The end of cheap china

A Vietnam consultant friend of mine sent me a Stratfor article (from about a year ago) talking about how rising labor costs in China were slowly causing low-end manufacturing to leave China for other countries, seeking my thoughts on the article. Stratfor’s theory is essentially that clothing manufacturing and mobile phone assembly are precursors to other industries and those two industries are already starting to leave China:

Even though the movement of two indicator industries — garment manufacturer and mobile telephone assembly — signals change, this is a transition that is as yet pre-statistical; few if any reliable trade numbers or volumes now exist to plot the contours of this shift. But it is, Stratfor has concluded, a shift that is already well underway.

Stratfor sees the following sixteen countries taking over (not necessarily completely) low end manufacturing from China, though “[T]he outlines of this group, what we call the Post-China 16, or “PC16,” are only now coming into focus. Indeed, the specific countries may change and the precise roles they play in this transition — their success in following the path China has trod — remain to be fully seen.

Stratfor came up with its list not by “looking for the kind of large-scale movements that would be noticed globally, but for the first movements that appear to be successful. Where a handful of companies are successful, others will follow, so long as there is labor, some order and transportation. Some things are not necessary or expected. The rule of law, understood in Anglo-Saxon terms of the written law, isn’t there at this stage. Things are managed through custom and relationships with the elite. Partnerships are established. Frequently there is political uncertainty, and violence may have recently occurred. These are places that are at the beginning of their development cycle, and they may not develop successfully. Investors here are risk takers — otherwise they wouldn’t be here.”

Stratfor does not see any one of these sixteen countries assuming the “factory to the world” mantle:

There is no single country that can replace China. Its size is staggering. That means that its successors will not be one country but several countries, most at roughly the same stage of development. Taken together, these countries have a total population of just over 1 billion people. We didn’t aim for that; we realized it after we selected the countries.

The point to emphasize is that identifying the PC16 is not a forecast. It is a list of countries in which we see significant movement of stage industries, particularly garment and footwear manufacturing and mobile phone assembly. In our view, the dispersal of industries that we see as markers of early-stage economic growth is already underway. In addition, there are no extreme blocks to further economic growth, although few of these countries would come to mind as having low political risk and high stability — no more than China would have come to mind in 1978-1980. I should also note that we have excluded countries growing because of energy and mineral extraction. These countries follow different paths of development. The PC16 are strictly successors to China as low wage, underdeveloped countries with opportunities to grow their manufacturing sectors dramatically.

Here are the sixteen:

  1. Mexico
  2. Dominican Republic
  3. Nicaragua
  4. Peru
  5. Ethiopia
  6. Kenya
  7. Uganda
  8. Tanzania
  9. Sri Lanka
  10. Bangladesh
  11. Myanmar
  12. Laos
  13. Cambodia
  14. Indonesia
  15. Philippines
  16. Vietnam

I find Stratfor’s analysis fascinating, but I am not so sure. I especially like how I have the benefit of analyzing the article a year later.

Booz & Company’s Strategy + Business website ran an article entitled, Is China the World’s Next Rust Belt?  The article is by John Juliens, a Booz partner out of its highly regarded Shanghai office. Despite the title, Juliens sees China manufacturing continuing to grow because the following five factors “likely more than offset the impact of China’s eroding labor cost advantage”:

1. Domestic demand. China’s rapid economic development will continue to add millions of new consumers to its already huge customer base. The country is, or soon will be, the world’s largest market for a wide range of goods, many of which need to be manufactured close to where they are consumed. In addition, Chinese tastes are sufficiently particular for it to often be necessary to design (and manufacture) products specifically for local customers. Technological developments, such as miniaturization and 3-D printing, will further enable these trends.

2. Urban–rural divide. China remains a highly diverse country with a wide gap between urban and rural incomes. In fact, almost two-thirds of its people still earn less than US$5,000 per year. In contrast to the nation’s more developed coastal regions, China’s less-developed inland regions continue to have low labor costs—suggesting that manufacturing activities could be shifted to retain the country’s labor cost advantage.

3. Operational excellence. To date, few firms have truly optimized their Chinese operations. This leaves substantial room for productivity improvements through, for example, more efficient machines and production setups, minimization of defects, leaner supply chains, and improved labor productivity.

4. Frugal manufacturing. China’s competitive advantage already goes far beyond cheap labor. For example, Chinese firms are often quite innovative in reducing costs by redesigning manufacturing processes, substituting cheaper “good enough” materials, and using simpler off-the-shelf components.

5. Investment versus comparative advantage. Economic theory dictates that when labor costs rise, businesses move elsewhere. However, countries can offer investment incentives to attract or keep businesses, and I believe that such incentives often trump the underlying comparative advantage. China, like Singapore—the country it most seeks to emulate—has the financial means and the will to wield this tool effectively.

