In 2015, China’s then finance minister expressed in public comments there was a “50/50 chance” his country would not escape the so-called “middle-income trap.” The phrase had been coined by two World Bank economists in 2006 to describe the commonly observed phenomenon of economic stagnation confronted by countries in the middle-income stage. For years, scholars have debated whether China will be able to avoid the trap and successfully graduate to being a high-income country. If China is to progress beyond its current status as an “upper middle-income” country, it will intuitively have to sustain growth. Innovation and technological advances are believed to be important in driving long-term growth, especially in China’s case as labour’s significance as a growth driver diminishes (due to a declining working-age population since 2011).

            Intriguingly, economist Paul Krugman has argued that China’s rapid output growth (and that of the four “Asian Tigers” before it) stemmed more from a “Stalinist” marshalling of certain inputs than genuine rises in productivity. Rises in both physical capital (e.g. roads, railways) and human capital (e.g. literacy) were what drove the country’s output growth. This was unlike the case for Japan prior, whose output growth also derived from significant increases in total factor productivity or TFP. Importantly, rises in TFP, often facilitated by technological advancements, are pivotal if countries are to transcend the middle-income stage successfully (Ibid.). Krugman’s assessment would thus suggest low chances for China graduating to the high-income category unless it can facilitate innovation successfully. However, it is worth noting that Krugman has been wrong before: entities affected by 1997 Asian Financial Crisis experienced a strong rebound in growth within two years instead of stagnating as he had predicted. All 4 “Asian Tiger” economies are also firmly in the high-income category today.

            Furthermore, there are signs increasingly that China is moving from a technology borrower to a technology leader, arguably reflecting its ability to facilitate innovation needed for productivity increases. The telecommunications company Huawei, which the US has sanctioned on national security grounds for allegedly having links to the People’s Liberation Army (PLA), is already the largest 5G manufacturer and has the greatest market share of equipment. The country has also made rapid advances in quantum technology, which can be used to hack encrypted communications. And in 2021, the US revealed Beijing had tested a hypersonic glide vehicle, capable of bypassing traditional missile defences with its non-parabolic trajectory. At a congressional hearing, a US general even opined the test came close to a “Sputnik moment” for China. Such developments seem to challenge the view that China has been unable to achieve technological breakthroughs on its own.

            Increasingly, Beijing seems to be placing its bets on a state-led approach to facilitating innovation. As early as 2015, its “Made in China 2025” techno-industrial plan envisioned the achievement of 70% domestically produced core content of materials in key industries by that year. In the first Politburo study session of 2024, Xi Jinping even called for “disruptive innovation.” Investment in science and technology by Beijing is also slated to jump 10% in 2024 alone according to a finance ministry draft budget report.

            Yet despite these efforts, China remains highly dependent on advanced countries for certain key technologies, with the US in particular attempting to restrict its access to these. Currently unable to produce the latest-generation semiconductor chips domestically (Financial Times 2024.), China was dealt a huge blow when the Biden administration tightened export controls on semiconductor manufacturing technology. In response, Chinese state-run media claimed Washington was trying to stymy the country’s technological rise and contain it. More recently, the US has also persuaded the Netherlands and Japan, which are critical in the semiconductor supply chain, to adopt export controls of their own in a further blow. In another sign of China’s dependence on foreign inputs and technology, many components for its first commercial airliner, the Comac C919, are sourced from joint ventures or foreign companies doing business in the country. The landing gear, for instance, is obtained through a joint venture with a German company while the engine is imported from a French-American one.

            Nevertheless, Beijing has shown perseverance in its bid to develop technology domestically. Xi recently remarked that China must “fight the battle in core technologies” and secure supply chains. In a significant domestic breakthrough, the country was able to manufacture 5 nanometre chips last year. Yet these are still a full generation behind the cutting-edge 3 nanometre chips produced elsewhere. The previously mentioned “Made in China 2025” plan and the forecast hike in science and technology spending also need to be seen in the broader context of achieving self-sufficiency. However, even as it mounts a bold effort on the technological front, the country faces increasing economic headwinds.

