For all our talk of tariffs, trade war, and corporate censorship, our China debate has largely ignored one of the main drivers of Beijing’s economic success: namely, its high dependence on foreign technology. Foreign technology—provided by American companies operating in China, U.S. universities educating Chinese students, and China’s aggressive pursuit of intellectual property and cyber theft—has been a central element of China’s growth methods. Without it, China’s high investment model would have been much less effective. With it, China has been able to achieve the fastest growth in history.
The story of how this worked has not been well understood. Many are aware that American and other Western companies offshored a lot of manufacturing in the 2000s, but few understand why Western offshoring happened when it did, why so much of it went to China, and how much it boosted China’s exports and growth. The combination of Western technology and China’s cheap labor created new forms of competitive advantage that shifted growth momentum from West to East. This trend operated in its strongest form from 2001 to 2007 but continues to shape China’s competitiveness today.
Over the past 35 years China’s share of global GDP has increased from 3 percent to 16 percent, while America’s share has shrunk from 35 percent to 24 percent. From 2001 to 2013 China increased its share of global manufacturing value added from 6 percent to 24 percent, overtaking both the United States and the European Union to become the largest manufacturer of goods in the world. From 2001 to 2007 China increased its exports fivefold, moving from the seventh largest exporter in the world to the largest.
When America political leaders supported China’s accession to the WTO in 2001, they had no idea that their decisions would lead to such outcomes. The conventional wisdom was that WTO accession would force China to open its markets, which would produce one-sided gains for the United States. Instead China launched a major mercantilist push—using an undervalued currency, state leadership, and recruitment of Western investors to achieve manufacturing hyper-growth.
Many think that China’s main vehicle for technology advance has been IP theft and forced technology transfers. Those have been contributing factors, but the biggest drivers of China’s gains and American losses have been two structural changes in the global economy. The first has been the fragmentation of global supply chains that allowed American and Western companies to offshore low-wage phases of production. The second has been the unusual effectiveness of China’s low-cost strategy, which has allowed it to sweep the field of labor-intensive manufacturing.
The Baldwin Shift
British economist Richard Baldwin has analyzed the change in the global order that made offshoring possible. According to Baldwin, new developments in information and communication technology around 1990 made it possible for Western companies to break up their supply chains into different components done in different countries. This enabled the companies to shift low-wage phases of production to China and other low-wage nations, as long as they sent technology with it. This provided major boosts to the industrial advance of the receiving countries, as Baldwin notes in The Globotics Upheaval:
Offshoring firms sent along their know-how with the offshored stages of production and displaced jobs. How could they have done otherwise? . . . It was exactly these technology flows that triggered the rapid industrialization in China and a few other developing nations. . . . They didn’t have to develop the technology themselves. The offshoring companies brought everything needed except the labor. You could call it “add-labor-and-stir” industrialization.
One of Baldwin’s key insights was that the combination of cheap overseas labor and Western technology created powerful new forms of competitive advantage. Cheap labor by itself is not a strong source of competitive advantage—all low-income countries have it. But offshoring combined the best of the two worlds and created a new business model that was superior to either one on its own. The new model produced major gains in the receiving nations, but imposed serious losses on the sending nations. In Baldwin’s words:
The result was a quite sudden and massive deindustrialization of the advanced economies. . . . Industrialization took a century to build up in advanced economies. Deindustrialization and the shift of manufacturing to emerging nations took only two decades. . . . [Western] workers no longer had privileged access to the know-how developed by their national firms. The monopoly that advanced-economy workers used to have on advanced-economy technology was broken. Manufacturing workers in the [West] found themselves competing with robots at home and with China abroad.
Baldwin’s theories provide critical insights. But as a guide to China’s rise, they need some additions and modifications. First, some manufacturing gains have gone to countries like Indonesia and Thailand, but the vast majority of them went to one country: China. China captured the lion’s share of the offshoring movement, which has allowed it to dominate catch-up growth.
Second, China’s gains from foreign technology did not start in the 1990s. They started at the very beginning of Deng’s reform push in the early 1980s, when companies from Hong Kong and other countries in the region opened plants in China. China already had two decades of foreign company-assisted manufacturing development under its belt when WTO accession helped it hang out an “open for business” sign.
