The argument in brief
China became the world’s largest destination for foreign direct investment(FDI), almost all of which is FDI in manufacturing and assembly, in 2003, before falling back into a solid second place. These FDI flows have revolutionized China’s industrial base and shifted the composition of Chinese exports from low-skill intensive to high-skill intensive goods and services.
What is the relationship between foreign manufacturing multinational corporations (MNCs) and the expansion of indigenous technological and managerial technological capabilities among Chinese firms? How are foreign manufacturing MNCs changing the skill-intensity of activities and the extent of value-added of operations within the domestic Chinese economy? To what extent, might foreign direct investment be helping propel China to become an export superpower “displacing Japan as the predominant economic power in East Asia”, as Ernest Preeg declares, making the country the “economic hegemon” in the region? Are multinationals “trading technology for sales in China”?
Multinational corporate investment in manufacturing and assembly can help “transform” developing host economies through four channels: 1) Foreign manufacturing investment can introduce new cutting-edge technologies, production processes, and management practices that are learned by local partners and imitated by domestic rivals who then set off on their own (horizontal spillovers and externalities from foreign investors to indigenous firms). 2) Foreign manufacturing investment can seek out and nurture supplier networks in a vertical direction that maintain world-class standards in cost and quality control, and upgrade their operations on a real-time basis (vertical spillovers and externalities from foreign investors to indigenous firms). 3) Foreign manufacturing investment can provide export externalities, introducing indigenous firms to international buyers and outlets. 4) Foreign manufacturing investment can build plants that incorporate capital, technology, and managerial expertise controlled by the foreigner, raising the productivity of a given set of activities in the host economy and providing payments for materials and labor used in the operations of the foreign plants.
China has been remarkably successful in designing industrial policies, joint venture requirements, and technology transfer pressures to use FDI via channels 1, 2, and 3 to create indigenous national champions in a handful of prominent sectors: high speed rail transport, information technology, auto assembly, and an emerging civil aviation sector. Prominent North American, European, Japanese, and Korean manufacturing multinationals rightly fear that they may find themselves launching rivals to their own market position when

they weigh access to the vast Chinese market against technology acquisition and management imitation on the part of Chinese partners and other indigenous competitors. Bringing in new technology to gain access to the Chinese market, whether for domestic market penetration or as a base for exports, may therefore often appear to individual foreign multinationals as making a Faustian bargain with the devil. “China can strike deals,” asserts Steven Pearlstein,“that may provide short-term profits to one company and its shareholders but in the long run undermine the competitiveness of the other country’s economy.”
II. Manufacturing multinationals and horizontal/ vertical spillovers to Chinese firms, with export externalities
Recent controversy about “indigenous innovation” policies is only the most recent manifestation of Beijing’s determination to use the lure of participation in the rapidly growing Chinese market, whether as a base for domestic sales or as a site for exports, to pressure foreign manufacturing multinationals to transfer industry best practices to Chinese partners and other Chinese firms in certain target industries.
High speed railroad transport
In high speed railroad transport, the State Council, Ministry of Railroads, and state-owned train builders(China North Car (CNR) and China South Car (CSR), have been particularly successful in combining access to the Chinese domestic market, favorable financing, and competition among foreign investors to induce transfer of technology and production processes to Chinese national champions. In 2004, the Chinese Ministry of Railroads solicited bids to produce train sets that could reach 200 km/ h. Alstom of France, Bombardier Transportation’s German subsidiary, Siemens of Germany, and a Japanese consortium led by Kawasaki submitted bids, with all except Siemens winning part of the contract. Alstom teamed up with CNR’s Changchun Railways Vehicles, while the Kawasaki-led consortium joined with CSR’s Sifang Locomotive & Rolling Stock. The fol- lowing year, Siemens won a contract to supply technology and build trains with CNR’s Tangshan Railway Vehicle Company. The same strategy was success in transferring technology and production experience for key components. CSR Zhuzhou Electric obtained traction motor know-how from Mitsubishi Electronic. Yongji Electric obtained traction motor know-how from Alstom and Siemens.
Siemens and Bombardier remained active in China by signing a“cooperation agreement on joint action plan for the independent innovation of high-speed trains in China” with the Chinese Ministry of Science and Chinese Ministry of Railway to develop and build a new generation of trains with a top operations speed approaching 400 km/h, which came into service in late 2010.
On the basis of expertise acquired from joint ventures with MNCs in the Chinese market, Chinese firms have gone multinational themselves, either alone or alongside their international partners. Acting on their own, Chinese train-makers and railroad construction companies have signed agreements to build high speed railroad systems in Turkey, Venezuela, and Argentina, while bidding on high speed rail projects in Russia, Brazil(Sao Paulo to Rio de Janeiro), and the United States (Los Angeles to San Francisco). Teaming up with multinational allies first met in the home market, China Railway Construction Corporation joined with Alstom of France to win Phase I of the Mecca to Medina high speed rail line, while CSR has partnered with Siemens to bid on Phase II.
