China’s risk: Bubbles burst, that’s what they do

In this IDC article for VentureOutsource.com, we explore the down side of the Chinese economic miracle for the IT manufacturing industry. China has become the largest center for the electronics manufacturing industry for a host of reasons. But what is the down side of being over invested in China? Below, we look at factors that could lead to a fracture in this critical global manufacturing location, but there is no need at this point in time to discuss the benefits of being invested in China. That is the accepted wisdom of the business community. This article, instead, raises the question any responsible executive should be asking, "what could go wrong?" Depending on whom you speak with, China is either the savior of the electronics hardware industry, providing the cost structure to sustain profitability as the industry matures, especially after the dotcom bubble; or China is a pariah on the world economy that has shortchanged its own population and the future of its country in order to keep its current political system in place. In any case, China did become the leading manufacturing destination through various policies the Chinese government adopted over the past thirty years to grow its manufacturing sector and the broader economy, by attracting foreign investment with low wages and other operating costs. The results of these policies and various other factors have come together to drive an economy growing nearly 10% annually, on average, since 1979. Controlling the exchange rate is the core policy tool used by the Chinese government, and may lead to the systems' eventual collapse. By controlling its exchange rate, China keeps costs below market levels for multinationals that operate from China. One element of this policy includes an enforced savings regime. Essentially, a business in China that earns foreign currency must exchange the currency for renminbi for use in China. Banks must then surrender foreign currency to the People's Bank of China at the official exchange rate it publishes. Completing this process, the Chinese government then does not reinvest the excess value of this currency transaction in China; instead China invests the money back in the US and other western markets. Keeping cash out of its economy is an attempt to prevent inflation from taking its toll on the Chinese economy by eroding the nations' construed cost advantage. The downside of these policies is the removal of the self-correcting influences of the market. This is the crux of the how the Chinese economy has been thrown out of balance, such as:

• While Chinese incomes are increasing, purchasing power does not appear to be keeping up. Prices for an array of consumer requirements are increasing yet there is insufficient monetary supply. This negates the consumer spending of the growing middle class.

• High import tariffs, often waved for export oriented manufacturing, protect Chinese electronics manufacturing but drive up costs of electronics for Chinese consumers.

• To keep from driving up inflation, the Chinese government has not reinvested in the country's infrastructure, so transportation burns dirtier gasoline; roadways and bridges are not sufficient to carry the current load; air and water pollution and toxic substances are endangering the health of the average citizen.

• To support manufacturing, rural land is being transformed into industrial parks, displacing farmers.

• Water and other resources needed for industrial use are diverted away from serving domestic needs.

This enforced savings regime has driven a 50% savings rate - almost double the rate seen in other major developing economies - and has created more than one trillion dollars in foreign assets. How China manages these funds, mostly overseas (with, according to some estimates, 70% in the US) impacts both conditions in China as well as global financial markets, thus challenging the abilities of the system to deal with the decisions made by the Chinese government. With Chinese leadership somewhat isolated from the global market economy, their decisions to date have not been the best. China's $3B investment in the Blackstone Group's IPO have lost (on paper) between one-third and one-half its value, to date. There are also numerous other social, political, and economic problems developing into major challenges for the Chinese government, most being been unintended consequences of various policy choices. These include:

• The Chinese population is aging rapidly and its labor force will shrink in the coming decades.

• Over population in Chinese cities is straining service delivery systems beyond their ability to cope.

• Competition between rural and urban populations, exacerbated by corruption and poor governance, is growing.

• The Chinese educational system cannot produce enough new workers capable of engaging in the global business environment.

• An income gap is developing between Chinese workers and a growing Chinese professional and entrepreneurial class.

• The gap between political and economic elites is increasing, so that political decisions, which impact the economy, are made without insight into the needs of the economy. This gap also leads to increased corruption, which in turn impacts other growing points of contention within the Chinese society.

• Chinese political elites, obsessed with maintaining control, use authoritarian measures at the same time as the information economy is taking hold in the country, increasing the frustrations of the average Chinese citizen.

Combined, all of these issues, and many others are becoming fault lines in the foundation that has allowed China to recover from the economic disaster of the Cultural Revolution. This includes the good will of the international community. The rise of China is threatening to displace large swaths of the global work force that rose to the middle class through manufacturing and related employment. As mentioned above, the inexperience of China's leadership has caused uncertainty in financial markets, engendering ill will toward Beijing. Additionally, China's foreign policy based on a narrow, and maybe near-sighted interpretation of its own self-interests, has alienated various segments of the international political community. Other nettlesome problems include a poor track record on intellectual property (IP) protection, human rights, and in the past year -- product quality. The end effect of China's efforts to grow its economy in a controlled manner is to throw its economy and the global market out of balance. Just as the housing / mortgage market in the US, the Internet Bubble, and countless other examples have shown, large systems out of balance tend to correct themselves. In China's case, the fault lines are deep in the foundation, making it more likely than not that China will experience serious disruptions in the next 10 to 15 years. Whichever path this disruption takes is impossible to predict, but for the electronics manufacturing services (EMS) industry, and the broader IT industry, such disruptions could cripple the EMS industry. According to IDC's latest research, illustrated below, 70% of EMS revenues originate from manufacturing operations in Asia, the vast majority in China. More specifically, China manufactures 100% of desktop motherboards, more than 80% of notebook computers, a large share of server components, more than half of all mobile phones and LCD panels, digital cameras, and an array of components. Every electronics device category a consumer or end-user touches plus, an increasing share of enterprise systems, are dependent on manufacturing capacity in China. Large-scale disruptions would crush supply, drive up prices, and depress end-user spending, with the ripples spreading out to other parts of the IT industry. There will not be a quick and easy way to shift manufacturing capacity. From a risk management perspective, EMS firms, OEMs, and their supply chain partners need to ensure they build diversity into their operational footprint in order to survive possible disruptions in China's business environment. Smart executives have seen the effects of geographic concentration in other sectors and have learned from these events, whether it was disruption to outsourced services when tensions ratcheted up between India and Pakistan in 2002 or when an earthquake severed a communications link in southern Taiwan one year ago. There is good reason why redundancy is built into communications networks, yet so many companies have not invested in such a strategy for their manufacturing operations. The future likely holds another paradigm shattering event for China. Will manufacturers be prepared to survive such an event? VentureOutsource.com, January 2008