China’s Next Transformation

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During three decades of favorable global economic conditions, China createdan integrated global production system unprecedented in scale and complexity.But now its policymakers must deal with the triple challenges of the unfoldingEuropean debt crisis, slow recovery in the United States, and a seculargrowth slowdown in China’seconomy. All three challenges are interconnected, and mistakes by any of theparties could plunge the global economy intoanother recession.

To assess the risks and options for Chinaand the world, one must understand China’s “Made in the World”production system, which rests on four distinct but mutually dependent pillars.

The first of these pillars, the China-based “world factory,” was largelycreated by foreign multinational corporations and their associated suppliersand subcontractors, with labor-intensive processing and assembly carried out bysmall and medium-size enterprises (SMEs) that have direct access to globalmarkets through a complex web of contracts. Starting modestly in coastal areasand special economic zones, the “world factory” supply chain has spreadthroughout China,producing everything from stuffed animals toiPads.

The “world factory” could not have been built without the second pillar:the “Chinainfrastructure network,” installed and operated mostly by vertically integratedstate-owned enterprises in logistics, energy, roads, telecoms, shipping, andports. This pillar relies heavily on planning, large-scale fixed investment,and administrative controls, and its quality, scale, and relative efficiencywere strategic to Chinese competitiveness and productivity.

The third pillar is the “Chinese financial supply chain,” which providedthe financing needed to construct and maintain the infrastructure network. Thissupply chain is characterized by the dominance of the state-owned banks, highdomestic savings, relatively under-developed financial markets, and a closedcapital account.

The final pillar is the “government services supply chain,” by whichcentral and local officials affect every link of production, logistics, andfinancial networks through regulations, taxes, or permits.Most foreign observers miss the scale and depth of institutionaland process innovation in this supply chain, which has managed (mostly)to protect property rights, reduce transaction costs, and minimize risks byaligning government services with market interests. For example, Chinese localgovernments became highly adept atattracting foreign direct investment (FDI) by providing attractiveinfrastructure and supporting services that facilitate the expansion of globalproduction chains.

With the onset of the current globalcrisis, and given dramatic changes in social media,demographics, urbanization, and resourceconstraints, all four pillars are now under stress. Production chains are facinglabor shortages, wage increases, and threats of relocation to lower-costcountries. Meanwhile, global investors are questioning local governments’solvency.

Chinese experts are now debating a key governance question: whichtop-level architecture would enable the country to adopt the reforms needed tomeet global and domestic pressures? Investors are concerned about Chinese equities’erratic performance, regulatory risks, andpolicy surprises, as well as the uncertainties stemming from greater volatilityin asset prices, including property prices, interest rates, and the exchangerate.

What makes the Chinese economy more difficult to read is the increasinglycomplex interaction of all four of its production system’s components, witheach other and the rest of the world.

First, favorable conditions for the growth of the “world factory” havebegun to dissipate. Production costs – interms of labor, resources, regulation, and infrastructure – have been risingdomestically, while consumption bubbles in the West have burst.

Second, the early success of “China infrastructure” was built oncheap land, capital, and labor. But, despite modern infrastructure, logisticalcosts within China are 18%of production costs, compared with 10% in the US, owing to various internal inefficiencies.

Third, the success of China’sfinancial system was built on state-owned banks’ financing of largeinfrastructure projects and foreign financing of export production through FDIand trade. The financial system has yet to address adequately the challenges offinancial inclusivity, particularly fundingof SMEs and rural areas, and exposure to excess capacity in selected industries.

Last but not least, the three pillars could not have remained standingwithout the anchor provided by the fourth. Until now, its success was based onpositive competition between local governments and different ministries,benchmarked according to performance indicators such as GDP and fiscalrevenues. Unfortunately, this has led to problems of social equity andenvironmental sustainability, which require complex coordination of bureaucratic silosin order to overcome the resistance of powerful vestedinterests.

There is general recognition and consensus that the path of reformrequires profound re-engineering of all four pillars. First, the productionchain must shift from export dependence toward domestic consumption. RealigningChina’sinfrastructure means emphasizing quality overquantity, and reducing state ownership and controlled prices in favor ofmarket forces. State orchestration shouldinstead be focused on fighting corruption, reducing transaction costs,promoting competition, lowering entry barriers, and removing excess capacity.

