Abstract
The excess supply of labor in China will be exhausted in the near future as the growth of the population slows down and the share of working-age people shrinks. Once the country crosses the “Lewis Turning Point”, the mobilization of resources can no longer drive growth. In order to compensate for the increasing labor cost and sustain its growth, Chinese firms will need to increase profitability by moving up the value chain. Although the overall strategic objective of upgrading is widely shared and the logic of the globally fragmented production system is now well understood, a strategic impetus is missing to make the transition happening in China. The article contributes some ideas to this debate. Since the challenges that China faces today are similar to the ones faced by South Korea and Malaysia 30 years ago, their experience can shed light to help China find a solution to upgrade its industry. As an impetus, China needs to shift its emphasis from “opening the market in exchange for technology” to “exchanging advanced technologies for other advanced technologies”. It is crucial to give priority to establishing a leading position in several technology-advance frontiers. This will require the Chinese government to take a proactive role in market orientation, resource allocation and the promotion of close collaboration between the public and private sector.
Introduction
Products made in China have been shipped to markets all around the world. This mirrors China’s success in liberalizing its economy and becoming a very dynamic exporter. The “reform and open-door” policy implemented by the Chinese government in the late 1970s allowed China to grab the opportunities brought about by the new division of labor and started a process of economic transition and growth. This process was accelerated by China’s accession to the World Trade Organization in 2001, which has moved the country towards a more rules-based economic system, with both tariff and non-tariff measures being significantly reduced. The resulting multilateral trade liberalization contributed to its outstanding trade performance. During the period 2002–2011, the total value of China’s foreign trade increased from US$0.6 trillion to US$3.64 trillion, with exports rising from US$325.6 billion to US$1.9 trillion and imports rising from US$295.1 billion to US$1.74 trillion. The annual growth rates of total trade, exports and imports were 21.7, 21.7 and 21.8%, respectively, which are almost twice those during the period 1991–2001 (14.8, 14.6 and 15.3%, respectively). Foreign direct investment in China, both inflows and outflows, has also steadily increased and China has been the largest recipient of foreign direct investment among the developing countries.
After three decades of rapid growth, China is the world’s third largest economy in terms of gross domestic product (GDP; after the EU and the USA), and the second largest trader (after the EU). 1 China’s impressive economic achievement, however, could be just another example showing that the mobilization of resources can drive an economy growing rapidly at the early stage of industrialization using cheap unskilled labor and importing foreign technology and capital (Krugman, 1994). It seems too early to call it a miracle or a “China’s model”. In 1980 when China started its economic reform to transition from a “planned economic system” to a “socialist market economy”, there were one billion Chinese people, over 80% of whom were at the time working in agriculture. This large pool of cheap labor in rural areas was vital to China’s high-speed with low-inflation growth in the following decades by keeping real wages low in industry (Lewis, 1954). 2 Investment in the industrial sector was more profitable since the growth in productivity was much faster than the rise in wage level. Some Asian newly industrialized countries (NICs), South Korea and Malaysia for example, have experienced this type of high-speed growth during industrialization. In case of China, the large population has allowed the transition to last for longer and the starting point of growth was much lower. 3
Besides the internal growth mechanism, a favorable international economic environment has also played a key role in supporting Chinese development. Post-Second World War globalization implies deep integration of the world economy and increased interdependence, especially after the Cold War era and the widespread application of information and communication technologies. Trade and investment liberalization along with the reduction in service costs has significantly facilitated global production sharing. Previously integrated production has been internationally fragmented into a variety of activities that are carried out where the necessary skills and materials are most competitively available, which are then linked by common value chains. This emergence of global value chains has accelerated the whole process of globalization. This has facilitated China’s imports of foreign technology and capital and accelerated its pace of industrialization. All of these factors have helped China achieve fast growth and be a “world factory”.
One of the biggest challenges for Chinese economy comes from the slow-down of its population growth. In 2012, for the first time in over three decades, China saw a drop in the working-age labor force. 4 This represented the termination of the “unlimited” supply of labor from rural areas. China will very soon reach, if it has not reached yet, the “Lewis Turning Point”. 5 When the labor in the subsistence sector is exhausted, further investment will cause industrial wages to increase. The net profit margin will decline and capital accumulation will become less effective in promoting economic growth.
This will cause serious problem to the Chinese economy because the majority of Chinese manufactures are still at the very low value-added end of the global value chains (GVCs), even though the share of technology-intensive products has also grown. China will very soon lose its advantage in exporting low-cost products as the country is approaching the “Lewis Turning Point”. To compensate for the higher labor cost and keep its exports profitable, Chinese firms will need to move up the value chain and increase the value added of products made in China. At the micro level, this means that firms have to keep growing via innovation and technological progress, while for the whole economy, this will require structural changes and industrial upgrades. The issues of structural changes and industrial upgrades cover not only economic but also expanded political and social aspects. Although China has included moving up the value chain as part of its long-term development plans, 6 without an effective impetus, it could still be just a slogan rather than a feasible blueprint. This motivates us to seek such a possible impetus that can act as a pole star for guiding industrial policies to promote the development of strategic emerging sectors.
While theoretically the economic logic behind the ongoing re-organization and re-location of production, based on production fragmentation, is now relatively well understood, the implications for economic policy-making in general, and industrial policy-making in particular, are not necessarily straightforward, especially for China, which has unique economic institutions and the world’s second largest economic size. One aim of this article is therefore to contribute to the debate on the next stage of development of the Chinese economy.