Aerospace
In aerospace, China similarly uses access to the Chinese market plus an informal “offset” policy to gain access to aviation technology and production expertise. Early in 2005, for example, China approached Airbus seeking an Airbus final assembly line to be built in China, and later in the same year signed a purchase order to import 150 Airbus A320s, worth approximately $10 billion. Eighteen months Airbus later set up a joint venture company to assemble the A320 in Tianjin, and an Airbus spokesman acknowledged a quid pro quo. In 2009, the Airbus affiliate delivered the first mid-sized commercial airliner fully made in China.
Information technology
In information technology, Lenovo has its origins in the Chinese Academy of Sciences’ Institute of Computing Technology in 1984 as a distributor of foreign computers under the company name Legend. Legend/Lenovo moved from reseller into service, repair, and replacement parts, hence into assembly in 1990. By 1997 Legend/Lenovo was the leading retailer in China, ahead of IBM, with a market share of 40 percent, gradually pushing its way into the Asia-Pacific market? The boost to Lenovo’ s global presence came from acquisition of IBM’s personal computer and laptop division in 2005, and by 2009 the company had established itself as the fourth largest vendor of personal computers in the world. Lenovo is slightly more than 50 percent owned by public shareholders, while 42 percent of the shares are held by Legend Holdings Limited. Because the Chinese Academy of Sciences owns 65 percent of Legend Holdings, the Chinese government is effectively Lenovo’s largest shareholder with about 27 percent of the stock.
Automotive sector
If the use of industrial policy to force technology transfer from foreign firms to indigenous companies is rather nuanced in China’s IT sector, the results were initially quite counterproductive in the automotive sector.13. Under the label of market-for-technology, Chinese policies from the 1980s into the 1990s offered foreign investors access to a high protected Chinese market in return for partnering with indigenous firms and promising to meet high domestic content requirements. Fearful of losing control over their intellectual property, as when the Chinese partner in the AudiFirst Automobile Works “expropriated”the production technology after Audi’s license expired in 1997, international companies hesitated to introduce their most advanced technology into Chinese JV plants, and employed assembly processes that lagged world standards by almost ten years. After accession to the WTO, steady (albeit sometimes

grudging ) liberalization of the domestic market and rapid growth in internal demand allowed the major international auto companies to achieve economies of scale, rationalize production, and reach out to indigenous suppliers who themselves are able to enjoy full economies of scale. Help from foreign automotive investors in meeting the more stringent quality, safety, and anti-pollution standards may allow for expanding export opportunities to Europe and North America.
In diverse sectors ranging from high performance batteries, to electric engines, to wind power and other green industries, Chinese authorities have shown interest in enticing foreign investors to set up operations and share technology and management techniques with indigenous Chinese companies.
Beyond these headline industries what has been the outcome more broadly from China’s desire to use foreign manufacturing multinationals for indigenous industrial growth and penetration of high tech international markets? I
II. Manufacturing FDI in China and the increasing sophistication of Chinese exports
Turning from sectoral case studies to aggregate data, there is no other way to describe the impact of foreign manufacturing investment in China except as massive. In 2003 China overtook the United States as the largest destination for foreign investment in the world, and then settled into second place. FDI inflows reached $168 billion in 2008, declining slightly to $143 billion in 2009.
M u l t i n ational corporations in manufacturing have been the force that has propelled China’s exports from low skill-intensive to high skill-intensive products. In 1992, the low skillintensive sectors in China accounted for 55 percent of China’s exports. By 2005 these same low skill-intensive sectors’ share had fallen to 33 percent. The composition of exports had shifted from a predominance of agriculture, apparel, textiles, footwear, and toys into machinery and transport products. Here the strongest export growth has been machinery, and within this broad classification telecom equipment, electrical machinery, and office machines constitute the largest shares. These more sophisticated sectors are dominated by processing trade, an arrangement in which imports are allowed into the country duty free where they are assembled for export. Processing trade exports of machinery and electrical products grew from $9 billion in 1992 to $323 billion in 2006, from 22 percent to 63 percent of all exports. Processing trade, in turn, is dominated by foreign multinationals (called foreigninvested firms or FIES, including both joint venture and wholly owned affiliates of foreign multinationals), especially for more sophisticated products. The buildup of the foreign presence has been nothing short of remarkable. In 1992, foreign multinationals accounted for 5 percent of exports in ordinary trade and 45 percent of processing exports. By 2006, foreign multinationals account for 28 percent of ordinary exports, but 84 percent of processing exports.
The share of processing trade, and the foreign firm share of exports, climbs rapidly as the skill intensity of the products increases. For wearing apparel, processing exports as a share of industry exports in 2002 was 45.1 percent, with foreign firms accounting for 39.2 per- cent of industry exports. For household electrical appliances, processing exports as a share of industry exports was 79.1 percent, with foreign firms accounting for 56.9 percent of industry exports. For electronic devices, processing exports as a share of industry exports was 89.7 percent, with foreign firms accounting for 87.5 percent of industry exports. For telecommunications equipment, processing exports as a share of industry exports was 91.2 percent, with foreign firms accounting for 88.4 percent of industry exports. For computers, processing exports as a share of industry exports was 99.1 percent, with foreign firms accounting for 99.4 percent of industry exports.
