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Deep Industrialization Is the Key to Crossing Over the Middle-income Trap


How can China overcome the middle-income trap? In this 2016 speech, Yao Yang, Dean of the National School of Development of Peking University, identifies what he sees as critical ingredients for avoiding this trap, and argues China should understand these as it aims to become a “high-income country by the centennial of the country’s founding.” He also seeks to dispel what he sees as several widely-held misunderstandings about China’s economic growth challenges.

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Recently, Yao Yang, Dean of the National School of Development of Peking University, gave a speech entitled “China’s Prospects for Economic Growth and Current Economic Situation.” This article is adapted from the content of this speech.


The 13th Five-Year Plan has set a very ambitious goal, calling for the economic growth rate to reach 6.5% for the next five years. Whether this goal can be achieved is highly related to whether China can cross over the middle-income trap. This article is divided into two sections. The first section looks at the commonalities of the countries or regions that have successfully crossed over the middle-income trap. The second section discusses China’s advantages and the problems we are facing.


Successful Experience in Crossing Over the Middle-income Trap


What helps countries cross over the middle-income stage and successfully reach high-income standards? As Tolstoy said in Anna Karenina, “All happy families are alike, but every unhappy family is unhappy in its own way.” Failure is actually very easy. Just make one mistake, and you may fail. High-income economies are all very similar. To become a high-income economy all aspects need to be in the best possible state.


Economies that have successfully grown from middle-income to high-income have all done the following.


First, high savings and high investment. At above 20%, the national savings rate in the United States is certainly not low. This savings rate mainly reflects corporate savings, while ordinary people save only a small amount, and the government has negative savings. High savings allows for high investment. When we talk about investment, it includes not only fixed assets, but also investment in scientific research. Engaging in scientific research means spending money, and China is willing to spend money in this regard. We have the Natural Science Foundation, which is already half the size of the U.S. National Science Foundation. At this rate of growth, it is estimated that it will surpass the United States within ten years.


Second, in-depth industrialization. Successful economies have all implemented in-depth industrialization. This in-depth industrialization means that industrialization lasts for a long time. After a country enters the middle-income level, industrialization needs to continue for about 25 years. The changes in the proportions of the various industries are significant. The proportion of agriculture constantly declines, while the proportion of the service industry constantly increases. Only the manufacturing industry is distinct, as its proportion first rises and then falls. This is the case in the United States, South Korea, Taiwan, and all other successful economies. At the peak of industrialization in these economies, employment in manufacturing could account for more than 30% of total employment, and the added value of manufacturing could account for more than 40% of GDP. It is often said that the manufacturing industry represents too high a proportion of China’s economy, while the proportion of the service industry is too low. In fact, the data shows that the share of manufacturing in China is only slightly high, and the difference compared with those successful economies is not great. The statistics on China’s service industry are inaccurate – it is estimated that about 10% of the service industry is not included in the statistics. If we add this missing portion, the proportion of the service industry will be higher, and the proportion of the manufacturing industry will be reduced.


Why is manufacturing important? The reasons include the following. First, manufacturing can create savings. Manufacturing has extremely high capital intensity, the return on capital is relatively high, and the savings rate of capital owners is high. Second, manufacturing improves the technological level of the entire country. Third, manufacturing supports the service industry. High value-added service industries such as finance and design must serve the manufacturing industry.


Take India as an example. Even if the United States outsources all telephone and software jobs to India, it would only employ 5 million people in India, only 1% of India’s workforce of 500 million. Plus, it is not possible for the United States to outsource all service jobs to India. If India wants to catch up to China, it has no choice but to rely on manufacturing, but India is not doing this currently. This is a serious obstacle to the sustained growth of India’s economy.


Brazil’s problem is premature de-industrialization. Starting in the 1980s, it abandoned the process of industrialization. Of course, this was tied to the sovereign debt crisis at that time. Since then, Brazil has suffered from a serious case of “Dutch disease.” What is “Dutch Disease?” During the oil crisis in the 1970s, the western world was very nervous. One after another, countries searched for oil, and oil fields were discovered in the North Sea. The large volume of oil exports from the Netherlands led to two results: First, the appreciation of the local currency made domestic goods extremely expensive. Second, the manufacturing industry completely disappeared. Brazil is in the same situation. This is a classic example of failure due to a lack of industrialization.


The third is large-scale exports by the manufacturing industry. Successful economies are export-oriented, and manufacturing accounts for a relatively high share of exports. In the 1980s, China exported some resource products and agricultural products, but the technical content of exported products continued to improve. Currently, machinery products represent the largest share of export products. Many people say that our exports are low-tech and the profits go to others (给别人打工). In fact, our progress over the past three decades has been unparalleled. No country has done it better than China.


The fourth is a high Human Development Index (HDI) value. In many indicators, successful economies are not very different from less successful economies. However, in education and health, they were superior to the failed economies from the very beginning. For example, Taiwan and South Korea popularized primary education very early on. China made many mistakes in the first 30 years after its founding. However, by comparing China and India in the 1970s and 1980s, we can see that China’s HDI value is much higher than India’s. This laid the foundation for China’s subsequent development.


The fifth is a stable macro economy. An important reason why Latin America has not developed over the long term is inflation. Inflation in Brazil in the 1990s was 20% per month. In this sort of environment, no one can run a business. China has done very well in this regard. Inflation peaked at 24% in 1994 and has been on the decline since, never exceeding 10% after 1997.


