In periods of strong growth, the stock market was stagnant. As growth fell back, the stock market surged. The stock market seemed to play a game all of its own, though over the long term the growth of equity value must come to reflect the productive capacity of the Chinese economy.

There are a number of reasons why this might have been so. China’s stock market is still very underdeveloped. Its absolute size, measured in volume of turnover, has more than doubled over the past year. But it still plays a very small role in the economy. It’s about a third of GDP, by one measure, compared with more than 100 per cent in developed economies. Less than 15 per cent of household financial assets are invested in the stock market. That is why rising share prices did little to boost consumption and why falling prices will not do very much to hurt it. The players in the market are small. Institutional investment is underrepresented. Corporations do not yet rely on equity financing for investment. The connection between the stock market and China’s economic performance is therefore much weaker than it is in developed economies.

That doesn’t mean that there are no problems to worry about in the transition of Chinese economic growth from rates of more than 10 per cent in the course of catching up to middle income countries, to lower rates, currently around 7 per cent, on the way towards higher levels of income. Indeed, there’s a whole literature out there that warns that middle income countries like China and a number of other emerging Asian economies, such as Malaysia and Thailand, face a number of major hurdles in the transition from middle to higher incomes, and others, like India and Indonesia, have still to break through to upper middle income. Over the past half century or so, many countries have committed to promoting economic development and catching up to the income and productivity levels achieved in advanced industrial economies. These emerging economies were the great hope for global growth. But the remarkable fact is that only 13 of 101 countries across the world which have made it to middle income status have been able to complete the transition from lower or middle income levels to high income levels since 1960, and catch up to the technological frontier. This is the so-called ‘middle income trap’.

David Dollar points to the strong empirical relationship between the quality of institutions (as measured by the World Governance Indicators’ Rule of Law index) and economic growth. Yet institutional quality does not change very much from year to year or sometimes even from decade to decade, so it is hard to explain why countries have periods of high growth followed by low growth (or vice versa).

The resolution of the puzzle, says Dollar, maybe that institutions which are well-suited to one phase of economic development may be ill-suited to another. One way to resolve the paradox of persistence of institutions and non-persistence of stronger than average growth rates is to focus on the quality of institutions relative to the level of development. ‘It turns out this can help explain why China and Vietnam, for instance, have seen such high growth in recent times: they have relatively low institutional quality in an absolute sense, but they have above-average quality institutions given their stage of development, which might, for instance, help to attract foreign investment to China or Vietnam rather than other Asian countries with similarly low wage levels but weaker institutions’.

Another question which Dollar raises is whether authoritarian institutions are better for economic growth than democratic ones. This could depend on the stage of a country’s development. When we look at the historical experience, in countries that have a per capita income below US$8,000, authoritarian institutions could see consistent higher growth. But at higher levels of income, democratic countries are likely to see higher growth than authoritarian ones.

This week’s lead essay is from Indermit Gill, of World Bank, and Homi Kharas, of the Brookings Institution, who, in a major World Bank study ten years ago, first coined the term ‘middle income trap’.

Some things haven’t changed, say Gill and Kharas. The importance of trade liberalisation is just as vital to middle income countries. Successful middle income countries are also likely to be those that encourage innovation, in which openness to trade and investment plays a key role. And the quality of financial markets and capital market liberalisation seems especially important to escaping the trap. These are the elements that are necessary to sustain productivity-based growth towards higher income levels.

On reflection, Gill and Kharas reckon they need to add three other issues that may prove decisive in the transition from middle to higher incomes for Asian economies yet to make the cut: problems that derive from demographic drag (getting old before becoming rich); building an open and creative environment that fosters risk-taking and entrepreneurship; and making external commitment to openness beyond trade and investment liberalisation. They might have also added dealing with environmental externalities.

Success in all these economic policy strategies is deeply intertwined with the capacity of political leadership, and the political systems in which they exercise it, to deliver. So achieving the 6 to 7 per cent growth that will get the middle income economies of Asia to high income levels in a couple of decades won’t exactly be a stroll in the park.

Peter Drysdale is Editor of the East Asia Forum.