Vertical and Horizontal Risks Along Industry Chains and a Dual-Pillar National System

Abstract

International competition in trade has intensified since 2018, which we believe is determined by the objective, changing, and increasingly balanced strengths of countries. A shift from international competition in trade to deglobalization is being accelerated by the Russia-Ukraine conflict. The rollout of the US CHIPS and Science Act of 2022 has had further impacts on established patterns of cooperation, and international industry chains face security challenges caused by looming deglobalization. By examining horizontal and vertical risks, this chapter sheds light on the implications for the evolution of industry chains, financial reshaping, and institutions amid security challenges.

Vertical risks refer to the increased costs of transactions between all parts of industry chains amid deglobalization. The costs weigh on the existing pattern of serial production, and are essentially supply-side risks. Efforts to mitigate these risks require a centralization-based transformation of industrial organization. Specifically, vertical integration on the supply side of the chip industry and other high-tech industries and horizontal integration on the demand side of natural resource industries can help reduce vertical risks by utilizing the innovation capabilities of large companies and other organizations. Horizontal integration on the demand side of natural resource industries can also help improve China's bargaining power in international markets, thereby reducing vertical risks in natural resource industries.

Horizontal risks refer to the decentralization of China as one of the core nodes for global production capacity. Such risks are essentially demand-side risks and can be mitigated by diversification. Region-wise, we believe the moves to proactively switch the mature production capacity of textiles, home appliance, and other industries from China to Southeast Asia and surrounding countries, can increase regional cooperation. More importantly, we think competition among diversified small companies and “natural selection” can improve the capability of guiding innovation, and exports of the renewable energy industry and other industries in which China has advantages can build a new “China-surrounding countries” technology diffusion model. Domestic demand is insufficient in China, as shown by the country's low household consumption rate (household consumption as a percentage of GDP). In addition to eliminating consumption barriers in auto and other industries, greater importance should be attached to the efforts to propel fiscal and tax reforms so as to alleviate the effects of compulsory savings, build an “olive-shaped society” (CICC Global Institute, CICC Research. Building an Olive-Shaped Society (《迈向橄榄型社会》, Chinese version). CITIC Press Group. June 2022.) and tap the potential of diversification in consumption.

From the perspective of serving the real economy, we think the moves to propel restructuring of the financial sector should follow the principles of the separation of the financial business from industrial sectors and the separation of various financial sub-sectors from each other so as to support the co-existence of centralization and diversification of industry chains. Positive interactions between financial markets and the real economy are not spontaneous, and require policy intervention. This means that efforts should be made to build a national system that encompasses the strengths of governments and markets, and the strengths of financial markets and the real economy. A catching-up system for “big companies, big governments, and big banks” can help mitigate vertical risks, and a leading system for “small and medium-sized enterprises (SMEs), system construction, and capital markets” can help reduce horizontal risks. A dual-pillar national system, which is an important mechanism for efforts to cope with security challenges along industry chains, should be a necessary condition, rather than a sufficient condition. The two pillars play an essential role in dealing with security challenges, and efforts should be made to resolve boundaries between governments and markets, the metrics of monopoly and competition, and the relationships between large and small companies.

Authors of this chapter: XIE Chao, YAN Xiaochang, LI Gen, LI Tongyue, LI Jin, WU Yunjie, BAI Hao, HUANG Kaisong. Translator: ZHANG Yi. Editors: Kenneth HO, Michael Hoare, YAN Xiaochang, LIU Xinran.

The CHIPS and Science Act of 2022, signed into law by US President Joe Biden in August 2022, includes a package of policies to support the development of the US semiconductor industry that requires recipients of financial assistance to sign an agreement prohibiting expansion of semiconductor manufacturing activities in China and other Countries of Particular Concern for a 10-year period. The US legislation exposes the division of labor along the international semiconductor industry chain to security challenges and reveals the intensified competition over industry chains. Such an intensified competition is determined by the changing strengths of countries, making the resulting security challenges along industry chains inevitable, and they may exist over the long term. With the Russia-Ukraine conflict accelerating the shift from competition to deglobalization, we think it is necessary to conduct a systematic study of managing the resulting security challenges and the potential evolution of industry chains.

The digital economy and green transition are of systematic importance to the evolution of global industry chains. The digital economy will likely reshape corporate boundaries. Since digital technologies reduce the cost of utilizing the market mechanism, companies that deploy them will likely continue to extend their boundaries as digital technologies may help firms reduce internal organizational costs and maintain their existing size.¹ The green transition imposes new restrictions on all industries as the cost of using environmental elements, supplied almost without limit at nearly zero cost under the extensive development model, will likely increase. For industries with different divisions of international labor, does industry chain security have the same implications? Are the risks the same across industries? With systematic factors such as the digital economy and green transition, do industry chains evolve in different directions? Should China utilize economies of scale, increase reliance on regional cooperation, or rely on industrial policies to cope with the evolution of industry chains?

We answer the above questions from three perspectives: Vertical changes along industry chains, cross-regional, horizontal movements of all parts in the production sector, and interactions between different parts along industry chains and between different countries along industry chains (also known as supply chain analyses). This chapter concentrates on the first two dimensions, Chapter 9 sheds light on supply chain analyses, several following chapters analyze different industries, and Chapter 18 focuses on the implications of investment.

