The Chinese 'Competitive Threat'

The explosive growth of Chinese exports over the past decade has led to much discussion of its 'competitive threat' in developed as well as developing countries. At the popular level, the threat seems quite clear. Between 1990 and 2002, PRC’s manufactured exports grew by 16.6% per annum, from $48 billion to $303.5 billion¹, raising its world market share over three-fold from 1.9% to 6.4%. In 2002, PRC overtook the UK and in 2003 it overtook France, becoming the fourth largest exporter in the world after the US, Germany and Japan. In the developing world it was by far the largest exporter; its share of manufactured exports more than doubled (in a faster growing total), from 11.3% to 24.1%.

In response to falling trade costs and greater international capital mobility PRC has emerged as a major exporter at both the labour-intensive low technology and increasingly at the knowledge-intensive higher technology end of the product spectrum. For the former goods the large labour surplus in rural PRC has ensured a plentiful labour supply for the export sector at what has been a relatively constant real wage set by the low opportunity of rural labour. The consequence has been that a in wide range of activities PRC has been the marginal supplier of low technology goods to the world market and its productivity and wage level have set world prices for these goods. PRC’s productivity has improved fast enough to offset increases in rural wages to ensure its competitiveness at the labour-intensive end of the spectrum. At the higher technology end export growth has been based on a combination of growing domestic capability and the activities of MNCs in relocating segments of the production chain to PRC take advantage of low labour costs. The key to PRC’s further progress here will be in its own capability development.²

The sheer speed, magnitude and range of its export expansion raised worries that competing countries were losing their overseas markets and FDI inflows. Latin America as a more industrialized region than PRC (its manufactured value added per capita in 2000 was nearly double that of PRC, at $627 as compared with $350, UNIDO, 2004) is a potential competitor particularly in the US market. The most direct threat has been perceived to be in Mexico. For example, The Economist describes the Mexican problem succinctly

"In the past two years it has become painfully clear that PRC is the favourite destination for the labour-intensive manufacturing that Mexico specialized in for the past three decades… The problem is simple. Labour costs in PRC, converted at the country’s artificially low exchange rate, are about a quarter of the level in Mexico. The result: about 300 manufacturing plants have moved from Mexico to PRC in the past two years, reckons the Labour Ministry. Especially affected is electrical assembly. Those plants that stay have cut wages… Not only is Mexican labour being undercut, but so is its privileged access to the American market. PRC has joined the WTO, and the United States is negotiating a freetrade agreement with five Central American countries… Not surprisingly, Mexico is dropping steadily down the international league tables of competitiveness." ('Mexico's economy: the sucking sound from the East', London, July 24, 2003)

2.1 Some Refinements

The popular notion of 'competitive threat' comes from business, where companies compete with one another and a gain in share by one is necessarily a loss by another. Transposing this to the national level means that trade is also a zero-sum game where one country gains at the expense of another: the loss of markets thus means a loss of jobs, incomes and growth. To the economist, this approach is misleading. The loss of markets in one industry does not imply that the country as a whole is less competitive'. Countries trade with each other in a range of products and it is unclear what higher or lower competitiveness means for an economy as a whole. The US, for instance, is becoming 'less competitive' in making apparel and 'more competitive' in making computers, but is it meaningful that the US is becoming 'less' or 'more competitive'?

Krugman (1994) argues that it is not. To him, "competitiveness is a meaningless word when applied to national economies. And the obsession with competitiveness is both wrong and dangerous" (p. 44). "International trade is not a zero-sum game" and treating it as such shows a lack of understanding of basic trade theory (p. 34). If all parties gain from specialising in trade, the entry of a new competitor can raise welfare for all partners – there is no 'competitive threat'.

Krugman uses the simple Heckscher-Ohlin (H-O) model to make his case. With efficient markets, perfect information, identical production functions across countries, no scale economies, no learning, full employment, fully mobile factors within economies, exogenous technical change, and all the other assumptions of static H-O models, all participants benefit from trade. The rise or fall of particular activities is irrelevant and the opening up of trade (or the entry of a new player) leads to a new equilibrium in which again all participants are better off. In this model, the pattern of specialization does not matter: since there are no externalities, innovation or differentiated products, all activities are equally beneficial and all factors yield equal returns on the margin. The size of the entrant and its rate of export growth also do not matter, since adjustment is instantaneous and costless.

In this model, PRC's entry induces other countries to move along their production possibility frontier and reach a higher social indifference curve, without friction, cost or delays, and with full employment throughout. While the extent of adjustment required is particularly large because of PRC's size, as long as markets are efficient there cannot be a 'competitive threat' (that reduces welfare). On the contrary, PRC's size opens up greater possibilities for new specialization (in higher wage economies in more capital and skill-intensive activities) and so larger welfare gains (though there are distributional consequences as resources move across activities with different factor intensities). The policy implications are simple – governments should not delay or prevent the adjustment but should permit free trade.