Other elements of China’s growth strategy have complemented and supplemented the foreign technology element. One has been China’s single-minded focus on keeping costs low and expanding market shares. China’s growth strategy has been similar to Amazon’s business strategy: compete by offering the lowest prices, plow your earnings into investment, and build market share relentlessly.
This strategy addressed two of China’s biggest challenges: moving workers from farms to factories and raising productivity. Development experience in other countries, as shown in Michael Spence’s The Next Convergence, suggests that shifting workers from rural to urban sectors raises their productivity by a factor of three to six times. Thus, the growth payoffs of moving workers to factories are enormous; the challenge is generating the jobs. Here China’s dominance of offshoring was key. Since “offshoring companies brought everything needed except the labor,” they helped China achieve very rapid urban shifts.
A second supporting element has been China’s extremely high investment. The Asian Tigers all used high savings rates to subsidize high investment, but China has taken these practices to an extreme. While the investment levels of most Asian Tigers peaked at 25-35 percent of their GDPs, China’s investment levels have ranged from 35-45 percent of GDP—unheard of for a major country.
China has a fundamentally different view of capital than America. America’s system focuses on the profitability of investments—high hurdle rates maximize returns on individual investments. China focuses on the volume of investment—it keeps capital extremely cheap in order to maximize the overall level of investment. While we think of the Chinese economy as labor-intensive, finance expert Michael Pettis argues that “China’s growth is actually heavily capital intensive. It is in fact among the most capital intensive in the world. . . . Labor may be cheap, but capital is free.”
Government support for favored investments actually goes further, to include massive subsidies. In the 2000s the government provided such large subsidies to Chinese solar panel producers that it not only drove foreign producers out of business but also hurt its own companies by creating global over-supply. In the electric vehicle industry the government not only gave subsidies to buyers, it also funded most of the build-out of the charging station network in advance of demand—a Chinese version of “if you build it, they will come.”
The Three A’s: Attract, Access, Adapt
China has used three general methods to tap foreign technology: attracting foreign investors by offering low costs, accessing foreign technology by forced technology transfers and IP theft, and adapting foreign technology in local products. We might call these the three A’s.
Attracting foreign investors was pushing on an open door. Companies from the East Asia region saw immediate opportunities in the 1980s and expanded their investments quickly. Later offshoring was very attractive to Western companies because it allowed them to cut costs and expand sales. Offshoring was particularly attractive to American companies because it helped them respond to domestic pressures from the shareholder value movement to increase returns on net assets.
China also worked hard to attract foreign investors. First, it made an early strategic decision to embrace foreign investment. As Harvard historian Julian Gewirtz has argued, China had been obsessed with technological advance since the days of Mao. After Mao died, the Communist Party leadership embraced foreign technology as a way to jumpstart growth under the label “foreign leap forward” (sometimes translated as “Western leap forward”). In this decision China pioneered a new path that differed from the paths of Japan and Korea (both of whom blocked foreign investment because they wanted to develop their export industries on their own.)
Second, China took proactive steps to make itself the most attractive destination for foreign companies. It created special economic zones to cater to foreign companies. It also “paid to play”—it accepted many costs and made many sacrifices in order to make itself the most attractive low-cost producer. These costs included low consumption levels (which allowed high saving and investment), harsh labor conditions, environmental degradation, and an undervalued currency. With these sacrifices and subsidies, China ensured that it offered more to foreign investors than potential competitors.
Because of its natural advantages and these special efforts, China was able to sweep the field of low-wage manufacturing. In effect, China specialized in being the low-wage partner of foreign companies.
China’s second method has been to get access to Western technology, including by monitoring open sources, sending students to the United States, IP theft, cyber espionage, forced technology transfers, and purchases of Western companies. Some of these methods (like monitoring open sources and sending students to our shores) are legal. Other methods (like forced technology transfers) are illegal under WTO rules but have been highly effective because many Western companies have been willing to comply as a cost of doing business. China has taken cyber theft to a new level by specializing in theft from private companies in the United States.
