Outlook 2005

China--get used to it.

Canadians have finally recognized that China is in the midst of a spectacular economic transformation. Most media coverage of China in recent months has focused on the challenges–jammed West Coast ports, the possible takeover of Noranda–and the competitive threat to sectors like apparel, plastics or auto parts. The real story, however, is that China presents the opportunity of the century. Economic growth has been spectacular for more than a decade, and China is working to slow its growth rate to below 10% to reduce bottlenecks and manage inflationary pressures. In 2005, its share of world trade will double from its 2000 level, reaching 6%. China now rivals the United States as the most popular destination for foreign direct investment. Can Canadian business seize the opportunity?

In general, that opportunity presents itself in two ways. The first lies in China's advantage in skilled but low-cost labour within global value chains, particularly in manufacturing. Outsourcing to China is politically sensitive, but it may be unavoidable for manufacturers trying to keep up with global competition. Foreign direct investment in a Chinese venture is often a key success factor. Few Canadian firms, however, are prominent today in manufacturing where standardized, low-cost labour is a critical factor.

The second opportunity is China's booming domestic market and the rise of its middle class. While China's is still largely a rural society, the urban middle class already exceeds 200 million people and will grow to 400 million by 2010. With aging populations in Europe, Japan and North America, middle-class consumers in emerging markets led by China will become all the more attractive. To sell to this burgeoning middle class, however, Canadian businesses will have to be directly positioned in the Chinese market. Again, this means using FDI in China as a key to market entry and customer service–exporting alone won't cut it.

How have we done so far? Canada's export market share in China has fallen since the mid-1990s, to just over 1%. Our exports of resource-based goods to China have recently accelerated, but so have Chinese imports from everywhere else. All the more striking, Canada's investment market share in China has fallen steadily, to a small fraction of 1%. Some FDI may be entering via Hong Kong and Taiwan, but the sad truth is that Canada's market share in China has slipped badly over the past five years.

Rather than building direct linkages, many Canadian businesses are riding the coattails of U.S. firms into China by acting as suppliers of inputs, as varied as iron ore and legal services, within an integrated North American economy. There's nothing wrong with this coattail strategy as an initial plan, but it is unlikely to generate the same dynamic benefits or opportunities as direct market contact. Access to market intelligence and business networks will remain at arm's length.

Without doing something more, we risk being second-tier players in China's international business. We will export natural resources, provide inputs to U.S. businesses active in China and perhaps one day sell specialized services, but Canadian business will not be integrated into the Chinese economy.

The conclusion? China is an opportunity, but Canadian business needs to expand its horizon and incorporate China as a central part of its business model. Think in Chinese terms and take a long view of the market–even if that means accepting smaller export profit margins and lower foreign investment returns as the price of establishing a meaningful market position. Unless Canadian business establishes greater direct market presence in China today, it may end up with very little presence tomorrow.

Glen Hodgson is vice-president and chief economist with the Conference Board of Canada.