Overview of the Industry Chain: From Efficiency to Security

Abstract

Division of labor and the ability to facilitate transactions lie at the heart of industry chains, supply chains, and value chains. Two major factors that determine how the division of labor and transactions unfold globally are efficiency and security. We can see from the history of industrial development that companies and markets are able to continuously improve efficiency by optimizing the division of labor and transactions, through which they can dominate the development of industry chains. Differences in factor endowments and equalization of factor prices among countries determine how industry chains are developed around the world under the principle of efficiency.

China’s reform and opening-up have improved the efficiency of its industry chains both domestically and internationally. Domestically, reforms have enhanced China’s marketization and industrial agglomeration, thereby unleashing the country’s economic efficiency. Internationally, opening-up has propelled China’s participation in the global industry chain and its cooperation with developed countries, resulting in the country becoming one of the leading forces of globalization.

How should we understand the security of industry chains and supply chains? From the enterprise perspective, security is mainly associated with maintaining the stability of supply chains. From the perspective of governments, security is to ensure the country’s industrial and technological superiority as well as independence from international competition, which is to some extent related to the backdrop of rising geopolitical risks.

After years of efficiency gains, China and the US’s pursuit of industry chain security somewhat goes against the principle of efficiency in the context of global industry chains, thereby necessitating efforts from both countries to control the resulting loss of efficiency. The two countries need to maintain bilateral economic and trade relations as well as the global trade system at the economic level.

Technological decoupling between countries would hinder technological progress and economic growth on both sides. However, the fundamental factor that determines a country’s technological progress lies in its national innovation system, which consists of the government, the market, universities, and companies. Ultimately, industrial competition between countries is competition in innovation.

Author of this chapter: ZHAO Yang. Other important contributors: XU Lei, NIE Wei, XU Enduo, DAI Rong. Translator: HUANG Jincheng. Editors: Kenneth HO, Andrew CHENG, XU Lei, LIU Xinran.

Efficiency and security are the two major factors behind geographical layout and the development of different industries. China’s reform and opening-up have greatly improved the efficiency of its economy. The economic and trade cooperation between China and the US has played a major role in globalization since the 1990s. However, the world today is seeing signs of deglobalization. As China’s economy continues to grow, and its industries are continuously upgrading, the two countries are gradually shifting from cooperation to competition. This is bound to have an impact on the configuration and distribution of global industry chains. When countries are committed to global peace and development, economic and trade cooperation is generally adopted internationally, and efficiency improvement is the primary focus of industrial development. However, when international geopolitical risks rise, so do concerns about security. From the perspective of enterprises, industry chain security is mainly associated with maintaining the stability of supply chains, shifting their strategies from just-in-time to just-in-case. From the perspective of governments, industry chain security is related to competition among countries. Every country wants to ensure its industrial and technological superiority in international competition to a certain extent. The pursuit of industry chain security by China and the US in the context of mutual competition may come at a cost of a certain level of efficiency loss. However, both sides cannot pursue security at any cost, and need to control the loss of efficiency. In this chapter, we examine the concepts and theories related to the efficiency and security of industry chains, and try to provide a framework for analysis and understanding of the efficiency improvement during China’s industrial development in the past four decades as well as the security issues currently faced by the country.

2.1 The “Efficiency First” Principle of Industry Chains

2.1.1 Division of Labor and Transactions Are at the Core of Industry Chains, Value Chains, and Supply Chains

An industry chain can be understood as an interrelated system formed by enterprises that produce various products or provide various services through the division of labor and transactions. From the macro perspective, the relationship between industries is neither chain-like nor net-like, but an intertwined formation depicted by the input–output table. Understanding the shape of industry chains from a macro and systemic perspective is crucial to the discussion of policies related to industry chains.

