Return to
China Array


Update on Manufacturing in China by Russell S Johnson, President of China Array Group, LLC.: August 2004.

Private Manufacturing: China's Salvation?

China's private sector, especially manufacturing, is seen as the country's economic salvation. But, investments being made in this burgeoning sector by local financial institutions may actually be compromising its ability to absorb workers from State Owned Enterprises (SOE) and the country side (the key to any salvation scenario) as well as undermining China's already overburdened banking system.

Historical Context

With its ability to create jobs, generate exports and meet growing domestic demand China's private sector is pivotal to the country's economic future. Its importance and acceptance has grown in stages from 1978 when private ownership was first deemed acceptable to 1992 when it was encouraged to 2003 when private entrepreneurs were accorded the ultimate (if ironic) imprimatur of communist party membership. Investment has moved in tandem with this growing political acceptance and economic success. During the 1980's and 90's, private industry in China was hampered by a shortage of investment capital, as domestic funding flowed to SOE's and foreign direct investment (FDI) was still building momentum. Despite the shortage, private manufacturers managed to secure sufficient funding to upgrade the antiquated capital equipment base they inherited from the central planning era. Firms started by adding basic machine tools such as hydraulic presses and CNC lathes aimed at cheaply improving labor productivity. Over the last five years, investment statistics and empirical evidence suggest that this incremental approach to capital expenditures has given way to accelerating investment in full scale, automated production facilities: including the latest in robotics, computerized "workerless" warehouses and other leading edge technology. This shift is transforming the manufacturing landscape in China.

Increasing Captial Intensity

From 1990 through 2001, investment in fixed assets in China grew at an annual rate of 13%; it jumped to 17% in 2002 and 30% in 2003. Through the first quarter on 2004 it is growing at close to 50% year on year. This 2004 increase is three times the increase of just two years ago and represents approximately 47% of GDP. The IMF estimates that 60% of China's capital investment is going to the private sector with the bulk of that going into manufacturing. The private sector accounts for approximately 35% of China's industrial output according to World Bank estimates. Through February 2003, total industrial production grew 23.2% over the previous year. SOE (the government's manufacturing sector) growth is flat or declining. Therefore, the 35% of the industrial base under private control drives this remarkable industrial growth rate. Stated another way, private manufacturing in China is growing at a rate in excess of 60% per annum.

Foreign Direct Investment (FDI), though widely covered in the media, is responsible for only a fraction of this investment surge. In 2002, China overtook the US as the leading destination for FDI: reaching $52 billion invested. Yet, FDI actually shrank as a percent of gross capital formulation. From 1990 through 2003, over $400 billion of worth of FDI flowed into China, yet, according to World Bank statistics, FDI's share of gross capital formation dropped from 15.1% to 9.6% during this same time frame. For each $1 of FDI there is now $9 of domestic investment, and the disparity continues to grow even as FDI hits new record levels each year. One broad measure of how this increased investment is being utilized is the incremental capital to output ratio, which correlates the increase in GDP with the increase in investment. During the 1990's, China's ratio of capital to output was three to one. Over the last five years it grew to 4.5 to 1, i.e. it now takes $4.50 of investment to generate $1.00 of new output. While this ratio would be expected to go up with increased capital investment, a 50% jump indicates sharply diminishing marginal returns.

Considering that 60% of fixed capital investment goes to the private sector, the increased inefficiency reflected in the ratio cannot be explained away by central government investment in non productive projects. In a country with a vast pool of skilled labor and a capital goods base that is still relatively small and antiquated, one would expect a smoother increase in the capital to output ratio. These Macro economic factors are confirmed empirically by hundreds of new huge private factories along the east coast of China that use state-of-the-art automation to produce automobiles, air conditioner, electric appliances, compressors, cell phones, auto parts and a host of other industrial goods: not to mention billion dollar semiconductor production facilities, pulp and paper mills, chemical plants, steel mills and other basic industry processing facilities.