This article comes up with some fresh ideas, in part based on the relevant experiences of other NICs in the East and Southeast Asian region by adopting a comparative method. It will focus on two case studies: South Korea and Malaysia. This case selection produces variation, to the extent that the first two generations of NICs are represented and that different policy orientations were followed. Country size and regional (political, geo-political, economic) contexts are more or less kept constant. We are aware that the cases are not perfect comparators for China, especially when country size is taken into account, even if we have avoided including micro-states (Taiwan, Singapore) in the comparative analysis. 7 Taking into account this caveat, the cases show sufficient features to make a comparison relevant and interesting. There are similarities in the export-driven growth paths and China’s average gross national income (GNI) per capita is close to that of South Korea and Malaysia in the early 1980s.
The rest of paper is organized as follows. The next section reviews the literature on the emergence of economic globalization and China’s involvement in the value chains, which provides a theoretical basis to explain the success of China’s extensive growth model. The following section evaluates China’s current economic situation and explains the constraints and the pressures on its long-term economic growth. The fourth section presents two case studies, one for South Korea and the other for Malaysia. The fifth section draws lessons from the Asian NICs’ experiences and discusses policy implications for China’s upgrade in the GVCs. The final section concludes.
The rise of China and the emergence of GVCs: literature review
The rise of China has triggered worldwide debates over Chinese development, which even led to the visualization of a “China model”. 8 Analyses based on different starting points and coming from different perspectives lead to different interpretations and prospects for the Chinese economy. While some optimistic observers are talking about an emerging economy that is maintaining two-digit annual growth based on the Beijing consensus, others point to the imbalance of Chinese economic growth and worry about its sustainability. Yet, although the discussion is highly divisive, most observers do agree that China’s economic growth is mainly driven by investment and trade, of which one of the determinant factors is China’s deep integration in the global production-sharing networks (Naughton, 2007; Wu, 1999; Wu et al., 2012).
In traditional Chinese philosophy, there are three necessary ingredients for success—timing (being at the right time, “Tianshi” in Chinese), place (benefitting from geographic advantages, “Dili” in Chinese) and people (getting support from others, “Renhe” in Chinese). The success of China’s export-driven growth is not an exception. First, China is integrating into the global markets at a moment of re-configuration of the international division of labor; second, China is growing in a context of economic interdependence and production sharing; and third, there is a Factory Asia behind China.
International fragmentation of production and the new division of labor
Technological progress, globalization and growth describe three very important aspects of the long-term evolution of the world capitalist economy (Archibugi and Michie, 1998). Their interactions are also very clear in the case of China. These interactions have been at the center of economic thinking from the early classical school (Smith, Ricardo), through Arthur Lewis’s structuralist school of development, to the neoclassic school, new growth theory and new trade theory. However, for the purposes of this article, we will focus on the recent scholarly literature on international fragmentation of production, which emphasizes the difference between current economic globalization and that of the nineteenth and early twentieth centuries, in that there is a much wider spectrum of goods and services subject to international trade (Jones and Kierzkowski, 2001), and which points out that the process is associated with the fragmentation, unbundling and off-shoring of production (Baldwin and Venables, 2011). 9 A huge reduction in transport and communication costs has made it possible to divide the previously integrated production process into a series of production blocks arranged by the technology of each participant. This was complemented by the opening up of large economies with abundant cheap labor (China, India and Brazil) on a scale far beyond any one of the NICs, and by the mobilization of labor forces using advanced technology supplied by multinational companies (Lamy, 2004).
A benchmark to distinguish fragmented technology from the integrated production pattern is the feasibility of geographically distributing the sub-stage production blocks. For that reason, competitiveness can be identified at the sub-stage production level, rather than at the level of aggregate production; and the characteristics and productivity of various categories of labor can be more clearly defined. This in turn leads to a finer division of labor and a new pattern of international trade via the expansion of global production sharing, where international trade and investments are increasingly organized within GVCs. Accordingly, countries just like firms, become specialized in specific functions of production instead of the total production effort.
Jones and Kierzkowski (1990, 2001) developed a framework for analyzing the international fragmentation of production, in which production is divided into sub-stage production blocks that are connected via service links. This framework highlights the importance of economies of scale in service links and predicts that fragmentation will spill over into international markets in response to lowering prices of services, increased tradability of services and a whole range of technical improvements and innovations that allow geographic dispersion of production. While a higher degree of production fragmentation could lower the aggregate costs of sub-stage production blocks, it could on the other hand lead to higher expenses on service links. In practice, lower costs of service links and a mature legal system will initially spur domestic fragmentation and outsourcing, while international fragmentation of production and global production sharing are stimulated by factors related to globalization, such as the deregulation in service sectors, the unification of international legal systems, international trade and investment liberalization, the facilitation of cross-border transportation, communication and knowledge transfer around the world. Baldwin and Venables (2011), taking a different perspective, emphasized the role of technology in dictating the organization of fragmented production and demonstrated the existence of multiple equilibria in organizing GVCs, taking into account both the cost-saving effects and the benefits of co-location of related stages. Finally, the development of national and international legal systems and institutional and regulatory frameworks may have an impact on the balance between intra-firm and inter-firm production fragmentation, through their effect on transaction costs.
From a dull goose falling behind to a hub of Factory Asia
Post-war history shows that the rise of successive waves of economic industrialization in East Asia and the development of a production-sharing network are closely connected. Ng and Yeats (2003) found that most of the fastest growing exports from East Asian countries occur in sectors of broad machinery and transport equipment, where production can relatively easily be fragmented. Japan played a crucial role in establishing regionally cooperative operation and other East Asian economies followed Japan to gradually achieve industrialization by upgrading their industries from relatively low valued-added to relatively high value-added. 10
This concept of a “flying geese” pattern of industrialization is attributed to Akamatsu (1962). 11 Akamatsu demonstrates how sectoral shifts of comparative advantages from relatively labor-intensive production to relatively capital- or technology-intensive production can lead to industrialization and economic growth. As the nation(s) in the higher tier find new comparative advantages in fields with greater value-added production, the relatively lower value-added production will be shifted to the nations in the following tier. The East Asian “wild geese” formation Akamatsu describes is composed of four tiers—Japan being in the first tier leading the group, followed by the four Asian Tigers 12 (the second tier), the four main ASEAN countries 13 (the third tier), and finally the others. In the late 1970s, the Chinese government decided to “open the door” to foreign trade and investment, and at that point China became a “dull goose” flying behind its neighbors.
