SPECIAL REPORT—For decades China achieved double digit growth rates. And in the last 30 years, the country lifted 500 million people out of poverty, the World Bank says. Today, China is the world’s largest manufacturer and exporter, and the second largest economy. However, its future is not so clear. In the coming years, the Middle Kingdom must overcome tremendous challenges that may significantly impact its competitiveness and social stability.

“China has now reached a turning point in its development path,” said Former World Bank Group President Robert Zoellick. “Managing the transition from a middle-income to a high-income country will prove challenging.” But that’s not all.

China continues to subscribe to many of the same economic policies and has exemplified many of the same behaviors that other Asian nations embraced early in their development. In the short term, these policies led to strong economic growth in Japan, South Korea and Taiwan. But over time, flaws emerged that proved damaging.

For example, at first these Asian nations effectively discouraged individual consumption due to poor or non-existent safety nets and channeled savings into selected industries protected from international competition. In addition, government subsidies, which diverted resources away from potentially more efficient enterprises, and low bank lending rates, which were offered to favored industries and state-owned enterprises, often came at the expense of productivity.

Plus, over time, government capital investment returned declining output. And the lack of effective checks and balances created levels of corruption that were difficult to curtail. China has not been exempt from these problems.

Stated by John Naisbitt, the author of China’s Megatrends, the Chinese consider corruption “one of their biggest challenges they face, especially at the local level.” Yet this is only one of several issues negatively affecting China’s overall performance.

How the Chinese leadership walks the line between economic reform and political liberties may be as dangerous as a high wire act.

Michael Novak, the author of more than 25 books on the philosophy and theology of culture, stressed that checks and balances are to the political order what competition is to capitalism. Unlike many countries, America is fortunate to have a strong system of checks and balances, as well as one that promotes competition. China does not. As a result, China’s brand of one-party authoritarian capitalism, often referred to as “socialism with Chinese characteristics,” is undergoing difficulties that are likely to increase.

With an understanding of the problems ahead, in November 2013 Chinese President Xi Jinping released his first economic blueprint. It called for market forces to play a larger role in the economy, along with many other reforms. However, analysts note many contradictions in the blueprint, expect Chinese state-owned companies to retain massive influence in the economy, and anticipate little or no real improvement in political reform in the near term.

The Problem with State-Owned Enterprises

To a major extent, the state, rather than the market, determines Chinese economic outcomes. And Chinese state-owned enterprises (reported by the Chinese Ministry of Finance to number more than 100,000 with assets of approximately $13 trillion) have provided much of this control. Because the state, and in turn, its companies typically use capital less efficiently than private firms, a number of problems have emerged.

Stated by the Paulson Institute, a think tank with offices in Chicago, Washington, DC and Beijing, “the returns of state-owned enterprises have sharply deteriorated. As a result, a significant part of the Chinese economy is underperforming. This creates a drag on economic output at a time when many other changes — an aging population, the maturing of housing and other infrastructure, and weak demand in the developed economies — are already shifting China onto a slower growth trajectory.”

Surprising to many reformists who were hopeful that President Xi Jinping would make significant changes early in his tenure, Chinese reliance on state-owned enterprises is likely to continue. In November 2013 during the Third Plenum of the 18th Chinese Communist Party Central Committee, the leadership reiterated that state ownership continues to be a “pillar” and “foundation” of China’s system, the Paulson Institute reports.

China’s Emerging Labor Shortage

China’s one-child policy introduced in 1979 to alleviate social, economic, and environmental problems now is causing many unintended consequences. And the recent relaxation of the law is unlikely to undo demographic problems ahead.

Reported in The Wall Street Journal, the United Nations Population Division indicates that each successive Chinese generation will shrink by 25 percent. Consequently, a decreasing workforce will be required to support an increasingly elderly population.

China is on the eve of a demographic shift that will have profound consequences on its economic and social landscape.

According to the International Monetary Fund 2013 working paper, “China is on the eve of a demographic shift that will have profound consequences on its economic and social landscape. Within a few years the working age population will reach a historical peak, and then begin a precipitous decline.” But that peak may already have been reached.

From 2011 to 2012, China’s working population, age 15 to 59, declined by 3.45 million to 937.27 million, says China Daily, a leading English-language news organization in China. And Ma Jiantang, head of the Chinese National Bureau of Statistics, said the working age population will steadily shrink.

But the labor shortage may be influenced by other factors as well. Shawn Mahoney, Managing Director of EP Consulting Group, a U.S.-China business consultancy, says “skyrocketing real estate prices are pushing urban rental prices through the roof. Consequently, many workers simply can’t afford to move to the cities where the factories are located.”

In turn, competition for Chinese labor and those with higher skills increasingly in demand have driven up labor rates. In fact, in the last few years, Chinese labor rates have risen approximately 18 percent annually, says global consulting firm InterChina Consulting. And when combined with a slow appreciation of China’s currency, rates may be rising up to 25 percent per year.

“Wage increases can be a healthy sign of economic development, but China’s is an unusual case,” says Yonh Siew Wah, a Singapore-based consultant. “Whereas wages typically rise in line with worker productivity — employers will pay more for employees who are able to produce more — China’s wage growth is mainly the result of government policies aimed at quickly increasing household income. Wage growth is far outstripping annual productivity increases.” These factors are making China a less attractive manufacturing location for American firms primarily interested in supplying North American markets.

