Given all the questions I’ve gotten recently about whether ASIMCO plans to move production to lower-cost countries like Vietnam to escape rising wage rates and inflation in China, I found the opening sentence in a recent Wall Street Journal article about Cambodia to be somewhat ironic:

As Vietnam’s overheated economy teeters on the brink of crisis, its neighbor Cambodia is being labeled the next frontier market for private equity.

Huh! Did I miss something? Or, is this just an outbreak of ADD (attention deficit disorder) that’s sweeping the international investment community? Overnight, it seems like we’ve gone from an investment focus on the third-largest economy in the world, with a population of 1.3 billion, to a brief stop in Vietnam, a country with an 85 million population and a GDP of $71 billion, to an even smaller Cambodia with a population of 14 million and a GDP under $10 billion.

Don’t get me wrong. I have nothing against Cambodia, and in fact, I really like the country. Carleen and I had the pleasure of meeting up with Libby, my youngest daughter who is making a year-long trip around the world, in Siem Reap over the May 1st holiday and spending a nice long weekend there. The temples of Angkor Wat are first-class sights and well worth a trip to the country. If you haven’t traveled there yet, I highly recommend it for your next tourist excursion in Asia. And, despite living through a tragic and terrible recent history, the Cambodian people seem genuinely nice. I have to admit that I found myself thinking about the opportunities that might be available there. But China it’s not.

In the meantime, what happened to Vietnam? If you haven’t been following the story, inflation hit a peak of 25.2 percent in May, and a proliferation of labor strikes is dragging foreign manufacturers into the country’s worsening economic crisis. Vietnam, it seems, has seen an influx of foreign companies in recent years, many of them clothing or footwear manufacturers seeking relief from rising labor and business costs in neighboring China. Last year, foreign companies applied to invest $20 billion in Vietnam (an amount that wouldn’t even make a dent in China), pushing up office rents and other costs.

A Credit Suisse research report observed that: “Vietnam is balancing on a beam at present. The situation has not yet deteriorated to a point where a crisis is inevitable, in our view, but we are hardly reassured about the economic and policy direction.” China, with its $3.2 trillion economy, deep labor pool and relative economic stability has never looked better.

All of this reminds me of my days on Wall Street in the 1980s. When I was running PaineWebber’s Investment Banking Division, I used to hold an 8:30 meeting every Monday morning to review deals and the markets. The highlight of the meeting was always a review of the previous week’s market activity by Bruce Foerster, our syndicate manager. Not only did Bruce show up every Monday sporting a different set of brightly colored, flamboyant suspenders, but he could have been a stand-up comic in another life. Usually, a few minutes into his review, he had everyone rolling in the aisles.

I’ll never forget one Monday when Bruce unveiled his “The grass is always brown” theory. Wall Street has always been a bit of a revolving door, with bankers changing firms after bonuses are announced almost as frequently as they change their shirts, but we were experiencing an unusually heavy wave of defections at the time. Everyone was looking over the fence at other firms, where the grass just seemed to be a whole lot greener than at PaineWebber. Being the consummate relationship person, Bruce always maintained contact with those who had left, keeping tabs on how they were doing. Bruce’s conclusion: rather than finding lush, green grass on the other side of the fence, the departing bankers inevitably discovered that “The grass is always brown.” Every firm has its advantages and disadvantages. It just so happens that the disadvantages of the firm you work for, and the advantages of the “other” firm, are always the most apparent.

So too with countries. Opportunity is where you find it, and there are good opportunities in every country in the world. Vietnam and Cambodia are but two examples. But they aren’t perfect, and neither is China. There are many things that all of us would like to be different, but the fact remains that China is, and will continue to be, the economic story of the 21st century. When China has inflation or hits some other bump in the road, we shouldn’t be so quick to conclude that the country has run its course, and that it is now time to begin looking for the next big thing. To paraphrase Winston Churchill, this is not the beginning of the end, but merely the end of the beginning as far as China is concerned.

