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| Pushan Dutt |
When economists talk of growth miracles, they refer to countries that grew rapidly and caught up with the level of the development of the U.S. Korea, among others, is the poster child of growth miracles. In 1950, Korea's per capita GDP was 6 percent of the U.S. Today that number is 71 percent. China's growth take-off started three decades later, and despite the vast differences in size, the two growth trajectories are nearly inseparable (see graph below). China's catch-up has lifted vast numbers out of dire poverty and is one of the finest achievements in the history of economic development.
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Going forward, will China follow Korea's trajectory, or will a confluence of policy shifts, geopolitical conflicts, and demographic constraints ensnare it in the dreaded Middle-Income Trap?
The middle-income trap refers to a level of development, approximately $15,000 in per capita GDP, where many fast-growing economies slow down. Unlike Korea or Japan, they fail to transition from middle-income to high-income. Economists Eichengreen, Park, and Shin find that at this level, growth of per capita income slowed on average from 5.6 percent to 2.1 percent per annum. Today, China's per capita GDP on a PPP basis is $14,620, and sustaining growth is the existential challenge for China's leadership and policymakers.
Much of the seismic change in China, including the travails in its real estate sector, the crackdown on consumer-oriented internet companies, the pivot towards advanced manufacturing, and the common prosperity initiative, can all be traced to China grappling with this challenge.
To date, China, like Korea before, has pursued a strategy of investment-driven growth using a combination of market-based reforms, activist industrial policy, and a long-term vision combined with effective governance. However, such a strategy eventually runs into diminishing returns, and countries must shift from investment-driven growth to innovation-driven growth. While China's manufacturing ability remains unsurpassed, it lags in innovation capabilities, especially in general-purpose technologies such as AI, robotics, 5G, etc.
It relies on foreign knowledge to provide the blueprints and schematics. The Made in China 2025 initiative seeks to accelerate this shift and push China towards a techno-strategic leadership and even technological self-sufficiency. The recent internet crackdown has focused on consumer-tech and EdTech companies, while encouraging investments in advanced manufacturing is a continuation of this trend.
Such a shift parallels the Chinese reaction in the 2016 THAAD missile defense dispute, where retaliation by China was highly selective. The headline victim was the Lotte Group's consumer-facing Lotte Mart, and bilateral tourism and entertainment exports took significant hits. Companies like Samsung, which supply innovation-intensive inputs, remained relatively unscathed.
However, China's innovation shift will not bear fruit overnight since general-purpose technologies take time to diffuse. An innovation ecosystem must emerge, technological advances must be effectively implemented and complemented with new skills and novel organization processes. Improvements in productivity that ultimately translate into economic growth may take decades to manifest.
Ironically, cracking down on innovative internet companies creates regulatory uncertainty and stalls the entrepreneurial activities needed to leverage such technologies. In the meantime, we can expect declining and volatile growth rates.
This creates a conundrum for Chinese policymakers as the political stability and legitimacy of the regime depend on continual growth. Confronted by any growth slowdown, China reverts to the original investment-driven growth model, with the real estate sector in the driving seat. However, an economy where the property sector accounts for 25 percent of GDP, financed by shadow banks, with high leverage, and more than one-fifth of unoccupied housing stock is not sustainable.
The recent travails of Evergrande are linked to China's effort to clamp down on leverage, stabilize the housing market, and rein in risks in credit markets. Allowing such firms to go bankrupt may shift beliefs about bailouts, thereby reducing overinvestments in real estate. However, a byproduct will be the economic pain felt by homeowners, contractors, and workers.
President Xi is unlikely to impose much-required market discipline in a politically critical year and is likely to choose economic stability even if it means continuing along the old path. On the international front, the Belt and Road Initiative, setting aside geopolitical considerations, is a continuation of the old economic model. Faced with a scarcity of investable ideas and projects, China invests in other countries to keep growth going at home.
Overall, there remains tremendous uncertainty about China's future growth and development path, further complicated by geopolitical tensions and the ongoing pandemic. If China commits to the innovation path, this will mean new opportunities for Korean high-tech industries and firms such as Samsung, LG Chem, and SK hynix.
They could play a key role in facilitating China's push towards technological advancement. At the same time, these companies must tread a narrow line between providing goods and inputs to the world's largest market while protecting their trade secrets and intellectual property from leakage and theft. We do live in interesting times.
The writer is a professor of Economics and Political Science at INSEAD.