I am not going to try to match either Juliens or Stratfor in analysis, but I am going to tell you that what our China lawyers have been seeing definitely more closely jibes with Juliens’ analysis than it does with Stratfor’s. We have seen straight line increases in interest in China manufacturing, both by companies already manufacturing in China and by those looking to start. If anything, I have been surprised by how unwilling both sets of companies are to explore other countries and by how those that have looked at other countries still so often choose China. Now admittedly, my law firm’s expertise/reputation in China is going to slant things towards China, but what I keep hearing from the newbies is how easy China makes it to get started and what I keep hearing from those already doing business with China is how easy it is to ramp up there.

In, China Factories Moving In Droves To Cambodia/Vietnam/Myanmar/Malaysia. NOT. we wrote on what we were seeing and nothing has really changed since then:

The article [Wary of China, Companies Head to Cambodia] does an excellent job at setting forth exactly what my law firm is seeing among its clients, which include the following:

  • Small clothing and shoe companies that seriously looked at moving operations to Vietnam or Cambodia but then chose not to do so because it would be “too difficult” to set up a supply chain in those places.  Just as described by Ms. Olchanetzky above.
  • Mid-sized and large clothing and shoe companies that have put their toes into Vietnam or Cambodia by doing a bit of outsourcing from those countries or by setting up small factories there.
  • Many companies of all kinds sending people to scope out Vietnam or Cambodia and, more recently and to a lesser extent, Myanmar.
  • Many companies looking at adding facilities or offices in Thailand or Malaysia or Indonesia, believing that those three countries are going to thrive in the next decade as ASEAN’s economic importance rises.
I actually think that my own law firm’s Asian plans are the norm, at least if our conversations are a good yardstick. Our clients are always asking us about our plans for more offices in Asia and we tell them something along the following lines:

Right now, our Vietnam, Cambodia, Thailand, and Myanmar work is all being done out of our existing offices by our traveling to those countries and working with the people we know there. Much of our work in those countries involves the basics like helping our clients contract with existing companies there and helping our clients register and protect their intellectual property there.  As more of our clients establish a permanent presence in some of these countries, we will look more seriously at opening a new office to serve that region.

The response to the above was invariably, “that makes complete sense and is pretty much how we are approaching things as well.”

But since we wrote the above posts, our Vietnam work has greatly increased and we view Vietnam as a viable China substitute on both ends of the manufacturing spectrum, but maybe not the middle. What we are seeing with companies manufacturing in Vietnam is that really large companies are going into Vietnam manufacturing with their own factories and SMEs are going into Vietnam to have things like clothing and rubber duckies manufactured there. What we are also still seeing is that China is still the place for most other manufacturing.

More importantly — and this holds true for both Vietnam and China — what we are really seeing is more and more companies looking to places like China and Vietnam as markets, not just as manufacturing centers.

Having said all this, however, we fully recognize that what one small US law firm is seeing now is not a great indicator of what is going to happen three, five, ten or twenty years from now, especially since much of the increase in our Vietnam work is no doubt due to Vietnam’s close connections with China.

So what is going to happen three, five, ten or twenty years from now? Will China be a rust belt? Will clothing still be manufactured there? Which if any of the Stratfor 16 can we expect to be ascendent and when? Answers please.

Every few days I make a point to go to the China section of AllTop News.  Not sure how to describe AllTop so I will simply crib its description straight from its site:

The purpose of Alltop is to help you answer the question, “What’s happening?” in “all the topics” that interest you. You may wonder how Alltop is different from a search engine. A search engine is good to answer a question like, “How many people live in China?” However, it has a much harder time answering the question, “What’s happening in China?” That’s the kind of question that we answer.

We do this by collecting the headlines of the latest stories from the best sites and blogs that cover a topic. We group these collections — “aggregations” — into individual web pages. Then we display the five most recent headlines of the information sources as well as their first paragraph. Our topics run from  adoption to zoology with photographyfoodsciencereligioncelebritiesfashion,
gamingsportspoliticsautomobilesMacintosh, and hundreds of other subjects along the way.

You can think of Alltop as the “online magazine rack” of the web. We’ve subscribed to thousands of sources to provide “aggregation without aggravation.” To be clear, Alltop pages are starting points—they are not destinations per se. Ultimately, our goal is to enhance your online reading by displaying stories from sources that you’re already visiting plus helping you discover sources that you didn’t know existed.

Bottom line: It’s a great place to keep up on the zeitgeist of China and a great way to learn of any new and interesting China blogs.

Lo and behold I came across two today, both interesting, but neither exactly new: Engaging China Blog by Geoff Nairn and the China Economics Blog by Robert Elliott.

