From the March 2011 issue of Treasury & Risk magazine

Defensive Tactics in China

The combination of higher costs and economic and monetary factors are prompting U.S. companies buying products in China for export to consider strategic shifts, including moving production to another country. And for those firms continuing to use the world's biggest factory floor, product quality--and the access to working capital funding it brings--is a growing concern. Times are certainly tougher for companies that rely heavily on commodities. Bajer Design & Marketing, a manufacturer and distributor of ironing, laundry and storage products, was not directly impacted by the 80% surge in the price of cotton last year. But in place of cotton, other firms began using polyester, required for many of Bajer Design's products, and that pushed up the price of the synthetic fabric by 30%.

Add to that higher oil prices boosting transportation costs and a 6% appreciation in the Chinese renminbi against the U.S. dollar over the last year. Plus, according to Moody's Analytics, wage increases in China ranged from 10% to 15% over the past two years, and annual inflation has hovered around 6%.

These factors all add up to significantly higher production costs for companies, such as Okauchee, Wisc.-based Bajer Design, that produce some or all of their goods in China and export them to the United States for sale.

"Those aren't costs that can easily be passed on," says Dean Krotts, a partner at Bajer Design, a private firm with sales approaching $100 million. "You can't just call customers and say, 'We're raising prices by 30%.'"

Until higher prices can be passed on to corporate customers and ultimately consumers--often a challenge, especially in today's environment--U.S. companies buying manufactured goods in China will have to swallow some of those costs. That could mean using a bit less of one component or a less expensive version.

"We're going to see a lot of people re-specifying their products," says Krotts, whose firm's products have been made in China since 1999, mostly by purchasing the goods directly from factories there. About 10% of Bajer Design's products come from a factory it built four years ago.

Corporate customers typically send written specifications along with any purchase order and will often will extend letters of credit--contingent on those specs being met--to provide their suppliers with working capital. If the specs aren't met, companies may withhold payment. So suppliers must be sure the factories producing their products are not taking problematic shortcuts.

"Our role is to ensure that quality is maintained," says Krotts, adding, "You have to be there to monitor production and play a part in it."

As a result, Krotts and his partner, Adam Kellogg, spend two weeks of each month between them in China overseeing production. They also send in random inspection teams during production, and they try to be present when goods are shipped from any new factory. Krotts says such monitoring hopefully results in a "continuity of business.

"The smart factory owners fall in place," he says. "And the ones that don't--you just stop doing business with them."

Increases in commodity prices often can be short term. The price of oil shot above $85 a barrel in recent months on concerns that Middle Eastern protests could disrupt supply. However, the price was still lower than the $140 a barrel it hit in the summer of 2008. If companies see increases in a commodity price as a short-term blip, they can use financial instruments to hedge that risk.

Wage increases, rising inflation and an appreciating currency, however, are most likely longer-term trends that can't be hedged with forward contracts and other financial instruments. One way to deal with those rising costs may involve some fancy footwork when negotiating with factories.

"A lot will depend on the bargaining power of U.S. companies and how much they can squeeze subcontrators," says Virendra Singh, director of economic research at Moody's Analytics.

A longer-term solution may be to source products from new geographies. Singh says the biggest source of cost increases is rising wages, but established relationships with factories can be sticky. "Once someone starts a factory near the coast and develops the network to export products, it becomes more difficult to move inland unless there's a compelling reason," he says, adding that increasing wages on the coast may provide that reason.

Moody's doesn't have data on geographical wage differences within China, Singh says, but "the government offers tax breaks and breaks on utilities for factories that are set up in the interior."

D.G. Macpherson, a senior vice president at Grainger who has headed the company's global supply chain operations since 2008, says most of the factories the industrial-supply distributor purchases from are still located on China's booming East Coast, where production costs and inflation have risen the most. Grainger goes straight to the factories, largely avoiding the trading firms that typically have brokered business relationships between Chinese factories and their foreign customers.

"We're seeing a lot more factories in the central part of the country, and they're being more aggressive looking for export business," says Macpherson. "The transportation infrastructure is good and improving."

He points to centrally located Sichuan province and nearby Chongqing, a city with about 30 million inhabitants. "A lot of capable manufacturing has popped up in that area over the last five years," Macpherson says.