This order of flight lasted until the early 1990s, when the lead goose slowed its speed and the followers caught up quickly. After signing the Plaza Accord in 1985, Japan accelerated the industrial transition of its followers, but then the Japanese economy fell into a liquidity trap and entered a decade-long recession in the early 1990s when its economic bubble collapsed. Meanwhile, South Korea and China continued to grow strongly and China eventually surpassed Japan as the region’s largest economy in terms of GDP, while South Korea has challenged Japan for the regional leadership in high-tech industries. Finally, the internet revolution provided countries with more options to access knowledge and new technologies.
Today, the Asian economy looks more like an integrated factory where “formerly national production processes have been unbundled and dispersed to the lowest cost location in East Asia” (Baldwin, 2006). China benefited from its abundant cheap labor and became a global manufactory. Compared with other developing economies in Asia, China is also rich in resources and has a larger market potential. Indeed, the process of regional integration in East Asia has entered a stage where two regional hubs of economic activities co-exist: Japan serves as a hub for high technology while China has emerged as a hub for labor-intensive activities (Baldwin, 2004; Chen, 2007; Chen and De Lombaerde, 2011; Chen et al., 2011).
China’s involvement in GVCs and export-oriented economic growth
Chinese exporting is mainly based on a “triangular trading system”, 14 where Japan and the four Asian Tigers first export capital goods and complex intermediate goods to less advanced economies, such as ASEAN and China, for processing operations. Kwan (2002) estimated the total imported content of products exported from China to account for over 50% of their final value, the figure being even higher for higher value-added products. The growth in intra-regional trade in parts and components in East Asia also mirrors China’s dependence on production sharing, especially from a regional perspective.
Fung (2005) showed that in 2003 over half of China’s total exports were processed exports, while about two-fifths of total imports were processed imports. 15 It was also shown that a 10% increase in foreign direction investment into China is linked to an increase of direct investment into the other East Asian economies by around 5.5%. More precise calculations were conducted by Koopman et al. (2008) using input–output analysis. Their study concluded that, for Chinese manufacturing exports as a whole, domestic value added as a share of the total value of exports was 51.3% in 2002, up from 47.1% in 1997. This figure rose to 62.8% in 2004 (Koopman et al., 2011: Table 3).
Focusing on Sino-US trade, Chen et al. (2001) showed that in 1995 less than 20% of Chinese exports to the US market could be interpreted as direct domestic value added in China. The rest of this value is indeed shared by the foreign suppliers of intermediate inputs and in fact most of this excess value came from East Asia. Their argument is supported by Kierzkowski and Chen (2009), who pointed out that intermediate input from abroad could be responsible for having enriched China’s factor endowment and strengthened its export capability. It is estimated that around 50–60% of China’s exports to the USA would be at risk of disappearing if China could not import parts and components. China’s exports to the US market are especially dependent on parts and components imported from Japan, Hong Kong, South Korea and the USA.
The calculation of the index of “export revealed comparative advantage” (XRCA) shows that by 2010 seven of China’s top 10 most “advantageous” export products were still unskilled labor-intensive low technology manufactures. Silk and pottery, two products that China has been famous for for hundreds of years, are still China’s top-most competitive export products. China did have a comparative advantage for exporting two categories of high-tech products—codes 752 (automatic data-processing machines and units thereof; magnetic or optical readers, machines for transcribing data onto data media in coded form and machines for processing such data) and 751 (office machines). However, because China’s export capability is indeed highly reliant on supplied intermediate inputs to complement its factor endowment, the country in general is still specialized in the relatively lower value-added sections of GVCs (Table 1). A typical example comes from China’s participation in producing the Apple iPhone and iPad: both of these products are assembled in mainland China, but by a Taiwan-based firm—Foxconn. The benefits for China are mainly the wages paid for the assembly activities. Kraemer et al. (2011) estimate that, for each iPhone (iPhone 4) or iPad (iPad 16GB) that Apple sells at US$549 and US$424 respectively, only US$10 (or 0.01% of the price) or even less is paid to Chinese workers. In contrast, gross profits gained by suppliers in South Korea account for 5–7% of the US$ sales price. This example also illustrates that foreign supplied intermediates and the influx of technology (associated with foreign direct investment) play vital roles in building China’s production capacity.
The export revealed comparative advantages, 2010.
Source: Authors’ calculation based on UNCOMTRADE data. Data retrieved on 1 February 2012.
Motivations and pressures to move up the value chain
Economic dependence and vulnerability
China’s location in the low value-added end of global value chains induces a two-sided dependence of the Chinese economy upon the global market—on one side, exports already accounted for 38% of annual GDP by 2007; on the other, foreign-supplied intermediate goods and technology played vital roles in building export capacity. This makes the export sector, and therefore the whole economy, vulnerable to external shocks from both the demand side and the supply side.
Whereas the lessons from the 1997–1998 Asian Financial Crisis were perhaps not too impressive, the export and import collapse along with the capital outflow during the 2008–2009 economic crisis were definitely a painful experience for China. Before the onset of the US credit crunch, policy-makers in China and many other East Asian countries were still discussing how to avoid overheating and inflation in the economy, 16 but all of a sudden, when global turmoil was triggered, they had to step on the brake sharply and turn to designing fiscal stimulus packages to fight against a growth slow-down. DBS (2009) estimated that in the last quarter of 2008, Asia’s exports fell by a greater amount than they did during the entire Asian Financial Crisis or during the high-tech bubble burst in early 2000s.
