Factory Closing: Why Is Anyone Shocked? This Was Coming…

Wednesday, February 27, 2008 9:33
Posted in category The Big Picture

The last couple of weeks has been an absolute flurry of reports and posts on the factory closings in the south, and I am a bit surprised by the coverage.

It has been linked to snow, labor shortages, to the RMB effect on trade, and a move to new low costs bases, and so on… and what makes me laugh a bit is that this is something that could not only be seen coming from a long way off, but where I think many reports are actually off is that they have failed to take into account a MAJOR cause of these closures.

These businesses were losers to begin with, they were being propped up by an inefficiency, and they would have closed in short order anyway.


1) First, let’s look at the announcements.  The Asia Footwear Association and Federation of Hong Kong Industries who are claiming that they are seeing large amounts of closures in the Guangdong province due to labor costs pressure.  No doubt, this accounts for a portion of this.  These are industries that are in constant need of labor, and apparently the members of both associations are in need to cheap labor. 

Next, let’s look at who is not making the announcements. I have not seen any announcement by Nike that they are moving, I have not seen any announcement that Addidas is moving, I have not seen an announcement that any other foreign brand is moving….and as my friends working in this company have not told me telling me about massive labor woes

so, my first conclusion/ assumption is that the organizations being referenced in these article are the those who have been consistently the lowest on the wage scale… and have only survived because they have exploited workers, and dodging a host of other things.

2) Let’s look at the articles for a moment.  14,000 factories are closing and larger factories are moving inland. So where are the little ones going?

Well.  I will provide two guesses: (1) they closed or (2) they were consolidated

With respect to the potential idea that they closed, it is important to remember just how fragmented many industries in China are: particularly in textile & footwear, but also in many others (cement, fiberglass, logistics, real estate development, food, automotive, etc).  Name an industry, and one can easy see where there are significanlty more companies today than there will be in 5 years.  It is something that crosses every provincail border in China, but it is something that is changing.. and fast.

BEsides domestic M&A activities dricing consolidation, we are now seeing local brands become regional brand and reginoal brands become national brands… and this dynamic is forcing a lot of waste (i.e. poorly funded and managed companies) to be removed from the system (i.e. closed).

3)  Let’s review the last 18 -24  months of policy.

Over the last 18-24 months (really 36) there has been an enormous amount of activity on the regulatory and monetary side that have impacted local manufacturers.  Of course, it has impacted foreign investors as well, but contrary to popular belief in many circles the steps taken to rework the M&A, labor, investment, energy, logistics, and other laws were done so with domestic considerations as a priorirty. … and in nearly all cases, whether fully enforced or not, it was the domestic manufacturer who was hit the hardest.

with respect to this thread though, it was the labor and tax laws that I think one can draw a direct connection to.  Many smaller shops closed as a result of these new laws, and while it hit the larger shops, they have been able to weather the storm a bit better

from the monetary perspective, you have the RMB and VAT.

The RMB has made prices for everything exported nominally more expensive, and it has surely had an impact, but it was the reduction of the VAT rebate that really hurt.

Reduction of VAT rebates over 3000 categories.. impacts those who are not adding value, but is a death blow to anyone who works in low margin industries that require low labor content (think steel stamped parts).  Those who were integrated, had a product portfolio, and had some market power were able to weather the storm – and even potentially pass on some of the increased cost.

Vice Chairman Michael Duke confirms much of this in a recent CNN quote

productivity improvements by its Chinese suppliers are helping to offset rising costs due to inflation and an appreciating yuan.

Take all the above, put that together, and where I am leading this horse cart is that while there are surely some factories who are moving to other areas of China, and there are surely some who will make it to other markets like Vietnam, the fact is that a large percentage of these organizations were losers and closed because their industry simply did not require them anymore.

They were unable to scale, they were unable to add value, and after VAT/ RMB/ rising costs were calculated they were no longer profitable.  It is a trend that many in China have been watching, and hoping for, for a long time, and it is simply a process that every mature economy goes through…

and where I think everyone should pay attention is that if your supplier recently moved because of costs, I would strongly suggest you look deeper into their operations before placing anymore orders…

Stay tuned.  I have written a sister post to this that looks at the recent news of china’s exporting of inflation where I question the logic behind that as well… and the third post on  all those reports of factories leaving for Vietnam is in the planning as well…

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14 Responses to “Factory Closing: Why Is Anyone Shocked? This Was Coming…”

  1. Jay Boyle says:

    February 28th, 2008 at 3:56 am

    Great post Rich! I would also like to add that China has recently enacted a new bankruptcy law that allows companies to close and assets and capital to be redeployed. The Chinese economy is still very inefficient but In my humble opinion this is real progress in the Chinese economy.

    Jay

  2. Josh UK says:

    February 28th, 2008 at 4:45 am

    As you mention, I am pretty convinced that Vietnam will be the next move. The next five years represents significant benefits for markets which are mature and operate on low margins (e.g. clothing). I’d say it’s five years behind China…

  3. Rich says:

    February 28th, 2008 at 5:05 am

    Hi Jay — Long time no see on All Roads. Business must be good! This inefficiency is smething that I see as an opportunity for best in class. I spoke to EU Chamber this morning on Green Supply Chain initiatives, and this was a point I hammered home…

    Josh – For your group, do you see Vietnam as an expansion of Asia operations, or a destination after pulling out of China? Both are very different, and I suspect that you will see more of the former – less of the latter – but that a real pulll away from China will result in more love for other regions of the world (EU will look to eastern europe – US and Mexico – etc).

