Having spent the first 20 years of my career on Wall Street, it’s impossible not to view the events now occurring in Manhattan with anything but complete horror. Consider what has transpired in just the last several months:

• Bear Stearns, one of the major U.S. securities firms, collapsed, and could only be sold after the Federal Reserve agreed to insulate J.P. Morgan, the buyer, from $29 billion of potential losses;

• FNMAE and Freddie Mac; the two largest mortgage lenders in the country, have been taken over by the U.S. government;

• Lehman Brothers, the venerable 158-year-old investment banking firm that survived two world wars, numerous recessions, stock market crashes and even the Great Depression, has filed for protection under the bankruptcy laws;

• Merrill Lynch, the firm that created Wall Street’s bull as an icon of American and stock market optimism, hastily agreed to merge with Bank of America over this past weekend in what can only be described as a shotgun marriage; and

• AIG, America’s largest insurance company with over $1.0 trillion of assets that ironically traces its roots to Shanghai, teeters on the edge of collapse.

As if that weren’t enough, executives at Goldman Sachs and Morgan Stanley are being pressed to explain why their firms have no further exposure to bad real estate and mortgage related loans and securities—and we haven’t even gotten to the hedge funds that are now facing redemptions and could soon be closing their doors as a result. I don’t know what it felt like in 1933 when the U.S. financial system last melted down to this extent, but it couldn’t have felt too much differently.

Given the way in which the entire world has become tied together financially and economically, the ripple effect of these events will be felt in every country around the globe. As America’s largest trading partner and the largest investor in the U.S. economy, China will be no exception. All things considered, though, the news isn’t necessarily all bad as far as China is concerned.

Expect to see the following:

• Slower Growth in Export sales to the U.S: Already sluggish, the current financial crisis will only exert further downward pressure on the U. S. economy. Banks and other lending institutions will be de-leveraging, conserving cash and reluctant to make new loans in the months ahead. With credit already tight and getting tighter, U.S. companies will be hard pressed to find the capital and loans needed to expand their businesses.

• Lower Commodity and Fuel Prices: In what can only be described as good news for China’s manufacturers and consumers, we are likely to be on the downhill side of the commodity pricing cycle. With lower global demand, the upward pressure on commodity prices is being alleviated. For example, U.S oil demand in 2008 is running 5 percent lower than last year due to high oil prices.  Lower demand, in combination with increased calls for offshore drilling in the United States, seem to have broken the speculative bubble in oil prices. That is why the cost of oil has fallen by one-third and is now trading below $100 per barrel.

• Less Inflationary Pressure: Lower commodity and fuel prices should also lower food costs, one of the major contributors to the recent bout of inflation that China has experienced.

• More Room to Stimulate the China Economy: With less inflationary pressures to deal with, the Chinese government should have more room to stimulate the Chinese economy in the aftermath of the Olympics and to counteract credit tightening and other measures it has taken over the past year.

• Upward Pressure on the Yuan Against the Dollar: The dollar has strengthened in recent months, slowing the fast appreciation of the yuan that took place at the beginning of the year. Given the current financial turmoil, the Federal Reserve will most likely be forced to lower interest rates and provide more liquidity to the marketplace. To the extent that it does, and absent efforts by China to intervene, pressure on the yuan to appreciate against the dollar will mount

• Near Term Downward Pressure on China’s Stock Market: With so much negative sentiment in the global financial markets, it’s hard to imagine how any equity markets in the world, including those in China, can be expected to perform well in the near term. However, if Chinese manufacturers begin to restore profit margins as a result of lower commodity prices, and if inflationary pressures are alleviated and the negative trends in China’s economy reversed, China’s stock markets could bottom as we near year-end . The Shanghai Index is trading below 2000, more than two-third’s below its high of last year.

• More Buying Opportunities in the United States: Financial assets are now being sold in the United States at fire-sale prices. While investing today in American banks, investment banks or financial institutions might be akin to “catching a falling knife,” the markets will eventually stabilize. When they do, China’s sovereign investment funds could be presented with some interesting, once-in-a-lifetime, buying opportunities in the world’s biggest capital marketplace.

