Will China Get Caught in the Middle-Income Trap?

Published on 2011-08-12

Head of the Eastern Unit at the Asian Development Bank, Dr. Yolanda Fernandez-Lommen, shares her thoughts on whether or not China is at risk of falling into the middle income trap.

As China’s economic development continues at a projected pace of 7 percent GDP growth per annum, the question that remains is whether or not China can successfully shift its economic base from capital investments and exports to consumption and services, thereby facilitating the country’s transformation into a high-income society. Failure to do so would resign China to the middle-income trap that has constrained many a developing nation. On the 28th of July, members of BritCham, AustCham and CanCham joined the Head of the Eastern Unit at the [Asian Development Bank](http://beta.adb.org/), [Dr. Yolanda Fernandez-Lommen](http://beta.adb.org/contact/fernandez-lommen-yolanda?ref=news/experts), at the Grand Hyatt to hear her thoughts on the issue.

#The Middle Income Trap

China has successfully made the transition from a low-income to a lower-middle-income economy; however, as Fernandez-Lommen points out, the transition from middle to high income is much harder. The possibility of China’s being ensnared by the middle income trap has recently drawn discussion in [*The Economist*](http://www.economist.com/node/18832106), [*Financial Times*](http://www.ft.com/intl/cms/s/0/2173923c-a286-11e0-9760-00144feabdc0.html#axzz1UmczJwzu) and other media, which, as Fernandez-Lommen, highlight the need for increased flexibility in policy making. While the 12th Five Year Plan outlines many of the key objectives for moving growth towards consumption and services and away from capital investments and exports, these are unlikely to succeed without bolder policy adjustments. According to Fernandez-Lommen, establishment of a low-carbon economy, increasing living standards and developing an innovation-driven industrial policy are the most crucial elements for China’s successful transition. Her discussion focused on the latter two.


In order to elevate the service sector’s proportion of GDP, Fernandez-Lommen posits that the government must:

- Engage in fiscal reform, shifting its public spending from investment in business to investment in public services.
- Sustain the high level of labour required by the service industries by absorbing incoming labour from rural-urban migration.
- Foster innovation by investing in research and development.
- Upgrade human capital by increasing the quality of education and training programmes.
- Develop capital markets and provide wider access to new financial markets.
- Increase private sector participation in provision of services and innovative products.
- Court foreign direct investment in the service sector.

#Increasing Living Standards

To create the proper environment necessary to drive consumption, Fernandez-Lommen feels the following are vital:

- Establish more complex safety nets with comprehensive benefits that will encourage people to save less and spend more.
- Prioritise social spending over direct investment.
- Reform income distribution to expand the base of consumers.
- Correct the regressive nature of the tax system and shift to a more progressive approach.
- Take significant steps to counter inefficient tax collection and local corruption.
- Improve redistribution of tax revenue either from the central government to the provinces or between provinces in order to alleviate the existing financial constraints that prevent some provinces from implementing or improving public systems.

According to Fernandez-Lommen, failure to address the economic and social aspects highlighted above will hinder China’s rise to a high-income economy. A shift in policy is therefore necessary to not only sustain growth, but to support the consequences of economic expansion.