Why Your 2015 China Business Strategy Must Include Asia

October 10, 2014 Posted by China Briefing Reading Time: 10 minutes

The China Price is Dead. It is the Asia Price that Counts.

Op-Ed Commentary: Chris Devonshire-Ellis

As we move into the tail end of 2014, many businesses are now starting to plan their China strategies for the forthcoming year. 2015 will be a significant year in Asia, with numerous trade development and incentive deadlines coming to fruition. These will have an immediate impact upon foreign investors in China, and in many cases will necessitate a change in business model.

While much media attention has concentrated upon the U.S.-led Trans-Pacific Partnership, this has yet to be finalized and potentially may never be so. Meanwhile, other agreements, which do not include the United States as a signatory, will ultimately shape the way that American and other foreign investors plan their 2015 strategies for China and beyond. Chief among these is the ASEAN Economic Community (AEC) compliance deadline that kicks in at the end of next year. Far too many China-focused executives, especially within SMEs, are blissfully ignorant of what this means and the impact it will have. Yet ignoring it could prove fatal.

Briefly stated, the AEC agreement reduces tariffs on products manufactured in ASEAN nations – and subsequently exported to China – to zero. This is due to affect some 90 percent of all products. Although countries like Indonesia, Malaysia, Philippines, Singapore and Thailand – the so-called “ASEAN 5” – are already in compliance, others are not. Of these, Cambodia, Laos and Myanmar can effectively be written out of the manufacturing/sourcing equation, as for the most part their infrastructure problems continue to threaten the sustainability of production. Their day will come in a decade or so.

The Vietnam question will really come into play next year – right on China’s border, with a relatively well developed manufacturing infrastructure, it is expected to be in AEC compliance by December 2015. The resultant abolition of import tariffs on products exported from Vietnam to China is going to have a huge impact on light-medium manufacturing – and the sourcing industry – in China. Plus, the Vietnamese government has China in its sights also as a direct competitor: Vietnam is expected to reduce its corporate income tax rate to 20 percent to coincide with AEC compliance – a full 5 percent lower than CIT in China.

The Vietnam Deadline

Given that Vietnam’s labor and production costs are generally about 30 percent of those available in the PRC, it is inevitable that production destined for the Chinese consumer market will leech away to Vietnam, despite the infrastructure gap between the two. If your company does not have a plan in place to assess China’s competitiveness (including comparison with Vietnam), then it needs to, and fast. If the cost dynamics indicate that Vietnam is the way to go, then you have just twelve months to make the switch. If not, your competitors will be churning out products at cheaper Vietnamese prices long before you will be able to.

Such transitions need not be overly dramatic, however. Our firm has had a presence in China for 22 years now, and in Vietnam for seven. During that time we have assisted many China-based foreign manufacturers in setting up additional operations in Vietnam. The general modus operandi has been to keep the China facility, and if necessary, switch some production – maybe some less-technical parts – to Vietnam. Only a small percentage of China manufacturers have closed their PRC operations entirely.

Evolution of the China Manufacturing Base

The onset of AEC and the rise of Vietnam next year also mean that the typical role of the China production facility will need to change. Whereas in the past, business licenses for pure production, domestic sales and export would suffice, the role of the China facility is soon likely to evolve. This will require import licenses to bring in products from your alternate factory, maybe a change in production facilities to include other component parts, as well as potential access to bonded warehousing for stock calls without the need to incur domestic VAT upfront.

As China’s domestic market increases in size, logistics issues will become more apparent and the supply chain may require deepening. All this requires thinking through. I suspect most China-based factories will start to provide more administrative and logistics services than has been the case to date – you will need to think about changing your business scope to allow for participation in these additional supply chain services.

The Infrastructure Issue

A lack of infrastructure in alternative Asian locations is often cited as a reason to remain in China. Generally speaking, and based on our clients’ experience, we have found that there is a formula for calculating the issue. True, inefficient infrastructure can translate into higher operational costs, despite lower wages and land use overheads. As a rule of thumb, however, we have found that if the alternative location can provide 70 percent of the production capacity achievable in China, then it makes economic sense to shift production.

Your typical China consultant or even Chinese executive doesn’t want to hear that, and will repeat the “infrastructure” mantra over and over again to dissuade a business from changing its strategy. Yet the real question isn’t actually an infrastructure debate. It is purely about economic cost, with infrastructure merely being one component part.

Beware of China-centric Management

It should not be forgotten that 20 years ago, Chinese infrastructure was not that great. Assessment was needed to ascertain whether or not production could be moved in full or in part from North America or Europe. Experienced engineers and production managers from these countries were sent over to examine the China potential. The same situation applies today, except with a worrying caveat: Chinese production managers do not wish to see their roles diminished.

China consultants don’t want you to move either. This attitude, which I call “China-centric”, has the potential to screw up your business. Head office should call the shots on any changes to your China business strategy and/or production, not the China entity. Your China-based team has a vested interest in keeping you where you are – but such short-sightedness could lead to the loss of your longer-term competitive advantage. It is time to get the Head Office boys to examine alternative destinations in Asia, not your China-based management.

India. What’s All That About?