Krotts says most of Bajer Design's production occurs within an eight-hour drive to ports. But the firm has begun to source some production further inland and will continue to do so. "The labor rates are cheaper, but you have to contend with raw material supplies and shipping finished goods to the closest port," he says. "This all adds time to the cycle."

Grainger, which had $7.2 billion in 2010 revenue, distributes more than 900,000 industrial supply products, mostly in the U.S. but increasingly in developing countries such as China. The global supply chain operations headed by Macpherson provide 1o% of Grainger's products, up from 7% a few years ago. The company sources 80% of those products from China and Taiwan, where the unit first bought products when it was established almost 15 years ago. "Now there are fewer differences between Taiwan and mainland China in terms of cost and quality," Macpherson says.

Macpherson calls the appreciation in the renminbi--at an annualized rate of 5.7% against the dollar since last June, when China broke its peg to the dollar--"relatively modest" so far. And to tame inflation, which tends to push up the value of the currency, the Chinese government has increased banks' reserve requirements and steadily raised the benchmark rate for one-year corporate loans.

"The fact that there's some inflation doesn't change the picture overnight," Macpherson says. In addition to costs, Grainger considers product quality and transportation time when choosing production facilities. Nevertheless, rising costs on the coast are prompting the company to look west, as well as outside China. He notes that Indonesia's natural resources give it an advantage when it comes to rubber-based products, while India has strong "engineering capability."

Singh points to Vietnam, Laos and Cambodia as countries already producing low-end products, such as textiles, that may now move up to more mid-range manufacturing of products such as toys and electronics.

"Chinese companies may also start looking to other countries in Southeast Asia," he says, noting that Vietnam already has the infrastructure to support exports, while Indonesia and the Philippines have skilled workforces.

Central and South American countries such as Ecuador, Colombia and Brazil may also benefit from companies looking outside of China, Singh adds, although less so other countries, including Argentina and Chile, that have higher costs.

China nevertheless remains an attractive country in which to source production for large multinationals, such as Grainger, because the country's massive internal market can handle price increases more easily since inflation and higher wages boost the local population's buying power. Grainger started distributing its products in China in 2006, Macpherson says. "China has a very heavy manufacturing bent, and our products service those customers."

Bajer Design has yet to tap the Chinese market. "But we did hire a sales manager and hope to develop something in the next 24 months," Krotts says.

The renminbi appreciation may also represent a short-term boon for multinationals that have shifted working capital to China to support operations there. A treasury official at a major multinational pharmaceutical company says intercompany loans the company makes to its corporate entity in China, mainly to support sales staff, become easier for it to pay back to the U.S.-domiciled parent. "We ultimately need fewer renminbi to pay off the same dollar loan," he says.

Bajer Design moved all of its production out of the U.S. in 1997, first to Mexico for a few years and then to China, where it worked through trading companies until the Chinese government loosened restrictions and gave export licenses to mainland factories.

Sourcing production to China enabled the firm to lower costs, Krotts says, but more importantly, it allowed it to add details to products that competitors didn't have and remain competitive on pricing.

After China's first big currency revaluation in 2008, "overnight our costs went up by 6%," Krotts says. Bajer Design typically sells its goods for 30 to 60 days at the old price before it passes through cost increases to its customers, which include major retail, pharmacy and hardware chains. "In the interim, we got nailed," he says. Last year was even worse, Krotts adds, as commodity price hikes and wage increases were added to the mix.

In terms of currency risk, there's little a smaller firm--without multiple affiliates across the world to shift money between in the form of loans--can do to hedge. For example, sending over cash to build up a balance in the local currency to cover expenses in inflation-adjusted renminbi is difficult because the banking system remains "pretty closed," Krotts says.

Bajer Design has considered finding new production facilities in countries such as Vietnam and India, but their production costs are currently similar to China's, "and it takes longer to ship goods," Krotts says. So for the foreseeable future, the firm plans to continue producing and sourcing goods in China.

Fortunately, Krotts adds, a major strength of China remains its worker productivity. "We believe China, even with rising costs, is going to be a mecca for manufacturing."

For more on doing business in China, see Hedging in China Also Emerging.

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