I was honored to learn that I have been included in the Forbes.com Business Visionaries Series presented by Microsoft. According to Forbes.com:

Business Visionaries are thought-provoking leaders with an enduring message. The standard is high. Each one of the BV’s profiled in Forbes.com’s new series is a proven leader, a known decision maker and, most important, a thought leader in the field of business.

Other authors in the series include such business luminaries as Robert Hormats, vice chairman of Goldman Sachs International; Jack Bogle, founder and retired CEO of the Vanguard Group; and George Soros, the famous billionaire investor. Needless to say, it’s nice to be in such great company.

My inclusion as a Business Visionary stemmed from an interview I did several months ago with David A. Andelman, an American executive editor at Forbes.com who is an accomplished author in his own right. David has a long history in journalism with The New York Times, The New York Daily News, CBS and CNBC, and  is the author of “A Shattered Peace: Versailles 1919 and the Price We Pay Today,” a look at the origins of many of today’s deepest global crises including the war in Iraq. David’s book is published by John Wiley & Sons and is a fascinating read about one of most pivotal events in modern world history.

Included on Forbes.com are two segments from our interview. In the Beijing Booming excerpt, I highlight the areas in China that I see as being particularly ripe for future development and investment. In Lessons From the East, David asked me what I thought Western businessmen could learn from what is going on in China today. Both segments were edited by David and Mia Haugen.

NBC and its affiliates have a ton of people here covering the Olympics, but even those not in China are featuring Beijing, China and the Games in their broadcasts from the States. In June, I was interviewed by Maria Bartiromo for her Wall Street Journal Report. Even then, much of the talk was about the upcoming Olympics—-and the environment. The full interview ran in the States this past Sunday evening at 7:30 pm on CNBC nationwide. The preview segment on the CNBC.com website was appropriately titled:

China’s Future & the Olympics

With the Beijing Olympics getting underway, Maria talks to Jack Perkowski–an American attempting to build a billion dollar business for a billion-plus population.

Beijing is surrounded by mountains, and so far Mother Nature hasn’t cooperated with the combination of rain and wind needed for my prediction of blue skies to become reality. After a beautiful weekend before everyone arrived last week, Beijing has been hot, humid and grey. Thankfully, it rained on Sunday; the city is much cooler today; and if the winds pick up, I may yet be redeemed for at least part of the period of the Games.

Beijing weather aside, the point I made in the interview is that the environment is one of the future constraints in the growth of China’s economy, and the government now recognizes this fact and has turned the corner in terms of how it thinks about these issues. I realize there is a very, very long way to go before China can fully address the many environmental problems it faces, but a mindset change was an important and necessary first step. From our vantage point as a manufacturing company with factories throughout the country, I see growing evidence that environmental impact is increasingly being factored into the country’s decision making.

First of all, local officials now bring up the topic of the environment—and the positive steps they are taking to improve it—-in discussions about their city, town or province. It’s clear that the environment is now part of the scorecard that the higher ups in Beijing look at in evaluating performance.

Secondly, I saw tangible evidence of a quite different attitude in my recent trip to our factory in Shanxi Province. Located about 1000 kilometers from Beijing, it sits near a steel processing facility that, in the past, regularly spewed orange smoke into the surrounding area. Despite repeated complaints to the local authorities, we could never get them to clean up their act. Now, it seems, government officials are visiting all of the factories in the area at least once a month to ensure that the rules are being followed.

Though tougher enforcement of existing environmental regulations was undoubtedly begun as part of the cleanup for the Olympics, the Chinese are no different than people in any other part of the world. Once people have clean air, they tend to want to keep it that way.

I was recently interviewed by a major Chinese automotive magazine regarding China’s global competitiveness. Apart from the information contained in the answers to their questions, the questions themselves provide some useful insights into what is on everyone’s minds in China. What impact is inflation having on China’s global competitiveness? Is China becoming less competitive with India, Vietnam and its other Asian neighbors?

