China’s Ensnared in the Middle-Income Trap

China has fallen victim to what economists call the middle-income trap. Economists consider a low-income country to have around $5,000 annual income per capita. Middle-income countries have between $8,000 and $15,000 annual income per capita. High-income countries begin at around $20,000 annual income per capita.

China’s per capita annual income is $12,970 — solidly in the middle income category. By the way, in the U.S. it’s $75,180, among the highest in the world (second to Switzerland).

Due to China’s extreme income inequality, it is more useful to think of China as having two populations. One population of about 500 million urban workers has an annual per capita income of about $28,000, while a second population of about 900 million villagers has an annual per capita income of about $5,000.

That would put the 900 million villagers solidly in the lower income category, not even close to middle income. And there is extreme income inequality within the 500 million high-income groups such that most of those would have a middle income of about $12,000 per year, while a select few would be earning millions of dollars per year each.

China is predominately a low-income country with a significant middle-income cohort and a tiny slice of the super-rich. This income inequality makes China’s climb out of the middle-income ranks even more difficult. And the super-elite cohort is a potential source of social unrest among the less well-off.

The conventional wisdom is that the rise from low-income to middle-income status is fairly straightforward. You begin by moving tens of millions (or in China’s case, hundreds of millions) of people from rural villages to cities. You provide decent if spartan housing, public transportation, and attract foreign direct investment to build manufacturing plants.

With some training, the city residents become adept at assembly-style manufacturing. Low labor costs allow goods to be assembled cheaply and exported at attractive prices. The cycle feeds on itself with more migration, more direct foreign investment, and expanded manufacturing capacity. Per capita income rises from the low to middle-income range.

But to make it to the big leagues of high-income status, you need high technology applied to high-value-added innovation and manufacturing. China lacks this. China advocates seem impressed that 90% of our iPhones come from China. That’s true, but Chinese value-added is only about 6%. If an iPhone costs $1,000, only about $60 goes to China’s net of import costs and royalties.

In fact,very few countries (excluding OPEC members) have ever made this leap from middle-income to high-income. The only examples in Asia are Japan, South Korea, Hong Kong, Taiwan, and Singapore.

This list leaves many more countries (Malaysia, India, Turkey, Thailand, Brazil, Mexico, Argentina, Russia, Chile, and others) stuck in the middle-income trap with China.

High growth from a starting point of low-income to middle-income is not surprising and should be expected. It’s not a “miracle.” It’s just what happens when you clamp down on corruption, build enough infrastructure, and move millions from the country to the city. China’s done that.

The key variable in forecasting Chinese growth in the years ahead is therefore technology. Can China not merely license foreign technology (at a high cost), but develop its own technology ahead of advanced-economy competitors?

The outlook here is not good for China.

They have shown little or no capacity to invent or produce in areas such as advanced semiconductors, high-capacity aircraft, medical diagnostics, nuclear reactors, 3D printing, AI, water purification, and virtual reality.

Projects that China has on display that are advanced (such as their bullet trains that run quietly at 310 kph) are done with technology licensed from Germany or France or are done with stolen technology. China has done little innovation on its own.

But the stolen technology channel is being shut down by bans on advanced semiconductor exports to China, and sanctions on the use of 5G systems from Huawei, for example.

On top of all that, China faces powerful economic headwinds in the form of excessive debt, adverse demographics, collapsing real estate markets, and a lack of oil and natural gas reserves. The country is also trying to reopen from its pandemic failures at a time when the world may be entering another global recession worse than 2008.

China also faces powerful geopolitical headwinds as a result of its genocide against the Uyghur minority, involuntary organ harvesting from political prisoners, concentration camps, female infanticide (over 20 million baby girls killed), suppression of religion, censorship, social credit scores, house arrests, and expropriation from entrepreneurs like Jack Ma of Alibaba Group.

Above all, China is handicapped by its return to Mao-style Communism under the leadership of the new Emperor for Life, Comrade Xi Jinping.

Xi has largely abandoned the relatively open economic policies of Deng Xiaoping, which prevailed from 1992 to 2007 under the leadership of Deng’s successors Jiang Zemin and Hu Jintao, with an updated version of Mao’s policies which place the Communist Party and its “core leader” at the center of all decision making and economic direction.

China’s economic headwinds can be summed up in three words — debt, demographics, and decoupling.

There is substantial empirical evidence that national debt to-GDP ratios in excess of 90% result in slower growth. It’s tough to precisely determine China’s, but its debt-to-GDP ratio is probably about 350%.

This problem is exacerbated in China by the fact that much of the debt is not spent productively. I have visited construction projects in the countryside of China where entire cities visible to the horizon were being built from the ground up.

Along with the cities were airports, highways, golf courses, convention centers, and other amenities. It was all empty. None of the buildings were occupied except by a handful of show tenants. Promises of future tenants rang hollow. The construction did create jobs and purchases of materials for a few years, but the debt-financed infrastructure was completely wasted.

The only ways out of a debt trap of the kind China has constructed are default, debt restructuring or inflation. The last two are just different kinds of defaults. The situation does not necessarily resolve itself quickly. The debt burden can persist for years. Just don’t expect robust growth while it persists.

China’s birth rate is now below what is called the replacement rate. That rate is 2.1 children per couple. China’s current rate is reportedly about 1.6, but some analysts say that the actual rate is 1.0 or even lower. At that rate, China’s population will shrink from 1.4 billion to about 800 million in the next 70 years.

That’s a loss of 600 million people in a single lifetime.

If you assume productivity will remain constant (a reasonable assumption if China fails the high-tech transition), and the population drops by 40%, then it follows that the economy will shrink by 40% or more. That’s the greatest economic collapse in the history of the world.

In all, the pandemic, demographics, debt, decoupling, technology, and global recession should negatively impact Chinese growth in the years ahead. This growth story inevitably bleeds into geopolitics in terms of a potential invasion of Taiwan and war in the South China Sea.

It is no doubt the greatest economic and geopolitical drama playing out in the world today with important implications for all investors.

The Daily Reckoning