Smart Manufacturing

Abstract

The smart manufacturing industry stems from the manufacturing and logistics industries, which is crucial to the formation and sustainability of an innovation economy. The manufacturing sector can support innovation activities, promote the industrialization of innovative products and services, and propel the innovation cycle. Furthermore, development of the logistics sector can significantly boost trade by lowering transportation costs, and can support complex supply chains. In addition, the logistics industry’s digital transition may have accelerated during the COVID-19 pandemic, and logistics plays a key role in supporting innovation in the digital economy.

China's manufacturing industry has developed rapidly since the 1990s, and its innovation capability has improved significantly. However, Chinese manufacturing companies are less active in pursuing innovation, as evidenced by their output and their revenue from innovative products. Reasons behind the weaker innovation include insufficient R&D investment, fragmented investment structure, and mismatch between R&D and production as well as between production and application. We also see deeper reasons for weaker innovation capability. China's manufacturing industry is export-oriented. The emphasis that companies place on capacity expansion also weighs on the innovation capability of the manufacturing industry.

We also examine the cost efficiency of domestic logistics, and find that while China has low logistics costs, efficiency could be improved. First, China is able to achieve low logistics costs at the expense of profit margin. Second, China’s labor efficiency remains relatively low. We attribute the low efficiency of China’s corporate logistics businesses to three factors: Low automation rate, low transport efficiency, and a lack of integrated transportation. Furthermore, China is not a strong player in international logistics, which limits its ability to build reliable supply chains.

Innovations in digital technologies present new opportunities for China’s smart manufacturing industry. For the manufacturing sector, we expect more engineering-based innovation and business model-related innovation to emerge in China given there is a new round of technological revolution and industrial transformation in the making with the integration of the digital economy and the manufacturing industry, and a possible flattening of the smile curve. The logistics sector may benefit from a large domestic market with stronger economies of scale, and technology could play a greater role here. We think logistics companies’ increasing R&D expenses and China’s leading 5G and AI technologies may help the country catch up in the area of logistics. There is also opportunity for China to develop its international logistics system as the competitive landscape of international logistics may evolve.

6.1 Manufacturing and Logistics are Essential for Innovation

Both the manufacturing and logistics sectors are essential for technological innovation. Manufacturing can support innovation activities, promote the industrialization of innovative products and services, and propel the innovation cycle. Logistics can boost trade by lowering transportation costs, and can support complex supply chains. Digital transition in the logistics industry is accelerating, and the development of logistics can in turn support innovation in the digital economy.

6.1.1 The Manufacturing Sector is the Engine for Innovation Activities

Manufacturing has three notable characteristics—intensive factor inputs, complex production processes, and economies of scale. As such, the manufacturing sector is the key facilitator of innovation activities, placing it in a position to contribute to industrial applications of innovative products and services, and is one of the sectors that is most active in pursuing innovation. The total factor productivity (TFP) growth rate of the manufacturing industry is higher than that of other sectors.¹ The manufacturing sector’s rapid technological advances make it a main engine of innovation, in our view.

Manufacturing is vital to innovation activities, in our opinion, as it underpins technological breakthroughs in semiconductors, biopharmaceuticals, and other high-tech industries. It also helps improve the performance of machinery, instrumentation, and other equipment, and is crucial to each step of the product innovation process, such as the inception of an innovative idea, trial production, and mass production.

The complexity of manufacturing processes means the sector may present more innovation opportunities than other industries. Experience in highly complicated manufacturing processes can help improve techniques and technologies, thereby facilitating innovation. A large manufacturing system, in our view, is the foundation of innovation.

Products of the manufacturing industry underpin innovation in other industries. Advanced equipment, laboratory instruments, and other key devices are crucial to innovation in all industries. They are the basic resources and the impetus for innovation. The machinery, instrumentation, and electronics manufacturing sectors contribute more to innovation than other sectors of the manufacturing industry, and they play an essential role in spurring innovation.²

Economies of scale in manufacturing can help reduce cost and spur innovation. For example, we estimate that a 100% increase in the installed capacity of photovoltaic (PV) units can reduce the cost of such units by around 13%, and a 100% rise in the installed capacity of wind power units can cut the cost of such units by about 7%. Lower costs will help companies rapidly upgrade alternative energy technologies, in our view.

Economies of scale help shape innovation clusters, enabling knowledge spillover. We think the process of shaping industrial clusters will create synergies between industries, make network-externality-based knowledge spillover possible, and spur innovation. Silicon Valley, Tokyo, and Shenzhen are typical innovation clusters (Fig. 6.1).

Fig. 6.1

Source Bloomberg, CICC Global Institute, CICC Research

Big firms tend to have higher R&D investment intensity than smaller firms (unit: US$1bn). Note We use data for top 200 technology-intensive manufacturing companies in China, the US, Japan, and Germany over 1993‒2020.

