Barry Naughton
“China’s Economic Growth and Technology Development: International Linkages and Implications for the US.”
Before the
U.S.-China Economic and Security Review Commission
Hearing on “China as an Emerging Regional and Technology Power: Implications for U.S. Economic and Security Interests.” February 12, 2003
RAPID GROWTH AND TECHNOLOGICAL DEVELOPMENT
As everyone knows, China is booming. Economic growth in 2003 hit 9.1%, despite a significant temporary slowdown in the second quarter due to the SARS epidemic. Production of passenger cars shot past 2 million units last year, 80% more than the year before. Exports grew 34.6%, but imports grew even faster, increasing 39.9%, and China emerged as the fourth largest trading nation in the world. Seen for years as a place of enormous economic potential, China is beginning to realize its potential.
The magnitude of change is especially striking in high tech industry, particularly electronics manufacturing. Some time during 2001, China emerged as the clear location of choice for new production and assembly operations by global electronics companies. Following a surge of investment, China’s exports of computers and peripherals increased by 54% in 2002, and then doubled in 2003, reaching $40 billion. Exports of electronics components, telecom equipment, and TV/ AV equipment have doubled in two years, from 2001 to 2003, and surpass $35 billion for the three categories together. The center of gravity of the global electronics assembly industry is moving to China.
China’s domestic market has now grown to be large, on a global scale, for a number of high tech products: telecommunications equipment (infrastructure and handsets), consumer electronics (especially television and video), and personal computers. The confluence of these big downstream markets has created huge demand for upstream products, including integrated circuits, display panels, and other high technology components. The vast majority of these items are still supplied by imports, but China has witnessed, since 2001, the birth of a handful of modern semiconductor firms that are only about two years behind the international technological frontier. Even highly sophisticated industries like chip design have made a small but significant start in China.
China’s rapid growth and dramatic technologic trajectory pose challenges to the United States. Like any economic relationship mediated through the market, the relationship has elements of competition and rivalry, as well as cooperation. However, it is a mistake to view the relationship solely or primarily in terms of rivalry. Rather, rapid Chinese technological development has come in the framework of international production networks that are predominantly coordinated by U.S. companies. Chinese firms fit into production, design and supply chains that are orchestrated by US companies. These relationships work strongly to the advantage of US companies and consumers. In the remainder of this written_testimonies, I will put China’s trade and technological relations in a broad context in order to highlight a few key features.
A TRIANGULAR RELATIONSHIP
First: Taiwan is the key intermediary between the US and China in high-technology industry. It is simply impossible to speak about high-tech industry in China without bringing high-tech industry in Taiwan to the forefront of the analysis. Taiwan has tremendous technological resources. It has a higher degree of dependence on electronics manufacturing and export than any other economy in the world. Taiwan is also the second-biggest investor in China, after Hong Kong. It is a much larger investor than either the US or Japan. Moreover, in a big change from the early years when much of Taiwan’s mainland investment was in light labor-intensive manufactures—such as shoes, garments, and sporting goods—for the past five years, Taiwan’s investment has been overwhelmingly concentrated in electronics-related enterprises.
In 2002, the most recent year for which we have official Chinese data, Taiwan investment apparently made up 8% of incoming FDI in China. But FDI from tax havens including the Virgin Islands, Cayman Islands, and Western Samoa accounted for twice as much (16%) of incoming FDI, and it is known that the majority of this investment comes from Taiwan. Even if only half of tax haven investment were from Taiwan (a highly conservative assumption to allow some Hong Kong investment), then Taiwan accounts for 16% of total FDI, second to Hong Kong’s 35%, and far ahead of number three US (at 10%), or Japan (8%), and the EU-15 (7%). Data for 2003 are not available yet, but a preliminary ranking of the top ten investors has been published, and it shows continued growth of tax haven investment, with Western Samoa rising rapidly in popularity. Thus, the Taiwan share has almost certainly increased further. In addition, both Korea and Japan significantly increased their FDI in China in 2003, and moved ahead of the US for the first time since 1997 (in the case of Japan) or ever (in the case of Korea).
