Some time ago, China realized that in order to grow and prosper, it would have to become globally integrated and make fundamental adjustments. It also understood that to do so meant becoming a full member of the World Trade Organization (WTO).

On December 11, 2001, after 15 years of negotiations, China officially became the 143rd member of the WTO. As part of its accession agreement, China pledged to undergo massive reform that would include significantly reducing its trade barriers. This move was predicted to result in greater access to Chinese markets. It also was anticipated to significantly improve China's ability to attract foreign direct investment — a necessary step in building a globally-competitive manufacturing sector.

But transitioning to a market economy is not the only change underway in China today. In November 2002, during the 16th Chinese Party Congress, Chinese leaders announced the country’s most historic transition of power. Hu Jintao, 59, officially succeeded Jiang Zemin to become the new Chinese Communist party chief. Jiang Zemin, however, will retain the position of Chairman of the Military Commission, a position now considered symbolic, since the military is no longer a major power broker.

As a result of these tremendous economic and political changes, China and the new nine-member Standing Committee of the Politburo have many challenges ahead. For example, social unrest is feared if economic growth does not function on all cylinders, while unemployment, deflation, mounting government debt, and a weak banking system are other serious concerns. Plus, as China continues to open its markets as part of the WTO accession commitments, unrestrained competition from abroad is anticipated to put heat on inefficient Chinese sectors, including agriculture and state-owned enterprises.

Although these challenges and the damage inflicted by the outbreak of SARS will continue to impact the Chinese economy for some time, sound economic expansion continues. Measured in gross domestic product (GDP), Chinese growth still reached 8.1 percent in 2002, and is anticipated to register 7.3 percent in 2003, and 8 percent in 2004, according to Bank of America's July 25, 2003 Global Economics & Financial Markets Weekly report. The 2002 better-than-expected rate was boosted by strong exports, foreign investment and consumer demand, in addition to Chinese government spending.

Overall, most analysts agree that China is emerging as a global economic powerhouse. And with the new generation of leadership who recently took office, China’s geopolitical position in the world is likely to become more dynamic. In fact, it is already having a profound impact on the Chinese manufacturing sector and its ability to engage in production-sharing with foreign companies.

Global Production Sharing Is Growing

Production sharing, also referred to as co-production, cross-border manufacturing and outward processing, occurs when producers in different countries share in the manufacturing of a product.

This process allows companies to complement each others’ strengths in order to create greater value, gain access to unique technology, raw materials and specialized intermediate inputs, reduce overall costs, and provide an important market for a company's component exports. For the United States and other more developed countries, co-production also provides the means to retain higher wage jobs, capital-intensive manufacturing, product development and design, and marketing-related activities at home.

In the European Union, most co-production involves apparel, auto parts and electronic products, and occurs mainly in Poland, the Czech Republic, Hungary, and Slovenia — countries with inexpensive but well-educated labor forces. A growing share of European co-production also is taking place in Northern Africa.

Companies in Japan, Korea and Taiwan primarily co-produce in China, Indonesia, Malaysia, Thailand, and the Philippines with a focus on apparel, auto parts, computer hardware, telecommunications equipment, electronic components, and appliances.

Major North American production-sharing includes the U.S. export of machinery, components and materials, and the U.S. import of assembled motor vehicles and auto parts from Canada and Mexico, apparel from the Caribbean and Mexico, and televisions, computer hardware and telecommunications equipment from Mexico. In addition, several global electronics companies assemble semiconductors in East Asia from wafers fabricated in the United States.

How big is production sharing? According to The World Bank, production sharing involves more than $800 billion or 30 percent of total manufacturing trade annually. And, it is increasingly becoming more important to European, Asian and U.S. companies.

When U.S. exports of components are co-produced abroad and re-imported by the U.S. as finished goods, they often enter the United States under Chapter 98 of the U.S. tariff code. This allows U.S. materials assembled, processed or improved abroad to be shipped back to the United States incurring duty only on the foreign labor and non-U.S.-made materials. As a result, these imports — which often contain substantial U.S. content — can be more price competitive than other imports without U.S. content. According to the U.S. International Trade Commission (ITC), production sharing has been responsible for generating new U.S. jobs and retaining those that would have been lost due to intense foreign competition.

