1. China’s Manufacturing Sector Since 1978 Mohammed Saqib Fellow Rajiv Gandhi Foundation

2. Introduction China’s real GDP grew at an average annual rate of 10 per cent and 9.7 per cent over the sub-periods 1978-1993 and 1993-2006, respectively. Combination of explosive economic growth and declining population growth rates has resulted in an annual average increase in per capita income of 8.5 per cent over the same period, significantly reducing poverty levels in the process. Manufacturing, in particular labour-intensive mass manufacturing, has been the engine of growth in China since sweeping economic reforms were initiated in 1978. Following the reforms in 1978, the emphasis of industrial policy in China has been on light industry, the production of consumer durables and dependence on external demand; consistent with China’s prevailing technical capabilities and comparative advantage in factor endowments, namely, the availability of surplus labour.

3. High Levels of Investment resulted in High Industrial Output

4. Change in Industrial Strategy… In early 1970s, China’s industrialization strategy, called the “Big Push” focused on the rapid development of five industries—iron & steel, cement, chemical fertilizers, oil & natural gas and farm implements. However, the program failed due to difficulty in reallocation of surplus labour from agriculture to highly capital intensive industries. The strategy of focusing on labour-intensive mass manufacturing, post 1978, has paid rich dividends. China has emerged a global manufacturing powerhouse, deeply integrated into global supply chain networks and in the process lifting close to 200 million people out of extreme poverty over the past three decades.

5. Profile of China’s Manufacturing Exports Products Exports in value (US$ billions) 2001 2005 Exports as a share of total exports (%) 2001 2005 Exports as a share of world exports (%) 2001 2005 Electrical, electronic equipment51.3172.319.322.65.912.3 Heavy Machinery33.6149.712.619.63.810.7 Light Machinery25.53.37.8 Apparel32.465.912.28.636.648.3 Footwear10.119.13.82.521.128.0 Toys9.119.13.42.521.031.0 Mineral fuels, oils, distillation products, etc8.43.21.4 Furniture7.622.42.82.99.817.9 32% 45.5% 19.4%13.6%

6. Table includes the top eight items by value, which collectively account for about 60 per cent of China’s exports in the two years chosen. If you look at absolute numbers, exports by value of electrical & electronic equipment in nominal terms increased three and a half times, while machinery exports increased over five times. China’s dominates export markets for low value added products such as toys, apparel and footwear, and is making rapid inroads into the global equipment and machinery market as well. However, China is still a few years away from competing as an exporter of goods at the higher end of the technology spectrum. China’s Export Basket

7. Focus of the Session “China’s Manufacturing Sector from 1978 to present” I. Broad overview of the Chinese manufacturing sector. II. Factors that led to the rapid growth of the manufacturing sector. III. Potential lessons for India

8. I. Overview of the Chinese Manufacturing Sector Coverage: A. Structural Composition of GDP B. Comparison of China and India’s Manufacturing Sector C. Contribution to Trade D. Regional Distribution of Industry E. Productivity in China’s Manufacturing Sector F. Ownership Patterns G. Size Profile of Chinese Manufacturing Sector

9. (A) Structural Composition of the Chinese Economy: 1978-2005

10. Structural Composition of the Chinese Economy Industry, comprising of mining, petroleum extraction and utilities, occupies a high share in China’s GDP. Agriculture, which contributed 28 per cent in value- added terms to the gross domestic product in 1978, saw its share decline to 13 per cent in 2005. The share of services in value added terms has correspondingly increased from 24 per cent of GDP to 41 per cent. Manufacturing makes up close to 75 per cent of the overall secondary sector (which also includes construction and industry), which makes value added in manufacturing about 35 per cent of GDP. The high share of manufacturing is related to China’s high investment rate, which keeps the demand for materials and machinery high and to government policies that promote industrial growth.

11. (B) Comparison of China and India 198019851990199520002005 Output (billion $, 1990 prices) China 47.092.3143.4323.6525.9881.6 CARG (%) 14.49.217.710.210.9 India * 23.933.549.669.488.8123.0 CARG (%) 7.08.26.95.16.7 Exports (billion $) China 9.013.546.2127.3223.7712.9 CARG (%) 8.527.922.511.926.1 India 4.54.812.020.429.760.7 1.520.011.37.815.4 Employment (millions) China 59.074.186.298.080.4 83.1 ** CARG (%) 4.73.12.6-3.91.6 India *** 27.732.535.040.847.8 CARG (%) 3.31.22.63.2 * : Figures for India are for financial year (April-March); ** : 2002 data; *** : Figures for 1983, 1987-88, 1993-94, 1999-00, 2004-05

12. Comparison of China and India ChinaIndia Manufacturing output in value added terms increased nineteen fold between 1978 and 2005 (from $47 Billion to $882 billion). High growth from 1990 to 1995, due to surge in FDI. Growth strategy driven by exports of manufacturing goods, resulting in dominating global markets in several labour intensive, low tech goods and increasingly in goods of intermediate sophistication. Accelerated by entry of foreign owned firms into manufacturing since 1992 and increase in FDI. Manufacturing sector grew five fold during the same period ($24 billion to $123 billion). Slow growth due to the combined adverse impact of the Gulf crisis and macroeconomic stabilization policies. Strategic focus of manufacturers on the domestic market, both due to the large market size and government policies that did not explicitly promote exports. The role of FDI in the Indian manufacturing sector has also been limited to date.

