BEHIND THE RED CURTAIN: PREDICTING THE IMPACT OF CHINAS GROWING ECONOMY ON THE U.S.

(Revised and updated version of Chinas Economy: What Does The Future Hold)

By LUC M. BERLIN UNKAP

July 26, 2011

Abstract
Although clear to all now, many people would not have predicted the now fact that Chinas Gross Domestic Product (GDP) would grow to become the 2nd largest of the world, eclipsing longtime holder Japan. Since the introduction of economic reforms in 1979, China has become the worlds fastest-growing economy. Moreover, the Chinese government has made strategic investments both economically and socially to ensure its relevance in the business world. Will Chinas economy keep its trend and propel the country to the top of the world economy echelon? This research paper examines and evaluates the sustainability of Chinas current economic conditions to see how they shape its future and the resulting implications for the United States.

Luc Berlin is an avid fan of global business management and macroeconomics. He has held critical business roles with innovative technology and ecommerce organizations and consults with visionary companies on developing international expansion strategies. A passionate globetrotter, Luc has lived in three continents, speaks fluent French, English, moderate Spanish, and is learning Mandarin. He is also the founder of www.miigle.com, an online platform that allows people to share, develop, and fund ideas from around the world. He has been a recipient of the ACS scholar award and a Finalist at the 2011 American Business Awards for Best Marketing Campaign in Computer Software. Luc is a graduate of Pepperdine Universitys Graziadio School of Business and Management. You may contact him at luki.berlin@me.com.

Table of Contents
Preface Part I Navigating Through Chinas Economic Past Prior to Economic Reforms Doing Away with Communism Part II Current Economic Conditions Abundant and Cheap Labor Force Investment in Education Manufacturing and Export A Growing Middle Class Part III - Economic Future: Opportunities and Long-Term Challenges Opportunities: Chinas Potential Economic Growth Long-Term Challenges: Economic and Political Reforms Part IV Implications of Chinas Economic Rise on the U.S. The Writings Not On The Wall Conclusion 3 4 5 5 7 7 8 9 11 12 12 14 16 18 19

BEHIND THE RED CURTAIN: PREDICTING THE IMPACT OF CHINAS GROWING ECONOMY ON THE U.S. Preface
Over the past decades, Chinas growth has been a leading case study in the economic world. Chinas Gross Domestic Product (GDP) is now the second largest in the world, eclipsing longtime holder Japan. Since the introduction of economic reforms in 1979, China has become the worlds fastest-growing economy. From 1979 to 2005 Chinas real GDP grew at an average annual rate of 9.6%. Last year, in 2010, Chinas GDP growth was 10.1% compared to 2.8% for the United States. Over the past decades, China has quickly risen from a developing country to a global economic powerhouse sprinting past every other Western economy, with the U.S. as the only exception. An online survey of over 723 economic researchers around the globe undertaken by Fast Future and Global Futures and Foresight (GFF) yielded the following results: 34% believe it will also grow at over 8% between 2011-2020 and 72% believe it will grow at over 6% in that period 38% believe Chinas GDP will have overtaken that of the USA by 2025 and 73% believe it will grow at over 6% in that period 78% of respondents believe that the Chinese stock markets will overtake the New York Stock Exchange in size 56% think the milestone will be reached by 2040 60% believe that Chinese companies could become the largest grouping amongst the global 500 by 2040.

These findings seem to affirm a growing consensus that Chinas reign as the largest economy in the world is no longer a matter of if but rather how soon. However, not everyone has bought into this possibility. Many people still believe that the U.S. will retain its crown as the worlds economic superpower. In his book The Next Hundred Million: America in 2050, Joel Kotkin, a presidential fellow at Chapman University in Orange, CA, predicts that population growth based on fertility rates and immigration pattern will increase the U.S. population today by roughly 100 million. Kotkin argues that this population growth will be a blessing to American prosperity and eventually help the U.S. maintain its edge on China. Will Chinas economy keep its trend and become the number one economic power in the world or will the United States, fueled by a boost in populace as Kotkin predicts, remain the global economic superpower? What will be the impact of Chinas fast growing economy on the United States? This paper answers these questions by looking at Chinas economic history and how it has influenced present days. Following the same approach, it examines and evaluates the sustainability of current economic conditions to see how they shape both Chinas and the United States economic futures.

