China’s Move up the Value Chain, America’s Response, and Future Outlook

China’s Move up the Value Chain, America’s Response, and Future Outlook

Moving Up the Value Chain

 

The Chinese economy is in a race against time.

 

            In May 2015, China formally laid out the concept of Made in China 2025 (中国制造2025). Since 2015, the core mission of MiC 2025 has defined China’s economic approach and, consequently, has informed much of the rest of the world’s stance—including the United States—in regard to dealing with China economically. In practical terms, MiC 2025 prioritizes the optimization of 10 key industries:

 

1) New advanced information technology

2) Automated machine tools & robotics

3) Aerospace and aeronautical equipment

4) Maritime equipment and high-tech shipping

5) Modern rail transport equipment

6) New-energy vehicles and equipment

7) Power equipment

8) Agricultural equipment

9) New materials;

10) Biopharma and advanced medical products.

 

            China has long realized that it needs to upgrade its industrial and manufacturing capabilities if it seeks to move to the more high-end links in the value chain. Stan Shih introduced the concept of the “smile curve” in 1992 to explain profits gained along different parts of the value chain. The smile curve can be seen in Chart 1—the highest value-added competencies are R&D (at the start of the curve) and sales and marketing (at the end). Manufacturing and assembly fall in the middle, at the low points.

 

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Chart 1 (Stan Shih)

 

Since the mid-2000s the central government has been appealing to move away from a manufacturing sector that relies heavily on low-cost manufacturing labor as its competitive advantage. In the 12th Five-Year Plan (2011-2015), the government outlined seven strategic emerging industries (SEIs) that would help China reorient its economy towards a more “high-quality” form of manufacturing. The MiC 2025 plan, elucidated in the 13th Five-Year Plan (2016-2020), is a more streamlined, more clearly framed improvement to the SEI model.

 

            The impetus for these plans is China’s desire to avoid the “middle-income trap:” an economic theory that has been applied, most recently, to countries like Brazil and South Africa. While the “middle-income trap” is not applicable to all economies and all situations, there is a notion within it that I believe saliently applies to China: 

 

            Much of China’s epic rise has been built on the back of a relatively low value-added economic activity: low-cost manufacturing. This includes high-tech assembly, clothing, and a host of other industries where China’s key competitive advantages have been scale and low-cost labor. However, as China’s labor costs begin to rise, the country will inevitably become less competitive in relation to cheaper export markets like South and Southeast Asia or Africa. This is a pressure that afflicts China from the bottom—an upward pressure. Simultaneously, though China is making rapid improvements in innovation and high-end manufacturing, it is still, on balance, behind countries like Germany, Japan, and South Korea in terms of high-quality manufacturing and behind the US in terms of innovation. These pressures come from the top—downward pressure. China does not want to get stuck, or partially stuck, in the middle. If wages rise too fast, China will lose its edge in manufacturing—jobs will migrate to the aforementioned cheaper alternatives. If China does not move up the value chain, thus providing newer, high-quality manufacturing jobs, in a meaningful way before this happens, a massive employment crisis could result in mainland China.

 

            The majority of recent Chinese economic policy is focused on this transition. Numerically, Chinese Research and Development investment has grown steadily for many years—crossing 2.1% of GDP in 2015. 

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Chart 2. Statistical Communique of the People’s Republic of China (2015)

 

            In the 13th Five Year Plan, the central government committed to increasing per-capita R&D spending to 500,000 RMB in 2020, up from 370,000 (a 35% increase). China wants to become more technologically self-sufficient and optimize its competitive advantage.

 

            When forecasting the Chinese economy over the next few years, it is these policies that must be most closely considered. The government will continue advancing MiC 2025, but in a less outward way. Notable was Xi Jinping’s omission of the phrase “Made in China 2025” at the most recent Economic Work Conference. Peng Yiming, a researcher at Tsinghua University, cited recent comments on behalf of party leadership in discussing China’s near-term economic outlook. “While there has been a lot of talk about the concept of increasing support to state companies while focusing less on the development of the private economy (国进民退), Xi and the Financial Stability and Development Committee have directly denied these statements.” Peng also described recent measures put in place to help private companies avoid defaults. These measures are largely in reaction to the simple fact that China’s economic growth is slowing. Growth will likely have to come through less traditional channels—i.e. more private sector participation. 

 

The American Perspective

 

            The rest of the world can essentially approach initiatives like MiC 2025 in one of two ways—or some combination of both.

 

1). Other governments can welcome Chinese innovation as “global innovation.” 

 

That is, the effects of more homegrown innovation and development from China will improve global wellbeing.

 

2). Governments can view such initiatives from a zero-sum perspective.

 

In this sense, China’s rise is not possible without a commensurate fall from somewhere else in the global economy. And, as MiC 2025 sets its sights on improving capacity in competencies that have traditionally been strongholds of developed economies, those are the economies where the competition would be most felt.

 

At present, the Trump administration and, in fact, the majority of the American political establishment, appears to hold the latter view. 

 

While the trade war between China and the US is, nominally, about specific products, it is my estimation that the current trade friction has more to do with MiC 2025 and China’s rise than anything else. 

 

It cannot be said whether or not the US’s actions are malicious or unfair to China. In fact, different actors within the US surely view China’s rise through different lenses. Broadly speaking, there are few politicians or elite interests within the US that view initiatives like MiC 2025 with unfettered positivity. Surely, there are those whom, for nationalistic reasons, want to contain China for the sake of American geopolitical dominance. However, most politicians and American business interests want to increase America’s gains from China’s rise. 

