FRENCH PHILOSOPHER Auguste Comte probably tried to cram too much into his pithy but seductive maxim when he said that “demography is destiny.” Even so, demographic forces can be relentless in shaping future prospects of nations and therefore can offer powerful clues about national possibilities for future prosperity and geopolitical power.

It is well-known that China’s population is aging. Less well-known and rarely examined is what this demographic shift might mean for the future of Asia’s largest and most rapidly rising power. A graying China will not necessarily be a China of economic stagnation and social turmoil. But understood in the context of the country’s current path of development, China’s aging demographics could be the single most important factor preventing the “Asian century” from being a Chinese-dominated one.

Despite its economic dynamism, East Asia is aging rapidly. Most attention is focused on Japan, considered the “grandfather” of the region. But in terms of ramifications for the future power balance, much more attention should be paid to China. Currently it has a population of 1.35 billion, but this number is expected to begin shrinking slowly by around 2030.

More important is the ratio of working-age people to those over sixty-five, considered aging or formal retirees. In the 1980s, the proportion of the working-age population (fifteen to sixty-four years old) was more than 73 percent of the overall population. Currently at about 68 percent, the working-age population is expected to decline to about 65 percent in 2020 and 60 percent in 2035.

The significance of these numbers becomes apparent when we compare the proportion of working-age people with formal retirees. When China began its market reforms in 1979, there were about seven working-age persons to every retirement-age one. Today, the ratio is about 5.5 to 1. Current projections suggest that by 2035 there will be fewer than 2.5 working persons for every retiree.

The age profile of the working population also matters. Studies show clearly that workers are at their most productive and innovative from their late twenties to their midforties. This has been the basis for China’s “demographic dividend,” the massive productivity generated by the combination of declining fertility levels and a mass of young workers entering the workforce with relatively few familial responsibilities. Productive labor-force capacity has risen faster than population since the 1979 reforms. This trend will be in reverse from around 2015 onward.

There are currently around 120 million Chinese people sixty-five years or older. By 2035, there will be around 320 million, with the overall population only around one hundred million larger than it is today. Even within the working population, in 2035 there will be 1.5 older workers (fifty to sixty-four years old) for each of their younger counterparts (fifteen to twenty-nine years old), which is the direct opposite of the current situation.

These trends are replicated in the pre-working-age generation. For example, the number of new students enrolling in primary schools declined from more than twenty-five million in 1995 to fewer than 16.7 million in 2008. Taken together, and although not as serious as in Japan, these statistics place China firmly in the “aging” category, alongside countries such as South Korea, Australia and the advanced economies of Western Europe.

Moreover, for a number of reasons it is extremely unlikely that these trends can be altered or reversed.

First, China’s aging population is largely the result of a dramatic increase in average lifespan, which has increased from under sixty-five years in 1980 to the current seventy-five years. Moreover, fertility rates have declined, from 2.63 children per woman in 1980 to about 1.5 in 2011. This trend is unlikely to change. Wealthier cities such as Shanghai (reporting a fertility rate of only 0.6, which is probably the lowest of any major city in the world) provide evidence that emerging Chinese elites, like their Western counterparts, are choosing lifestyle and career expectations over larger families. Although the country’s “one-child policy,” in place since 1979, has been enforced unevenly across different provinces, it still has had the effect of keeping the number of childbearing women artificially low. This reality, combined with the widespread Chinese preference for sons over daughters, leads to estimates that there will be a surplus of some forty million men of marriageable age by 2020.

Actual figures into the future could vary slightly from the trend lines. But little can be done about China’s aging demographics over the next few decades. Even if the one-child policy were to be abolished, the aging trend wouldn’t be reversed to any appreciable degree for several decades.

NOW LET’S consider China’s economic-growth model in the context of this aging trend. Premier Wen Jiabao has more than once described his country’s growth model as “unstable, unbalanced, uncoordinated and unsustainable.”

The basis for Premier Wen’s assessment, widely endorsed by Chinese and international economists, is that China must move away from exports and fixed-asset investment (in short, building things) as the dominant drivers of economic growth. From the mid-1990s to early this century, net exports accounted for about half of China’s growth each year. From around 2003 onward, fixed-asset investment drove around 40 percent of GDP growth. In 2009, due to the massive fiscal and monetary stimulus ordered by the government in response to the global slowdown affecting China’s key export markets of America and the euro zone countries, 80–90 percent of growth was the result of capital investment. This is reflected in the increase in formal bank lending used for fixed investment. Such lending jumped from $150 billion in 2001 to $380 billion in 2003, then to $750 billion in 2008 and $1.4 trillion in 2009. (The figures in 2010 and 2011 dropped slightly to around $1.2 trillion.) On the back of increasing bank loans and other bank credit that now amount to around 250 percent of GDP, fixed investment is currently responsible for around 50–55 percent of GDP growth.