            In recent years, but especially since the Covid-19 pandemic, China has confronted flagging GDP growth and a worsening of other important indicators such as consumption, exports, and factory activity. The quick initial rebound in growth the country registered in 2020 even as other major economies contracted seems to have been due more to the earlier lifting of restrictions (compared to countries which became virus epicentres later) as well as a so-called “low base effect,” where growth tends to be higher from a base of low economic activity. Eventually, other major economies would also experience strong rebounds in growth as restrictions were lifted while a resurgence in infections and the strict adherence to a “zero-Covid” policy suppressed economic activity within China. Not only were consumer and business confidence considerably weakened by uncertainty and pessimism caused by the draconian policy, which was suddenly abandoned in December 2022, companies suffered balance sheet problems. Many SMEs have yet to recover their prior financial standing with liquidity remaining a key concern as evidenced by postponed payments. As a result, private economic activity has been subdued. The South China Morning post had even reported that about 4.37 million micro and small businesses shut down in the first 11 months of 2021 whereas only 1.32 million new ones were registered in the same timeframe. According to Kevin P. Gallagher, China did not see the consumption boost most expected due to pent-up demand after Covid-19 restrictions were removed. In a further headache, exports declined 7.5% in March on a year-on-year basis in Dollar terms while factory activity expanded only slightly, after contracting the previous 5 months. Consequently, for the 2024 fiscal year, the Politburo has set a growth target of around 5% – relatively modest for a country which not long ago registered double-digit growth. And even the country’s Premier has conceded achieving this target will “not be easy.”

            Incidentally, there has been policy unpredictability not directly related to Covid-19 as the Chinese Communist Party (CCP) has sought greater control over the functioning of the economy. In 2020, Beijing suspended the issuance of an IPO by technology giant Ant Group, which would have been the largest recorded had it gone through. The group’s founder, Jack Ma, also disappeared from the public eye temporarily under mysterious circumstances. As Beijing deepened its crackdown on the technology sector as a whole, mass layoffs followed. Then in 2021, it surprised many by banning the private tuition sector entirely too. Simultaneously, Xi has publicly called on China’s state-owned enterprises (SOEs) to “execute the will of the party.” New provisional regulation introduced in 2020 also means CCP committees within an SOE now wield more power than the board of directors. Xi’s increasing emphasis on SOEs, crackdown on private enterprises and exertion of greater party control over production seems to contrast with the approach followed by his predecessors since China’s market reforms began in 1978: allowing the private sector to grow gradually while reforming or shutting down more inefficient SOEs. Hence, it seems China is increasingly abandoning the very playbook which helped it achieve robust economic progress in the past four or so decades. Tellingly, the New York Times even published an opinion piece in August 2023 titled “The Real Problem with China’s Economy: Xi Jinping’s Government.” The author of the piece, Eswar Prasad, asserted the CCP needed to realise that without a strong relationship with the private sector, the transformation of the economy into a “high-tech one capable of generating more productivity and employment growth” was unrealistic.

            At the same time, sentiment has soured among foreign investors and businesses as well. The erosion of Hong Kong’s autonomy through the 2019 passing of a draconian national security law by Beijing has led to a trend of capital flight from that territory. US sanctions passed in response also seem to further threaten Hong Kong’s status as a global financial hub. In 2014, a new counter-espionage law had granted Beijing sweeping powers over private companies, domestic and foreign. It even allowed the confiscation of equipment and property on national security grounds. Incidentally, amid worsening tensions with Beijing over the disputed Senkaku islands and security concerns, Tokyo has been funding the relocation of Japanese companies’ production lines from China since 2020. By 2023, foreign direct investment (FDI) inflows into the country had slumped to their lowest since 1993.

            Worryingly, the country also confronts a high domestic debt burden, which stands at nearly 300% of GDP today. Unlike other major economies, which generally cut back on spending (the US is an exception due to its unique financial system), China doubled down on fiscal stimulus in the wake of the 2008-09 global recession. In the short to medium-term, this had the effect of propping up GDP growth rates to higher than what they would have otherwise been. However, the effects of years of stimulus have not only worn off but increased the country’s domestic debt significantly, especially among provincial governments and real estate developers.

