Since the beginning of last year, China has seen significant factory closures. Two-thirds of Chinese companies that export small toys, for example, shut down in the first nine months of 2008, according to China’s customs bureau. In the first 10 months of 2008, according to official figures, 15,661 enterprises in Guangdong, the manufacturing-heavy southern province, shut their doors. Over half of those – about 8,500 – ceased trading in October alone.
The World Bank has forecast that China’s growth in 2009 could drop to 7.5 per cent, the lowest in nearly two decades. Reports suggest China’s economy expanded by only 6.1 per cent in the first quarter of 2009. These growth rates sound very high by western standards but China has been enjoying double-digit growth for more than two decades and these reduced rates are hurting.
China’s manufacturing sector contracted for the eighth consecutive month in March 2009, according to the CLSA China Purchasing Managers Index. However, the rate of decline eased for the third month running while in April the index rose, indicating an expansion of the Chinese manufacturing sector for the first time in nine months. This was driven by an increase in domestic demand while export sales continued to decline. Overall prices charged by manufacturers continue to fall.
Schmittzehe & Partners, a China-focused advisory firm, undertook in-depth research into this phenomenon at the end of 2008 in order to better understand the underlying picture and the implications for CPOs. We carried out structured, in-depth interviews on the ground in China with industry associations, factory general managers and finance directors, bank loan managers and senior procurement executives.
What kind of factories have been closing down?
Over the past two decades, China has implemented various policies to encourage the establishment of export processing in China to use its low-cost labour and bring increased prosperity to the country. The sector rapidly flourished but many such companies, lacking any real intellectual property, have become producers of low-margin commodity products that have caused them to subsist on single-digit profit, and rely on the very incentives China had put in place to attract them.
Businesses with an overreliance on orders from overseas – especially from the worst-hit markets such as the US – and foreign exchange-sensitive income have been hardest hit. The most at-risk companies tend to both have little intellectual property and typically be selling to intermediaries. “Those that can’t pay their banks tend to be original equipment manufacturers (OEMs), low-tech, very labour-intensive and highly polluting,” says a veteran factory general manager at a Hong Kong furniture manufacturer based in the Pearl River Delta (PRD).
“Most were already operating on very low margins and were already in financial difficulty even before the developments over the past 12-18 months.”
Certain sectors, such as shoes, toys and furniture, have been particularly hard hit. In such sectors, low margins have often forced companies to ignore labour and environmental law. As local governments stepped up their efforts to enforce such laws in mid-2008, these companies became very exposed. Plastic injection and electro-coating have also been badly affected, adds the factory manager.
Closures have been across the board, whether they are Chinese state-owned, private or foreign organisations, but the latter group seems to have been particularly hard hit. According to the Chinese general manager, operations, at a leading Hong Kong-owned manufacturer that has been working in the PRD for the past decade, foreign manufacturers don’t receive as much protection as local mainland ones; the latter generally enjoy better government relations.
Moreover, the local government tends to seek to offer its compatriots benefits so that they can remain in the region. Another reason for this is that many closures have not been bankruptcies but a “relocation” of resources which is easier for foreign entities.
Among the foreign manufacturing companies, the most affected group seems to be Hong Kong factories, followed by Taiwanese, which is not surprising as they represent the two largest groups of foreign factories in the PRD. Export-orientated companies tend to be concentrated in the PRD as well as the Yangtze River Delta provinces of Zhejiang and Jiangsu, but the former has more foreign-owned small and medium-sized enterprises whereas the latter is home to a higher concentration of local Chinese companies.
According to a senior figure at the American Chamber of Commerce in Hong Kong, the closures of Hong Kong manufacturers are in part due to their ownership now being in the hands of second-generation family members who had been considering exiting the business anyway and see the current downturn as their chance.
“We have now a second generation who take over but prefer to take the money and find another business with better returns so want to invest their money elsewhere,” he says. Moreover, Hong Kong manufacturers have traditionally been quite dominant in a number of the key at-risk, low-margin export processing sectors such as furniture, toys and shoes.
