China’s Underpopulation Crisis

India has one, too.

A crowded street in China

China’s vast supply of cheap labor and India’s army of capable engineers have attracted enormous flows of foreign investment to their countries over the past several years. Analysts have dubbed the result the “Asian miracle.” But beneath our assumptions about the future of economic growth in these two countries lie important questions about how long these trends can remain quite so miraculous.

Between 1978 and the end of 2004, China took in $563.8 billion in foreign direct investment, more than 10 times the total that Japan amassed between 1945 and 2000. India, meanwhile, now accounts for almost two-thirds of all the information-technology work off-shored from the United States, and the resulting revenue is expected to nearly quadruple over the next five years to around $60 billion.

The advantages of investment in China are well-known. Less well-understood is a looming demographic challenge that could undermine China’s ability to grow rich before its population grows old. Emerging-market investors in search of an alternative should note that India faces a demographic challenge of its own.

Recent reports from researchers at Deutsche Bank and Goldman Sachs suggest that China’s workforce may begin to shrink sooner than we thought. According to Deutsche Bank’s analysis, the percentage of working-age Chinese in the population (those aged 15 to 64) will peak around 2010 at 72.2 percent. Over the next 40 years, that number will fall steadily to just 60.7 percent, according to U.N. forecasts. The steep drop is due in large part to China’s one-child policy, first implemented in 1979. Also, many Chinese retire before they are 64; China’s current retirement age is 50 for most women and 60 for most men.

There are two reasons this shift will put considerable strain on China’s economic performance. First, the country’s explosive economic growth over the last several years is due mostly to its plentiful supply of cheap labor. When the working-age population begins to drop five years from now, China’s appeal to international investors may begin to fall as well.

Second, by 2050, every 10 Chinese workers will support seven Chinese who are too young or too old to work, according to Goldman Sachs. Even that projection is based on the optimistic assumption that the central government will soon persuade its citizens to work until they are 64. The Deutsche Bank study includes a warning from the International Monetary Fund that the transition from the current pension system to a more sustainable one could cost developing China $100 billion, not including the financial burden on local governments.

The population is aging in Japan and in many European countries, as well, but these states are already wealthy. The financial stresses on China, where the average per-capita income remains a fraction of those of developed states, will be much more difficult to bear. Then there are the health-care costs. No one can forecast with confidence what it will cost China to care for the 265 million citizens who will be over the age of 65 by 2020. The worst of the crunch is many years away. But the new reports suggest that the shrinking of China’s labor force will begin by the end of this decade.

What’s more, as China’s economy has grown, so has the level of social unrest within the country. The number of what the Chinese government calls “mass group incidents” has risen by about 10 percent a year for more than a decade. In 2004, that number reached 74,000 and involved some 3.7 million people, according to the Chinese security minister. That’s more than 200 protests across the country per day, involving an average of 50 people.

China’s growing demographic problem may persuade some foreign investors—already wary of the opaque, authoritarian political system and the increasingly well-coordinated and violent protests—to further diversify their portfolios away from risks in China.

Perhaps some of that investment will flow toward India, the rising economic star that is today in China’s considerable shadow. India’s democracy, its relative transparency, and its commitment to economic liberalization offer enormous advantages for investors who are concerned by the Chinese Communist Party’s long-term ability to contain steadily growing social unrest. India’s workforce will continue to grow for the next several decades and will likely surpass China’s by 2040. So, there is good reason to believe that India is the safer long-term investment bet.

But India has a demographic problem of its own. If China’s comparative advantage in attracting foreign investment lies in its enormous supply of unskilled labor, India has profited from its considerable pool of skilled workers, many of them English-speaking, who have filled the country’s growing number of high-tech and service-sector jobs.

But that pool is in danger of reaching its natural limit, as well. According to a report released in December by McKinsey & Co. and the Indian IT trade association Nasscom, if the flow of service-sector jobs continues to grow at its current rate, and if India fails to enact substantial reform of its education system, the country will face a shortfall of 350,000 business-process staff and 150,000 IT engineers by the end of 2010. As the shortage of qualified workers grows, the expansion of India’s service sector could shift into reverse, at an enormous cost to the country’s still-fragile economic development.

India’s world-class IT and engineering schools are not the problem. In fact, India already graduates five times as many engineers each year as the United States. The real problem lies in India’s universities and in its woefully uneven level of primary education. The McKinsey-Nasscom report suggests that only 25 percent of India’s university graduates have the basic skills—including the minimum level of spoken English—needed for work in the sectors that have fueled India’s recent growth. The percentage of Indians who leave school by age 10 is 40 percent. Not coincidentally, 40 percent of Indian citizens are illiterate.

The most formidable obstacle to Indian efforts to reform its education system is that local governments control education policy. As a result, development of a coherent solution to the shortage of qualified faculty, inadequate educational infrastructure, and the current system’s inability to produce the skilled workers its fast-changing economy demands will be both profoundly difficult and time-consuming.

There’s very little chance that China and India can quickly solve these problems. It will be decades before China can redress its demographic deficit, particularly given the central government’s deep reluctance to ease immigration restrictions. In the short term, India’s education system can be improved at the margins, but the country’s factionalized politics ensures that the level of policy coordination between the central and regional governments necessary for broader reforms is unlikely to develop anytime soon.

For the next several years, China and India will continue to profit from large inflows of foreign investment, but investors in these states will do well to remember that past performance is no guarantee of future results.