Spotlight on China: Middle Income Trap New Leadership's Biggest Challenge

China faces an unprecedented challenge in steering its "economic miracle" into the next generation amid slowing growth abroad and frustration at the pace of political reform at home as the nation prepares for its once-every decade leadership change.

The 18<sup>th National Congress of the Chinese Communist Party meets in Beijing this month against a backdrop of slowing economic growth and a heretofore unseen level of interest into the private lives of the country's political elite. Managing the two forces will prove critical to maintaining both social order in the world's most populous country and ensuring the global economic recovery retains its key lynchpin over the next decade. However, an ageing population, huge credit bubbles and rising inequality among ordinary citizens means China faces a serious "middle income trap" that could turn the next phase of its miracle into something a bit more mortal.

"Simply put, the challenge for the new leaders is how to do more (social good) with less (economic growth)," wrote Societe Generale's China economist Wel Yao. "From an economic standpoint, the task is not to defy gravity once again, but rather how to mitigate the pain of growth deceleration to a tolerable degree."

Gravity-defying is perhaps the most apt term to describe the three decades of 10 percent growth China has enjoyed since embarking on its historic reforms in 1978 under Deng Xiaoping. The free-market adaptations lifted the poor, agriculturally-dependent nation of 1.3 billion into the Asia Tiger that now consumes more energy than any country on earth and overtook Japan as the world's second-largest economy earlier this year.

Repeating that historic achievement seems next to impossible, however, because China is starting to show signs that its miracle is beginning to fade.

It's almost impossible to conceive, but China could be looking at a labour shortage in the coming decade of the nation's new leadership. It's One-Child policy (often cynically referred to as a One Son Policy and first introduced in 1978) has had a profound impact on population growth but has helped restrict the development of a working-age labour force, whose growth has slowed from around 2.5 percent each year in the 1980s to around 1 percent over the past decade.

A portion of this decrease, many argue, is down not only to the ageing population - 170m Chinese will soon be over the age of 64 - but also the inequalities of China's wage and benefits system. Urbanisation, or the moving of agricultural workers to manufacturing hubs in the mostly costal city centres, created enormous wage and living cost pressures. However, as many as 1 in 3 migrant workers are unable to qualify for the wage adjustments and social benefits available to urban workers with a fixed address. As a result, those workers are returning to the countryside and creating labour shortages in key manufacturing hubs.

At the same time, China's unit labour costs have been rising steadily, to the point where they are now around 60 percent of those found in the United States. The increase further erodes China's export competitiveness while simultaneously hampering its domestic consumption.

In effect, argues SocGen's Yao, the inability - or unwillingness - of China's ruling elite to make the necessary changes in law and practice that would allow a smoother, longer-term transition of the workforce constitutes one of many examples of China's "middle income trap": the idea that economic growth begins to slow, and eventually reverse, if the middle class finds upward mobility impossible.

That transition only becomes possible, she says, when the elite is prepared to make rules changes and political reforms that loosen its grip on the controls of the economy.

Many more would argue that's unlikely.

The face of China's new reputation for political corruption became a lot more recognizable last month when the New York Times published a scathing feature that detailed the more than $2.7 billion in wealth amassed by the family of China's outgoing Premier, Wen Jiabo.

The revelation comes just days after the rare expulsion from the Communist Party of Bo Xiali, whose wife Gu Kailai was convicted of murdering British businessman Neil Heywood. Earlier this year, Xi Jinping, China's vice-president and potential successor to President Hu Jintao, was reported to have built a similar-sized fortune through a network of investments linked to his extended family.

Beneath the headline stories of hypocrisy and enrichment, however, resides an even larger barrier to deeper political and market reform; the country's 114,000 state-owned enterprises.

SOEs, as they are called, dominate the domestic economic landscape, contribute around 20 percent to China's total GDP and employ around 10 percent of his workforce. They also enjoy lower borrowing rates, pay around a third less in tax than their private rivals and stand in the front of the queue for favoured government contracts.

Their profitability, as well, is intricate to the financial health of China's many local authorities, who rely on the hard cash they generate to make up for the delayed funding from central government.

The interconnection with the banking sector is also a concern, given the size of state-owned banks (70 percent of total financial assets - much larger than the global average) and the overall indebtedness of the corporate sector (around 125 percent of GDP). A great portion of that debt was amassed during Wen's 4 trillion renminbi ($650bn) stimulus splurge in the wake of the 2008 collapse of Lehman Brothers.

Collectively, the issues facing any of the new seven members of the Communist Party's Politburo Standing Committee will likely erode a good portion of China's growth potential, although there's little agreement as to when and how much. The natural momentum of the world's largest exporter with more than $3.3tn in currency reserves from which to manage its export competitiveness will surely grant it the ability to meet or come close to its recent track record of 8 percent annual growth.

Ignoring reforms in the interim, however, will clip that figure quickly in the intermediate term, with the inevitable trickle-down impacts on income, wealth and employment. Wen himself has warned that joblessness remains one of the country's key threats to stability. This year alone there were more than 25 million jobless - nearly 7 million of them recent college graduates.

No one is suggesting a "Chinese Spring" when the Congress hands over power to the new government in March of next year - and the brutal suppression of the last great movement for change that ended 23 years ago in Tiananmen Square reminds us why.

But decades of Arab dictatorships fell last year not by the hands of traditional political revolution but by the massive popular uprisings sparked by economic protest from the unemployed.

China's former foreign minister, Zhou Enlai, was famously (and apocryphally) quoted in the early 1970s as having said it was "too soon" to learn any lessons from the French Revolution.

I'm sure his successors would disagree about the Arab Spring.