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UPDATED: March 2, 2011 NO. 9 MARCH 3, 2011
Avoiding the Middle-Income Trap

EMPTY WORKSHOP: A clothing factory in Wuhe County of central China's Anhui Province cannot operate to its full capacity because of serious shortages of labor this February. The dearth of factory workers sends an urgent call for industrial upgrading (LI JIAN)

The news China surpassed Japan as the world's second largest economy in 2010 has put China in the limelight. China's per-capita GDP has reached $4,000, turning the country from a lower middle-income country to an upper middle-income country. But the economic growth model is still extensive and the income gap between the rich and the poor is widening.

Past experiences show some Latin American countries achieved fast economic growth through cheap labor and raw material costs, but their economy stagnated and encountered more economic and social problems after they entered the middle-income group. China should be alert and avoid such a "middle-income trap." Cai Fang, Director of the Institute of Population and Labor Economics at the Chinese Academy of Social Sciences, offered his insights on Caing.com. Edited excerpts follow:

China, once an abundant provider of low-cost workers, has reached what is called the Lewis turning point—the point at which a developing country's industrial wages begin to rise quickly when the supply of surplus labor from the countryside tapers off.

In the decades to come, China may still be the world's manufacturing base, with its manufacturing industry remaining competitive, but we should be aware that changes will have taken place, both outside and inside. These changes will surely pose a series of challenges to the country. If not properly handled, China's sustainable growth will be undermined and the country may plunge into the "middle-income trap."

The first challenge is how to improve total factor productivity, a better gauge of an economy's use of its production resources. With sufficient supply of cheap labor, China has enjoyed a booming economy propelled by rich demographic dividends. However, as the supply of low-cost labor declines, total factor productivity should become the main driving force to China's economic growth, instead of the input of only capital and labor.

China must ensure free market entry and investment opportunities and equal access to resources, and let the market play its basic role in resource allocation. Only in this way can we improve the competitiveness of China's manufacturing sector and maintain its comparative advantages. If the government continues to protect backward industries, the total factor productivity will not be able to be improved.

Whether China can improve the quality of its labor force, to replace its established quantitative advantage, will also be a challenge.

The current labor shortage plagues some areas in China. At the same time, industrial upgrading is requiring a higher contribution of human capital, or skilled labor force. If the demand for the high-quality labor cannot be met, industrial upgrading will remain stagnant, which will also cause the dilemma of job-finding difficulties amid labor shortages.

Average wages for ordinary workers grow at about 10 percent annually, which on the one hand can alleviate the unbalanced income distribution to some extent. But we should be more cautious about the phenomenon that some parents, especially those in rural areas, may ask their children to drop out of school for the short-term benefit. This practice, if widespread, will result in the inability of the country's next-generation laborers to adapt to the needs of economic restructuring and industrial structural upgrading.

The third challenge is forming a wage negotiating mechanism through the establishment of labor market rules instead of just supply and demand.

Labor is not like other commodities in that its price cannot be decided by supply and demand alone, but also labor market rules.

Experiences from Japan and South Korea show, in the post-Lewis turning point era, governments have established market rules, so that it can determine the wages together with the labor demand and supply mechanism.

Although Chinese economists have not reached an agreement on building a wages negotiating mechanism, at least an institutional labor force platform should be established in China.

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