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%.

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.

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."

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