???????? ????? ????????One of my recent presentations, I was asked what impact $130 a barrel crude oil is having on the growth of China’s auto industry. It was a good question, one that deserved a much better answer than I could give. With the price of crude increasing so quickly–a 17 percent increase in May alone when oil hit its peak–it’s very difficult to tell. I replied the only way I could by saying, “I don’t know.”

On the surface, the industry continues to motor along, with passenger cars increasing by 20 percent year over year through May, and trucks increasing by an even faster pace at about 25 percent. Those figures can be a bit misleading, though, given that the Chinese government is controlling fuel prices and insulating consumers from the most recent price shocks.

Gasoline math and comparing prices around the world is a bit tricky. In continental Europe, for example, where consumers are paying the equivalent of $8 per gallon at the pump, analysts estimate that the various governments are taking up to 70 percent of the retail price in taxes. The United States, where the government’s tax take is only 11 percent of the retail price, is probably a better reflection of true market prices. At $4 per gallon near my farm in New Jersey, the true cost of a gallon of gasoline is about $3.56, net of taxes. Even at that discounted number, however, the price of a gallon of either gasoline or diesel is still quite a bit lower in China. A recent survey of prices in Beijing showed that both gasoline and diesel are selling at the equivalent of just over $3 per gallon. The last time the Chinese government raised the price of fuel was at the beginning of November, 2007 when crude oil was about $95 per barrel.

As far as the appetite for passenger cars in China is concerned, it’s very difficult to tell what effect today’s high prices for oil are having on demand. The Chinese consumer is still living in the world of November, 2007, which as the rest of the world has found, is ancient history in terms of oil economics. It’s difficult to believe, but oil was only $65 per barrel, less than one-half the May peak, at about this time last year.

The situation in trucks is even more complicated. In addition to controlled pricing for diesel, demand for trucks is being impacted considerably in the first half of 2008 by the expected implementation of Euro III emission standards for heavy duty trucks on July 1. Because a Euro III compliant truck will cost from 15 percent to 25 percent more than one that meets only Euro II standards, truck buyers are ordering all the Euro II trucks they can, while they can.

What happens after July 1 is anyone’s guess. While the secular demand for trucks continues to increase, pre-buying in the first half, combined with diesel shortages across China, are bound to have an impact. Because refiners have not been allowed to pass along higher raw crude costs, they lose money on any diesel they sell and have been limiting production. Moreover, the recent earthquake in Sichuan Province has caused diesel to be diverted to Sichuan and other provinces impacted by the quake. Diesel is the fuel used to power the large numbers of trucks and construction equipment used in the rescue and rebuilding efforts, as well as the generators that are providing temporary sources of electricity to the millions of homeless.

At 11:30 pm the other day, one of my colleagues saw a long line of trucks at one gas station on the Fifth Ring Road in Beijing, the drivers asleep in their cabs, waiting to fill up. In areas like Hunan Province, truck drivers, after waiting for more than one hour, are being told that they can only refill 700 yuan worth of diesel, which at today’s prices represents only 25 to 30 percent of what a typical tank can hold.

With no relief from diesel shortages in sight, and the normal questions looming as to how rigorously China will enforce the new emissions regulations come July 1, the outlook for truck sales in the second half of the year is unclear.

Unfortunately, I don’t think anyone can answer the question posed at the beginning of this article with any degree of certainty. We will all just have to wait and see.

??????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.

“Of all the industries you could have picked,” I am frequently asked, “Why automotive components? It’s a mature industry.” And that’s true. In developed economies like the United States, automotive is a mature industry. But in developing economies like China, it can be a growth industry.

Ever since it joined the World Trade Organization in December, 2001, the production and sales of vehicles—trucks, buses and passenger cars— in China has increased by at least one million units each year. China’s auto industry has grown by an incredible 20 percent to 50 percent each and every year since WTO entry, and in 2008, China will produce over 10 million vehicles, most likely surpassing vehicle production in the United States.

