1.03  Hu-Wen's Restructuring and Rebalancing & Xi-Li's Supply-side Reforms

2 August 2018

Rebalancing & Restructuring Under the Hu-Wen Administration

 

With China's accession to the WTO in 2002, FDI spiked and economic growth accelerated. The country’s GDP per capita doubled within a decade after its accession to WTO.  By 2011, China has overtaken the US as the world’s largest producer of manufactured goods.

Despite the achievements, however, much of the growth was low value-add, debt-fuelled and investment-driven using imported manufacturing technologies at the expense of the workers’ welfare while causing also extreme environmental degradation.

 

By the early 2010s, China was beginning to experience labour shortage and increasingly unbearable environmental pollution. Rising affluence has also created a burgeoning middle class of sophisticated consumers demanding higher quality products that require engineering and manufacturing capabilities many local producers do not yet adequately possess.  At the same time, the value chains have also become more complex as differentiated needs and rapid urbanization require businesses to manage, make, and deliver an increasingly diverse arrays of customized products to more and more remote locations. Between 2013 and 2015, for example, almost two-thirds of the growth in demand for fast-moving consumer goods was projected to come from smaller (Tier-three and Tier-four) cities, which outnumbered their Tier-one counterparts, such as Beijing or Shanghai, by a factor of 20. For businesses, this means smaller and smaller lot sizes and deliveries to households farther and farther “out there.”[1]

 

Meanwhile, China’s exports were dampened by rising wages and other factor costs and by the appreciation of the renminbi. The uncertain global economic environment since the 2008 Global Financial Crisis further complicated life for manufacturers everywhere but more so in China because of its role as the factory of the world. Annual demand growth for the China’s steel industry, for example, slowed to 3% in 2012 after a decade of double-digit increases. The lower capacity utilization and cutthroat competition resulted in a 56% decline in average profit margins for the industry from 2010 to 2012. Similarly, in China’s massive auto industry, annual growth rates between 2008 and 2013 fluctuated between 7% and 52%.[2]

 

Moreover, fundamental macroeconomic reality dictates that as a country becomes richer, relative role of manufacturing will inevitably decline. Empirical evidence suggests that manufacturing’s relative contribution to a national economy tends to peak when it reaches 20% to 35% of the country’s GDP. In 2012, that figure for China was roughly 40%. As a result, as the aggregate economic growth declined, manufacturing growth slowed even more quickly. China was beginning to lose some new factory investments to lower-cost locations, such as Vietnam, as multinationals producing labour-intensive goods, like textiles and apparel, seek to diversify beyond China to reduce costs and mitigate political and supply-chain risks.[3]

 

In short, even though China’s rise to manufacturing pre-eminence had been amazing, its advantages gained through lower costs of labour and capital as well as efficiency-driven innovations were fast eroding. Rising costs, more sophisticated consumers and fundamental macroeconomic realities, amid a progressively more challenging external environment, meant that yesterday’s approaches to manufacturing were losing their relevance. It did not help also that China’s manufacturing productivity was only a fifth of that of developed economies even though the country accounts for 25% of the world’s manufacturing activities, more than any other country in the world.[4] Unless effective measures were drawn to fundamentally reform China’s manufacturing sector, there was a real danger that China falls into the middle-income trap that have plagued many developing economies.

 

Efforts to restructure the economy (i.e. to shift China away from low value-add growth) began as early as 2006 on the eve of China’s 11th Five-Year Plan (FYP, 2006 – 2010) when Hu-Wen administration launched its 15-year plan to foster "indigenous innovation" (自主创新) in advanced technologies. The initiative to move the manufacturing sector up the value chain, however, was interrupted by the 2008 Global Financial Crisis and the ensuing Great Recession during which external demand for China-made good plummeted. To pre-empt a hard landing of the economy, a 4 trillion yuan infrastructure-focused stimulus package was hastily implemented.

 

The fall in export due to decline of external demand brought home the unsavoury reality that high growth driven by investment and export growth was no longer sustainable. Contribution to GDP by investment at that point was high at about 45%. Consumption, on the other hand, contributed only about a lowly 30% compared to as much as 70% in some Western economies. Policymakers began to embark also on a strategy of rebalancing to increase the GDP contribution of consumption relative to export and services relative to manufacturing, in addition to the strategy of restructuring to move the Chinese economy up the value chain.

Hu-Wen Administration’s Seven “Strategic Emerging Industries”

By 2010, on the eve of the 12th FYP (2011 – 2015), restructuring efforts to gravitate the manufacturing sector to the higher end of production value chain culminated in the identification of seven "strategic emerging industries" (SEI, 战略性新兴产业) that were seen as vital for China to achieve mastery in if it was to become an advanced economy. They were energy-saving and environmental protection industry (including efficient energy, advanced environmental protection and resource recycling), new generation information technology industry (including next generation information network, core electronics, high end software and new information service), biology industry (including bio-pharmaceutical, bio-medical, bio-breeding and bio-manufacturing industry), high-end equipment manufacturing industry (including aviation equipment, satellite, rail transportation, marine engineering and intelligent equipment), new energy (including nuclear energy, wind energy, solar energy and biomass), new materials (including new functional materials, advanced structural material, high performance composite material) and new-energy auto industry.[5]

Twenty projects were identified for the 12th FYP period to help develop leading-edge advanced technologies for these SEIs through investment in R&D from state and industry sources, accumulation of intellectual property, setting of distinct technical standards, and leveraging foreign firms’ access to the Chinese market in exchange for foreign technologies. In addition, the plan also set the goals for SEI-related industries to account for 8% of the economy by 2015 and 15% by 2020.[6]

 

One industry that benefited from the Hu-Wen administration’s efforts was the internet industry. Aggressive investment in broadband infrastructures by the state helped to improve connectivity and lower usage costs. Number of internets users spiked from 210 million in 2007 to 564 million in 2012 and 688 million in 2015.[7] More importantly, the internet became not only a tool for information acquisition and communications. With the widespread use of smartphone, internet also began to exert influence on all areas of people's lives including consumption and entertainment.