Engaging China Blog actually started the same year we did — way back in 2006 and we even did a blogpost announcing its addition to our blogroll:

Just added Engaging China Blog to our blogroll and we recommend our readers check it out.  Engaging China describes itself as follows:

EngagingChina aims to keep you informed about the new strategic opportunities in China’s  fast-growing economy — and warn of potential pitfalls.

There are plenty of other sites that write about China.  But in their enthusiasm to describe this fascinating country, readers risk not seeing the wood for the trees.

Our focus at EngagingChina is strategy, pure and simple.

And unlike other sites, we look across the range of fast-growth industries, rather than concentrating on just one.  That’s because the lessons to be learned from doing business in China are rarely sector-specific.To be sure, the challenges facing electronics companies are different from those facing investment banks or wind farms.  But there are also plenty of parallels. We want to encourage this cross-fertilization by drawing readers from different industries and backgrounds.

Geoff Nairn, the founder and managing editor of Engaging China, is a veteran business journalist and long-term contributor to the Financial Times.

I agree with Mr. Nairn’s views of China, but I disagree with his perceptions on the Chinese blogosphere.  All Roads Lead to ChinaChina Business ServicesChina Economic Review Blog, and Diligence China [now China Solved] all “look across the range of fast-growth industries, rather than concentrating on just one” and they do an excellent job of it.  ImageThief and Danwei, though to a large extent focused on media, are great blogs that also often look across the range of fast-growth industries.

Having said this, however, China being as vast as it is, and as quickly changing as it is, there is definitely room for another stellar China business blog, and Engaging China definitely fits that bill.

In e-mail correspondence with Mr. Nairn, I learned he is “a Brit” currently living in Spain.  He has been a journalist in various European countries for nearly 20 years.  For the past decade, he has been a regular contributor to the Financial Times (FT), “writing mostly on IT and telecoms, but also areas like  renewable energy, medical innovation and financial technology.”

Mr. Nairn first became interested in what he calls the “China story,” while writing a magazine article on Cable & Wireless back in 1987.  According to Mr. Nairn, C&W wanted to use Hong Kong as a springboard to the mainland and it had built a fibre optic network in the Shenzhen SEZ. “The idea that China would one day be a huge and attractive market for western tech companies then seemed far-fetched.  A decade on, I was writing about the  internet boom.  A  clutch of  China dotcoms listed on Nasdaq and the western world woke up to the advances that had been made in China’s economy.”

Mr. Nairn sees China as “impossible for western businesses to ignore” and he aims his blog at helping them better understand it.

Mr. Nairn described EngagingChina to me as follows:

It is not an “insider’s view” on  doing business in China — that would be presumptuous, as I don’t live in China. Nor do I set out to exhaustively detail every  Chinese announcement made by Microsoft, each new store opened by Carrefour or every mobile phone model launched in China.   There are other sector-focused China sites that do that, but they are often light on analysis and sometimes one cannot see the wood for the trees.  EngagingChina’s focus is strategy, pure and simple.   To narrow it down, it covers a handful of sectors that are developing rapidly — IT and telecoms, China’s consumer boom, financial services, energy and the environment, and high-tech.

Engaging China has rapidly become one of my daily “must reads.”  It is both thoughtful and original and I urge all readers interested in China business to check it out.

The new EngagingChina looks as though it has not missed a beat as it still consists of short pithy China business update posts.  For example, its five most recent posts consist of the following:

Do check it out.

The China Economics Blog is another recently revived oldie but goodie.  Back in 2010, in a post entitled, China Blogs: That’s The way, Uh-Huh Uh-Huh, We Like It, Uh-Huh, Uh-Huh. Part V, we explained why that blog was on our blogroll:

China Economics Blog. This blog describes itself as a “place to find news, observations, statistics, information on undergraduate (BSc and BA economics) postgraduate (MSc economics) and academic analysis of important issues for China’s economy including economic growth, inequality, stock market, shares, exchange rates, the environment, foreign direct investment, WTO and much more” and that is exactly what it is. I read it for its usually spot on and clearly written China economic analysis.

I have every reason to believe the same will hold true of its latest incarnation.  Its three posts since its return consist of the following:

Do check it out.

And let us know what you think of them both.

We have written countless posts bemoaning the end of cheap China and discussing how that is going to impact companies doing business in China.  We have also written countless posts discussing the countries we see coming to the fore as China replacements.  Obviously, companies are going to need to make very complicated and fact-laden decisions on whether they will stay in China or go elsewhere.

The Economist Magazine recently came out with an excellent article on these very things.  Entitled, “The end of cheap China: What do soaring Chinese wages mean for global manufacturing?” it does a great job highlighting some of the issues involved with making the decision to stay in China or go elsewhere and we recommend you read it if you are or will be facing that same decision.

For more on manufacturing moving out of China, check out the following:

What do you see happening out there?