Chinese exports and imports plunged in tandem: the value of imports abruptly turned from double-digit growth in October (15.4%) into a double-digit decrease in November 2008 (−18%) and both imports and exports experienced a continuous decline (on a year-to-year basis) in the following 12–13 months. In May 2009, exports fell by a record amount, dropping 26.4% compared with the same month in 2008. In the first quarter of 2009, China’s total imports and exports fell by more than 30 and 20% respectively (Figure 1)
Monthly export/import year-to-year growth rates.
The collapse is first of all due to the weakened demand from global markets, especially from China’s main trading partners such as the EU and the US. Table 2 shows that most of China’s top trade partners (except South Korea) experienced negative GDP growth between 2008 and 2009. Accordingly, Chinese exports to the EU and the US fell 19 and 12%, respectively. Shipments of electronics dropped 21%, steel 32.5% and toys 14.7% (World Bank, 2012).
Annual GDP growth of top trade partners of China, 2007–2009 (percentages).
Source: The World Bank Databank; data retrieved on 31 July 2012.
Additionally, there are link effects in the regional production sharing network that cause any contraction of global demand to affect China’s exports. For instance, when the Japanese Finance Ministry announced in December 2008 that exports from Sony and Toyota had plummeted by one-third from the same period in the previous year, 17 it was a warning not only for the Japanese economy but also for the whole East Asian economy. As leaders in the world automobile and electronic industries, respectively, both Toyota and Sony have fragmented their production internationally and built up production-sharing networks involving participation from many other East Asian countries. While their exports mainly depend on the demand for final products by the global market, their need for parts and components, services and assembly activities determines the size of output and exports of those suppliers in China, South Korea or the ASEAN states that belong to the existing industrial value chains. Therefore, the weak demand faced by Japanese producers caused a flow-on affect upon producers in other countries. Indeed, the demand crunch in the West hit the producers of intermediate goods almost immediately after the export of finished products plummeted.
Similar link effects also occurred on the supply side. Foreign-supplied parts and components are one of the key factors of China’s competitiveness and export capacity. In addition to its Asian neighbors, such as Japan and other Asian NICs, advanced economies in the West are also major sources of intermediate inputs to China. When the crisis spread from Wall Street to Main Street and migrated from the USA to Europe and then the rest of the world, a large number of upstream suppliers either went bankrupt or reduced their scale of production. This subsequently limited the productivity of downstream producers and thereby further reduced exports. This explains why imports by China started to drop earlier than exports did (Figure 1).
The Chinese export sector was also affected by the economic crisis via its links to the global financial markets. There are basically two channels linking the export sector to the global financial markets. First, foreign capital injections played an important role in China’s export-driven growth, especially since a majority of firms in the export sector are foreign invested. In 2011, foreign invested firms altogether contributed to 52.4% of China’s total exports and 49.6% of its total imports (Chinese Custom Statistics Bureau, 2012). Second, more and more firms had increased their borrowing from foreign funding sources since the mid 2000s when the Chinese economy resumed rapid growth, but domestic credit was increasingly tightened. 18 This in turn meant they had a greater exposure to external refinancing risks. In 2008, when the economic turmoil spread throughout the world, these firms found it difficult to borrow abroad any more—just as the tightening of domestic credit in China just reached its peak. 19 Many producers in export-oriented industries 20 were forced into bankruptcy as they were hit not only by the sudden market contraction but also by difficulties in refinancing external debts. Since the performances of upstream and downstream production in a production-sharing network are highly correlated, any dysfunction in one link in the industrial value chain may cause the whole production network to break down (Chen and De Lombaerde, 2010).
Furthermore, in China many workers have been employed directly either by the export sector or by sectors providing services to the export sector. The contraction in this sector consequently caused large-scale unemployment. In early 2009, the Chinese Commerce Minister told the BBC that approximately 10 million migrant workers had lost their jobs in China as the global economic slowdown deepened (BBC News, 2009). The official figure (the seasonally adjusted unemployment rate of urban force) reported by the National Bureau of Statistics of China was 4.3% as of March 2009. 21 Without any effective “buffering” mechanism to protect the laid-off workers, especially rural workers, such a large scale of unemployment is likely to trigger social instability.
For most manufactured goods, assembly is the most labor-intensive stage within the production life cycle. At present, international trade statistics only show the total value of goods. As an exporter of finished goods, their total value is credited to China’s balance sheet independently of the value-added that China contributes. For instance, although the assembly activity in China only adds around US$10 to an iPhone or iPad, each iPhone or iPad unit that China exports to the USA adds US$229–275 to China’s trade surplus (Kraemer et al., 2011). A formal analysis of the Sino-US trade deficit conducted by Kierzkowski and Chen (2009) shows that, on average, the real surplus that China gains from trade with the US may account for only one-third of the total value printed on the balance sheet. A lion’s share would eventually go to those economies (mainly the other East Asian countries) that supply China with parts and components. In other words, the whole East Asian region is clearly the prime beneficiary of the Sino-US trade surplus, not just China alone.
Thus, the figures shown on China’s trade balance sheet contain value added by all intermediate suppliers. A significant share of China’s trade surplus with the USA or EU represents indeed “transiting surplus”, which eventually goes to Japan or Asian NICs. In the previous example, South Korea contributes much more to the total value of the iPhone and iPod. South Korean producers gain US$26 and 34, respectively, from each unit of iPhone4 and 16 GB Wi-Fi iPad sold in the US market. When there are political concerns, complaints or criticisms about the trade imbalance or the outsourcing of production, China, the exporter of the finished products, frequently becomes a target of attack, while those countries located in the higher stages of value chains are “hidden”, even though they benefit much more from products labeled “Made in China”. The point is that, since China is already the world’s leading exporter, 22 its further growth by exporting more will probably create tensions with its trade partners.
