GlobalAutoTV

"Merger & Acquisitions in China"
David S. Eberly

china resources

Need an office in China? Office suites, meeting rooms, virtual offices, network access

free downloads

CHINA: "FIEs transformed from contract processing factories may continue to enjoy import tax relief"

CHINA: "FIEs transformed from contract processing factories may continue to enjoy import tax relief" article. Article by KPMG International.

proceed to download

eJournals

backCHINAtalk July, 2008

Economist's Corner: Potential problems for firms with China operations

An appreciating exchange rate and rising costs.

The Exchange Rate

Chinese policymakers think that the cornerstone of China’s economic success has been their fixed exchange rate. The primary purpose for having a fixed rate policy was to promote exports by making the Chinese renminbi (RMB) more competitive. This fixed rate has made China hyper-competitive; a result is that trade surpluses and foreign exchange reserves have swelled.

Though the fixed rate policy was loosened in 2005, the still interventionist exchange rate policy is not sustainable because it is partly responsible for higher levels of inflation in China. Inflation in China has been on an upward trend and it was 8.5 percent in April 2008: a near 12 year high (the highest was 8.7 percent in February 2008). The exchange rate is believed to be partly responsible because of two reasons. They are: 1) the cheap exchange rate has led to massive capital inflows because of high trade surpluses, and 2) speculators have brought in a lot of money into China to make a capital gain from the expected exchange rate revaluation. When foreign money enters the system, it enters the monetary base and leads to inflationary pressures. The central bank can control the former, though only to an extent, through a process known as sterilized intervention while the latter is pretty much impossible to control. Inflation is defined as “too much money chasing too few goods” and these two types of inflows are causing the ‘too much money’ part.

In a monetary policy report1, the People’s Bank of China wrote that “analyses using economic theory and empirical evidence from other countries show that a stronger domestic currency helps to rein in domestic inflation”. To be sure, the financial community expects an appreciation. Figure 1 shows that banks expect the renminbi to appreciate by 8.5 percent in a year’s time and it is very likely to continue appreciating post that.

The Cost of Manufacturing

Manufacturing costs in China are going up. The producer price index was up 8.1 percent YoY in April 2008 – the highest it’s been since December 2005. This is understandable given rising commodity prices but manufacturing firms in China typically operate on razor-thin margins and rising costs have forced many manufacturing units to shut shop.

The other problem(s) in China is that labor prices are increasing rapidly because there is a talent-shortage in China – something of a paradox in the world’s most populous nation. It does not mean that its entire population is fully employed; it just means that it just cannot find enough skilled people. The Associated Press writes, “Despite its huge pool of unskilled rural laborers, China's supply of experienced, skilled talent falls far short of demand.” 2

When China first started opening up its economy in 1984, the country was sold to foreign manufacturers as a country with a vast labor pool and more importantly, a cheap labor pool. In the 1980s, China was arguably still an economic backwater with poor physical infrastructure and its only selling point was its labor. That is changing for some time now. Figure 2 compares the normalized average annual wages of the U.S and China. Between 1997 and 2006, the average annual wage of the U.S went up by 40.1 percent while China’s went up by a staggering 224.5 percent. In fact, the annual average wage in China went up by 362.8 percent between 1994 and 2006.

Labor laws in China have always been lopsided with employers having a stronger hand. On January 1, 2008, a new labor law, the ‘Labor Contract Law’, went into effect and this law gives labor unions a stronger hand is widely expected to increase labor costs.

It is very likely that manufacturers and retailers will continue to see their costs rise because labor costs are only set to go up but that’s only if they can find enough talented labor. Either way, it’s a loss.