Burying the Competition (China)

WHEN PHILIPS Electronics began prospecting for opportunities in China in the early 1980s, the Dutch company adopted what seemed an obvious strategy at the time: Sell products to a billion Chinese.

China, however, didn't go according to plan. Instead of becoming a market of boundless demand for Philip's irons, televisions and other wares, China became a place where the company made its products--and then shipped them elsewhere. Today, Philips operates 23 factories and produces about $5 billion-worth of goods in China each year, but nearly two-thirds of that is exported overseas. "Our initial vision was to sell in China," says Johan van Splunter, the head of Philips' Asian operations. "Things turned out a bit differently."

Not just for Philips. From General Electric to Samsung Electronics to Toshiba, as well as thousands of Chinese companies, manufacturers are finding that using China as an export base is often more profitable--and almost always far easier--than selling goods inside the country.

The result is that China, once viewed by wide-eyed executives as the market of future riches, is instead becoming the world's factory floor. China's often-devastating competitiveness is helping to redraw the global corporate landscape, forcing companies around the world to scrap old business strategies--and some businesses altogether--and to come up with new ways to compete.

One upshot of China's emergence as a manufacturing powerhouse: It's becoming an increasingly powerful global deflationary force. China's manufacturing prowess is pushing down prices on a growing range of industrial, consumer and even agricultural products that it sells around the world. Beginning in May this year, U.S. imports from China have begun to consistently outstrip those from Japan.

And while China for decades has sent mostly low-end products like textiles and toys to the U.S., it's now starting to sell more sophisticated goods to American consumers, like computers and DVDs. In June, exports from China of electronic products to the U.S. hit $1.2 billion, up 12.3% from May. China's hi-tech exports to the U.S. are now growing faster than any other export, up 47% in the first seven months of this year from a year earlier.

Maryjo Cohen, president of National Presto Industries, a manufacturer of pressure cookers, griddles and other kitchen appliances, feels China's deflationary forces first-hand from her office in Eau Claire, Wisconsin. Between 1998 and 2001, total U.S. imports of household cooking appliances from China more than doubled to $640 million. As a result, National Presto has been forced to drop the price of its griddles from $49.99 to $29.99 in just three years. To keep costs low, Cohen decided early this year to shut down plants in Mississippi and New Mexico and expand production in China. "We've had these plants for a very long time," she says. "It really hurts to say goodbye to them."

China's exports to the U.S. affect a broad cross-section of industries. Televisions and audio equipment rose at a 13% annualized rate between 1998 and 2001, to $6 billion in 2001; tools and metal implements were up by a 23% annual rate to more than $1.5 billion in 2001; sporting goods rose at 16% to $2 billion.

And as imports from China are rising, U.S. retail prices in many of these categories are falling. TV-set prices have fallen on average by 9% each year since 1998, according to U.S. Labour Department data. Tool prices have fallen 1% each year on average. Sports-equipment prices have gone done by a 3% annual rate.

Though the flood of cheap Chinese imports has translated into some lost jobs for U.S. workers who compete against

Chinese manufacturers, it's a boon for consumers like Amatsia Salomon, who operates a New York limousine service. Emerging from a busy Home Depot store on a recent weekend, after spending $48 on a combination ceiling fan and light fixture made in China, Salomon says: "Years ago, we would say, 'Made in China, we don't want to buy it, because it's very cheap quality.'" Then he adds, "Today, this looks good . . . and it's inexpensive."

Not far behind him, Eileen Spink walks out of the same store after buying a Black & Decker rotary tool she'll use to reupholster a chair. A few years ago, she paid about $100 for such a tool. But the one she just bought, made in China, cost $39.97. "Who's dumb enough to pay $70 for something that does the same thing?" she asks.

In Japan, China's low-price exports are reinforcing an already torrid deflation rate that has plagued Japan in recent years, despite all-time low interest rates. Matsutake mushrooms, prized for their delicate aroma, used to be considered such a luxury that they appeared only in minuscule quantities in Japan, either sliced in soup or cooked in rice. But imported matsutake mushrooms from China cost one-tenth the price of those grown in Japanese and account for almost two-thirds of matsutake mushrooms sold in Tokyo's biggest wholesale markets.

Aeon Co., which operates a big Japanese supermarket chain, started selling a small refrigerator made by China's Haier Group in February, priced at ¥19,800 ($160) and a washing machine for ¥9,800--about 20%-30% less than Japanese models. Aeon initially expected to sell 20,000 Chinese refrigerators in the first year, but revised its forecast to more than 30,000 after it sold more than 15,000 since the end of February, when it first stocked the product.

China itself is undergoing one of the most powerful deflationary periods in modern history. In the past seven years, average prices have declined by nearly 20%. A decade ago, the price of a 21-inch colour TV in China was a little over $400. Today, it's just $80--and still falling.

"China's rise as a manufacturing base is going to have the same kind of impact on the world that the industrialization of the U.S. had--perhaps even bigger," says Andy Xie, an economist with Morgan Stanley in Hong Kong.

