Risks of doing business in China

Fourth of a series

Editor’s Note: The following is a Deloitte Research study that looks at the changing landscape of the worldwide garment industry in the face of the lifting of trade restrictions in January this year and the potential reverberation of such action on global trade. The report was written by Ira Kalish, the Global Director of Consumer Business at Deloitte Research. The Saipan Tribune is re-printing the study in a series of articles, with permission from Deloitte Touche Tohmatsu.

Protectionisim

Although China holds the promise of great riches, it also involves many risks. The greatest risk (discussed in detail later) is protectionism on the part of importing countries, especially the US. Political support for freer trade has diminished in the US and Europe. Governments on both sides of the Atlantic have not been shy about imposing trade restrictions in order to assuage the concerns of domestic industries. This has certainly been the case in the US when it comes to apparel. Moreover, the terms by which China entered the WTO allow the US to impose severe limits on Chinese apparel imports. Clearly concerned about the potential for protection, the Chinese government has even offered modest constraints on exports in order to fend off protectionist action.

Exchange rate

One factor that is contributing to protectionist sentiment is China’s exchange rate. Widely regarded as overvalued, the renminbi (China’s currency) has been the bane of protectionists in the US. Some members of the US Congress have offered legislation that would impose punitive tariffs on China if it fails to revalue the renminbi. They reason that China’s leaders are holding down the renminbi’s value in order to keep China’s exports cheap. They regard this as a form of dumping and believe that it has contributed to America’s current account deficit.

It is true that China’s government has maintained a fixed exchange rate. It is also true that China’s leaders are concerned that revaluation would adversely affect the price competitiveness of China’s exports. Yet China’s exchange rate policy has not been the cause of the US current account deficit. A large gap between saving and investment is the proximate cause. Nor would revaluation have a big impact on that deficit.

Still, there are reasons to expect China to revalue. First, maintaining the fixed exchange rate requires China to purchase foreign currency reserves in exchange for renminbi. This leads to excessive money supply growth in China which can be inflationary (although inflation has lately declined after an initially large increase). Second, rapid money supply growth feeds China’s inefficient banking system and exacerbates the problem of excessive lending to loss-making state-owned enterprises. Third, a revaluation would lower import prices and effectively increase the purchasing power of Chinese consumers. This would have the salutary effect of shifting growth away from reliance on exports and toward domestic demand.

Therefore, there is a not insignificant probability that China will revalue its currency in the near future. If it does, the effect would be to increase the cost of exporting from China. This would especially matter to companies with highly labor intensive processes. A large revaluation might encourage some apparel producers to shift capacity to other lower-wage countries.

Intellectual property

One of the biggest headaches for branded apparel and textile companies sourcing their product in China is protection of intellectual property (IP). China has had a problem in enforcing such protection. The biggest IP problem comes from the actual contract manufacturers, some of whom produce extra output for their own distribution channels. The result is that the brand value is diminished by the availability of identical product at much lower prices. For branded companies doing business in China, the challenge then is to find reliable contract manufacturers and to properly police them.

Rising costs

Another risk of doing business in China is the fact that costs might rise significantly in the near future. Why? The reason is that China’s economy is booming, thereby creating bottlenecks and shortages which affect the cost of production. In the past year the availability of electric power has been limited, often forcing factories to temporarily shut down at the behest of arbitrary government officials. Although massive investment in transport infrastructure is taking place, the system is not yet sufficient to handle the current growing volume of trade. Thus there are frequent bottlenecks on roads and at ports. Finally, as the economy overheats, wages are rising rapidly in the big coastal cities where most apparel and textile manufacturing takes place. Some producers are moving further inland where wages are substantially lower. Yet this often involves costlier and more time-consuming transportation.