Indeed, fixed investment as a share of GDP jumped from a relatively sustainable 35 percent in the 1980s to 45 percent in 2004. Many analysts now believe that fixed investment amounts to more than 60 percent of GDP. Still a poor country, this means that China is pouring far too large a percentage of national savings into building things that are not utilized or wanted by the population, and its households are consuming too little. Even during periods of rapid industrialization in Japan, South Korea and Taiwan during the 1950s, 1960s and 1970s, fixed investment as a proportion of GDP stayed below 30 percent, except for one or two years when it approached 35 percent. To be sure, the movement of rural citizens into cities and surrounding suburbs is always associated with a rise in fixed investment, and China is no different. However, with an urbanization rate of only around 1–1.5 percent each year, we are witnessing the most rapid (and undoubtedly unsustainable) buildup of capital investment in any economy in recorded history.

Economically, the country’s reliance on fixed-asset investment is enormously wasteful. The vast majority of fixed-investment activity is undertaken by centrally and locally managed state-owned enterprises (SOEs), even though domestic private firms are generally two to three times more successful on measures such as return on investment, profitability and economic efficiency. These SOEs dominate all major sectors of the Chinese economy (except for export manufacturing), including commodities, utilities, chemicals, heavy industry, infrastructure, construction, shipping, banking, finance, insurance, media, education, renewables, IT and advanced IT platforms. They also receive around three-quarters of all formal bank loans issued by the state-owned and state-dominated banking sector throughout the country.

This massive SOE bias would make more economic sense if the approximately 120 centrally managed and 150,000 locally managed entities were deserving of such support. Some well-known Chinese state-owned giants such as Sinopec, China Mobile and the China National Petroleum Corporation make enormous profits each year, albeit in virtual monopoly environments within which they enjoy privileged access to capital. Yet, even among better-run centrally managed SOEs, around 80 percent of all profits are generated by fewer than a dozen companies.

The performance of the locally managed SOEs is even more abysmal. According to consolidated estimates of various case studies, 19 percent of SOEs were unprofitable in 1979, 40 percent were unprofitable in 1997 and 51 percent sustained losses in 2006. It is reported that risk-management procedures in this lending have been highly questionable, and an estimated 30 percent of bank loans are extended for “policy” reasons rather than sound commercial considerations. Thus, fears of a growing problem of nonperforming loans (NPLs) would appear to be well grounded.

Indeed, this cycle has been replayed before. Between 1998 and 2005, the government injected more than $250 billion worth of cash to bail out its banks. During the same period, around $330 billion worth of these NPLs were transferred off the books of Chinese banks into specially created “asset-management companies,” with the banks receiving the full worth of the NPLs in return. To date, the average recovery rate of NPLs by asset-management companies is about 25 cents on the dollar.

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.”

Second, sustained economic growth based on productivity gains is only one part of the solution as China ages. The other is to ensure that across-the-board household incomes increase at least as rapidly as overall GDP growth. In other words, there needs to be a massive transfer of assets and opportunity from the state-owned sector toward the private sector in order to raise significantly household wealth and income. This also would help the economy transition toward more domestic consumption, a necessary development for sustained growth.

Significantly increasing household income and total factor productivity (TFP), meaning getting more output from capital and labor, will require a winding back of SOE wealth and opportunity—and, by implication, the role of the Communist Party in the Chinese economy.

For example, land reforms in the early 1980s allowed plot holders to produce whatever they wanted after meeting minimum quotas and selling surplus produce at market prices. This led to the rise of “township and village enterprises,” a spontaneous and unplanned explosion of community-led small industry. Although these were technically owned by local governments, they were run by private households that were allowed to keep most of the profits. Importantly, household incomes during this decade of Chinese rural entrepreneurialism rose at rates that corresponded with GDP growth. This period actually witnessed the effective retreat of the state in economic activity, and four-fifths of the poverty elimination that has occurred since 1980 was achieved during this first decade.

But then the state reclaimed much greater dominance over the economy in the aftermath of the countrywide protests in 1989, which led to the Tiananmen Square violence. The regime realized it faced a peril in becoming irrelevant to rising new elites, and the Communist Party thus decided it must remain the dominant dispenser of career, business, professional and even social opportunity. Thus did it tie the future of various elites to that of the party. The SOEs were returned to a dominant role in the economy, as evidenced by the nature of the current Chinese economy.

The problem is that the vast majority of Chinese SOEs don’t perform well in comparison with private firms. That’s because they are fed on easy diets of cheap and below-market credit rates as well as tax and subsidy privileges, and they are shielded from having to compete with domestic and international private firms. Thus, they thrive in a corporate culture and economic setting in which commercial success often is based more on political connection and maneuvering than on economic efficiency and innovation. Studies show that even China’s largest and most efficient SOEs perform two to three times worse than domestic private Chinese firms on measures such as profitability, return on assets, return on equity, return on sales and TFP. Remember that these are the same SOEs that receive three-quarters of the country’s on-the-books bank loans, otherwise referred to as formal finance. In contrast, domestic private firms are frequently forced to borrow from the “shadow” banking sector at rates that are at least four or five times higher than for formal loans.

To drastically raise both household incomes and TFP—and to avoid potential social catastrophe as the country ages—Beijing will need to oversee the massive and rapid transfer of national wealth from the state-corporate sector to the private and household sector. Options include a major SOE privatization drive, although such policies will be pointless if well-connected families are allowed to snap up shares in SOEs, as occurred during the 1990s and earlier this decade.