Second: Taiwan firms, and now increasingly China firms, have been involved in a long-running partnership with US firms. This partnership has been extremely beneficial to all sides. Initially with Taiwan and Singapore, but now increasingly centered in China, these partnerships have been crucial to the remarkable technological dynamism that the US has displayed in the past ten years. In general terms, US firms managed to create a division of labor in which US firms concentrated on research and development, but also on the creation of new products and new technological standards, while portions of the manufacturing were carried out in various places in the “China Circle,” or greater China. Whether the technology was the Internet, or the defining standards of the personal computer—the Intel processor and the Microsoft Windows operating system—US companies set the standards. However, the ability of US companies to actually set the standards depended on their ability to also produce the systems for a price that could earn consumer acceptance. Standards were not just mandated by powerful corporations: they had to win acceptance in an intensely competitive world market. And win acceptance they did, frequently to the disadvantage of firms in Japan or Europe.
This process was clearly at work in three key sectors: microprocessors, computers, and hard disk drives. In all three of these areas, US firms faced vigorous competition from Japanese firms in the 1980s. By the mid-1990s, in each of these cases, US firms had turned back the Japanese firms, and had established their systems as clearly predominant in the world market. It was not a simple matter of technological superiority. In many of the most relevant fields (such as magnetic storage capacity), Japanese technology was equal, or superior, to US technology. Rather, US firms prevailed by creating open, “modular” production networks that delivered lower costs and much faster time to market than Japanese firms were able to provide. Open technological systems in which any producer could “plug in” to the completed product, so long as he conformed to the dominant technological standard, proved to be superior from a cost standpoint. This permitted production chains to become vertically dis-integrated, allowing individual firms to specialize in the specific link of production in which they could be most efficient. The producers who emerged to fill this role were overwhelmingly located in the broader Chinese region. Sometimes these were US firm subsidiaries or joint ventures, and sometimes they were indigenous firms in Taiwan, Hong Kong, or Singapore. China region firms developed substantial technological and manufacturing capacities in partnership with US firms. In turn, they provided the low-cost manufacturing that enabled US-based design standards and products to prevail.
During the mid-1990s this model was simply pushed one step further onto the China mainland. As producers in Taiwan and Singapore moved up market, to more sophisticated components, they increasingly moved labor-intensive final assembly stages to the China mainland. There, they replicated the patterns which they themselves had pioneered in partnership with US firms. Producing sometimes through their own subsidiaries, and sometimes by subcontracting to indigenous firms, they began to build electronics industry clusters on the mainland, initially specializing in final assembly. This system has had three important corollaries:
1. China is a lot less high tech than it looks. Most Chinese “high tech” exports have actually just been assembly jobs, putting together high-tech components, brought in from the rest of Asia.
2. Trade fit into a triangular pattern. China imported enormous quantities of components and sub-assemblies, and then exported finished products, primarily to the US.
3. China established a whole system of “processing trade” (discussed in detail in Professor Hanson’s written_testimonies) to allow imported inputs to enter the country easily and without tax, so long as they were promptly assembled and re-exported. This part of the Chinese economy was low tax and free of government interference, even when the government was trying to steer the rest of the economy. It grew up under the predominant influence of US and Taiwan firms and investors.
In the last few years, some important changes have meant that this simple picture is no longer quite so simple. The export system is no longer as completely separated from the domestic market as before, and the traditional triangular trade is rapidly upgrading. Nonetheless, the fundamental framework is intact.
OPENING THE DOMESTIC MARKET
In the earlier stage of China’s export development, the export economy was quite separate from the domestic economy, which was protected by trade barriers and subject to pervasive government attempts to steer economic and technological development. With China’s entry into the World Trade Organization (WTO), this is now beginning to change. While China’s implementation of WTO commitments has been uneven, and frustratingly slow in some areas, the bottom line is that WTO entry really is transforming the Chinese economy and making it much more open. We can see this by examining trade statistics for “Ordinary Trade” imports: that is, goods imported for the Chinese domestic market, not involved in any export-processing regime. Even as overall trade and imports have grown rapidly, Ordinary Trade imports have grown much more rapidly, and have sharply increased their share of total imports. Ordinary trade imports in 1997 were only 27% of total imports, and only 4.3% of GDP. By 2003, this figure has soared to 46% of total imports, and a remarkable 13% of GDP. Ordinary Trade imports have grown 30% per year since 1997 (including a 46% jump in 2003). US companies that used to produce in China only for export are now beginning to develop mixed strategies that target the Chinese market as well. As China opens its domestic distribution networks this year and next year, those strategies will become increasingly powerful. (For example, Dell Computer, which is already gaining market share in China’s domestic market, will adapt a range of new sales initiatives.)
