On China and middle-income traps, the Greek tiger.. interesting report

China's tremendous development over the last three decades  has been truly awe inspiring and the key  issue it faces  today is if it will fall into a classic "middle-income trap" – the tendency of fast developing countries to slow dramatically as their per capita GDP reaches middle-income levels.  With this question in mind, the World Bank and the Chinese Development Research Centre (a research centre serving the Chinese Cabinet)  recently produced a  468-page report which contains some fascinating information and also covers the reforms  required over the next few decades if  China is to  become a high-income economy.  To  highlight some of the interesting  observations  from the report:

-China has grown by 10% per annum over the last 30 years, bringing 500 million people out of poverty.  It is now the world's second largest economy, and its largest manufacturer and exporter.

-The two key two factors behind this have been the transformations from a rural, agricultural society to an industrial, urban one and from a command based economy to a market-based one.  The initial conditions for change in 1978  were near perfect , with the  spark coming from agricultural reforms which included the key introduction of the household responsibility system.

-Even if China grows at a third (6.6%) of its growth rate over the last three decades (9.9%) it should  become a  high-income economy by 2030, even though its per capita income will be a fraction of that in advanced economies.  

-"Growing up is hard to do".  Many countries have rapidly developed into middle-income economies  but few have made it to high-income  levels.

-Factors like low-cost labour and easy technology adoption which  caused rapid growth in these  countries,  disappeared when they reached  middle-income status.

-As countries reach middle-income levels,  the underemployed rural labour force dwindles and wages rise, eroding competitiveness and productivity growth from resource reallocation and technology catch-up.  If these countries cannot increase productivity through innovation (rather than relying on foreign technology), they find themselves trapped.  There are  many examples of  Latin American and Middle East countries which have stagnated since the 1960s and 1970s.  

- The report featured a fascinating chart which classified countries as high-income if their per capita GDP, measured at purchasing-power parity, exceeds 43% of America's.  It plots each country's income per person (adjusted for purchasing power) relative to that of America, both in 1960 and in 2008. If every country had caught up, they would all be in the top row.

 -Of the 101 middle-income countries in 1960, only 13 passed that threshold to become high-income economies by 2008 – including  Greece(?), Hong Kong, Ireland, Israel, Japan, Portugal, Korea, Spain, Singapore and Taiwan.

- For China to achieve this transformation,  critical reforms need to be undertaken to ensure a smooth transition -  covering land, labour, power, competition,  banking, capital markets, state-owned enterprises, taxes and spending.

Fascinating  report with a wealth of information and provides an insight into what are the key requirements for economies to achieve high-income status.  What is particularly  revealing is the list of the 13 countries which have made the transition successfully from middle-income to high-income status. Countries with world-class multinational companies like Japan, Korea, Taiwan and Israel stand out – while countries  without any national champions like Greece, Spain, Portugal, and Ireland are currently floundering. (It is interesting to observe, that for all its problems, India already has  a robust list of world-class multinational companies giving it the base to eventually move into a high-income status.)  This will be the critical test for  China over the next decade or so – whether it is able to nurture a stable of world class multinational companies which are able to successfully compete and innovate in global markets? I think they will achieve this transformation successfully as they have built a tremendous industrial infrastructure around their manufacturing base, presenting a generationally attractive buying opportunity for their stock market which has significantly lagged their economic performance over the last decade.

-The country which stands out in the above chart is Greece – contrary to current popular opinion, Greece has not always been a basket case. As The Economist blog points out:
-"Greece's per capita income was only 28% of America's in 1960, (that is very roughly where China stands today). Over the next 12 years, however, the Greek economy grew at an Olympian pace of 8% a year on average. Greece then suffered a quarter century of inflation and stagnation, before resuming its convergence after 1996. By 2008 it had caught up to 52% of America's income level"
- As Paul Krugman notes-" Fifteen years ago Greece was no paradise, but it wasn't in crisis either. Unemployment was high but not catastrophic, and the nation more or less paid its way on world markets, earning enough from exports, tourism, shipping and other sources to more or less pay for its imports." 

-So what happened?  As Richard Koo points out (via Simon Hinrichsen in the FT):

- "A balance sheet recession struck the German economy on  bursting of the IT bubble, which hit Germany hard. The Nasdaq-like Neuer Markt plunged 96 per cent in value. As Germans increased savings, aggregate demand decreased. With fiscal policy somewhat constrained by the Stability and Growth Pact,  the ECB had to step in.

-Germany's actual fiscal deficits modestly exceeded that threshold on several occasions, but the resulting fiscal stimulus was far from sufficient to prop up the economy. The ECB therefore took its policy rate down from 4.75% in 2001 to a postwar low of 2% in 2003 in a bid to rescue the eurozone's largest economy.

-But those ultra-low rates still had little impact on Germany, where balance sheet problems were forcing businesses and households to minimize debt. The money supply grew very slowly, and house prices continued to fall. Naturally there was only minimal inflation in wages or prices.

-The countries of southern Europe, which had not participated in the IT bubble, enjoyed strong economies and robust private sector demand for funds at the time. The ECB's 2% policy rate therefore led to sharp growth in the money supply, which in turn fueled economic expansions and housing bubbles and wage inflation.

-In other words, there would have been no need for such dramatic easing by the ECB—and hence no reason for the competitiveness gap with the rest of the eurozone to widen to current levels—if Germany had used fiscal stimulus to address its balance sheet recession.

-The creators of the Maastricht Treaty made no provision for balance sheet recessions when drawing up the document, and today's "competitiveness problem" is solely attributable to the Treaty's 3% cap on fiscal deficits, which placed unreasonable demands on ECB monetary policy during this type of recessions. The countries of southern Europe are not to blame.

-And so it is today. Essentially, Germany and the periphery have traded places. But the 1% policy rate and a 10-year Bund yield under 1.5% are clearly too low for a strong economy like Germany and have prompted house prices to rise sharply for the first time in 15 years. So instead of letting fiscal policies help smooth out the imbalances — monetary policy is at the forefront. A tool not right for the job."
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