Falling birth rates and a shrinking workforce are not just China’s problem; many European countries, including Russia, are experiencing similar situations. This, however, is not a problem in the United States, which has a growing population partially due to immigration. And an expanding population, which typically reflects an increase in the size of its workforce and consumer base, is beneficial to an economy, boosting demand and economic growth. A shrinking population has the opposite effect.

Cultural Obstacles to Innovation

Creating clusters like Silicon Valley, which is the envy of the world, the United States continues to be the hub of global innovation. This is reflected by the fact that approximately half of all utility patents granted by the U.S. Patent and Trademark Office went to Americans in 2012 (1.8 percent went to Chinese inventors). In turn, newer U.S. technological developments — green industries, clouds, tablets, smart phones, hydraulic fracturing, 3D printing, nano technology, and biotechnology — will become the drivers of future U.S. economic growth.

This success is partly the result of America’s acceptance of failure which is considered part of a normal development process. This attitude also encourages risk taking — an essential ingredient in innovation. From a cultural perspective, Chinese business failure often results in “losing face,” which is tantamount to public disgrace. Consequently, it is often repeated that the Chinese would rather do nothing, than do something wrong.

The Japanese proverb, “The nail that pops up is always hammered down,” discourages individuals to “go against the grain” or question the process, and instead encourages them to conform to specific norms. Adopted by the Chinese, this mindset is seemingly opposite of the American cultural right to question authority and challenge the system.

The goal of becoming an innovative society cannot be achieved while hierarchical, authoritarian patterns persists in education and in the workplace.

“The goal of becoming an innovative society cannot be achieved while hierarchical, authoritarian patterns persists in education and in the workplace,” says John Naisbitt. Freedom of inquiry, a Western ideal that has led to independent thinking, is not historically part of the Chinese totalitarian rule. “Modern scientific breakthroughs need people who are willing to question their forefathers’ point of view and their bosses’ orders,” Naisbitt notes. A “hierarchical, authoritarian thinking is China’s highest hurdle in changing from the workshop of the world to a leading innovative country.”

But Chinese culture is slowly changing, says Mahoney. “To a greater extent, the Chinese are exemplifying traits that promote innovation. However, the Communist Party structure is resisting this.” Tim Ebsary, Director of Business Development for American Commercial Strategies, a California-based firm that works closely with Chinese companies, says “where there is capitalism, there is innovation,” and indicates that Chinese innovation is on the rise.

Although many Chinese firms are beginning to make inroads in innovation, analysts say they nevertheless will be dependent for some time on the purchasing of new technologies through mergers and acquisitions.

What’s the result? Approximately half of Chinese exports to the U.S. are not of Chinese origin, the U.S. International Trade Commission reports. And if one delves deeply into U.S. high technology imports from China, what is revealed may be surprising.

For example, according to a 2011 University of California Irvine study, Apple’s 4G iPhone, which retails in the U.S. in excess of $600 if purchased without a wireless phone contract, is assembled in China at a cost of approximately $180. China’s value-added, which involves labor and no components, is $7.10 per unit or just less than 4 percent of the import cost.

“Many people in the West believe that contention and discord lead to breakthroughs, new ideas and innovation. But conflict and disharmony, especially in such serious matters as governance, do not fit the Chinese mentality,” Naisbitt remarks. China’s cultural reluctance to challenge the status quo does not encourage home-grown innovation.

In the United States, many innovations begin in the garages of millions of entrepreneur’s homes. This process is considerably different than a government body like China’s that chooses winners and losers, and invests accordingly.

Increasing Demands for Freedom

On June 4, 1989, a pro-democracy protest ended in the declaration of Chinese martial law and the death of several hundred or possibly thousands of civilians in Tiananmen Square. Since then, strong economic growth and low unemployment may be two of the most important factors supporting social stability and preventing a repeat of the Tiananmen tragedy. In turn, it is increasingly clear that the Chinese leadership’s legitimacy is strongly tied to its ability to provide economic opportunity.

As a result, the leadership continues to focus on economic growth and job creation, much of which is attributable to international trade and globalization. In turn, Chinese global engagement has led to free market reforms, and the growth of an entrepreneurial and middle class — that are demanding more liberties and freedoms. Moving forward, how the Chinese leadership walks the line between economic reform and political liberties may be as dangerous as a high wire act.

Once markets are liberalized, it’s a matter of time before their political systems follow. The adage “open markets open minds” has repeatedly proven true. Look no further than the former Soviet Union to understand what occurs when the flow of information and trade enter dictatorial states.

The year 2011 marked the point at which the Middle Kingdom’s urban population exceeded 50 percent of the country’s population, China’s National Bureau of Statistics reports. This not only means more than half the country’s citizens now live in cities, many of who recently migrated there from the countryside in search of jobs, but that low-income and perhaps somewhat disenfranchised workers exist in large concentrations. Thus, if China’s economy doesn’t perform well, social unrest may spread faster than in the past and possibly cripple the country.

Not long ago Chinese economic growth measured in double digits. This year it is expected to register 7.5 percent and next year 7.3 percent, the International Monetary Fund reports.

Although considered high by developing country standards, these growth rates may not be sufficient to generate the level of opportunity necessary to stave off dissent. Consequently, the leadership’s reluctance to move ahead more quickly with reforms may need to be reconsidered.

About The Author John Manzella [Full Bio]

John Manzella, founder of the Manzella Report, is a world-recognized speaker, author of several books, and an international columnist on global business, trade policy, labor, and the latest economic trends. His valuable insight, analysis and strategic direction have been vital to many of the world's largest corporations, associations and universities preparing for the business, economic and political challenges ahead.




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