Lessons from Mexico & Japan

By TOM ORLIK

Is China the next Japan or the next Mexico?

One worry for investors is that China will go the same way as Japan. Like Japan once did, China is playing a game of rapid catch-up with the U.S., with growth in output driven by high levels of investment and exports. As also happened in Japan, that growth model has led to the buildup of stress points in the domestic economy: a bubble in the real-estate sector and bad loans in the banks.

The crucial difference is the level of development. Taking 1990 as the date when Japan's growth faltered, gross domestic product per capita, measured in purchasing-power-parity terms, had already reached more than 90% of the level in the U.S. Capacity to grow by catching up was all but exhausted. The real-estate bubble burst when Japan's urbanization rate was above 60%. In an already predominantly urban society, fundamental demand wasn't strong enough to pick up the pieces.

In 2009, China's GDP per capita was 18% of that in the U.S., and the urbanization rate had just touched 50%. The contrast is clear.

Significant scope to grow by catching up to the world economic leader remains. If the ghosts towns that loom large in the bear case against China are a genuine problem, continued urbanization means fundamental demand should remain strong enough for China to grow through it at some point. A Japan-style lost decade doesn't appear to be in China's immediate future.

A more realistic threat is that China is the next Mexico. Mexico grew through exporting low-value-added goods to the U.S, without paying too much attention to niceties like improving human capital and developing an efficient financial system. But as lower-cost competitors entered the world economy, a weak education system and inefficient allocation of capital started to act as constraints on growth. China took export market share and growth stalled. Mexico's GDP per capita languishes at 28% of that of the U.S., a lower level than in the early 1980s.

Bloomberg News

Reform of the financial system has fallen by the wayside in China. Above, Chinese flags fly on boats in the Bohai New Area port zone of Cangzhou, Hebei Province, China.

Here, China might have more to worry about. Wages in the low-skill manufacturing sector are rising fast. On their current trajectory, they will double in the next five years. Low-skill jobs have already started to migrate elsewhere and will continue to do so. Public spending on education, at 3% of GDP in 2009, compares unfavorably to an average of 5% in the grouping of upper-middle-income countries to which China aspires. Reform of the financial system has fallen by the wayside as banks continue to funnel savings to low-yielding state-sponsored projects. (see Red Capitalism by Carl Walter)

To be sure, China's record of economic management is much stronger than Mexico's. And the government talks a good game about the importance of reform. But words have so far not been matched by action. In August this year, a move to bulldoze schools that provided education to the children of migrant workers in Beijing seemed emblematic of policy makers' priorities. With education part of the key to avoiding the middle-income trap, it is bulldozed schools, rather than ghost towns of empty apartments, that are the bigger threat to China's development.

Write to Tom Orlik at Thomas.orlik@wsj.com