Chinese producers are moving up the value chain

Wages and production costs are rising rapidly in China. Tom Mitchell tells us, in a long piece in Monday's Financial Times, how China is handling cost rises by boosting value:

After crossing the Sharp Knife Gate waterway, the highway running west out of the Zhuhai special economic zone enters a predominantly agricultural landscape of banana fields and irrigation channels. But this small hint of Eden on the western fringe of the world's largest manufacturing base, the Pearl River Delta in China's southern Guangdong province, will not last long. Green hills are being ripped open for landfill; electricity pylons march across the fields; and factories soon begin to appear, sporadically at first and then in greater concentrations. One manufactures art supplies, a second bowling balls, another cold-weather gear, a fourth yachts.

“The most important change has been the factories along the road. There weren’t any here three or four years ago,” says Winston Poon, general manager of Zhuhai’s nearby Gaolan port, a 50-50 joint venture between the municipal government and Li Ka-shing, the Hong Kong tycoon. Mr Li also controls 45 per cent of Zhuhai’s main power plant, which spills acrid smoke into the air as it feeds the factory sprawl.

Zhuhai’s rapidly changing landscape may be an environmental wasteland in the making but it also suggests that the Pearl River Delta’s export economy is in rude health. As such, it would appear to contradict manufacturers’ complaints about rising labour, raw material, currency and regulatory costs, which have intensified over recent months.

Adding weight to these complaints is the first evidence in more than five years that the much-vaunted “China price” paid by US and European Union retailers is also rising. Once the pricing benchmark for manufacturers the world over, the China price inspired both anxiety and enthusiasm in the west and generated a stampede of foreign investment into Guangdong and other provinces.

Yet the Pearl River Delta’s exports continue to surge at a 30 per cent year-on-year clip, suggesting that the region is maintaining its overall competitiveness despite rising cost pressures. Its ability to do so has huge implications for China, rival manufacturing centres across the developing world and rich-nation consumers.

In the latest example of the cost pressures being brought to bear on local manufacturers, this month Shenzhen – the special economic zone bordering Hong Kong – informed employer and labour representatives that it was raising its monthly minimum wage by as much as 23 per cent, from Rmb690 ($86, £46, €68) to Rmb800-850, with effect from July.

Such an increase would be largely symbolic. Most foreign-invested manufacturers in the Pearl River Delta, which account for about 60 per cent of the region’s exports, pay above the statutory minimum and have been largely unaffected by the region’s labour shortages. But the sheer scale of Shenzhen’s planned minimum wage increase highlights just how quickly costs are rising.

“Everything has gone up. You wouldn’t believe what we pay for [our workers’] food,” says Donald Hay, chief executive of Hayco, a manufacturer of household cleaning and electrical products that employs some 6,800 workers in Shenzhen. “We’ve just contracted out the kitchens.”

But while Mr Hay admits that labour costs are “getting to the limit” and might force him to consider moving some operations to cheaper localities inland, at most he would shift established product lines that require less management attention. Shenzhen’s other advantages, from proximity to suppliers and Hong Kong’s pool of “unsurpassed” managerial talent, mean that it remains a great place to manufacture.

...About two hours north of Zhuhai, in the more heavily industrialised municipality of Foshan, the world’s largest manufacturer of microwave ovens is also wrestling with higher costs – and is staying put.

Zhao Weimin, vice-director of the chairman’s office at Galanz, lists the challenges faced by his company, which exports 65 per cent of its output. Galanz’s wage costs for its 30,000-strong workforce have surged as factories have bid up the price of labour; oil-based plastics, copper and steel are more expensive than ever; and the elimination of a value added tax rebate has in effect increased the VAT it pays on components by about 18 per cent.

But instead of retrenching or decamping to somewhere cheaper, Galanz has focused on improving efficiencies at its microwave oven plant. Studying Toyota’s manufacturing processes, it adopted team-based production and management units. Previously a sprawling, centrally controlled company, Galanz split itself into 16 subsidiary units, each controlled by an autonomous but accountable general manager. Procurement is still handled centrally, to maximise bargaining leverage with suppliers.

The company also diversified in grand fashion by building a 2m sq m air-conditioning factory – the world’s largest – in neighbouring Zhongshan, where it manufactures both under its own label and for foreign brands. “The more sons you have, the more happiness,” Mr Zhao says. “Like microwaves, air conditioners are low-tech, labour-intensive products and we excel in those.” Galanz produced 2.5m air conditioners last year and expects output to grow by about 60 per cent this year.

