Slowing China, good news for India

Alok Ray | Updated on January 19, 2018

Investors in China are looking at poorer countries, where diminishing returns from capital and labour are yet to set in

No doubt, the Chinese economy is slowing down. Even the Chinese Planning Commission has projected a GDP growth rate of around 6.5 per cent for 2016-20. This is largely attributed to the ongoing global slowdown that has impacted Chinese exports and the rising wages in China, affecting its international competitiveness in labour-intensive manufacturing.

Investors — both Chinese and foreign — are now looking for cheaper production locations elsewhere. As a result, these developments are opening up a window of opportunity for India, which is potentially becoming a relatively attractive production and investment choice.

But is this slowdown a temporary blip? India cannot bank on a temporary weakness of others. But if the Chinese economy slows down permanently, it would have a long-run depressing effect on the price of oil, minerals and other commodities which would benefit net importers of such goods like India.

Historically, no country has been able to sustain a near 10-per cent annual GDP growth rate for over some three decades or so. This has been the case for Soviet Union, Japan, other East Asian miracle countries such as South Korea, Singapore, Taiwan and Hong Kong — not to speak of earlier developed countries like Holland, Britain or the US which never experienced even a 4- per cent growth rate for any extended period.

The middle income trap

Hence, the statistical probability of China being an exception is low. But, then, exceptions and low probability events occur. So, we have to understand the basic reasons why high growth eventually slows down and in what respects the Chinese story may be different. In this connection, economists talk of a ‘middle-income trap’. The World Bank classification of a middle income country is one with per capita income (PCI) of more than $1,045 but less than $12,746 in 2014 while China’s PCI is $7,380.

The middle-income trap is nothing but the operation of the law of diminishing returns. According to this theory, it is easier for a poor country to grow at a fast rate by accumulation of physical capital ( investing in machines, factories and infrastructure) and developing human capital ( investing in education and skill formation for workers). Using more workers (by shifting people from the rural areas) in higher productivity industrial occupations in towns and copying or adapting superior technologies available in other developed countries is part of this process.

But this kind of growth would eventually slow down as use of more machines and workers would yield diminishing returns. Over time, the supply of surplus workers from the country side would dwindle, pushing up the wage rate. For China, this problem has been further accentuated by the official ‘one-child policy’.

The scope for using simpler low-hanging technology borrowed from others in labour-intensive processes (often low value-added assembly operations) would progressively diminish. In addition, the cost of land, energy and finance picks up with rising demand, cutting further into the country’s international cost competitiveness.

The rising cost (and increasing social awareness) of pollution and environmental damage caused by rapid industrialisation also acts as a constraint on growth of industries running on coal-fired energy or spewing chemicals.

In other words, at the middle income stage, the country gets sandwiched between competition from lower cost poorer countries and more innovative high income nations. Graduation to high-tech manufacturing or high-skill service activities is not easy. The education and skill level of workers needs to be continuously upgraded.

Innovation and more

Also, a culture of innovation and ‘creative destruction’ (allowing firms/industries to die and new ones to rise) has to be cultivated to move up the value chain. Since this process of graduation becomes progressively harder, it is observed that many countries such as Brazil, Malaysia, Thailand, South Africa reaching the middle income range got trapped at that level and have not moved to the high income category.

In any case, the longer-run trend growth rate of GDP of mature industrial economies like Britain, US and Japan lies between 2 to 3 per cent per annum which is broadly determined by its productivity growth.

So, even if China becomes able to break the middle income trap and joins the high income club, the days of double digit growth would be over. The vacuum created by the gradual exit of China from the export market of labour-intensive manufactures would open up opportunities for other nations, including India.

Coming back to the question of whether China would be able to graduate to a high income country, the majority opinion among Western experts is that China would not succeed unless it reforms its ‘extractive’ political institutions.

By that, they mean the prevailing single party political system with party leaders and cadres often deciding where and how private enterprises would run (through allocation of contracts and bank credit based on ‘connections’ and bribes), lack of free competition between state enterprises and private firms, arbitrary controls on free flow of information through internet and social media, insufficient protection of intellectual property rights, absence of independent judiciary and press, and exodus of talent to the Western countries in search of greater personal freedom.

Will the model change?

Though the Chinese political leaders have a continuing interest in high growth, the political institutions would stifle innovation and competition. Though, unlike the former Soviet Union (or China under Mao), China since the late 1970s has allowed a far more market-oriented economic system and incentives, the lack of political freedom and inclusive institutions would eventually obstruct its transition to a first world economy.

But, then, China has proved its doomsday critiques (predicting a collapse or hard landing due to mounting bad debts of state-owned banks and local bodies) wrong for a long time.

In any case, the world would wait with great interest to see whether the so-called ‘authoritarian’ development model of China would prove to be a viable alternative to the standard Western model of development emphasising political democracy, beyond the middle income stage.

Though there are several authoritarian states in the rich income category, all of them — Qatar (with a PCI of $92,000), Kuwait ($49,300), UAE ($44,600), Saudi Arabia ($25,140), and Russia ($13,220, just barely above the threshold) — are rich in oil or natural gas with ownership concentrated in a few families. By contrast, China is deficient in natural resources with a wider dispersion of wealth.

The writer is a former professor of economics at IIM, Calcutta

Published on January 05, 2016

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