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.

??????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.

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.

Over the past several weeks, I have spoken to literally thousands of students, university professors and corporate executives about China and doing business here. Not surprisingly, interest in the country has never been higher.

China’s continued economic growth and the upcoming Olympics are two obvious reasons, but my sense is that China watchers have begun to realize that China is in transition, and they have a myriad of questions about how the country is evolving. China, the land of low labor costs and the world’s manufacturer of cheap, low technology products is giving way to a new China:  that is rapidly moving up the value added chain and becoming a large producer of more sophisticated, higher margin products.

This upward movement in manufacturing is being driven by four factors: higher wages, higher raw material prices, an appreciating yuan, and government policies which have reduced tax rebates for exports. The effect has been to drive China’s manufacturers out of low-technology, highly labor intensive products where profits are already low and are being squeezed, and into higher technology, more sophisticated products with higher profit margins.

After five years of double-digit growth in China’s Gross Domestic Product (GDP), per capita incomes are up across the board. At the beginning of this century, China was a $1 trilllion economy with per capita incomes of under $1,000. By 2007, the country’s GDP had grown to over $3 trillion, and average per capita incomes had increased to approximately $2,500. The government estimates that there are about 900 million people in China’s rural population. If we assume that this segment of the population earns $500 per year on average, then the remaining 400 million people in China are earning over $7,000 per year. Per capita incomes in major cities are even higher. Shenzhen is now $10,628; Guangzhou, $9,302; Shanghai, $8,594; and Beijing $7,370. Clearly, products that were profitable for Chinese factories to produce at the turn of the century when the country’s average per capita income was considerably lower can no longer be produced profitably today.

On top of rising income levels and expectations, raw material prices have increased dramatically since 2005, and the yuan has appreciated by over 15 percent against the dollar. Manufacturers of higher technology, higher value-added products at least have some chance of passing higher raw material costs on to customers. Producers of low technology products typically do not. Likewise, a more valuable yuan makes low technology, highly labor-intensive products that much more expensive on global markets.

The result of rising wages, higher raw material prices and an appreciating yuan has been a giant margin squeeze for Chinese manufacturers, particularly those that have been overly dependent on exports to the United States. (The yuan has actually declined in value against the Euro since July 2005 when China allowed its currency to float within a narrow band.) We are now seeing the economic reaction to the significant changes in manufacturing input prices that have occurred over the past several years.

China changes so quickly that there are advantages to seeing the country through a fresh set of eyes. Often, the best insights into how China works are provided by those who are the newest to it. This view was re-enforced by a recent column in The New York Times, Seeing the Sights of Industrial China: 2 Factories, 2 Futures, written by business columnist Joe Nocera.

Joe is now visiting China for the first time. He had received a copy of my book, and wanted to have a general conversation before he got on the plane for Shanghai, his first stop. By Joe’s own admission, he knew little about China, but was looking forward to the trip and seeing the country first-hand. What I found most interesting about the article is that the two factories he discussed he visited on his first two days on the ground. It didn’t take him long to get into the swing of things! By juxtaposing the two factories in the way that he did, he provides an unusually fresh, clear and insightful picture of China in transition.

Shanghai Jinjue Fashion Company, a manufacturer of inexpensive clothing, fit Joe’s image of a typical Chinese factory to a “T.” As he describes it, Mr. Jin, the board chairman, is the “classic low-cost, tight-margin, squeeze-every-penny manufacturer, the kind of entrepreneur who has been the backbone of China’s astounding economic rise—and who has been the primary beneficiary of the low yuan, which has spurred the market for China’s cheap goods.” Problem is, Jinjue is now in trouble. Hurt by rising labor costs and an appreciating yuan, it is no longer competitive and orders are now going to factories in Vietnam and Mexico. With higher costs and an underutilized factory, Jinjue is losing money.

Li Xianshou, founder of ReneSola, a manufacturer of silicon wafers used in solar panels that recently listed on the New York Stock Exchange, is another story. When ReneSola was established in 2001, it assembled solar panels, which it then sold to companies in Germany and Japan that made the wafers. As Joe’s article relates, Li soon discovered that:

assembling the panels was the lowest cost, lowest value part of the solar industry.” “It is a commodity business,” he said. “And it can attract a lot of competition.” So in 2005, he decided to take the big leap. He got out of the solar panel business and into the more profitable solar wafer business.

