination of rising incomes and growth in fixed assets, results in rapid GDP growth.

NEXT: Why a slowdown?