The Republic of Korea and Taiwan are the only economies of appreciable size to have transformed themselves from low-income to high-income status inside two generations. China has already matched, if not surpassed, the speed of the earlier part of these two far smaller economies’ journey. The biggest question, not only in global economics but arguably also in world politics, is whether China will finish what it has successfully begun, or crash along the way. The answer is that the obstacles ahead are formidable. China might overcome them. But it is also imaginable that it will fail to do so, or, at least, that the journey will take longer and be more difficult than many now imagine.

The stakes are very high. If China were to succeed even partially, its economy would be bigger than those of the United States and the European Union combined. If its political system were to remain largely unchanged, the world’s largest high-income country would then not be a democracy, unlike all the others. This would partially reverse the triumph of liberal democracy, hailed at the end of the Cold War.¹

The journey that lies ahead for China is to become a high-income society. Other societies have achieved prosperity merely by exporting valuable commodities. But that is not development. It is also not a path open to China. While China has used—indeed, abused—its endowment of natural resources, particularly water, air and fossil fuels, during its period rapid economic growth, these resources have always been far too limited to generate even temporary prosperity for so huge a country. Indeed, the abuse of its resources is now creating significant challenges of environmental degradation.

As was true of South Korea and Taiwan (and Japan before them), China’s most valuable resource is its hard-working, increasingly well-educated and enterprising people. In the course of their development, the other East Asian economies transformed the structure, sophistication, and size of their economies and, in the process, the quality of the labor force itself. This has also been China’s path.

Hong Kong and Singapore managed to do much the same thing. But they are just city-states, with populations of seven and five million, respectively. South Korea, with fifty million people, and Taiwan, with 23 million, had to manage the challenges of urbanization in much the same way as China. With a population of 1.4 billion, China is in another class altogether. Indeed, in respect of size, only India is comparable. But from the economic point of view, what China has achieved since 1978 can indeed be compared with what South Korea achieved after its reforms in the early 1960s. Yet it is also important to note one possibly decisive difference: Western powers, notably the United States, wanted South Korea and Taiwan (and Japan and West Germany before them) to succeed because they were dependencies and allies during the Cold War. The West is far more ambivalent, if not yet determinedly hostile, to China’s ambitions.

So, what is the journey that lies ahead? What are the main obstacles in China’s way? What might its leaders do in response?

The Journey Ahead

The best measure of the standard of living generated by an economy is gross domestic product at purchasing power parity.² Relative GDP per head at purchasing power parity is also the best available indicator of opportunities to raise living standards by catching up on the productivity levels in more advanced economies. As the most productive of the large economies since the late 19^th century, the United States has long been the benchmark. In 1962, South Korea’s real GDP per head (at PPP) was a little under 10 percent of U.S. levels (see figure 1). Just over fifty years later, it had risen to close to 70 percent. At that point, South Korea’s GDP per head had also caught up with Japan’s, whose relative GDP per head had been falling since the early 1990s.

Figure 1

South Korea’s real GDP per head rose at a trend rate of just over 6 percent a year between 1962 and 2015. But this should be divided between the era of ultra-high growth between 1962 and 1997, when real GDP per head rose at a trend annual rate of just over 7 percent, and the era of merely fast growth between 1998 and 2015, when real GDP per head rose at a trend rate of 4 percent. The dividing line between these two periods was the Asian financial crisis. As is often the case with such crises, this marked a turn for the worse in South Korea’s growth rate.

Since the policy of “reform and opening up” began under Deng Xiaoping in 1978, China’s GDP per head at PPP is estimated to have risen from just 3 percent of U.S. levels to 25 percent. In 1978, China was not only relatively far poorer than South Korea had been in the early 1960s, when the latter’s reforms began; it was even absolutely poorer: China’s real GDP per head in 1978 was half that of South Korea in 1962. It took a quarter of a century of fast growth before China’s real GDP per head reached the same position, relative to the U.S. economy, as South Korea already enjoyed in 1962. It took another 13 years for China’s GDP per head to reach a quarter of U.S. levels, which South Korea achieved in the mid-1980s. Between 1978 and 2015, China’s real GDP per head rose at a trend rate of 7.5 percent, slightly faster than in South Korea between 1962 and 1997.

