China beyond 2012: Can it escape the slowdown called the middle income trap?

07/12/2011 8:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

When will China overtake the United States as the world’s largest economy? That’s the question that’s getting most of the attention right now. At current growth rates the Chinese economy—at a GDP of $5.7 trillion at the official exchange rate or $10.1 trillion at purchasing power parity, which corrects for the differences for prices among different economies—will catch the $14.7 trillion U.S. economy sometime around 2016 on purchasing power parity (according to the International Monetary Fund), or in 2020 at the official exchange rate (according to The Economist.)

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

However in terms of per capita GDP China lags well behind with GDP per person of $7,600. Korea’s GDP of $30,000 is actually closer to the $47,200 per capita U.S. GDP than China is to Korea.

Why is this important? Because of something that economists call the “middle income trap.” Developing economies showing fast rates of growth have a tendency to slow down once they hit per capita GDP of $7,000 or about where China is now. Over 40 economies have reached that $7,000 per capita GDP level over the last 100 years or so, according to economic historian Angus Maddison. Of those, 31, or more than 75%, have shown a drop in their economic growth rate over the decade after they’re hit $7,000. The average drop in growth was 2.8 percentage points.

For some countries this drop in growth is temporary. Growth reaccelerates once the economy works through the transition from the export-driven, manufacturing-heavy model that typically fuels fast early growth. 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 took off again in years after the crisis after reforming it economy. Since the end of 1997, the Korean economy has grown at more than twice the speed of the average developed economy in the Organization for Cooperation and Development.

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 of the Latin American economies that boomed in the 1960s and 1970s only to stagnate for the 1970s and 1980s. Only recently have countries such as Peru, Chile, and Brazil reaccelerated.

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

To hugely over simplify, in the rise to middle-income status a country converts cheap agricultural labor into more valuable manufacturing labor. In addition massive investment in fixed assets—infrastructure, factories, and housing—fuels the growth of the domestic manufacturing sector at the same time as supplying infrastructure for future, and potentially more efficient, growth. The resulting bigger scale of that manufacturing sector plus that supply of cheap labor leads to rapid growth in exports that, with domestic growth from a combination of rising incomes and growth in fixed assets, results in rapid growth.

Countries that reach middle-income status stall for a variety of reasons that include the depletion of supplies of cheap labor that leads to rising industrial wages, a failure to move up the global value chain that 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 that of Korea and the United States.

For example, Korea’s economy isn’t nearly as reliant on manufacturing as China’s. In 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%. In the United States it’s agriculture 1.2% agriculture, 22.2% industry, and 76% services. (All data is from the CIA World Factbook.)

In Korea about 3% of the labor force works in the agricultural sector, 39% works 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% worked in industry, and 34.1% worked in services.

One last set of figures: In Korea fixed investment accounted for 28.7% of GDP. In the United States the figure was 12.8%. In China fixed investment represented almost half--47.8% of GDP—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 still 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 work force still in the agricultural sector provides such a huge pool of potential labor?

There’s the possibility, indeed the likelihood, that the data is wrong.  It dates from 2008 and the percentage of China’s workforce in the agricultural sector is undoubtedly lower now in 2011. But China’s hukou system of household registration, which has created a 150 million- to 240 million-strong army of migrant workers who work in China’s exporting provinces and yet are still officially residents of predominantly agriculture provinces hundreds of miles away also distorts the data.

But there’s also the possibility that quickly rising costs and labor shortages even with a still-huge pool of agricultural labor also testifies 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 desperate for the cash that development brings in have all certainly slowed the consolidation of agricultural holdings and the increases in agricultural efficiency that freed so much farm labor during U.S. economic development. The hukou system itself bears part of the blame. Designed to produce an army of 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, and 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. Giving these workers benefits comparable to their official 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 system have created a $1.8 trillion to $2.9 trillion future bill that the Chinese economy will have to pay in one way of the other. (For more on this bill and the hukou system see my post June 20 post  http://jubakpicks.com/2011/06/21/china-confronts-its-next-growth-hurdle/ )

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, officially 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. Korea can’t be called an under-achiever on this front with massive companies such as Samsung investing in new capacity in industries from computer chips to computers to LEDs to cell phones to TVs. But fixed asset investment is still just 28.7% of GDP in Korea compared to almost 50% of GDP in China.

There’s nothing wrong with massive investment in infrastructure and 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 just lines the pockets of well-connected individuals or provides a subsidy to inefficient industries or just serves to generate statistical growth in the absence of real economic growth—this investment just squanders the hard-earned wealth of a developing economy.

Certainly there are signs of that some of China’s fixed asset investment is being wasted. The recent scandals over China’s high-speed rail system show evidence 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 convincing evidence 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 some 75% of them will go bad. (For more on this see my post http://jubakpicks.com/2011/07/06/chinas-audit-missed-500-billion-in-local-government-loans-moodys-says-and-about-75-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 over-reliance on fixed asset investment is a temporary result of government policy.

Second, there’s the view that structural problems in the Chinese economy enable wasteful investment of this sort. And these structural problems represent another facet of the middle income trap for China.

In my July 8 post http://jubakpicks.com/2011/07/08/why-china-will-escape-the-dreaded-hard-landing-for-2011-and-2012/ I contrasted the boom and bust in the U.S. hard-drive industry in the 1980s to the present with the current boom in investment by local governments in virtually identical projects build around stations on new legs of the high-speed rail network. Bankruptcy and acquisitions whittled the 200 U.S. hard drive companies started in the boom to just three major players today.

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

Take the case of Wuhan, a provincial capital about 400 miles west of Shanghai and 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% higher 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 last 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 1) that’s a drop in the $120 billion bucket and 2) Wuhan is likely to get at least part of that $2.3 billion 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 a minimum, effective bankruptcy laws in China, an end to off-the-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 difficult in making these kinds of changes—like reforming the hukou system—are exactly why there is such a thing as the middle income trap.

So what comes next for China and investors? In the 2011 to 2012 time span 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 slows slowly enough so that Beijing’s leaders can avoid thinking that they’re facing a crisis—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 would probably in fact produce an increase in global growth, but would just add to the odds to a disruptive adjustment somewhere before the end of the decade. The self-interest of China’s current leadership favors this head-in-the-sand approach. (Chinese politicians are no different in this from U.S. politicians.)

Or China might get lucky. Some far-sighted part of the leadership, with the power to push through the kinds of reforms that 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 post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

 

 

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