Consumption cannot be only driver

Increased investment in high-tech and knowledge-intensive industries also needed to ensure comparative advantage

China's economy is at a crossroads. As 2013 begins, 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 labor costs, and growing inflationary pressures?

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 Party's congress in November, Chinese leaders declared their intention to double per capita income by 2020, unleashing 64 trillion yuan ($10.2 trillion) of purchasing power.

Indeed, with roughly 130 million middle-class consumers, the mainland's domestic market holds significant potential. The Boston Consulting Group estimates that, with an average annual GDP growth rate of 7 percent in China and 2 percent in the United States, Chinese domestic consumption will rise to half that of the US by 2015, and 80 percent in 2020 (assuming that the renminbi appreciates at an average rate of 3 percent against the US dollar over the next few years).

Moreover, the current-account surplus plummeted from more than 10 percent of GDP in 2007 to 2.8 percent in 2011, reflecting China's decreasing reliance on exports to drive economic growth. In 2010, China's imports ranked second in the world, and they are expected to grow at an average annual rate of 27 percent in the next few years, outpacing export growth by five percentage points. As a result, the total value of imports is expected to exceed $10 trillion in only two years, providing lucrative investment opportunities and broader markets for foreign investors.

This potential is not lost on multinational companies. A survey conducted in May by the State Council Development Research Center asked 394 Chinese and foreign companies about their future strategic orientation in China. Most of the respondents viewed China not only as a market opportunity, a research-and-development base, and an export base, but also as a high-end manufacturing base, a regional-headquarters site, and a service base. 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 been "reshoring", seeking to bring manufacturing home, they have been establishing innovation facilities in China. Multinational companies have created nearly 1,000 R&D centers in China, including 194 in 2010 alone, enabling them to develop products for the local market. More than 1,400 foreign-funded R&D institutions are currently operating in China, and data from China's Ministry of Commerce indicate 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 percent of total global manufacturing, it receives less than 3 percent of the world's manufacturing R&D investment. As a result, China's capacity for innovation remains relatively low, with its high-tech and knowledge-intensive industries unable to compete globally.

On average, China's industrial enterprises are relatively small, and, although its industrial labor productivity (real manufacturing value added per employee) has improved over the last decade, it remains much lower than that of developed countries - 4.4 percent of the US' and Japan's productivity, and 5.6 percent of Germany's. And the "pauperization" 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 that of developed countries' manufactured goods. Whereas one unit of intermediate input in developed countries typically generates one unit or more of added value, in China the ratio is only 0.56.

As China's demographic dividend disappears, its low-end labor market is shrinking, driving up its once rock-bottom labor costs and diminishing its rate of return on capital. Over the next decade, as Chinese workers demand higher salaries, basic benefits, and improved working 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 fueling US reshoring. Given that Chinese wages are rising at an annual rate of 15 to 20 percent, productivity adjusted wage rates in low-cost US states are expected to exceed those in some coastal regions of China by only 40 percent 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 the preferred destinations for developed country investors.

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 their efforts 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.

The author is a fellow of the China Information Center and of the China Foundation for International Studies, and a researcher at the China Macroeconomic Research Platform. Project Syndicate