08 June 2015
chain reaction

Asia's global value chains -- Part 1

Asia’s exports through global value chains have been a key driver of development. But Asia is not making the most of these value chains, and new risks and challenges are emerging.

“Where do you think that your iPhone was made?” This is my favourite question to my economics students at Tokyo’s Sophia University.

They all respond “China!”. But the situation is much more complex than that, as Chinese professor Yuqing Xing explained in his seminal paper on the iPhone. The iPhone is merely assembled in China, usually by the Taiwanese company Foxconn. And this assembly process accounts for less than 4% of the iPhone’s manufacturing value.

In reality, the iPhone is produced through a “global value chain” (GVC) which starts with its conception and design in California. High tech components come from Japan, Korea, Germany and the US, with Japanese components contributing fully one-third of the value of the iPhone. The iPhone is then assembled in China, while California manages the marketing and branding. The result of this supply “fragmentation” is that Apple directly employs only 63,000 of the more than 750,000 people globally involved in designing, selling, manufacturing and assembling its products.

Many of us still harbor a nationalistic perception of how products are manufactured. But this does not make any sense in today’s world of GVCs. Very few products are made in one country. Our exports depend on imports from other countries. Most products are thus made “in the world”.

Another example which is attracting a lot of attention is the Chinese smartphone boom led by companies like Xiaomi, Lenovo and Huawei, which are undercutting giants such as Apple and Samsung. But once again, a significant portion (sometimes up to half by value) of the insides of those handsets is made by Japanese companies.

A similar story can be told for clothing, much of which today is manufactured in China, Bangladesh, Vietnam, and Cambodia. For example, a jacket sold in the US for $425, but manufactured in China, might have manufacturing costs representing only 9% of the total sales value, according to the Fung Global Institute. US companies would account for much of the other 91%, through their intellectual property, services like retail, logistics, and banking, and profits. In other words, products like jackets, which seem to be manufactured goods, are substantially packages of intangible, knowledge-based services. In fact, all manufactured goods embody large shares of services.

In short, world trade and production are increasingly structured around GVCs which represent a new phase in the evolving globalization of the world economy. Production of goods and services is now fragmented into different phases, with many of these phases located in different countries, according to their comparative advantages. GVCs are typically led and coordinated by multinational enterprises (MNEs), whose investment decisions shape trade patterns, with a significant share of trade taking place within MNEs’ networks of affiliates. Overall, the OECD estimates that MNE-coordinated GVCs account for some 80% of global trade.

All things considered, Asia’s GVCs bring many benefits to the participating companies, countries, and consumers. For example, over the past 15 years, income associated with GVCs in China grew sixfold, even though MNEs still account for over half of China’s exports.

But we must extend a big thank you to our Japanese friends for their contribution to developing the GVCs of today. Asia’s GVCs really began to take off in the 1980s, led by offshoring by Japanese companies. So first of all, we must go back and tell the story of Japan’s rise as an exporting colossus.

Japan leads Asia’s export-driven development

When Japan began its long recovery from the destruction of World War 2, it focussed on export-oriented development. Being dependent on imports of natural resources, Japan needed export revenues to finance its imports.

In fact, Japan never practiced free and open trade and investment. On the contrary, the Japanese government played a very active role in transforming Japan from an exporter of low-tech to an exporter of sophisticated high-tech manufacturing products. While Japan did not practice free trade and investment, it did exploit its comparative advantage, based on its skilled and hard-working population.

Japanese infant industries were assisted by subsidies, barriers against imports and foreign investment, and privileged access to finance (this is known as the “developmental state" strategy). This assistance gave Japanese industry a jump-start, some breathing space for 'learning by doing', and enabled it to exploit economies of scale. From a nation that specialised in steel, ships, petrochemicals, cement and textiles in the 1950s and 60s, Japan moved on to automobiles, cameras, electronics, and office equipment in the 1970s and 80s, and is now a world leader in semiconductors, robotics, precision instruments, liquid crystal displays, and high-tech parts and components.

This development strategy, led by the "iron triangle" of business, bureaucrats and politicians, was very successful in engineering the upgrading of the Japanese economy. But not all attempts to foster infant industries worked, such as the cases of aviation and chemicals, as Richard Katz has argued. And while close relationships between banks, enterprises and their suppliers ensured stability, too many financial decisions were based on such close relationships, rather than rigorous credit assessment, resulting in many bad loans.

As Japan's exports flooded world markets, and it racked up large trade surpluses, Western governments pushed back. They tried to limit Japanese exports through protectionism, and by encouraging Japanese enterprises to invest in their markets.

In 1985, Western leaders pushed Japan to allow the yen to rise via the 'Plaza Accord'. As the higher yen adversely affected the competitiveness of its exports, Japanese companies began relocating labor-intensive parts of their manufacturing industry elsewhere in Asia, especially to East and Southeast Asia.