The manufacturing sector drives the innovation-application-investment cycle as this sector can convert innovations into economic returns, and provide capital for additional innovation activities. High capital intensity in manufacturing, which represents productive investment, can contribute to a high savings ratio. It can also lay a foundation for economic growth and innovation in developing countries, particularly in East Asia.³

Manufacturing helps improve labor productivity, and stimulates innovation. This sector can not only create jobs for surplus labor in the agriculture industry, for example, but also stimulate the migration of labor from low-productivity sectors to high-productivity sectors, in our view. Manufacturing companies, via innovation, can improve labor productivity and create competitive advantages. As such, we believe innovation is vital to the growth of manufacturing companies.

6.1.2 Logistics is Vital for Technological Innovation

Logistics supports commodity trade, and facilitates production and circulation. In the digital economy, the penetration of new technologies into various logistics processes is accelerating, and improvements in logistics quality and efficiency support the efficient circulation of goods and information. As a result, we think logistics is closely linked to technological innovation. In this section, we explain why the development of the logistics industry is vital for technological innovation from three aspects.

6.1.2.1 Development of Logistics Industry Facilitates the Circulation of Productive Factors

Logistics links manufacturing and consumption, thus boosting the circulation of productive factors. Manufacturing is characterized by more efficient division of labor and large-scale production. However, consumption is fragmented and diverse. As the mismatch between manufacturing and consumption creates demand for logistics, logistics closely links manufacturing and consumption, creating value from the movement of productive factors. Logistics is also the link between key processes in industrial goods production. Raw material logistics, production logistics, finished goods logistics, and distribution logistics link raw material procurement, manufacturing, goods distribution, and consumption. As a result, logistics accounts for more than 90% of the time in manufacturing and sales. Its efficiency thus determines the efficiency of the circulation of productive factors.

Circulation costs fall rapidly with the advancement of logistics. For example, the introduction of shipping containers in 1966 significantly improved logistics efficiency and reduced logistics costs. Loading efficiency of US freighters increased from 1.7t/hour to 30t/hour, and loading and unloading costs fell to around US$0.16/t from US$5.8/t.⁴

Shipping rates have remained low in absolute terms for years with improvements in shipbuilding technology (shipping accounts for over 80% of global freight volume). Thanks to upgrades in shipbuilding technology, vessels have become larger with higher carrying capacities, leading to lower unit shipping cost. In 2020, the average capacity of dry bulk carriers was 2.4 × the level in 1970, according to Clarkson, and the unit shipping cost of a 170,000t vessel was just 60% of that of a 70,000t vessel in 1970, according to Maritime Economics. In absolute terms, the average annual freight rates of dry bulk carriers and containers have stayed low.

Falling global logistics costs facilitate global trade and goods circulation. According to the World Trade Organization (WTO), the value of exported goods as a percentage of GDP rose to 24% in 2011 from around 7% in 1966 after containers were introduced to shipping (Fig. 6.2).

Fig. 6.2

Source WTO, CICC Research

Value of exported goods as a percentage of GDP is rising.

6.1.2.2 Logistics Plays a Great Role Amid Technological Innovations and Industrial Upgrades

More complex supply chains impose higher requirements on logistics. According to Wind, the proportion of labor-intensive industries in the domestic manufacturing industry fell by 7.8 ppt to 22.8% over 1999–2020, capital-intensive industries grew by 5.8 ppt to 40.0%, and technology-intensive industries increased by 2 ppt to 37.3%. Specifically, the structure of manufacturing value added is changing, with computer communication and electronic equipment seeing a 0.19 ppt increase in their annualized share and the automobile industry recording a 0.17 ppt rise in its share.

Supply chains are becoming more complex amid industrial upgrades. As vehicle and electronic communication device manufacturing involves complex production techniques and multiple types of raw materials (a vehicle has around 20,000 parts), managing their supply chains is more complex and difficult. Therefore, we think supply chain logistics should upgrade along with industrial upgrades. Meanwhile, the demand for real-time logistics in the supply chain is increasing. For example, in the US from 1970 to 1980, airfreight of high-value-added products amid industrial upgrades boosted FedEx’s business (FedEx’s air package volume rose at a CAGR of 35% over 1977–1988) according to FedEx historical data.

The reduction in costs and improvements in efficiency in the manufacturing industry are driving upgrades in the logistics industry. According to the National Bureau of Statistics (NBS), profits of Chinese industrial companies were under pressure in the past decade, with profit margin falling by 1.1 ppt from 2010 to 6.2% in 2019 (Fig. 6.3). However, we expect third-party logistics to help companies lower costs and improve efficiency through supply chain management. According to the European Commission, companies expect supply chain logistics to help increase production efficiency by 10%, shorten production time by 25–35%, and reduce total cost by 10%.

Fig. 6.3

Source Wind, CICC Research

Industrial companies’ profit margins have been under pressure in recent years.

