In less than a generation, China evolved from a scrappy developing nation into the world’s factory.
In less than a generation, China evolved from a scrappy developing nation into the world’s factory. However, China’s manufacturing environment is continuing to change rapidly.
Two short decades ago, adding manufacturing in China was a strategy reserved for the largest global players. Since then, the country has attracted foreign direct manufacturing investment at an unprecedented rate from companies of various sizes and industries, thanks to low production costs, a vast supply of labor, and preferential tax treatment for foreign investors.
Nevertheless, China’s production costs have risen steadily, particularly in the highly concentrated manufacturing centers in coastal regions. In addition, in an effort to spread the manufacturing wealth to more of the country and broadly extend the economic evolution enjoyed by its highly developed coastal cities, Beijing has eliminated or dramatically reduced preferential treatment for the majority of new manufacturing activities near the coast.
In the future, China’s appeal for manufacturers will likely rely less on its operating cost advantage (that is, labor) and more on its growing domestic market and talent base. China will likely still compete globally for low-cost manufacturing; but it will also force companies seeking the lowest-cost production locations to look outside of China, or further into China’s interior, to increase savings.
To understand the future for foreign manufacturers in China, and other potential markets for that matter, it is important to grasp the fundamental strategies and drivers behind why companies decide to deploy manufacturing operations offshore. Companies offshoring manufacturing and related operations typically fall into one of the following camps:
- Cost Cutters – aim to lower production costs by locating in areas with abundant, low-cost production inputs (typically meaning lower labor costs, but also including lower-cost taxes, utilities, transportation, or even enhanced government incentives)
- Market Builders – seek to establish in areas where they can effectively penetrate a new or growing base of customers, driven by convenient market access, logistics, and customer demographics
- Talent Seekers – strive to attract and retain specific pools of knowledgeable, creative, technologically advanced talent for R&D or advanced manufacturing and are attracted to destinations with renowned educational institutions, incumbent companies with similarly high talent requirements, and living conditions conducive to attracting highly qualified, educated, and mobile talent
The continued evolution of China’s economy and its corresponding policy changes are shifting the value proposition and deployment decisions of the “Cost Cutters,” “Market Builders,” and “Talent Seekers.”
Cost Cutters – Shifting Currents
Cost Cutters who established low-cost production in China’s coastal region a decade ago have faced steadily rising operating costs. Wage escalation has been particularly notable, averaging roughly 11% per year during the last decade in Shanghai and many industrial zones in the surrounding Yangtze River Delta region (see Exibit 1 above).
Rising operating costs have been exacerbated for many foreign companies operating in China by the steady appreciation of the Chinese Yuan (RMB) against home-country currencies and those in traditional export markets. Between 2005 and Q1 2012, the RMB appreciated by about 40% against the U.S. Dollar in total, and while analysts expect that rate to slow from a 5% annual clip in 2011, Yuan appreciation against the dollar is expected to average around 2% to 3% per year over the next several years1.
In the meantime, China’s incentives policies have undergone dramatic changes since 2008, significantly undercutting support for low-cost manufacturing by foreign companies and shifting support to R&D-intensive, IP-generating operations. Gone are the days of a drastically reduced income tax rate for foreign-owned companies. A single corporate income tax rate of 25% now applies to foreign-owned and domestic companies from year one of operations, unless the operations qualify for R&D tax incentives or High and New Technology Status. Increasingly these programs require demanding thresholds such as intellectual property ownership and creation, number of employees with university degrees, and specific R&D related expenditure and employment levels. The remaining incentives which do apply to traditional “cost cutting” industries are geared towards China’s interior rather than the coastal regions.
China also faces growing competition from other low-cost manufacturing destinations both in AsiaPac (e.g. Vietnam, Indonesia, India, Bangladesh) and globally (e.g. Latin America, Central/Eastern Europe, and increasingly, Africa). None can yet match the depth of China’s labor pool and, in most cases, the robustness of its infrastructure to support manufacturing. However, many are developing rapidly in these areas, most offer lower cost labor, and some are providing attractive tax holidays. As China’s production costs rise, particularly in the coastal regions, these countries are becoming increasingly viable alternatives.
In addition to the factors above, several other trends are encouraging companies to consider manufacturing closer to their end consumers. The ability to mitigate risks related to fuel price volatility, supply chain disruption, or currency fluctuation (particularly related to further revaluation of the Chinese RMB) make a strong case for near-shoring or even re-shoring of production, and are causing many companies exporting from China to the United States or Europe to reevaluate their supply chains.
The current of Cost Cutters is shifting away from China’s coast. Flows are increasing to interior China, as well as other low-cost countries. However, the once torrent river of Cost Cutter investment flowing to the coastal region is dwindling, and may soon become a trickle.
Market Builders – A Building Wave
As the allure of more than 1.3 billion potential customers garners increasing attention in corporate boardrooms globally, Market Builders have begun to surpass Cost Cutters in the race to establish or expand production in China. As disposable incomes steadily rise (see Exibit 2 above), particularly in China’s most affluent urban centers, corporations find themselves increasingly motivated to localize production to directly serve growing consumer demand.