Until that time, Japan always had “value chains”, but national rather than GVCs. Big automobile and electronics companies, like Toyota and Sony, were typically surrounded by small and medium enterprises which supplied parts and components. Such big companies were also members of vast conglomerates, known as “keiretsu”, and much business took place within these groups. These national value chains were thus “unbundled” into GVCs following the hike in the yen.

Japan was not alone with its developmental state strategy. Korea implemented a similar approach, as government policies fostered the development of its own conglomerates, known as “chaebol”. And Korea was equally successful, as evidenced by its very rapid development, and the global market penetration of chaebols like Samsung, LG, Hyundai and KIA.

Birth of GVCs

Many factors combined to facilitate the development of GVCs, in addition to the movement in the value of the yen. Liberalisation of trade and investment policies meant that other Asian markets were more open, and companies could take advantage of their low labor costs. Governments offered great incentives like tariff free imports, and tax concessions, especially through special economic zones and export processing zones. Loose policies with regard to labor rights and environmental standards were usually the norm. And China’s membership in 2001 led to an acceleration of GVCs in the 2000s.

Declining transport costs also played a role, as it became less costly to ship components from one location to another. The falling cost of passenger aviation made it easier for managers and engineers to travel between locations. Rapid progress in information technology provided an essential tool for the coordination of what have become very complex value chains. The WTO Information Technology Agreement removed tariffs on key technology and telecoms products. And the close location of a large number of economies of diverse levels of development and comparative advantages provided an open opportunity to tie these economies together through GVCs.

Politics also played a role in the involvement of China in Asia’s GVCs. In 1978, Chinese Vice Premier Deng Xiaoping visited Japan, the first visit of a Chinese state leader to Japan. Deng visited a Panasonic TV factory in Osaka and asked company founder Konosuke Matsushita to help him modernize China’s electronics sector.

Moved by the personal appeal for help, Matsushita, then 83, vowed to do everything he could. He visited China and found factories using technology from the 1940s. Throughout the 1980s Matsushita transferred technology, trained Chinese workers and otherwise helped China modernize its industry through 150 separate projects.

China learned how Matsushita made everything from electric irons to transformers and semiconductors. In return, Matsushita earned the Chinese government’s goodwill and gained unparalleled expertise in manufacturing and selling in the Chinese market.

Panasonic's investment in China was just part of the wave of Japanese investment in emerging Asia that was a crucial to the establishment of the region’s GVCs. Over the years, Japanese companies have invested over $300 billion in Asia, with $100 billion in China. These investments were usually supported by Japanese government development assistance, which generally financed infrastructure. Some 23,000 Japanese companies now operate in China, employing 10 million Chinese workers, while Japan’s employment in Thailand is over 400,000.

And after Japan led the way in establishing Asia’s GVCs, multinational companies from other countries followed suit. This was the birth of “Factory Asia”.

Today, Japan makes another unique contribution to Asia’s GVCs, through its production of high-tech parts and components, as in the iPhone example discussed above. For example, today Japan accounts for 21% of semiconductor supply, 49% of optical components, 57% of image sensors, 40% of microcontrollers, 33% of display drivers and 60% of silicon wafers. Asian airline companies buying the Boeing 787 Dreamliner might be surprised to learn of the numerous Japanese components inside this “American plane”, things like the center wing box, forward fuselage, lavatories, wing box, tires, and prepreg composites.

Many of these parts and components are made by a new wave of small and medium Japanese companies, referred to as “hidden champions” by Professor Stefan Lippert of Tokyo’s Temple University. These products may fly under the radar because they are not highly visible, branded consumer products. But they are critical to the functioning of GVCs.

Before we leave the great story of Japan’s contribution to GVCs, we must also take a quick look at the downside.

Japan’s retrograde policies at home

While Japan has a great deal of “forward participation” in Asia’s GVCs through its outward FDI and exports, its “backward participation” is underdeveloped. In other words, Asia’s GVCs have very little visible imprint in Japan through the use of foreign intermediate products like parts or components, or the local presence of foreign investment enterprises. The vast majority of goods and services consumed in Japan reflect domestically created value added.

Going back to the developmental state days, Japan has always had very restrictive policies for inward foreign investment and imports. Although today, the Japanese government is actively promoting inward FDI under its Abenomics programme, as the US State Department says: “Foreign investors seeking a presence in the Japanese market or to acquire a Japanese firm through corporate takeover face a number of challenges, many of which relate more to prevailing practices comprising the business environment rather than to government regulations.” Among the most notable of these are an insular and consensual business culture that is resistant to hostile M&A, a lack of independent directors, cross-shareholding networks among listed corporations, and exclusive supplier networks and alliances between business groups that can restrict competition.

With large outflows and small inflows of FDI, Japan has always been an outlier among advanced countries. Its stock of inward FDI represents only about 3.5% of GDP, compared with 19% for the US or 29% for Germany, according to OECD statistics. Even North Korea’s stock of inward FDI, which represents 12% of GDP, is much higher than Japan’s. While Japanese companies boost economies and productivity overseas, and create many jobs (1.4 million jobs in the US automobile industry alone, for example), Japan receives a fraction of the same benefits in return.

