China's growing pains

ADIDAS, the world's second-largest sportswear company, is confronting an unexpected problem. The costs of labour, materials and red tape are spiralling up in its great production heartland in southern China.
It used to be that money made the rules and multinationals such as adidas could extract a better deal by threatening to move overseas. The company runs more than 250 factories here, after all. Each clothing factory employs 3000 people, on average, while every shoe factory has seven times that number.
But the Chinese Government is no longer interested. Instead, it recently abolished export rebates, introduced tougher environmental and labour laws and increased the minimum wage — squeezing production margins even tighter.
"The message coming from local governments and, to a lesser extent, the central government, is very clear," says William Anderson, head of social and environmental affairs at adidas. "They're saying don't tell us about your problems, relocate."
For thousands of small and multinational manufacturers the story is the same. For them, the world economic order is turning on its head.
The factories that stretch across China are choking on their own success. They have exhausted what was thought to be a bottomless barrel of cheap Chinese labour. They have erected their sheds on the peasant farmland that is cheaply available.
They have devoured so much oil, cotton, rubber, coal and steel that commodity prices have remained "stronger for longer" than the world has known. They are rapidly using up China's political tolerance for filling the earth, sky and waterways with toxic waste.
There are no more obvious corners to cut and few remaining efficiency gains to extract. Low-end manufacturers are shutting down or moving out. A Hong Kong business association claims 3000 factories have shut down in the Pearl River delta this year. The Guangdong local media is full of reports and pictures of newly abandoned factory floors. But a growing proportion of the world's manufacturers are steeling themselves to push their rising costs to the final stop on the production chain: the consumers.
adidas, which sourced about 100 million pairs of shoes and 125 million garments in China last year, says it is packing up a large part of its Chinese production and moving to the country's lower-wage, but logistically challenging, inland provinces.
The company is not ready to reveal any price-rise plans. "We have no immediate plans to change the pricing policy of our products," says Anne Putz, head of corporate public relations at head office in Germany. But other manufacturers are making their intentions clear. They are relocating, skimping on inputs and fighting as best they can to give consumers some of their pricing pain.

"The consumer, our customers, have pushed for years to get the lowest possible price and they feel because it's made in China it's got to be cheap," says Michael Morison, who runs an electronics packaging company called PRT Manufacturing in Shenzhen. His major cost is plastic, derived from oil. "The cost of oil is killing us," he says. "But we can never pass on more than 50% because on the other end of the phone you hear these guys scream."
WESSCO International supplies a large proportion of the world's airline amenity bags to companies such as Qantas.
Last year, managing director Petros Sakkis shifted his efforts from trying to squeeze increasing quantities of cheap plastic goods at diminishing prices out of his Chinese production lines. Instead, he's been roaming Vietnam, Thailand and India for factory space.
"Rising cost pressures are pushing us to be more aggressive in moving our production out of China," Sakkis says. "Where to? That's the big question. You've got to start from scratch because there is no paradise."
Sakkis won't talk about his prices, as each contract is negotiated individually. But Jo Austin, who edits trade magazine On Board Hospitality, spells it out. "The rising costs will be passed on to airlines and airlines will pass them on again," she says. "But rather than pay more, airlines are reducing product, particularly at the back of the plane."
Whether consumers pay higher air fares or receive a lower-service flight, they will be paying more for less.
For decades, consumers have had the better of the world's manufacturers. But the tide is starting to turn. The battle between them will affect the political fortunes of leaders such as Premier Wen Jiabao, who last week said inflation was the biggest concern of the Chinese people, and Prime Minister Kevin Rudd, who says the consumer price index is his biggest economic challenge.
This week, China's Bureau of Statistics shocked the economic world with a consumer price index reading of 8.7% for the year to February. Most of that was driven by food prices, but upstream inflation pressure is growing just as fast. China's producer price index jumped 6.6% in the year to February, from a virtual standing start in the middle of last year.
And the evidence is that the sudden emergence of China's domestic inflation problem has coincided with an upward shift in export prices. The US Bureau of Labour Statistics reports import prices from China fell by about 1.5% annually from 2004 to mid-last year. But the latest annual figures show Chinese import prices rising 2.5%. Chinese statistics show the country's export prices are up 6.5% in a year in US dollars, the currency of most Chinese export deals.

