Snehal (name changed) was setting up a fine dining restaurant in South Mumbai. When I met him a few years ago, Shehal had just returned from a trip to China. He had gone there to buy furniture and fittings for his restaurant. He described his experience of walking through a humongous mall, accompanied by a salesperson and a ‘tiny little Chinese girl’ with a notepad. Every time he liked something, the girl would write it in her pad. The furniture was delivered to him in Mumbai and paid for in Indian Rupees. According to Snehal, a lot of what he bought was just not available in India. What was available in India was much cheaper in China. And finally, the whole experience of buying was hassle free: something he did not think could have happened here. This is just one of the countless stories I have heard or read about manufacturing in China. Goods are cheaper there, there is more variety, the quality is good and the overall experience is excellent. Ignore the current troubles that China is facing, China is a manufacturing superpower. It is the manufacturing superpower. How did China do it? In this post, I make a few observations without pretending to have anywhere near the complete answers. But first, let us take a quick look at why manufacturing is important.
The economic historian Joe Studwell has argued that early in the development cycle of a society, the best way to increase productivity is by manufacturing. This is because the majority of the population is unskilled, and machines used in manufacturing increases its productivity most easily. All countries that have made a breakthrough into the high income bracket in the last century — Japan, Taiwan and South Korea — started with manufacturing. This allowed large proportions of their population to be productive and earn relatively high wages. There are a few people who believe that India can bypass manufacturing by focusing on high value services such as Information Technology. I would like to remind them that IT in India employs a very small percentage of the population. Not very surprising when you realize that only 1 in 4 youth in India enrolls in college!
China — like its successful neighbors — focused on manufacturing and has flourished.
China’s amazing manufacturing story
In his book, India’s China Challenge, Ananth Krishnan describes the Yiwu market in Zhejiang. The market stretches over 5.5 million square meters or 750 football fields. From Tanjore style paintings of baby Krishna, to ‘authentic’ Rajasthani jewelry to ‘authentic’ Kanchipuram sarees the market has everything. According to Krishnan, 4,00,000 Indian businessmen visited the market every year. Imagine being so good at manufacturing that you make traditional goods of other countries!
China doesn’t just manufacture trinkets. It is very good in many complex industries as well. In his book, China’s Economy, Arthur Kroeber has a list,
‘China has moved from being a producer of low-end textiles and cheap consumer goods in the 1980s to a country with successful and large-scale automotive, shipbuilding, machinery, electronics, chemicals, and precision instruments industries.’
‘Chinese firms are important producers of ships, high-speed trains, mining and construction machinery, and power generation equipment, including nuclear reactors.
One of the challenges of writing this essay is that the word manufacturing covers a wide variety of activities. From making cheap plastic spoons that would sell for a few Paise to making the latest computer chips that can be made only in machines that cost more than USD 150 Million! China is present in nearly every niche (though not in high end computer chips) and when you add it all, China’s output is impressive.
Take a look at this chart from the World Bank. In comparison with China’s meteoric rise, the outputs of India and Germany look nearly flat. In actuality, India quadrupled and Germany doubled their outputs over the period!
In some circles in India, there is an impression that Chinese manufacturing is of low quality. That may have been true a decade ago. When I talked to businessmen who have imported manufactured products from China, they spoke of a different concept of quality. Whereas German manufacturers provided only the highest quality at a high price, Chinese companies can provide products of different quality at different price points. From perhaps a slightly lower than German quality but at much lower price to a lower quality at a very cheap price.
China manufactures more than anyone else in the world. A significant portion of this is high quality. It built almost all this capacity in the last three decades. How did China do it? What challenges did it overcome?
The manufacturing challenge
In his excellent book “How Asia Works”, Joe Studwell argues that economics of development is different from economics of efficiency. A key part of this difference is in manufacturing. A challenge for any country is that in the initial years, manufacturing needs support before it can compete with companies from developed countries. One key reason is that manufacturing can mainly be learnt by doing. Even when entire working plants are transferred, it takes a lot of learning for the new owner and workers to produce goods of the same quality as the original plant. During this period of learning, entrepreneurs need a lot of handholding. This support can be in the form of subsidies, cheap inputs (including funding) and tariff and non-tariff barriers to imports.