In absolute terms, however, China became as rich as today’s South Korea already in the early 1990s. The fact that U.S. GDP per head itself continues to rise explains the difference between China’s relative and absolute performances. China is chasing a moving target. Opportunities are increasing as more new ideas are put into practice in the world’s most advanced economies. This means that, over time, a given income per head, relative to the U.S. economy, implies a higher absolute income.

If China were to match South Korea’s success in catching up on U.S. GDP per head, after the latter’s GDP per head reached a quarter of U.S. levels, it would take China roughly another three decades. Because China started off relatively (and absolutely) much poorer than South Korea, it would then have taken seventy years to achieve what South Korea managed in a little more than half a century.

Obstacles to Completing the Journey

This is certainly an imaginable future. But it is also an unlikely one (though certainly not inconceivable), because China confronts at least five interconnected obstacles to continued progress. Some of these obstacles threaten to slow China’s growth sharply.

First, under relatively conservative assumptions about the prospective growth of U.S. real GDP per head (about 1 percent a year), achieving what South Korea did would imply growth of more than 4 percent a year in real GDP per head over another three decades. Regardless of past performance, it’s questionable whether China can sustain such a high rate of economic growth.

In an important recent piece, Lant Pritchett and Lawrence Summers of Harvard University conclude: “History teaches that abnormally rapid growth is rarely persistent, even though economic forecasts invariably extrapolate recent growth. Indeed, regression to the mean is the empirically most salient feature of economic growth.”³ In simpler terms, this means that it is far more likely than not that fast growth will slow toward the world average. Such slowdowns have been very common. Indeed, South Korea’s performance was quite extraordinary, as China’s has been, at least so far. One must not casually assume that the extraordinary will continue. That hope has delivered many a disappointment. Moreover, the rapid ageing of the Chinese population will make sustaining high growth of GDP per head even more difficult, since its population of working age is set to grow significantly more slowly than its overall population.

Second, if China were to achieve the envisaged growth, its economy would also expand roughly five-fold over the next generation. Given the already huge economic size and limited domestic resources of China, this would put substantial strain on the world’s environmental and economic “carrying capacity.” China’s population is, after all, substantially larger than that of all of today’s high-income countries combined. One must imagine huge improvements in the supply and use of scarce natural resources, not just by China, but by the rest of the world too. At some unpredictable point, environmental constraints might assert themselves. This might not halt economic growth, but it could slow it substantially relative to what small countries such as South Korea have been able to achieve.

Another set of constraints could be the capacity to accommodate such a huge shift in relative economic and geopolitical weight. All sorts of stresses would emerge in China’s relations with neighbors, in its relations with other powers, in the absorptive capacity of world markets, in the global monetary and financial systems, and in global institutions. In the past, such huge shifts in relative power have destabilized the world with devastating results, at least in the medium term.

Third, it is unwise to assume that China will remain politically stable or, if it does, that it will achieve the improvements in the quality of governance needed by a sophisticated high-income economy. Professors Pritchett and Summers note, pointedly, that “salient characteristics of China—high levels of state control and corruption along with high measures of authoritarian rule—make a discontinuous decline in growth even more likely than general experience would suggest.”

Unlike all other high-income countries, China is extremely authoritarian. South Korea was also authoritarian (though not communist, of course) at roughly the same point in its economic development as China is today. But South Korea changed in the late 1980s and 1990s. The resultant upheaval was substantial. Something similar might lie ahead for China. Xi Jinping’s current crackdown, including his anti-corruption campaign, suggests that he fears such a possibility. But his actions—including the fear he must be generating among millions of officials—might prove counterproductive, and even bring about the instability he fears.