Although everyone is on the China bandwagon today, that was not always the case. It wasn’t long ago that global auto executives questioned how a country whose per capita income is only $1,000 (approximately the level for China at the beginning of this century) could possibly afford to buy passenger cars. No one asks that question anymore. But, it should not have taken so long for industry observers to become believers. As early as 1992, anyone who believed that China’s economy would continue to grow, could easily predict, as day follows night, that China would have a very large auto industry. Quite simply, there is no other way to get people and goods around a country the size of China without a system of highways—and plenty of trucks, buses and passenger cars.

When I came to China in 1992, the first thing that struck me about the country was its size. China is big. Almost to the square kilometer, China is the same size as the United States, which meant that every industry was fragmented, and companies were doing business locally rather than nationally. As China’s transportation and telecommunications infrastructure improved, I reasoned, industries would begin to consolidate, and companies able to do business nationally would come to the forefront. Rather than investing in individual companies, therefore, it became more important to pick an industry and develop a strategy for creating the leading company in that industry.

But that begged the question: What industry? Fortuitously, I was invited to attend a Euromoney Conference in Shanghai in September, 1992, and I went there hoping to get some answers. As I describe in Managing the Dragon, here is what happened:

One of the featured presenters at the conference was Dr. Stefan Messmann, a senior executive with Volkswagen. In his remarks, he explained to the roughly 300 people in attendance that Volkswagen viewed China as one of its key growth markets. The company had already invested more than $350 million in two joint ventures, in Shanghai and Changchun, and had clearly taken an early lead in the race to develop China’s automotive industry.

I was surprised. At that point, it wasn’t clear that China even had an auto industry. The streets were filled with bicycles and a couple of trucks here and there, but passenger cars were few and far between. The ones you did see were typically imported Mercedes, which usually belonged to government officials. But here was a high-ranking Volkswagen official saying that China was going to develop a major automotive industry. More important, he was saying that Volkswagen, a major player in the global industry, was counting on China for a great deal of growth. I sat up in my seat and started to listen more closely.

But, autos are a big industry that accounts for over 12 percent of global GDP. What segment of the auto industry should I focus on? When he finished his presentation, Dr. Messmann opened the floor for questions. His response to the first provided an answer.

“What’s your biggest problem?” somebody asked.

Without a moment’s hesitation, Dr. Messmann replied, “Our biggest problem is getting an adequate supply of high quality parts.”

When I’d been in investment banking, I had called on a number of companies in the automotive components area. Though times were tough then, in the late ’70s, I looked back at financial statements from the ’50s and ’60s and saw that these companies had all been very profitable. This had been America’s growth period in autos. GIs returning from World War II, people like my dad, wanted to get on with their lives and were buying houses, refrigerators, and cars in huge numbers. As General Motors, Ford, and Chrysler expanded production, components companies could literally fill up their plants for the year after three golf dates with buyers from the Big Three. If Messmann was right, the same thing was now about to happen in China 40 years later.

“Wow!” I thought to myself. As Yogi Berra had said, “This is déjà vu all over again!”

Dr. Messmann gave me the first hint that auto components might be a good industry to investigate. After all, if companies like Volkswagen were looking for new suppliers in China, there seemed to be a vacuum that needed to be filled, and that spelled opportunity.

I didn’t see Dr. Messmann again until last week, nearly 16 years later. In writing Managing the Dragon, I learned that he had left Volkswagen and was now teaching law at Central European University, a very interesting English-speaking graduate school in Budapest that was founded by George Soros, one of Hungary’s most famous émigrés. After communicating by e-mail, Dr. Messmann invited me to Budapest to meet CEU’s senior faculty and to deliver a lecture at the school.

