16 12 2018

Why does the US hate “China 2025”?

China is no longer a low-wage economy. To avoid being caught in a trap where its products are neither really cheap, nor really good, it wants to go upmarket, moving from low-tech standard products to high-tech, high-value products. This is what the strategy “China 2025” is about, supported by big government funding. Is this a legitimate strategy, or is it unfair competition? The US thinks the latter and is determined to do what it can to stop it. But they are unlikely to succeed.

I have by chance had the privilege as part of my work to follow China’s development closely with regular visits to the country. When I first visited the country in 1998, China was decided to join the World Trade Organisation, WTO. I must admit, I thought they were crazy. China was a that moment still a very poor country, and the economy was mainly dedicated to assembling products for Western Companies, based on cheap hard-working labour. My thought was that by joining the WTO, they would as so many other developing countries get stuck in the role as low cost producers, as WTO would not permit them to carry out the industrial policy needed to break out of that role. China finally joined WTO in 2001, and it has developed enormously since. So I was clearly wrong.

The reason seems to be two things. Firstly, WTO rules actually accepts that developing countries can support industrial development in a way developed countries are not allowed to – but very similar to how these countries developed themselves in the past. Secondly, this issue is not well-defined. It is not clear which countries are in the developing country category (it is self-defined), and it is not clear what they are actually permitted to do. So it is up to other member state to complain, if they think something is wrong. China has clearly bent the rules – and in many cases rightly so. And because of the size of the country and their interest in getting access to the market, many countries have turned a blind eye. Now the US is up in arms, and even if EU and Japan keep a low profile to avoid antagonizing China, they are quietly supporting the US.

But can China still claim to be a developing country, and can its industrial policy be justified? If we look at the world’s ten biggest economies in purchasing power terms (that is, taking into account what you can buy for the money), China has since 2000 made a big leap forward. It has left India in the dust and is now richer than Brazil. But despite the breathtaking growth, China is actually still poor, with the modest stated goal of becoming a moderately prosperous society by 2021.

As mentioned, wage costs in China are now rising rapidly. Average hourly wages in China’s manufacturing sector trebled between 2005 and 2016 to $3.60. That’s more than five times hourly manufacturing wages in India, higher than any Latin American country (except Chile) and is more on par with countries such as Portugal and South Africa. So China wants to move up the value chain, and the 2015 strategy “China 2025” (actually it is called “Made in China 2025”) is one of the most recent policies to achieve this. You can of course find people who think that “China 2025” is a waste of money because we all know that Government interference in the production sector  is doomed to fail. Just as you could find people two decades ago who thought that the Chinese growth miracle was simply a result of the Government stepping aside and letting private firms do the job. If that was the case, nobody would bother. But most do.

The policy targets 10 industries: information technology (including artificial intelligence), robotics, aeronautics, high-tech shipping, rail transport equipment, self-driving and electric vehicles, and biopharma. The main instrument is to make public funding available to increase investments in a number of high-tech areas that are currently dominated by the United States, Japan and Europe, but which are considered crucial for the future development of these industries.

What is particularly thrilling for some foreign companies is that “China 2025” sets targets for market share by Chinese producers within a number of high-tech sectors. This is seen as a direct attack on the companies that are presently dominating these industries, and it is said to be a violation of WTO rules. China insists that as it is not mandatory but rather indicates policy goals and furthermore is open for participation by foreign companies, it is in compliance with the WTO rules.

What is my take on it? Firstly, it is no doubt necessary for China to avoid falling into the mentioned middle income trap (even if there are those who insist it doesn’t exist), and abundant evidence from countries that have succeeded in continuing developing (such as Japan, Singapore and Korea) tells us that industrial policy plays a big role in passing from one stage of development to the next. Secondly, will it work for China? Success it absolutely not guaranteed, but past Chinese experience indicates they may be able to do it. China has invested heavily in education so there is a big pool of well-educated young people, and sizeable funds are made available for research and development. This combined with targeted policy intervention has the potential to drive development within high-tech areas. There will be failures, but no doubt also many successes. So I think the policy has a fair chance of success - the main risk for China is not related to “China 2025” but rather to the high level of income inequality and the explosive growth in debts, a risk they share with other countries as e.g. the US.

