When the World’s Factory Hikes Prices

By Julie Walton

US-based executives have been streaming into Shanghai for global strategy meetings this year. Because China is increasingly the market in which US-China Business Council (USCBC) member companies see significant growth—more than 90 percent of membership survey respondents said that the China market was a top priority for their company last year—executives meet here to see what dynamic economic growth looks like in practice.

I often speak to these groups about China’s operating environment. Despite the diverse composition of the company delegations, the executives often ask similar questions:

• How well are other US companies performing in China?
• How serious are rising costs and inflation in China?
• Because of rising cost, are companies relocating investments to interior provinces, or even to other countries?

Though USCBC does not have a crystal ball, the increased availability of market-focused information and the generosity of USCBC members in sharing their own experiences make it easier to identify trends in China’s business environment for executives.

Past performance and future prospects

Most USCBC members tell us their China sales outpaced their global sales in 2010, and first quarter 2011 numbers indicate that companies may be on track for a repeat performance. Because China plays a big role in certain business units’ overall profitability, some companies are relocating senior management of those units to China, often to Shanghai. Many of these business units have already experienced tremendous growth in emerging markets, especially in China, and thus want to run their businesses from the place of greatest growth. Many companies are also developing new products for the China market and exploring ways to leverage China as an incubator of ideas for products that can be sold in other emerging markets.

Of course, market expansion in China is never guaranteed, and the question of rising costs seem to weigh heaviest on executives’ minds as they consider their companies’ future in China.

How much?

The costs of various materials and business factors—from iron ore to human resources—are rising in China, and companies are feeling the pinch. Minimum wages in Beijing have increased almost 21 percent since last year, and wages in Tianjin and Shandong have each risen 26 percent (albeit from low levels). Many companies have told USCBC that they have had to raise white collar salaries roughly 20 percent recently to stay competitive. Fuel costs have also risen, affecting logistics and supply chains. And China’s consumer price index inflation in the first quarter of 2011 rose nearly 5.5 percent, surpassing the central government’s official goal of 5 percent. China is no longer a low-cost environment for many primary inputs, and companies must rebalance corporate expectations about costs and new investment to better match China’s economic conditions with company plans for regional growth.

Given that most USCBC companies have invested in China to serve the China market, relocation to other areas—especially to Southeast Asia or India—is difficult. Therefore, companies are thinking more critically about managing expansion and new investment throughout the region. One executive noted that if China accounts for less than 50 percent of a product’s sales, the company adds new capacity to its facilities in India instead of China. According to this executive, India is a less expensive manufacturing option for their product segment when China is no longer the primary sales market.

Meanwhile, many companies are considering moving inland. USCBC sources suggest that companies often move to China’s interior provinces to tap new markets in addition to seeking lower costs. Though Foxconn Technology Co., Ltd. acknowledged that lower labor costs played a role in its decision to open plants in Anhui and Chengdu last year, HSBC Holdings plc’s opening of branches in Chengdu and Chongqing to expand its customer base a few years ago is more typical of most companies’ desires.

USCBC members tell us that, depending on industry and business needs, China’s central and western regions might not be less expensive than the coast once costs related to transportation networks, proximity to supply chains, and talent recruitment are taken into consideration. At the same time, most companies that are “in China for China” will need to consider westward expansion at some point since demographic and urbanization trends, along with central-government policy goals, indicate that China’s interior will be the next “emerging market.”

All of this suggests that smart companies should carefully evaluate their cost structures and regional options when plotting future investment and growth trajectories in China. Untapped cost efficiencies may ultimately be the most significant approach to dealing with rising input prices and an increasingly competitive domestic market.

Julie Walton ([email protected]) is the US-China Business Council’s chief representative in Shanghai.