China's impact on global price deflation shouldn't be overstated. Despite its rising domination in many export markets, China is but one force driving prices lower around the world these days. Changes in the global economy--like the Nafta free trade pact and European economic integration, both of which improved the flow of goods--mean the world faces an ever larger supply of goods, even as demand is little changed. Gains in technology have spurred productivity, helping hold down prices. And now the slowdown in the U.S. economy, by far the world's biggest consumer and its most important engine, has added significantly to the global glut of goods.

A COMPREHENSIVE REORDERING
What's more, changes in the world economy are altering the way global inflation is calculated. Services, once a small player in the world economy, account for an increasingly large portion of global economic output. That's especially true in the U.S., where by some estimates the service sector makes up more than half of annual economic output. That means manufacturing doesn't drive inflation like it used to. The falling prices for manufactured goods could be more than offset by rising prices for many services such as education, health care and housing.

Still, what's unfolding now in China is the tip of a sweeping re-ordering of how and at what cost industrial goods are supplied to the global economy, many business executives and economists believe. It's also bringing about a comprehensive shake-up among the companies that supply those goods.

China is now the world's fourth-largest industrial producer behind the U.S., Japan and Germany. China makes more than 50% of the world's cameras; 30% of its air-conditioners and televisions; 25% of its washing machines and nearly 20% of all refrigerators. A private Chinese company, Guangdong Galanz Enterprise, now accounts for 40% of all microwave ovens sold in Europe; Wenzhou, a city in eastern China, sells 70% of the world's metal cigarette lighters. China is among the world's biggest aluminium, copper and steel producers. Even Chinese farm produce, once too expensive for the global market, is finding its way onto dining tables in the U.S., Europe and Asia. Since 1996, Chinese export prices have slid 15%, according to BCA Research, a Montreal market-research firm.

Nearly half of all the goods China sends overseas each year are made by foreign companies, such as Motorola and Philips, manufacturing in that country. Foreign investment continues to soar and is on pace to hit a record $50 billion this year. Motorola says its total investment in China will reach $10 billion within four years, up from $3.7 billion now. Honda Motor is setting up China's first export-focused car factory. Toshiba is building one of the world's biggest laptop-computer factories outside Hangzhou with output next year pegged at 750,000 units and growing to 2.4 million in 2004--the vast majority of that destined for export.

For large U.S. retailers like Target and Wal-Mart, China has also become a huge well-head of supply. Wal-Mart has been buying goods in China and stocking its stores with them for more than 20 years, and the supply continues to grow. About $10 billion in Chinese-made merchandise makes its way to Wal-Mart store shelves every year, either directly from manufacturers in China or other suppliers that source their goods in the country.

Wal-Mart's suppliers must meet tough standards, but companies in China are getting over this and still keeping their costs low, according to executives. In February, Wal-Mart set up a new independent sourcing unit, based in the southern city of Shenzhen, to buy directly from Chinese factories, with most of the goods going to the U.S., say executives.

General Electric is following a similar sourcing strategy in China. The company's sales revenue in China reached $1.6 billion last year. But GE plans to expand the amount of goods it buys in China to at least $5 billion over the next three years, up "several times" from the current level, says Geoff Li, the company's spokesman in China. The move will have an impact on U.S. consumers. More of GE's trademark refrigerators, for instance, will be made by independent Chinese manufacturers, after which GE will stick its label on the products. And more parts for GE's gas-turbine engines, used to generate electricity, will be made in China. Says Li: "China has great manufacturers and very competitive prices."

In its crudest form, China's jungle capitalism works like this: A new product is introduced, often by a foreign company, and within months a throng of manufacturers, many of them private Chinese companies, start cranking them out. Raging competition sets in, sending prices sliding. And before long producers look to new markets, increasingly overseas.

Driving all this is a jumble of forces that have spawned one world's most competitive markets. A tidal wave of foreign investment worth more than $600 billion over the last two decades has taught the country some of the most modern manufacturing techniques. A ferocious appetite for foreign technology has powered productivity gains across the economy, while a nationwide entrepreneurial zeal has sprouted from the shambles of its once centrally planned system.

LABOUR IS THE KEY
Reinforcing this already potent mix is the world's deepest, and cheapest, pool of manufacturing labour. Though China's population is now 1.3 billion, nearly 700 million people live on farms, earning on average just $285 per year compared with the average U.S. household income of nearly $40,000 a year. These minuscule wages have slowed China's transition to a consumption-driven economy along the lines of that of the U.S. Yet they also created a bonanza for factory bosses in China: an almost endless supply of low-priced labour that not only allows companies to control costs, but often to cut them dramatically.

China's manufacturing strength is born out of what many might describe as a weakness: severely skewed economic growth. The vast population coupled with a poor interior has fed the country's export-oriented industries with cheap labour. Most migrant workers head to factories around China's wealthy coastal cities, fuelling low-cost production for exports.

Over the past decade, China's pace of growth has doubled that of wages adjusted for inflation. What's more, there is no sign of this trend abating, as major manufacturing cities show minimum wages can be held steady, or even pressed lower, by opening the gates to workers from poorer parts of the country.