What a great two days! Dr. Messmann and CEU could not have been more hospitable, and Budapest is a fabulous city that is full of history. As I also learned, CEU is one of a kind. Founded in 1991 with the explicit aim of helping the countries of Central and Eastern Europe and Central Asia transition from dictatorship to democracy. CEU’s 1400 students come from 80 different countries. As I stood there answering their questions, I was struck by the fact that the students surrounding me were from Slovakia, Russia, Uzbekistan, Kazhakstan and Nigeria, countries I rarely come in contact with. Like students everywhere, they were eager to learn more about China and how they might do business here.

Just as Dr. Messmann opened my eyes to the auto components opportunity in China 16 years ago, he has now opened my eyes to a new part of the world. I want to learn more, but my instinct is that this is a very interesting part of the world that may be a great connection for any China business. The region is comprised of countries that, like China, have emerged from closed economies and are now rapidly making up for lost time. These countries have much in common with China, including a lower cost perspective, and are rich with many talented and motivated people with a strong desire to get ahead.

Once again, thank you Dr. Messmann.

I’ve been using an iPhone with a China Mobile SIM card for over half a year now. The device is without rival in the industry, so when I put it on my wish list of things to get when they come to China, (let’s put Lou Malnati’s Chicago style pizza in there) I was ecstatic to find that friendly hackers had engineered a method for me to get around the barriers that the failed Apple- China Mobile talks presented.

While the Apple-China Mobile talks non-delivery is as common knowledge as the fact that thousands of the hacked phones run on other-than-AT&T networks, what is not so well known is that the Apple-China Unicom talks seem to have nonetheless gingerly moved along. In fact, I’ve been informed that you can buy a 4GB iPhone through China Unicom for around 4 thousand RMB. Mind you, every Chinese national that I know with the Apple phone has an 8GB version, which tells you something about the supply line it came from, but never mind that. I’ll be investigating the veracity of the Unicom situation this week. Still, I can’t get the Apple-China Mobile talks out of my head. While not seeing eye to eye on profit structures and distribution are to be expected, its a shame that Apple didn’t stay the course and decide to go another route, one that would have been better for them now and more importantly for their future in China.

The mistake that Apple made here is one bigger than just approaching the deal the wrong way. If that was it then I’d be lumping it together with the NFL’s unfortunate attempt at an exhibition game in Beijing and call it a day. Suffice it to say Western companies using Western “tried and true models” will land face first in a fall. First of all, Apple has failed to see the value of the street credentials they already have here: the iPhone is already desired by the Chinese consumer for its revolutionary combination of technologies, excellent usability, and its just more than slightly back breaking high price. One thing stands salient about the target relevant consumers here, the device’s price conveniently nestled just within a few months salary can do nothing but attract them to it, whether they can afford it or not. This is something China Unicom and China Mobile can confirm for us; they have phones for sale in their service centers that run past the 2500 RMB mark that do nothing to scare buyers off. Second of all, if Apple sold the devices out of their own stores, bypassing an exclusivity deal with the provider for a piece of the services take, then they would see realistic and long term tactical results in creating a sales channel and a brand exposure all in one. China is a market where brand recognition is nascent and rapid wealth accumulation is coupled with an appetite to spend and have the latest and greatest. Even if Apple sold the device out of flagship stores at a loss, they would be benefitting by associating themselves with the mystique of a product that almost stands apart from its brand. An early take on this approach would have been substantially more impressive, not least of all on a balance sheet, than the strike heard ’round the world that the China Mobile talks became.

Creating a lifestyle product at relatively or outright high prices is not a new winning concept in China. If Apple needs to know where to steal some good ideas from, the answer is Nokia’s Vertu brand. By Creating an association with luxury and exclusivity, Vertu continues to expand and turn heads even at an entry level price of around 35,000 RMB. Adjust the Vertu message and tone of voice to match the iPhone price and volume expectations as necessary, and Apple could recover gracefully from passing by a great opportunity. With their recent underwhelming unveiling of the Mac Book Air, now is as good a time as any.

