China’s hidden shipbuilding subsidies and their impact on its industrial dominance

Our news feeds have recently been invaded by discussions of a forgotten issue: protectionism. Strategic trade, industrial policy and even trade wars are once again at the forefront of our minds. Regardless of why these measures are adopted, it is essential to understand their consequences for world trade and welfare. In recent work, I focus on China, where government guidance has allegedly turned its industries into world leaders and where the ‘invisible hand’ of the state is gaining ground by the day.

Industrial policy
Over the past two decades, Chinese firms have rapidly come to dominate a number of capital-intensive industries, such as steel, auto parts, solar panels, and shipbuilding. The share of labor intensive products in Chinese exports fell from 37% to 14% between 2000 and 2010 . On a monthly basis, in 2011 the US imported advanced-technology products from China 560% more than it exported to China.

China’s market share has expanded rapidly in a number of manufacturing sectors, including steel, solar panels, auto parts, and shipbuilding

By contrast, the monthly US-China trade surplus in scrap (used as raw material) grew by 1187% between 2000 and 2010 . (U.S.-China Economic and Security Review Commission (2011)). The share of labor-intensive products in Chinese exports fell from 37% to 14% between 2000 and 2010. In 2011, on a monthly basis, the United States imported advanced technology products from China 560% more than it exported to China. By contrast, the monthly US-China trade surplus in scrap (which is used as raw material) grew by 1,187% between 2000 and 2010.

Government subsidies are often invoked as a possible contributing factor to China’s expansion.”China is the workshop to the world. It is the global economy’s most formidable exporter and its largest manufacturer. The explanations for its success [include the] seemingly endless supply of cheap labour (…) another reason for China’s industrial dominance: subsidies.” (“Perverse Advantage”, The Economist, April 2013 ). But although industrial subsidies have steered industrialization and growth in several regions (notably in East Asia), little is known about their quantitative impact on production reallocation across countries, industry prices, costs and welfare.

Government subsidies to industries are notoriously difficult to detect and measure, and this problem is particularly acute in China (Haley and Haley, 2008). International trade agreements also prohibit direct and in-kind subsidies, so it is not surprising that there are few explicit data. We often do not know if subsidies exist, let alone their magnitude.

My research assesses the consequences of government subsidies for industrial evolution, focusing on the recent Chinese expansion. I first develop a methodology for detecting the presence of subsidies and gauging their magnitude. The main objective is to recover the ‘true’ costs of potentially subsidized firms.

I then apply this strategy to the world shipbuilding industry, a long-time target of industrial policy. In 2006, China identified shipbuilding as a ‘strategic industry’ and introduced a plan for its development. In a short time, its market share had doubled from 25% to 50%, leaving Japan, South Korea and Europe trailing behind.

Some observers have asserted that China’s rapid rise was driven by hidden subsidies that reduced shipyard production costs, as well as by a number of new shipyards constructed as part of the government plan. My research is designed to assess the relative contribution of these interventions.

Government interventions in the form of subsidies are arguably prevalent and subsidy disputes abundant. Yet both domestic and global policy-makers, such as the World Trade Organization (WTO), have difficulty in designing and adopting appropriate measures to respond to them.

Deciding on subsidy complaints is difficult for two reasons. First, in the words of the WTO in 2006, ‘systematic data (on industrial subsidies) are non-existent; reliable sources of information are scarce and mostly incomplete… because governments do not systematically provide the information’.

Second, there is the challenge of how to prove ‘injury caused’ by the alleged subsidies. Ideally, a difficult question needs to be answered: how would this industry have evolved in the absence of the alleged subsidies?

Shipbuilding in China and elsewhere

Figure 1: Shipbuilding dry docks

Figure 1

Alongside the steel, mining, and automotive industries, shipbuilding is one of the major recipients of subsidies globally. Governments often see it as a strategic industry because it increases industrial and defense capacity, generates employment, and has important spillovers to other industries (such as iron and steel).

From the 1850s, Britain was the world leading shipbuilder, until it was overtaken by Japan in the 1950s, which in turn lost its leading position in the 1970s to South Korea (where shipbuilding today represents 4.5% of GDP).

China’s 11th National Five-year Economic Plan 2006-2010 was the first to appoint shipbuilding as a strategic industry in need of ‘special oversight and support’. As part of the national plan, the central government unveiled an official shipbuilding blueprint to guide the medium and long-term development of the industry, which set the goal of China becoming the largest shipbuilding nation within a decade.

The plan has specific output and capacity goals involving investment in shipbuilding infrastructure and financial support for output growth, including increased credit allowance and low input prices.

Consistent with these government programs, Figure 1 shows China’s rapid expansion in shipbuilding dry docks, a measure of shipbuilding capacity. Much of this expansion was realized through the construction of new facilities, so that the industry experienced a massive entry wave in 2005 and 2006.

In contrast to this capital expansion, subsidies that reduce operating costs cannot be observed directly. Yet consistent with such measures, China’s production and market share increased dramatically as the programs were announced (Figure 2). Indeed, China’s market share more than doubled across all major ship types within one to two years.

Figure 2: China’s market share

Figure 2

In addition, China’s shipbuilding is mostly geared towards export sales, which comprised about 80% of its production in 2006; this suggests that the increase in market share is unrelated to any increases in domestic consumption. World prices of new and used ships also dropped in late 2005, during a period when ship prices were trending upwards due to increased demand for freight (Figure 3).

Figure 3: Appropriately averaged new and used prices of Handysize bulk carrier vessels

figure 3

Detecting hidden subsidies

How does one gain an insight into the Chinese government’s support for firms when the measures applied are secret? My work uses techniques that combine data on firm choices and an economic model to detect the presence of subsidies. In particular, my approach aims at uncovering a ‘gap’ between the observed firm choices (in this case production) and the choices the model would imply.