Part I Navigating Through Chinas Economic Past

Contrary to popular belief, Chinas economic downfall did not begin with the introduction of communism by Mao Zedong. According to Kent Deng of the London School of Economics, Chinas economic, cultural and technological superiority decline began when in 1433 emperor Xuan De stopped foreign trade and

construction of big naval vessels. Isolated from the rest of the world, China began a cycle of decay that lasted until the late 1970s at the end of Mao Zedongs Cultural Revolution.

Prior to Economic Reforms

In a Congressional Research Service Issue Brief, Mr. Wayne Morrison of the Foreign Affairs, Defense, and Trade Division perfectly described the economic environment in China prior to the economic reforms of 1979. According to Mr. Morrison, a central goal of the Chinese government was to make Chinas economy relatively selfsufficient. China maintained a centrally planned, or command economy. The state directed and controlled a large share of the countrys economic output. It also set production goals, controlled prices, and allocated resources throughout most of the economy. Foreign trade was generally limited to obtaining only those goods that could not be made or obtained in China. Private enterprises and foreign-invested firms were nearly non-existent. As a result of these government policies, the Chinese economy was left relatively stagnant and inefficient because of few to no profit incentives for firms and farmers; competition was virtually nonexistent, and price and production controls caused widespread distortions in the economy.

Doing Away with Communism

Beginning in 1979, China launched several economic reforms. According to Mr. Morrison, the central government, led by Deng Xiaoping created ownership incentives that allowed farmers to sell a portion of their crops on the free market. The government also established four special economic zones along the coast of the

purpose of attracting foreign investment, boosting exports, and importing high technology products into China. Additional reforms included a decentralization of economic policymaking, tax and trade incentives, development zones, and the elimination of state price controls. Since Deng Xiaoping began the modernization process in 1978 by de-collectivizing the farms, Chinas economy has grown substantially faster and the country has gone on a remarkable and unprecedented program of urbanization, marketization, privatization and globalization in the words of University of Michigans Kenneth Lieberthal.

Table 1. Chinas Average Annual Real GDP Growth Rates, 1960-2005

Source: Morrison, W. (2006). CRS Issue Brief for Congress. Chinas Economic Conditions.

Part II Current Economic Conditions

As of 2010, China had the highest GDP growth rate in the world - at 10% - and is expected to continue developing rapidly in the near future. The government has taken great strides to increasing domestic consumption by leveraging its abundant population through low cost labor, both currently seen as the biggest drivers of growth. Bureaucracy and corruption are perceived as the most significant growth barriers. Critical concerns have also been raised about human rights, the environment, freedom of speech, inequality, internal tensions, stresses on the banking system and the potential for overheating. Regardless, one cannot refute the amazing economical progress China has made, taking 400 million people out of poverty and laying the foundations for future development. Lets look at the Chinese economys commanding heights in other words leading factors that are driving their economic prosperity.

Abundant and Cheap Labor Force

The constant flux of large populations of villagers, looking for a modern lifestyle, into the cities has given China a large pool of low-cost labor against which most other countries cannot compete. Only India stands out to be a clear exception. Indeed, in the GFF and Fast Future online survey, the scale of the market, low cost labor and Chinas growing capacity for innovation were identified as the top three factors attracting people to establish a presence in China or grow an existing one. A prevalent problem for the many companies that have shown an interest in the Chinese market is lack of direct experience. Others are concerned by the countrys

communistic stance and might be waiting to see if China shows real signs of evolving into some form of capitalism.

Investment in Education
Another commanding height in Chinas current and future economic growth is investment in education. In 2010, the Chinese government vowed to increase its spending on education from about 3.3% to 4% of the countrys gross domestic product (GDP) in 2012, narrowing the gap with the U.S. which education spending roughly equals 4.8% of its GDP.

Fig 1.a Education spending as percentage of GDP Comparing U.S. and China

Source: Environmental Scan. (2003). OCLC. Worldwide Education and Library Spending.