China’s governance indicators also fall far short of what would be expected of a high-income country. According to the World Bank, the country ranks in the fifth percentile of all countries (from the bottom) in voice and accountability, in the thirtieth percentile in political stability and absence of violence, in the 66^th percentile in government effectiveness, in the 45^th percentile in regulatory quality, in the 43^rd percentile in the rule of law, and in the 47^th percentile in control of corruption. Except in voice and accountability, this record is far from poor. But South Korea, in contrast, is now in the 69^th percentile in voice and accountability, 54^th percentile in political stability and absence of violence, 87^th percentile in government effectiveness, 84^th percentile in regulatory quality, 81^st percentile in rule of law and 87^th percentile in control of corruption.

In sum, China needs a great deal of improvement in governance if it is to sustain high levels of economic growth over an extended period. It is doubtful whether any country in which the Communist Party rules as an absolute sovereign can achieve the necessary improvements. Certainly, this has not happened anywhere else. That is why communism collapsed in so many countries in the late 1980s and early 1990s.

Moreover, a serious slowdown in growth might well catalyze political unrest, instability, and then a crackdown. The suppression of the Tiananmen Square protest worked, at least from the economic point of view, in 1989. But it is far from clear that such a policy would work as well now. China’s current opportunities are very different. It now has a far more advanced and internationally engaged economy, dependent on rapidly rising technological and economic sophistication.

Fourth, China is either at or close to the “Lewis turning point,” at which the labor market starts to tighten as the pool of underemployed rural labor dries up. The sharpness of this turning point is likely to be exacerbated in China’s case by the effects of the longstanding (and only recently modified) one-child policy.

The Lewis turning point is named after the Nobel-laureate economist Arthur Lewis, who thought the pattern of economic development should be analyzed in relation to the abundance of surplus agricultural labor. Before the surplus disappears, real wages will be stagnant and growth will be driven to a significant extent by increased employment. After the surplus disappears, growth of employment will necessarily slow, real wages will rise rapidly, profitability will be squeezed and economic growth will become more dependent on investment and innovation and less on the continued transfer of surplus labor from low-productivity agriculture to high-productivity urban activities.

Whether China has already passed the Lewis turning point is open to debate, since its rural population is still almost half of the total (according to World Bank figures). But China already shows two symptoms of having passed that point. First, real wages have been rising rapidly since the turn of the millennium.⁴ Second, the trend rate of real economic growth has slowed sharply toward 7 percent (and probably even less, in reality) since 2012. While this is still fast growth, it is well below the previous rate of 10 percent a year or more (See figure 2). Xi Jinping even talks of a “new normal.” But getting smoothly from the old normal of 10 percent growth and cheap labor to a new normal of 6.5 percent growth (or less) and ever-more expensive labor is tricky. When a bicycle slows, it becomes more likely to topple over.

Figure 2

Fifth and most pressing, the economy now attempting to make this transition is, in the words of former Premier Wen Jiabao, “unstable, unbalanced, uncoordinated and unsustainable.” But the problems in this regard are much greater than when Mr. Wen first said this, about a decade ago. While he talked about the unbalanced economy, Mr. Wen’s government allowed the imbalances to grow further right up to the end of his term in 2012. These imbalances are far greater than in other East Asian economies, such as Japan or South Korea, at comparable stages of development.

There exist at least three significant dimensions to China’s lack of economic balance: Its growth has become far too reliant on investment; its internal debt has grown unsustainably fast; and its national (not just household) savings rate is far too high to be absorbed productively at home. Let us consider each of these imbalances.

The most important fact about China’s current pattern of growth is its dependence on investment as a source of supply and demand. This has been particularly true since 2000. Since then the share of gross capital formation in GDP rose from 35 percent—not an exceptional level for a fast-growing east Asian economy—to almost 50 percent, which is far higher than during the periods of fast growth of Japan and South Korea (see figure 3). This extraordinarily high rate of investment has implications for both demand and supply.

