China: a balanced viewpoint.

For the past two years, there has been a steady stream of articles and seminars about the growing importance/threat of the manufacturing base in China. It has been difficult to pick up a paper or magazine that has not celebrated China as the fastest-growing economy in the world and the new center of the global automotive community. The expansion of the Chinese economy has been so rapid that it has even begun to affect material prices in North America. The price and availability of steel, for example, has been dramatically impacted by the demand of the Chinese producers. Scrap prices have skyrocketed and there is a predicted shortage of several types of steel over the coming months. Ironically, most of this demand has been driven by Western companies setting up shop in China.

So how long will this manufacturing tilt to the East last? Are there large portions of manufacturing in the Western world that will be eliminated due to their inability to compete with China? IRN's primary concern regarding China has been the unrelenting optimism. No matter what seminar you attend or article you read, the theme is that China's economy is on a steady upward trajectory and it is only a matter of time until it is the largest manufacturing base in the world. Does this kind of hype sound familiar? Having participated in the automotive industry since the early 1980's, I have been here before. In the mid to late 1980's, everyone was proclaiming that the Japanese economy would dominate the world. That was just before the economic bubble burst and Japan entered a 15-year period of decline. In the mid 1990's, it was South America and the emerging economies like Thailand and Malaysia. IRN has several clients that had just opened their brand new plants in Brazil or Thailand only to close them 12-18 months later, after the economic meltdown of the late 1990's. And finally, I am sure there are many readers who believed the same thing about the Internet, only to see their personal portfolios decline by 60-80% in the 2000-2001 timeframe.

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In fairness, however, it would be equally incorrect to ignore China. A lot of the hype in certain sectors is real and there is little question that over time, the Chinese market will represent one of the largest economies in the world. So what is the truth about China and how can we effectively evaluate the risks and rewards of this opportunity?

The Potential Risks

To begin with, let's look at the strengths and weaknesses of this market:

The key is to always remember that China is still, in essence, a Third World country with many of the instabilities that implies. In the automotive industry, for example, the phenomenal growth in auto sales is not country wide but highly concentrated. Fifty percent of all vehicle sales have been in just three provinces: Shanghai, Beijing, and Guangdong. Eighty percent of all sales have been in the coastal provinces. The remainder of the country is still rural, poor, and totally undeveloped.

There are three primary areas that are of concern in the short to medium term:

Political Instability

It is important to keep in mind that China is attempting something that has never successfully been done before, economic liberalization without political liberalization. We view the potential outcomes in four quadrants:

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While the Western world is betting that China will end up in the upper right-hand quadrant ("Richer and Freer"), we are betting that they will stay in the "Rich But Repressed" quadrant.

The Looming Financial Crisis

Perhaps the most serious weakness in the Chinese economy is the fragility of its banking sector. The main segments of the banking system--the central commercial banks--are essentially insolvent, and will face a huge competitive threat in the coming decade as foreign banks are granted access to the Chinese market. A failure in this sector could trigger widespread economic disruption and social unrest. A few anecdotes:

* Non-performing loans in China are estimated at 40-50% of the total. It would take over $500 billion to fix the problem, which is more than 40% of annual GDP.

* The banks are incredibly inefficient. Assets per employee for Chinese banks are one fifth of their U.S. counterparts.

* Banks are required to lend money to support government objectives, including targeted industries and enterprises. The majority of the policy loans are financed with credit extended from the Central Bank and at times this policy lending has accounted for over 50% of central commercial bank lending.

Why China Still Cannot Be Ignored

While there are real concerns about the potential for short-to-medium term instability in China, in the long term it still represents the largest new market in the world. It is a huge opportunity and potentially a huge threat to every Western manufacturer. Key areas to consider include:

* It will be one of the largest automotive markets in the world. Regardless of the short-term concern about overcapacity, China still represents the growth market for the global automotive industry. Most important for suppliers, the automotive supply base is still very immature. An example of this is while in 2002 General Motors imported $220-million of components from China into its North American facilities; in the same year it also imported $2.2-billion of components to support their Chinese facilities. There remain significant opportunities for most North American suppliers

* A center for innovation. While this also relates to their propensity to steal Western intellectual property, China is currently the center of innovation for many products and processes. Ignoring this opportunity and threat puts many Western suppliers and OEMs at risk.

* Some products can be produced significantly cheaper in China. While the strategist Michael Porter will tell you labor rates are the least sustainable competitive advantage, there are certain products and components that can be made much less expensively in China. In some instances the cost difference is 40-60%. If your product is basically a low value-added commodity and/or highly labor intensive, it probably can be made more cheaply in China.

Last but certainly not least, if you decide to go to China, make it a strategic vs. a reactive decision. Unless you have determined that you want to participate in the Asian market long term, do not establish a presence there strictly to ship product back to North America. That can be more easily done through a global sourcing strategy than by making a long-term commitment to a market you know nothing about. And be prepared. As the hype about the "China Miracle" begins to wane, it will soon be replaced by an equal level of hype about India.

By Kim Korth, President, IRN, Inc. [e-mail]