China’s Gross Domestic Product (GDP) is expected to grow at 9.7 percent in 2008, fueled by increasing domestic consumption, high investment levels and an undervalued currency that will continue to drive exports. The trade surplus is expected to exceed $235 billion in 2007. The Chinese government’s attempts to slow the super-heated economy by raising interest rates are not likely to succeed because the country’s artificially undervalued currency will continue to fuel exports and a concurrent inflow of foreign capital. China’s foreign currency reserves exceed $1.3 trillion, and this capital will continue to fuel speculative domestic investments and create asset bubbles. Moreover, the CSI 300 index of Chinese stocks has climbed more than 85 percent this year. Speculation by Chinese investors in the local capital markets show no signs of abating, even as the Chinese government increases various taxes on transactions.
Without an adequate correction in the currency, inflation will become a growing concern. It is likely to jump from the current consensus forecast of two percent to a real inflation rate that exceeds four percent. A growing inflation rate, coupled with the increasing likelihood of U.S. trade sanctions to counteract the Chinese currency, may force the Chinese government to allow its currency to appreciate from 10 percent to 15 percent in 2008.
U.S. trade sanctions and/or a significant appreciation of the Chinese currency are likely to occur in 2008. As a result, China-based manufacturers will experience dramatic erosion in margins as well as concurrent profit declines. The fledgling IT and business-process outsourcing (BPO) sectors are expected to suffer the most significant downturns. Currently the bulk of China’s ITO and BPO has been focused on supporting other Asian countries. The primary reason: Chinese language closely resembles other Asian languages, and many Chinese living in coastal areas like Shanghai speak Japanese. Any significant appreciation in the Chinese currency will quickly erode the benefits that Asian BPO and ITO providers enjoy in China. And as the switching costs for BPO and IT are quite low, companies can be expected to quickly move these operations back to domestic sites.
China has failed to make significant inroads in the BPO sector, specifically within the English-language arena, primarily because of language constraints. The country still faces major challenges within the IT outsourcing sector as a result of poor IP and patent-protection laws. In fact, China’s illegal copying of movies, music and software cost companies $6.2 billion in 2006 sales, according to an estimate by lobby groups representing Microsoft, Walt Disney, and Vivendi. Although China has not made significant gains in IT software outsourcing, the country has become a major platform for IT hardware outsourcing with a significant presence from Korean, Taiwanese, American and Japanese firms.
Sourcing to Shift from China
The expected appreciation of the Chinese currency and/or U.S. trade sanctions in 2008 will have a particularly severe impact on these sectors of the Chinese economy. Technology advances have continued to erode the benefits of labor arbitrage that China has previously leveraged and, with a sharp appreciation in the Chinese currency, China will lose the benefits of currency arbitrage. The net result will be a shift in sourcing away from China and more IT manufacturing taking place in such key domestic markets as the U.S. and Japan. Alternatively, sourcing will shift to other developing countries such as Brazil, which have good infrastructure and a solid manufacturing base.
The undervalued currency has had a negative impact on other developing countries. Most notably, India and Brazil, both of which have suffered losses to exports due to the appreciation of their respective currencies. These countries can be expected to benefit from the appreciation of the Chinese currency, as their exports will become more competitive. Additionally, a stronger Chinese currency is likely to force the Chinese government to expand the development of the domestic consumer market that has been held subservient to exports and DFI.
India, by contrast, has allowed its domestic market to act as the engine for economic growth. This has resulted in a much more balanced trade picture between India and the other trade partners. India has become a major importer of aircraft from the United States, Europe and Brazil the direct result of growing domestic air traffic and the privatization of the Indian airline industry. India has also developed a world-class textiles sector but much of the production in this sector is now being consumed domestically as a result of a rapidly growing middle-class.