In 1987, the ITC conducted a survey of 900 U.S. firms that co-produced utilizing the predecessor to Chapter 98. When asked what they would do if this U.S. Customs provision were eliminated, the firms said they would turn to foreign suppliers of components, drop labor-intensive products and import them from East Asia, move all manufacturing to Asia, cut back U.S. production and target a market niche not threatened by imports, or go out of business.

Sharing manufacturing strengths with high and low-wage countries has become an important strategy for many companies worldwide. However, while co-production has been beneficial for many firms, some have invested in foreign-based production sharing facilities only to find unexpectedly low levels of productivity, excessively high turnover, poor infrastructure, and a corrupt legal system. Consequently, many firms have abandoned their efforts.

China Is Emerging as a Production-Sharing Giant

A flow of foreign direct investment (FDI) into a fledgling manufacturing sector is a sign of an emerging production-sharing industry. And nowhere is this more evident than in China today.

In 2002, the United Nations estimated that world FDI flows declined to approximately $534 billion, representing a decrease of 27 percent over 2001. Surprisingly, however, FDI flows into China rose to nearly $53 billion in 2002, and they even surpassed the United States', which were $30.1 billion, according to the Organisation for Economic Co-operation and Development (OECD). FDI flows into the U.S. have slowed considerably, from a high of $307.7 billion in 2000, making China the world's leading FDI destination.

Importantly, more than two-thirds of world inbound Chinese investment is directed to the manufacturing sector. And a larger portion has been flowing into higher value-added sectors such as semiconductors. Yet, investors continue to resist transferring their highest value-added operations to China, according to The U.S.-China Business Council.

A growing number of foreign component suppliers also are establishing facilities in China — a precursor to the emergence of FDI-led integrated supply chains. A strong domestic supply chain, something Mexico, for example, has not been able to establish, is another important factor helping to position China as an increasingly attractive destination for manufacturing FDI.

Additional factors, including lower costs for labor, energy, water, and taxes, as well as subsidized inputs, have led to a shifting of sourcing from Mexico to China for apparel, electronic products and telephone equipment, according to Ralph Watkins, U.S. International Trade Commission's Program Manager for Production Sharing. As the demand for these products increases, more investment in Chinese plants and equipment is likely.

The Benefits of WTO Membership

China's relatively new status as a member of the WTO and its WTO-mandated process of liberalization and reform are anticipated to accelerate inward FDI. And much of this may be at the expense of Asian developing countries and perhaps Mexico, who will increasingly compete with China for global FDI.

With the opening of China's markets, U.S., European and other companies plan to export more goods to China in coming years. As this occurs, even more FDI is expected to flow into the China for the purpose of establishing sales and service facilities. In turn, these companies likely will source more of their goods from within China.

How low will Chinese tariffs fall? According to the U.S. Department of Commerce, as part of the WTO accession agreement, China promised to reduce tariffs from a 1997 average of 25 percent to 8.9 percent. Nearly all reductions are anticipated to be in force by January 1, 2005, with the remainder completed by 2010. Some specific examples of average duty reductions include: 6.4 percent on IT products to 0 percent, 6.5 percent on medical equipment to 3.9 percent, 8.8 percent on chemicals to 6.9 percent, 7 percent on pharmaceuticals to 4.2 percent, 8.2 percent on scientific equipment to 5.4 percent, and 22 percent on agricultural tariffs to 17.5 percent, and 31 percent to 14 percent on U.S. priority agricultural goods.

Importantly, China agreed to provide non-discriminatory treatment to all WTO members. This means foreign individuals and enterprises will be accorded treatment no less favorable than that accorded to enterprises in China with respect to the right to trade.

Furthermore, China is expected to eliminate non-tariff barriers and use a tariff-rate quota system for wheat, corn, rice, cotton, and soybean oil. Plus, it has agreed to improve intellectual property protection, as well as allow foreign banks to deal in the renminbi, the Chinese currency. As a result, increased pressure for interest rate liberalization and an accelerated movement toward full currency convertibility are expected.

For the most part, China thus far has lived up to its WTO commitments. According to the U.S. Trade Representative (USTR), "Overall, during the first year of its WTO membership, China made significant progress in implementing its WTO commitments, although much is left to do." However, the USTR indicated that serious concerns exist in some areas, where implementation has not yet occurred or has been inadequate.

