Since 2005, bank loans have more than doubled with little change in lending policy. Indeed, state-owned banks were ordered to roll over an estimated $1.7 trillion worth of maturing loans to local SOEs at the end of 2011, with most of the capital having been used for the construction of speculative high-end residential property by these local government-owned “financial vehicles.”

Estimates by major rating agencies, international accounting firms and other researchers of the true size of NPLs in the Chinese financial system vary from 40 to 150 percent of GDP. Although no one knows the true extent of the NPL problem in the Chinese banking system, there is widespread recognition by Chinese authorities and economists that a growth model driven by building things that are neither required nor used is not a sustainable path for the country. Indeed, the widespread Chinese and international focus on transitioning from a fixed-investment (and to a lesser extent, export-led) model toward growth based on domestic consumption is an explicit admission that the viability of the economic approach since the early 1990s is coming to an end.

THE CONCEALED NPL problem in the banking system is only one downside to arise from the two-decade-old, state-dominated economic approach that took hold several years after the Tiananmen interlude from 1989 to 1992. In fact, a potentially more ominous problem for China can be seen in the relationship between its increasingly “unstable, unbalanced, uncoordinated and unsustainable” economic model and the lingering challenge of its aging demographics. This poses a mutually reinforcing and potentially vicious downward spiral for the country’s long-term economic viability.

Thus, China faces the prospect of becoming the first major country in history to grow old before it grows even moderately rich. This is a function of both its stagnant agrarian economy resulting from the socialist experiments in collective agrarian and industrial production of the Mao Zedong years and the fact that life expectancy has risen dramatically over the past three decades due to public-health advances. But one cannot solely blame Mao’s legacy or even the three-decade-old one-child policy for China’s predicament. Chinese Communist Party (CCP) policies since the early 1990s have resulted in outcomes that leave the country woefully unprepared for its aging demographics despite the country’s sustained period of rapid economic growth.

Economic growth has far outpaced population growth since the 1979 reforms. Indeed, per capita income has increased from less than $200 in 1980 to $7,800 (based on purchasing power parity and in constant 2000 U.S. dollars). Based on current growth rates, GDP per capita should reach middle-income levels of around $16,000 in a decade’s time.

However, focusing only on dramatic increases in GDP per capita as a measure of China’s economic and social progress is highly misleading for two reasons. First, in China’s state-dominated economy, revenues of the country’s tens of thousands of SOEs have been rising at an average of 20–30 percent each year since the mid-1990s. It is estimated that half of all domestic savings in the country’s financial system is by SOEs.

In contrast, mean disposable household incomes have been rising by only 2–3 percent a year over the same period. Ominously, various studies suggest the disposable income of some four hundred million Chinese has actually stagnated or declined over the past ten years. Other studies suggest that absolute poverty (defined as living on less than $1.50 per day) has actually increased over the same period. Currently, just under half the country is subsisting on less than $2 per day.

Second, dividing national output by the number of people gives no indication of how wealth is actually distributed throughout the country. In reality, when considering measurements of income distribution such as the Gini coefficient, China has gone from being the most equal society in all of Asia to the least equal within a generation. Its Gini coefficient level has risen from 0.25 in the 1980s to 0.38 in the 1990s to 0.57 currently (where 0 represents perfect income equality and 1 represents perfect income inequality). In contrast, the Gini coefficient in India is 0.37; it is 0.43 in the United States, 0.38 in Japan and 0.42 in Russia. The reality is that, although Chinese households have the highest savings rates in the world as a proportion of disposable income, the amount being saved will not be sufficient for many retirees, perhaps even a majority.

The fact that countries such as India have maintained a steady Gini coefficient throughout the last decade of rapid growth suggests that the particular growth model, rather than rapid growth itself, determines levels of inequality. Indeed, medium household income in the first decade of Chinese reform (1979–1989) rose at similar growth rates, but levels of inequality remained stable. It was only after state corporatism took hold in the mid-1990s that income inequality increased.

