On the surface, China seems to have fully recovered from the depths of the global recession and consolidated its position as the world’s biggest exporter and the second-largest economy behind the United States. Although China’s GDP growth rate steadily declined from 11.4% in 2007 and 9.6% in 2008 to 8.7% in 2009, it went up again, to 9.6%, year-on-year, during the third-quarter of 2010. Moreover, China’s trade surplus has also started to rise. During the third quarter of 2010, its surplus was $65.6 billion, or 31% higher than a year earlier. That was the largest quarterly figure since its $114 billion surplus in the last three months of 2008.

But the very strength of the recovery is putting China back on a collision course with its trading partners — and in the process, possibly undermining its path toward long-term prosperity and a more “normal” pattern of consumer-driven development. With a swelling middle class of perhaps half a billion people, China has to become less focused on export-fueled growth, experts say, and more focused on making consumer goods. Yet the World Bank recently forecast that China’s trade surplus will grow from $247 billion in 2010 to $273 billion in 2011 and $314 billion in 2012.

Will China’s rising tide of exports swamp the economies of its largest trading partners? Can China manage to raise the value of its currency, the renminbi, to levels that its trading partners consider “fair,” without thwarting its own progress toward becoming the world’s most populous consumer society? And if all that weren’t enough to worry about, will other troubling issues that are lurking in the background — China’s shifting demographics, steep rise in inflation, massive real estate bubble and need to produce higher-value products — put a brake on both export growth and the transition to a consumer economy?

In short, despite its rebound, China faces a raft of complex, widely misunderstood challenges, experts say, adding that some of these challenges, if they were understood, could present opportunities for the United States and other trading partners. 

Building Up the Interior

The good news about China, according to optimists like John Frisbie, president of the U.S.-China Business Council, is that millions of workers in its long-isolated interior will soon be joining the middle class, adding impetus to the shift to a more normal, more balanced consumerist economy. As wages and other costs along the well-developed eastern coast continue to rise, manufacturing sites there are becoming less cost-effective. China is moving full speed ahead to modernize the Yangtze River Basin, home to some 400 million people, spending massive amounts to upgrade transportation infrastructure and electric power plants. Nationwide, plans call for the government to spend more than $100 billion over the next few years just on its high-speed rail system.

Upgrades in China’s physical infrastructure will also make it more cost-effective for non-Chinese multinationals to source components and products from locations deep within China, as well as distribute foreign-made products to consumers there. In Wuhan, the most populous city in central China’s Hubei province, a retail complex known as Mall City is becoming one of the largest shopping centers in the world, expanding to some 400,000 square meters of space.

China’s eagerness to improve its infrastructure is not misplaced or exaggerated, argues Nicholas Lardy, senior fellow at the Peterson Institute for International Economics in Washington, D.C. Lardy notes that China ranks only 27th internationally in the World Bank’s 2010 analysis of global trade logistics, which measures infrastructure development and customs efficiency. “Clearly, there is scope for many more economically productive infrastructure projects in China,” says Lardy. 

On the trade front, Frisbie points out that American exports to China reached $69.6 billion in 2009, or 330% higher than the volume recorded in 2000, the last full year before China joined the World Trade Organization. Over those years, U.S. exports to the rest of the world grew by just 29%. Despite the recession, almost half of all U.S. states registered increases in their exports to China in 2009 versus 2008, while only 10 states showed declines.

“Many [U.S.] companies are doing a good business in China, and many small companies find China a good market,” says Rob Mulligan, who heads the Washington office of the U.S. Council for International Business (USCIB), which represents U.S. companies at the International Chamber of Commerce. “There is progress in some areas, but a lack of progress in other areas. There are ebbs and flows.”

Negative Long-Term Demographics

Nevertheless, there are major clouds on China’s horizon. One widely disregarded but key issue: China is facing demographic challenges that threaten to slow its long-term expansion and change the path of its economic relationship with the United States, notes Marshall Meyer, a professor of management at Wharton. “We are at an inflection point of major change in China’s demographic patterns,” Meyer says.