1. Jack, with RMB appreciation and increased inflationary pressures, does China still have an advantage in the export of automotive components in your opinion?

It’s true, inflation has spiked up in China over the past year, primarily due to rising costs of food and raw materials. Raw material prices are priced globally, however, so companies in other countries are affected to the same degree as those in China by rising prices for these manufacturing inputs. As a result, there is no loss of competitiveness by China based companies from higher raw material prices alone.

Many cite rising labor costs in China as a threat to China’s competitiveness globally, particularly given the changes brought about by China’s new labor law. While absolute labor costs have indeed gone up, rising wages have not contributed greatly to inflationary pressures in China because productivity has increased by a greater amount. For example, ASIMCO’s overall wage costs went up by about 18 percent across the company in 2007. Yet, we don’t consider rising labor rates a significant risk factor going forward due to the increased productivity of our work force. In the words of one of our General Managers, “Yes, Jack, our wage costs have gone up, but the base rate has remained the same. We are paying more for productivity.”

At ASIMCO, and at good companies all across China, the implementation of lean manufacturing to reduce waste and inefficiencies in the manufacturing process; the move to higher value added products, and an increase in the capital/labor ratio over the past five years has resulted in increased productivity of the work force. If productivity goes up faster than wages, then there is no impact on inflation or relative competitiveness.

A more productive labor force, and a move to higher value added products, can also act as partial offsets to the impact of an appreciation in the yuan. Increases in the value of the yuan strike hardest at products that are highly labor intensive. With products that requires more raw materials, for example, a higher valued yuan will make it cheaper for companies in China to buy raw materials. That is why exports from Japan to the United States from 1985 to 1988 increased substantially, despite a 50 percent increase in the value of the yen against the US dollar during that same period. It’s also why exports from China to the United States continue to increase, despite an almost 20 percent appreciation of the yuan against the US dollar since mid 2005. While a rising currency may impact the relative competitiveness of particular products, it does not necessarily impact the relative competitiveness of the country as a whole.

Let’s also remember that cost is not the only reason why companies source from China. Most global companies now have ambitious plans for the China market that depend on them developing an effective supply chain in China. Apart from cost, that is another major reason why Chinese companies have an export advantage over companies from other countries.

2. How do Chinese auto components companies deal with increasing cost pressures?

There are a variety of ways. First, a company needs to rethink and rebalance its customer and product mix. Products or customers that were profitable before may not be profitable now with the higher input costs. Second, companies need to do “value engineering” to reduce the use of expensive raw materials in its products. Third, companies need to implement lean manufacturing to reduce waste in the manufacturing process. Finally, companies need to increase their product development efforts. Margins are highest when a new product is first introduced, and then decline as the market becomes more mature. A steady stream of new, higher value added products is the single best way to combat higher costs.

3. Are there any threats from India to exports from China?

From time to time, we run into direct competition from India, but not very often. The China auto market is much bigger than India’s; the China market has many more components companies and is more competitive; and I believe that, overall, costs are lower in China. I don’t see Indian components companies as any greater competitive threat than companies from other countries.

4. Are multinational companies now thinking of moving their purchasing projects from China to India other low cost Asian countries?

For market reasons, I sincerely doubt that many multinationals are considering moving a substantial portion of their purchasing programs from China to other low cost Asian countries. MNC’s want to be bigger players in China, and they need to develop their China supply base.

Moreover, I doubt that costs in India are lower than in China, and any labor cost advantages that countries like Vietnam may have can quickly disappear with 25 percent inflation, which Vietnam is experiencing today. You have to remember that Vietnam is a much smaller country than China. Its population of 85 million people, while large, is only 7 percent of China’s; and its GDP of $71 billion is a fraction of China’s $3.2 trillion. Any significant increase in investment and jobs can quickly lead to inflation, as it is dong currently.

Finally, China manufacturers are much better developed than those in most other Asian countries. Exporting to the global auto industry requires a certain amount of manufacturing sophistication. A great deal of technology has already been transferred to China, and Chinese companies have been developing more sophisticated capabilities for some time.

