MANAMA: China, in the next couple of years, will need a massive investment of roughly $420 billion to create an infrastructure aimed at facilitating the country’s transition out of a low-end manufacturing economy, said a report released by Lehman Brothers.

China faces overcapacity owing to excessive investment in low-end textiles, toys, shipping, autos, retail and refineries and much of this was created by businesses which took advantage of poor environmental regulations, low wages, cheap land and abundant capital. Many of these advantages have now vanished.

The overcapacity is only slowly being addressed because many of these industries employ large pools of labor. More importantly, China is embarking on a specific program of raising the ‘floor price’ of the country by forcing pollutive, low-margin businesses to go elsewhere. It is furthering what is already an impressive infrastructure build-out. China most emphatically does not want to become another emerging market low-end manufacturing “has-been”. The stakes are high, with clear implications for equities.

Along with this not insignificant overcapacity, we see much larger and more problematic shortages in power, rail, renewable energy, gas distribution, broadband, water, livestock, coal, cement and several others. That is why addressing the shortages now is so vital. Without addressing them, a move up the value-added curve is unsustainable. So, these shortages are really defining China as we go into 2009. The next nine quarters are front-loaded with spending which should provide a burst of activity to the economy.

A good portion of China’s shortages is directly related to cleaning up the environment to prevent further shortages in potable water, clean air and productive soil. A large portion of China’s coal, steel and cement capacity, for instance, is being shut down to prevent further environmental damage, in addition to safety issues. An important corollary to this is the need to overhaul prices and allow de-regulation — to motivate the private sector to step in and address these shortages. Currently, price controls and subsidies are creating myriad unintended consequences which are hampering a supply response. Without an overhaul of the regulatory pricing scheme, China’s intention to move to the next level will falter. This is particularly true for utilities, gasoline, gas distribution, rail, and ports.