【原创】Should China’s Manufacturing Industry Transition Toward ...

Should China’s Manufacturing Industry Transition Toward Both Ends of the “Smiling Curve”?

-  A Comparative Analysis between China and Traditional Manufacturing Powers

Wang Qian¹(王茜) and Cheng Du² (程都)

¹ Department of Finance, The Graduate School of Chinese Academy of Social Sciences, Beijing, China 

² Chinese Machinery Industry Information Academy, Beijing, China

Abstract: The manufacturing sector in China has surpassed that of the United States in terms of scale. Yet it still suffers from the shocks of an international economic downturn, the lack of core technologies, and the impact of “re-industrialization” of the developed economies. Based on an evaluation of the “smiling curve” theory and selected trade data from 1991 to 2011, this paper performs a comparative analysis of the differences between the manufacturing sectors of China and those of the traditional manufacturing powers in terms of product categories and architecture. This analysis is conducted in order to explore the question of whether China should transition from being the “world’s manufacturing plant” to both ends of the “smiling curve”. The paper then introduces Japan’s “inverted smiling curve” to explore whether profit margins remain in the manufacturing sector. Research shows that China’s manufacturing capacity, especially its “integrated” product assembly capacity, has not been fully realized, and that the development of the manufacturing sector can still yield high market returns. As a result, it is necessary for China to continue the path of being the “world’s manufacturing plant”.

 Keywords: “smiling curve”, manufacturing industry, modular type, integration

JEL Classification: O14   

The manufacturing industry is one of the traditional core industries and the cornerstone of economic prosperity in developed countries. In recent years, China’s manufacturing industry has been growing rapidly in terms of the overall size and is catching up progressively with developed countries. As estimated by IHS (Information Handling Services), a U.S. research firm, in 2010 China accounted for 19.8% of the global manufacturing output whereas the U.S. accounted for 19.4%. China thus became a country with the highest proportion of the world’s manufacturing output and ended the U.S. record of being the largest manufacturing country from 1895 to 2009. However, China’s manufacturing industry lacks core technologies while at the same time the U.S., Japan, Europe and other developed economies have renewed their effort to develop an advanced manufacturing industry and promote “re-industrialization”. The increasingly more intense international competition threatens China’s manufacturing dominance. Within a short period of time, Chinese researchers have rushed to scrutinize China’s manufacturing industry. One group of commentators argue that China has “degenerated to being the ‘world’s manufacturing plant’”. In their view, “manufacturing” implies low value and the low end of the value chain. They appear to maintain that China should abandon the role of being the “world’s manufacturing plant” and should instead move up to both ends of the “smiling curve” as early as possible. This paper conducts a comparative analysis of the manufacturing sectors in China and those of traditional manufacturing powers to explore whether China has accumulated sufficient technology and experience in the manufacturing and assembly sectors and whether China is in urgent need to move up to both ends of the “smiling curve” because the manufacturing sector has allegedly become “unprofitable”.

1.The Concept and Controversy of the “Smiling Curve”

The “smiling curve” is a concept proposed by Stan Shih, Chairman of Acer Group of Taiwan, in 1992 to “rebuild Acer”. The left and right ends of the curve represent the research/innovation and marketing/services sectors with high added value along the value chain, and the middle part represents the assembly/manufacturing sectors with low added value. Shih believes that when enterprises have accumulated sufficient experience in low value-added sectors, they need to constantly progress towards high value-added sectors to expand profit margins. With this strategic thinking, Acer Group seized the two major aspects of R&D in the upstream and marketing in the downstream to become one of the industry’s most successful brands.

Subsequently, the smiling curve theory began to receive academic attention and is used in the research and analysis of various industries by scholars (Tian, Han, 2004; Yu 2005; Ye, Liu 2008; Lu, 2010; Wang, 2011; Parkinson. LF, 2012). Some scholars propose that China’s manufacturing industry should move up both ends of the smiling curve. Ma and Ji (2005) argue that the “modular” development trend of products makes developed countries focus on high value-added R&D and marketing activities and outsource the low-value-added assembly/manufacturing sectors to developing countries. With a weak industrial base, China needs to move up both ends of the smiling curve to avoid falling into the trap of “harvesting poverty”. This view is shared by Yang and Zeng (2009), who propose the “smiling curve” strategy for China’s manufacturing industry: China should strive for the upstream research and innovation, keep the manufacturing advantages in the middle, and expand the downstream marketing services. Sun (2010) analyzes the situation from the perspective of the international division of labor and points out that China has played the role of the “workers at the assembly line” for the world’s manufacturing powers. China’s manufacturing industry is at the low-end of the global value chain and must fight for the “technical advantage” and “brand advantage” in the higher end of the “smiling curve” value chain. Zhao (2012) suggests that the “re-industrialization” policy of the U.S. has posed a threat to the international competitiveness of China’s manufacturing industry and China would be in a passive position in the international competition if it doesn’t move up the value chain in a timely manner.