8.1 The Origins of International Industry Chains: Technological Progress and Thawing of International Relations

The industrial organization of the semiconductor industry chain represents a typical Wintel model (“Wintelism”), characterized by modular outsourcing, division of labor, and collaboration. However, Microsoft and Intel did not popularize division of labor and collaboration, which had emerged earlier as part of the Toyota model (“Toyotism”) in the 1970s. A mainstream view attributes the success of the Toyota model to the revolutionary concept of lean production. A central characteristic of lean production is that it reduces costs by operating with smaller inventories and reacts proactively to market demand for customization. If the concept of lean production brought about outsourcing, division of labor, and collaboration, why did the US, a country that underwent industrialization earlier than Japan, choose the vertically integrated Ford model in the 1920s? Why was a model of vertical disintegration, division of labor, and outsourcing not considered to improve production efficiency?

From a top-down perspective, we note that the prevalence of the Ford model in the 1920s and onwards coincided with deglobalization. As the isolation of national markets became increasingly clear, trade as a percentage of global GDP continued to decline, and the potential market sizes of companies continued to shrink. The Toyota model, prevalent in the 1970s, began to take shape in the early years of the post-war era at the same time as re-globalization. It might seem that re-globalization made the Toyota model possible, helping to turn the concept of lean production into reality (Fig. 8.1).

Fig. 8.1

Note Data as of 2019. Source Our World in Data, CICC Global Institute

Trade as a percentage of global GDP and forms of industrial organization.

8.1.1 Improving Efficiency: The Implications of Vertical and Horizontal Industrial Organization Amid Globalization

Why don’t companies outsource functions that are subject to diminishing returns to scale to specialized firms? We believe that because the size of the market for these functions might be too small to support specialized firms or industries.² An important implication of globalization for industry chains is that globalization can create a positive cycle which helps promote division of labor by increasing the size of the market, and division of labor, in turn, helps expand the size of the market.³ Globalization may well explain why the idea of lean production could be put into practice under the Toyota model. The prevalence of the Toyota model was supported by post-war re-globalization, which brought about an expanding global market and promoted vertical division of labor along industry chains. For enterprises in the age of deglobalization, they need not only division of labor and collaboration, but also a large enough market scale.

From a horizontal perspective, we think globalization reflects the thawing of international relations. The world entered an unprecedented phase of relative harmony after the end of the Cold War in the 1990s. Global average tariffs declined year by year as international relations thawed. Today, China is the world's largest developing country, and the US is the world's largest developed country. Their cooperation is at the core of broader cooperation along international industry chains, giving rise to a G2 model that concentrates on the spread of technologies. According to the technological gap model, the difference in the levels of technologies between countries can help promote international division of labor and international trade.⁴ The model suggests that leading companies with advanced technology typically outsource low value-added production to non-leading countries after developing new products. Non-leading countries collaborate internationally, and in the process of industrial chain division, gradually narrow the technological gap with leading countries through learning. Leading countries propel technological progress in lagging ones, and non-leading countries bring about increases in demand in leading ones, and the entire industrial chain cooperation process creates benefits for all participants. The technological gap promotes division of labor and collaboration between countries, and it also improves production efficiency.

8.1.2 Reducing Transaction Costs: Technological Progress Offers Possibilities in Reducing Transaction Costs; Thawing of International Relations Makes Possibilities a Reality

The traditional view emphasizes that the division of labor improves efficiency,⁵ while ignoring that division of labor also incurs costs. Double marginalization was identified in studies of industrial organization conducted in the 1950s. This issue occurs when companies are arranged vertically into upstream and downstream collaborative production models. Upstream and downstream companies do not make the same profit, and they add markups along industry chains to maximize their profit, resulting in final product prices being higher than the vertical integration-based marginal costs.⁶ Double marginalization shows that division of labor brings about increases in transaction costs, such as search, contract negotiation, supervision and control, and transportation. Factoring in transaction costs, we believe international division of labor occurs not only because it improves efficiency but also because the magnitude of the improvement in efficiency exceeds the magnitude of the increase in transaction costs.

Transaction costs inherent in international division of labor were reduced by two leading factors in the previous period of globalization: Technological progress and a thawing of international relations. Technological progress helped reduce the costs of transportation, telecommunications, and other transaction costs. Thawing of international relations reduced transaction costs among countries, and expanded the scope of the market economy. It is noteworthy that transportation and telecommunication costs declined more rapidly during the period of deglobalization before the end of the Second World War. With the end of the Second World War, the declines in transaction costs that were linked to technological progress moderated⁷ before a new period of globalization started.

Globalization after 1945 can be divided into three phases, i.e., peace, cooperation, and harmony, according to trade as a percentage of global GDP (Fig. 8.1). First, the peace phase witnessed the beginning of re-globalization. Second, during the cooperation phase after the 1970s, globalization accelerated, to a large degree, benefitting from the collapse of the Bretton Woods system. The Bretton Woods system supported post-war economic recovery, promoting global integration in trade and other fields. The continuation of this system, which utilized fixed exchange rates and required restrictions on cross-border capital movements, also confined the development of transnational corporations and the depth of cooperation along international industry chains. The collapse of the Bretton Woods system was conducive to cross-border capital movement, and the resulting rapid development of transnational corporations gave rise to a second accelerated period of globalization.