However, if this support continues for a long time, there is no incentive for the entrepreneur to improve. After all, if a business is not under any pressure, why would it make its products cheaper or improve their quality? Competition is one inoculation against such complacency. Another is demanding customers. In the initial years such customers would be mainly in the world markets as the domestic customer is not very discerning.
Support your nascent manufacturing industries strongly and then force them to become world class. According to Studwell, this is the model followed by Japan, South Korea and Taiwan and also China.
China overcame the challenge of learning partly by getting the world to teach it.
Learning from the world
China gave extremely generous terms for foreign manufacturers and wooed them aggressively. In its Special Economic Zones (SEZ), China took all kinds of steps to ensure that foreign firms were welcome. Fast clearances? No problem. Infrastructure to facilitate rapid export of output? Check. Cheap credit? Sure. Labor problems? No chance. Governments and party officers would make big promises to potential investors and would nearly always deliver. Kroeber has statistics on the importance of Foreign Direct Investment (FDI) in manufacturing and exports in China.
‘From 1985 to 2005, annual FDI inflows averaged nearly 3 percent of GDP*, a very large number. For South Korea and Taiwan during their comparable high growth eras (the early 1970s to the early 1990s), FDI inflows were only about half percent of GDP. And in Japan from the mid-1950s to the mid-1970s, FDI was basically non-existent, running at less than 0.1 percent of GDP.’
The foreign firms imported a lot of the products manufactured in China. Here is Kroeber again,
‘The exports of Japan, South Korea, and Taiwan were exclusively booked by domestic firms. In China, this has not been true at all; since the early 1990s a third or more of exports were produced by foreign invested firms, and the foreign share peaked at 58% in 2005.’
‘…over 80 percent of “high-tech” exports from China were produced by foreign firms, and the foreign share is still around two-thirds.’
In addition to generous terms, China did one very important thing. It made manufacturers feel welcome. Potential investors would be wined and dined and wooed. This was in sharp contrast to how manufacturers were being treated in the West. There, they could at best hope for a staid respectability. At worst manufacturers would be thought of as greedy, exploitative folk with no concern for their workers or for the environment. In China they were superstars. No wonder investments rushed in.
China was fortunate with its timing as well as its Geography.
Luck in history and lucky in geography
Let me be clear: it was not all luck, but China did get lucky with its geography and also timing. This is what Arthur Kroeber had to say about China’s lucky circumstances
- ‘Good neighbors: The successful export-drive development of Taiwan, South Korea, and especially Japan gave Chinese policymakers an easy-to-follow template for industrial development.
- Hong Kong: When China started its reforms, Hong Kong was already a world-class port and trading hub with a modern legal and financial system. This gave Chinese manufacturers quick access not only to global trade routes but also to much of the “soft” infrastructure needed for a modern economy.
- Timing: China was fortunate to open up to trade just at the moment when the shipping container, invented in the 1950s, was beginning to make possible the creation of global production chains, spanning multiple countries, because of steep reductions in long -distance shipping.
- A “killer app”: By the late 1980s, culturally similar Taiwan had established a sophisticated electronics industry, which moved en masse to China in the late 1990s, creating a world-class electronics manufacturing base almost overnight.’
Add to this the fact that the country had a lot of support from the United States. As highlighted by Henry Kissinger’s trip in 1971, the US wanted to bring China into its sphere of influence or at least to be neutral in the cold war. This support to China continued in 90s, 2000s and 2010s. There was a widespread intellectual and political consensus in the US that offshoring manufacturing to China was good for both countries.
The foreign investments kick started manufacturing in China. The foreign buyers also demanded a high quality output. Chinese employees and entrepreneurs learnt from this experience and built local companies. When they started, they got the support. One important way this support was provided was by making sure that their inputs were cheap.
Businesses flourish if inputs are cheap
Perhaps the most crucial way of supporting manufacturing is by ensuring that it gets cheap inputs. These inputs include raw material, energy, land and finance. If a manufacturing company has to pay a high proportion of its sales to commodity sellers and to energy providers, it has less money to reinvest in itself to become bigger and also less money to pay for more skilled employees. In other words, it is important for terms of trade to be favorable for manufacturing companies and not for commodity and energy providers. Similarly, if a business pays a lot for land or pays a high cost of capital, then it has less money to grow.