Now instead of competing with other Chinese companies, he is competing with German and Japanese companies—where his cost advantage is huge. His company has created a technology for using recycled wafers and other materials ,which is helping him avert the shortage of polysilicon, the material from which the wafers are made. He employs 3,300 people, up from 20 in 2005, and pays his line operators upward of $500 a month. From a standing start three years ago, ReneSola is among the world’s top five suppliers of solar wafers.

Two different companies; two different Chinas; two different futures.

I recently met with a finance professor from a major U.S. business school who happens to be a native of China. Reflecting on the two weeks he had already spent getting re-acquainted with his home country, his first comment to me was telling: “This place has bubble written all over it.”

You don’t have to be a finance professor to come to the same conclusion. Signs are everywhere—from an inflated stock market, to growing inflation to ever increasing apartment prices. The questions are: Does China have a hard or soft landing, and what does it feel like? What happens after the Olympics?

I have to keep reminding myself that I have already been through a relatively hard landing in China. In 1994, China’s economy was overheated and inflation peaked at 24.1 percent. Zhu Rongji, China’s then-economic czar, had a simple solution. He immediately clamped down on credit, dramatically slowing the growth in China’s economy.

In 1992, 1993 and 1994, China’s Gross Domestic Product (GDP) grew by 14.2 percent, 14 percent and 13.1 percent, respectively. From this blistering pace, GDP growth slowed to 10 percent by 1996, and fell to a low of 7.6 percent in 1999. Although these growth rates still seem high by global standards, many economists at the time questioned whether they were overstated, with the Chinese government attempting to put a good face on a sluggish economy. In fact, analysts began to track measures such as the growth in electricity demand as proxies for economic growth. These metrics suggested slower growth than advertised by Beijing and appeared to be more reliable indicators as to the overall health of the economy.

The China economy of 2008 is a great deal larger and infinitely more complicated than the one that existed in 1994. It is therefore doubtful that simply restricting credit would ever work today, although this hasn’t stopped China’s government from trying. The general efforts by China to slow down its economy have not brought it to a screeching halt, but there are growing signs that we are on the other side of the high growth cycle.

A good benchmark is the Shanghai stock market, which has essentially done a round trip over this past year. At the beginning of 2007, the Shanghai Composite Index was just above 3,000. By mid-year, it had nearly doubled to 6,000. Last week, it slumped to 3,411, its lowest level since April 9, 2007. The Shanghai Index has fallen 35 percent this year, making it one of the worst performers among Asian markets.

PetroChina, the poster child for the China stock market, made its debut in Shanghai in early November and nearly tripled in price to 43.96 yuan in its first day of trading, giving it a market cap of over $1 trillion. Last week, it fell to 16.99 yuan, barely above its IPO price of 16.70 yuan.

Other signs are less dramatic but nonetheless apparent. Baoshan Iron reported last week that 2007 net profit fell by 2.8 percent on higher ore prices, suggesting a weaker market where higher raw material prices cannot be automatically passed along to customers. Inflation continues to be an issue, increasing to 8.7 percent in February, after a 7.1 percent rise in January, marking its fastest pace in nearly 12 years. Partially to offset higher food prices, China’s main source of inflation, the yuan has been allowed to increase sharply against the dollar, thereby reducing the cost of imported grain.

“I think the People’s Bank of China is worried that food inflation could turn into headlines inflation. Wages are increasing quite strongly….and for this reason they have to control excess liquidity more tightly,” said Sebastien Barbe, an economist at Calyon Credit Agricole CIB.

All of this suggests an economy which will begin to slow, if it has not already. What the rest of 2008 brings, and whether the inevitable emotional letdown after the Olympics has an economic impact, is anyone’s guess. However, it is certain that Beijing is pulling a number of levers to cool an overheated economy and bring it down to a more sustainable level of long-term growth.

“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.