There have been countless articles written on how the end of cheap China will mean the end of foreign companies going to China, but that has barely happened at all.  This article, “Analysis: Investors make $100 billion bet on China’s drive up value chain,” by Kevin Yao of Reuters, nicely encapsulates what is going on out there by way of foreign direct investment (FDI) into China.

Essentially, FDI has slowed a bit, but is still massive and all of the talk of companies going into places like Indonesia or Vietnam has been to a large extent just talk.  This is what I have been seeing as well and I have to admit that it is NOT what I have been predicting:

I am particularly surprised at how so few of my law firm’s clients have moved over to Vietnam, especially those in industries, like clothing, shoes, and pet toys where to me it makes complete sense for them to do so.  I am even more surprised at how few of our new clients going into Asia for the first time are looking to countries other than China for their manufacturing.

And I have a new theory as to why this is the case.  My theory, which may be less a theory than a fact-based observation, is simply that these companies do not know how to go into any country other than China. I will call this the “I would love to, but…” theory.

Let me explain.

My law firm represents a large number of clothing and shoe companies, most of which are fairly well known brands and have fairly high margins, but most of which are not massive.  In the last year or so, these companies have seen an increase in bad product from China. The typical scenario goes something like this:

  1. Chinese company provides US company with bad product.
  2. US company refuses to pay whatever is still owed for the bad product.
  3. Chinese company goes ballistic and threatens US company that it will do horrible things to it if US company does not pay.
  4. US company complains to me and I suggest that now might be a great time for US company to just walk away from China and set up manufacturing in a place like Vietnam.
  5. US company says that it has heard great things about Vietnam and it would love to go there but it has no clue how to do so.
  6. US company then strikes a deal with Chinese company and keeps producing in China, slowly diversifying to other Chinese manufacturers.

So why does the US company not go to Vietnam?  Simply because it lacks the people in its organization with any Vietnam expertise and because there is no clear and easy path for SMEs to get into Vietnam. The path is less than clear because Vietnam lacks a “soft infrastructure” of well known and highly regarded experienced consultants with offices in the United States. Vietnam also lacks a network of people (and even seminars) in the United States who can talk of their Vietnam experience.  There is at least a couple of how to do business in China seminars in every good sized American city every year, but one on Vietnam anywhere is a rarity.   Vietnam is simply too much of an unknown.

So for SMEs, there is this massive knowledge and fear gap regarding places like Vietnam and that gap is creating an “I would love to” Catch-22.

That’s my new theory.

What do you think?

Just read a really excellent Foreign Policy article, entitled, “The end of the Asian Miracle.” [link no longer exists]  The article is written by Antoine Van Agtmael, “the investment guru who coined the term ’emerging markets.'”  To grossly summarize, the thesis is that the following five pending “game changers” could bode ill for China and bode well for the United States:

  1. The shale gas explosion
  2. The erosion of low-cost advantage
  3. The burden of aging populations
  4. The smartphone revolution
  5. The fighting spirit of smarter competition

I found number two the most interesting because it is the most immediate in the sense that it is already directly relevant to Western manufacturers.  According to Van Agtmael,China is no longer the place for manufacturing,” for the following reasons:

  • A large wage gap remains but even narrowing it will have a big impact. In a dinner speech at the Brookings Institution, Jeff Immelt of GE claimed that an American factory worker can be competitive at $15 per hour with a $3 worker in China.
  • Unit labor costs in the United States, according to OECD data, have declined from 100 to 88 since 1995, better than anywhere in the developed world except Sweden (80). For comparison, Spain (135) and Italy (120) are much higher. That’s good news for U.S. global competitiveness.
  • According to several manufacturers I met with who have plants in China, China now suffers from a lack of technologically trained manpower. Bangladesh and Vietnam are now lower-cost manufacturing centers than China — even Thailand, the Philippines, and Mexico are becoming wage competitive.
  • Productivity per manufacturing worker is also better in the United States than widely assumed. Hyundai, for example, has car plants in South Korea, the United States, China, and India and “unit per hour” production is actually highest in Alabama.
  • World-class Indian car axle maker Bharat Forge found that Chinese workers in its plants had only 40 percent of the productivity of other workers. The Pune hub (near Mumbai) has become much more competitive because of trained labor and better transportation (a container trip to the port used to take at least two days but now only four hours and the port is more efficient).
  • Of course, China’s enormous competitive advantage is not just in wages but also in its scale for assembly-type production, infrastructure, internal competition, and growing domestic market. These advantages are not going to disappear overnight but are now being questioned.

