Chang-Hong Whitney04.04.08
China is facing the threat of inflation yet again. Although it may seem to be a distant concern for most people, this threat is all too predictable for many China-based business veterans. Given the high-flying GDP growth in recent years and influx of capital and investment from all directions, there have been worries that China’s economy might be overheating. In fact, during the recent National People’s Congress, President Wen Jiabao acknowledged the immanent inflation threat and made a pledge to contain inflation at 4.8% in 2008 by “taking powerful measures to increase effective supply while curbing excessive demand.”
What’s Contributing to Inflation Threats
A look at history helps to put concerns into perspective. Since the beginning of its economic reform in the late 1980s, China has experienced two other inflation threats related to supply and demand. The first arose between 1985 and 1988, when a shortage of supplies threatened the economy. The second inflation, between 1993 and 1996, largely was caused by accelerated investments, which triggered a cycle of expansion in terms of demand. Thankfully, both inflation threats were effectively controlled by the Chinese government.
At present, however, the inflation facing China seems to be multi-dimensional in nature. Since June 2007, China’s Consumer Price Index (CPI) has been climbing, reaching 6.5% in August and 7.1% in January—its highest in 11 years. The global shortage of oil and high demand for such resources by Chinese industries have resulted in price increases for raw materials and energy. Furthermore, water prices increased 20% in August compared with prices in the beginning of 2007. As a result of these types of increases, there are higher costs to make products; in turn, consumers are being forced to pay higher prices for finished goods, affecting the everyday life of average citizens.
A large influx of foreign investments also has forced China to increase its currency supply in exchange for foreign currencies. The nation’s supply of Renminbi (RMB), China’s currency, has gone ahead of production growth, negatively impacting RMB value. To control the overall impact on its economy, the National Development and Reform Commission (NDRC)—the macro economic management agency under the State Council—has implemented new measures, such as temporary control on price increases for food items.
Meanwhile, a strong economy and imbalance in trade with the United States, coupled with the slowdown in the US economy, has contributed to the appreciation of Chinese currency against US dollars. The US dollar exchange rate against RMB dropped from RMB 7.8 per dollar in the beginning of 2007 to 7 in February 2008. The appreciation of RMB is especially hard for export-oriented businesses. Because product pricing is dictated by standards set in the international market, Chinese manufacturers are unable to transfer increased costs to their customers at the same rate. According to the China Textile Industry Association, two-thirds of its member companies reported profits in the third quarter of 2007 that were below the industry’s average. These companies’ average profitability was only 0.16%. The total loss was close to 10 billion RMB (approximately US $1.38 billion) in 2007.
The worldwide slowdown in the economy also has led to a reduction in orders. In January, order volume dropped 10% compared to the same period last year. Some senior industry experts already have predicted that prices for Chinese-made toys, clothing and other consumer products sold to the US market will increase by 10% in the next two years. With costs accelerating for energy and labor, Chinese suppliers may have no other alternative than to increase sales prices for their products.
Taking all of these factors into consideration, clearly there is cause for concern. What should companies who source Chinese products do?
Consider These Other Factors
The Chinese and foreign press, which have been rife with news reports about this issue, often have featured commentators who advise companies to look for alternative sources for making their products in China. For consumer and other low-tech products, it is possible to find many suppliers around the country. Medical device buyers, however, have more limited options. Bound by regulatory restrictions, complex manufacturing requirements and the need for skilled labor pools, device companies only tend to have a few highly qualified and reliable Chinese suppliers that can meet their specialized needs. International purchasing agents may have to hunker in, bundle up and pray for the economic storm not to disrupt their supplies.
In the meantime, they can explore some unique features of the Chinese economy.
Government subsidies. Understand that China still is a centrally controlled economy. Therefore, government intervention during a time of crisis always is expected. To sustain growth and maintain low unemployment rates, the central government may reinstall subsidies for exports (such subsidies gradually were reduced or abolished in recent years after other countries complained about unfair trade practice).
To control the use of energy and key raw materials, the Chinese government also has reduced or abandoned most VAT reimbursements for exported products that heavily rely on raw materials. One may ask if it is possible to reverse such a policy in light of maintaining production and saving jobs. The objection to such a notion indicates that China already has much higher exports than imports, and reinstalling the subsidies may increase this gap—causing the economy to continue to overheat. According to some opinions cited in the China press, the government should provide subsidies to imports, hence increasing supplies to wrangle control over price increases. No matter what subsidies may occur, one can be sure that macro-economic polices and measures will play a big part in the everyday life of the business world. Therefore, one should keep an eye on such developments and help suppliers take advantage of any subsidies—and, in turn, transfer the benefits to the export pricing.
New policies. Besides the obvious, organic causes for rising labor costs, China’s new labor law, released in mid 2007 and effective as of January, added to the burdens facing manufacturers, pushing them to reconsider China manufacturing opportunities. A report from Guangdong province showed that many export-oriented factories have moved or are considering moving. Such moves are traumatic to the device industry, because the re-qualification and re-certification involved with new locations or entities take time to complete and disrupt the supply chain. Increased regulations—from product approval to product safety to pollution control—also threaten the bottom line of each medical manufacturer doing business in China. Sourcing managers truly should understand the real health of the supplier to ensure they can respond appropriately, if necessary.
Exchange rates. Over the years, China has been under pressure to relax its exchange rate policy. Since 2006, the Chinese RMB exchange rate against US dollars has been steadily rising. One US dollar, which used to be traded into RMB 8.3 in the past, is only worth RMB 7 nowadays. With the inflation threat in the horizon, there are more discussions about where the exchange rate will go down in the months to come. Some economists have predicted that the US dollar will continue to devalue against Chinese RMB, dropping to or below 6.9 per dollar by end of 2008.
Keep It Real
There is always one inevitable fact of life: It is what it is. There may be nothing one can do with the current situation, nor may anyone be powerful enough to change or even accurately predict the outcome. It is important for all of us to keep an objective view of this situation as China is going through an adjustment period.
During a macro-economic session hosted by the NDRC, many well-known economists debated if China is truly in the threat of inflation. Some strongly believed that price increases are a natural product of economic growth and that food pricing, for example, was not at a level high enough to induce inflation across board. All of the economists did agree, however, that the average citizen’s comfort level regarding inflation is a critical issue. The suggestion was for the government to do what it can to reduce the impact on people’s lives. Another hot debate at this meeting pertained to whether China reached its peak of double-digit GDP growth in 2007. Some economists believe that China has, in fact, done so. Others estimated that GDP growth would turn a corner after June, when both investment and export may begin to level off.
It is easy to see that there is no one theory or viewpoint on China’s present and future economy. After a few years of being on top of the world, this downturn may be a necessary reminder to the world that it should have a healthy and objective expectation on China. The best way to weather such a period might be to promote bilateral trade. China remains to be one of the largest economies in the world, with enormous demand and a rising middle class. It is up to all of us to fulfill needs and sustain the corporate objectives for China operations.