6.1.2.3 Logistics Requires Further Post-Pandemic Digitalization; Transition from Just-In-Time (JIT) to Just-In-Case (JIC) Creates Greater Need for Flexibility

As the global supply chain was hit hard by the COVID-19 pandemic, we expect the development of digital logistics to accelerate, and the flexible deployment and dispatching of supply chain logistics are likely to receive more attention.

COVID-19 has accelerated the development of digital logistics. Demand for contactless delivery has surged due to COVID-19, and we see sizable growth potential in unmanned application scenarios or scenarios with less human involvement. As demand for contactless delivery grows, the demand for intelligent logistics technology will likely increase, raising requirements for its application and reliability. For example, the delivery of goods and materials by unmanned vehicles played a vital role in combating the COVID-19 resurgence in Guangzhou in June 2021.

Development of digital logistics will continue to accelerate. A survey on the impact of COVID-19 on supply chain logistics in 2020⁵ found that 64% of companies plan to speed up digital supply chain transformation after COVID-19 subsides, and 58% plan to accelerate the coordinated construction of end-to-end supply chains. We expect an increasing number of companies to use digital logistics management platforms to respond quickly to changes in transportation status, making it transparent and controllable.

From JIT to JIC, flexible deployment and dispatching of logistics has strengthened. After COVID-19 disrupted supply chains, we expect the following changes in the logistics industry. First, a transition from JIT to JIC. Logistics efficiency and costs will no longer be the priority, and adaptability will become more critical as it would allow companies to respond better to emergencies. Second, supply chains will be more localized and fragmented. As revealed by the survey mentioned in the previous paragraph,⁶ more than half of the companies surveyed stated that they would optimize regional supplier distribution and prepare more suppliers for key products.

We think logistics companies need smarter and more compatible operation systems to address strategic redundancy and a fragmented supply chain, thus allowing logistics centers to be more compatible with multiple businesses and responsive to emergencies. Furthermore, deployment and dispatch will be more convenient, and logistics capacity can be replenished or expanded quickly.

Looking ahead, the development of logistics is likely to encourage technological innovation in the digital economy. We expect logistics to accelerate production, goods turnover, and product upgrades in the upstream industries, supporting manufacturing and product innovation. Meanwhile, logistics can meet the diverse needs of consumers via highly efficient parcel collection and delivery, and support consumption innovation by restructuring the three factors in consumption: Consumers, goods, and consumption scenarios (Fig. 6.4).

Fig. 6.4

Source CICC Research

Logistics links manufacturing and consumption; manufacturing and consumption are being upgraded.

6.2 Global Experience in Smart Manufacturing and Supply Chain

We provide examples to discuss the possible ways of encouraging and utilizing technological innovations in manufacturing and logistics sectors. For example, the US government has played a key role in manufacturing innovation in the country, while Shein, an emerging Chinese fashion retail brand, has been able to expand its business efficiently by building up a smart supply chain.

6.2.1 The Path of Manufacturing Innovation in the US

The US has taken the lead in innovation, as demonstrated by its many achievements that are of great global significance. The value added of the US manufacturing sector represented about 25% of the total value added of manufacturing globally over 1970‒2000. Leading information and communications technology (ICT) companies that emerged in Silicon Valley in the 1990s, e.g., Apple, Cisco, IBM, Intel, and Microsoft, accounted for about 66.7% of the global hardware, software, and service market.⁷ In 2020, 10 of the top 20 companies in the global biopharmaceutical market are US companies, according to Pharmaceutical Executive.

Government has played a key role in making the US one of the world's most innovative countries. For example, the Defense Advanced Research Projects Agency (DARPA) has funded many R&D programs related to the internet, computer chips, self-driving vehicles, and global positioning system (GPS) technologies since its establishment in 1958.⁸ This agency has played a crucial role in helping the US maintain its competitive advantage in technology. Key to DARPA's success in spurring innovation is the use of public funds to conduct venture investment and to steer strategically important R&D projects with high uncertainty and that attract little private sector investment.

The US government also plays an important role in facilitating the commercial use of innovative products and services. US government agencies directly fund companies’ R&D projects.⁹ Government procurement is crucial to the commercial use of innovative products and services in the early years of such products and services. The US government also introduced the Small Business Innovation Research (SBIR) and Small Business Technology Transfer (STTR) programs to stimulate innovation among small- and medium-sized enterprises (SMEs).

Furthermore, the US government has helped create an innovation-friendly environment. For example, the government has created an innovation ecosystem consisting of companies, universities, research institutions, and consumers; has built a technology transfer system to facilitate the commercial use of innovative products and services; and uses tax incentives to stimulate innovation.

The US government has recently encouraged companies to relocate their production bases to the US to stimulate innovation. In 2019, the value added of the US manufacturing industry as a percentage of the country’s GDP dropped to 11% from 16% in 2000 as the US’s share of the global manufacturing industry declined to 17% from 26% in 2000.¹⁰ The US has encouraged manufacturing companies to return to the country since 2010. The Biden administration plans to raise the minimum US content for manufactured goods purchased by the federal government from 55 to 60%, and then to 75% in 2029.