Under the leadership of Chairman Mao Zedong, who died in 1976, the Chinese were told to have large families, thereby tripling the population in little more than a generation from 400 million to 1.2 billion. China’s population pyramid was then very wide at the base and narrow at the top in terms of age distribution. The switch in policy that was implemented following the Cultural Revolution — to one child per family — initially produced a population pyramid optimal for economic growth. That is to say, the largest segments of the population were neither old nor young but in the middle — it was closer to a diamond than a pyramid. More recently, however, the one-child policy is creating an inverted pyramid, leaving too few workers in the lower-age brackets.

“So you would expect economic growth to slow down as the population ages,” notes Meyer. “The Chinese population will soon look very much like Europe,” making China into a “much more normal” economy in that respect.

Thanks to the inverted pyramid, Meyer adds, fewer workers will be available to expand manufacturing output as the number of retirees gets larger. In addition, China will have to spend more on social security and medical care. Yet under the current system, it is already “very hard to collect benefits,” suggesting that “a lot of people will have to draw down on their savings.” Little support from family members can be expected in a society where there is one grandchild for every four grandparents, he adds, which means that the continued aging of China “will put [significant] stress” on its society.

Meyer predicts that the Chinese workforce will start to shrink in absolute terms in 2015. Already, he notes, younger workers — those under the age of 25 — are declining in absolute numbers. All other things being equal, when the percentage of older workers increases, labor costs increase, since older workers are less productive in manual jobs.

As the economy slowed in early 2008, a number of plants were shut down and workers were sent home. More recently, plants have been re-opening and many workers have returned to the eastern provinces. China went very quickly from unemployment to a labor shortage, and “wages went up like crazy,” Meyer says, which makes China “a little less competitive internationally.” Inflation on other fronts is also a major problem. For example, food prices were up 10.1% in October compared with October 2009. All of these trends mean that “the Chinese economy inevitably turns inward,” says Meyer. “The balance of trade shifts and growth will slow. China will not have explosive growth in exports. Low-cost manufacturing for exports won’t continue to work.”

So far, China’s growing prosperity has been based largely on its ability to manufacture lower-end products at competitive prices. But as costs rise in China, the country has to move up the value chain. “China is worried because it doesn’t want to be only a low-end manufacturer,” says Gerald McDermott, a former Wharton professor who is currently a professor of international business at the Darla Moore School of Business at the University of South Carolina. To design and manufacture high-value-added products, China needs to develop a workforce with a large number of first-rate, innovative engineers.  

Revaluing the Renminbi: Limited Options

Another unresolved issue is the value of China’s currency, the renminbi. China’s trading partners continue to complain that the Chinese currency is undervalued, providing China’s exports an unfair competitive advantage in global markets.

Although many critics of China view renminbi revaluation as some sort of quick solution to the trade problem, the Chinese government’s options are limited because of the country’s high inflation, notes Meyer. “The Chinese government can’t control inflation,” he says. Food prices “have gone haywire,” and supermarket prices are very close to those in the United States, despite much lower incomes. Real estate is now in a bubble, with some prices higher than in the United States.

To try to curb inflation, China raised its benchmark one-year lending and deposit rates by 0.25 percentage points in October and again in late December. Even before the latest bump up, these rates had been far higher than in the United States for some time. But when China raises its rates, more “hot money” goes there to enjoy a higher return, Meyer notes. The People’s Bank then collects more U.S. dollars, and the United States urges China to raise the value of the renminbi, even as “the purchasing power of the renminbi is deteriorating,” says Meyer. “It’s a mess.”

What are China’s viable options? Meyer says that if Beijing revalues the renminbi, the country’s exports will weaken and “China’s economy will slow down. The question is, can China grin and bear it politically? Long-term, a slowdown helps curb inflation, but at the cost of greater unemployment, which is politically very difficult.” In an attempt to dampen inflation, China has tried to impose “administrative controls” on banks aimed at getting them to lend less. But those controls don’t work, according to Meyer, because the banks create off-balance-sheet entities that issue loans in renminbi at very high interest rates. “Overall, governing China is even harder than governing the U.S.,” says Meyer, noting that the country is stretched thin, dependent on labor imported from its own countryside, on imported technology, on imported raw materials and energy, and on export markets.

