November 2011 Archives

Heavy equipment manufacturing is an interesting measure of the maturity of China's economy. Its one thing to build a bulldozer, but its quite another to build a bulldozer that can compete with the best in the business. And right now, China is aspiring to achieve just that. But is it there yet? Not quite.

Measuring progress
China's progress in heavy industry exports during the last decade, however, is very impressive. The chart below illustrates just how well China performed in terms of total heavy industry exports in 2010 (y axis), and CAGR from 2000 to 2010 (x axis). It now stands just behind the US, Germany and Japan, but its growing much faster than those. 

Major Exporters of Heavy Equipment.png

As the note explains, 'heavy industry' here refers to a bundle of exports of 10 trade items, in all of which China has  immensely increased its share of world exports. To illustrate this further, the following chart shows these items individually, and contrasts where China stood in 2000 vs. 2010. Its quite a change, as you can see. 

Growth and Share of Heavy Equipment Exports.png

Competitive champions
So the statistics illustrate a clear picture of China's emergence in heavy industry. Yet when it comes to actually competing with the best, does China's best efforts measure up? I want to take one example to discuss this: construction equipment. The 'Bulldozers, etc.' and 'Derricks and Cranes' categories in the chart above refer to such construction equipment for which China has registered rapid progress in the last decade. And if China has become competitive it means that its leading construction machinery manufacturers have done so as well. 

Its no surprise then to discover that China now has three companies in the top ten of construction equipment manufacturers globally; only six years ago, the highest ranked Chinese company was in 33d place. The ranking I am referring to here, which used sales revenue for the 2010 calendar year, is the Yellow Table published in the magazine International Construction (downloadable with registration), which lists the top 50 global construction manufacturers (Im referring to the April 2011 edition of the magazine). 

Its very interesting how the Yellow Table ranking corresponds with the first bubble chart above: the US, Germany and Japan lead, followed by a few other countries and China. In the 2010 Yellow Table, Caterpillar (US) is at the top, followed by Komatsu and Hitachi (Japan), Volvo (Sweden), Liebherr (Germany) and Doosan (S. Korea). Then, in 7th, 9th, and 10th place follows the Chinese competitors Sany, Zoomlion and XCMG. Other Chinese companies in the top 25 are Liugong (20) and Shantui (22).   

Being competitive vs. matching the best
But how competitive are the likes of Sany, Zoomlion, XCMG and Sany really? Can they really compete with Caterpillar and Komatsu? The short answer to this question is no, or at least not yet. The longer answer is more complex, and needs to be looked at in terms of the situation in a specific market. I am going to briefly refer to the South African market for this purpose. 

Buying a bulldozer or a wheel loader is not just a case of buying a bulldozer or a wheel loader. Construction companies and mines will want to be absolutely sure that the machine they buy will work as long as its supposed to. And they will want to know that if a part is needed, it can be provided without delay. For every hour that the machine does not work on a mine, the mine loses a stack of cash. Reliability and longevity is everything. Price is not unimportant obviously, but quality is more important. 

So consider the disadvantage that new Chinese competitors in South Africa face against long established players like Cat and Komatsu. While you will pay more for a Caterpillar machine, you know when you buy it that the after sales services coming with that machine will be top notch. If it breaks, Caterpillar will supply a new part within 24 hours. As new entrants in the South African market, the Chinese competitors cannot yet match this service offering. Their machines cannot yet match the performance of a Caterpillar or a Komatsu, even though they have come a long way in the last few years. 

A different future
And thats just the rub: Chinese manufacturers have come this far, its very unlikely that they will not become serious competitors to the best in the business sometime in the future. The Chinese are learning the ropes fast, they know that you need to put down deep roots in a country to be able to supply the kind of after sales services necessary to compete with the best, in addition to building quality machines. They are not quite there yet, but they are getting there. 

Some of them even seem poised to step up to another level of competitiveness right now. One example is the Chinese producer Shantui, whose main product is a bulldozer. Shantui hails from China's Shandong province, where Shantui had originally set up a factory based on Japanese technology. Shantui has now been in South Africa for a few years, and just a few weeks ago it launched a whole new facility in Johannesburg, which I attended. 

Shantui has run an advertising campaign in South Africa proclaiming itself as the world's #1 bulldozer manufacturer, and seem to have placed great emphasis on the right kind of after sales services. Shantui was also able to present feedback from some of the users of its machines which glowed with appreciation of the quality of the machines, and it also announced that its sales in South Africa in the last few months have gone through the roof.

