China has just displaced Japan as the world’s second-largest economy and is likely to dethrone the U.S. as the number one sometime between 2020 and 2030. Years of double-digit GDP growth — we forecast 10% for 2010 — have put China on that path. But over the next few years, the gains will slow. That’s in part due to math, since the economy was growing from a small base, but a host of serious structural flaws also looms large. Fixing them will take major reforms that, so far, Beijing has proved unwilling to make — in no small part because they would require the Communist Party to loosen its grip.

Here are seven of the most entrenched problems we see taking some of the sizzle out of China’s lightning growth.
By Andrew C. Schneider

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7 Reasons Not to Fear China

For decades, the measure of success for local and provincial government officials has been the number of jobs created for a rapidly growing urban workforce. That usually means building factories or adding infrastructure, whether needed or not. Such overcapacity leads to waste of scarce resources, deflation and dumping of excess production abroad.

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Overcapacity

Local officials force state-owned banks to finance construction at next-to-nothing rates, with no regard for borrowers’ suitability. Inevitably, nonperforming loans pile up on the banks’ balance sheets. Beijing already recapitalized the four largest state banks once, forcing ordinary depositors to foot the bill, which hurt consumption. Now bad loans are once again on the rise, a result of the $586-billion stimulus China poured through banks last year.

Though Beijing could manage another bailout, it certainly can’t keep it up forever.

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Financial Mismanagement

Sure, Chinese colleges graduate many times the number of engineers and scientists that American universities produce, but such statistics are misleading. To meet the quotas for graduates set by Beijing, academic programs dilute their standards. They further inflate their count by counting as engineering students those studying to become mechanics or industrial technicians.

The result is that many of these graduates fall far short of the standards imposed by U.S. colleges and universities. When they graduate, many are unable to find work in their professions.

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Flawed Education

Those engineers and scientists who do measure up -- the cream of Chinese universities or those who study overseas and return home -- often have little freedom to explore. If they work for state-owned firms or universities, Beijing dictates the direction of research and development. Many gravitate to the more open atmosphere at private firms, but these companies can’t get loans to grow because state enterprises gobble up the capital. Beijing aims to compensate by forcing multinationals to transfer advanced technology as the cost of doing business in China, but foreign firms are fighting back hard.

Remember, China builds the iPod — it didn’t invent it.

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Stifled Innovation

Water pollution and water shortages pose the most serious problems. They cause health ailments, damage agriculture, jam up hydroelectric dams, interfere with manufacturing and limit urbanization. As aquifers dry up, soil erodes, turning an area the size of Connecticut to desert every year. The resulting dust storms add to the country’s already horrendous air pollution. Beijing’s preferred solution to the problem is a massive south-to-north river diversion project. Odds are, that will make matters worse, draining water from already overtaxed southern supplies.

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Environmental Degradation

One of the major reasons Beijing has such a hard time dealing with all the problems mentioned above is that so many individuals have a vested interest in keeping things exactly as they are. Communist Party officials pay for their advancement, then aim to earn back their investment. Local governments seize houses and land, sell them to developers with little compensation for those displaced, then take kickbacks from the construction companies. This hits U.S. and other foreign companies operating in China as well.

Beijing does make examples of particularly corrupt officials and business leaders, sometimes even executing the offenders. But the problem of corruption is endemic, costing as much as 10% to 13% of annual GDP, according to Transparency International.

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Corruption

As the generation of the Cultural Revolution retires,
the burden of their care falls heavily on the smaller generation of the one-child policy. As fewer workers support more retirees, competitiveness will suffer. For an illustration of what this could mean, China need look no farther than Japan.

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An Aging Population

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