5. Are there any lessons that China can learn from Vietnam’s current financial crisis?

Vietnam is in a different place than China from a development point of view. It is more like China was in 1994 when inflation peaked at over 21 percent. Time and time again, in country after country, inflation has proven to be any country’s biggest threat to economic development. The major lesson from Vietnam is that every country has to be vigilant about nipping inflation in the bud. All governments, not just China’s, have to have sound fiscal policies that keep spending under control and monetary policies that ensure its money supply does not grow too quickly. Inflation results when there is more money chasing the same amount of goods.

6. Are there any suggestions you can give to local auto components companies who want to export?

If a company wants to develop exports, the most important thing it can do is to change the “mindset” of its managers and employees. Although the China market is changing daily, global customers are still more demanding than Chinese customers. “Close” is not good enough in international markets, as it sometimes is in China. Processes and specifications need to be followed exactly, with no deviation or changes. And. deliveries have to be made on time. Every employee has to understand the requirements of selling to the international market.

Apart from the mindset change, Chinese companies have to improve their quality and management systems to compete internationally.

7. Are there any different plans or actions that ASIMCO is taking in its export program?

Eighty-five percent of what ASIMCO makes in China, we sell in China. Exports are important, but our main focus is the China market. If we can sell the right product to the right customer at the right price, we will export. If not, we prefer to focus on the China market. Because ASIMCO’s China business is growing so rapidly, I do not see our percentage of exports, which is currently 15 percent of sales, changing dramatically in the years ahead. In all of our export contracts, we negotiate clauses which provide for price adjustments for changes in raw material prices and currency fluctuations. In today’s market, you have to do this. Otherwise, you are certain to lose money.

As anyone who lives and works in China knows, obtaining visas is becoming a bigger and bigger problem here. So much so that some, like the Australian foreign minister, are warning that this could harm future trade and business. In a recent interview, Stephen Smith told reporters in Hong Kong: “It is important that the Chinese authorities understand the potential practical, on-the-ground difficulties that this is causing.” Whether this is part of the overall pre-Olympic tightening that may begin to dissipate when the last athlete leaves Beijing, we won’t know until later. In the meantime, individuals and businesses alike need to understand the new restrictions and how to best deal with them.

To this end, Jason Inch, a Shanghai-based consultant and co-author of the soon to be released “Supertrends of Future China,” did us all a favor by putting together in one place some of the most current thoughts on the visa issue. Last week, Jason commented on his blog, China Supertrends, about a recent panel discussion and networking event in Shanghai which was sponsored by Beijing-based China Entrepreneurs and whose theme was “The State of Entrepreneurship in China.” I had the pleasure of serving on the panel along with Taiwan entrepreneur Raymond Chang, who is bringing a new take to home television shopping in Shandong; and Rocky Lee, an American lawyer with DLA Piper who heads its Asia Venture Capital and Private Equity practice.

We did not have time or the occasion that evening to discuss the visa issue and how it impacts entrepreneurs in China, so Jason provided a nice summary in his post. He referenced the changes you should know about and how this might affect your personal and business travel plans; a timely post on the subject from Dan Harris of China Law Blog; as well as several posts from China Herald.

I won’t repeat all of the advice, wisdom and observations contained in these sources, but merely refer you to them.

The Wall Street Journal recently ran an article regarding arbitration in China that described the pros and cons of Western companies submitting to arbitration in China or insisting on arbitration in more neutral venues such as Sweden. 

It’s an excellent article as far as it goes, but what it doesn’t emphasize is that arbitration is only the first step towards resolving legal conflicts in China. Whether a complaint is arbitrated in China or outside the country, the enforcement of any arbitral award that involves China will require a trip to a Chinese court, and that leads to the issue of enforcement.