Supply chains and value chains are closely related to industry chains. A supply chain is characterized by the supply relationships between enterprises in an industry chain. It can be an upstream-downstream chain or a supply network. Compared to an industry chain, a supply chain highlights the materials that are the focus of corporate supply management. In contrast, a value chain refers to the value distribution in an industry chain, i.e., the distribution of product value among different enterprises in the industry chain. If the enterprises in an industry chain are located around the world, they constitute a global value chain. For example, Apple organizes numerous companies through its design, procurement, production outsourcing, marketing, and sales, collectively forming the iPhone industry chain. The supply relationships and management of various components involved in the iPhone manufacturing process, such as procurement, transportation, warehousing, and insurance, constitute the iPhone supply chain. The enterprises involved in iPhone manufacturing receive different portions of the product price, thereby forming the value chain of the iPhone industry chain.

The concepts of industry chain, value chain, and supply chain all reflect the fundamental characteristics of modern industries: The production process of modern goods involves complex division of labor and transactions. If we are talking about classical goods such as wine and wool, which often appear in the works of classical economists, then we do not need the concept of industry chain, nor do we use the concepts of supply chain and value chain. The production process of these classical goods involves simple division of labor, mostly within a single production unit. Because of such simplicity, transactions during the production process are also relatively simple. However, the production of modern goods such as cars, mobile phones, and computers often involves a large number of intermediate goods and services. Most modern goods need to go through complex division of labor and transactions before reaching consumers, and their production often requires the collaboration of dozens of companies. Due to sophisticated division of labor, the production process of these goods requires high complexity in transactions between enterprises and management strategy within enterprises. This production process for modern goods, based on complex division of labor and transactions, is what the concepts of industry chain, value chain, and supply chain have in common.

2.1.2 Efficiency of Industry Chains: Transaction Costs, Geographical Factors, and Economies of Scale

The complex structure of industry chains is the result of the pursuit of economic efficiency. Industry chain configuration under the “efficiency first” principle places efficiency improvement as the top priority. In a sense, economic efficiency is almost identical to the degree of division of labor and transactions. Adam Smith’s profound illustrations in The Wealth of Nations shed light on this matter: “But whatever division of labor can be introduced always creates a proportionate increase of the productive powers of labor… Because the power of exchanging is what gives rise to the division of labor, the extent of this division must be limited by the extent of that power—i.e., by the extent of the market.”

Now that the scope of market transactions determines the extent of division of labor, and the division of labor increases efficiency, why not organize all of the division of labor through market transactions rather than placing some of the process within enterprises? It is Ronald Coase who raised and answered this question. The “efficiency first” principle, from the perspective of enterprises, is reflected in the pursuit of profit maximization or cost minimization. As the division of labor became increasingly complex, the management costs of enterprises were gradually split from production costs and analyzed separately. Coase was the first to notice another cost in economic activity: Transaction cost. While the market facilitates the division of labor and increases efficiency, there is no free lunch. To make a transaction, one needs to search for a counterparty, negotiate contract terms, sign the contract, and ensure its execution. A party that breaches the contract would be held liable. All these procedures entail costs. Although the division of labor through market transactions improves efficiency and reduces production costs, it increases transaction costs. However, while organizing the division of labor within enterprises through instructions for management from supervisors would lower transaction costs, it would also increase management costs. The equilibrium between management costs and transaction costs at the margin determines the boundary between enterprises and the market. Among transactions costs, the most important part is the cost incurred to overcome information asymmetry. This is because the completion of transactions relies on the trust between parties, but people do not fully know each other and rarely share the same information, forcing people to spend time, effort, and money to build trust. This opens the door to the new institutional economics. A good institution can reduce the cost people pay to build trust, facilitate transactions and the division of labor, and raise efficiency. Therefore, institutions as the sum of norms that influence people’s economic behavior determine the level of efficiency and the form of industry chains.

