Analysis: Asia's economic history foretells Chinese slowdown

Participants run past the Tiananmen Gate during the 2010 Beijing Marathon on a rainy day in Beijing, October 24, 2010.

GYEONGJU, South Korea (Reuters) - The past is not an infallible guide to the future, but a reading of how East Asia's economies developed suggests China needs to get ready for an appreciable slowdown in growth in the years ahead.

And that same history lesson must have Beijing praying that it can follow in the footsteps of vibrant South Korea, not stagnant Japan.

Last weekend's gathering of the Group of 20 major economies was aimed at securing short-term growth and currency stability.

But the opulence of the lake resort where G20 finance ministers met was a vivid illustration of how South Korea has avoided the so-called middle-income trap and continued to push living standards closer to those of advanced countries.

For decades, many countries in Latin America and the Middle East have failed in this task. In Asia, the Philippines is a prominent example.

"Many countries make it from low-income to middle-income, but very few actually make that second leap to high-income. They seem to get stuck in a trap where your costs are escalating and you lose competitiveness," said Ardo Hansson, a World Bank economist in Beijing.

Not so South Korea. When war on the divided peninsula ended in 1953, the south was poorer than the north.

By 1997, though, South Korean per capita GDP (at purchasing power parity exchange rates) had reached 57 percent of the average of the Organization for Economic Co-operation and Development, a forum of industrial democracies that Seoul joined a year earlier.

The 1997/98 Asian financial meltdown set back many middle-income countries across the region. Investment, vital to sustain medium-term growth, has still not recovered to pre-crisis levels in Thailand, Malaysia and the Philippines.

South Korea, though, after nearly defaulting on its debts at the end of 1997, pulled itself together and resumed its march up the value chain.

DON'T STOP REFORMING

The key reason is that Seoul embarked on far-reaching market reforms. In particular, the government reduced the power of the chaebol, sprawling debt-heavy conglomerates whose links to the state created the impression that they were too big to fail.

But many did fail as South Korea injected more competition into the economy, liberalized imports and deregulated the financial sector that was a captive source of funding for the chaebol.

"They really changed the rules of the game for the large corporations. It became clear that being big and being close to government was not enough to keep you alive," said Randall Jones, who heads the OECD's South Korea desk.

Since the crisis, the country has grown more than twice as fast as the OECD norm, propelling per capita GDP to 83 percent of the group average by 2008.

"Korea is a success story because of what they've been able to do during the past decade, and it's the wave of reform back in 1997/98 that gave them that second wind," Jones said.

The lessons for Beijing seem evident. The chaebol can be likened to China's state-owned enterprises, which generally enjoy cozy monopolies and favorable financing from state-owned banks that are themselves cosseted.

Beijing needs to emphasize the efficiency of investment, not its scale. It must foster innovation and make it easier for more-productive private firms to enter sectors such as finance and logistics.

"Part of it is just making sure that you are creating new sources of growth all the time," said Hansson at the World Bank.

A HISTORY LESSON

A particular lesson from South Korea is that investing in human capital is critical to avoiding the middle-income trap.

"Korea, 50 years ago, already had very high levels of educational attainment. There has to be some sense in which making that final leap really depends upon widespread access to high-quality education," Hansson at the World Bank said.

Emulating South Korea would help China to improve the structure of its economy and actually benefit from the loss of momentum that history suggests is looming.

According to data compiled by the late economic historian Angus Maddison and cited by Morgan Stanley, about 40 economies have attained a per capita GDP level of $7,000 over the past century or so.

Remarkably, the average growth rate of 31 of those 40 countries was 2.8 percentage points less in the decade after the $7,000 inflection point was reached than in the preceding decade.

Japan and South Korea hit the $7,000 mark around 1969 and 1988, whereupon their annual average GDP growth rates decelerated in the following decade by 4.1 and 2.4 percentage points respectively, Morgan Stanley calculates.

China's per capita GDP today is less than $4,000 at market exchange rates, but the bank reckons it reached Maddison's magic number, which is based on purchasing power, in 2008.

"If history is a guide and the law of gravity applies to China, China's economic growth is set to slow," Morgan Stanley said in a recent report.

China's slowdown might be gentler given its continental-sized economy and the potential for catch-up in the poorer interior. But the development experience of its neighbors, including Taiwan, is a benchmark too powerful to ignore.

Morgan Stanley has penciled in average GDP growth of 8.0 percent a year from 2010-2020, down from 10.3 percent from 2000-2009.

Slower, though, can mean a better balance. In Japan and South Korea consumption and labor income rose sharply as a share of GDP in the decade after growth peaked, while their service sectors expanded strongly.

China's new five-year plan proclaims the same goals.

"China is not unique. It will follow the pattern of Korea and Japan and, after the inflection point, consumption will take off and investment will decline," said Steven Zhang, a Morgan Stanley economist in Shanghai.

(Additional reporting by Aileen Wang; editing by Richard Pullin)