A senior Chinese Wal-Mart procurement executive pointed out that Hong Kong not only had more SMEs in the PRD than Taiwan but that they also tended to be less stable. The factory general manager in the PRD added that, compared with Taiwanese manufacturers, Hong Kong’s “tend to be more subject to environmental than labour laws. They find it would cost them a lot of money to improve their plant’s environmental conditions.”
Hong Kong, and to some extent Taiwanese, manufacturers have been suffering from operating on much shorter horizon business plans with higher gearing so they can grow faster and start to break even earlier. According to the Wal-Mart executive, manufacturers’ business plans are based on the old policy, which still applies for companies established pre-2007.
Under these rules, if they receive foreign investment, they pay no corporate tax for the first three years and half the normal level of corporate tax for the following two years, so manufacturers will need to reach free cash flow by year five. As a result, they need loans to help them achieve scale in time and hence find “breathing room” by year five, which results in more aggressive gearing. Because many such manufacturers are operating on single-digit margins, increases in costs can destroy what margin there is.
A good number of Taiwanese manufacturers also look exposed. A number of sources, including the managing director of a large company with manufacturing and suppliers in the PRD, mentioned many Taiwanese companies were closing up and relocating. “Taiwanese companies tend to run more often because they are registered as private companies owned by one individual [sole proprietorship] and their legal structure is typically not legal,” says the CFO of the furniture company.
“They exist as a Chinese company in China and they don’t tend to declare anything, be it turnover or purchases, and suppliers don’t provide VAT invoices. If they suddenly have to pay all their taxes including back taxes they will find themselves in trouble. They also tend to not pay taxes.”
Korean companies, more prominent in north-east China, which is closer to their home country, have also been affected although they were mentioned much less. In part, this is because there are simply fewer Korean manufacturers in China and in part because many are either larger or in higher-margin sectors such as electronics.
According to a source at the Guangzhou Korea Trade Centre from the Korea Trade-Investment Promotion Agency (KOTRA), there have indeed been Korean closures; in fact, since many have found the process of closing an entity in China so complicated and time-consuming (the source suggested it takes at least six months) some of them simply upped and left. This has been widely reported in the local press, harming their reputation among many Chinese workers.
Mainland Chinese manufacturers have also been affected but have been less likely to close than Hong Kong and Taiwanese companies. According to a deputy secretary-general of the Shenzhen SME association, under the bureau of the Shenzhen government, local SMEs are comparatively stable and so far there have not been many closures.
Meanwhile, according to the Wal-Mart procurement executive, mainland manufacturers benefit from a number of factors that include longer return on investment targets and better payment terms. But trends suggest mainland closures have been on the increase, something echoed by local media and bank findings.
Interestingly, a number of sources indicated that Hong Kong manufacturers were less likely to default on payments than their Taiwanese and Korean counterparts. “There are very few cases of Hong Kong investors closing their enterprises on the mainland without paying off their loans,” says a Dongguan director at the Federation of Hong Kong Industries. “The mainland Chinese Superior People’s Court recently issued a new announcement that mainland appeals could be conducted in Hong Kong. This does not however affect Taiwan companies and some of those might not pay off their loans.”
Resources to reopen
According to the Hong Kong AmCham Textile & Apparel Committee chairman, larger factories have more resources to call on to open facilities elsewhere, which helps them to manage the risk. Smaller factories in the PRD are the businesses most affected at the moment.
The Wal-Mart procurement executive agrees that size matters. “There seems to be a threshold and those above that seem to be able to keep going,” he says. Some sources pointed to the threshold as being around 1,000 employees, while the CFO of a PRD-based furniture manufacturer puts it at around 500-600.
According to sources, about half of closures are actually a case of the factory moving to a cheaper location in China or overseas. Of the remainder, only half are bankruptcies and the other 50 per cent are orderly closures with the financial resources being reallocated to other means of income. The managing director and owner of one trading company, with offices in Hong Kong and sourcing from China, explained that Hong Kong and Taiwanese companies were trying to move outside the PRD and Shanghai River Delta to places where there is more labour and the laws are not enforced.
Overall, it tended to be Hong Kong and Taiwanese companies that moved, the only difference being their destination. “Taiwan manufacturers typically move to Vietnam, as do the Koreans, and some back to Taiwan,” he says.
