CHINA
16 September 2014
China is climbing the global value chain
China is making good progress climbing the global value chain, according to Yuqing Xing, Professor of Economics at the Tokyo-based National Graduate Institute for Policy Studies.
China is making good progress climbing the global value chain, despite the unavoidable challenges, Professor Yuqing Xing told the ACI.
Xing has just completed a three-year appointment at the Asian Development Bank Institute (ADBI). He is returning to his position as Professor of Economics at the Tokyo-based National Graduate Institute for Policy Studies.
While at the ADBI, Professor Xing undertook important work on global value chains (GVCs). In one seminal paper, Xing analyzed how the iPhone widens the US trade deficit with China. In another paper, he measured the value added in China's exports.
GVCs offer new opportunities for industrialisation and development, according to Xing. Countries like China can plug into GVCs according to their comparative advantage. China undertakes the assembly phase of the iPhone (and many other electronics products), while the design and branding are done in the US, and high-tech components are made in Japan, Korea and Germany.
China's developmental success is due to it finding the right slot in the GVC -- the low-value added, labor-intensive slot. China is thus exploiting its large reserves of medium-skilled labor. The challenge facing China now is how to "climb" the GVC by undertaking higher value-added activities.
Emerging economies have greater opportunities for development than did Japan, for example, a few decades ago before the advent of GVCs. Japan needed to develop whole industries, like automobiles. It built up industrial capacity by buying and copying (through reverse engineering) technology and know how.
Today's GVCs in East Asia were initiated by Japan after the hike in the value of the yen starting in 1985. The fragmentation of the GVC into multiple phases was facilitated by information technology which enables the complex coordination of GVCs.
While it is now easier to find a slot in GVCs, there is also a risk of getting stuck doing low value added activities. Countries like China must be activist in seeking to climb to higher value added activities. Professor Xing suggested several strategies for taking advantage of the opportunities of GVCs.
First, being open to foreign direct investment, as China has been, is critical. For example, the iPhone is assembled by the Taiwanese company, Foxconn. And many other Asian and Western companies now have bases in China. As Chinese workers are employed by foreign investors, their skill and knowledge levels improve as they absorb knowhow -- this is also the case for local Chinese companies who do contract work for foreign investors.
Second, education and training of Chinese workers is critical to improve their ability to work for foreign companies, and to also improve their capacity to absorb knowledge and technology. The OECD PISA (Programme for International Student Assessment) indicates that China is doing pretty well for literacy, numeracy and scientific ability of 15 year old students. The city of Shanghai is now topping the program, ahead of other Asian, as well as Western countries like the US and Germany.
Third, outward foreign investment by China is providing a fast track up the GVC. When Chinese companies buy foreign companies, they are acquiring brands, distribution and marketing networks, technologies, and know how, much of which is embodied in the workforces of the acquired companies. Examples include Lenovo's purchase of IBM's personal computer business, Haier's acquisition of Sanyo, Suning Appliance's takeover of Japanese electronics retailer Laox, and Lenovo's joint venture with Japan's NEC.
What are the main challenges facing China as it climbs the development ladder, we asked Professor Xing. After all China is endeavouring to avoid the "middle income trap", where countries progress stops at a middle income level.
Xing noted that recent incidents highlight the challenge of maintaining product quality. The problem is that one or two high profile cases can tarnish the whole "China brand".
China doesn't have a meaningful system of product liability. As it has been developing rapidly, the government has been more concerned with protecting companies rather than consumers. This needs to change and the government needs to develop effective enforcement capacity.
Today, China can produce anything, but it must improve is quality. In particular, China has much to learn from Japan's excellent craftsmanship, professional diligence, and longer-term business orientation.
China has not yet reached the point of becoming an "innovation nation". It is still copying existing products like smartphones. The challenge is to do so as well, or better, than others, and to do so much more cheaply.
But China is upgrading its technology and innovating "along the value chain". By participating in just one slot of a GVC, a company can benefit from its exposure to other, adjacent, phases of the GVC.