Favorable terms of trade are much more important for low value added manufacturing. A company that makes high precision engineering products can pay slightly higher for raw material as the raw material cost would be a small percentage of total costs. A garment manufacturer or a leather goods manufacturer, however, would be much more sensitive to raw material costs. Such low margin businesses generally are high employment generators. If the inputs are high costs, higher employment generating businesses suffer more.
China has kept most of its commodity and energy producers in the public sector. What is more, the prices that these businesses can charge have been regulated. This meant that the terms of trade were favorable for manufacturing companies using these commodities. Many authors describe how China has resisted pressure to go to a system of ‘market prices’ for such inputs. Non-price interventions such as restrictions on export of raw material are other measures that supported manufacturing.
The commitment of the Chinese government to low input prices can be seen from the Rio-Tinto incident in 2007 as revealed in the book The Party. When BHP-Bilton, the largest mining company in the world, launched its takeover bid for its Anglo-Australian rival, the Chinese saw it as an unambiguous threat. The international price of iron ore had increased fivefold in the five years to 2008. One of the reasons is of course the demand from China itself but China believed that the supply had been kept low by big suppliers by systematic underinvestment. Chinalco, a state owned diverse mining group, made a bid for Rio-Tinto. The bid did not go through but Mr. Xiao Yaqing, president of Aluminum Corp of China (Chinalco), took credit for derailing the BHP-Bilton’s bid. Mr. Xiao Yaqing later went on to take a central government position and eventually become a minister.
While keeping prices of raw material low, China managed to induce its public sector to continuously increase its production of commodities. The coal production in China is a good example. It has kept up with the demands of its hungry power plants.
Note that I am not saying that China’s commodity producers are efficient. They may not be. However, cost efficiency may not be the most important factor in delivering commodities cheaply and reliably to manufacturing companies. For example, in India the coal price at a power station can be 5 x of the pit head price. Coal India Limited (CIL) may be bloated. However, the contribution of CIL to the high price is limited. High taxes and transportation costs are what is responsible for these high prices. Imported coal is also a lot costlier than domestic coal for the same reasons. A well executed policy of keeping raw material cost low is way more important than making sure that the public sector units are as low cost as possible.
Let us next look at how China kept land costs low for its manufacturers.
A big difference between China and the rest of the world is that the laws protecting the property rights of rural Chinese are weak. Local urban governments can take over their land in return for a low compensation. In the past local governments have done precisely that. They have then given manufacturing companies as well as real estate developers cheap land. The local governments have two incentives to do that.
Unlike most other places in the world, local governments in China can retain the profit from buying cheap farm land and then selling it. In fact, this profit from land dealing is a significant part of the revenues of many local governments. For some localities, profit from land sales has been as high as 20% of the total revenue. Secondly, local governments were allowed to keep a portion of taxes collected from businesses in their area. Furthermore, a significant portion of the compensation of the local governments officers could come from this share of taxes.
This structure incentivises local government officers to get cheap land for businesses. In general, it creates incentives for more and more businesses to be created. This structure also has ensured that local governments aggressively solicit businesses and deliver on regulatory clearances very quickly.
In the initial learning phase, one of the most important sources of support for businesses is cheap capital.
Patient and cheap Funding
One of the characteristics of Asian tigers -Japan, South Korea and Taiwan — is financial repression in early years. This is inevitable. When manufacturers are learning and are supported by the financial system in the early years, the returns to the depositors are low. In each of these countries, a generation of population accepted low deposit returns. This was an important contributor to the success of manufacturing companies in these countries. This was true in China too.
In the late twentieth century, the Chinese banking system was fairly immature. In the 1990s, the system was dominated by 4 banks known as the Big Four. When the country went into an investment spree, it was supported by the Big Four. The fast lending led to many bad loans and in 1998, the bad loans in the Big Four had reached a staggering 1/3rd of GDP. Kroeber believes that the bailout of the banks was the reason for low deposit rates for savers. He estimates that in 2004–2013, the average real deposit rate was a negative 0.3 percent! Depositors accepted this rate and manufacturing in the country benefited.