That's different than what unfolded in China's main export rivals. Whether Japan, South Korea, Taiwan or even Thailand, Asian economies gave up industries as wages rose and the costs of production became too expensive. Not so China. It is holding on to low-end industries, like toys and textiles, and garnering a growing slice of the high-end, hi-tech sector as well.

How long can this ragged balancing act continue? It depends. Not least on how effectively an authoritarian government can deal with social unrest while managing widening wealth disparities. Pockets of labour unrest have erupted this year. Yet China has a few cards in its favour. A booming private sector adds to its export clout, absorbing excess workers and keeping costs very low. And in the long run, the Chinese government's control over its currency, which isn't freely traded, offers another tool to make sure its exports stay competitive.

Consider what Unilever, the Anglo-Dutch consumer-products firm, is up against. In the 16 years since it began investing in China, Unilever's soaps, washing detergents and shampoos gained wide popularity among Chinese consumers. For years, its biggest competitors were Procter & Gamble and Johnson & Johnson, also big investors in China.

Not any more. Over the past three years, a private Chinese company, Nice Group, has rocketed past Unilever and everyone else to become China's No. 1 seller of laundry detergents. A Nice spokesman says the stunning growth is the result of its "low manufacturing cost and high quality." After conquering the detergent market, Nice says it's now expanding into toothpaste. And it has the attention of Unilever.

"Our most serious competitors," says Zeng Xiwen, Unilever's spokesman in China, "are private Chinese companies." Unilever has responded to this threat in part by reorganizing its China business to cut costs. It recently merged its five Shanghai factories into a single entity, bringing its accounting, marketing and sales under one umbrella. "We have to become more efficient," says Zeng.

China's impact on world prices and corporate strategies is likely to increase. Its entrance into the World Trade Organization is breeding lean and hyper-competitive private Chinese companies turning their sights overseas to alleviate price pressure at home.

In the eastern port city of Wenzhou, home to some of the country's earliest private industries, Chinese companies have been undercutting foreign competitors in China for years. Along a short stretch of a road full of potholes are three Chinese companies that now account for almost half of the market for low-voltage electronics, or machines that help transmit electricity. Now they are starting to challenge the likes of Switzerland's ABB and Germany's Siemens on more sophisticated power-transmission equipment.

Inside the squat white-panelled factories of Chint Group, women in blue smocks fasten wires to plastic switches moving along an assembly line. Their work is fast and cheap, with each employee earning just $150 a month on average. Last year the company's exports rose 28% to $35.8 million. Chint executives hope to maintain this export clip by targeting new markets, such as the U.S. and Europe.

Beijing gave Chint and others a boost recently by allowing them to bypass state-designated middlemen, driving down their export costs. Another WTO bonus is falling import tariffs, which mean these companies can now buy foreign manufacturing equipment at much reduced prices, making the final product they export even cheaper. These simple changes have had a profound impact: private Chinese companies raised exports by nearly 50% in the first half of this year.

Now Chint and other Wenzhou circuit breaker companies are looking to strike alliances with multinationals, exchanging cooperation in production and sales for support as they seeks to establish their brand names overseas.

But some foreign executives, like Paul Chan, senior vice-president of ABB China, are wary after seeing low-cost Chinese producers take business from them on the mainland. "They can destroy the rules of the game," says Chan.

Jon E. Hilsenrath in New York and Miho Inada in Tokyo contributed to this article

THE GLOBAL PRODUCER
China, the world's fourth-largest industrial producer behind the United States, Japan and Germany, makes:

-- more than 50% of the world's cameras;

-- 30% of the world's air-conditioners and televisions;

-- 25% of the world's washing machines;

-- nearly 20% of all refrigerators.

The problem is that the diruption to the world which China's transition to a modern economy will bring is huge. If the Chinese government remains an authoritarian one the likelyhood of that disruption erupting in expansionist wars is very great. The domestic market can not expand until wages within China grow to a level high enough to purchase more of consumer goods. Demand for many of the entertainment type consumer goods is dependant upon the quality of entertainment offered. That quality is dpendant on free expression.

In the interim the manufacturing capacity of the rest of the world wil attrophy in response to cheap Chinese labor.
The resultant deflation in the rest of the world will tend to dry up the market for Cinese exports eventually.

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Services, once a small player in the world economy, account for an increasingly large portion of global economic output. That's especially true in the U.S., where by some estimates the service sector makes up more than half of annual economic output.

"By some estimates"? Where have these guys been for the last twenty years? Mars?

The service sector currently accounts for 80% of US GDP, and climbing....

bookmarked

Now, we shall not forget, in the rush into China they are destroying the markets overseas in Asia that actually purchase US goods.

Its kind of like a bank trying to force its depositors into bankrupcy. It might work for one year, but then what?

The method of calculation should NOT be based solely on price, which now, price is about 90% of it.

The US should come up with a strategy, and a formula.

First, designate potential manufacturing countries.

Second, the countries who have the highest % of their imports coming from the US, will win the lion's share of contracts for manufactures. Everyone else gets discriminated against.

Its a rough idea/plan/brainstorm, but it has potential.

The people using the China method of doing things are stuck halfway in a micro and macro view, but their macro is not macro enough.