While China's products may be lower in quality than those of Japan or the US, they are also much cheaper. They have thus been able to penetrate many emerging markets like Southeast Asia, India, Africa and Latin America.
Will the continuing appreciation of the Chinese exchange rate threaten China's position in GVCs?
No, was the firm answer from Professor Xing! The exchange rate has appreciated by 35% in recent years, with no impact. Foreign investment enterprises do not just shift major investments (which are "sunk costs") in response to exchange rate movements. If anything, movements in the exchange rate are very often a spur to improvements in efficiency. Also, over time, many companies experience falling costs as the scale of their production increases ("economies of scale"). Further, the impact of the exchange rate on a product's total costs of production are minor, when China's value added is small.
Professor Xing emphasised the importance of improving China's human capital. While Chinese youth, usually pushed by their parents, want to study at university, China needs more vocational education and training. Many university graduates have difficulty finding jobs, while the labor market is calling out for more technicians. It is important to change mindsets about education and training.
China's universities also need to encourage more free thinking and creativity. At the moment there is too much emphasis on rote learning and repeating answers.
Xing remarked that when he was a student in China, he had to find the answer to the question. But when he studied in the US, the challenge was to find the question. "What is the right question?" Only by finding the right question can we really solve the world's problems.
In light of all these factors, Professor Xing is very confident of China's ability to climb the GVC.
His own research indicates that China is gradually contributing more and more value added to its exports. The domestic value added in China's processing exports (where China assembles imported components) has increased from 25-30% in 1997 to 45% in 2012. And such processing exports have declined as a share of total exports. This trend will likely continue, as processing exports represent a high share of exports to slow-growth high income countries, but a small share of exports to high-growth lower income countries.
"All things considered", said Professor Xing, "China seems very likely to avoid falling in a middle income trap. The prospects for continuing to climb the GVC in the years ahead look very strong."
Executive Director
Asian Century Institute
Xing has just completed a three-year appointment at the Asian Development Bank Institute (ADBI). He is returning to his position as Professor of Economics at the Tokyo-based National Graduate Institute for Policy Studies.
While at the ADBI, Professor Xing undertook important work on global value chains (GVCs). In one seminal paper, Xing analyzed how the iPhone widens the US trade deficit with China. In another paper, he measured the value added in China's exports.
GVCs offer new opportunities for industrialisation and development, according to Xing. Countries like China can plug into GVCs according to their comparative advantage. China undertakes the assembly phase of the iPhone (and many other electronics products), while the design and branding are done in the US, and high-tech components are made in Japan, Korea and Germany.
China's developmental success is due to it finding the right slot in the GVC -- the low-value added, labor-intensive slot. China is thus exploiting its large reserves of medium-skilled labor. The challenge facing China now is how to "climb" the GVC by undertaking higher value-added activities.
Emerging economies have greater opportunities for development than did Japan, for example, a few decades ago before the advent of GVCs. Japan needed to develop whole industries, like automobiles. It built up industrial capacity by buying and copying (through reverse engineering) technology and know how.
Today's GVCs in East Asia were initiated by Japan after the hike in the value of the yen starting in 1985. The fragmentation of the GVC into multiple phases was facilitated by information technology which enables the complex coordination of GVCs.
While it is now easier to find a slot in GVCs, there is also a risk of getting stuck doing low value added activities. Countries like China must be activist in seeking to climb to higher value added activities. Professor Xing suggested several strategies for taking advantage of the opportunities of GVCs.
First, being open to foreign direct investment, as China has been, is critical. For example, the iPhone is assembled by the Taiwanese company, Foxconn. And many other Asian and Western companies now have bases in China. As Chinese workers are employed by foreign investors, their skill and knowledge levels improve as they absorb knowhow -- this is also the case for local Chinese companies who do contract work for foreign investors.
Second, education and training of Chinese workers is critical to improve their ability to work for foreign companies, and to also improve their capacity to absorb knowledge and technology. The OECD PISA (Programme for International Student Assessment) indicates that China is doing pretty well for literacy, numeracy and scientific ability of 15 year old students. The city of Shanghai is now topping the program, ahead of other Asian, as well as Western countries like the US and Germany.
