The story shifts from east to west

As the west recovers and emerging economies start to struggle, the pattern of growth is reversing
October 16, 2013

The new European Central Bank headquarters under construction in Frankfurt © Rex/Action Press

Something unusual is happening in the world economy. Over the summer, economic forecasters have become more optimistic about the prospects for economic growth in the western world for the first time in four years. But in emerging and developing countries, there are new concerns about weakening economic growth and instability. This about-face in the fortunes of richer and emerging countries wasn’t in the script we have been reading in recent years. Even though rich countries are by no means out of the woods yet, some things are starting to go right. By contrast, China and many of its emerging market peers are slowing down for more than temporary reasons. Many could easily get stuck in a so-called “middle income” trap and fail to become yet more prosperous.

A pendulum shift back to advanced countries?

The end of a long recession in Europe, and the broader western economic upturn, including in Japan, comprises unequivocally positive news, even though caveats abound. All recessions end eventually, and the west still faces a long, hard slog to regain control over and lower public debt, find new drivers of growth and employment, and develop coping mechanisms to deal with the consequences of ageing societies.

For now, though, the cyclical trend is improving. The OECD, a group that represents more than 30 advanced and developing economies, said in its Interim Economic Assessment, published in September, that momentum in the global economy was starting to shift towards the rich world, and away from emerging markets. This view corroborates widely followed economic data, and surveys of business and consumer confidence that suggest stronger economic performance than at any time since the bounce back from the 2008 recession. The annualised momentum of industrial production in G7 economies, for example, was about 5 per cent this summer, compared with an average of zero in a group of major emerging countries, comprising the five Brics and Indonesia. Turning to GDP, it looks as though advanced economies will provide a third of global growth in 2014, up from a fifth in 2012-13, and less than that in 2011.

The UK government will doubtless take heart from the upward revisions to growth forecasts. The UK might even be a top three growth achiever in 2013 and 2014, with GDP expected to rise by 1.5 per cent and 2.3 per cent respectively. The government’s decision to reinflate the housing market and mortgage demand may be the economic equivalent of recidivism, but it will probably hold the economy up well enough for the 2015 election.

In Europe, Germany is doing relatively well, and other countries will at least have some growth in 2014 as the intensity of austerity lessens. But we should be under no illusion that Europe has stumbled across a strategy to promote and distribute economic growth around the eurozone, or that the crisis over escalating sovereign debt and weak banks is over. The re-election of Angela Merkel won’t make a big difference—there is still much unfinished business and risk to the economic health of the eurozone.

The United States is a better example of things that can go right, even if not yet convincingly. The political fight over the increase in the the US Treasury’s borrowing authority, and the stubborn resistance to Obamacare, remind us of the country’s ugly budgetary politics. And the diffusion of low-pay jobs and decline in the employment rate remain worrisome. But private sector economic activity has been doing fairly well, employment has been slowly expanding, and labour and capital are gradually being reallocated to advanced energy and manufacturing technologies, boosting US labour and product competitiveness.

Meanwhile, in emerging markets....

The economic predicament of western countries has become standard fare, but what are the serial growth disappointments in emerging markets in the last couple of years all about? The colourful hyperbole about emerging markets and über-optimism have given way to a more sobre reflection that emerging markets are, themselves, facing deep, structural problems.

China’s 10 per cent growth spurt is over, and it is now dependent on rapid credit creation to deliver even the 7.5 per cent expansion rate, which the government hopes will be the new “normal.” China’s growth slowdown may, in fact, only be half over, as it ratchets down to about 4-4.5 per cent over the next decade. Brazil’s growth spurt has faltered despite strong credit growth amid concerns about inadequate investment, infrastructure building and official trust in the private sector. India was recently thought likely to be the next 10 per cent growth story, but it is now growing at little more than 4 per cent under the weight of bureaucracy, corruption, high deficits, and a hostile attitude to foreign investment. Russia, still mostly an energy giant, suffers from a lack of political competition, a weak legal and regulatory framework, corruption, poor investment incentives and a small manufacturing base.

Among this disparate group of countries, along with others such as Malaysia, Indonesia, Thailand, Mexico, Chile, Turkey and South Africa, many have found the the global economy is a tougher place in which to sell exports to hard-pressed western consumers. The world really has changed and and there’s little end in sight. But there’s more. After the growth feast of rapid economic catching up in the 1990s and 2000s, a relative famine has arrived for two reasons.

First, the exceptionally benign global economic conditions of that period have now ended. Second, rapid growth has swollen the ranks of middle income countries, typically with income per head of between $5,000-15,000. Now, many of the high-flyers are finding that in economic development, there are some things that are unrepeatable. For example, you can only get a growth boost from joining the World Trade Organisation once. The same goes for other transformational factors, such as the provision of better sanitation and public health, transferring labour from low productivity agriculture to high productivity manufacturing, enrolling children in secondary schools, building essential infrastructure, and adapting imported technology.