Transportation costs also play an important role in the configuration of industry chains. Where enterprises decide to have their supply chains and how they are managed are largely determined by their aim to reduce transportation costs. However, transportation costs have long been overlooked by economics. Johann Heinrich von Thünen, a nineteenth-century economist, pioneered economic geography with his theory of freight costs influencing agricultural distribution and land rents in The Isolated State. Nevertheless, economic geography as an area of study did not follow the path Thünen had started. Instead, it focused on the analysis of specific cultural-geographical particularities. It was not until Paul Krugman published his book Geography and Trade in 1991 that spatial factors were re-introduced into the analysis of trade and production, and the new economic geography was born. Krugman argued that transportation costs lead to increasing returns to scale, i.e., economies of scale, in spatial agglomeration of production. The new economic geography attributes economies of scale to underlying factors such as geographical space and transportation costs, rather than spillover effects and positive externalities that are yet to be explained in depth.

2.1.3 International Configuration of Industry Chains: Comparative Advantages, Economies of Scale, and Multinational Corporations

The division of labor and transactions can take place across national borders, and in fact, trade activities predate the origins of countries. The international order formed by trade rules and geopolitics constitutes a broad “system” that determines international transaction costs and influences the form of global industry chains. At the heart of classical trade theory is David Ricardo’s theory of comparative advantage, which argues that trade should take place between countries with different factor endowments, and countries essentially “export” their relatively abundant factors and “import” their relatively scarce ones through trade. However, Bela Balassa observes that intra-sector trade in similar products has grown between countries with similar factor endowments after the Second World War.¹ Because of increasing returns to scale, industrial countries with similar resource endowments have become more specialized in the production of goods within a sector, and enjoyed economies of scale brought about by the international market. As such, economies of scale have become another force driving international trade and division of labor apart from comparative advantage. Before the First World War, international trade mainly took place between industrial countries and resource countries, with comparative advantage playing a dominant role. After the Second World War, with various institutional arrangements for trade liberalization, there was a growing trend of intra-sector trade between industrial countries as companies pursued economies of scale.

We can understand international trade as a kind of cross-country arbitrage in essence. Production costs of goods vary in different countries due to distinctions in factor endowments, creating room for arbitrage. Arbitrage activity reduces room for arbitrage, that is, international trade leads to equalization of factor prices across countries. However, Paul Samuelson has found that if differences in factor endowments between two countries are large enough, international trade would not be able to fully realize cross-country arbitrage from factor price differences.² If international trade cannot fully realize the potential efficiency gains, the “efficiency first” principle would open up other paths. In the past few decades, the progress in information technology and the deepening of globalization greatly reduced management and transaction costs, and expanded the scope of companies and markets. As such, multinational corporations (MNCs) have emerged. MNCs transfer capital and proprietary assets associated with capital, including technology, management know-how, and market channels, from capital-abundant countries to labor-abundant countries, forming the international configuration of industry chains. Elhanan Helpman points out that the emergence of MNCs and the accompanying capital flows have led to sufficient cross-country arbitrage, equalizing factor prices even in two countries with very different factor endowments.³ The dominance of MNCs in the global configuration of industry chains has led to an unprecedented manifestation of the “efficiency first” principle.

The emergence of MNCs requires not only sufficient economic incentives, but also technological, institutional, and geopolitical conditions. On the technological front, the information technology revolution made it possible to manage industry chains on a global scale. On the institutional front, the signing of the General Agreement on Tariffs and Trade (GATT) after the Second World War and the establishment of the World Trade Organization (WTO) in 1995 paved the way for lowering tariffs and advancing regional collaboration. On the geopolitical front, the improvement in China’s relations with the US and other Western countries in the 1970s, the independence of Eastern European countries from the Soviet Union and the end of the Cold War in the late 1980s, ushered in peace and development as prevailing themes in the world. The rise of MNCs in the 1990s was closely related to the various conditions at the time.

