The Competitive Edge -- China's Day Of Reckoning Is Coming Soon

Some clouds are beginning to form on the horizon of China's growth model.

The Chinese economy has grown at an astonishing rate the past 30 years, thanks to an opening to the world, skillful government management and the sound work ethic and entrepreneurial skills of the Chinese people. But the growth model behind this success is showing some signs of strain that should occasion reflection on the part of businesses involved in the booming Chinese market.

China has been able to grow so rapidly by investing massively in its production capacity and the infrastructure needed to support it. An ever-growing and opening world economy has provided a large part of the market for its products, especially manufactured goods. Fixed investment accounts for over 42% of the Chinese economy, compared to a norm around 17% for the United States, and only 20% and 28%, respectively, for fast-growing Malaysia and Indonesia. On the other hand, personal consumption expenditures, which represent over 70% of U.S. GDP and 61% in India and Thailand, was only 35% in China in 2006, down from nearly 40% earlier this century.

This massive investment is leading to excess capacity in many individual sectors. China now has capacity for producing nearly 500 million tons of steel, at least 125 million tons over domestic consumption. Breakneck expansion in other metals, manufacturing and materials sectors has placed a premium on exporting goods because of relatively weak domestic demand -- the exact opposite of the U.S. model, where the consumer reigns supreme. An undervalued Chinese currency exacerbates these forces by promoting exports, creating massive liquidity to finance investment and discouraging consumption.

This cycle is weakening corporate profits and the Chinese banking system. It may also undermine political stability by keeping purchasing power artificially low. Moreover, criticism of the Chinese trade surplus is growing among the principal trading partners.

In addition, the rapid pace of export growth is starting to strain supply chains in the United States and Europe. Each year, according to a recent study by Boston Consulting Group (BCG), growth in the volume of freight entering the North American West Coast is equivalent to the annual throughput of the Port of Vancouver. Due to a variety of siting, environmental and resource constraints, neither port nor ground transportation expansion is maintaining this pace.

Such an imbalance between internal and external demand, and between investment and consumption, is unlikely to persist indefinitely. Rebalancing would involve measures to stimulate internal Chinese demand and reduce fixed investment, and likely would involve drastically increased government spending on social services such as health, education and pensions, currently only 3% of GDP.

One part of the process will be further appreciation of the Chinese yuan, which should stimulate imports and bolster domestic demand for consumer products. Chinese export growth would likely subside as its cost structure slowly converges with that of more developed economies. Strains in the East-West supply chain will not be quickly resolved, leading BCG to suggest that U.S. firms consider diversifying production closer to home in the Americas and finding ways to cut time and inefficiencies from the production networks.

Chinese leaders have shown great skill in avoiding sharp contractions in their economy since 1978, but recent slowdowns in construction and government restrictions on investment suggest a day of reckoning will soon arrive: The conventional wisdom is that the post-Beijing Olympics period will be an obvious inflection point. Business leaders should start planning now for a China with higher consumer spending power, more spending on social services, less spending on fixed investment, reduced subsidies for exports and a probable slowing in domestic growth during the transition to a more balanced economy.

Dr. Duesterberg is president and CEO of the Manufacturers Alliance/MAPI, an executive education and business research organization in Arlington, Va.

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