While long-term economic predictions should be made with caution, demographic trends and declining savings rates are likely to slow China's GDP growth in the decades to come

----By Brian Schwarz

Western think tanks and consulting groups like to issue reports that analyse global economic environment decades in the future. Projecting China's future growth rates, researchers at Goldman Sachs last year, for instance, claimed that China's economy could overtake the United States by 2041. In March, PricewaterhouseCoopers (PwC) reached a similar conclusion in a report called "The World in 2050" when it predicted that in the next 44 years China will likely overtake Japan and Germany and rank alongside America as the most powerful country in the world.

While such predictions may prove to be true, it is important for foreign politicians and business leaders dig a little bit deeper into these reports and try to separate the myth from the reality. With soaring GDP growth rates in the past three decades and a huge population, China has generated its share of oft-repeated myths involving its massive labour market and high national savings rate. A complex new reality is starting to emerge.

A limited surplus

A common Chinese myth involves its seemingly endless supply of cheap workers. In August, China Daily warned that the country's one-child policy has led to an aging population and labour shortages that could undermine a key basis for the country's economic growth.

The article cited a 2005 United Nations study saying the number of people aged 60 or over is expected to rise to 31 percent of the population in 2050, or more than 430 million people, from just 10.9 percent in 2004. By comparison, the projected world average will be 21.7 percent in 2050. For a developing country with per capita GDP of just above US$1,000 the outlook was "unprecedented".

This is not the first time the national government has analysed the problem. In fact, demographic experts in China have raised alarm bells for some time that the country faces a shortage of labour in the near future due to plummeting population growth. Last year Xinhua News Agency reported claims made by Xie Fang, deputy director and researcher with the Institute of Population and Labour Economics at the Chinese Academy of Social Sciences:

"China's population is expected to peak at 1.44 billion by 2033 while the labour population is not expected to increase after 2011. However, the peak time came much earlier than expected thanks to that [sic] the national policy of family planning has worked and that the old-age population grows. As a result, the decline of the increase rate of the labour population has materialised in recent years."

Mr Xie concluded by citing statistics showing the proportion of jobs and job hunters increasing year by year in 117 cities nationwide, climbing as much as 95 percent in the second quarter of 2005 compared to 65 percent in the first quarter of 2001.

These demographic trends are turning China's labour market from a "limitless supply" into a "limited surplus" with labour supply gaps showing up in the manufacturing strongholds, notably in the southern city of Shenzhen. According to a survey late last year of mostly labour-intensive firms in Shenzhen, there is an estimated shortage of 100,000 workers. The shortage in the city of Dongguan is even more severe.

Labour turnover is approaching 50 percent in many low-tech industries, according to the Institute of Contemporary Observation. Guangdong province says it has 2.5 million jobs that remain unfilled, while Jiangsu, Zhejiang and Shandong provinces say they, too, face the same challenge. Managers have been reportedly forced to increase wages and improve working conditions to attract and keep their best workers.

According to a recent purchasing managers' survey taken by the London-based NTC Research, the price of Chinese goods at the factory gates has jumped upward in the last four months. This growing talk of labour shortages and soaring turnover rates has hit the bottom line. A report in January by the American Chamber of Commerce found that rising labour costs have lowered profit margins at 48 percent of US manufacturers on the mainland.

As the Chinese population ages, this talent crunch is only going to get worse as more businesses, both domestic and foreign, expand operations. The key test will be if more firms invest in labour saving technology, improve productivity and move up the value chain.

The saving challenge

Much of China's large pool of savings is sitting in corporate accounts and personal accounts. A second myth involves frugal Chinese consumers stashing a high percentage of their income every month. With a strong emphasis on family, it is true many young Chinese families are trying to support their parents who had no opportunity to save for themselves before the reform era started in 1978.

A United Nations study warns that China faces a "pension time bomb" from its aging population. By 2020, about a third of Shanghai's residents will be over 59, remaking the city's social fabric and placing huge new strains on its economy. The global implications of this demographic shift are hotly debated. Some experts forecast that the country's savings surplus will continue for the foreseeable future.

On the bright side, a study entitled Will China Eat Our Lunch or Take Us Out to Dinner? by two German researchers, Hans Fehr and Sabine Jokisch, concludes a flood of Chinese savings over the next forty years could turn the anticipated capital shortages in North America, Europe and Japan into capital gluts instead. But new research notes that the high total saving rate of China is mostly the result of a higher corporate saving rate, which stands at twice the world average.

When compared with neighbouring India, the Chinese start to look like heavy spenders. According to a May 2006 report by McKinsey, "Putting China's capital to work," Chinese households save 23.8 percent of their disposable income, not particularly high compared to the saving rates of Asian tigers in their high-growth period.