Just after the ball dropped in New York City’s Times Square to welcome the New Year, I posted my five predictions for China in 2008. Four were exclusively Chinese issues, but the fifth dealt with the country’s relationship with the United States, its largest trading partner. Here is what I said:

2. China Bashing By Presidential Hopefuls: President Clinton did it when he was running for his first term as President, and President Bush did it as well, so expect both the Republican and Democratic candidates, whomever they may be, to talk tough on China in 2008. The US economy may be in recession; GM, Ford and Chrysler have already cut production schedules and predictions are that auto sales will be at their lowest levels in ten years; and oil prices will most likely remain high. China is an easy scapegoat and will be blamed for all of these ills, and more. Expect tough talk on the currency, worker conditions in factories, China’s support for Iran and other rogue regimes, and the environment.

While I of course have my own political leanings, MTD, the site, and Managing the Dragon, the book, are apolitical and refrain from making comments on how China, the United States, or any other country for that matter runs its government. It is therefore with great trepidation that I wade into political waters by commenting on any of the presidential candidates. I do so only because the views and attitude of the next president, whomever he or she may be, towards China will impact those of us doing business here.

At the beginning of this year, Mitt Romney began running an ad that addressed the issue of China as the largest of all Asian Tigers. In the 30-second ad, Governor Romney said that he would “level the playing field with China,” sparking some debate as to what exactly he meant by that statement.

In the run up to the Florida primary last week, he gave some hints as to the measures that he might take to deal with China. In Florida, Governor Romney faced a tough battle with Senator John McCain, a battle which he ultimately lost, and the subject of the economy was front and center. When asked about the economy generally, Romney said that one of the problems is that China is competing unfairly with the U.S. by manipulating its currency and “stealing” the intellectual property on products where the U.S. has a technological edge. When asked specifically about the large U.S trade deficit with China, he repeated these two points. Presumably, his policy as president would be to get tough with China on both issues.

I don’t mean to pick on Governor Romney, but he was the first to make my point in the New Year. All of the candidates have made similar comments with respect to the China currency, and some, like Senator Obama, have made even more drastic statements. (Senator Obama said before Christmas that he would ban all toy imports from China, a statement he later retracted.)

Nonetheless, Governor Romney is a businessman and he should know better than to pin the blame for America’s economic woes on China’s currency policy.
As the election process moves into high gear, the economy promises to be issue number one. So, expect more rhetoric on China in the months ahead, and more assertions that the U.S. trade balance would improve—if only China would stop manipulating its currency.

This assertion - made so readily by many politicians regardless of background - is not supported by any empirical data. In fact, all of the evidence points the other way. From 1985 to 1988, the amount of yen that could be purchased with one dollar dropped from 250 to 121. Despite this significant appreciation of the yen, exports from Japan to the U.S. increased from $69 billion to $90 billion during these three years. 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 13 percent against the dollar, with the exchange rate (yuan to the dollar) dropping from 8.3 then to just crossing 7.2 this week. What have China’s exports to the U.S. done since then? They have increased by over 40 percent from $163 billion in 2005 to $233 billion in 2007. In both cases, American imports haven’t decreased when the currencies of its major suppliers have appreciated. American consumers have just paid more for the goods they purchased.

I don’t believe that anyone would disagree with the idea that the U.S. must work closely with China to improve the protection of intellectual property rights. In an election year, however, with each candidate focused on the American audience, it is tempting to use tough rhetoric when discussing this issue. Accusing China of “stealing technology” may play to nationalistic sentiment and pick up a vote or two in the short term, but it won’t play well in Beijing. After all, the Chinese leadership has the same ability as Tim Russert to download videos and printed statements from 10 or 15 years ago, let alone recorded statements made in this campaign. It would be wiser to be a bit more diplomatic and assume that every statement made by a presidential hopeful is heard around the world.

Last week, Tata Motors Ltd., India’s largest truck maker, unveiled what is being touted as the world’s cheapest car, the Nano, priced at 100,000 rupees, or $2,500. The Nano will cost only half as much as Suzuki’s Maruti 800, the cheapest car currently available in the Indian market. Ratan Tata, the company’s chairman, said he was inspired to develop the car when he saw a family on a scooter and then thought of building an automobile that was all-weather safe, fuel-efficient and affordable. Almost 500 engineers worked on the project over the past four years, he said. Tata plans to produce 250,000 Nano’s per year. With its eyes set on the global markets as well as its home market in India, Tata is also in talks with the Ford Motor Company to acquire Ford’s two luxury brands, Jaguar and Land Rover.

