Have MNCs hollowed out their domestic economies to China?

It is hard to open a newspaper or magazine these days without finding some discussion of the threats posed by China’s growing economic heft. The reactions of many American policy makers lie somewhere between fear and loathing.

A casual glance at recent postings suggests that even Vox is infected with a certain obsession with China. Back in July, Tim Besley and Masa Kudamatsu cited China in their provocative discussion of economic growth under successful autocracies. In August, Daniel Lederman, Marcelo Olarreaga, and Guillermo Perry discussed the impact of economic growth in China on Latin America. In early October, Peter Schott submitted a thoughtful review of the extent to which China effectively competes with developed countries in global markets. Toward the end of the month, Shang-Jin Wei took on the conventional wisdom concerning change in China’s exchange rate regime, which is one of the world’s most hotly debated public policy issues.

Despite the growing interest among Western policy makers and economists in the Chinese economy, and the increasing numbers of books and articles that provide excellent analyses of this economy, misperceptions about China and the role of Western firms in the Chinese economy continue to distort popular understanding and complicate international economic relations.1 This seems to be particularly true in the United States.

Many otherwise well-informed experts on international economics believe that US FDI in China is large, that US multinational enterprises (MNEs) have significantly enlarged the US-China trade deficit by shifting production aimed at the US market to Chinese affiliates, and that this production shift has undermined investment at home and in other countries. Current conventional wisdom also suggests that US MNEs are moving cutting edge R&D to China, in order to take advantage of vast legions of low cost technologically skilled workers. Our recent research, based on comprehensive surveys of US multinational activity in China, suggests that each one of these suppositions is largely false.2

First, US FDI in China is surprisingly small relative to nearly any relevant benchmark. US firms account for a small component of total FDI inflows into China. US affiliates have contributed very little to Chinese fixed asset investment or employment growth.3 Moreover, in 2004 the Chinese operations of US firms accounted for only 1.9% of total foreign affiliate sales and 0.7% of total foreign affiliate assets. These small numbers reflect China’s poverty, its distance from the US market, and, to a lesser extent, its imperfect institutions. As the Chinese economy grows and Chinese consumers become richer, investment will increase. But it is likely to be many years before American firms conduct a sizable fraction of their activity in China. We believe that European MNEs are similar in this regard.

Second, US affiliates in China have played very little role in China’s export growth. While foreign firms are currently responsible for nearly 60% of China’s total exports, US firms account for only a very small portion. Foreign firms based in other Asian countries are the dominant force behind China’s export surge. US affiliates are overwhelmingly focused on sales to the domestic market. The notion that US MNEs significantly contribute to America’s large trade deficit with China by moving production of goods intended for the US market to their Chinese affiliates is simply not born out by the data. It appears that this same generalization largely applies to European multinationals.4

Third, there is little evidence that increased US MNE investment in China is associated with less investment elsewhere. If investment in China is not that large and primarily focused on the domestic market, there is no reason to think that recent or future growth in FDI in China will crowd out significant amounts of investment at home or in most other host countries. Again, we think this is probably also true of European MNEs.

Finally, our review of US multinational R&D data and US patent data convinces us that China has not yet emerged as a major technological power, nor is the level of US R&D activity in that country large enough to contribute significantly to such an emergence. This appears to contradict much that Americans read in the popular business press. US CEOs like Intel’s Craig Barrett have publicly asserted that China poses a threat to the current dominance of US-based technology firms, including his own. More academic analyses suggest that China is rapidly becoming an important global center of innovation. In its 2005 annual survey of global FDI trends, the World Investment Report singled out the growth of foreign R&D centers in China, then numbering several hundred, as a development of particular significance.5 Other scholars, including Schott (2006) and Rodrik (2006), have found an unusually high degree of technological sophistication in China’s export pattern.6

However, the real extent of innovative activity performed in China by US multinationals is quite modest. In 2004, US firms spent $622 million on R&D in China; an amount that was about 0.3% of the total R&D undertaken globally by these firms. China even accounted for less than 13% of total R&D undertaken by US firms within the Asian region. It is hard to reconcile these small numbers with the view that US firms are shifting the locus of their R&D activities to China.

US patent data paint a similar picture. Any individual or firm seeking legal protection for its innovations in the United States must apply for a patent grant from the US Patent and Trademark Office. Given the importance of the US market, US patents obtained by China-based inventors are a useful indicator of inventive activity in China. Like R&D spending, patenting in China is growing rapidly, but it is starting from a low base. In between 2000-2006, China-based inventors obtained 3,447 patents in the United States. This is not large relative to more advanced Asian countries. Over the same time period, inventors in Japan received nearly 241,000 patents, and inventors in Taiwan received over 39,000. An interesting and distinctive feature of China-generated US patents is the frequency with which these patents were generated by international teams that include both inventors in China and inventors based elsewhere, including the United States. The vast majority of US patents generated in the US or in Japan are invented by teams of individuals located solely within those countries. However, in 2006, nearly half of China’s US patents were the work of international teams. This surprising fact could indicate that China’s raw engineering talent – impressive though it is – often requires additional input from skilled researchers in more advanced countries in order to generate true innovation.

Has China become an important R&D center for a small number of US companies, even if it remains less significant in aggregate terms? Not yet. By far, the leading US firm in terms of China-generated patents is Microsoft. Yet even Microsoft’s China-generated patents amount to less than 4% of its total cumulative patents as of the end of 2006. And if we restrict ourselves to patents with only mainland Chinese inventors, the fraction drops to about 1.5%.

How can we reconcile this low level of innovation with findings that indicate a high level of sophistication among China’s exports? China has become an important exporter of goods that are technology-intensive, but relatively little of the technology embodied in these goods has been created in China or by Chinese companies. Instead, China continues to import much of the high value-added parts and components that go into these goods.

The myth: Western MNEs hollowed out their domestic economies

China’s industrialization has transformed the world, and its emergence as a major trading economy is one of the key economic developments of our time. But Western observers need to understand that Western firms have played a relatively modest role in these developments. That recognition is important, partly because it gives the Chinese their due, but mostly because it lays to rest the myth that Western MNEs have hollowed out their domestic economies in their quest to build up China as the world’s factory. In addition, despite the many concerns that have been raised, China has not yet emerged as a technological superpower, and US data refute the notion that Western MNEs rely on China as their engine of innovation. As Europe’s own trade deficit with China grows and political tensions rise, we hope the debate in Europe may be better informed by these key facts than the debate in the United States has sometimes been.

 

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Footnotes

1 For example, see the World Banks report, Dancing with Giants: China, India, and the Global Economy.
2 The detailed results of our study appear in Lee Branstetter and Fritz Foley, “Facts and Fallacies about U.S. FDI in China,” NBER WP 13470.
3 These facts have long been recognized by specialists in the Chinese economy. See Nicholas Lardy’s book, Integrating China into the Global Economy (Brookings Institution Press, 2002) for an academic perspective.
4 Lardy (2002) makes this point, as does Branstetter and Lardy, “China’s Embrace of Globalization,” NBER WP 12373. See also Jon Anderson, 2006, “What Happened to the MNCs?” UBS Investment Research: Asia Focus, September 29, 2006.
5 United Nations Conference on Trade and Development, 2005, World Investment Report 2005: Transnational Corporations and the Internationalization of R&D, United Nations, New York.
6 Peter Schott, “The Relative Sophistication of Chinese Exports,” NBER WP No. 12173; Dani Rodrik, “What’s So Special about China’s Exports?” NBER WP 11947.