MACHINERY SECTOR: FORWARD-LOOKING

INVESTMENT RELATIONS

PERSPECTIVE

OF

EU-CHINA

TRADE

&

1. Summary of sector developments During the last decade, trade and investment relations with China have been of increasing importance to European machinery manufacturers as a major export market, a production base or as a location generating more and more visible competitors. We focus on the mechanical engineering sector: which is the leading sub-group within the total EU-25 engineering sector accounting for nearly two thirds of the total EU-25 engineering production output. It includes power-generating equipment (31% EU output) and the much bigger sub-segment of non-electrical machinery (63% EU output) for many different industries (Note: 2004 figures). For electrical machinery as a whole, the EU-25 recorded a trade deficit of USD 45.7 billion in 2004. The biggest contributors to this deficit were office machinery, computers as well as radio, televisions and communication equipment. It is likely that EU-25s deficit with respect to electrical machinery will continue to widen in the next 5-10 years. This sub-sector is not a focus of the study. In 2004 EU-15 held 38% of the world trade in mechanical engineering equipment, while China accounted for only 6%, however with on average 18% growth from 2001 to 2005. The last decade has seen significant investments in this sector as China has broadened its industrial base. A significant shift has occurred away from the dominance of state owned enterprises (SOEs) to private domestic companies and foreign invested enterprises (FIEs). This trend has been driven by SOE reform and foreign direct investment (FDI). Another trend is the reduction of dependence on imports through import substitution. Chinas policy towards FDI has encouraged export-orientated foreign investments, especially through Special Economic Zones (SEZs). Consequently, a large proportion of Chinas surging machinery trade is generated by foreign-invested firms. Power generating equipment- is a restricted industrial sector requiring foreign companies to set up Joint Ventures (JV) as opposed to Wholly Foreign-owned Enterprises (WFOE). Foreigninvested companies (FIE) in this sector tend to be larger than non-electrical machinery producers. Since 2001 China has made substantial investments in the power-generating industry. Overinvestment in inefficient small power generation plants was countered with investment restrictions in 2004. Between 1996 and 2005, China maintained a trade deficit of power-generating equipment with the world, 21% of which could be attributed to EU-25 in 2004. This deficit is slowly reducing and can be expected to achieve a faster turn-around into a surplus than for non-electrical machinery. Meanwhile, Chinas average annual exports of power-generating equipment have soared. In March 2006, FIEs made up 18% of all companies operating in the Chinese powergenerating equipment sector and constituted 33% of the total Chinese industry sales. Both importers and Chinese manufacturers which have also built up substantial manufacturing capacities of power-generating equipment have been doing well. Nevertheless, 29% of the sub-sector suffered losses in 2005, up from 22% in 2004. Compared with the output productivity of employees in SOEs in 2005 and 2006e, FIEs is over 70% higher, and that of private Chinese companies is over 40% higher. Despite this fact SOEs have the highest profits rates in 2006 due the nature of these pillar industries which have economies of scale and are supported by direct and indirect government subsidies and technology transfer. However, SOEs have much lower return on investment (ROI) than both FIEs and private Chinese companies. The non-electrical machinery sub-sector, where private Chinese companies dominate more than in the power-generating equipment segment, has also seen significant SOE reform. In 2006, FIEs made up 17% of the total number of companies with a share of 28% of the industrys sales value. They are either larger and/ or more productive than their Chinese counterparts. As with the power-generating equipment industry, FIEs in the non-electrical machinery segment are far ahead with respect to their output productivity. Here as well, China is still dependant on imports. Nonetheless, Chinas exports of non-electrical machinery are

