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?

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Why a slowdown?

Countries that reach middle-income status stall for a variety of reasons. These include the depletion of supplies of cheap labor (which leads to rising industrial wages), a failure to move up the global value chain (which requires expanding the service sector’s share of the economy), and a continued over-reliance on massive investment in fixed assets to drive economic growth—even as the return on that investment falters.

You can get a sense of China’s exposure to these problems by comparing its economy to those of South Korea and the United States.

South Korea’s economy isn’t as reliant on manufacturing as China’s:

  • In South Korea, 3% of GDP comes from the agricultural sector, 39% from industry, and 58% from services.
  • In China, the sector breakdown is agriculture, 9.6%; industry, 46.8%; and services, 43.6%.
  • The US economy is 1.2% agriculture, 22.2% industry, and 76% services. (All data are from the CIA World Factbook.)

Now for labor:

  • In South Korea, quite similarly, about 3% of the labor force works in the agricultural sector, 39% in industry, and 58% in services.
  • In the United States, the comparable figures are 0.7% agriculture, 20.3% industry and 79% services.
  • In China, in 2008, 38.1% of the labor force worked in agriculture, 27.8% in industry and 34.1% in services.

One last set of figures:

  • In South Korea, fixed investment accounted for 28.7% of GDP.
  • In the United States that figure was 12.8%.
  • In China fixed investment represented almost half—47.8%—of all economic activity.

Some parts of China’s middle-income trap emerge even from this cursory top-down view.

For example, with 38% of the labor force employed in the agricultural sector, China should still have ample supplies of cheap labor. Yet the country reports labor shortages in the export-engine provinces along the coast.

And wages are climbing rapidly. The latest five-year plan promises an annual 13% increase in the minimum wage over the life of the plan.

Why are labor shortages and rapid wage inflation showing up now in China, if that 38% of the workforce still in the agricultural sector provides such a huge pool of potential labor?

There’s the possibility—indeed, the likelihood—that the data are wrong. The numbers date from 2008, and the percentage of China’s workforce in the agricultural sector is undoubtedly lower now.

But China’s hukou system of household registration, which has created an army of 150 million to 240 million migrants—people who work in China’s exporting provinces, but are officially residents of predominantly agricultural provinces hundreds of miles away—also distorts the data.

NEXT: Data May Not Be Right

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Data May Not Be Right
Quickly rising costs and labor shortages—even with a huge pool of agricultural labor—also testify to inefficiencies in China’s economy.

A lack of land rights, a shortage of rural capital, and high land prices (due to development pressure from projects funded by local governments) have all slowed both the consolidation of agricultural holdings and the increases in agricultural efficiency that freed so much farm labor during US economic development.

The hukou system itself bears part of the blame. Designed to produce cheap labor to drive China’s manufacturing-export economy, the system also guaranteed that these migrant workers would not have access to health care, education for their children, or pensions in the places where they worked—because officially, they didn’t live there, but back in the provinces.

And that has created a huge class of workers who are increasingly unhappy that they have been excluded from so much of the wealth created by the Chinese economy.

However, giving these workers benefits comparable to those of their counterparts in the cities where they work would cost Beijing an estimated $1.8 trillion to $2.9 trillion. It’s cheaper, in the short run, to increase the minimum wage by 13% a year.

In effect, the economic distortions of hukou have created a $1.8 trillion to $2.9 trillion bill that the Chinese economy will have to pay someday. This is exactly the kind of structural problem that troubles a developing economy as it hits middle-income status.

And the issue of rising wages and labor shortages doesn’t exhaust the problems that the hukou system has created for a China that wants to avoid the middle-income trap. For example, migrant workers don’t have the kind of job security or company loyalty that’s conducive to developing the increased skills that China will need from its workers to move up the global value chain.

The distortions of the hukou system, however, are subtle in comparison to the problems for China’s economy created by its massive over-reliance on fixed-asset investment to drive growth.

South Korea can’t be called an underachiever on this front, with massive companies such as Samsung investing in new capacity in industries including computer chips, computers, LEDs, cellphones and TVs. But fixed-asset investment is still just 28.7% of GDP in South Korea, compared with almost 50% of GDP in China.

Wasted Investment
There’s nothing wrong with massive investment in infrastructure, industrial capacity, and real-estate developments—especially in a developing economy—as long as that investment produces a positive rate of return.

When it doesn’t—when it instead lines the pockets of well-connected individuals, or provides a subsidy to inefficient industries, or simply serves to generate statistical growth in the absence of real economic growth—this investment squanders the hard-earned wealth of a developing economy.

