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China is Moving Up the Value Chain

China’s economy is in a new development phase of rapid export growth.

Just when you think you’ve got the Chinese economy figured out, it undergoes a profound structural transition in the seeming blink of an eye. For the last several years we have come to think of China as the workshop of the world. In this view, China tends to import huge amounts of raw materials and intermediate goods from abroad, combine them with super-cheap labor and virtually free capital, and then turn around and ship an armada of assembled products out to the rest of the world—particularly to the US and the European Union.

Until very recently, Chinese imports and exports have indeed tended to move in tandem (Figure 1), bolstering the view of those who saw China as a giant assembly line. Sure China ran a substantial (and growing) trade surplus with the US and to a lesser extent the European Union, but that surplus was nearly offset by a trade deficit with China’s neighbors in Asia (which exported intermediate and capital goods to China) as well as the world’s major commodity producers.


China will always need to import a large share of its raw materials. However, we have now entered an era where China no longer needs to import huge amounts of intermediate goods. Since 2000, Chinese production of industrial boilers has doubled; its production of chemical fiber, steel, and plastics has roughly tripled; and its production of semiconductors has surged nearly seven-fold. Moreover, detailed analysis of China’s trade data show that for a number of important processing industries—such as machinery, white goods, autos, and office equipment—the ratio of final exports to imported components has surged in recent years, suggesting that China is increasingly supplying its export machine.

China has funded this breakneck industrial development by channeling a huge pool of captive domestic savings into fixed asset investment, which now exceeds 50% of GDP (compared to 20-30% in most other economies in Non-Japan Asia). China has also sucked up the lion’s share of foreign direct investment (and the technical expertise that often accompanies it) from its neighbors in Asia. Chinese FDI has increased from $4 billion in 1990, to $41 billion in 2000 to $70 billion in 2006.

What are the implications of this new phase of Chinese development? We can think of a few possibilities. First, we would expect the prices of intermediate goods worldwide to face downward pressure in the coming years just as prices of assembled goods have been squeezed over the last decade. A bit further down the road, we will start to see substantial disinflation or even deflation in the price of capital goods as well.

While China has clearly reduced its reliance on important components, its economic policies remain much too heavily focused on the supply side of the economy. Ironically, the development of its supplier base makes it even more imperative that China wean itself from export-led growth. Export-dependent industries now account for an increasingly high proportion of China’s economic growth, thus making the economy more vulnerable to shock in external demand or the exchange rate. We would strongly advise individuals not to base their China strategy on the presumption of a strong RMB. Moreover, absent a substantial expansion of domestic demand in the next few years, a Chinese growth recession will morph from a possibility into a probability.

Edward Klaff is a Boston-based economist.