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The subsidy regime
It’s well-known that China derives its export prowess from a well-oiled manufacturing set-up. What’s not known is that a blatant subsidy system backs it
COMMENTS PRINT

Don't tell us what to do; we'll do what we want to do and how we want to do it.

Handout culture

Dragon's bite: A handout culture is prevelant across all sectors

That's China on Tibet. That could well be China in world trade: purposeful, unrelenting and willing to go to great lengths to achieve its objective. China's objective has been to manufacture goods like crazy, price them cheaper than anybody else, and flood them into world markets.

It is succeeding. Between 2000 and 2006, according to the IMF, China's share in world exports increased from 4.7% to 10.8%, making it the number two exporter in the world, after the European Union (43.8%) and ahead of the US (10%). That's also the highest increase among the top five exporters, two of whom lost share (US and Japan) and two others only managed marginal gains (EU and Korea).

Sop story

The Chinese export story is built as much on a well-oiled manufacturing set-up, as on an incentive regime that rolls out the red carpet to all those who come under its circle of influence. Support aside, that carpet has generous sops and handouts, which can do wonders to the cost of production of businesses—and, therefore, the price at which they sell their goods. The entire production chain—from raw materials to labour, land to power, financing to exports—is subsidised, mostly implicitly, sometimes even explicitly.

These extraordinary support structures are giving a headache to nations and businesses outside. Chinese companies are able to price their goods cheaper to capture markets, as a visit to any industrial wholesale market will establish. As do the Chinese export numbers, especially to India. In 2006, exports from China to India increased by 63%, the highest among the top 20 export partners of China, aided in no small measure by its flourishing subsidy regime that runs into billions of dollars annually.

More and more details of that subsidy system, and how it is one of the pistons of the China manufacturing and exports engine, are emerging by the day. Two things are driving this flow of information.

The first is China's entry into the World Trade Organisation (WTO) in 2001, which forces it to share more information. In 2006, China submitted a report on its subsidies to the WTO Committee on Subsidies and Countervailing Measures. Although most of the subsidies mentioned in the report are not supported by data on their extent and coverage, it is the first sign of public admittance by China of a subsidy culture that is, as suspected but not stated, vast and complicated. Says Nagesh Kumar, Director-General, Research and Information System for Developing Countries, an economic policy think-tank: "While some of the subsidies are WTO-compliant, a majority of them are not."

The second is the increasing research being commissioned by countries reeling under the impact of the progressive Chinese onslaught. In steel, for instance, the near four-fold increase in Chinese steel capacity between 2000 and 2006—which catapulted China into the number one slot in steel manufacturing, and turned it from an importer to an exporter—prompted a series of studies in the US and Canada on the Chinese way of manufacturing.

Two reports—by law firm Wiley Rein and by Usha CV Haley from the University of New Haven—dissect the Chinese steel sector to highlight the unfairness of a manufacturing set-up that uses subsidies as a tool to increase price competitiveness in world markets. It's not just steel. Chinese manufacturing is marking its global presence in virtually every sector, a subsidy component is embedded in most of them. (Read: On artificial support)

History lesson

The seeds of this edge or edginess, depending on the side looking at it, were sowed in the late 1970s, when China started liberalising. The country adopted an aggressive pro-export strategy through active participation by local authorities, and investors from Hong Kong and Taiwan looking for a source of cheap labour. A variety of approaches were employed to promote an export culture: geographical and sector targeting, a liberal foreign investment regime and easy access to export financing.

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The big push came in the 1980s, when China set up special economic zones (SEZs) along its east coast. Here, economic activities—manufacturing, banking, trade and foreign investment—took place in a more autonomous, liberal and incentivised environment than in the rest of the country. In the mid-nineties, China turned its attention to State-owned enterprises (SOEs) in inland provinces, and directed them to replicate the SEZ export model.

China has a private sector, but it is structured in such a way that the State is still omnipresent. Chinese companies can be classified into four categories: unlisted SOEs, listed SOEs, private companies (most of which are owned by politicians) and joint ventures (mostly between foreign companies and SOEs).

That enables the State to run, what experts term, a mercantilist strategy. The strategy is to capture markets through lowest prices, which it is able to execute since it controls resource ownership and cost of inputs. Says R Venkatesan, Senior Fellow and Head Industry Programme, National Council for Applied Economic Research (NCAER): "Energy costs in China are effectively the lowest in the world."

Subsidy for exports

The subsidies given to manufacturing units in China are many and diversely spread—and hence difficult to quantify. That task is made difficult by the information vacuum, the arbitrary nature of these handouts and the complexity in pricing.

Wiley Rein has tried to quantify the subsidy benefits for the steel sector, where the government controls 19 of the top 20 steel companies. According to Wiley Rein, Chinese steel companies received subsidies worth US $79.1 billion between 2000 and 2007 (See table: Not All Steel).

China extends subsidies to virtually all industries, giving special attention to those of strategic importance like steel, energy, textiles, resource extraction, computing, software, research and development (R&D), and automobiles, among others. Says Manoj Pant, Professor of Economics at School of International Studies, Jawaharlal Nehru University: "China periodically changes its taxation laws to give advantage to various manufacturing sectors."

