By Andrew Sheng and Geng Xiao

China must balance institutional innovation with orderly reforms to preserve the integrity of its economic foundations and emerge from the forthcoming slowdown in good shape.

During three decades of favorable global economic conditions, China created an integrated global production system unprecedented in scale and complexity. But now its policymakers must deal with the triple challenges of the unfolding European debt crisis, slow recovery in the United States, and a secular growth slowdown in China’s economy. All three challenges are interconnected, and mistakes by any of the parties could plunge the global economy into another recession.

To assess the risks and options for China and the world, one must understand China’s “Made in the World” production system, which rests on four distinct but mutually dependent pillars.

The first of these pillars, the China-based “world factory,” was created by foreign multinational corporations and their associated suppliers and subcontractors, as small and medium-size enterprises (SMEs) with direct access to global market carried out the labor-intensive processing and assembly required. Starting modestly in coastal areas and special economic zones, the “world factory” supply chain has spread throughout China, producing everything from stuffed animals to iPads.

The “world factory” could not have been built without the second pillar: the “China infrastructure network,” installed and operated mostly by vertically integrated state-owned enterprises in logistics, energy, roads, telecoms, shipping, and ports. This pillar relies heavily on central planning, large-scale fixed investment, and administrative control. Its quality, scale, and relative efficiency is strategic to Chinese competitiveness and productivity.

The third pillar is the “Chinese financial supply chain,” which provided the financing needed to construct and maintain the infrastructure network. This supply chain is characterized by the dominance of the state-owned banks, high domestic savings, relatively under-developed financial markets, and a closed capital account.

The final pillar is the “government services supply chain,” by which central and local officials oversee every facet of production, logistics, and financial networks through regulations, taxes, or permits. Most foreign observers miss the scale and depth of institutional and process innovation in this supply chain, which aims to protect property rights, reduce transaction costs, and minimize risks by aligning government services with market interests. For example, local governments in China became highly adept at attracting foreign direct investment (FDI) by providing attractive infrastructure and supporting services that facilitate the expansion of global production chains.

With the onset of the current global crisis, and given dramatic changes in social media, demographics, urbanization, and resource constraints, all four pillars are now under stress. Production chains are facing labor shortages, wage increases, and threats of relocation to lower-cost countries. Meanwhile, global investors are questioning local governments’ solvency.

Chinese experts are now debating a key governance question: which top-level architecture would enable the country to adopt the reforms needed to meet global and domestic pressures? Investors are concerned about Chinese equities’ erratic performance, regulatory risks, and policy surprises, as well as the uncertainties stemming from greater volatility in asset prices, property prices, interest rates, and the exchange rate.

What makes the Chinese economy more difficult to read is the increasingly complex interaction of all four of its production system’s components, with each other and the rest of the world. For instance, favorable conditions for the growth of the “world factory” have begun to dissipate. Production costs – in terms of labor, resources, regulation, and infrastructure – have been rising domestically, while consumption bubbles in the West have burst. The early success of “China infrastructure” was built on cheap land, capital, and labor, yet despite modern infrastructure, logistical costs within China now make up 18% of production costs, compared with 10% in the US, owing to various internal inefficiencies. China’s financial system has also yet to adequately address the challenges of financial inclusivity, particularly funding of SMEs and rural areas, and exposure to excess capacity in selected industries.

Last but not least, the three pillars could not have remained standing without the anchor provided by the fourth. Until now, its success was based on positive competition between local governments and different ministries, benchmarked according to performance indicators such as GDP and fiscal revenues. Unfortunately, this has led to problems of social equity and environmental sustainability, which require complex coordination of bureaucratic silos in order to overcome the resistance of powerful vested interests.

There is general recognition and consensus that the path of reform requires profound re-engineering of all four pillars. First, the production chain must shift from export dependence toward domestic consumption. Realigning China’s infrastructure means emphasizing quality over quantity, and reducing state ownership and controlled prices in favor of market forces. State orchestration should instead be focused on fighting corruption, reducing transaction costs, promoting competition, lowering entry barriers, and removing excess capacity.

For the financial supply chain, the key is to address systemic risks and realign incentives in order to induce investors to support the engines of real economic growth, rather than the creation of asset bubbles.

The Chinese miracle was engineered by institutional and process innovation at all levels of the government services supply chain. China requires nothing less than another radical re-engineering to become a more balanced, socially equitable, and sustainable economy. That process has already begun with another round of experimentation through three new Special Economic Zones in Hengqin, Qianhai, and Nansha to pilot the emergence of a creative, knowledge-based services economy.

Of course, such an economy relies crucially on the quality of governance. The real challenge for Chinese officials is how to balance creativity and institutional innovation with order, thereby ensuring the integrity of all four of its economy’s pillars.

*[This article was originally published by Project Syndicate on August 16, 2012].