However, some scholars have different opinions. Long (2009) questions the scope of the application of the “smiling curve” theory, arguing that while the theory offers a good explanation of the industrial division of labor, it is inapplicable to the internal organization of a large company. In his opinion, technology R&D and marketing services alone cannot achieve a company’s goals; on the contrary, they would result in fragmentation. Wen and Zhang (2009) choose the crystalline silicon solar cell industry for a case study, and find that the industrial value chain is not a “smiling curve”, but a sloping curve from up left to bottom right. Liu (2012) affirms the policy merits of the theory, but believes that this theory has industrial and product limitations. The core competitiveness of the manufacturing sector is reflected not only in product volume, but also in production method. If China wants to “produce machines with machines” and “export machines” like developed countries do, it should go beyond the “smiling curve”. Zhuang and Jiang (2010) are concerned that if China is too eager to move up both ends of the “smiling curve”, it might risk neglecting the manufacturing section in the middle where the core competitiveness of China’s manufacturing sector lies. This “dumbbell industrial structure” with a hollow middle would result in decreased quality, increased cost, and the ultimate loss of market competitiveness. The research of Deng (2012) on the private manufacturing sector in Zhejiang province confirms this point, as he finds that a growing number of private enterprises in Zhejiang began to refocus on research and innovation under the influence of the “smiling curve”, but excessive innovation led to shortened market cycles for the new products, decreased product quality, and compromised business efficiency. Zhejiang’s private enterprises are generally small in size and lack capital, technology, and R&D personnel, and thus are unable to upgrade to both ends of the “smiling curve”. 

The authors of this article agree with the undeniable value and reference significance of the “smiling curve” theory. But is the theory universally applicable? Has China accumulated sufficient technology and experience to move up both ends of the “smiling curve”? Is the manufacturing sector “unprofitable”? These issues will be further analyzed.

2. Analysis of Product Categories and Architecture in the Manufacturing Industry

Products of different categories and architectures require different technical conditions in the manufacturing process, and the value created by each manufacturing process is different as well. To facilitate further analysis, we will first define product categories and architectures.

2.1 Product Category

The System of National Accounts divides products into three basic categories of capital goods, intermediate goods, and consumer goods. Capital goods are machinery and transport equipment used in production. Intermediate goods are the raw materials, semi-finished products and accessories used in production. Consumer goods are goods for the public or consumers. Capital goods and consumer goods are final products.

2.2 Product Architecture

Product architecture is the rules of assembly of the core components of a product and the basic concept of the relationship between the components. The selection of product architecture determines product functions, the division of parts, the allocation of functions to the components, and the interaction between the components, among others (Fujimoto, 2007). From the perspective of product architecture, products that need to be assembled can be divided into “modular” products and “integrated” products. The components of “modular” products comply with standardized design and are universally usable, while the optimal results of “integrated” products can only be achieved by coordinating the design of the parts. The differences between “modular” products and “integrated” products are shown in Table 1.

The characteristic of the “modular” architecture is that each part (or module) has been given a very independent function, so various parts are highly “separated”. Because of the completeness of each part’s function, the interfaces between the parts are relatively simple. Assembly does not require sophisticated technology and is labor-intensive. The main technical elements are included in the design and manufacturing of the parts with full functionality.

“Integrated” architecture means that the relationship between the functions and the parts is complex, and various parts need to be “coupled” precisely to realize the contemplated functions. For example, an important function of the car is to provide passenger riding comfort. This holistic, systematic function cannot be realized by any specific part, but is instead realized by the coordination of the tires, suspension systems, shock absorbers, chassis, engine, drive shaft, and many other parts. The relationship between the functions and the parts is not one-to-one, but one-to-multiple, multi 40 32662 40 13305 0 0 8558 0 0:00:03 0:00:01 0:00:02 8556ple-to-one, or multiple-to-multiple. The assembly process of these products has high technical content and is typically technology-intensive.

3. Analysis of Differences of the Manufacturing Industry between China and Traditional Manufacturing Powers

The processing of intermediate goods and assembly of the final products is the purpose of the manufacturing sector. It plays a connecting role in realizing the design along the industrial chain and providing a foundation for marketing and service. With a huge processing trade sector, China has become known as the “world’s manufacturing plant”. China appears on the outside to have a strong product assembly and manufacturing capability, but does this appearance reflect reality? In order to get to the truth, we need to base our conclusion on a comparative analysis of international trade data on China and traditional manufacturing powers. The accessed data are correlated in the following way: the United Nations Statistics Division integrates the Standard International Trade Classification (SITC) with the Standard International Trade Classification (SITC) using Broad Economic Categories (BEC), and the Organization for Economic Cooperation and Development (OECD) connects the Broad Economic Categories (BEC) with International Standard Industrial Classification (ISIC) using the bilateral trade database classified by industries and end-users, thus generating information on the international trade of intermediate goods and final products of different architectures.

