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.