China Economy 2025: Eluding the Middle Income Trap

This chapter is part of the China Forecast 2025 report – read the Foreword and download the PDF here.

Our call:

• By 2025, Beijing will have had little choice but to reform its way out of challenges that result in a Chinese economy that will likely become more open, balanced, and efficient.
• China faces one of the most daunting external environments in decades, which ironically will likely push Beijing to further embrace foreign direct investment (FDI) and improve the business environment.
• On the domestic front, China’s “internal circulation” agenda will be less about self-reliance but focus on improving productivity and inducing more local competition, while keeping a lid on financial risk.
• The pursuit of reform priorities means that at the end of the 14th Five-Year Plan (FYP, 2020-2025), China will likely have eluded the “middle-income trap” and become a near-majority middle-class country.

Key assumptions:

1. Beijing will relearn some of the lessons from Deng Xiaoping by moderating its approach that balances improving its economic relationships abroad while improving its business and investment climate at home.
2. Beijing will continue to be hawkish on local finances as its main tool to induce reforms and local competition by forcing them to operate in a resource-constrained environment.

Leading indicators:

1. Sustained increases in FDI flows and portfolio investment for consecutive years, while annual surveys of foreign businesses in China show continued improvement and confidence in the business climate.
2. Local debt/GDP ratio stabilizes over the next few years.
3. Surpassing the high-income country threshold as defined by
   the World Bank (~$13,000 GNI per capita). 

Base Case (70%)

From the vantage point of 2020, the Chinese economy is under considerable strain, both externally and internally. First, China has bungled its relationship with a number of G20 economies that have repercussions for market access. Second, China faces a slew of legacy problems and secular trends that constrain growth, ranging from local debt and an aging population to a less competitive business environment. 

These challenges are not intractable, but overcoming them will require Beijing to adapt its current approach to managing both the external environment and domestic reforms. Skepticism abound over the prospects of reform, but our base case is one in which China reforms its way out of current challenges. 

This certainly seems at odds with present trends, but it is premised on Beijing’s renewed emphasis on economic security as a result of its assessment of the external environment. That is the single most important variable that has changed significantly over the last few years and that will remain challenging for the foreseeable future. Yet it is precisely because of this pressure that the prospect of meaningful changes in the Chinese economy is more likely than it has been in nearly a decade.

These changes center on three key issues: 1) further openings to foreign investment to stabilize the external environment; 2) domestic reforms to improve the business climate; and 3) prioritizing the expansion of the middle class to bolster domestic consumption. In fact, these will likely be the defining themes in the 14th FYP that takes China through 2025 and that will set a foundation for the next two FYPs through 2035, a crucial year for meeting Xi Jinping’s national rejuvenation objective.

Analysis:

1. More Openness to Stabilize External Environment

For all the talk of China’s inward turn, it actually remains a relatively open economy, which means that it is especially sensitive to volatility in the external environment (see Figure 1). The Chinese economy still depends on global markets for demand, technologies, and capital. Yet it is currently facing a confluence of factors: anemic global economic recovery as a result of the pandemic, the rapid deterioration in market access of advanced economies, and continued decoupling of technology supply chains. 

Figure 1. Exports Matter Much More to China Than To the US (% of GDP)
Source: Wind.

The search for organic demand isn’t exclusive to China, and it should be able to withstand the near-term impact on exports. More crucial over the next few years is China’s access to markets and technology, which are becoming constrained as tensions with the United States and other major economies mount. Since value-added manufacturing and technology sectors are integral to China’s future economic development, current dynamics, if left unattended, could seriously dampen that future. This would in turn undermine Xi’s “national rejuvenation” objective, which is largely defined in economic terms.

Beijing’s latest concept of “internal circulation” has been interpreted as its attempt to offset external volatility by closing itself off. But that would be disastrous for the economy. For example, Huawei has recently admitted that Washington’s latest ban has effectively crippled its development of advanced chips. Moreover, when it comes to cross-border financial transactions, China will continue to rely on the SWIFT system, which cannot be replaced by a domestic alternative. 

Even if China can achieve marginally more technology independence over the next five years (see technology base case), it simply cannot quit global capital. This is because China is increasingly reliant on foreign portfolio inflows to balance its financial account (see Figure 2). If foreign capital senses that China is untethering itself from global markets, capital inflows will quickly dry up as investors swiftly exit. Capital flight of such proportions would create a currency crisis that dwarfs the 2015-2016 episode. These considerations impose limits on the extent of Beijing’s inward turn.

Figure 2. China Is Increasingly Reliant on Foreign Portfolio Inflows ($ billion)
Source: State Administration of Foreign Exchange.

Instead, Beijing will likely respond by making the China market much more open in order to prevent what could become a wholesale isolation of the Chinese economy. Although cognizant of the fact that a return to the old normal before 2016 isn’t likely, Beijing’s wants to arrest the rapid deterioration in the external environment. A stable external environment was a necessary ingredient in China’s remarkable growth over three decades and the main purpose of Deng’s “hide and bide” principle. 