Pressures to upgrade
The Chinese government is aware that export-oriented growth based on advantages in labor-intensive activities cannot be sustainable in the long run. After 30 years of rapid growth, China faces a bottleneck in its development, for which a fundamental solution is to move upward in GVCs. The twelfth Five-Year Guideline of the Chinese government (2011–2015) has highlighted its strategic ambition to turn the country’s coastal regions from being the low-cost “global factory” into hubs of high-end manufacturing, R&D and service activities. The view that China is going to be a leading economic power will indeed only be meaningful if it manages to upgrade its economy. However, it is not necessary to abandon labor-intensive activities; the key is to increase domestic value-added via innovation.
There are both internal and external pressures for upgrading Made-in-China in GVCs. Internally, costs have started to rise at a faster pace when compared with increases in productivity. These include increasing rents, more restrictive environmental and safety regulations, and most importantly, increasing labor costs. The Standard Chartered (2012) survey suggested that manufacturing wages in the Pearl River Delta, one of the most dynamic and export-oriented economic zones, have increased steadily—by 11% in 2010 and 10% in 2011. Foxconn, a major Chinese supplier to Apple, has raised its pay for production line workers nearly five-fold since 2010 and it even plans to double the minimum salary by the end of 2013. 23 The pressure raising labor costs comes from three channels: (1) the slow-down of population growth; (2) the awakening of human rights, property rights and environmental concerns; and (3) unbalanced development and inequality. The external pressures mainly arise from the emergence of new low-cost competitors and the changing environment of the global markets where economic crises are slowing down economic growth, especially in the EU and the USA.
With respect to the first channel listed above, in the past 30 years, China has benefited from its great “demographic dividend” (a rising share of working-age population) to build its competitiveness in labor-intensive industries. In China, the family planning policy has tended to accelerate the fall in the demographic dividend as one can clearly observe a path of decreasing population growth rates since the 1990s. The sixth national population census conducted in 2011 showed that the average annual growth rate of the population between 2000 and 2010 was 0.57%, half the previous decade’s rate of 1.07%. Population growth is much slower than that of GDP, which has been growing at close to a double-digit rate since 2000. While the share of population aged between 15 and 64 had increased to around 74% by 2010, a dramatic drop by 6.3 percentage points in the share of population aged under 14 (17% in 2010 compared with 23% in 2000) was observed. The International Labour Organization (2010) estimated that the working-age population will reach a peak at around one billion in 2015. After a period of gradual decline, the working-age group will quickly contract after 2030 (Figure 2).
Population aged 15–64 years in China, 1950–2070 (thousands).
With regard to the second channel, the popularization of internet use has helped awaken consciousness about human rights, property rights and environmental concerns. Most of the blue-collar workers in China only received a limited education, and a large number of them are workers from the countryside. They are a very vulnerable group of people who are poor, powerless, poorly or even uneducated, and cannot protect their rights. This situation, in combination with a underdeveloped legal system, gave birth to the phenomenon of the so-called “Chinese sweatshops”. This situation has been changing recently though as, on the one hand, the government has issued a series of laws or regulations to protect workers’ minimum wages, compensation and working conditions, while on the other hand, increasing educational levels among younger workers make it difficult for companies to make workers accept conditions like those accepted by earlier generations (Accenture, 2011: p11). Meanwhile, the internet has proved to be an effective channel for the public to access knowledge and seek assistance. Chinese workers have started to say no to China’s model of low wages and weak protection. This is evident when observing the rising number of strikes taking place to demand higher pay, better working conditions or the closing down of highly polluting industrial projects.
With regard to the third channel, unbalanced development, and the consequent rising inequality, has become an ever more serious problem. There is not only inequality between individuals and social groups, but also, more seriously, an imbalance between coastal regions and the hinterland, and conflicts between the public and the private sectors. The inter-regional imbalance resulted from the fact that the Chinese government gave priority to development in the coastal areas, where the export-oriented firms are clustered. While cities in eastern China have achieved high-speed growth, most regions in central or west China, where a large number of migrant workers come from, have not proportionally shared in the benefits of economic growth. For instance, in 1980 the average income levels in Fujian (a coastal province) and Jiangxi (a hinterland province) were more or less the same, while in 2010, GDP per capita in Fujian was almost twice that in Jiangxi. As the government started to stimulate the hinterland economy, fewer workers moved to the coastal areas. Moreover, it has been argued that the Chinese government should pay attention to improving people’s quality of life instead of continuously increasing public savings. This indeed seems to be a call from the public that the government can no longer turn a deaf ear to. As improving living standards becomes an issue of increasing concern, the government has been pressed to shift its policies (including currency revaluation and an increase in the minimum wage) in favor of improving local workers’ welfare and away from maximizing benefits to manufacturers and investors in China (Accenture, 2011: 8). In 2011, authorities in 25 out of 31 provinces had increased the minimum wage rate by around an average of 20%.
The external pressures to move China up in the GVCs arise from competition from other low-cost producers and from the global economic slowdown. While wages of Chinese workers continued to increase quickly, wages in other low-cost countries remained stagnant or rose only slowly. Figure 3 shows that the Chinese average hourly rate in US$ terms is higher than that in Vietnam, Indonesia and India. Comparing Vietnam and China, the rate of wage increases in both countries was relatively stable, and the wage gap was generally consonant with the difference in labor productivity. Since 2008, however, this wage gap has started to widen because of general increases in the minimum wage in China, the appreciation of the Chinese currency (RMB), and the devaluation of the Vietnamese currency (DONG) against the US$ (Figure 3).
Average hourly wage, China, Vietnam, Indonesia and India, 2000–2011.