Many of the above are just various ways of saying the same thing: productivity in China is generally not very good at all, particularly when compared to countries like the United States.  I now have a term for the problems that are so often inherent in manufacturing in China: the phantom 20%.  I tell clients who are just starting to manufacture in China that in my experience (which really is the experience of my clients), it usually is not worth doing unless the cost savings are projected to be at least 20%.  Of course this 20% figure can vary considerably, depending on the risks involved in manufacturing a particular product in China. But the point of all this is that there are a lot of inefficiencies and uncertainties in China of which Western companies new to China often underestimate and those costs can be the difference between cost savings and cost increases.

Definitely not saying you should not manufacture in China, but I am saying that you do need to look at your cost numbers with a jaundiced eye. People have been talking about the end of cheap China for years now (click here for a television interview I gave in China last summer on this topic), but I am definitely feeling as though this is the year that American companies are really starting to account for this and looking elsewhere in Asia for their manufacturing needs.

What are you seeing out there?  What China costs were caught you unprepared?

Too good a line not to repeat. It is from the China Business Leadership Blog, in a post entitled Is the End of Cheap China the End of China for the West?  The post is on how AmCham’s recent China business climate survey reveals that “82 percent of respondents surveyed plan to increase investment in their China operations in 2012, with 66 percent saying their goal is to produce goods and services for China, an 8 percent increase from two years ago.” The quote I like is the following:

I do not see any companies around me that are doing the right thing and failing in China. I do personally know companies that are struggling. All of them are struggling because they do not have the right thinking to succeed here as they would if properly led and supported.

In other words, the way you manage your business in China will determine whether you succeed there or not. This mimics something I am always saying, which is that 90 percent of my law firm’s clients seem to be doing very well in China.  I then talk about how, at least to a certain extent this is a self-selective group in that this is a group that is willing to pay American lawyer rates to assure their success in China and so they probably are not skimping in other areas either. Implicit though in all that I am saying is that it is, at least for the most part, the foreign company’s own actions that determine whether it will succeed in doing business in China.

Do you agree?

For more on what it takes to succeed in doing business in China, check out the following:

Since we started this blog back in 2006, we wrote of how you should expect and prepare for China wages and other prices to rise. In our very first month, way back in January, 2006, in a post entitled, “China is Booming, Go There for Growth,” we warned of rising China prices:

This article discusses how “a majority of the world’s top chief executives plan to invest in China over the next three years to win customers” and to win market access, rather than just to reduce costs, which are expected to rise quickly over the next few years in any event.

SMEs should be thinking likewise.

For how much longer will China remain the world’s factory?

A month later, in, “Doing Everything Right in China — A Danfoss Primer,” we talked of the benefits of recognizing that “China has gone from being just a cheap place for OEM manufacturing to becoming a multi-tiered high growth market for goods.”  Then way back in April, 2006, in “China Is Expensive — NOT. Go Second Tier And Life Will Be Good,” we talked of how China’s rising prices were pushing foreign companies into China’s second tier cities.

And we have been writing of this ever since, most recently in a series of posts, we titled, “The End of Cheap China”:

The media has picked up on the whole “end of cheap China” meme and has been writing on it and its meanings frequently over the last few months. In “FDI in China: inland and at your service,” the Beyond Brics blog wrote of how China’s rising wages will push foreign direct investment (FDI) in manufacturing to China’s inland provinces, rather than outside the country.  Beyond Brics cites to an Economist Intelligence Unit (EIU) report predicting China’s inland provinces will be attracting “huge amounts of FDI in coming years.”

“The other big trend identified by the EIU is that services is attracting more investment than ever. FDI in both wholesale and retail has grown by nearly 40 per cent a year over the past five years.” Back in January, 2006, In part I of what became a twenty part series, called Service Sectors in China Will Reign, we predicted China’s service sector would boom.

We predicted all this (along with countless others) because it was all rather obvious. We knew that as foreign companies poured into China and hired Chinese employees, wages would have to increase and with that, spending. We knew that as foreign manufacturers poured into China or simply sourced their products to Chinese factories, the need for companies to service the manufacturers and those who profited from it would increase.

Earlier this year, in a post entitled, “The End of Cheap China, But Not China Manufacturing,” [link no longer exists] China Business Blog & Podcast wrote of how China’s rising prices would influence foreign investment into China. It too concluded that manufacturing would move inland.

In a recent article, “For Some U.S. Manufacturers, Time to Head Home: More companies are assessing the true cost of outsourcing,” Business Week too writes of rising costs in China and of how this is pushing low-end manufacturers to return home.

In Is the era of a ‘cheap China’ coming to an end, Week Magazine rightly views the end of cheap China as “an undeniable sign of economic growth and progress.”

In an oft-cited article from earlier this month, entitled, The End of Cheap China, the Economist Magazine seeks to answer the question of “What do soaring Chinese wages mean for global manufacturing?” Like China Business Blog & Podcast, it concludes that China manufacturing will shift inland and move up the value chain. The Economist concludes its article with the following statement that is actually THE big question:

The pace of change in China has been so startling that it is hard to keep up. The old stereotypes about low-wage sweatshops are as out-of-date as Mao suits. The next phase will be interesting: China must innovate or slow down.

