China in Transition

For Whom Does the Smiling Curve Smile?
- China is caught in the immiserizing growth trap

Chi Hung KWAN
Consulting Fellow, RIETI

China has come to be called "the world's factory," but its competitiveness is limited to labor-intensive production processes such as assembly. When we speak in terms of the "smiling curve," which shows the value added to a product at each part of the manufacturing process from research and development until it reaches the consumer, China's strength lies in the "chin" of the curve. In contrast to the high-value added upstream (R&D and manufacture of main parts) and downstream (sales and after-sales services) of the supply chain, the assembly process that makes up the midstream portion is not only the process that adds the least value to a product, it is also becoming increasingly unprofitable due to intensifying competition. Reflecting this, the slopes of the smiling curve have become increasingly steep with time ( diagram ).

In 2003, China's exports exceeded $400 billion, of which 55% was classified as processing trade. As the saying "both heads outward" goes, processing trade is greatly dependent upon foreign countries to handle the upstream and downstream parts of the chain. In fact, when we look at the value added by each part in a personal computer which bears the label "Made in China," we see that the CPU is made by Intel in the United States, the motherboard and display unit are produced in Taiwan and the hard disk in the U.S. - not a single component is manufactured in China ( table ). Meanwhile, many of the final products are exported to industrialized countries and sold under foreign brand names. Even in such low-tech sectors as clothing, China is excluded from processes which have the greatest value added such as design and sales. Of the fleece clothing sold at Uniqlo stores for ¥1,000, only about ¥100 is value added in China.

In addition, technological innovation called modularization and changes in the global political and economic climate have intensified competition in the chin portion of the smiling curve, and the curve's slopes have become steeper. In the 1960s and 1970s, when Japan was still a newly industrializing economy, the supply chains of most products were located in industrialized countries. As a result of this, relatively high wages had to be paid even for labor-intensive manufacturing processes. However, since then, progress in modularization, which allows the division of a supply chain into more or less independent processes, has made it possible to commission processes with low value added to developing countries, thus reducing the profitability of midstream processes. Also, the end to the East-West conflict and economic globalization have increased the number of countries shouldering labor-intensive manufacturing processes, not only to China but also to the former socialist countries of eastern Europe as well as the ASEAN nations and developing countries such as those in Central and South America, thereby lowering the value added during midstream manufacturing processes.

Industrialized nations like Japan have come to specialize in the upstream and downstream manufacturing processes - the two edges of the smiling curve that add the most value to a product - while at the same time keeping total manufacturing costs low by outsourcing to developing countries. As the slopes of the smiling curve have become steeper, the terms of trade for industrialized nations, which is the relative price at which their technology is exchanged for developing country labor, have also become increasingly advantageous. From the viewpoint of developing countries such as China, this means that the terms of trade have deteriorated, thereby reducing real income.

In agriculture, there is a phenomenon where farmers' income falls in times of a good harvest because prices fall. A similar phenomenon can be said to be seen in China's manufacturing sector, as the more products it exports, the cheaper the prices of the products become. The fact that the average monthly wage of a worker is still some $100, despite China having enjoyed growth of about 9% for the past 25 years, is an indication that the fruits of this economic development have not been fully enjoyed by Chinese workers. In order to escape from this trap of immiserizing growth, China must try to reduce excess labor in rural areas, which is pushing down wage levels, and advance its industry in a way that strengthens manufacturing processes on the two edges of the smiling curve.

Diagram: Changes in the smiling curve over time

Diagram: Changes in the smiling curve over time

Table:Breakdown of the value added to a "Made in China" personal computer

Table: Breakdown of the value added to a "Made in China" personal computer

(Note)The data are based on a PC "Made in China" by a major Chinese maker (as of April 2002).

January 16, 2004
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January 16, 2004