To do this, I estimate the cost function of potentially subsidized firms – that is, the relationship between output and operating expenditures – and I examine its behavior around 2006. I am particularly interested in whether the cost function exhibits a ‘break’ in 2006 – that is, an abrupt change that makes Chinese shipyards produce as if their costs are suddenly lower.

The simplest version of the model works as follows. There is a global market for ships; ship-owners across the world participate by deciding to buy new vessels. Depending on the market conditions, notably world trade and the current fleet level, ship-owners have a certain ‘willingness-to-pay’ for a new ship. When world trade grows and the total number of ships is low, ship-owners have a high willingness-to-pay and invest in new vessels. The more vessels they buy, the more the fleet grows and their willingness-to-pay declines.

I consider shipyards located in China, Japan, South Korea and Europe. Each shipyard decides how many ships to build by comparing the ship market price, given by the ship-owners’ willingness-to-pay, and its production costs. The shipyard keeps producing, as long as the price exceeds the cost of the additional vessel.

For example, suppose a shipyard produces three vessels during a quarter: this must mean that the shipyard’s profitability was higher for three vessels rather than either two or four. This implication of optimal behavior makes it possible to use the observed ship prices and quarterly firm production to uncover the shipyard’s cost function.

Naturally, the world is substantially more complicated than this and the actual model employed is more flexible in several dimensions. Both shipping (demand side) and shipbuilding (supply side) are at the mercy of large macroeconomic swings and firms operate in the shadow of severe uncertainty about both international trade and input shocks (such as steel prices).

Moreover, in both shipping and shipbuilding, firms’ expectations are important. On the demand side, ships are long-lived investments for ship-owners, and so their demand depends on expectations about future growth and fleet development. On the supply side, ship production takes time: building a ship takes two to five years and thus shipyards accumulate backlogs, which can affect their future costs, through expertise acquisition and/or capacity constraints. The model can account for these factors.

Falling costs for Chinese shipbuilders

The cost function obtained from my analysis reveals a significant drop for Chinese producers equal to about 13-20% of the cost per ship, corresponding to a total of US$1.5-4.5 billion between 2006 and 2012. There is also evidence that Chinese shipyards are less efficient than their Japanese and South Korean counterparts.

China’s industrial subsidies reduced shipyard costs by 13-20%, corresponding to US$1.5-4.5 billion, between 2006 and 2012

The intuition for the estimated cost decline is simple: it is practically impossible to explain the rapid increase in China’s market share observed in Figure 2 with other economic mechanisms consistent with this model. Simply put, Chinese firms are ‘over’ producing compared with my theoretical prediction.

To corroborate this, I provide evidence that a number of possible alternative explanations for the recovered cost decline cannot adequately account for the observed patterns. The drop is only present for Chinese shipyards – there are no ‘breaks’ in the cost functions of Japanese, South Korean or European shipyards. This suggests that the Chinese drop in costs is not due to some sudden global technological change.

In addition, the results are robust to many different specifications for the cost function, as well as different ways to account for other temporal changes. I find it particularly convincing that the results hold when only shipyards that existed prior to 2001 are considered. This suggests that cost declines are not driven by new shipyards, which may have a different technology or may be ‘learning by doing’.

The impact of subsidies

I use my economic model to quantify the contribution of government interventions as Chinese shipbuilders seized a large part of the global market.

Hidden subsidies shifted production away from low-cost Japanese shipyards towards high-cost Chinese shipyards

First, I find that the Chinese interventions led to substantial reallocation in production: in the absence of China’s government plan, Chinese market share is cut to less than half, while Japan’s share increases by 70%. If only new shipyards are removed, China’s share falls from 50% to 40%, suggesting that new shipyards played an important role though not the predominant part in China’s expansion.

Second, ship prices experience moderate increases in all countries in the absence of China’s plan, as the latter shifted supply outward.

Third, in the presence of subsidies, freight rates decrease moderately because of the larger fleet between 2006 and 2012 and more so over time, as building ships takes time. As a result of China’s plan, cargo shippers gain about US$400 million in shipper welfare over that time period.

This calculation implies that a frequent assertion that China developed shipbuilding to benefit from low freight rates for its trade seems to be unsubstantiated. Indeed, the benefits of subsidies to shipping are minimal. Perhaps instead, the Chinese government is aspiring to externalities for sectors such as steel and defense, or even national pride (Grossman, 1990).

Fourth, subsidies create a wedge in the alignment of production and costs: they lead to a large increase in the industry average cost of production (net of subsidies) by shifting production away from low-cost Japanese shipyards towards high-cost Chinese shipyards.

In conclusion, the results of my study suggest that Chinese subsidies dramatically altered the geography of production and countries’ market shares. Although price (and thus consumer) gains are small in the short run, they may grow in the long run as the operating fleet becomes larger.

It is doubtful, however, that such gains will justify the extent of the estimated subsidies. This is corroborated by the soaring Chinese excess capacity in numerous manufacturing sectors. In collaborative research in progress, I am studying these long-run effects of Chinese subsidy programs on industry structure.

This article summarizes ‘Detection and Impact of Industrial Subsidies: The Case of Chinese Shipbuilding’ by Myrto Kalouptsidi (Harvard University), published in the Review of Economic Studies.

Further reading

Grossman, Gene (1990) ‘Promoting New Industrial Activities: A Survey of Recent Arguments and Evidence’, OECD Economic Studies 14: 87-126.

Haley, Usha, and George Haley (2013) Subsidies to Chinese Industry: State Capitalism, Business Strategy, and Trade Policy, Oxford University Press.