As China becomes an increasingly active player in the international market, how will traditional economic powers such as the United States and Europe cope? Axel Merk, Portfolio Manager of the U.S.-based Merk Hard Currency Fund, looks into this issue in his article titled “China: Embrace the Competition.”
　　Competition from China is only going to intensify, so the developed West needs to stop whining and embrace it. While the United States and Europe are addressing China’s rise differently, neither has any alternative but to take up this challenge.
　　
　　Feeling the pressure
　　
　　The U.S. consumer has been the primary recipient of cheap Asian imports. U.S. policymakers have fostered consumption through monetary and fiscal policies, i.e. through low interest rates and low taxes.
　　U.S. policies have accelerated Asia’s growth. While the intent of U.S. policies has been to foster U.S. growth, there have been serious unintended consequences. Notably, the stimulatory economic environment, which has also been fostered by most Asian states subsidizing their exports through pegged, low exchange rates, has caused a shortage of commodities worldwide, high commodity prices, and low consumer-goods prices.
　　Corporate America, faced with high commodity prices and an inability to pass on higher costs, has had to accelerate its outsourcing to retain margins. The pressures have directly contributed to disappointing job and real wage growth.
　　As the United States has pushed growth while dismantling its manufacturing sector, its current-account deficit exploded to more than $800 billion in 2005, or more than 6 percent of gross domestic product. Foreigners need to finance the current-account deficit at a rate of more than $2 billion every day, just to keep the dollar from falling.
　　In Europe, consumers have increased savings in recent years, as they are reluctant to spend in a challenging economic environment. Asia is knocking on the doors of European consumers, and corporate Europe is feeling the pinch.
　　Whereas the U.S. economy is known for its flexibility, Europe is known for its rigidity. Corporate Europe has been unable to adjust quickly enough to compete with China effectively. Many Europeans believe it is impossible to compete with “l(fā)ow-cost China” and that protectionist measures must be taken to “preserve” European culture.
　　The recent protests by French students reflect a fear many Europeans share that they don’t want to give up their many social benefits, including job security. Europeans see China as a threat to their culture: They are scared they will have to adopt a Chinese lifestyle.
　　However, it is time to get rid of one myth: China is not a low-cost country. True, China is a low-wage country, but wages are only one component of the costs faced by manufacturers, and not only that, a bidding-up of wages in the booming coastal areas in recent years shows that Chinese wages do obey the laws of economics in spite of the country’s huge population. Producers in China also face the same high raw-material prices as the rest of the world; many regions in China face high transportation costs, which further increase raw-material prices; the still-underdeveloped infrastructure in much of China increases the cost of doing business; and China’s opaque regulatory/ bureaucratic environment further burdens its producers.
　　And notably, competition within China is utterly cutthroat. It is not merely that the Chinese seem to be competitive by nature, but rather, pro-growth policies ranging from pegging the yuan to the dollar to easy access to loans and other government policies have created too many businesses chasing each and every opportunity.
　　Successful investors in China understand the opportunities and challenges of the region. Investments in highly efficient, scalable enterprises make sense assuming there is demand for the products produced. They need to be large-scale investments to overcome high fixed costs and to operate profitably with a high-volume, low-margin business model.
　　Investors in China take great care to have highly defined production processes with great emphasis on quality control. The attention to quality control recently is the result of China’s reputation for poor-quality goods a decade ago.
　　How times have changed! A low-skilled Chinese worker today may produce more consistent quality than a highly skilled Eastern European worker. Partly because quality is less of a concern with a highly skilled worker, less emphasis is placed on production automation and quality control in much of the West.
　　The Chinese approach is more scalable and at the end of the day may yield superior quality. Also, it should be noted that a couple of hundred thousand highly qualified engineers are entering the workforce every year in China.
　　Indeed, the Chinese are gradually realizing that even they cannot compete on cost alone--investors concerned primarily about cost are moving to cheaper places such as Viet Nam. Instead, China is working feverishly and successfully to service the later stages in the value chain.
　　
　　How to adjust
　　
　　The way to respond to such a competitive challenge is to learn and adjust your own way of doing business. But that does not mean Americans and Europeans have to work at Chinese wages.
