The ‘Double Trap’ in China – Multiple Equilibria in Institutions and Income and Their Causal Relationship

Abstract

While institutions are said to be poor in China in cross-country comparison, recent research indicates that at the provincial level, institutional quality plays in fact an important role for the economic success of a province in China. Our paper aims to add further arguments to this discussion by focusing on the concept of club convergence. In particular, we analyze whether institutional quality in low-income provinces converges to the level experienced by relatively highly developed provinces or whether there exist multiple institutional clubs over the period 1997-2007 by using the log t test proposed by Phillips and Sul (2007). Our findings indicate that there exist multiple institutional clubs within China, three rather small clubs which follow an above-average high institutional quality path and two clubs which find themselves on a relatively low institutional quality path and which together account for the majority of provinces. Using the same methodology, we find that various provinces of the poor institutional clubs are additionally caught in a low-income trap. In a next step, we analyze the causal relationship between poor institutional traps and low-income traps in China. Using a recursive bi-variate probit model enables us to control for the problem of endogeneity in the institutions-income relationship. We find evidence that institutional traps are important determinants of income traps, giving rise to the recently identified phenomenon of a ‘double trap’. Finally, our findings indicate that human capital and urbanization are additional important determinants of income traps, while globalization is decisive for avoiding poor institutional traps.