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Why China's Surging Economy Is in Trouble

By Dan Carroll – May 15, 2013 at 7:24PM

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While China's GDP is on the verge of overtaking America's, the Asian nation faces a gauntlet of daunting economic challenges in coming years

Much has been made of China's rapid economic growth in recent years. The world's second-leading economy has grown from an average regional player 30 years ago into a powerhouse today, commanding a gross domestic product of more than $12 trillion when adjusted for purchasing power. According to the OECD, China's GDP will overtake the U.S.' for the top spot worldwide by 2016.

But is China really the economic superpower many have been hyping it as? A closer look reveals a country facing numerous challenges in the years ahead -- and a nation that isn't ready yet to take its place at the world's economic peak. Investors caught up in this growth story shouldn't overlook a Chinese future fraught with risks.

A rising middle class brings problems
The rise of China's middle class is one of the pivotal demographic shifts of the early 21st century. The OECD currently estimates that about 10% of China's population is in the middle class -- a number that could grow to as high as 40% by 2020. With that rise comes a bevy of problems that threaten to derail the government's lofty growth predictions.

China's government has made no small show of its desire to urbanize its mostly rural population. While hundreds of millions of Chinese live in peasant conditions today, Beijing plans to bring many citizens into cities over the coming years. That move will be costly: Many middle-class citizens in China already vie for more benefits as the Chinese economy grows, and increasing welfare -- particularly as the urban population swells -- will crimp Beijing's coffers and hurt plans to invest more into areas of critical need, such as infrastructure. Forget about leveraging its economic size internationally; China will have a hard time keeping up domestically.

Housing costs have exploded in Chinese cities as the nation's urban population swells. Prices in Beijing grew more than 8% year over year in March alone, and the Chinese government's attempts to curb housing prices have met resistance from municipal half-measures and reluctant local officials.

It's doubtful that the housing market will crash like America's did in 2007 and 2008 -- JPMorgan's chief exec of Chinese investment banking points out the strong demand and low leverage in the country's housing sector -- but there are other reasons for concern. The growing bubble in housing prices in a culture that prides home-ownership could push many younger people of the middle class to overpay for housing, which threatens budgets and consumer spending -- perhaps the most important cog of leading economies around the world.

Granted, consumer spending is predicted to grow substantially in China as the middle class rises. Signs have already emerged of growing consumption. Retail sales jumped more than 12% year over year in January and February, and Chinese consumption has plenty of room to grow: It currently makes up about 37% of GDP -- far less than in economies such as the U.S. Still, Chinese middle-class consumers face high prices for many goods, and the era of "Made in China" cheap goods is coming to an end, further threatening consumer spending power as the middle class struggles to take hold.

Cheap manufacturing screeches to a halt
China's low-wage manufacturing has lured many companies to invest in the nation, but the country's poorer neighbors have taken note. Developing economies such as Cambodia and Vietnam are drawing cheap manufacturing away from China as wages rise in the world's second-largest economy. Corporate investment from Chinese and Japanese firms has flowed into newfound wealth in Southeast Asia's smaller economies, with $850 million entering Cambodia alone in 2011. That's a critical problem for China, which has long used its advantages in trade and investments to buoy its growth.

Once again, the problem of the middle class's rise rears its head. Labor costs and worker demands at Chinese plants -- made famous by Foxconn's worker troubles -- will continue to drive away cheap manufacturing as the middle class swells and more Chinese citizens demand fair working conditions. China's neighbors will benefit, but Chinese prices and imports are likely to rise as manufacturing flees for greener pastures.

Chinese labor and manufacturing have grown so pricey that even advanced economies could benefit from China's loss. The Boston Consulting Group in 2011 estimated that wages and benefits would grow at a rate between 15% and 20% a year -- a hike that could even send manufacturing back to the United States in a twist of the historical "Made in China" trend. Once again, Chinese exports could be poised to fall just when Beijing needs them to support the growing middle class and urban population.

