`China is a global player in trade and foreign investment. But its financial sector is weak so much so that for China to have credibility in the global market it needs to hold massive foreign currency reserves. This is a sign of weakness not strength.'

Rasheeda Bhagat

Recently in Singapore

There is a lot of hype today about China being the "factory of world"


the explosion in its manufacturing sector. But the surprise, says Dr Yuwa Hedrick-Wong, Economic Advisor to MasterCard International, is that "in terms of value add, the real factory of the world is the USA."

In 2004, the US manufacturing value-add $1,470 billion was twice that of China's ($701 billion). There is no doubt "that the Chinese growth is much higher; 14 per cent average annual growth rate, compared to 3 per cent in the US, but still the US is much ahead."

While the figures tell this story what is causing all the controversy in global business and politics is the shrinking US labour force in manufacturing. In 1992, the manufacturing value-add in the US was just under $1 trillion. As it grew to $1.4 trillion in 2003, the number of people employed in manufacturing fell from 28 million to 17 million.

"On the one hand, you can say this is wonderful because productivity in the US is rising and manufacturing is getting more efficient. But from the point of view of domestic politics, this is a disaster. People are losing their jobs not only to China but also to India. Today, a lot of people engaged in manufacturing are there not to make things, but to run IT centres or to work with the outsource parlour most probably in India. And those jobs are being outsourced as well. That is the challenge in the new global reality," says Dr Yuwa.

Never smooth sailing

As the percentage of American workers engaged in actual goods production shrank from 68 per cent (28 million) in 1992 to 52 per cent (17 million) in 2003, and China's exports to the US increased between 1994 and 2004 at an annual average growth rate of 25.98 per cent, headlines in the US talked about the country's growing trade deficit with China. "It is never cent per cent smooth sailing for China. What people don't talk about is China's trade deficit with other Asian countries." For example, according to WTO data, Korea has a trade surplus of $68 billion with China; Malaysia and Russia each a surplus of $20 billion; Japan ($19 billion) and Thailand ($13 billion). Only India has a trade deficit of $0.2 billion with China.

"The problem for China is trade surplus and deficits with the wrong people; deficits with Asian countries but surpluses with the US and the EU! So the Americans and Western Europeans bash China; this is the challenge it will face for many years to come." Meanwhile, he adds, China's huge trade surplus with the US is used to push American government bonds and "that gives rise to accusations of China being a currency manipulator. `You buy US bonds and keep the currency low and undervalued so you can export more to the US'; that's the story you hear in the US."

Sign of weakness

So what is behind this story? Dr Yuwa argues that China's buying of so much of US treasury bonds is a sign of weakness and not strength. "Today China is a global player in trade and foreign investment. But its financial sector is so weak that for China to have credibility as a player in the global market it needs to hold massive foreign currency reserves. This is to sufficiently reassure the investor that if you go to the China market, the banking sector might collapse tomorrow but they have enough American dollars in their vault to pay you back, and you won't end up holding a bunch of funny money. That is what China is doing, and to me it's a sign of weakness not strength."

He adds that till China fixes its financial sector, it would need to hold huge quantities of US treasury bonds to reassure international investors; it has no choice. But the danger in this is that it could potentially lose a lot in the future. At present, China has a reserve of $800 billion, the biggest foreign exchange reserve worldwide. "But I believe that China is hugely exposed and vulnerable because the longer term trend is for the US dollar to depreciate. They are not stupid, they know this but they have no choice. For such a major player in the international market, if you have a non-convertible currency, when your banking sector is weak, the only way people will play with you is if you have a certain amount of reserves. That's a sign of weakness," says Dr Yuwa.

On the extent to which the Chinese yuan is undervalued, he says: "Economic fundamentals inform us that a currency is undervalued if in that country the increase in productivity is higher than the increase in wages. That appears to be the case in China, where between 1994 and 2004 labour productivity increased by 150 per cent and wages by 138 per cent. This is not surprising; we all know about the surplus labour in the countryside."

But on the other side of the coin, one can also argue that the Chinese currency is overvalued. The same economic fundamentals tell us that a currency is overvalued if the inflation rate is lower than the inflation rate in another country with which the exchange rate is calculated. During the same period, while inflation grew by 20 per cent in the US, it did so in China by only 8 per cent. From this perspective the yuan is overvalued, he argues.

"But the real issue is that in the global market we have an increasingly connected/integrated economy without a global currency... that is the cause of the challenge faced by China and other emerging markets." The world had a proxy global currency US dollar that was managed in the US but with a worldwide impact.

Win-win for Americans

There is a built-in systemic bias for the devaluation of the dollar, Dr Yuwa says, adding: "Imagine that you are an American who holds assets both in the US and overseas, which is the case for many US companies. When the US dollar devalues, their foreign assets increase in value but their domestic assets remain unchanged in dollars. Others suffer from the decline of their asset value domestically when their currency devalues, but for Americans there is nothing to lose but only net gain."

With a built-in systemic bias when global economies operate with a proxy global currency that is not truly global, China's integration in the global market was difficult with a weak domestic financial system.

Explaining the reason for a situation of a "permanent currency crisis in the global market," Dr Yuwa says the problem was that the US had a Federal Reserve with the mandate by law to maintain growth and price stability in the US. But the impact of the Fed action was felt worldwide. "Two-thirds of the US dollar notes are circulated outside the US. So when the Fed Reserve prints money ... I mean metaphorically... by raising interest rates, to increase liquidity, it is increasing the global circulation of a global currency. But they have a mandate that is defined by law domestically."

Understanding consumer needs

Returning to China's booming economy, and the resultant regional integration in Asia that was already happening to a certain extent, Dr Yuwa says, "What we have seen up till now is likely to be dwarfed by what will happen in the next 10-15 years when China and India get a combined middle-class consumer base of 1 billion. For businesses to be successful they would have to be truly targeted to this huge potential market or else they'll fail," he says.

Within this broad class of middle-class consumers, differences in gender, age, educational background and geographic locations, all of which are important to identify a segment of the true potential customers, would have to be understood. "Within the same level income if you don't understand the differences in gender, age, etc, you could end up with customers who have no interest whatsoever in your product," he says.

Shock in store for Europe

"Today when I speak at the American Chamber of Commerce in China, there are small and medium American companies there that I haven't heard of, and I say, `Wow! they're really here now.' But that's not the case for Europe. Of course, we have Siemens and Alcatel and they are everywhere, but we are yet to see small and medium size European companies in Asia; when we do, we'll know they are leveraging Asia."

Meanwhile, the resentment in the US against China and India is "the tip of the iceberg. Europe hasn't seen it yet, but they'll be shocked when it hits them. The kind of political backlash in a country like France will be terrible, and very controversial. Europe has not woken up on how to leverage Asia."

In 1995, the EU actually exported more to China than it imported. That picture has completely changed. "Today Western Europe, especially the EU, is preoccupied with absorbing new members from Eastern Europe; when that process begins to settle, then they'll turn their attention to Asia. And that's when European companies will outsource more to Asia, what American companies are doing, but on a much bigger scale... at least 10 times bigger."

(Response may be sent to rasheeda@thehindu.co.in)

(This article was published in the Business Line print edition dated July 14, 2006)
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