Tough Times Call For Smart Measures
June 23, 2008
The growth in China in the past 10 years has been unprecedented. China is still the most popular destination for foreign manufacturing investments on the globe. In 2007 it attracted more than $80 billion in Foreign Direct Investments (FDI). The China economy continues to “over heat.” The average annual GDP growth in 2002-06 was 10.3%, while per capita GDP growth was 9.2% due to the population increase.
This “cancerous” growth comes with very high costs in terms of quality, efficiency, banking/securities controls, and geo-political fallout. In order to cool off the economy, the Chinese government has implemented some stop-gap measures over the past 18 months. Some of the key measures that impact US companies already doing business in China are wages, exchange rates, and taxes.
Wages
In Guangdong province, which has some of the lowest wages in the PRC the labor rates have increased over the past five years from 463 Yuan, 577 Yuan, 676 Yuan from 2002, 2004, 2006, respectively. The average wage has increased 25% from 2002 to 2004 and 17% from 2004 to 2006, which is 46% over this time period. This does not include any burden, such as medical, meals, lodging, etc.
The total wages for employees in China reached 2.34 trillion Yuan in 2006 from 1.32 trillion Yuan (US$309 million) in 2002 (minus inflation), according to the National Bureau of Statistics (NBS). The average annual wage of an employee reached 21,001 Yuan in 2006, up 70% by real terms from 12,422 Yuan in 2002, after deducting price hikes. In other words, the largest resource in this country has increased its cost to 25% per year in almost every industry.
Exchange Rate
The China RMB or Yuan was historically pegged to the US dollar at a rate of 8.2865. In 2005, the currency was allowed to free float and as of May 31, 2008 the exchange rate to the dollar was 6.9348 or a 19.5% increase in value since the adjustment in foreign exchange policies. This translates to a 1% decrease in profits of a local Chinese company for every 3% devaluation of the dollar.
Taxes
According to official statistics, as of the end of 2005, there were about 500,000 companies with foreign investment registered in China. Of those, about 330,000 had started operating. About 55% of the foreign companies operating reported losses between 2001 and 2004. In 2005, the figure dropped to 42.96%. It is interesting that while Chinese enterprises, including state-owned, joint-stock and private companies, have been making profits in recent years, nearly half of all foreign-invested businesses have been losing money. Yet while so many foreign enterprises claim to be losing money, China witnesses a continual rise in its FDI. According to a research report by the National Bureau of Statistics on foreign companies claiming to be making losses in China, two-thirds of them have “extraordinary losses.” Chinese officials believe many of these foreign companies are in fact using transfer pricing and other ways to reduce taxable income. In reaction, China is phasing out its practice of charging lower corporate tax rates for foreign-owned companies.
Another key impact on the tax is Value Added Tax (VAT) which is paid when goods are used or made in country. This VAT is then refunded if the goods are exported. However, this is not a 100% refund. In fact, there have been three rounds of VAT rebate reduction since 2005. China’s rates of VAT rebate for exports comprise five levels, i.e., 5%, 9%, 11%, 13% and 17%. On 1 July 2007, China adjusted the VAT rebate rates for certain exports. The most recent China reduction of the export VAT rebate in July 2007 has further impacted profitability of most companies. An example of this would be a company that has two plants in China: Assuming Plant A has >90% local content and Plant B has >35% local content, a reduction in VAT rebate by as little as 2% means Plant A’s profit margin will been reduced by over 3% and Plant B’s by over 1%. This is based on the value added portion of work “in-country.”
Risk Mitigation
These are some of the key economic effects that are a natural progression for a developing nation. However, as the policies change the consequences have a rippling effect on many companies. In order to maximize on the cost advantages and mitigate the risks of a one-country strategy, as the PRC continues to make policy changes, we offer the following alternatives.
- Cost Optimization
One of the major advantages of China’s development and influx of FDI is the maturity and depth of supply chain infrastructure that has been established. Many Western organizations are perhaps not “localized enough” to be able to optimize these supply chains. In difficult times, relationships become a critical factor to ensure one takes advantage of supply chain processes. Collaboration rather than individual activities brings greater purchasing leverage by optimizing the supply chain relative to costs, lead times, and freight. Local knowledge is to know how to classify your products. Perhaps changing from fully built to “semi-finished goods”, with finishing taking place closer to the end customers will allow the company to optimize on the VAT rebates.
- Two Countries, One Strategy
Companies that are already established in the PRC or are in the process of doing so, need to have a “multi-country” Asia strategy. This means moving or establishing a presence in other parts of Asia, i.e., Vietnam, India, while keeping the same strategy for lower costs and or proximity to markets. It is estimated that over 40,000 Hong Kong based enterprises have done just that.
- Time To Bring It Home
Maybe the strategy you set three to five years ago did not come to fruition or conditions have changed so much that it is time to bring some of the operations/activities home and minimize the investments. Although China has intoxicated investors throughout history, it is neither the only nor the right answer for everyone. North America and parts of Europe (Eastern) are still very viable business investments for manufacturing and sourcing, depending on the margin sensitivity of the business. However, this strategic change should not be taken lightly, since investments in time, capital and resources have been established. The winds of economic change will shift again and to re-establish in the PRC will be very costly.