China’s economy is at a crossroads. As 2013 begins, foreignand domestic observers alike are asking which path the country’s economicdevelopment should take in the next decade. How can China ensure stable andsustainable growth in the face of significant internal and external challenges,including slowing medium- and long-term growth, risinglabor costs, and growing inflationary pressure?
After the global economic crisis weakened external demand,which sustained China’s unprecedented economic growth for three decades, theauthorities agreed that internal demand, especially domestic consumption, mustbecome the country’s new growth engine. At the Chinese Communist Party’scongress in November, China’s leaders declared their intention to double per capita income by2020, unleashing 64 trillion renminbi ($10.2trillion) of purchasing power.
Indeed, with roughly 130 million middle-class consumers,China’s domestic market holds significant potential. The Boston ConsultingGroup estimates that, with an average annual GDP growth rate of 7% in China and2% in the United States, Chinese domestic consumption will rise to half ofAmerica’s by 2015, and 80% in 2020 (assuming that the renminbi appreciates atan average rate of 3% against the US dollar over the next few years).
Moreover, the current-account surplus plummeted from more than 10% of GDP in 2007 to 2.8% in2011, reflecting China’s decreasing reliance on exports to drive economicgrowth. In 2010, China’s imports ranked second in the world, and are expectedto grow at an average annual rate of 27% in 2011-2015, outpacingexport growth by five percentage points. As a result, the total value ofimports is expected to exceed $10 trillion in only two years, providinglucrative investment opportunities and broader markets to foreign investors.
This potential is not lost on multinational companies. Asurvey conducted in May 2012 by China’s State Council Development ResearchCenter asked 394 Chinese and foreign companies about their future strategicorientation in China. The respondents most often viewed China not only as amarket opportunity, a research-and-development base, and an export base, butalso as a high-end manufacturing base, a regional-headquarters site, and aservice base. The results also reflected China’s declining attractiveness as abase for product assembly, low-cost manufacturing, and parts production.
In fact, while the US and other developed countries havesought to bring manufacturing home (“reshoring”), they have been establishinginnovation facilities in China. Multinational companies have created nearly1,000 R&D centers in China, including 194 in 2010 alone, enabling them todevelop products for the local market. More than 1,400 foreign-funded R&Dinstitutions are currently operating in China, and data from China’s Ministryof Commerce indicate that 480 of the world’s top 500 companies have establishedlocal subsidiaries.
But China cannot rely on consumption as its only growthengine. History has shown that a one-dimensional development model cannotensure sustainable competitiveness, just as no single market can sustain globaldemand. Given this, China must continue to develop its manufacturing sector.
China is the world’s top manufacturing country by output.But, while it accounts for 19.8% of total global manufacturing, it receivesless than 3% of the world’s manufacturing R&D investment. As a result,China’s innovative capacity remains relatively low, with its high-tech andknowledge-intensive industries unable to compete globally.
On average, China’s industrial enterprises are relativelysmall, and, although its industrial labor productivity (real manufacturingvalue added per employee) has improved over the last decade, it remains muchlower than that of developed countries – just 4.4% of America’s and Japan’sproductivity, and 5.6% of Germany’s. And the “pauperization” phenomenon – inwhich companies must adjust their commercial strategies to cope with an impoverished consumer base – is increasingly affectingtraditional industries, further undermining China’s capacity for sustainabledevelopment.
Moreover, the quality of Chinese-manufactured productscontinues to lag behind that of developed countries’ manufactured goods.Whereas one unit of intermediate input in developed countries typicallygenerates one unit or more of added value, in China the ratio is only 0.56.
As China’s “demographic dividend” disappears, its low-endlabor market is shrinking, driving up its oncerock-bottom labor costs and diminishing its rate of return on capital.Over the next decade, as Chinese workers demand higher salaries, basicbenefits, and improved working conditions, the country may well lose thecomparative advantage that has driven its manufacturing boom.
While manufacturing wages remain significantly lower inChina than in the US, the rapidly narrowing gap is already fueling Americanreshoring. Given that Chinese wages are rising at an annual rate of 15-20%,productivity-adjusted wage rates in low-cost US states are expected to exceedthose in some coastal regions of China by only 40% in 2015. Add to that reducedenergy costs in the US, owing to the country’s shale-gasrevolution, as well as the global supply chain’s complexity, and China’s costadvantages will soon be negligible.
Meanwhile, other emerging economies – including Vietnam,India, Mexico, and Eastern European countries – are vying for China’s positionas the world’s factory. These lower-cost alternatives are fast becomingdeveloped-country investors’ preferred destinations.
Although the enormous potential of China’s consumer marketcan provide a new impetus for economic growth, the country’s economictransformation cannot succeed unless it upgrades its manufacturing sector.China’s leaders must begin by increasing investment in science and technology,focusing their efforts on parlaying keytechnological breakthroughs into higher-value-added production. Only bycombining growing Chinese consumption with enhanced Chinese manufacturing willthe country be able to develop a new comparative advantage, which is the key tosustainable growth over the next decade.