In sharp contrast to Japan, while Korea also had very restrictive FDI policies in the early days of its rapid development, its reforms beginning in the 1990s have been both rapid and far-reaching. Based on the OECD FDI Regulatory Restrictiveness Index, Korea was the biggest reformer of its policies towards FDI between 1997 and 2010 among a sample of 40 developed and emerging countries. Korea’s stock of inward FDI now represents 14% of GDP, very much higher than that of Japan. Thus, it is not surprising that Korea’s exports embody an important element of foreign parts and components, often from Japan.

Another factor restricting both Japan’s and Korea’s participation in GVCs is the high level of protection of their very inefficient agricultural sectors. Both countries are among the very worst offenders in the OECD group of advanced countries. Along with Norway and Switzerland, Japan and Korea provide world record protection to their agricultural sectors, with well over half over of gross farm receipts coming from producer support.

In both countries, the agricultural sector failed to modernize in tandem with the manufacturing sector. Protection was ramped up to help farmers, rather than forcing them to become efficient. Thus, agriculture is now withering away, with the average age of farmers over 60 years.

Food security is often used as a justification for maintaining agricultural protection, even though Korea imports over 90% of its food requirements, and Japan imports 60%. In reality, developing an efficient agricultural sector, through reduced protection, is perhaps the best way to promote food security. A highly protected, low-productivity, inefficient agriculture does not help at all.

GVC opportunities

The advent of GVCs can offer a fast track to development. It is no longer necessary for one country to be capable of every phase in the production of, for example, an automobile or television, as was the case when Japan and Korea were in the midst of their fast growth periods -- their developmental state policies are no longer relevant to the new world of GVCs.

Today, it is only necessary to perform one stage or task in the GFC to be able to hook onto the development opportunities. Similarly, small and medium enterprises have greater opportunities to participate in GVCs, by exporting just one part or component.

Densely complex GFCs now criss-cross East and Southeast Asia for a wide range of products, notably electronics, automobiles, machinery and clothing. Indeed, GVCs are more developed in Asia than in any other part of the world.

Each country specialises in tasks according to their comparative advantages. For instance, Hong Kong and Singapore tend to specialise in logistics and finance, and be home to corporate regional headquarters. Japan and Korea focus on branded product designs and high tech components, Malaysia and Thailand specialise in mid-range manufacturing. Indeed, Thailand has become a regional manufacturing hub for the automobile industry in particular, being used by companies like Toyota, Mazda and Ford. China specialises in product assembly and lower-skilled manufacturing, Bangladesh and Cambodia in clothing manufacture, and Indonesia and Mongolia in natural resources. Companies from America, Europe and Japan have generally created and designed much of the products manufactured in GVCs. These advanced economies have been the major consumer markets, though this is starting to change with the rise of Asia 's middle class and the prolonged stagnation in many Western markets.

In short, GVCs enable participating countries to more effectively exploit their comparative advantage. East and Southeast Asian countries participating in GFCs have experienced very rapid economic growth, poverty reduction and rising incomes. GVCs have led to a dramatic increase in trade within the Asian region, especially of parts and components.

GVCs have also been empowering for women, even if they remain undervalued and are stuck in low-paid jobs. Women are very active working in factories for garments and textiles, electronics and commercial horticulture. In this way, GVCs improve women’s lives and can promote more inclusive development.

But not all Asian countries have managed to integrate into GVCs. Much of South Asia is missing the GVC boat, and being left behind, although India has been very active in the development of GVCs for IT-based business services.

What must a country do jump on the GVC train?

Since GVC participation by low and middle income countries is mainly driven by FDI from multinational enterprises, it is critical to foster an investment-friendly ecosystem. This means good transport, logistics and other infrastructure, human capital, open trade and investment policies, intellectual property protection, minimal red tape especially for customs procedures, and strong institutions. This is where South Asia has been found wanting.

And despite the great sophistication of East and Southeast Asia's GVCs, this region is not yet making the most out of its GVC opportunities. Most countries could make great improvements in their investment ecosystem.

Only Singapore, Japan, Hong Kong and Taiwan make it into the world top 20 in the World Bank’s Logistics Performance Index, and also in the World Economic Forum’s Global Competitiveness Index. Outside of North East Asia, most Asian countries score poorly in the OECD’s PISA study, which assesses the education performance of 15 year old students. Countries like China, India, Indonesia, Myanmar and to a lesser extent Malaysia have very restrictive FDI policies according to the OECD, while investors have great difficulty penetrating the Japanese market according to the US State Department.

And only Singapore, Japan, Korea, Hong Kong make it into the top 20 of the World Justice Project’s rule of law index. Needless to say, the rule of law is necessary for the respect of intellectual property, enforcement of contracts, and human and labor rights of staff working for multinational enterprises.
Tags: asia, global value chains, gvc, supply chain