China will soon become the planet’s largest economic power, testifying to the major impact that global industrialization is having on the world’s economy.

Now in second place behind the U.S., China accounts for 16.6% of global gross domestic product, slightly behind the U.S.’s 19% share. But with GDP growth of 10% a year, China could soon overtake the U.S., which is growing by 3%-4% a year.

In contrast, China accounted for 11% of global GDP in 2000, vs 21.4% for the U.S.

Other emerging economies are also expanding quickly. India overtook Japan this year as the third-largest economy, at 6.4% of global GDP. (Japan accounts for 6.1%.) Collectively, the Asian economies — excluding Japan — account for a quarter of world economic activity, vs 17.7% for Euroland, the 13 countries that use the euro as their currency.

As emerging countries industrialize, learning to harness lower wages to produce and export goods and services at lower prices, they are displacing developed economies. And, in this new world order, the countries and companies that will thrive are those that can supply the emerging economies with the materials and goods — such as resources, machinery and equipment — they need to fuel their industrialization,

But there’s a caveat: as the emerging world industrializes, it produces more and more of what it needs. Companies in the developed world that process these materials or make goods will soon face competition from firms in the emerging countries. So, the only real winners of global industrialization in the developed world will be the producers of raw materials that emerging countries don’t themselves possess.

But companies in the developed world are taking steps to make sure they survive global industrialization. They are moving to produce goods in the emerging countries — either by building their own facilities or by outsourcing to local firms. Many industrial companies are already in the process of transforming themselves into entities that focus on product design and customization, sales and after-sales service.

As a result, both outsourcing and the increased geographical diversification of sales are making many industrial companies less susceptible to economic cycles than in the past, resulting in a much steadier flow of earnings and cash.

Peoria Ill.-based Caterpillar Inc. — a major manufacturer of construction and mining equipment, diesel and natural gas engines, and industrial gas turbines — is an example. In the 1999 economic slowdown, CAT’s earnings fell from peak to trough — by about 30% to $1.30 a share from $2 a share. This year, net income is expected to be up despite the slowdown in the U.S. economy. The reason? As of 2004, says Steve Way, portfolio manager at AGF Funds Inc. in Toronto, only half of CAT’s production took place in the U.S., vs 75% in 1993.

The wave of accelerated global industrialization is fairly recent. An emerging country needs a certain level of industrialization before it becomes a significant force. Although annual growth in the emerging world averaged 6.9% from 1980 to 2007 — excluding 1998, a year after Asia was hit by financial and economic crises — it wasn’t until 2000 that China’s industrialization gave it an 11% share of world GDP, which turned out to be enough to start chipping away at the U.S.’s share.

Sometimes, there is also a catalyst that accelerates the process. In China’s case, says Don Reed, CEO and president of Franklin Templeton Investments Corp. in Toronto, it was that country’s entry into the World Trade Organization in 2001.

As a result, U.S. companies have moved to become global companies in the past five years, although this trend only become a major factor for European companies in the past two years, says Joe D’Angelo, portfolio manager at Signature Advisors, a unit of CI Investments Inc. , in Toronto.

D’Angelo believes the globalization of industrial companies is about halfway done overall. But it is not an even process. In some industries, such as toys, clothing and furniture, the process of setting up manufacturing offshore is 70%-80% completed, he says, while in others, such as auto parts, it’s less than 10% underway. Within the industrial sector, smaller items such as small engines can be produced in low-wage countries such as China, then exported to markets in which they will be used.

@page_break@Another way to look at how far globalization has come is through export penetration, says Patricia Fee, money manager at IG International Management Ltd. in Dublin. The percentage of production exported by industrial companies in Europe has doubled and gone up by 33% in the U.S. in the past 10 years. European companies currently export about 30% of their production to the U.S. and 20% to the rest of the world; U.S. firms export 20% of production to Europe and 20% to the rest of the world.

Companies can now afford to make the requisite foreign investments, Fee says, because of much stronger balance sheets.

Fee also notes that many industrial companies can charge more for their goods these days because demand is high. Examples include firms making machinery for resources companies, which is getting very high prices, and companies involved in developing power generation (industrialization requires a lot of energy).

Another driver of globalization, according to Charles Burbeck, head of global equities at HSBC Halbis Partners in London, is the advantage of setting up production in emerging markets and avoiding the legacy costs of pensions and benefits that are so expensive for firms in the West, particularly in the U.S.

In addition, companies can now source raw materials regardless of where production occurs. In the past, a company would put out a tender for a specific input within the geographical area that surrounded the manufacturing plant. Now, a company can put out a global tender through the Internet. The greater number of firms bidding, the less the company will have to pay.

