China shock 1.0 referred to how beginning the 90s, low-cost Chinese manufacturing led to disruption of manufacturing in the west. But that was largely related to low-tech products manufactured at scale where cost competitiveness was key. However, the west, in particular European countries like Germany retained a strong hold on high tech industrial and automobile manufacturing. Now, as we have featured plenty an article in this space about the rise of Chinese high-tech manufacturing in cutting edge industries, that is being disrupted too. This piece refers to it as China shock 2.0.
The piece begins with an example of a Chinese company Mega Senway which makes sensors used in EV chargers. These sensors until as recently as 2019 were a niche product largely made by Swiss and German companies. The EV boom in China has created such a scale (20k in 2019 to 10m now) that the sensors now sell for less than a tenth of the price in 2019, forcing the Europeans to exit.
How do the Chinese do it? “Vicious domestic competition, coupled with vast industrial scale, ample pools of engineering talent and some of the highest subsidies in the world, has generated world-beating Chinese champions in EVs, solar panels, batteries, wind turbines and a lengthening list of advanced manufacturing sectors.
But the same forces that forge those companies also tend to generate overcapacity, crushing margins at home while flooding global markets and fuelling trade tensions. Aided by an undervalued exchange rate, Chinese groups are cutting a swath through the most advanced industries around the planet.
“Companies that can survive in China are unbeatable anywhere else in the world,” says Huang He, an investor in Mega-Senway and more than a dozen other Chinese industrial groups. Chinese founders have to “use every possible means” to survive, he says, collectively creating the country’s unmatchable competitiveness. “China is full of engineers — tech barriers last six months to a year at most.””
The Chinese refer to such vicious domestic competition as ‘neijuan’ or involution:
“It forces companies like Mega-Senway to move fast. Huang explains how they cut their own costs so dramatically over just a few years. First they acquired the factory that manufactured the sensors they designed. Then he visited nearby factories to study their best practices.
A worker testing their finished sensors initially did it one at a time, he says. Huang redesigned the testing jigs to test four at a time, then eight, with a worker constantly loading or unloading batches. Now he has replaced the workers with robotic arms.
“We would update our processes two or three times a year,” Huang says. “The pressure came that fast.”
…BYD, the world’s largest EV maker, saw its average selling price per car fall from Rmb143,100 in 2021 to Rmb119,223 last year. Nio, one of China’s premium EV brands, has lowered the price of its flagship ES8 SUV by about 20 per cent since its 2018 debut, despite packing much more technology into the car.
…“Since 2018, China’s whole supply chain has transformed — new EV sales are now a hundred times what they were back then, so costs across the entire supply chain, batteries and everything, have come down enormously,” he says.”
The west is pushing the Chinese hard. But after a brief reference to anti-involution last year, the Chinese aren’t backing down: ““The so-called issue of ‘China’s overcapacity’ does not really exist and should not be used as a pretext for political manipulation,” Beijing’s foreign affairs ministry said last month in response to renewed US efforts to increase tariffs on China.
…when Chinese leaders last month formally launched the country’s five-year plan for 2026-30 they signed off on overwhelming state support for sectors ranging from biomanufacturing to robotics.”
Take for example humanoid robots. State support has spawned off a plethora of companies in the area: “The founder of a robotics company in western China ticked off the subsidies that have helped him get started: grants to help his customers purchase his robots, subsidies to expand his factory vertically instead of horizontally, money for rooftop solar panels and energy storage and a “smart factory” plaque from the provincial government with more attached benefits.
His competitors get the same benefits, he says, acknowledging it may have contributed to the onslaught of new rivals that has forced his prices down 10 per cent over the past year. “At the same time, we wouldn’t be here without them,” he says. “The benefits outweigh the downsides.”
The system creates more and more companies fighting for the same piece of pie, says Huang He, whose group, Northern Light Venture Capital, is an investor in Mega-Senway. The problems arise when the government money for nurturing companies becomes what sustains them, he says.
“Local governments are reluctant to let their local companies fail,” he says. “That’s why overcapacity is so hard to fix.””
As Charlie Munger said incentives drive behaviour: “Value added tax generates nearly 40 per cent of China’s tax revenue, and the central government splits the receipts with the localities where products are made, giving them a direct stake in keeping factories running.
Adding local production capacity also creates the growth that officials are largely judged on, and any large-scale lay-off could threaten social stability, Beijing’s overriding priority.
“Officials are scared of missing their GDP targets. Nobody is scared of overcapacity,” says another founder, who asks to remain unnamed. “As long as you’re manufacturing, there’s VAT revenue. Whether you sell [a product] or make a profit, that doesn’t really affect them.””
Companies which otherwise would have shutdown are kept alive preventing market forces from doing their job: ““Analysts often confuse the global competitiveness of Chinese manufacturing with manufacturing efficiency but these are two very different things,” said Michael Pettis, a senior fellow at the Carnegie Endowment for International Peace.
“China’s manufacturing competitiveness depends on an undervalued exchange rate, very cheap financing and very low wages relative to productivity.””
If you want to read our other published material, please visit https://marcellus.in/blog/
Note: The above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. The information provided is intended for educational purposes only. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India (SEBI) and is also an FME (Non-Retail) with the International Financial Services Centres Authority (IFSCA) as a provider of Portfolio Management Services. Additionally, Marcellus is also registered with US Securities and Exchange Commission (“US SEC”) as an Investment Advisor.
