Richard Koo of Nomura  trying to answer the question of why structural reforms are needed now in China, a good starting point is the fact that China has recently passed what economists call the Lewis turning point.

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Richard Koo

Richard Koo: Lewis turning point

The Lewis turning point refers to the point in time when, as part of the process of industrialization and economic development, the excess labor in rural villages is fully absorbed by urban factories.

From the perspective of a capitalist (business owner), a country in which the Lewis turning point has not been reached is one in which it is possible to attract almost unlimited numbers of rural workers by offering a given wage, a very advantageous situation from the capitalist’s viewpoint.

In this world, there is no need whatsoever for the capitalist to worry about labor shortages. His business can continue to grow as long as he has the ability to create products that will sell and the funds to acquire the necessary production facilities. Capitalists capable of supplying such products are therefore able to profit handsomely in the period before the Lewis turning point is reached, which encourages them to invest even more.

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Richard Koo: Capitalists benefit until Lewis turning point is reached

Figure below shows the situation in terms of labor supply and demand. The labor supply curve is nearly horizontal (DHK) until it reaches the Lewis turning point (K) because there is an essentially unlimited supply of rural workers seeking to work in the cities.

Capitalists profiting from this flat labor supply curve expand the demand for labor as they continue to invest, causing a rightward shift in the labor demand curve (from D1 to D2 in the graph).

As the labor demand curve shifts to the right, total wages received by workers increase from DEFG at D1 to DEIH at D2 due to an increase in the width of the rectangle under the labor supply curve. The increase, however, is linear.

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Richard Koo

The profits earned by capitalists are expressed as the triangle formed by the intersection of the labor demand curve and the labor supply curve. As the labor demand curve shifts right, this increases from BDG at D1 to ADH at D2, in what is a far more than linear pace of growth.

Until the Lewis turning point is reached, in other words, investment expands and capital’s share of GDP increases along with GDP itself, which benefits the capitalists. One reason why a handful of business groups were able to accumulate such massive wealth in the western nations a hundred years ago and in pre-war Japan is that the labor supply curves they faced were essentially flat.

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Richard Koo: Next 15–20 years will be critical for China

That suggests the next 15 to 20 years will be critical for China. If it is successful, it will join the ranks of the developed economies and enjoy a rich “retirement.” If it fails, it will remain stuck in the middle income trap.

Many pundits are predicting that China will overtake the US to become the world’s largest economy by such-and-such a year if the economy continues to grow at the current pace. But it is meaningless to apply the growth rate of a country that has yet to reach the Lewis turning point and also enjoys a massive population bonus to one that has already reached the Lewis turning point and has a negative population bonus.

In that sense, the new government’s focus on quality instead of quantity and its reduced emphasis on high growth rates are very appropriate given the realities it faces.

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That said, it remains to be seen whether China can overcome its problems and break out of the middle income trap in the time remaining, particularly since public demands are likely to grow as the nation passes the Lewis turning point.