Within hours of the announcement, my inbox was filled with e-mails from around the world, friends and colleagues wondering what this meant for China. Most phrased their questions diplomatically, but one friend was particularly blunt and asked the question that was really on everyone’s mind: “Jack, if this is true, doesn’t it mean that India just ate China’s lunch by developing the world’s cheapest car?”

Of course, I had heard rumblings of what Tata was doing before this, and had also heard that Nissan was planning a $3,000 car, but now that Tata’s official announcement was out, I decided to try and understand better what was taking place. By the end of the day, after my colleagues at ASIMCO and I had completed our research, I concluded that rather than designing the Nano, Tata should have instead bought a set of prints for the Alto from Suzuki; removed the radio, air conditioning, passenger side mirror, and one windshield wiper; and contracted to have the car manufactured in China. By doing so, Tata would have ended up in about the same place as it did with the Nano, and saved 2,000 man years of engineering in the process. Here’s how we came to this startling conclusion.

We began by surveying the market to find the most economical car that we could buy in China. Our first thought was of Chery’s QQ, but with a dealer price of RMB 30,800, or $4,219, it was still a bit out of our price range. We then found that we could buy an Alto from Jiangnan Alto, based in Xiangtan in Hunan Province, for RMB 23,800, or $3,260. (For the history buffs out there, Xiangtan may sound familiar because it is the birthplace of none other than Chairman Mao.) Because the $3,260 is the customer price, we took 95% of that amount ($3,097) to adjust for the dealer profit and get a dealer price comparable to the $2,500 price tag for the Nano.

In 1988, Chang’an Machinery, an arm of a large industrial/military company belonging to the Chinese Central Government called Norinco, signed a deal with Suzuki Motor Corporation of Japan to develop and produce Suzuki’s Alto minicar in China. The Alto was first produced by Chang’an in Chongqing, but then in 1992, Norinco added manufacturing capability at three of its other locations, including Jiangnan Machinery in Hunan Province. The two other facilities ultimately quit producing the Alto, but Jiangnan continued on. To date, we estimate that Chang’an Auto and Jiangnan Alto have produced and sold over 600,000 Alto’s in China.

On the surface, Jiangnan Alto’s price, while the lowest in China, appears to be 20% higher than the Nano. But, comparing the Nano to a Jiangnan Alto is like comparing an apple to an orange. These are very different cars as shown by the chart below which Sophy, my assistant, prepared with the help of one of our engineers.

Nano vs Alto Chart

The Nano is a stripped down car compared to the Alto. It does not have a radio, air conditioning, a passenger car mirror and two windshield wipers, all of which are standard with Jiangnan’s Alto. Moreover, the Alto has a much larger engine with more horsepower and an enhanced ABS braking system. The engine alone, we estimate, accounts for at least $400 of the $600 price difference. Add in the price of a radio, air conditioning and ABS, and the Alto is more than price competitive with the Nano.

But we didn’t stop there. All of the articles about Tata’s Nano mentioned that the Maruti 800 was the next cheapest car in India and cost twice as much as the Nano. Knowing that the Maruti 800 was also developed by Suzuki, I asked Sophy to compare its features with that of Jiangnan’s Alto. A few minutes later, she came into my office and said, “Except for the price, $5,000 versus $3,097, these are exactly the same cars!” India’s Maruti 800 is an Alto by another name. In other words, on an apples to apples comparison, making the same car in China is almost 40% cheaper than it is to make it in India!

Despite the hype surrounding the Nano, China is the unquestioned low cost producer in the world when it comes to products like passenger cars. Could a Chinese car company produce a car that sells for $2,500? Absolutely. The reason none do is that even the low end car buyers in China want engines of a certain size and certain features like a radio. Chinese assemblers aren’t just trying to make cheap cars. They are trying to make cars that Chinese consumers want.

