Understanding the Middle-Income Trap: China’s Current Economic Predicament

At the heart of discussions at this year’s China Development Forum was the looming risk of China falling into the so-called ‘middle-income trap.’ This phenomenon, where rapidly growing economies slow down as they reach middle-income levels without ever achieving high-income status, is a critical concern for the world’s second-largest economy. Following decades of near 10% annual growth, China’s economy has notably decelerated, with growth rates dipping to 5.2% last year, a sharp contrast to its previous rapid expansion. With the International Monetary Fund forecasting a further slowdown to 3.4% by 2028, the question arises: can China avoid the middle-income trap that has ensnared many before it?

The Structural Hurdles in China’s Economy

China’s economic slowdown is attributed to several structural issues rather than temporary cyclical factors. The country faces challenges such as an aging population, a burst real estate bubble, and a towering debt ratio nearing 300% of GDP. Additionally, a shift from market-oriented reforms towards state capitalism has been observed, with excessive credit-fueled investment favoring state-owned enterprises (SOEs) and local governments. Compounding these problems is the recent crackdown on the tech sector and other private businesses, which has dented business confidence and curtailed private investment.

The Broken Growth Model and the Need for a New Direction

China’s traditional growth model, based on low wages, light manufacturing, and export-led growth, is no longer viable in the current global context of de-globalization and protectionism. The imposition of technology sanctions by Western countries and a domestic economy characterized by high savings and low consumption rates are further constraining growth. Chinese authorities are now promoting a shift towards high-quality growth, emphasizing technologically advanced manufacturing. However, without an increase in domestic demand, particularly from private consumption, this strategy risks leading to overcapacity and potential global market disruptions.

Reforming for a Consumption-Driven Economy

To counteract deflationary pressures and avoid the middle-income trap, China needs to pivot towards a growth model that focuses on domestic services and private consumption. However, this requires significant reforms, including improving social insurance, increasing real wages, and redistributing SOE profits to boost household spending. Despite discussions on enhancing domestic demand, Chinese policymakers have been slow to implement the required fiscal and policy changes necessary to stimulate private consumption.

Leadership and Policy Direction: Xi Jinping’s Role

While China recognizes the need to revitalize growth through a more sustainable economic model, it remains to be seen if its leaders fully grasp the extent of the challenge. Under President Xi Jinping’s tenure, there has been a noticeable return to state capitalism, raising questions about the commitment to necessary market-oriented reforms. The sidelining of known reformers, such as Premier Li Qiang, in favor of those who support state capitalism, casts doubt on China’s trajectory towards opening up and reforming its economy. The actions China takes in the coming year will be pivotal in determining whether it can escape the middle-income trap and set itself on a path to robust growth.