Processing Exports Remain Crucial to the Chinese Economy
By Yuqing Xing

Processing Exports Remain Crucial to the Chinese Economy

May. 11, 2016  |     |  0 comments

After eight consecutive months of negative growth, China’s exports in the March of 2016 finally reversed the course, and surprisingly rose 11.5 percent. Many China watchers interpreted this as a sign of export recovery. I think it is too early to make the call.

Examining the details of exports reveals that the positive growth was mainly driven by the 23 percent growth of ordinary exports, which actually fell 25.4 percent earlier in the month. The volatile growth of ordinary exports in February and March was caused by the seasonality of China’s traditional holiday — the Spring Festival. This festival follows a lunar calendar, which makes the holiday season start at different periods of the calendar year, affecting the calculation of monthly exports. The holiday season of the Spring Festival often results in a big swing in the production of ordinary exports.

In contrast to ordinary exports, processing exports, which I have been watching closely, showed no signs of stabilizing and continued to move along a downward trend. Specifically, pure assembly exports, one group of processing exports which are wholly made of imported materials, fell a further 11.1 percent, while mixed assembly exports, the other group of processing exports made of imported and domestically produced parts and components, followed the same suite and dropped 5.6 percent. The persistent fall of processing exports is very alarming and challenges the recovery of export growth, as processing exports remains more than one third of China’s exports.

Processing exports used to account for more than 50 percent of China’s exports before the global financial crisis. At its peak, its share reached as high as 57 percent. In the era after China’s WTO entry, the drastic expansion of processing exports powered the double-digit growth of China’s exports and eventually transformed China into the No.1 exporting nation in the world. In recent years, the expansion of processing exports has slowed substantially. Pure assembly exports have shrunk every year since 2007. Mixed assembly exports plummeted more than 10 percent in 2015, the first year it grew negatively since China embraced processing exports as a driver of export growth. The significant contraction of processing exports in 2015 dragged down the overall performance of China’s exports, which was a critical engine driving the double-digit growth of the Chinese economy.

Processing exports is actually a subset of global value chains’ (GVCs) activities. By engaging in processing exports, Chinese firms have been successfully integrated with GVCs and gained access to the global market. Lacking in brand recognition, global distribution networks, and advanced technology, Chinese firms face tremendous difficulties in penetrating international markets, in particular the markets of high-income countries, where consumers prefer branded products and high-tech gadgets. As participants of GVCs, Chinese firms specializing in processing exports can overcome these obstacles easily by leveraging on the advanced technology, brands, and global production networks of the lead firms of the GVCs, entering international markets and enjoying the benefits of the world economy.

GVCs have actually functioned as an effective vehicle for Chinese firms to sell their low skilled labor services and low value added parts and components to consumers in international markets. Besides the intrinsic comparative advantage in abundant labor endowment, plugging into the value chains of the global manufacturing industry by specializing in processing exports, explains most of China’s export boom in the last decades. It is the processing exports that transformed China into the largest high-tech exporter. As a matter of fact, 80 percent of China’s high-tech exports falls into the category of processing exports. China’s leading position in the export of information technology products, such as mobile phones, laptop computers, and digital cameras, was achieved through processing exports.

Processing exports are traditionally regarded as a low valued segment of GVCs. After the rapid expansion of processing exports in the last decades, this is no longer necessarily true for many Chinese firms. The domestic value added of China’s processing exports has risen substantially over time and achieved 45 percent from below 20 percent twenty years ago. More and more domestically produced parts and components have been used in mixed assembly exports, where domestic value added has increased to almost 50 percent of gross values. Moreover, firms specializing in processing exports can evolve from pure assemblers to original equipment manufacturers, original design manufacturers, and eventually original brand manufacturers. In other words, processing exports offer a clear path to move into the upper ladders of GVCs. It is imperative to emphasize that technology innovation and moving into high value added segments require not only huge investment in research and development, but more importantly a pool of highly qualified engineers and scientists. The successful experiences of Japanese, Korean, and Taiwanese firms suggest that the evolution of firms from low value added to high value added segments of GVCs occurs step by step rather than in a leapfrog fashion.

