Robert Samuelson March 19, 2013

China has fallen into the “middle-income trap” — a significant event full of domestic 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, the slowdown isn’t China’s fault and was entirely predictable. The explanation is the middle-income trap.

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

Growth slows as countries reach middle-income status — not truly rich but no longer desperately poor. Since World War II, many countries have followed this cycle, according to a study by economists Barry Eichengreen of the University of California at Berkeley, 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 economy was expanding at a scorching rate of nearly 9 percent annually; it then slowed to about 3 percent, reports the study. Growth revived in the 1980s 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, the Netherlands, Estonia and Denmark all experienced middle-income slowdowns.

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. For comparison, the United States grew 1.9 percent in 2013 and Brazil 2.3 percent. 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 in industry, housing and infrastructure, fueled by easy credit. Export-led growth faces two problems: Global trade has slowed, and China’s American and European customers — worried about their own unemployment — resent its 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, building materials — and create losses for banks and other lenders. From 2008 to 2013, loans to Chinese businesses and households jumped from about 120 percent of gross domestic product (a measure of the economy) to roughly 180 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 buy more. Their stronger spending would keep the economy humming. Just recently, officials indicated they would raise interest rates on bank deposits within two years. This is regarded as crucial to stimulating consumer spending. If depositors receive more interest income, it’s argued, they will spend more. Higher deposit rates would also combat industrial overcapacity by discouraging cheap loans to firms.

That’s the theory. What if it doesn’t work? China’s headlong rush into modernity has created conflicting attitudes. People expect more jobs, higher wages and better living standards. They also resent industrialization’s pervasive pollution and the self-enriching land grabs 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? How would the communist party respond? Might it not survive? The slowdown has already hurt countries (Australia, Brazil) that satisfied China’s huge appetite for raw materials. How would a deeper slowdown affect the global 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.