China losing its manufacturing edge

28 May 2012 00:00  [Source: ICB]

Rising labor costs in China, along with intellectual property rights concerns, could result in a North American manufacturing revival

Five years ago, if anybody claimed that a North American manufacturing revival was underway, one might have been tempted to question his or her sanity. At that time, the region was being flooded with cheap goods from China as jobs flowed in the opposite direction - eastwards.

Manual workers 

 Pic credit: Rex Features

But now, a serious argument can be made that a big recovery in North American manufacturing activity is taking place. Abundant shale gas is adding to the confidence of the US petrochemical industry. Availability of cheap feedstock, via shale gas, has led to plans for raising ethylene capacity by as much as 29% by 2017. This is coinciding with rising labor costs in China, lingering intellectual property rights concerns, logistics factors, the need for manufacturing some finished goods close to consumers, as well as a stronger yuan.

The rise in labor costs in China relative to the countries with which it competes in manufacturing is not a new phenomenon, as the chart from global management consultancy Accenture illustrates.

Over the last few years, petrochemical producers and traders say that wage inflation in China has accelerated as a result of tighter labor supply and government efforts to tackle inequality through mandated increases in minimum wages.

"It used to be you could employ a worker in a packaging plant, a low-skilled manual worker, for [yuan] CNY800-1,000/month [$127-158/month]. Now, it costs CNY3,300/month," says the head of a Singapore-based polyolefins trading company.

Leading Western manufacturers have responded to the erosion of China's labor cost advantage by moving their operations elsewhere. Vietnam, for instance, overtook China as US-based footwear and clothing company Nike's largest production base in 2010.

But for higher-value manufacturing, intellectual property rights - rather than just labor costs - are a key factor in making investment decisions, according to Accenture in its study on global investment patterns.

"China's lack of good intellectual property rights protection has been a problem for many years, and we have yet to see any significant improvement," says a senior executive with a Western specialty chemicals producer. "If you invest in China, you are taking a big risk that an employee will walk away with your patented technology, resulting in a low-cost competitor building a replica plant. You can try to gain redress through the legal system, but the system tends to favor local companies."

The Accenture study looked at other risk parameters for investors, such as politics, the economy and the tax system, and concluded that the US was ahead of China. The World Bank's 2011 "ease of doing business" analysis, which ranks 183 different countries on 10 metrics, assigned the US an overall ranking of four, 83 slots ahead of China.

"The fundamentally stable political situation [in the US], mature tax and legal systems and an excellent operational environment make the overall environment very favorable," said Accenture in its study, drawing on analysis from the Economic Intelligence Unit and IHS Global Insight.

"The economy, which encountered a severe crisis in 2007 due to the housing market bubble, emerged from recession in late 2009, and is on a very gradual path of recovery."

However, Accenture also noted that the US faces considerable challenges from growing economies such as China and India.

"[China] has seen a tremendous rise in the last few years, well supported by its burgeoning economy, political stability and secure environment. However, with widespread issues, such as corruption, inflation, forced relocation, evolving tax and legal systems, increasing pollution and labor issues, the country faces formidable challenges in the future," Accenture said in its study. "In addition, though its economy is diversified in most respects, the policy stimulus applied in 2008-2010 has increased its reliance on investment to drive growth."

Further reasons to be optimistic about the future of North American manufacturing include logistics and supply chain factors.

Recent natural disasters, such as the floods in Thailand and the tsunami in Japan, have raised concerns among US finished goods manufacturers about being dependent on long supply chains.

Another advantage of buying chemical raw materials and components locally is that it is easier and quicker to make manufacturing adjustments, said Accenture.

This is particularly important in the high-end consumer electronics industry, where new products must constantly be launched and existing products frequently adapted.

"Our discussions with dozens of electronics component manufacturers reveal that some segments are beginning to 're-shore,' others are near-shoring [mainly in Mexico] while still others have chosen to stay offshore," said Accenture.

"A new business strategy is emerging in the electronics industry based on the need to build in the market where the component will be used, unless there is a compelling reason to offshore. The segments that are selecting North America as a manufacturing base include high technology [where intellectual property rights are a concern] as well as mid-volume and military applications."

Accenture notes that the "innovation cluster" concept is important - a famous example being California's Silicon Valley. "Being closer to not only components and chemicals suppliers, but also research and development facilities and universities, producing highly qualified future employees, are all big advantages in high-tech industries," it said.

However, Accenture notes that China still dominates lower down the electronics value chain, in the higher-volume applications.

"It is not just about labor costs in China when it comes to certain mid- or low-value segments of the electronics industry," says the specialty chemicals executive. "China has an army of good engineers, great design skills and sophisticated supply chains that will ensure that it retains an edge."

China, it is often claimed, also has an incredibly flexible and hard-working contract manufacturing workforce, willing to get out of bed in the middle of the night in response to the demands of Western customers.

But there is anecdotal evidence this is changing. "I have noticed a change in attitude among the 1990s babies compared with their parents. They expect wages to increase every year, they expect better living and working conditions, and they expect not to have to work as hard," adds the head of the Singapore-based polyolefins trading company.

The investigation by the US-based Fair Labor Association (FLA) into China-based electronics producer Foxconn could also have implications for the flexibility, as well as the cost, of Chinese contract manufacturing.

In March, the FLA found that Foxconn breached several Chinese regulations, including a maximum working week of 49 hours. The company is China's largest private-sector employer and manufactures 40% of the world's electronics.

The non-profit association being allowed into Foxconn by the Chinese authorities might be significant, as is the fact that the investigation was initiated by US-based consumer electronics firm Apple - one of Foxconn's major customers. Apple has since agreed to raise wages in response to the report.

The results of the Foxconn investigation could lead to a "race to the top" by contract manufacturers in general, said Auret van Heerden, president and CEO of the FLA, in the UK's Guardian newspaper. This would, he hopes, lead to a big improvement in pay and in working conditions throughout China.

Improving working conditions and wages at contract manufacturers such as Foxconn are also objectives of the Chinese government's 12th Five-Year Plan (2011-2015).

This shift in manufacturing competitiveness will have huge implications for the global petrochemicals and chemicals industries. We will revisit this subject in later chapters.But suffice it to say, old investment models, based on China's status as the world's lowest-cost manufacturing location, no longer apply.


By: John Richardson
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