For better or for worse, I have had a fair amount of experience dealing with the legal system here. Because it such an important issue, I devoted a section to it in my book, Managing the Dragon. Here is what I wrote:

Contrary to what most people think, China does in fact have a body of law and a legal system, including courts and arbitration panels where grievances can be brought.  On December 29, 1993, the National People’s Congress adopted a Company Law, which has been refined over the years and was last modified in 2006. The point is that China already has laws on its books. The difficulty lies in enforcement. 

There’s an International Arbitration Tribunal in Beijing, made up of both Chinese and Western judges, where a contractual dispute with a Chinese partner (or something of that nature) can be taken.  When I was researching the idea of setting up a business in China, I was told that a foreign investor or company could get a fair hearing in arbitration, and that foreign companies had actually prevailed in a majority of the cases.  I have found this to be true.

During the course of our history in China, we’ve had three cases that have gone to arbitration, two that we brought and one that was brought by one of our Chinese partners.  What we didn’t realize at first, but soon learned, is that prevailing in arbitration and getting an arbitral award is actually only the first–and the easier–step in the process.  Having the arbitral award enforced is the second and harder part. Because the job of enforcement reverts to the Chinese court system, the party with better relationships in the area in which the grievance occurred has a substantial advantage.

In the first case, we were new at the game and thought winning in arbitration was everything.  With the Tribunal’s ruling in our hand, we marched off to court in Harbin, the site of the complaint–only to find that our Chinese partner already had the system wired.  Despite several years’ worth of efforts, we got nowhere.

The second case was the one you read about in Chapter 8, where the general manager and our Chinese partner in Anhui had set up a competing factory in violation of a non-compete agreement that he’d signed only months earlier. Right was clearly on our side, and we won in arbitration.  But this time, we lined up support from the local government ahead of time. Armed with a favorable ruling, we asked them to help and got what we wanted in one meeting, presided over by the Party Secretary.  We never even had to go to court.

In the final case, a Chinese partner that we had bought out–with the blessing and encouragement of the local government–made claims against us and took us to arbitration.  (The local government was as frustrated as we were with the actions of the Chinese partner over the years, and believed we could better develop the business if it were wholly-owned.)  The case wasn’t credible and we won rather easily.  At all times, the local government was on our side, so enforcement wasn’t an issue.

My best advice on legal actions is to avoid them at all costs and use them only as a last resort.  The outcome is uncertain, and it’s going to take time–no matter what.  In all three arbitration cases, even though they were open and shut according to any objective legal advisor, it took a year to go through the arbitration process.  If you then have to go to court to enforce the award, you can easily add on a couple of years.  And that whole time, the business that’s the subject of the dispute will be in turmoil, with a cloud of uncertainty hanging over it.  Under these circumstances, given the competitiveness of the Chinese market, final victory will probably be pyrrhic, if it ever comes at all.

Maybe the best reason to avoid legal action in China is that once you go down that path, all other avenues for resolving a dispute are foreclosed.  We had this experience in each case.  Once we had filed arbitration, the local and provincial governments took the position that the matter was being resolved through the legal system, and they didn’t want to interfere.  Once the legal gauntlet is thrown down, you have no choice but to see it through to the end.  In my experience, negotiation is a better way to go.

All that said, the legal system is evolving and improving every day.  With government support and help from international legal experts, the body of law governing commercial transactions and contracts in China is becoming increasingly sophisticated.  It’s no longer so different from the legal frameworks that exist in the most developed countries.  But the key link remains enforcement through the judiciary system, and in this area personal relationships will continue to play an important role for some time to come. 

The article cites a case involving PepsiCo and a Chinese bottler. As part of their joint venture agreement, the parties agreed to resolve any disputes through arbitration in Stockholm. Subsequently, Pepsi took its partner to arbitration in two separate arbitration complaints, alleging several breaches of various contracts and seeking an order terminating the joint venture. The lead judge in the arbitration proceedings was Swedish, and along with the judge selected by Pepsi, sided with Pepsi. Both arbitrations were decided in Pepsi’s favor and were wrapped up in 2005.

