China can overcome the middle-income trap with technological innovations

China's GDP only grew by 2.5% in the first half of 2022, likely indicating an abrupt end to years of fast growth. So what lies ahead for China in its next phase of economic development?

Setting aside short-term shocks from the pandemic and the property market crisis, the real challenge for the Chinese economy is to overcome the middle-income trap while maintaining technological progress amid the China-US confrontation.

In 2019, China's GDP per capita reached US$10,000. History tells us that a majority of economies tend to stagnate and fall into the middle-income trap once they attain this level of development. Of the economies that industrialised following the Second World War, only Israel and the Four Asian Tigers managed to increase their per capita GDP from US$10,000 to more than US$30,000. Even then, it took these economies an average of 24 years to do so and their annual economic growth dropped to 5% in the process.

Middle-income economies can no longer compete on the basis of cheap labour. Instead, they need to rely on technological innovation to sustain growth. But it is also at this point that developed countries start to view the middle-income economies as competitors, making it much more difficult for the latter to import technology.

China's situation is even more precarious. Its size and difference in ideology have brought much anxiety and unease to the US. Over the long term, China will need to innovate to develop while dealing with the immense pressure arising from its decoupling with the top technological power in the world.

Can the Chinese economy overcome the middle-income trap? Is China's decoupling with the US unavoidable? Based on the current response of the Chinese government, I am cautiously optimistic.

Firstly, China has implemented various industrial policies to seize the opportunities of the fourth industrial revolution. This has helped it to gain a competitive advantage in digital economy domains such as AI, big data, the Internet of Things, etc. Academics worldwide are recognising that unlike in traditional industries, government investments in emerging industries and cutting-edge technology can lower risks and boost entrepreneurship when appropriately deployed, helping countries lagging behind to leapfrog those in front.

Research by Peking University professor Wu Xiaoying shows that in its broadest sense, the digital economy contributed around two-thirds of China's economic growth in the last two decades, attesting to the efficacy of such policies.

China's industrial policies have always come under strong criticism from the US. Intriguingly, in recent years, the US, Europe and Japan have made more public investments in critical and emerging technologies to counter China. For example, the CHIPS and Science Act of 2022 by the Biden administration will provide up to US$52 billion in subsidies to the US semiconductor industry. In a departure from convention, leading companies in the industry will receive direct subsidies from the US government.

Next, as it becomes harder for China to bring in new technology from abroad, adopting foreign approaches will become the main driver of progress for the Chinese technology industry. It is generally believed that the Chinese way of making innovation a national undertaking differs greatly from what the rest of the world is doing.

In fact, many adaptations from developed markets can be observed in the Chinese way. For example, in basic research, top Chinese universities and research institutions have borrowed heavily from US practices such as having the pre-tenure track and chief scientist position. In the manufacturing sector, the high profile technologically advanced small and medium-sized enterprises (专精特新企业) scheme draws on what Japan and Germany are doing. As for the innovation consortium (创新联合体) tasked with developing generic industrial technology, their roots can be traced back to the innovation alliances in developed countries that develop crucial semiconductor expertise.

Third, even though its conflicts with the US continue to escalate, the Chinese government is still doing its best to improve the domestic business environment to attract multinational companies. This also gives it unhindered access to learn from these companies that are part of global value chains.

According to a survey by the American Chamber of Commerce in China, the proportion of American companies indicating that the business environment in China had improved, increased from 24% in 2016 to 50% in 2020. Over the same time period, the respondents also felt that problems such as competitive neutrality, protection of intellectual property and forced technology transfer have improved by varying degrees.

The above-mentioned points show the efforts made by the Chinese government in using innovation to drive further national development and avoid the middle-income trap. This has resulted in the economic and innovation system of both China and the US becoming more alike.

Successful implementation by China has, in turn, led developed countries to borrow from its approach. Putting these factors together, Nobel Prize-winning Dutch economist Jan Tinbergen and Professor Cui Zhiyuan of Tsinghua University each pointed out the phenomenon of "institutional convergence".

It may well be that in time to come, common values are needed to maintain the global division of labour, but a certain amount of institutional convergence can ensure that in terms of the economy and innovation, the values of both China and the US do not become grossly misaligned, and decoupling is limited.

If that is the case, barring a black swan event, both countries will then maintain a long-term relationship of competition and cooperation, competing yet learning from each other. In all likelihood, it may be against this backdrop that the Chinese economy narrowly avoids the middle-income trap.

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