Figure 3

With regard to supply, analysis by the U.S.-based Conference Board (Total Economy Database) shows that additional capital has been almost the sole source of additional supply potential since 2011. The contribution of the growth of “total factor productivity,” which measures the change in output per unit of inputs (and is, accordingly, a measure of innovation), has fallen to nearly zero. The contribution from labor supply (both quantity and quality) has also been negligible (see figure 4). Inevitably, with the investment rate rising and the rate of economic growth falling, returns on investment have declined on average and, without doubt, far more rapidly still at the margin, almost certainly to negative levels. The “incremental capital output ratio,” a measure of the additional output generated by a given level of investment, has risen from about 3.5 in the late 1990s to close to seven in recent years. Thus, investment’s ability to generate additional GDP has halved over this period.

Figure 4

Daniel Gros of the Brussels-based Centre for European Policy Studies has shown that China’s average capital-to-output ratio is higher than that of the far-richer United States. It is almost as high as that of Japan and likely soon to surpass even the latter’s levels. If China’s capital-output ratio is merely to stabilize at current levels, and the economy is to grow at, say, 6 percent, the investment share in GDP needs to fall by about 10 percentage points, to around 35 per cent of GDP. That is where it was during much of the 1990s. It would also still be high by international standards.

Gros explains:

[H]igher investment rates cannot lead to permanently higher growth rates, just a higher output level. The “acceleration” of growth from higher investment cannot be permanent because once the investment rate reaches a certain level, returns will start to fall and growth will return to its underlying rate. An over-investment cycle . . . arises if the temporary nature of the growth boost from a shock to investment is not recognised. This seems to have been the case in China after 2008.

The proposition here—that a decine of 3-4 percentage points in the rate of economic growth could produce a fall of as much as 10 percentage points in the share of investment in GDP—is known as the “accelerator.” The accelerator is then connected to GDP on the demand side, via the “multiplier,” this being the impact of a change in spending (in this case, on investment) on aggregate demand. The interaction between the accelerator and the multiplier makes GDP vulnerable to large downward shocks in demand once decision-makers decide that the lower growth sharply reduces the profitability of planned investment.

The vulnerability to such a shock to demand has hugely increased over the past 15 years simply because investment has increased so much. Back in 2000, household consumption generated 47 percent of aggregate demand, government consumption 17 percent of demand and investment 34 percent of demand. Net exports also contributed just over 2 percent of demand. By 2007, household consumption had shrunk to a mere 37 percent of demand, government consumption had shrunk to 14 percent of demand, investment had risen to 41 percent of demand and net exports had jumped to an enormous 9 percent of demand. China’s economy had become extraordinarily dependent on both very high investment and very high external surpluses (see figure 5).

Figure 5

Then the global financial crisis hit, threatening China’s ability to sustain its huge external surpluses without a slump in domestic output. How did the authorities respond? They promoted an even bigger investment boom, much of it in real estate (see also figure 2). This offset the decline in net exports and maintained economic growth at close to 10 percent between 2009 and 2011, despite the global crisis.

In brief, the rise in the investment share in GDP of the past 15 years, and particularly since 2008, is unsustainable. It must ultimately turn into a period when investment grows more slowly than GDP, possibly much more slowly. And given the very high capital-output ratio, it might even shrink.

This unsustainably high investment rate is very far from the end of the story. It is only an element of it. Two other significant and ultimately unsustainable disequilibria are associated with the investment boom. One is the suppression of household incomes via still-low wages and low interest rates on bank deposits. Michael Pettis, professor of finance at the Guanghua School of Management at Peking University in Beijing, has argued persuasively that only ever-rising implicit taxation of households has made the extraordinarily high spending on increasingly low-return investments feasible.⁵

According to the World Bank, the share of household disposable income in GDP bottomed out at 59 percent of GDP in 2011. This number looks plausible: Since the share of private consumption in GDP is 40 percent, it would mean that households save a third of their income (see figure 5). The World Bank data also seem consistent with Conference Board data that the share of labor compensation in GDP was 40 percent in 2014, down from 51 percent in 2000 and even a little below 42 percent in 2008.

Given the very low shares of consumption, wages, and household disposable incomes in GDP, private consumption can lead growth if and only if a combination of two things happens: First, households radically reduce their savings rate; or, second, income that now accrues as corporate-retained profits or as government revenue is transferred to private households. But the former is quite unlikely in an environment of high policy uncertainty, such as exists today. Meanwhile, the latter would threaten both the incentive to invest and the ability to fund such investments. In any case, the adjustment remains small. The share of household disposable income in GDP was still only 61 percent in 2013.