6.2.2 Shein: An Emerging Fashion Retail Brand Supported by Smart Supply Chain in China

Founded in China, Shein is a cross-border business-to-consumer (B2C) e-commerce platform that integrates design, production, and sales. The firm, which primarily sells clothing, has a high turnover ratio, and offers quick delivery as well as good value for money. It has entered international markets with a cross-border e-commerce platform. Shein also has a well-built manufacturing supply chain in China. We think its successful operating model is supported by its intelligent supply chain logistics system.

Shein’s intelligent supply chain logistics system supports its “small order + repurchase” model. From the sales end, the company’s monitoring of data on its independently built e-commerce channel enables it to respond more quickly to demand. From the production end, it prefers to cooperate with small and medium-size factories and rarely defaults on the payment for goods. It also provides financial support to suppliers, allowing them to purchase more equipment, and helps them introduce automation equipment to manage the production of multiple SKUs and products with various types of fabrics and sizes. Shein has also strengthened its control over suppliers. Suppliers must connect to its self-built supply-chain information system, allowing the company to conduct full-process data analysis of production and sales.

Shein has adopted a real-time monitoring system for domestic and overseas inventories. Its inventory management system is also connected to the upstream production system, allowing the company to control inventory replenishment and minimize inventory pressure. It also has intelligent cross-border delivery logistics. Shein digitalizes logistics information and uses big data algorithms to calculate delivery routes, thereby improving logistics efficiency.

China's manufacturing has gained an advantage in production capacity, with increasing interaction between R&D and manufacturing activities (and between manufacturing and consumer activities). Technological innovations may also benefit the logistics sector by lowering logistics costs and improving efficiency. In the next section, we evaluate China’s manufacturing innovation and analyze the Chinese logistics industry’s cost efficiency and value chain security.

6.3 Development of Manufacturing and Logistics Sectors in China

China is becoming increasingly important in the global manufacturing and logistics industries. Nevertheless, technological innovations in China's manufacturing industry remain insufficient, and the cost efficiency of China’s corporate logistics businesses still needs to be improved. We analyze the reasons behind such deficiencies.

6.3.1 Status Quo and Challenges of China’s Manufacturing Sector

China's manufacturing sector has developed rapidly since the 1990s. China represented 2.5% of the output of the global manufacturing industry in 1990, ranking No. 8. The percentage reached 6.5% in 2000 and 18% in 2010, with China ranking No. 4 and No. 1 in contribution to the global manufacturing industry. In 2019, China accounted for 29% of the output of the global manufacturing industry, notably exceeding the percentages for other countries.¹¹

The R&D expenses of China's manufacturing sector have increased since 1990, exceeding that of Germany and Japan (Fig. 6.5). Meanwhile, China's manufacturing industry chain continues to improve, with companies launching novel products and rolling out new designs.

Fig. 6.5

Source OECD, CICC Global Institute, CICC Research

R&D expenses have increased markedly in China's manufacturing sector.

Nevertheless, technological innovations in China's manufacturing industry remain insufficient. First, the capability of China's manufacturing sector to innovate is relatively weak. The manufacturing sector consists of multiple subsectors that rely on different factors and production processes. Innovation capability of manufacturing subsectors varies.

Second, China's manufacturing industry is less active in pursuing innovation. The 2018 OECD Oslo Manual defines two types of innovation in manufacturing: Product innovation (including significant and gradual improvements in products) and process innovation (this includes innovation in production processes, organization, and management).

Data from NSF and the China Statistical Yearbook on Science and Technology shows that the percentages of Chinese manufacturing companies conducting product innovation and process innovation are 5 ppt and 7 ppt lower than that of their counterparts in the US. Specifically, the percentages of Chinese chemical companies innovating in products and processes are both more than 8 ppt lower than that of their US counterparts (Fig. 6.6).

Fig. 6.6

Source NSF, ZEW, Japan Science and Technology Agency, China Statistical Yearbook on Science and Technology, NBS, CICC Global Institute, CICC Research

Number of manufacturing companies conducting product innovation and process innovation. Note We use 2015–2017 data for US and Japan; 2017 and 2019 data for Germany; and 2016–2018 data for China.

Third, China's innovation-related output is lower than that of the US, Japan, and Germany. Companies developing new products account for 2% of the total number of manufacturing companies in China (vs. more than 10% in the US, Japan, and Germany). Novel products contribute 1% of revenue at Chinese manufacturing companies (vs. around 5% in the US, Japan, and Germany).