2.2 Globalization and Deglobalization

2.2.1 China Becomes the World’s Factory by Improving Efficiency

The new economic geography pioneered by Krugman in 1991 is essentially an economic theory of manufacturing development. It almost perfectly predicted the path of development of China’s manufacturing industry in the following two decades. By calculating the change in the total factor productivity (TFP) of China’s industrial enterprises, we find that the rapid development of China’s manufacturing industry after the 1990s well reflects the efficiency gains brought by the agglomeration effect and the regional division of labor (Fig. 2.1). The country’s ability to achieve agglomeration effect can be attributed to the market mechanisms and liberalized market transactions introduced by China’s reform and opening-up. This, coupled with the large number of migrant workers in coastal cities, promoted industrial agglomeration and achieved economies of scale. Entering the 1990s, China set up capital markets, advanced reforms in the modern enterprise system, fostered the development of the private sector, and phased out state-owned enterprises in most industries. These market-oriented institutional reforms laid the foundation for China’s accession to the WTO. In 2001, China joined the WTO, marking full participation in the division of labor in global industry chains, which further boosted its economic efficiency. The country became a global manufacturing hub within just a few decades.

Fig. 2.1

Note Spatial agglomeration is measured by the Ellison-Glaeser (EG) Index based on the National Bureau of Statistics’ industry classification standard. The values of high-tech and low-tech industries are the average values of the EG Index for corresponding industries. See Ellison, Glenn, and Edward L. Glaeser. “Geographic concentration in US manufacturing industries: a dartboard approach.” Journal of political economy 105.5 (1997): 889-927. Source Chinese Industrial Enterprise Database, CICC Global Institute

Spatial agglomeration of China’s industrial system increased.

China’s accession to the WTO was crucial for it to improve its economic efficiency. The combination of comparative advantages and economies of scale has greatly improved not only China’s economic efficiency, but also the efficiency of global industry chains. Some Chinese towns along the country’s southeastern coast have become global manufacturing hubs for a particular product. For example, Xidian, a town in Ninghai county, Zhejiang province, produces 70% of China’s flashlights and exports its products worldwide. Among the town’s 110,000 people, 60,000 of them are migrant workers. China’s industrial enterprise data shows that foreign companies in the country gradually lost their leading edge in TFP to local Chinese companies after China’s accession to the WTO, and were eventually overtaken by local Chinese companies (Fig. 2.2).

Fig. 2.2

Source Chinese Industrial Enterprise Database, CICC Global Institute

Difference in the average TFP between domestic and foreign companies in high-tech industries.

2.2.2 China-US Cooperation is the Main Thread of Globalization

The term globalization is used to describe the tendency of integration in the world economy, politics, and culture. The globalization that people now talk about mainly refers to the globalization since the end of the Second World War. This process can be divided into two phases, with the end of the Cold War as the dividing line. In the first phase, international organizations such as the United Nations, International Monetary Fund, World Bank, and GATT were established, and there was a certain degree of collaboration in global politics as well as the global economy. However, globalization did not fully unfold amid the confrontation between the US and the Soviet Union. In the second phase, after the end of the Cold War, economic and trade relations went beyond international trade, and the rise of MNCs brought about the global configuration of industry chains, creating conditions for equalization of global factor prices as revealed by Helpman. From an economic perspective, the second phase of globalization has truly reflected the tendency of integration in the world economy.

The most distinctive feature of globalization is China’s partnership with developed countries led by the US, and China’s rise as one of the world’s largest economies. The macro-level mechanism behind this is as follows: (1) The substantial differences in factor endowments between China and the US created the largest cross-border arbitrage opportunities in the world, while trade in finished goods was not sufficient for fully realizing the cross-border arbitrage; (2) MNCs and cross-border capital flows adjusted the distribution of industry chains between China and the US, which is the essential thread of this round of globalization. This story is perfectly illustrated by the macroeconomic performance of China and the US. First, China and the US are the two largest trading partners in the world. Second, the US is the world’s largest foreign investor, while China is the country with the largest capital inflows other than the US. From 1995 to 2022, the US’s cumulative foreign direct investment (FDI) inflows and outflows both exceeded US$5trn, ranking No.1 in the world; the Chinese mainland and Hong Kong SAR combined recorded about US$5trn of cumulative FDI inflows; the Chinese mainland recorded US$2trn of cumulative net FDI inflows, the largest in the world.

