February 6, 2013

FORTUNE — Not too long ago, the mere mention of the “China price” could send shivers down the spines of executives in developing countries trying to compete for outsourcing contracts.

Typically, Western multinationals would demand the lowest price possible, which in reality was bench-marked by the ultra-low prices they could get from Chinese producers. Lower prices meant lower margins. And other developing countries eager to break into the global supply chain had no choice but to go along.

But dramatic changes in China’s demography, specifically the rapid decline of its labor supply in the coming two decades, will make the “China price” a thing of the past. (Rising wages in China have already reduced the country’s cost advantage.)

Based on China’s fertility rate and population growth, a recent study by two economists at the International Monetary Fund suggests that, without any changes in policy or the birth rate, China will begin to experience a labor shortage in about a decade. In fact, by 2025, the country could face a shortfall of 28 million workers.

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The magnitude of change is astonishing if we consider that, as of 2010, China had a surplus of 150 million laborers. The net reduction in the nation’s labor supply from 2010 to 2025, according to this study, could be close to 180 million.

Unfortunately, boosting the fertility rate through policy, such as relaxing the one-child policy in urban areas, will not fill the shortfall. International experience shows that once fertility falls below a certain level, it is unlikely to recover even with government-provided inducements.

Moreover, in China’s case, it is plainly too late. Even if we assume an immediate reversal of the one-child policy (which Beijing has so far rejected), newborn babies will start entering the labor force by around 2030, well into the era of soaring labor shortage. In any case, even if China manages to raise its fertility rate from the current 1.6 births per woman to the replacement rate of 2.1 births per woman, the IMF study estimates that this will produce only 11 million more laborers by 2025, a drop in the Chinese bucket.

There are a few ways the Chinese government can address the economic impact of ageing and declining fertility rate. All of them require decisive action and bold reform.

One obvious approach to China’s looming labor shortage is not to increase its supply (which is impossible in the short term), but to raise its quality and productivity. In the last three decades, most of China’s productivity gains came from moving excess rural labor from low-productivity agricultural activities to higher-productivity manufacturing and service sector activities. But this one-off increase cannot be repeated. To extract more productivity gains from China’s shrinking labor pool, the only solution is to invest in education.

At the moment, the mean years of schooling of Chinese adults is only 7.5, lower than many other developing countries, such as Sri Lanka (8.2), the Philippines (8.9), Mexico (8.5), and Malaysia (9.5). A lot of this has to do with the Chinese government’s underinvestment in rural education. Unlike their urban counterparts, most rural children have no publicly funded high-school education. As a result, the majority of migrant laborers have no more than a middle-school education.

But increasing investment in rural areas can be politically difficult and administratively challenging. In the Chinese political system, rural residents are among the weakest social groups and have the least amount of political influence. The Chinese state, more often than not, victimizes this group with taxes and land seizures, rather than serve their interests with social programs. Administratively, Beijing will have to ensure that corrupt local officials will not steal additional education spending. This will require greater transparency in government spending and vigilant oversight by the media.

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Another solution is to raise China’s retirement age to make existing workers stay in the labor poor longer. Increasing the retirement age for women from 55 to 60 and for men from 60 to 65 could make a significant difference. The IMF study estimates this measure alone will expand the labor supply by 32 million by 2025 and essentially eliminate the predicted labor shortage. But again, this measure would only provide a one-time, short-term solution, and could have undesirable social consequences in the immediate future since it will likely increase unemployment for the younger population, not a politically palatable prospect for Chinese leaders who are obsessed with short-term gains.

A potentially revolutionary change in Chinese farming — from the current household-based small farms to large mechanized farms — will likely reduce the demand for labor in the countryside and free up workers to head to urban areas. The greatest obstacle here is China’s land ownership system. Consolidating land holdings in rural areas will not be possible without the privatization of land ownership. To the Chinese government, this is a political fraught debate better left alone for now.

Finally, the Chinese government will have to improve the efficiency of the existing labor market by reforming the household registration system (known as houkou in Chinese), a Maoist legacy that discriminates against the rural labor force. Eliminating this system will not, strictly speaking, raise the absolute supply of labor, but it should remove the barriers to labor mobility, with the efficiency gains offsetting decline in labor supply.

Again, this reform presents difficult political challenges for Beijing. Most governments in urban areas are resisting this reform because they do not want to be responsible for the costs of paying for the education, healthcare, and retirement of hundreds of millions of migrant laborers. Another potential hurdle to houkou reform is the disposal of the land titles held by migrants. Right now, they have the leasing rights to their agricultural land, but they do not want to give them up even if they move to urban areas (while local governments in rural areas salivate over the same land). A solution to this problem will be both elusive and expensive.

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So there is both good news and bad news coming from China’s demographic decline. The Chinese government should take heart that it has effective solutions to moderate the economic effects of adverse demographic trends. But it must also be aware that implementing such solutions will require unprecedented political courage.

Minxin Pei is a professor of government and non-resident senior fellow of the German Marshall Fund of the United States

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