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Cross the Rubicon

Helping Your Company Sell Into, Raise Capital From, and Find Partners in Emerging Economies

Cross the Rubicon - Helping Your Company Sell Into, Raise Capital From, and Find Partners in Emerging Economies

Discovering China’s Interior

Last week, the Vale Columbia Center at Columbia University published a new report on China’s inbound FDI.  Titled “The Unbalanced Dragon:  China’s Uneven Provincial and Regional FDI Performance”, the report points out some important trends which illustrate in detail how the country’s next phase of economic development is going to be different than what has characterized inbound FDI over the last twenty years.  For companies frustrated at the crowded markets and expensive costs related to operating in and selling to China’s Tier 1 cities, the report shows how China’s economy is shifting from being almost exclusively a phenomenon of the eastern seaboard to one experienced more broadly across the entire country, starting with provinces in the middle of the country and ultimately working its way westward.

In support of this conclusion, the Vale report notes that regarding the eastern seaboard “its share in China’s total FDI inflows declined from 89% in 1987-1990 to about 75% in 2007-2010.”  What is driving this?  As we have written about previously, China’s eastern Tier 1 cities (Beijing, Shanghai) are becoming increasingly expensive places to conduct business in.  At least one major American retailer, Best Buy, has signaled that its strategic retreat from the Chinese market is because of this fact, but that it intends to make another approach at the Chinese consumer, this time through less competitive and costly Tier 2 cities.  Count me as someone uncertain this is likely to help Best Buy be more successful; however, that is a point for another day.

The much more important point the Vale report shows is that while China’s eastern seaboard is still the preferred destination for FDI (as it says, “the share of the Coastal Region in total FDI inflows remains higher than its share in China’s GDP [84% vs. 56%]”), the middle section of the country is becoming increasingly important.  The report notes that one area of needed improvement that will likely further accelerate this trend is more favorable implementation of special economic zones for provinces in-land.  As the report says, “while China’s overall regulatory framework is the same for all provinces, the Coastal Region benefitted from early economic liberalization and the establishment of Special Economic Zones; this created an enabling environment for export-oriented and market-seeking FDI.”  Another way of looking at that is that while Beijing may articulate formal economic development regulations, in China the question is always how these are implemented at the local level; thus far, implementation has been much smoother along the coast.  But, this is changing.  What is important to take away from this observation is also that foreign companies are likely to find more receptive and aggressive provincial and municipal-level leaders with respect to offering tax incentives and other economic benefits for companies expanding in the middle section of the country.

For companies who view China primarily through the lens of a sourcing economy, the role of China’s middle provinces is going to become increasingly important.  China’s eastern seaboard is experiencing high wage inflation that is unlikely to abate any time soon; consequently, hedging strategies need to start looking at whether identifying vendors further inland is a smart trade.  The exchange for lower wages is going to be higher transportation costs and some additional time in your supply chain.  For companies who view China as a market to sell into, the growth of China’s inland provinces is an opportunity to further refine your sales and marketing approaches, keeping in mind that in China distribution channels and tastes are likely to be highly fragmented and regionalized.  As such, give yourself some time and space to reconfigure what worked in Tier 1 cities for what will work within Tier 2 cities.  Overall, the growth of China’s inland cities and provinces is an exciting opportunity that will be necessary if China is to become an economy with a vibrant middle class.

 

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The Supply Times, They Are a Changing

Hardly a week goes by now where some economic indicator does not come out which gives further reason to believe that China’s future as the factory floor is swiftly coming to an end.  For China’s manufacturers (in particular their SME sector), inflation is hitting them on every front:  their cost of capital has gone up precipitously over the last 6 months, wage inflation continues, raw material inputs are more expensive, and food for their dormitory-housed workers has similarly escalated.  Beijing is walking a very fine line – one American business needs to appreciate the implications of – between saying good bye to the country’s past as the world’s low-cost producer, and welcoming its future (whatever that might be).  China is at a critical moment where its economy will need to take the next step forward into higher value manufacturing, which the developed world is quick to point out, does not always create as many jobs as economic planners might think.  That’s a topic for another day however.

 

What is relevant is that for American businesses reliant on their Chinese suppliers, 2012 marks the year where their supply chains might have to change.  At the very least, your supply chains in China are going to get more expensive.  This means a couple of things:  first, you need to be paying more, not less, attention to your existing Chinese suppliers.  These are the moments in time where cutting corners becomes very attractive to them.  Yes, I know you probably have been doing business with many of your vendors for over a decade; but that was then and this is now.  Don’t be Mattel and make the mistake of thinking everything is fine during a period when you know your suppliers are under stress.  Look under rocks, poke the anthill, and get really pro-active with your due-diligence and quality auditing.

 

Second, now is the time to start looking for other domestic Chinese vendors and to begin protecting yourself in case you have to make a move to another vendor.  The unfortunate reality of the likely economic shakeout that China will be going through over the next 6-18 months is that many vendors who appeared stable are going to fold and go out of business.  We are already hearing stories about people struggling to get tooling back from a bankrupt supplier or pre-paid inventory sitting in a container not released for shipment, etc. etc.  This means now is a good time to double check that you have back-up plans in China.  Where is your next group of potential vendors?  What are their costs?  How quickly can they scale production up?  Do they need tooling to be in a position to help?  And, as Dan Harris over at ChinaLawBlog points out, now is the time to make sure your supply agreements are kosher and executable in China.  By the time you find out you need these, you don’t want to be asking if they are actually enforceable.  Find that out now.

 

Third, now is the time to start thinking beyond China.  As I wrote in an earlier post, I am a short-term bear but long-term (hopeful) bull on China.  That doesn’t mean I am convinced its manufacturing sector is going to look like it does now, at least when seen from the point of view of American importers, in three to five years.  Frankly, if inflation picks up, or China’s governmental policies mandate faster changes, this transition from low-cost manufacturing could happen more quickly than even I think.  The point is this:  now is the time to begin deploying some limited resources to take your products and evaluate whether other low-cost manufacturing centers might be able to produce them.  Vietnam comes to mind, but as I’ve written about here, you have to make sure you are looking at more than just a factory’s infrastructure.  There are bigger questions about logistics, power, duties, etc. that need to be figured out.

 

China is going through a major transition, the likes of which it has not experienced since the late 80s and early 90s.  Frankly, on a global scale these trends may not have been seen at such an impactful level since the American economy embraced the second Industrial Revolution after our Civil War.  The point is this:  with big strategic headwinds facing the Chinese economy, now is the time to review, reinforce, and re-energize your supply chain strategy.  If you wait until it’s too late then, well, it will be too late!

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