China's surprise July 21 revaluation of the yuan will probably prove to be the most important business story of 2005. As a result, both inside and outside of China, there has been a great deal of commentary on how different sectors of China's economy stand to gain, or lose, from the policy change.

But the most important question is, how will the stronger yuan affect China's competitiveness over the long term? In fact, when the question is seriously analyzed, the answer is that the revaluation could boost China's general competitiveness. What is more, the entire world may benefit from a more competitive Chinese economy. China's most basic economic challenge, for the next generation, will be to move from a low value-added, investment-driven economy to a high value-added, efficiency-driven one. The stronger yuan, and the outside world, will both play a significant role in causing this shift.

Business chains: China's hidden strength

China's vast, underpaid labor force is widely regarded as the foundation of its competitiveness. But cheap labor is not the key ingredient in the recipe. True, the average manufacturing job in China pays only $115 per month. But many other developing nations, such as India and Indonesia, have a large supply of inexpensive labor - yet China has pulled ahead of them, and other developing nations, as a top business and investment center.

Why?

What has made the biggest difference is that China has successfully built a set of complete business chains, especially in the manufacturing sector. The term "business chain" encompasses all the phases a product goes through before it reaches the customer, from raw material, to parts manufacturing, to assembly, marketing, the provision of technology and capital, and so on. To a far greater extent than competing countries, China has successfully achieved critical mass for its business chains: increasingly, all the required elements are present within the country.

Very significantly, China's business chains increasingly directly connect final products with global markets and buyers: In 2004 alone, Wal-Mart purchased about $18 billion worth of products made in China. General Electric (GE) aims to reach $5 billion in outsourcing in China in 2005, and Philips did $9 billion of business in China in 2004.

A dominating reason for the localization of business chains in China is that the country has become the number one global consumption market. This rising Chinese consumption has become a magnet for international rush.

In 2004 alone, China manufactured nearly 180 million mobile phones, 80 million of which were sold to Chinese customers, helping to make China the world's biggest mobile phone market with 360 million subscribers. International telecom players have little choice but to compete in China if they intend to win in the world marketplace. Nokia's global leadership in 2004 was helped in no small measure by its $6.9 billion in business from China. This foreign rush has further expanded the business chains.

The great advantage from complete business chains is that all manufacturers, Chinese or domestic, can make all sorts of products in one place - China. Naturally, they have decisively helped to make China a new economic center around globe.

All participants have gained vast opportunities in the process. For now, making any end-products gets support from a self-sufficient business chain inside China.

In one extreme case, Geely Group, a private, fast-growing Chinese firm which has been manufacturing cars since 1998, has been able to sell nearly 100,000 cars to 27 developing nations in Southeast Asia, Eastern Europe and Africa. Its quick growth comes from the fact that there are already thousands of auto parts makers inside China. Geely Group is no more than an assembler of parts made by these Chinese manufacturers. However, it has been able to produce the cheapest cars in the world: Geelys sell for as low as US$3,800, a price point which has created a market not only in China, but in many developing nations as well. Improbably, the company is even planning to team up with the Hong Kong government for a new plant in Hong Kong, which aims to sell sedans to the international market.

Foreign MNCs and the business chains

China's complete business chains have helped the country's enterprises to exhibit the international economy's key virtues: efficiency, convenience, competitiveness and low cost. A small increase in the value of the yuan exchange rate can hardly harm these ever-growing business chains. The latest trend is for foreign multinationals to set up research and development centers within China; IBM, Sony, Philips, Microsoft, Siemens, Intel and LG, among others, have set up more than 600 R&D centers in the country. These centers are not only responsible for producing products localized to cater to Chinese demand, but in many cases, next-generation products for the global markets. Countless businesses from the developing world have also rushed into China, developing the business chains even further.