A significant reduction in exports is often only what actually kills organisations. Many of the factories closing down have been operating for years on low single-digit margins, which have increasingly turned negative owing to a number of factors:
Local government regulatory enforcement: While the central government had gradually been adding to its labour laws, in 2008 local governments began to enforce them more stringently. As a result of the recent factory closures, local governments have begun to relax their enforcement again while the central government has directed state-owned manufacturers to reduce wages rather than lay off workers. Local governments also began to enforce environmental laws much more diligently in 2008.
Local government policy: Guangdong Province, for example, has been trying to squeeze out low-value-adding export processors and replace them with companies higher up the value chain.
Central government fiscal changes: The level of VAT that exporters could reclaim was reduced in 2008.
Inflation: Rising wages, raw material and energy costs have all come together.
RMB appreciation: The local currency has been steadily appreciating against the US dollar.
Will more close down?
Despite the Chinese economic stimulus package (see panel, above), factory closures continue and we believe that the way many Chinese manufacturers are financed could mean much larger problems on the horizon. Apart from direct and indirect support by the banks, manufacturers are also financed via credit terms with suppliers and delaying payments to other parties, including their own labour force. The managing director of a company with manufacturing and suppliers in the PRD, for example, pointed out that most creditors are operating on a net 30-day credit line with suppliers.
More worrying is the fact that because many export manufacturers on the mainland struggle to get sufficient bank financing from the Chinese state-owned banks, which prefer to lend to larger and typically state-owned companies, a good number of them are financed via real estate-based, asset-backed loans. However, the medium to high-end real estate sector in China suffers from significant oversupply and a number of cities, especially Shenzhen, have seen signs of significant declines in real estate values. This could spell trouble for the owners and hence manufacturers. The only alternative for the latter is to source from the expensive but pervasive black market.
The best will survive
Although factory closures continue, the strongest manufacturers will survive. Their strength has a lot to do with their business model and whether this allows for larger margins, either through having their own brand or dealing directly with the ultimate brand, and the extent to which they have invested in their own intellectual property, automation or efficiencies, and a greater general level of operational sophistication.
According to the veteran factory general manager, the survivors will typically manufacture their own products. This provides better margins. Some have also introduced automation and processes to reduce labour. The CFO of a PRD-based furniture manufacturer also suggests survivors may have been able to increase prices (most, however, are not completely successful), and have more to offer than simply processing trade. Unlike the companies that close down, their businesses are not focused solely on price but also offer design, quality and heritage. In addition, the survivors rarely work through traders but deal directly with the end customer. Their higher margins allow the manufacturer to observe labour and environmental laws more closely.
The Wal-Mart procurement executive suggested survivors tended to be closer to their customers in terms of relationship and, importantly, have steady customers that pay on time. “Lots of traditional businesses, if they have a steady customer that pays on sight and a stable business, won’t need a lot of financing as they will get 30 days from their suppliers.”
The weaker manufacturers, however, will fail to adapt and do not have the resources and ability to survive what could be a protracted period of difficulties. Closures may well spread to an increasing number of “at-risk” manufacturers due to knock-on effects along the supply chain, and a potential property crash that may cause banks to repossess the properties used as collateral for loans. Sources believe the problem may well spread to larger manufacturers, while alternative production bases have not always proved to be the solution manufacturers that have relocated plants there had hoped.
The veteran general manager of the furniture factory estimates that 10 per cent of manufacturers in the PRD will close down in the coming three years. The CFO pointed to the knock-on effect along the supply chain of closures to date.
“In Hong Kong, if you place an order, you have to place a deposit,” he says. “If the supplier closes down, you lose the deposit and you lose the order too, as you can’t supply or you spend a lot extra to still deliver.”
Of course, these closures are forcing consolidation in a good number of export industries, which, in the long term, could be healthy for the sector and good news for those who survive.
Some of the stronger manufacturers will take advantage of the situation to acquire distressed assets, increase efficiencies, reduce costs and increase exposure to less at-risk markets such as the Chinese domestic market. These survivors will then be in a much stronger position as power shifts to the suppliers with a reduced overall supplier base.
