Pay rise doesn't necessarily hinder growth

A Chinese scholar has sparked a fierce public debate by saying that the rapid pay rise will hinder China's economic growth. The remark and the subsequent debate are suggestive of a big problem China is facing: the middle-income trap.

It is a phenomenon that occurs in countries whose economic growth relies on cheap labor to produce goods for export. With increase in wages, these countries lose their cost-based competitiveness. The countries ultimately fall into the trap if the wage levels increase beyond the critical point before they manage to transform the economic development model - and their products cease to be cheap for the global market and they cannot find any higher value-added alternative.

The trap occurs roughly when a country's per capita GDP is between $6,000 and $10,000, a point at which economic development falters and per capita GDP tends to flatten. China has reached such a point in its development cycle. So, what can it do to avoid the trap?

China has waited too long to implement some important reforms. Hence, any new initiative taken now, or in the near future, will produce undesirable side effects, whose costs have to be borne by other components of the economy - this means solving one problem could create another, depending on the relative negotiating forces at play.

China is also in the process of transforming itself into a more consumer-based economy, which is possible only if there is a healthy increase in workers' salaries. Of course, increasing workers' salaries will have a direct negative impact on companies' profits. But this is not the end of the story, for increasing salaries will also increase private consumption, and this additional consumption will boost companies' revenues. This, to a certain extent, will counterbalance the negative effects of higher salaries.

Who benefits and how from this? Industries driven by consumer products, such as retail, white goods and automobiles, could be the net beneficiaries. The losers, on the other hand, would be industries whose products are not directly targeted at consumers - for example, infrastructure investment entities, the capital goods sector and companies dealing in raw materials. Such industries and companies would see their cost bases rise without the counterbalancing effect of increased revenues.

The other consideration one has to make is that, neither all workers nor all consumers are the same. In particular, individuals who already are in the higher-income group show less propensity to spend more despite a pay rise. That is to say, such people will spend only a fraction of the extra money they earn from increased salaries. At the other end of the spectrum, individuals in the low-income group tend to spend a larger proportion of their earnings.

According to the laws of economics, as your income grows it becomes increasingly "difficult" to spend everything you earn (one can eat only three times a day, go on holiday a certain number of times a year and buy only so many luxury items, and so on). Therefore, the policy of increasing wages should be targeted mainly at the low-income group. If the policy is focused on this disadvantaged group, it will not only ensure that a very high percentage of the increased wages is spent on consumer goods, but also help narrow the income gap.

However, there are always net losers in this approach and, as is often the case, political considerations can be more important than economic factors. So, tackling the wage issue must be only the first step toward avoiding the middle-income trap. In the longer term, China will have to put to use its great creative and innovative potential, which now faces layers of obstacles.

The process of removing those layers could start with a thorough reform of the education system, to build a new system that would encourage young students to express their genuine views and develop their own critical thinking. Only then will creativity and innovation start playing the most vital role in economic growth and allow China to shed the image of the "factory of the world".

The author is head of China Economic Policy Program at Nottingham University Business School.