FRBSF Economic Letter
2003-30; October 10, 2003
Is Our IT Manufacturing Edge Drifting Overseas?
The United States arguably is the world's foremost producer
of information technology (IT) products, and for many of these products,
the U.S. defines
the "leading edge," or most advanced available technology.
Within the U.S., the Twelfth District in particular specializes in IT
production. However, amidst the current prolonged slowdown in worldwide
IT spending, signs are emerging of a potential erosion of the U.S. competitive
advantage. In 2002, the U.S. trade deficit for IT products increased
substantially, with China accounting for much of the change. The rising
U.S. IT trade deficit indicates a shift in the locus of IT manufacturing
activity, which may be holding down growth in the domestic IT manufacturing
sector to some degree.
In this Economic Letter, I examine the changing patterns of IT trade
to help assess whether the U.S. competitive advantage is indeed eroding.
Some U.S. manufacturers of IT products are well-positioned to take advantage
of the shift toward low-cost overseas assembly operations in China and
other countries. However, the longer-run impact of these shifts, especially
given China's growing skill base and the tax advantages conferred on
firms that locate there, may point to the need for a renewed domestic
focus on economically sound policies to help the U.S. IT sector realize
its full potential in the years ahead.
IT trade flows show increasing
trade deficits with China
To put the IT trade balance in context, it
is useful to compare the U.S. trade balance in manufactured IT products
to that for other manufactured
products (Figure 1; trade balance expressed as the ratio of imports to
exports).  The definition of IT used here largely corresponds to the broad
definition used by the American Electronics Association, which includes
computer, electronic, and communications equipment, consumer audio and
video equipment, and medical and other instruments. The U.S. trade deficit
began to increase substantially in 1997, when the U.S. dollar was in
general quite strong (although it depreciated in 2002). Although the
trade deficit for IT products has been smaller than for other manufactured
products in ratio terms, it increased noticeably in 2002, as exports
fell substantially and imports remained essentially flat. In dollar terms,
the increased IT trade deficit in 2002 is large, about one-third of the
estimated decline in the value of U.S. IT output in 2002.
During most
of the 1990s, the U.S. IT deficit was most pronounced with Japan. But
as of 2002, the U.S. IT trade deficit with the rest of East
Asia outstripped the U.S. IT trade deficit with Japan (in ratio and dollar
terms). Within East Asia, the net increase can be accounted for entirely
by trade with mainland China, as the U.S. IT trade deficit with other
major East Asian trading partners has been relatively constant (Hong
Kong is included separately from China). Of the $17 billion increase
in the U.S. IT trade gap in 2002, close to half ($7.2 billion) was due
to the change in trade flows with China alone, as U.S. imports from China
rose sharply while exports to China rose only a bit. Most of the remaining
increase in the IT trade gap in 2002 ($6.4 billion) was due to a change
in trade flows with the European Union (a sharp drop in exports accompanied
by nearly flat imports). The growing importance of East Asia in the IT
manufacturing supply chain is consistent with the regional pattern in
worldwide semiconductor sales revenues, based on region of use. In recent
years, growth has been noticeably more rapid in Asia (excluding Japan)
than in the rest of the world. This has caused a sharp increase in Asia's
share of worldwide sales since early 2001, which was largely matched
by a sharp decline in the share of sales to the "Americas" (mostly
the U.S.)  (Figure 2). China probably accounts for a large portion of
that growth, due to its expanding role as a center for low-cost manufacturing
and assembly of standardized IT products; according to the Chinese Semiconductor
Industry Association, the overwhelming majority of semiconductors used
in these products are imported into China. As examples, China accounts
for a significant and growing share of worldwide output of notebook computers,
flat-panel displays, game boxes, DVD players, mobile phones, and handheld
computing devices. Some Chinese companies that design and manufacture
their own products, such as the computer maker Legend, have made substantial
inroads in the rapidly growing domestic Chinese market. However, such
companies have had little or no success at selling their products in
overseas export markets.
A substantial amount of Chinese IT production
takes place at foreign-owned establishments or through foreign outsourcing
of manufacturing and assembly
activities to Chinese companies. A key incentive for foreign manufacturers
is low production costs relative to alternative locations; Chinese
labor costs are quite low compared to labor costs in advanced industrial
nations
or developing countries that compete with China (although China's cost
advantage shrinks substantially when productivity differences and non-labor
costs are taken into account). Moreover, in 2000, China implemented
a series of tax policies that give preferential treatment to foreign
IT
manufacturers who locate in China. These policies include reductions
in the national value added tax for foreign semiconductor makers who
establish manufacturing sites in China and reductions in national and
local income taxes for foreign enterprises that specialize in IT products
(see Chao and Sussman 2003 for details). In addition, China has the
advantage of a large and growing number of skilled engineers, many of
whom received
training and sometimes IT work experience in the U.S. and other advanced
countries.