            Meanwhile, the fragile state of the property sector, which generates 24% of GDP, has also exacerbated fears over the country’s broader economic trajectory. Much of the money extended as part of China’s years-long stimulus spending went into real estate, resulting in significant overcapacity: the country has “ghost cities” that are largely uninhabited and in 2017 it was estimated that 65 million apartments – or a fifth of all homes – were vacant. The disruption of construction activity due to China’s “zero-Covid” policy affected the balance sheets of major real estate developers as well. In 2021, the second largest of these companies, Evergrande Real Estate, was declared to be bankrupt after defaulting on debt payments. This sparked a scare throughout the sector, with developers’ balance sheets coming under scrutiny. In the time since, property prices in major cities have fallen. Chinese now prefer to stash away their savings instead of spending on real estate, which is no longer seen as a safe investment. With both overcapacity and falling demand, downward pressure on property prices seems destined to persist, even feeding fears of asset price deflation similar to that in Japan in the 1990s, which derailed years of robust growth and led to a so-called “lost decade.”

            Complicating matters, consumer and producer prices have also been dropping, further fuelling deflationary fears. In January 2024, the Consumer Price Index (CPI) fell 0.8% compared to a year earlier, its sharpest fall in more than 14 years (moderate rises in CPI are reflective of a buoyant economy). This followed a 0.3% decrease in December. And in January as well, the Producer Price Index (PPI) fell 2.5% from a year earlier. It was the sixteenth consecutive monthly drop in PPI. As a result of these downward pressures on prices, the country is witnessing its worst deflation currently since the Asian Financial Crisis in 1997.

            Yet despite all these problems, the Chinese Communist Party has demonstrated a remarkable ability to adapt consistently, successfully rebalancing at pivotal moments. Having witnessed the catastrophic planning failures of Mao’s Great Leap Forward, which induced nationwide famine and plunged output, the reformist-minded Deng Xiaoping led the country to embrace market reforms from 1978, which put it on a high-growth path. At the time of the Tiananmen protests, it also seemed China could experience a regime collapse or that the CCP’s reform agenda would be seriously undermined at the very least. However, the party emerged unscathed and the country’s GDP growth rebounded strongly not long after.

            Similarly, the current CCP, and Politburo in particular, have reaffirmed their commitment to implementing reforms needed to keep the Chinese economy buoyant. Signalling a course correction in response to overcapacity and the slowdown in real estate, Xi has emphasised the need for productive investment rather than speculative investment. This seems to reflect the Politburo’s strengthening desire for revenue generation and avoiding further sunk costs. What is more, Beijing did not double down on fiscal stimulus in the 2024 budget despite the utility of this instrument in propping up short-term growth rates in a slowing economy. This could all suggest Beijing is still versatile and willing to pursue reform pragmatically where and when needed.

            Despite these recent moves, certain scholars are not optimistic about China’s future prospects – and even its current performance. Daniel Rosen of the Rhodium Group highlights the regulatory repression which has “frightened away investors” and overinvestment in property that has led to debt crises for the largest property developers. He believes there is “no logical way” investment added as much to GDP in 2022 as Beijing claimed and estimated that the country’s GDP grew between 1 and 2% in 2023, far lower than the official figure of 5.2%. And in a widely publicised article in the Financial Times, Ruchir Sharma opined that China’s failure to facilitate productivity increases coupled with demographic problems meant it would only overtake US GDP in 2060, if ever. It must be noted that even if China were to have a GDP equalling that of the US today, its GDP per capita would still be much less intuitively, due to GDP being distributed among a population roughly four times larger. Hence, a China which does not match the US in GDP size is very likely to remain a developmental laggard in terms of income of the average citizen. Ultimately, whether or not China is able to work around its mounting challenges, be they economic or demographic, depends on the willingness and ability of its leadership to implement new measures and embrace reform rather than resisting it.

Note: This short analysis focuses more on economic factors. Part 2 will focus more on demographic factors such as falling fertility rates and ageing population.