13. (C) Contribution to Trade: Manufacturing Exports &Total Exports: (1980-2005)

14. Contribution to Trade The manufacturing sector has made a significant contribution to China’s trading profile, with increasing exports and a rise in foreign exchange reserves to almost $1.5 trillion at the end of 2007. The composition of exports changed rapidly from being dominated by the export of petroleum until the early 1980s, to one dominated by light manufacturing. The sharp increase in exports beginning in the late 1980s was due to a combination of factors such as the Coastal Development Strategy, the contribution of Export Processing zones and the participation of foreign owned enterprises in China’s manufacturing sector. The value of exports far exceeds that of imports, which has resulted in a positive trade balance.

15. (D) Regional distribution of Industry in China: 2004Region Gross Industrial Output Value (billion Yuan) Share in national total (%) Employment (millions) % of National Average number of Employed Persons (millions) Guangdong3152.014.213.414.4 Jiangsu2947.713.310.211.0 Shandong2467.911.19.410.1 Zhejiang2122.79.68.69.3 Shanghai1459.46.63.43.7 Beijing + Tianjin 1209.45.43.33.5 Hebei1019.44.64.44.7 Henan923.74.25.35.7 Liaoning914.14.13.53.8 Fujian751.63.43.73.9 National Total 22231.676.393.070.0

16. Regional Distribution of Industry The table includes the top 10 industrial regions, which account for three fourths of gross industrial output and 70 percent employment in industry. These regions are also the most prosperous in China. However, Chinese industrial policy of locating or encouraging industrial investment in certain select regions has exacerbated imbalances that existed in 1978. Chinese reformers choose these regions due to favorable endowments, particularly with respect to infrastructure, compared to other regions of China, and with the hope that the success in coastal regions would gradually spill over to other regions. But the redistributive effects have not been encouraging, with widening regional differences and increasing investment in favor of the Eastern seaboard and the Pearl River Delta region, despite rapidly rising wages and Government incentives to locate in interior regions.

17. (E) Productivity in China’s Manufacturing Sector: Changes in Total Factor Productivity (TFP) in Chinese Industry (1952-2005) Period Output Growth TFP Growth Capital Contribution (%) Labour Contribution (%) TFP (%) 1952-197810.51.674.310.814.9 1979-19928.6-2.7120.910.3-31.1 1993-200510.53.270.91.128.0 1979-200510.00.392.15.12.8 Source: Selin Ozyurt, "Total Factor Productivity Growth in Chinese Industry, 1952-2005"

18. Variation in Total Factor Productivity (TFP) TFP growth in the pre-reform period was positive (1.6 per cent) but a fall was witnessed during the early years of the post-reform period (1979-92). This fall could be due to the absence of incentives to increase productivity and lagged responses of enterprises to respond to reforms in the mid-1980s. TFP has increased since the early 1990s and indeed shows an accelerating trend, due to the much higher productivity levels of Township and Village Enterprises (TVEs) and Foreign Funded Enterprises (FFEs), whose share in total output had increased since the early 1990s. The retrenchment of superfluous labour in SOEs in the mid 1990s and the movement of labour from agriculture to the more productive manufacturing sector were the other important reasons. Due to intensive capital investment, labour productivity has also increased.

19. (F) Ownership Patterns in Chinese Industry (1978-2004) - by gross output value

20. Ownership Patterns The period since 1990 is characterized by two broad trends: (i) The declining collective contribution of SOEs and collectives, and (ii) An increasing role played by FFEs, in China’s manufacturing economy. Collective contribution of SOEs and collectives, declined from 70 per cent of output in 1997 to 41 per cent in 2004, due to privatization of Township and Village Enterprise (TVEs). Thus, resulting in increased share of ‘private’ enterprises. FFEs contribution to industrial output was almost twice that of the domestic private sector in 2004 (31.5 per cent vs. 16.5 per cent). The contribution is more pronounced in the production and export of high value added goods. SOEs still account for almost 40 per cent of China’s industrial economy and have exclusive control of the ‘commanding heights’. Thus SOEs still dominate many key manufacturing industries such as shipping, coal, oil, power generation and telecommunications. However, even for SOEs within the reserved sector, the Chinese government has insisted on SOEs meeting performance benchmarks, imposed hard budget constraints and allowed SOEs to retain some of their earnings for investment in technology and R&D.

21. (G) Size Profile of China’s Manufacturing Sector Period Large Scale Industry Medium Scale Industry Small Scale Industry No of Enterpri se % of total gross industri al output value No of Enterpri se % of total gross industri al output value No of Enterpri se % of total gross industri al output value 1996 705739.41687015.248251845.4 1997 719839.61674014.444456846.1 1998 755841.31585014.114167244.6 1999 786443.41437113.613979843.0 2000 798344.71374112.514116142.8 2001 858947.01439813.114826939.9 2002 875246.21457112.815823441.0 2003 198434.42164733.117259132.5 2004 213531.32555728.7134757140.0

22. Distribution of Manufacturing Sector by Size The contribution of small and medium firms was 60 per cent in 1996, decreased to 53 per cent in 2001 and has increased gradually to 69 percent in 2004. Government policies have played a vital role in enabling at least a fraction of Chinese enterprises to rapidly acquire size. Wing & Yiu (1997) in a study on the impact of firm size on performance of manufacturing firms in Shanghai reported a high level of technical efficiency for ‘small’ firms (employing up to 99 workers) as well as for large firms (with over 1000 workers). Mid range firms (between 100 and 999 workers) displayed lower levels of efficiency. Broadly the acquisition of scale economies seems to have benefited at least of the export-oriented variety.

