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50

Dear Client:

Washington, Dec. 16, 2011

About half of Americans believe that China is the worlds largest economy. Its not. The U.S. gross domestic product is more than double Chinas. But it wont be for long...China is rapidly becoming an economic colossus. Thats why this special four-page year-end Letter is all about China its emergence as a global economic power and the implications of that for the U.S. More specifically, its a look at where China is likely to be 10 to 15 years from now not only economically, but also in terms of demographics, geopolitics and more.
ECONOMIC GIANT

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Lets start with the size of Chinas economy and its breathtaking growth. Until early 2003, Chinas economy was inconsequential in global terms. It was around that time that it reached critical mass 15 WHOS NO. 1? big enough, for example, to gobble up large quantities $30 of commodities and the ships needed to transport them, GDP, in trillions 10 (current U.S. dollars) $25 and having a corresponding impact on global prices. 5 Today, China is No. 1 on several scores: U.S. $20 China The most prodigious trader and largest foreign creditor. 0 Y2000 Y2004 Y2008 Y2012 Y2016 Y2020 Y2024 Y2001 Y2005 Y2009 Y2013 Y2017 Y2021 Y2025 Y2002 Y2006 Y2010 Y2014 Y2018 Y2022 Y2026 Y2003 Y2007 Y2011 Y2015 Y2019 Y2023 Y2027 $15 The greatest contributor to global economic growth. Tops in production of ships, steel and automobiles. $10 Plus China, including Hong Kong and Macau, $5 is the worlds largest exporter of goods and services.
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0 Chinas GDP will top that of the U.S. by 2026 Sources: IMF, World Bank, Goldman Sachs sooner if growth in the Asian country exceeds an average of 7%-7.5% a year (it has been increasing at 9%-10%) BY ANOTHER MEASURE or if U.S. growth averages less than about 2.5% a year. $20 GDP, in trillions, Of course, if the U.S. economy performs much better by purchasing power parity than expected (which we think unlikely), itll take longer. (current U.S. dollars) $15 Measuring differently, the switch comes a decade earlier. When expressed in terms of purchasing power parity $10 meant to neutralize the impact of different currencies U.S. U.S. total output will slip below Chinas around 2016.
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China

Neither measurement reveals the whole picture, though. The figures dont take productivity into account...one hour 15 05 00 of U.S. manpower yields seven and a half times as much Source: IMF as an hour of cheaper, but less skilled, Chinese labor. And they dont consider the tremendous difference in population size... 1.3 billion Chinese vs. 313 million Americans. On a per capita basis, Chinas GDP is 16% of U.S. output, and that economys rapid gains wont change that ratio much.
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Living standards for most people arent even close and probably wont ever be. Over half of Chinas people live in rural areas, many of them without the kinds of conveniences Americans take for grantedmodern kitchen appliances, cars and paved roads to drive them on, up-to-date dentistry and communications, and more. Even counting urban population, only one-fifth of the Chinese people have flush toilets.
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& INDUSTRY

Beijing is determined to move Chinas production up the value chain. It wants to shift the countrys industrial focus away from inexpensive goods, such as apparel, footwear and toys, produced largely with unskilled labor. To do so The government has targeted seven major industries for expansion and intends to provide large government subsidies to finance rapid growth in them. Efforts in alternative energy output are already being felt in U.S. markets, both positively and negatively. China now dominates the manufacture of solar panels and wind turbines, as well as equipment for shale gas exploration. That trims costs to consumers of those products, but it slams companies that are producing them on this side of the Pacific, nabbing big chunks of both U.S. and third-country markets. China also has big plans for next-generation nuclear power plants and bioenergy. The other industries designated for a big push: Alternative materials, including rare earths. Environmental protection and conservationpollution controls, wastewater recycling, seawater usage and more. Electric and hybrid cars plus fuel cells. New-generation information technology...virtual technology, cloud computing, high-end software, novel display systems and so on. Sophisticated capital equipment for offshore drilling, satellites, aircraft, high-speed rail and more. Plus biotechnology. As competing Chinese production picks up, so, too, will trade tensions. Already, a flood of inexpensive Chinese solar panels has the U.S. mulling import curbs. In response, Chinese officials are slapping import duties on autos made in the U.S. Over time, however, Chinas trade surplus with the U.S. is likely to shrink. One reason: A gradual shift from an export-led economy in China to one that is fueled more by domestic demand. Doubtless, the Asian giant will remain one of the worlds largest exporters, but an increasing share of its activities will be oriented toward meeting growing demand of a burgeoning middle class within its own borders. Look for consumer spending to soar in coming years, propelled higher by rising wagesup an average of 15% a year (10% after adjusting for inflation). Increasingly, Chinas population will thirst for a broad array of consumer products from home appliances, electronics and luxury goods to more meat in their diets. Also feeding domestic spending: Giant infrastructure improvements, from highway construction to railroad expansions, funded by Chinas government.
U.S.-CHINA TRADE

