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Chinese Puzzle: Why China Is the Big Loser From the Headline Events of 2011

The first three months of 2011 have been interesting in the sense of the old Chinese curse, "may you live in interesting times." The year began with unforeseen uprisings in North Africa and the Middle East, which have now bloomed into armed conflicts in Libya, Bahrain and Yemen. Then Godzilla struck Japan in the form of a cataclysmic earthquake and tsunami, followed by a nuclear crisis of nearly fathomless horror. Finally, here in the U.S., a new political movement swept into office, promising severe austerity measures regardless of short-term consequences.

China has so far avoided the direct brunt of all this turbulence. That does not mean they will dodge the ricochet.

Crisis? What crisis? Conventional wisdom would say these events work to China's advantage. Regional rival Japan, which China recently passed to become the world's second-largest economy, was dealt a crippling blow. The U.S., Great Britain and France have now been dragged into another regional conflict with no clear exit, reminding the world afresh of their unsavory legacy as colonizers, petro-imperialists and military hegemons. America's deficit hawks are so bent on curtailing government spending, and so hostile to President Obama on every front, that they appear unconcerned that their policies are likely to cause more economic distress by reducing employment and demand before recovery has a chance to set in.

China, meanwhile, continues its impressive rise. According to the most recent OECD forecast, China's GDP will grow at 9.7 % this year, down from previous double-digit highs, but still building on more than a decade of historically-unprecedented expansion. The country is in the peak years of its demographic dividend, with more than 60% of the world's largest population in working age, compared to low numbers of dependent children and elderly. Many of China's homegrown companies have become global players. The nominally-Communist country is now home to more billionaires than anywhere outside the United States.

Trouble beneath the surface. In fact, recent events have struck China like a torpedo below the waterline, exacerbating long-term structural problems. The uprisings in the Middle East, which seemed to come out of nowhere from a political standpoint, are actually the products of a powerful mix of demographics, new technology, and rising expectations: elements that are also present in abundance in China.

The Chinese government has preempted dissatisfaction among its educated, wired and increasingly affluent urban youth by delivering the goods: rising opportunity and lifestyle improvements to meet rising expectations. Many have long feared that if China's growth should stall, all that youthful patriotism might curdle into the kind of discontent seen in other countries where a brittle old establishment was unable to satisfy the ambitions of the young.

China's government is very eager for that not to happen. But in China's export-fueled economy, social harmony is purchased at a cost, and that cost has been going up. At first it was possible to achieve staggering economic gains by moving a large portion of the low-productivity agricultural workforce into more productive manufacturing work, where low wages and appalling working conditions still seemed like an improvement over life in the countryside.

Now the low-hanging fruit has been harvested. Most of the exogenous gains have been realized, and a shrinking pool of available workers is driving up wages even in low-skilled work. Meanwhile, as Chinese companies climb the value chain, it's increasing the demand for higher skills, which command a higher price. Production costs are rising faster than the perceived value of Chinese brands overseas.

Energy costs are rising. Events in the Middle East have sent oil prices surging above $100 a barrel, which not only increases the costs of production for China's manufacturers, but also increases the price of exports because of higher shipping costs. It does not help that most of the world's known oil reserves are sitting underneath the countries that are ground-zero for this year's most spectacular political turbulence, or, like Saudi Arabia and the Gulf States, now seen as likely candidates for social unrest.

Then there's Japan, which generates about 30% of its domestic energy from nuclear power, a number that was projected to rise to 40% by 2017. Confidence in nuclear power is probably not real high in Japan just now. That means that in the short term, the world's third largest economy will be wading into the world oil market for a rising, rather than shrinking, portion of its energy needs, competing with China, India and other emerging economies for a scarce and increasingly uncertain commodity.

More competition, fewer customers. China's costs are rising just as new competition is coming online from even lower-wage economies in South Asia. Meanwhile, their biggest customer, the United States, is pursuing policies likely to slow an already tepid recovery by reducing government spending and demand, which means exporters will have to compete harder for increasingly broke and penny-pinching U.S. consumers.

Chinese demographics are about to go negative in a big way. Starting in 2016, the legacy of the one-child policy and the lifespan-increasing benefits of affluence combine to make China the fastest-graying society in world history by the 2030s, and well into crisis by mid-century.

This is the environment in which the Chinese government must continue to deliver historic, unprecedented rates of economic growth or face the prospect of severe social and political unrest.

When all you have is a hammer, everything looks like a nail. Unsurprisingly, China has adopted the one policy option available: its state-controlled banks and institutions continue to buy up huge quantities of dollars to artificially depress the value of its own currency, thus keeping the cost of its exports competitive. China then has three choices for what to do with those dollars, all of which benefit the United States. It can buy our assets, which inflates the value of our stock market and real estate; it can buy our debt, which keeps interest rates low and keeps our political system afloat; or it can buy our stuff, which employs Americans and reduces our trade deficit.

All of this comes at a steep price to the Chinese consumer, who subsidizes Chinese industry by paying artificially high prices for imports, while setting aside huge savings to pay for retirement and the care of elderly parents.

Some say this policy is unsustainable. History shows that when governments are faced with a choice between the unsustainable and the unacceptable, they choose the unsustainable every time.

Hard choices ahead. There are signs that China's economy is trying to shift away from over-reliance on exports toward one driven by indigenous demand, investment and entrepreneurship. We hear this story every year. Maybe this year it will come true, and China will be able to decouple its economic growth from currency manipulation and co-dependence on U.S. deficits.

Until then, China will have to decide whether to address the long-term issues of demographics, export dependence, energy and domestic demand brought into focus by the events of 2011, or just keep trying to outrun them with economic growth on overdrive.

Rob Salkowitz is a consultant, speaker, and author of three books including Young World Rising: How Youth, Technology and Entrepreneurship are Changing the World from the Bottom Up.