Growth through Innovation An Industrial Strategy for Shanghai By Shahid Yusuf Kaoru Nabeshima April 22nd, 2009

Chapter 2
The Economic Context

Although, agriculture played an important role in the first half of the 1980s,⁹ much of the impetus since has derived from continuous double digit growth of industry supported by domestic and foreign demand.

Rapid evolution and technological catching-up of manufacturing coupled with expanding exports of sophisticated industrial products, have been largely responsible for China’s industrial performance to date (Holz 2008; Schott 2006). Manufacturing activities are likely to remain the engine of China’s urban growth for the next decade and possibly longer (see Figure 2 .1 and Figure 2 .2). Other countries have also attempted to achieve high growth rates through industrialization, however, few have equaled China’s performance and the question frequently asked is, why has China done so much better than most other developing nations. There are six possible reasons.
Figure 2.1: GDP Composition of China, 1979-2006

Source: World Development Indicators

Source: World Development Indicators

Second, this accumulated industrial capacity was vital in leveraging the gains from the opening to trade and to foreign direct investment (FDI) starting in 1979 and accelerating after 1994 (see Figure 2 .3).¹¹ Trade and foreign direct investment are the source of three main benefits: they channeled capital into export oriented light industries in the initial post reform years and stimulated the growth of this important sector.¹² Since then, domestic capital and FDI has flowed into high tech manufacturing industries, services and real estate as well. Trade and FDI have served as vehicles for technology transfer embodied in plant and equipment and also knowledge transfer on plant operations, management, business organization, work place practices, logistics and other areas.¹³ These have substantially augmented productivity in foreign invested firms and through knowledge spillovers, in domestic enterprises.¹⁴ FDI has partially ameliorated the distortions in China’s financial markets and made more capital available to SMEs producing tradable goods (Y. Huang 2005). FDI has accelerated the integration of China’s manufacturing sector with the global economy. This process, assisted by the overseas Chinese diaspora, is enabling Chinese producers to tighten their links with international production networks and consolidate their entry into foreign retail markets (Bair 2009; Rauch and Trindade 2002; Yusuf and others 2003).¹⁵ Trade and FDI will continue to promote technological change in Shanghai during the medium term albeit to a lesser degree as local capacity grows.

Third, the large volume of domestic investment in production capacity and in physical infrastructure has complemented FDI and conferred several significant benefits. It has rapidly increased capital labor ratios and introduced new technologies embodied in capital equipment which confer productivity and quality advantages and contribute to China’s industrial competitiveness. Factor productivity which is the main source of differences in per capita GDP among countries rose by 3-4 percent between 1993 and 2005 (see Table 2 .1).¹⁶ By enabling Chinese producers to quickly ramp up capacity, the outlay on production capacity has accelerated ‘learning’ and made it easier to achieve the production scale required by foreign buyers,¹⁷ Moreover, investment spending generates domestic demand and alongside exports and growth, this has been a consistent source of growth.
Figure 2.3: Foreign Direct Investment Inflow to China, 1990-2006

Source: World Development Indicators

These six elements highlight the role of industrialization: an early start at building industrial capacity; FDI that initiated the growth of exports; the high level of investment in plant, equipment and infrastructure; rapid accumulation of human capital on a broad front; the attention given to R&D; and the geographically concentrated spiral of urbanization. Together they are responsible for the stimulating and sustaining China’s growth to date. Each contributing element depended upon a succession of policy initiatives that after experimentation and validation, defined and progressively elaborated China’s unique development strategy.²⁶ In other words, policies that gave primacy to or accommodated these six elements were ultimately responsible for the huge economic strides taken by the country during the past three decades.

Starting in the 1980s, China’s industrial efforts were assisted by the global industrial product cycle,²⁷ and by the strategies of MNCs and of major retailers in the United States. Rising costs of production in their home countries and the emerging capacity to manage dispersed operations with the help of IT, persuaded the MNCs to transfer the manufacture of mature standardized commodities whose production technologies had stabilized and become codified, to East Asia. The big retail chains in the United States found it expedient and cost effective to source from overseas (Bair 2009).²⁸ As transport costs fell, the cost advantage enjoyed by East Asia producers grew (Hummels, Ishii and Yi 2001).²⁹ Starting in the 1980s and at an accelerating rate in the second half of the 1990s, China was able to grasp the opportunities as they emerged by building production capacity and acquiring the manufacturing capability and scale demanded by foreign buyers. According to Hamilton and Gereffi (2008), it was the speed with which Chinese and other East Asian manufacturers adapted to the needs of contract manufacturing which explains why they were able to beat the competition. Furthermore, as China’s technological know-how improved, it diversified into medium and high tech products at a faster rate than other countries and established a commanding lead in markets for a wide range of manufactures. Table 2 .4 shows that China currently dominates the export market for various types of garments, toys, furniture, and leather goods.

This is the past. What of the future. China is now the world’s second largest exporter and the second largest manufacturer. Maintaining the recent trend rates of growth of the existing mix of products in the unfolding world environment will be difficult, perhaps impossible.³⁰ Market saturation for some manufactured exports, rising domestic costs of production, natural resource scarcities and trade frictions³¹ are some of the factors arguing for a growth and export strategy which more fully harnesses technology assimilation from abroad, domestic innovation, productivity growth, industrial deepening, and the potential residing in business services still a relatively under-developed sector in China. The “low cost” model and industrial widening are still capable of delivering growth, but to a lesser degree. Thus, if gains in productivity, backward integration to increase value added, and innovation to generate new goods and services, better processes and better business models are the means of achieving sustainable growth, then strengthening technological and innovation capabilities promises the highest payoff.³² By building and tuning and coordinating technological capabilities and creating a functioning innovation system, the economy will be more productive, less resource and energy intensive and better able to generate goods and services enjoying wider profit margins.³³