Factories Staying Put in China

In December 2006, the Qingdao Morning Post reported that 30 South Korean employees from Xinyi Leather Products and Xinwu Leather Products had suddenly left, leaving 300 Chinese employees unpaid and US$14 million in debts to local banks.

Quoting anonymous local officials, the Shanghai-based 21st Century Economic Report said authorities were increasingly tightening environmental regulations and enforcing workers’ rights. In the year that followed, more South Korean companies used the same exit strategy. As of January, at least 103 Korean companies had reportedly left Shandong Province., with one company in Yantai, Segang Textiles, left behind 3,000 employees and US$4.17 million in debts.

A recent survey by the American Chamber of Commerce in Shanghai and Booz Allen Hamilton found one of every five foreign companies are considering moving their China operations as a new Labor Contract Law that kicked in January 1 increased costs for producers. The yuan jumped 7 percent against the US dollar in 2007 and is continuing its upward trend this year

By early this year, the news of fleeing overseas companies deserting workers in the Pearl River Delta had spread to western newspapers as well, with the story making front-page news across Asia.

Although the story appears to have been overblown, however, that doesn’t mean there hasn’t been trouble. Speaking to the 21st Century Economic Report, a lawyer for the Yantai Korean Merchants Association said the new Labour Contract Law is affecting businesses with small margins: “If each worker is paid 100 yuan more every month, the monthly cost of the company will go up by 300,000 yuan... Besides, according to the new law, businesses have to pay 30 percent of the social insurance for their employees and this increased the pressure on Segang’s cash flow.”

The phenomenon has spread beyond Qingdao as officials put more emphasis on labour and environmental regulations. Workers at a textile factory in Chongming Island, near Shanghai, held seven South Koreans hostage last November after they moved to sell its manufacturing facilities. After a seven-day standoff, the workers were paid their wages. Nor is it is only underfunded South Korean businesses that are looking at a closing their China operations. The Federation of Hong Kong Industries says up to 7,000 Hong Kong-owned factories operating in Guangdong will close by the end of this year.

And there is little hope that things will get any easier in the coming months. Manufacturers expect salaries to go up by as much as 20% in July when new minimum wage regulation takes effect, said Eddie Wu, vice-president of the Hong Kong Electrical Appliances Manufacturers Association. “Everything is getting more expensive. The best we can do is negotiate with the customers. If we have a lot of competitors, we have no ammunition… Small companies, they’ll close down.”

But while it is impossible to ignore the number of businesses shutting down in the Pearl River Delta, rather than an exodus, it appears to the beginning of an economic realignment that could bring online the fabled domestic market of 1.3 billion consumers. Those departing are mostly smaller businesses with few employees. Big shops with thousands of employees are still better off staying in China, partly because they may not be able to find enough people in Vietnam to staff their shops.

Jonathan Anderson, head of Asia-Pacific economics at investment bank UBS, says the conditions are in place for a shift in the Chinese economy away from its hallmark low-cost manufacturing base. This is not to say that Chinese exports will become irrelevant any time soon. Growth has slowed in the last five years but exports are still growing at 20 percent per year.

“There is no sign of ‘evacuation’ from coastal provinces to date, and no market share losses in traditional labour-intensive sectors. In short, no indication at the macro level that exporters might be in trouble,” Anderson wrote in a recent note.

What’s more, Chinese exporters do not appear to be losing their edge. According to official data, which looks at bigger companies in a number of sectors, light industry reported an increase in profitability in 2007 as export manufacturers passed on costs by hiking prices. The share of exports out of Guangdong is dropping, but exports from neighboring provinces like Fujian, Zhejiang and Jiangsu are rising. The sum leaves the total share of exports from the region virtually flat at about 60 percent.

“Once we account for this fact, there’s very little support left for the idea that producers are fleeing the coastal areas in significant numbers,” Anderson wrote.

Timothy Kim is a good example. In the last decade, Kim has seen his company expand exponentially. A business that was once two people with a phone and a desk is now a multi-million dollar international enterprise with a large showroom in Hong Kong and a fully integrated factory in Dongguan, in the Pearl River Delta manufacturing hub that produces about 60 percent of China’s exports.

“Everybody says we have to go to Vietnam… Wrong. Stupid,” says Kim.

Kim’s Silver Star Kitchenware makes all kinds of metal kitchen products. His large showroom in the New Territories is jam packed with pots, pans, ladles, thermos, forks, knives, strainers and woks. The showroom is shining with metal. Kim makes every part of the product in-house.

“We make everything: The screws, handles, everything. This industry is a materials industry. Materials is 70 percent. Labor is maybe 20 percent. Vietnam cannot compete,” Kim says. “This is a materials business and you can’t get good materials anywhere else.

“You want quality, you have to do it under one roof. Upstream and downstream are important,” he says. “Labour costs in Vietnam and China are about the same in real terms.”

Vietnam’s infrastructure is weak and its labor pool is not always cheaper than China’s. It has a population of 86 million and its US$2 billion economy is a fraction of China’s but up until last year, it was growing at more than 8 percent annually.

China may no longer be the cheapest manufacturing locale but manufacturers have boosted their efficiency to compensate and passed on some of the increased costs to suppliers. China also has a relatively good infrastructure, plenty of manpower and access to quality raw materials – whether domestically produced or imported in vast quantities. Companies are moving out of traditional manufacturing hubs like the Pearl River Delta but they are often smaller companies with little value-added. “China is actually keen to develop high-end production and also get rid of low-end production plants that are contributing to pollution,” said Sherman Chan, an economist at Moody’s.

Costs and regulations have been getting more onerous across China for several years, with officials often targeting high polluting enterprises. The issue came to the foreground before 2006 when the small South Korean operators started leaving China, often under the cover of night.

Kim, of Kitchen Star Silverware, has a long list of reasons why moving to other locations makes very little sense. Finding quality materials in Vietnam or Cambodia is very difficult, he says. Stability is measured in months, not years. Quality employees are not always easy to find and there is not the plentiful supply that can still be tapped in the Pearl River Delta. And, while inflation has hit China, it is nothing compared to what it has done to Vietnam.

Still, operating in China can be tricky and old models may no longer work.

“You must restructure your company into Chinese style combined with American or European style,” says Kim. “More scientific.”