The focus on a quick fix by China also misses another point, adds McDermott. “It is a truism that short-term fluctuations in exchange rates don’t have much impact on trade balance.” However, longer-range foreign exchange rate strategies do have an impact. “It is one of China’s strategies to manage its exchange rates,” as most developed countries attempt to do. What’s more important is China’s long-term strategy to manipulate its currency. “China can do that because [it earns] a lot of U.S. dollars,” McDermott says. “It is not about moving the renminbi versus the dollar in a sudden way; it is about long-term management.”

Beyond Questions of Cost

The currency issue deflects attention from the more fundamental issue confronting the United States of how to rebuild competitiveness in those global markets where it has lost ground because costs at home have risen too steeply. McDermott suggests that people should be asking this key question: “What are the kinds of [trade] deficits that we should care about?” The United States will never be able to compete in every manufacturing sector, says McDermott. Fortunately, he adds, “a growing [number] of people are now oriented toward steering the U.S. back to regaining some edge in more sophisticated manufacturing” sectors where it could regain its competitiveness despite the higher costs involved in making goods at home.

For example, notes McDermott, “There is no reason to say that it is more efficient to produce” solar or other innovative sorts of alternative energy in China — or elsewhere outside the United States. “We must distinguish the different segments” of manufacturing by looking beyond just the low end (which we associate with China and other low-wage producers) and the high end (which we associate with the U.S and other developed countries). What gets lost too often, he says, is the vital middle range of technology, where the U.S. can still compete against China and other lower-wage countries, but may not be able to do so because of uncompetitive trade practices or the failure of corporate managers to recognize such opportunities. According to McDermott, executives need to ask: “Are there areas of more sophisticated manufacturing and technology where we should be playing a large role? And if so, why is this not happening? Let’s get beyond questions of cost.”

Stephen Kobrin, Wharton professor of multinational management, adds that Americans need to find a way to deal with an even more fundamental issue: China represents an alternative model of economic development that defies traditional assumptions that capitalist systems can’t function without liberal democracy and free-market competition. “China makes us question those assumptions,” Kobrin says. Though it has strayed far from its Communist roots, he notes, its government remains authoritarian and its state-owned corporations continue to play a strong role in the economy. In addition, “China certainly manipulates its currency, and makes it difficult for foreign companies” to expand in its domestic markets.

Until recently, U.S. companies have “been very reluctant to speak out” about the challenges they face in that market, Kobrin says. More and more firms are now complaining, not so much about the lack of transparency in the Chinese system but about overt discrimination against foreign firms. What they are calling for is “a level playing field based on assumptions about fairness and the rule of law.”

In that regard, the USCIB recently completed its annual survey of U.S. multinationals and submitted its findings to the U.S. Trade Representative. Mulligan says intellectual property protection is “an ongoing problem for a wide range of companies,” which still complain about such challenges as copyright and trademark infringement, counterfeit Chinese-made parts that damage foreign companies’ brands in China, and foreign companies’ lack of access to Chinese government procurement contracts. Despite ongoing negotiations, China has yet to become a party to the WTO’s Agreement on Government Procurement, which China committed to ratifying when it joined the WTO in 2001.

“The debate is getting a little more acrimonious,” states Meyer. “Everyone has a problem here. The problem for the U.S. is that we have too much debt, and China holds too much of it. Historically, that doesn’t bode well” since “debtor nations lose power” sooner or later. Americans, he says, want to benefit from the low prices of importing from China, but they end up in debt. What few people seem to realize, however, is that China will also ultimately pay “a much bigger price than the U.S.” when Chinese people get older and their savings have eroded due to inflation. China has been “printing money like crazy, and the mortgage mess in the U.S. could look trivial compared with the set of bubbles that need to be addressed” there, he suggests. As China takes measures to lower its inflation rate, real estate values could collapse. “The real issue is not the value of the renminbi but the mechanism they use to achieve the valuation.” The Chinese take in U.S. dollars but they don’t sell them. Instead, they print more renminbi. “If the Chinese government sold the U.S. dollars they earned, then the value of the renminbi would go up, the prices of their exports would go up and fewer U.S. dollars would enter China.”

What needs to be done? To begin with, “our rhetoric has to change,” says Meyer. “Talking about currency manipulation goes nowhere. We may want to go over the heads of the Chinese government and say to the Chinese people: ‘This is not in your interest. Have you noticed that your government is printing more money than any government in the world? To protect your savings, let the market determine the value of the renminbi.'”