growing fast (average of 33% annually from 2000 to 2004). The trade deficit here is likely to remain beyond 2010 before it turns into a surplus. Chinese manufacturers are already establishing a strong foothold in the world market for lowand medium-tech machinery. They are not yet advanced enough to supply high-precision, high-tech machinery but China is a leading supplier in mass-scale production of lower valueadded machines and components. The main driver for Chinas export growth in both sub-sectors is the cut-throat competition in the domestic market, caused by excessive capital investment. Despite almost all input factors of production becoming more expensive, prices for machinery and equipment have on average dropped. 15% of machinery companies producing in China made losses in 2005 (31% of these companies were FIEs). Some 23% of all machinery companies were unprofitable in March 2006. Despite this SOEs are to some extent sheltered through government support. For both sub-sectors it is likely that the average SOE in China would make a loss if they had not received government subsidies. A cycle has emerged during the last 5-10 years as described in Figure 1. SOEs and other Chinese operators make capital investments and upgrade production facilities, partly with the help of subsidies and other support from state and especially local governments. FIEs also invest in local manufacturing. Foreign technology pours into the country via foreign direct investments, via technological partnerships or via imitation. Domestic production capacity increases and improves. Overinvestment/ competition and a lack of real cost accounting (subsidized industry) results in downward spiralling of prices despite a parallel increase in costs of industry inputs. The price pressure is augmented with the development of sales in less developed regions of China (rural areas), which call for cheaper products. Chinese companies continue to advance their technical quality through a combination of R&D, technology transfers and copying or adapting foreign innovations. The market position of foreign companies is therefore seriously threatened and we should expect their profits to fall, or that they potentially leave the market. A broadened installed capacity in an already overcrowded domestic market leads to increased export volumes, with the added advantage that Chinese companies experience better margins through export. As competition in export markets increases (e.g. Southeast Asia) the cycle requires renewal with the opening up of more advanced markets for Chinese products. This is likely to result in increased technology pressure on Chinese companies and further exploitation of foreign-owned IPRs. European investors are increasingly compromised by market access obstacles, investment restrictions, loss of IPRs and through competition with subsidized competitors. Many rules, regulations and practices are not fully implemented by authorities as the Chinese government favours import substitution. Note: there is growing concern amongst European operators that Chinese exports to third markets are supported by government incentives to host countries (e.g. barter deals for oil).

Figure 1
1. Capital investments (+subsidies) European/ international technology transfer

In summary, the Chinese competitive strengths are characterized by: -Low cost production -Subsidised operations -Cheap IP acquisition -Protected markets -Government support in export markets

4. Exports to third markets

Threat to European manufacturing Sector

3. Market consolidation Price Wars

2. Improved domestic production and larger capacity

Import substitution policy

2. Future development scenarios Scenario 1 Power-generating equipment:

Assumptions: 1) Domestic Chinese consumption (demand) for power-generating equipment to grow 25% p.a. on average until 2010 (compared to 40% per year 2001 to 2006e), to increase installed capacity for power generation. 2) Domestic investment in production capacity remains strong. SOEs and private Chinese companies upgrade. Expansion of their local production value by 35% p.a. on average 2006-2010 (down from 40% 2001 to 2006e). 3) FDI in production capacity extension weakens: Growth of production output 25% (2006 to 2010) compared to an average growth of 52% (2001 and 2006e). Further expansions likely to be smaller. With the diversification of energy sources, smaller manufacturers of more specialized equipment will seek a market entry in China. 4) Imports are to grow by only 15% p.a. (2006 to 2010 down from an average of 25% in 2001 to 2006e). Local production increasingly replaces imports. Regardless of import substitution trends, the domestic market will still require high value-added equipment from abroad. 5) As the domestic market saturates: the will be a shift from domestic to international markets. Outcomes: Large scale, quality domestic production in China is increasingly crowding out imported machinery. The level of production pushed into exports in this scenario is expected to reach 32% of the Chinese output in 2010. The value of import will reach the value of exports by 2008.

Scenario 2 Power-generating equipment:

1) In this scenario FDI slows down, resulting in less output growth of FIEs in China 2) SOEs and private Chinese companies continue to expand their production capacity. Eases market pressure on domestically producing firms. Catering for domestic markets first, export share of local manufacturers in 2010 would rise to 23% (compared to 32% in the first scenario), stabilising its average annual growth at 26% p.a. (2006 to 2010). In this scenario the value of Chinese exports will reach the value of imports into China in 2010.