Here is where the article makes my point. The last paragraph begins with: “Meanwhile, PepsiCo has yet to recover on the judgment…” Those final words say it all. Arbitration is only the first, and the easiest, of the two steps. Enforcement is where the rubber meets the road in China.

??????The Harvard Business School pioneered the use of case studies as a teaching aid for business school students, and the case study method remains a lasting trademark of the school.

Over a two-year period in the early 1970s, I had the pleasure of reading, analyzing and discussing three cases per day at HBS. During those two years, my classmates and I acted as “pretend CEOs“ of hundreds of companies in a variety of industries, and we had the opportunity to make three good, or three bad, decisions each and every day. More often than not, the cases dealt with business situations that had arisen years earlier. But that was OK. After all, business conditions in the 1950s and 1960s weren’t all that much different from those in the 1970s.

With the emergence of China, however, many of those cases may have to be rewritten, and a whole new set of cases needed to deal with today’s rapidly changing competitive landscape. China’s announcement on Sunday that it has formed a company to make passenger jumbo jets provides one example. Until China’s emergence as one of the world’s largest economies, CEOs of leading global companies did not have to deal with what I call “The China Dilemma.” Here’s how it works.

Imagine that you are the CEO of a very large, U.S. company that makes a very high ticket, very sophisticated product that must meet the highest possible safety standards. Due to the long development times for new products, a very high level of capital expenditures, and the sheer complexity of the product, the number of companies competing in the global market has been reduced to two: your company and its European competitor.

Just as the large developed markets for your product in the United States, Europe and Japan are maturing and industry growth is slowing, China begins to emerge from 30 years of hibernation, embarks upon a reform program that leads to incredible economic growth, and because it needs but can’t make your product, China rapidly becomes one of your largest markets, with years of fast growth ahead for as far as you can see. Naturally, you and your European rival begin battling for market share in this very attractive new market.

Now for the China dilemma. Should your company’s strategy be to continue to export from the U.S. to China, or should it be to secure a long-term market position by manufacturing in China and perhaps entering into a joint venture there with one of its industry players?

The arguments against going to China are compelling. By continuing to manufacture only in the United States, existing facilities can be better utilized; there’s less concern about intellectual property getting out; and proven quality and management systems ensure smoother operations and enhanced financial stability.

On the other hand, setting up in China is problematic. Completely new plants must be built; know-how must be transferred; workers and managers must be trained; profits must be shared; and joint ventures are messy. The only arguments for establishing operations in China are securing a long-term position in the local market through a manufacturing presence in the country — and a lower cost structure.

One important piece of information that will play a role in your decision making is the likelihood that a Chinese company can build the capability on its own and ultimately compete with you and your European rival. Therefore, you ask your engineers to provide their assessment. Their probable answer: “Not impossible, but very, very difficult. The technological and other hurdles are simply too high.”

A typical case study would then end with you staring out your office window, pondering the inevitable question: “What should you as CEO recommend to your board?”

The industry of course is the passenger jet industry, and the companies are Boeing of the U.S. and Airbus of Europe. Although I have not been privy to their boardroom discussions over these past several years, the question posed by the China dilemma has undoubtedly come up. Neither company has seriously pursued the China route. We are now seeing the predictable outcome of those decisions — China has decided to go into the business of making passenger jets.

In what may be the largest start-up of all time, the central and Shanghai governments and China’s two largest aircraft manufacturers have joined forces and are injecting 19 billion yuan ($2.72 billion) into the new venture. What’s at stake? Certainly, China’s domestic market that Airbus estimates will increase fivefold by 2026. But the global market is likely to be up for grabs as well. After all, whoever wins in China is also likely to be the winner globally.

Can the newly-formed China Commercial Aircraft Co. succeed? Nobody knows for sure, we’ll all just have to wait and see. However, you can bet that it will get a lot of help. My guess is that suppliers and engineering consultants to Boeing and Airbus, not wanting to miss the potential new customer prize of the 21st century, are already beating a path to China with offers of help in design, development and manufacturing. Those technical hurdles may not be so difficult to overcome.