To see of how this shift looks at the factory level compare snapshots of two factories visited by the author in 1991 and 2004. At the first factory, steel tubes were being crimped manually using a car jack. The worker would pump the jack handle while watching a pressure gauge to insure proper indentation of the tube. The jack was later replaced by a used hydraulic press at a cost of US$300.00 increasing productivity seven fold and improving quality consistency (not to mention reducing wear and tear on the worker). Compare this to a single segment of a newly build assembly line that produces air conditioners. In the packaging and shipping section of the line (which could be adequately handled manually) a box is picked by a robotic arm, opened, sealed on one end and place on a conveyer. The finished product is automatically laid in the box, which is then closed, sealed and bar coded. It continues by conveyer to be placed on a shelf by a computerized trolley, to be picked later (again automatically) for shipping: a sophisticated system dedicated to eliminating labor from packaging and shipping. Taken individually, each of these new automated production facilities is as efficient and competitive as any in the world. Taken cumulatively, they mark a structural shift in China's private manufacturing to a more concentrated capital base: a move away from buying machine tools for incremental productivity gains to, instead, building large turnkey facilities. It is not just that China is adding industrial capacity, but rather that it is adding that capacity in blocks of automation not easily redistributed in the event of a realignment of assets due to changing economic circumstances. Have these private firms gone too far in the direction of capital intensity thereby disrupting the balance between capital and labor that has made them so successful to date? And, if so, why?

Operational Leverage

Operational Leverage One way to get an idea of how this more concentrated capital intensity might impact China's economy is to compare it to the already heavily automated manufacturing base in the West: against which China has competed over the last 25 years and now seems intent on emulating. Western factories have been working for decades to substitute capital equipment for expensive labor. The competition between China and the West has always been seen as that of cheap labor versus automated manufacturing: China's labor-intensive factories versus capital-intensive factories in the West. The crux of the comparative advantage reduced to the cost of labor in China versus the cost of capital in the West. An extension of this debate encompassed the topic of operational leverage, i.e. fixed costs versus variable costs in production. Western factories invested capital to reduce labor man-hours (variable costs) per product. The increased capital investment, in turn, raised the breakeven sales levels needed to cover higher fixed costs. However, once sales surpassed breakeven, additional incremental sales flowed to the bottom line as profit: the definition of high operational leverage. (Conversely, of course, if sales did not reach breakeven, the firm experienced losses.) Until recently, China's factories were perceived as being labor intense with low fixed costs and, hence, lower breakeven thresholds. Cheap labor made man-hours per product less significant. Flexible labor policies (in private factories at least) allowed variable costs to increase or decrease relatively easily to match changes in the market: the definition of low operational leverage. China's manufacturing sector could expand and contract with less dislocation than that of the West, burdened as it was with the high fixed costs related to a capital intense base. All of which raises the question, why are manufacturing firms in China spending billions of dollars on fixed capital investment to save man-hours on some of the lowest cost, highest skilled labor in the world, as rising unemployment threatens the country's social stability? First, capital, like labor, is relatively cheap in China. The individual savings rate is around 40% and those savings are captive to China's banking system. Deposits grew 21% in 2003, which nearly equaled the 20% increase in bank loans during the same time period. Studies suggest that FDI entering China does so at lower required rates of return than elsewhere as companies scramble to get a toehold in the country's burgeoning economy. Successful private domestic companies plow much of their considerable retained earnings back into plant and equipment. The sheer magnitude of investment ($666 billion in 2003) flowing into an economy with a real GDP about the size of Italy's leads to over investment in capital goods. Secondly, world markets demand products made to specifications that are achievable only by using the latest capital goods. In the last 20 years, China has grasped the fact that to be a supplier to the world, it must meet international standards. Factories across China have received ISO 9000 series accreditation: visitors are met with banners proclaiming the firm's ISO qualifications, as well as a list of other international standards met by the factory. As China moves up the industrial food chain to more critical, and complex, components, it must develop the manufacturing expertise and install the sophisticated equipment necessary to make these components to world-class specifications. Japan and Taiwan, two major sources of FDI, have a bias toward automation, which gives their investments a higher capital intensity. Japan has contributed thousands of engineers, whose experience is concentrated in automated manufacturing, to work in China. They come as part of Japanese investments or are available to Chinese companies having been forced out of their jobs in Japan by the decade long recession. Taiwan has an estimated 500,000 citizens working on the Mainland. This combination of investment and personal has tilted the manufacturing infrastructure in China toward automation.

