Robert Samuelson March 19, 2013

China has fallen into the “middle-income trap” — a significant event full ofdomestic and international implications. Its economy is visibly slowing; lower-than-expected industrial production and exports are the latest evidence. Global stock markets have responded nervously. But in some ways, theslowdown isn’t China’s fault and was entirely predictable. Theexplanation is the middle-income trap.

To economists, the term describes an inevitable cycle for poor countriesaiming to become rich. Early gains are often rapid, as countries adoptwell-known technologies and management practices. Workers move fromsubsistence farming into basic manufacturing: textiles, clothes, shoes.Growth soars. Wages improve. But it gradually becomes harder topiggyback on advances made abroad. Countries have to rely more on localinnovation, entrepreneurship and investment.

Growth slows as countries reach middle-income status — not truly rich but nolonger desperately poor. Since World War II, many countries havefollowed this cycle, according to a study by economists Barry Eichengreen of the University of California atBerkeley, Kwanho Shin of Korea University and Donghyun Park of the Asian Development Bank.

Japan is a classic example. In the late 1960s and early 1970s, its economywas expanding at a scorching rate of nearly 9 percent annually; it thenslowed to about 3 percent, reports the study. Growth revived in the1980s but then slumped again. It went from 4.6 percent in 1990 to about 1 percent over the next seven years. South Korea, Ireland, Israel, theNetherlands, Estonia and Denmark all experienced middle-incomeslowdowns.

Now it’s China’s turn.

Since 1978, when market reforms began, annual economic growth has averaged about 10 percent. In 2012 and 2013, it fell to 7.7 percent. The International Monetary Fund predicts further declines this year (7.5 percent) and next (7.3 percent). It might go lower.

Of course, most countries would be thrilled with 7 percent growth. Forcomparison, the United States grew 1.9 percent in 2013 and Brazil 2.3percent. Still, China faces a tortuous transition. Its economic strategy is outmoded. It needs a new one. So say many economists. China’s rulers seem to agree.

The old strategy has relied on export-led growth and huge investment inindustry, housing and infrastructure, fueled by easy credit. Export-ledgrowth faces two problems: Global trade has slowed, and China’s American and European customers — worried about their own unemployment — resentits aggressive export tactics. As for massive investment in industry and real estate, that’s produced gluts of factories and homes.

Economist Nicholas Lardy of the Peterson Institute says that a burst housing bubble poses the largest risk to China’s economy. It would hurt satellite industries — steel, buildingmaterials — and create losses for banks and other lenders. From 2008 to2013, loans to Chinese businesses and households jumped from about 120percent of gross domestic product (a measure of the economy) to roughly180 percent of GDP, reports the credit rating agency Moody’s. A strong economy helps borrowers service these loans. A sharp slowdown would change matters.

The new strategy is consumer-led growth. Chinese would save less and buymore. Their stronger spending would keep the economy humming. Justrecently, officials indicated they would raise interest rates on bankdeposits within two years. This is regarded as crucial to stimulatingconsumer spending. If depositors receive more interest income, it’sargued, they will spend more. Higher deposit rates would also combatindustrial overcapacity by discouraging cheap loans to firms.

That’s the theory. What if it doesn’t work? China’s headlong rush intomodernity has created conflicting attitudes. People expect more jobs,higher wages and better living standards. They also resentindustrialization’s pervasive pollution and the self-enriching landgrabs of business and communist party elites.

Will there be a backlash if these expectations are further disappointed by a slowing economy with higher unemployment and lower wage gains? Howwould the communist party respond? Might it not survive? The slowdownhas already hurt countries (Australia, Brazil) that satisfied China’shuge appetite for raw materials. How would a deeper slowdown affect theglobal economy? Would China become more nationalistic abroad to distract from domestic discontent?

Make no mistake: The middle-income trap is no minor inconvenience. It’s a big deal for China and the world.