Wage increases caused companies in labor-intensive industries to shift production to other low cost countries in Southeast Asia or to relocate from coastal areas to the hinterland. On 28 July 2012, Adidas, a German sporting goods company, formally shut down its only wholly owned factory in Suzhou and canceled its contracts with the company’s suppliers in China. In replacement, it moved its production to ASEAN countries like Vietnam or Cambodia, where the factory workers’ salaries are estimated to be 40–60% lower than in China. Although Adidas officially claimed that the closure was due to a strategic adjustment to realign global resources, it was widely accepted that China’s rising wages and higher import taxes and currency appreciation all played a role in Adidas’ decision to move. Nike, a main rival of Adidas, started shifting its outsourcing orders from China to Vietnam and Indonesia from 2005, and in 2009 it closed its last fully owned shoe factory in China. As the production costs keep soaring, China might no longer feature strongly in multinational corporations’ supply chain operating models in the years to come.
The 2007–2008 economic crises, the ongoing euro-zone debt crisis and the slowdown of the world economy have added additional challenges to the Chinese economy, including the global demand contraction, the supply chain break-up and the depletion of funding. More seriously, the continuous economically tough times may allow protectionism to return, even though this could lead the world economy to greater risk of more closed markets and a stalled recovery (Evenett, 2012). As one of the most export-dependent economies and the country with the world’s largest trade surplus, China could be the first victim of rising protectionism. A series of problems are foreseeable following the fall in exports—economic slowdown, increasing unemployment and social instability.
Lessons from South Korea and Malaysia
Based on GNI per capita figures, China became a middle income country in 2010. The sustainability of Chinese economic growth relies on its capacity to move towards higher value-added industries. The experiences of South Korea and Malaysia may help to shed light on the possibilities of such an upgrade to higher value-added production. Both countries entered the category of “upper-middle-income countries” by the end of the 1970s. In 1981, their income levels measured by GNI per capita were exactly the same, around US$2000. Afterwards, South Korea developed at a much faster pace than Malaysia. It took South Korea 15 years to transition from an upper-middle-income country to a high-income country. Malaysia, however, still finds itself in the “middle income trap”. In 2011, the average annual income per capita of South Korea was 2.5 times that of Malaysia (Figure 4). One of the determinants of such divergence is that South Korea has managed to build up new competitiveness in high-tech production while Malaysia is still struggling to move into higher value-added products.
GNI per capita, 1980–2011 (current US$; using the World Bank Atlas method).
South Korean success
South Korea joined the Organisation for Economic Co-operation and Development (OECD) in 1996 and became a member of the club of the world’s wealthiest nations. In 2010, it became a member of the Development Assistance Committee of the OECD. This made it the first nation to have transited from being an aid recipient to an aid donor. GNI per capita in South Korea has been above US$20,000 since 2007, solidly placing it in the group of high-income developed countries.
South Korea represents an illustrative case of how a developing country can eventually build up core competitiveness in high-tech industry and transit into a globally competitive and innovative economy. South Korea not only uses international trade as an essential component of its development policy, but investments in human capital and infrastructure also made it possible to move into higher value-added areas along the value chain (Lim, 2010).
There were two “big jumps” in the development trajectory of the Korean economy: the transition from labor-intensive manufacturing to a technology- and capital-intensive economy in the 1980s and 1990s, and the transition toward a knowledge economy since 2000. These two phases of value-added upgrade came along with the rapid rise in average income levels. The average growth rates of GNI per capita in 1980–1997 and 1999–2008 in South Korea were 12 and 10%, respectively (Figure 4). In both economic stages, industrial policies adopted by the government played a vital role. 24
In the 1980s, South Korea was no longer a poor country after more than 20 years of high-speed growth. Rising productivity was witnessed thanks to the technology transfer associated with foreign investment and the government’s attempts to promote domestic R&D capability. 25 A small number of large Korean firms even became potential competitors in international markets (OECD, 2009). The largest challenges came from increasing labor costs and a reliance on imported technologies. This looks similar to what the Chinese economy is facing today. To assist economic development, the Korean government gradually liberalized the domestic market to “push” Korean firms to improve their technological capabilities through technology transfer from abroad and investment in their own R&D, as well as to seek access to more advanced technology through foreign direct investment (OECD, 2009). In addition, the Korean government used industrial policy within a context of market discipline to protect and subsidize domestic producers for an extended period of time to improve their competitiveness in international export markets (Foxley and Sossdorf, 2011). Furthermore, the government also increased public investment in expanding R&D and the higher education system. In the 1990s, the country strongly promoted local high-technology innovation and continued pursuing high-value-added manufacturing.
Since 2000, after a quick recovery from the Asian Financial Crisis, the Korean economy’s transition towards an advanced knowledge-based economy has accelerated with overall productivity being improved by domestic innovation. At this time, South Korea has achieved a substantial technological capability in areas such as IT, automobiles, LCDs and semiconductors. 26 Moreover, Korean firms have also started to exploit emerging technologies such as nanotechnology and biotechnology. As the country’s general competitiveness in high-end products has been gradually strengthened, the South Korean government becomes more proactive in exploring markets abroad via trade liberalization—either multilaterally or bilaterally.
At the heart of the success of the South Korean economy lie the “catch-up to leadership” strategy and the “adoption to innovation” policies. Initially, South Korean firms behaved as fast market followers rather than as creators of new technologies. The government chose to support their exports so as to gradually move up towards the high value-added end of the value chain. Korean firms not only focused on developing cutting-edge high technology, but also attempted to benefit from the exploitation of existing technologies. Accordingly, many Korean firms have been catching up with advanced firms in industrially advanced economies in terms of deepening and broadening their technological capabilities as well as enhancing their connections with customers in the advanced markets (OECD, 2009). Many of them are still producing large volumes of products under sub-contracting and licensing agreements, even though they have reached the innovation frontier in a variety of export products. In this way, the leading Korean firms are able to access new knowledge first, and then use their own R&D capacity and human capital to quickly adopt these technologies. Strategically, their innovation will focus on the need for some specific products or components in order to avoid challenging their subcontracting partners (especially the global market leaders) directly. As foreign partners can also benefit from these innovative achievements by getting components or services with higher quality/lower cost, they continue to outsource or sub-contract activities to South Korean suppliers.