Compared with mixed assembly exports, the domestic value added of pure assembly exports, which requires only low skilled labor, is much lower. After a rapid growth of more than three and half decades, China has turned into a middle-income country on average. Whether those low value added assembly jobs remain important and Chinese firms should exit from the sector, is debatable among economists and policy makers. The education structure of the Chinese labor force nonetheless suggests that low value added assembly jobs remain crucial for the Chinese economy. Among 1.0 billion worker forces, 40 percent have attained only middle school education, far from enough to undertake high-value added tasks, not even mentioning to take part in technology innovations. The low educated workers need jobs matching their skills so as to make a living. Processing exports provide employment to this group of workers, who belong to the low-income group of Chinese society and are vulnerable to economic shocks.

Firms specializing in processing exports can evolve from pure assemblers to original equipment manufacturers, original design manufacturers, and eventually original brand manufacturers.

Reorienting the Chinese economy to the service sector has been recommended by many economists, both inside and outside China. It is crucial to understand that there are two distinctive service sectors. One is a high value added service sector, such as banking, finance, information technology, research and development, etc. The other is a low value added service sector, such as transportation, retail, hotels, restaurants, etc. The high value added service sector employs only highly educated workers, which consists of a very small portion of the labor force. Taking India as an example, it is famous for its information service industry, which exported USD 86 billion in 2014, the largest among developing countries. The information service industry of India, however, accounts for less than 1 percent of the Indian workforce.

For a low skilled worker, switching from a low value added manufacturing job, such as assembling export products, to a low value added service job, such as delivering meals, packages of online shopping, or driving a taxi, may not necessarily lead to income enhancement. In terms of productivity growth, the source of wage increase, manufacturing employment generally has more potential than service employment. The downward trend of the US median household income since 2000 is closely related with the shrinking manufacturing job sector, one of major challenges faced by the US in the age of globalization. Given the importance of processing exports in supporting employment, in particular the massive number of low skilled workers, it is too early for China to give up on processing exports.

The share of processing exports decreased to 37 percent by 2015. It cannot be explained as a healthy adjustment of the export structure as the fall has been accompanied with a decreasing and even negative growth of exports. The shrinking of processing exports is mainly due to the gradual exits of both domestic and foreign firms from processing exports. Wage increases and cumulative appreciation of the RMB against the USD have eroded the competitiveness of both domestic and foreign companies doing assembly tasks in China. In the last 10 years, minimum wages rose 10 percent annually on average across the country. Officially raising minimum wages can help enhance the income of the low-income group and alleviate the income disparity. On the other hand, if wage growth exceeds workers’ productivity growth, firms’ profits and competitiveness will be undermined. Additionally, employers’ contributions to all benefits of employees, such as pension, healthcare, and unemployment insurance, are based on wages. The actual cost increase of manufacturing processing exports would be much higher than what the wage increase indicates. Chinese firms engaging in processing exports generally have no pricing power and cannot pass on the increased labor cost to foreign buyers. They have to accept processing fees set by lead firms of value chains, and absorb the increased labor cost either by improving productivity or lowering profits. If they fail to cope with the rising labor cost, they will exit processing exports or relocate to third countries, which undercut the export capacity and employment of the Chinese economy.

Moreover, since July 2015, the RMB appreciated cumulatively against the USD by more than 35 percent. Processing fees or the prices of China’s processing exports are all invoiced in the USD. There is no automatic transmission mechanism to pass on the RMB appreciation to foreign contractors or buyers. Chinese firms have to shoulder all the cost associated with the RMB appreciation. The empirical research suggests that wage increases and the appreciation of the RMB are the two factors driving down processing exports. Specifically, for a 1 percent increase in Chinese manufacturing wages, the share of pure assembly exports is expected to fall 1.6 percentage points and that of mixed assembly exports to decrease by 1.1 percentage points; a 1 percent nominal appreciation of the RMB against the USD would be expected to lower pure assembly exports and mixed assembly exports by 2.4 and 2.1 percentage points, respectively.

To revive processing exports, a flexible exchange rate regime is necessary. The pace of raising the minimum wage should slow down, and at least not exceed the growth of labor productivity.

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