China must act fast to escape middle income trap

Source:Global Times Published: 2017/5/11 22:08:39

Action needed to escape middle income trap

Illustration: Peter C. Espina/GT

Has China fallen into the middle income trap? My answer would be yes. Based on the available data, in the late 1990s, investment of 1 yuan ($0.14) could bring an increase to GDP of about 0.4 to 0.5 yuan. Now, an equivalent investment would bring only a 0.07 yuan increase to GDP.

Another set of data, for the Producer Price Index (PPI), shows that from March 2012 to the second half of last year, the PPI remained in negative territory. Why did this happen? It is because of overcapacity. Under the pressure of overcapacity, a lot of companies cut prices to boost their sales. But the overcapacity showed that no new investment is needed in industrial fields across China.

Investment income will always be negative when the investment is conducted with the PPI continually dropping. Therefore, not only has our investment income reached zero, but it has fallen below it. The current extremely low capital gains indicate that it is barely possible to get a return on investment.

In this situation, a great deal of economic phenomena can be understood more easily. Funds and resources are draining away from the real economy toward areas such as the stock market. The government is anxious about money that has gone to the stock market instead of the real economy. The panic caused by the stock market crash in 2015 put a dampener on some people's investment in stocks, but this led them to transfer their interest to real estate speculation.

Once the capital gains equal zero, the middle income trap will occur, which points to the failure and futility of macroeconomic policy. The government has printed a lot of money that did not flow into the real economy, but to asset price speculation instead. Fiscal policy also failed as it could not contribute to boosting GDP. Private investment fell sharply, because the returns are so meager. The government then rushed to invest, but the result was overcapacity.

Against this background, it is ridiculous to talk about expansionary fiscal and monetary policies. These policies aim to stimulate investment, but our economy does not need capital. More investment means more capacity; more capacity means the PPI will continue to decline. In the second half of last year, the PPI started to rise, and some people said this showed the Chinese economy had been stabilized, but I do not agree. It was actually the result of eased monetary policy in the first half of last year.

From this year, the money supply has been decreasing, suggesting a slowdown for the economy in the second half of the year. If the money supply continues going up, housing prices will be beyond administrative control and the current exchange rate will also be difficult to maintain.

At present, with the feeble investment stimulation, there are two key aspects of our corresponding policies. The first one is to keep to the "new normal" economic status, which diminishes the expectations from 10 percent growth of GDP. Second, the central government proposed supply-side reform. One of the ultimate goals of this reform is to enhance enterprises' efficiency, in the process of which institutional guarantees are desperately needed. I propose that four measures are needed for this reform.

First, protection of private property rights can establish stable future profit expectations for entrepreneurs. Only in this way can long-term investment be encouraged. Protection of private property rights is a prerequisite for long-term investment in research and development, and the most effective way to protect property rights is to set up a sound legal system for it.

Second, the scope of the State-owned economy should be narrowed. State-owned enterprises seldom have pressure to be innovative, because there is little risk for them of going bankrupt. However, if private enterprises are lacking in innovation, they will go out of business.

Third, deregulation is needed. Excessive regulation is the biggest enemy of innovation. The reason why world-class Internet companies appeared in China is that when the Internet took off in the country, the government did not pay too much attention to it and did not try to restrain the industry. A free environment and flexible resources are vital for innovation.

Fourth, the government should implement across-the-board tax cuts. This would alleviate the burden on enterprises, and transfer resources from administrative coffers to the market for more autonomous allocation.

The article was compiled based on a public speech by Xu Xiaonian, professor of economics and finance at China Europe International Business School.

Newspaper headline: Action needed to escape middle income trap

Posted in: INSIDER'S EYE

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