Avoiding the Middle-Income Trap in the People’s Republic of China

Comprehensive reforms are key for the People’s Republic of China to avoid the middle-income trap and attain high-income status.
Comprehensive reforms are key for the People’s Republic of China to avoid the middle-income trap and attain high-income status.

By Yolanda Fernandez Lommen

The People’s Republic of China's transition from a middle-income to a high-income country hinges on implementing reforms in domestic consumption, service sector development, addressing income inequality, and modernizing financial and fiscal systems.

No one can say that the second largest economy in the world is trapped. Decades of structural change and rapid growth allowed for a swift transition from a low-income to a middle-income country. The challenge today lies in moving up to higher-income status. How could the People’s Republic of China (PRC) avoid the trap? 

The Chinese economy is well known for its resourcefulness, and despite slowing growth, the economy still has untapped potential. Under the right policy-mix, the economy could easily grow by 7% in the next two decades, making the high-income level scenario a likely one by 2030. Then, what has to be done to ignite the PRC’s ascend? 

One of the main tasks for policy makers under the new leadership would be to strengthen domestic demand by fostering consumption as a driver of growth, mitigating the historical dominance of investment. This will rebalance the sources of growth while shielding the economy from external demand shocks. At about 36% of GDP, Chinese consumption stands well below international standards, constrained by high precautionary savings in the absence of safety nets, shrinking wages over GDP, poor redistributive mechanisms, limited access to financial services, and shortages of affordable housing.

To avoid the trap, policy makers also need to search for new sources of growth. Good options include boosting the services sector, and greater urbanization. Services play a major role in improving production efficiency, and promoting technical progress and innovation. However, the sector remains below potential in the PRC. Its expansion is constrained by excessive market concentration, insurmountable entry barriers, labor market rigidities and skill mismatches. My earlier blog Why Should the People’s Republic of China Unlock Services? provides insights into these challenges. On its side, accelerating the urbanization process as pledged by the new leadership would unleash employment opportunities and growth, and create further scope to develop services in the new cities. It would also serve as a vehicle to foster private investment and increase the participation of the private sector in the economy, a key element to upgrade innovation in the economy and spur growth. 

To elude the trap, the new leadership is tasked with designing a comprehensive reform package of mutually supportive and consistent policies to sustain growth and make it inclusive.

All attempts will fail if the greatest challenge ahead, income inequality, is not tackled. As state redistributive mechanisms have been weakened in the transition toward a market-oriented economy, the PRC has turned into one of the most unequal countries in the world. Inequality, if not reduced, will hinder future growth as it undermines consumption, constrains development in poorer regions, and generates social tensions. Income redistribution policies and social safety nets need to be strengthened to close the inequality gap, through increased budget support and improved government’s transfers to poorer provinces and households. Rapid population aging, analyzed in my previous blog Aging: A threat to the People’s Republic of China’s Growth, add to the challenge.

To elude the trap, the new leadership is tasked with designing a comprehensive reform package of mutually supportive and consistent policies to sustain growth and make it inclusive. In this challenge, further reforming the financial sector and fiscal and taxation policies is crucial for success.