Under a shadow

Eyes glued to the screen of his laptop computer, a small grin of satisfaction creeps onto the salesman’s face. He is sitting in a small booth, the walls adorned with colorful children’s clothing, deep in the bowels of a huge steel and glass exhibition center on the banks of the Pearl River in Guangzhou.

Pan outward and the booth becomes a dot in a sea of tiny textile emporia. The items on display may differ – in the clothing section alone they range from silk ties to military fatigues – but every stallholder’s purpose is the same: to market their goods to the wider world.

Does this salesman’s smile betray the satisfaction of a man who has received an order that will keep his factories working overtime for a week? The answer is revealed as he spins the computer around to a colleague sitting opposite. Playing cards stream across the screen – he has finished his game of solitaire.

Quiet day at the office

It is the final week of the twice-yearly China Import and Export Fair – a key indicator of the demand for Chinese-made goods, also known as the Canton Fair – and there are few buyers. Some estimates put the attendance at 60% down from a year ago, and salespeople sit around sleeping, chatting or playing computer games.

"It got quite busy on the first day but since then it’s been very, very quiet," said Julie Duan, who works in the international sales department at Pasteur, a suit maker based in Wenzhou, Zhejiang province. "We came here to increase our overseas business, but maybe it is not a good time for us."

Thanks to a 30% boost in capacity, this year’s fair – which ran from mid-October to early November – was supposed to be the biggest ever, but contracts signed amounted to US$31.55 billion, down 15.8% year-on-year. In the event’s 52-year history, only once before has it recorded negative growth and that was in 2003 during the SARS epidemic.

The fair can be seen as a proxy for the escalating struggles of the Chinese exporter. Export growth fell to 19.2% year-on-year in October from 21.5% in September, well below the year high of 30.3% reached in March. The malaise has been prompted by falling demand for goods in recession-hit Europe and the US, coupled with rising costs at home. The strengthening renminbi is also a problem. As the US dollar weakened last year, many traders switched to the euro as the standard currency for overseas contracts. But a subsequent decline in the euro has left them burned once again.

"[The devaluation of the euro] has been a fatal strike on Chinese traders," said Wu Jianhai, a Wenzhou-born businessman involved in sourcing. "Half of my clients are in the red, with the rest operating on very thin profit margins."

Much of the initial pain has been felt in the steel, toy and clothing sectors, all of which posted notably weak growth in the first nine months of the year. China’s larger state-owned steel mills have responded by cutting output, and there is ongoing talk of consolidation.

The plight of the toys and clothing sectors, which are highly fragmented and dominated by private operators, has been there for all to see in the newspapers.

In mid-October, Hong Kong-listed Smart Union, the world’s largest contract toy maker and a supplier to the likes of Mattel and Disney, went into liquidation, leaving around 6,500 workers jobless. Earlier in the month, official reports claimed 3,631 toy exporters – over half the industry total – had gone out of business so far in 2008.

Other reports painted an equally glum picture of the clothing and textile industries, with more than 10,000 export-oriented players closed and two-thirds struggling for survival. Once again, the rising tide that drowned many smaller players has also claimed some major ones as well. The headline closure was Zhejiang Jianglong, China’s largest textile dye operation, based in the textile-heavy city of Shaoxing. Tao Shoulong – who turned Jianglong into a Singapore-listed company with four factories, 4,000 employees, 300 suppliers and US$110 million in sales last year – fled in October.

Drowned by debt

It seems the demise of Tao’s firm can be traced back to loans taken out to fund large investments in expansion and new equipment. When exports began to shrink, he was unable to pay off the debts.

It is a familiar story. Not eight months ago, a Guangdong-based garment maker with 10 factories and contracts to supply the likes of Tommy Hilfiger and Polo told CHINA ECONOMIC REVIEW that his firm was offsetting higher labor costs by investing in automation. He was bullish about China’s prospects in the face of competition from Vietnam and Bangladesh. Now this garment maker is not returning phone calls and the company is said to be struggling financially.

"Everybody is ordering less and they are ordering less from China," said Dan Entac, CEO of Tradelink Technologies, which provides supply chain tracking software to the company in question.

"We are staffing up in India and next year we will go to Vietnam and Bangladesh – this is where our customers are going to place orders. We have got to that tipping point where they have to go and look for cheaper products because they are not into big orders any more. It was okay when you had high volume and high demand."