23. II. Salient Features of China’s Manufacturing Revolution Coverage: A. Liberalization of Agriculture B. The Rise of Township and Village Enterprises (TVE) C. Economies of Scale D. Labour Reforms E. Human Capital F. Ownership Reform G. Foreign Direct Investment (FDI) H. Agglomeration Effects

24. (A) Liberalization of Agriculture The Third plenum in 1978 adopted two new policies: –An across-the-board increase in procurement prices –The transfer of management responsibilities to collectives. Thus, not only increasing rural incomes, but also facilitating the procurement process, as the need to coerce surplus grain out of farmers diminished. The collectives used their new found autonomy to introduce incentive systems (‘work points’) to reward performance. The introduction of the ‘Household Responsibility System’ (‘Household Contracting’) in 1981-82 led to explosive growth in food grain production. The cornerstone of this system was the ‘dual pricing’ system, whereby farms had to sell a pre-decided proportion of their output to the government at state fixed prices, but were free to sell the remainder at market prices.

25. Bottom-up process, characterized by a movement to a less labour-intensive pattern of agriculture, released excess labour to move to non-agricultural activities. The increase in productivity and hence rural incomes stimulated demand for consumer goods, which was met by rural enterprises. Growth of the manufacturing sector especially in the coastal areas has also been attributed to rural migrant workers, who have a nationwide strength of nearly 100 million. They migrate due to the malfunctioning of the fiscal and redistributive system. Excess supply of labour pushes down the wages, which predominantly explains the ‘vast pool of cheap labour’ associated with China. Despite the economic benefits of this resource, it is still a challenge for social policy in China to devise a more inclusive social policy that would include migrant workers as well.

26. (B) The Rise of Township and Village Enterprises (TVEs) TVEs Structure: TVEs were essentially small and medium size enterprises that proliferated in select areas of rural China in the late 1970s an played a transformational role in the Chinese economy. Collective TVEs at one time dominated the entire TVE sector, with high employment rates till 1995. Public ownership of TVEs was a Chinese cultural characteristic that emphasized cooperation and thereby enabled local actors to resolve incentive problems without explicit contracts. An alternative explanation [Chang & Wang (1994)] saw TVEs as adaptations to political constraints, insecure property rights and underdeveloped markets.

27. The contribution of the TVEs: In value added terms, the contribution of TVEs more than quadrupled from 6 per cent of GDP in 1978 to 26 per cent in 1996. More importantly, they crucially helped reduce unemployment and in the process lifted millions out of poverty. By adopting the appropriate mix of factor ratios, TVEs were able to boost rural employment from 28 million in 1978 to 135 million in 1996. TVEs increased rural incomes, absorbed surplus labour from agriculture, reduced the wide rural-urban gaps prevalent in China and helped mitigate the problem of under supply of consumer goods, typical of a controlled economy. The increase in rural incomes further stimulated demand for consumer goods, which led to existing TVEs augmenting capacity, in addition to new players who sought to tap rising demand. More broadly, as a result of the new competition policy, TVEs forced SOEs to make their operations more efficient. This led to tremendous increases in overall productivity in the manufacturing sector as a whole in China.

28. What made TVEs so successful The availability of surplus labour both as a consequence of the reallocation from agriculture and due to rural migrant workers coupled with pent up demand for consumer goods provided favorable ‘initial’ conditions for TVE growth in the early years of the reform. This was further aided by the following two factors: (1)TVE Structure and Business Model: TVEs were perceived as low- tech firms whose services were highly localized in nature. As a result, TVEs were excluded from the “plan”, providing them with a great deal of autonomy. TVEs were able to develop eclectic business models that allowed them to be extremely adaptive. The most significant implication of this flexibility was with regard to ownership. Several new TVEs started after the mid 1980s, were registered as ‘collectives’ for ideological reasons, but were run as de facto private firms,. These arrangements enabled the creation of new incentive structures that in turn led to much higher levels of productivity and dynamism within the sector.

29. Government policy towards TVEs: On the one hand, TVEs received no leeway in the form of cheap credit, but had to rely on their own resources to support their investment plans. This helped TVEs choose the appropriate factor mix. Investments by TVEs were financed through borrowing at market rates or through retained earnings. Denial of cheap credit forced TVEs to be not only extremely efficient, but discouraged a capital intensive growth strategy. Government liberalized its competition policies to enable TVEs to compete in markets that were historically monopolized by SOEs, thereby enabling them to share monopoly profits. Market liberalization provided TVEs with access to a much larger market, thereby accelerating the ‘scaling up’ process. The government also contributed to TVE growth by providing generous tax credits. However, a significant proportion of profits had to be paid to the local governments. These tax revenues were ploughed back into public works, mainly in the form of infrastructure and often back into the TVE itself.