In addition to bank loans, Chinese manufacturers got cheap equity capital too. China has many investment vehicles that own shares in both public and private companies. Significant portion of the funds of these investment vehicles comes from the Central and provincial governments. This capital is usually patient capital with not as much emphasis on returns. Here is Kroeber on more recent such vehicles,
‘Since 2014, central, provincial, and city governments have set up around 2,000 “government guidance funds” to promote high-tech development. …In practice, however, most of these funds seem to be thinly disguised subsidy programs, used to channel money to domestic technology companies, with little or no expectation of a commercial return.’
Production linked incentives is another way of providing cheap capital. My interaction with businesses revealed many instances of the price of finished goods being equal to or lower than the cost of raw materials. When asked how they managed to sell at such low prices, their Chinese counterparts would tell them that it was because of the volume linked incentives they got from the government.
One illustration of the effect of cheap finance is Chinese steel. For many years, China exported steel to India. It imported some iron ore from India and coking coal from Australia. Indian producers could not compete with the Chinese prices. This is when Indian producers used Indian iron ore which they would have got at a cheaper price because they would not need to pay the high transportation cost that the Chinese producers had to pay. The Indian producers were also using Australian coal. Clearly, low cost of capital and other incentives were at least partially responsible
Cheap (and patient) funding not only makes it easy for manufacturing businesses to compete, it also makes it easy for them to become big. In many businesses, big is better.
Quantity is its own quality
In many industries, having a large size is a big advantage. If you are a big company, you can negotiate and get a lower price from your raw material and your equipment suppliers. Your capital expenditure is spread over a much larger output. Your high production levels mean that you can fulfill bigger orders that your smaller competitors cannot. In short, there are benefits to being large. It is easier being large if the cost of finance is lower. The scale of Chinese manufacturing is huge. Kroeber points out,
‘From 2000 to 2014, China’s steel production rose nearly seven fold, from 129 to 823 million tons, by which point China produced about half the world’s steel…(for cement) again China was responsible for about half of world’s output.’
Imagine the advantage Chinese steel producers would have had if they were buying rolling mills! The scale advantage of Chinese manufacturing is not only in large individual factories but also in Infrastructure.
Chinese infrastructure: Best in the world?
Snehal’s Chinese suppliers could deliver furniture to him in Mumbai, because they could rely on all the logistical, payment and other infrastructure that would be involved. Infrastructure is key to success of manufacturing. I will not spend too much time on Chinese infrastructure here as that topic requires an article of its own and my colleague is working on it. Kroeber has a pithy remark that sums up the China infrastructure advantage,
‘…by the early 2000s, China had a unique and probably unbeatable combination of low, developing-country labor costs and good, almost rich-country infrastructure.’
Today, much of China’s infrastructure may be better than many rich countries.
I will point out that good infrastructure can work for manufacturers in ways that may not be obvious. For example, if a province makes dormitories and food and entertainment places for workers, businesses find it easier to get and retain them. The workers may also stay in the factory just a bit longer and may be that much more productive.
There is universal praise for the productivity of Chinese workers. Let us look at that next.
High productivity — structure or culture?
I heard jealousy in the voices of Indian manufacturers, when they talked about productivity of Chinese workers. According to them, one big reason for this productivity is that compensation in many factories is mainly for piece work. That is, the workers get paid on the basis of the number of products they have manufactured. This compensation structure incentivises workers to increase productivity. However, such a structure can also violate the rights of workers if applied unfairly. In such a scenario, it seems that the Chinese workers do not have recourse to remedies such as protective laws and unions as they would have in other countries like India.
In his book, The Party, Richard McGregor pointed out that the All China Federation of Trade Unions is China’s sole legal trade union body. This body is controlled by the Communist Party of China (CPC). Workers did not have the right to form independent unions.
