Reasons for Leaving China, and the Emergence of the Asian Century

February 21, 2013 Posted by China Briefing Reading Time: 9 minutes

China is not the only location for export-driven manufacturing, and the evolution of emerging Asia is leading businesses to adventures elsewhere

Op-Ed Commentary: Chris Devonshire-Ellis

Part II of a three-part series:

Part I: The China Conundrum – to Leave or to Stay?
Part II: Reasons for Leaving China, and the Emergence of the Asia Century
Part III: Reasons for Staying in China, and the Emergence of One Billion Consumers

Feb. 21 – A little over 13 years ago, as the final seconds of the 20th Century ticked down, every headline seemed to predict the rise of China and the development of what would probably become known as the “Chinese Century.” The 1800s were dominated by the British Empire, the 1900s had belonged to the United States, and now China’s rise would see the development of the Middle Kingdom as a notable global force.

While there are many who still believe that China’s ascension to the top of the global power pyramid is going to happen, being that it’s only been 13 years in, it is difficult to make predictions about a century that most of us will not live to see out. Yet, even from this early vantage point, it appears that the China dominant perspective may have been misjudged; or, to be polite, a bit overly optimistic.

It is important to remember that at the start of this century, there were two main schools of commercial thought on China:

That China would provide the world with access to a market of 1.2 billion people; and
That China had a young, available, inexpensive, and relatively disciplined work force.

Despite the first point being intrinsically true due to China’s status as the most populous nation in the world, and the second point proving true due to the quick development of China’s economy over the past two decades, China’s one-child policy (implemented nationwide in 1982) has meant that China’s labor force is shrinking at an increasingly rapid rate. China’s population statistics are now bearing this out as fact.

China today is in fact one of the fastest aging populations in the world – and that cheap labor is becoming a thing of the past. It is also a phenomenon that has not gone unnoticed by the central government. Wary of inheriting a huge population of aged, but poor citizens, it has been state policy over the past few years to get more money in the pockets of Chinese nationals and to implement what, by global standards, is a relatively expensive contribution-based state insurance scheme.

These policies have had the effect of increasing minimum wages across the country by an average of 12.6 percent each year from 2008-2012, with this impacting vertically upon more senior-level employees. It is hard to justify to senior staff that lower level employees have increases of 12.6 percent when senior employees cannot. In fact, senior employees are asking for even more, and 20 percent to 25 percent annual increases are not uncommon. The effect therefore of raising the minimum wage has been a massive wholesale increase in salary costs across businesses based in China at all levels. It is hard to know whether the policy-makers who introduced these mandatory increases realized they would feed such an inflationary salary cycle over the past four years.

When you combine these increases with every employer’s mandatory social insurance and housing fund contributions for each employee at roughly 35-45 percent on top of salaries, these costs begin to add up fast.

Thanks to these changes, even relocating a factory into a cheaper inland region of China is now proving costly because the increased infrastructure and transportation expenses eat into most of the relocation savings, and also because these areas too have experienced large increases in wage overheads. While this increase in disposable income levels across China is good news for businesses wishing to sell to the China market, it is becoming increasingly difficult for export-driven businesses to justify a China presence unless at least a portion of the manufactured products are destined for the domestic Chinese market. At the end of 2012, Adidas closed its remaining manufacturing WFOE, while Starbucks has moved its coffee mug manufacturing plant back to the United States and Home Depot have already left, closing seven stores in the process. The Beijing Administration for Industry and Commerce has announced that 217 foreign property companies deregistered in 2012, while Korean underwear manufacturer BYD has closed two of its three China plants and relocated them to Indonesia.

Competition for this type of export manufacturing driven business model is appearing right around the corner as China’s free trade agreement with ASEAN kicks in come 2015 (see the previous issue of Asia Briefing for a detailed explanation of what this means). This means that factories based in a Southeast Asian country such as Vietnam may sell products without any duties to the Chinese consumer market. When one factors in Vietnam’s lower wages, land-use costs, and soon to be lower levels of corporate income tax for foreign investors (compared to China),the implications are clear: unless you want to sell specifically to the domestic Chinese market and can justify having a factory in-country, business models involving China production units purely for export are not as valuable, or viable, as they once were.

This trend has already begun, with Hong Kong’s South China Morning Post recently reporting that over 10,000 Hong Kong-invested factories in China’s Guangdong Province alone have closed their operations since 2011. Such news is indicative that this trend is already well underway and will affect other regions in addition to Guangdong.

China’s economic development over the past two decades has also woken up many previously rather sleepy Southeast Asian countries and governments. Countries with single party states such as Vietnam and Myanmar have now come to realize that the wealth and security of tomorrow is created through commerce and global engagement. Vietnam, specifically, has even gone so far as directly targeting China as a competitor for manufacturing-based, export-driven FDI as it is set to reduce its corporate income tax levels to two points below that of the PRC from Jan. 1, 2014, on top of introducing a number of sweeping investment reforms and export processing and manufacturing free trade zones along its eastern coast (a strategy employed by China nearly 20 years ago).

Consultants that only sell the idea of business in China are likely to suggest that Vietnam’s infrastructure is still not up to par. However, that too is rapidly changing with the Vietnamese government introducing massive construction and road, rail and port development schemes. A drive from the airports in Hanoi and Ho Chi Minh City into their respective downtown city centers will provide a visual snapshot of the infrastructure developments currently taking place in Vietnam. In spite of the developments and investment uncertainty, it is worthwhile to remember that China too developed along these exact same lines not so long ago.