    Hope all is well
    R

  4. Josh UK says:

    February 28th, 2008 at 9:12 am

    Personally, and how I portrayed it in a senior management presentation, was that it would be an expansion of operations for us. But we’re only in the early stages of sourcing from Asia really (1.5% of our material purchase comes from LCC sources – 2/3 of that from China). We will definitely not be pulling out operations from China, we will expand on them instead. But as I say, we’re a sourcer, not a manufacturer. For manufacturers and mature markets, the move inland, like Chengdu as you know, is and will continue to happen first, before shifting over to Vietnam.

  5. Josh UK says:

    February 28th, 2008 at 9:14 am

    Oh and on the subject of Eastern Europe – Ukraine and Slovenia represent significant possibility. Current thought is that the new Central Europe will fall in line more with labour prices of the EU. In my opinion of course…

  6. Jay Boyle says:

    February 28th, 2008 at 7:09 pm

    Another thing that is driving these closings is that Beijing has recently shuffled some municipal officials around and started to enforce pollution laws. Many factories in the smaller towns remain open because they are in effect subsidized through guangxi or relationships.

    Many of the private factories that I have done due diligence on over the years don’t have the proper land use rights, are on the residential electricity grid, do not have the pollution control equipment and are not paying their workers pensions and other taxes. They were never sustainable.

    Jay

  7. Rich says:

    February 28th, 2008 at 7:41 pm

    Thanks Josh

    With regard to moving to Chengdu, that is typically 2nd/ 3rd investment for many firms who are in China, and I have a post going up about that regions soon to be export based market…. which will result in an interesting dynamic

    with regard to your firm’s choice to further invest in China, and to invest in other countries, this goes to the heart of my arguement. For Vietnam to be the “next China” it really need to draw higher levels of investment.

    Maybe I am wrong, but SE Asia and Aus/ NZ have done well in supplying many of the raw materials China needed, and the play in those markets is moving to some sub assembly. Textiles is the outlier on this. Vietnam has always been strong there, but clothing is much different than auto parts, faucets, ceramic tiles, etc, etc.

    Interesting insights on Eastern Europe. I have had a few people from here tell me about their efforts in that region and some have fared better than others.

    Thanks for the insights!
    R

  8. Paul Tittmann says:

    February 29th, 2008 at 8:12 pm

    My background – 30 years of Asian sourcing , trading business experience. I starting producing in Vietnam in 1992, and my first Canton Trade show was 1977…..

    My two cents on Vietnam – its investor friendliness for manufacturers who need to put in alot of capital is still very poor compared to China .

    One can easily buy and sell from Vietnam – think ‘place a purchase order and trade,” but, its a long way from providing serious manufacturers with what China can offer.

    For companies who have large enough volumes to think of allocating mixes between China and X, then Vietnam is a good choice for 10-15% of their total. Or companies who may buy some thing from China that one market duties high, (think US antidumping duties on candles from China ) , set up production in Vietnam and avoid the duties .

    But no way Vietnam will be the replacement for China.

    One simple problem – Vietnam Logistics infrastructure needs alot more $, and capacity is insufficient to meet even current demands. lead times for shipment s to consumer markets are 25-50% slower than from China ( = cost of inventory of Vietnam purchases a hidden extra cost, often uncalculated in China vs. Vietnam landed cost comparisons made by purchasing types, who aren’t responsible for inventory or cost of capital. )

    The Taiwanese have been masters at hedging their manufacturing investment bets between China and Vietnam ( Taiwan’s Pou Chen Group whose footwear unit Yue Yuen manufactures for adidas, Nike, etc, have roughly 80/20 production splits of their models between China and Vietnam…THEY aren’t making major changes in those % even now )

  9. Rich says:

    February 29th, 2008 at 10:50 pm

    Thanks for your insights Paul.

    It looks like both you and Josh have similar takes on the mixing, and your numbers on the logistics are very interesting. I really think logistics will be a big hurdle over the next 3-5 years..

    With regard to mixing, is Vietnam going to comete with the Mexico’s, Eastern Europe, etc.. or will its real value be in supporting China operations?

    Thanks again. Great insights
    Rich

  10. Josh UK says:

    March 4th, 2008 at 1:43 am

    In my opinion it will support the China operations, it won’t be competition for near to market countries like Ukraine; because they don’t have the same benefits (i.e. Eastern Europe has shorter lead times, Vietnam may be potentially cheaper).

  11. Rich says:

    March 8th, 2008 at 3:50 am

    Thanks Josh.

    R

  12. Michael says:

    April 20th, 2008 at 3:28 am

    How is this region of china’s workers effected. What do you think will happen to labor in this region

  13. madmilker says:

    April 9th, 2009 at 7:44 pm

    12 comments and not one with the letters USA….sad!
    made in America……….priceless!

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