[Special Feature: The Future of Free Trade] Development Strategies and Bottlenecks of Chinese Industry: The Future of the US-China Trade War

2018/08/06

The Chinese economy has developed dramatically through 40 years of "reform and opening-up" policies. In 2010, China's nominal GDP overtook Japan's in dollar terms, making it the second largest in the world. In response, the Xi Jinping administration, which came to power in 2012, advocated the rejuvenation of the Chinese nation to the Chinese people and called for the realization of the Chinese Dream.

Prior to the discussion in this paper, let us briefly look back at how China achieved such dramatic economic growth.

Professor Kaname Akamatsu once proposed the "Flying Geese Model of Development." This refers to a development process in which emerging countries, in order to catch up with advanced nations, import capital goods in the early stages to establish industries, thereby enabling import substitution and eventually attaining export capacity. China's "reform and opening-up" basically followed this model, attracting foreign direct investment (FDI) through various preferential policies to compensate for the lack of capital and technology in the early stages. At the same time, it required foreign companies to balance their foreign exchange and mandated that they not only sell products and commodities within China but also conduct production activities domestically and export their products.

For China, attracting foreign companies became a shortcut to economic development, as not only capital but also superior technology and management know-how were brought into the country. Furthermore, it was expected that local companies would receive technology transfers from foreign firms, leading to the upgrading of the industrial structure. As a result, China became the "factory of the world" in just 40 years, and it is even said that it will overtake the United States to become the world's leading advanced nation in the not-too-distant future. In fact, the World Bank has pointed out that if China's nominal GDP is evaluated by the purchasing power parity (PPP) of the yuan, China's economic scale has already surpassed that of the United States.

Originally, Chinese people have a strong national consciousness that China is the center of the world. Over the past 100 years, the country was invaded by the Great Powers, and on top of that, civil wars and power struggles were incessant. The fact that the Chinese economy lagged far behind as a result of this fueled a Chinese complex and created a strong desire to surpass advanced nations as quickly as possible and restore its status as a world leader. Currently, an ideal atmosphere has been created for political leaders to consolidate their power base by responding to this national consciousness.

Furthermore, catering to such public sentiment, some researchers loudly exaggerate China's national power. Their leader, Professor Hu Angang of Tsinghua University, has consistently shown an optimistic view of the future of the Chinese economy and praises successive leaders of the Communist Party as great figures in Chinese history. At a recent seminar held in Beijing, Professor Hu boasted that "China's level of science and technology has already completely surpassed that of the United States."

While many researchers question this line of argument, the Chinese Communist Party and government seem to welcome such positive rhetoric, and the media also appears to receive it favorably. As a result, Chinese nationalism is expanding rapidly like a bubble.

Generally, when developing countries try to catch up economically, where they should start and the path they take varies by country. There is no single economic growth model that can be applied to every nation. Deng Xiaoping, who once promoted the "reform and opening-up" policy, described this as "crossing the river by feeling the stones."

Nevertheless, examining the cases of advanced nations reveals that there are many commonalities in the basic elements (fundamentals) for successful economic development. One is a high literacy rate and level of basic education. Japan spent 150 years since the Meiji Restoration building one of the world's most advanced foundations for basic education. Generally, emerging countries tend to emphasize elite education to achieve economic development, but raising the level of basic education is actually more important. Another important factor is to hurry the development of economic-related laws to guarantee the smooth operation of economic activities.

So, what did China pursue? At the end of the Mao Zedong era prior to "reform and opening-up," the Communist Party called on the people to realize the "Four Modernizations," which included science and technology.

However, science and technology are not the same thing. Much technology consists of inventions created by on-site engineers and workers. For example, the "Kanban" (Just in Time) system thoroughly implemented by Japanese automakers can be said to be the crystallization of rationalization and efficiency born from rich on-site experience. However, it is not science. Also, Kampo medicine was not created through the analysis of the molecular structures or components of herbs, but is the result of accumulating experience in administering them to patients. Probably even a Kampo doctor could not scientifically explain why a certain herb is effective for a specific disease.