For the financial supply chain, the key is to address systemic risks andrealign incentives in order to induce investors to support the engines of realeconomic growth, rather than the creation of asset bubbles.

The Chinese miracle was engineered by institutional and process innovationat all levels of the government services supply chain. China requires nothing less than another radical re-engineeringto become a more balanced, socially equitable,and sustainable economy. That process has already begun with another round ofexperimentation through three new Special Economic Zones in Hengqin, Qianhai,and Nansha to pilot the emergence of acreative, knowledge-based services economy.

Of course, such an economy relies crucially on the quality of governance.The real challenge for Chinese officials is how to balance creativity andinstitutional innovation with order, thereby ensuring the integrity of all four of its economy’s pillars.

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关键词：formation transform format FORMA Trans economic mistakes recovery system triple

During three decades of favorable global economicconditions, Chinacreated an integrated global production system unprecedented in scale andcomplexity. But now its policymakers must deal with the triple challenges ofthe unfolding European debt crisis, slow recovery in the United States, and a seculargrowth slowdown in China’seconomy.To assess the risks and options for China and the world, one must understand China’s“Made in the World” production system, which rests on four distinct butmutually dependent pillars.(triple challenges)
The first of these pillars, the China-based “worldfactory,” was largely created by foreign multinational corporations and theirassociated suppliers and subcontractors, with labor-intensive processing andassembly carried out by small and medium-size enterprises (SMEs) that havedirect access to global markets through a complex web of contracts.the second pillar: the “China infrastructure network,”installed and operated mostly by vertically integrated state-owned enterprisesin logistics, energy, roads, telecoms, shipping, and ports.This pillar relies heavily on planning, large-scalefixed investment, and administrative controls, and its quality, scale, andrelative efficiency were strategic to Chinese competitiveness and productivity.The third pillar is the “Chinese financial supplychain,” which provided the financing needed to construct and maintain theinfrastructure network. This supply chain is characterized by the dominance ofthe state-owned banks, high domestic savings, relatively under-developedfinancial markets, and a closed capital account.The final pillar is the “government services supplychain,” by which central and local officials affect every link of production,logistics, and financial networks through regulations, taxes, or permits.Most foreign observers miss the scale and depth of institutional and process innovation in thissupply chain, which has managed (mostly) to protect property rights, reducetransaction costs, and minimize risks by aligning government services withmarket interests.(four pillars of Chinese economy)
First, favorable conditions for the growth of the“world factory” have begun to dissipate.
Production costs – in terms of labor, resources,regulation, and infrastructure – have been rising domestically, whileconsumption bubbles in the West have burst.
Second, the early success of “China infrastructure” was built oncheap land, capital, and labor. But, despitemodern infrastructure, logistical costs within Chinaare 18% of production costs, compared with 10% in the US, owing tovarious internal inefficiencies.
Third, the success of China’s financial system was builton state-owned banks’ financing of large infrastructure projects and foreignfinancing of export production through FDI and trade. The financial system hasyet to address adequately the challenges of financial inclusivity,particularly funding of SMEs and rural areas, and exposure to excess capacityin selected industries.
Last but not least,last pillar has led to problems of social equity andenvironmental sustainability, which require complex coordination of bureaucratic silosin order to overcome the resistance of powerful vestedinterests.(chanlleges in the four pillars)

There is general recognition and consensus that thepath of reform requires profound re-engineering of all four pillars.
theproduction chain must shift from export dependence toward domestic consumption.
Realigning China’s infrastructure meansemphasizing quality over quantity, andreducing state ownership and controlled prices in favor of market forces.
For the financial supply chain, the key is to addresssystemic risks and realign incentives in order to induce investors to supportthe engines of real economic growth, rather than the creation of asset bubbles.
State orchestrationshould instead be focused on fighting corruption, reducing transaction costs,promoting competition, lowering entry barriers, and removing excess capacity.( solutions to the chanlleges)