Industry Week, a leading print and online magazine which targets manufacturing, operations, and purchasing executives in all manufacturing industry sectors, asked me to write a book-related article for their publication. With trade, currency and the economy being hot topics in this election year, the IW editors provided an ideal forum for me to discuss one of my own favorite topics: China’s different, and lower, cost perspective.

The fact that Chinese look at money differently, in my opinion, has more to do with China’s cost competitiveness than any simple explanation relating to exchange rates. When Americans look at an RMB 100 bill, they automatically divide by 8 (the amount of Chinese yuan to the dollar that has been in effect for most of my time in China ) and see $12.50. When Chinese, on the other hand, look at that same 100 RMB bill, they see more like what Americans see when they look at a $100 bill. I devote an entire chapter in my book to this phenomenon and how it impacts manufacturing and purchasing decisions at both Chinese and foreign invested factories in China. Apart from its impact on cost structures, it also begins to explain why there are two markets for any product in China, a subject which I also discuss at some length in a follow on chapter.

Large economies like those of the U.S. and China are complicated with many interdependent variables. When one variable changes, everything else changes, sometimes in ways that aren’t so predictable. When the Japanese yen appreciated by 50 percent against the U.S. dollar from 1985 to 1988, exports to the United States did not decline as one might have expected. Instead, they increased from $69 billion in 1985 to $90 billion in 1988. Similarily, China’s exports to the United States have increased by 40 percent, from $163 billion in 2005 to $233 billion in 2007, despite a 15 percent increase in the yuan against the dollar over that period.

I’m not saying that exchange rates don’t have some impact, but merely moving exchange rates in one direction or another is not the silver bullet that most politicians believe it to be. Something more fundamental is at work. The entire Industry Week article can be read here.

As China deals with its most serious bout of inflation in 15 years, the debate rages as to whether the country is losing its competitiveness in the global economy. Inflation and China’s enactment of tougher labor laws are often given as the reasons why factories in lower wage countries such as Vietnam, Cambodia and Sri Lanka are now getting work that was once done in Chinese factories.

There is no doubt that jobs are being re-sourced from China to lower cost countries, mostly in Asia. Dan’s recent post, Trickling Down - Chinese Off-shoring, described how even state-run Chinese companies are moving production out of China. But inflation is not the reason.

Most of China’s inflation today is due to higher food costs, which are in turn caused by greater demand for grain, which is increasingly being used to produce bio-fuels in the United States and elsewhere. Oil priced at over $100 per barrel is not only driving up production and transportation costs for everyone, but it is also driving up the cost of food, as grain is diverted to feed new ethanol plants rather than people.

Moreover, higher food prices are not a China only issue. In addition to incidents like the stampede for cooking oil at a supermarket in Chongqing that killed 31 people, there have also been tortilla demonstrations in Mexico and pasta protests in Italy. Likewise, rising raw material costs affect factories everywhere, not just those in China.

Rather than inflation, Dan quite correctly attributed the movement of production out of China to the process whereby countries pass low-value-add industries off to less developed markets as they develop—the so-called “Flock of Geese” effect. It is not inflation, but increasing productivity which raises standards of living and brings changes in the relative economics of countries in a fluid global economy.

Wang Qing, chief China economist at Morgan Stanley, has stressed that Chinese competitiveness is not about to disappear and goods from Asia’s most populous nation will remain cheap for years. This is the case as products move up the value chain from toys and clothes to cars and high-tech machinery, according to Mr. Wang. “What’s more important is that you should not just focus on nominal wage growth, you also need to pay attention to labor productivity growth.” In other words, an average person in China is being paid more today, but it is not inflationary because productivity is going up much faster.

Nonetheless, it might seem as though this shift in production is happening relatively early in China’s industrialization process, and that China has arrived at this point much faster than other economies. That speaks to another important aspect of China’s development—the fast rate of change of its economy. China changes so quickly that facts about the country need to be frequently checked and re-checked. Even though I know this to be the case, I am constantly reminding myself to do so.