Moreover, there has been a dramatic shift in the Chinese government’s effort to shape China’s technological trajectory. To be sure, the Chinese government is still aggressively interventionist, and tries very hard to foster national technological capabilities. But the old-style industrial policy, picking “national champions” and propping them up with loans and preferential policies, or forcing foreign firms to partner with domestic firms and transfer key elements of their technology—these policies are largely finished. They have been discarded by the Chinese government because they simply didn’t work. Instead, the Chinese government now seeks to foster key domestic industries across the board, providing the same privileges to big and small firms and (more crucially) to domestic and foreign firms alike. The government promotes technological standards that it believes will give a competitive advantage to domestic firms. These policies are still sometimes intrusive and controversial, and occasionally push the boundaries of what is permissible. They are also policies premised on the belief that the most the government can do is temporarily influence market conditions, and if it acts skillfully, contribute to long-term development by providing temporary advantage to local firms.
Much more important is the investment in physical infrastructure and education the government provides. China’s technological successes would be inconceivable without both. For example, the new network of limited access highways, now second only to the US in length; and the fiber optic telecom backbone network, are both essential to economic progress. Even more important, a sustained effort in tertiary education has brought the proportion of China’s work force with some college education (about half in 3-year technical schools) from a sorry 0.9% in 1982, to a respectable 4.7% in 2000 (But compare the 52% in the US). The Chinese government’s ability to sustain this investment effort has been far more important than the hit-and-miss fragments of “industrial policy,” even in its most recent, relatively sophisticated, version.
A MORE COMPLEX TRIANGULAR RELATIONSHIP
The recent surge in China’s technological development has been accompanied by a transformation of economic interactions beyond the simplest version of the triangular model. Originally, there were certain links in the production chain that were simply too technically sophisticated to be replicated in China, and the only activities in which China participated were the less sophisticated stages of global production chains. That has changed. But before we examine the differences, let’s look at the continuities:
First, China’s high tech exports still come predominantly from a few coastal clusters where foreign investment is concentrated. More than 80% of China’s “high tech” exports in 2003 came either from Guangdong or from the Lower Yangtze (greater Shanghai) region. Well over half the total comes from five industrial clusters in Dongguan, Shenzhen, Suzhou, Kunshan, or Shanghai. Each of these clusters has lots of foreign investment, and a strong Taiwan presence. The producers are either foreign firms or closely linked subcontractors qualified by the foreign firms. Foreign firms continue to increase the share of China’s exports they produce, reaching 55% in 2003.
Second, the triangular pattern of trade and deficits persists. China has a huge surplus with the US, but deficits with its East Asian neighbors that are almost as large. The $120 billion deficit with Chinese that the US projects for 2003 is part of a network that also produces Chinese deficits of $40 billion with Taiwan, a $24 billion deficit with Korea, a $15 billion deficit with Japan, and deficits of $8 billion and $5 billion with Malaysia and Thailand respectively. Most of the deficit with China’s neighbors consists of semi finished goods or components. Overall, China runs a modest surplus (1.8% of GDP).
However, China’s participation in these networks is no longer as predictable as before, and is not entirely confined to the final assembly stage. For example, China has begun to manufacture integrated circuits that are not far behind the world leading edge. These are the offshoot of the integrated circuit fabrication industry in Taiwan that caught up with the world technological frontier around 1995. The individuals now starting “trailing edge” IC factories (“fabs” or “foundries”) in China gained their experience in Taiwan firms, and before that in US firms. The outstanding example is Richard Chang (Zhang Rujing), head of Semiconductor Manufacturing International Corporation (SMIC), based in Shanghai. Literally thousands of engineers and managers have come from Taiwan to China to launch this industry. SMIC is now mass-producing chips at .18 micron, while Intel’s new Prescott processor, released February 2, uses .09 microns. Thus, the gap between SMIC and Intel has shrunk to slightly less than 2 generations of chips. In related fashion, China—again following Taiwan—has begun to develop significant chip design facilities, with substantial government money going into training and research institutes. However, overall chip design capabilities are still rudimentary, and value of sales is limited: about US $200 million in 2002.