Thomas Friedman’s argument that “the world is flat”⁴ is in fact a reflection of factor price equalization between China and the US. As Helpman predicted, there was a rapid equalization of factor prices between China and the US as a result of cross-border capital flows. In fact, China was the only large economy that continued to significantly narrow its labor income gap with developed countries over the past 40 years. China’s labor income per capita was less than 1% that of the US in 1984, but has risen to about 20% that of the US in 2021 (Fig. 2.3), demonstrating a significant increase. Over the same period, India and Russia, two other large economies, failed to achieve the same large increase in labor income as China did. Moreover, China’s large population has played a vital role in the evolution of globalization. China had sufficiently different factor endowments from those of developed countries, making it a more desirable destination for cross-border arbitrage than Russia and Eastern European countries. After the Cold War, MNCs flocked to China, and the combination of international capital and China’s cheap labor drove rapid development of the country’s manufacturing industry.

Fig. 2.3

Source Wind, Federal Reserve Economic Data, CICC Global Institute

Per capita labor income in China, India, and Russia since 1984.

China’s wise decisions in assessing the situation and adapting accordingly were essential to the country’s emergence as a leading force in globalization. China normalized its diplomatic relations with Japan in 1972 and established diplomatic relations with the US in 1979. The improvement in China’s diplomatic relations with developed countries was a prerequisite for economic and trade cooperation. Moreover, the improvement of cross-strait relations in the 1980s created a supportive environment and attracted a large number of companies from the Taiwan region of China to invest in the Chinese mainland, providing capital for the Chinese mainland’s economy to take off. China started its reform and opening up in the 1980s and implemented a series of market-oriented reforms in the 1990s, paving the way for its WTO accession in 2001. China’s reform and opening up, coupled with international geopolitical conditions at the time, created the country’s economic miracle. Economic and trade ties are the ballast of China-US relations. This speaks to the fact that the economic and trade ties between China and the US, which are based on the substantial differences in factor endowments, are the basis for win–win cooperation between the two countries.

2.2.3 Deglobalization: China and the US Shift From Cooperation to Competition

China and the US are major winners of globalization. The main benefits that China has gained from globalization are substantial growth in household income and technological progress in the manufacturing industry. The main benefits for the US are growth in corporate earnings and stabilization of price levels. MNCs’ industry chain distribution between China and the US has brought substantial profits to US companies. In constant prices, US corporate earnings increased nearly 40-fold in the past two decades (Fig. 2.4). However, ordinary US workers have not benefited much from globalization, or have even suffered in relative terms. US labor income growth has lagged far behind profit growth, and labor income as a share of US GDP has declined significantly since 2001 (Fig. 2.4). The stagnation of income growth for ordinary US workers has to some extent been masked by low inflation, as low-priced manufactured goods from China depressed long-term inflation in the US. This “Hillbilly Elegy” in the US has allowed populist political leaders to come to power.⁵

Fig. 2.4

Source Wind, Federal Reserve Economic Data, CICC Global Institute

Return on capital and labor compensation in the US.

China’s factor endowments have also changed during the process of globalization. Labor and capital are the most important factors in manufacturing. On the labor side, China’s working-age population began to decline in 2016, and the country’s labor costs began to rise even earlier (i.e., the “Lewis inflection point”). After nearly four decades of family planning, China has switched its labor force advantage from quantity to quality. Government and family investment in education has significantly raised the educational level of the labor force. Compared to 1980, the quality of China’s labor force has improved substantially despite the shrinking quantitative advantage. On the capital side, China’s capital-output ratio (capital stock divided by GDP) has approached that of the US after rising in the past four decades (Fig. 2.5), and China is no longer a capital-scarce country. The narrowing of differences in factor endowment between China and the US means shrinking room for cross-country arbitrage by MNCs and capital flows. When differences in factor endowment between China and the US narrow to a certain degree, further equalization of factor prices between the two countries can be achieved simply through trade in manufactured goods. In this sense, the narrowing of economic differences between China and the US has to some extent reduced the role of globalization in promoting economic efficiency.

Fig. 2.5

Source Wind, Haver, CICC Global Institute

Capital-output ratios of China and the US.