3.1 A Comparative Analysis of the Export Structure of “Modular” Products of China, Japan and South Korea

Most of the products in the radio, television and communication equipment and apparatus industry (ISIC, 32) are “modular” products, and Japan and South Korea are the world leaders in this industry.

Figure 1 is a comparison of the percentages of intermediate goods of the total exports by the radio, television and communication equipment and apparatus industries of China Japan and South Korea from 1991 to 2011. As can be seen from the figure, the percentages of Japan and South Korea were higher than the percentage of China in the entire 20-year period. The percentage of China fluctuated slightly between 30% and 50%, while that of Japan and South Korea remained in the 60-80% range.

Figure 2 shows a comparison of the percentages of final products of the industry’s total exports by China, Japan and South Korea from 1991 to 2011. The percentage of China’s exports was higher than 50% while the percentage of Japan and South Korea was lower. In 2011, the percentage of Japan decreased from 54.8% in 1991 to 23.6%, while the percentage of South Korea was only 22.4%. 

Based on a comparison of the export structure of intermediate goods and final products of China, Japan and South Korea, we find that the percentage of exports of China is high in final products and low in intermediate goods. This shows that China has become a major assembly country in the radio, television and communication equipment and apparatus industry.

3.1 A Comparative Analysis of the Import and Export Structures of “Integrated” Products in the Machinery Industry of China and Six Traditional Manufacturing Powers

Most of the products in the machinery industry (ISIC, 29) are “integrated” products that require complex assembly technology. The U.S., Germany, Japan, France, Great Britain and South Korea are the world powers in this industry.

In terms of the percentage of exports of final capital goods, Figure 3 shows that Japan ranked first, with a standing percentage of around 70%. Germany ranked second, with a percentage that is approximately 10 percentage points lower than Japan. China ranked the lowest, and its percentage of final capital goods did not exceed 40% until 2007.

The situation with the percentage of imports of capital goods is quite the opposite. As shown in Figure 4, the percentage of China’s imports of machinery capital goods consistently ranked the first. The percentage was more than 84% in the mid-1990s. Despite the drop to 70% in 2011, the percentages remained high. For the other countries, the percentage of South Korea was similar to China, and the percentages of the remaining countries had been less than 50% since 2000, including Japan which decreased to 40%.

The situation is not promising even when judged by the time-tested indicators the Chinese people have always taken pride in. Figure 5 shows that for a long period of time Germany and Japan were No. 1 and No. 2, respectively, for exporting final capital products by the general machinery industry. Germany’s exports in 2008 were USD131.1 billion, 33% higher than Japan. In 2011, China still ranked lower than the U.S., with the U.S. being No. 3 and China being No. 4. 

A comparison of the general machinery trade data of China and the six traditional powers (the U.S., Germany, Japan, France, Great Britain and South Korea) in the past 20 years reveals a noticeable contrast between the general machinery industry (which is based on “integrated” products) and the radio, television, communication equipment and apparatus industry. China has a low export percentage and high import percentage of “integrated” products, indicating a severe lack of assembly technology of the industry. Every year, a large number of final products assembled overseas pour into the domestic market and pocket high profits. This is part of the reason why the Chinese manufacturing sector appears to be “unprofitable”.

4. Lesson from Japan’s “Inverted Smiling Curve” for China’s Manufacturing Industry

According to Stan Shih, the first proponent of the “smiling curve” concept, the highest profit margins lie with research and innovation in the upstream and marketing and innovation in the downstream, and low profit margins lie with the manufacturing sector in the midstream. However, a survey of manufacturing enterprises by the Japanese Ministry of Economy, Trade and Industry found that 44.4% of the enterprises obtain the highest profits in the manufacturing and assembly sectors, followed by sales, service and R&D design (see Figure 6).

The value chain of machinery, automobile and other industries appears as an “inverted smiling curve” (see Figure 7). Manufacturing and assembly sections are still the main sources of profits and manufacturing and assembly capacity remains the core competitiveness of these industries.

In addition, the manufacturing of key parts in each industry is the “gold mine” of the industry chain. China is a large producer of construction machinery, but 70% of the industry’s profits are used to import engine, hydraulic parts and other key components. Some SMEs in the electronics and semiconductor industry in Japan focus on the production of individual parts to occupy a major share in the niche market and obtain high profits. For example, Nidec Corporation accounts for about 75% in the global market share of hard drive motors of computers. Murata, TDK and Taiyo Yuden focus on the capacitors used in the production of mobile phones and computers. A study by the Asian Development Bank shows that Japan gained a total of USD60.60 for each iPhone produced in 2009, the highest profit in all participating countries.