“They can now get the cream of the crop in terms of labour, allowing them to produce faster and leaner,” says the managing director of a China sourcing company. “They are also changing their export licence to manufacture more for the domestic market. Before, they might have been restricted to 95 per cent export and they might reduce this to, say, 60 per cent, although this will have an impact on their VAT structure.”
But the overall situation is likely to get worse before it gets better, says one experienced Chinese banking executive. “The US is delaying payments and demand continues to decline in terms of invoice billing.” The managing director of a furniture manufacturer with operations in the PRD points to his past experience in the UK, suggesting that more factories tend to close at the end of a recession.
“None of the markets are going to come back in a hurry so there is more pain to be felt,” he says.
Implications for CPOs
Beware of “foreign” – Hong Kong, Taiwanese and Korean – China-based export processing manufacturers as they are the worst hit.
Beware of being overly aggressive with suppliers based on “commodity” relationships. If they fail, you will
Develop a comprehensive set of measures to put suppliers at ease. Some suppliers may be reluctant to take on new customers or orders, or worried about delayed payments.
Select the strongest suppliers and invest in longer-term relationships with them, locking them away from competitor supply chains. Work strategically with your suppliers to help them become stronger through joint automation and efficiency programmes.
Expect continued supply contraction as more manufacturers close and expect some stronger suppliers leveraging this to negotiate better terms.
Invest in supplier and supply chain due diligence, taking into account the complex and often hidden financial vulnerabilities such as off balance sheet financing based on a weak real estate and stock market.
The China stimulus package
In November 2008, the Chinese government announced an aggressive RMB 4 trillion (approximately $586 billion) economic stimulus package, the largest in the country’s history.
The package is an interesting economic construct, the idea being that the central government injects roughly a quarter (RMB 1.18tr) and three other parties are expected to match that, creating a “multiplier effect”. The other contributors to the pot are to be local provincial governments, banks and businesses.
The spend is being allocated across seven project categories (see figure 1). The money is to be invested in over 100,000 projects over the course of two years. Most are construction projects.
It is important to consider the package as part of a wider economic policy to stimulate the economy while achieving the government’s longer-term policy objectives. Other policies include:
Exports: Cuts in the VAT rebates for exports made in 2007 have all been reversed, stalling the gradual appreciation of RMB with possible depreciation
around the corner, and there have been reductions in export tax on some items, including steel products and fertilisers.
Credit: Interest rates have already been cut and further reductions are expected, along with increases in lending quotas. Part of the rise in lending is aimed at smaller businesses, which have historically been neglected in China. Tax deductions are to be introduced on fixed capital investments.
Construction: Insurance companies have now been permitted to invest in construction projects, banks are expected to extend favourable loan conditions and more corporate bonds will be issued.
Wealth disparity: The “home electronics to the countryside programme” has been widened to provide cash subsidies for more electronic goods for the whole country.
Social welfare: A RMB 850 billion budget has been earmarked to improve medical coverage and equality of care over two years, instead of the original plan of 11 years. The Social Insurance Law of 2008, which outlines every citizen’s right to social insurance, has been bolstered by one-off payment transfers. Overall, the central government has increased its planned spending on health by 38 per cent, education by 24 per cent and social security by 22 per cent.
Financial system: The stock market will soon allow short-selling and margin trading, while provincial governments will soon be able to issue their own bonds.
Land reform: The latest measures have been intended to legalise the transfer of rural land rights, which should enable peasants to borrow against their land, rent it out or sell it.
Environmental technology: Reductions on sales tax for fuel-efficient vehicles have reportedly resulted in a significant increase in sales.
What the implications?
Sales: The main opportunity of the stimulus package for foreign companies lies in identifying the main mainland companies likely to win the majority of the bids and seek to supply them.
Procurement: Chinese suppliers in certain key areas such as industries related to construction may see full order books in the coming months as projects come on stream. A number of the fiscal policies related to, but not part of, the stimulus package, such as revised VAT rules, are aimed at easing pressure on exporters.
For more coverage of this topic, see the white paper by Schmittzehe & Partners, which is available from www.sandpconsulting.com