We also discussed the middle income trap because China’s lofty ambition and the optimism accompanying it, depends crucially on avoiding it, based not so much on assertion, but on sound policies. Policy is indeed the area where we begged to differ, perhaps inevitably, because this is where economics and politics intersect.

For example, in order to gauge China’s economic future, it helps to look back to see how change was managed. Cue a crusade of pragmatic reform over 3-4 decades, but many of the things done in the past were one-offs or now have limited potential. These were things like transferring labour from low productivity agriculture to higher productivity urban manufacturing, enrolling children in schools, establishing basic property rights, privatisation, building basic infrastructure, joining the WTO, creating the world’s biggest private housing market, and, importantly introducing rules-based governance and institutions. These policies paid huge dividends in the form of total factor productivity (TFP) growth, which were associated closely with the policies of reform and opening up. 

Yet, both TFP growth and the impetus of reform have stalled in recent years. TFP growth has become quite pedestrian, rising only 0.7% p.a. in the decade ending 2018. While it has held up in business, it has been flat in housing, government and infrastructure, which are precisely the sectors that have demonstrated the largest increases in the ratio of capital to output – a measure of inefficiency – and which the government has tended to rely on and pump credit into every time the economy has needed a boost, including most recently in 2020.

China’s leaders are certainly aware of these problems, all the more as they face the harshest external commercial and political environment for half a century. Their responses have been written in to the recently approved 14th Five Year Plan (2021-25), and other political, industry and technology plans beyond. At the heart lies the newly crafted Dual Circulation Strategy Ostensibly, this is a plan to underpin China’s existing external trade, supply chains and international engagement (albeit de-Americanised) while establishing a new focus on domestic production, supply chains, consumption, and self-reliance in new technologies. Stripped of the rhetoric and internal contradictions though, it is basically a Chinese version of decoupling.

To realise the domestic objectives, though, China’s leaders will have to embrace trenchant reforms to start to change the economy’s structure, and strengthen productivity growth over the medium-term. Household consumption is often referred as the focal point for future progress but sustained lifting of the consumption share of GDP has revealed a systemic problem.

To lift the consumer sector, policymakers would need to undertake extensive wealth and income redistribution, reform social welfare, tax laws, and  the urban household registration systems, and overhaul the legal and functional structures of central and local governments.  Yet, none of these things figure on the political agenda. A recent People’s Bank of China working paper on demographics argued specifically that the  high consumption rate of developed economies should not be taken up by China, which should persist with its investment focus – which is unfortunately associated with misallocation of capital, inefficiency, and growing indebtedness.

China’s predominantly domestically owned and owed debt, and its state-owned banking system suggest that it can avoid a Lehman, or Argentina or typical emerging market style crisis. Yet the authorities must balance lower growth, rising defaults and credit events, the weak funding structure of the liabilities of  many of China’s 4000 odd banks outside the big five, and the sensitivity of the financial system and balance sheets to anything but perpetually low interest rates. Addressing endemic financial instability is most likely to be reflected in slower growth, balance sheet stress, financial repression, and downward pressure on the exchange rate.

This makes for a tough backdrop against which to raise productivity growth to avoid the middle income trap. And it’s the tougher because getting trapped is essentially about the quality of for example, economic, competition, legal, regulatory and educational institutions, that allow societies to extract greater value from investment, and workers to operate at higher levels of efficiency and productivity. The new and edgier emphasis on the primacy of state institutions and the party has meant that the operating environment for the private sector is no longer as supportive of entrepreneurship and true innovation.

Turing its back on reform and opening up for a highly centralised and controlled totalitarian system may prove to be the deepest of all flaws in China’s aspirational economic model, in which reliance on innovation figures prominently. There is little question that China has shown remarkable capacity in some research-based science and engineering inventions and outcomes. Yet it lags in so-called foundational technologies that include semiconductors and integrated circuits, and in key industries such as autos and airplanes.  And with some exceptions in technology, finance and telecomms, it also lags in true innovation, which is not so much about R&D as it is about business-related activities that value know-how, an understanding of competitive markets and design, and finance and management. 

Ultimately, then, sustainability comes down to governance and institutions, and it is here that China may be found wanting.