A core message of “quality not quantity” was apparent in the work reports presented to the National People’s Congress in March as China reinforced its plans for the future of foreign investment.
Introduced last autumn, this policy indicates that Beijing will no longer welcome foreign investment or exports in two categories: products that consume large amounts of energy or create much pollution in the production process; and products that involve a low level of skill and rely on cheap wages, energy and materials.
The primary means of addressing this is through taxation: The value-added tax (VAT) rebates that once helped manufacturers protect their profit margins have been reduced or revoked.
For products in the first category – primary industrial goods such as cement and raw chemicals – the thinking is easy to follow. China wants to reduce consumption of energy and raw materials and to clean up its environment. It would be irrational to support investment in areas that directly conflict with this policy.
Meanwhile, the decision to no longer support products in the second category, such as toys and textiles, is backed by two policy objectives. First, China would rather nurture the use of new technologies than support industries in which it has already mastered the skills. Second, China is aware of the frictions cause by its trade imbalance and will therefore no longer encourage production of low value added products targeted primarily for export.
It is important to note that the goods in these two categories represent much of what China produces and exports. For many manufacturers, the VAT rebate on these goods is often the entire source of profit – and so removing it is essentially a notice to stop production. As such, a degree of local resistance in certain areas is to be expected.
But the initial amendments to VAT rebates, introduced on July 1, 2007, illustrate in very concrete terms how the policy is intended to work. Furthermore, the appointment of the China Customs Bureau, an agency controlled by the central government, to police the system suggests that Beijing is unwilling to stand for local intransigence.
As a general rule, China imposes a 17% VAT on all exports but, in order to encourage manufacturers, a 13% rebate of these exports has been available. On July 1, though, the Ministry of Finance completely revoked the rebate for high pollution/high energy products. For low value added products, the rate was reduced to as low as 5%.
The changes applied to more than 9,000 export items across 1,718 product categories.
A look at the impact on a specific product type shows how the change in VAT rebates fits within the new trade policy. Steel is a good example, as it implicates all of the concerns raised by the new policy – production uses large amounts of energy and raw materials and causes pollution, while exports of raw steel involve no additional value added and cause trade friction.
However, other goods made from steel involve varying degrees of value added and the rebate changes reflect this.
The VAT rebate for steel pipe, which involves no value added, is reduced to zero. Moving slightly up the value added chain, cast iron house wares and stainless steel tableware now qualify for a rebate of 5%. For power tools, the rate is 9% and for more sophisticated cutting and shaping tools it is 11%.
Both the Chinese manufacturers and the foreign buyers were surprised by the decision to focus on low value added products and the use of the VAT rebate as a mechanism for enforcing the new policy.
The first response of Chinese manufacturers was to absorb the increase, dealing with it through substitution of components and ingredients. This was a major factor in the large number of quality issues for Chinese goods that arose in the second half of 2007.
Now that contracts are being renewed in 2008, manufacturers are seeking to pass on the entire tax increase to their foreign buyers. Together with renminbi appreciation and the costs of the new labor contract law, most foreign buyers of these products are seeing increases of 10-20%.
This is a major change in such a competitive market. But having looked at switching to suppliers in other countries, many foreign purchasers concluded that there is currently no real replacement for the scale and expertise offered in China.