Many assume that China’s cost advantage in manufacturing comes from cheap labor. But in China’s burgeoning steel industry, our research suggests, massive government energy subsidies, not other factors, keep prices down. These subsidies have broad implications for how companies compete and collaborate with Chinese businesses.

                In 2005 Beijing designated steel as a pillar industry for the Chinese economy. China was the world’s largest producer of steel, with 27 percent of global production, but until then it had imported 29 million tons of steel annually. That year, China suddenly transformed itself from a net steel importer to a net steel exporter. In 2006 the country became the world’s largest steel exporter by volume, up from the fifth largest in 2005. Today it remains the world’s largest consumer and producer of steel, with 40 percent of global production.

                How did China make these astonishing gains so quickly and manage to sell steel for about 19 percent less than steel from US and European companies? Labor accounts for less than 10 percent of the costs of producing Chinese steel, and Chinese steel doesn’t appear to rely on scale economies, supply-chain proximities or technological efficiencies to lower its costs.

                Let’s look in detail at the probable source of this cost advantage. In research conducted with funding from the Alliance for American Manufacturing—work that draws heavily on our decade-long previous study of Chinese industry—we found that total energy subsidies to Chinese steel (from 2000 to midyear 2007) reached $27 billion. About 95 percent of that amount was for coal. (These numbers are conservative best estimates, based on data from Chinese, US and international agencies, industry associations, individual Chinese companies and other sources.) Our analysis of the relationship between the increase in energy subsidies and the growth of Chinese steel production and steel exports showed a powerful statistical correlation; this is not a chance association.

                Our research revealed that energy subsidies to the steel industry were paid to the energy sector and passed on through lower energy prices, which suggests that the energy supplied to China’s other manufacturing industries is subsidized as well. The steel industry may benefit disproportionately from energy subsidies because of its voracious appetite for coal, but the energy subsidies obviously help other industries, too.

                Foreign companies doing business in or with China or competing against Chinese rivals need to recognize a few things about subsidies. First, they can be abruptly affected by political forces. For example, the November 2007 World Trade Organization subsidy-reduction agreement between the US and China cut export subsidies to foreign companies located in China but maintained subsidies to Chinese companies. This shows how subsidy-based cost advantages of foreign companies located in China can suddenly evaporate.

                Second, companies that offshore to, or source or import from, China may suffer price shocks if they don’t discount fluctuating, subsidy-based cost advantages. Our research showed that under scrutiny, subsidies from Beijing often dry up, only to be replaced to varying degrees by subsidies from provincial and local governments, which use them to support employment, build self-sufficiency and promote import substitution locally. Companies should establish relationships with industry and government officials in China so that they know the source of subsidies and can gauge the risk of reduction and subsequent price increases.

                Before foreign companies cut other suppliers loose in favor of lower-priced Chinese sources, they should be mindful that Chinese firms’ prices may fluctuate abruptly as subsidies shift. Foreign firms should therefore retain some original supply relationships until Chinese suppliers prove reliable over the medium term.                 

Usha C.V. Haley is a professor of international business and the director of the Global Business Center, and George T. Haley is a professor of industrial marketing and the director of the Center for International Industry Competitiveness, at the University of New Haven in Connecticut. The full report is available at americanmanufacturing.org.

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