China is the world's top manufacturing country by output. But, while it accounts for 19.8 percent of total global manufacturing, it receives less than 3 percent of the world's manufacturing R&D investment. As a result, China's capacity for innovation remains relatively low, with its high-tech and knowledge-intensive industries unable to compete globally.

On average, China's industrial enterprises are relatively small, and, although its industrial labor productivity (real manufacturing value added per employee) has improved over the last decade, it remains much lower than that of developed countries - 4.4 percent of the US' and Japan's productivity, and 5.6 percent of Germany's. And the "pauperization" phenomenon - in which companies must adjust their commercial strategies to cope with an impoverished consumer base - is increasingly affecting traditional industries, further undermining China's capacity for sustainable development.

Moreover, the quality of Chinese-manufactured products continues to lag behind that of developed countries' manufactured goods. Whereas one unit of intermediate input in developed countries typically generates one unit or more of added value, in China the ratio is only 0.56.

As China's demographic dividend disappears, its low-end labor market is shrinking, driving up its once rock-bottom labor costs and diminishing its rate of return on capital. Over the next decade, as Chinese workers demand higher salaries, basic benefits, and improved working conditions, the country may well lose the comparative advantage that has driven its manufacturing boom.

While manufacturing wages remain significantly lower in China than in the US, the rapidly narrowing gap is already fueling US reshoring. Given that Chinese wages are rising at an annual rate of 15 to 20 percent, productivity adjusted wage rates in low-cost US states are expected to exceed those in some coastal regions of China by only 40 percent in 2015. Add to that reduced energy costs in the US, owing to the country's shale-gas revolution, as well as the global supply chain's complexity, and China's cost advantages will soon be negligible.

Meanwhile, other emerging economies - including Vietnam, India, Mexico, and Eastern European countries - are vying for China's position as the world's factory. These lower-cost alternatives are fast becoming the preferred destinations for developed country investors.

Although the enormous potential of China's consumer market can provide a new impetus for economic growth, the country's economic transformation cannot succeed unless it upgrades its manufacturing sector. China's leaders must begin by increasing investment in science and technology, focusing their efforts on parlaying key technological breakthroughs into higher value-added production. Only by combining growing Chinese consumption with enhanced Chinese manufacturing will the country be able to develop a new comparative advantage, which is the key to sustainable growth over the next decade.

The author is a fellow of the China Information Center and of the China Foundation for International Studies, and a researcher at the China Macroeconomic Research Platform. Project Syndicate

(China Daily 01/22/2013 page8)