Both trends offer opportunities for U.S. firms to mine a rich vein of demand. In general, America will retain its edge in high-tech items and can expect to continue to sell precision machinery, power-generation equipment, optical and medical equipment, air- and spacecraft, pharmaceuticals, electrical machinery and computer software. Plus growing sales of a wide range of consumer products. And soaring farm exports, padding the U.S. ag trade surplus with China. More Chinese investment in the U.S. will help trim the ledger imbalance, too. In recent years, Chinese firms have pumped up acquisitions of U.S. oil & gas firms; technology, electronics and medical device companies; machinery & equipment makers; manufacturers of communications equipment; auto and renewable resources firms. They have a penchant for manufacturing and tech firms with well-known brand names: Chinese carmaker Geely bought Volvo from Ford. Lenovo acquired IBMs PC business. U.S. assets in Chinese hands hit $6 billion in 2010. In 2008...$1.2 billion. Congress is leery of China buying into sensitive U.S. industriesoil, aircraft and the likeand politicians will keep a close eye on any such activity down the road. But expect the buying spree to go on, financed with Chinas huge stockpile of foreign currencyover $3 trillion, three times the size of the second-largest cache of reserves, held by Japan. Dollar-denominated assets, including Treasury securities plus Fannie Mae and Freddie Mac bonds, are 65%-70% of Chinas foreign reserves.
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YUAN VS. DOLLAR

Will the yuan replace the dollar as the worlds favored reserve currency? Not likely, or at least not for years. Chinas currencycalled the renminbi in international transactions...will be more sought after for daily transactions as Chinas share of global trade and investment continues to expand. But It faces huge obstacles to assuming the role of global reserve currency. First, its value must float freely and it must be freely convertible to other currencies. Though Beijing is taking steps...only slight progress so far. Second, China lacks the deep, broad, unfettered financial system needed to provide the liquidity for massive, constant and low-cost capital movements. Finally, investors must see China as the safest place to put their money. And that wont happen as long as the government in Beijing remains opaque.

Look for China to spread its wings further in coming years, investing heavily in Africa, South America and Asia to guarantee supplies of natural resources such as oil, natural gas and iron ore. Last year, that nation sank nearly $65 billion into business ventures around the world. Though thats just 60% of what was poured into China by other countries last year, outward investment flows are rising rapidly. Investment in sub-Saharan Africa gets particular attention. It nabbed 44% of Chinas business investment abroad between 2005 and 2010. In addition to oil and other raw materials, China now buys Egyptian oranges, Ghanaian cocoa beans, Ugandan coffee and more. It has also forgiven loans it made to 35 African nations. China is beefing up its ties to other Asian countries, crafting free trade pacts and participating in more regional meetings. Its already the regions largest customer.
GLOBAL TRADE

Expect Beijing to hold on to its mercantilist policies as long as it can. Foreigners, including U.S. firms, will get the opportunity to trade and invest in China as long as what they do helps Chinaand doesnt threaten Communist Party rule. Joint ventures will dominate, since outright foreign ownership is shunned. And foreign firms will have to yield technology to access Chinas markets. Chinas rise will come with challenges that could delay or derail its ascent: A banking and financial system in need of both liberalization and regulation, with fewer restrictions on the movement of capital, expansion of stock & bond markets and more-transparent accounting, but also sensible oversight of the financial system. Inflation and potential asset bubbles, fed by Chinas newfound wealth. Debt-laden cities and towns in the wake of a five-year construction boom. The cost of massive infrastructure buildup to boost domestic consumption. Growing social unrest as human rights concerns garner more attention.
HURDLES

A labor force that will grow more slowly. Thanks to Chinas one-child policy, starting around 2015, annual increases in the most productive part of the workforce 35- to 54-year-oldswill dwindle and then reverse, just as more workers are needed. And a rapidly aging population, straining government budgets. Though China benefits now from a younger population profile and a much lower ratio of oldsters to working-agers than in the U.S., its low fertility rate spells problems in later decades.
China U.S. 2015 2025 2035 2045

Total Pop.
1.39 bil. 1.44 bil. 1.45 bil. 1.41 bil. 333 mil. 363 mil. 390 mil. 414 mil.