Malaysia’s “middle income trap”
The GDP of Malaysia has expanded at around 6–8% per year on average over the past three decades. However, the country’s average income continued to be in the “high-middle-income zone” even in 2010. There is evidence of a declining contribution of labor productivity to growth—the contribution of total factor productivity growth to per capita GDP growth dropped from 30% in the period 1960–1980 to 12.5% in the period 1980–2000. The World Bank (2005) concluded that Malaysian GDP growth since 1980 has mainly been driven by physical capital accumulation rather than by total factor productivity improvement.
The basic concept behind the middle income trap is that, as domestic costs increase and new low-income countries undermine the competitiveness of labor-intensive manufacturing, developing countries in the middle-income group must move up the value chain toward production that involves higher technology content. Malaysia’s stagnation is due to a combination of various factors such as regulatory burdens, macroeconomic uncertainty and a shortage of skilled labor (World Bank, 2005). Above all, weak innovation capability has prevented many Malaysian firms from moving up to higher value-added stages as only a small number of them have moved from producing import substituting import-competing goods to becoming major exporters of those goods (Woo, 2009). The Global Innovation Index published by INSEAD shows that Malaysia’s overall innovation capability has been even lower than that of China. 27
The fundamental weakness of innovation in Malaysia is evident in its inefficient industrial policy and weak education system. Like other Asian emerging economies, Malaysia has realized the importance of innovation for its long-term growth. The problem is that, compared with its Asian neighbors, the Malaysian government did not have enough effective policy instruments to encourage local R&D activities or to accelerate technology spillovers from multinationals. Unlike many South Korean or Taiwanese firms who have successfully built up productivity in original design manufacturing or original brand manufacturing, most Malaysian firms’ technological upgrades heavily depend on original equipment manufacturing. While this is just like what many local firms in Singapore have done (Lai and Yap, 2004), the Singapore government managed to assist domestic firms to quickly move up the value chain by using assistance programs such as the Local Industries Upgrading Programme (LIUP) 28 to encourage multinationals to transfer their technology, know-how and human resource expertise to local enterprises. In the case of Malaysia, neither the New Economic Policy (NEP) nor Vision 2020 has provided similar support for local suppliers to upgrade through collaborations with multinationals.
A direct result of the weak education system in Malaysia—no Malaysian universities or institutes have obtained positions among the Top 100 of the Times’ World University Rankings—is the lack of skilled manpower required for industrial upgrades. More seriously, the ethnic Bumiputera preference policy discourages young talent from minority ethnic groups, typically Chinese and Indian, from receiving higher education. This institutionalized ethnic discrimination has, furthermore, prevented full mobilization of human resources and discouraged investment in the private sector.
Implications for China’s upgrade in the GVCs
The experiences of South Korea and Malaysia contain both encouraging and discouraging messages. Above all, innovation capacity is most vital among all the determinants of industrial upgrades. A country has to build up a pool of skilled labor by improving the coverage and the quality of its education system as well as investing in human capital and R&D in order to support its long-run growth. At the minimum, a well-functioning national innovation system 29 requires a commitment to technology-based development; a strong educational system and thereby highly skilled manpower; and good relationships between industry and tertiary institutions. Emerging economies can additionally take up “latecomer” advantages, such as trade openness and the international fragmentation of production that has facilitated technology-spillovers. With effective policy instruments, developing countries can attract foreign investment and encourage technologically advanced multinationals to accelerate the process of technology transfer.
As the Chinese economy faces the challenges that South Korea and Malaysia were facing 30 years ago, the experience from both countries could be a useful reference for Chinese policy-makers. However, one should realize that those policy instruments that have effectively fostered industrial upgrades in South Korea may not work for China. On the other hand, a nuanced look at Malaysia’s policies and policy instruments, and their relevance for China, is probably justified.
For instance, it will be much more difficult for Chinese firms to get access to advanced technologies from the USA or the EU even if they did attempt to follow a path similar to that South Korean firms have followed. The legal system in China is still immature despite substantial progress after the World Trade Organization accession, and the resultant lack of effective protection of intellectual property makes foreign subcontracting partners reluctant to assign tasks involving advanced technology to Chinese firms. Moreover, the potential threats from rising Chinese competitors will be much bigger than those from any other Asian country. Compared with Malaysia, inequality in Chinese society is also much more serious with a GINI index co-efficient of 0.48 in 2010. One of the common criticisms of Malaysia’s NEP comes from its emphasis on income redistribution. Although it is beyond the scope of this paper to discuss the NEP in detail, China could learn to use some of the instruments of the NEP to reduce the income gap there, a policy which may consequently contribute to social stability and stimulate industrial upgrades.
The Chinese economy faces problems arising from the unsynchronized pace of economic growth and domestic technological change. This becomes more serious when the country is under pressure to “move forward” to higher value-added stages in GVCs. It is probably not sufficient to rely on the functioning of the markets to solve these problems and achieve industrial upgrades, so the use of specific policy measures will probably be necessary to coordinate productive activities, facilitate innovation and assist industrial upgrading. The Chinese government may well need to do more to strengthen domestic innovation capacity.
China has applied the strategy of “opening the market for the exchange of technology”—aiming at multinationals’ advanced technology and capital; China also opened its domestic market and set a policy preference for foreign investment. The strategy focuses on those projects involving high-tech content since after three decades of capital accumulation capital is no longer as scarce in China as high technology is. Indeed, many cities in the economically developed coastal area have stopped inviting or have hesitated to invite new low-tech and labor-intensive projects and have turned to attracting investment with high technology or new technology by offering not only preferential tax conditions or lower land-use rent, but also bank loans with preferential interest rates. In the mean time, the government is encouraging labor-intensive projects to shift from the eastern and coastal provinces to central or western provinces.
