Hello Qingdao, bye-bye Shanghai?

Is China''s economic centre of gravity heading north?

Ever since the reform of 'reform and opening up' was launched in 1979, the engine of the Chinese economy has been the Southeastern coastal regions - with an emphasis on trade, and joint ventures producing and exporting light industrial (that is, labour rather than capital intensive) goods. The Chinese have dubbed this model 'extensive' rather than 'intensive,' meaning it has flourished on plentiful and cheap inputs of low-cost labour, subsidized capital and cheap land.

But results shows that the coastal areas performed surprisingly poorly in the first half of last year, to the extent they were outperformed in absolute as well as relative terms by other, traditionally poorer, provinces. Aside from the obvious impact of the government's macro tightening measures, Chinese experts believe this raises two important questions.

The first is whether China's rise as a heavy industry power (ie capital intensive industries such as coal, oil, cars, cement and semiconductors) and chemical manufacturing power (oil refining and petrochemicals) will cause the centre of gravity to swing north and west. Shanxi, Inner Mongolia and Henan have been experiencing a mini-boom off the raw materials (mainly coal but also metals and ore) they extract to supply China's factories.

This wealth creation and dynamism has been obscured by a flow of reports on coal mining accidents in Shanxi and Henan. Shandong, a northern province on the Yellow Sea, strong in agribusiness and industry and well placed to link up the eastern seaboard and northern parts of the country, is also attracting attention. So too is Tianjin's recently established special economic zone Binghai, which outperformed Shanghai's Pudong in terms of local GDP last year.

Some foresee a new and vibrant economic hub comprising Beijing as a research and development centre focused on its universities, and providing financial and other services; Tianjin as a manufacturing and logistics centre and Hebei province providing the lower valued-added links in the supply chain.

The second question is what the slowdown in the southeast means in terms of changing China's traditional economic model.

First, here are some figures which are worrying the eastern seaboard dwellers, as quoted by 21st Century Business News, a respected Chinese bi-weekly: Guangdong province's industrial value came to around Rmb 398 billion ($49.2 billion) in the first half of the year, an increase of 17% year-on-year. But Shandong produced 400 billion of industrial value added, an increase of 29% year-on-year. Shandong also took top position nationally in terms of overall profitability, with Rmb 91 billion.

This is the first time any province has pushed Guangdong into second place since 1997, when Guangdong first surpassed the province of Jiangsu for the number one spot. In terms of enterprise revenue growth, coal-rich Shanxi's total went up 101% year-on-year, Shandong's 80%, while Jiangsu, Guangdong and Shanghai saw rates of 21%, 16% - and zero for Shanghai.

In addition, almost 30% of Guangdong's industrial enterprises recorded a loss, while the number of Guangdong enterprises in China's version of the Fortune 500 for 2004 dropped by 45. And according to official figures, the Yangtze River delta comprising Shanghai, Jiangsu is seeing weaker growth year-on-year in the key indices of fixed asset investment, industrial value, loan growth and foreign direct investment - even falling below the national average in some cases.

This marks the first time these areas have seen declining growth rates in a decade.

Chinese experts point out that growth has always been dynamic and uneven in China. Thus, after taking off first, Guangdong and Fujian were rapidly followed by Shanghai, Jiangsu and Zhejiang provinces. The question is now whether that growth will move further north. The corollary to this question is whether growth will come at the expense of the traditional hubs by presenting a different economic model.

One reason the Shanghai and Guangdong areas have been under pressure is that firms have been hit by rising raw material prices. One Chinese academic, Zhao Xiao of the Beijing University Guanghua School of Management, estimates input prices have increased by 4% more on the same period last year than the rise in retail prices.

"The more manufacturers sell, the more money they lose under current conditions," he notes, adding that it is difficult for Chinese companies to change these habits. "Chinese companies in the export sector compete fiercely with Indian and Southeast Asian companies in labour-intensive products. Chinese companies don't want to give up market share even in the face of raw material price rises, so they keep on producing at cost or at a loss," he says.

As a result of this pressure, coastal companies are looking to alter their business model, preferably by migrating upstream where the big profits are in the coal and oil industry. But these are areas held by government giants running quasi monopolies, so they are stuck unless they move into more value-added services. Here, however, their weakness in research and development is likely to hold them back. That weakness is partly the result of a lack of protection for intellectual property rights.

Says Zhao, "Companies in Shanghai and Guangdong have relied on low labour costs, cheap land and low-cost capital in the form of subsidies out of the public purse. But costs are rising beyond their control, and they don't really know what to do."

In fact, some heavy industry has sprung up around Nanjing, Shanghai and Guangzhou, argues one southern businessman. "But some of these areas, such as the car industry, steel and cement are exactly the same areas that the government's macro tightening measures are most affecting, " he says.

Extractive industries, while also classified as heavy industry thanks to their capital intensive nature are difficult for southern businesses to access for simple geographic reasons: Coal and oil is far to the north of the eastern seaboard.

The same businessman is also more pessimistic on Shandong's growth prospects.

He says, "Shandong has admittedly prospered recently mainly as a result of its heavy industry and chemical plants, but the province has two major problems, namely water shortages and the fact that it lacks a 'hinterland,' that is, a large local market. Shanghai and Guangzhou, in contrast, have been able to expand for many miles up the Yangtze and Pearl rivers respectively."

What is interesting to foreign observers is the absence of debate in the local media about services. China economists abroad talk a lot about the importance of services, as does the country's central government, but in practice such an upgrade seems more of an aspiration than a realistic short or medium term goal.

Paul Cavey, China economist at Macquarie Bank in Hong Kong believes China's economic model is not on the cusp of any rapid transformation, although he does acknowledge some changes.

"If you look at foreign investment, the big German, Japanese and US firms are indeed putting a great deal of money into heavy industry - cars, semiconductors and other capital intensive industries," he comments. "In contrast, the early-wave investors from Hong Kong and Taiwan focused more on light manufacturing, such as textiles and toys. But what is occurring amounts to a broadening of the economic structure rather than anything close to a substitution."

Cavey adds that although increasing the services component of GDP (currently around 38% compared to a world average of 60%) is more of a long-term goal, the government is deadly serious about it.

"The big advantage of services - and of light industry- is that they employ lots of labour. So a vibrant services sector would help with social stability, as well as taking advantage of China's cheap, plentiful labour," he says.

It is a delicate issue. China's light industrial, export-led model, based on low inputs and an under-valued currency, is experiencing strain from trade disputes and rising input costs. Some elements of heavy industry - cars and steel spring to mind - have languished after initial vigorous growth. Extractive industries may be experiencing an unsustainable boom. Quite where that leaves China will be the big question for the end of 2005 and 2006.