Is China No Longer Competitive?

Tuesday, August 19, 2008 20:55
Posted in category Uncategorized

Yesterday I was asked to appear on CNBC’s Squawk Box to discuss whether or not China still had a competitive edge:

For the interview, we are keen to discuss the impact of high oil prices on China’s manufacturing sector and how that has impacted the global supply chains. Does it still make sense for foreign companies to have their manufacturing plant based in China. Is the low-cost theory still valid with high oil prices.

A simple question, that has been asked more frequently lately as the price of oil surpassed 150 USD a barrel.  There were predictions that globalization would stop at 200 USD a barrel, predictions that firms would return home, and so on.

When addressing these questions, all valid, it becomes more and more clear to me that a rethink of what “doing business in China” means is needed.  it is not a simple thing where a change in the RMB, increase oil, or labor costs will impact everyone, and it is not as simple as each will be impacted differently.  there is now a very wide array of firms who are operating in Chin,  selling to China, or trying to find a way to defend their market against a Chinese product.  To be honest, little has fundamentally changed in that regard in the last 18 months.

With that, here is a list of constraints that I feel play the largest role on a what the impact of macro events may be.  It is surely not the complete list, but it is a start.

1) What is your China platform?
At the most fundamental level, firms with different platforms in China are going to have different exposures to macro conditions, and the impact of those conditions for good or bad will depend on that platform

Traders (exporting Chinese products) will be exposed at a greater level to RMB changes, RMB conversion regulation, China domestic raw material increases, and the price of oil.

Importers (selling foreign products into China) will be exposed on the negative side to higher risk of policy interference and the price of transportation, but will benefit with the RMB appreciate as their goods get cheaper

Manufacturing for sale in China – perhaps the safest model of all in terms of short term shock protection, firms who have successfully established manufacturing and distribution in China will find they are the better insulated against transportation costs and the RMB.

2)  Where is your market?
As I discussed in late last year, the AMCHAM Shanghai report showed that many firms had already transitioned their operations to move away from an export model to a domestic sales model, and this makes a lot of financial sense as global prices for materials rise, transportation costs go up, and the RMB continues to appreciate.

Through procuring ones raw materials in China, paying staff in the RMB, and billing locally, firms have essentially removed the RMB shock from their system (assuming they are using 100% local materials).

Additionally, if a firm is manufacturing and selling into the China market (again, assuming they are using 100% local materials), they have gone a long way to remove the risk associated with transportation as the Chinese market structure for petro is not market based and the government has been heavily subsidizing the domestic market.

3)  Where are your competitors?
There is a saying that a rising tide lifts all boats, and in China this is also true for industries that have moved en mass to China (plushy toys, screwdrivers, etc).  For in these industries, firms can more readily raise their prices to adjust for the inflationary pressure,

For firms who have a 40/40/20 global split will have a harder time holding their margins as their pricing must remain competitive with firms who are not experiencing similar currency, labor, other adjustments.

4) Where are your suppliers?
Related not only to whether or not one is importing or sourcing locally (importers are benefiting now from RMB shift), where this component is important is whether or not a firm’s supply base moved to China or not.

Unlike the question of competitors, where there was some benefit if one’s industry had moved to China, having an entire supply base in China can be a good and bad thing.  It is a good thing if both then supplier and competitor base are in China as the ability to raise prices improves, but if the supplier base is here and the competitors are elsewhere, a firm is going to have to potentially squeeze their margins

5) Is your product high tech or high labor?
Particularly important lately, when we hear of firms having problems with margins, it is by and large news that is coming from low tech/ high labor industries – stamping, textile, etc. Exposure against transportation is quick high for these items as a percentage of the product cost, and with labor costs and the RMB appreciation these goods are seeing pressure from all angles.

For firms like Intel, Dell, and Nokia who are averaging a low percentage labor and transportation, the real exposure is the RMB, and for many of these firms they are finding markets in China for their goods

6) Were you previously compliant?
Something that many equations leave out of the picture is that if your operations were compliant from Day 1, then the need to make changes is significantly reduced.  We have seen this in a number of firms in guangdong lately as they werenot fully compliant with the labor law, and so when it was implemented, their previous margins were destroyed

This is a question that can be applied to many different areas, the environment and material quality being the to most recent ones

Wrap up:
Taking the above  constraints into account, you can quickly see that there are many models in China and that  each model will be impacted in different ways. For those firms who are localizing their operations, selling into the China market, have a strong supplier base in China, and have been compliant in their operations, these are the good times as the inflationary price pressures from the RMB adjustments, global oil prices, etc could be avoided.  Firms who were stamping steel parts in Wuhan and sending them to Detroit through contract manufacturers, the risks of price adjustments and policy shifts are going to be much greater.

With different models creating different levels of exposures, it is clear to me that firms need to be careful about how they structure themselves.  In truth, were the RMB to go the other way, we could once again find that exporters are in the best position while importers have a touch time competing.

It simply is not as easy as saying Vietnam is the next market, or that China is no longer competitive.  Each, market will hold different levels of potential for each firm based on a number of constraints, and it is very important that decision makers start fully understanding the context of the situation.

so, were I to rerun the interview, I would have started there…  What are the other constraints that I missed?

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One Response to “Is China No Longer Competitive?”

  1. Silk Road International Blog » Where should you be? says:

    August 22nd, 2008 at 6:22 pm

    […] China blog has listed out some great questions and comparisons between China and Vietnam. Read the full post here. Dan at (China Law Blog) beat me to commenting on this. His post is […]