Although this strategy has helped China quickly build up productivity in low-tech or even middle-tech stages, there is no guarantee that it will assist China to move further up the value chain. First, even though China has a large potential market, it is not certain how many foreign partners are willing to offer the high technology at the core of their long-term competitiveness simply in exchange for better market conditions. Because China is already the world’s second largest economy in terms of GDP, it is quite understandable that multinationals will worry more seriously about potential threats from Chinese competitors. Indeed, for most foreign investors, the increasing local productivity is supposedly one of the factors they take into account when making their initial investment decision, rather than being the main outcome of the investment. A large country like China first has to independently develop its capacity in a few technology frontiers and quickly build up productivity within them as this will give the country possibilities for “trading” domestic technology for foreign high technology. That is, China needs to move towards a strategy of “exchanging advanced technologies for other advanced technologies”.
Second, since a number of multinationals have already decided to locate production involving high technology in China, it is necessary to have a mechanism to assist domestic firms to adopt these technologies and become prompt followers, particularly as there are still big gaps in productivity in China’s export sector between the domestic producers and the foreign-owned firms. In this regard, the experience of South Korea and Singapore is relevant. In order to facilitate technology spillover, the Chinese government may think of supporting managers or technicians from domestic firms to obtain training in the multinationals, and offering preferential treatment to those foreign companies who commit to provide such training.
Third, with regard to its large population, China should still keep up labor-intensive production while attempting to move up the value chain, especially as industrial upgrades in the well-developed coastal areas will trigger the relocation of a large number of labor-intensive activities which would still be suitable for most less developed regions in central and western China. In most cases, Chinese domestic producers have also fully grasped the technology of these products. If there were sufficient policy preferences compensating for the disadvantages in infrastructure, communication and transportation, China could keep the relocation of labor-intensive activities to within the country—from the coastal regions to the hinterland, rather than abroad.
Fourth, the Chinese government should encourage domestic enterprises to build their own value chains. Compared with some less developed ASEAN states or countries in central Asia, China already has several advantages in capital and technology. Therefore it may consider its neighbors as potential partners instead of as competitors. For instance, China is the most advanced economy in the Greater Mekong Sub-region. Although the direct participants, Yunnan province and Guanxi Zhuang Autonomous Region, are less developed areas of China, they nevertheless receive central government support to play an active role in sub-regional cooperation with Cambodia, Laos, Myanmar, Thailand and Vietnam. This situation provides an experimental field for Chinese firms to set up their own networks, play as the leader of the value chain and stay at the top of the value pyramid.
In the long term, China needs to fundamentally enhance its innovation capacity via improving the coverage, the quality and the fairness of the current education system. China has strongly emphasized the development of higher education but has not paid enough attention to lower-level education, particularly development in training skilled technical workers. This has directly led to a structural dilemma in the labor market, whereby, on one side, many firms are having difficulties in recruiting and keeping technicians and highly skilled workers, and on the other side, graduate unemployment is on the rise. To resolve this structural problem, the government should set up more industry-oriented training institutes at professional schools to supply more technical workers on demand. It will be a good option to establish joint training centers cooperating with leading multinationals.
Meanwhile, the government should shift its focus on educational reform from quantitative expansion to qualitative improvement. The decline in general quality should not be neglected. China has reformed its higher education system via commercialization, decentralization and increased enrolment (Wu and Zheng, 2009). China’s current higher education system is already the largest in the world, with one-quarter of all 18–22 year olds now in a tertiary institution, and hundreds of new universities established over the past decade. This attempt to expand the capacity of higher education is praiseworthy, but the problem for China is that it has been doing this in a “leap-forward” way, to the extent that not only the labor market, but also the available educational resources, cannot keep pace with the growth (Zhao and Sheng). The average student–faculty ratio in universities and institutions of higher education stood at 16:1 in 2006, compared with 4:1 in 1980. Farell and Grant (2005) estimated that fewer than 10% of the college graduates in China could work directly for a foreign company owing a lack of practical skills or the absence of teamwork.
Finally, the de facto unfairness existing in the Chinese education system should be eliminated. The experience of Malaysia shows that the damage resulting from educational unfairness in the national innovation system could be fatal. At the very least the unfairness will lower the efficiency of the whole innovation system, even though its negative impacts in China are not necessarily so serious owing to its much larger population base.
Concluding remarks
The implementation of an export-oriented growth model has helped China to kick start economic growth and achieve a rapid increase in GDP over the past three decades. However, it is not likely that advantages solely based on labor-intensive activities will sustain growth in the long run. The Chinese economy faces problems arising from the unsynchronized pace of economic growth and technological progress. One large bottleneck is the lack of fundamental competitiveness in high-tech, high value-added production. Although the logic of globally fragmented production is now well understood and the need for industrial upgrading is recognized also in Chinese political circles, there is no consensus view on how (i.e. via which policies) China could move up the value chain in order to protect the sustainability of its growth over time.
As a strategic impetus, with the government’s involvement, China can first of all set up its leading position on a few advanced technology frontiers, and shift its emphasis from “opening the market in exchange for technology” to “exchanging advanced technologies for other advanced technologies”. This does not mean that China should abandon labor-intensive industry immediately. Owning more technology advantages could strengthen China’s bargaining power in the international economic and technical cooperation. An essential message from South Korea’s success is the need to set up of an effective domestic innovation system to facilitate new technology adoption, and to stimulate domestic innovation. South Korea’s experience in achieving to industrial upgrades gradually without shuffling off labor-intensive activities overnight could also be desirable.
Footnotes
Funding
This research received no specific grant from any funding agency in the public, commercial or not-for-profit sectors.