With China moving up the value chain into more sophisticated activities, and with output and exports exploding, is the old model obsolete? In fact, the underlying structure of the old model remains intact, while the networks undergo continuous rapid upgrading. The result is an increasingly detailed and increasingly complex division of labor. Certain skills that were once scarce, are gradually diffusing, and China has taken advantage of this trend, and is in turn a major beneficiary. The ability to manufacture sophisticated ICs is becoming much more widespread. East Asia (outside Japan but including China) has dramatically increased its share of global production, and the European industry has also revived. But while IC fabrication skills have diffused, the sophistication and complexity of the entire value chain—including design, fabrication, and integration into final uses—has continuously increased. As the chips themselves have developed much more capacity and are much cheaper (following Moore’s Law), other parts of the value chain, such as chip design, loom larger in the overall cost structure. Moreover, downstream uses for the chips diversify away from the formerly dominant personal computer, to include all kinds of new applications: new wireless products and digital video products, especially. These diverse end products imply even greater demands on the design process, particularly with the advent of complex “system on a chip” (SOC) products. Therefore, designers have been forced to de-construct the design process, breaking it down into discrete steps, creating re-usable modules, and “mechanizing” some activities, in a way that echoes what happened to the hardware production process beginning thirty years ago. Stages of the design network are relocating to Asia (first Taiwan, then China) as well.
In this process, production and design networks are becoming so much more complex that they can no longer be reduced to any simple, uniform characteristic. Nor can China’s participation be pigeon-holed as it could earlier. But we can ask: Are these changes overturning the kinds of relationships that existed earlier, or are they extending them? The answer is clearly that these are evolutionary changes that are highly consistent with the pre-existing relationship among firms in the US, Taiwan, and China. In the case of IC design, for example, specialized design firms provide the most sophisticated design services, and also produce the design “building blocks” that must be integrated into a specific chip design. In order to tie together various processes efficiently, leading multinational corporations attempt to develop “platform leadership” strategies in which they make decisions about the overall system architecture, the interfaces among different parts of the design, and the degree of intellectual property protection they seek to maintain. In both these stages, US firms play a predominant role. Specialized global suppliers of design building blocks are predominantly US (indeed, California) firms, including MIPS, Rambus, and DSP. “Platform leadership” is exerted by large multinationals like Cisco, Dell, or Intel. These “Global flagships” preside over both global production and global design networks. Firms in China, and in Taiwan (which still overshadows Chinese firms in design capabilities) are integrated into this overall system. Because design building blocks are still a long way from fully codifiable “plug and play” elements, ongoing technical assistance and sharing is required, and firms stress long-term cooperative relations with their design and manufacturing partners.
AMERICAN FIRMS ARE ARCHITECTS OF GLOBAL NETWORKS THAT INCORPORATE CHINA
American firms, in other words, still play crucial roles as the architects of global design and production networks. US firms manage these networks so that, whenever possible, there are multiple suppliers in China. The high-tech clusters—such as the five clusters that account for more than half the hi-tech exports—generally have multiple suppliers in close proximity competing for similar business. The network architects maintain a degree of competitive pressure, even as they build long-term cooperative relations with their most reliable, and highest quality suppliers. Taiwan intermediaries often cooperate in maintaining this intense cost pressure on suppliers.
Indeed, this kind of structure is common in US trade relations with China, even outside the high-tech sector. Companies that bring in running shoes, toys, or garments nearly always maintaining contractual ties with a number of local suppliers. Moreover, enormous changes—and significant productivity gains—have taken place in American retailing and distribution in the past twenty years due to the sustained focus on reducing inventory. A single-minded focus on reducing inventory has led American retailers to insist that suppliers produce smaller batches, deliver goods more quickly, and demonstrate greater flexibility to respond to constantly changing demand. Where have US retailers found suppliers willing and able to do this? In China, of course, with the relationship again mediated by Taiwan and Hong Kong businesses. It is not an accident that the American retailer with the most sophisticated inventory management techniques, Walmart, is also the largest importer of goods from China ($12 billion last year).
