China and the Middle Income Trap

March 24, 2016
Entrepreneurship, Innovation





As China's unprecedented economic growth slows, the country finds itself facing off against economic history, according to a professor at Duke University's Fuqua School of Business.

Professor Emeritus Arie Lewin said no transforming economy that has developed at China's current rate ever became a high income economy without ultimately adopting liberal economic reforms. How China plans to tackle that dilemma is the subject of "China's Innovation Challenge — Overcoming the Middle Income Trap," a new book co-edited by Lewin. He is a former chairman of the Duke Academic Council, was director of the Duke Center for International Business Education and Research for 18 years and the founding editor of the journal Organization Science. His research focuses on strategic renewal, innovation and adaptation of organizations in a global business context.

The Chinese reforms of the late 1970s drove mass migration from rural agrarian communities and created an explosion of industrial activity, accompanied by massive investments in infrastructure. The country is now faced with sustaining that growth.

"It's successful, "Lewin said, "but it is coming to an end. Migration of new labor is down to a trickle, and the costs of labor have been going up, making China less competitive."

The middle income trap is an economic conundrum based on the observation that the growth of an emerging economy based on manufacturing and cheap labor tends to level off and stagnate - unless the economy can find innovative ways to compete with more advanced economies.

"Scholars who have studied this issue claim that no economy has escaped the middle income trap and become a high-income economy without also buying into liberal democratic principles," Lewin said. "The basic idea is that as you grow the economy, you're building up the middle income class, which expects to be empowered, to live under transparent rules, to have democracy, and to feel that things are fair."

But China - which the World Bank predicted in 2013 would fall into the middle income trap - shows no sign of adopting democratic reforms.

"They won't do that," Lewin said. "So what will they do?"

China has already begun the shift toward becoming a consumer service economy.

"That already accounts for 50 percent of the economy in southern China," Lewin said. "But the returns are much lower than the value-added returns you get in a manufacturing economy."

Consequently, in the last three years the Chinese government has focused on innovation, Lewin said. Through successive dynasties of emperors, the Hong Kong-neighboring cities of Shenzhen, Guangzhou and Hangzhou have been hubs for innovation but are often viewed as rogue cities. The challenge for the Chinese government is how to replicate the entrepreneurial nature of these cities to other parts of China, Lewin said.

"It's a scale problem," he said. "You can't take away the miracle that the economy grew by about 10 percent until 2010 and about 7 percent since then. It still is unbelievable. The leadership understands the strategic importance of transforming China into an innovation economy, and that would be a major accomplishment."

But Lewin said history has thus far maintained that continued growth must be accompanied by institutional reform to keep it going. He cited the example of South Korea, which was transformed from a poor agrarian economy to an industrial economy in 20 years, during which it adopted democratic principles. Singapore, Taiwan, Hong Kong, and Japan after World War II are other examples.

"The Chinese say maybe Korea is a reasonable model and we should learn something from that," Lewin said. But, he added, they reject Hong Kong, Singapore and Japan, claiming the same circumstances don't apply to a country of 1.3 billion people.

"It may well be that China will develop indigenous solutions to this," Lewin said. "But in comparison to the policies that gave rise to China as the factory of the world, the next transformation is probably much more daunting. The bottom line is that because of its pragmatism, China will likely find a way. It's hard to believe they will not. But there are no ready-made solutions."

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