China's economic model has a weak spot. Here's their plan to fix it.

Summary:

China's the world's most dominant productive economy, but lags global peers in value chains.

The giant trade surpluses accumulated by the Chinese factory and logistics sectors are largely negated by their deficits in business services.

Apple Corporation serves as a case example. Apple has outsourced almost all its production to China, while retaining product design and branding. But it's in those areas where most of the profits are realized: Apple's share of all the supply and value chain activities in the manufacturing of their devices is over 75%; Apple's partners in China earn just 25% of the channel profits.

Chinese policymakers are now focused on developing key "zero-to-one" industries, by dramatically increasing R&D as a share of corporate profits. And, they will push to eliminate many of the foreign companies that offer high-priced services that simply piggy-back on work Chinese companies are actually doing, such as logistics and trade finance. Strong examples here include foreign freight forwarders, who charge up to thousands of dollars in extra commissions and fees for EACH CONTAINER, though they perform few actual services themselves.

Report:

China’s economic model does have a weak spot. They dominate the supply chains of raw materials, and China is the factory of the world. They also now control the logistics systems—the shipping and railroads from raw materials sources to the refineries and the factories here, and from here to global consumer markets. China is a dominant productive economy. But they leave a lot of money on the table, on the very top of the value chain, and at the very bottom.

Consider a company like mine, Direct Equipment Corporation. Tens of thousands of companies are similar to mine—we contract with Chinese factories to build heavy equipment, which we private label for our own company in the Untied States, and sell to customers in America. At the other extreme are companies like Apple, who outsources their production of hundreds of millions of phones and tablets, and sell those products in our markets. The Western companies do some of the design and innovation for new products—along with the branding and marketing and customer service, and it is we who collect most of the profits. And in China’s mind, that’s a lousy deal—they are doing most of the work, but most of the profits are going to someone else. And that’s what they’re hoping to fix.

This is China’s blueprint for the strategy to now move down the value chain by doing a lot more of the innovation at the top, and taking over the business services at the bottom.

Supply chain is the flow from raw materials, to refining, to machining and factory work, and all the logistics involved in producing something and getting it to the final customer. But the Value Chain is where the money is. At which points is new value being created, and new profits being earned? And it is in the Value Chains that China is trying to catch up.

Zero to one innovation is the building of an entirely new industry, where none existed previously, and new technologies and standards need to be developed. AI and robotics are key examples here, and we’ve reported on China’s efforts in AI and robotics. It is a global race to develop these industries, and all the innovations in AI and robotics are new. Everyone, everywhere is doing zero to one.

China is also developing a new industry for drones, what they call a “low-altitude economy”, which is NOT being done anywhere else. This low-altitude economy is going to transform China’s logistics and supply systems, making those faster and more efficient by going node-to-node, and eliminating bottlenecks. Doing that, they hope, will reduce China’s spending on logistics by 5 percentage points, saving over $800 billion per year economy wide.

Tertiary industries are those that do not directly create products. And it’s in these industries that China is foregoing profits, because China’s business services industries are underinvested.

Huang Qifan is the official whose strategy is detailed in this report, and Huang was a key architect in building up Shanghai and Chongqing, two of the economic powerhouses here in China. And he makes the point again, with respect to Apple and companies like them. Apple’s partners in China do most of the work, but those Chinese companies earn only a quarter of the profits from Apple’s value chain. Apple makes three fourths of the profits from the products that are made here, going all the way back to the mines that haul the magnets out of the ground to make all the world’s smart phones actually work. And for pharmaceuticals the profit margins earned by Western firms are obscene, thousands of percent in markups on drugs that are designed here, tested here, produced here, then shipped to companies whose only value add is the branding and licensing to sell in foreign markets.

Looking at this from the perspective of a supply chain—it’s almost all China. It’s Chinese companies that pull the raw materials out of the ground all over the world, bring them here for refining and machining and factory production and even the packaging, then the shipping to the company that handles advertising and last-mile delivery. But on the value chain, up-front innovation and business services are mostly foreign companies, and to China, that seems to them like the easy part.

On the first point China will be investing more on the zero-to-one innovation. Currently Chinese companies reinvest about 5% of their profits into R&D, which is a fourth what Western firms do. Then they need a new focus on business services, service sectors that are oriented toward producers. China has an enormous services sector, but only a third of that is aimed at producers. In Western countries, it’s almost half. Western countries have key advantages here—advertising, marketing, banking, insurance, international settlements. China has huge trade surpluses, much of which is negated by the deficits in services. Specifically, Chinese policymakers will be focused on logistics services, banking and trade finance, and insurance. China’s deficit here is almost a hundred billion dollars per year.

When you do business with Chinese factories, the difference in cost for these business services is stark. For example, the difference between using a freight forwarder in Singapore or New York or London, compared to using the one which is recommended by the Chinese factory, is thousands of dollars on a single container. And if a buyer uses a Letter of Credit issued by a US bank, instead of one in Hong Kong—the difference there is hundreds of dollars, and it takes a lot longer.

China’s challenge is to squeeze the middlemen out of the logistics and payment systems, and it may be simply to better inform end buyers as to what shipping and payment options are available. Those profits will probably eventually be wrested away from the logistics companies in the US and Europe that aren’t actually providing any of the logistics at all. For the banking and insurance, that trend looks favorable to China, too, as they further develop their financial systems that are outside Western regulation.

Resources and links:

Resources and links: South China Morning Post, China urged to fix services ‘weak link’, increase investment in zero-to-one innovation https://www.scmp.com/economy/china-economy/article/3242330/china-urged-fix-services-weak-link-increase-investment-zero-one-innovation

SCMP, China’s economic powerhouse seeks AI, humanoid robotics, low-altitude economy upgrade

https://www.scmp.com/economy/china-economy/article/3272011/chinas-economic-powerhouse-seeks-ai-humanoid-robotics-low-altitude-economy-upgrade

SCMP, Chinese drone prepped for mass production as demand for aerial deliveries soars

https://www.scmp.com/economy/china-economy/article/3288773/chinese-drone-prepped-mass-production-demand-aerial-deliveries-soars

Value Chain In Supply Chain Management

https://qodenext.com/blog/what-is-value-chain-in-supply-chain-management/