Does this dispose of the 'competitive threat'? Unfortunately not: the result depends crucially on the assumptions of the canonical H-O model. If these assumptions are relaxed to allow for greater realism – scale economies, differentiated products, adjustment lags, uncertainty, technological gaps, externalities and agglomeration effects, endogenous technical change, cumulative learning, information failures, unemployment, immobile factors domestically and mobile ones abroad, large firms with market power, and so on – the outcome can be quite different. There remain benefits from specialization and trade remains a non-zero sum game, but the realisation of the benefits in imperfect markets depends on the ability of each economy to create (or attract) competitive capabilities and to move into activities that offer the best opportunities for growth, technological development and spillover benefits (here the structure of comparative advantage does matter).

Alternative perspectives on international trade to the simple H-O model help to clarify the adjustment problem. For example, the new ‘economic geography literature’ (ironically also associated with Krugman, as for example in Krugman 1998) views trade through models where increasing returns to scale, learning and externalities have an important role. This alternative type of trade model predicts strong tendencies to geographical concentration and clustering with cumulative gains. International dispersal of activities like manufacturing (but the arguments apply to any increasing returns sector) requires either large cost increases in established production centres (for example due to rising wages or congestion costs) or major falls in trade costs.

Recent globalization trends can be interpreted as a process of falling trade costs where these include not just transport costs and import tariffs or tariff equivalents, but also the less obvious time costs of goods in transit, search costs as trading partners search each other out, control and management cost in organizing a supply chain internationally and unofficial policy barriers, including unofficial payments. Falls in trade cost, in fact, have been shown empirically to have a relatively large impact on trade flows. In the 1990s, PRC, with its large labour surplus and increasing outward policy orientation and openness to FDI, was well placed to take advantage of these cost decreases.

The prediction of these models is that the de-concentration process will itself be highly inequitable and a limited number of new dispersed production centres will emerge (Puga and Venables, 1996). Hence economies that lack the flexibility to move quickly into increasing return activities may find that once producers in rival economies become established the process of catch-up may be lengthy and difficult. From this perspective the rise of the first and second tier Newly Industrialized Economies (NIEs), in part the result of FDI flows from the older established producer Japan, represents one of stage industrial dispersal, with rapid growth in PRC, also strongly influenced by FDI flows in part from the NIEs themselves, a more recent dispersal stage. The question at hand therefore is what are the implications of this more recent dispersal of production for economies in Latin America?

For an economy or group of economies (like LAC) the current process of falling trade costs and its impact on their relations with PRC can be considered from the conventional perspective of trade diversion (if they lose market share to lower cost or higher quality Chinese goods) and trade creation (as markets are created by impact of PRC on both world trade and LAC exports). If the first effect has negative effects, provided resources are flexible, the conventional H-O analysis indicates the second should be sufficiently strong for all to benefit, at least potentially.³ However if one accepts that the trade (and production) structure of an economy matters for long-run growth due to the power of increasing returns, externalities and so forth, alternative trade models caution against this simple conclusion.

In addition, analysis that focuses on the technology structure of trade suggests that the move up the technology ladder is not automatic (in response to changing factor prices) but is dependent on many factors including the policy environment (such as targeting of hi-tech FDI, creation of high level specialized skills, promotion of R&D and so on). It is also seen as path-dependent, cumulative and gradual, so that countries can go on diverging over time with no inbuilt tendency to gravitate to some universal norm. (Lall 2001) A more technologyintensive export structure is also more dynamic as across industries there is a trend over time for technology-intensive activities to grow faster in trade. In part this reflects the faster growth in production and demand of innovative products. In part it also reflects the tendency for some high-technology products to relocate to developing countries to take advantage of low labour costs; the high value-to-weight ratio of these HT products makes them particularly suited to such fragmentation (Lall, Albaladejo and Zhang, 2004).

In this more realistic world, the entry of a large, efficient low-wage competitor like PRC into new export markets can involve significant adjustment costs and, where full and rapid adjustment is not attained, can lead to welfare losses. The outcome depends on two factors:

• The similarity of export structures in the competing countries, with greater similarity calling for greater adjustments on the part of the established producers.
• The speed, cost, nature and extent of adjustment in each country. These depend on the efficiency of existing markets and institutions in each country (and access to foreign capabilities), which in turn depend on the efficiency of policy to overcome market and institutional failures where they exist.⁴

Lall and Albaladejo (2004) examine the problems of economies in East Asia (EA) adjusting to competition from PRC. LAC has two advantages over EA: greater economic distance from PRC and more different export structures (with more inter-industry complementarities). While there are industries in which LAC faces direct and intense competition from PRC – the most obvious examples are electronics in Mexico and apparel in Mexico and Central America – LAC should, in general, face lower adjustment costs and benefit more from bilateral trade with PRC.

