China rushing to escape low-value manufacturing trap

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Wu Zongjun used to be the face of China's growth miracle.

Twenty years ago, armed with a third-grade education and not much else, he started the Yiwu Lianfa clothing factory, one of the legions of small manufacturers that made China the "Workshop of the World," helping lift 500 million people out of poverty.

But now China's policymakers are entranced by the potential yields from sectors such as biotechnology and robotics - they have little interest, complains Wu, in the underwear and socks his once-thriving factory churns out.

"Government support of low-end manufacturing hasn't been good for several years," said Wu, speaking to Reuters from the manufacturing hub of Yiwu, about 300 km (200 miles) south of Shanghai in the coastal export powerhouse Zhejiang province. "Interest rates are too high, labor costs have been rising and we aren't making enough profits."

That's painful for Wu, who cut his workforce by two-thirds down to 100 workers in response, and the trend poses wider risks to the recovery prospects of an economy expected to expand at its slowest pace in a quarter of a century this year.

For all the media infatuation with high-tech firms, low-end manufacturers still make up a large slice of China's economic base, contributing the bulk of the manufacturing sector's GDP share, around 40 percent.

The situation poses a major conundrum for China.

President Xi Jinping's "China Dream" imagines the country competing with cutting edge firms in Europe, the United States and Japan for market share in high-margin industries. Dinky underwear factories don't feature.

Thus Beijing made a calculated decision to prepare its low-end manufacturing sector for retirement, withdrawing subsidies, increasing employee and environmental regulation, and letting the exchange rate appreciate.

The hope was that factory owners would evolve, but so far the result has been weakness: deflating pricing power, shrinking employment and razor-thin profit margins, with knock-on effects on overall economic health.

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"I'm not saying the government wants to get rid of traditional industries," said Stanley Lau, chairman of the Federation of Hong Kong Industries. "But with the actions they are taking and the policies they are launching, they'll eventually kill traditional industries."

That could be a big loss given the aggregate contribution these sectors make, and their role in driving exports.

According to data from the International Trade Center, China had around 80 percent of the world's export market share in the "umbrellas, walking-sticks, seat-sticks and whips" category in 2013, along with similar product lines; much of China's export value-added is still driven by apparel, shoes, toys and furniture.

Made in China 2.0

The "Made in China 2025" program, announced during a major government meeting in February, proposes to restart a move up the value chain that stalled in the aftermath of the global financial crisis, when Chinese firms gorged on stimulus credit to speculate in real estate.

The initiative designates 10 industries, including robotics, medicine and advanced materials as targets for investment and policy support.

Capital has flowed in, driving extraordinary valuations in China's stock market, where the tech-heavy ChiNext growth board now features an average price-earnings ratio of around 140 (the U.S. Nasdaq 100 index stands at 20).

The government says the innovations delivered through Made in China 2025 will trickle down by making factories more efficient.

But that will make it difficult to offset job losses down the value chain, especially if the efficiency gains come from replacing workers with robots subsidized by the 2025 initiative.

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"We have a lot of bodies being absorbed by low-paying jobs, which keeps them employed," said Chi Lo, economist at BNP Paribas. "But in the meantime, high-end industrial labor is shedding people."

Even in advanced economies, the GDP contribution from high-end manufacturing is smaller than one might think; the United States, for example, is still very dependent on bread-and-butter sectors for its economic stability.

Official U.S. data showed that "data processing, internet publishing, and other information services" contributed only 0.5 percent of the country's value-added GDP in 2013, and computer systems design and related services added another 1.4 percent. Meanwhile, the manufacturing sector added 12 percent, and 5.6 percent of that was non-durable goods.

At his clothing factory in Yiwu, meanwhile, Wu is also trying to innovate to survive, albeit more modestly - launching a line of hemp socks he says you can wear for weeks before they start to smell; he's tested them himself.

"It's not realistic to expect everyone to manufacture computers and high-tech airplanes," he said.

"To me, if I can make my socks in an environmentally sustainable way, reducing my use of energy and chemicals, that makes me a high-end manufacturer."