30. Government policy towards TVEs (contd.): To increase GDP and thus higher local tax revenues, local governments took several short-sighted actions and sacrificed long term objectives. Indiscriminate support resulted in the bankruptcy of local governments, competition for Foreign Direct Investment led local governments to compromise on environmental and safety standards, offer generous tax holidays and low cost land to investors. These distortions notwithstanding, local governments by virtue of acting as guarantors, helped TVEs overcome their teething problems by providing the finance needed to get started. As a result, TVEs gained size rapidly and were not undercapitalized as is the case with comparable firms in developing countries.

31. The Eventual Decline of the TVEs: The period from 1978-1996 is described as the “golden age” of the TVE sector. However, a shift in national priorities towards building markets and institutions, more restrained macroeconomic policies directed at controlling inflation and greater financial independence and accountability for banks considerably diminished the innate advantages that TVEs possessed in the early 1980s. With increased exposure to global forces, urban firms were forced to expand beyond their traditional niches and adopt nationwide strategies, which inevitably brought them in direct competition with TVEs. The unique positioning that had contributed to TVE growth was considerably diminished, due to eradication of scarcity of consumer durables prevalent in pre- reform China. Finally, rising incomes had made the average Chinese consumer more discriminating and demanded higher quality products than what TVEs with their outdated technologies could provide. Privatization of TVEs seemed the inevitable next step.

32. Privatization of TVEs: Changes in the external economic environment, increase in costs of public ownership and encouraging official policy, with significant easing of restrictions on private ownership, reduced the need for private firms to masquerade as ‘collective’. Privatization of TVEs has proceeded irreversibly, with only 10 per cent of the TVE labour force still employed in publicly owned enterprises as of 2006. In conclusion, TVEs dramatically transformed China’s economic landscape by absorbing surplus labour, helping address problems of scarcity of consumer goods, laying the foundation for export oriented mass manufacturing and in later years, being in the vanguard of the privatization process. A limitation of the TVE model was its limited spread: vast swaths of rural China were untouched by TVE development. It is no coincidence that these areas are among China’s poorest.

33. (C) Economies of Scale China’s manufacturing sector (especially the export-oriented mass manufacturing component) is characterized by scale—the ability to engage in large scale production at relatively low marginal costs. The bases of China’s large scale production are a trained and disciplined labour force, process standardization, large scale procurement system and the ability to generate large volumes [Chandra & Sastry (2002)]. This has several advantages both in the form of direct and indirect economies. Direct economies are manifested as lower average production, transportation & transaction costs, which enable Chinese manufacturers to adopt a strategy of ‘large volumes, low margins’, crucial in obtaining market share in export markets characterized by intense price competition. Indirect economies of large output volumes and standardized production processes have enabled producers to aggressively negotiate lower input and component costs with suppliers, thereby increasing their competitiveness. Chinese manufacturers routinely procure through common agents, thereby obtaining volume purchase and volume discounts.

34. Economies of Scale (contd.): Mass production by its very nature involves a lot of wear and tear. The average age of equipment in China is 6 years. Technological advances are embedded in the latest technology and one could reasonably conclude that the process of capital accumulation in China is not merely physical but is aimed at improving the quality of capital stock. Mass production in China has strong feedback loops within the economy in stimulating demand for capital goods. The policy of encouraging production to locate in clusters has significantly contributed to the rapid development of forward and backward linkages. Suppliers assured of a solid customer base have scaled up to meet predicted demand and in the process have lowered their own marginal costs of production.

35. (D) Labour Reforms In the final years of the command system, 99 per cent of China’s work force was in publicly owned undertakings, two thirds in agriculture and the rest in assorted economic activities. Employment system was characterized by two basic facets—job security and the utter absence of mobility. The Government controlled virtually all hiring decisions and allocated people to jobs, rarely in consonance with their skills and abilities. Strict restrictions on movement, especially from the rural to the urban areas further curtailed mobility. This resulted in SOEs being saddled with extensive redundant labour. Low levels of efficiency in SOEs led to losses that were eventually subsidized by the Government. For rationalization of the labour force, particularly in the SOEs, the Contract labour system was introduced in the mid-1980s. Under it, firms could hire workers depending on perceived need and lay them off in the event of a downturn. This flexibility allowed newly formed enterprises to scale up aggressively: new firms could freely hire labour without having to worry about retaining them in the event of a downturn.

36. Labour Reforms (Contd.): In the early 1990s, the government extended these ‘flexible’ labour policies in combination with other enterprise reforms such as hard budget constraints, greater autonomy to managers, wage flexibility, to SOEs in a bid to improve their bottom lines. This resulted in the layoff of over 25 million workers of the SOEs between 1996 and 2002. The policy narrowly called ‘Xiagang’ referred not merely to layoffs from SOEs, but also to the post-layoff rehabilitation process. The 3-stage rehabilitation program to assist workers affected by SOE layoffs. –Retraining and skill augmentation through Re-Employment Service Centers –Unemployment Insurance for retrained workers who could not find jobs within 3 years –Welfare support from the Minimum Living Standard Guarantee program, at the end of their eligibility period. However, the effectiveness of the programs varies widely by region and is biased towards the urban worker. Chinese policy makers are faced with a peculiar policy dilemma created by the evolving labour market. On the one hand, excess supply of labour in China suggests labour productivity will continue to grow at a faster rate than labour costs. On the other hand, rising wages could eventually erode China’s comparative advantage in cheap labour.