Scenario 1 - Non-electrical machinery:

Non-electrical machinery segment comprises machines and components for many different industries and applications, hence more difficult to predict. Specific client industry developments/ policies e.g. agricultural equipment might continue to experience high growth rates from 2006, or heavy-duty machines used in the building industry, the cement and steel sectors are likely to continue to suffer from government measures aimed at reducing excessive investment. Assumptions: 1) Domestic Chinese consumption (demand) of non-electrical machinery and equipment to grow by on average 20% p.a. from 2006 to 2010 (compared to 30% per year from 2001 to 2006e). Limitations in current income levels of Chinese households a factor for capital investment of companies. 2) Investment in production capacity remains strong with domestic firms upgrading facilities and continued FDI. Marginal drop in sales growth. 3) FDI slightly lower, hence growth in local production of FIEs levels off at an annual growth rate of 25% for the years 2006 to 2010 (compared to average of +38% p.a. 2001 to 2006e).

4) Imports are assumed to grow by an average annual rate of 15% for the years 2006 to 2010 (compared to 27% from 2001 to 2006e). Increased competition induces Chinese companies to move up the value chain by upgrading their technology and increasing exports. 5) Export push if domestic market too competitive. All scenarios consider stable exchange rate and macro-economic/ political conditions Outcomes: Exports from China to the world markets in this scenario are set to grow 34% on average per year from 2006 to 2010. Strong competition in the Chinese market drives domestic producers to adopt more professional export strategies. Export value expected to almost reach the value of imported machinery in 2010. The market share of imported machinery in the Chinese machinery consumption of nonelectrical machinery would then decrease to 27% by 2010, down from the current level of 32%.

Scenario 2 - Non-electrical machinery:

1) Again, the second scenario assumes the investment environment for foreign investors will deteriorate (costs of doing business in China, competition). 2) Hence, additional investment by foreign machinery manufacturers slows, growth in foreign-invested companies revenues is assumed to be on average 10% p.a. (2006 to 2010). Outcomes: The average annual growth in exports from China would stabilise at 22% from 2006 to 2010, cooling down from an annual average growth rate of 35% during the years 2001 to 2006. Chinas export value would reach almost 70% of the import value in 2010. Imported equipment would meet 22% of the Chinese non-electrical machinery demand in 2010, down from 34% in 2005. To summarise the scenarios outlined above, we believe that both foreign and local machinery manufacturers investment behaviour will be of major importance for Chinese export development. The extent of the investment depends on many factors, especially the attractiveness of the Chinese manufacturing environment relative to other low cost countries and the availability of capital and incentives from banks and individuals (including subsidies).

3. SWOT analysis of European and Chinese machinery sector Europe China

Strengths - Innovation/ technology, quality, brand, customer service - In 2004: EU-15 accounted for 38% of world trade in mechanical engineering machinery China only 6% (34% in 2001) Strengths - Low manufacturing costs - Rapidly evolving domestic industry/ technology/ know-how - High export growth (First targets: markets with lower quality requirements, i.e. Eastern Europe, SE Asia, Middle East and South America) - Fast/ opportunistic Weaknesses - High manufacturing costs, associated with R&D and production in home markets - Slow business decisions Opportunities - Large Chinese market Weaknesses - Lack of innovation/ technology, quality, brand, customer service level - Low efficiency, low ROI Opportunities - Increasingly access to foreign IP

- China: Low-cost production - Competition: catalyst for innovation - Fostered environmental policy Threats - No level playing field for EU firms in China: Chinese companies supported by govt. policy, e.g. subsidies, technology transfer, favourable govt. procurement rules - IPR infringements - Chinese producers incl. foreign-invested companies need to push excess production into exports (3rd country markets)

(partnerships/ technology transfers and other techniques) - Government support for import substitution, esp. to the benefit of SOEs or local champions Threats - Too much competition in own low-tech segment, makes profit margins fall - Prices for production factors (e.g. wages, land) rise fast in China, making imports from EU relatively cheaper - Enforcement of WTO agreements, falling import quotas - Reverse of rules discriminating foreign competitors

