China's economy is at a crossroads. Foreign and domestic observers alike are asking which path the country's economic development should take in the next decade. How can China ensure stable and sustainable growth in the face of significant internal and external challenges, including slowing medium- and long-term growth, rising labour costs and growing inflationary pressure?
After the global economic crisis weakened external demand, which sustained China's unprecedented economic growth for three decades, the authorities agreed that internal demand, especially domestic consumption, must become the country's new growth engine. At the Communist Party's congress in November, leaders declared their intention to double per capita income by 2020, unleashing 64 trillion yuan (HK$79 trillion at exchange rates now) of purchasing power.
Indeed, with some 130 million middle-class consumers, China's domestic market holds significant potential. The Boston Consulting Group estimates that, with an average annual GDP growth rate of 7 per cent in China and 2 per cent in the United States, Chinese domestic consumption will rise to half of America's by 2015, and 80 per cent in 2020 (assuming that the renminbi appreciates at an average rate of 3 per cent against the US dollar over the next few years).
Moreover, the current-account surplus plummeted from more than 10 per cent of gross domestic product in 2007 to 2.8 per cent in 2011, reflecting China's decreasing reliance on exports to drive economic growth. In 2010, China's imports ranked second in the world, and are expected to grow at an average annual rate of 27 per cent in 2011-2015, outpacing export growth by five percentage points. As a result, the total value of imports is expected to exceed US$10 trillion in only two years, providing lucrative investment opportunities and broader markets to foreign investors.
This potential is not lost on multi- national companies. A survey conducted last May by the State Council's Development Research Centre asked 394 Chinese and foreign companies about their future strategic orientation in China. The respondents viewed China not only as a market opportunity, and a base for research and development as well as export, but also as a base for high-end manufacturing and services, and a regional headquarters site. The results also reflected China's declining attractiveness as a base for product assembly, low-cost manufacturing and parts production.
In fact, while the US and other developed countries have sought to bring manufacturing home ("reshoring"), they have been establishing innovation facilities in China. Multinational companies have created nearly 1,000 research and development centres in China, including 194 in 2010 alone , enabling them to develop products for the local market. Data from the Ministry of Commerce indicates that 480 of the world's top 500 companies have established local subsidiaries.
But China cannot rely on consumption as its only growth engine. History has shown that a one-dimensional development model cannot ensure sustainable competitiveness, just as no single market can sustain global demand. 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 per cent of total global manufacturing, it receives less than 3 per cent of the world's manufacturing R&D investment. As a result, China's innovative capacity remains relatively low, with its hi-tech and knowledge-intensive industries unable to compete globally.
On average, China's industrial enterprises are relatively small, and, although its industrial labour productivity (real manufacturing value added per employee) has improved over the past decade, it remains much lower than that of developed countries. And the "pauperisation" phenomenon - in which companies must adjust their commercial strategies to cope with an impoverished consumer base - is increasingly affecting traditional industries, further undermining China's capacity for sustainable development.
Moreover, the quality of Chinese- manufactured products continues to lag behind those from developed countries. Whereas one unit of intermediate input in developed countries typically generates one unit or more of added value, in China the ratio is only 1:0.56.
As China's "demographic dividend" disappears, its low-end labour market is shrinking, driving up its once rock-bottom labour costs and diminishing its rate of return on capital. Over the next decade, as workers demand higher salaries and improved conditions, the country may well lose the comparative advantage that has driven its manufacturing boom.
While manufacturing wages remain significantly lower in China than in the US, the rapidly narrowing gap is already fuelling American reshoring. Given that Chinese wages are rising at an annual rate of 15-20 per cent, productivity-adjusted wage rates in low-cost US states are expected to exceed those in some coastal regions of China by only 40 per cent in 2015. Add to that reduced energy costs in the US, owing to the country's shale-gas revolution, as well as the global supply chain's complexity, and China's cost advantages will soon be negligible.
Meanwhile, other emerging economies - including Vietnam, India, Mexico and eastern European countries - are vying for China's position as the world's factory. These lower-cost alternatives are fast becoming developed-country investors' preferred destinations.
Although the enormous potential of China's consumer market can provide a new impetus for economic growth, the country's economic transformation cannot succeed unless it upgrades its manufacturing sector. China's leaders must begin by increasing investment in science and technology, focusing on parlaying key technological breakthroughs into higher-value-added production. Only by combining growing Chinese consumption with enhanced Chinese manufacturing will the country be able to develop a new comparative advantage, which is the key to sustainable growth over the next decade.
Zhang Monan is a fellow of China's State Information Centre and of the China Foundation for International Studies. Copyright: Project Syndicate