37. (E) Human Capital Governments commitment to increase in stock of human capital has never faltered even during periods of massive political upheaval. Investment in primary education has been largely unaffected, leading to a significant decline in illiteracy. As early as 1982, two thirds of the population was literate and basic industrial skills were widely disseminated in the population. This significantly helped the reallocation process from agriculture to industry. Given the low returns to education, individuals had no incentive to invest in higher education due to the fundamental misalignment between increases in social productivity and individual rewards. Through the 1990s, an individual Chinese worker could enhance his income by 4-5 per cent for every additional year of schooling completed, lower than the world average of 10 per cent. Returns to education has now increased to 10 percent since 2000. FFEs are also bidding up the wages of individuals especially with management training and/or English language skills, further increasing the incentives to invest in education.

38. Educational Attainment of Population (percent) Population, 15 and above 1982 1990 1995 2000 2004 Tertiary (above grade 12) 0.91.72.34.76.7 Upper middle (up to grade 12) 10.09.49.414.415.6 Lower middle (up to grade 9) 23.827.231.039.1_ Primary (up to grade 6) 30.843.243.632.9_ No formal schooling 34.518.513.69.0_

39. Most noticeable is increase is in the number of individuals with a high school education (includes ‘tertiary’ and ‘upper middle’), from 10.9 per cent of the population in 1982 to 22.3 per cent in 2004. The number of college graduated has tripled from one million in 2001 to over three million in 2005. The shift in focus towards higher education has resulted in primary education, even though illiteracy continues to decline steadily. Average age of schooling has increased from 6 in 1990 to a little over 8 in 2003. The government has initiated the following steps to bolster educational and training levels in the general population. - Increase the average age of schooling to 9 years. - Increase outlays for education from 3 per cent of GDP currently to 5 per cent by 2009. - Focus on traditionally disadvantaged groups such as women in rural areas and children of migrants who have to attend makeshift schools because of exorbitant fees charged by mainstream institutions. - Address differences in the quality of education between rural and urban schools.

40. (F) Ownership Reforms Literature broadly suggests that privatization has improved firm performance. Privately owned (both domestic and foreign) were forced to be efficient due to intense market competition. Privatization of SOEs has improved their performance. Song & Yao (2004) in a study of 683 state owned firms find that privatization positively impacted profitability (defined as return on capital) but had tepid effects on unit costs and labour productivity. Dong & Pandey (2007) in a comparative study of the impact of labour reform and ownership restructuring on the manufacturing sectors of China and India, report that these two factors collectively explained 30 per cent of the productivity increases in China. Ownership change contributed more to productivity improvements than labour reform.

41. (G) Foreign Direct Investment (FDI) The Fifth National People’s Congress in 1979 passed the ‘Law of the People’s Republic of China on Joint Ventures Using Chinese and Foreign Investment’, formally granting legal status to foreign investment. FDI brought in a bundle of management experience, marketing channels and technology, in addition to the basic inflow of resources. FDI in China has three distinctive characteristics: - Predominant form in which China has accessed global capital. - FDI has predominantly been directed towards the manufacturing sector (as opposed to services or extractive industries in other developing countries). - FDI inflows have traditionally been from other East Asian countries, mainly Hong Kong and Taiwan. FDI inflows have grown from barely a trickle in the early 1980s to about $75 billion in 2005, making China one of the top two FDI recipients in the world and by far the biggest destination among developing countries.

42. (1) Timeline of Policy Changes: Chinese policy makers moved vigorously to create the enabling environment to attract Foreign Direct Investment through a series of policy measures and institutional changes. Tuan & Ng (2004) classify the reforms into three stages which evolved sequentially. The first phase was of initial development, followed by a period of consolidation and finally a period of fast development. - Fundamental institutional reforms at the national level (1979-86), involving the creation of institutional infrastructure, laying the legal foundation for FDI and the removal of ideological constraints. - Reforms to move towards a market economy (1987-91) and emerging as a transitional state. Reforms had a regional orientation and focused on specific policies to encourage inflows. - The third stage of reforms beginning the early 1990s, were mainly concerned with FDI absorption via the creation of agglomeration economies.

43. (2) Empirical determinants of FDI Factors that attract FFEs to host countries, include a mix of economic factors such as GDP, GDP per capita, wage levels, inflation and unemployment rates, measures of the quality of physical infrastructure, membership in regional trade agreements, social indicators such as literacy rates and measures of institutional development (corruption levels). Specifically for China, Zhang (2001) identifies market size, the availability of agglomeration economies (measured as a share of manufacturing in a province’s GDP), quality of transportation (measured by density of rail and road networks in a province), literacy rates and openness of the economy as statistically significant predictors of FDI. ‘Agglomeration Economies’ is a term used to describe the benefits that firms derive from locating near each other. It is related to the idea of scale and network effects.