The Chinese governments National Outline for Medium and Long Term Educational Reform addresses almost all major issues from the education system and the quality of teaching to school enrollment. China understands that although low-cost labor is

having a significant role in driving its economic growth, it would need a well-educated and highly skilled workforce to maintain it. According to a report by Mike Baker of the BBC News, University enrollment in China has reportedly risen from under 10% of young people in 1999 to over 21% in 2006. As recently as 1996, China produced just 5,000 PhD students a year. That was only about half the number in the UK, Japan or India. Since then, China has overtaken every other country in the world except the U.S. in terms of the numbers of doctoral degrees awarded. However, the dilemma that China faces is that many of their college-graduates face long stretches of unemployment. As Cindy Fan, associate dean of social sciences and professor of geography at the University of California, Los Angeles, perfectly states, Unemployment among college graduates is a hot-button issue in China. A large number of young people have little other than materialism and consumerism to believe in a general description of Chinese society today since socialist ideology lost its grip. Not having a job is a perfect recipe for social unrest.

Manufacturing and Export

As the U.S. economy increasingly becomes mostly service-driven and U.S. manufacturers relocate to foreign countries, Chinas manufacturing industry has picked up its pace and is well on its way to leading the world. A report by the Financial Times found that The U.S. is poised to relinquish its throne as the worlds biggest manufacturing country by output to China by the end of 2011. In 2009 the U.S. created 19.9 percent of the worlds manufacturing output, compared with 18.6 percent for China. The major driver in Chinas manufacturing prowess is its large pool of cheap labor. Chinas poor human rights record, corruption and relaxed

environmental regulations are also seen as strong and unpopular contributors to its competitive advantage against Western manufacturers. China has also taken leadership in developing areas such as sustainable and renewable energies, high technologies, which will only reinforce its position. Along with manufacturing, Chinas export shows no sign of slowing down. Figures obtained from the Chinese website Peoples Daily Online show the following outcome: Chinas foreign trade maintained its powerful growth momentum in 2010, as the countrys overall trade volume reached $2.97 trillion USD, a 34.7 percent increase year over year. Of the total trade, exports accounted for $1.58 trillion USD, growing 31.3 percent, while imports made up nearly $1.40 trillion USD, rising 38.7 percent over 2009. China's trade surplus last year hit $183.1 billion USD, down 6.4% from 2009.

Additionally, the Chinese Customs Administration said on its website that Chinas trade surplus is on a continuous decline in the past few years, which proves that the country is moving towards a gradual balance of trade. These numbers should of course be taken with a grain of salt given the Chinese officials history of slightly embellishing facts. But if true, these foreign trade statistics in 2011 are keeping with the trend of 2010. According to news from the Ministry of Commerces website, Chinas foreign trade amounted to $295 billion USD in January 2011, a 44% jump year over year.

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I suspect manufacturing and foreign trade will continue to play significant roles in shaping Chinas economic future. I predict that the trade surplus will continue to decrease as Chinas middle-class grows and Chinese peoples contribution to the domestic economy increases.

A Growing Middle Class

Despite holding communist political views, the Chinese government seems to understand that a countrys economic prosperity is built on the back of the middle class, much like the United States in the 1940s and 1950s. Therefore, it is no coincidence that the growth in Chinas GDP mirrors the growth of its middle class, which according to a report by the McKinsey Global Institute, will reach 612 million by 2025, then accounting for 40 percent of Chinas population. Even as Chinas overall economic growth moderates, according to the report, incomes in urban areas will rise faster than GDP because of higher labor productivity and rising education levels. Undoubtedly, the growth of the Chinese middle class will also be driven by the countrys continued urbanization into more regions. More importantly, as Chinas economy re-balances toward domestic consumption, it will reduce its reliance on exports. A large, well-educated and highly skilled Chinese middle class will emerge as a driver and sustainer of the countrys economic growth. As Mike Moore suggested in his book Saving Globalization, China is going through the same process that Japan, Singapore, and Taiwan experienced. As living standards rise, a middle class emerges that seeks out better social outcomes. This is the virtue of free markets and globalization (Moore, p. 40).

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Part III - Economic Future: Opportunities and LongTerm Challenges

