Subsidies at the Root of the China Price

In an article from the June issue of the Harvard Business Review entitled "Subsidies and the China Price" Usha C.V. Haley and George T. Haley (both professors at the University of New Haven in CT) summarize their larger report on the use of energy subsidies to boost the Chinese steel industry. The larger report is available from americanmanufacturing.org/.

They write that

Many assume that China's cost advantage in manufacturing comes from cheap labor. But in China's burgeoning steel industry, our research suggests, massive government energy subsidies, not other factors, keep prices down. These subsidies have broad implications for how companies compete and collaborate with Chinese businesses.

According to the report, the subsidies go to domestic energy producers (e.g. coal mines) and are then passed along as lower costs to energy consumers including the steel industry. China continues to engage in strategic trade policies designed to boost its position in key industries.

In 2005, Beijing designated steel as a pillar industry for the Chinese economy. China was the world's largest producer of steel, with 27% of global production, but until then it had imported 29 million tons of steel annually. That year, China suddenly transformed itself from a net steel importer to a net steel exporter. In 2006, the country became the world's largest steel exporter by volume, up from the fifth largest in 2005. Today it remains the world's largest consumer and producer of steel, with 40% of global production. How did China make these astonishing gains so quickly and manage to sell steel for about 19% less than steel from U.S. and European companies? Labor accounts for less than 10% of the costs of producing Chinese steel, and Chinese steel doesn't appear to rely on scale economies, supply-chain proximities, or technological efficiencies to lower its costs.

Instead, what happened is that China boosted its energy subsidies, which now total more than 27 billion dollars per year.

The authors note that one important implication of their work is that foreign companies doing business with Chinese suppliers should be aware of the risk that subsidies underlying the "China Price" might be removed at any time because of political calculations. Companies should maintain supplier relationships with other sources until they are sufficiently confident in the "medium term" reliability of Chinese suppliers.

Another implication, not discussed in the HBR article, is that consumers and economists in the U.S. should not assume that low prices from China are the result of natural comparative advantage or low cost labor. It isn't cheap labor that gives Chinese steel companies an advantage, but cheap (e.g. subsidized) coal.

Although in the short term Chinese decisions to subsidize exports make those exports cheaper for us to buy, the longer term risk is that these subsidies will help Chinese producers gain other kinds of comparative advantage while driving other world producers out of business. In the short term, subsized and distorted export prices hurt American workers and companies in export-competing industries. In the medium term they could hurt all Americans.