5. Conclusions and Suggestions

5.1 Conclusions

Through an analysis of the differences between the manufacturing industry of China and that of traditional manufacturing powers, and based on an analysis of Japan’s “inverted smiling curve”, we can draw the following conclusions:

First, China has a high capacity in the assembly and production of “modular” products, but the traditional developed countries still enjoy an advantage in the assembly process and technology for “integrated” products. Comparatively, China does not have the ability to assemble the parts to complete the manufacturing of machines and still relies heavily on imports. Many of the “integrated” products belong to the equipment manufacturing industry, which should be important support for China to enter heavy chemical industry, to upgrade manufacturing industry, and to expedite the development of strategic emerging industries. A transition towards both ends of the “smiling curve” proposed by Stan Shih is possible only when enterprises have accumulated sufficient experience and ability in the manufacturing sector. Currently, China still lacks the capacity to assemble “integrated” products. Therefore, it is necessary for China to continue to learn the assembly and manufacturing processes for “integrated” products in order to advance to become the “world’s manufacturing plant” on a higher level.

Second, the “smiling curve” is not universal in the manufacturing sector and should be considered in the context of specific circumstances of different industries. In many manufacturing enterprises, especially enterprises that manufacture “integrated” products, profits remain in the manufacturing or even assembly section, and the further development of the manufacturing section can still yield high market returns.

5.2 Suggestions

First, China should continue to take advantage of technology diffusion by foreign firms and develop manufacturing and assembly technology for “integrated” products. Since China’s economic reform and opening-up, its manufacturing technology has made considerable progress. The initiatives to widely attract FDI are indispensable to this progress. Foreign firms introduced not only foreign capital, but also technology and equipment, as well as trained local technical personnel, laying the foundation for Chinese enterprises to develop global, advanced technology and independently produce innovations. The last wave of globalization made “modular” product production more thorough. The production of “integrated” products requires closer cooperation between upstream and downstream enterprises, and the industrial chain is less open, posing obstacles for new market entrants to be integrated into the industrial chain and learn the relevant technologies. In recent years, labor shortages in developed countries, increased competition in the global market, as well as a number of other factors have caused leading enterprises to focus their attention on the redevelopment of the industrial chain with production outsourcing to reduce costs and enhance competitiveness. China should seize this opportunity to guide foreign investment into advanced manufacturing enterprises in China and to develop manufacturing and assembly technology for “integrated” products so as to become part of the industrial chain.

Second, China needs to reinforce research efforts on materials, processes and components to enhance the industrial base. The production volume of China’s manufacturing industry has been quite large, but the research of materials, processes and components has lagged behind the pace of industrial growth and has become the constraints that impede further development. Special support from the government has primarily been directed to the manufacturing of main engines, but research of materials, processes and components has not been given adequate attention. This has, to a certain extent, promoted the development of “modular” products, which are easy to assemble, but not the development of “integrated” products. China should put more emphasis on the R&D of materials, processes and components, enhance the industrial base, break the development bottleneck, and improve the quality of industrial development.

Third, China needs to develop SMEs with special competitiveness and strengthen control over the industrial chain. The prosperous enterprises in the U.S., Japan and developed countries in Europe are not only large-scale industrial enterprises, but also SMEs that focus on a particular area. These enterprises have developed long-term businesses in specialized areas and have mastered the most advanced technology and processes, and as a result occupy a monopoly position in the market segments and control the industry chain. Such examples include Germany’s “hidden champions” and Japan’s “technology leaders”. SMEs will continue to be an important force for technological innovation and continue to have great impact on the manufacturing industry. China should also pay more attention to the development of SMEs, reinforce efforts to support manufacturing SMEs with “special focus, intensive R&D, niche products and enthusiasm for innovation” to become the leading power in the manufacturing industrial chain and strengthen the control over the industry chain.

Fourth and lastly, China should implement a government-led, business-oriented intellectual property protection strategy. In time, technological innovation will surpass resources, labor, capital and other factors to become the first driving force for future development in the manufacturing sector. To curb the catch-up efforts of developing countries and to protect the interests of innovators, developed countries have proposed more stringent intellectual property protection requirements during cooperation with developing countries and limited the technical development of other countries with the patent strategy. Therefore, the mere learning of foreign advanced technology cannot serve as a long-term plan, and independent innovation is the only way for China to become a manufacturing power. The Chinese government should develop intellectual property strategies at the national level, raise general awareness of intellectual property, create a social and institutional atmosphere to respect and protect intellectual property rights, and encourage enterprises to gain intellectual property rights on the core technology for “integrated” products through independent research. In addition, the government should guide the industry to make sound intellectual property development plan, assist enterprises to use intellectual property rights to protect their own interests, break the industry’s dependence on patents from developed countries, and engage in further development.

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