44. Typology of FDI Inflows Typology for FDI inflows is defined by: Vertical FDI involving moving part or all of a production process to a host country to export components or finished products back to the ‘home’ country or to a third country (s). FDI directed at the domestic market is referred to as ‘horizontal’ FDI. Vertical FDI is generally associated with the labour intensive, export oriented manufacturing sector seen in China and South East Asian countries and is drawn to country with low wage levels and the quality of physical and human capital. Horizontal FDI on the other hand is concerned mainly with market size. Vertical FDI is seen to generate more lasting forward and backward linkages within the host country and hence was the preferred mode of FDI in East Asia. China adopted a similar policy towards FDI, severely restricting access to the domestic market to foreign firms during the early years. It was only after 1992 that foreign firms were allowed access to the domestic market.

45. 198019851990199520002005 Total FDI Inflows in China (billion $) < 0.1 1.73.535.938.479.1 Share in Manufacturing Output (%) 2.314.322.531.4 Share in Manufacturing Employment (%) < 0.1 0.72.54.15.3 Share in Manufacturing Exports (%) 34.547.359.8 Share in Total Exports (%) 31.546.958.3 The contribution to exports and especially manufacturing exports has been equally spectacular. Exports by FFEs are now close to 60 per cent of China’s total exports. The figures are more impressive in high tech exports, where the share is close to 85 per cent. (3) Impact of FDI in China The contribution of FDI to total manufacturing output has increased fifteen times and accounts for almost a third of all production. More importantly, it is not restricted to merely labour intensive, low value added sectors, but is increasingly evident in high technology industries as well.

46. (billion yuan) 20002005 Industry Foreign- funded Enterpr ises Total % of Tota l Foreign- funded Enterpr ises Total % of Tot al Food Manufacturing 56.4144.339.1137.7377.936.4 Textile Industry 109.4514.921.3320.21267.225.3 Garments and Other Fiber Products 111.2229.148.5229.0497.546.0 Papermaking and Paper Products 50.2159.031.6145.5416.135.0 Printing and Record Medium Reproduction 19.861.732.146.8144.332.4 Raw Chemical Materials and Chemical Products 118.4574.920.6419.71636.025.7 Medical and Pharmaceutical Products 40.4178.122.7104.8425.124.7 (4) Distribution of FDI Inflows by Industry Table below gives the participation rate of foreign-funded companies in various industries within the manufacturing sector for the years 2000 and 2005. (Cont…)

47. (billion yuan) 20002005 Industry Foreign- funded Enterprise s Total % of Total Foreign- funded Enterprise s Total % of Total Chemical Fiber 43.7124.335.172.6260.827.8 Plastic Products 82.9190.043.6216.6506.842.7 Metal Products 96.5254.038.0239.5655.736.5 Transport Equipment 162.5536.530.3673.21571.542.8 Electric Equipment and Machinery 160.3483.533.2526.51390.137.9 Electronic and Telecommunications Equipment 540.3755.071.62271.22699.484.1 (4) Distribution of FDI Inflows by Industry Table below gives the participation rate of foreign-funded companies in various industries within the manufacturing sector for the years 2000 and 2005. (Contd.) 13% Increase

48. 19851990199520002004 Contractual JV 342021184 Joint Development JV 307211 Equity JV 3553503528 Wholly Foreign-Owned 120274667 (5) Modes of Entry of FDI: Table indicates the changing modes of entry for foreign capital into China between 1985 and 2004. The modes of entry in early days were a mixture of contractual joint ventures, joint development projects and equity joint ventures. The most remarkable change in the mode of entry has been the preponderance of Wholly Foreign Owned firms in China since the mid 1990s. The proportion of Wholly Owned Firms has increased from 1 per cent in 1980 to 67 per cent in 2004. Above all, this reflects growing confidence among foreign firms in China’s business environment.

49. Contractual Joint Ventures were flexible agreements of association, where no enduring legal entity was created and Foreign firms were linked to a domestic partner partly due to legal necessities and also to leverage the domestic partner’s knowledge of the domestic market. Joint Development projects were contractual joint ventures specifically tailored towards oil exploration projects. In Equity Joint Ventures, the foreign firm would reap the benefits of long term involvement, whereas the Chinese side would benefit from sharing of information. Such relationships did not work out very well, specially in case of SOEs, as foreign firms were interested in profits and increased market share whereas the domestic firms were interested in maintaining employment and accessing foreign technology.

50. Provinces Total Investment (billion US $) % of Total Guangdong 288.919.7 Jiangsu 265.718.2 Shanghai 200.713.7 Beijing + Tianjin 117.58.0 Zhejiang 101.97.0 Liaoning 81.55.6 Shangdong 78.65.4 Fujian 75.35.1 National Total 146482.7 (6) Regional Distribution of FDI in China Table ranks the top eight provinces by levels of FDI stock for the year 2005. The eight provinces collectively account for about 83 per cent of FDI stock in China. Guangdong and Fujian provinces have always had an FDI to GDP ratio above the national average of approximately 3 per cent since 1999. The FDI-GDP ratio was 13 per cent for Guangdong and 11 per cent for Fujian for the period 1993-2003 and inflows were large enough to transform these regional economies.