Third, in the 1990s, an unprecedented post-Cold War harmony period emerged. Amid a thaw in international relations and accelerated globalization, countries worked cooperatively along industry chains. Rapid technological progress before 1945 brought about the possibility of globalization, but the world wars and other intense international conflicts offset the technological dividend and exposed the world to deglobalization. Overall, we believe that the technological progress brought about the possibility of reducing transaction costs in division of labor and collaboration and thawing of international relations transformed this possibility into the dividends of globalization.

8.1.3 A Second Deglobalization: Intensified International Competition Pushes up Transaction Costs

International relations have thawed in the seven decades since the end of the Second World War. The evolution of international relations in peace, cooperation, and harmony, coupled with advances in telecommunications, information technology, and in other technologies, helped to notably reduce the transaction costs incurred by the horizontal international division of labor and the vertical disintegration of industry chains. These changes promoted globalization. However, it seems that globalization has come to a new inflection point. The pattern of international industry chains centered on G2 cooperation has faced challenges since the recent US-China trade frictions, which led to intensified international competition. The Russia-Ukraine conflict has accelerated the switch from competition to deglobalization. Efficiency improvement enabled by division of labor along international industry chains is at risk of being offset by higher transaction costs amid competition. International industry chains are faced with increasingly clear security challenges. We have analyzed implications of vertical disintegration and horizontal division of labor brought about by globalization. The implications of deglobalization for industrial organization can also be analyzed from vertical and horizontal perspectives (Fig. 8.2).

Fig. 8.2

Source CICC Global Institute

Evolution of industry chains and a dual-pillar national system amid security challenges.

8.2 Vertical Risks: Utilizing “Centralization” to Mitigate Vertical Risks

Vertical risks are essentially supply-side risks. For example, the pattern of cooperation along high-tech industry chains is centered on the diffusion of technologies between China and the US, and is unlikely to continue. Vertical risks are notable in high-tech industries. In addition to vertical risks in high-tech industries, China is exposed to these risks in other industries. From the perspective of vertical serial production, China needs to obtain high-end equipment, intellectual property rights, key components, and other high-tech products from the US and other countries. It must also purchase raw materials from resource exporting countries. The methods for mitigating vertical risks in high-tech and natural resource industries are different. We believe vertical risks in high-tech industries should be resolved by vertical integration on the supply side, while horizontal integration on the demand side is the main method for mitigating vertical risks in natural resource industries.

8.2.1 High-Tech Industries: Supply-Side Vertical Integration Accelerates Catch-Up Innovation

At the micro level, vertical risks along industry chains include higher transportation costs, delays in component supply, and other supply chain risks. In Chapter 9, we argue that efforts should be made to improve supplier management and increase logistics, information flow, and capital flow-based interactions between upstream and downstream companies, thereby making supply chains more stable and resilient. The fundamental method for mitigating vertical risks in high-tech industries is to accelerate catch-up innovation. The move to return to vertical integration can help reduce vertical risks. The higher the costs of utilizing the market mechanism, the greater the willingness of companies to extend their boundaries. To extend these boundaries, companies may integrate vertically and reduce the steps in the division of labor, which can help them avoid increasing transaction costs amid intensified international competition. More importantly, vertical integration may utilize the advantages large companies have in catch-up innovation, mitigating vertical risks in high-tech industries. Compared to smaller companies, larger organizations typically own more intellectual property rights, invest more in R&D, boast greater human capital, and have more of the elements considered essential to innovation. Small companies mostly do not have sufficient collateral or stable cash flows, and their access to finance is limited. Large companies have comparative advantages in risk mitigation and financing. Their cash flows tend to be more stable, and they are more capable of bearing the burden of substantial R&D investment.

Vertical risks in the semiconductor industry, high-end equipment industries (such as high-end machine tools, robots, and aircraft industries), and other high-tech industries are essentially vertical risks related to industrial manufactured goods. The key to resolving these issues does not lie in continuously expanding the production capacity of manufactured goods, but lies in a range of production steps in upstream industries. It is noteworthy that Japan has clear advantages in the semiconductor material industry. Its global share of products in semiconductor manufacturing (mostly dynamic random access memory [DRAM] chips) notably exceeded that of the US in the 1980s. Japan began semiconductor manufacturing after the US. In the manufacture of mainstream chip-related goods and upstream raw material industries, Japan caught up with and surpassed the US by leveraging the Very Large Scale Integration (VLSI) plan launched in 1976. The plan had three main characteristics: Big government, big companies, and vertical integration. In terms of big government, the Japanese government directly organized related companies to form a group through which they cooperated closely. The former Ministry of International Trade and Industry was responsible for leading and offering technological support. Five big companies—Hitachi, Mitsubishi, Fujitsu, Toshiba, and Nippon Electric Company (NEC)—were key enterprises in the plan. In terms of vertical integration, the five key enterprises vertically covered important parts along the industry chain. Thanks to this “big government and big companies-based” vertical integration, the VLSI plan helped Japan rapidly catch up with and surpass the US semiconductor industry.⁸