Certainly, there are signs that some of China’s fixed-asset investment is being wasted. The recent scandals over its high-speed rail system show that costs were inflated in order to benefit politically connected companies and individuals.

The recent national audit of lending platforms connected to local governments showed that some of this $11 trillion in lending went to projects that would never generate enough cash to pay off the loan. Moody’s Investors Service estimates that $540 billion of these loans were so badly underwritten that 75% of them will go bad.

There are two ways to look at China’s fixed-asset investment figures:

  • First, there’s the view that this is a temporary problem created by China’s decision to stave off the effects of the global economic crisis by flooding the system with cash for this kind of demand-generating investment. The problem now is getting this cash infusion out of the economy. From this point of view, China’s overreliance on fixed-asset investment is temporary.
  • Second, there’s the view that structural problems in the Chinese economy enable wasteful investment of this sort. And these structural problems represent a facet of the middle-income trap for China.

In my July 8 column, I contrasted the boom and bust in the US hard-drive industry in the 1980s to China’s current boom in investment by local governments in virtually identical projects built around stations of the high-speed rail network. Bankruptcy and acquisitions whittled the 200 hard-drive companies started during the boom to just three major players today.

There’s no comparable mechanism to whittle down—or prevent—duplicative, inefficient investment in China.

NEXT: A Visit to Wuhan

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A Visit to Wuhan
Take the case of Wuhan, a provincial capital about 400 miles west of Shanghai. It’s China’s ninth-largest city.

The local government is in the midst of a $120 billion development plan that includes two new airports, a new financial district, a new cultural district, and a riverfront promenade with an office tower 50% taller than the Empire State Building. If this sounds to you like Wuhan rebuilding itself in the image of Shanghai, I think you’re right.

How is the city paying for this? Off-balance-sheet debt—borrowed, ultimately, from state-owned banks.

In 2011, Wuhan plans on spending $22 billion on infrastructure. That’s five times the city’s tax revenue. To meet the gap, the city has sold land—about $25 billion in the past five years—and borrowed more money. In 2009, for example, one of the city’s off-balance-sheet financial platforms borrowed $230 million and then used $80 million of that to repay old loans.

Is Wuhan broke? You bet. Does Beijing know? Absolutely—after all, the financing is coming from state-owned banks. Will the city be forced into bankruptcy, or forced to cancel its grandiose plans? Not likely.

Beijing has ordered the city to repay $2.3 billion to state-owned creditors this year, but that’s a drop in the $120 billion bucket. Plus, Wuhan is likely to get at least part of that $2.3 billion back from state-owned lenders, through one back-door route or another.

Do you see an effective restraint on Wuhan’s building spree? I don’t. And putting one in place would require, at minimum:

  • effective bankruptcy laws in China;
  • an end to off-balance-sheet lending and borrowing;
  • and a change in career incentives for local government officials, who know that the way to climb the hierarchy is to generate jobs and economic growth.

The difficulty in making these kinds of changes—similar to reforming the hukou system—is exactly why there is a middle-income trap.

What’s Next for China?
So what comes next for China and investors? I think we’ll see more of the same, as China’s leaders make sure the economy doesn’t rock the boat during the transition to a new national leadership team in 2012.

After that? Well, the average 2.8-percentage-point deceleration in economic growth produced by the middle-income trap would take China from its current 10% growth rate seriously close to the 7% growth rate that most China analysts think is needed to keep job growth ahead of population growth.

If growth slows, and does so slowly enough that Beijing’s leaders can avoid thinking that they’re facing a crisis (here, the old story about how to cook a frog without it jumping out of the pot comes to mind), then I think we’ll see a gradual increase in growth-enhancing measures to compensate.

That would be effective in the short term, and it would probably produce an increase in global growth. But it would add to the odds of a disruptive adjustment before the end of the decade. The self-interest of China’s current leadership favors this head-in-the-sand approach (in this way, Chinese politicians are no different from US politicians.)

China might get lucky. Some farsighted leader, with the power to push through the kinds of reforms that South Korea pushed through, could get China through the middle-income trap relatively quickly and painlessly.

My indicator of choice here is the financial-services sector. If you see reforms opening up that sector to actual competition from overseas players, it would be a sign that China is starting to tackle at least one of its economy’s structural problems.

Full disclosure: I don’t own shares of any of the companies mentioned in this column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. For a full list of the stocks in the fund as of the end of March, see the fund’s portfolio here.