Broadly speaking, China's success story was a strategy of attracting companies from industrialized nations to China and learning superior technology and management know-how from those companies. This strategy itself was brilliantly successful, but it also has flaws. For example, companies in industrialized nations that possess cutting-edge technology are constantly evolving and upgrading their technology. This is a gradual process involving the steps of mastering existing technology and developing new technology. However, because Chinese companies have not built up from basic technology, they cannot further develop the mastered technology on their own and continue to learn technology from foreign companies indefinitely.

Under these circumstances, it is also an undeniable fact that some Chinese companies are resorting to illegal acts instead of learning technology from foreign companies through legitimate methods. In the background, the psychology of the Chinese people trying to catch up with and overtake industrialized nations in as short a period as possible is likely at work.

Currently, behind the trade war against China initiated by the Trump administration, it is said that in addition to the trade imbalance, there is the illegal acquisition of high-tech technology from US companies by Chinese firms. Will China be able to break out of this situation? The outlook is not necessarily optimistic.

From 1958 to 1960 during the Mao Zedong era, the "Great Leap Forward" was promoted, mobilizing the entire nation to set completely unachievable steel production targets. As is well known, the Great Leap Forward ended in failure, devastating the countryside and, according to one theory, resulting in tens of millions of deaths from starvation.

And now, the Xi Jinping administration is promoting an industrial promotion plan that could be called a new Great Leap Forward, namely "Made in China 2025." However, originally, the main actors in industrial promotion should be companies, and the government should play a supporting role. In China, the government plays the leading role in everything. The lesson left by the former planned economy was precisely the failure of the government, but unfortunately, that lesson does not seem to have been sufficiently utilized.

An anomaly occurred in the Chinese economy around 2015. Exports, which had been expanding steadily until then, saw negative growth for two consecutive years in 2015 and 2016 (Figure 1). Trade is the lifeline for the Chinese economy. Why did exports, which had been growing steadily, suddenly slow down? Since no particular economic crisis occurred in China's export destination countries during this period, we must look inside China.

The most likely factor is the rise in labor costs, which is a burden for the export manufacturing industry. Figure 2 shows the trends in minimum wages in Beijing, Shanghai, and Guangzhou. Over the past 15 years, they have been raised by approximately 10% almost every year. Among China's export manufacturing industries, high-value-added industries such as semiconductors and machinery can handle the rise in labor costs to some extent, but for medium- and low-value-added industries such as shoes, textiles, and sundries, the surge in labor costs is a matter of life and death. Not only foreign companies operating in China but also local export companies are moving their factories overseas one after another.

However, this movement itself is not necessarily a negative factor for the Chinese economy. This is because if minimum wages are not revised during the process of economic development, worker dissatisfaction will grow and could develop into serious social problems. Rising wages can be said to be an inevitable result of economic development. What is important is to upgrade the industrial structure in line with the rise in wages. Upgrading the industrial structure means reducing the weight of low-value-added industries and increasing the weight of medium- and high-value-added industries from a macroeconomic perspective. To achieve this, China needs to work on technological innovation.

In summary, what is hindering China's economic development is not the rise in labor costs, but insufficient efforts to work on technological innovation and upgrading the industrial structure.

Looking across Chinese industry in general, one clear trend can be seen. Most of the heavy and large-scale industries such as steel and shipbuilding—the so-called Old Economy—are dominated by state-owned enterprises. In contrast, the so-called New Economy related to the internet has many private companies. State-owned enterprises are protected by government policies and receive financial assistance, and in recent years, under the "Strong-Strong Alliance" policy, mergers and acquisitions between large state-owned enterprises have been promoted, making their scale even larger. State-owned enterprises in shipping, petrochemicals, railway vehicle manufacturing, and steel are representative examples. To use the words of President Xi Jinping, state-owned enterprises are being made "bigger and stronger."

However, these words contain two contradictory meanings. This is because a big company is not necessarily a strong company. Has the performance of state-owned enterprises improved through the expansion of scale? State-owned enterprises have rapidly increased their market dominance through expansion and are enjoying more monopoly profits. On the other hand, their efficiency has not necessarily been strengthened. The excess capacity in heavy and large-scale industries that has become a problem in recent years all belongs to state-owned enterprises. Generally, in a private company, equipment and personnel are adjusted according to performance, and management rationalization is sought. In contrast, state-owned enterprises are protected by the government and enjoy monopoly profits in the market, so their efforts toward management rationalization are insufficient.