Forcing state-owned banks to lend on merit rather than on policy and political considerations will allow millions of private firms to prosper based on business acumen (at the expense of less efficient SOEs). That in turn will help ensure that families operating in this fair economic environment can acquire enough wealth over time to look after themselves when family members reach retirement age.

However sound these reforms may be in economic and social terms, the country’s current elites aren’t likely to welcome them, given that SOE dominance and the Communist Party’s command over privilege and largesse distribution are seen as essential to regime survival and the standing of the elites. It’s important to note that the three most senior positions within an SOE (chairman, president and party secretary) are all directly appointed by the Communist Party’s Central Organization Department. Further, there is an identifiable “princeling”—one of the two dominant factions within the CCP—in at least one of the top three positions in all but one of the largest seventy SOEs. It is also questionable whether provincial and local officials who depend on SOEs for power, relevance and revenue will agree to any genuine privatization policies.

Finally, China’s looming inability to handle its aging demographics is reflected in the historical reality that, unlike China, all advanced economies grew rich before they grew old. Large advances in productivity and innovation, prerequisites of ongoing economic growth, are extremely difficult to achieve in poor and aging societies—particularly in countries that lack sound rule-of-law principles, intellectual-property rights and allocation of capital based on merit rather than political connection. Across all economies, productivity and innovation (alongside adequate and effective investment in human capital such as education) tend to come primarily from workers in their thirties and forties. Thus, even if China were to increase its retirement age from sixty to sixty-five or higher, productivity and innovation gains would be relatively slight.

MODERN CHINA is a rich and strong state overseeing a weak country and poor people. This means that the resources available to Communist Party members are fueling China’s rise as a formidable strategic player with impressive capabilities. But as China grows, so too does its domestic vulnerability, confirmed by worsening governmental corruption and domestic discontent that is growing more rapidly than the economy.

From the Communist Party’s point of view, it has no good options vis-à-vis the country’s aging future. Meaningful economic reforms that would enhance the capacity of Chinese households to provide for themselves in retirement would severely dilute the economic relevance of the CCP. They also could cause an immediate and dramatic decline in output during the transition, with unpredictable consequences for regime security. But failure to pursue such economic reforms will endanger the sustainability of overall economic growth, worsen the national capacity to meet the challenges of an aging society and increase the already-serious domestic vulnerabilities faced by China’s rulers. Either approach will increase the “existential anxiety” of the regime, a term used by my colleague Linda Jakobson of the Lowy Institute in Sydney.

China also faces difficult fiscal decisions. Currently, it devotes a large share of government finances to enhancing Chinese national power and influence through double-digit spending increases for its military, the People’s Liberation Army (PLA), and its paramilitary, the People’s Armed Police (PAP). Although the economic and social problems emanating from the country’s aging crisis will not be pressing for at least a decade, major decisions affecting the country’s ability to meet that crisis will need to be made by the next generation of leaders. Whatever decisions are made, the impact on the CCP’s fiscal and other commitments will be profound.

For example, the average sixty-five-year-old in urban China currently depends on the state for around 60 percent of his income, with about 27 percent coming from family transfers and the rest from labor income. In rural China, home for more than half of those sixty-five years and over, the state only provides about 5 percent of their income, with 45 percent coming from labor and 50 percent from family transfers. As retirees approach seventy years and over in both urban and rural China, the share of income from labor declines steeply as they become physically less able to work. Yet, the state picks up a declining share of the income needs in both urban and rural China, with family transfers and savings making up the difference. The reality is that the state will need to increase significantly its burden of providing income for retirees (especially in rural China) as the population ages and the capacity of children to bear the financial burden of their aging parents is strained.

China will also have to raise welfare spending appreciably to avoid social catastrophe. Currently, state and local governments spend around $96 billion on public health, including insurance programs, an increase from about $30 billion in 2007. Even so, more than half of all medical costs are individually borne by citizens in urban areas; in rural settings it is more than 75 percent. In a 2011 budget of around $887 billion, at least $205 billion was spent on the PLA and PAP. The true figure for the latter was probably closer to $300 billion. As China ages, an increasing amount of resources presently devoted to enhancing national power and prestige will need to be diverted toward improving the lot of its own people.

China’s demographic and economic challenges can be seen in an intriguing statistical projection comparing China with the United States in one significant area. In 2025, China’s population will be about 3.2 times that of the United States. By 2050, it is projected to fall to only about 2.2 times the size of the U.S. population. This profound population decline, in real terms and in relation to other great powers, confronts China with serious economic, political, cultural and social threats. The question is whether the country can successfully counter those threats and fulfill its current ambitions for economic growth, social stability, and expanding regional and global influence. The odds may not be great that China will manage to remain on its current course and dominate what many analysts see as the coming Asian century.

John Lee is the Michael Hintze fellow and an adjunct associate professor at the Centre for International Security Studies in Sydney University and a nonresident scholar at the Hudson Institute.

Image: Flickr/Garry Knight. CC BY-SA 2.0.