These production networks, and the American position in them are strongly beneficial to the US, in three respects: (a) U.S. corporations, controlling the design, supply, and marketing channels, earn the bulk of the revenue from sales in the US of goods produced by them in China. For example, Seagate’s Wuxi factory exported $1.22 billion worth of hard disk drives in 2002, predominantly to the US. However, this one factory also imported $1.27 billion worth of components in that year. Value-added in China was a small percentage of the value of the goods imported by the US, certainly less than 10% of the total. More crucially, a rough calculation indicates that over 50% of the value of those goods accrued to US citizens, either as wages in design, research, or marketing; or as profits. (Another 30-40% accrues to residents of other Asian countries who produce components assembled in China.) (b) U.S. consumers pay much less for goods. For example, the fact that American students and schools can now buy an excellent Dell Computer desktop for about $500 is the result both of technological progress and the transplanting of Dell’s formerly Taiwan-based networks to the mainland.
(c) Potentially most important: the partnership of US corporations and China-based factories has enabled the success of US research and corporate strategies. In a world marked by globalization and intensifying competition world-wide, the remarkable successes enjoyed by US corporations—and the US economy—in the past ten years have been by no means fore-ordained. The US has increased its economic weight among the OECD (developed) countries, and increased its technological importance as well. The fact that it has been able to do so is of course primarily due to US domestic factors, but the partnership between the US and China region producers has been a key enabling factor. China production has allowed US producers to implement low-cost solutions that have led to the competitive success of their strategies, products, and standards. The networks that enable that kind of success are becoming even more complex, and more inter-dependent, and their contribution to US technological and competitive capabilities are probably increasing.
CONCLUSION
The major economy that has lost relative position in the global economy in the 1990s was Japan. A major contributing factor was Japan’s historic crisis and its relative withdrawal from Asia and the world (Japan’s share of global trade and outgoing FDI declined substantially during the 1990s.) That is exactly the point: Preoccupied with its own problems, Japan did not take advantage of the opportunities on which US firms seized. They missed the opportunity to restructure their production networks, bring Asia and China closer into the production chain, and push down their own production costs. Recently, Japan has re-assessed its position. Restructuring in Japan—particularly in the electronics industry—has accelerated. Investment in China has surged, and surpassed US investment last year for the first time since it fell behind. At this juncture, exactly what the US should NOT do is to emulate what Japan did in the 1990s. According to Ernst (2003), the Japanese tried “to retain an unequal division of labor that ke[pt] the development and production of leading-edge and high value-added products and production stages in Japan. They also tr[ied] to minimize possible leakages of technological knowledge. But their capacity to sustain this flying geese pattern of specialization [was] gradually eroded by intensifying competition both from above and below” It would be particularly ironic if we launched onto this failed path just as Japan, coming out of a lost decade, was committing itself to a renewed involvement in China and Asia.
REFERENCES
Chinese trade and investment data from the Ministry of Commerce at www.mofcom.gov.cn/, US data from Department of Commerce Bureau of Economic Analysis at www.bea.gov/bea/international/. Deficits calculated from importing country statistics. Estimated size of China’s IC design industry from Mike Clendenin, “Link by link, China crafts its industry,” EE Times, December 8, 2003
Ernst, Dieter (2004) “Internationalisation of Innovation: Why is Chip Design Moving to Asia?" Honolulu: East-West Center Economics Working Paper # 62; forthcoming in International Journal of Innovation Management
Ernst, Dieter (2003), “A Contrarian Force in Asian Regionalization? Transformations of Japanese Production Networks in the Electronics Industry,” in Katzenstein, P.J. and Takashi Shiraishi (eds), Remaking Asia: Beyond Americanization and Japanization, Ithaca: Cornell University Press.
Howell, Thomas et al. China’s Emerging Semiconductor Industry. Washington, D.C.: Dewey Ballantine LLP, for Semiconductor Industry Association, October 2003.
Naughton, Barry, 1996, “China’s Emergence and Prospects as a Trading Nation,” Brookings Papers on Economic Activity, 2: 1996, pp. 273-343.
Naughton, Barry and Adam Segal, “Technology Development in the New Millennium: China in Search of a Workable Model,” in William Keller and Richard Samuels, eds., Crisis and Innovation: Asian Technology After the Millennium. New York: Cambridge University Press, 2002. Pp. 160-186.