May 2008 Archives

Is low-cost country sourcing set to become a victim of the rising costs of oil?

A new article from Purchasing.com reports on an Economics and Strategy Report from CIBC World Markets in Toronto, whose chief economist believes that the rapidly rising costs of transportation may be reversing globalization as businesses are forced to look closer to home for suppliers. Claiming that rising costs will once again make the world rounder, the article notes that the combination of global raw material costs and high energy costs in China have led to receding Chinese exports of such products as steel, furniture, footwear, metal goods and industrial materials. Interpreting the CIBC World Markets Report as a sign that transport costs are erasing China's labour savings edge, the Montreal Gazette cites from the report that it currently costs $8,000 to ship a standard 40-foot container from Shanghai to the North American east coast, up from just $3,000 in 2000, and at $200 per barrel of oil, the cost to ship the same container is likely to reach $15,000, making the cost of moving goods the largest barrier to global trade today.

While the greatest impact of rising oil prices is on poor, oil importing countries, record prices even have energy producers concerned. During talks between energy producers and consumers held in Rome in late April, OPEC oil ministers insisted the problem has nothing to do with short-term supply but is rather the result of a weak U.S. dollar. Yet in October last year China Dialogue analyzed the findings of a German energy study produced by the Energy Watch Group (EWG) which found that petroleum output peaked in 2006 and henceforth would drop annually. Expecting world oil production to fall by as much as half by 2030, the study envisioned apocalyptic consequences when extreme shortages of fossil fuels and rising demand lead to economic restructuring and social breakdown. In China, the rising price of oil is particularly daunting, as Donald Straszheim comments at Forbes.com, because while its strong economy has been a key driver inflating prices, China has a burgeoning appetite for oil with demand growing 65% faster than the U.S. and four times faster than India, complicated by China having to import over half of its oil while controlling retail prices with inflation in excess of 8%. 

Cargonews reported this week that, in response to the dizzying rise of bunker fuel prices, shipping lines have shredded almost all of last year's customer contracts, in contrast to previous years when contracts were usually extended for another year. As fuel prices are making it hard for lines to make a profit, oil price shock has replaced the traditional arm wrestling at the negotiating table over the rates for the peak season from July through October. Hence more emphasis is being placed on volume discounts, guaranteed sailing dates and shipments, and long-term pledges by shippers.

Dan Gilmore at Supply Chain Digest recently analyzed the cost impacts of rising oil prices on supply chain network design. Incorporating the analysis of MIT professor and supply chain thought leader Dr. David Simchi-Levi, who used data from a real consumer goods company, it was found that every $10 per barrel price increase of crude oil amounts to a 4-cent per mile increase in transportation costs in the U.S., yet when the price of crude oil surpasses $150, things really start to change:
At that point, rising transportation costs start to significantly impact both where products are made and what the distribution network looks like...Rising oil prices would have the effect of changing the way we think about outsourcing and offshoring, after 10 years of a mad rush to China and other Asian locations.
Yet if $150 is an ominous benchmark, Gilmore expects that we will blow past $200 in a heartbeat, so with some fitting hyperbole of the doom that awaits us, Gilmore likens the impact of rising fuel costs to an unwitting frog in a pot of water being slowly heated:
We're being boiled alive, but may not realize it until its too late. The US economy and our supply chains can be very resilient, but at some point in both, something has to give. 
In the latest of their TrendWatcher series, the Institute for Corporate Productivity last week produced a piece entitled China's Quality Squeeze, which incorporates a range of statistics, notably:
  • 70% of product recalls in 2007 involved Chinese goods, a scenario which has been greatly helped by the
  • 30% annual increase of Chinese imports to the U.S. from 2001 to 2005, so that today
  • 40% of all U.S. consumer imports come from China.
This despite the range of well-publicized China supply-chain quality lapses and gaffes of 2007, which have, however, not significantly dampened foreign firms' confidence in continuing to source from China. Instead, the strategic impact of the recent wave of quality concerns in China is inducing companies to inject more stringent quality control measures in their dealings with Chinese suppliers. Even so, the TrendWatcher piece continues, in its examination of best practices and risk factors for sourcing goods from China, a Quality Executive Board (QEB) survey found satisfaction with Chinese imports confined to a relatively small segment of companies that have developed long-range supply chain strategies that employ diligent pre-contract vetting and costly onsite visits.

In outlining how sub-quality products can reach the international marketplace, contract manufacturer Mike Bellamy at Smart China Sourcing recently pointed to how bad things can happen when a certain set of factors overlap. The fast growth of China's production base in recent years has given rise to a rapidly changing environment with a wide range of manufacturers of various quality standards. And as today's communication technology facilitates increasing numbers of first-time foreign buyers to suffer from a lack of experience in sourcing from China, an uninformed choice may lie at the root of product quality problems. (See also Sebastian Bretau at China Success Stories on how product inspection, auditing and testing can be used to spot potential issues before shipping, rather than upon delivery).