Expanding Local Bank Lending to Private Businesses

Expanding Local Bank Lending to Private Businesses The single biggest influence on the growing capital intensity of China's investments is local bank lending. Total bank lending in China has increased 100 fold since 1980 expanding to a total of $2.15 trillion at the end of the first quarter of 2004: a 20% increase over first quarter 2003. Bank lending to private enterprises is growing faster than the economy at large. According to the World Bank, between 1994 and 2002 domestic credit to China's private sector grew from 92% to 136.5% of GDP (for context, FDI equals 3.9% of GDP). So, on a GDP base expanding at 9% per year, the domestic credit component increased by 48%. Much of this increase is coming from local branch banks of the major state owned banks and a variety of second tier financial institutions, which are also theoretically under state banking control. China's banking system is becoming a conglomeration of widely dispersed financial institutions straining at central bank control. The four major state-owned banks, which make 60% of the country's loans, have 116,000 branch banks and 1.4 million employees. The other 40% of the banking system's loans are made by the following financial entities: Three policy banks, 11 joint-stock commercial banks, four asset management corporations, 112 city commercial banks, 192 business branches of foreign banks, 209 representative offices of foreign banks, 723 urban credit cooperatives, 34,577 rural credit cooperatives, three rural commercial banks, a rural cooperative bank, 74 trust and investment corporations, 74 finance companies, 12 financial leasing companies and the China Postal Savings and Remittance Bureau. Decentralization of the government and the banking system in China has created a local alliance of municipal governments and branch banks that, for a variety of reasons outlined below, has an incentive to invest in large automated facilities. Their lending tends to increase capital intensity, raise financial leverage, mismatch the rate of return with risk, and misalign the time horizon of the investment instrument with that of the facility being financed. To understand how this local lending alliance has come about and why it is so inclined to capital-intensive investment, one must step back and look at the political and economic forces that created this nexus of local participants: government officials, bank branch managers and entrepreneurs. Prior to 1978, China had to manufacture domestically virtually everything the country required having broken with the West after World War II, with the Soviet Union and Eastern Block countries in the mid 60's and with Japan, Taiwan, South Korea and India-the major players in Asia at the time-having gone to war with each of these countries at one time or another. This domestic manufacturing task fell to the massive State Owned Enterprises. When China opened to the West in the mid 70's, only select SOE's were authorized to trade with foreign firms. Despite stringent restrictions, exposure to foreign trade gave Chinese engineers their first experience selling to a customer other than the central government and, later, the impetus to start their own private ventures. Out of this manufacturing tradition came the first entrepreneurs for large-scale private enterprise, but these pioneers faced serious political and economic obstacles. Politically, China's private sector first started to evolve out of the exclusively state controlled economy in the early 1980's. Deng Xiaoping's 1978 economic reforms left open a small window for private enterprise in China. The now famous "socialism with Chinese characteristics" edict, while primarily an attempt to reform SOE's, also allowed agricultural "side-occupations", set up Special Economic Zones and gave tacit approval to private enterprise. While unprecedented, it was still a tepid endorsement of capitalism. (Not until 12 years later, in 1992, did Deng publicly proclaim "markets are as compatible with socialism as with capitalism.") Furthermore, Deng's edict was delivered to a populace with fresh memories of an earlier one from Mao Zedong to "Let 100 Flowers Bloom" ("a movement of ideological education carried out seriously, yet as gently as a breeze or a mild rain…." according to Mao), which encouraged intellectuals to criticize the communist party and then promptly sent them to jail or the countryside for doing so under the Anti-rightist Movement.

