Part 2 Mechanism and Pattern

China Becomes the World Factory: “Passive” and “Active”

“Flying Geese Mode” and International Industry Transfer: “Flower Drum Transfer”

Since the 1960s, the economic runway of the East Asian region has been staging a relay of international industrial transfer. The participants, in chronological order, were: developed economies of Japan→newly industrialised economy, that is, Hong Kong of China, Korea, Singapore, Taiwan of China→four ASEAN countries, that is, Indonesia, Malaysia, the Philippines, Thailand→developing countries that are implementing opening-up strategy, such as China and Vietnam. In the “flying geese mode”, characterised by the multi-layer industry transfer, the goose that spearheads the flight formation is Japan which, after the Second World War, snatched the title of “World Factory” from the US.

At the end of 1985, the Chinese Government relaxed its policy to attract foreign capital, and to encourage export-driven foreign enterprises to come to China to invest in factory building. Then Hong Kong and other economies entered China on a large scale. On the basis of the free flow of essentials and reasonable allocation, China continued to dynami cally receive dynamic transfers from the world's advanced industries, and to realise the huge output growth. In the mid and late 1990s, Chinese citizens said goodbye to shortage, and they created unprecedented material wealth. Since the turn of the century, students of economics no longer（like their teachers）study the book Shortage Economics—a book on socialist economy by Hungarian economist Janos Kornai.

In 1997 and 1998, after the Asian financial crisis, China took over from Japan the role of “World Factory”. In a way, China “reluctantly” became the World Factory. The Asian Financial Crisis messed up the outskirts of global finance, but the function of the world's financial centre—to allocate the world's resources—has not been harmed. They are still in demand, and still growing.

As the production lines of Southeast Asian economies have been hit hard, the orders from the US and Europe were directed to China. But at that time, China's production capacity was not sufficient to cope with the flood of order. So what happened? Wall Street and the City of London exercised the basic function of finance, and effectively allocated the global resources. The inflows of direct investments have brought along capital, equipment and technology. China had cheap land, labour, and environment to entice them; China had an extensive market, and in individual years the foreign capital coming to China exceeded that of the US and was ranked No.1 in the world.

At that time, China's orders were from the US and Europe. China's production capacity was built with foreign capital. The red flower in the “flower drum transfer” game suddenly landed on China, and China became the new “world factory”, which henceforth became an integral part of the global industry chain. China's newly acquired excess production capacity, the surplus of its current account, and the world's top foreign exchange reserve, all contributed to China's monopoly of the global allocation of capital resources.

For the development of China's economy itself, the fact that China was made the “world factory” was both a blessing and a reason for concern. The blessing is that China has more deeply penetrated into the gushing current of the global economy, with more jobs created, faster economic growth, upgrading of the industrial structure, better welfare for the producer and consumer, and the significantly higher salaries for the government, enterprises and residents. On the other hand, what was worrying was that China's road to trade imbalance was a journey of no return, and for a prolonged period China was stuck in the low valueadded, high carbon-emitting position of low to medium end production. The product piloting, the production of key spare parts, as well as sales and after-sales service were all in the hands of developed countries; the production of modular spare parts was scattered over newly industrialised economies of Korea and Taiwan of China, and the packaging task, which offers little profit margin, was transferred to China.

The truth behind every phenomenon is usually surprising. For an Apple iPod player that has 451 spare parts, its retail price in the US is US$299, and the US local enterprises and workers reaped a maximum of US$163 in value added. This includes US$80 for Apple Corporation, US$75 for the distributors and retailers, and US$8 for the spare part manufacturer. Japan reaps an added value of US$26, and what China gets is only US$4 of processing fee. For every iPod exported to the US, China's trade surplus to the US would increase about US$150. The Chinese workers get only US $8 in income for every iPad computer, which is only 1.6% of the retail price. And for every iPad sold, Apple Corporation gets US$150, which is 30% of the retail price. Compared with Korea—where the main spares are produced—China's share of the profit was less than 1/4.

With China becoming the world's factory, trade between China and other economies will manifest a triangular trade pattern based on an industry chain division of labour. The production essentials, industrial structure and complementary situation have made the regional situation in the entire East Asia region a highly related system of international division of labour. In this system, apart from Hong Kong having a trade surplus, China's trade with different systems in Southeast Asia frequently experiences a trade deficit. China's trade with other economies such as the US and European Union countries has huge amounts of surplus in the current account. On the other hand, Southeast Asian economies'trading with China and other countries are all in surplus.

