Why China is putting the brakes on export-driven growth

FORTUNE -- Growth in China is going to slow. After the country posted 11.9% growth in the GDP for the first quarter of this year compared to last, there's really no other option. For one, the sovereign debt scare in Europe, which has eroded the purchasing power of China's largest export market, will be a big knock on the economy. The Chinese government has even set their full year growth estimate at 9.1%, explicitly implying a slow down is coming. And, with the Shanghai Composite down 26.5% year to date, Chinese equity prices confirm this.

Savvy investors are realizing that China's growth remains attractive because Beijing is battening the hatches by turning to a new group of consumers: their own citizens. Over the past several weeks, China has taken a number of steps to increase its citizenry's purchasing power -- none arriving with more fanfare than the de-pegging of the yuan.

Despite the prospects of a stronger currency, the People's Bank of China still mandates that the yuan only fluctuates 0.5% from the daily official rate. As a result, the yuan's appreciation might not be the silver bullet China is looking for to stimulate domestic consumption. Domestic consumption has actually fallen over time until a small recent rebound, as the chart above shows. As a share of GDP, personal income has had an even more dramatic decline: 53% in 1999 down to just 39.7% in 2009.

That said, there have been a number of positive developments regarding wage growth and government stimulus that will help move China forward towards a more consumption-oriented economy, rather than one that has been fueled by manufacturing and exports in recent years. Here's an incomplete list:

Wages: In April, Shanghai raised minimum wages 17% to 1,120 yuan per month. Guangdong (China's largest export base) raised minimum wages in five locales within the province by an average of 21%.

Cash for clunky ovens: On June 3rd, China extended its home appliance trade-in program until 2011. Sales of such appliances have reached 54 billion yuan and 5 billion yuan of subsidies were handed out since the start of the program.

Job growth: On June 8th, a survey indicated that Chinese employers' hiring plans reached a six-year high.

More jobs: On June 11th, the IMF reported that the surplus of rural workers for labor-intensive work has fallen to about 25 million from roughly 120 million in 2007, which is bullish for wages in that sector (less supply). Conversely, research from China International Capital Corp. that suggests that 31 million Chinese will return to the labor market in 2011 after the completion of projects resulting from the government's 4 trillion yuan stimulus package. Net-net: supply of labor-intensive workers is still shrinking but perhaps at a slower rate, which is net bullish for wages.

More wages: On July 1st, Bejing increased monthly minimum wages by 20% to 960 yuan. In a similar fashion, Henan (China's most populous province) raised its minimum wage by 33% to 600 yuan per month.

Rising wages to empower the Chinese consumer

All told, more than 20 provinces and municipalities plan to increase minimum wages this year, according to the Ministry of Human Resources and Social Security. As a result, we should begin to see evidence of accelerating domestic consumption in the coming months. Furthermore, companies that are positioned to service the Chinese local economy (i.e. domestic retailers and savings deposit institutions) will see an added kick from this wave of wage inflation.

In short, while China built its impressive industries on the back the global economic boom of the past twenty years, it's now figuring out how to sustain them by turning its citizens into better consumers.

Will higher salaries just mean inflated prices?

Yes and no. The bulk of the wage inflation is coming from the labor-intensive manufacturing sector, where thin margins in certain subsectors of that industry (i.e. textile manufactures) warrant passing through higher costs. In those sub-sectors that can perhaps afford to absorb the hit to margins (auto manufacturers, CPU manufacturers, construction), inflation won't immediately take hold, if those sectors refrain from passing through price increases to consumers.

The latest CPI reading in China is +3.1% over last year. A likely scenario is that this round of wage inflation is passed through to importers of Chinese goods, with the E.U. and the U.S. being the largest recipients (20% and 17%, respectively YTD through May).In other words, there will be some lag time before Chinese consumers have to worry about inflation hitting their newly fattened wallets.

And keep in mind, China is a save-first economy, so 20-25% wage inflation doesn't instantly equal 20-25% more consumer spending. Some portion of that will be socked away for a rainy day. Even that may turn out to be a net positive for the Chinese economy: The last 12-18 months have seen a huge growth in loans as the middle class has struggled to keep up with soaring real estate prices. With more money in their pockets to service that debt and recapitalize lenders, China may avoid walking into the credit bubble trap that nearly felled the U.S. economy two years ago.

-- Darius Dale is an analyst at Hedgeye, a research firm based in New Haven, Conn.