So time will tell if this is really the beginning of big things for Shantui. But I can picture a time when a Shantui bulldozer or a Sany wheel loader will be among the best brands in their classes. Its happening, but give it some more time. 

A New Approach to China Procurement

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China's procurement environment is changing under the weight of both old and new trends, and procurement managers worldwide must adapt to a new opportunity landscape. A different approach is now required that takes advantage of China's more sophisticated manufacturing base.

For the past 10-15 years, China has been the undisputed darling of purchasing managers worldwide. The goods Chinese suppliers export to the EU and US range from apparel and electronics to heavy machinery, all of which have grown steadily in the past decades to place China in the number one spot for overall exports volume. Exports of machinery and equipment to developed countries have particularly enjoyed rapid growth over the past ten years (see chart below, right). But since 2006-07, new issues such as an appreciating currency and increasing labour costs have started to impact both the real and perceived competitiveness of China as a source of manufactured goods. How should a procurement manager re-assess China in the light of these and other changes? How can they assure that competitive advantage is gained by investing in a China sourcing operation? How to benefit from the long-term trends and evolving landscape of China’s manufacturing base?

Old news: Labour and currency issues 

 Labour cost increases and rapid rises in input prices, mostly for commodities and energy, were a significant problem for the Chinese manufacturing industry in the years preceding the global financial crisis. The crisis provided a brief respite, with declining exports and capacity utilisation releasing upward pressures on prices and wages. But since early 2010, the trend has resumed, with labour costs increasing by 14.3% in real terms in 2010, and PPI inflation reaching 5.5%. Not only is labour becoming more expensive, but there is also a shortage of experienced white collar workers, engineers and managers which are increasingly in high demand. 

In addition, the Chinese government is allowing the gradual appreciation of the renminbi, with has risen by 21% against the US dollar over the past five years. With pressure from the US and other developed countries for China to further appreciate its currency, this trend is likely to continue for the foreseeable future. Other trends that are not new but continue to plague the Chinese manufacturing base are intellectual property protection; weakly defined and poorly implemented quality management processes; governance issues in supplier selection and management; and inconsistent product quality. 

Wages and Exports.jpg

New trends 

There are also more recent discernable trends which are negatively affecting the pricing and availability of Chinese exports. The government is increasingly implementing trade restrictions such as export bans or export quotas, and also reducing VAT export rebates and in some cases placing export duties on certain commodity-type products, especially energy-intensive goods or low-value-added processed raw materials. On the other hand, newly emerging or existing sources of manufactured goods, such as Vietnam, Thailand, Malaysia, Indonesia, and the Philippines, have started to look comparatively better from a labour cost perspective. Governments across the region have started implementing some of the policies that brought success to China’s leading export manufacturing industries, and are offering increasingly attractive investment incentives to manufacturers. Procurement managers across the globe are under pressure to evaluate these up and coming low-cost countries, and determine the best approach for avoiding increasing costs in China and taking advantage of these opportunities.

Estimating the extent of change 

From our experience in China and our understanding of China’s manufacturing strengths and weaknesses, none of the trends described above are surprising. They all fit into the mould of the long term income rise of China’s population, as well as government policy goals of increasing the value added of local manufacturing, reducing the country’s energy and raw materials dependency, and shifting the growth engine of the economy away from export-oriented manufacturing towards a more balanced portfolio of investments, including boosting local consumption and the service exports are forecasted by MEPS to fall by 37% this year, while seamless tube exports will only see a modest 8% growth. To better understand how to take advantage of this shifting China procurement equation, we need to re-assess the key elements of China’s traditional manufacturing competitiveness. What began 30 years ago as a cheap labour outsourcing base for unsophisticated goods has changed dramatically to become a continent-scale country of widely varying costs, standards, capabilities and business environments.

In terms of labour costs, cost to company per employee is increasing across China due to uneven supply, high demand, inflationary pressure, organised labour demands, and growing social spending requirements. But Western China still offers large pockets of very reasonable wages for skilled and semi-skilled labour, and foreign and local manufacturers in China are increasingly taking advantage of this. While it is true that wages are rising quickly in coastal regions, labour productivity gains due to investment and technical upgrades, especially in the machinery industry, have kept pace with the rise in labour costs (see chart above, left).