 

For China to fully transition from low-quality manufacturer/developing country, it needs technology and specialized knowhow. It is inconceivable that domestic R&D alone will solve this problem. In fact, according to Hu Quan, President of Research at China Academy, because China has often channeled its R&D resources into State Owned Enterprises (SOEs), its R&D expenditures have not been as effective as they may have been had they spread across smaller enterprises who may be less risk averse and more agile.

 

 In recent history, China’s tried and true method for technology acquisition has been joint ventures with foreign companies, direct acquisitions of foreign companies, and, it is widely alleged, cyber espionage. For the US, these activities were more tenable and negligible when China was a small, undeveloped economy on the other side of the world. However, now, the US has broadly woken up to the fact that China needs these technologies to achieve its growth goals and it is no longer willing to provide them through the above channels. This is partly for economic reasons. The US’s major competitive advantage is and has been innovation and marketing—the two ends of the value chain “smile curve,” which provide the highest profit. The US would like to see China pay more—much more—for access to this competitive advantage. Hence, Trump’s insistence on intellectual property reform in China. 

 

Another crucial reason is security. There is, of course, a close linkage between technology and defense. According to Adam Minter at Bloomberg, the US—and its Asian allies Japan, South Korea, and Taiwan—have increased the scrutiny with which they evaluate potential acquisitions of their companies by China. For example, China made $34 billion worth of bids for US semiconductor companies in 2015. Yet, they only completed $4.4 billion in global semiconductor deals that year. Consider the 2018 ZTE crisis. The Trump administration briefly instituted a ban on exporting semiconductors to ZTE in response to sanctions violations. The company imports 25% of its semiconductors from the US and would not have been able to function without these inputs. ZTE quickly capitulated to US demands and the ban was lifted, but it served as a reminder that China must improve its domestic high-tech manufacturing sector. China produces only 16% of the chips it uses, even though it is the world’s biggest chip market. Consider chart 3, showing various attempted Chinese takeovers of American companies blocked by the Trump administration in 2017 through April 2018 alone. It provides a clear illustration that the US is attempting to shut off another channel of Chinese technological knowledge acquisition. Peng Yiming noted that, if China is unable to acquire knowledge through transactions and knowledge sharing with foreign companies, it may look to channel enormous R&D resources into institutions such as Tsinghua and Peking Universities. 

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Chart 3. Bloomberg.

 

The US would like to gain concessions from China before China becomes self-reliant and indigenously innovative enough to the point where the US can no longer use its leverage. Trump’s trade war is a crude tactic toward realizing this end. It is, above all, a reminder to China that if it wants to participate in the open world trade system it has to reflect that system itself. 

 

Long Term Effects

 

            Made in China 2025’s goal is to make China more self-sufficient in the high-quality manufacturing sector. Trump’s trade war is an indirect challenge to this ambition. It is a mechanism by which the United States seeks to have more input concerning China’s rise up the value chain and potential displacement of the US and its allies in various high-margin industries.

 

            In many ways, the trade war will accelerate the realization of some pieces of the MiC 2025 initiative. In response to rising production costs in China, some factories have already begun migrating operations to cheaper regions like Southeast Asia. Sam Cobb, the owner of a flooring company in Missouri told the New York Times that his main Chinese supplier had already started shifting production to economic zones in Cambodia and that other companies were following suit “as quickly as possible.” In these scenarios, much like when Nike produces shoes in China, there are real job and wage losses in the company’s home country, yet the profits still flow to the company’s executives and its shareholders (if it has any). 

 

Another effect is the importance of the RMB in international transactions. A tendency for more heavy-handed trade tactics on the part of the US will increase the speed with which China internationalizes the RMB. Iran and Russia are already accepting RMB in energy deals to get around American sanctions. Trump’s trade tactics ultimately have the effect of reaffirming to China that it must be less systemically reliant on the United States. 

 

Daniel Rosen, a partner at the Rhodium Group, said that the initial losses from the tariffs would not be disastrous. However, over time, there would be “(a) loss of productivity and dynamism in both economies, as the logic of globalization breaks down and goes into reverse.”

            

In the longer term, the trade dispute is the first battle in a longer war that many experts view as inevitable. “The long-term fear is that the two side will fall into the Thucydides Trap,” said Fang Songying, Associate Professor at Rice University and an expert on US-China relations. Professor Song’s comments referred to Professor Graham Allison’s research that, when a great power is threatened by a rising power, war is often the result. The Thucydides Trap is surely unlikely to snag the US and China in the near term, but is important to keep in mind as these small, regional and industry-specific battles begin to take place between the great power of the day and its most formidable challenger.

 

China will continue on its march to develop its indigenous high-tech economy and the United States will likely continue pushing to make China more open. In many ways, the trade war and the Trump administration’s policies will slow certain aspects of Made in China 2025, such as technology acquisition and concept generation. However, in other ways, American policy toward China will accelerate trends that are already underway such as RMB internationalization and migration of manufacturing to developing economies. The appropriate question is not if China will realize these advancements, but when and how involved the United States will be. There is no question that China will push ahead with its move up the value chain. This is a reality that its government knows it must embrace to become a fully developed economy. China will not retreat from this key initiative, but, due to shifting American policy, it will have to become more creative in the ways it achieves it.

 

 

Acknowledgments and Works Consulted

 

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