However, there are limits to globalization for the industrial sector. For example, companies won’t move all their production of physically large or heavy products to the countries or regions that have the lowest wages, D’Angelo points out. Transportation costs are too high, transportation bottlenecks can develop and the length of time required to ship such products means companies would have to have huge inventories of finished goods to make sure they don’t lose sales to competitors.

Furthermore, companies don’t want all their eggs in one basket. If a political crisis happens in a country in which a large amount of production takes place, companies can be crippled. Ideally, companies want to produce products in the markets in which they’re selling them, not only because of the resulting geographical diversification but also because it avoids currency risk.

As a result, there will not be a massive shift in production to China and the rest of Asia. AGF’s Way suggests the next leg of globalization will probably be in Eastern Europe and Mexico, as both markets are investing in infrastructure and expanding production. As well, they have reasonable access to the markets of Western Europe and the U.S., respectively, facilitating exports to those markets.

In the simplest sense, the opportunities from globalization come down to volume. Greater demand means global companies can produce more, usually without a commensurate increase in costs, Fee says, which boosts the bottom line.

There’s another benefit, which D’Angelo calls the “golden egg” of globalization: with rising incomes, consumers in emerging countries will be demanding more and more goods, services and infrastructure for which industrial companies will provide the machinery and equipment.

Then, there are the opportunities for restructuring as new markets open up and participate in merger and acquisition activity.

Nevertheless, there are risks associated with globalization. One in particular is bottlenecks with suppliers. D’Angelo says that at one point, CAT couldn’t increase output because there weren’t enough tires being produced for its machines. But, as Fee points out, this can also be an opportunity for smaller players to break into a market and establish a presence. A current example is wind turbines.

Another limitation is the difficulty of establishing a presence in many emerging countries. Fee says it can be difficult getting regulatory approval because there isn’t much transparency in these markets. And the political environments can be volatile. There may also be barriers to imports that may be key to production.

Currency risk can also be an issue, although that can be minimized by doing as much production as possible in the markets in which the goods are being sold.

Inflation is yet another risk, but it’s a more general one. There can be more demand for goods and services than can be met with current production, causing prices to rise because those wanting to buy are prepared to pay higher prices. The same thing can happen for wages and production inputs. Certainly, the current very high energy and metals prices are the result of this.

Way notes that China’s stock market has gone up 150%-200% this year. He believes this is a bubble that the Chinese authorities will be able to burst by gradually allowing domestic investors to invest outside the country. Already, China is allowing investment in the Hong Kong stock market. But this underlines the risk of runaway inflation.

Globalization also means an increasingly competitive environment for industrial companies. Local firms in emerging markets are becoming very efficient, says Way, and will be snapping at the heels of the western firms: “You can’t rest on your laurels.”

Reed notes that because of the low wages in emerging economies, eight of 10 items produced can be thrown out and a reasonable amount of profit can still be made on the tenth. Once the firms become more efficient — and fewer and fewer items are thrown out — they become competitive forces with which to be reckoned.

And companies in emerging countries are getting “dramatically better,” says Burbeck. China, for example, is producing good-quality tools and machinery such as used to be made in the U.S., Europe and Japan. This, in turn, means that other emerging countries can now afford to buy these tools and machinery. In other words, globalization is a double-edged sword.

Fee agrees, saying that the greater efficiency that comes with globalization means competitors get more efficient, as well.

The key for success in the industrial sector is to have and maintain leadership in product quality, says D’Angelo. Companies such as CAT, Eaton Corp. and General Electric Co. in the U.S.; Siemens AG in Germany; and ABB Ltd. in Switzerland spend 2%-3% of sales revenue on research and development and always have leading products that solve problems for customers.

European firms are very good at this, he says. He points to Sweden-based Atlas Copco AB and Sandvik AB, which outsource some of their commoditized inputs to countries such as China while concentrating on design, working with customers to solve problems, and innovation and service.

D’Angelo expects that in the next five years, leading industrial firms will derive 40% of their revenue from after-sales service. He suggests looking at companies that are moving up the value chain, are efficient, concentrate on their core competencies and invest in R&D and servicing.

Also, relationships with customers are very important, he notes. The decision to buy is not just based on price — particularly true as manufacturers move up the value chain.

Fee, for her part, recommends looking at companies with a technological advantage, a wide range of activities, a strong balance sheet, and a good and growing emerging-market presence. She also suggests companies with restructuring activities, pointing to Siemens, which could get rid of activities that she describes as “low-hanging fruit.”

Way warns, however, that it’s unlikely that profit margins will rise further. They are already at historical highs in the U.S., so companies will have to rely on top-line revenue growth.

Reed recommends looking at more than just earnings growth. If companies are increasing their net income by cutting costs rather than selling more, they will eventually hit a wall once there are no more costs to cut. IE