8.2.2 Natural Resource Industries: Demand-Side Horizontal Integration Helps Improve Bargaining Power

It is not just vertical integration that can help build big companies and industry groups. Horizontal integration can also centralize production, and help big companies leverage their advantages in innovation. German company IG Farbenindustrie Aktiengesellschaft (IG Farben) was one firm to utilize horizontal integration. Germany was a birthplace of the Second Industrial Revolution. While the country had coal mines, it lacked oil and other important natural resources. IG Farben played a substantial role in mitigating Germany’s vertical risk in natural resources by developing coal-based synthetic fuels and rubber to resolve inadequate supplies of gasoline and rubber caused by limited oil reserves.⁹ Innovative industrial production of urea, Nitrophoska, and other fertilizers helped notably improve agricultural productivity, and eased the impact of insufficient land resources on food supply.¹⁰

Horizontal integration laid the foundation for the firm’s strong capability in innovation. In 1904, Bayer and BASF, two major chemical companies, along with the smaller firm AGFA, collaborated to establish an interest group in an example of horizontal integration. In 1916, Hoechst and four other chemical companies cooperated with the 1904 interest group to counter intense international competition in trade during WWI that was supported by the German government. In 1925, the eight members of the 1916 interest group merged into a single enterprise called IG Farben, putting the final touch to their horizontal integration by exchanging their corporate shares for those of the new enterprise.

Bayer, BASF, and Hoechst, the three largest firms among the eight IG Farben co-founders, were producing dyestuffs soon after their establishment at the end of the nineteenth century. These technologies were obtained from the UK, France, and other industrialized countries, and Germany soon caught up and surpassed both the UK and France in chemicals. In the UK and France, which had previously led the industry, organizations utilized horizontal integration strategies to compete with Germany.¹¹

We think the history of IG Farben shows that horizontal integration helps companies share technology and other innovations, as well as raw materials. Using the example of the firm’s second horizontal integration (1916–1925), we note that the eight members of the 1916 interest group operated independently, but emphasized the unified allocation of raw materials.¹² IG Farben centralized member companies’ demand for raw materials to the greatest possible degree after they merged into a single firm in 1925. This example shows that horizontal integration helps make centralization on the demand side of resources possible. Centralization enhances demand-side companies’ bargaining power against supply-side firms, helps improve the control that demand-side companies have over supply of resources, and mitigates vertical risks amid resource constraints. More importantly, we believe that, horizontal integration should be propelled by policy during a phase of intensified competition (factoring in the “resource curse¹³”).

Innovation and initiative play essential roles in the supply of chips, large aircraft, high-end machine tools, and other industrial manufactured goods. The allocation of property rights for industrial manufactured goods requiring advanced technologies is less subject to non-market forces, and it is influenced by people's creativity and initiative. The geographical distribution of oil, iron ore, nickel, cobalt, and lithium is determined by nature. For a country, the use of geographic range which is dominated by the expansion of state power is a more effective means of obtaining more sufficient and reliable natural resources. Therefore, the more natural resources a country has, the more difficult it is for that country to have an advanced manufacturing industry. This country is more likely to be thrown into turmoil by intense competition between international forces. China accounts for a high proportion of the consumption of many natural resources that face vertical risks. However, China does not have advantages over sellers in the natural resource markets as Chinese buyers do not act in a collective manner in global resource markets, they negotiate separately with companies on the supply side, and they have yet to gain the positions that China should have in negotiations. We think intensified international competition means that countries are increasing intervention in their economies. Increased national intervention in natural resources which are mainly allocated by state power is inevitable. China should consider utilizing demand-side horizontal integration to improve its innovation capability and enhance its bargaining power so as to mitigate vertical risks in resources amid intensified competition.

8.2.3 Propelling Industrial Digitalization Transformation and Reducing Post-Centralization Internal Organizational Costs

Centralization, including supply-side vertical integration in high-tech industries and demand-side horizontal integration in natural resource industries, can push up internal organizational costs at companies and cause problems of diseconomies of scale and diseconomies of scope. Companies’ operating efficiency may decline and their integration strategies may fail if these problems are serious. Judging from the experience of Tesla, we think industrial digitalization can help reduce post-centralization internal organizational costs. Modern automakers mostly utilize the Toyotism, which is characterized by division of labor and collaboration along industry chains, while it seems that Tesla is shifting back to vertical integration represented by the Ford model. Tesla does not seem to have notable problems with diseconomies of scale, diseconomies of scope, or higher internal organizational costs. First, Tesla utilizes advanced production technologies to reduce its internal organizational costs. For example, integrated pressure casting substantially reduces the number of components involved in manufacturing and shortens the process compared with traditional autobody pressing and welding techniques. The firm requires fewer employees and manufacturing facilities, thereby notably reducing its internal organizational costs and gaining efficiencies in vertical integration. Tesla is not a conventional automaker; it is a digitalized company engaged in car-making activities. The firm has a decided advantage in industrial digitalization. For example, Tesla has built a software and hardware integrated operating model¹⁴ and construct a digitalized service ecosystem.¹⁵ Data elements, unlike oil and other physical resources, are virtual resources. Digitalized companies with substantial data are likely to conduct cross-sector business operations and gain economies of scope.¹⁶ Industrial digitalization can also help companies reduce internal organizational costs and create economies of scale. Efforts should be made to propel industrial digitalization in tandem with vertical and horizontal integration so as to reduce post-centralization internal organizational costs and improve the capabilities of mitigating vertical risks.