In other words, although China has become the largest export market for more and more East Asian developing economies, yet a large part of the imports from East Asian economies are used on consumer products exported to the US and European Union. It is estimated that for every US$100 of processed products exported to the US and the European Union, about US$35 to US$40 is contributing to the growth of East Asian economies. The pattern of global trade has become this—the capital products, spare parts and other complex intermediary products exported by East Asian economies are processed and assembled in China into finished products which are exported to US and European markets（See Figure 2.1）.

Compared with other economies, China, as the “world factory”, has a unique kind of foreign export where processing trade accounts for up to half of the total. China is like a bakery—on the one hand, it imports flour, and adds in the necessary ingredients and labour cost, and bakes all sorts of bread. On the other hand, it exports cheap and delicious bread. This also reflects the simple truth that bread is more expensive than flour. The selling price of the end product must be higher than the raw materials. So it is only natural that China's processing trade will have a surplus.

We have all along been saying that in order to change the mode of foreign trade we must raise the added value of processing. But the higher the added value is, the higher the percentage of China's income from the selling price is, and therefore the higher the trade surplus is. This results in a conflict between the goal of “balancing trade” and the means of “raising the added value”. In the meantime, the higher the value of the RMB is, the lower the price of the imported raw materials priced in RMB is, and the higher the price of the exported products is, and the higher the surplus of the processing trade is. In the current situation, it is only when the Chinese economy overheats, with more imported raw materials and primary products being used in domestic production departments rather than export production departments, that China will have a trade deficit.

“Wintelism” and the “Magnet Effect” of Global Production Network

After the modern mega industry was established in the second industrial revolution, the Western enterprises with the US as a representative implemented the Ford production mode, pushing the global economy to a new phase of growth. Under the Ford system, there is a clear division of labour between the brain and the body, with very fine division of tasks. As a result, there was a drastic increase in labour productivity, making possible the large scale production of industrial products and mass consumption.

In the 1960s, the Japanese manufacturing industry led by Toyota, based on Japanese cultural tradition and enterprise characteristics, underwent organic fusion with the Ford system and the flexible mode of production, creating the Toyota production mode, and motivating the modernisation of the Japanese industry and the overseas expansion of enterprises. Under the Toyota system, labourers are the long-term asset of enterprises, and the designers and producers could have interchanges without barriers, making possible the optimisation of the production scale based on the market situation.

Under the Ford system and the Toyota system, although many products have a multi-nodal value chain, yet enterprises compete on the total value chain. As the individual value nodes have not yet developed into independent industrial departments, a single value node will not have a significant impact on the result of the competition. Hence the two models are represented by the car industry. Before the 1990s, “Blue Giant” IBM and its competitors in Japan and Western Europe also followed the Ford system（some also encompassing the Toyota system），and the production system included hardware, software, after sales service and vertical systems such as financing and rentals.

Since the birth of the personal computer in the 1970s, the computer industry had a basis of horizontal division of labour that differs from that of the Ford system. With the software-hardware integration of Microsoft Windows and the Intel chip, the entire computer industry quickly shifted from a vertical structure to a horizontal structure. In the latter half of the 20th century, especially after the late 1980s, a new international production mode gradually formed, under Wintelism that had standards as the core. This took place against the background of the abandonment, crossing and breaking in between Ford and Toyota modes. This became a production mode that adapts to the international competition in the age of economic globalism under the conditions of high technology.

The characteristic of Wintelism is that it works around product standards against the background of effective global allocation of resources, resulting in the production and integration of product modules under the control of systems. In the entire process of completing the product value chain, the standard setters in the division of labour together with the module producer achieve a control mode based on winwin situation. Under Wintelism, the global production network uses multinational corporations as the vehicle and the horizontal mode or horizontal-vertical mode in the global value chain. In an industry based on division of labour according to production phases, there is the manifestation of drastic expansion of trade within the product, and this drives the depth and breadth of economic globalisation on a large scale.

Modularisation, outsourcing and mass customisation are the three supreme tools in enterprise operation under Wintelism. In contrast with Fordism that only pursues scale effect and scope effect, the agglomerative effect has an important role to play in “separation and integration” on the platform of Wintelism. It is actually with modularised production, outsourcing and supply chain management and the development of the modern logistics industry that Wintelistic enterprises can achieve mass production of new products within a short period of time.