Embracing FDI can help China build significant foreign stakeholders in the Chinese economy that can serve as a counterweight to conflicts in other geopolitical arenas that are less amenable to immediate solutions. This is likely a reason behind accelerated talks on a possible EU-China investment treaty.

While Beijing may well be relearning some of Deng’s lessons, China is also learning its own lessons on the long-term cost of protectionism. In sectors such as financial services and automotives, instead of nurturing globally competitive firms, protectionism has instead led to rampant rent-seeking and resulted in less competitive industries. Curtailing the negative effects of protectionism was likely a key reason behind Beijing’s decision to further open both the financial services and the auto sectors, even amid the US-China trade war.  

Openness, on the other hand, has been a crucial contributor to competitiveness in the Chinese economy. In many sectors, companies tend to rely more on their incumbency and local protection, rather than innovation, to maintain their market share. Foreign competition can bring that needed “gaiatsu” (foreign pressure) to raise the game of domestic firms and create a more competitive environment overall. Therefore, the push for openness is more aligned with domestic considerations and serves China’s own interest, making it more likely in the current environment.

Since protection of domestic firms has been a major source of unfair competition, the State Council has already rolled out policies for creating a more level playing field, emphasizing the protection of intellectual property. Beijing wants Chinese firms to catch up with the global frontier, and openness predicated on fair competition is the only way to credibly do so. The market entry of Tesla as a wholly foreign-owned enterprise fits with this approach.

2. Reform Execution Will Surprise on the Upside

More openness, however, seems to be at odds with “internal circulation.” But the concept, much like “supply-side structural reforms,” is more of a repackaging of reforms that, if executed well, will make China more productive and more competitive. This is because unlike short-term demand that can be boosted through stimulus, sustained domestic demand over the long term depends on organic growth. That kind of virtuous growth requires productivity enhancements, of which market competition and a healthy business environment are indispensable

As a result, internal circulation actually complements openness because relying on the size of China’s market alone is no longer sufficient to attract significant FDI. Foreign investors need and expect more assurances on an improving business environment and fair competition—both of which require reforms to achieve. Notable pessimism on reform progress over the last decade has been justified, in large part because reforms resided more in rhetoric than action. But our base case expects much better performance on reform execution over the next five years.

That expectation hinges on a main factor: the central government’s “decoupling” from local governments. That is, local governments will be forced to confront hard budget constraints as Beijing remains hawkish on containing local debt and continues to cut off various borrowing and financing channels (see MacroPolo’s local government debt product).  

This strategy of forcing local governments to operate in a resource-constrained environment means that they will need to seriously reform, rather than borrow and spend, their way out of economic challenges. Out of constraints usually emerge more resourcefulness, which is what Beijing intends. For local governments, competition will intensify across numerous dimensions, chief among them human capital. 

As the size of China’s labor force continues to shrink, ever fiercer competition among cities and regions for human capital, particularly skilled labor, will lead to more relaxation of the hukou system. With the exception of a few first-tier cities, most Chinese cities have de facto abandoned hukou requirements for college graduates so they can permanently settle. 

These expected changes will also benefit skilled blue-collar migrant workers. Being able to settle down in a city removes a significant factor of instability for migrants, many of whom end up returning to their hometowns in their 40s. Being able to live more permanently in cities will improve the lifetime income of migrants because urban wages are higher and can alleviate some of China’s labor shortage pressures.

Attracting skilled workers is one thing, more opportunities and career prospects will need to be created at the same time to ensure that they stay. This means cities also need to compete harder to lure the most promising businesses into the local economy, including foreign investors. The local business environment matters greatly in such competition, which could actually lead to a “race to the top” on creating incentives and pro-business regulations that better ensure fair competition.

In essence, Beijing no longer wants, nor can it afford, to subsidize economic development as extensively as it did for decades. Instead, it will prioritize subsidizing public goods and social services to support quality of life improvements and to adapt to massive demographic shifts. As such, the central government is tightening its purse strings to allow competition and market factors to determine the fate of local economies. As a result, investment, industry, and human capital will increasingly agglomerate to more productive regions, and those that fail to improve their business environment will become laggards in this competition. 

Controlling the purse strings, however, does not mean Beijing intends to micromanage local development. To execute these reforms necessarily entails a healthy dose of local experimentation. Beijing will be careful to not stifle the well-known entrepreneurialism of local governments. It has simply defined more clearly where local governments cannot color outside the lines. For instance, Beijing will not tolerate more corrupt and rent-seeking behavior, but it has also explicitly stated that local officials will not be punished for the negative consequences of experiments as long as they’re conducted above-board to earnestly support development. 

The end of business as usual for local governments will be a painful process, but it is also necessary to get meaningful progress on reforms. This is fundamentally how China’s growth model changes. 

3. Eluding the Middle-Income Trap: Creating a Large Middle Class

Along with progress on reforms, China by 2025 will likely become a near-majority middle-class country and by implication, a much more consumption-driven economy. 

