Opinion World

China’s Ship Has Sailed

Subsidies given by the Chinese government have given their shipbuilding industry an unfair advantage over competitors. How should we respond?

The use of subsidies for promoting a specific industry has been an interesting, though controversial, topic for decision-makers and academics alike. Often, this debate generates more heat than light since the precise numbers are hard to come by–particularly if the industry being targeted has a strategic dimension, and the country employing the policy lacks a credible and transparent statistical system.

A paper published last year in the Review of Economic Studies by the Harvard academic Myrto Kalouptsidi has sought to fill this gap. It has quantified the extent and implications of the Chinese subsidies for the strategically significant global shipbuilding industry. Though the paper is mainly aimed at academic economists, its findings must be of interest to others too. As such, its conclusions deserve wider dissemination.

Kalouptsidi sources her data from Clarksons Research, a globally renowned shipping intelligence provider. From the shipbuilding contracts, firm-level variables such as ship prices (both old and new vessels) are extracted. They are combined with other relevant variables, such as steel price, to rigorously estimate the demand and supply of ships on the basis of plausible assumptions. This forensic examination uncovers a startling trend in the shipbuilding industry.

China’s eleventh five-year economic plan (2006-2010) had declared shipbuilding a ‘strategic industry’ and promised ‘special oversight and support’. The declaration was followed by an enormous expansion of shipbuilding capacity as measured by the number of shipbuilding dry docks. The number of dry docks increased five-fold, and crossed 100 by 2012. In parallel, Chinese market share in the global shipbuilding also scaled, mostly at the expense of Japan. Average Chinese market-share in the post-2006 period jumped from 17% to 57% in the bulk carriers segment, and from 16% to 39% in the containers segment.

The paper claims that the increase of market share is explained by the declining cost of production, which works out to be between 13 to 20% in the same period. The reduction in unit cost is a post-2006 China-specific phenomenon. The production process of bulk carriers (on which this study is focused) is quite old, and there was no major technological breakthrough in the year 2006.

Consequently, the entire difference between the pre-and-post-2016 cost of production can be attributed to hidden subsidies, which are estimated to be around USD 6-8 million per vessel. Based on this unit subsidy, the total quantum of subsidies works out be around USD 4.5 billion between 2006 and 2012.

There is one pattern that is not explicitly discussed, but which should be obvious to a careful reader of the paper. This finding may be more interesting than the actual reported estimates. No matter how one parses data, without subsidies, Japan turns out to be the most efficient and cheapest producer. But once subsidies are accounted for, in the majority of the cases, the Chinese cost of production turns out be slightly less than Japan’s. It is as if the quantum of subsidies is carefully calculated and strategically decided to undercut Japan. No wonder this policy has reconfigured the entire geography of shipbuilding industry.

Seen in purely economic terms, the quantum of subsidies is hard to justify in a rigorous cost-benefit exercise. As per the counterfactual analysis, these subsidies marginally reduced ship prices and freight rate. Because the reduction was marginal, final consumers (that is consumers of the shipping services) gained around USD 400 million. As explained earlier, even the cost to Chinese exchequer was much higher (around USD 4 billion).

It would be a mistake however to assume that such policies are driven by vanity and ‘national pride’ alone. Shipbuilding has substantial backward and forward linkages with other sectors such as steel and engineering construction. There are strong dynamic ‘learning-by-doing’ effects as well. As Andrew Erickson notes: “It typically takes about 10 repeats in the construction of a given type of ship to maximize production efficiency”. Besides, commercial shipbuilding industry has strong complementarity with the modernization and expansion plans of the Chinese navy.

How should Indian policymakers deal with the Chinese challenge? There are three potential courses of action. The simplest of them would be to match Chinese subsidies penny-by-penny. The difference in financial capacity implies that this may not be feasible. Even the institutional context may be different: Chinese subsidies are often routed through state-controlled financial institutions that face little scrutiny. Replicating such opaque arrangements may not be even desirable in a democratic setup where the parliament is supposed to control spending in a transparent manner.

The second option would be to explore the possibility of technological cooperation with nations such as Japan and South Korea, which have been adversely affected by the Chinese industrial policy. It should be remembered that even though shipbuilding is a capital-intensive business, low-skill labor costs still account for about one-sixth of the entire cost-of-production. If production in India can slash the the wage bill by half, much of the impact of Chinese subsidies could be absorbed.

A third option comes from the recognition that the bulk of Chinese ships are exported. Giving subsidies to export-oriented units is against the spirit, if not the letter, of the World Trade Organization rules. A public discussion of such distortionary practices may raise the cost of continuing with the subsidy policy.

[Note: The figure and table used in the article are reproduced from the NBER working paper version of the above cited paper. Reproduction is only for the limited purpose of discussion and comment as per standard fair use practices. (c) 2014 by Myrto Kalouptsidi.]

About the author

Avinash M Tripathi

Avinash M. Tripathi is an Associate Research Fellow (Economics) at the Takshashila Institution. His research interests include competition policy and financial risk management. He prefers a profound answer to a silly question rather than the other way around.