However, Galanz has still had to pass rising costs on to its customers, especially in Europe – the company’s most important export market. It is not alone. In March Li & Fung, a trading company based in Hong Kong with HK$55.6bn (US$7.2bn, £3.9bn, €5.6bn) in annual sales, also reported that the average unit retail price of the myriad consumer products it sources for US and EU buyers had increased by 2-3 per cent after six years of deflation.

The higher prices reflect in part a deliberate strategy by manufacturers and retailers to shift to higher-value products, which command fatter margins. “I think the world is getting a little bit tired of competing on price,” says William Fung, Li & Fung’s managing director. “Product differentiation is key. No one wants to sell a commodity and compete against Wal-Mart.”

Research by Global Sources, a Hong Kong-based trade-show organiser and publisher, shows that export values are growing faster than volumes for everything from hair dryers to tyres. “Companies are not just making the same thing and charging more. They’re adding value,” says Michael Kleist, who runs Global Sources’ industry research team in Shenzhen. “Almost everyone is trying to get off the bottom level, because once they drop their price they don’t get it back.”

“Our product mix has shifted to higher value,” adds Mr Hay, whose company began making its first electrical implement – electric toothbrushes – in 1999 and has been expanding its higher-end product portfolio ever since. Hayco also achieved a measure of vertical integration by acquiring a plastic mould factory in Shenzhen.

Such moves up the value chain help explain why there appears to be little correlation between anecdotal evidence of rising costs and South China’s overall export performance, which remains robust. Guangdong’s exports, the vast majority of which are manufactured in the Pearl River Delta, increased 24 per cent year-on-year in 2005 and 29 per cent in the first quarter of this year. And in yet another display of the region’s export prowess, this month some 250,000 buyers from more than 200 countries attended Guangzhou’s China Export Commodities Fair (more popularly known as the Canton Trade Fair) and three China Sourcing Fairs in Hong Kong.

...The geography of the Pearl River Delta also provides manufacturers with a degree of flexibility. Development has traditionally been concentrated east of the river, which is also where two of the region’s only three natural deep water container ports – Kwai Chung in Hong Kong and Shenzhen’s Yantian – are situated. As a result, manufacturing costs are highest in Shenzhen and in Dongguan, which borders the special economic zone to the north.

Development of the west delta, where Zhuhai is located, has lagged. Investors who relocate across the river enjoy lower land and utility costs, though they cannot escape the impact of last year’s modest revaluation of the renminbi and higher raw material prices.

The industrial sprawl now racing through Zhuhai’s outskirts is evidence that this shift in the delta’s economic gravity is well under way. So too are the large quantities of coal and timber that lie on Gaolan’s docks, awaiting transport to the west delta’s power plants and furniture factories.

...It was in anticipation of precisely this shift that Mr Li, the world’s tenth richest man according to Forbes magazine, first invested in Gaolan in 1994. Though still a bulk port focused on feeding the region’s ravenous appetite for raw materials, Gaolan is also the Pearl River Delta’s last natural deep-water harbour and thus a promising future container port.

A model in the port’s administration building displays Mr Li’s vision for Gaolan, with six berths servicing large container ships and neat stacks of export-laden containers occupying docks now littered with coal and wood. Gaolan’s first two container berths are scheduled to come on line next year. In 35 years, Mr Li turned one container berth in Hong Kong into a 42-port empire across 20 countries that is today valued at $22bn. Gaolan is his bet that the Pearl River Delta will remain a global manufacturing centre for decades to come.

Comments

[claus vistesen]

Very important topic ... especially the way it relates to what you wrote about IMF's global economic outlook recently and the possible correlation between inflation and globalization as a result of lacking spare capacity. What will it mean for the global output gap when China comes storming up the value chain and crucially; will it continue to be positive sum from the Western world's pov?

[Arthur Eckart]

It's predictable. China is producing similar to the Industrial Revolution of 1871-1914, with the notable differences that there's little invention, and of course, it's an open economy. China is more like Japan in the 1960s, when it created junk and then eventually specialized in a few industries where quality improved. China needs to differenciate to better compete with other Third World competitors rather than continue to sell (or dump) at the lowest prices. However, it seems, China is gradually moving in that direction. A global output gap may be more fleeting than a domestic output gap, because of shifts in the goods market-money market-foreign exchange market through changes in interest rates and currency exchange rates.

[Arthur Eckart]

The chart in the article shows the U.S. share of world manufacturing output increased over a period when U.S. manufacturing jobs decreased by large numbers and when there were huge annual U.S. trade deficits. So, it seems, both U.S. manufacturing productivity and the value of U.S. manufactured goods increased greatly (see link below). Also, the chart suggests, China is taking market share away from Japan, while China's share of world manufacturing output increased sharply.

http://www.newyorkfed.org/research/current_issues/ci12-2.pdf

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