Many shoemakers have already gone in that direction. Jason Long, owner of Dongguan-based GM Bright Star, which makes molds for running shoes, among other things, saw the export share of his output sink from 90% to 50% in October 2007 when Adidas shifted production to Indonesia and Vietnam.

China is sufficiently blessed in terms of skilled labor, scale and logistics that it won’t lose its entire manufacturing base (See "Demanding safety" on p42). But what these changes show is how dependency on low-end labor-intensive exports can breed volatility, which in turn raises issues of long-term economic sustainability.

China’s exports-to-GDP ratio was 36% last year. However, if you strip out the value-added element – i.e. the lion’s share of the profit on a computer that goes to the Taiwan company that made the parts rather than the mainland company that did the final assembly – the country’s exposure falls sharply (some say to as low as 10%). With domestic consumption and investment the key drivers of the economy, China is better positioned to weather the storm than the likes of Taiwan (20%) and Singapore (30%).

Waning growth

At the same time, though, much of China’s recent growth has come on the back of strongly rising net exports. Should this decline – some economists expect it run into negative territory in 2008 – GDP growth will take a hit. Growth projections for 2009 range from below 6% to 8%-plus, depending on how effectively you think China can stimulate its domestic economy and rejuvenate real estate, and how deeply you think the export shock will run over into other areas.

"As exports slow or drop, revenue will decline so there will be less money to invest," said Wang Tao, chief China economist at UBS, an investment bank. "I expect investment in export-related sectors to be negative next year, so that’s a big spillover effect. We have not seen the worst yet at all."

Richard Brubaker, managing director of China Strategic Development Partners, which offers consulting and sourcing services, takes it a step further. He notes that a huge amount of China’s investment to date has gone toward building infrastructure to sustain the export boom that is now under threat.

"Suzhou is an hour away from Shanghai and has a population of 5 million. Almost 80% of its infrastructure investment went into supporting factories that do exports," Brubaker said. "Everything from noodle carts to residential housing is linked to the export economy."

Conscious of the social ramifications of leaving thousands jobless, the government has stepped up efforts to support manufacturers. This has largely involved the reinstatement of value-added tax rebates for certain exports following the reduction or removal of these rebates in the boom times of 2007. Clothing and textiles were the first to get a rebate hike at the end of July. Then, in late October, Beijing announced that rebates would be increased for 3,486 categories of products, including clothing and textiles, toys and small appliances. The government is trying to get banks to lend more freely to small-scale export-oriented enterprises, something banks are not generally inclined to do during a slowdown.

The measures are variously described as passive and piecemeal. They are compared unfavorably with the more pragmatic efforts of local governments, which are bailing out firms and subsidizing the wages of those whose employers close shop without tying up loose ends (See "Overexposure: The cluster effect reversed" on p30).

"Demand is coming down so even if the government increases tax benefits, I don’t think manufacturers can benefit from it," said Paul Wang, general manager of Anhui Haitian Import & Export, a trading company that exports fabrics and accessories, mostly to the US and Europe. "Whatever gains are made, manufacturers have to give most of it to the buyers."

Certainly, more targeted government action would be required to stem the tide of trouble spreading through the manufacturing sector and beyond.

Industrial patterns

From his base in the eastern city of Qing-dao, Steve Dickinson, a partner at law firm Harris & Moure, which has clients in the sourcing business, has noticed geographical fluctuations in the attitudes of exporters. He contrasts the rising panic in the Yangtze and Pearl River deltas with a more phlegmatic approach in Shandong.

"We have not got to the point where people are really noticing it here," said Dickinson, who writes a regular column in CHINA ECONOMIC REVIEW.

"When I talk to them about a problem coming down the pipeline, they say it’s no big deal. They won’t be saying that in three months’ time."

More striking, though, are the industrial fluctuations. The problems that first became apparent in clothing and toys – where demand and export orders are typically seen as being highly flexible – are visible in other areas. Exports of machinery and electronic goods, which accounted for 58% of China’s total exports last year, were up 24% year-on-year in the first nine months, compared with 28.1% for the same period in 2007. The value of signed contracts in these industries at the Canton Fair was up just 1.2% on last year, the slowest growth in years.