Although the aircraft manufacturing business may be the most dramatic case study of all, every industry is likely to face its own version of the China dilemma in the years ahead. If the wrong decisions are made, the best days of the current crop of global leaders may already be behind them.

It didn’t take long for the 65 percent hike in iron ore prices by Cia Vale do Rio Doce (CVRD) to work its way into the Chinese economy. Last week, Baosteel, China’s largest steel producer and the company that negotiated the new iron ore supply agreement with the Brazilian producer on behalf of China’s steelmakers, raised prices by up to 20 percent, significantly increasing manufacturing costs for companies making everything from appliances to cars in the process. The sell recommendations went out immediately, as stock market analysts concluded that China’s manufacturers would not be able to pass along the higher cost of steel to consumers in China’s price competitive industries.

I’m not so sure they are right.

In meetings with several of my managers earlier this week, I was pleasantly surprised to learn that they are already passing along higher raw material costs to customers. In 2005, when we were hit with the first significant run up in raw material prices, input costs had not changed appreciably in more than 20 years and everyone was caught flat-footed. Particularly in a country like China, where prices had only been going one way—down—managers were not used to pressing customers for price increases. Now it seems, they are doing so very aggressively.

When I commented that we had obviously learned a lot over the past three years, my managers shook their heads and said it was true. “We are getting better at negotiating increases, but there is more to it than that. 2008 is different from 2005. Since 2005,” they said, “companies that have not raised prices have either lost all of their cushion, or have fallen by the wayside. As a result, companies that have survived and prospered during this period have a greater ability to negotiate with customers in 2008 than they did in 2005.“

Besides being heartwarming, this conversation confirmed my suspicions as to why inflationary pressures are now coming to the surface, not only in China but around the world. When the first raw material price shockwave hit in 2005, manufacturers the world over, including those in China, were caught in a giant cost/price squeeze. China’s emergence as the world’s workshop had lowered the price for just about every manufactured product, while rising demand in China had helped to increase the price of every raw material. At the same time, competition in and from China prevented manufacturers from raising prices, resulting in decreased profit margins. If what my managers are telling me is correct (rising producer prices suggest that they are), that is bad news for inflation, but good news for manufacturers seeking to restore profit margins. With all their cushion gone, manufacturers have no choice but to pass along higher costs, and consumers have no choice but to accept them.

At the Economist Automotive Conference in Shanghai Thursday, I discovered another silver lining in this latest spike in steel prices. In his presentation, the speaker before me, Jerry Van Alphen, Vice President-Finance of Alcoa Asia Pacific, extolled the virtues of using aluminum in products like automobiles. Cars that use more aluminum are lighter, and lighter vehicles burn less fuel. As a result, automakers have been seeking to replace steel with much lighter aluminum wherever possible as part of their efforts to develop more fuel-efficient, environmentally-friendly vehicles. One impediment to doing so is the fact that aluminum, pound for pound (or kilo for kilo), is more expensive than steel. With the significant increases in iron ore and steel prices, however, steel is now pricing itself out of more and more applications. Whereas the ratio of aluminum to steel prices has historically been in the range of 5 to 1, this ratio has now been reduced to 3.5 to 1, improving the relative economics of using aluminum. Therefore, higher steel prices may actually help the transition to lighter, more fuel-efficient vehicles. That’s good news for everyone.

Admittedly, I may seem to be grasping for straws in trying to find some positives in this latest hike in steel prices. In business, though, sometimes you just have to take good news wherever you can find it.

Due to the decentralized nature of China’s economy and government, every industry in China is very fragmented. As soon as demand for a particular product begins to grow, development oriented government officials in every village, county and municipality across the country encourage the banks and entrepreneurs in their area to set up a new plant.

Why are China’s government officials so motivated to build new plants? New jobs created by new factories are one obvious reason, but not the only one. Also at stake is the 25 percent share of the 17 percent Value Added Tax (VAT) that the local governments are allocated from sales of products made by the factories in their areas. The VAT is the lifeblood of the government infrastructure in China. It pays the bills for the central, provincial and local governments, including the salaries of the government officials.