China has taken a different approach regarding internet companies. Contrary to its openness to foreign companies in other fields, China has sharply constrained the abilities of Google, Amazon, and Facebook to operate in China. Instead it has protected and promoted its own local counterparts (Baidu, Alibaba, and TenCent). Like America’s FAANGs, China’s BATs have been highly profitable and are strong investors. They have also benefitted from American technology because of the open access of algorithms, movement of people between Silicon Valley and China, and strong Chinese presence in American companies and universities.
China’s third method has been to adapt foreign technologies in local products. According to business analysts Dan Breznitz and Michael Murphee, Chinese companies don’t try to compete with Western companies at the cutting edge of technology; instead, they specialize in products that are “one step behind.” They focus on process improvements that make them more efficient partners in multinational production or allow them to produce lower-cost versions that are more suitable for China and other emerging-market countries.
Chinese companies have been highly adept at creating local versions that offer 80 percent of the value at 50 percent of the cost. MIT analysts Edward Steinfeld and Jonas Nahm argue that this is an important form of innovation. Western designs are the starting point, but Chinese companies modify the designs to make them cheaper to produce, faster to deliver, and easier to scale, which involves innovation in engineering and manufacturing processes. Because these contributions make the products commercially viable to more people, Chinese companies have “become critical players in a global, cross-border quest to commercialize new-to-the-world technologies.”
“One step behind” and 80 percent of the value for 50 percent of the costs may sound like inferior approaches to innovation. But there are two types of disruptive innovation. One is entirely new products that create new markets; another is lower-cost products that gradually improve their quality and take market share from the previous leaders. As a case of the latter, Harvard Business School Professor Clayton Christensen cites the example of mini mills in the U.S. steel industry: Mini-mills first specialized in rebar but gradually improved the quality of their production, which eventually allowed them to displace integrated steel mills.
In a sense this is what China has been doing with its focus on 80 percent of the value at 50 percent of the cost. It has created new, lower-cost products that appeal to customers in China and other emerging-market nations. It started with low-end products but moved on to more sophisticated versions over time (like Huawei phones). These products have allowed Chinese companies to make rapid gains in local markets and in exports. If America has led high-end disruptive innovations, China has led bottom-up disruptive innovations.
How much difference has China’s access to foreign investment and technology made in China’s gains in exports and GDP? First, foreign companies have been responsible for a very large share of China’s manufactured exports, especially its high-tech exports. Second, experts believe that foreign technology has made very large contributions to China’s GDP. According to business analyst Michael Enright, foreign investors and foreign-invested enterprises accounted for 33 percent of China’s GDP and 27 percent of its total employment in 2013. According to investment banker Stewart Paterson, China’s accession to the WTO caused its GDP to be twice as large in 2016 as it would have been otherwise.
These are very high numbers. But if we think about the broader historical processes at work, it is plausible that the impacts would be quite large. The Baldwin shift has not been an incremental change in the global economy. It has been a fundamental structural change in which a major source of Western productivity and growth—the technology of Western multinationals—became globally mobile. This has provided enormous boosts to China’s economy.
Offshoring has also focused on manufacturing, which is disproportionately important for economic growth. Since the beginning of the Industrial Revolution national growth performance has been highly correlated with leadership of manufacturing. In the late 19th and early 20th centuries the United States and Germany gained at Great Britain’s expense. After World War II Japan and Europe reduced their gaps with the United States. In these cases, most manufacturing was done within national borders, advanced economies dominated manufacturing, and growth was long and slow. The Baldwin shift changed this system. Now production could move across borders, which helped China greatly. If Western growth was a marathon, China’s has been a sprint.
Foreign technology has acted like steroids in China—it still had to go to the gym in the form of making domestic reforms and investments, but foreign investment made its strength gains at each step much greater.
Costs to America
How costly has China’s strategy and U.S. offshoring been for America? Some economists believe offshoring has been good for the United States. For example, George W. Bush’s Chairman of the Council of Economic Advisors Greg Mankiw said in 2004, “Outsourcing is just a new way of doing international trade. More things are tradable than were tradable in the past and that’s a good thing.” Others recognize that American workers have suffered serious setbacks, but attribute them to technology rather than globalization.