Opportunities: Chinas Potential Economic Growth
Based strictly on present conditions, Chinas economic future looks very promising. The countrys GDP is growing at astonishing rates, millions of people are being lifted out of poverty, unemployment is low, the middle class is expanding, the governments investment in education is producing highly skilled workers, foreign trade is pacing at double-digits growth, and the doors have been opened to foreign investors. Going back to the survey undertaken by GFF and Fast Future, 37% of respondents thought that by 2020 it would be common for American and European workers to be employed by Chinese companies. One question amidst the minds of many economists must be: Could China fully adopt a capitalist economic model? Many people seem to believe that China will introduce a new economic model a sort of hybrid between communism and capitalism. The answer to this question will certainly play a role in the future economic picture of China. I personally believe that the Chinese government is not ready to give up its reins on the people and will not adopt a purely capitalist economy. That said, China has seen and tasted the benefits of a free-market system and will be willing to ride that wave as long as it promotes economic fortune but does not interfere with the governments rule. Chinas economic success will also be driven by foreign investors and businesses seeking to tap in the increasing purchasing power of the Chinese people. Similarly to what we saw here in the United States, this new middle class is anxious to throw away the rags and live in riches. This Western, mostly American, influence of heavily 12

consumer-driven markets at the expense of savings could propel China into even faster economic growth; but not without bringing a few problems such as inflation, high personal debt, and others to which the American public is well familiar. Fig 1.b Survey results of when U.S. and European workers will be more commonly employed by Chinese-owned companies

Source: Talwar, R. (2007). The Future of Chinas Economy: The Path to 2020 Opportunities, Challenges and Uncertainties.

As the Chinese market place grows, it will play an increasingly important role in influencing the way Western businesses operate. American and European companies will evolve and adopt new paradigms to cater to the Chinese population. We will most certainly see more Chinese occupying high-level executive positions in Western organizations.

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Fig 1.c Survey results of the impact of the Chinese marketplace on Western business operations

Source: Talwar, R. (2007). The Future of Chinas Economy: The Path to 2020 Opportunities, Challenges and Uncertainties.

Long-Term Challenges: Economic and Political Reforms

It is impressive to see the economic growth China has shown over the past decades and many economists project that it will enjoy a fairly healthy growth in the near future. However, China still faces several reforms it needs to implement before it can enjoy the full potential of its economy. According to Wayne Morrisons Brief on Chinas Economic Conditions to the U.S. Congress, failure to implement the following reforms could endanger future growth: State-owned enterprises (SOEs), which still account for about one-third of Chinese industrial production, put a heavy strain on Chinas economy. Over

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half are believed to lose money and must be supported by subsidies, mainly through state banks. The subsidies divert resources away from potentially more efficient and profitable enterprises. The banking system faces several major difficulties due to its financial support of SOEs and its failure to operate solely on market-based principles. Chinas banking is regulated and controlled by the central government, which sets interest rates and attempts to allocate credit to certain Chinese firms. Corruption poses another problem for Chinas banking system because loans are often made on the basis of political connections. This system promotes widespread inefficiency in the economy because savings are generally not allocated on the basis of obtaining the highest possible returns. Public unrest over pollution, government corruption, and growing income inequality poses threats to social stability. The Chinese government reported that there were over 74,000 protests (many of which became violent) involving 3.8 million people in 2004 (up from 53,000 protests in 2003) over such issues as pollution, government corruption, and land seizures. The Chinese government often disregards its own environmental laws in order to promote rapid economic growth. A 2005 United Nations report stated that the income gap between the urban and rural areas was among the highest in the world and warned that this gap threatens social stability. The report urged China to take greater steps to improve conditions for the rural poor, and bolster education, health care, and the social security system.

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The lack of the rule of law in China has led to widespread government corruption, financial speculation, and misallocation of investment funds. In many cases, government connections, not market forces, are the main determinant of successful firms in China. This limits competition and undermines the efficient allocation of goods and services in the economy.

Based on the aforementioned reasons, it is unlikely to see China reach its full economic potential as long as the Government does not remove its grip on the economy.

Part IV Implications of Chinas Economic Rise on the U.S.

There is no absolute consensus on whether or not China will surpass the U.S. economically, but most economists agree that China as the economic superpower would be a tremendous blow to the U.S. economic and political leverage. Looking at current economic indicators such as GDP and access to factors of production between both countries, the U.S. still enjoys a far greater advantage than China. The U.S. remains the most productive country in the world with a GDP of $14.7 trillions USD, compared to Chinas $5.9 trillions USD. Additionally, the U.S. $47 thousand USD GDP per capita far exceeds Chinas $7,600 USD GDP per capita. The truth is, despite its fast growth, China still has hundreds of millions of people living in extreme poverty, which remains a big concern but also an opportunity for the Chinese government. The U.S. undoubtedly still remains the most technologically advanced economy in the world. It still has the best schools and a highly educated and diversely skilled workforce.