Will China be able to innovate fast enough to make up for the fact that it is no longer cheap? What impact will China’s slowing economy have on all of this?

What do you think?

In part IV of our continuing series on the end of cheap China and the impacts arising from that, co-blogger Steve Dickinson wrote about the increased risks product buyers are facing from their China-based manufacturers. That post concluded with Steve talking about why paying your Chinese manufacturer in advance for product can be so risky. In this post, Steve addresses other, better, payment options. 

To summarize my last post (The End Of Cheap China, Part IV. More On How YOU Must Prepare For It), the following are the basic rules you should employ to pay for product produced by Chinese manufacturers:

  • Avoid paying an advance deposit. If you must pay an advance deposit, understand the risk. Do not throw good money after bad in sticking with a manufacturer that shows it cannot do the job.
  • Inspect the product before you pay. Ideally, do the inspection after delivery. If you inspect the product in China, take into account the risk of deception.
  • Take your inspection seriously. If the inspection shows a problem, either cancel the contract or insist on a remedy. It is surprising how many buyers ignore the results of their own inspection. I have seen several cases recently where buyers contracted for OEM manufacturing of their product using the terrible 30/70 system discussed above. Having read about the problems of defects from China, they paid for a pre-shipment inspection. The inspection showed numerous surface defects, suggesting deeper problems with the product. However, as a result of feeling stuck by their deposit and being under time pressures, they paid the full amount and had the product shipped anyway. In each case, numerous defects appeared, rendering the entire shipment essentially worthless. They could have filed suit in China, but either the amount did not justify the cost of suit or they did not have the resources to sue. If your product inspection reveals a problem, take this seriously. Do not payuntil the problem is solved. Do not think that a theoretical right to sue will save you from disaster. International litigation is expensive and uncertain. Do not allow yourself to be put in a position where such litigation is even a possibility.

The above discussion shows how truly unusual the situation is in China concerning product sale. For most countries in the world, the standard product purchase and sale contract is something like this:

  • Payment is made after inspection. In most cases, the inspection is made in the country of delivery to prevent fraudulent substitution.
  • Inspection is made by a truly independent and expert inspector. The inspector usually works for an internationally recognized inspection agency with a long track record of expertise and independence.
  • Payment is made pursuant to an irrevocable letter of credit issued or confirmed by a major international bank.

The key to this system is the participation of truly independent, trusted intermediaries: the inspector and/or the bank. In drafting purchase agreements where such trusted intermediaries will be used, I focus far less on the litigation/ dispute resolution process because my client’s protection comes from the payment system itself. I Instead focus on creating a set of clear rules so that the intermediaries will be able to do their job with no chance of mistake or misunderstanding. If my drafting is unclear, the inspector or bank will simply reject and I have to try again.

The situation in China is oftentimes completely different. In the China trade process, the usual trusted intermediaries are not permitted to operate. Inspections are done by state owned inspection companies. Letters of credit are issued by state owned banks. Since the 80s, these state owned entities have shown that they are not independent. They will virtually always side with the Chinese side in the case of a dispute.

The result is that they are seldom used. Without the services of trusted intermediaries, the Chinese trade system is set up so that one side of the transaction bears excessive risk. In smaller transactions, the foreign buyer usually bears the risk. In large transactions, the Chinese seller usually bears the risk. This would not be necessary if the Chinese companies and government simply made greater use of the existing system of well established inspection and trade finance.

However, I see no movement at all in this direction. The risk is considerable and must be taken into account in all purchases from China.

Buyer beware.

DAN’S ADDITION: Many years ago, I represented a US Company that was sued for having provided allegedly rotten food to a foreign fish buyer. The foreign company sued my client in a US Federal Court for the bad food. The foreign company’s case hinged entirely on a Chinese government inspection of the fish, which said that the food was bad. Very soon after the case was filed, we told the foreign company plaintiff that there would be no way it could prevail because the Chinese government inspectors would never testify and without them, they had no evidence of bad product. Two years later, and right before trial, we settled the case for a pittance because the Chinese government inspectors had avoided being deposed and would not be showing up for trial. I mention this to point out that even in those cases where the Chinese government inspection reveals bad product, you may not be able to use that inspection in such a way to ensure a real recovery. This case was maybe five years ago and things may have changed since then, but I doubt it. 

By: Steve Dickinson

In my previous post in this series on the end of cheap China, I noted that the risks relating to purchases from Chinese manufacturers are rising in the export sector in China’s Eastern provinces. Given the risks, it surprises me that I still see many buyers who continue to use the worst payment system possible in their dealings with Chinese manufacturers. The standard (terrible) system for payment in most of the export sector is: 30% down payment on signing of contract with the remaining 70% payable prior to shipment.