Overall, we think that insufficient R&D investment as well as deficiencies in the system encompassing R&D, production, and application of new technologies have hindered innovation in China’s manufacturing industry. First, R&D investment in China is insufficient. OECD data shows that Chinese manufacturing companies’ R&D investment reached Rmb1.4trn in 2018, equal to 75% of the level in the US. Second, the investment structure is relatively fragmented. Sectors that are oriented toward technological innovation account for less than 50% of the R&D investment in the manufacturing industry in China¹² (vs. 80% in the US). In addition, basic R&D projects only account for 0.3% of the R&D investment in China's manufacturing industry, while investment in industrial application and test-related projects is relatively high. Third, investment in R&D staff needs to be improved. Equipment accounts for a high percentage of Chinese manufacturing companies’ R&D expenses, while investment in R&D staff remains insufficient in China.

Mismatch between R&D and production, and between production and application also weigh on innovation capability. Regarding the mismatch between R&D and production, the crucial problem is a lack of commercialization of advanced technologies. For example, China has more patents on electrical equipment and engines than the US, Japan, and Germany. However, the commercial use of advanced technologies remains limited in the domestic electrical equipment and engine industries. As for the mismatch between production and application, developing and improving core devices requires sustained feedback from customers, in our view. Companies need to keep fine-tuning parameters and technologies in accordance with the use of their products.

We also see deeper reasons for the weaker innovation capability of China's manufacturing sector.

China's manufacturing industry is export-oriented. The integration of its manufacturing industry into the global industrial value chain gives China access to innovation resources, but reduces its motivation to independently improve R&D capability. High-tech products as a percentage of China's exports have stayed at 40% since the country’s accession to the World Trade Organization (WTO) in 2001, while the percentage of high-tech products in its imports has increased to 60%.

Companies’ emphasis on capacity expansion and lack of investment in basic R&D projects weigh on the innovation capability of the manufacturing industry. Chinese manufacturing companies have higher capex than their counterparts in the US, Japan, and Germany, but their R&D investment remains relatively low.

We note that nearly half of the listed manufacturing companies in China are recognized as high-tech companies. As a result, the effective tax rate of the manufacturing industry in China is lower than that in the US, Japan, and Germany (except for the pharmaceutical and metal product sectors, Fig. 6.7). The low effective tax rate for a wide range of manufacturing companies may play a limited role in stimulating innovation, in our view.

Fig. 6.7

Effective tax rates in China, US, Japan, and Germany. Note We base effective tax rates on listed companies’ FY20 data. Source Bloomberg, CICC Global Institute, CICC Research

Regarding direct R&D subsidies, according to the OECD, these subsidies account for less than 50% of government subsidies for companies in China. The subsidy intensity is high at 0.21% in the US, with direct R&D subsidies representing around 66.7% of US government subsidies for companies (Fig. 6.8).

Fig. 6.8

Source OECD, CICC Global Institute, CICC Research

R&D subsidies in China, US, Japan, and Germany.

6.3.2 Cost Efficiency and Value Chain Security of China’s Logistics Industry

According to data from the Ministry of Transport, in 2019, China’s logistics costs totaled Rmb14.6trn, accounting for 14.8% of GDP; logistics costs for the US were Rmb11.1trn, representing 7.6% of GDP. Logistics costs’ absolute value and share of GDP are higher in China than in the US.

Meanwhile, China’s per tonne-km logistics costs were 35% lower than the US’s. In 2019, China’s freight volume (47.1bn tonnes) was 2.7 × that of the US (17.7bn tonnes), and the turnover volume of freight transport (nearly 20trn tonne-km) in China was 2 × that of the US (nearly 10trn tonne-km). Therefore, China’s per tonne-km logistics costs (Rmb0.73) were 35% lower than that of the US (Rmb1.12). Specifically, China’s per tonne-km transport costs (Rmb0.39) were 47% lower than that of the US (Rmb0.73), and China’s per tonne-km warehousing costs were 40% lower than that of the US. As a result, we think China’s logistics costs are not high.

However, we do not believe that low logistics costs directly lead to high efficiency. First, China achieves low logistics costs at the expense of profit margin. In the last decade, the average profit margin of the domestic logistics industry was around 3.7%, 4.4 ppt lower than that of the US (vs. 8.1% in the US) (Fig. 6.9). Second, China’s labor efficiency is only one-fifth of that of the US. According to the National Development and Reform Commission, over 50mn people work in China’s logistics industry, nearly 10 × the number in the US (5.2 mn), which means the labor efficiency of the logistics industry in China is only one-fifth of that of the US (and the average salary in the domestic logistics industry is also one-fifth of that of the US).

Fig. 6.9

Source Wind, CICC Research

Comparison of Chinese and US logistics companies’ operating profit margin.

What caused the efficiency gap in logistics? We think China has achieved world-leading consumer business efficiency but lags behind the US with regard to corporate business. For example, the per capita package handling volume of express delivery is 190 pieces in China compared to 60 in the US. Using JD and Amazon’s warehouse operations as further examples, the daily package delivery volume, sorting efficiency, and accuracy of JD’s “Asia No. 1” warehouse are close to that of Amazon’s warehouses. Although the efficiency of consumer logistics businesses is already high in China, the proportion of consumer business in the sector is low. For example, the scale of China’s express delivery market is around Rmb900bn, representing only 6.2% of China’s logistics costs (Rmb14.6trn). Therefore, we think it is the corporate business that mainly drags the efficiency of China’s logistics.