The business chains are bound to expand further because all their participants, whether foreign or Chinese, have vast vested interests in their continued progress. As long as China continues to be politically stable with fast-growing consumption as well as a friendly business environment, foreign investors and multinationals will continue to treat China as a priority. This foreign rush has naturally led to greater competition in China’s marketplace, thus helping the nation to become more open and dynamic in all sorts of ways.

This new economic center has already altered global map. Different nations are now trying to take advantage of the opportunities China offers to boost their own long-term development. But some are doing better than others. Japan Inc, in spite of recent Japan-China tensions that have somewhat cooled Japan Inc's ardor for China, is arguably doing better than US Inc. The auto industry is an example. Both Japanese and American automakers have sought to reduce costs by shifting production to lower-cost countries; US firms have mostly gone to Mexico, while Japanese firms have used China. But the scale of Japan's investment in China is greater, and partly because of the greater scale of the market in China as compared to Mexico, the potential gains to Japanese firms are greater. Japanese automakers are now considering selling their Chinese-made cars to international markets.

The challenges of the strong yuan

At the same time, the yuan's appreciation will undeniably take a toll on Chinese exporters, in particular textile and consumer product makers, whose profit margins were already low, usually below 5%. So, they must try hard to move up in the value chain or possibly be forced out. But they are more vulnerable to potential punitive measures imposed by foreign governments, which would have more adverse consequences on their health.

All is said, domestically, there are tough issues raised by the strong yuan. But there are more fundamental issues China must resolve. One of the most pressing is overcapacity, especially in the manufacturing sector. China Inc does have enormous challenges ahead. But these challenges go well a rising yuan.

Indeed, the overcapacity issue is worsened by two factors: first, there are simply too many players in most economic sectors. In air-conditioner manufacturing, for example, there are more than 50 companies now, although this is actually an improvement from the 400 that existed in 2000. Though the market is still growing fast, many of these companies are no longer profitable. Kelon, the Chinese market leader in making cooling products, which trades on both the Hong Kong and Shenzhen stock exchanges, has been making serious losses lately, chiefly due to the overinvestment in the sector. As a result, its controlling shareholder has recently changed hand.

But achieving a rational consolidation is very difficult for now, because most of these companies are still controlled by government. Consolidation is clearly necessary, and would be much easier if political interests could be completely separated from the business world. But this remains a tough task for today's China. Indeed, this excessive government power remains the largest roadblock for China’s progress.

Fundamentally, China must resolve the institutional barriers coming from a traditional government domination. To move away from the government-centered economy and society is an urgent necessity. But there is hardly any alternative or shortcut.

Another difficult issue is that most Chinese manufacturers don't have sufficient intellectual property and cutting-edge technology. Instead, they must pay high prices to buy technology from the outside world. This problem is a significant contributor to the poor profitability of many Chinese manufacturers. For example, in 2004, China produced some 73 million TV sets; but most Chinese TV makers lost money.

In general, to most Chinese manufacturers, a rising yuan will produce both good and bad effects. On the minus side, their already low profit margins are further eroded by loss of the competitive advantage provided by the weak yuan when selling to Wal-Mart and other international buyers. But on the plus side, throwing away the undervalued-currency crutch could force them to become more competitive. This means that China Inc would have no choice but to focus more on innovation, intellectual development and rational consolidation, among other beneficial measures. In the long term, this pressure should make China Inc perform better.

China has walked a long way to reach this stage of development, despite all the imperfections. Above all, China has successfully integrated its economy with the global economy to a high degree within the last three decades. This has created vast new opportunities for the entire world, China included. Though there remain huge trade, political and economic issues for China and the outside world to work on, the entire world has directly benefited from the expanding Chinese pie. The small, but decisive increase in the yuan's value shows, above all, that China is committed to playing its part in the maintenance of a stable, growing global economy.

George Zhibin Gu, author and business consultant based in China, is the author of a newly released book, China's Global Reach: Markets, Multinationals and Globalization (www.Trafford.com), Sept 2005) and Made in China: Players and Challengers in the 21st Century (Portuguese edition, (www.CentroAtlantico.pt).