Venture Capital without the Capital

Would-be entrepreneurs were understandably reluctant to openly spring into capitalism. An even greater problem for those willing to take the plunge was the total absence of private capital. For private manufacturing enterprises to surmount the dual problems of questionable political standing and the complete lack of private funds a new form of ownership developed known as the Township Village Enterprise (TVE). (China's municipalities are broken down into smaller, semi-autonomous townships that have their own mayor and party secretary.) More than 150,000 TVE's existed in China at one point. While it has often been theorized that TVE's were a form of quasi-socialist ownership unique to China, more accurately they were a rough form of Venture Capital (ironically, without the capital) managed by local governments: a means of providing seed capital to entrepreneurs when no capital existed in the country, as well as providing a socialist cover for a capitalistic endeavor ("wearing the red hat" as entrepreneurs have come to refer to it). A manufacturing start-up requires five basic elements: buildings, utilities, machinery, employees and customers. A Township would provide those assets under its control, namely buildings and utilities, to an entrepreneur in exchange for a share of the private company's profits. The arrangement was loosely referred to as an industrial collective for political reasons. The manufacturing entrepreneur, who invariably came from State Owned Enterprises, used his connections with management at his former SOE to procure the other elements needed to start his business: machinery, employees and customers. Their former colleagues at the SOE would help equip the new factory with cast off (in many cases prematurely) machinery and tools, and would subcontract work out to the TVE thereby providing it with a stream of income. Later, SOE personnel would simply steer SOE customers directly to the TVE: often times foreign firms that had a predilection for working with private factories: especially after a couple years of trying to negotiate the dense bureaucracy of the SOE's. For their efforts, the SOE colleagues would receive some form of remuneration from the private factory, while maintaining political cover by couching their assistance in terms of helping to build private enterprise according to Deng's edict. TVE's that grew received further assistance. Those that faltered literally had the lights turned off and were put out of their buildings to make room for more promising candidates. It was a classic venture capital system with the local government in the role of venture capitalist using buildings and utilities instead of capital to fund start-ups. As a TVE grew, the entrepreneur would buy out the government's equity position and go onto the local tax rolls. Although the government ceased to be a direct owner, it still played a large role in developing businesses, increasingly supplemented by retained earnings generated by growing firms and FDI that, at first trickled, and then flooded in. Over time, the rise of private enterprise, and the key role played by the local governments, started to dilute the central government's control over municipalities. Coinciding with the decentralization of government was a similar devolution of control from China's Central bank to local financial institutions. According to an article in the December 2003 issue of Foreign Affair by David Hale and Lyric Hughes Hale, China's large state owned banks are growing at 8% per year, whereas other lending institutions are growing at an annual rate of 27% and account for 45% of new lending. Historically, China's banks lent almost exclusively to SOE's: a sort of public works program to hold workers at SOE's until the private sector could absorb them. It is widely held that this lending to state enterprises was a misallocation of resources, which starved the dynamic private sector of investment capital. While true, this shortage of investment capital imposed discipline on the private sector forcing a more efficient use of limited resources. It also had the unintended effect of pushing private firms into the arms of foreign investors. Local government officials could hardly be expected to sit by and watch private firms rapidly develop right in their own municipality, often using foreign funds, without giving some thought to ways of participating themselves. With the twin decentralization of the government and banks, local officials and bank managers found they had a stronger alignment of interests with each other than with their Central Government counterparts. This alignment provided the perfect means for participating in the manufacturing bonanza in their communities.