There are other drivers at work here also as an increasingly wary United States – in a view shared by many Asian countries surrounding China – is becoming concerned with obtaining all of its purchasing needs from one source (i.e. China). The United States is wise to factor this into commercial engagement with the PRC, as global alarms went off when China suddenly cut its supply of rare earth minerals to Japan after a recent political spat. The fallout from this was not just restricted to Japan. Many global companies, especially in IT, rely on Japanese and Taiwanese component supplies in order to fulfill their order books. China’s disagreements with Japan upset the global supply chain, an issue Chinese hawks in the government do not seem to have taken on board.

To combat this, the United States and several other countries have initiated the development of the Trans Pacific Partnership, a U.S.-led trade bloc that specifically excludes China. This exclusion, of course, has also earned Chinese scorn. Yet, behind the rhetoric lies a serious message: this 11-country trade pact (which includes the United States, Vietnam, Canada, Australia, Chile, Singapore, New Zealand, Brunei, Peru, Mexico and Malaysia) is specifically aimed at providing its members with alternative product manufacturing sources and sourcing capabilities.

One expected impact of the TPP Agreement between the United States and Vietnam is an increased number of investments into Vietnam’s technology and manufacturing knowhow from American investors, which, when combined with the proposed TPP tariff reductions, will assist Vietnamese companies in upgrading its capabilities to meet international quality standards. Currently, 80 percent of Vietnamese textile fabrics fail to meet U.S. quality standards and are forbidden from being exported into the United States. As such, the American market will likely be opened up to an additional supply of Vietnamese companies that have, at present, supplied China with their lower quality goods. China has less stringent quality demands and pays less for its imports than the American market.

The Vietnam-U.S. TPP Agreement is expected to be fully negotiated and executed in late 2013, and its execution will likely increase competition for the Chinese textile industry from Vietnamese competitors in addition to triggering increased foreign investment into Vietnam’s export processing zones.

Vietnam is not the only beneficiary of the trend of increased divergence from China-based manufacturing. American investments and the value of its exports to the region have increased across the board as follows:

The Vietnam issue mentioned above can be seen manifesting itself in the huge 842 percent increase in U.S. sales over the past 10-12 years. However, India also stands out as a destination of note – raking in a 475 percent increase in American exports due to similar reasons – although India, like China, represents a significant consumer market in its own right. That said, operational costs in India remain far lower than in China. Furthermore, like Vietnam, any business executive that arrives in Delhi or Mumbai’s redeveloped international airports and takes a trip into the respective city centers cannot be anything but impressed by India’s progress as the country rapidly works to upgrade its infrastructure.

The East Indian port city of Chennai is another case in point. Already home to the third-largest expatriate population in India, Chennai is also a manufacturing home for MNCs such as Nokia, BMW, Siemens, Dell, Motorola and Foxconn among many others. Chennai also hosts the Asian headquarters and back-office operations for many global financial institutions such as the World Bank, Standard Chartered Bank, Bank of America, The Royal Bank of Scotland, Goldman Sachs, Barclays, HSBC, ING Group, Asian Development Bank, Credit Suisse, Deutsche Bank and Citibank. Air Asia, the ASEAN region’s largest budget carrier, has also just announced plans to enter into a joint venture with Tata of India – the new regional hub for the airline after Kuala Lumpur and Bangkok will be Chennai once the Indian aviation authorities approve the deal. That, by any stretch of the imagination, is quite the world-class portfolio.

The reasons for these developments are clear: as China’s working population ages and becomes more expensive, alternative Asia beckons. Vietnam in particular is leading the new Asian wave of investments for export-driven manufacturing, and India now offers not just export manufacturing opportunities, but also – like China – the ability to sell to an increasingly wealthy middle class population. In fact, India’s middle class today is about the same size as China’s, which makes it a rising star as a combined base for export manufacturing and for domestic sales that not even contemporary China can match.

China’s continuing evolution can perhaps best be explained in a re-calibration of the popular opinion at the turn of the century that the 2000s will belong to China. Instead, I predict the 21st Century will more aptly be headlined as “Asia’s Century,” and although China will very much be a part of that, other countries in the region will be too.

For those businesses that are involved in export-driven manufacturing, it is the Asian connection that counts. This is now the reason for re-assessing China’s role within global trade and the development of emerging Asia in order to better absorb the ongoing financial battle between production costs and the demands of the global end user.

Part II of a three-part series:

Part I: The China Conundrum – to Leave or to Stay?
Part II: Reasons for Leaving China, and the Emergence of the Asia Century
Part III: Reasons for Staying in China, and the Emergence of One Billion Consumers

Chris Devonshire-Ellis is the founding partner and principal of Dezan Shira & Associates – a specialist foreign direct investment practice, providing corporate establishment, business advisory, tax advisory and compliance, accounting, payroll, due diligence and financial review services to multinationals investing in emerging Asia. Since its establishment in 1992, the firm has grown into one of Asia’s most versatile full-service consultancies with operational offices across China, Hong Kong, India, Singapore and Vietnam as well as liaison offices in Italy and the United States.

For further details or to contact the firm, please email china@dezshira.com, visit www.dezshira.com, or download the company brochure.

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