8.3 Horizontal Risks: Utilizing Diversification to Mitigate Decentralization Risks

In an environment of security challenges, there are vertical and horizontal risks for industry chains. As shown by changes in global trade flows of finished products over 2000–2019, China overtook Japan to become one of the three largest global trade centers for finished products (Fig. 8.3). The other two centers were the US and Germany. The tripartite pattern has evolved into a pattern in which China has accounted for a larger share of global trade flows of finished products since the beginning of the COVID-19 pandemic. Influenced by deglobalization, the US and Europe have recently rolled out policies to reduce their reliance on the center of production capacity in China, giving rise to decentralization related horizontal risks. Centralized big companies and groups can naturally help non-leading countries catch up. However, non-leading countries that intend to take leading positions need to keep improving their capabilities in new sectors and industries. The US has a strong capability of guiding innovation, which we believe is mostly attributable to diversification and competition among small companies, and to the rapid growth of these companies. Factoring in security challenges, we believe centralization is required only in industries that have vertical risks, and diversification is needed to mitigate decentralization risks. Diversification can help improve the capabilities of guiding innovation and make possible the sustained cooperation between China and surrounding countries.

Fig. 8.3

Note Finished products refer to final merchandise exports absorbed by direct importing countries. According to the analysis framework of global value chains, a country's total exports can be broken down into exports of finished products, and exports of intermediate products. The curves represent the export of goods from the upstream node to the downstream node in a clockwise direction. Regarding node colors, purple represents Europe, orange represents Asia and Australia, and green represents the Americas. The color of the curve is the same as the color of the exporting country. The size of the node represents the total export value of the economy, and the thickness of the curve represents the size of the bilateral trade volume. The chart shows bilateral trade of more than US$5bn (measured in 2000 constant USD). Source Gross Trade Accounting: Official Trade Statistics and Measurement of Global Value Chains (WANG Zhi, WEI Shangjin, and ZHU Kunfu. Gross trade accounting method: Official trade statistics and measurement of the global value chain. Social Science in China Press, 2015.), ADB MRIO database, CICC Global Institute

Global trade flows of finished products.

8.3.1 Regional Cooperation: Relocating Production to Southeast Asia and Surrounding Countries; Increasing Regional Cooperation Along Industry Chains

The first question China needs to answer is: Does it needs to maintain all industry chains in its efforts to mitigate decentralization risks? For industry chains that are in severe oversupply, can moves to keep all production capacity within the country ensure the security of industry chains? All countries make a trade-off between security and efficiency due to their resource limitations. Securing industry chains does not mean a country should pursue large production capacity in all industries. Instead, countries should make themselves irreplaceable along international industry chains.¹⁷ It seems that keeping all production capacity along mature industry chains that are in severe oversupply in China is unnecessary. Diverting such production capacity to other countries and regions can help mitigate horizontal risks.

Which regions will benefit China most, if China diverts production capacity to these regions? First, as shown in Fig. 8.3, the economic and trade ties between China and the US notably exceed such ties between other economies. The ties between most Asian countries, such as Southeast Asian countries, and China were closer than their ties with the US. The curves that linked China to other countries grew thicker in 2021 compared with their levels before the COVID-19 pandemic in 2019. In addition, the ties between China and Southeast Asia also grew notably. Second, horizontal risks in an environment of deglobalization are that the linkages between the three trading centers, especially the linkage between China and US, will likely weaken. Weakened ties between the three trading centers mean that other economies within each cluster will be of greater importance to regional centers. Direct ties between the three centers are likely to weaken, and they are likely to build indirect ties by increasing their cooperation with other economies within each cluster. In a period of deglobalization, the ties between the three regional centers and other nodes will likely play a greater role compensating for the weakening ties between the three regional centers. This shows that moves to increase regional cooperation are important for mitigating horizonal risks. We think that Southeast Asia may be the top pick for China as it takes the initiative to guide the diversification of mature industrial chains.

Which industry chains should be diverted? From the perspective of horizonal risk, we think China should first consider diverting industries that are in severe oversupply. Most of these industries are also targets for decentralization in a period of deglobalization. China’s factor endowments are switching from abundant labor and scarce capital to abundant capital and scarce labor. Even if there were no horizontal risks in decentralization, the rising labor costs linked to the fading demographic dividend would no longer support China’s large-scale production capacity. China may divert capital to countries that have large labor forces, combining its capital and the human resources¹⁸ of other countries. Members of the Association of Southeast Asian Nations (ASEAN), many of which are enjoying a demographic dividend, may take the lead in receiving mature industries that are notably subject to rising labor costs. Diverting industry chains to these countries, and increasing cooperation between China and ASEAN along industry chains, can help China utilize regionalization to mitigate horizontal risks. These moves conform to changes in the pattern of China's endowment factors, and will likely enhance China's interests.