Why is this a terrible system for the Buyer? Let’s consider the deposit system first. It is common for a Buyer to learn that the manufacturer is not able to make the product, makes the product with excessive defects or substantially delays in delivering the product. If the Buyer has paid a 30% deposit, the Buyer is basically “stuck” with the manufacturer and is not able to go elsewhere even after these problems are discovered. I have seen many Buyers who find themselves trapped in this way.

More important, the need for deposits reveals weakness of the manufacturing sector. Many foreign buyers naively believe the deposit is retained in a special account or is at least reserved for their own project. This is not the case. The 30% deposit is not used as any sort of security. Rather, the deposit is used as a financing tool for the manufacturer. Most raw materials for production are purchased with these deposits without regard to the specific project or buyer. Other costs are paid from the same general deposit fund.

As a result, when there is a problem, the deposit is almost never returned. There are two reasons for this. First, the manufacturer has already spent the money on costs and simply does not have the funds available to pay a refund. Second, the manufacturer knows that the amount of the deposit is so small that there is little risk of the foreign buyer filing suit for a refund. Indeed, normally there is not contract so the basis for requiring a refund is not clear. Thus the Buyer is forced to negotiate a price reduction or an extension or some other make-do remedy with a manufacturer that has already revealed ts clear weaknesses.

Now consider payment of the 70% upon shipment and prior to delivery. Under this approach, if the Buyer does not inspect in China, the Buyer only discovers what has actually been shipped after the payment and after the product has been delivered to the buyer. To consider the risks, consider these stories that have come into my law firm over the years:

  • Buyer purchases carrying cases for its notebook computer. Computer is 8 inches wide. The cases arrive. They are beautiful, except for one “minor” problem: they are all seven inches wide.
  • Buyer purchases jewelry bracelets with clasps that are to be mounted on the left side. The bracelets arrive. They are beautiful, except for one minor problem: the clasps are all mounted on the right side.
  • Buyer purchases hand blown glass Christmas tree ornaments. The ornaments arrive just in time for holiday sales. The are beautiful except for one minor problem: the ornaments do not include a ring on top for mounting on the tree.
  • Buyer purchases candle lamps. Lamp must be made from inflammable safety materials. Buyer pays extra for use of this material. The lamps arrive. They are beautiful except for one minor problem: they are made from normal, flammable paper and plastic and explode into flames at the touch of a match.

In each case, the Buyer received a full container of 100% defective product. The defect was so obvious that it would have been discovered by even the most rudimentary inspection prior to shipment. By failing to inspect, the buyer suffered a total loss. So much for the China price.

Of course, the more common thing is finding a smaller number of defects that result in damages ranging from 10% to 30% of the delivered product. Since the money has been paid, if these defects are discovered only after delivery to the buyer, then the buyer is entirely at the mercy of the manufacturer and is virtually without an effective remedy. The manufacturer knows that the amount at issue is too low to justify a lawsuit on the part of the buyer. If the manufacturer is looking for repeat business, the most common result is that the manufacturer will admit there are defects, refuse to pay a refund or damages and will instead offer a “credit” (typically 5% to 10%) against future purchases.

As with advance deposits, the “credit for defects” system is also a terrible system for the buyer that virtually always ends in failure. Let’s take a look at how this works. In order to obtain the credit, the buyer must purchase from a manufacturer who has already shown that it will make a defective product and not give a refund for having done so. Buyers then get locked in a downward spiral. Each shipment has defects, and the amount of the credit grows. The manufacturer knows that the price for the subsequent shipments will be discounted, so the manufacturer gets even sloppier. So defects increase and delays become common. Finally, the buyer just gives up and writes the whole thing off or simply goes out of business due to the lack of adequate product.

Some buyers have finally understood that making payment prior to inspection is an invitation to disaster. Many buyers now perform inspections in China prior to shipment. This is an excellent trend and is basically required for protection of the buyer. However, this approach is still not as safe as inspection after delivery in the home country of the buyer. The basic reason is that we are aware of many times where Chinese manufacturers deceived inspectors and shipped non-conforming product.

As I mentioned in my previous post, some really bold manufacturers will substitute an entire container of non-conforming product by replacing a sealed container with an alternative. More often, manufacturers will rig the container so that conforming product is easy to find, with non-conforming product hidden deep in the container or in alternative locations on the loading dock. The only way to avoid these deceptive practices is to inspect at the place of delivery in the home country of the buyer and to make payment after that inspection is complete. Most Chinese manufacturers will strenuously resist payment only after inspection upon delivery. Buyers should therefore at a minimum inspect in China prior to shipment and then take into account the inherent risk in this practice. The price the buyer pays is actually substantially higher than its face value since this inherent risk is built into the price.