At the same time, no LAC economy comes near the mature EA NIEs (Singapore, the Republic of Korea and Taipei,China) in terms of industrial capabilities,⁵ though there are pockets of advanced capabilities in the larger economies, like automobiles, pharmaceuticals and aircraft (in Brazil). In general, however, the opportunities for LAC 'keeping ahead' of PRC in terms of the product complexity are narrower. Certainly, none has the possibility of relocating industrial activities in PRC to take advantage of its lower costs. Where they compete directly, therefore, it is more likely that LAC will find it more difficult to keep ahead of PRC. Moreover, the intra-industry or vertical 'sharing' of export activity happening in EA is much less feasible between LAC and PRC. Not only does economic distance place a barrier, the two main industries in which such sharing occurs, automobiles and electronics, have limited potential for intra-industry trade between LAC and PRC. PRC is not a major auto exporter and products are too 'heavy' (in terms of value to weight ratios) to make such longdistance interchange feasible.⁶ In electronics, PRC is a major player and products are light enough to permit trans-continental production sharing (many hi-tech components originate in the US). The major electronics exporter in Latin America, Mexico, has been losing exports and jobs to PRC, although as we see later there are in fact some signs of intra-industry trade, and the net longer-term trend is unclear.

LAC may face a more serious threat over the long term: the export specialization of most countries is heavily biased towards resource-based and primary products. It is not geared to dynamic categories in world trade and offers few technological or skill benefits. Chinese growth may well constrain their future ability to diversify into more dynamic, technologyintensive products, and so downgrade their potential comparative advantage. While we cannot analyse this possibility with past trade data, we can gauge from past trends the direction in which the region is heading, particularly in bilateral trade.

2.2 Measuring the Competitive Threat

There is no accepted methodology for quantifying a 'competitive threat' with the type of data available here. In the business literature, the common measure of competitive performance is relative market shares, and we start with this: in the simplest case, there is a competitive threat if PRC gains export market share and the other country loses. The intensity of the threat is given by the extent of the relative change. We look at competitiveness both in world markets and in the main market for LAC, the US.

However, such market share data do not show how LAC and PRC actually interact with each other at the product level. While it is not possible to infer direct causal relationships for the competitive impact of Chinese entry (only detailed fieldwork can show such relationships), it is possible make some progress by examining combinations of market share changes for PRC and neighbours. Using the technique in Lall and Albaladejo (2004), we distinguish five outcomes (Table 1 [PDF 111KB | 1 page]) and quantify the exports that fall under each over time.

All the measures are only suggestive, since the data cannot, as they stand, prove that PRC causes a change in the export performance of the other country. There are, moreover, caveats in each indicator. For instance, the data may suggest a 'partial threat' where PRC is raising market share faster than the other country (i.e. in PRC's absence, given that the other country is competitive, its share may have risen faster). However, it is possible that PRC is helping the other country to compete better by complementing it within an integrated production network and so preventing its market share from doing even less well. This may be plausible for EA economies in some sectors but is much less so for LAC. In the 'direct threat' PRC gains and the other country loses market share. Within EA, this may be compatible with the losing country placing export facilities in PRC and so extending its competitive advantage (this is the case with textiles and clothing and some electronics). For the PRC-LAC interaction this pattern is highly unlikely, so that a 'direct threat' is unambiguously negative and the share of the direct threat category in an economy's total exports is our preferred measure of threat.

We examine the potential for competition between LAC and PRC by measuring the similarity of their export structures over time. This is done at several levels:

1. At the broad technological level, we examine the overlap between PRC and LAC in primary product and four technological categories of manufactured exports: RB (resource based), LT (low technology), MT (medium technology) and HT (high technology) (see Table 2 [PDF 120KB | 1 page]). These four categories for manufactures are further disaggregated into nine sub-categories, capturing different technological or structural features, for further analysis. This technology classification offers several other benefits. It allows us to gauge the basis of each country's comparative advantage and its evolution over time. It shows how the country is 'positioned' to benefit from innovation and from changes in global trade patterns and it provides an indicator of whether the country will move up or down the technology ladder as a result of the competitive interaction with PRC.⁷
2. We use another broad level of classification, this time in terms of product 'sophistication'. We group all exports into categories of sophistication according to the average income of the exporter of the product in world markets, hypothesising that a 'rich man's export' has certain characteristics of interest, such as greater differentiation and branding, better design and specifications, and more advanced technology. This allows us to compare goods within one of the given technology classifications.⁸
3. At the more detailed product level, we examine the statistical correlation between the export structures of PRC and LAC. Higher correlation indicates greater potential for direct competition and rising correlations over time show that this potential is growing.
4. Finally, we examine the most direct trade interaction between PRC and LAC, their bilateral trade. Apart from showing the values and net trade balances in aggregate, we group the trade by technological characteristics to see how their relative advantages are evolving. This indicates (very broadly) the direction in which PRC may influence LAC's future comparative advantage.