 

Online shopping, in particularly, grew rapidly in both the number of users and the size of transactions. In 2014, for example, online sales increased by 49.7% year on year to $454.2 billion (RMB 2.789 trillion, 10.6% of total retail sales), larger than the $303.9 billion (6.5% of total retail sales) spent in the US. On just the Singles' Day on November 11, 2014 alone, the gross merchandise volume of Alibaba Group, the leading e-commerce company, increased by 57.7% year on year to a record high of RMB 57.1 billion.[8] It has been projected that, by the end of 2020, the consumption of online information products and services is expected to grow at least 11% per year to reach RMB 6 trillion.[9]

 

Supply-side Reforms Under the Xi-Li Administration

 

Despite efforts by the Hu-Wen administration to reform China’s economy, however, there was no changing of the fact that rapid growth over the past 30 years was mainly driven by three demand-side forces (i.e. investment, export and consumption) which are only useful for resolving short-term and aggregate problems but will in the longer term result in problems such as overcapacity and structural imbalance in the economy.

 

China’s RMB 4 trillion infrastructure-focused stimulus package, which ran from 2008 to 2011 in the aftermath Global Financial crisis, is a good case in point. The stimulus led to lavish spending on public works and created a voracious demand for steel and coal which in turn led to excessive investments in these industries. Hard landing of the economy was averted but when the demand effect of the stimulus wore off, the Xi-Li administration which took over in 2013 was laden with the problems of excessive capacity and the increasing number of “zombie” firms (e.g. perennial loss makers which are technically insolvent).

 

Moreover, Hu-Wen’s innovation and SEI approach was perceived as too narrow in terms of development goals set. By 2015, it was also not fully exploiting China’s strength in its fast-growing internet industry which began to blossom after 2013, putting China’s virtual economy ahead of even the developed economies.

 

To resolve the contradiction between supply and demand and to create a more sustainable engine for future growth, the Xi-Li administration embarked on supply-side reforms in 2015, building on China’s internet industry success. The shift away from demand-side policies meant that China’s medium and long-term potential economic growth rate in the future would be decided more by supply side factors. Measures implemented include

  • cutting excess capacity especially in high polluting and high energy-consuming industries by gradually eliminating outdated industrial capacity;

  • improving and upgrading traditional industries through modern technology and management;

  • reducing business costs by putting an end to unregulated excessive charging practice by industry associations, chambers of commerce and various societies; and

  • encouraging innovation and entrepreneurship to cultivate high quality, high-efficiency, low energy-consumption and low pollution emerging industries.

 

It is against this background that the Xi-Li administration launched three major supply-side initiatives, building on China’s success in internet industry:

  • In 2014, the Mass Entrepreneurship & Innovation Initiative (“大众创业万众创新”,简称“双创”) was launched to unlock the spirit of innovation and entrepreneurship of the hardworking and enterprising Chinese people.

  • In 2015, the Internet Plus Initiative (互联网+) was launched to rejuvenate the traditional sectors by integrating it with China’s highly successful internet industry. A vibrant services sector, for example, would not only help China to rebalance its economy by increasing the contribution share of consumption in the overall economy relative to a manufacturing sector overly dependent on export growth. At the same time, it would also help Chinese services companies to compete more effectively outside China and increase their international presence.

  • Also in 2015, the Make in China 2025 (中国制造2025) action plan was launched to restructure the low value-add investment-driven industrial sector to one that is high value-add and innovation-driven using indigenously developed technologies. Directly inspired by Germany “Industrie 4.0”, the 10-year action plan builds on the Internet Plus Initiative by integrating the industrial sector with the internet industry. MIC2025 is thus China’s ambitious action plan for the nascent Fourth Industrial Revolution that the industrialized economies in the West have embarked on since 2013.

 

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REFERENCES

[1] See McKinsey. (2013). “A new era for manufacturing in China.” McKinsey Quarterly. June 2013.

[2] See McKinsey. (2013). “A new era for manufacturing in China.” McKinsey Quarterly. June 2013.

[3] See McKinsey. (2013). “A new era for manufacturing in China.” McKinsey Quarterly. June 2013.

[4] See Forest Hou, Arthur Wang, and Ting Wu. (2017). “A digital upgrade for Chinese manufacturing.” McKinsey Quarterly. May 2017.

[5] See Yau. (2012). “China Releases 12th Five-Year Plan for National Strategic Emerging Industries.” China Briefing. 25 July 2012.

[6] See SwissNex China. (2013). “China’s 7 Strategic Emerging Industries.” 28 October, 2013.

[7] See China Internet Watch. (2018). “Whitepaper: China Internet Overview.” May 2018.

[8] See Kwan Chihung. (2015). “The Internet Industry Has Become the Growth Engine of China.” REITI. 8 April, 2015.

[9] See See China Daily. (2017). “China's IT, internet industry prospers.” 6 September, 2017.