While policymakers in the U.S. and Europe have been struggling this year to re-ignite economic growth, Beijing has been busy trying to tamp its economy down.  Worries about excessive growth have caused Beijing to hit the brakes repeatedly in an attempt to avoid overheating. Third-quarter figures showed a modest slowdown, the fourth quarterly decrease in a row, indicating that measures to curb inflation and speculation were having some effect.

But the challenge to produce a soft landing is part of an even larger problem. Although the economy must slow from current rates, growth must remain high enough to keep internal social pressures from boiling over.  Unfortunately, according to the government’s newest five-year plan, China also now knows it can no longer count on the U.S. as its “consumer of last resort.”  Instead, China must attempt to increase its own domestic demand in order to maintain robust – and sustainable — growth.

To accomplish that goal, China must somehow redirect its economy, the world’s second largest, transforming it from a global manufacturing and assembly platform to one that is based on technology, services and innovation and is capable of nurturing a rising consumer class.

The task is daunting.

“First, China has to transform its demand structure, from export oriented to more reliant on domestic consumption,” says Huang Guanhua, deputy general managerof the research department and chief economist at the China Asset Management Co.Ltd., or ChinaAMC, a major funds management company in China. “Second, it has to transform its industry structure, which has to shift from the heavy chemical industry to a more balanced structure with a stronger service sector. And third, it has to transform its growth model, shifting from a high investment, high energy consumption model to one that is more innovative and more productive.” The country will also have to focus more on environmental protectionand energy saving, Huang adds.

To be sure, China’s economic policymakers have decades of experience orchestrating far-reaching restructurings and reforms. But they face a supreme test in trying to overcome the obstacles that stand in the way of implementing a model that is powered by domestic growth drivers, experts at Wharton and elsewhere say.

Even with a narrowing in the trade surplus in 2010, China’s trade imbalance relative to the size of its economy is still well above that of Japan in the 1980s.  Heavy investment continues to be the chief driver of China’s GDP growth.  And, despite rising demand among Chinese consumers, domestic consumption continues to decline as a share of overall spending and still plays a more modest role in China than in any other major economy.

“The portion of household income in GDP hascontinuouslydeclined in recent years and it remains at quite a low level,” says CHINAAMC’s Huang, “which will pose challenges if we want to rely more on domestic consumption.”

Nevertheless, officials in China and elsewhere have begun to argue that without the domestic reorientation, China could face a steady erosion of its economic growth momentum – or even a sudden, politically destabilizing slowdown.  A survey earlier this year of more than 1,000 institutional investors by Barclays Capital, for instance, found that the potential for a so-called hard landing in China was the biggest underpriced risk in financial markets.

All things considered, “it’s definitely time” for an economic transition in China, says Marshall W. Meyer, Tsai Wan-Tsai professor of management and sociology at Wharton and a longtime China scholar.

The Case for Change

One of the primary issues confronting policymakers is that much of China’s GDP growth since the mid-1990s has been fueled by investment drives in infrastructure and urban construction organized by central and local governments.  Fixed-asset investment has risen from about 30% of GDP during the 1980s to about 45% currently, a level that is problematic since economists believe this kind of spending tends to be wasteful and inefficient compared with market-driven investment.

Another point of pain for China is an over-reliance on exports. While export growth continued to slow in the third quarter, it still rose nearly 16% over the same quarter in 2010. And exports to the United States are once more on the rise, up 14% in October after several months of growth in the 10-11% range. Such high levels can only increase pressure from the U.S. and other countries to allow still faster currency appreciation.

However, with domestic inflation still running high, real wages on the rise and the renminbi continuing to gradually appreciate, Chinese manufacturers also are coming under increasing pressure. 

Even so, engineering the shift from low-wage, export-processing industries to higher-value manufacturing activities and service industries is far easier said than done.

“This is tricky, because as the [country’s] new five-year plan acknowledges, China cannot continue relying on massive fixed-asset investment and low-cost manufacturing to buoy GDP growth,” says Wharton’s Meyer. “However, what the central government wants and what local authorities will deliver may be very different.  For instance, calls for rural land reform and increased consumer spending are hardly new, but land reform has not happened and both wages and household consumption as a percentage of GDP have continued to slide.”

The central and local governments often have different agendas, says CHINAAMC’s Huang. “The locals focus on the speed of growth, which is a key index for their performance,” he says, “but the central government has to manage the macro picture,” including inflation and the wealth gap. Although some local governments in developed cities like Shanghai “have a more balanced target and focus,” those in less developed regions “still focus on growth speed.”

In addition, experts caution that China’s economic dynamics remain extremely complex. As an example, they say, the country must continue to invest significantly in housing, transportation and other big infrastructure projects. China’s Ministry of Transport, for example, plans to invest $950 billion by the end of 2015 on upgraded roads, bridges and ports. 

“You have to understand that the stock of investment in China relative to the labor force is actually quite low – about 14% of what it is in the U.S.,” says Yukon Huang, senior associate in the Carnegie Endowment’s Asia Program and former World Bank country director for China.  “There's tremendous catching up to do.  So the bottom line is, yes, consumption needs to increase, but investment has to stay higher than normal as well.”

