Reposted with permission from the Harvard Business Review.
Last week, LDK Solar, a struggling Chinese manufacturer of solar wafers and panels, announced that it had missed $24 million in bond payments. This news followed the bankruptcy in March of Wuxi Suntech, the main operating subsidiary of the world's largest maker of solar panels, after it defaulted on a $541 million bond payment.
It is no coincidence that this upheaval in the Chinese solar industry is occurring at a time when the central government's subsidies that had financed the industry's explosive expansion have declined even as problems in the global solar-panel market have soared.
Since 2008, through government subsidies, the manufacturing capacity of China's solar-panel industry grew tenfold, leading to a vast global oversupply. A surge in exports of Chinese panels depressed world prices by 75%. In 2012, China's top six solar companies had debt ratios of over 80%. Our research showed that without subsidies, these companies would be bankrupt. If the Chinese government sticks to its decision to stop funding unprofitable solar-panel manufacturers and support a revamping of the industry, more bankruptcies and restructurings are sure to follow.
While it is encouraging to see the Chinese government rethinking its support of the solar-panel industry, it would be foolish to interpret this move as a reversal of its overarching policy of aggressively subsidizing targeted industries in order to dominate global markets.
A Rise Fueled by Subsidies
For the past five years, we have examined how China swiftly moved from being a global bit player and net importer to the world's largest manufacturer and exporter in capital-intensive industries where it had no labor-cost advantage. We witnessed industrialized countries become exporters of commodities and scrap to China. In 2000, labor-intensive products constituted 37% of all Chinese exports; by 2010, this fell to 14%.
In parallel, from 2004 to 2011, U.S. imports of technologically-advanced products from China grew by 16.5% percent annually, while similar U.S. exports increased by only 11%. In 2011, the U.S. imported 560% more technologically-advanced products from China than it exported to that country. Meanwhile, the annual U.S. trade surplus with China in scrap and waste grew from $715 million in 2000 to $8.4 billion in 2010.
Government subsidies to produce technologically advanced products and undercut foreign manufacturers have buttressed China's trade prowess. Since 2000, the value of Chinese exports more than quadrupled. In 2009, China surpassed Germany to become the world's largest exporter. In 2010, it overtook Japan to become the second-largest manufacturer, and its foreign-exchange reserves became the largest in the world. Last year, China overtook the U.S. to become the biggest trading nation (as measured by the sum of goods exported and imported).
In the Chinese industries we studied -- solar, steel, glass, paper, and auto parts -- labor was between 2% and 7% of production costs, and imported raw materials and energy accounted for most costs. Production mostly came from small companies that possessed no scale economies. Yet, Chinese products routinely sold for 25% to 30% less than those from the U.S. or European Union.
We found that Chinese companies could do this only because of subsidies they received from China's central and provincial governments. The subsidies took the form of free or low-cost loans; artificially cheap raw materials, components, energy, and land; and support for R&D and technology acquisitions.
Since 2001, when China joined the World Trade Organization, subsidies have annually financed over 20% of the expansion of the country's manufacturing capacity. The state has willingly paid the price of economic inefficiency to accomplish political, social, economic, and diplomatic goals. Huge Chinese subsidies have led to massive excess global capacity, increased exports, and depressed worldwide prices, and have hollowed out other countries' industrial bases.
Case Examples: Steel and Paper
Take steel. In 2000, China was a net importer of steel with 13% of world imports and 16% of global output. By 2007, it had become the world's largest producer, consumer, and exporter of steel. Tellingly, energy subsidies to Chinese steel totaled $27 billion from 2000 to 2007. Today, China produces half the world's steel. Even though its highly fragmented industry has no scale economies or technological edge, Chinese steel sells for 25% less than U.S. and European steel.
Similarly, $33 billion in subsidies from 2002 to 2009 helped China triple paper production and overtake the U.S. to become the world's largest paper producer. This is despite the fact that its industry has no scale economies, is geographically fragmented, and the country has one of the smallest amounts of forest in the world per capita. Even though its industry has to import vast amounts of pulp and recycled paper (mostly from the U.S.), Chinese paper sells at a substantial discount to U.S. and European paper.
Other Nations Must Fight Back
Some have argued that Chinese subsidies help consumers by keeping prices low. Our research leads us to conclude that like other monopolies, Chinese companies will raise prices as international competition retreats.
Because of massive Chinese subsidies to several industries, no free trade exists and markets have failed. To survive, U.S. and European companies must seek government support to open Chinese markets and to protect themselves from subsidized products domestically. And national governments and trade blocs must heed these calls. If they don't significantly increase pressure on Chinese governments and businesses, the devastation that Chinese subsidies have wreaked on other countries' economies will continue.
Usha C.V. Haley is a professor of management and the director of the Robbins Center for Global Business and Strategy at West Virginia University. George T. Haley is a professor of marketing and the director of the Center for International Industry Competitiveness at the University of New Haven. They are the authors of Subsidies to Chinese Industry: State Capitalism, Business Strategy, and Trade Policy (Oxford University Press).
Reposted with permission. This Harvard Business Review blog originally appeared on April 25, 2013 at http://blogs.hbr.org/cs/2013/04/how_chinese_subsidies_changed.html