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Moderating China's Growth: Part Two - Developing Intellectual Capital

As China’s surplus of cheap labor disappears, it may start to focus more on the less labor intensive IT and service businesses, competing more directly with counterparts in the U.S.

Ever since the late ‘70s, China has been known as a low-cost, high-growth phenomenon. Its economic transformation began 30 years ago, as it emerged as a low-cost manufacturing center. More recently, companies such as Internet equipment maker Huawei have been competing with multinationals at higher levels, as China looks to develop the intellectual capital of a developed nation.

And with the economy growing at 9 percent, even in the aftermath of the financial crisis, a middle class and consumer culture is taking shape. While China has not crossed the threshold from emerging to developed economy, it is getting there very fast. 

[Click here to access the complete rankings of the 2011 All-China Research Team and read the profiles of the region's Top Analysts].

China’s $6 trillion economy is not without its challenges, though. Over the last year, it has grappled with higher inflation and what many experts believe is a real estate bubble in some markets. And despite the relative prosperity of many urban regions, the country as a whole still has a low per-capita income. The most fundamental and important hurdle may be demographic, though.

Thanks to a slowing birthrate, mandated decades ago, by China’s one-child-per-family policy, China’s population is rapidly aging. While other countries, notably Japan, are struggling with whether they will have enough workers to support the older generations, the problem is magnified by China’s population of 1.3 billion, the largest in the world. And since China is a key source of demand for countless markets and industries around the world, it’s ability to solve the problem in satisfactory way is key to global growth.

Population growth in China over the last decade dropped to 0.57 annually, and the fertility rate of 1.5 percent is among the lowest rates in the world, and well below the replacement rate of 2.1 percent, the Washington Post said, citing data from the Brookings Tsinghua Center for Public Policy in Beijing. Over the same period, the number of people under 14 has fallen by one third while the number of people over 60 has increased by 20 percent, creating a scenario in which China’s population is expected to peak at 1.45 billion in 2029, Brookings said.

While China’s economy is still on track to become the largest in the world, other emerging markets might pace global growth. India and Indonesia have younger populations and are expected to grow much faster.

Over the next 20 years, India’s working age population is expected to increase by 200 million; China’s is expected to grow by 4 million during that same period, and decline by 51 million during the following decade, according to Gerard Lyons, chief economist and head of research at Standard Chartered Bank.

And then there’s Indonesia, where the average age is 28.  “Walking around Jakarta is almost shocking in comparison to Japan. Adolescents and young adults are simply everywhere. They jam the malls and restaurants, hang out in the public squares, and fill the buses. One strains to see grey hair, and usually succeeds only when a large family group is present,” says blogger Michael Auslin, of the American Enterprise Institute. “It is a type of society Japan can but dimly remember, and one which even China will soon begin to forget.”

And when what?

An aging population may add to China’s already considerable inflationary pressures, some experts fear. Businesses already are competing for labor, and wages rose 20 percent in China last year. "It will become harder for productivity to keep up with faster wage growth, while the consumption share of GDP should soon start to rise, reducing economic overcapacity. All this points to higher structural inflation pressure," Nomura analyst Sun Chi said in a report cited by China Daily.

As China’s surplus of cheap labor disappears, it may start to focus more on the less labor intensive IT and service businesses, competing more directly with counterparts in the U.S.

As the population peaks, so will China’s demand for raw materials, which has helped push the price of commodities ever higher. The peak in demand will have an impact on many industries. “China’s government claims it has so far “averted” 400 million births due to the (one-child) policy – but that could represents a good amount of potential demand for all types of commodities, not to mention metals used in construction and automotive applications among others,” according to Metal Miner magazine.

Some experts argue that China’s leadership will engineer a soft landing. “As China’s working-age population will continue to outnumber the net consumer population in next 15 years or even longer, the supply capacity of the economy will remain relatively strong for years to come.  Therefore, the economy has the ability to hold the long term inflation in check,” says the research department at China International Capital Corp., the investment. (CICC soared in the latest ranking of Institutional Investor’s All-China Investment Team, placing 2nd in the 2011 report.)

That is why CICC forecasts a gradual slowdown in the economy to 9 percent from 10 percent, the average of the past several years.  “We expect the potential GDP growth will moderate to 8 percent to 9 percent during the 12th five-year plan period, and then further decline to 7-8 percent during the 13th five-year plan period,” CICC researchers say.

They expect the CPI will likely rise to 5.4 percent and top at about 5.8 percent in June, gradually declining to 5 percent in the third quarter and 4 percent in the fourth quarter of 2011, for an average of 4.8 percent for the year.

China faces additional inflationary pressures, including powerful demand for resources.

During the last few weeks there has been a lot of speculation about whether the drought that has afflicted the vast rice-growing regions near the Yangtze River will drive up food prices and push inflation even higher. And there’s plenty of cause for concern: the regions account for 30 percent of China’s grain output, and prices for grains and futures have increased since the drought, the worst in 50 years, hit the region between March and May, according to Barclays.

If that isn’t enough, the growth of China’s money supply, aided by the cheap Yuan, is inflationary, too.

There’s no reason why China can’t manage a transition to a slower growth economy with a bigger focuses on service industries and the consumer sector. But the risk is that the prosperous parts of the country will start to slow down, even before the less-developed areas have caught up with the urban cores.

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