We have been writing frequently regarding the end of cheap China because we are just about every day seeing how this impacts our (mostly American) clients. This post by Steve Dickinson is on how buyers of manufactured product from China’s Pearl River Delta are going to be impacted by the end of cheap China. Here is Steve’s post:

The excellent Chinese financial journal Cai Jing recently published an article, entitled, Dire Straits in the Pearl River Delta, detailing the financial problems facing export-oriented manufacturers in the Pearl River Delta region of Guangzhou Province. The article includes the standard lament that these businesses are not being adequately supported by the central government. However, the truth is that these manufacturing businesses are under financial pressure simply because they are no longer competitive. These manufacturers of toys, clothing, shoes, furniture and housewares are standard high volume, high employment, low technology and low margin operators.

The Chinese government has decided to let them go for three very good reasons. First, they do not represent the high technology manufacturing that China wants for the Pearl River Delta. Second, they are largely controlled by foreigners, mostly from Hong Kong, Taiwan Korea and Singapore. Third, and most important, these manufacturers are simply no longer competitive. It is well known that wages in China have increased greatly. However, other costs have also increased substantially in this region: raw materials, utilities, rent and taxes have all dramatically increased over the past five years. When all of these costs are combined, the Pearl River Delta manufacturers simply can no longer compete with their competitors in Asia and elsewhere in the world.

What these manufacturers want are subsidies from the Chinese government that will allow them continue to operate when normal economics would force them to shut their doors. The answer from the Chinese government has been clear. Financing will be made available to domestically owned manufacturers that can show that they have a viable business. All others will need to shut down. There will be no “hand outs.”

Many buyers are convinced that the central government will eventually step in and save these failing businesses. They believe that the need to create jobs will trump any other concerns. This belief is misguided. It is a central theme of the 12th Five Year Plan that the Pearl River Delta manufacturing region will be transformed from low value added to high value added manufacturing. The government does not want to provide jobs for migrant laborers in this region. It wants the migrant laborers to return home and take jobs in Sichuan and Henan and other central provinces. The government encourages low value added manufacturing to move to those regions and it is providing numerous incentives for such moves. In parallel, the Chinese government has no intention of preserving these Pearl River Delta businesses with subsidies when such a practice is directly contrary to government policy.

It is therefore certain that over the next two years we will see a major change in the whole export manufacturing sector that extends from Wenzhou down to Zhuhai. During this period, many companies will fail. Many of these companies will have a long and excellent track record of performance. But they will still fail because their business model no longer works.

In this environment, there are substantial risks that foreign buyers must prepare for with great care:

  • Many buyers pay an advance deposit for products. Many failing manufacturers will collect these deposits with no intention of ever manufacturing the product.
  • If a manufacturer is struggling, the level of defects will rise to a shockingly high level. Manufacturers that owe a credit or refund from prior defects will not pay. There is also tremendous pressure for the manufacturer to substitute low quality or non-conforming components to save money. Lead content paint on toys or low quality fasteners on clothing are examples.
  • Many buyers pay for their product at the time of shipment without doing an inspection of the product. This leads to a great risk of fraud in dealings with a manufacturer who is going to go out of business in a short time. Some standard frauds are as follows:
    • The manufacturer simply does not ship the product. Sometimes the manufacturer will convince the buyer to make a payment to a new bank account. Often this bank account is in the wrong name or even in a different country. When the buyer complains that there has been no shipment, the manufacturer claims the buyer is the victim of fraud by someone other than the manufacturer. We are seeing this one a lot, with the “new” bank account being a personal (rather than a business) one.
    • The manufacturer takes payment, and then ships an entirely different product or a non-conforming product. For example, a container of frozen fish will turn out to have one layer of fish and the remainder of the container is bricks. Or a container of a frozen food product when unfrozen will turn out to be entirely rotten product. We had a client receive a shipment of frozen salmon that was so rotten that the container was declared a hazardous waste site right on the dock.
    • Even where the buyer inspects, we have recently seen a number of cases of outright fraud. In these cases, the buyer watched the product be loaded and the container sealed. The manufacturer then switched the container on the dock and sent an entirely different product to the buyer.