The subsidies too are diverse, intended to capture market share and to keep the wheels of production moving. The export focus of these subsidies is sharp. A September 2007 Standard Chartered research paper, On the Ground, China, tells how incentives are used to promote outcomes: "Our furniture maker reported he had heard one estimate of total subsidies available to the local furniture industry of RMB 10 billion ($1.3 billion) a year. The manager described, for instance, a new scheme for which firms that can prove that they have paid all their VAT on inputs and who export all their production qualify for a 5% sales cash subsidy from the Shenzhen Government."

Liberal lending policy

Selective sheltering: Banks lend to state-owned firms on easy terms based on government directives

The export focus is most noticeable in the system of tax benefits, which includes exemptions, reductions and credits linked to exports. The value-added tax (VAT) subsidy program with the greatest impact is the 'value-added tax rebate program', which makes direct payments to exporters based on their export performance. In 2006, the EU had this to say on this programme: "China seems to be operating a complex system of VAT refunds on exports. This system is not transparent, as refunds seem to be given on a discriminatory basis. Discriminatory refunds could make the system a subsidy instrument. It also seems that changes to the VAT rebate are implemented retroactively and apply to companies in free trade zones, which should not be subject to VAT."

Most of these subsidies are difficult to determine since China changes the name and form of the subsidy at will. "Very often, China changes the name of the subsidy, while retaining its nature to maintain ambiguity," says Biswajit Nag, Associate Professor at Indian Institute of Foreign Trade (IIFT). Many provincial governments give implicit subsidies with fancy names like the market exploration fund, export credit insurance, offshore processing trade project, loan interest subsidy, export research and development fund and outward looking enterprises development fund. The Guangdong provincial government even has an 'anti-dumping proceedings fund'.

All the subsidies given by China are potentially dwarfed by the impact of its currency on exports, which is perhaps the largest subsidy of all. Economists and policymakers across the world agree that the Renminbi (RMB) is well below what it would be if China let it float—estimates of the extent of the undervaluation range from 35-55%. The undervalued RMB makes Chinese goods more competitive than goods from other economies, and is also a major factor for foreign companies setting up base in China. When the subsidies are thrown in, manufacturing in China becomes a powerful proposition.

The message China is sending to its manufacturing sector—state, private or foreign —is to keep up the export charge, we'll provide support, even make good the damages. China even uses subsidies to grant lifelines to loss-making SOEs and to stage-manage its manufacturing set-up. So, it gives cash grants, makes equity infusions, converts unpaid debt into equity. It even manages mergers, a case in point being Bosteel getting a 48% stake in Xinjiang Bayi Iron & Steel Group for free, in spite of the latter's assets being worth RMB 6.7 billion ($ 0.95 billion).

Elsewhere, China's infamous banking system is dominated by government-run banks, which typically extend loans based on directives from the Central and provincial governments. Mostly, they lend to SOEs and industries favoured by the government, that too on preferential and non-commercial terms. Standard and Poor's estimates that 40% of China's State-owned bank loans, or about $800 billion, are non-performing in nature. By one account, the Central government has spent about $250 billion to bail out the four main State-owned banks.

Where is China bankrolling all this from? Unlike most economies, including India, which are perennially running a deficit, China has had a trade surplus since 1994. "The subsidies could be largely financed from its vast trade surplus," says Debashis Chakraborty, Assistant Professor at IIFT. In 2000, China had a trade surplus of $24 billion. In 2006, following the explosion in exports, this figure had increased to $177 billion.

China and India

Other countries also give out subsidies, but on a much smaller scale, as they either don't have the deep pockets like China or don't want to distort their domestic market. Now that China is a member of the WTO, there will be pressure on it to reduce this subsidy regime.

"Just like every member of the WTO, China will have to deliver on its commitments,

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and we will be watching very carefully," EU Trade Commissioner Pascal Lamy had said on the eve of China's accession to the WTO. Seven years on, little has changed. China's engagement with world trade is still characterised by opacity, resulting in it being consistently denied market-economy status—when goods are charged normal duty rates—by leading industrial nations. Says Chakraborty: "WTO members raise the subsidy issue in informal sessions, but no one has succeeded in verifying or quantifying the extent of the subsidies."

Despite having to pay higher duties, despite having the maximum number of anti-dumping cases slapped on it, China continues to play the price card—supported by subsidies—to buy market share. Says Nag: "China is docile at multi-lateral forums like the WTO, but it is aggressive in bilateral trade negotiations, and uses it to settle disputes, whether related to dumping or subsidies by offering the country concerned sops and exclusive trade relations."

India has reason to be threatened by the Chinese export model, which is making inroads into India, and hurts the MSME (micro, small and medium enterprises) segment the most. Lamenting the absence of foresight in economic policy and planning, analysts say Indian manufacturers will have to increase their cost-competitiveness, as well as move up the value chain. "India cannot afford to give its manufacturing sector subsidies," says Pant.

India scores over China in some sectors like high-end auto components, pharmaceutical and inorganic chemicals. Says Nag: "India is investing heavily in fundamental research, focusing on R&D in value rather than volumes. India has a better record in Intellectual Property Rights, which is leading to high-end product innovation."

Whether and when China will start cutting back on its subsidies is anyone's guess. In the past, Singapore and South Korea built their economies on a similar pattern—heavily incentivised export growth. Once the foundation was laid, they did away the incentives. In China's case, it is unrelenting. It's why experts like Amir Ullah Khan, Director at IDF Research, feel India should forge a closer economic relationship with China to explore world markets together. As the debate continues, the formidable Chinese juggernaut—built on intent, infrastructure and incentives—rolls on.

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