Having done these things, sustainable growth becomes a lot harder. We know it is because among the World Bank’s [188-strong] membership of countries, territories and islands, there are only 35 rich countries (excluding oil states) with income per head of $25,000-50,000. Most countries end up in a middle income trap, that is, stuck between simple and advanced stages of economic development. Brazil, Argentina, Venezuela, South Africa, Russia, and Malaysia are among many countries that are trapped. It isn’t the end of growth, but it is the end of high, sustainable growth.

The World Bank showed in a report last year that of 101 countries or territories that were classified as middle income in 1960, only 13 succeeded in getting out of the trap. Japan, was a special case of a previous high income country destroyed by war. Some small states or oil producers such as Hong Kong, Singapore, Israel, Mauritius, Equatorial Guinea, and Puerto Rico did well. Spain, Portugal, Greece and Ireland were part of the European recovery story. The two “classic” high income transformations were South Korea and Taiwan.

What most of these countries were able to do was to embrace economic and political reform, and build socially inclusive and high quality institutions. They absorbed and implemented many western best practices from political competition and the role of markets, to meritocracy, the rule of law, trusted legal and regulatory institutions, income equality, and high levels of educational attainment, research and development and innovation. It is widely acknowledged nowadays that the key to becoming a high-income nation, or jumping over the “Bric wall,” lies in the politics of enabling institutions. Cue China. Can the Communist Party’s renowned pragmatism succeed where most other countries have failed?

China’s time for reform

It is too early to say whether China has become trapped because it has only been a middle-income country since 2001, when income per head passed $1,000. Now it is about $6,500 but we may not know until the 2020s whether or not China was able to jump the Bric wall. There is no doubt that leaders are aware of the risks. Last year, Premier Li Keqiang gave his backing to a World Bank study advising China how to avoid the trap and earlier this year, Executive Vice Premier, Zhang Gaoli, said that China’s biggest challenge, is to “stand up to the test of striding over the middle income trap.”

Most of China’s leaders know that their economic model has to change. Twenty years of unconstrained, turbo charged growth has left the economy chronically unbalanced. Typical examples include the dominance of the state over the private sector, rule by law over the rule of law, investment over consumption, manufacturing over services, and growth over the environment and social cohesion. Liberal thinkers in China allege that the dominance of the state is stifling competition, distorting markets and the prices of everything from water to raw materials and energy, encouraging rent seeking and corruption, and leading to the abuse of power, rising income inequality and social fragmentation. Moreover, many of these issues have been obscured by rapid credit creation and debt accumulation. China is developing its own real estate bubble, and bad debt problems in local governments, state-owned enterprises and banks.

Changing the model is now urgent. The labour contribution to growth turned negative in 2012 as China’s working age population fell for the first time. Rapid ageing means it will continue to do so, and it will not be offset without strong gains in university educational attainment levels. The capital contribution to growth is bound to decline one way or another as the economy rebalances away from investment. The investment that does occur must become more efficient, and be financed in ways that don’t risk financial instability. For high and stable growth in the future, and the chance to catch up with the living standards of rich economies, China has to reform its economic model to one based on innovation, entrepreneurship, technological progress, and household consumption of goods and services.

This would produce a very different China from the one we know today. It would grow more slowly, perhaps at 4 per cent rather than at 7 to 8 per cent. But the fruits of growth would accrue largely to households, not the state, and China’s significance in the global economy would go far beyond the over-stated attribute of being the biggest economy in the world. It might bring China into the lower echelons of the rich world by the 2030s. On the other hand, if China didn’t rebalance much or well, it would almost certainly become trapped long before.

Many of China’s leaders are not short of intent when it comes to reform, but there are trenchant questions over their capacity and willingness to implement reform. The simple reason is that a major reform programme would have to take power away from state enterprises, banks and other entities, local and provincial governments, powerful families and the military, and empower citizens, households, private sector companies, and an independent legal system. Li Keqiang and other liberal-minded officials have come close to saying so but the omens aren’t encouraging.

President Xi Jinping came to power with Leninist rhetoric about purifying the party, and has been waging an aggressive campaign to this effect, including just recently the pursuit of a vengeful sentence against the disgraced Bo Xilai. He has come out strongly against any public debate about constitutionalism, imposed severe restrictions on the use of the internet for political and policy purposes, and insisted that educators avoid discussion about freedom of speech, judicial independence, universal values, civil society and rights, and past mistakes of the party.

This begs the question as to how China’s institutions can change and adapt, allowing economic freedom and initiative to flourish, and disruptive change to occur? The answer is that leaders may yet try to push incrementally the boundaries of economic reform, but always short of anything that came close to threatening the party’s raison d’être, which is to rule unopposed, and retain control over the commanding heights of the economy. Here lies the middle income trap that Chinese leaders know they want to avoid.