Asia Intelligence Briefing : April 2008

China General Business Warning: Pre-Olympic Shutdown Rumored

There are rumors circulating that the Chinese government may shut down many process and manufacturing operations for as long as three weeks prior to the start of the Olympic Games in Beijing. Most affected would be Chinese 'air polluting' factories that are 'up wind' from the Beijing Olympic venues. The rationale is obvious to anyone who has followed the controversy surrounding athletes who have complained about competing in Beijing's suspect air quality. What the Chinese Government is prepared to do is inflict significant short term damage in the local businesses sector, to protect the name, reputation and success of the Olympic Games.

The warning for you is simple; if you are doing business in the northern half of China then you may well be impacted by unplanned and unexpected factory shutdowns. If you don't think you're operating there, then make sure your Southern China operations are not receiving materials or parts from that region. It is likely that the impact of such an action will, in effect, be just like a second Chinese New Year, all over again. The additional impact is that Chinese companies already operating on the edge of financial viability may well take this opportunity to shut down or to relocate elsewhere.

We must caution you that PRA's staff in China, though viewing this as a viable possibility, have been unable to verify the rumor. Chinese officials, very understandably, would be reluctant to make any statements regarding the facts, true or not. We, however, urge you to evaluate the likely impact and make reasonable alternative arrangements, such as three weeks of inventory increases, just in case these 'shut downs' comes to pass.

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Now is the time for suppliers to ante up and get a piece of the action in China

If you thought that China's manufacturing base was happy just producing relatively low value and modest technology, then one look at China automotive should convince you otherwise. Their long-term plans are to produce world-class vehicles at China prices and take a significant percentage of the world's markets by managing the labor costs of their business activities. Up the ante one more level, and it comes as no surprise to those of us who watch closely the development of China business, that China is already on the verge of launching its first home-grown 90-seat passenger jet, ARJ 21. However, this admittedly 'underwhelming airplane' is but a preparatory step to China taking on Boeing and Airbus in the Jumbo market.

The two divisions of China Aviation Industry Corp, that have for the past fifteen years been manufacturing wings and fuselages for Airbus and Boeing, will be providing the technical knowhow supported by financing from the state-owned Assets Supervision and Administration Commission, supported by the Shanghai government. The long-term plan is to build a 400-plus-seat jumbo jet by 2023. The company has been capitalized with $2.85 billion (U.S.) and the Chinese government is prepared to pump another $5 billion into research and development for this project. It should be noted that neither Japan nor South Korea ever managed to achieve viable aerospace industries at this level and additionally, even individual European countries could not survive in this market without combining the joint assets of the British, French, German and Italian aerospace industries.

China is certainly not exhibiting any shortage of confidence in its plans to build the most advanced aircraft currently operating around the world. Undoubtedly, it will leverage off the work, and the experience gained by various Chinese aerospace companies that have been working in support of 'off-set procurement contracts'* for aircraft entering the Chinese market.

Additionally, the West will again likely feel obliged, through business pressure negotiations, to contribute to the success of these projects by selling those technologies that China Aerospace does not possess; think engines, avionics, and flight control dynamics. Get ready, because China is likely to accomplish building an aerospace capability in an unimaginably short period of time. Good for world travel or bad for western prestige? As always in the global context, it all depends. While China has a long way to go to become a viable Aerospace competitor, assuming it will not happen or wishing it away will not make it go away. Better to prepare yourself for the arrival of a 'Chumbo' Jet to an airport near you.

(*Off-set procurement is the mechanism by which the country buying a product forces the seller to not only provide the product, but also to provide technology training, designs and Intellectual Property, as well as a share of the manufacturing.)

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China Wage Increases Causing Companies to Look for Other Options

Over the next three months, it is expected that as many as 20,000 factories in the south of China will either shut down or relocate deeper into China or offshore. The reason for this? China's factory costs over the past two years have continued to rise rapidly and the competition between them has been so fierce that owners have not been able to compensate by raising their prices.

The increase in material costs, the increasing value of RMB, the reducing purchasing power of the US Dollar and now the Chinese government's newly enacted labor laws have taken already slim margins and destroyed them. Add to these factors the slowdown in global growth along with the likelihood of a continuing slowing or downright downturn in the U.S. economy, and China's manufacturing base has not had to face such obstacles. Particularly hard hit are makers of low-value products; for example, more than 3,000 shoe factories shut down in 2007 and as many as 30,000 textile factories either lost money or made no profits during 2007. For the past eight years, exports to the U.S. had followed the normal trend of increasing month by month, often running at an annual increase of 20% percent per anum. Admittedly there were weather-caused delays in February this year, but the decline in shipments of 5.3% still shows a dramatic downturn of the value of exports destined for U.S. shores.

China is not the only country that is likely to struggle with this new realization. Exports account for 37% of China's GDP, but South Korea's GDP is dominated by a 43% export margin. Nevertheless, China is today still more vulnerable than South Korea, because it has dramatically overbuilt factories and capacity.

Irrespective of the state of the U.S. economy, China's factories face an increasing problem: their original competitive advantage was the large number of low paid workers. But those labor costs have increased as much as 50% in the last three years and now new labor law imposed on the region by Beijing are further increasing the cost of operations. One of the new labor law provisions entitles workers who are to be laid off to receive one month's severance for every year they have been employed by the company. This means that if you want to shut down your operation, you need to have an increasingly large war chest just to fund the compensation liability. One can easily see the likelihood of companies shutting down because they are already technically insolvent. Generally speaking Chinese companies do not accumulate a substantial financial reserve with sufficient funds to cover the expense of shutting down the company. Additionally, these issues have the potential to impact an additional sector of the Chinese economy, namely China's vulnerable banking system. Fearing a wave of defaulting industrial loans, they may well feel obliged or be obliged to pull them back, in turn forcing companies to shut down. It is always hard to understand what Chinese banks could or might do, but it's easy to see that such an event could become a self-fulfilling prophecy like the recent Bear Stearns debacle in the U.S.A.

What to do?

If you own your own facilities in southern China, consider moving inland, where local government is likely to be more flexible and the vast numbers of willing workers who would be prepared to work for minimum wage are likely to be more plentiful for potential hire.
If you are sourcing from third-party organizations, make sure you do not have all of your eggs in one basket. Spread your purchase orders around, dividing the total order into two and using at least one factory that is inland.
Finally, remember that China is not the only market that you can either buy from or operate within. Vietnam, India and other Asian countries all have considerable capabilities that may well be able to support your Global initiative.

It is, of course, important to make sure that you balance your needs accurately against each country's capabilities to ensure that you are achieving the best economic return for your time and effort.

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Ivaturi Named Head of Pacific Rim Alliance Hyderabad, India, Office

Ravi Ivaturi has been named managing director of Pacific Rim Alliance's office in Hyderabad, India, where he will lead efforts to help U.S. and European businesses access the growing Indian market.

Ivaturi brings his knowledge of bridging U.S. and European companies with Indian companies after having worked abroad, most recently for India's TVS and Sons, parent company of the TVS Group, in the United Kingdom and mainland Europe, where he developed its brand in distribution and supply chain for automotive parts for Tier 1 and OEM clients.

"It is in response to the overwhelming demand for access to India, alongside our traditional access to China that has led to the opening of the India office," said Pacific Rim Alliance President and CEO David Hemmings. "Ravi is more than qualified to support the business development requirements of PRA's clients in the India subcontinent."

Ivaturi holds a Masters Degree in International Marketing and Business from Oklahoma City University.

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