Chinese exporters of manufactured goods are also taking advantage of the massive local market. The demand for new plants, equipment, infrastructure – often one third to half of world demand – has created significant economies of scale and of scope for most of China's manufacturing sub-industries. The competitiveness and innovation in the construction machinery sector, for example, have primarily been driven by the country’s infrastructure build-up over the past 15-20 years. The same effect has benefited the producers of steel commodities and structural steel, construction materials, trucks, barges, electrical equipment, power generation equipment, etc. The infrastructure build-up and procurement demand, initially fuelled by foreign-invested companies and with some assistance from government procurement policies, government-approved projects, and the availability and low cost of land and capital, have generated a highly competitive and increasingly sophisticated plethora of local producers that are now dominating the Chinese market and aiming for global expansion.

The size and growth of China’s manufactured goods market is in effect supporting a self-sustaining cycle of cut-throat competition that features innovation, capacity expansion and upgrading, and ‘learning by doing’. Suppliers and clusters of suppliers compete with each other but an engineering talent pool and the related innovation usually travels freely and contributes to China’s overall manufacturing competitiveness. They take advantage of the more than 600,000 students who graduate with engineering degrees every year, excellent transport infrastructure, especially in coastal regions, and generally supportive government policies favouring Chinese high value added manufacturing. As industries across China consolidate and manufacturers grow and become more assertive in their quest for value-added production and profitability at home and abroad, firms sourcing from China must address the following question: How can we protect and consolidate our savings in sourcing capital goods from China through the establishment of a China procurement operation? At the same time, how can we move to the next level and take full advantage of an increasingly sophisticated manufacturing base?

A new approach: Drawing in the supplier and sourcing goods of increasing complexity

The structural changes in China’s competitiveness across the sourcing spectrum will require procurement managers to shift some of their commodity spending from China to other LCCs, while increasing their orders of machinery, complex parts and high-value added consumables in China. In our view, the key to taking full advantage of a broader spectrum of cost and feature innovation present in the Chinese market is to move from a customer-supplier model of price-based sourcing with strictly dictated specifications and standards to a partnership-based approach where the supplier takes an active part in the overall project and in specifications design. This would entail a structured and patient exchange of ideas, a deeper understanding of Chinese manufacturing practices and standards, and above all, an open mind from both the customer and the supplier. Commercial practices would also require modifications. Contract management with Chinese suppliers generally relies less on contract enforcement and more on relationship management, so many of the standard contractual clauses traditionally used by international procurement teams are either not applicable or not enforceable in China, and thus create unnecessary burdens on suppliers and ultimately increase the total costs of the contract.

Ultimately, a sophisticated foreign buyer of Chinese capital equipment will probably need to adopt a number of Chinese standards, practices and approaches – all without compromising quality, environmental and labour protection standards, or good governance.

Note: This article originally appeared in the section China Sourcing Strategy of the September 2011 edition of The China Analyst. 
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Two weeks ago I had the honor of attending, “The 10th Anniversary of China’s Accession to the WTO: China’s Learning Curve,” conference jointly held by the Research Center for Chinese Politics and Business at Indiana University and the China Institute for WTO Studies of the University of International Business and Economics. Sun Zhenyu, China’s former Ambassador to the WTO, was among the over 40 speakers from the WTO, Chinese and foreign governments, law firms, and leading universities scheduled to share their insights and thoughts nearly 10 years since China became a WTO member, including how China and the WTO itself has changed in the time since.  

During the second panel of day one titled, “The Effect of WTO Entry on China’s Economic Reforms and Economy,” Mr. Christian Murck, President of the American Chamber of Commerce in China and Dirk Moens, the Secretary General of the European Union Chamber of Commerce in China, shared their insights on China’s current status as it moves towards a complete market economy. While both concluded that foreign companies have undoubtedly benefited greatly from China’s accession and economic progression, they both conceded there is still a lot of room for improvement. To start, SOEs continue to enjoy too much preferential treatment (easy access to low interest rates), stifling competition and some would argue, stifling innovation. Simply put, more reform is needed for China to declare itself as a true market economy.  Other common problems/concerns shared by American and European businesses alike is the high degree of discretion local governments in China have when issuing and implementing laws, which makes it difficult for businesses with a nationwide presence to develop a unified China strategy. In the coming years as China’s working age population peaks, and labour shortages become more widespread, China’s hukou system must be reformed so that workers can move more freely between cities and companies can hire the necessary personnel. In fact, it can be easily argues that addressing these issues is in China’s best interest, as Chinese companies also face the same problems.

