Aztec Eagle, Chinese Dragon: Human Capital Spillovers in Global Value Chains

I recently completed the last draft of my forthcoming paper titled: “Aztec Eagle, Chinese Dragon: Strategic Rivalry between Mexico and China in Global Value Chains in the Context of the Trans-Pacific Partnership”, whose title is largely self-explanatory – I examine just how interstate legal arrangements (free trade deals) can influence the competitiveness of a nation’s trade.

But here I’d like to briefly explore an issue which is not the main focus of the paper, i.e. the effects of ‘upgrading’ (moving up to high-margin manufacturing in the specific case of the paper) in global value chains. My article is all about the rivalry between Mexico and China in obtaining that prized position as the last rung of the ladder before reaching the American consumer. Here, I’d like to ask why they do so.

The simple answer is that countries seek to extract more margin from their produce and that is certainly true here. But there’s one more great benefit of being at the very top of this ‘food chain’ – human capital spillovers. The general idea of such spillovers is that entities which interact a lot have quite significant spillover effects, i.e. a Mexican manufacturing hub (with lower levels of human capital stock than its American peers) will accumulate more human capital from interactions with its business partners. At the factory level, see this study for an empirical analysis.

So why are Mexico and China positioning themselves to be in as close contact as possible (their economic clusters at least) with the American multinational firms running the whole global value chain? Not only do they get a larger slice of the revenue pie, but they can also keep on accumulating human capital and moving up to generating more value, through the following effects:

  1. More human capital stock spilling over leads to productivity catch-up
  2. Which in turn leads to higher value added
  3. Leading to the emergence of more innovation in the economy initially poorer in human capital
  4. Bringing this economy closer to the technological frontier (this is economic development!)

Quite obviously, both Mexico and China want to keep growing and avoid the middle income trap, so ‘leeching’ human capital off more advanced economies is definitely a good strategy, not only in manufacturing, although the manufacturing effect is probably most visible in both countries as their growth models are largely based on goods exports. There are some voices arguing that human capital spillovers don’t, in fact, have the effect I described above, but I think it’s safe to say that they are in the minority.

How are Mexico and China doing in catch-up based on human capital spillovers?

So how are the Mexican and Chinese efforts to perform the human capital leeching stunt going? To understand what’s happening in these two economies, we first have to examine what global value chains, the mechanism these countries are counting on for spillover, are. As I write in my paper:

Craig and Mudambi provide a definition and rationale for global value chains, by stating:

“GVCs exist when production is disaggregated into constituent activities and geographically dispersed. They incorporate all the activities related to producing a good or service and delivering it to the end user. The fragmentation of GVCs into constituent activities is of particular interest to the advanced economies like the U.S., due to its high wage rates and relative openness “.

The same authors go on to observe, that in the last two decades global value chains have changed the nature of international trade, as they have allowed dividing manufacturing or business processes into increasingly smaller modules , each of which can be produced and/or supplied by a specialised cluster of production or services . This has implications for all trade rivalries. While in the cited example of Chinese and New Spanish products reaching Europe in the colonial period, this produce was made or extracted from start to finish in the countries of origin, today most globally-traded products are manufactured using a series of imports and exports of increasingly complex and higher value-added merchandise.

The world economy has gone from a dominant role of trading in end products to participating in value and supply chains, where the higher up in the process you are, the higher the rewards and the more complex the technology and inputs required. As always, being close to the final consumer pays, but the structure of modern trade has raised the stakes. Therefore, each production cluster, such as the Chinese coast or Mexican industrial heartland, strives to offer technological and logistical excellence within highly-specialised clusters of production, knowledge and know-how. These clusters are the immobile element of global value chains, while companies operating some (or sometimes most) of the stages of global production are a highly mobile component. In this paper I focus on the immobile part – the clusters , which use economies of scale and agglomeration to achieve a comparative advantage and move closer to the end-product link of the GVC.

Thus the context of Sino-Mexican rivalry is that world trade is increasingly broken down into modular specialised hubs for specific components of the given value chain.

And for many products and lead companies (the multinationals coordinating or controlling the value chains) there is just one hub for the highest-value-added production – at the very end (and technological frontier) of the process. So it follows that whoever gets to occupy that position in the trade routes leading from Asia to North America will have the greatest chance of rising to rich-world status. These are the stakes and in the case of Mexico and China, as far as I can tell, the winner takes it all – they’re competing for the same market in largely the same export products.

Fair enough, we have to ask then who is actually winning. Up until recently this would be China:

Figure 1. Global export volumes, Mexico and China, 1963-2007 (in billions USD)

mexico china

Source: WTO, International Trade Statistics 2007, http://www.wto.org/english/res_e/statis_e/its2007_e/its07_toc_e.htm (23.02.2014)

 

Both worldwide (above), and in the American market (see below):

Figure 2. Mexico and China: exports to US 2000-2007 (in billions USD)

mexico china

Source: U.S. Census Bureau, U.S. Imports for Consumption for Selected World Areas and Top Ten Countries, Foreign Trade Statistics

But the tide is turning, especially so with the ongoing negotiations on the Trans-Pacific Partnership (TPP). Mexico is poised to gain access to countries specialising in very cheap labour (e.g. Vietnam, Cambodia, Indonesia), solving its sourcing problem, and it already is an active participant in NAFTA, opening up the possibility of a global value chain running from the mentioned South-East Asian countries, through Mexico, to the US, leaving China out in the cold.

This, of course, might well contribute to the fact that it will be Mexico powering away from China in GDP per capita terms, rather than the Middle Kingdom catching up. After all, more direct interactions with the American consumer market and technology- and human capital- rich lead companies, equals more catch-up.

In the paper I point out Mexico’s strengths which can lead to this outcome:

Returning to Mexico’s efforts to position itself at the top of the Asian-North American GVC, this Latin American country has several key competitive factors, which may enable it to achieve or retain its high-margin manufacturing position:

1. Lower transportation costs

2. Less time from manufacture to market

3. Easier communication and supervision of production

4. Greater flexibility for changes in production

5. More transparent government regulations

6. Better protection of intellectual property

Meanwhile, China…

is faced with several key challenges:

1. The appreciation of the Chinese yuan

2. Rising labour costs in the industrial core

3. Rising costs of imported inputs

4. Growing demand from China’s middle class

5. Increasing shipping costs of finished goods to North America

And since the political considerations of the TPP don’t favour China joining this club in the foreseeable future, I conclude:

Mexico’s current advantage is its membership in the NAFTA trade bloc, giving its products preferential access to the American consumer, while China’s forte is the FTA signed with ASEAN countries, providing it with an edge in low-cost sourcing. Thus, while China is still the dominant exporter in Asian-North American GVCs and seeking to upgrade and move into higher-added-value manufacturing, the implementation of a TPP including Mexico will put it at a distinct disadvantage in comparison with the Aztec nation.

The introduction of the TPP may re-establish healthier trade relations between Mexico and the US which were eroded to a certain degree by China’s aggressive trade expansion. The agreement in question goes far beyond tariff reduction, introducing many measures promising to streamline supply chains and harmonise standards. In all, by staying out (or being kept out) China risks losing significant market share to its Mexican rival and, in consequence, falling into the middle income trap, as it fails to move to higher value-added activities.

In other words, I’m betting on the Aztec Eagle in this race to accumulate human capital. While there are many other factors determining the outcome of the Sino-Mexican rivalry, the one I’m describing here is definitely one of the most important. After all, without sufficient human capital stock you can’t have a modern and innovative economy.

This article is an edited version of the original post which first appeared on the author’s blog: www.janfabisiak.com

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