Under Wintelism, speed is king. The focus of market competition is that while it maintains product differentiation, it also guarantees the speed of high-tech product introduction and industry upgrade, so as to achieve perfect intergration of constant product innovation and mass production. This drastically shortens the life cycle of traditional products. Once a new product is launched in the market, it will need to depend on the multinational production system to quickly complete the expansion of the global market. If a product is not expanded to other markets by the early stages of the product life cycle, the enterprise will have difficulty achieving economy of scale, and even achieving breakeven of the research and development costs.

To achieve the highest efficiency of production, accompanying the expansion of the global production network, the global FDI maintains its growth with a drastic increase in the number of multinational transactions in spare parts and semi-finished products. Since the 1990s, some developed countries have been shifting their capital-technology-intensive industries to developing countries, even including the higher value-added processes in their high-tech product production, such as research and development, processing manufacturing and services. This forms a new type of outsourcing and processing. Under this pattern, while the output countries（mainly developed countries）optimise their costs, the input countries（mainly newly industrialised economies and developing countries） will enhance their level of technology and optimise their industrial structure, thus achieving a win-win situation（See Figure 2.2）.

If we say that the Ford system is a product of internalisation, and the Toyota mode is a product of industrialisation, then Wintelism is the inevitable result of economic globalisation. This new type of multinational production system reorganises the global industrial structure, and sharpens the sensitivity to scale and cost, bringing new opportunities and challenges to East Asia. In the production network of the East Asian region, the horizontal division of labour and trade have broken through the traditional “flying geese” mode and achieved rapid development. Since the mid 1990s, China has fast become the base of original equipment manufacturing（OEM）. The huge market, low costs and the large pool of talent and supporting capacities have made China the top choice in the new round of global industrial transition.

Purchasing in China has become an irreplaceable component in the global production chain. China's cheap labour costs and the ability to achieve the required standard have benefitted a large number of multinational corporations. These companies look at their supply chain built up in China as an indispensable part of their global strategy. No internationally renowned high-tech company can complete their design, purchasing, production and sales without involving the Chinese market.

China captures capital, technology, machine and equipment from Japan, Korea and Taiwan of China, and imports high end spare parts and modular spare parts. China also imports resource products as well as primary and intermediary products from Southeast Asian countries, and at the same time acquires financial, legal and trade services from Singapore and Hong Kong of China. After processing, assembling, manufacturing and packaging, China exports the products to North America and European countries, or uses these products to satisfy domestic demands.

At the start of China's reform and opening-up in 1978, China's exports were ranked 32 globally. The introduction of the global value chain and the integration with the global and Southeast Asian production networks enabled China to achieve exports of US$62.09 billion, US$249.2 billion and US$1,201.6 billion respectively in 1990,2000 and 2009, and achieve global ranks of 15th,7th and 1st position. Since 2002, and with the exception of 2009 due to the impact of the international financial crisis, China has maintained export growth rates of between 20% and 30%. Export demand has been one of the important pulling forces in the rapid development of the China economy for many years.

Relying on the strong brand effect and the global setting of the sales and service networks, developed countries have reaped the largest share of the profit in the global industrial value chain. On the other hand, China finds itself in the lower value adding parts of the production process, and reaps only the benefits of processing and assembly. Although the developed countries such as US and Europe have a deficit in their current account, yet their own industrial structure determines that the deficit will not reduce their employment rate, but actually increase their employment rate in the areas of research and development, sea transport, sales and marketing and financing. Correspondingly the manufacturing industries in developed countries have, to different extents, experienced the trend of “hollowing out”.

From this, we can see that driven by market forces, China has assumed the position of a packaging and assembling centre in the global production network. Through the trade investment network, China and other economies have formed competitive and cooperative relationships in the industry chain or certain parts of the production line. This has formed a balance in the context of imbalance, and a win-win situation between the setters and implementers of standards and regulations.

At present, China has in reality become the world's product processing centre, one of the world's largest product suppliers, and one of the world's largest importers and exporters of goods and services. As the market vehicle for the mutual dependence of the Chinese economy and the global economy, the global production network will still achieve the bi-directional Magnet Effect. The Chinese economy cannot be separated from the world, and the global economy needs China. In short, China's development has become an organic part of global economic development.