Beijing has long believed a sizeable middle class is integral to China’s development. According to China’s official income bracket definitions, “middle income” is defined as a monthly per capita income of more than 2,000 yuan (~$290)/month. In other words, a four-person household requires an annual income of at least 96,000 yuan (~$13,500) to be considered middle class. As of 2019, only 31% of the population, or 430 million, qualify as middle income or above (see Figure 3). 

Figure 3. Fewer Than One-Third of Chinese Considered
Middle Class
Source: Wan Haiyuan & Meng Fanqiang (2020).

Raising incomes has been China’s longstanding goal, and the first phase of it was focused on poverty elimination, a goal that Beijing will have achieved by the end of 2020. The next cohort that China will focus on is likely the 600 million low-income citizens that still live on less than 1,000 yuan (~$150)/month, according to Premier Li Keqiang. 

Bringing this income group into the middle class will require an emphasis on income redistribution to households, which will likely be a focus in the next FYP cycle through 2025. To do so, Beijing can rely on two main policy instruments: rationalizing the property market and forcing income transfers. 

Property ownership is crucial for raising the income of rural residents. Currently, many types of property are owned by the rural collective, including township and village enterprises, which are a legacy of early reforms. Although rural residents have nominal ownership over these assets, most of them don’t receive many benefits from the assets. 

But the trend is moving in a positive direction. Rural property ownership has been more clearly defined, ownership certificates have been issued, and rural residents now have greater freedom to cash out from their land by either renting it out or leasing it long term. These changes will allow rural residents greater control over these assets and generate income from them.

For low-income urban residents, direct income transfers will be necessary. China has not performed well so far on redistributing income from corporates to households (see Figure 4). This is largely a result of China’s growth model over the last 20 years—the government used taxes from corporates to finance massive investments rather than transfers to households.

Figure 4. Net Income Transfers to Households Have Been Negligible (% of GDP)
Source: Wind.

But as China’s growth model shifts gears, so too will the balance between investment and income transfers. For one, there’s simply less need for investment in the economy and therefore fewer excuses to not focus on household transfers. After all, Chinese people are effectively the shareholders of state-owned enterprises (SOEs), and for years they have received almost zero dividends.

Assuming the policy priorities detailed above are executed, combined with the effect of organic income growth, it’s likely that hundreds of millions will enter into the middle class by 2025. Breaking this down, currently 12.3% of the Chinese population live on 1,500-2,000 yuan ($210-$290)/month and 17% of the population live on 1,000-1,500 yuan ($140-$210)/month. The vast majority of the former income group is expected to reach middle income by 2025, while at least one-third of the latter income group should also have a decent shot at making it with the help of pro-income policies and organic growth. 

This means that an additional 17% of the Chinese population, or roughly 240 million, should reach middle income by 2025, bringing the total size to roughly 650 million. That means for the first time in China’s modern history, nearly half the population will be middle class or above.

Secondary Scenario (30%)

Although the base case has a high probability of materializing, a confluence of several factors and political risks will lead to a scenario in which China regresses on both opening and domestic reforms. 

For one, Beijing’s efforts on opening and creating a better business climate may find little reception among OECD countries, as they do not find Beijing’s overtures sincere. A frustrated Beijing will instead concentrate its efforts on consolidating relations with emerging markets, making it less necessary to maintain openness and attract FDI. 

In addition, Beijing could veer too far in pursuit of technology independence and expand protections beyond specific vulnerabilities such as semiconductors to cover all high-tech industries. This would naturally accelerate the pace of technology decoupling with OECD countries and directly undermine openness efforts. Finally, OECD countries may turn inward and focus on their domestic challenges in the post-Covid era. This will lessen the pressure on Beijing and buy it more time to kick the can down the road when it comes to openness. 

The execution of domestic reforms hinge on continuity in local debt containment and fiscal prudence. But two political risks associated with the outcomes of the 20th Party Congress in 2022 could undermine this condition and disrupt the continuity. The first centers on personnel changes and the second on central-local dynamics. 

On personnel, the key risk is the replacement of Vice Premier Liu He, who will be 70-years old in 2022 and is expected to retire in accordance with the age limit norm. In addition to the key portfolio he holds on US-China and SOEs, Liu has held the line on tackling debt throughout Xi’s second term. His departure could mean less emphasis on deleveraging and more lax oversight of local governments’ financing activities. This will especially be the case if Guo Shuqing, who is now the second most powerful finance official and aligned with Liu on debt containment, fails to get Liu’s job. 

On central-local dynamics, the post-20th Party Congress landscape could usher in a political rebalancing that restores power to local governments. More powerful local governments would make Beijing’s efforts to deleverage and de-risk the financial system much less likely to succeed. Removing this constraint on local finances would likely mean a return to business-as-usual for local governments, thereby eroding the key condition for reforms and market competition to take hold.

Houze Song is a research fellow at MacroPolo. You can find his work on the economy, local finance, and other topics here.