Morningstar Magazine - February/March 2018 - 40

Strategies

capital" once "brute-force capital formation
eventually becomes unsustainable."4 As discussed
in the December/January 2018 issue ("China
Is Running Out of Cheap Growth, Page 42), China's
rapidly rising capital-output ratio certainly
suggests the days of high returns have passed.
Risk Factor: High Old-Age Dependency Ratio
China Risk Assessment: Moderate, but Rising

Precedent suggests China's aging population,
a topic we tackled in the June/July 2017
issue ("China's Next 10 Years," Page 60), will put
it at greater risk of a slowdown. Eichengreen,
Park, and Shin note that a rising old-age
dependency ratio-the number of seniors for
every working-age adult-tends to be "associated
with lower savings rates and [falling] labor
force participation rates."5
Currently, China has 14 seniors for every 100
working-age adults, which is typical among
middle-income countries. However, this ratio will
increase by about 50% over the next 10 years.
By 2026, China's old-age dependency ratio will be
on par with countries like the United States,
Canada, and Australia today.
Risk Factor: Undervalued Currency
China Risk Assessment: Low

Countries with undervalued currencies appear
to have a harder time escaping the middle-income
trap. That might appear counterintuitive, as
a cheap currency should make it easier to compete
in foreign markets. Eichengreen, Park, and Shin
argue, however, that "countries with undervalued
currencies have less incentive to move up the
technological ladder out of unskilled-laborintensive, low-valued-added sectors and, thus, find
it more difficult to sustain rapid growth."6
While it's difficult to say so for sure, we doubt
the Chinese yuan is undervalued at present.
The global relationship between market exchange
rates and purchasing power parity exchange
rates suggests the Chinese currency might be

4 Eichengreen et al. 2012.
5 Ibid.
6 Eichengreen et al. 2014.
7 Ibid.

Morningstar February/March 2018

overvalued by 20% or more. If Eichengreen
and colleagues are right, this should make China
less likely to fall into the middle-income trap.
Risk Factor: Low High-Tech Share of Exports
China Risk Assessment: Low

Eichengreen, Park, and Shin find countries with
limited high-tech exports are at increased risk
of a significant slowdown. This may indicate, they
argue, a failure to transition from labor-intensive
products to knowledge-intensive products.
High-tech exports comprise about 26% of China's
manufactured exports. That's among the highest
shares globally. But given China's role as
assembler of many high-tech devices, it probably
overstates the country's innovation prowess.
Risk Factor: Low Secondary Education Attainment
China Risk Assessment: Moderate, but Falling

Countries with poorly educated populations
are more likely to succumb to the middle-income
trap. Eichengreen, Park, and Shin find
secondary education (junior high and high school
to Americans) to be especially critical. The authors
hypothesize that middle-income countries
with fewer high school graduates find it "harder
to move up market when challenged from
below by other late-industrializing, low-laborcost countries."7
China would appear to rate as somewhat
risky on this measure. The country's
population aged 15 and older averages 2.65 years
of secondary education, less than the
middle-income country norm of about three
years. But the risk posed by an undereducated
workforce is receding. New entrants to
China's workforce are far more educated than
the previous generation, a consequence
of the country's unusually rapid development
and periods of unrest that kept children
out of school. Accordingly, the education gap
between China's workforce and that of
its peers is set to close in the years to come.

Even Odds of Escaping

China carries some of the markers historically
associated with the middle-income trap, including
rapid GDP growth, a high investment share of
GDP, and an aging population. Yet on other factors
that tend to predict slowdowns, including
an undervalued currency and limited high-tech
exports, China appears comparably low risk.
On balance, while we would not regard China to
be at especially high risk of falling into the
middle-income trap, the odds of escape if it does
aren't that great either. We're inclined to agree
with the assessment of the country's former
finance minister Lou Jiwei, who in a 2015 speech
at China's prestigious Tsinghua University
pegged the country's chances of avoiding the trap
at 50/50.
For China to improve its odds, it must tap new
sources of productivity growth. Academic
research consistently finds that the few countries
that make the leap to high-income status tend
to perform well on four key dimensions:
institutional quality, innovation, human capital,
and information and communication infrastructure.
In forthcoming articles, we'll evaluate China
across those four criteria and gauge the
country's prospects for joining the ranks of highincome countries. K
Dan Rohr, CFA, is director of equity research, basic
materials, with Morningstar Research Services.

Table of Contents for the Digital Edition of Morningstar Magazine - February/March 2018