To consider variations in competitive performance within Latin America, we analyse data for 18 countries with substantial industrial sectors for 1990-2002. The countries are divided into the following groups:

• LAC: All the 18 countries below taken together
• LAC-M: LAC excluding Mexico because Mexico becomes an outlier after 1995 when it joins NAFTA
• LAC Big 3: The 'big three' are Argentina, Brazil and Mexico.
• LAC Big 2: Argentina and Brazil only, again to exclude the outlier Mexico.
• LAC Medium 4: The 'medium four' are Chile, Colombia, Peru and Venezuela
• LAC Small 11: The 'small 11' are Bolivia, Costa Rica, Ecuador, El Salvador, Guatemala, Honduras, Jamaica, Nicaragua, Panama, Paraguay and Uruguay.
• LAC S 10: The 'small 10', S11 excluding Costa Rica because its Intel plant in the late 1990s, and resulting high technology exports, make it an outlier in the group.

The technology classification used is shown in Table 2 [PDF 120KB | 1 page].

2.3 Changes in World Market Shares

As a rough guide to trends in competitiveness we first consider changes in world market share (WMS) for LAC and PRC 1990-2002. As Table 3 shows, PRC gains WMS in all products, marginally in primary products and massively in LT and HT products. For all exports LAC raised its world market share by two percentage points in the 1990s, after losses in the 1980s. However, its performance is very modest compared to PRC and EA more generally and in part represents a catch-up from the losses of the previous decade. Surprisingly for a relatively resource-rich region, LAC’s WMS in primary products barely changes (from 12.4% in 1990 to 12.7% in 2002. In manufactures, its WMS rises from 2.3% to 4.9%, with the main WMS gains in complex MT and HT products (3.4 and 3.0 points, respectively). But this improvement in the technological structure of LAC exports is due almost entirely to Mexico. Mexico accounts for almost all of LAC’s improved WMS in pure manufactures (LT, MT and HT); the rest of LAC (LAC-M) loses in LT while its gains in MT and HT are marginal (0.2% and 0.4%). In the resource-based categories, Mexico loses in primary products and gains slightly in RB manufactures, while LAC-M gains small market shares in both. Mexico is a larger exporter in all pure manufactured export categories than the rest of LAC put together. In absolute terms, LAC-M remains a tiny global player (with under 2% WMS) in all segments apart from primary and RB products, fashion products and process industries.

See Table 3 [PDF 111KB | 1 page]

Within LAC Argentina and Brazil (LAC- Big 2) perform very poorly. Their manufactured WMS stagnates at just over 1% over 1990-2002. There are different industrial trends in the these two economies: there are rises in WMS of 0.2 points or more in primary products, agrobased RB, automotives and other HT (aircraft and pharmaceuticals), but these are offset by declines in LT and process MT products. The Med 4 (Chile, Colombia, Peru and Venezuela) suffer a loss in primary products, with gains in RB, automotives, MT process and other HT. The 11 small LAC economies lose in primary products and gain in agro-based RB, other LT, process and engineering MT, and electronics. Within this group all the gain in electronics comes from Costa Rica. Several small LAC economies depend heavily on fashion cluster exports, but their WMS declines once Costa Rica is excluded.

In summary, LAC without Mexico does poorly, raising its world market share in all manufactured exports by less than 0.2 percentage points; the weakest performance is by the two large economies, Argentina and Brazil. The largest world market shares held by LAC-M are in primary and resource-based products and MT process industries, industries that offer relatively low technological and other spillover benefits and that tend to grow slowly in trade. Mexico, by contrast, behaves like an EA NIE, with significant gains across the spectrum (primary products excepted). Similarly when a group of the ‘50 most dynamic products in world trade’ are identified their share in exports from Latin America (LAC-18) at 46% in 2002 is broadly similar to their trade share for both PRC (48%) and world trade as a whole (50%). However this comparison is strongly biased by the inclusion of Mexico and when it is excluded (LAC-M) the share of these dynamic products falls to 36%.⁹

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