Beyond TVE's

Governments still use land, buildings, water, electricity, tax reduction etc. to nurture growing firms. However, those things cost governments money. Local banks (and other financial institutions) furnish a potent tool for funneling money directly to promising firms: money that costs the local government nothing and is without recourse in the event of failure. Using local bank branches, city government officials have reprised (and expanded) their role as venture capitalists to a portfolio of local entrepreneurs. The use of low cost bank loans to fund what is essentially a venture capital operation mismatches the risk of investment with the cost of funds. China's banking system bears the consequences of this mismatch: absorbing the full loss when a venture fails, but receiving only standard bank interest rates, if it succeeds. Local government officials, bank managers and entrepreneurs, on the other hand, reap tremendous gains on the winners while washing their hands of the losers. This local lending also encourages a strategy of double leverage, as firms combine high operational leverage (i.e. high fixed capital investment) with high financial leverage (i.e. high bank debt) to super charge returns on equity (ROE) in expanding markets, while at the same time ratcheting up the risk of loss in declining ones. It also misaligns the time frame of the underlying investment with the financial instrument used to fund it. Long-term investments are generally financed with investment instruments having commensurate time horizons, such as industrial bonds. Local financial institutions in China are financing factories primarily with short-term bank debt adding a further imbalance to already over leveraged investments. In a conventional venture capital startup there is a trade off between the balance sheet and the profit and loss statement. Assets are expensive, paid for with significant equity dilution or high interest rate loans. The venture capital firm, risking its own money, allows the entrepreneur to add only those assets that provide sufficient profit to justify their high cost. A large increase in assets for a small incremental increase in profits would not be deemed worthwhile. The Chinese municipal government's version of venture capital distorts both sides of the investment equation. The "investors" (local government officials and branch bank managers) do not risk their own money. They gain (surreptitiously) on the winners, but disassociate themselves from the losers: non-performing loans can be disguised, shifted to other subsidiaries, or delayed indefinitely from coming to light. It would be as if the return on investment for a traditional venture capital portfolio were calculated including only those ventures that made money. The entrepreneur, unconstrained by a risk adverse investor, purchases capital intense assets (raising operational leverage) with cheap, short term debt (raising financial leverage) to create an inverted triangle of leveraged capital assets balanced on a tiny fulcrum of (mostly sweat) equity. With the manufacturing start-up so excessively leveraged a small incremental increase in profit has an exaggerated impact on the entrepreneur's return on equity. The overall system drives up capital intensity by skewing investment decisions in favor of capital investment. Small gains in profit are worth large investments in capital because the debt is non-recourse to the local government and banks, and so steeply leveraged as to be worthwhile to the entrepreneur. Additional factors reinforce the concentration of capital in large-scale production facilities. Engineers coming out of the manufacturing colossuses of the SOE's are inclined to overbuild in an attempt to create manufacturing dynasties of their own. The early asset based nature of assistance entrepreneurs received from the Townships and the SOE's, i.e. land, buildings and machinery, gave them an incentive to become more capital intense. If fixed assets were the currency of investment, best to get as much of them as one could. A burgeoning high tech industrial base confers prestige on local government officials: how much more impressive to show visiting VIPs through a state-of-the-art automated assembly line than a labor intense job shop with simple, but serviceable, machine tools. This industrial boosterism is a bit like the "skyscraper syndrome" that was a precursor to the Asian financial crisis in the late 90's, when it seemed that each of the countries that fell victim to the crisis had plans for or had partially built the largest skyscraper in the world as an emblem of that country's success. The skyscraper as symbol has been replaced today with the gigantic automated production facility-the ultimate status symbol being the semiconductor chip manufacturing plant: the size and thickness of the wafer being produced further refining chip status for the manufacturing connoisseur. Another manifestation of industrial prestige is successful companies providing jobs to government officials leaving the public sector: a further incentive for the "venture capital" system to back winners. Coupling financial leverage with the high fixed operating costs inherent in an automated manufacturing facility creates a volatile mix. If strong sales volumes enable the factory to operate above breakeven capacity and cover debt service costs, the double leverage generates huge returns on equity. On the other hand, if sales volumes fall below breakeven, operating losses mount precipitously as the automated factory continues to run below capacity and the debt load continues to require servicing. As long as volume keeps growing returns are spectacular, just as the losses will be spectacular, if volume drops. The implications for a hard landing in a recession are obvious, as are the dangers to thousands of sub-suppliers captive to these manufacturing behemoths.