An early big-name casualty was Hong Kong-listed home appliance maker BEP International Holdings, which closed its plant in Guangdong toward the end of October due to spiraling export volume.

Delayed reaction

Christopher Devereux, managing director of Chinasavvy, a Hong Kong- and Guangzhou-based company involved in manufacturing and sourcing, first noted signs of trouble among his engineering clients about five months ago. Factories with 120 machines were only using 30, and gradually this escalated into a more recent spate of closures.

"Before, a lot of the factory owners were quite arrogant, saying they were so busy that they may consider taking our business," Devereux said. "Now they are searching for business. The amount of suppliers e-mailing me looking for business has gone up fivefold."

The fallout is reaching all the way up into the logistics sector. Throughput at China’s ports was up 8% year-on-year in October from 6% in September, but these numbers are a far cry from the double-digit growth of previous years. Mark Millar, vice president of Supply Chain Asia, notes that the shipping lines are bringing additional capacity on stream next year, having made their plans before the rot set in. This excess capacity may force costs down even further. Air freight carriers will also need to reconsider their plans.

"Freight forwarders have a much more flexible cost model so it will be less painful for them to adjust – but it’s going to be a tough year for the whole logistics industry," Millar said. "It will be interesting to see how much demand can be sustained by the Chinese domestic market."

Despite what they might say, many export-oriented manufacturers don’t have the same level of flexibility to enable them to refocus on the domestic market. Exporters operate on a relatively straightforward basis: they receive a deposit from the customer, go into production, and get the balance of their payment on shipment. It is high-volume, low-margin work that doesn’t translate to the domestic market because no distribution or marketing is involved, Chinasavvy’s Devereux said.

And, of course, a firm might not be making goods for which there is a sustainable market in China. "How many rubber ducks do the Chinese people need?" asked Harris & Moure’s Dickinson.

With exports having deteriorated faster and further than had been anticipated, exporters are returning to the drawing board. Fook Lung is a Hong Kong company that operates out of Guangzhou, providing corrosion resistant finishings for door lock sets. Most of its products are exported to North America and business declined by at least 60% in September and October.

Norman Wong, the company’s general manager, said it is looking at ways to cut back. This includes reducing salaries for senior management, with Wong himself taking a 50% pay cut.

China Strategic’s Brubaker has seen companies shift strategies in the name of survival. A factory may rent out a production line to a competitor, or two operators may come together to share space. The other option is to move further inland in the hope that cheaper labor costs will offset greater logistical challenges. Although this strategy has proved popular with some, it requires up-front investment and firms are now struggling to raise capital.

Accentuate the positive

There are companies that see the current slowdown as an opportunity to review their businesses and management structures to achieve greater efficiency. This is the case with Leo, a Shenzhen-listed firm that exports water pumps and mechanical gardening equipment. Speaking at a conference in Shenzhen in October, CEO Zhang Lingzheng said his response to flattening sales would be to "strengthen the management and reduce waste."

Consolidation is inevitable in China’s fragmented manufacturing sector and the current slowdown is pushing this process forward. Those engaged in homogenous competition, with nothing more to offer than a low price, are being squeezed out, or so the thinking goes (See "Guangdong: Eye of the storm").

"Some people set up factories just because they see others making money. They don’t understand the products, and what they produce is inexpensive," said Anhui Haitian’s Wang. "When the economy was doing well these companies could survive, but now they will struggle. The ones who will benefit are the bigger players and those who focus on quality."

Chinasavvy’s Devereux agrees that the downturn is likely to push up quality because China will shift from being a seller’s to a buyer’s market, which in turn should hasten the decline of the low-margin manufacturer. Yet he, like many others, remains only cautiously optimistic about to how quickly this can be achieved. Improving operations in Chinese companies hinges on more fundamental issues such as filling the current vacuum in middle management, Devereux said.

What’s more, for the companies themselves, the primary objective is weathering the storm – and they may be prepared to do this at any cost.

"Our accounts receivables are down and we are worried about cash flow," said Fook Lung’s Wong. "Business will continue to be slow in the two months until Chinese New Year. After that, we just don’t know what will happen."

In early November the number of passengers departing each day from Guangzhou’s main railway station had swollen to 130,000 as migrant workers, shed by struggling manufacturers, made their way home. With the future still uncertain, it may be a while before they return.