We attribute the low efficiency of China’s corporate logistics businesses to three factors. First, low automation rate. According to MIR Databank, the automation rate of logistics was 20% on average in China versus 80% in developed countries. According to Cushman & Wakefield, the proportion of modern warehousing and logistics facilities was 7% by gross floor area (GFA) in China versus 22% in the US. The second is low transport efficiency. According to the Ministry of Transport, the empty-loaded rate of freight transport was 40% in China versus 10–20% in developed countries in 2019. The third is the relative lack of integrated transport. According to the Ministry of Transport, combined sea-rail transport volume made up only 2.6% of Chinese ports’ transport volume in 2020 versus 20–40% for developed countries.

In addition, China is not a strong player in international logistics, which limits its ability to build reliable supply chains.

China has a trade deficit in transport services. Its goods trade is growing rapidly. However, unlike the international goods trade, which has seen a trade surplus for some time, transport service remains the second largest area for which China has a trade deficit (second only to tourism). According to NBS, the transport services trade deficit reached US$58.84bn in 2019.

China is not a strong player in shipping. Most import trade adopts cost (C) terms. As foreign export service providers have their preferred forwarding and shipping companies, most of China’s import trade adopts cost and freight (C&F) or cost, insurance, and freight (CIF) pricing, which means that exporters are responsible for transportation. However, most of China’s export trade adopts F terms, or free on board (FOB) pricing. Most foreign shipping companies are familiar with local ports and transportation, and as smaller domestic companies have weak bargaining power in exports, foreign importers are responsible for transportation.

Domestic airlines only account for around 35% of international airfreight volume in China in 2019. According to the International Air Transport Association, airfreight only accounts for 0.2% of international freight by volume but 36% by value in 2019. According to the Civil Aviation Administration of China, in 2019 foreign airlines account for around 65% of the international airfreight volume in China, with DHL, UPS, and FedEx comprising nearly 75% of the international express delivery.

China’s all-cargo aircraft transport capacity is only 11% that of the US in 2021. According to Planespotters.net, providers of contract fulfillment for door-to-door services only make up 37% of China’s all-cargo aircraft transport capability. In contrast, FedEx, UPS, and Amazon together account for 73% of all-cargo aircraft transport capability in the US. As of January 2021, China had around 185 all-cargo aircraft with a total capacity of around 8,903 tonnes, which is only 11% of the US’s total of 79,906 tonnes (from 1,125 aircraft).

We attribute China’s weak presence in international logistics to developed countries’ first-mover advantage in the market.

6.4 New Opportunities for Manufacturing and Logistics

In our view, despite the challenges mentioned earlier, there are new opportunities for China’s manufacturing and logistics sectors. As the smile curve is likely to flatten in the digital economy, manufacturers are embracing more innovation-driven development opportunities. The logistics sector is set to benefit from the large domestic market with stronger economies of scale, and technology can play a greater role here.

6.4.1 Digital Economy Empowers Manufacturing: The Smile Curve is Likely to Flatten

The manufacturing sector has shifted to automation from large-scale standardized production, and it is likely to see diversification and customization due to continuous technological advances. Looking ahead, we think that the digital economy will alter the nature and form of manufacturing, presenting innovation-driven development opportunities to manufacturers.

The “smile curve” depicts how the value added varies across the different stages of bringing a product to the market. Value added at the R&D and marketing stages is typically higher than that at the manufacturing stage, as the barriers to entry are lower for manufacturing firms, competition is fierce, and these firms are likely to be replaced.

The smile curve is likely to flatten in the digital economy for three reasons (Fig. 6.10). First, the relationship between manufacturing and innovation is likely to become closer. Digital technologies enable manufacturing companies to simulate and verify innovative products at the R&D stage, thereby shortening the duration of the R&D-to-production period. Second, digital technologies can help cut costs and improve operating efficiency in manufacturing, warehousing, and logistics. Third, manufacturing-related services facilitate innovation activities. Manufacturing companies, thanks to the digital economy, can have access to demand estimates and IT-enabled interactive management systems. We think that the digital economy will help processing and assembly companies roll out manufacturing-related services, propel the shift from traditional manufacturing to service-oriented manufacturing, and stimulate innovation.

Fig. 6.10

Source CICC Global Institute, CICC Research

We expect the smile curve to flatten due to the digital economy.

Innovation presents new opportunities for manufacturing in China. For engineering-based innovation, integration of production and R&D improves competitive advantages of manufacturing companies.