The Other Side of the Equation

IThe Other Side of the Equation China's state banking system and its millions of depositors end up as the backstop for this practice of making high-risk loans with cheap bank debt. If a venture succeeds, the banking system gets 5-¼% interest (the current bank rate). If it fails, the bank takes a total loss in the form of non-performing debt (which can take months or years to show up on the bank's books). The dichotomy between the rate of return and the risk of the venture creates an unsustainable investment model that corrodes the banking system. Efforts to bring local lending under control are proving ineffective. According to China's Bank Regulatory Commission, through February 2004 city commercial banks had the largest volume of growth with $72.55 billion. Urban and credit cooperatives registered month-on-month growth of 106% and 57% respectively. In response to a central bank mandate issued at the beginning of 2004 that banks reduce the percentage of non-performing loans (NPL) on their books, joint-stock commercial banks saw the absolute value of non-performing loans increase $56.8 billion according to China's Banking Regulatory Commission. However, the percentage of non-performing loans actually went down by 0.5%, as the total of new loans grew even faster. Rather than shrink the numerator (i.e. NPL), these banks simply expanded the denominator (total loans). But, who knows how much potential bad debt is lurking in these new loans? Raising reserve requirements (which the central bank has done three times in the last year), or increasing interest rates will not necessarily stem the tide of lending by this quasi venture capital system either. Lenders being insulated from risk caused the upward spiral of local debt in the first place. In effect, rates do not matter to those initiating the loans; so raising them will do little to curb this profligate lending. Until there are direct consequences to the initiators of the loans, the problem will persist. In fact, raising interest rates would increase the debt service on the highly leveraged factories, which could accelerate their transition into non-performing status. Trying to stop projects by central government fiat has also proved difficult, since another common strategy at the local level is to build a factory without getting the proper licenses beforehand and then presenting the finished facility as a fait accompli. One of the largest and most successful cell phone manufacturers in China followed this strategy and attributes much of its success in getting a jump on the market to it. As a non-industrial example, in April 2004, to save scarce arable land and water, the central government ordered a halt to plans to construct of as many as 1000 new golf courses in China. Of 10 courses under construction in Beijing alone only two had the appropriate licenses. On an even more basic level, the Central Bank has just recently started to crack down on lending by banks to related parties, including management and shareholders. It has also halted lending to certain overheated segments of industry, such as steel and cement making. The government's current policy of instilling discipline in the banking system by instituting market reforms is eerily reminiscent of Deng's 1978 SOE reforms, which are remembered today for sanctioning private enterprise, but were originally focused on making SOE operations more market oriented. Looking back on 25 years of consistently declining SOE performance, one is not optimistic about a top down reform of the banking system based on artificially applied market principals. The most alarming aspect of this lack of control is that these leverage industrial projects are being duplicated in Townships, Municipalities and Provinces across China, often in the same or overlapping industries. China has 31 provinces, 656 cities (each with a multiple of townships) and 48,000 districts (roughly equivalent to counties) and strong regional loyalties. While cross provincial investment is growing, for a system that still relies heavily on guanxi and local government support, localized investing will continue to dominate. It is estimated that China has 120 domestic automobile manufacturers: virtually all seem to have aggressive plans for expansion. Nearly every foreign auto manufacturer has some form of joint venture in China as well; published announcements put their cumulative planned investments at $20 billion. This in a country already producing nearly twice as many cars as there is demand (4.9 million to 2.6 million according to government statistics). The country's 15 largest air conditioner manufacturers account for approximately 85% of the domestic market: each has plans for a major expansion. Articles trumpet the fact that China is now (or will soon be) the leading producer of televisions, DVD players, digital cameras etc., however one wonders what will be the result if individual municipalities simultaneously rush to enter these seemingly lucrative markets. Chinese manufacturers will have less flexibility to react to market vagaries: once a hallmark of their factories, as duplication of investment creates not just overcapacity, but concentrated, capital intensive, financially leveraged overcapacity. This makes a soft landing in a recession more difficult, as local industrial domains across separate geographic regions cut prices to maintain volume in an attempt to cover the fixed production costs and cover debt service. Since the larger volumes across the board cannot be sustained, eventually some of the factories will shut down forcing thousands of subcontractors, which rely on the large factories for the bulk of their sales, to shut down as well. These sub-suppliers are a mitigating factor against the tendency toward capital intensity. Mostly small (under nine employees) component manufacturers, they are not particularly capital intense and tend to be flexible and opportunistic. However, they are dependant on their large automated customers and vulnerable to a domino effect in the event of wide spread insolvency among the big firms.

Productivity: Two Moving Targets

In the late seventies, books were being written predicting Japan would surpass the US as the world's largest economy. Japan, of course, faltered, but of equal importance, is the fact that the US responded with some impressive productivity gains of its own. The same will be true in the competition between the US and China. What form will this productivity competition take in the future?

The capital intense US model will gain productivity from reduced computer costs and from the integration of its automated systems. Whereas, earlier systems had each stage of production programmed separately, firms increasingly now have the ability to program the entire production process from bill of materials to finished goods with ever decreasing human involvement. China can increase productivity rapidly and cheaply by retrofitting current machine tools with inexpensive computer technology, which has been perfected by the West over the last three decades, and by replacing antiquated tools with more up-to-date, efficient models.

Ironically, as China invests in productivity improvements, it will inevitably move toward the capital intense model of the US. Thereby, dissipating its most powerful current advantage: low cost, skilled labor. Eventually, as both sides continue to invest in capital equipment, the competition will shift to that of managing capital intense systems with the key factor for success being managerial talent, which will spur demand for MBAs. So, the story has a happy ending for B-Schools everywhere!

Home | Principals | History | Yangtze | Contact us | e-mail | Stainless Steel | Plastics
Return to Top of Page

Copyright © 2001 China Array & All rights reserved.