For example, I have tended to think of China as a $1 trillion economy with an average per capital income of about $1,000. That’s more or less where China was at the beginning of this century and those were the numbers I had stuck in my head. You can imagine my shock when I rechecked the numbers recently as I began thinking about this subject of rising wages. China is now a $3.3 trillion economy, with an average per capita income of approximately $2,500. Both numbers are quite a bit larger than those I was carrying around in my head. I should have known that double-digit economic growth for more than five years would have had a substantial impact on GDP and per capita income, but I did not make the connection until I checked the facts. I was also somewhat startled to find that per capita income in Shenzhen is now $10,628; Guangzhou, $9,302; Shanghai, $8,594; and Beijing $7,370. These also are much higher than the numbers I have been using and explain why jobs are moving elsewhere.

Chinese factories are moving up the economic ladder and are now producing higher value-added products. Increasing amounts of capital are supporting each worker. Competition, both in China and in the global economy, requires that production costs be reduced to absorb higher raw material costs. Managerial skills are improving; training is prevalent; and tools such as lean manufacturing and Six Sigma are being employed throughout the country. As a result, companies in China and their employees are becoming more efficient. Under these circumstances, it is no wonder that productivity is on the rise in China. You can see it in the numbers.

Rather than being an end to China’s competitiveness in the global economy and its reign as the world’s workshop, the re-sourcing of production to other countries is sign that China is still in its early stages of industrialization. As productivity increases, and Chinese workers become better paid, better trained and more adept at producing more sophisticated products, China will begin to manufacture products that have only been possible to produce in the most developed economies in the world.

Some things in life are easily predictable. For example, as sure as day follows night, it was easy to predict that China would emerge as the foreign bogeyman as Senators Clinton and Obama battled for primary votes from blue collar workers in Ohio. And that’s exactly what happened.

Sen. Obama has been traveling through the Buckeye State peppering his stump speeches with references to factory workers who see their equipment “suddenly unbolted and shipped off to China.” Sen. Clinton, in equally vivid terms, paints a similar picture: “Today, China’s steel comes here and our jobs go there,” she tells her audiences. (Wall Street Journal, February 28, “ U.S. candidates ramp up rhetoric against China”)

Both candidates have been hammering China for exporting lead painted toys and contaminated pet food to the United States, which is a fair point, although banning all toys from China, as Sen. Obama once suggested, is naïve since China makes about 80 percent of the world’s toys.

Both candidates also accuse China of keeping the value of the yuan low to maintain competitiveness, and have co-sponsored a Senate bill that would establish guidelines to determine if countries such as China are manipulating their currency. In Sen. Clinton’s words, “The policies of George W. Bush have allowed the Chinese government to become our banker…We play by the rules and they manipulate their currency,” as if the millions of Americans who shop at Wal Mart and buy Chinese-made products, and the legions of investors the world over anxious to invest in the fast-growing Chinese economy, have had nothing at all to do with any of this.

While the pat answer given by politicians for the reason why the U.S. runs such a large trade deficit with China is convenient because it shifts the blame elsewhere, large, sophisticated economies like those of China and the United States are complicated with many interdependent variables. If you change one variable, how do all of the others change? If China’s currency appreciates, its labor costs will be more expensive in terms of world markets. But, with a more valuable currency, what China pays for its raw materials would theoretically be less. In a case where the cost of a product is 50 percent material and 50 percent labor, you could argue that the net effect of the currency fluctuation would be zero. Since the bulk of China’s exports to date have been lower-value-added products, the raw material component is high. In a period when raw material prices are increasing substantially, a more valuable yuan might only enhance China’s competitiveness versus their U.S. counterparts—not the outcome politicians want.