51. (7) Country of Origin Effects In early 1980s, rising educational levels in Hong Kong and Taiwan increased wages for skilled workers in those countries. As a result, employers found it difficult to hire and retain labour and started looking for alternative locations. China, with large investment opportunities, extensive concessions for investors and similar cultures and traditions, was the best choice for these Non Resident Chinese (NRC) investors. Most investment from Hong Kong and Taiwan is vertical and directed at international markets. Table: FDI Inflows by Country of Origin (in US$ Billion) YearJapanUS Europ e Hong Kon g Taiwa nMacauNRCTotal NRC as % of total 19974.33.24.420.63.30.424.344.255.0 19983.43.94.318.52.90.421.943.849.9 19993.04.24.816.42.60.319.338.849.7 20002.94.44.815.52.30.418.138.447.2 20014.4 4.516.73.00.320.044.245.3 20024.25.44.117.94.00.522.349.345.2 20035.14.24.317.73.40.421.547.145.7 20045.53.94.819.03.10.622.754.941.2 20056.53.15.618.02.20.620.779.126.2

52. Firms owned by ethnic Chinese are generally in low technology areas and use mature, standardized technologies. On the other hand, non-Chinese foreign investors (especially from the United States) are more likely to be capital intensive, engaged in innovative activity and share technology locally as they are looking for long term growth in the domestic market. Initial FDI from Japan had a profile similar to that from Hong Kong and Taiwan: labour intensive and export driven. However, more recent investment from Japan is in higher value-added products such as electronics and automobiles, motivated by the maturation of Chinese investment policy. FDI from the European Union was a little over $ 5 billion in 2005 and has a qualitative profile similar to the US. Other important investors in China are Korea and Singapore.

53. (8) Special Economic Zones (SEZs): With opening of the first SEZ in 1979 in Shenzhen, 1980s saw a proliferation of diverse SEZs (consisting of both private domestic and foreign enterprises), offering investors a vastly different operating environment whose benefits included: - Lower tax rates (including complete tax holidays) for periods raging from 3 to 10 years. - Fewer and simplified administrative and customs procedures. - Duty free imports of components and supplies. - Ownership rights. - High levels of autonomy which allowed firms to adopt innovative incentive structures. - Superior infrastructure compared to the rest of China. Formation of industrial clusters within the SEZs by firms in closely related industries, resulted in the establishment of extensive networks of supply chains, which significantly reduced transaction and transportation costs, both at the user and supplier end. Thus resulting in lower costs of production and enhanced export competitiveness of Chinese exports.

54. (9) Agglomeration Effects: China’s low costs are reflected in the entire supply chain from component sourcing to manufacturing, logistics, warehousing, storage, and commercial transactions created through clusters. There are now well over 1,000 supply clusters for export products, covering almost every major product category, from ferrous metal processing, construction ceramics, textile, electric appliances, household hardware to undergarments, toys etc. The majority of supply clusters are located in China’s most developed eastern provinces of Guangdong, Fujian, Zhejiang, and Jiangsu, and large metropolitan areas such as Shanghai, Beijing, and Tianjin. In terms of industrial output, labels and badges produced in Wenzhou account for 45% of China’s total output; lighters produced in Wenzhou make up 70% of the world market; neckties in Shengzhou in Zhejiang account for 80% of China’s production and 30% of the world’s total and PC cases produced in Qingxi in Dongguan account for 30% of the world’s total.

55. Types of Clusters Hub-and-spoke, where a giant manufacturer (mostly large SOEs or their JVs) is surrounded by a large number of suppliers and supporting firms in the local region. –Generally, the hub company used to be highly regulated and limited to capital-intensive industries such as telecommunication, energy, utility, steel, and chemicals. –Most of the enterprises in the industrial clusters are privately owned small & medium sized enterprises (SMEs). For instance, as the birthplace of industrial clusters in Zhejiang, Wenzhou has very few SOEs: over 97% of enterprises are privately owned. Clusters of privately owned SMEs: These non-SOEs depend on their own means for economic survival and produce well over half of the national GDP and contribute an overwhelming share of Chinese exports. In addition, these private companies advance the productivity and profitability of the whole economy and contribute substantially to new job creation in China. High-tech industrial clusters, also emerged in the early 1980s. Formed by a group of scientists and scholars from universities and colleges, and located in the surrounding areas of the universities and research institutes, they play a crucial role in knowledge generation.

56. Role of the government in cluster development In the early 1990s, the Chinese government established Science and Technology Industrial Parks (STIPs) to speed up the development of high-tech industries. These parks attracted IT companies, and now about 50 per cent to 80 per cent of IT products are produced by enterprises in the STIPs. Local governments also formulated preferential policies concerning land use, taxation, administration services, charges, etc. so as to create a sound and flexible external environment to attract foreign investments. Some of the major responsibilities of local and central govt. include: 1. Formulating measures and policies to attract investments. 2. Easing regulations and opening up creative financing and taxing mechanisms. 3. Regulating the market to form a fair competition environment. 4. Improving local environment and providing sufficient infrastructure to support technology innovation. 5. Facilitating opening of commodity exchange markets. 6. Organizing commodity exhibitions and trade fairs. 7. Providing assistance and guidance for technology upgradation.

57. III. Lessons for Coverage: A. Government Policies B. Reforms directed at SMEs C. Reform of Labour Laws D. Infrastructure E. Administrative Inefficiencies F. Foreign Direct Investment G. Developing Human Capital H. Firm Level Initiatives

58. (A) Government Policies To promote industrial growth and a high investment rate which keeps demand for materials and machinery high. Current savings and investment rates are both around 35 per cent of GDP, as compared to 23 per cent of GDP at the turn of the century. However, India leads China in efficient use of investment. The Incremental Capital Output Ratio (ICOR) for India in 2006 was 3.7 as compared to 4.4 for China. Public investment especially in agriculture and infrastructure needs to increase sharply. Promotion of policies that rationalize exchange rates and provide and advantage to Indian manufacturers.

