Thomas White Global Investing
China
China Stamp
June 3, 2011
A Postcard from the Asia Pacific
China: No longer the workshop of the World?

China manufacturing

As factory wages in China are on the rise many Western companies are scouring Southeast Asia for cheap labor. Some companies are shifting some or all of their manufacturing facilities to countries like Vietnam, Indonesia, the Philippines, and India.

What is common between Top Form International, a lingerie maker, Coach, a U.S.-based accessories brand, and General Electric, the American company that manufactures everything from nuclear reactors to fluorescent bulbs? For those of us not glued to the financial press the question might sound a bit tough. No worries. We will provide you with the answer.

All these companies and a dozen more, some well-known and some not-so, either shifted a part of or their entire manufacturing operations from China to other countries in the past year.

So, what is happening in China, the workshop of the world?

It is a well-known fact that during the last four decades, companies from the developed world, particularly from the U.S., flocked to China to set up factories. The single most attractive factor fueling this transition was the cheap and abundant Chinese labor, typically at a fraction of U.S. labor costs. In the course of the last four decades manufacturing of various goods such as textiles, footwear, electronics, as well as the assembling of numerous other durables shifted unabatedly to China.

But that trend might now well be slowing and in some cases might even be reversing. Labor in China is no longer as cheap as it used to be. And firms such as Top Form, Coach and GE, who have moved labor operations out of China, are prime examples of the paradigm shift. According to various estimates, basic manufacturing wages in China soared 69% in the period between 2005 and 2010. For the next five years, wages are forecasted to grow at an annualized rate of 17% in China. Consequently, productivity gains from manufacturing in China and the U.S. are expected to grow at roughly the same rate.

The western outfits that depended on China for manufacturing are now looking for new places to set up shop. Purely on the basis of labor costs, these companies seem to be favoring Southeast Asia countries. Currently, monthly wages for manufacturing sector workers in Indonesia and Vietnam are around $130, almost a third of the $420-a-month wage in China. Thailand and the Philippines too have labor costs that are substantially lower than that in China. In recent months a number of companies such as Kyocera, a Japan-based printer making company, Nokia, the Finnish mobile phone giant, and Japanese auto firm Toyota have all favored Vietnam for some of their manufacturing facilities.

Some US companies are quite comfortable manufacturing their products in their own homes despite high labor costs. Caterpillar, the Illinois-based maker of cranes and other excavation equipment, is even bringing some of its operations to Texas from China. Sometimes issues related with lengthy supply-chains could erase the significant amount of gains that are accrued by outsourcing manufacturing. For these reasons, some US companies also feel manufacturing using cutting-edge technologies are best done at home rather than outsourcing to foreign countries.

Still, China’s advantages in certain key sectors of manufacturing easily outweigh some of the recent disadvantages. One advantage is the supplier network and infrastructure that developed in China over the past four decades. For example, China retains the advantage in some key sectors like electronics which need an ecosystem of large component suppliers. In such a case, a US electronic firm that wants to manufacture mobile phones will be better off producing it in China because all the subcomponents required to produce the phone can be more easily sourced in China. In contrast, firms like Caterpillar, which do not have such disincentives to move away from China, could still hunt for manufacturing bases that offer more advantages.

Yet, there are some advantages to keeping some manufacturing capability in the Middle Kingdom. For one, China has great potential to consume in the foreseeable future. China’s consumer market is expected to expand at a rapid pace over the next several decades. The market for all kinds of durables ranging from cars to air conditioners is likely to grow by leaps and bounds. According to certain estimates, the luxury goods market in China is likely to triple by 2020. And manufacturing goods for Chinese in China could after all be a good strategy.

Nonetheless, China’s current manufacturing capacities are well above the domestic needs in most sectors. Even if domestic consumption expands at an accelerated pace as expected, it will be several years or even decades before domestic demand catches up with aggregate capacity in many sectors. So it is unlikely that rising domestic demand will drive increased manufacturing capacity expansion, except in select sectors where China is not yet a large manufacturer.

What’s more, manufacturing facilities in China now predominantly cater to export markets, but as labor arbitrage shrinks, as it has been over the past few years, manufacturing in certain labor-intensive industries is expected to slow. All these factors point to some amount of migration of factory capacity to other countries with low factory wages.

Even Coach, the trendy handbag-maker that is moving some of its production out of China, is waiting it out for this kind of equilibrium in China. Thanks in part to increasing real wages among China’s workers, the company feels more Chinese consumers will flaunt its accessories. Coach plans to triple its sales in China to $500 million in the next four years from $100 million now. But by the time China’s domestic market for its bags catches up, the New York-based company would have cut its global production capacity in China to 40-50% from the current 80%.

Meanwhile, it appears that countries like India and the Philippines could expect a new factory from Coach soon.

 

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