8.3.2 Supply: Diversification, Competition, and Natural Selection; Utilizing Small Companies to Improve the Capabilities That Guide Innovation

In the effort to mitigate horizontal risks, China should consider if it is possible to divert production capacity to nearby countries. Whether a potential target country is willing to accept China’s production capacity is an important limiting factor. As a result, China needs to maintain its appeal to non-leading countries by transferring advanced technologies in an effort to increase regional cooperation and smooth the migration of industry chains, in our view. The technology diffusion-based pattern of industry chain cooperation between China and surrounding countries is more sustainable than the G2 technology diffusion model. We believe that to maintain long-term cooperation between China and smaller economies, China must have a long-term and sustainable advantage in innovation, which can be attractive enough to these countries in terms of technology transfer. Given the technological gap-based product cycle theory,¹⁹ we think China should continue to develop new products, technologies, and industries in order to build a sustainable “China-surrounding countries” technology diffusion model. This would help China maintain a leading position in technology, lay the foundation for sustained regional cooperation along industry chains, and mitigate horizontal risks in a more effective way. Efforts to build the capabilities that guide innovation require decentralized small companies rather than centralized large companies. In terms of R&D spending and human resources, larger companies enjoy competitive advantages over smaller ones in innovation capabilities. However, we believe innovation requires more than technological strength: It also needs a high propensity and strong capabilities to change organizational structures, i.e., adapting to the change of external environment and enhancing the competitiveness of enterprises.

From a corporate perspective, leading innovation in many cases refers to new products that are differentiated from current mainstream products,²⁰ which naturally embeds the ability to disrupt the products made by large companies. As a company becomes larger, it faces greater obstacles when embracing leading innovation, since its interests and those of its partners and shareholders tend to be tied deeply to its products. In contrast, smaller companies face lower internal organizational costs when pushing leading innovation. We believe they are more willing to rely on leading innovation to challenge the dominant positions of large companies. Positive externalities from innovation indicate that smaller companies can turn their propensity for leading innovation into revolutionary products even if their technologies are less advanced, in our opinion.²¹ Smaller companies are more likely to promote leading innovation, and they play an indispensable role in mitigating horizontal risks. In its efforts to avoid large companies’ overreliance on mature technological paths, China can give full play to SMEs’ spirit of innovation when it moves mature production capacity to other countries. The market mechanism, which is characterized by decentralized competition and survival of the fittest, should be allowed to choose the future technological route so as to enhance the possibility of China's continued leading development in advantageous industries.

8.3.3 Demand: From Overreliance on Centralized Investment to Increasing Diversified Consumption Potential

The implication of diversification for leading innovation is also reflected in the fact that diversified demand is more likely to propel leading innovation. Companies may utilize differentiated innovation to meet the needs of different consumers. A company is likely to gain higher returns via innovation if it identifies differentiated market demand earlier than other companies, and responds to the demand through R&D and production.²² The success of a supply-side differentiation strategy, to a large degree, is determined by demand-side diversity. As demand becomes more diversified and more differentiated, it is likely to prompt companies to conduct more radical leading innovation, in our view.

Diversified demand can help unleash the consumption potential of large countries, mitigating decentralization-related horizontal risks. Judging from US history since 1980, we think the rapid outward migration of industry chains will likely result in the problem of “middle class collapse”,²³ a state of economic stagnation in which the incomes of well-educated middle class groups stagnates. One way to resolve this issue is to consider the job market’s ability to withstand the migration of industry chains. However, structural fine-tuning of industries and the progress of productive forces should be taken into account. The key to resolving this issue lies in the efforts to expand domestic demand and support reemployment of displaced workers. Such efforts require support from policies to stimulate domestic demand. Regarding demand, domestic and foreign demand, investment demand, and consumer demand can all boost GDP. However, different types of demand have different implications for security of industry chains amid deglobalization. (1) Domestic and foreign demand: Other countries are unlikely to influence China's decisions on the geographical locations of its industry chains no matter how high the tariffs or non-tariff barriers that these countries impose on China's products are if China's production capacity is utilized to meet China’s domestic demand. The fundamental reason why some of China's industry chains face horizontal risks is that other countries implement tariff policies on the back of their substantial domestic demand. (2) Investment demand and consumer demand: Production is the means, while consumption is the purpose.²⁴ As a country’s household consumption rate rises, it becomes more appealing to manufacturers when they decide the geographical distribution of their manufacturing facilities. Higher rates of household consumption are essential to countries amid deglobalization since only household spending power can offset the downward pressure on aggregate demand. In China, foreign demand and investment demand currently account for a high proportion of total demand, while household consumption is relatively low.

More importantly, China's household consumption rate is lower than the level implied by its demographic dividend.²⁵ Possible reasons include the lack of consumption scenarios and limited spending power. The lack of consumption scenarios refers to a situation in which people have spending power but consumer demand is not fully realized. For example, the potential demand for automobiles, which is an essential part of household consumption in developed countries, has yet to be fully unleashed in China. We think efforts could be made to alleviate restrictions on consumption scenarios such as restrictions on purchasing cars. Insufficient purchasing power is a more important reason behind the low rate of household consumption in China. Attention should be paid to the effects of compulsory savings, which is caused by a system that divides taxes between the central and local governments, competition between local governments, and land-based financials.²⁶ Theoretically, moves to increase investment and demand can boost economic growth. However, we think the implications of such moves are different from the perspective of the competition among local governments. Government expenditure that is earmarked for local households to directly boost consumer demand in a region will likely cause the spillover of household demand to other regions, while government expenditure utilized to boost local investment in a region generally helps increase fixed assets within the region. Competition among local governments means the achievements of a local government are reflected not only in its performance but also in comparison with other regions. Local governments under this model are more willing to stimulate investment in a centralized way, and are less likely to utilize consumer demand, which is more fragmented.