59. (B) Reforms directed at SMEs They need to change: –Certain industrial sectors are ‘reserved’ for SMEs and hence firms would be disqualified from receiving preferential treatment if they grew above a certain size (measured as capital investment in plant and machinery). –Secondly, the regulatory framework, especially with respect to labour laws is biased against larger firms. –SMEs struggle to gain access to credit and have often to borrow in informal markets at a premium much above official interest rates. A review of the currently restrictive implementation of the credit policy towards SMEs needs to be urgently undertaken by the Reserve Bank of India to promote the growth of SMEs and provide easy access to credit.

60. (C) Reforms of Labour Laws In India, the Industrial Disputes Act (1947) forbids firms with over 100 employees from laying off or dismissing workers without explicit government permission, which is rarely granted. The Contract labour Regulation and Abolition Act (CLRA,1970) did allowed firms to hire labour on a contract basis, but still maintained considerable Government control, especially over the retrenchment process. The Government reserved the right to declare a certain activity outside the purview of the CLRA law, effectively denying the firm the option of retrenching redundant labour. Employers are not given the true flexibility to make hiring decisions. As a result, the additional legislation has not allayed employers’ anxieties and they continue to be wary about fresh hiring. India needs to study the Chinese experience, especially in how workers displaced from jobs could readily find alternative employment in a rapidly growing economy. This obviated the need for elaborate security nets.

61. (D) Infrastructure India invests an estimated 3 to 4 per cent of its GDP on infrastructure (though this proportion has gone up recently) as opposed to 9 per cent in China. There is a shortage of electric power, in addition to which the unit cost of power is much higher for Indian manufacturers. Supply is of poor quality and unreliable. Transportation bottlenecks not only result in inordinate delays but prevent the emergence of supply chains as in China. A recent study highlights that the difficulty in establishing supply chain networks as a principal reason that has discouraged FDI in manufacturing. The GOOD NEWS is that the government seems determined to remedy the situation by way of legislative changes such as the Electricity Act (2003) and investments of the order of $500 billion in infrastructure over the next five years.

62. (E) Administrative Inefficiencies: The regulatory maze is very complex and unraveling the knots is burdensome and time consuming. The present structure of entry and exit laws has discouraged new businesses from entering. The World Bank (2008) identifies high start up costs and needless delays as the reasons that have dampened investor interest in India (it takes 35 days to start a business in India, compared to 6 in Singapore). Similarly it takes 10 years to shut down a business in India (compared to 2.4 in China). Administrative reforms percolating right down to the state and local government level need to be undertaken. While far from a panacea, the use of ICTs could go some way in alleviating this problem. Certain states, especially in Southern and Western India (Andhra Pradesh, Karnataka, Gujarat, Maharashtra) have undertaken these reforms and have reported considerable success in reducing delays and inefficiencies.

63. (F) Foreign Direct Investment China has fared much better in attracting FDI, with inflows as a percentage of GDP are 1.9 per cent for India and approximately 3 per cent for China. FDI could still contribute the qualitative edge for India through technology transfer, exposure to better management practices and gaining entry to export markets. India needs to learn from China to enhance quality rather than sheer quantity of inflows. A comprehensive policy review needs to be undertaken, given that FDI in India has traditionally been more horizontal (market seeking) than vertical. India would also have to work on creating an ‘enabling’ environment for FDI by improving the quality of physical and human capital, reducing administrative delays and maintaining macroeconomic stability. To obtain the qualitative benefits of FDI, India would have to invest heavily in infrastructure and introduce policies to encourage firms to ramp up their manufacturing capabilities.

64. (G) Developing Human Capital High illiteracy rates, especially among the rural population, makes adaptability to industrial jobs difficult, significantly raising the training and reorientation costs of firms. India needs to increase not just the number of institutions imparting technical education, but also the quality of education. India lags behind China in the general level of education as well. Initiatives like the Sarva Shiksha Abhiyan, which seek to improve both the literacy rate and the quality of education, need to be expanded and encouraged. Industrial Training Institutes (ITI) must be improved with more relevant curricula. The manufacturing sector in India will also have to accept its share of responsibility in developing human capital, by allocating resources to ensure that continual skill upgrading programs are instituted.

65. (H) Firm Level Initiatives Indian manufacturing firms suffer because of higher cost of utilities, uncertain policy regimes, labour rigidities and infrastructural glitches as described earlier. However, firms need to themselves undertake certain measures to overcome these problems. Chinese firms have moved up the technology and scale ladder by interacting with world class firms through “contract manufacturing”. Developing strong dependable links with suppliers has yielded compounded benefits to Chinese manufacturers in the form of reduced variability in quality and delivery, higher precision and lower costs. Indian companies could also accomplish this with a little effort. Indian manufacturers are wary of such arrangements, because of a fear that buyers may suddenly cancel orders, rendering built up capacity redundant. Need is of greater integration into global supply chains to minimize this risk, with specific set of strategies for Indian manufactures.

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