China excels at manufacturing, while developed countries have gained an advantage in R&D. They have maintained this competitive advantage due to the separation between manufacturing and R&D. We think that the relationship between manufacturing and R&D will become closer as the smile curve is likely to flatten amid the growth of the digital economy. Thus, Chinese manufacturing companies will likely achieve engineering-based innovation by leveraging their advantage in the manufacturing industry chain.

The use of digital technologies shortens the technology upgrade cycle. Improving manufacturing techniques and advanced technologies requires multiple steps, i.e., R&D, tests, and enhancing the level of technological maturity. Such steps are not only capital and human resource intensive, but also take time. Digital technologies and models can simulate components, products, and manufacturing processes to shorten the technology upgrade cycle and help companies improve their competitive advantages.

The digital economy increases the interaction between manufacturing and R&D projects, which can help drive innovation. For example, additive manufacturing can help companies shorten the material and equipment R&D cycles, simplify the R&D and design process, and propel technological innovation, in our view. We think that the engineering-based innovation, empowered by China's industry chain advantage, and the design innovation amid the growth of the digital economy, will present new development opportunities for the manufacturing industry in China.

For innovation in business models, integrating production and application enables manufacturing companies to expand into more industries.

We think that manufacturing companies will roll out manufacturing-related services as the relationship between manufacturing and services is likely to become closer as the smile curve flattens.

First, we expect manufacturing activities to require more producer services—design, R&D, and management consulting services, among others—as well as energy and raw materials. The need for innovative design, customized services, supply chain management, network-based collaborative manufacturing services, service outsourcing, smart services, financial services, systematic solutions, and other producer services will likely increase. Second, we think that manufacturing companies will pay closer attention to the value of their services in the whole life cycle of their products. Manufacturing-related services will improve the customization, collaboration, and sharing economy in the manufacturing industry, in our view.

Manufacturing companies have benefitted from China’s large market, and we think going forward, they will continue to drive manufacturing innovation thanks to the integration of manufacturing and services. They are likely to achieve diversity and innovation-driven growth as customer demand varies, competition is tough, and profits are typically higher in a large market.

6.4.2 Developing Domestic and International Logistics

6.4.2.1 How Much Potential is There for China’s Sizable Logistics Market?

Domestic logistics market should enjoy strong economies of scale given its large size.

First, China has a large population and fragmented resources, creating high demand for flows via transportation networks. China’s large population (indicating large logistics demand) and land area (fragmented resources) create ample demand for transport. We note that the degree of utilization of network-based transport sectors (e.g., highways, high-speed railways, and airports) is high in countries with larger populations, which helps them realize the optimization of technology and operation models, thus boosting logistics efficiency.

Second, a large logistics market implies multiple layers of demand, and business model innovations may create economies of scale. As large countries have greater demand for logistics and different layers of consumption (some traditional, some innovative, and with consumers at different consumption levels), companies need to constantly develop new business models to keep up with demand. For example, the rise of e-commerce platforms in the early twenty-first century changed consumers’ shopping habits (shifting from offline to online), which boosted the development of express delivery.

Third, the logistics sector benefits from the more favorable environment for technology application and economies of scale found in large countries. New technologies are usually expensive due to higher R&D expenses. However, we think it is easier to have new technologies widely applied in a large logistics market given its economies of scale as the price of new technology will gradually fall with greater penetration. Technology upgrades can also help raise logistics efficiency.

A comparison of leading logistics companies in subsectors illustrates the domestic logistics industry’s significant growth potential. Based on data accessibility and company comparability, we compare leading Chinese and US logistics companies from three subsectors: Freight forwarding (KNIN and Sinotrans), express transportation (ODFL and ANE), and express delivery (UPS, FedEx and SF-Express). In general, leading Chinese companies’ revenue and profit are only one-quarter to one-half that of their US counterparts. Profit margins for Chinese logistics companies are also lower than that of US names (1.2 ppt lower for freight forwarding, 7.8 ppt lower for express transportation, and 4.0 ppt lower for express delivery).

As the US has more concentrated upstream and downstream logistics industries, which have clearer competitive landscapes following industry consolidation, its leading companies are larger and enjoy higher profit margins. We expect the domestic logistics industry to become more concentrated and its profit margin to rise. In our view, a more concentrated logistics industry should also help lower costs due to economies of scale.

6.4.2.2 How to Improve Logistics Efficiency and Unleash the Logistics Industry’s Growth Potential?

China has diverse application scenarios for 5G and AI, and we expect it to catch up with other countries in logistics in the digital economy.

How can China improve its logistics efficiency? From a macro perspective, we expect the digital economy to make logistics services more tradable and digital technology more accessible.

Digital economy makes logistics services more tradable, which may boost efficiency. Historically, services have been considered non-tradable, but the digital economy enables the completion of tasks or trade with no interactions between humans, which was previously impossible. The COVID-19 pandemic also highlighted the role of the digital economy. We think trade creates competition, and competition may bring new ideas, concepts, and technologies, resulting in higher sector efficiency. We thus expect more tradable logistics services to help increase sector efficiency.

