The End Of Cheap China

China used to be every buyer's dream: A large scale of cheap products due to a never-ending flow of labour and resources. Over 20 years of unprecedented export growth and constantly falling prices made China the world's workshop – a fact that logically resulted in many overseas companies moving their production to this land of export miracles. Many benefited from China's low-cost supply base. But this export paradise may soon lose its shine, as the times of cheap China seem to be over. Reasons for this change are manifold and originate from diverse macro-economic trends:

A) Currency: Since the Yuan was unpegged from the US Dollar in July 2005, China has followed a consistent path of gradually valorising its currency. An appreciation from 8.1 to 7.5 Yuan/USD in two years shows where the road is going. Yet, the pressure for further appreciation by the US continues unabated.

B) Quality: Traditionally, "Made in China" is not considered to stand for high quality. But the latest series of defective products and contaminated food shows that Chinese product quality (and safety) may have become a real problem. Clearly this trend doesn't work in favour of China exports.

C) Natural Resources: Raw material prices worldwide have been steadily on the rise since 2002 and are expected to keep rising. China as a growing player in the world economy is one of the main drivers for this price development especially in energy and metals.

Currency valorisation, product quality or resource prices are all (at least partially) subject to external influences. More importantly, however, certain macroeconomic tools in the hands of the PRC government are used to navigate the country towards a less one-sided trade balance. Two of these instruments have recently caused a major stir:

D) VAT Rebate Cuts: The latest changes in China's VAT refund policy mark another step away from the existing status as a cheap production source for foreign
companies.

New VAT Refund Regulations The Ministry of Finance and the State Administration of Taxation jointly announced the reduction or removal of VAT refunds for 2,831 export items. The regulations were announced on June 19 and became effective on July 1, 2007. Export items not benefiting from rebates anymore include fertilizer, cement and certain industrial chemicals. Reduction of VAT rebates applies for item groups such as clothing, toys, furniture, glassware, bags, electronic machinery etc. Amongst the ten items that are declared ‘tax free' are paintings, sculptures, nuts etc.

Reasons for using VAT as a measurement for export regulation do not only exist in terms of controlling growth, but also in regards to which industries are preferred for export. China's massive trade surplus induced by its export growth led to the government's intervention.

Reasons for New VAT Refund Regulations To discourage activities in certain low-value industries where China in many cases already has a major market share (e.g. 80 % of US toy imports) as well as for "high energy, high polluting and scarce resource-consuming" products. To encourage production of higher value products such as telecoms equipment, auto parts, industrial intermediate products, machinery. Deutsche Bank estimates that these high-end exports will grow 30 to 40 % p.a. for the next three to five years. To reduce the overheated export growth and thus the pressure on RMB devaluation which has recently led to frictions between China and its trade partners.

These government actions have an immediate and direct impact on foreign companies buying from China. Different options of how to react to these new developments are available, some of which include renegotiating prices with existing suppliers, reviewing of HS codes and possible re-labelling of products, changing of suppliers or even switching sourcing activities to another country.

As for the first option, many suppliers in China have razor-thin margins: A survey by Kurt Salmon Associates revealed that the profit of a Chinese shoe manufacturer is about 1% of the US retail price. Would they be able to absorb additional cost even if they wanted to?

A core challenge when switching one's sourcing activities to another country is to find a comparable sourcing system in regards to logistics and infrastructure. Over the years China has built a formidable position in providing efficient supply chain processes which many countries such as Vietnam, India or Mexico will find difficult to provide. The possible lack of such a smooth-running infrastructural network can make the switch a less attractive choice – even if staying means paying. Historically sourcing of durable consumer goods has over the years moved from Japan to South Korea, Taiwan, then Hong Kong and lately China. Are companies ready to "move" again?

E) Processing Trade Regulations: Another effort of Beijing officials aiming to curb export growth in labour-intensive, low-value industries includes new regulations in the field of processing trade. These can also be interpreted as attempts to keep bigger portions of the value chain within the country by forcing companies to use materials and parts from China.

Processing Trade The term "processing trade" refers to the business activity of importing all or part of the raw and auxiliary materials, parts and components, accessories, and packaging materials from abroad in bond and re-exporting the finished products after processing or assembly by enterprises within the mainland. Export processing trade accounted for 55% of China's total exports in 2005 and dropped slightly to 53% in 2006. In the first five months of 2007, exports and imports related to processing trade grew at 22% and 12% respectively.

Processing trade is generally forbidden for a number of items listed in the processing trade prohibition list (PTPL). Currently, for many products with a VAT refund rate of 0%, prohibitions are in place concerning the import of raw materials free of customs duty. It is important for companies with products newly introduced in the VAT rebate cut list to monitor the development in the PTPL if they are manufacturing for export.

A new processing trade policy will take effect on August 23, 2007 covering 1,853 materials in the fields of plastics, furniture, textiles and for other labour-intensive industries. Companies engaged in the production of these items are required to place a deposit with the Bank of China.

The deposit amounts to 50% of the value of the imported materials – a percentage that will most certainly create immense cashflow challenges to affected enterprises. In addition, companies have to register their process trade contracts with the authorities. If the firms fail to implement these contracts, i.e. do not export those goods but sell them on the domestic market, they will lose their deposits to the customs house. The new policy only applies to regions in East China including Beijing, Tianjin, Shanghai and Guangdong.

Outlook: All of the abovementioned trends point into one direction: China exports are undergoing substantial changes.

The macro perspective shows a move in China's export strategy towards high-end products and efforts to increase value creation in the country. From a company's viewpoint China will no longer remain the sourcing paradise it used to be. This will certainly pose a challenge of alarming proportions to companies involved in consumer goods business with the Middle Kingdom.

Pro-active counter measures and cost savers could be considered in the areas of supply chain optimisation and streamlining, outsourcing of non-core activities or improvement and strengthening of quality assurance systems. But the end of "cheap China" is in sight.

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