In all these cases, the manufacturer is relying on two things:

First, due to the low value of any single container, no foreign customer will bother to sue in China.

Second, since the manufacturer plans to go out of business and “disappear,” the manufacturer simply is not worried about legal liability.

Note that past history with a manufacturer is no guarantee that these problems will not occur. As I noted above, even “good” companies will fail when the business model no longer works. Often, these “good” companies are the cleverest at extracting the most funds from their long term foreign customers. These owners are smart, and they apply their considerable intelligence in making the best of their difficult situation.

Given the current economic hardship in the southern coastal region, all buyers must take particular care to guard against these risks. Those of us who have been in China for a while have seen all this before. It always happens during an economic shift or slowdown in China. Previous examples are the late 1980’s when SOEs were forced to stand on their own and then again in the late 1990s when the effects of the Asian financial crisis were felt in China. We also saw some of this in 2008. This period will be no different.

Buyer beware.

  • Twofish

    1) What these manufacturers want are subsidies from the Chinese government that will allow them continue to operate when normal economics would force them to shut their doors.
    Not necessarily. What a lot of the manufacturers want is some sort of assurance that the local government won’t come after them for back wages/back taxes when they do shut down. If you can shut down your factory, keep title to your land, and then figure out some sort of forgiveness for back wages/back taxes, you are doing really good.
    Shutting down a business can be as tricky as running a business.
    2) Second, since the manufacturer plans to go out of business and “disappear,” the manufacturer simply is not worried about legal liability.
    The manufacturer is worried plenty about legal liability. Just not your legal liability. The local government can toss the manufacturer in jail for back taxes. Unpaid workers can come and riot and beat them up. Some client in the United States is the last of their worries.

  • Your article is far too pessimistic and does a disservice to the ‘smart’ Chinese businessman. It’s actually been like this in Guangdong since before 2007 due to the removal of tax incentives rather than a rise in labor as you suggest. But the result is the same, factories closing and going instead to Vietnam and Bangladesh and East India and Thailand following the cheaper labor. So its not all bad as the larger Chinese businesses have just shifted production and still service orders, often from a small China office rather than a China factory, while the processing/manufacturing is done elsewhere in Asia. The small under capitalized will go under, but that layer of businesses has already gone. Whats left now are order hubs for Asian manufacturing and they won’t go bust.

  • Robert V.

    Thanks for writing about this as we just fell victim to what you describe. We had a six year relationship with our manufacturer and then all of a sudden the product quality went into steep decline. We kept asking for credits for the bad product and for the last six months they kept saying they would give it to us but they never did. Our last product order never came at all and nobody would take our calls. We have since learned that the company is no more and nobody is to be found. I keep trying to figure out what we could have done differently and what we can do the next time to prevent this.

  • Rambu Tan

    Three south China ports are in the top ten busiest ports in the world by container for 2011. Hong Kong, Guangzhou and Shenzhen so real trade is not stacking up with your views. Unless they were all full of substandard or nonexistant product of course, cunningly placed there to rip off unsuspecting Americans: http://en.wikipedia.org/wiki/List_of_world's_busiest_container_ports

  • Very good list of potential problems! I have seen most of these cases, except for “the manufacturer then switched the container on the dock”.

  • If I can make one positive comment about the outlook that you describe so well it is this.
    At least the capitalist system is alive and functioning in China. The ‘change or die’ philosophy that in theory underpins anglo-saxon commerce also underpins chinese commerce.
    It’s sad to think that so many American businesses will suffer because they get caught by businesses that disappear, but perhaps as China gets more expensive and the importance of business continuity becomes evident, American and European firms will once again become competitive.

  • Ernest Cooper

    I find myself disturbed at your suggestions that “smart” Chinese businessmen and “good” Chinese companies are apparently all waiting in the wings in South China to deceive American buyers into paying for goods, only then to immediately commit corporate hari-kari and declare bankruptcy as soon as the money hits their account. The idea to me seems absurd and is not representative of the many years of fine service I have received from my supplier(s) throughout the region. May I ask if you have experienced any actual legal cases of the phenomena you have taken such pains to describe?