Australia does not compile country-specific import price data. But UBS's China economist, Jonathan Anderson, says Chinese export prices are rising into the US, Europe and Japan — so it's a fair bet they're rising in Australia, too.
"It is accelerating," Anderson says. "And the reason we expect it to continue to accelerate is that labour pressure is unabated."
So far, Reserve Bank governor Glenn Stevens has been spared the added inflationary headache of rising Chinese import prices, thanks to the mercurial Australian dollar. The rising dollar means Australia's purchasing power is rising faster than China's US-dollar-denominated export prices. But that relief will last only for as long as the commodities-driven rise of the Australian dollar outruns the structural upward shift in the Chinese currency. "Going forward, that won't necessarily be the case," Anderson warns.
Macquarie Bank's China economist, Paul Cavey, agrees it is only a matter of time. "Whichever way you look at it, Chinese export prices are moving up," he says. "At some point it must begin to have an impact on Australian inflation."
China's cost pressures are spreading deeper through the system. More than half the increase in the producer price index was caused by coal and steel, and those shocks will be amplified by a second round of increases as steel and energy-intensive producers pass their pain down the production chain.
Australian consumers and businesses have enjoyed an unprecedented, sustained rise in purchasing power because prices for the commodities Australia exports to China are going through the roof and, at least until now, prices have been falling for Chinese goods. But booming commodity prices are starting to embed themselves in many of the manufactured goods Australia buys from China.
China's steel makers have more than offset the huge rises in iron ore and coking coal by simply pushing them down the line. Steel-intensive users are pushing the costs on to the next line of producers.
An employee at Morimatsu Industry, a Japanese company that manufactures in Shanghai, says steel accounts for half the costs of the huge steel tanks it makes for chemical and mineral processing. He says he will add the 20% rise in steel prices this year to product prices, and charge customers that include BHP Billiton in Australia.
Tyre maker Goodyear, which also sells to Australian miners, says it is lifting productivity to absorb rising costs of rubber, energy and shipping. But it is also asking customers to pay. "But yes, eventually, consumers bear the brunt, just like they pay for increases of other products from raw materials or natural resources," says Goodyear's regional communications director, Ron Caston.

It helps that resource-intensive producers can point to record commodities prices to explain their cost problems to customers. It also helps that they tend to sell to other producers, such as mining and Asian construction companies, that are flush with cash.
Tom Ren, a Shanghai businessman who runs FineKing, a chemical company, says his inputs are derived from oil and therefore getting more expensive. He sold the world 300 million yuan in polyurethane gap filler products last year — the stuff builders use to seal the cracks between windows and walls.
Ren writes his key financial variables on the back of a notebook to show how rapidly his costs are rising. But they are not rising as fast as his efficiency gains. "Our cost keep going up and up and up, but so is our productivity," Ren says. And then he adds one crucial detail: the price of the products he sells are slated to rise 20% this year. Rising costs haven't hurt his bottom line.
Makers of heavy machinery and equipment tend to start from a less-efficient base than their labour-intensive cousins, meaning they have more room to raise productivity and preserve margins. More importantly, they have pricing power.
One observer, whose private equity fund controls $US4 billion ($A4.2 billion) in the Asian region, including in China and Australia, says rising costs are sorting Chinese exporters into three groups. "The guy who sells products that are really super-commodities are passing their cost increases on because their customers understand what's happening in the world market," he says. "The low-end manufacturers, like hardware, textiles and low-end auto-part suppliers, like cooling fans, are being hammered. But those who can differentiate on product or use a lot of technology are OK. Anybody who has a bit of technology in their product can pass that on."
It turns out that cost pressures are far from defeating China. Meguri Aoyama, who heads the Asia section of the Japanese Government's export and investment promotion centre, JETRO, says China's labour-intensive manufacturers will struggle. But prices for resource-intensive products such as cement, paper and steel will keep rising.
But the overriding theme of Chinese industry, he says, is that rising costs are pushing the world's most competitive manufacturers to scramble faster up the technology chain. For Toyota, he says, rapidly improving technology will easily counter rising steel costs. The car maker, which is likely to overtake General Motors as the world's No. 1 this year, is helping turn cities such as Guangzhou from low-wage manufacturing centres to high-wage, high-tech capitals.

"Guangzhou's becoming the Detroit of Asia. In five years, the situation has totally changed," says Atsuo Kuroda, who is responsible for China trade and investment at Japan's Ministry of Economy, Trade and Industry.It is a little more than a decade since China cemented its name as "the world's factory" for being the home of low-wage manufacturing. But the country is moving on.
Rising costs are igniting yet another round of creative destruction. They are forcing some companies out of business, others deeper into China or into southern or South-East Asia while giving others the impetus to advance up the technology ladder.
The Chinese Government is encouraging the transition. "They're saying 'we want to move up-market, upscale, we prefer auto to apparel'," says Anderson at adidas. So his company is shifting its China manufacturing inland, where it can provide jobs to China's remaining low-wage workers and direct its products towards the country's rapidly growing domestic market.
China is treading a similar path to Japan, Korea and Taiwan before it, except on a much larger scale.
With these precedents, and provided the Chinese Government can put a lid on the CPI this year, economists expect consumers might hurt a bit during the transition but will end up back on top.
"Cost pressures are rising so everybody is talking about whether China will push up the prices of its products and therefore inflation everywhere," says Huang Yiping, chief Asia economist at Citigroup.
"But I don't think that will happen. If China succeeds in exporting autos, for example, then China will remain a deflationary force for a long time to come."
The times of an ever-falling "China Price" for labour and resource-intensive manufactured goods is probably over. But the era of a new China Price for cars, sophisticated electronics and even aircraft is probably around the corner.

ps: I saw it on The Age, then think a lot.