Apart from theory, the numbers suggest that a more valuable yuan may not be the silver bullet for trade that it is thought to be. In the 1980s, Japan was in the same place as China is today. Exports to the U.S. were increasing, Japan’s trade surplus with the U.S. was growing, and politicians were screaming about the currency. From 1985 to 1988, the number of yen that could be bought with one U.S. dollar dropped from 250 to 121 in three short years, a 50 percent appreciation against the U.S. dollar. Yet, exports from Japan to the U.S. increased from $69 billion to $90 billion during that period. The yen continued to appreciate over the next 12 years, with the exchange rate falling to 100 yen to the dollar by 2000. Yet, exports continued to rise and reached $146 billion by the end of the last century.

Experience so far with China is following a similar pattern. China dropped the dollar peg in July 2005 and began allowing the yuan to float within a narrow band. Since then, the yuan has appreciated by about 15 percent against the dollar, with the exchange rate (yuan to the dollar) dropping from 8.3 then to less than 7.2 now. What have China’s exports to the US done since then? They have increased by over 40 percent from $163 billion in 2005 to $233 billion last year. In both the case of Japan and China, American imports haven’t decreased when the currencies of its major suppliers have appreciated. American consumers have just ended up paying more for the goods they purchased—not a good deal for Americans already worried about rising inflation and a recession.

Election rhetoric and politicking aside, the danger the U.S. runs in this presidential campaign is letting the nationalism genie out of the bottle. Once out, it is difficult to get back in. A Wall Street Journal-NBC News poll in December showed that 58 percent of Americans surveyed said that globalization was bad for the country, while 28 percent believe it has been beneficial. A decade ago, 48 percent said globalization was harmful while 42 percent supported it.

When Americans think about globalization today, China is at the top of the list. “Why are the Chinese buying all of our oil?” I was asked on one of my recent trips to my farm in New Jersey. Americans already know far too little about China, and are quick to blame the country for everything from $3 per gallon gasoline to factory closings. At a time when China’s role in the global economy is getting larger, not smaller, education and intelligent debate is needed. This is not the time for responsible politicians to be feeding America’s fears.

A couple weeks ago, I had the opportunity to meet with a top manager from one of China’s largest textile companies and tour one of the 100 or so factories that they contract with or own throughout China. The company - a state-owned enterprise (SOE) founded under government directive in the 1950’s - is a shining success story in China’s public sector, exporting more than USD 3 billion in clothes every year to almost every major clothing label in the world. This transition, from a company immune to market forces to a fierce global competitor in its own right, represents how China has, as Barry Naughton puts it, “grown out of the plan.”

But in order to remain competitive, this SOE is currently offshoring large percentages of its workforce to Indonesia (10 percent), Cambodia (8 percent), Thailand (1 percent) and has plans to contract factories in Bangladesh in the near term. This point is extremely significant, as the company is state owned and is thus expected to be fiercely nationalistic in its business practices.

The manager I spoke with had no reservations about the off-shoring. As he saw it, by shipping apparel jobs overseas, he was helping, not harming the Chinese worker. As he put it, “Off-shoring is good for China. Think about it, textiles used to be the number one export industry for China, but today electronics have surpassed textiles. That’s good for Chinese workers because they can make more money manufacturing electronics.”

This trend, often referred to as the “Flock of Geese” effect - where countries pass their low-value-add industries off to less developed markets as they develop - is indeed taking place in China. In 2007, China’s principal exports were office equipment (USD 87.1b) followed by telecoms equipment (USD 68.5b) and then apparel and clothing (USD 61.9b) [Economist World In Figures 2007].

In light of the loyalty American workers expect from their companies, and the uproar over U.S. outsourcing to China, this anecdote speaks loudly; Chinese workers face intense outsourcing pressures and job insecurity the likes of which American workers will never understand, but the overall trend is towards higher value sectors and a stronger economy. This manager’s belief that he’s being a patriot by off-shoring might not find receptive ears in the States but rings true here in China.