A growing rich-poor divide also influences China's savings rate. In 2003, 1.86 percent of the wealthiest Chinese households controlled 60 percent of the total stock of liquid financial assets in China, and they certainly have a much higher saving rate than poor people. The same McKinsey survey indeed shows that the lowest income quintile of Chinese households save only 20 percent of their income.

And a large majority of Chinese are concerned about their ability to build a financial nest egg for their family's future. Stephen Roach, chief economist at Morgan Stanley, says family dissatisfaction is mounting over the amount they are able to set aside each year. In 2004, 68 percent of all Chinese in a Gallup survey were dissatisfied with their ability to save - a meaningful deterioration from the 61 percent reading in 1997.

A 2005 report also from McKinsey said just 37 percent of those surveyed agreed or strongly agreed with the statement "I feel confident about my financial future." While respondents confirmed that they saved a quarter of their family income, the survey results support the view that China's savings rate is high because the country's social safety net is thin and most Chinese must pay for health care and pensions out of their own pockets.

The average Chinese family has thousands of yuan stashed away in the state-run banking system earning only a low rate of interest. While rates earned on bank deposits are starting to inch upwards, there is a tendency toward more conservative investments. Many Chinese feel nervous about risking more hard-earned yuan in the domestic stock exchanges often plagued by corruption and poor regulatory oversight.

Millions of Chinese will probably not be able to rely on government handouts. Another McKinsey study in March noted that just 3 percent of government spending in China supports social welfare. According to the China Ministry of Labour and Social Security, the government will need an additional RMB740 billion to cover future pension expenses. The situation will likely worsen because the population is aging rapidly - with average life expectancy expected to reach 79 years by 2020.

Declining competitiveness

As the government's pension obligations mount, many firms are struggling to maintain their competitive edge. According to a report released by the World Economic Forum, China's overall global competitiveness has, in fact, declined for the past three years. While China's soaring trade surplus and GDP growth grab headlines, China fell to 49th in the world for economic competitiveness, down three notches from the same list last year.

While Finland and the US earned the highest marks, the report cites China's inefficient government institutions and corruption as major causes for the country's fall in the rankings. Even though every economic evaluation system has its defects, this report should be required reading for anyone thinking of investing in the Middle Kingdom.

Long-term economic forecasts should be viewed with caution. While it is undeniably true that China's rise creates a major challenge for Western economies, it is important to keep its economic growth in perspective. While its is difficult to predict who will be the world's largest economy in 2050, more people are starting to uncover some of China's hidden weaknesses.

China's pension time bomb

China's pension challenge is based on demographic trends and inadequate government policies regulating the financial sector. Implemented in 1979, China's family planning policies have prevented the birth of an estimated 300 million people. With a strong social obligation to provide for their parents after they retire, many single children are struggling to satisfy this heavy burden.

Even with impressive economic development, the personal incomes of the younger generation have not risen fast enough to support a growing number of pensioners, according to a government report recently published in the China Youth Daily. China's national saving rate is close to 50 percent and its household sector saves about 30 percent of current income, according to Morgan Stanley's Stephen Roach.

The national government started to reform a purely "pay-as-you-go" pension system in 1997 and introduced one that combines a basic pension with personal savings accounts, but the current system does not cover those who retired before 1997, leaving a large pension shortfall. Employee pensions are supported by contributions paid by both employers and employees.

According to a United Nations study released in 2005, the number of people aged 60 or over is expected to rise to 31 percent of the population in 2050, or more than 430 million people, from just 10.9 percent last year. By comparison, the projected world average will be 21.7 percent in the same year. The report said the appearance of an aging population in a developing country where per capita GDP has only just exceeded US$1,000 was "unprecedented".

What can be done to prevent this looming crisis? In a paper entitled "China's pension system: Caught between mounting legacies and unfavourable demographics", published earlier this year, Deutsche Bank researcher Tamara Trinh presents a series of policy recommendations. First, she called on Beijing to centralise pension system management and further liberalise capital markets to create financial products with higher returns and longer maturities. Second, foreigners should be allowed unmitigated access to the domestic capital markets to increase the pool of capital available.

In a similar study in 2005, McKinsey called on China's policy makers to consider proposals to turning more state-owned enterprises into publicly traded ones, thus generating additional equity around them. And creating a system in which employers and employees would make contributions to designated funds, with payouts in proportion to their performance and to each individual's contribution.

While Beijing is firmly aware of the crisis, a few local officials have damaged public trust in the system. In late August, a pension fund scandal was uncovered in Shanghai, the country's financial capital, involving the city's former mayor, Chen Liangyu. Currently Shanghai's most senior official in Beijing, Chen sits on the Communist party Politburo. While the city's pension deficit has grown to US$88 million, according to a report in the Financial Times, government officials led by Chen are accused of misusing funds to speculate in real estate.