In a familiar refrain recurringly echoed by Silk Road International's David Dayton, Bellamy writes
The single most critical action you can take to ensure a successful sourcing program is to visit your selected factory.
In fact, in Dayton's experience, the money saved from not coming to China multiple times will be lost in missed delivery dates or quality problems. Yet simply making it to China is not enough, because without painstaking diligence on your part, you're not going to get what you asked for. In Dayton's list of rules for international purchase managers, this diligence includes, among other things:
  • personally speaking Chinese (I suspect, the first problem)
  • personally and physically having samples tested and confirming they match production, and
  • never getting angry in the midst of problems (the challenge is to get your supplier to like you).
And if you do make it to your Chinese factory, Dayton advises, beware if their answer to all your questions is 'no problem, of course we can do that,' because then you are simply not going to get what you asked for.
quake3.JPGWhile China remains gripped in the traumatic aftermath of the devastating Sichuan earthquake that have juxtaposed extreme tragedy and national outpourings of grief with heroism and sheer determination to save more lives, the economic impact of the quake is largely regarded as limited. While an important producer of agricultural products, Sichuan comprises about 4% of China's GDP production and most of the province's developed areas were left largely undamaged. Chinese government sources estimated the quake to have affected 14,207 industrial companies, however, which may have incurred losses of 67 billion yuan, equal to about 0.5% of China's GDP for 2007. State-owned enterprises are estimated to have incurred losses of about 30 billion yuan, and around 3,000 employees of these companies are injured, dead or missing.

As such the quake is expected to rather aggravate inflation than impede economic growth, and the loss of farm output in Sichuan will impact already tight supplies of rice and pork. Anticipating more upward pressure on prices, Premier Wen Jiabao this week described the quake's impact as uncertain, and of immediate concern is the formidable challenge of sheltering close to 5 million residents left homeless in Sichuan. Yet coupled with the effects of a mature industrial base and the new labor law, the quake could amount to what David Dayton at Silk Road Blog calls a perfect storm of price increases, and production costs from most of China's east coast relying on cheap labor from other provinces will be directly affected.

Yet while the quake is a human tragedy more than an economic one, much of the uncertainty rests on the potential impact on China's energy infrastructure and raw materials supply. The Green Leap Forward has put together a posting on the quake's impact on energy in Sichuan, which is a major onshore gas producer and China's largest hydropower generating region. Sichuan's electricity grid is reportedly running at 76% of pre-quake levels with 27 power stations shuttered, and 22 coal mines in Sichuan, Chongqing and Gansu were also affected by the quake. Furthermore, the operations of Dongfang Turbine, which produces 30% of China's locally made turbines (and is also the third largest domestic manufacturer of wind turbines), were virtually wiped out. In addition, with 391 dams believed badly damaged by the quake, the Water Resources Ministry has acknowledged major safety issues with reservoirs, hydropower stations and lakes. Earlier this year, the deputy minister of Water Resources admitted that roughly 37,000 of the country's 87,000 dams are in a dangerous state.   
This year's World Intellectual Property Day on April 26 focused on celebrating innovation and promoting respect for intellectual property (IP). In his message to mark the eighth World IP Day, World Intellectual Property Organization (WIPO, of which China is also a member state) director general Dr. Kamil Idris hailed the growing popularity of World IP Day, and explained what IP has to do with the really big issues like global warming or the things that add spice to life:
Without Intellectual Property Rights (IPRs), many new technologies developed to tackle global problems would never see the light of day and the great sporting events, which entertain and unite us, would not be broadcast into homes across the globe.
With the added significance of the greatest sporting event taking place in China this year, China's role in protecting the things that add spice to life remains a hot issue. To illustrate its achievements as well as its determination with IPR, China welcomed IP Day this year by means of a Book Burning, where as many as 47 million pieces of pirated and illegal publications were destroyed across China.

Despite the evident importance attached to protecting IP in China (IPR guidelines were last month approved by the State Council in lieu of a national strategy) and the series of campaigns launched in recent years against crimes related to the infringement of copyrights, trademarks and patent rights (more than 4,300 people were tried and convicted on IPR infringements in 2007), the 'Special 301 Report' on the global state of IP (annually produced by the Office of the U.S. Trade Representative) described China as troublesome for failing to protect U.S. patents and copyrights. From an article at Industry Week, the Special 301 Report emphasized China's overbearing role in a sophisticated global counterfeiting network (citing estimates from U.S. copyright industries that up to 95% of their members' products sold in China are pirated), and attributed this to inadequate IP rights enforcement and high criminal thresholds in China. (See also Business Week on the fifth annual Global PC Software Piracy Study and its findings on the pronounced rates of software piracy in second and third-tier Chinese cities).

