Friday, June 22, 2007

Cross-Straits Integration and Industrial Catch-Up

Cross-Straits Integration and Industrial Catch-Up:
How Vulnerable Is the Taiwan Miracle to an Ascendant Mainland?

Edward S. Steinfeld

The chapter argues that a profound, essentially technologically driven transformation has occurred in the organization of production world wide, China’s emergence as a manufacturing hub is only one element of this shift.

In this chapter, Steinfeld makes the case that because of the above mentioned shift, Taiwan finds itself in an uncertain situation. However, also because of the shift—in which economic activities rather than entire industries can be relocated—the situation may not be as dire as some might think.

The Evolving Cross-Straits Economic Relationship
In recent years, Taiwanese investment in mainland China has grown considerably, often due to Taiwanese firms moving their production activities there to reduce costs. This is despite ROC regulations designed to limit such investment. As the text says, “what can be observed are increasingly dense connection between two economies at complementary, phased stages of development, albeit two economies separated by a vast political division.” As China integrates into the world economy, this connection grows and deepens as well.

Shifting Architectures of Global Production and Mainland Chinese Competitiveness
The varying degrees of modularity in production architectures have played an important role in China’s industrial development. This same modularity has also posed certain challenges. Due to the nature of modularized production products (standardized, codified), there are few alternatives in terms of remaining competitive other than high volume and low cost. This poses the risk of being replaced by a lower-priced competitor. The author poses three strategies for dealing with this situation: 1) the producer creates the modularized product that everyone else must design around, 2) the producer can shift away from modularization, and 3) the producer can provide key services like overall product definition, branding, and marketing in order to shape the supply chain.

Because these options all require some degree of innovation, they pose somewhat of a challenge for commodity manufacturers. It allows the rule makers (lead firms) to force rule takers to scramble to respond to their innovations.

Mainland Chinese Domestic Firms: Corporate Structure and “Price Wars”
One of the main characteristics of Chinese domestic industry is the intense competition based on price. Rather than causing a shakeout of smaller, less competitive firms and industrial upgrading, little of that has been in evidence. Instead, there has been the development of a pattern of corporate organization that is unlike that of many of China’s global counter parts. First, Chinese firms tend to be both newer and smaller than their counterparts. Second, the operations of Chinese firms tend to be localized. Third, Chinese firms are relatively shallowly integrated into global supply chains. Fourth, Chinese firms are under intense pressure to upgrade their technological capabilities.

The pressures these firms face force them to try to reduce costs or to rapidly change product lines—processes often thought of as innovative. True innovation and moving into higher value product lines doesn’t often occur, and firms find it difficult to maintain their “innovative” strategies because everyone else can pursue them as well.

Drivers of Mainland Pattern: Style, Capacity, and Policy
The patterns describe result from the interaction between three factors: government reform style, state capacity, and industrial policy. This interaction has simultaneously enabled and constrained Chinese firms’ integration into the global economy, the result of which is those firms are highly dependent on foreign firms that coordinate global supply chains.

Reform Style
The informality and decentralization of China’s reform style which has made it possible to transition into a form of capitalism has also made property rights unclear and financing of firms almost impossible, which has limited enterprise growth.

State Capacity
The Chinese realized that the usefulness of informality and decentralization had served its purpose and began to formalize its market system. Unfortunately, the state’s capacity for this reform was limited, particularly regarding the central government’s ability to coordinate policy across its administrative hierarchy, and in the government’s ability to regulate the commercial activity in the civil sphere. There is a certain level of lawlessness that has lead to a large number of unpaid loans which continues to grow. This causes liquidity problems as firms have uncertain relationships with state banks.

Industrial Policy
The industrial policy pursued by the Chinese government is a “comparative advantage” strategy, in which China uses its relative factor endowments (surplus labor, scarce capital) by specializing in the production and export of goods that require those factor endowments. They have also opened up the markets to competition, both domestic and foreign, in an effort to winnow out the less competitive firms. Because of the modularity of global industry, there is an emphasis on creating environments, rather than firms, and to develop the capability to “accord control and high returns in the international supply chains.”

Industrial Policy and the Building of National Champions
In contrast to the stated desire to use comparative advantage to help reform and shape industrial policy, China also desires to follow the Japanese and Korean models of the past to create “National Champion” firms—self-reliant, vertically integrated pillar firms—which are just the kind of firms that comparative advantage and technological innovation select against. This is probably due in large part because of the degree of control that the old models afforded the state over industry. There are some important differences, however, between China’s situation and those of Korea and Japan in the past. First, the Chinese economy of today is much larger and more diversified than those of the other countries in the past. Second, whereas Japan and Korea aimed to focus limited resources in certain key industrial giants, China’s efforts tend toward duplication of industries throughout the country. Third, the models of Japan and Korea required a high degree of protectionism, which, since joining the WTO, China will have difficulty defending. Even if these conditions did not exist, the two goals (allowing comparative advantage and competition to shape industry and creating large conglomerates) are essentially irreconcilable visions of industrial development.

China’s Emerging Multinationals and the Question of “Catch-Up”
Despite the issues mentioned above, some Chinese firms have been very successful in building powerful brands and in becoming global players. On an industry-wide scale, the Chinese motorcycle industry has been very successful. Most of the success of Chinese firms and industries is based on low cost production, even in more high-tech segments. Product innovation and definition are still beyond the grasp of most Chinese firms. Because of the emphasis on modularity, profit margins are very slim and the low entry barriers make competition very strong. One strategy to overcome this would be to reverse the standardization trend, allowing Chinese firms to control the connectivity between production modules and thereby achieve a degree of vertical integration.

The Issue of Catch-Up
The environment that China occupies today is much different from that of Japan or Korea in the past, in which manufacturing processes and innovation were highly proprietary to individual firms. Today it is activities, rather than industries, that move between countries. Also, in contrast to the past, today the incumbents are not manufacturing firms, but rather engage in high-value non-manufacturing activities. For this reason the relationship between Chinese firms and incumbents is more of a complimentary nature, rather than one of competition. In addition, because of the increased modularity of production processes, the boundary between industries and nations is blurred. For that reason it is risky to emphasize vertically integrated firms. Doing so can cause an industry to become captive to a supply chain, limiting innovation and cross-fertilization. The current Chinese emphasis on vertically integrated, “national champion” firms isolates the best Chinese enterprises from state-of-the-art technology, and limits their ability to become “rule makers.” This results in a widened gap between Chinese firms and foreign lead firms.

Although many manufacturing activities have been moved from abroad to China, it cannot be said that new Chinese global competitors have emerged. “Shifting geography has . . . failed to bring a comparable shift in control and capabilities.” In the old model, new firms could jump in at the low-end of a production process and hope to master the process to the point that it could eventually compete with lead firms. Now, due to modularization, this path to development is cut off. Because of this, Taiwanese firms still possess a strong advantage over Chinese firms.

There are a lot of political and security concerns between Taiwan and the mainland, and the current climate—which impedes cross-straits business—does not help matters. Still, Taiwanese firms, in part due to there deep imbeddedness in networks, maintain a powerful competitive advantage.

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