Change of levels in China's economic playing field can result in smooth or hard ride for firms

The growth of manufacturing in China was one of the most important economic stories of the 20th century. China's ability to cope with the potential loss of manufacturing jobs will be one of the most important stories of the 21st century.

China's economic growth over the past 30 years has been extraordinarily rapid and broad because the country was able to shift enormous resources from low-productivity activities (agriculture) into higher productivity activities (factories). At the same time, technology and managerial skills were imported from abroad, partly through investment on the part of foreign firms that sought to take advantage of the country's large base of low-cost labor.

These "easy" sources of growth have now been largely used up, however, and China's advantage as a low-cost manufacturing site is rapidly eroding. The loss of labor-intensive manufacturing jobs is inevitable, and indeed should be welcomed. Costs are rising because China is growing richer.

Firms choose the location of their manufacturing activities based on calculations of multiple variables, and the "re-shoring" of manufacturing to relatively high-cost locations like the United States reflect these calculations. Although labor costs in the US continue to be higher than in China, in cases where transport costs are high, speed to market and market responsiveness is important. Or where there is a desire to cluster near key suppliers and research and development centers, the benefits of locating in the US will balance the slightly higher labor costs.

But these same calculations put China in an extremely fortunate position. First, the size of the domestic market creates a powerful pull for global firms. Foreign firms must locate a full-range of activities - not just low value-added assembly operations - within China to be able to customize for the market, and to respond quickly and flexibly to changes in consumer demand.

Secondly, the supply chains in China are extremely well-developed and the strengths of these networks are not easily or quickly duplicated elsewhere.

The challenge in China will be ensuring that Chinese firms are able to move into the higher value-added activities that are not reliant on low-cost labor.

In research that I have conducted with Loren Brandt, an economist at the University of Toronto, we analyzed a range of industries in the relatively mature manufacturing sector that are the core of the Chinese economy. Consistently, the sectors in which Chinese are most successful in upgrading their capabilities are those in which there is strong consumer demand in the full range of market segments and few restrictions on the types of firms supplying each segment.

On the demand side, the low-end segment is critical because Chinese firms have a natural advantage over foreign firms and provides space for firms to incubate their capabilities. The high-end segments provide firms with information on the attributes that higher-end users value, and the incentive to develop the capabilities necessary to deliver these attributes.

On the supply side, there need to be channels through which firms are able to acquire the information they need to technically upgrade. Knowledge and technology from domestic sources - domestic firms, research institutes and universities - are critical, as they are from foreign sources (technology licensing and foreign firms producing within China).

The role of the government is critical. By interfering on the demand side, through tariffs or other restrictions, state policy can remove crucial steps on the developmental ladder. By interfering on the supply side, through preferential access to credit and restrictions on entry, the government might inadvertently choke or eliminate the companies that are most capable of supplying a particular segment. It is extremely difficult for the policymakers to predict which firms will be most successful at responding to market demand.

Huawei, for example, is often touted as one of China's most successful global champions, but it was not initially targeted by the central government as a key firm in the telecom sector.

In essence, the objective of the government should be to create a playing field that allows domestic firms to capitalize on their natural advantages in the domestic market and for resources to flow to the firms that do so most effectively. If this is done well, China will be a formidable manufacturing power for many years to come.

The author is a professor of Chinese business studies at the Said Business School at Oxford University. The views do not necessarily reflect those of China Daily.

(China Daily 04/12/2013 page8)