Moreover, in this system, which divides taxes between the central and local governments, local governments are reliant on land parcels to obtain the proceeds earmarked for centralized investment, which is in fact a form of land-based financial activities, in our view. Under the land-based financial model, local governments’ sources of independent income are correlated with the price of land parcels, and the upside potential of land prices are determined by housing prices.²⁷ The land-based financials model is a reason behind the high housing price to income ratio in China, and it also gives rise to the effects of the compulsory savings that dampen consumer demand.

Overall, the moves to offer production and goods for consumption to the fast-growing working population required substantial investment when China enjoyed a demographic dividend. Centralized investment under the competition model played an important role in China's economic growth. However, as the demographic dividend wanes, the model and the land-based financials in the system that divides taxes between the central and local governments are hindering the consumption potential in China via compulsory savings. To mitigate horizontal risks amid deglobalization, efforts should be made to reduce the overreliance on the centralized investment-based economic growth model. China could utilize fiscal and tax reforms to reduce compulsory savings, and build an olive-shaped society to unleash the seemingly fragmented but substantial consumption potential of households.

8.4 A Dual-Pillar Financial System: Implications of Financial Reshaping Amid Vertical and Horizontal Risks

From the perspective of serving the real economy, we think the financial industry should propel restructuring of financial organizations that support the evolution of industry chains amid security challenges. By examining the relationship between financials and innovation, this section sheds light on the implications of the evolution of industry chains for the organizational restructuring in the financial industry.

8.4.1 We Think Banks Are Better Suited for Supporting Catch-Up Innovation Led by Big Companies

The vertically integrated VLSI plan in Japan and horizontally integrated IG Farben in Germany utilized the innovation capabilities of large groups to mitigate vertical risks. Japan in the 1970s and Germany in the early twentieth century were economies dominated by banking systems. Commercial banks were an important source of funds for the VLSI plan.²⁸ However, a mainstream view holds that banks are ineffective in propelling innovation and may be detrimental to innovation, a view that contradicts the experience of Japan and Germany. This mainstream view considers only financial structure, and neglects the structure of innovation. In fact, innovation can be divided into “catch-up” innovation, “leading” innovation, and innovation by large firms, smaller ones, mature companies or startups. The formation of financial structures in Japan and Germany was directly linked with the “catching-up” strategies of countries lagging in international competition. German unification took place at the end of the nineteenth century. There was a strong desire for the country to catch up with the UK, France, and other leading countries. German banks mobilized their financial forces to provide a full range of financial services for companies. The government was tolerant towards mixed business operations and integration of financial business and industrial sectors. These moves facilitated the formation of the universal banking system in Germany. Similarly, Japan during the Second World War needed to utilize banks, which were more subject to government control than other financial institutions, to centralize financial forces across the country and build a banking system in its efforts to support its enormous war machine. In our view, the risk appetite of commercial banks is not closely related to corporate innovation, but is mainly driven by their liabilities and operating models. Commercial banks do not effectively support innovation among smaller firms with little collateral or startups with unstable cash flows, in our view. However, they seldom refuse to support innovation among larger companies with ample collateral or startups with stable cash flows. In summary, banks can effectively support large and mature companies, and the larger the company, the more innovative it is.²⁹ Banks under the highly centralized financing model can centralize financial services and resources to serve the real economy, as evidenced by their support for the catching-up strategies of non-leading countries and their moves to improve the innovation capabilities of large companies. Banks, especially large banks with substantial funds, are best suited to provide support for large companies and groups in order to utilize centralization to mitigate vertical risks in the organizational transformations of industrial sectors.

8.4.2 Leading Innovation Requires the Capital Market, Especially a Booming Equity Investment Market

Small companies play a more important role in mitigating horizontal risks as they are more willing to promote leading innovation. Banks are willing to offer financing services to companies with collateral. Small companies in many cases do not have sufficient collateral. In addition, leading innovation is likely to disrupt expectations around companies’ cash flows, which we think may dampen banks’ willingness to support leading innovation. The reason behind the US leadership in the global semiconductor industry chain is that Apple and many other US companies that are willing to promote leading innovation helped bring about the creation of a new phase in the internet era. The establishment and development of many of these companies was supported by booming US capital markets. The capital market is essentially a highly fragmented investment and fundraising system. Investors with different risk appetites directly make decisions on fund supply to provide capital support for different high-risk projects. Effective support for leading innovation requires positive interactions between primary and secondary markets. The primary market plays a main role in promoting leading innovation, and the ample financial resources in the secondary market can help companies improve their innovation and industrialization capabilities for new products and new industries. More importantly, the secondary market is one of the most important channels for divestment for equity investors in the primary market, and it can improve equity investors’ investment capabilities and willingness to invest. Positive interactions between primary and secondary markets can promote leading innovation, in our view.³⁰

