The Credit Crisis May Not Be China's Biggest Problem

The best investment ideas rarely come from the latest news item or brokerage research report. They're often found on the fringes of finance or outside the?field?altogether. Right now, everyone is focused on China's poor economic data and the potential for a hard landing in future. This is fair enough given the possible fallout. But despite what some think, China's credit crisis will end at some point.?And?perhaps it will be?sooner than most?believe if the new leaders are serious about tightening policy rather than reflating the?credit bubble.

Asia Confidential is going to explore an issue which has the potential to have a larger impact on China's future than the current credit crunch.?Few?in the investment industry and even fewer in China itself are aware of it. But it is well-known in the?world of technology.

That is, the internet is currently transforming the manufacturing industry in a similar?way to what it did to the publishing world before. Anyone with internet access and?desktop fabrication tools can?become a manufacturer nowadays.?That's lowered the barriers to entry and resulted a deluge of smaller entrepreneurs becoming manufacturers.?Previously, you'd have?needed millions of dollars or a much larger company to manufacture your ideas. Today, it can all be done with a few clicks of a mouse.

This transformation?may have far-reaching consequences. Large manufacturers?are on notice given the number of small entrepreneurs entering the space. As are mass production companies which deal with large orders. That's where China comes in, being?the world's largest mass manufacturer. For start-up manufacturers won't want the expense of large orders or the transportation costs associated with small orders from China. They're likely to look for more nimble suppliers who are closer to home. That means China's manufacturing dominance could be under serious threat, and soon. And manufacturers in the developing world may be the ones to benefit.

The potential impact from this change on China will be the focus of this week's newsletter and we'll follow up with the broader economic and investment implications in?our next issue.

The internet enters the real world

There are two powerful, yet opposing?forces?which?are likely to drive?the global economy going forward. The first is significant over-indebtedness in the developed world continuing to?weigh on?economic growth, despite what the Paul Krugmans of the world would have you believe. The second is extraordinary technological change which?has the potential to?propel future economic growth.?Which?of these forces?will have the greater impact in the long-term?

It's?unsurprising?that Chris Anderson,?a former editor of technology magazine Wired, thinks that changes in the tech world will be key driver of future economic growth. In his book, Makers: The New Industrial Revolution, Anderson makes a?strong?case that the digital revolution is about to move beyond our laptop screens into the real world of physical goods, with dramatic consequences:

"The past ten years have been about discovering new ways to create, invent, and work together on the Web. The next ten years will be about applying those lessons to the real world."

What exactly does he mean by this? Well, manufacturing has gone digital. Physical objects can be designed on laptops and the designs can?be shared online as files. Factories have been able to do this for decades but the?big change is that now anyone with a regular computer can do it :

"...anyone with an invention or good design can upload files to a service to have that product made, in small batches or large, or make it?themselves with increasingly powerful digital desktop fabrication tools such as 3-D printers. Would-be entrepreneurs and inventors?are no longer at the mercy of large companies to manufacture their ideas."

Anderson likens this change to what happened?to the publishing industry almost three decades ago. In 1985, Apple released?LaserWriter, the first real desktop laser printer, which combined with the Mac, revolutionised publishing. Up until then, publishing had?used extensive manufacturing including printing plants and so forth.

Desktop publishing took publishing out of the factories into the online world. And thousands of professionals and amateurs?entered the industry which was once dominated by large media groups.

Anderson suggests that 3-D printers and other digital fabrication tools are to manufacturing what the LaserWriter and Mac were to publishing 28 years ago.?While these tools are somewhat expensive and difficult to use at the moment, that'll change as it did for the LaserWriter.

As Anderson sums up:

"Transformative change?happens when industries democratize, when they're ripped from the sole domain of companies,?governments, and other institutions and handed over to regular folks.

We've seen this picture before: it's what happens just before monolithic industries fragment in the face of countless small entrants, from the music industry to newspapers. Lower the?barriers to entry and the crowd pours in...

... The Internet democratised publishing, broadcasting, and communications, and the consequence was a massive increase in the range of both participation and participants in everything digital - the Long Tail of bits.

Now the same is happening to manufacturing - the Long Tail of things."

The new industrial revolution?

Anderson goes much further than these changes just impacting manufacturing, however. He reckons this is the start of a new industrial revolution which will drive increased productivity and economic growth for decades to come. A big call, to say the least.

To see why he thinks this way, we need to step back several hundred years,?to the first industrial revolution in the mid 18th century. Then, the great empire of Great Britain was struggling under the weight of its many colonies abroad.

That changed in 1766 with the invention of the spinning jenny by James Hargreaves, a weaver in Lancashire. The pedal-powered machine allowed a single person to spin eight cotton threads at a time rather than just one. The spinning jenny, along with the steam engine and better power looms invented later on, transformed manufacturing productivity. Increased mechanisation meant you could do much more with less.