The second disequilibrium closely associated with the investment boom is soaring indebtedness. This has become particularly significant since the global financial crisis, which led to the decision by China’s policymakers to expand credit in order to support a huge surge in investment. “Total social financing” (a broad credit measure) duly jumped from 120 percent of GDP in 2008 to 208 percent in the third quarter of 2015.⁶ According to the McKinsey Global Institute, gross debt in China jumped from 157 percent of GDP in the last quarter of 2007 to 227 percent in the last quarter of 2012 and 290 percent in the second quarter of 2015. In contrast, gross U.S. debt was only 270 percent of GDP in the last quarter of 2014.⁷

Many imagine that the principal danger created by this rise in indebtedness is that of an unmanageable financial crisis. This is mistaken. In China, an unmanageable crisis is still quite unlikely: It is not only a creditor nation; its government is solvent, it owns and controls the main banks, it is able to regulate private capital outflows, and it offers domestic residents relatively few financial alternatives to bank deposits. The true risks created by the debt overhang are two-fold.

The first risk is that leverage works in both directions. During a boom, borrowers obtain higher returns than they expected. During the subsequent bust, both they and the lenders obtain lower returns than they hoped and duly reduce their risk-taking. This happens even if there are not waves of bankruptcies. But if bankruptcies are feared, people will become very unwilling to take risks, because they do not know how large the ultimate losses will be and where they will fall. One might describe this condition as one of pervasive distress. It should be added to the accelerator and multiplier as a powerful mechanism for weakening the economy. As professor Pettis stresses, conventional economics does not pay sufficient attention to such balance-sheet effects.

The second risk concerns the sustainability of investment. To sustain growing investment, borrowing must rise. But as economic growth and returns on investment fall, this must look increasingly unwise to both spenders and lenders. Thus, even without any financial crisis, caution about further increasing indebtedness would guarantee a sharp economic slowdown. The dilemma, then, is that the policymakers must want both to prevent and to promote a further build-up of debt.

The International Monetary Fund argues that, “Without reforms, growth would gradually fall to around 5 percent with steeply increasing debt.” Yet even with reforms, history suggests that it is extremely hard to move off of an unsustainable path smoothly. One can think about this relatively precisely. The main element to focus upon is the national savings rate.

Assume that the level of investment needed to support growth at 6-7 percent a year is 35 percent of GDP. This level of investment is, as past Chinese experience suggests, probably consistent with a roughly stable level of indebtedness: that is, it does not require an explosive increase in debt in support of unprofitable investment. Assume, too, that one wishes to avoid a current account surplus. Then the national savings rate also needs to fall to 35 percent of GDP. For that to happen, public and private consumption must rise to 65 percent of GDP. Assume public consumption were to rise from 10 to 15 percent of GDP and private consumption from 40 to 50 percent of GDP. Assume, too, that households continue to save 30 percent of disposable income. Then household disposable incomes would need to rise by 10 percent of GDP, from 60 to 70 percent. This would slightly more than reverse the decline in the share of household disposable income in GDP over the past 15 years. It would also mean that savings in the rest of the economy—corporate and government—would also roughly halve relative to GDP.

At its recent rate, notes professor Pettis, this adjustment could take a quarter of a century. It is almost inconceivable that it could take place, without heroic policy measures, in less than a decade. But this means that investment must continue to be far higher than 35 percent of GDP for a substantial period. That almost certainly mean a continuation of poor-quality investment and soaring excess capacity..

The path of reform and successful adjustment, if not blocked altogether, is extremely difficult. This is why, Pettis argues, the only way out is to accept lower rates of economic growth. But this, too, might not work. Once the rate of debt-financed investment starts to fall, the economy risks a severe crisis, as the accelerator-multiplier-distress engines go powerfully into mutually reinforcing operation. Moreover, the continuation of high household savings means sustained increases in indebtedness, as households continue to lend to the rest of the economy.