8.5 Thoughts and Implications: A Dual-Pillar National System

Overall, the key to utilizing centralization to mitigate vertical risks lies in leveraging the advantages of large companies and other groups in catch-up innovation, moves that require financial support from centralized banking systems with substantial funds. This form of organization is the large companies and large banks-based organizational model in this book. Utilizing diversification to mitigate horizontal risks is more reliant on the efforts to tap the potential of diversified consumption to boost demand, move some mature production capacity to Southeast Asia and surrounding countries to increase regional cooperation along industry chains, and build a sustained “China-surrounding countries” technological cooperation model. Such efforts require financial support from diversified capital markets. This form of organization is called the “SMEs and capital markets-based” organizational model in this book. These organizational models are not spontaneous, and their formation requires public policies. In addition, a national system that mobilizes the strengths of governments and markets, along with the strengths of financial markets and the real economy, is an important mechanism for efforts to cope with security challenges along industry chains.³¹ The government plays a different role in each organizational model. For China, we believe the government should build a dual-pillar national system that both catches up and leads. A catching-up national system supports centralized “large companies, large governments, and large banks”, and a leading national system supports diversified “SMEs, system construction, and capital markets”. Large banks and companies in China are mostly state-owned enterprises (SOEs). As a result, governments can play an important role in centralization, and banks need to increase the effectiveness of policy-based finance. In a leading national system, the diversification, competition, and “natural selection”-based market mechanism plays a key role in making leading innovation possible, and we think that governments should build market systems that are conducive to free transactions and full competition. Overall, public policies are of great significance to catching-up and leading national systems. A dual-pillar national system is a necessary condition, rather than a sufficient condition, for the moves to resolve vertical and horizontal security challenges along industry chains. To cope with security challenges, efforts should be made to resolve the following four issues related to the two pillars.

First, boundaries between governments and markets: Traditional national systems generally help resolve security issues regarding the supply of public goods. Security of industry chains is related to the interests of a country. However, the key to maintaining the security of industry chains lies in the moves to mitigate supply risks related to consumer products. Both the supply and demand sides of public goods are public sectors, having equal positions in negotiations. However, those on the demand side of industry chains are mostly individual consumers, and companies should be the suppliers as they are equal to consumers in negotiations.³² One main difference between a dual-pillar national system that is built to mitigate security challenges along industry chains and traditional national systems is that the former should give full play to companies. Designing a suitable market-based incentive plan to stimulate companies is of great importance to the moves of coping with security challenges, as centralization may push up internal organizational costs.

Second, the metrics of monopoly and competition: Centralization, including vertical and horizontal integration, may see large companies increase their market share and expand their presence to multiple industries. Consideration should be given to contestability in order to understand the antitrust issue and the problem of disorderly expansion of capital amid deglobalization. To judge if there is a disorderly expansion of capital, we think efforts should be made to assess if moves to expand into multiple industries are supported by forces external to the markets³³ (such as integration of financial business and industrial sectors) rather than paying attention to the number of industries in which companies expand their presence. In terms of the antitrust issue, we do not think that the size of companies and their market share are the only metrics to judge if a monopoly exists. The most common method of judging whether a monopoly exists is to see if corporate integration is followed by monopolistic conduct that hinders competition. More importantly, diversified competition is not just the key to dealing with horizontal risks, but even within large centralized enterprises, it is also an important means for maintaining dynamism in an organization.

Third, relationships between large and small companies: Large companies taking the lead in sectors facing vertical risks is a more efficient method of mitigating such risks. However, it is not a must for large companies to continue to operate businesses in these sectors after they mitigate vertical risks. The social benefit–cost ratios should be the determining factors in deciding if large companies should continue to operate these businesses. A vertically integrated organizational structure may need to be vertically disintegrated after vertical risks are mitigated, and efforts should be made to create an ecosystem that is conducive to small companies innovating and forming new businesses and that helps small companies undertake businesses that are split off by large companies. Demand from large companies plays an important role in supporting small companies’ leading innovation. In China, SOEs are mostly large companies, and non-state-owned enterprises are generally small companies. The close relationships between large and small companies in a dual-pillar national systems mean that SOEs and non-state-owned enterprises should establish solid partnerships.

Fourth, which of the two pillars is more important, and which should be prioritized? China is still catching up, and mitigating vertical risks is a top priority. As such, we think a centralized, catching-up pillar for “large companies, large governments, and large banks” is of greater importance in the short term. In the long term, we believe the efforts to build a diversified pillar for “SMEs, system construction, and capital markets” is more important. However, it may not be appropriate to build a catching-up pillar first, then build a leading pillar after mitigating the vertical risks. Vertical risks have attracted more attention, while horizonal risks have also arisen in renewable energy, home appliances, and other industries. More importantly, once a system is established, it will be strengthened by people who benefit from the system unless this system is exposed to intense external forces. In an indirect financing-dominated financial system, China should not only propel the simultaneous construction of the two pillars, but also accelerate the construction of the leading pillar under the principles of the separation of financial business from industrial sectors, and the separation of various financial sub-sectors from each other,³⁴ due to systems’ path dependence and the need to achieve leading innovation in the global market in the future. Moves to accelerate construction of the leading pillar conform to the requirement of the 20th National Congress of the Communist Party of China that the country “will increase the proportion of direct financing”.³⁵