However, if we look at China’s impacts in broader economic terms, they appear much more substantial and much more negative. First, the shift of manufacturing from America to China has had high costs because manufacturing has high productivity and multiplier impacts. When manufacturing slows in the United States, it reduces a prime driver of jobs and growth.
Second, innovation tends to follow production. When the offshoring movement began, many thought American companies could “innovate here and manufacture there.” But as analysts Sridhar Kota and Tom Mahoney point out, “innovation in manufacturing gravitates to where the factories are.” “Innovate here and manufacture there” has often become “manufacture there and innovate there.”
Third, the entry of millions of low-wage Chinese workers into the global production system has suppressed Western wages. If Western workers have to compete in the same markets with low-wage Chinese workers, Western wages will decline. And given the size of the Chinese workforce and the enormous gap in wage levels, the impacts are likely to be quite large. Stewart Paterson puts it this way:
The ramifications of allowing this kind of free trade were bound to be severe. On the one hand, we had a nation of 1.2 billion people with an average income of less than $1,000 a year, and on the other we have the developed-world economies of America, Japan, and parts of Europe with labor costs twenty times higher and a combined population of around 900 million. . . .
Through the last thirty years of the twentieth century, median household income in the U.S. grew at a steady pace of about 5.3 percent. In the first decade after China’s accession to the WTO, that growth slowed to scarcely above 1 percent in nominal terms. In real terms the median household income actually fell 10 percent in that decade. . . .
The inescapable conclusion is that economic engagement with China from 2001 onwards led to a rapid and dramatic deterioration in the real earning power of workers in the developed world. There has not been a period in which median earnings in the developed world have been so stagnant for so long since the Victorian Age.
Can China Innovate?
What about the future? Does the fact that China has achieved spectacular growth with the assistance of foreign technology in the past mean that it will continue to do so in the future?
Many analysts say the answer is no. They make three main arguments. First, China’s growth has already slowed since the Great Recession, and will slow more because of China’s aging population, high corporate debt, and declining productivity. Second, many believe that trade tensions with America will lead to increased decoupling of the U.S. and Chinese economies that will sharply constrain China’s access to foreign technology. Third, many believe that China is setting itself up for failure with its ambitious goals in Made in China 2025, which call for Chinese companies to not only reduce their dependence on foreign technology, but also challenge Western companies in global markets. The critics don’t think China’s companies will be able to do either of these because China’s statist system will keep them from innovating.
The critics have some good points. China’s growth is likely to slow, possibly a lot—in the short run because of high debt and in the long run because of a severe aging problem. China’s leaders have under-estimated how hard it will be to compete with Western multinationals at the cutting edge. If they aim for a purist version of Made in China 2025, they will probably face much more serious difficulties than they expect. However, if they pursue a more nuanced approach, they may do better than the critics think, for several reasons.
First, China can pick and choose where it reduces its reliance on foreign technology. It can focus on those areas where it thinks it can advance (like electric vehicles) and in other areas (like semiconductors and technical education) count on continued technology flows from American companies and universities who want to maintain strong ties with China.
Second, China doesn’t have to compete with Western multinationals in the most advanced products; it can continue to rely on strategies of “one step behind” and 80 percent of the value at 50 percent of the cost. These strategies are likely to become even more powerful sources of competitive advantage in the future. Most of the future growth in global demand will not come from aging Western societies, but from the rapidly expanding middle classes of China and other emerging-market nations. China has comparative advantages in the types of goods these markets want. Western companies will also continue to want to partner with Chinese companies to produce for these markets. Thus China is likely to continue to be a strong exporter and continue to benefit from foreign company linkages.
Third, China will continue to benefit from its advantages in cheap capital, including its large public investments for research and education and its low hurdle rates for private investment. For example, China is making massive public investments in quantum computing and large private investments in industrial robots.
The United States may continue to lead in the most advanced forms of technology, but China is also likely to be a strong competitor, especially in manufactured products for emerging-market nations. Who will lead technology in the future, then? The answer may not be fully satisfying to either Washington or Beijing: It could be both nations.