In addition to these structural differences, it seems that factory work is associated with higher status in China than in India. There seems to be a much higher appreciation of workers, especially skilled workers. A senior executive from a Multi National Company described, with admiration, how in their planning meetings, senior skilled workers such as welders would be present. And they would contribute to the discussion especially in their field. This executive felt that China had some of the best welders in the world and the respect they get is a significant contributory factor to the quality of their output and their productivity. People are proud to ‘work with their hands’. Unfortunately, this is not so in many communities across India.
China now has some of the world’s most skilled workers as well as engineers in many industries.
Not automantons but very skilled workers
A lot of manufacturing work requires skill. More obviously, skill and learning are crucial in improving the manufacturing process. If you look for them, you will find many testimonials for the skills of Chinese workers.
In 2017, Tim Cook the CEO of Apple said,
“China has moved into very advanced manufacturing, so you find in China the intersection of craftsman kind of skill, and sophisticated robotics and the computer science world. That intersection, which is very rare to find anywhere, that kind of skill, is very important to our business because of the precision and quality level that we like.”
“The products we do require really advanced tooling, and the precision that you have to have, the tooling and working with the materials that we do are state of the art. And the tooling skill is very deep here. In the U.S., you could have a meeting of tooling engineers and I’m not sure we could fill the room. In China, you could fill multiple football fields.”
China now also has the best engineers in all kinds of niches and as a person with an engineering degree, I cannot but compare the situation with India. I graduated from IIT Bombay in the early 90s. A few of my batchmates and I met recently. When I looked around at the small group, I realized that except one person, everyone had careers in finance or software. Even the exception was in a commercial function. As someone who has been in both software and finance, I am in no position to criticize individual choices, but there is no doubt that a lack of preference for manufacturing jobs is not limited to blue collar workers. Thirty years ago most of us did not want to work on the shop floor. It was more lucrative and more prestigious to work in an office. Unfortunately, this is still true.
It is relatively easy for governments to support businesses. It is much much tougher to prevent these businesses from becoming inefficient. After all, if support allows me to make profits, why would I strive hard to become better. I don’t have a complete answer to this crucial question but a big part of the answer is competition.
Many industries in China have fierce competition
China has had fierce competition in industry after industry. For example, Kroeber says that there were 120 car companies in China in 2019!
Entry into any industry was easy and hence entrepreneurs had to be fiercely competitive. If a company that was supplying components to a MNC was unable to deliver on quality, there were others who would take their place. This competition was fueled by entrepreneurs as well as by governments. As discussed earlier, provincial and city governments were allowed to keep a portion of tax revenues collected from businesses in their jurisdiction. What is more, a significant portion of compensation of government officials could come from this revenue. The senior party and government officials would be judged by the party on the basis of the manufacturing and tax performances of their provinces / cities. So cities competed with other cities and provinces with other provinces. The interests of entrepreneurs, senior political leaders and government officers were aligned. Everyone wanted entrepreneurs to get into new industries and do their utmost to make their business successful.
At the beginning of the manufacturing boom, most of China was rural. Young men and women from villages across the country traveled long distances to stay near factories so that they could make more money. It helped a lot that factory work, especially in the previous decades, had a lot of dignity.
Extreme government support, aggressive entrepreneurship and a disciplined work culture combined to propel Chinese manufacturing. Was there a downside at all?
Many accelerators but no brakes
This article is not the place for detailed accounting of environmental costs paid by the Chinese. It is certainly not the place to even attempt to figure out if the trade off was worth it. I would only note that, by all accounts, China has paid enormous environmental costs. I would also note that many reports suggest that the country has become much stricter against polluters in recent years.
The other big risk of the Chinese model is that of overinvestment. It was in the interests of entrepreneurs, financers, political leaders and government officers to say yes. So they did. There was nobody to say no. There are multiple reports of overinvestment in real estate. There are also some reports of overinvestment in manufacturing.
As the demand environment for Chinese manufacturing changes in the coming years, we may get some indication of the costs the country would have to pay. The costs would include financial costs including bad bank loans and spoilt government finances. The costs would also include wrenching social costs that come from sudden unemployment. How high would these costs be? It is impossible to say. Hence, it is impossible to say whether the tradeoff the country made to become the manufacturing superpower was worth it.
Over the past years many business leaders have shared very interesting insights. I present one story that illustrates many themes touched upon in this article.
