Is China Too Expensive?

Businesses that adopt the dual strategy of sourcing from China while also selling products to the Chinese market are poised to reap the greatest rewards.

Labor shortages, wage inflation, rising taxes and Renminbi appreciation drive some to conclude that China's heyday is over. Critics point to surging economic growth that has led to 15% nominal wage increases for the past few years. In addition, recent legislation aimed at protecting workers' rights has boosted the costs of labor. Adding further pressure, the Chinese government is decreasing or eliminating export rebates for a broad range of labor intensive or environmentally unfriendly products and phasing out tax incentives for foreign investment. Meanwhile, the Renminbi has gained more than 20% on the dollar since 2005. Despite these seemingly negative factors, the vast majority of corporations plan to increase investment in China. Why?

Consider the Alternatives

Vietnam is often considered a viable alternative. Indeed, the Dong is one of the few currencies that depreciated against the dollar over the past several years-- a definite plus for firms sourcing from Vietnam. Though the compensation of Vietnamese workers is still quite low compared to their Chinese and Southeast-Asian neighbors, rising costs of living are inciting greater wage demands, which have already manifested themselves as large-scale strikes at foreign-owned companies. Besides, with inflation of over 25%, Vietnam finds itself on the doorstep of a broader economic crisis that could challenge the commitments to reform and trade liberalization.

Furthermore, Vietnam lacks the infrastructure to supplant China as a sourcing powerhouse. China has been funneling around 12% of its GDP into infrastructure development and is forecasted to invest close to $10 trillion more over the next decade. Indeed, Shanghai alone supports over five times the shipping volume of all Vietnam's seaports combined.

On the labor front, China's workers outpace Vietnam's in terms of both education level and productivity. In fact, the productivity gap is so large that Vietnam's unit labor costs do not fall far below China's, despite the significant wage differential. Only low value-added industries like furniture and apparel can fair well in such a skill-starved environment. To various degrees, these arguments apply to all of China's Southeast-Asian alternatives.

Meanwhile, China's export mix has changed dramatically since 2000. Technologically intensive industries have claimed an increasing share of exports, and the domestic content of electronics has tripled, indicating growth in value-added. As wages rise, small manufacturers that rely on low-skill labor rather than productivity improvements are exiting industries, while larger firms that emphasize efficiency are gaining market share. With the continued fall of the dollar and rise in shipping costs, some manufacturers may consider moving operations to Europe and North America. But at least another decade will pass before Southeast Asia can become a viable large-scale alternative to China.

Besides, an argument based solely on a cost comparison misses the larger issues and bigger prize for sourcing from China: Domestic demand. As a function of its size, Vietnam cannot compete with China on either the supply or the demand side of the equation. On the supply side, with the number of foreign-owned and-invested factories in Asia growing every year, even China has begun to suffer from labor shortages in some sectors and regions. Vietnam's comparatively shallow pool of qualified labor cannot support a large inflow of manufacturers. On the demand side, the persistent rise in wages in China is an indication of a growing middle class with vast consumption potential. As Chinese domestic demand continues to grow, firms will want to tap this emerging consumer market. The companies that have established a strong supply chain and continuous presence in China will enjoy a competitive advantage.

China is a large continental economy that is relatively open to trade. The overwhelming majority of foreign manufacturers originally chose China for its low labor costs and generous tax holidays, and the country has since become uniquely plugged in to the global manufacturing network -- with the regulations, infrastructure and local supplier base to support the needs of foreign enterprises. This process involved a tremendous amount of work on the part of foreign firms and local workers, who had to overcome cultural, linguistic and bureaucratic barriers erected by decades of insular socialism.

It has also required an impressive level of resolve on the part of the Chinese government, which persevered in its commitment to economic reform in the face of skyrocketing inflation and the ensuing mass protests of 1989. Vietnam's dedication to liberalization has yet to weather a serious storm. No wonder many manufacturers are reluctant to abandon their strongholds in China -- where the business processes are now familiar and relationships established -- and face the challenges and risk of moving to a new location. The firms that do decide to expand into Vietnam or elsewhere in Southeast Asia usually do so as part of a "China plus one" strategy, exploring lower-cost alternatives while maintaining or even increasing investment in China.

For those firms staying in China for the long haul, profit-optimizing strategies have not run dry -- far from it. According to our recent work, the majority of foreign manufacturers neglect to fully apply international best practices such as integrated planning systems, inventory optimization processes and lean techniques. And too few companies have pursued the most obvious line of action -- a dual sourcing and sales approach that capitalizes on China's domestic demand and leverages global relationships to supply existing multinational customers active in China and targeting local companies that want the service levels and products from international providers.

But that may be changing. In an effort to encourage employee loyalty and reduce turnover, some multinationals are taking the lead in providing training and perks, including international rotation programs for top talent. Others are cutting costs by introducing automation and creating lean factories. Yet another option is to "go West," a euphemism for shifting operations from the traditional production bases in the coastal region to the West, North, or anywhere off the beaten track. These areas lag somewhat in terms of human resource quality, productivity and infrastructure, but offer lower labor costs, a more abundant supply of workers, as well as investment incentives from local governments eager to attract business.

In an environment of rising costs and mounting price pressures, enterprises that fail to improve profitability and maintain a competitive edge will be absorbed by their more successful rivals. We are already witnessing the beginning of a string of consolidations taking place across sectors and regions, with international firms purchasing Chinese industry leaders, and local and regional companies gaining ground on scale and scope. This natural evolution and consolidation process is creating a smaller group of larger, more competitive, more confident companies. That's good news for China's fragmented manufacturing sector and for the national economy as a whole.

Why China Is Still Attractive

In short, China has become more expensive, and some companies, especially labor-intensive and logistically sensitive providers, are choosing to move to cheaper locations. However, the majority of firms still stand to benefit from sourcing in China. And those who adopt the dual strategy of sourcing and domestic sales are poised to reap the greatest rewards.

Michael Deering is CEO of Alaris Consulting. Francis Bassolino is Managing Director of Alaris China and Lyuba Tovbina is an Associate of Alaris China. Alaris is a management consulting firm serving industrial products, consumer products, consumer package goods, pharmaceutical, distribution and retail clients. Alaris, which has offices in Chicago, Shanghai and Mumbai. www.alarisconsulting.com.

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