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Searching for an edge

by Bennett Voyles

May 30, 2012

Most people agree that China is losing its labor cost edge. So what will be the country’s next competitive advantage?

In a surprising announcement in May 2011, luxury handbag manufacturer Coach said that it would transfer at least half of its production facilities from China to countries like India, Vietnam and the Philippines where the production costs are much lower. At the time of this announcement, production in China accounted for almost 85% of Coach’s total production and according to CEO Lew Frankfort, the idea was to bring it down to 40-50% of the total. Ironically, the China market continues to be Coach’s most important consumer market outside of its home market of North America, but rising wages in the country are forcing the company to consider other countries.

Coach is not the only one. Several companies are considering relocating manufacturing elsewhere. This is a worrying development for China. According to Ministry of Commerce statistics, foreign direct investment in all sectors fell 2.8% in the first quarter of 2012, to $29.48 billion – the fifth straight month of declines. At the same time, Chinese export investments have surged 94.5%, to $16.55 billion, which the ministry blamed on rising wages and other costs.

That doesn’t mean every company is packing up, or stopping fresh investment. But it does suggest that China’s low-cost labor advantage is diminishing.

If cheap workers are gone for good, what will China now use for a trump card?

A Gradual Loss

A number of factors have begun to make Chinese labor less competitive, says Wang Yijiang, Associate Dean and Professor of Economics and Human Resource Management at Cheung Kong Graduate School of Business.

Inflation in the cities is leading to a decline in migration from the countryside, reducing the supply of new workers. “Ten years ago, they travelled the distance, made a few hundred yuan and were able to save a lot and send money home… But nowadays they say the money you earn here, you have to spend it all so why bother?” he says.

At the same time, taxes and government spending are also crimping the supply. Taxes and fees make profits very thin for most companies, reducing the amount of money left to hire workers or raise wages. Operating on razor-thin margins, businesses lose “this capability to substantially increase labor pay even just to catch up with inflation. So real income, many people tend to believe, has actually declined, or at best, stayed relatively stable and stagnant.”

Inadequate salaries discourage rural people from moving to the city, while welfare programs discourage work. “(Welfare programs) take labor out of the labor market. Many people would rather spend time to play cards and hang around to receive easy money than to work hard to make the nominally higher but inflation-adjusted low-wage income,” says Wang.

Curiously enough, China’s famed one-child policy may also be having an impact, creating a pampered generation that doesn’t want to get their hands dirty. “(The one-child generation) has two parents and four grandparents – everyone pouring resources into supporting them, everyone wanting them to have a happy life… In industries like manufacturing and other businesses that require hard and dirty work, these are not the people to fill the job vacancies,” says Wang.

Restrictive labor laws that went into effect in 2008 may be taking a toll as well. As businesses have a limited ability to fire workers, companies won’t take a chance on training unskilled workers, limiting the supply of skilled workers, and encouraging companies to automate. The automation wave is already sweeping across China, and the scale of automation is unprecedented sometimes. Take for instance, electronics manufacturer Foxconn which recently pledged to replace 1 million of its workers with machines over the next five years.

For all these reasons, manufacturers, especially those at the lower end, may become more interested in Vietnam and other lower-cost markets, says Wang.

Not So Fast

But is the situation as bleak as it sounds? Some say the risk that China will lose its manufacturing base to foreign companies is overstated. Shaun Rein, managing director of the China Market Research Group, and author of The End of Cheap China, argues that the expertise and scale of Chinese factories are now so advantageous that relocation is no longer really possible.

“China will not lose its dominance in manufacturing anytime soon,” Rein says. “It is very hard to move an entire ecosystem of manufacturers from one country to Vietnam. It is more likely that these factories will move to other parts of China, as Intel and Foxconn have already done.” Many of these original equipment manufacturers (OEM) are owned by Taiwanese. It is easier for them to move within China, deal with employees and government officials, than move to new countries that have different languages.

Instead, he argues, rising labor costs plus a government push to wean the economy away from manufacturing exports to services and consumption do mean a major shift is on the way, but not a bad one. “Workers will leave factories and move towards the service sector,” Rein predicts.

Access to the growing Chinese market could be one strong suit. With over 160 cities with more than a million inhabitants – Europe by comparison, has 36 – and an increasingly developed retail market, domestic market exposure may be a key advantage.

And not just in size, but the potential for innovation. “In a number of industries – mobile phones, for example – Chinese consumers are already as (if not more) sophisticated than their Western counterparts, so Chinese domestic competition already has to hit a higher bar than foreign firms might in their own home markets,” says Bill Fischer, Professor of Technology Management at IMD business school in Lausanne, Switzerland, and a specialist in Chinese business.

But given the reluctance of the Chinese to spend, it would be a mistake to rely entirely on the Chinese consumer. However, Fischer says, given the reluctance of the Chinese consumer to spend, such an evolution may be a long time in coming.

A Customer Focus

Instead, Fischer bets that service-rich manufacturing that pays increasingly close attention to the customer’s needs as China’s next killer app.

“I see emphasizing more service-intensive manufacturing, rather than pure services, for example, and more innovation as a way of differentiating Chinese manufactured products from the commodity-offerings of the newly emerging low-wage states,” Fischer says.

The key here, in Fischer’s view, is market-driven innovation that pays extraordinarily close attention to customer needs, and then delivers on them. This can be done by adapting products to meet customer needs. For example, when Haier learned in the 1990s that its washing machines were being used by peasants to make their vegetables more attractive for the market, the company didn’t send out instruction manuals telling them to only use their washers for clothes. Instead, it created a model with gentler agitators.

Or it can be done by adding new services. Broad Air Conditioning, for instance, has made a reputation for itself as a service leader, providing remote-monitoring and maintenance of its air-conditioning units. Ironically, Fischer notes, “while foreign firms competed on price, Broad was more expensive but also much more service-intensive.” Huawei and Haier have also built strong franchises by paying extremely close attention to customer needs.

But such a conversion will be difficult, he acknowledges, given the scarcity of strong global Chinese brands. “‘Made-in-China’ is still not a brand that inspires enthusiasm or trust,” he says.

Without that trust, consumers will resist buying more complex products and offerings. “Each time we see another product quality scandal in China, it diminishes the chances for this happening in the short-term!” he says.

Handled well, however, Chinese companies will move from an era in which they all shared a single advantage (cheap labor) to one where they will be able to develop different kinds of advantages – a privilege, Fischer notes, that “typically only large nations can enjoy.”

So what’s the bottomline? “The downside… is that China will lose its cheap labor advantage. But the upside is that to survive, we have to upgrade the value chain, the technology in terms of innovation and so on,” says Wang. “The good thing is that it does represent the future – that’s the direction that a country should be moving to in any case. But it’s bad at the same time because you have a large population which is uneducated and cannot follow the trend, who cannot move up along with the businesses. So these people will be left out.”

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