I just finished reading Managing the Dragon, by Jack Perkowski. It is a great book for anybody trying to understand modern China, its opportunities and challenges. Here I want to reproduce his description of two very interesting things ignored by most foreigners:

-1- The local governments’ incentives

A 17% value-added tax (VAT) has been levied on most manufactured goods since 1994. Local governments get a quarter of the VAT collected in their area, so they have a strong interest in attracting companies that will produce, sell, and pay taxes. What matters is the size of the project and the amount of sales (or more precisely, of gross margin) it will generate. As a result, local governments, which have more freedom than most foreigners think, have been very business-friendly.

Local officials have “tremendous influence” over local banks and their decisions of who should receive loans. Large factories get funded with–relatively–small equity and huge bank financing, because local governments want the VAT. So investors are quite happy with the return on their (small) investment and push as many projects as possible.

-2- Consequences on Chinese industry concentration

The local authorities’ actions lead to the fragmentation of industries, as each city—independently—wants to boost its manufacturing base. For example, in the early 20^th century, the US car industry was concentrated in Detroit, and economically speaking it made a lot of sense. It became (a little) more fragmented because of high-cost unionized labor, but certainly not to the point China has reached.

Now I understand something that used to puzzle me. I see companies that are based in the Zhejiang/Jiangsu area and can source all their inputs from there, and others in the Guangdong that sell the same products and also find everything locally… Similarly, there are countless trading/sourcing/project management firms (mostly in Shenzhen or in Shanghai) that can find nearly everything they need in their area. They don’t need to open other offices around China, and most often they don’t bother to look for faraway suppliers.

Why is this possible? Because every city is looking for local optimization (i.e. attracting investment that generate VAT) by giving tax rebates or other incentives, and industry clusters (or geographic concentration) seldom develop.

-3- Consequences on the China price

From what I wrote above, investors keep setting up factories, banks keep lending to them and cities want ever more business. What happens when supply surpasses demand? Overcapacity and falling prices. In the West, companies that make losses finally disappear through bankruptcy. In China the local banks keep lending, because one less factory means less VAT. No profit is acceptable here!!

Another factor: a fundamentally different cost perspective

In Perkowski’s words:

The Chinese have a fundamentally different cost perspective. They think about money differently. The effect of this different cost perspective is that Chinese managers instinctively and relentlessly search for manufacturing solutions that fit into China’s framework of affordability. What they consider affordable or appropriately priced is radically different (and less expensive) from what might be acceptable outside of China.

How does it work out? A Chinese manufacturer will always haggle over price and look for cheaper alternatives. But the Western manager in charge of a foreign-invested plant will just compare costs with what he is used to paying in his country, and he is happy with the list prices he is offered. Costs that are scrapped to the bone also include workers’ compensation and living conditions, of course.

As a result, locally-managed Chinese factories tend to run on lower costs than their competitors.