Ever since I first came to China in 1993, the China versus India debate has raged. At that early date, the auto industries in each country were about the same size, and at least on paper, each promised to become the largest in the world. For many reasons, China’s auto industry has forged ahead to become the world’s second largest, distancing itself from that of India’s. In many industries, India has strong advantages over China. In auto’s, though, China remains the biggest, fastest growing market and the world’s future industry leader.

In the world of IP, China is America’s recalcitrant stepchild. Software piracy runs rampant to the point where if one wants to purchase a legal copy of Microsoft anything, one will simply run into the software stonewall of unavailability - at every major computer outlet in whichever city you please. These same places are happy to install a copy of Windows Vista on your computer for free, assuming you bought, say, a hard drive from them. Registered, licensed, and real software products over the price of a hundred dollars generally don’t exist. To narrow the focus, I am only going to approach the gaming industry, or the online gaming industry to be specific.

Currently, the three major companies for game consoles are Nintendo, Sony, and Microsoft. Microsoft has the most integrated online gaming service with its service dubbed Xbox Live, by which console users can connect and play with each other for a nominal sum - $8 a month, or $50 for the year. Nintendo and Sony have both neglected to set up a unified online server system that connects gamers to each other. Can anyone say market opportunity?

The essential hubris of American IP attitudes in relation to China comes into play here. Microsoft’s Xbox Live service shuts down your account and restricts access to online gaming if they detect that you have a modified machine. Hardware modifications by pirates - who are scattered all over the city of Beijing and are readily available - cost about $20, giving you access to play pirated games for about 6 RMB each (less than a dollar). This is a very extreme difference to the retail price of $60 per game for the newest generation of Microsoft consoles, the Xbox 360. In China, the volume of unmodified, original Xboxes is negligible. Given that the average college graduate makes about 3000 RMB a month in Beijing, 400 RMB for a retail game is obviously ridiculous and out of the question. After paying the price for an Xbox, it is almost unfeasible to not modify the machine, considering the price differences. As for Nintendo, Wiis come pre-modified when you buy them at stores, meaning you can’t even find unmodified Wiis, if Nintendo even had an online game service. Sony currently does not have the piracy problems due to its Blu-ray formatting, although things like this are just a matter of time. The PS3 will surely be modified in the future.

So how does the Xbox Live business model work, anyway? Xbox Live commits subscribers to monthly or yearly fees, fees that are not likely to disappear once a customer has the taste for online gaming with his game console. Online gaming is an essential feature, and without it consoles become almost like a computer without the Internet. The costs for Microsoft to provide this service are negligible, since all Microsoft has to do is set up servers that connect gamers to each other. In general, anybody who owns of of these consoles will want to play online. It is one of the primary features that this new generation of consoles claims to have, and turns the consoles into vehicles for repeat subscriber purchases.

So how would Microsoft make money here? Microsoft must realize that, given a per capita income of $1740, China will not aggressively pursue mom-and-pop shopkeepers who modify Xboxes and sell games for a dollar. Instead, Microsoft should focus on aligning the interests of the government to make Microsoft money. As of yet, Sony and Nintendo do not have established online gaming services for its consoles. Microsoft should approach China Netcom, the main DSL provider for urban areas, and have it grant exclusive rights to provide online game services to all console service providers. The way in which Microsoft would do this is by having China Netcom create a partnership company that would have these exclusive rights, while the company provides a username and password service that connected, say, the Xbox Live service to users that had a DSL account - virtually all Xbox, or any other console owners. Imagine that! The government suddenly has an interest in providing online services for games through its own SOE. Microsoft could simply add its monthly or yearly fee for Xbox Live service as a line item on China Netcom’s DSL bill. When Nintendo and Sony are good and ready to provide online game services, it would have to do so through Microsoft, who would already have established itself in this essential market. This would also allow Microsoft to open up its Xbox Live services to users who may have modified machines, in that since China Netcom is an SOE, Microsoft realizes that the revenue from the repeat services it would be providing will accumulate revenues that would otherwise be completely lost. This would all be internal to China, essentially relieving Microsoft of responsibility in punishing pirates, given that the modifications on these console machines never stop. The pirates in Hong Kong were active and engaging in sales when the first games on CD-ROM were being released in the 90’s. The mainland certainly won’t be able to stop it for the foreseeable future. There are revenue streams open, though. You just need the right kind of fishers.