There are several parts to the India question. Yet there is no doubt that it needs to be part of your strategic considerations for 2015. India remains little understood in terms of China strategy, but then again, our firm has been one of the very few to have developed an India practice, now also in its seventh year. In simplistic terms, India has been problematic in the past due to it having a series of coalition governments in place for the past 30 years. This has meant that much needed reforms have not been carried through and the country has essentially atrophied. In 1990, India’s total annual GDP was US$143 billion, just behind China at US$183 billion. By 2010, that gap had widened to US$1.15 trillion to China’s US$4.67 trillion.

There are numerous reasons for this, beyond just Indian governmental paralysis. One of the most important, however, is the worker demographic. In the years between 1990 and 2010, China was able to capitalize on a boom in young workers and become the workshop of the world – mass cheap labor was the foundation of China’s success story. India did not possess an equivalent dynamic at that time, and its government stagnation coincided with this period.

This, however, has now changed, and the impact is being felt very quickly. For the first time in three decades, India has elected a government with a mandate to change – the BJP having won an absolute majority in India’s democratic process. A business and investor-friendly government will help enormously in pushing through reforms, including the tax breaks and investment incentives necessary to attract international attention. But what is more, India now has the worker demographic that China once enjoyed.

Back in 1990, the average age of a Chinese worker was 23. Today he/she is 37. This year, the average age of an Indian worker is 23 and labor costs reflect this – Indian labor is now 20 percent of the contemporary China price. Indian workers are available in huge numbers too – a fact not unnoticed by the Chinese Communist Party, who need to keep their new middle class happy by supplying them with cheap essential products – not an easy task when your own workforce is becoming prohibitively expensive. This is why China has recently agreed to invest USD20 billion in Indian infrastructure. Only India has the workforce and cost base able to supply a market that size. If ever there was a sign that China has passed on the baton of ‘workshop of the world’ to India, then this is it.

This doesn’t mean that China businesses should all be rushing off to set up factories in India. But it does mean, that like China 20 years ago, India now offers two opportunities: manufacturing for both the export market and the country’s own middle class consumer market. It is a little known fact that India’s middle class today is about 250 million – the same size as China’s. And at 20 percent the price of China labor, it will not be long before India-based foreign manufacturers are calling the global shots with the new competitive ‘India price’. Also, while India doesn’t have a Free Trade Agreement directly with China; it does have a Double Taxation Avoidance treaty in place with China and an FTA with ASEAN. All of which brings us back to ASEAN and that 2015 AEC deadline.

ASEAN. Why Should I Care?

Principally, because of the China-ASEAN Free Trade Agreement discussed earlier, which by the way can be accessed on our ASEAN Briefing website here. ASEAN matters on several levels, not just owing to AEC reducing Chinese import tariffs to zero. It works the other way around too, and China manufacturers can sell to ASEAN nations duty free. With sizeable and relatively wealthy countries such as Indonesia, Singapore and Thailand right on the doorstep, why isn’t your China factory selling to ASEAN?

As a base for selling to China, India and ASEAN’s own middle class population of 150 million people, placing a manufacturing facility in the ASEAN region is starting to make an awful lot of opportunistic and economic sense. This is why Dezan Shira & Associates has alliance members in Indonesia, Malaysia, the Philippines, and Thailand. Placing a subsidiary operation in ASEAN opens up doors to supplying China more competitively, as well as strategically developing new markets in ASEAN itself and the massive market of India. If looking for sales and revenue growth, ASEAN can be a vital tool to achieve that – three markets for the entry price of one.

Singapore: The Center of Asia

In terms of development strategy though, ASEAN centers on Singapore. The country is a world class financial center, and is regularly voted number one in global ease of business rankings. Crucially, Singapore also has a freely convertible currency and is a Beijing-approved RMB trading center. While the rest of Asia lags behind in currency convertibility, Singapore is now acting as the Asian Treasury from which one can finance and administer other Asian locations.

As a member of ASEAN, Singapore also enjoys FTA status with China and India – meaning that if you can get the local sourcing ratios right, it is possible to manufacture in ASEAN – say in Vietnam or other destinations such as Indonesia, Malaysia, the Philippines and Thailand – and sell to both. Here, Singapore can act as the operational hub for arranging the financing of your China entity, which is just one of the services our Singapore office provides, along with the usual corporate establishment, regional tax planning, multi-location accounting and business advisory.

But why Singapore and not Hong Kong? Because mainland China’s FTA with ASEAN does not include Hong Kong, and as yet, the territory has no such agreement of its own – a thought that may yet give pause to Hong Kong protesters as they ponder its ramification and the superiority of Shanghai in this regard. Hong Kong – and we have had an office there too, since 1992 – is still a viable option for holding a company in China, as there are tax and beneficial ownership bonuses to consider that can positively affect a China investment. But Singapore is the real hub to the greater wheel of Asian regional expansion.

Conclusion

To summarize where growth and opportunities lie in Asia, including ASEAN, China and India, I produced an article yesterday entitled “Looking for Growth? Forecasts for Asia 2015.” Not just the pontifications of an armchair economist, Dezan Shira & Associates has offices in each of the countries featured and I have visited them all over the past few months. This is one of the only “on-the-ground really been there and observed first-hand” executive summaries you will find, and while you may not necessarily agree with my comments, it will bring home an unmistakable fact: planning your China strategy for 2015 requires a pan-Asian perspective.

Chris Devonshire-Ellis is the Founding Partner 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, in addition to alliances in Indonesia, Malaysia, Philippines and Thailand, as well as liaison offices in Italy, Germany and the United States. For further information, please email china@dezshira.com or visit www.dezshira.com.

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