To put this in context, better machines had been made before, but economic growth had been stagnant for several hundred years prior to this. But these inventions proved very different. They resulted in Great Britain's trebling between 1700-1850. From 1800-200, average per capita income increased 10x. There were many reasons for the cause and effect, which we won't go into?here for wont of space.

The second industrial revolution happened from 1850-1918 when the rise of factories was joined by technological breakthroughs. Namely, the building of railroads and?steam powered ships, which?resulted in similar productivity gains to transportation.

Anderson sees the internet age as the third industrial revolution. You may be somewhat sceptical given that the?Web has been around for some time. But Anderson isn't saying that the Web itself?is creating the revolution. Instead, he's suggesting that its application?to the real world?is:

"Computing and communications are ...?"force multipliers," doing for services what automation did for manufacturing.?Rather than amplifying human muscle power, they amplify brain power. They can?also drive productivity gains in existing industries and create new ones. And by allowing us to do existing jobs faster, they free us up to do new ones."

Manufacturing won't be the same

I happen to largely agree with Anderson that the internet is transforming the world of manufacturing. And if this is right, it's worth thinking about some of the implications:

• As alluded to earlier, as everyone had become a blogger today, everyone will become a manufacturer tomorrow. Supply will pour into the space. Every amateur handyman and inventor has the tools to run wild now.

• Larger manufacturing companies will inevitably lose significant market share. They'll have to adapt to a rapidly changing environment.

• It will result in an abundance of niche products. Consumers?will benefit from this choice, even if there'll be too much of it! Prices of?mid-to-low end manufacturing goods could well come down. They did for newspapers, so why not physical?goods?

• Manufacturing supply chains will?see substantial changes. Small producers will want small batches. They'll also prefer not too hold inventory ie. manufacturing on demand. And they'll?obviously want to reduce costs,?such as transportation.

"Made in China" under threat?

If you're thinking that point 5. above may relate to China, you'd be right. After all, the country is the world's largest mass manufacturer. China's business model, relying on low cost, productive workers to deliver goods largely to the developed world, has worked brilliantly for decades. But if Anderson is right, as I suspect he is, then that could all be about to change.

There are bound to be interjections at this point, suggesting that China's low costs will still be unrivalled going forward. That's not entirely true anymore. Double digit rises in wages in recent years, along with a much stronger yuan, have significantly bridged the gap.

And don't forget that Chinese manufacturing productivity still lags many developed world countries. For instance, the U.S. is 3x more productive than China. In fact, the Boston Consulting Group estimates that the net manufacturing costs of China will equal the U.S. by 2015. Also, the manufacturing costs in Mexico, neighbouring America, dropped below that of China last year.

Consider also that labor is becoming a less important component of manufacturing costs due to the increased use of robots. For example, labor is just 15% of the cost of making a car in the U.S. That percentage is likely to decline further, making other costs such as transportation more important. That makes geography crucial?and?where low cost, skilled manufacturers in Mexico and the U.S. may have a further edge over those in China.

All of this points to the potential for a radical shift in market share from China back to?developed countries?and those?close to these countries.

What China can do about it

If you believe that this shift will happen, then the obvious question is: what can China do about it? I'd suggest that China needs to quickly upscale its manufacturing base. In economic parlance, it needs to move up the value chain.

It could do worse than look at the example of South Korea, which has become a manufacturing powerhouse,?the Germany of Asia if you like. It's moved from being a simple, low cost manufacturer to a sophisticated, world class?maker of electronic products, cars, steel, industrial machinery, robotics and?biotech.

To follow this path, China needs significant changes though, such as:

• Government-owned?companies which dominate much of manufacturing need to be privatised.

• Small entrepreneurs?need?greater incentives including grants, tax breaks in key areas.

• The legal system needs to be changed to allow competition to flourish and re-dress when it's not allowed too.

• Better and?more transparent licensing to give?great security to manufacturers in their endeavours.

• Changes to?education to encourage innovation and creative thinking. Currently, high schools and universities in China?put far too much emphasis on learning via memorisation. I'd argue that this explains much of why China?has excelled?at copying the inventions of others in recent years, rather than creating their own.

The other obvious change that should happen is for China to decrease its reliance on exports in favour of consumption to drive future economic growth.

Much of the debate about future reforms in China have focused on this consumption issue. But any switch towards consumption will take a long time. In the meantime, manufacturing will remain a dominant driver of growth.

If I'm right about China's manufacturing dominance soon being under threat, the issue warrants far more attention than it's received to date.

This post was originally published at Asia Confidential: http://asiaconf.com/

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