China, with its 7 to 8 percent average annual growth, is slowly regaining its historical prominence in world output. By some estimates, in 1820 China’s economy accounted for 36 percent of global GDP (by comparison, in 2001 the United States produced 33 percent). In the last 10 years alone, China rose from the 12th largest economy (based on exchange rate calculations) to the 6th. With continued growth China will be a key source of demand for the global economy. Such a development would be critical if the United States economy were slowed by "balance sheet repair."

China’s exports totaled $266.2 billion in 2001—equivalent to 5 percent of the world’s total exports—and are on track to surpass that figure this year. (Note that half of this total comes from foreign manufacturers or their joint ventures in China.) China makes more than 50 percent of the world’s cameras, 30 percent of its air conditioners and televisions, 25 percent of its washing machines, and nearly 20 percent of its refrigerators. A private Chinese company is among the world’s biggest aluminum, copper, and steel producers. Guangdong Galanz Enterprises now accounts for 40 percent of all microwave ovens sold in Europe and Wenzhou, a city in eastern China, sells 70 percent of the world’s metal cigarette lighters. Even Chinese farm produce, once too expensive for the global market, is finding its way onto dining tables in the United States, Europe, and elsewhere in Asia. In June exports of electronic products from China to the United States hit $1.2 billion, up 12.3 percent from May.

When Philips Electronics began prospecting for opportunities in China in the early 1980s, the Dutch company adopted what seemed an obvious strategy at the time: sell products to a billion Chinese. Instead China became a place where the company made its products—and then shipped them elsewhere. Today Philips operates 23 factories and produces about $5 billion worth of goods in China each year, nearly two-thirds of which are exported overseas. From General Electric (GE) to Samsung Electronics to Toshiba, as well as thousands of Chinese companies, manufacturers are finding that using China as an export base is often more profitable—and almost always far easier—than selling goods inside the country. GE’s sales revenue in China reached $1.6 billion last year. GE plans to expand the amount of goods it buys in China to at least $5 billion over the next three years. More of GE’s trademark refrigerators will be made by independent Chinese manufacturers, after which GE will stick its label on the products, and more parts for GE’s gas turbine engines, used to generate electricity, will be made in China.

China has also become a huge well-head of supply for large U.S. retailers like Target and Wal-Mart. Wal-Mart has been buying goods in China and stocking its stores with them for more than 20 years, and the supply continues to grow. About $10 billion in Chinese-made merchandise makes its way to Wal-Mart store shelves every year, either directly from manufacturers in China or from other suppliers that source their goods in the country.

In China, concern about the evolution of market-based institutions drives high precautionary savings (surpassing the $1 trillion mark in August), depressing domestic demand. The dysfunctional financial system channels domestic savings through the state-owned commercial banks, resulting in excess levels of credit for state-owned enterprises. This feeds excess capacity—sustaining domestic deflation—and starves the private sector of capital. Thus the most productive segment of the economy focuses on overseas markets to generate funds internally. This over-reliance on the external sector "exports" China’s own deflation to the rest of the world.

Since 1996 Chinese export prices have slid 15 percent according to BCA Research, a Montreal market research firm. As U.S. imports from China are rising—televisions and audio equipment rose at a 13 percent annualized rate between 1998 and 2001 to $6 billion in 2001, tools and metal implements were up by a 23 percent annual rate to more than $1.5 billion in 2001, and sporting goods rose at 16 percent to $2 billion—U.S. retail prices in many of these categories are falling. The prices of televisions have fallen, on average, by 9 percent each year since 1998 according to U.S. Labor Department data; tool prices have fallen 1 percent each year, on average; and sports equipment prices have dropped by a 3 percent annual rate. While the flood of cheap Chinese imports has translated into some lost jobs for U.S. workers who compete against Chinese manufacturers, it has been a boon for consumers.

National Presto Industries, a U.S. manufacturer of pressure cookers, pans, and other kitchen equipment, has felt China’s deflationary forces first-hand. Between 1998 and 2001 total U.S. imports of household cooking equipment from China more than doubled to $640 million. As a result, National Presto has been forced to drop the price of its pans from $49.99 to $29.99 in just three years. To keep costs low, the company decided early this year to shut down plants in Mississippi and New Mexico and to expand production in China.

"China’s rise as a manufacturing base is going to have the same kind of impact on the world that the industrialization of the U.S. had—perhaps even bigger," says Andy Xie, an economist with Morgan Stanley in Hong Kong, China. Yet China’s impact on global price deflation should not be overstated. Despite its rising domination in many export markets, China is but one force driving prices down around the world. Changes in the global economy like NAFTA and European economic integration, both of which improved the flow of goods, mean that the world faces an ever larger supply of goods, even as demand changes little. Gains in technology have spurred productivity, helping to hold down prices. And now the slowdown in the U.S. economy, by far the world’s biggest consumer and its most important economic engine, has added significantly to the global glut of goods. In any case, the falling prices of manufactured goods could be more than offset by rising prices for many services such as education, health care, and housing.

Nearly half of all the goods China sends overseas each year are made by foreign companies such as Motorola and Philips manufacturing in that country. Foreign investment continues to soar and is on track to hit a record $50 billion this year. Motorola says its total investment in China will reach $10 billion within four years, up from $3.7 billion now. Honda Motor is setting up China’s first export-focused car factory. Toshiba is building one of the world’s biggest laptop computer factories outside Hangzhou, with output next year pegged at 750,000 units and growing to 2.4 million in 2004, the vast majority of that destined for export.

China’s "capitalism" works like this: a new product is introduced, often by a foreign company, and within months a throng of manufacturers, many of them private Chinese companies, start cranking it out. Raging competition sets in, sending prices sliding, and before long producers look to new markets, increasingly overseas. Driving all this is a combination of forces—foreign investment worth more than $600 billion over the last two decades, an appetite for foreign technology, and a nationwide entrepreneurial zeal—that have spawned one of the world’s most competitive markets.

Of China’s population of 1.3 billion people nearly 700 million live on farms and earn, on average, just $285 per year, compared with the average U.S. household income of nearly $40,000 a year. These minuscule wages have slowed China’s transition to a consumption-driven economy along the lines of that in the United States; however, they have also resulted in an almost endless supply of low-priced labor that not only allows companies to control costs, but often to cut them dramatically. Competitive labor costs are not limited to low-skilled industries: the labor cost advantage is also extremely strong in sectors that require highly skilled employees, such as the science and technology sectors.

Over the past decade China’s pace of growth has doubled that of wages adjusted for inflation. A booming private sector adds to its export clout, absorbing excess workers and keeping costs low. And in the long run the government’s control over its currency offers another tool for ensuring that China’s exports stay competitive. As the Chinese government relaxes its export rules, a new generation of nimble Chinese companies—particularly private enterprises—is beginning to focus on overseas sales as well. Exports by private Chinese companies increased by nearly 50 percent in the first half of this year.