Possible Policy Responses

The obstacles to a smooth transition to a different economic structure, given what this means for the distribution of income, the operation of the financial sector and the structure of the economy, are huge. Correspondingly, the ability to avoid a hard landing or, more likely, a sustained period of lower growth than is now officially expected, is arguably far less than many believe. Probably, the best approach would be to continue with reforms while trying to put more spending power into the hands of consumers and investing more in public consumption and environmental improvements. Such a response would be in keeping with China’s needs. It would also require the deliberate and coordinated use of monetary and fiscal mechanisms, in order to sustain demand and shift the distribution of income towards private and public consumption. The magnitudes involved, as noted above, would be large.

In practice, however, policymakers are far more likely to try two other, ultimately self-defeating, but immediately simpler alternatives: yet more investment-promoting domestic credit; and a big real depreciation of the renminbi, with a view to creating a bigger trade surplus. Both would be dead ends.

Further reliance on the credit engine merely guarantees a bigger slowdown in the end. Meanwhile, the Chinese economy is now far too big to run a sufficiently large current account surplus sustainably. Yet so long as the national savings rate remains not far short of 50 percent of GDP, any substantial decline in investment must lead to a bigger current account surplus. With an apparently reasonable investment rate of, say, 35 percent of GDP, continuation of such a high rate of saving would imply an annual current account surplus (and so net capital exports) of 15 percent of China’s GDP. This would be $1.5 trillion, 15 times the capital of the vaunted Asian Infrastructure Investment Bank. Even Xi Jinping’s “one belt, one road” investment program could not absorb such a huge surplus of investible funds.

Moreover, a steep decline in the external value of the currency could just be the product of letting the currency adjust to market forces. The decline in investment opportunities, capital flight, and the desire of highly indebted companies to repay their foreign debts are already combining to create strong downward pressure. China’s huge foreign currency reserves fell by close to 20 percent between mid-2014 and the end of 2015. Yet, if the currency were allowed to depreciate and the external surplus were to soar, the rest of the world could not run the corresponding current account deficits sustainably. The latter would almost certainly create a protectionist backlash, huge financial crises, or, more probably, both. The only way out is for the government to borrow and spend the surplus savings itself or accelerate the transfer of income to Chinese households. The best way to do the former would be to raise spending on public consumption, including a huge environmental cleanup. The best way to do the latter would be to tax corporations and subsidize consumption.

A discontinuity in China’s economic growth is now far more likely than it has been for decades. Moreover, such a discontinuity might not be brief. The challenge facing policymakers is, after all, huge. They need to re-engineer a highly unbalanced and slowing economy without letting it crash. Many analysts, suspicious of Chinese statistics, think the situation is already far worse than official sources suggest, with growth running at closer to 4 percent than 6 percent.⁸ If so, the investment rate is even more radically unsustainable than now appears to be the case.

Chinese policymakers have a stellar reputation for the quality of economic management. But the same was also true of Japanese policymakers three decades ago. There is no doubt that Chinese officials allowed the economy to move onto a radically unbalanced and ultimately unsustainable path after 2000 and especially after 2007. For policymakers to manage a transition to a pattern of growth that is not investment- and debt-led, without losing their way at least for a while, would be an extraordinary achievement.

It is also important to consider the political implications. A big question is how the reforms and adjustments now required fit with the concentration of political power in China. Some believe the latter is a necessary condition for the former: only a strong leadership can overcome the obstacles to reform. But a leadership committed to Communist Party supremacy and the concentration of power in its hands might prove unable to accept the necessary decentralization of the economy. At the same time, it might not survive a long period of weak growth.

It is perfectly possible, perhaps even likely, that China will become a high-income country one day. But the path ahead looks very bumpy. The huge imbalances built up in the past are becoming binding constraints today. Many countries have looked very impressive until they ceased to be—or, to recall once again Herb Stein’s immortal wisdom: “If something can’t go on forever, it won’t.” The next stage for China’s economy is a conundrum. Its resolution will shape the world.