Economic changes are throwing up challenges for companies

In China, double-digit growth over the past few years has transformed the country into the manufacturing hub of the world. However, as the country becomes more interconnected with global economies, it is also more susceptible to a worldwide economic slowdown.

China's projected GDP growth of 7.5 percent this year is the lowest that we have seen in the past decade, even if it still is substantial, and there are some challenges to doing business.

China remains a strategically important market for multinationals, but they also face challenges as they expand their presence in the world's second-largest economy. These include the increasing economic weight of inland provinces, strengthening of local competition, and an economy not immune to the current global economic malaise.

Some multinationals maintain that China is no longer a cheap location for manufacturing goods and to which services can be outsourced, at least relative to other emerging economies. We may therefore see a big change in the world's production chain, as factories relocate to either cheaper countries such as Vietnam or Bangladesh, or to China's inland regions.

China's once cheap labor offered a major cost advantage for manufacturers. But the country's ageing population has changed the cost equation.

However, the overall outlook is positive, and according to a recent global manufacturing survey by KPMG, the US is expected to lead growth for the manufacturing sector over the next 12 to 24 months, followed by China.

For the report, 2012 Global Manufacturing Outlook: Fostering Growth through Innovation, 241 senior global manufacturing executives were surveyed. It found that 76 percent of respondents are optimistic about their business outlook over the next 12 to 24 months, despite the lingering debt crisis, slowing global economy and high levels of household debt across the developed world.

Fifty-seven percent of respondents said they believed the cost structure of their business models will need to change over the next 12 to 24 months. They also continue to rationalize their operations. And 54 percent of respondents said "exiting unprofitable product lines and/or geographies" will become more important for them over the same period.

Meanwhile in China, labor costs have increased by 15-20 percent a year on average over the past four years. This together with the appreciating yuan has meant that China is no longer a low-cost manufacturing base. This in turn has forced the pace of transformation and a transition to greater levels of automation and innovation in order to drive margin growth. This is a positive change and is also in alignment with China's current policies.

Price volatility on cost inputs, risk in the supply chain and uncertain demand are the main challenges highlighted by most respondents to the survey.

To reduce costs, some global manufacturers are positioning their facilities close to end-markets. A majority of respondents said they believe near-shoring is either "effective" or "highly effective" at improving agility, lead times, risk management, information flow/synchronization and total cost.

Rising costs in the Chinese mainland have also triggered a shift of labor-intensive manufacturing further inland, and in some cases countries across Southeast Asia and South Asia where costs are lower. They are also becoming more sophisticated about where they locate their offshore facilities. Many, for example, now use a "China +1" strategy, adding an additional production base in a lower-cost country in Asia. The aim is to maintain their responsiveness to the Chinese market but also to help reduce the impact of wage inflation.

And yet some multinationals say that benefiting from China's growth story is no longer so simple and that it will be far harder to capture the growth opportunities in the inland provinces compared with the coastal provinces. They describe the inland provinces as higher-cost, lower-yield and more fragmented places to do business. However, some of the largest multinationals seem to find it possible to invest for the long term in the inland provinces, whereas the smaller ones tend to be happy to stay in the coastal provinces, at least for now.

Meanwhile, China is also moving up the value chain for manufacturing activities, in line with objectives outlined in its 12th Five-Year Plan (2011-15). Over half of respondents who plan to increase sourcing activities in China and India selected research and development for China, and more than 77 percent selected "product development/design" for India.

The country is going through an unprecedented transformation and is likely to emerge stronger, with a greater focus on moving up the value chain in productivity and labor input. There are clear signs that the country is moving in this direction, with a key focus on qualitative growth versus quantitative growth of the past.

The report also notes that global manufacturers are increasing activities in innovation and collaboration, keeping a longer view of a return to sustainable growth. Seventy-two percent of respondents said transformational innovation is either in full swing or will be in the next 12-24 months, as manufacturers increasingly look to invest in expanding their product and service offerings in order to remain competitive.

The 12th Five-Year Plan, for example, has placed more emphasis on value-added manufacturing across seven priority industries: new energy, energy conservation and environmental protection, biotechnology, new materials, new IT, high-end equipment manufacturing and clean energy vehicles.

The current economic recovery, fragile though it is, promises to produce an even greater surge of innovation as the pace of technological change accelerates and different technologies are combined more frequently.

Accordingly, we expect to see significant investment in high-value manufacturing for traditional industries and for government-backed investments in advanced technology industries in China in the near term.

When you also take account of the growing pool of educated talent, the continuing focus on research and development and the drive toward leanness and measuring performance, a core foundation appears to be being laid for the transformation to a more sophisticated manufacturing industry in China.

In the long run we see greater opportunities for foreign companies to establish full-fledged manufacturing operations in China with a primary focus on the Chinese market.

Intangible assets can be moved into the Chinese operations to increase their market competitiveness. The Chinese tax authorities have implemented several regimes to grant favorable tax treatment to foreign invested companies that develop and own technologies in China, conduct local research and development activities to maintain such intangible assets, and interact with Chinese customers directly to tailor goods or services for domestic markets.

And we do not foresee an end to China as the world's manufacturer. For a start, there simply is no natural alternative to China. The country exports almost as much as the rest of emerging Asia combined ($1,900 billion versus $2,000 billion annually, or 1,500 billion euros versus 1,588 billion euros) and 12 times that of North Africa. And, as if that were not enough, some of China's largest container ports also have much more capacity than entire competing countries, such as India or Vietnam.

There is also optimism that Chinese manufacturers are responding to the challenges by investing in capital equipment, as a substitute for capital, or learning new production techniques, such as lean manufacturing, to save on costs. Some multinationals even expect that within two to three years Chinese manufacturers can hold prices steady, or even start cutting prices again. If so, China will hold on to much of its manufacturing capacity.

The author is a partner with KPMG China. The views do not necessarily reflect those of China Daily.

(China Daily 07/20/2012 page11)