But won’t it affect the rest of the world negatively, as the Chinese break into high-tech markets? That depends. If a Chinese Company takes over a monopolistic market from a Western Company and creates a new monopoly, there isn’t much to celebrate. But this is unlikely to happen. The most likely effect is more competition, more innovation and more choice. Some companies in the developed countries may not be able to survive, but most will adapt and develop. The example often cited to show how Chinese competition can be detrimental, is the solar industry. The Chinese solar industry is barely two decades old and now produces 60% of all solar panels in the world. It started with some Western Companies outsourcing production to China, but then the Chinese Government with favourable policies, including subsidies, succeeded in getting local companies set up. One of the big changes when China enters an industry is scale, and with scale comes economies of scale, and if there is competition, prices drop. And they have dropped dramatically. Furthermore, even if China produces 60% of all panels, they are also by far the biggest market for solar panels, as around 47% of the new installed capacity in 2018 is in China. So the "China-effect" has been that solar now is competitive even with coal, without any subsidies. The down-side is that some companies in the developed countries did not survive. Others moved on improving their technology to offer higher quality and more efficient products.

But let us look at a more recent example. One of the industries China is now trying to penetrate is semi-conductors, the small chips that traditionally go into computers (processors and memory), but which are now found in more and more products, partly as a result of the much hyped Internet of Things. As China is the main location for production of all sorts of goods, China is also the major user of semi-conductors, taking more than half of world production. Only 15% of the Chinese demand is produced in the country, the rest is imported. “China 2025” wants 40% of this demand to be covered by local production by 2020 and 70% by 2025, not necessarily by Chinese firms, but by production facilities located in China.

Why would they want that? As mentioned, one thing is that they want to move up the value-chain, but with the US cutting off Chinese telecom giant ZTE from US produced components earlier this year bringing the company to the brink of collapse, it became clear to the Chinese just how dependent they are on foreign supply and how easily this can be cut off by hostile foreign countries. This was, as it has been said, China’s “sputnik-moment”. So now it has become a national urgency to break this dependency. Thank you, Mr. Trump.

Will they be able to do it? There are two main elements in the production: the design of the chip (done in many cases by “fab-less” companies), and the actual production of it (done at “fabs” working on order). The “fabs”, of which most are located in the US, South Korea, Taiwan, Japan and Europe, are extremely expensive, but China is now investing heavily (around 31 billion USD) in the construction of fabs. The equipment providers are mainly from US and Europe, so they are cashing in.

Regarding design of the chips, China is still well behind, but it has made some progress lately. Huawei is now producing its own mobile phone processor (the latest called Kirin 890), which is close in specification to the most advanced processors from Apple, Samsung and Qualcomm (Snapdragon). But it is still – as is the Qualcomm processor - based on an (expensive) patent from the British company ARM. And to run the phone, Huawei still needs Alphabet’s Android operating system. Chinese company Zhaoxin is now producing a quite capable PC processor, based on a cooperation with US company VIA. And Chinese company Yangtze Memory Technologies is progressing on non-volatile memory (found in solid-state hard drives). So they are catching up.

Should we be worried? Actually, this should be beneficial to all of us, as the Chinese may disrupt harmful technology monopolies in the coming years, with very little risk that the Chinese companies will be able to establish new monopolies. So we are likely to get more choice and more affordable products. Perhaps even another smartphone operating system for those who are tired of Android’s quasi monopoly, as Huawei is said to be developing a Linux based alternative (as Samsung has tried without much success with their operative system Tizen). We may also get computers that are not based on the INTEL/AMD quasi monopoly but on open source hardware (based on the instruction set RISC-V instead of x86/ARM), meaning that small companies will be able to enter the market without having to pay heavy monopoly fees for using standards owned by INTEL/AMD and ARM. So don’t take all this hand-wringing about the Chinese seriously. In most cases (not all) it is likely to be a good thing.

What we should take seriously is the global uncontrolled gathering of data. And they are all in it: Google, Facebook, Microsoft, Amazon, Yandex, Vk.com, Tencent, Alibaba – you name it. Hand in hand with the intelligence agencies. But that is another story.

 To read first article on this theme, click here.


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Thorbjorn Waagstein

Thorbjørn Waagstein, Economist, PhD, since 1999 working as international Development Consultant in Latin America, Africa and Asia.

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