Agreement on Government Procurement

The Agreement on Government Procurement (GPA) is a legally binding and plurilateral agreement in the World Trade Organization (WTO) focusing on the subject of government and local government agencies procurement (the only one of its kind to date). The procurement in the Agreement includes a variety of goods, ranging from commodities to high technology equipment, and services. The GPA was established to eliminate discriminative laws and practices against foreign supplies and suppliers in government procurement among member countries. For member countries, the market opportunity is significant as the government procurement of goods and services typically accounts for 10-15% of GDP for developed countries, and up to as much as 20% of GDP for developing countries. Subsequently, the GPA is currently being reviewed among the 42 members, so that it “reflects the realities of government procurement in the 21st century,” according to senior Swiss trade diplomat Nicholas Niggli, who chairs the government procurement committee. An updated version will expand the coverage (range of government procurements) in terms of the entities or sectors covered, which, according to the International Centre for Trade and Sustainable Development (ICTSD), would liberalise access to billions of dollars worth of public procurement contracts.

According to a recently released working paper from the WTO’s Economic Research and Statistics Division, the total value of additional market access commitments that could result from GPA accession by 42 WTO members is in the range of USD 380-970 billion annually.   The accession of the five BRICS countries – Brazil, China, India, Russia (not yet WTO member, see below) and South Africa – would, by itself, add in the range of USD 233-596 billion annually to that value. Currently, Albania, China, Georgia, Jordan, Kyrgyz Republic, Moldova, Oman, Panama and Ukraine are negotiating accession.

On 28 December 2007, China delivered its application and initial (largely ceremonial) offer for acceding to the GPA to the WTO Secretariat.  Subsequently, on 9 July 2010, China submitted a revised and improved coverage offer. Although China has 15 years of WTO negotiations experience, it is taking a different approach this time around as shown in the first three years of negotiations. According to a working paper presented at the conference, China, lacking a formal political process of interest, is utilising its political leadership, organizational arrangements, academia and public opinion to help guide its negotiations. China has pledged to submit a “robust improved offer” before the end of the year, to be reviewed at the WTO's ministerial gathering on 15-17 December. According to ICTSD, the offer would outline China’s proposal for which Chinese government agencies would be covered under the agreement, what thresholds would apply, and other coverage-related details. While it is expected to well received by existing GPA members China’s accession is not expected to be concluded by the end of the year.

Russia’s Impending Accession

After 18 years of negotiations, Russia and its USD 1.9 trillion economy is on the verge of joining the WTO after recently accepting a trade deal in early November with Georgia, the former Soviet republic with which it fought a short war in 2008. The compromise deal on monitoring mutual trade was the last major hurdle that will secure Russia’s integration into the global economy and arguably the biggest step in world trade liberalization since China joined the WTO. President Dmitry Medvedev is hopeful that Russia will formally join the 153-member club by the end of the year. On November 10, Russia won approval from the WTO’s Working Party, which will draw up a final document for approval by WTO trade ministers in Geneva on December 15; Moscow will then have until mid-June to ratify its membership, which will become effective 30 days later.

Accession is expected to stimulate Russian economic growth, boost gross domestic product by an extra 11% in the next 10 years and help encourage global companies, especially those based in the European invest in Russia. The biggest beneficiaries of the WTO deal are global companies based in the European Union, by far Russia's biggest trading partner, the U.S. and other countries. According to Andrew Somers, head of the American Chamber of Commerce in Russia, "The benefits for Russia are basically long term. It's going to normalize Russia as an investment destination market. Over time, Russian companies will be forced to be more efficient and competitive." While Russian companies and exporters such as Russian steelmakers are set to benefit tremendously through more favorable treatment in tariff negotiations abroad (the average maximum Russian import tariff is set to fall to 7.8% from 10%), some domestic manufacturing industries which have been largely shielded from global competition such as food processing, textiles and construction materials, will most likely suffer. Looking ten years into the future, if Russia does indeed join the WTO, it will be interesting to see how much the business landscape in China has changed, and if China is any indication, Russia will be remarkably different.

The map below illustrates the concentration of industry in China, using cities to identify locations where resources and competencies have been concentrated to produce a competitive advantage in a specific industry. 

Industrial Clusters.png
Click on the map for a bigger view. 

This map provides an interesting perspective on what is made where in China. Some of the cities listed on this map has become famous for their particular industrial cluster, just a few examples of which are bra's and ladies underwear in Shantou (Guangdong); electronic products in Dongguan (Guangdong); transport equipment in Shandong; and lighters in Wenzhou (Zhejiang). The clusters are predominantly still located in the eastern part of the country, but as the distribution of the dots on the map illustrates, there is a lot going over a many provinces, not only in the coastal areas.