  • Tony Xiao

    And the local goverment sells all your machinery as well to cover back taxes/wages

  • The Guangzhou Grinch

    The suggestion that a Chinese businessman would deliberately declare bankruptcy on the strength of a perceived benefit of receiving payment for an order and then not having to fulfill it to an American customer is just plain daft.

  • Twofish

    One thing that I’ve found is that asking a lawyer about business relationships is like asking a divorce lawyer about marriages. The lawyer has a very different perspective because he isn’t involved heavily in the happy relationships.
    AsianBizDaily: At least the capitalist system is alive and functioning in China. The ‘change or die’ philosophy that in theory underpins anglo-saxon commerce also underpins chinese commerce.
    In fact no. There are parallel economies in China with the big state owned enterprises running along side the “petty capitalist” sector. The “petty capitalist” sector does not get government support, and in fact it works the reverse since you’ll find that a lot of the “petty capitalist” companies get capital from local government that want a return on their investment. The big SOE’s do get tons of state support (mainly low cost bank loans), but they rarely are involved in deals with US SME’s.
    The economic down turn as actually shrunk the “petty capitalist” sector as the government has been pouring money into the big SOE’s and letting small companies dry up without support. It’s also killed most of the local support for “Anglo-American capitalism” which is also making the Chinese economy in general less “capitalist.”

  • Dan

    @ The Guangzhou Grinch
    I completely AGREE with your comment that “the suggestion that a Chinese businessman would deliberately declare bankruptcy on the strength of a perceived benefit of receiving payment for an order and then not having to fulfill it to an American customer is just plain daft.” We never said that and if you would have read the post, you would know that. What we said was that companies that is going bankrupt anyway have been known to do this. Big difference. Do you understand that difference now?

  • Twofish

    Very, very important legal point….
    “go bankrupt” != “go out of business”
    People use these two terms to mean the same thing whereas in legal terms, they often mean completely the opposite.
    go out of business = stop operations of a business
    go bankrupt = go through a legal process to deal with unpayable debts
    These two things often mean opposite things since the purpose of declaring bankruptcy more often than not is to *prevent* a business from shutting down. The parent company of American Airlines just declared bankruptcy and the main goal of the court is to keep the planes flying. General Motors and Chrysler both went bankrupt, and it was a very good thing, since they were changed into healthy companies.
    The problem is that when small Chinese companies go out of business, they rarely “go bankrupt”. The just shut their doors and leave a big mess behind, and much of the reason for that is that Chinese bankruptcy law is not well developed, so shutting down and leaving a mess is the most rational thing to do.
    If you have doing business with a company that is under financial stress, you often *want* them to go bankrupt. The reason for this is that under bankruptcy law, vendor debt is gets extremely high priority (remember that the point is to keep the company in business), so if a company goes bankrupt, it goes under court supervision and if you are a supplier or critical customer, you are very likely to get paid or your stuff.
    Even in the worst case scenario, the business is under court supervision so that there is someone at the other end of the phone that you can talk to to see what is going on. If the business is not salvageable, then there is an orderly process of liquidation (or at least that’s the theory).
    The problem with Chinese companies is that bankruptcy laws are very new and untested, and it’s not in the rational interest of anyone to use them, and so we have a mess because when businesses go under, there is no good process to either save them or shut them down in an orderly process.
    Finally, there is a financial reason for some of this mess. China is very heavy in the export sector because small business can’t get credit from state banks so that they have to rely on vendor financing in order to survive. A lot of US companies are actually in the Chinese banking business in that they are providing loans to Chinese businesses without realizing it.

  • Window Shopper

    You and I have never spoken, but I just came back from a two week “working” vacation in Myanmar. I was there to scope it out as a possible future site for my company (a mid-sized manufacturer that already has facilities in China and Vietnam). My sense of the place is that it has tremendous potential, but it’s not there yet. The government folks are just too green and it was disconcerting that they seemed not to have answers to so many of my basic questions. Hoping to “vacation” there again soon though.

  • Elemental

    This “end of cheap China” meme of yours is getting boring. You are writing about things that we have all known for at least five years. China isn’t cheap any more. Wages and rents and regulatory costs are rising. We need to go elsewhere if cheap is what we want. China is no longer cheap. It’s the end of cheap China. Yawn. Let’s please move on.