Consequences of the aging crisis
Perhaps China's greatest problem is one of age. Many have talked about the coming consequences of China's long-standing one-child policy and its effect on an aging population, but the numbers and impact on China's future economy are staggering.

The IMF already sees a potential labor shortage of more than 100 million workers in the near future as the nation's working-age population shrinks -- a casualty of China's low birth rate. As Time reports, China's elderly could grow to more than 30% of the nation's total population by the 2040s. With China already racing to provide enough benefits to a growing middle class, supporting a surging senior population will be a monumental challenge. Younger Chinese consumers can hardly be expected to pick up the slack in a slower-growth future.

Something has to give, and it will most likely be China's economic growth. Productivity will be hit as the country ages and a smaller workforce tends to a growing senior demographic -- a trend already looming over Asian rival Japan. Japan's aging population that will tax social-support systems and the workforce paint a bleak picture of what will likely come to China in the future.

Despite all this, China has some trends going for it. Even with its current slowdown, the world's second-largest economy is growing faster than than 7%, so something as drastic as contraction is unthinkable in the near future unless the hurdles above grow into a wall. China's technological growth will also help productivity and overall economic growth even as challenges mount. While cheap labor and manufacturing wane, innovation could take their place as a key economic driver in a more educated and wealthy society. Already, innovative firms such as Baidu (BIDU 2.64%), the top Chinese search engine that is now the fifth-most-visited Internet destination in the world, have shown promise for China's economy and investors alike in taking advantage of the technologically developing nation.

Even with those advantages, however, China's future challenges are significant enough to keep this nation from ascending high enough to flex its economic muscle on a global stage in the coming few decades. If China will ever take up the mantle as the world's economic leader, it will not be through a leap to the top, but rather through a hard-fought, decades-long struggle as the nation modernizes and progresses.

What's an investor to do?
China's growth story has captivated investors lately, although Chinese markets haven't capitalized on growth. The Hang Seng Index (HSIINDICES: ^HSI) has stayed flat over the past two years, and China's recent slowdown has kept the index from matching the high-powered markets of the U.S. and Japan. How should China's impending hurdles affect your investing approach to massive economy?

As with any market, look for strong companies with real lasting power. Tech firms like the aforementioned Baidu are in a strong position to capitalize on China's technological development. Chinese Internet users grew 10% last year, swelling to more than 560 million in a trend that will help Baidu and other online leaders. Furthermore, leading Chinese tech firms have partnered with global leaders to help solidify their leadership as the middle class grows. Internet firm SINA (SINA) has already established alliances with Apple and Alibaba recently -- two moves that should help bolster the company's long-term future by capitalizing on Chinese iOS users and growing advertising revenue at its social-media service.

On the other hand, risky bets become far riskier in China. With transparency already in question in China, investors looking for great companies should stay clear of Chinese stocks without real competitive advantages.

For risk-averse investors, the best way to invest in China may be to buy stock in large multinational firms operating in Asia's largest economy. Industrial giant Caterpillar (CAT 1.46%) has recently expanded operations in China as its sales in slower-growth areas such as Europe wane. Caterpillar plans to capitalize on the country's infrastructure investment and urban growth as the company attempts to dig out of its own recent slowdown. While Caterpillar still trails some competitors in the world's second-largest economy, its commitment to growing its presence across the Pacific -- even as the industrial sector continues to lag -- is an inviting prospect for investors looking for safer picks in China.

In all, while China is poised to continue its growth story, significant challenges remain that should hinder this country's rapid ascension to the economic elite. China's GDP may overtake the U.S.' in coming years, or it may not. What's clear is that it will take much more than the world's top GDP for China's economy to emerge as a true world leader.

Fool contributor Dan Carroll has no position in any stocks mentioned. The Motley Fool recommends Apple, Baidu, and SINA. The Motley Fool owns shares of Apple and Baidu. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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