In part V of this series, I will discuss payment options that can reduce your risks.

Last week, we did a post enttitled, “The End of Cheap China, With A Giant Caveat.” The point of that post was to pick up on the widespread discussion regarding the end of cheap China, but to highlight how this “end” has, and will continue to, impact foreign companies very differently. Our initial “end of cheap China” post was based mostly on a “Made in America, Again: Why Manufacturing Will Return to the United States, a Boston Consulting Group study that jump-started the end of cheap China discussion.

Yesterday, i was alerted to two very recent and very good articles addressing the end of cheap China issue. The first is a post by Michael Zakkour over at the China Business Blog and Podcast, entitled, “The End of Cheap China. But Not China Manufacturing.

Michael starts by positing that “the cheap China era is over, but China manufacturing isn’t.” He goes on to note the following, all of which he contends portend just fine for Chinese manufacturing:

  • China is not going to be able to build a service and consumer driven economy within the next five years.  
  • China’s interior provinces are still a viable alternative for manufacturing, as compared to the more expensive and saturated coastal cities. China’s 12th Five Year Plan “makes clear that more equal development and sharing of wealth is a priority.” This equalizing of wealth will mean a continued and increased push to move manufacturing inland.  
  • “America will not win back the “low value-add, commodity based manufacturing jobs it once had.” These jobs are going to SE Asia and South America. 
  • “China is working toward moving commodity based manufacturing inland, but is also developing higher value-add and higher technology manufacturing in the coastal areas. It is NOT abandoning manufacturing and it has the money to support and subsidize it where needed. In other words China will move from selling toothpicks to the machines that make them (formerly bought from Germany).”
  • China’s has “stellar” manufacturing infrastructure, which makes it very difficult for other countries to compete.
  • Western companies are shifting manufacturing to China to create and manufacture products for China. 
  • Chinese manufacturers are improving in terms of efficiency and quality and this will provide a new advantage for China.

I think Michael is right and his explanation above provides support for the fact that we have not really seen much of a slowdown in terms of our clients’ manufacturing in China, other than on the very low end.

The other article is an Economist article, entitled, “The End of Cheap Goods?” This article focuses on what Bruce Rockowitz, CEO of Li & Fung, calls the phases of Asian manufacturing:

He [Rockowitz] argues that Asian manufacturing has gone through a number of phases, each lasting about 30 years. When China was isolated under Mao Zedong, companies in Hong Kong, Taiwan and South Korea grew expert at making things. When China reopened in the late 1970s, after Mao’s death, these experienced Asian operators converged on southern China. With almost free access to land and labour, plus an efficient port and logistics hub in nearby Hong Kong, they started to make things ever more cheaply and sell them to the whole world.

For the next 30 years manufacturers in China helped to keep global inflation in check. But that era is now over, says Mr Rockowitz. Chinese wages are rising fast. A wave of new demand, especially from China itself, is feeding a surge in commodity prices. Manufacturers can find some relief by moving production to new areas, such as western China, Vietnam, Bangladesh, Malaysia, India and Indonesia. But none of these new places will curb inflation the way southern China once did, he predicts. All rely on the same increasingly expensive pool of commodities. Many have rising wages or poor logistics. None can provide the scale and efficiency that was created when manufacturers converged on southern China.

Rockowitz, like Zakkour, does not see manufacturing leaving China. He just sees it getting more expensive:

Nothing can replace the Chinese miracle. “There is no next,” says Mr Rockowitz. Prices will now start to rise by 5% or more each year, with no end in sight. And that may be optimistic. So far this year, Mr Rockowitz says, Li & Fung’s sourcing operation has seen price increases of 15% on average. Other sourcers of Asian toys, clothes and basic household products tell similarly ominous tales.

At the same time, according to the Economist, China is “shifting to more sophisticated products, such as electronics:”

Some of the more striking offerings at the [Computex] fair were ultra-cheap versions of global hits. A company named BananaU advertised tablet computers with Google’s Android operating system for $100. Another pushed Windows-based thin computers looking much like MacBooks for under $250. E-Readers were everywhere and available for a song.

Whether these products can be produced or sold in developed markets is unclear. The quality may be “B” for Banana rather than “A” for Apple. The intellectual property embedded in some devices may not, ahem, have been paid for. But still, the booths were packed.

Amazingly enough, prices for these electronics goods are “falling sharply” and this is attributed to Chinese manufacturers “learning how to get more from fewer hands.” The article concludes by saying that “Li & Fung may be sounding the closing bell on one era of production, but the Taipei [Computex] computer fair suggests that another is emerging.”

What are you seeing out there? What exactly does “the end of cheap China” really mean for manufacturing and overall?