Ultimately, the Xi Jinping administration is trying to create substantial state-owned conglomerates by merging large state-owned enterprises as a symbol of the restoration of a powerful nation, but state-owned enterprises that do not make sufficient efforts toward management rationalization continue to hold a lot of excess capacity.

On the other hand, IT companies in the New Economy, such as internet search engines and online shopping, are driving the Chinese economy, but there are also challenges. For example, online shopping companies like Alibaba and Tencent are increasing sales thanks to 800 million internet users, but they depend on things like computer OS developed and standardized by US companies, and the technology itself is not controlled by Chinese companies.

In summary, Chinese industry is expanding its scale and increasing sales against the backdrop of a huge population, but its technological strength is not as strong as it is said to be. How to strengthen technological power is an important policy issue facing the Xi Jinping administration. And the aforementioned "Made in China 2025" is precisely an industrial promotion policy that seeks to strengthen the manufacturing industry in particular.

The "Made in China 2025" strategy is a policy in which the government focuses on fostering key industries. However, why did 40 years of "reform and opening-up" policies fail to promote Chinese industry? And can the government foster industry in the first place?

Let's take the automobile industry as an example. Not only China but almost all emerging countries have formulated national car strategies and worked on promoting the automobile industry. Surprisingly, however, China did not designate the automobile industry as a key industry during the Mao Zedong era (1949–76). This was because China faced an extreme oil shortage at the time, and automobile manufacturing focused on buses and trucks.

Since "reform and opening-up," the Chinese government included the fostering of the automobile industry as a priority item in its industrial policy for the first time. As a basic concept, it partially opened the automobile market to foreign capital and implemented preferential tax systems to attract direct investment from foreign manufacturers. Of course, if foreign manufacturers entered China as they were, there was a risk that they would dominate the domestic market. Therefore, joint ventures with Chinese manufacturers (mostly state-owned enterprises) were made a condition for foreign manufacturers entering China. Later, the entry of some private manufacturers such as Geely and BYD was also permitted.

However, looking at the subsequent development of the automobile industry, the gap in technological strength between Chinese and foreign manufacturers has not narrowed at all. One reason for this is that in the case of automobiles, there are as many as 30,000 parts, so it is necessary not only to improve the quality of parts but also to have the technology for integration in assembly. Therefore, it takes time for emerging country manufacturers to catch up.

In the end, the Chinese government gave up on improving the technological level of fuel-engine vehicles (gasoline and diesel) and shifted its focus to the development of electric vehicles (EVs), where it can stand on the same starting line as foreign manufacturers. Electric vehicles have fewer parts compared to fuel-engine vehicles. The key component is the onboard battery to run the electric motor. Incidentally, the volume of onboard batteries shipped by Chinese companies is currently said to be the highest in the world.

In fact, an important suggestion can be obtained from the consideration of the catch-up process in the automobile industry. What is hindering China's industrial development is not so much a lack of technological strength as the atmosphere of the "Great Leap Forward" that permeates Chinese society. The Great Leap Forward is an approach that tries to catch up with advanced nations in a short period; to use an analogy, it is the idea of trying to make a Chinese company that is like a toddling baby run all of a sudden. However, the basis of manufacturing is to foster excellent engineers and diligently polish technology. In the current situation, even if they receive technology transfers from foreign manufacturers, Chinese manufacturers cannot continuously develop that superior technology.

In this atmosphere, Chinese companies try to obtain technology from foreign companies by any means necessary. It is precisely the sense of caution against this that forms the background of the current US-China trade war. The trade war happening before our eyes should be understood not as a problem of trade imbalance, but as a US counterattack against the challenge of Chinese companies trying to obtain the technology of US firms.

China expanded its economic scale to the second largest in the world through 40 years of "reform and opening-up" policies. However, the technological strength of Chinese companies is, on average, still at the level of middle-income countries. The Chinese government is impatient to improve its technological strength in a short period, but that very impatience has become a bottleneck for improving the technological level. Manufacturing and the human resource development for it are, so to speak, a 50-year plan, or rather, a 100-year plan. As the saying goes, "more haste, less speed," the more impatient one is with manufacturing, the less the technological strength improves. There are no shortcuts in technological development.