4. Obstacles to trade and investment

Discrimination and market access: Some government ministries (backed by NDRC) are reluctant to remove market obstacles for foreign competitors because China is not a developed country. Chinese domestic companies/ industries would potentially lose out if they competed with foreign companies on a level playing field, i.e., without government protection. Local content requirements: The Chinese government is reverting to its old practice of encouraging foreign manufacturers to comply with some of the formerly mandated practices in biddings for government projects. i.e. 70% local content rule is enforced in government procurement projects for imported machinery and equipment e.g. wind generators. Apparently, some SOEs as customers of FIEs in China demand 70% local content of purchased equipment as well. Investment rules: The Government attaches certain ownership restrictions to companies supplying power-generating equipment. Foreign enterprises cannot enter the industry as wholly owned foreign enterprises (WFOE) but must establish JVs with domestic partners. Government Procurement (GP): In 2004, GP accounted for <1.3 % of Chinas GDP. However, public spending was approximately 15% of GDP (not formalized as GP). This results in grey area where public spending can be allocated straight away to local bidders only. Subsidies: This concerns areas such as the transfer of ownership including cash grants/ debtfor-equity swaps/ interest subsidies/ debt forgiveness and deliberate extension of nonperforming loans/ currency management/ energy and raw material subsidies. Even without state level support for SOEs the local governments which provide the vast majority of subsidies currently are not bound by any international agreement. Intellectual Property Right Infringements: Average Chinese manufacturer cannot afford to allocate much of its earnings to R&D (est. less than 1% of turnover). Product development efforts are often limited to re-engineering of foreign advanced machinery. R&D activities include simplifying foreign machine models/ adaptation to the local market/ copying or simplifying single machinery functions is also common.

Costs of obstacles to industry: (Results of feedback from industry questionnaires)

1. Administrative costs associated with delays following all manner of protectionism 2. Loss of revenue because of subsidized markets (approx 10% sales price) 3. Loss of IP investment and from this market share (most significant long term impact)
5. Policy recommendations by priority

Improve protection and enforcement of Intellectual Property Rights (IPR) Eliminate industrial policies that discriminate goods of foreign origin in the Chinese market

Note 1: 1)Implicit and explicit measures adopted by the Chinese government to ward off foreign competition in key domestic industries such as technology transfer and local content rules for certain types of machinery are not in line with the WTO agreements and should therefore be terminated. 2) China signed the Agreement on Subsidies and Countervailing Measures (SCM) However, this agreement does not affect the local governments subsidies to state-owned enterprises, which accounts for the vast majority of the official subsidies.

Effect Chinas ratification of WTOs Government Procurement Agreement (GPA)

Note 2: Often there are explicit or implicit local content rules on compulsory technology transfers as a precondition for the Chinese government accepting the bid of a foreign firm. The latter is a serious threat for EU machinery industry as their long-term competitiveness is entirely dependent on their technological edge.

Support Chinas opening of the banking sector

Note 3: Chinese state banks are one of the major tools used to subsidise state-owned enterprises.

Lobby for a revaluation of the Chinese Yuan

If the aforementioned issues could be resolved/ improved, EU-25 machinery companies could engage in business in China without fear of losing competitiveness due to market obstacles

Supporting competitiveness of European industry in Europe:

Although not covered in this report there are topics that could help to strengthen the economic environment within the EU as well:

Improve the financing options for small and medium enterprises (SMEs) in Europe to provide enough capital to participate fully in an economic upswing Liberalizing labour markets Making taxes more consistent and transparent, lower taxes Supporting innovation/ education

6. Recommendations for competitiveness

Leverage cost benefit of China market within global operations Foster innovation, research & development especially energy efficiency and renewable. (High probability of losing IP in China. Issue will be to lose it at a time when it is less important.) Streamline costs, increase efficiency Operators need realistic assessment of their products market potential and risk in China Identify and compare alternative investment locations in Asia

7. Selection of findings from the industry survey (provisional)

Figure 2- How competitive are Chinese enterprises operating in your core sectors in the Chinese market?
56% 38% 31% 31% 25% 19% 6% 0% Today 1 little importance 4 significant importance 2 some importance 5 utmost importance 0% In 5 years 3 moderate importance 6%

60%

% of responses

50% 40% 30% 20% 10% 0%

European ccompanies surveyed expect competition from their Chinese counterparts to increase in the next five years. Todays average response rate of 2.6 places the competition of Chinese enterprises at a level of some to moderate significance. This perception increases to 3.5 indicating that companies expect local enterprises to pose an increased and significant threat in the next five years.

* DISCLAIMER
Please note that that the executive summaries of several sectors of the study on the future opportunities and challenges of EU-China Trade and Investment relations of DG Trade being carried out for the European Commission are preliminary results. Therefore, the Commission accepts no responsibility or liability whatsoever with regard to the information in the summaries or for any losses or damage resulting from the information being quoted or used in any other manner.