China Profit Margins Shrinking as Investors Consider Asia 2.0

October 1, 2010 Posted by Chris Devonshire-Ellis Reading Time: 5 minutes

Op-Ed Commentary: Chris Devonshire-Ellis

Oct. 1 – I’ve just been speaking on China-India demographics at the Leading Edge Alliance annual M&A conference in Chicago. The LEA is an accounting network of over 160 firms in 90 countries with a combined revenue of some US$2.4 billion in 2009. Member firms (of which Dezan Shira & Associates is one) are the largest practices in their respective regions outside of the Big Four. To put the size of the network into perspective, if the members all traded under one brand such as PWC, rather than the individual names members possess, the Leading Edge Alliance would be the second largest accounting practice in the world. Ernst & Young, Deloitte, and KPMG would all be smaller. So when LEA member firms get together to discuss global M&A, it’s pretty big deal sizes that get bandied about and the bankers and VC funds are there in droves to listen to what’s going on and pitch for deals.

I’ve already written about the changing demographics in China in my recent piece China Demographics Dictate India As Global Manufacturing Hub and outlined what my experiences between China and India have been, together with gut instinct and some impressive World Bank data. Consequently, it’s also good to hear from LEA member firms about their clients, especially the China-based ones, and how they are faring. The prognosis, however, is generally not good. There were too many stories of manufacturing businesses, some in fairly hi-tech industries, having profit margins squeezed so much via a combination of higher labor costs, price rises in local parts, increased tariffs and so on that several members complained that their clients were increasingly unable to justify a China presence. The reasons I explained were the labor law issues, through which China is essentially passing off part of the costs of pension funds to foreign businesses, an aging workforce that is becoming more expensive to maintain, and rises in basic materials in China. The country has just gotten that much more expensive.

While there’s a certain inevitability about that, it’s not just China that is at fault here. Foreign investors have long gotten used to the “China Price” and are now reluctant to cede any ground in their need to maintain healthy margins. Not for nothing do many Chinese factory owners complain that it is the foreign businessman who makes all the money, leaving Chinese businessmen with very little. It’s sobering to read in the pages of China’s Global Times that for Mattel toys, for example, a single toy typically brings it a profit of around US$3.60, out of which the Chinese manufacturer earns about 1.5 cents. Yet those margins need to be maintained, or the business will go elsewhere. Purchasing departments are never known for their generosity, and China is about to lose business because of it.

But it’s not purely an economic issue. It’s also a deliberate policy on behalf of the Chinese government. The upshot of this is that China is becoming choosier in the types of investment it wants, and this is manifesting itself via the process of becoming more expensive, especially in basic manufacturing. This is also to be expected, as for several years now the Chinese Government has been warning that the country needs to move up the value added chain. That is happening, and consequently in certain industries (low end manufacturing in particular) China is no longer the place to be. In response to the question over profit margin erosion in China, it was also mentioned that Mexico – where the client has a second factory – is becoming increasingly dangerous as drug related violence hinders the ability to get on with normal business. A combination of a loss of confidence in Mexico and an increase in operating costs in China is leading U.S. manufacturers to consider Asia 2.0. For these, Vietnam rings true, and Ho Chi Minh City (I was also there recently) is booming with the voices of U.S. businessmen looking at setting up plants. We should know, after all Dezan Shira & Associates is also in the country. The other sensible option for relocating a China-based manufacturing unit for the U.S. market would be Chennai on India’s Southeast coast. That’s just across the Andaman Sea from Thailand and shipping costs from Chennai or Ho Chi Minh City to the United States are very similar. The China plus one strategy it seems is being fulfilled.

However, it’s not all bad news for China. Although I personally feel the country is entering into a two to three year period of some uncertainty (the leadership will be replaced in 2012), and things may be a little rocky for China until 2015, the country is still a great destination for investments that focus on newer technologies. In some, China is stealing ahead globally. Bio-engineering for example is highly regulated in the United States and the European Union, yet research continues apace in China. New sources of energy too are very much a China play, as are areas in aerospace and innovative engineering. China continues to evolve and is moving upstream. But for foreign investors finding profit margins squeezed, it’s a sign your China adventure now needs to be replaced with a home away from home elsewhere in Asia. China is becoming more selective as concerns the FDI it wants, and squeezing those it doesn’t out of its borders is just part of the never ending merry-go-round of global manufacturing, sourcing, and supply chain development. If that rings true for you, then Vietnam and India are the places to consider as manufacturing hubs in order to maintain profit margins.

Chris Devonshire-Ellis is the principal and founding partner of Dezan Shira & Associates, establishing the firm’s China practice in 1992. The firm now has 10 offices in China. For advice over China strategy, trade, investment, legal and tax matters please contact the firm at info@dezshira.com. The firm’s brochure may be downloaded here. Chris also contributes to India Briefing , Vietnam Briefing , Asia Briefing and 2point6billion