“Taking coal to Newcastle” is an old British saying that refers to a pointless activity. Newcastle, one of the centers of Britain’s Industrial Revolution, was for centuries the main source of coal for London. Coal was so plentiful in Newcastle that the idea of taking coal there represented the epitome of foolishness in the minds of the British.

Taking coal to Newcastle, Australia in 2008, however, may not be such a bad idea. The price per metric ton of coal out of Newcastle, Australia is a key benchmark for the Asian market, and that price has tripled from US$40 per ton at the end of 2006 to over $120 today. While many other factors have been at work over the past year, bad weather in China has caused coal prices to spike 34 percent in recent weeks.

If you are like me, you have been taking coal for granted. Unlike oil resources, the majority of which are concentrated in a relative handful of countries, coal is everywhere. Besides, it is a nasty, dirty source of energy, which is falling increasingly out of favor at a time when concerns for greenhouse gases and global warming are at a peak. Right?

Well, it turns out that the opposite is true. The world can’t seem to get enough of the black stuff, and China’s switch from being a coal exporter to being a net coal importer has been one of the reasons why the balance of global coal supplies has been tipped, and the world is now facing shortages—and much higher prices.

Shai Oster, a veteran China reporter who now covers energy matters for The Wall Street Journal out of Beijing has just written an excellent, comprehensive piece on this subject with his colleague, Ann Davis. If you haven’t seen it, I encourage you to take a look. Among other lessons, it once again demonstrates just how pervasive China’s impact has become on the rest of the world.

Some of the key points in the article which particularly struck me:

• China has long been a huge supplier of coal to itself and the rest of the world. But in the first half of last year, it imported more than it exported for the first time, setting off a near-doubling of most coal prices around the world. The capper came in late January when a winter of punishing snowstorms and power shortages led Beijing to suspend coal exports for at least two months.
• Five years ago, China exported 83 million more metric tons of coal than it took in. Last year, that surplus had fallen to two million. The rapid loss of more than 80 million tons in exports amounts to about 12 percent of the internationally traded market.
• For the world, which uses coal for about 40 percent of its electricity, the result is similar to what happened after China became a net importer of oil in 1993.
• Chinese coal demand grew nearly 9 percent last year, raising its share to a quarter of the world’s consumption.
• China’s need for coal is rising as other factors around the world are putting severe strain on supply for the fossil fuel. Flooding at major mines in Australia since mid-January has dramatically stunted that major coal producer’s exports to Asian markets.
• Demand is rising quickly elsewhere. Japan, one of the world’s biggest importers, is burning even more coal since an earthquake damaged a nuclear reactor last year, doubling one utility’s coal intake. Longer-term pressure comes from India, which has mounted a major expansion of coal-fired electricity plants that is driving up the country’s coal imports despite its large domestic reserves.
• Some experts say coal prices could remain high or even keep climbing through 2009 or beyond, weighing on the already-slowing world economy. Even though coal is a leading source of atmosphere-warming greenhouse gases, its share of the world’s energy diet is increasing — which could help keep its price up in a recession.
• Although the use of cleaner-burning alternative fuels is on the rise, fast-growing energy consumption is expected to underpin coal demand. Still a relatively cheap — and abundant — alternative to oil, coal is sought in rapidly industrializing nations such as Brazil, India and Vietnam as well as China.
• And Chinese regulations have contributed to shortages. China has freed domestic coal prices to rise with demand, but has capped electricity tariffs. That led power plants to order less coal — leaving them short of coal when the storms hit.
• The coal shortage has rippled through other commodity markets, hurting China’s output of steel, copper, zinc and aluminum as electricity is being diverted for domestic industry and household heat and electricity. China’s largest copper producer, Jiangxi Copper Co., shut down some plants, contributing to higher U.S. copper futures.

Along with everything else, this is obviously not good news for inflation in China, which is now at its highest levels in 10 years.