Twelfth District trends
Some U.S. firms are well-positioned to exploit
China's growing role in IT production and trade. Although the lack
of import data precludes
calculation
of IT trade balances for Twelfth District states, export data are
available. California IT exports to China grew rapidly in 2000
and 2001 (Figure
3).  Although these exports fell a bit in 2002, they remained at
a level nearly double that in 1999, which suggests that IT producers
in California
have been able to exploit the rapid growth of IT production in
China by substantially increasing their exports of intermediate IT products
to China.
This trend was even more pronounced in the District outside
California, which saw a surge in IT exports to China in 2000-2002.
Most of
this increase was attributable to Oregon in 2001 and to Oregon
plus Arizona
in 2002.
This surge largely reflects increased exports of Intel microprocessors
for use by Chinese computer makers; Intel has manufacturing facilities
in both states, and the export increase was especially pronounced
for the detailed product category that includes microprocessors.
Although
IT exports to China were over twice as large for California as
for the rest of the District in 2002, the increase for these
other states
in
2002 was larger than the decline for California. Moreover, for
the District as a whole, IT exports to East Asia outside of China
fell
during 2000-2002,
which suggests that to some degree China is supplanting other
East Asian countries in the worldwide IT supply chain.
Of course, some
Twelfth District IT firms may be harmed by increased direct competition
from overseas manufacturers. However, Twelfth
District IT companies in general are well-positioned to take
advantage of the
growth in low-cost production in China. The District's geographic
proximity to Asia reduces the cost of the necessary business
contacts throughout
the region. Moreover, the District's extensive Asian population
and culture provides a commonality that supports sustained
business partnerships.
Understanding the shift
One key question arising from these trade patterns
is: What caused such an abrupt shift in the U.S. IT trade deficit
with China
in 2002? A partial
explanation lies in the nature of the slowdown in worldwide
IT sales that began in late 2000. The slowdown has been
especially pronounced
for business spending on IT capital goods, which also
is the focus for U.S. IT exports. By contrast, China specializes more
in exports
of IT
consumer goods. Growth in U.S. consumer spending in 2002
therefore
led to solid increases in U.S. IT imports from China,
while
U.S.
IT exports
to China grew more modestly.
In addition, as discussed
above, in 2000 China instituted policies aimed at supporting development
of the IT industry.
Around
the same time, China
also achieved more complete acceptance in the world trade
community. In particular, China was granted Permanent
Normal Trade Relations
(PNTR) with the U.S. in October 2000 and membership in
the World Trade Organization
(WTO) in December 2001. Because it takes time to establish
new production facilities and to invest in new business
relationships—such as contracts
for outsourced production—China's IT trade surge in
2002 likely reflects in part a lagged response to IT development
polices
and the country's
newly acquired trade status.
Despite the significant trade
inroads China's IT industry made in 2002, the immediate threat to U.S.
ascendancy
in worldwide
IT development
and production remains somewhat limited. China's recent
gains largely reflect
normal product-cycle dynamics, in which the diffusion
of technology enables less advanced countries to manufacture
products that
initially were manufactured
only in advanced countries. At this time, China's IT
sector
focuses primarily on assembly of less-advanced products
at low cost,
which does not threaten
the U.S. dominance in leading-edge technology and innovative
products. Moreover, China's growing role as a low-cost
producer generates
substantial benefits for U.S. users of IT products
through resulting price reductions
on IT equipment.
In the longer run, however, the U.S.
may face a significant trade-induced reduction in domestic IT manufacturing
activity and an erosion
of the knowledge and skill base associated with it.
This may undercut the
competitive advantage enjoyed by U.S. IT manufacturers,
which is based on the ability
to identify and develop innovative products that
spur worldwide growth
in the IT industry.
A variety of policy responses
to this long-term challenge are possible. One area of active concern
is the protection
of intellectual
property
of foreign firms locating in China; the Chinese
have strengthened domestic law in this regard in recent
years, but enforcement
reportedly remains
an issue. In conjunction with China's targeted
tax policies, the resulting transfer of technology and
innovation will
support the
expansion of
China's IT manufacturing sector, possibly at the
expense of IT manufacturers in the U.S. Thus, China's
strategic
IT policies
place a burden on
the U.S. to identify and implement economically
sound strategies to maintain
the base of skills, knowledge, and physical capital
underlying IT innovation, thereby allowing the
U.S. IT sector to
realize its full
potential going
forward. Such policies may include, but are not
limited to, public
support
for advanced education and training programs and
federal and state tax policies that recognize the
unique financial
features
of IT
manufacturing, especially in regard to rapid capital
depreciation and the substantial
upfront costs of research and development activities.
Rob
Valletta
Research Advisor
Reference
[URL accessed September 2003.]
Chao, Howard, and Lawrence Sussman. 2003. "Semiconductor
Investment Heats up in China: A Legal and Tax Guide." Report,
O'Melveny & Myers
LLP, June.
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