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.

With the onset of the current global crisis, and given the recent changes seen in social media, demographics, urbanization and resource constraints, all four pillars are now under stress. Production chains are faced with labor shortages, wage increases and threats of relocation to lower-cost countries. Meanwhile, global investors are questioning local governments' solvency.

Chinese experts are now debating an important governance question: what top-level architecture would enable the country to adopt the reforms needed to meet global and domestic pressures? Investors are concerned about Chinese equities' erratic performance, regulatory risks, and policy surprises, as well as the uncertainties stemming from greater volatility in asset prices, including property prices, interest rates and the exchange rate.

What makes the Chinese economy more difficult to read is the increasingly complex interaction of all four of its production system's components, with each other and with the rest of the world.

First, favorable conditions for the growth of the "world factory" have begun to dissipate. Production costs - in terms of labor, resources, regulation and infrastructure - have been rising domestically, while consumption bubbles in the West have burst.

Second, the early success of "China infrastructure" was built on cheap land, capital and labor.

Third, the success of China's financial system was built on State-owned banks' financing of large infrastructure projects and foreign financing of export production through FDI and trade.

Last but not least, the three pillars could not have remained standing without an anchor provided by the fourth. Until now, its success stemmed from constructive competition between local governments and different ministries. Unfortunately, this has led to problems related to social equity and environmental sustainability, which cannot be overcome without a complex coordination of bureaucratic silos in order to combat the resistance of vested interests.

There is general recognition and consensus that the path of reform requires profound re-engineering of all four pillars. First, the production chain must shift from export dependence toward domestic consumption. Realigning China's infrastructure means emphasizing quality over quantity, and reducing state ownership and controlling prices in favor of market forces. State orchestration should instead concentrate on fighting corruption, reducing transaction costs, promoting competition, lowering entry barriers and removing excess capacity.

For the financial supply chain, the priority should be on lessening systemic risks and realigning incentives to induce investors to support the engines of real economic growth rather than the creation of asset bubbles.

The Chinese miracle was engineered by institutional and process innovation at all levels of the supply chain for government services. China requires nothing less than another radical re-engineering to become a more balanced, socially equitable and sustainable economy. That process has already begun with another round of experimentation through three new Special Economic Zones in Hengqin, Qianhai, and Nansha, which will help promote the emergence of an innovative, knowledge-based services economy.

Of course, such an economy relies heavily on the quality of governance. The real challenge for Chinese officials will be how to balance creativity and institutional innovation with order, thereby ensuring the integrity of all four of the country's economic pillars.

Andrew Sheng is president of the Fung Global Institute, and Xiao Geng is director of Research at the institute. Project Syndicate.

(China Daily 08/24/2012 page8)