08/16/2010 09:56 am ET Updated May 25, 2011

How Long Will China's Economy Be the Second Largest?

Many probably saw the headline today stating that China's economy is now the second largest in the world and may soon eclipse the United States' economy. The growth in China's economy has been tremendous, an engine that began taking off with the loosening of restrictions during the Deng Xiaoping era and has accelerated ever since.

Some interpret the growth in China's economy as a validation of its embracing capitalism but there is also a major factor of government planning involved. Yes, government planning and economic growth can go together in spite of many people's mantra to the contrary (see Singapore for another example).

While China's manufacturing dominates much of the world's consumer products, this will not likely last forever. Importers are looking to diversify their production since companies know they should never rely on a single supplier. Investments in Vietnam, Indonesia and other countries which have low wage costs will continue in the future. China will feel pressure externally from other countries producing competing products and will need to migrate up the value chain to drive higher margins while mitigating wage pressures. China is making huge investments in higher education to help them design and manufacture higher end products in the future but internal pressures will be significant. As more and more Chinese enjoy Western style lifestyles in Shanghai, Beijing, Hong Kong and other major cities, factory workers will be less likely to continue accepting low wages and long hours in monotonous toil. The days of motivating Chinese workers by encouraging support for the good of the party are long over. China has an astoundingly high level of inequality and this inequality will be one of the most critical issues that the Chinese government will need to address over the coming years in order to maintain strong growth.

While many reading about China's overall economy immediately think that China is a developed country, they need to remember that China has an enormous population with many living in poverty. There are hundreds of millions of rural Chinese living slightly above subsistence and factory workers struggling month to month while a small percent of the population enjoy what we, in the West, would term comfortable lives. As China's economy continues to grow, it remains to be seen if the percent of people living these comfortable lives continues to grow or if the wealthy in China end up owning more and more of the country while the factory workers and rural poor continue to struggle.

So what do I think of projections of when China will eclipse the United State's economy? As I have stated in previous articles, economic projections 20 or 30 years out tend to be little more than guesswork. There is no question that if China and the United States both continue their current pace of economic growth, then China's economy will be larger than that of the United States in the next few decades. Of course, there was a huge "if" in that sentence. Japan's economy grew at a tremendous pace for much of the post World War II period, based on an export economy supported by an undervalued currency. Over time, other countries began competing with Japan for its export products and internal wage pressures developed. Not coincidentally, Japan's economy has been relatively stagnant for about 2 decades.

Calculating growth curves is easy on paper, growing an economy is much tougher. It is much easier for an economy to grow at 10% per year when an economy is smaller. Just as the life cycle of a company often has a rapid expansion phase until they become a large company and then the growth slows down, China will find that maintaining such a rapid growth rate will be a huge challenge, one that can't be solved by simply dropping a different growth assumption into someone's economic forecast.