The sixth is a stable political environment. The failed economies often see government overthrown, while the successful ones have mostly stable political situations.


The seventh is a lower degree of inequality. This is probably the area where China is lacking at present, while the successful economies have done this very well. For example, in Taiwan, the Gini coefficient is less than 0.37, and income distribution is very fair. The Gini coefficient for mainland China is high because of its huge size and the huge gap between urban and rural areas and different regions.


China’s Advantages and Problems


China has two huge advantages: one is the advantage of a large country, and the other is the advantage of economic reform.


The advantage of being a large country is first reflected in the scale of university enrollment. There are about 30 million students in Chinese universities, and more than 6 million students graduate every year. In addition, we have the largest number of scientific researchers in the world, and R&D investment already exceeds 2.1% of GDP. If this proportion increases by 0.1% every year, it will reach the 2.5% level of developed countries by 2020.


The advantage of being a large country is also reflected in our huge space. China’s land area is larger than that of Europe, our population is 2.4x that of Europe, and our internal differences are also greater than those of Europe. The gap [in the level of development] within China is far greater than the gap between the coastal regions of China and developed countries. In the past, development mainly relied on the coastal regions, but in recent years, inland areas have begun to close the gap rapidly.


The advantage of economic reform is also important. In this round of economic reform, financial reforms have been relatively thorough. By liberalizing shadow banking and other methods, the government has successfully realized the marketization of interest rates. Due to the risk-averse nature of banks, a financial system dominated by banks is not suitable for innovation. If we want to promote innovation through finance, we must turn to direct financing or capital markets. Through capital markets, the whole society bears the costs of innovation, while the innovators personally enjoy the benefits. China is currently working on developing capital markets.


Next, let’s talk about the short-term problem China faces, the slowdown in economic growth. There are three reasons for this. One is that the world economy is adjusting. The second is that China’s economic structure is adjusting, that is, the peak moment in our industrialization process has already passed. The third is the influence of the economic cycle. Many people have been talking about structural issues, ignoring the economic cycle. In fact, China has experienced a total of four cycles of seven years each since the 1990s, and we are now at the bottom of the economic cycle.


When analyzing these issues, we need to dispel some misunderstandings.


The first misunderstanding is attributing the root cause of all problems to overcapacity. It seems that all we have to do is solve overcapacity and then everything will be perfect. In fact, the last round of economic growth was too good, and business expectations were too optimistic, so they increased investment. Eventually, overcapacity emerged in the cyclical adjustment of the economy. It is because of the recession, and especially the lack of demand, that there is excess capacity, not vice versa. Reducing production capacity is best performed by the market. Otherwise, all private enterprises will be affected, making capacity reduction a rent-seeking method for state-owned enterprises. Instead, the government should make full use of production capacity.


The second misunderstanding is that, because China’s investment efficiency is declining rapidly, investment should be curtailed. Actually, the efficiency measured by economists is total factor productivity. This is a residual concept, and it is completely procyclical. During an economic upswing, production capacity is fully utilized and efficiency is high. However, during an economic downturn, the operating rate is very low, many workers do not have jobs, and efficiency is very low. This calculation method is not accurate.


The return on investment (ROI) is indeed declining, but it is also reasonable. The ROI of capital depends on the marginal product. Before, there was a steady flow of cheap labor from the countryside to the cities and towns that could combine with capital, so the marginal product of capital did not decline. Now that the transfer of labor has basically ceased, the marginal return to capital has naturally declined. In addition, a lot of investment is in infrastructure construction. This kind of investment has a long period and is slow to produce results. In addition, many returns are social returns, which greatly improve the welfare of the people, but these are not necessarily economic returns.


The third misunderstanding is that supply-side reforms and structural adjustments are the only options to improve the speed and quality of China’s economic growth. Actually, supply-side reforms involve implementing the communiqué of the Third Plenum of the 18th Party Congress, letting the market play a decisive role in resource allocation, and improving medium and long-term growth potential. Of course, in the short term, there are tasks to do, such as reducing capacity, destocking, and deleveraging, but in the long run, we must improve efficiency.


These actions do not contradict demand management. We are now in a period of economic downturn, so the actual growth rate has not reached the potential growth level. The only way to increase the economic growth rate is through demand management. In terms of methods, demand management is nothing more than monetary policy and fiscal policy. Contrary to popular belief, fiscal spending has been declining since 2012, and the savings of government agencies and institutions have risen sharply. This is a major mistake in the context of an economic downturn.


In summary, during the 13th Five-Year Plan period, the potential growth rate of the Chinese economy will remain above 6.5%. As the current growth rate is lower than this level, demand management must be carried out. The central government must instill confidence in enterprises so that entrepreneurs have good expectations. At the same time, the central government must increase the intensity of reform. If it can do this, China will be able to cross over the middle-income trap and achieve the dream of becoming a high-income country by the centennial of the country’s founding.


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Cite This Page

姚洋 (Yao Yang). "Deep Industrialization Is the Key to Crossing Over the Middle-income Trap [深入的工业化是跨越中等收入陷阱的关键]". CSIS Interpret: China, original work published in Xinhua News Agency [新华社], July 14, 2016

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