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Revised Forecast Advances Date of China Becoming the Preeminent Global Manufacturer

12 Aug 08

Rapid growth in certain manufacturing segments will help China overtake the United States as the world's leading manufacturer within a decade.

Recent forecast revisions suggest that China will overtake the United States as the world's leading manufacturer earlier than previously anticipated. Measured in real value-added terms, China's share in global manufacturing is projected to overtake that of the United States by 2016–17. This is helped by the Asian giant's rapid gains in the market shares of textiles, basic metals, computer equipment, appliances, and mineral products.

The United States will, however, continue to lead in selected high-valued manufacturing industries such as aerospace, pharmaceuticals, and specialized equipment. Also, the manufacturing sector accounts for only 12.5% of U.S. GDP, while the service sector is substantially more dominant. In contrast, 36% of the Chinese economy is engaged in manufacturing.

The concept of "value added" rather than "gross output" (i.e., sales revenue) is the appropriate measure of manufacturing sector growth. It corresponds to the sector's contribution to overall GDP and, as in the case of GDP, the value-added measure avoids the double counting of business-to-business transfers.

Furthermore, the measure in "real" (i.e., inflation-adjusted) terms reflects the true sector contribution, resource use, employment, and productivity growth, devoid of the influences of relative inflation in the respective countries, as well as the impacts of changes in exchange rates. In nominal U.S. dollar terms, U.S. manufacturing weakened sharply in 2007, and despite the outlook for a modest recovery in the coming years, China's unprecedented growth rates should secure the largest share in global manufacturing as early as 2009.

Note that nominal U.S. dollar terms incorporate the impacts of higher inflation in China as well as the impact of the changes in exchange rate. When a domestic currency strengthens relative to the U.S. dollar, then actual economic growth measured in the domestic currency will be exaggerated when converted to U.S. dollar terms.

An obvious follow-up question is whether the prospect of China’s ascension in manufacturing is a cause for concern. Will the rapid rise in China’s manufacturing sector choke the U.S. economy? But closer scrutiny suggests that such anxiety is probably unfounded.

Instead, the expanding Chinese market is more likely to open up greater opportunities for the United States as well as other producers. Several important areas of economic growth—such as finance, information technologies, and business services, in addition to such manufacturing industries as aircraft, pharmaceuticals, heavy capital equipment, and scientific and medical equipment—are all expected to remain larger in the United States than in China.

The U.S. manufacturing industries projected to lose the most ground in terms of world output share are textiles, basic metals, mineral products, computers, electrical equipment, and household appliances.

Choosing the Right Measure to Compare Manufacturing Sector Output

One easily understood measure of manufacturing output is gross output (GO), defined as the sum of all sales revenue across all production units within the manufacturing sector. Such summing up of sales revenue, however, results in substantial double counting in terms of output.

To illustrate, note that the purchase price of a car includes the cost of parts that the auto manufacturer buys from the parts manufacturer. The price of parts, in turn, includes the cost of iron and steel and other inputs purchased by the parts manufacturer. Consequently, adding up the sales revenue of the car manufacturer with the sales revenue of parts manufacturers and the sales revenue of iron and steel manufacturers to get gross output results in obvious double counting of output—potentially multiple times.

Such business-to-business (B2B) inter-industry transactions are taken out of the GDP calculation, to avoid double counting the true size of output. In addition, gross output includes the value of imported inputs, which is not a legitimate component of sector production. So, total gross output (sales) is a flawed measure of the true size of the sector's output.

A better measure is industry value added (VA), defined as sales revenue less the cost of all purchased inputs, thereby eliminating any such double counting of B2B transfers, as well as the value of imported inputs. Consequently, the sum of VA across all sectors represents GDP.

The distinction is important, since the U.S. manufacturing sector has a higher share of VA in total revenues (GO) than does the Chinese manufacturing sector. The U.S. share is 36%, while China's share is much lower, at 25%. The lower share in China partly reflects the large import components in its manufacturing industries; importing parts for assembling and re-exporting is a significant share of China’s manufacturing sectors. Moreover, the smaller share of VA in GO in China also results from the lower of labor productivity in Chinese manufacturing, along with lower wage rates and management costs, narrower profit margins, and more modest fixed-cost components.

Global Insight’s forecast is for Chinese inflation to be greater than in the United States. Furthermore, China's robust economic growth is also expected to support an appreciation of yuan relative to the U.S. dollar in the coming years. Hence, manufacturing VA in China measured in nominal U.S. dollar terms shows a faster rate of growth than when measured in real dollar terms.

Implications of China’s Manufacturing Growth for the U.S. Economy

The anxiety that the rapid growth of China’s manufacturing sector will be at the expense of the manufacturing sectors of the other countries, particularly the United States, should be mitigated for several reasons.

The relative decline in U.S. manufacturing's world share is not a sign of weakening future prospects for the United States. Rather, China's rapid manufacturing growth will help raise its consumer income and infrastructural development needs, thus opening up vastly greater trade opportunities for the U.S. manufacturing and service industries where the United States enjoys a comparative advantage. Global value-added manufacturing, estimated at US$8.8 trillion in 2007, is projected to expand another US$7.0 trillion by 2015, with China accounting for US$2.9 trillion of that growth.

In the past, while China saw its manufacturing growth surging at a 10–15% compound annual growth rate (based on real, value-added terms) in its post-liberalization period, U.S. manufacturing growth remained above 3%, with no evidence of choking by the rapid Chinese expansion. Global Insight projects China's manufacturing growth to be trimmed from its current 15% to 8% by 2015, and U.S. manufacturing growth to be roughly stable, around 2.2%.

Furthermore, manufacturing means more to the China economy than it does to the U.S. economy. As noted above, manufacturing accounts for more than one-third of China's GDP, but only about one-eighth of U.S. GDP, where there is a much greater reliance on the service sector, including the financial activities, wholesale and retail trade, and other business services.

Globally, manufacturing accounts for only 17% of GDP (in nominal terms), while the service sector weighs in at 65%. The U.S. share of world services output, currently at 32%, will remain far larger than China's share, currently at 3.7% and expected to reach only 8.0% by 2015.

While foreign demand has supported China’s manufacturing growth in recent years, future expansion will be increasingly diverted to meet growing domestic demand instead. Indeed, income gains and the consequent demand growth within this giant nation will enhance rather than hinder opportunities for external producers.

by Prem Premakumar

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