Working-Age Pop.
(age 20-64)

Ratio of the Elderly to Working-Agers

Median Age
35.6 39.1 43.2 45.6 37.1 38.2 39.3 39.6

903.8 mil. 909.5 mil. 860.3 mil. 813.0 mil.

197.1 mil. 203.8 mil. 212.5 mil. 225.9 mil.

Source: Center for Strategic and International Studies

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On the political fronta period of testy relations between the U.S. and China. With the U.S. still in an economic slump, China bashing will be popular on the campaign trail for both presidential and congressional candidates. Labor unions want punitive trade measures to offset Chinese subsidies, and even some advocates of free trade favor countering Beijings alleged currency manipulation. Meanwhile
RISING TENSIONS

China is increasingly throwing its weight around, provoking confrontations with other countries vessels, declaring the oil-rich Spratly Islands as its territory, etc. And its military is fast becoming a force to be reckoned with for the U.S. and its Asian allies. Since 2000, China has modernized its forces, upgraded weapons and developed doctrine and tactics. Its military now includes over 60 submarines six of them nuclear powereddozens of warships and soon, a second aircraft carrier. Though they havent been tested in battle in years, Chinas land forces are formidable. In response to the muscle flexing, the U.S. is stepping up its Asian presence, as the recent announcement that U.S. troops will be stationed in Australia attests. New top brass in Beijing, to take office in late 2012, may also be problematic. Xi Jinping and Li Keqiang, the likely president and premier, will face growing criticism of Chinas management of its finances and its handling of state-owned enterprises. Moreover, the leaders-in-waiting lack both Hu Jintaos experience on the world stage and strong domestic support. And as younger men, they have no direct memories of the Cultural Revolution or of the problems that developed during Mao Zedongs rule, so theyre much more inclined to view Chinas ascendancy in the world as inevitable. Their more staunchly nationalistic attitude will tend to raise some hackles. But over time, as Chinas economy matures, odds are tensions will decrease rather than increase. Beijing wont try to remold global economic and trade systems because China has benefited spectacularly from them and has a growing stake in it. More likely, Beijing will move slowly, influencing narrow-interest issues, sometimes in parallel with the U.Sas in efforts to fight piracy off the Somali coast. But sometimes the Middle Kingdoms interests will put it at odds with the U.S. Fewer American workers will be affected by job losses, as Chinas economy shifts to higher-value production. And as China transforms from an export-driven to a consumer-driven economy, the Chinese will become avid buyers of U.S. goods. What does Chinas rising star mean to the U.S.? Some loss of prestige, yes. But no real loss of influence. The fact is, Americas economic preeminence and clout have been slowly diminishing since the 1960s. That erosion will continue in the years ahead as the U.S. cedes the No. 1 spot in economic size to China and as global economic and political power continues to become more diffuse. America has a mix of assets that cant be easily replaced. Among them: An open, stable government. Innovative financial systems. Top-notch higher education. And a population that, compared with most of the world, is educated and productive.
CHINA VS. U.S.

Still, much will depend on how well the U.S. addresses its own shortcomings: Crumbling infrastructure needs rebuilding and secondary education, improvement. The economy needs revitalization, and burgeoning federal deficits must be controlled. History tells us not to underestimate China. The awakening giant nearly always exceeds expectations, achieving more in less time than believed possible. Yours very truly, Happy Holidays Dec. 16, 2011 THE KIPLINGER WASHINGTON EDITORS

Copyright 2011. The Kiplinger Washington Editors, Inc. Quotation for political or commercial use is not permitted. Duplicating an entire issue for sharing with others, by any means, is illegal. Photocopying of individual items for internal use is permitted for registrants with the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923. For details, call 978-750-8400 or visit www.copyright.com.

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