As I landed in Beijing on Sunday afternoon, fresh from two weeks of holidays spent in the United States, I was reminded once again how the environment will certainly be one of the big stories in China in 2008. The Olympics will call attention to China’s air quality, but even absent the games, the environmental strains caused by a rapidly industrializing economy are being felt all over the country. The thick layer of grey air and smog which blanketed Beijing was not hard to miss as our plane descended.

While trucks are only one cause of air pollution in China, Keith Bradsher of the New York Times did an excellent piece recently, Trucks Power China’s Economy, at a Suffocating Cost, in which he described the impact on the environment of the growing use of trucks in China. The article begins by vividly painting a picture that is all too familiar to those of us who travel the country.

Every night, columns of hulking blue and red freight trucks invade China’s major cities with a reverberating roar of engines and dark clouds of diesel exhaust so thick it dims headlights……..

Trucks are the mules of this country’s spectacularly expanding economy — ubiquitous and essential, yet highly noxious.

Trucks here burn diesel fuel contaminated with more than 130 times the pollution-causing sulfur that the United States allows in most diesel. While car sales in China are now growing even faster than truck sales, trucks are by far the largest source of street-level pollution.

Tiny particles of sulfur-laden soot penetrate deep into residents’ lungs, interfering with the absorption of oxygen. Nitrogen oxides from truck exhaust, which build all night because cities limit truck traffic by day, bind each morning with gasoline fumes from China’s growing car fleet to form dense smog that inflames lungs and can cause severe coughing and asthma.

The 10 million trucks on Chinese roads, more than a quarter of all vehicles in this country, are a major reason that China accounts for half the world’s annual increase in oil consumption. Sating their thirst helped push the price of oil to record levels this year, before a recent decline, and has propelled China past the United States as the world’s largest emitter of global-warming gases.

Yet cleaning up truck pollution presents complex problems for China’s leaders.

What are those complex problems? They are fundamentally economic and relate specifically to China’s diesel economy. Trucks, as well as agricultural vehicles and other forms of transportation that are used by the two-thirds of China’s population which depend upon the agricultural sector for employment, are powered by diesel fuel. Diesel oil is cheaper, and because diesel engines provide more power, they are much better than gasoline for use in trucks where maximum power is required. All medium and heavy duty trucks in China converted from gasoline to diesel engines in the early 1990s.

Diesel engines tend to have a bad and undeserved reputation—-consumers think of black smoke, difficulties starting in cold weather, and noisy engines. In the United States, for example, the use of diesel engines is limited to trucks and buses. General Motors tried to introduce diesel-powered passenger cars in the early 1980s in response to the oil crisis of the 1970s with little success. Whether the failure of diesel engines to catch on in the U.S. has been due to poor execution, inadequate education as to their inherent advantages, or a lack of a sufficient diesel infrastructure, the fact is that virtually all passenger cars in the U.S. use gasoline engines.

Europe is a completely different story, however. Because diesel engines get approximately 20 percent better mileage per gallon, and because diesel fuel is cheaper, diesel engines are used not only in trucks and buses, but also in passenger cars. In fact, the European market is almost evenly split between cars which use gasoline and those which use diesel. Since Europe in many ways leads the world in developing new emissions technology, the diesel engines that have been developed there are every bit as environmentally friendly as gasoline.

As China tries to achieve a balance between industrial development and environmental impact, new ways of powering its economy must be developed. New technologies such as hybrids and hydrogen vehicles will undoubtedly play a role in the long term, but neither can offer relief in the short term. Despite the pollution caused by diesel powered trucks in China today, diesel engines provide the best near-term hope for China to improve fuel efficiency and address growing environmental concerns.

China will implement Euro III emission standards for trucks in 2008, which will add to the cost of transportation and increase inflationary pressures. While the technology already exists for diesel engines to meet Euro V and even Euro VI standards, adopting these technologies would increase the purchase price of trucks and the cost of transportation well beyond amounts which the China market can afford. In other words, the technology for clean diesel exists, but it is too expensive for China at this point. Modifying these existing technologies in a way that enables them to fit within the framework of affordability in the China market represents one of the biggest commercial opportunities of the 21st century.