This generally positive assessment is shared by many, including The U.S.-China Business Council, who said, "Tariff reductions appear to be occurring satisfactorily. For certain products, China has lowered tariffs ahead of the WTO schedule. China has done a relatively good job of issuing and revising legislation to meet its yearly commitments."

However, the council identified a number of problem issues, including transparency, how China will allow foreign firms to expand their scopes of business, and in some instances, outright protectionism.

In his testimony before a U.S. House of Representatives' subcommittee on May 22, 2003, Frank Vargo, Vice President, National Association of Manufacturers, said, "China's initial track record shows many positive achievements, but there are some problems that have already become evident."

For example, Vargo pointed out that China is manipulating its currency and not allowing it to adjust to market forces for the purpose of achieving a competitive advantage. As a result, some economists believe the renminbi, also known as the yuan, is undervalued by as much as 40 percent as compared to the U.S. dollar. In turn, this artificially lowers the Chinese cost to manufacture goods and makes Chinese exports more attractive.

The WTO Membership Short-Term Impact

Nevertheless, the effect of China's tariff reductions are already evident. For example, from 2001 to 2002, Chinese world imports rose by 21 percent to reach $295 billion, according to the WTO (in contrast, U.S. world imports rose by 2 percent). As a result, China moved up two spots to become the United States' seventh largest export destination, buying $22 billion in U.S. goods. If Hong Kong were added, China would move into fourth place. Importantly, in 2002 China ranked as the United States' fastest-growing export market.

But the impact of FDI in China's production-sharing facilities is even more striking. For example, in 2002, China become the United States' third largest supplier, selling $125 billion in goods to the U.S. This represented 38 percent of Chinese world exports, which reached $326 billion in 2002.

U.S. imports from China created a U.S. trade deficit of $103 billion in 2002. This was $33 billion more than the U.S. deficit with Japan. Why is this happening?

Much of the U.S. deficit with China is due to China’s growing competitiveness in many of the same industries as other Asian countries. This has made China an increasing threat in the region, especially in textile and electrical appliance sectors.

The U.S. trade deficit with China reflects a shift of U.S. labor-intensive imports away from higher-wage Asian countries to lower-wage China. As a result, low-tech products the U.S. previously imported from other Asian countries are now being imported from mainland China. Consequently, the U.S. trade deficit with China has increased, while the deficit with other Asian countries has decreased.

The Future of Co-Production in China

From 1980 through 1990, China’s GDP growth averaged 10.1 percent annually. Over the following decade, 1990 through 1999, its annual growth slightly increased to 10.7 percent, the highest in the world according to the World Bank.

As a result, China's annual GDP is approximately one-ninth of U.S. GDP and represents 3.6 percent of world output, according to Kei-Mu Yi of the Federal Reserve Bank of New York. But this is changing quickly. Kei-Mu Yi predicts China's output to reach United States' between 2017 and 2027.

In the future, more and more co-manufacturing is expected to shift to China. Already, China is the world leading supplier of labor-intensive sewn products, and it accounted for 67 percent of U.S. imports of footwear; 66 percent of toys, dolls, games, sporting goods and bicycles; 64 percent of lamps and luggage; 38 percent of consumer electronics except TVs; and 20 percent of computer hardware in 2002, according to Watkins.

Factors To Consider

Although China has much to offer, before investing in it or any other country for the purpose of establishing a co-production facility, treasurers and other senior managers must review a number of factors.

According to Watkins, these include the following: labor costs, electricity costs, local supplier base, transportation costs and transit time, the availability of skilled labor and their level of productivity, international telecommunications costs, the ability to transfer technology, the level of manufacturing and management flexibility, the protection of intellectual property, the level of transparency in government regulations and administrative actions, and the existence of free trade agreements.

Production sharing can give a company the means to become more globally competitive. However, as noted above, a variety of risks exist. As a result, there is no substitute to sound research.

This article appeared in June 2005. (BA)

John Manzella
About The Author John Manzella [Full Bio]
John Manzella, founder of the Manzella Report, is a world-recognized speaker, author of several books, and an international columnist on global business, trade policy, labor, and the latest economic trends. His valuable insight, analysis and strategic direction have been vital to many of the world's largest corporations, associations and universities preparing for the business, economic and political challenges ahead.

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