Balancing institutional innovation and order will lay foundation for China to sustain its economic growth
During three decades of favorable global economic conditions, China established an integrated global production system that was unprecedented in scale and complexity.
But now policymakers must deal with the triple challenges of the unfolding European debt crisis, slow recovery in the United States, and a slowdown in secular growth in China's economy. All three are connected, and mistakes by any of the parties could plunge the global economy into another recession.
To assess the risks and options for China and the world, one must understand China's "Made in the World" production system, which rests on four distinct but mutually dependent pillars.
The first of these pillars, the China-based "world factory", was largely established by foreign multinational corporations and their associated suppliers and subcontractors. Labor-intensive processing and assembly was meanwhile carried out by small and medium-size enterprises that have direct access to global markets through a complex web of contracts. Starting modestly in coastal areas and special economic zones, the "world factory" supply chain has spread throughout China, producing everything from stuffed animals to iPads.
The "world factory" could not have been built without the second pillar: the "China infrastructure network", which was installed and operated mostly by vertically integrated State-owned enterprises in logistics, energy, roads, telecommunications and ports. This pillar relies heavily on planning, large-scale fixed investment and administrative controls, and its quality, scale, and relative efficiency were strategic to Chinese competitiveness and productivity.
The third pillar is the "Chinese financial supply chain", which provided the financing needed to construct and maintain the infrastructure network. This supply chain is characterized by the dominance of State-owned banks, high domestic savings, relatively under-developed financial markets and a closed capital account.
The final pillar is the "government services supply chain", by which central and local officials affect every link of production, logistics and financial networks through regulations, taxes or permits. Most foreign observers miss the scale and depth of institutional and process innovation in this supply chain, which has managed - mostly - to protect property rights, reduce transaction costs and minimize risks by aligning government services with market interests. For example, Chinese local governments have become highly adept at attracting foreign direct investment by providing attractive infrastructure and services that support the expansion of global production chains.
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