Pramod (name changed) has run a mid-sized component manufacturing company for decades. In the 2000s, Pramod tackled the sharp increase in demand for his products by importing from China. The prices that he had to pay were always low and his deliveries always reached on time. There were times that the price was near that of Pramod’s raw material for the same component. Pramod believes that incentives from the Chinese government were at least partially responsible as was the fierce competition within China.
Even today, Pramod finds it difficult to compete with the Chinese manufacturers in the Asian markets. In addition to price and quality, the Chinese manufacturers have another advantage. In every market, there are multiple containers going from all parts of China every day. Small Chinese suppliers can promise 1–2 day deliveries even for small orders (less than a container) whereas Pramod may have to wait for 15–20 days because the number of containers going from India to that country may be very low. The advantage of scale can come up in many ways.
One of Pramod’s best selling products requires him to build a hollow 150 mm Brass tube with an inner diameter of 5mm and an outer diameter of 8 mm. For years, he bought 8mm Brass rods and drilled 5 mm holes in them. The holes would need to be drilled from both sides and would need four separate drilling operations (to take out the drilled material). There were additional challenges of making sure that the alignment from both ends was right. A few years ago, Pramod’s Chinese supplier suggested an alternate method which some European manufacturers had perfected. A 25 mm rod of Brass could be heated and then molded into a tube. The Chinese partner designed and manufactured the machinery needed for this process and installed it at Pramod’s India factory. His Indian competitors have not been able to duplicate this process in spite of years of trying. This is one of the reasons why Pramod believes that even in relatively simple manufacturing operations, the skill levels of Chinese are much higher than that in India.
Let me quickly summarize this long article and discuss implications for India.
Summary and implications for India
How did China become a manufacturing superpower?
- Any country Starting manufacturing has a challenge. Manufacturing can be learned mainly by doing. In the initial learning phase manufacturing needs a lot of support.
- One way China tackled the problem was by making itself a very attractive destination for export oriented factories of MultiNational Companies (MNC). The export share of MNCs is very high even now. Eager Chinese workers and future entrepreneurs learned the basics of how to produce high quality goods.
- China was lucky both with its timing of manufacturing push and because its neighbors helped it start up and also provided it with inspiration.
- China supported MNC and local manufacturing companies with cheap raw materials and energy. The manufacturers were also supported with cheap land and fast regulatory clearances. Workers were not only available for low wages but also disciplined and eager to learn. There was also a lot of support from cheap and patient capital.
- The Chinese infrastructure miracle was another great support for manufacturing.
- Such a high level of support can make entrepreneurs complacent. This has not happened in China. One of the big reasons is fierce competition. The decentralized nature of the country’s governance and the entrepreneurial nature of the society means that there were hundreds of companies in many sectors.
- This competition, along with eager entrepreneurs and workers has meant that the Chinese output is now very high quality.
- A feature of Chinese manufacturing is scale. Partly supported by cheap capital, many Chinese factories are very large and this allows them to produce goods much more efficiently than many of their competitors.
- Manufacturing has a much higher status in China than in many other countries, including India. This applies both for blue and white collar workers.
- On the back of government support and the efforts of entrepreneurs and workers, China is now a leader in both scale and quality.
- There are costs and risks to the way China developed. Environmental degradation is an obvious cost. The other is overinvestment.
The 11 point list is scary. It looks almost undoable in the Indian context. We can think that India does not have a chance to do what China did and not even try. Or, we could look at each of the points above and ask ourselves how India could do the same. For example, China has kept energy prices low. How can India do the same? Manufacturing in China is cool. How can India do that? How can we make patient capital available for manufacturers while ensuring that they don’t become complacent and remain inefficient? All these are complex topics and I hope to write about some of them in the future.
* A lot of the FDI in China may have come from Hong Kong. Also, there are credible claims that significant parts were round tripping — that is Chinese businesses bringing back money disguised as foreign investment. However, even accounting for this, the differences are stark.
A big thanks to all business leaders who have taken so much time andd patiently explained what they do. I am deeply grateful.
I am trying to understand China better and this is my third article on India and China comparisons. I will keep posting what I learn in this list — Viewing China through an Indian lens.
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