Business

Saturday July 18, 2009

The global value chain


THINK ASIAN
By ANDREW SHENG

Asian corporate strategies play a great role in the development of Asia, but their limitations are also the limitations to Asia’s growth. Asia’s great success in its export-led manufacturing strategy was attributed historically to Asia being monsoon economies, where the seasonal nature of rice farming led to Asians being culturally adept at working together in rice fields and in the dry season, skillful at weaving and other handicrafts, so that the agricultural labour force adapted quickly to assembly-line manufacturing. Of course, forward-looking government policies to open up to foreign manufacturing, the attention to social infrastructure and education helped to equip their economies to copy, learn and then slowly move up the value chain.

Japan’s export-led manufacturing strategy was successfully imitated throughout East Asia and in the famous flying geese formation, the four Dragon economies (Taiwan, South Korea, Hong Kong and Singapore) followed by four Tigers (Malaysia, Thailand, the Philippines and Indonesia) rapidly formed the global supply chain. China did not emerge as an export giant until the early 1990s, but today forms the core of the supply chain by sheer size and market capacity. No regional corporation with global ambitions can ignore its China strategy.

South Asia went a slightly different path. Heavily influenced by Fabian socialist philosophy, the region adopted a protected import-substitution strategy, so that its manufacturing prowess could not compete with East Asia. But India was able to find a market niche in IT services, exploiting its large human talent in science and mathematics in knowledge-based work. Nevertheless, Indian manufacturers, particularly family-based companies, have become formidable competitors globally in steel and other areas.

But the Asian corporate and economic strategy had a fundamental flaw. In mobilising savings to invest in manufacturing, East Asian governments typically protected the services and distribution sectors, so that the financial sectors were not well developed. The result is that trade surpluses generated from manufacturing exports remain largely intermediated via Western banks and the financial centres of London, New York, Hong Kong and Singapore, rather than through domestic capital markets.

Ultimately, this dualistic strategy – strong in manufacturing, weak in financial services – led to the Asian crisis and also the global imbalance. Of course, Western banks also failed because they did intermediate their savings in a prudent manner, but we must understand where they failed before Asians can avoid the same mistakes.

As my forthcoming book, From Asian to Global Financial Crisis to be published by Cambridge University Press in the autumn will demonstrate, the global supply chain is a network and the Asian and current financial crises are in effect network crises. First of all, Asian manufacturers learned that Metcalfe’s Law works through the cluster and economies of scale effect. Metcalfe’s Law states that the value of the network is exponentially related to the number of users. In their search for scale, Japanese, South Korean and today Chinese firms have expanded at almost any cost, very often through high leverage, incurring huge risks.

But if you look at value chains, you discover that there are three key parts – the manufacturing, distribution and trading side. A T-shirt could cost less than US$1 to manufacture, but the distribution, marketing and trading costs will take more and more margin, so that the final product could be sold for more than US$20–US$100 depending on the design, branding and quality. You can imagine how much profit the cotton farmer gets from his sales of raw cotton.

East Asian corporations are waking up to the fact that as their production becomes commoditised, and even high-value items such as mobile-phones and netbooks have become commodities, the value chain or profit lies more in the trading and distribution side. The key question is whether these corporations have the skills and ability to exploit value in this part of the game, which is currently dominated by Western firms. This is not for want of trying.

Japanese manufacturers initially used trading houses (sogoshoshas) such as Mitsubishi, Mitsui, etc. to source their raw materials and in-house banks to finance their trade. Gradually, as the manufacturers gained confidence, they established their own distribution chains, so that you can find Sony and Toyota manufacturing and distribution companies throughout the world. The relative role of the trading houses diminished, but not before a few, like Sumitomo, lost money trading commodities.

In my experience, one thing is remarkable: Asian companies have not yet established world-class trading companies. The reason is that the trading side is the most knowledge intensive and individualistic of business. This is not to say that a few, like Li and Fung, have not pioneered in the distribution and services side of the export supply chain, or Wilmar in trading, distribution and production of edible oils. But it is obvious that despite the efforts of particularly the Japanese and Singaporeans, no Asian houses have successfully established investment banks or made consistently large profits in proprietory trading on a global scale. Hong Kong’s home-grown investment bank Peregrine blew up in 1998.

You only have to read the autobiography of Robert Rubin (In an Uncertain Age, 2003), how he grew up in the tutelage of generations of traders and bankers, before you realise the specialist and deep knowledge embedded in old houses like Rothschilds, Morgan and Goldmans. It takes a lot to breed a great trader; so much easier being a property developer.

·Datuk Seri Panglima Andrew Sheng is adjunct professor at Universiti Malaya, Kuala Lumpur, and Tsinghua University, Beijing. He has served as adviser and chief economist to Bank Negara, deputy chief executive of the Hong Kong Monetary Authority and chairman of the Hong Kong Securities and Futures Commission.

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