In the digital economy, digital technologies (e.g., 5G, AI, and cloud computing) are more accessible and can be more easily applied, which may help solve the logistics industry’s pain points, including labor intensity, high cost, and poor management. The traditional logistics industry is labor-intensive, but China’s demographic dividend is fading. Meanwhile, the logistics market is quite fragmented, with low levels of digitalization and informatization. In the era of the digital economy, we think technologies (e.g., 5G, AI, and cloud computing) have become more accessible and more easily applicable, which will notably optimize logistics companies’ business procedures and operations.

From a micro perspective, China’s logistics industry is increasing R&D spending, and technology helps reduce logistics costs as well as improve efficiency. R&D spending in China’s logistics industry is increasing. The country’s logistics R&D expenses/revenue ratio rose to around 0.4% in 2020 from 0.1% in 2016 (with 2016–2020 five-year average at 0.28%), but its R&D expenses/revenue ratio is only one-third that of the US, whose 2016–2020 five-year average is 0.89%. However, the Chinese express delivery sector’s R&D expenses/revenue ratio has risen to 1.3% in 2019 and 2020, which is already higher than that of the US express delivery business and equivalent to that of the US logistics industry in 2000 (Fig. 6.11).

Fig. 6.11

Source Ministry of Transport, U.S. Bureau of Transportation, CICC Research

R&D expenses/revenue ratio of express delivery companies and other logistics companies.

Given China’s 5G and AI technologies and data from its large logistics market, we expect technology to make logistics smarter and more efficient in the digital economy. AI and 5G are being used to replace humans in simple and repetitive tasks, assist and empower humans (e.g., unmanned trucks, unmanned aerial vehicles, unmanned warehouses, express automatic sorting, smart parcel lockers, smart customer service), and optimize business processes and management (e.g., warehouse management, transport management, smart maps, route planning). The benefits of technology can be seen in the case of the Manbang platform, a vehicle-goods matching platform in China. As a result of efficiencies created through the use of technology, drivers on Manbang can currently drive 12,000 km per month (up from 9,000 km) and take an average of 20 orders per month (up from 14). Their empty-loaded rate has fallen to 34% from 38%. We estimate a 1% decline in the empty-loaded rate of domestic trucks would lower logistics costs by around Rmb17bn and cut carbon emissions by around 7.20 mn tonnes.

6.4.2.3 Diverse Modes of Transportation and Cross-Border E-commerce May Change the Competitive Landscape of International Logistics

As previously mentioned, China is not a strong player in international logistics, which limits its ability to build reliable supply chains. We now examine the three trends that are shaping the international logistics system, namely the regionalization of supply chains, the more diverse cross-border transport as well as rail transport’s increasing share, and synergies between domestic brands and logistics companies’ overseas expansion. These trends may change the competitive landscape of international logistics, offering China new opportunities to develop its international logistics system, in our view.

Intra-regional logistics is growing as the trend of “deglobalization” becomes more visible. According to the WTO, global trade has weakened since 2008 (we evaluate global trade by calculating the ratio of total exports to output), showing a visible deglobalization trend. Deglobalization has two major impacts on the international trade landscape. First, industry chains are becoming more regionalized. To diversify procurement, the US and European countries are expanding the scale of production and supply in surrounding countries to develop a greater number of shorter supply chains, as demonstrated by a World Bank Group report.¹³ Intra-regional cooperation has grown in depth and breadth. Second, supply chain localization may accelerate. Developed countries have focused more on manufacturing since the 2008 financial crisis. For example, the US has introduced a series of policies to encourage advanced manufacturing companies to return to the country.

Cross-border transportation is becoming more diverse, with land and airfreight playing greater roles. According to the WTO, shipping’s share of total cargo transport service fell by 10 ppt over the last decade. Land transportation’s share of cross-border transportation has risen by 9 ppt in the last decade and has grown further despite the COVID-19 pandemic. Global airfreight volume rose steadily from 2009 to 2018, with its share of global export freight rising by 2 ppt in the last decade. We note that developing countries have a greater voice in land and air transport than in shipping, highlighting the strategic importance of developing new global transportation channels.

Cross-border e-commerce is supporting Chinese brands and logistics companies’ overseas expansion. In recent years, the cross-border e-commerce industry has become more mature. We think the short distribution chain and high effectiveness of the logistics system have helped cross-border e-commerce companies achieve data sharing and have brought brands directly to consumers. According to 100ec.cn,¹⁴ China’s cross-border e-commerce trade volume grew at a CAGR of around 58% over 2015–2020. We expect cross-border e-commerce businesses to maintain a CAGR of around 20% over 2021–2025, with total exports to reach nearly Rmb5trn by 2025. Cross-border e-commerce platforms may also contribute to the globalization of Chinese logistics by allowing Chinese exporters to select logistics companies.