As China-US cooperation was the main theme of globalization in the last couple of decades, the main theme of deglobalization is the shift from cooperation to competition between the two countries. China’s sizable labor force, multiplied by its rising labor productivity, puts the country in a position to catch up with the US in GDP terms. China’s GDP at purchasing power parity (PPP) has already surpassed that of the US. Since the US economy is dominated by the service sector and the Chinese economy is dominated by the manufacturing sector, China has also surpassed the US in terms of GDP from material production. As China catches up with the US in economic terms and the two countries’ factor endowments converge, there has been some overlap in the roles of China and the US in the global economy, intensifying competition between the two countries. Increased economic competition, in turn, tends to bring the risk of geopolitical conflicts. Because of the fundamental significance of China-US cooperation in globalization, China-US relations serve as a ballast for the world economy. If the cooperative relationship between China and the US changes, the world economy may face certain disruptions.

2.3 Industry Chain Security Concerns: Controlling the Loss of Efficiency

2.3.1 Industry Chain Security: Understanding From Different Perspectives of Companies and Governments

Industry chain security is generally understood as the resilience and robustness of supply chains. This understanding is mainly from a micro perspective of enterprise management and emphasizes the smooth operation of MNCs’ transportation, logistics, warehousing, and production processes. The earthquake that hit Japan on March 11, 2011 led to a temporary breakage in many industry chains, sounding the alarm of global industry chain breakage for the first time. The COVID-19 pandemic caused disruptions to industry chains and supply chains, again triggering security concerns. In response to the increasingly normalized supply chain disruptions, MNCs are shifting their supply chain strategies from minimum inventory and just-in-time to just-in-case by taking measures to increase the redundancy and diversification of supply chains. These measures include increasing inventory and spare production capacity, adding suppliers, and expanding the geographical distribution of production capacity, among other efforts. Essentially, this pursuit of industry chain security can be regarded as management adjustment (from the perspective of companies) to combat tail risks, and its core concept is still to maximize the risk-reward of companies, which is not contradictory to the “efficiency first” principle.

Industry chain security from the perspective of governments is different from that from the perspective of companies. The US government’s industry chain security policies go far beyond the scope of enterprise management. The US government has stated that its aim is to enhance the country’s competitive advantage and leadership in the global economy, and to ensure its leadership in technological innovation.⁶ This understanding of security apparently goes beyond the issues of supply chain resilience or robustness typically discussed in the literature. For China, there is no clear definition of industry chain security at the national level, and the government’s emphasis on industry chain security is often aimed at ensuring controllability in core technologies in important industries, a pursuit largely in response to the US’s threat of “decoupling”. China’s industry chains use US technology extensively in product manufacturing and R&D. The US has long been the largest source of China’s technology imports. Net US exports of intellectual property royalties to China reached US$8.25bn in 2021, while China’s exports of intellectual property royalties to the US were only US$520 mn in the same year.⁷ This asymmetry allows the US to use “decoupling” as a threat, and China has to deal with this risk.

Government-level considerations of industry chain security may be inconsistent with the efficiency principle. Such inconsistency has two possibilities. One is that there may be a contradiction between efficiency and security on different time horizons. The pursuit of efficiency is generally reflected in corporate behavior to maximize profits, but entrepreneurs may focus too much on short-term goals and corporate behavior may pose industry chain security issues in the long term. The other is the fallacy of composition. While efficiency and security are consistent from an individual perspective, they could be inconsistent from an aggregate perspective. The market behavior of companies under the “efficiency first” principle, when added up, may be in conflict with the pursuit of security from the perspective of the entire economy. The contradiction between security and efficiency is also reflected in the fact that the pursuit of security goals is sometimes at the expense of efficiency. In particular, security considerations that are focused on ensuring controllability to a large extent mean reducing transactions and division of labor, which are sources of efficiency. Therefore, the pursuit of ensuring controllability could lead to a certain loss of efficiency.