European Commission president Jose Barroso in March claimed that China is the source of 80% of all fake goods in the world, and while acclaiming the concrete steps taken by the Chinese government to rein in rampant counterfeiting in China, State Intellectual Property Office spokesman Yin Xintian acknowledged last month the uphill struggle against piracy in China, where an IPR protection system has only existed for a relatively short time of about 20 years. Yet as China Esquire urges, China's apparent predominance in global IP violations should be seen in the context of its large population, and in fact the Chinese government should be commended for its determination to enforce IP regulations:
Yes, there is always much more to do. But we are talking about stemming a flood...It will take a LONG time before IP is as highly regarded as it is in America... But for now, can we just applaud the government's efforts?
And for now, moreover, the U.S.-China Business Council recommends (link from Thomasnet.com) any successful China IP protection strategy to have both defensive and offensive elements, with companies required to combine all the necessary preventive measures (i.e. rigorous auditing, educating of employees and speedy registering of works) with devoting time and resources to detecting violations and taking legal action, because
A company's legal rights mean little in China unless the company chooses to protect them.
Business-to-business (B2B) is still a relatively novel concept in sourcing from China, as most payments are still made via more conventional methods, i.e. bank transfers and Letters of Credit. As Bill Dodson writes at This is China! Blog,
For most companies in China, the websites are little more than brochures for brick-and-mortar operations that provide a service or product that is paid for in ways other than the internet. B2B in the form of e-commerce has been more difficult to monetize - especially in China - because the products on offer have to go through a manufacturing process that may or may not involve design, testing and quality checks.
In addition, international transactions are further complicated by currency conversion issues:
A company cannot simply wire money to a Chinese bank if the supplier does not have a foreign currency account at the bank. The supplier also requires permission to convert the payment into RMB that the bank will hold in the company's RMB account. Such complexity and sophistication are beyond the reach of most suppliers, which are miles away from banks that likely do not support such services in the countryside anyway.
Alibaba's Alipay, originally created to support online auctions at Alibaba Group asset Taobao, however, is China's first attempt at an online payment system, and portals like Alibaba and Made-in-China are increasingly inserting themselves in online transactions between buyers and sellers. Alibaba this week also announced plans for a partnership with Intel to launch a special B2B computer to meet the e-commerce demand of small and medium enterprises in China. The computer will be embedded into Alibaba's e-commerce platform for SMEs, and is expected to be released within the year.

Yet as China's B2B industry grows rapidly and as China expands domestically and internationally, certainly there is room for more than one Alibaba? So concludes Seeking Alpha, while profiling e-Future, a player that is growing at an exponential pace in the B2B industry. In less than one month, e-Future has launched two new websites to go along with its www.99114.com.cn, and as Seeking Alpha reported in March, for the duration of last year e-Future grew by 79%, making it a veritable cash cow due to the fees the company obtains for software contracts provided to customers.

See also Source Juice: Importing over the Internet? Challenges, opportunities, and hedging your bets!
It is now well known that the famous - and hitherto unanimously considered cheap - China price is inexorably inching upwards. In fact, everything in China is going up, from yesterday's estimated earthquake death toll to manufacturing costs to wedding costs and of course, inflation. As China gradually moves up the value chain, however, despite the odd snow storm and earthquake, the inevitably rising China price is detrimental to China's status as the best country for low cost sourcing, compared to emerging opportunities offered by countries such as Vietnam, Turkey, India and others in Central and Eastern Europe.

In a survey for the American Chamber of Commerce's annual white paper, more than two-thirds of member companies agreed last month that China was losing its competitive advantage in global markets due to rising costs, Industry Week reported. The top five business challenges in China were listed as human resources constraints, inconsistent regulatory interpretation, unclear regulation, lack of transparency and bureaucracy. Industry Week earlier this month reported on a recent study of foreign manufacturers in China conducted jointly by the American Chamber of Commerce Shanghai and management consulting firm Booz Allen Hamilton, which found that 54% of companies manufacturing products in China agreed that China is losing its competitive edge to other low-cost nations like India and Vietnam, yet 83% intended to maintain their current operations in China despite the rising costs of manufacturing.

While China is supposedly struggling to hold on to its prime position for cheap low cost country sourcing, new importers often do not realize the full impact of hidden costs of customs and shipping until the first order from China is complete. At Smart China Sourcing, Dylan Blankenship outlined what items need to be included to calculate total landed costs, and how to minimize these. A quote from a factory in China is only the beginning of the calculation, and it is important to clarify the exact terms of sale and what charges are the responsibility of each party, factory and buyer. Smaller importers can often pay less by negotiating to ship containers under a bigger importer's existing contract, helping them to meet their shipping quota. Additional costs may accrue, however, from relevant duty costs, courier/postage of original documentation, customs broker coordination fees, and 'last mile' providers that deliver to the final destination.