　　The United States has the great advantage in that it has a highly flexible economy. Unfortunately, well-intended but mistaken policies have pushed the U.S. economy toward consumption and debt rather than investments. The United States is now in such a weak position that no policymaker dares to call for changes that foster savings and investments rather than consumption; such policies may induce a severe recession in the short term. Yet, this may be precisely the medicine the United States needs if it wants to prevent the risk of ever-increasing pressure on the dollar as the current-account deficit escalates.
　　The rise of gold and the dollar’s weakness over the past couple of years are warning signs of what may come should there not be a change in policies. Given the high consistency in fiscal and monetary policies in the United States, we have little faith that such policies will be instituted.
　　Europe--because of its relatively high consumer savings--is structurally in a stronger position to compete with Asia. However, rigid European structures are preventing corporate Europe from arming itself for competition. Executives waste time arguing over social benefits and wrangling with bureaucrats and local activists instead of focusing on repositioning their businesses to compete in a constantly changing world.
　　If the West does not want to adopt Asian wages, it must compensate by providing incentives rather than obstacles to investment. The West must think of itself as being a couple of steps ahead of the Chinese in the value chain, and vigorously defend that position by constantly reinventing itself. Reality must be faced: There are certain types of jobs that cannot survive in Europe. But there are also certain jobs that cannot survive in China and have moved to Viet Nam.
　　In the United States, most agree that job guarantees like those the French students have been fighting for are bad for business. A company does an incompetent employee a favor by laying him or her off, so that he or she can find a more suitable job rather than wearing the company down in a dead-end career. Many Europeans think differently: It is inhumane to use an employee like a pawn, and an employee must be able to plan to have a family and life.
　　A capitalist may counter that it is an inefficient allocation of resources to pursue the European model, and that the threat of losing a job may be an incentive to work harder.
　　Our interpretation is more moderate: We argue that the best companies attract the best employees. Many successful large enterprises pride themselves in low employee turnover not because it is the law, but because they provide a morale-fostering, and thereby a more productive, environment for their staff.
　　Workers who seek job security should work for companies that offer it. But the companies that want to adapt should not be held back. There will be “ruthless” companies with high employee turnover, but we doubt that these will be the most successful ones in the long term. Employee, employer and customer loyalty is a privilege, not a right.
　　Americans and Europeans need to get their act together quickly, as the rest of the world is not waiting. Consider LG, the South Korean electronics giant. After building a significant presence in much of Asia, it has not only started to conquer the more remote areas in China, but is ready to compete in the United States. Last fall, Home Depot started to aggressively push appliances by LG. LG mobile phones are heavily promoted in various U.S. markets. Western companies may have a very difficult time competing with firms such as LG that know how to operate profitably on a large scale in Asia.
　　Unfortunately, this discussion may be rather academic, as fundamental change appears unlikely in the United States and Europe alike. In the United States, there is such an obsession with top-line growth that the side effects, including an ever-increasing risk to the stability of the dollar, may mushroom. And Europe will always be slow-moving, and will not become an agile competitor. Having said that, many individual European companies have been able to compete much more effectively. With further reforms, these companies could become more daring in expanding their businesses within Europe, rather than shifting production abroad.
　　This does not mean that one cannot negotiate hard with Asia to help level the playing field. For example, the United States or Europe could mandate that imports be produced according to certain environmental standards. Existing auto-industry standards, which require a certain level of fuel efficiency in cars and the presence of pollution-control devices such as catalytic converters, are one example of this approach.
　　Free-market advocates are always reluctant to introduce such measures, as they can easily become a back door to protectionism. In the end, however, these are political questions that elected officials should decide upon.
　　As Asia is becoming more ambitious all the time, and the fallout in the United States and Europe more pronounced, we are afraid protectionism may reign at the end of the day as the standard of living in the West comes under pressure. In the United States, the risk is that protectionist measures may scare away capital--capital needed to finance the current-account deficit and to keep the dollar from falling. In Europe, the danger is that protectionist measures will discourage further reform, worsening the continent’s competitive position even more.
　　

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