Third, outward foreign investment by China is providing a fast track up the GVC. When Chinese companies buy foreign companies, they are acquiring brands, distribution and marketing networks, technologies, and know how, much of which is embodied in the workforces of the acquired companies. Examples include Lenovo's purchase of IBM's personal computer business, Haier's acquisition of Sanyo, Suning Appliance's takeover of Japanese electronics retailer Laox, and Lenovo's joint venture with Japan's NEC.
What are the main challenges facing China as it climbs the development ladder, we asked Professor Xing. After all China is endeavouring to avoid the "middle income trap", where countries progress stops at a middle income level.
Xing noted that recent incidents highlight the challenge of maintaining product quality. The problem is that one or two high profile cases can tarnish the whole "China brand".
China doesn't have a meaningful system of product liability. As it has been developing rapidly, the government has been more concerned with protecting companies rather than consumers. This needs to change and the government needs to develop effective enforcement capacity.
Today, China can produce anything, but it must improve is quality. In particular, China has much to learn from Japan's excellent craftsmanship, professional diligence, and longer-term business orientation.
China has not yet reached the point of becoming an "innovation nation". It is still copying existing products like smartphones. The challenge is to do so as well, or better, than others, and to do so much more cheaply.
But China is upgrading its technology and innovating "along the value chain". By participating in just one slot of a GVC, a company can benefit from its exposure to other, adjacent, phases of the GVC.
While China's products may be lower in quality than those of Japan or the US, they are also much cheaper. They have thus been able to penetrate many emerging markets like Southeast Asia, India, Africa and Latin America.
Will the continuing appreciation of the Chinese exchange rate threaten China's position in GVCs?
No, was the firm answer from Professor Xing! The exchange rate has appreciated by 35% in recent years, with no impact. Foreign investment enterprises do not just shift major investments (which are "sunk costs") in response to exchange rate movements. If anything, movements in the exchange rate are very often a spur to improvements in efficiency. Also, over time, many companies experience falling costs as the scale of their production increases ("economies of scale"). Further, the impact of the exchange rate on a product's total costs of production are minor, when China's value added is small.
Professor Xing emphasised the importance of improving China's human capital. While Chinese youth, usually pushed by their parents, want to study at university, China needs more vocational education and training. Many university graduates have difficulty finding jobs, while the labor market is calling out for more technicians. It is important to change mindsets about education and training.
China's universities also need to encourage more free thinking and creativity. At the moment there is too much emphasis on rote learning and repeating answers.
Xing remarked that when he was a student in China, he had to find the answer to the question. But when he studied in the US, the challenge was to find the question. "What is the right question?" Only by finding the right question can we really solve the world's problems.
In light of all these factors, Professor Xing is very confident of China's ability to climb the GVC.
His own research indicates that China is gradually contributing more and more value added to its exports. The domestic value added in China's processing exports (where China assembles imported components) has increased from 25-30% in 1997 to 45% in 2012. And such processing exports have declined as a share of total exports. This trend will likely continue, as processing exports represent a high share of exports to slow-growth high income countries, but a small share of exports to high-growth lower income countries.
"All things considered", said Professor Xing, "China seems very likely to avoid falling in a middle income trap. The prospects for continuing to climb the GVC in the years ahead look very strong."
Author
John WestExecutive Director
Asian Century Institute
REFERENCES:
- Professor Yuqing Xing's personal homepage- How the iPhone Widens the United States Trade Deficit with the People’s Republic of China, by Yuqing Xing and Neal Detert. ADBI Working Paper No. 257. December 2010 Paper revised May 2011
- Wall Street Journal Professor Xing's work on the iPhone. 15 December 2010.
- The People’s Republic of China’s High-Tech Exports: Myth and Reality. Yuqing Xing. ADBI Working Paper No. 357. April 2012
- Measuring Value Added in the People’s Republic of China’s Exports: A Direct Approach, by Yuqing Xing. ADBI Working Paper No. 493. August 2014