The government’s formulation of industrial policies from a security perspective can be seen as a kind of market intervention to provide public goods. A typical example of security is national defense, which is also a classic example of government provision of public goods. When major economies all understand industry chain security as controllability, the concept of security is linked to geopolitical factors and becomes more comparable to national defense. The industry chain security considerations of the Chinese and US governments are to some extent both related to rising global geopolitical risks. Due to the uncontrollable nature of geopolitical risks, industry chain security is to some extent tied to national security. The impact of geopolitical conflicts on industry chain security is mainly manifested in the risk of export bans faced by a country. For example, Russia could ban its energy exports to Europe, and the economic sanctions imposed by Europe and the US on Russia are in a sense also export bans. Once industry chain security is linked to national security due to geopolitical risks, it is no longer subordinated to the “efficiency first” principle as cost–benefit considerations would to some extent be put aside.

2.3.2 Coping with Security Challenges From Rising Geopolitical Risks With a National Innovation System

The end of the Cold War created favorable geopolitical conditions for deepening globalization, but the current global geopolitical landscape is changing in the direction of deglobalization. The Russia-Ukraine conflict has led to a significant rise in global geopolitical risks. In this context, economic participants are set to intensify their pursuit of security if their risk appetite remains unchanged. Therefore, companies’ industry chain and supply chain management need to be more resilient and robust. Governments also need to make more efforts and investments to pursue industry chain security.

In the context of rising geopolitical risks, many countries naturally regard controllability of industry chains as a security goal. However, given the complex division of labor and transactions in global industry chains, at present, almost no country can achieve full controllability in all important industries and technologies. Even the US has not really achieved this in all important industries. At the beginning of the COVID-19 pandemic, the US experienced a serious shortage of production capacity for masks, respirators, and some medical devices, and had to rely heavily on imports.

How should we measure industry chain security? There is no standard metric for this due to the different aspects of security. Terms of trade, concentration ratio of imported products, and market concentration ratio of exported products can be used to measure a country’s industrial competitiveness and dependence on other countries. People often use the localization rate of a product or an industry to measure the degree of controllability. However, it is worth noting that all these metrics are somewhat one-sided. In particular, we should not forget that an industry chain is essentially a starry sky-like industrial system with macro characteristics, and the localization rate is only a static metric. Excessive pursuit of the localization rate of a product or an industry is likely to miss the forest for the trees.

Industry chain security issues that are geopolitically related essentially involve technological competition between countries. From the US’s perspective, industry chain security is centered on maintaining technological superiority. From China’s perspective, industry chain security lies in catching up technologically. The two countries’ industry chain security considerations fundamentally lie in technological competition. Recognizing this, we do not need to overly worried about China-US decoupling. The US’s industrial reshoring and friend-shoring policies might not contradict China’s security and efficiency. As noted earlier, the geographical distribution of industries is largely subject to the laws revealed by the new economic geography. A large number of MNCs moved their production bases to China starting in 1990s, mainly in light of China’s factor endowments at the time. As China’s economy develops and factor endowments change, some MNCs and even local Chinese companies are relocating part of their businesses to other countries. This is a natural result of economic development and does not necessarily hurt China’s industrial efficiency and security.

Technological decoupling between the US and China indeed poses a security challenge to China’s economy. This is not a security challenge that would put China’s economy in danger of collapse, but one that would mainly limit the pace of China’s economic development and capacity to improve its innovation. For example, US restrictions on high-end chip exports to China will not halt China’s economic growth or cause a major recession in China’s economy. The damage of such technological decoupling to China is that it would curb the growth rate of China’s technological innovation, but it should not wipe out China’s ability to advance technologically.