Ironically, some of the same factors which dampen China’s appeal for cost cutting exporters (fuel price volatility, shortening the supply chain, etc.) enhance its attractiveness for manufacturers focused on the domestic market. Industry-specific drivers can also spur companies to localize in China, including rapid product design/development responsiveness in consumer products; just-in-time supply chains in automotive or industrial products; or healthcare reimbursement requirements for pharmaceutical and medical device producers.
China’s income growth has consistently outpaced other emerging markets, with expectations for the trend to continue for the foreseeable future. Between 2007 and 2011, annual growth rates in real disposable income were stronger and better sustained in China than in other traditional BRIC countries. Meanwhile, as a new generation of emerging markets (sometimes referred to as the New BRIC) offers compelling opportunities for cost arbitrage and market growth, none present the market size or consistent growth rate of China (see Exibit 3, below). The Economist Intelligence Unit anticipates that real disposable income in China will likely grow at an average annual rate of ~10% from 2012 through 2016; compared to 4.5% in Indonesia, 4.2% in South Africa, 3.7% in Turkey, and 4.7% in Vietnam.
The wave of manufacturers entering or expanding in China primarily for market building objectives continues to swell. Aligned to support future expansion of Market Builders are the demographics, supply chain considerations, and China’s economic policies. With many of the Cost Cutters moving on to less expensive destinations, Market Builders appear to be taking over as the growth wave for China’s manufacturing sector.
Talent Seekers – Testing the Waters
The much-hyped global War for Talent has taken on growing importance in the manufacturing sector as the mechanization of production lines increases. Talent Seekers see vast opportunities to spur innovation by tapping a globalized talent pool. In China and other emerging markets, they also increasingly face the need to customize innovation to suit local and regional demands, and support market-building objectives.
China offers an increasingly abundant talent pool for next-generation manufacturing and R&D. The annual number of engineers from graduate-level degree programs in China more than doubled from 2004 through 2008, though it has plateaued at 120,000 to 130,000 graduates per year since (see Exhibit 3, above). Nevertheless, the rapid growth in the early 2000’s makes China one of the most abundant markets in the world for new, graduate-level engineering talent. In comparison, engineering output from graduate-level programs in the United States was approximately 56,000 in 20112 (see Exibit 4, below ).
However, quantity of engineering graduates does not necessarily equate to quality. IMD, in its 2011 “World Competitiveness Report,” ranked China 50th globally (out of 59 countries in the survey) in the category of Qualified Engineers3. Over the last decade, China has consistently ranked in the bottom 20% of countries surveyed in the Qualified Engineers category.
China’s operating environment presents other challenges for Talent Seekers related to intellectual property protection, regulatory stability, and competition for talent. For example, the Economist Intelligence Unit rates China a 3 on a 0 to 4 scale for Protection of Intellectual Property Rights (where 0 is most favorable)4. China’s score equals that of many lesser-established manufacturing destinations, including Bangladesh and Vietnam, while countries such as the United States, Singapore, Japan, and Poland score much more favorably. Moreover, competition for top talent in China continues to be fierce – particularly for experienced, English speaking engineers who have their pick among the top foreign or domestic employers.
As China’s talent pool deepens and improves, the country will likely continue to garner attention from talent-seeking manufacturers globally. However, ongoing concerns around IP protection, talent quality, and labor competition are causing many companies to proceed cautiously — gently wading into China’s talent pool versus diving in headfirst.
China’s manufacturing seas are shifting. The country is no longer the nirvana for pure Cost Cutters that it was 10 to 15 years ago, but is much more attractive to Market Builders, and increasingly, Talent Seekers. China has evolved and matured, and foreign manufacturers expanding or deploying there will need to do the same. The next generation of foreign manufacturers in China are more likely to employ a more holistic business model – one that embraces the principles of Cost Cutter, Market Builder and Talent Seeker, striking a balance between low operating costs, serving new customers, and gaining a competitive human resources edge. Their global competitiveness may depend on it.
Deloitte Consulting LLP
About the authors
Josh Timberlake is a senior manager, Neale Rath is a manager, and Darin Buelow is a principal in the real estate and location strategy practice of Deloitte Consulting LLP.
Portions of this article were excerpted from a Deloitte Review Issue 5 article, entitled “China: Still Manufacturing’s Shining Star?”
1 The Wall Street Journal, MarketWatch Inc., April 16, 2012.
2 American Association of Engineering Societies, Engineering Workforce Commission, 2012
3 The IMD World Competitiveness report measures survey responses from executives operating businesses in 59 countries representing every region of the world (including 13 Asia Pacific countries). The Qualified Engineers category asks executives to rate the country in which they operate based on the following statement: “Qualified engineers are available in your labor market.”
4 Source: The Economist Intelligence Unit Limited, 2012