Can China make the leap to a high-income future?

“What if this is ‘as good as it gets’?” Jack Nicholson asks, as he walks through his psychiatrist’s waiting room in the eponymous film. At the recent meeting of G-20 finance ministers in Shanghai, participants were asking much the same question – and not just with regard to medium-term expectations of weak global growth. Many are now wondering whether China’s current growth rate will be as good as it gets for a long time to come.

Determining the validity of such fears requires understanding what is driving China’s economic slowdown. Some offer a straightforward explanation: China, along with other major emerging economies, has become ensnared in the dreaded “middle-income trap,” unable to break through to advanced-economy status. But this assumes that some exogenous force or tendency causes countries to become “stuck” at a particular income level – a view that one academic study after another has debunked.

To be sure, countries do often struggle to achieve high-income status. According to the World Bank, only 13 of 101 countries classified as middle income in 1960 had reached high-income status in 2008. Moreover, some middle-income countries, after promising growth, spent decades “trapped” at a certain per capita income level. Argentina, for example, kept pace with the United States in per capita income growth from 1870 to 1940; since then, the gap has been widening steadily. In this manner, even countries that make it to high-income status sometimes regress to middle-income levels.

But there is no historical necessity that dictates that countries get stuck at particular levels of income. On the contrary, studies suggest that fast-growing low-income economies are also likely to become fast-growing middle-income economies, and ultimately to graduate to high-income status. If an economy gets stuck, it is because it has failed to adjust, as the basis for growth changes. And, in fact, the lack of capacity for self-transformation normally would have been visible at low-income levels, too.

What, exactly, does the needed adjustment entail? While the specifics vary across countries, the innovation-focused Neo-Schumpeterian growth theory, proposed by the economists Philippe Aghion and Peter Howitt, offers some important insights.

Aghion and Howitt view innovation as any change that leads to the introduction of new products or processes in the market where a firm operates. Countries far from the world technology frontier are better off imitating existing technologies and adapting them to local conditions, but over time such countries must improve their capacity for innovation. Studies have also shown a positive link between innovation and social mobility, and even between innovation and income inequality.

Central to the innovation-focused perspective is the notion that economic growth requires technology transfers and an environment in which new firms can form, grow, and exit (thereby reallocating factors of production to more successful firms). Quality of management obviously plays a key role, but institutions and human capital also matter; corruption, credit constraints, and lack of access to high-quality education all make economic transformation more difficult.

But fostering innovation is not a silver bullet. While providing returns to innovators can help to spur more innovation, it can also allow businesspeople to capture too large a share of the transformation process. For example, whereas Bill Gates has probably been good for economic transformation, the Mexican telecoms billionaire Carlos Slim has not. Encouraging one kind of innovator could easily give rise to the other.

What does all this mean for China? As the country attempts to create the conditions for greater genuine innovation, it must also address myriad short-term challenges. It is caught in a deflationary spiral, with falling prices and increased anxiety over the economy’s prospects reinforcing each other. And excessive lending to the corporate sector, particularly in manufacturing, has led to massive excess capacity and a growing mountain of bad debt, suppressing growth.

Compounding the challenge, China’s economy is more globally relevant and interconnected than ever before, which means that any action it takes can have far-reaching effects. With tried and tested policies unlikely to work in this new context, the government is having to improvise. And, as anxious markets clearly recognize, that approach carries the potential for policy mistakes.

Nonetheless, there is good reason to believe that China can succeed, given that the country’s economic history indicates an impressive capacity for transformation. Of course, China’s economy has come a long way since Deng Xiaoping initiated the policy of reform and opening up in 1978. But even in more recent years, the skill content in China’s output has improved radically, and resources have been successfully transferred from agriculture to the services sector, rather than to the manufacturing sector, where large state-owned firms still dominate many industries.

If the recent research debunking the middle-income trap is correct, China – one of history’s most miraculous growth stories – has a very good chance of succeeding in the transition to high-income status with similar vigor. The underlying structural changes that have occurred in China in recent years reinforce this optimism. China will need to continue reforms and overcome vested interests, particularly in the state-owned sector, but its chances of success remain high.