There is a long history of technological competition between countries, and this is fundamentally competition between national innovation systems. Any existing technology is bound to be replaced by new technology. Even if a country is able to monopolize an existing technology, it does not mean that it will be able to monopolize new technology. Future technological advantages will arise from areas of science and technology that are still unknown to us today. Therefore, technological competition between countries essentially does not lie in particular technologies, but lies in countries’ ability to systematically generate new knowledge, new technologies, and new products. A country’s ability to innovate depends on its own innovation system and is not subject to external restriction on a particular technology. The key to achieving controllability does not lie in achieving these in particular technologies, products, or industries, but lies in establishing an effective national innovation system to ensure the constant generation of economically viable innovative technologies and products. The national innovation system is an ecosystem composed of government, universities, companies, and the market. Fiscal spending, finance, and software and hardware infrastructure play important roles in the national innovation system. The roles of the market and the government are both indispensable and need to be coordinated. The market plays a fundamental role, and the government needs to make up for the failure of market mechanisms in basic research.⁸

2.3.3 Orderly Competition Between China and the US: Controlling Efficiency Losses From Deglobalization

Deglobalization inevitably leads to efficiency losses. Historically, when major economies shifted from cooperation to competition, it often impeded the global flow of goods and factors, leading to a decline in international trade and investment. The post-First World War setback in globalization continued until 1937 and spanned the entire Great Depression. During this period, international trade and associated fund flows declined significantly (Fig. 2.6). How could China and the US minimize efficiency losses while pursuing security? An important manifestation of deglobalization is the shift in the China-US relationship from cooperation to competition, accompanied by a rise in geopolitical risks. To control efficiency losses from deglobalization, China and the US can first ensure that competition takes place in an orderly manner.

Orderly competition between China and the US at the economic level means that the two countries need to maintain a bottom line in their economic and trade relations. Where should this bottom line be? The latest round of globalization essentially adds MNCs and accompanying FDI as well as information flows on top of traditional international trade relations. The bottom line of deglobalization should be to maintain normal international trade. With China-US decoupling, MNCs would re-distribute their FDI according to the principles of efficiency revealed by economic geography and comparative advantage theories, and global industry chains would be re-configured under respective security concerns of China and the US. This is bound to have an impact on global trade. However, trade in manufactured goods between China and the US and between the two countries and third-party countries should not be cut off or reduced on a large scale. Global trade should not be fundamentally affected.

Orderly competition between China and the US at the level of international economic and trade order means a retreat from the WTO’s full and universal free trade to preferential bilateral trade agreements and regional trade agreements, but not uncontrolled trade frictions (see Chapter 4 for details). China and the US can leverage their economic influence and compete economically on a global scale, but they should not disrupt normal economic activities with each other’s economic and trade partners. In this way, economic competition between the two countries could be conducive, rather than detrimental, to the economic development of other countries in the world.

On the one hand, the US can certainly promote manufacturing reshoring and friendshoring to meet its global industry chain security needs. On the other hand, China can certainly promote manufacturing innovation and upgrading through industrial policies to enhance its industrial competitiveness and independence in order to meet its industry chain security needs. However, for both countries, the pursuit of security will likely lead to a loss of efficiency. Both countries should not pursue industry chain security at any cost. Both countries need to assess the optimal extent to which security can be pursued in light of the efficiency loss in practice, and strike a balance between security and efficiency.

Controlling the loss of efficiency is particularly important for China, which still lags far behind the US in terms of economic efficiency. Although China has made substantial progress compared to 40 years ago, China’s GDP per capita is still only about one-fifth that of the US as of 2021. Security concerns can only be addressed through technological progress, which in turn is part of economic growth. Therefore, security concerns ultimately have to be addressed through economic development, which requires emphasis on efficiency. For China, security and efficiency are more unified, and it is more necessary for the country to maintain its strategic focus. In the face of the changing geopolitical landscape, China could adhere to peaceful development, and continue to strengthen the foundation of economic development and technological progress to ensure that its economy continues to grow along the trend line. Fundamentally, efficiency could be considered in the pursuit of security; if security is pursued regardless of cost, both efficiency and security could be lost.

Fig. 2.6

Note The 15 countries are Argentina, Australia, Canada, Denmark, Finland, France, Germany, Italy, Japan, the Netherlands, Norway, Spain, Sweden, the UK, and the US. Source Obstfeld, Maurice, and Alan M. Taylor. Global capital markets: integration, crisis, and growth. Cambridge university press, 2004. Our World in Data, CICC Global Institute

Industrial countries’ ratio of current account surplus to GDP.