The link between suppressed household income and dangerous levels of income inequality, on the one hand, and the country’s state-dominated economy, on the other, is unmistakable. In a system where around 150,000 SOEs receive the lion’s share of capital and market opportunity at the expense of tens of millions of private corporate and informal firms, a small number of well-connected “insiders”—generally those with political connections or ties with the Communist Party or SOEs—benefit disproportionately from the current growth model.

That the Chinese model is geared toward a relatively small number of well-connected firms and individuals is reflected in numerous surveys. One such survey, conducted by the Beijing-based Horizon Research Consultancy Group in 2011, showed that nearly two-thirds of respondents (businesspeople in urban China) believed that knowing the right people with political connections was the primary factor in determining success or failure. A Business Week poll indicated “political connections” were overwhelmingly seen as the key to business success. It is no accident that more than 80 percent of the approximately eighty-five million CCP members make up the Chinese middle class and elite.

The favored position of the corporate state at the expense of the household sector is visible in other policies as well. For example, the need to provide for oneself in old age in the face of a one-child policy that precludes multiple children as an old-age support mechanism contributes to the high savings rates of Chinese households, approaching 40 percent of net income. Since there are no alternatives, household savings are deposited in state-owned banks and pay extremely low interest rates (around 1–2 percent on average over the past decade). These state-owned banks extend the majority of their loans to SOEs at below-market rates, and most of these loans go into fixed-asset investments. Thus, the country’s struggling households are effectively subsidizing the investment activity of the country’s bloated and inefficient SOEs.

It is clear that China’s suppressed household sector and unequal growth exacerbate the country’s unpreparedness for an aging population, since many future retirees will be in a far worse and more vulnerable financial position than they otherwise could be as citizens of a rapidly growing economy without such distortions. Indeed, the economic suppression of the average Chinese citizen in favor of SOEs—resulting in household income significantly lagging behind rates of GDP growth—is reflected in the country’s infamously low levels of domestic consumption. As a proportion of GDP, Chinese domestic consumption—at 33 percent—is the lowest of any major economy in the world. This compares to around 70 percent for the United States and 60 percent for Japan.

This unpreparedness is exacerbated by the reality that only around 15 percent of Chinese workers, mainly from some SOE-dominated sectors, have some form of central, provincial or local pension fund. According to one recent Organisation for Economic Co-operation and Development study, only around 10–15 percent of those with a pension will still depend primarily on their children for old-age support. For those without a pension, the number jumps to over 50 percent.

Although the current pension scheme covers a minority of citizens, the consensus among experts and researchers is that the state’s pension liability amounted to about $2.7 trillion in 2010 and will hit $2.9 trillion in 2013. Calculations by a team based at Fudan University led by Cao Yuanzheng, the chief economist with the Bank of China, estimate that unchanged pension policies will lead to liabilities of $10.25 trillion by 2033 (or almost 40 percent of GDP, based on a generous assumption of 6 percent GDP growth per year). There also is the question of mismanagement and even misappropriation of these pension funds, particularly by local officials. According to a report in the Economist, about half of the pension funds run by provincial authorities have lost value, while reports of local governments reneging on pension liabilities are widespread.

IN ISOLATION, GDP growth rates offer no decisive indication of how a country is actually faring. After all, the economy of the former Soviet Union officially tripled in size from 1950 to 1973, but a mere two decades later it had imploded. While China’s economic development appears far more impressive, the country’s challenges inherent in its aging demographics remain highly daunting.

For starters, growth through ever-increasing levels of capital and labor inputs will not do the trick. The ratio of capital input needed to achieve an additional dollar of output has jumped from around 2 to 1 in the early 1990s to around 7 to 1 currently, which is 50 percent more inefficient than what is seen in economies such as India’s. The ongoing buildup of NPLs in the Chinese banking system is merely one such indication of declining capital efficiency. The country’s aging demographics also mean that the seemingly endless supply of cheap labor underpinning the country’s construction and manufacturing sectors will gradually recede. But sustainable growth will depend on China’s capacity to use capital and labor much more efficiently than it has to date. As economist Paul Krugman of Princeton and the New York Times puts it, “Productivity isn’t everything, but in the long run it is almost everything.”