As a result of this phenomenon, industries in China can transition from a state of under-capacity to one of over-capacity virtually overnight. Whereas only a handful of companies are likely to manufacture a particular product in a developed country like the United States, hundreds of companies may make the same product in China.

China’s steel industry is a case in point. At the turn of this century, China had approximately 100 million tons of steelmaking capacity, putting its industry on a par with those in other large economies like the United States. But, as demand for steel rose due to rapidly increasing economic growth all over the world, but most notably in China itself, steel plants proliferated, with every local government in China having one built in its own backyard. China now has over 500 million tons of capacity, about one-third of the world’s total steelmaking capacity, and an estimated 100 million tons of over-capacity.

A Wall Street Journal article, China’s Steel Woes, which appeared on January 29, 2007 (only available through subscription), pointed out that there are somewhere between 300 and 1000 companies in China. No one really knows for sure. The article also said that Baosteel, the largest steel company in China, accounts for just 5 percent of the market.

With this as background, I was interested to read the article, China’s Steelmakers Gain Allure As Sector Mergers Gather Steam, which appeared in the Asian Wall Street Journal earlier this month. The article takes the view that China’s steel industry is ripe for consolidation (a view which I share), and quotes analyst predictions that by 2010, the industry will be restructured around five steel conglomerates with combined capacity of about 250 million metric tons (a prediction which I very much doubt). That would represent nearly 50 percent of the expected annual output for China’s entire steel sector, compared with 29 percent that now comes from the country’s 10 largest steelmakers. I question this prediction because the top five steel companies in China account for just 20 percent of the country’s total capacity today, and I am not aware of any industry in China that has consolidated to that extent in such a short period of time.

In fact, most industries in China are becoming more fragmented, not less so. In the early 1990s, there were over 120 vehicle assemblers in China. Everyone who studied the industry concluded that number was way too high, and that the industry would soon consolidate. Even the China government shared this view. Stated public automotive policy in the 1990s was that the industry would consolidate around “Three Big, Three Medium, and Three Small” vehicle assemblers.

That’s not what happened, though. Today, there are over 60 separate legal entities making passenger cars alone. When China’s truck and bus makers are added to the mix, the number of vehicle assemblers easily exceeds the number in existence in the early 1990s. Given the fast growth of China’s auto industry, new car and truck assemblers pop up all the time. There would be even more but for the minimum capital requirements imposed by China several years ago. Predictions for consolidation in autos, steel or any other industry in China tend to vastly underestimate the strong forces of decentralization at work in the country.

The other point of the article which I take some exception to is that the consolidation of China’s steel industry is necessary to deal with the consolidation that is occurring in the global iron ore industry. I fail to see how the consolidation of China’s steel industry, even if it were to occur, would help. Unlike ArcelorMittal and US Steel, two of the largest steel companies in the world, China’s steel industry is vulnerable because it is not vertically integrated and must depend upon imports of critical raw materials. If the BHP Billiton/RioTinto merger goes through, the combined company would control over 40 percent of global iron ore production. No amount of consolidation in China can produce a company strong enough to deal with such a stranglehold on the world’s iron ore supply by one company. Of all of the steel companies in the world, the China steel industry has the most to lose by the proposed merger. Consolidation is not the answer. Moreover, if other industries are any guide, China’s steel industry is likely to remain very fragmented for some time to come. That’s why I suggested not long ago that a Chinese entity buy Rio Tinto, rather than let BHP Billiton snap it up.

While detailed figures will be available later this week, ASIMCO’s inside sources tell us that China produced 8.8 million trucks, buses and passenger cars in 2007, more than expected and a 22 percent increase from the 7.2 million vehicles produced in 2006. In 2008, most industry analysts predict China’s vehicle production to grow to more than 10.0 million vehicles.

With some reports that U.S. vehicle production may drop to less than 10.0 million vehicles in 2008, China may be the world’s largest producer of vehicles as early as 2008 or 2009, much sooner than anyone has expected.