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In Depth October 22, 2009, 5:00PM EST

China's Economy: Behind All the Hype

Despite an impressive rebound, an innovation shortfall may hobble sustainable growth

http://images.businessweek.com/mz/09/44/600/0944_36china.jpg

Brian Stauffer

By Dexter Roberts and Pete Engardio

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Guizhou Province: Infrastructure remains a big driver of China's GDP growth Ryan Pyle/Corbis

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The C919, due out in 2016, is meant to directly challenge Boeing and Airbus Zhou Lei/Xinhua Press/Corbis

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Devotion President Ma has shifted his company's focus to biofuels Paul Hu/Assignment Asia

At the parade marking the 60th anniversary of the People's Republic of China, tanks and missiles trundled past the Forbidden City and down Beijing's Chang'an Avenue. Battalions of soldiers goose-stepped in perfect unison. Overhead, fighter jets soared in tight formation.

But close on the heels of this military extravaganza came floats highlighting a less bellicose side of China, what the leadership calls "indigenous innovation." On one, a 10-foot-high microscope, giant test tubes filled with blue liquid, and a white telescope signified China's scientific and technological achievements. Another featured a replica of a bullet train and a passenger jet to represent China's ambitions in transportation. A green-energy float was studded with windmills and oil rigs and flanked by hundreds of red-helmeted energy-industry workers, each carrying a solar panel.

From a rostrum perched above the giant portrait of Mao Zedong at the Gate of Heavenly Peace, President Hu Jintao watched over the proceedings. "The Chinese people have stood up," Hu declared, quoting Mao, who uttered those words at that very spot 60 years ago. The country, Hu added, is "full of confidence in the bright prospects of the great rejuvenation of the nation."

VINDICATION, FOR NOW

That sense of triumph permeates China these days. The mainland's quick rebound from the worldwide financial meltdown seems to have vindicated its brand of state-led capitalism. As the West struggles to recover, China is on track for 8% growth this year and is about to overtake Japan as the world's No. 2 economy and Germany as the No. 1 exporter. Now the mainland is charging ahead in new industries, unveiling homegrown airliners, electric cars, and high-speed trains.

But delve beneath the muscular statistics and hype about advances in strategic industries, and China doesn't seem so prepared to catapult into a role of global economic leadership. Experts familiar with highly touted Chinese achievements such as commercial jets and high-speed trains say the technologies that underpin them were largely developed elsewhere. There is no Chinese Sony, Toyota, or Samsung on the horizon. While Beijing's $586 billion stimulus package and a 150% increase in bank lending have spurred impressive growth, "the question," says Morgan Stanley (MS) Asia Chairman Stephen S. Roach, "is the quality of that growth."

By Beijing's own admission, the economic model that has powered China for three decades can no longer be counted on to move it forward. The mainland has prospered largely through construction and by exporting all manner of consumer goods churned out in low-wage factories; workers parked their savings in state-run banks, which then loaned the money to companies to make more stuff. But technology and managerial knowhow came mostly from multinationals, and the costs—pollution, decaying social services, and a yawning gap between the urban rich and rural poor—were largely ignored. Though that model has fueled phenomenal growth, Hu and others now call it "unbalanced" and "unsustainable."

So in recent years, Beijing has been heralding a new economic vision. The key elements: Grimy factories will give way to renewable-energy industries and a growing service sector; Chinese consumers, rather than stretched Americans and Europeans, will underpin demand; and instead of churning out me-too goods for little profit, Chinese companies are supposed to create innovative products based on home-grown technologies.

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