So foreign manufacturing multinationals have been responsible for changing the composition of China’s exports, but it is almost exclusively the foreign firms who are producing the more sophisticated exports. The importance of this observation comes into clearer focus when examining China’s growing presence in export of what are classified as“Advanced Technology Products”.
IV. Domestic content and value-added in China on the part of foreign multinational exporters: a comparative perspective
In processing trade where foreign investors are heavily represented, Nicholas Lardy shows that the import content of processing trade exports has steadily declined, overall, meaning that the domestic content and value-added in China have been on the rise. In the first half of the 1990s the import content of processing trade exports was approximately 80 percent (domestic content 20 percent); by the late 1990s, it was around 65 percent (domestic content 35 percent). By 2007, the import content of processing trade exports was 60 percent, with domestic content 40 percent.
But Robert Koopman, Zhi Wang, and Shang-Jin Wei find that the decline in the import content is concentrated at the low-skill intensive sectors of processing trade exports. 22 As the skill-intensity of exports increases, the percentage of the value of the final product that derives from imported components rises sharply. For wearing apparel, the per-

centage of the value of the final product that derives from imported components is 62.4 percent. For household electrical appliances, the percentage of the value of the final product that derives from imported components is 76.3 percent. For electronic devices, the percentage of the value of the final product that derives from imported components is 85.2 percent. For telecommunications equipment, the percentage of the value of the final product that derives from imported components is 91.6 percent. For computers, the percentage of the value of the final product that derives from imported components is 96.1 percent.
Greg Linden, Kenneth L, Kraemer, and Jason Dedrick provide a fascinating look at who captures value in advanced electronics products exported from China, and where those who capture value are located. Value-capture means the margin for the firm after paying for inputs and labor. Their target is Apple’s iPod assembled in China with a retail price of $299 in 2005. In their estimation by far the most costly input in the iPod is the 30GB hard drive from Toshiba, which costs $73 or more than 50 percent of the total input cost, with a margin for Toshiba of about $20, which they assign to Japan. The second-most valuable input is the display, with a factory price of $20, plus margin of $6 for Toshiba-Matsushita, which they again assign to Japan. Next are two microchips from US companies, Broadcom and PortalPlayer, leading to $7 in margin assigned to the US. The SDRAM Memory comes from Samsung, with$0.67 assigned to Korea. There are more than 400 additional inputs, with values from $4 to fractions of a penny. Apple’s gross profit meanwhile is $80, or $155 if distributed through Apple’s own retail outlet. The margins for the companies involved in the creation of the iPod(above costs of materials and labor) total$190: $163 accrue to the US, $26 to Japan, $1 to Korea, if the iPod is sold in the US. Some portion of $75 allocated to retail and distribution would go to other players if the iPod were sold outside the US.
Linden, Kraemer, and Dedrick conclude that “the value added to the product through assembly in China is probably a few dollars at most” (the popularly accepted figure is $4). They argue that while Apple’s margins are high within the electronics sector, the“geography” of value-capture for the iPod is fairly representative for the industry.24 Robert Koopman, Shi Wang, and Shang-Jin Wei support this contention with their finding that Japan, the United States, and Europe (EU15) are the main sources of foreign content for computers and electronics in China, accounting for about 60 percent of imported components.
V. Flow-Back to the MNC home economies
Despite the appearance of small number of increasingly well-known Chinese national champions in manufacturing in the domestic market and abroad, most of the burgeoning new activities taking place in China have been remarkably well constrained to and contained within the plants owned and controlled by foreign multinationals and their international suppliers.
In their dissection of the “valuecapture flows” for Apple’s iPod, summarized earlier, Greg Linden, Kenneth L. Kraemer, and Jason Dedrick suggest that the value-added attributed to the parent company that contributes a component or performs an integrative function to a product in China flows directly back to MNC headquarters. This is almost surely too simplistic, especially for US MNCs,given the American territorial tax system with the foreign tax credit and deferral that encourage US MNCs to use transfer pricing to keep accumulations of earnings offshore.
Rather than try to track down capital flows and hiding places within integrated MNC networks, the more sensible approach is to ask a slightly different kind of question: if MNC headquarters use earnings from China, like earnings from elsewhere, to fortify their corporate position in world markets, what kinds of activities will those earnings help maintain or expand, and where will they be located?
For the United States the most recent data show that US-headquartered MNCs have 70 percent of their operations, make 89 percent of their purchases, spend 87 percent of their R&D dollars, and locate more than half of their workforce within the US economy. This predominant focus on the home economy has persisted over time and changes only very, very slowly at the margin.
Thus, while manufacturing MNCs may build plants in China, shift production to Vietnam, outsource to Mexico, take a chance in Costa Rica or the Czech Republic, develop a new application in Israel, the largest impact from deployment of worldwide earnings is to bolster their operations in their home markets.