Assessing the Risks

China faces dangers on a number of fronts.  In addition to the concerns about inflation and the prospect of economic overheating, widening income disparities threaten to aggravate social tensions. 

At the same time, China’s emerging consumer market is vulnerable to being squeezed if excessive investment spending, faltering export sales or monetary tightening lead to a sharp deceleration of growth, according to an  analysis by The Signal Group, an economic and competitive intelligence firm that publishes the monthly China Signals report. 

Signal Group’s assessment cited several factors that could elevate risks during China’s economic transition. These included the threat of low-end manufacturers being forced to order widespread layoffs and shutdowns, a potential shift of more export-processing activity to competitors such as Vietnam and Cambodia and increased social instability if growth rates should fall below levels needed to generate jobs for the 30 million to 40 million people who enter the labor force each year.

“No emerging country is able to grow very rapidly based on its own consumption – that can take you to only 3% to 4% growth a year,” Carnegie’s Huang notes. “That's fine if you are a developed country, but it's not at all fine if per capita income is $4,500. It’s not a growth strategy.”

For now, China’s growth remains strong relative to the rest of the world — GDP rose at an annual rate of 9.1% in the third quarter — although worrying signs persist.

Lurking in the background is the property bubble. “The macro controlling policy on the property market right now is effective,” CHINAAMC’s Huang says, “although the risk in the long run still remains as China’s rapid urbanization pushes up demand.”

Another major risk, according to Huang, is the rising level of nonperforming loans of local government financing vehicles. The central government has recognized this risk, Huang adds, and it will be difficult to get funding for any new projects. By not expanding the lending pool, China hopes to “leverage the economy’s growth to digest the risk,” he explains.

Huang identifies yet two other risks: the global economic downturn and the hike in commodity prices, which deeply affects China because of its heavy reliance on imports for its energy supply and agricultural goods. 

Meanwhile, Chinese policymakers will be preoccupied in the coming months with next year’s leadership transition, experts say, inevitably sharpening factional divisions within the ruling Communist Party and raising the potential for new social unrest.

Prospects for Business

Zhou Xiaochuan, the Chinese central bank governor, says China is already working on the economic transition. “One day we’ll have a domestic market, too,” he said at a press conference earlier this year, although adding that it may take a decade or more.

For now, the rise in the renminbi’s exchange rate underscores the apparent shift in Beijing’s currency policy to one aimed at controlling inflationary pressures, experts say.  Although experts say China’s leaders remain conservative on how much appreciation they will permit, a stronger renminbi will help boost consumer purchasing power in China.  In addition, appreciation against the dollar helps to control imported inflation for oil and other commodities whose global prices are denominated in dollars. 

In the meantime, rising affluence almost certainly will further fuel Chinese consumers’ appetite for foreign brands in the near term, analysts say.  This will not only pull in additional imports — which surged 28.7% in October — but also boost demand for goods made in China by local subsidiaries of U.S. and other foreign consumer companies. 

Indeed, urban consumer spending is expected to remain robust as long as inflationary pressures persist, while companies geared to the rural economy could benefit from rebalancing efforts to spur growth in the countryside.  Migration of manufacturing activity from more expensive coastal areas, in particular, is expected to sustain the momentum for rapid urbanization in inland cities, expanding the potential market for capital equipment and building supplies as well as consumer durables.

The service sector, one of the major focus areas under the new economic plan, also is expected to benefit. “That’s where the big opportunity lies in my eye,” Wharton’s Meyer says, highlighting the need for a more vibrant legal system, higher quality accounting services and more. “My guess would be the opportunities in China now lie more in services, and knowledge-based professional services… even more so than in manufacturing things.  These [service-based] industries are not well developed, and demand will almost certainly grow.”

China’s state-owned enterprises, on the other hand, may face some new challenges.  Carnegie’s Huang, for instance, recently outlined an argument calling for state-owned corporations to pay much higher dividends to the government in order to fund important social expenditures. 

“These companies have seen their profitability and rates of return soar in the last decade or so — since they are owned by the state, the state should be getting the returns, but it is not,” Huang argues.  Instead, he says, these enterprises are investing their retained earnings in often-illogical areas, such as real estate, or lending money to other companies.  “There’s something wrong here… but it could be a quick fix: All you have to do is decide that the amount of dividends should be close to 10% to 15% and you change where the money flows and who spends it.”

Elsewhere, property developers, upstream oil, and the financial sector, among others, are expected to benefit if inflation can be constrained as the economy continues to grow.  On the other hand, analysts say, should China’s economy overheat and run into a hard landing, almost all would suffer. 

“Remember, growth is a two-edge sword,” says Wharton’s Meyer. “On the one hand, China has been running a growth-driven economy – it’s been a GDP engine, and growing every year.  The issue now is, can it generate the right kind of growth?  If you only get it in capital investment, you get it like Japan in the 1990s.  So the key is the balance between investment and consumption, and changing that is a herculean task.”