An X-ray of China’s industrial muscle

China’s manufacturing boom is well known; over the past 25 years the Chinese share of the value-added by the manufacturing sector worldwide has increased almost tenfold. Nor has the pace of that change eased, for in the six years since the onset of the financial crisis China’s share has still risen by more than one percentage point every year – faster therefore than in the previous 12 years. Chinese value-added manufacturing overtook the combined output of Japan and Korea in 2009, that of the United States in 2014 and by 2016 or 2017 may well surpass than of the European Union.

But China’s population is more than double that of the EU and four time that of the U.S. The value-added of its manufacturing industry would need to quadruple to achieve the same per capita output as in Europe or America. Despite the rapid advances of recent years, the Chinese economy’s resurgence may have only just begun.

Historically, China’s manufacturing has been driven by its state-owned enterprises, but their dominance began to change a quarter of a century ago with the arrival of the Chinese or foreign-owned contract processing companies that assembled products without even owning the raw materials. Along with the reform of its state-owned enterprises, China also saw foreign direct investment in manufacturing gain ground steadily, and all of these developments were aided by special tax regimes for domestic profits as well as imports.

The change in ownership of manufacturing industry became even more pronounced in the middle of the last decade when China’s constitution was changed to recognise private property, and when company law was simplified by reducing the capital needed to form an enterprise. In the six years before that change, private sector value-added had been growing three percentage points faster every year than the state-owned sector, and in the following decade the gap widened to almost five percentage points. The domestic private sector was, meanwhile, expanding in relation to companies owned by shareholders from outside the Chinese mainland.

Private sector enterprises in China’s industrial sector have achieved extremely high rates of return. Despite the international financial crisis, the average return last year on equity before tax was 25%. With high returns and low taxation, private sector manufacturing in China has generated a large number of billionaires, even when measured in U.S. dollars. Of the 58 people with identified wealth last year of over $3bn, nearly 40% had amassed their fortune in manufacturing.

Rising wages have been seen as a threat to the development of the Chinese economy, and certainly average pay has risen significantly in real terms. The pay of a migrant worker in China relative to that of an unskilled worker in the United States, let’s say as a janitor, has almost doubled since 2008. Yet an unskilled American worker still earns almost five times more than a Chinese counterpart. This rapid increase has pushed the earnings of migrant workers in China well above their average earnings in countries like Indonesia, Thailand and the Philippines.

The rise in migrants’ earnings has also boosted domestic demand in China. Labour intensive industries have been able to switch output to the domestic market just as their shares of export markets for products like clothing, textiles, footwear and toys had begun to stabilise or even to fall. And Chinese entrepreneurs in these industries have reacted to higher wage costs by boosting manufacturing investment. The domestic value-added of the labour intensive industries’ output has risen faster since 2008 than that of the most capital intensive industries.

China’s industrial polices have long aimed to upgrade existing industries to higher value added by moving up the global value chain. China’s industrial policies have been typified by changes in its semiconductor industry. The first policy phase attempted to create national champions, but that was a failure. In the past decade, a new set of policies encouraged foreign investment with the aim of transferring technology to China. High-tech zones were created and foreign companies offered a special tax regime. The end result has been a strong rise in the semiconductor industry’s output, but chiefly for domestic consumption. China uses over half the semiconductors produced worldwide, but its semiconductor companies account for only 2% of global sales.

The overall result is that while China is now the leading exporter of high-tech products, the impact on its local economies has not been in line with that. Around four-fifths of China’s high-tech exports are by processing companies that import and then assemble parts in China, and re-export finalised goods. The sector’s share of gross domestic value-added is less than 45%. After allowing for royalties and the profits of the foreign-owned companies, the share of high-tech exports that are genuinely Chinese is below a third.

The government introduced new guidelines for the semiconductor industry a year ago that featured a National Investment Fund with a capital of just under $20bn. It is to be used for capital injections and to aid consolidation amongst Chinese companies, and some provincial governments are expected to create their own funds along the same lines. The objective is to raise overall Integrated Circuits (IC) production by 20% a year by 2020.

Chinese firms have struggled to enter the main semiconductor industry, but a number are making headway in communication devices. The boom in low-cost smart-phones from Chinese manufactures such as Huawei, Xiaomi, ZTE and Coolpad has been built on local semiconductor design companies specialising in communication chips.

Another key development has been the new foreign investment law and related regulations making it easier foreign companies to invest. The new law means investors will no longer have to obtain pre-approval before setting up a company, unless the investment is in a restricted area and on a negative list. China’s revised list of restricted or prohibited industries is now limited to only some mining areas, utilities, energy, finance and automobiles. From a European or American point of view, the main disappointment has been the placing on the restricted list of joint ventures in automobile production, and significant restrictions also remain in the finance sector.

The joint venture requirement for automobiles is designed to ensure technology transfers needed for a Chinese car industry. Allowing foreign companies to produce cars in China has been a major success, with vehicle production three times greater than before the 2008 onset of the western financial crisis, making it significantly larger than in North America or the EU. Although the Chinese sometimes claim that their six major companies account for 85% of domestic sales, the fact is that 70% of these domestically produced cars are from foreign joint ventures. Only one in six of the cars attributed to China’s six major automobile companies is produced by the Chinese partner. China’s car exports are insignificant because of poor productivity, design and quality.

The joint venture structure has also failed to yield technology transfers as foreign partners keep the JV separate from their Chinese partner, which will generally provide senior staff for marketing, human relations and government relations while the foreign partner contributes the engineering and technical staff. To overcome this problem, the Beijing government has insisted that JVs produce a Chinese model, with the JV partners responding by re-badging models from their global model portfolio not yet produced in China. To differentiate such products from their foreign brands, prices were set at a level competitive with domestic Chinese models. Consumers then turned to the new cheap JV brands and so accentuated the decline in the market share of the domestic Chinese producers.

The major industrial policy successes in the upgrading of its manufacturing industries have so far been confined to areas where both producer and the purchaser companies are state-owned, rather than by selling to consumers. Key examples are high-speed trains and wind turbines, and even in these areas, as with semiconductor foundries, there have been allegations of intellectual property theft, with severe penalties sometimes imposed.

China’s aircraft industry falls between the automobile and railways sectors as an industrial policy success. The Chinese government has long wanted an aircraft industry capable of competing on world markets, but so far no Chinese commercial aircraft has obtained foreign type approval. China’s development of new aircraft is running well behind schedule, highlighting the lack of advanced engineers.

Human capital is key factor to all forms of innovation. China’s physical capital is quickly renewed and replaced and half of the capital stock in its manufacturing industry is less than three years old. But human capital takes much longer, and although the human capital stock has grown rapidly, achieving the average education levels of advanced countries will take decades. This lack of experienced and qualified managers is reflected in a growing number of research projects where quality is lagging.

Chinese manufacturing has expanded rapidly over the past two decades, but is still far from being a mature, advanced sector. Rapid wage increases have put pressure on traditional labour intense industries, even though they are adapting. Return on equity remains high, dropping only slightly in the recent downturn, and that provides an incentive for the private sector to increase investment. In labour intensive sectors, investment is still increasing at a rapid pace, suggesting that private entrepreneurs who are responsible for nearly 90% of that investment are moving away from labour intensive production so as to remain competitive.

The fundamental factor affecting China’s drive to upgrade manufacturing will be the rate at which well-educated engineers graduate from universities at home and abroad. That can already be seen in areas where knowledge evolves most rapidly, such as communications and internet applications. But it will take time for a new generation of engineers to make a difference. The best industrial policy for China is that it announced in 2013 of letting the market decide on the allocating of resources.