China is walking itself into a trap

China is in a hairy situation.

The officials are upping the risks of a "middle-income trap" after enjoying decades of rapid growth. This kind of stagnation has ensnared many countries in Latin American and Southeast Asia.

We all know that China is trying to pull off an economic pivot, but the government isn't truly committed to creating a real free market, according to the latest report by Alex Wolf, an emerging markets economist at Standard Life Investment.

The global investment firm, which manages $360 billion in assets, estimates that China's economy has grown at a slower rate of 5% per year as its debt-fuelled, state-investment-led growth model ran out of steam and became counter-productive. China has reported a growth pace of 6.7% in the second quarter.

Here is SLI (emphasis added):

"This presents challenges both for Chinese officials when looking for policy precedents, but also for world leaders struggling to accommodate China's rise. China is now at a crossroads; to move from middle to high income will require changing the foundations of the economy. Doing any less will ensure that China follows the path of the majority of other countries that have reached middle-income status since the 1960s: stagnation and the 'middle-income trap'. What China needs to do is relatively clear - transition to more consumption-driven, higher valueadded growth. To make this transition, the state will have to decrease its role as a direct participant in the economy, our view is that anything less will ensure productivity slows and growth stagnates."

While policymakers seem to understand the need for reform, the losses that stem from loosening their grip on resources and capital made it politically difficult, according to the note. This has translated to underwhelming fiscal reforms across local governments and disappointing attempts to improve governance of local capital markets.

Most importantly, the much-needed reform on state owned enterprises hasn't really materialized. The government called for "mixed ownership" as part of its SOE reform in late 2015, though there weren't concrete plans on how the state would let go of its control. Instead, the current reforms are creating "stronger, better and bigger" SOEs, which further cemented the party's power.

By restructuring the SOEs, China would have to deal with higher unemployment and boost household welfare spending. By overhauling the financial sector, the government would have less direct control over credit growth, resource allocation and the exchange rate. And officials would have to accept lower growth rate today in order to promote sustainable growth down the road.

To be sure, these are difficult tradeoffs. But the Chinese government has to these steps in order to fully transition into a high-income status, according to the note:

"By our estimation, the main reforms and precursors that are necessary to improve productivity and continue driving growth are: a) highly competitive and contestable goods and services markets; b) the free flow of information and ideas; c) strong protection of intellectual property rights; d) an unbiased and trustworthy legal system that strengthens the rule of law; e) a transparent regulatory system; f) deep and liquid capital markets; g) welfare and land reform; and h) emphasis on education and research. While China's short-term risks are well understood and the rebalancing away from rapid investment growth will drag on near-term growth, we are increasingly less optimistic about China's long-term growth potential. In other words, we see the risks increasing of China falling into the so called 'middle-income trap'."