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However, as great and comforting as listing those achievements sounds, the U.S. GDP growth rate has been relatively stagnant at a mere 3% compared to Chinas explosive 10% GDP growth rate. Over the past decade, China has successfully moved a population greater than the size of the U.S. from poverty into working class. This has often been referred to as the greatest human migration in modern times. Chinas middle class is now the largest in the world and is expected to grow faster than any other country. Also considering the fact that China has the worlds deepest financial reserves, the future of the Chinese peoples purchasing power is not to be overlooked. More importantly, assuming that both the U.S. and Chinas growth rates keep their respective pace, it would only take 11 years for Chinas GDP to exceed the U.S., as shown on my linear projection in the table below.

Fig 1.d Comparison of China and U.S. future GDP based on current GDP growth rates

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But as we all know, economies rarely remain constant especially over an eleven-year period. However, there is a trend and one to which we should all pay great attention.

The Writings Not On The Wall

Arguably, another important question we also fail to entertain or at least ask in the economic battle between China and the U.S. is: Does China want to be number one? We have mostly assumed and debated unilaterally on Chinas likelihood to surpass the U.S. but rarely do we talk about the benefits China has enjoyed with the U.S. having the highest GDP in the world. Lets not forget that most of Chinas growth has been spurred by American consumption. We cannot neglect the role American consumers have and are still playing on the Chinese economy. Can China maintain such a high growth under Chinese consumption? I believe these are valid questions that often times fall between the cracks of our debates. It is certainly more fascinating to contemplate the possibility of a new economic world order. In the world of GDPs, interests, and inflations, change can sometimes be very exciting. Occupying the top spot in the economic echelon would require China to assume a much broader responsibility and accountability towards the rest of the world than it has shown willingness to. For one, more transparency would be required from the Chinese government. Many of the externalities China is currently struggling to control, such as pollution, human rights abuse, poor intellectual property protections, and corruption, will be exponentially amplified and scrutinized once leader of the economic world.

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I find it highly unlikely that the Chinese government will want to have that much light shun upon them and attract that kind of attention. In my personal opinion, Chinas aim is to quickly narrow the GDP gap between itself and the U.S. to increase its political leverage but eventually settle as second best in economic rankings. The marginal return on achieving the number one economic rank might not outweigh the opportunity cost.

Conclusion
Since 1979, Chinas economic growth has surpassed every other nations and I believe the country could become the world economic superpower if it so desires. However, I dont think it will, at least not in the next 10 or 15 years, not because it cant but because the cost would be too great. It will require a fundamental shift on the Chinese governments way of doing things such as lessening their grip on the country, provide more transparency, and assume greater responsibilities vis--vis the rest of the world all of which I hardly see occurring. That said, it is clear that China has strategically invested both domestically and abroad to pave its way into the number one spot. For example, the rising ownership of U.S. government debt gives the Chinese government great leverage on economic and political matters. Along this line, China has achieved numerous milestones such as the worlds largest manufacturer and exporter, the fastest growing middle class, leadership in technological innovation, the second nation with the highest number of doctorates, and so on to ensure its relevance in the global economic forum. Everyone talks about China. As Mike Moore further suggested in his book Saving Globalization, lets not forget that China once dominated the worlds economy, China is not joining the

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world economy, it is rejoining it (Moore, p. 32). Regardless of whether or not China eventually overtakes the United States as the worlds largest economy, China is and will remain an economic power that will continually shape the world.

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Moore, M. (2009). Saving Globalization: Why Globalization and Democracy Offer the Best Hope for Progress, Peace and Development. John Wiley & Sons (Asia), pp.32 48 Morrison, W. (2006). CRS Issue Brief for Congress. Chinas Economic Conditions. Downloaded PDF on May 5, 2011, pp.3 17. Peoples Daily Online. (2011). Peoples Daily. China Trade Hits $2.97 trillion in 2010, rising 34.7%. Last retrieved on Jul 26, 2011 from http://english.peopledaily.com Talwar, R. (2007). Stanford University. The Future of Chinas Economy: The Path to 2020 Opportunities, Challenges and Uncertainties. The New York Times. (2010). Educated and Fearing the Future in China. Retrieved on May 17, 2011 from http://roomfordebate.blogs.nytimes.com Wang, H. (2010). Growth of Chinas Middle Class. Last retrieved on Jun 3, 2011 from http://helenhwang.net

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