China is Sneezing – Will the Global Supply Chain Catch a Cold?

Spend Matters welcomes another guest post from Santosh Nair of GEP.

The IMF recently stated that 2013 will be the first year in which emerging markets will account for more than half of the world’s GDP. China is the largest of these emerging markets, accounting for a fifth of global manufacturing. But recently China’s economy has been showing signs of weakness driven by several macroeconomic factors: slowing exports, a strong currency, shrinking domestic investment, and tightened credit. A lot of these changes are a result of government’s push to shift the Chinese economy to a domestic consumption based model.

This shift has impacted the Chinese labor cost advantage as well. US labor wages were estimated to be 22 times Chinese wages in 2005, but in 2013 they will be just seven times the latter. This had led to a lot of discussion around the end of the Chinese manufacturing era and a possible shift to other Asian countries like Vietnam (or a return of manufacturing to US shores). While some shift is inevitable, such calls are premature because of the following reasons:

  • Chinese wages may be rising fast, but so is Chinese productivity: Chinese wages have risen sharply in recent years, but labor productivity has been rising even faster (at a clip of about 10% annually since the early 1990s and even more quickly in the past decade). This has been driven by technological progress, increased capital investment, and rising human capital. This consideration alters the cost comparison equation significantly.
  • Institutional knowledge and infrastructure: The country’s infrastructure and intimate knowledge of production processes make them a leader in total cost of manufacturing. Other countries like Vietnam and Bangladesh may offer lower hourly wages, but additional costs are incurred due to lower productivity, higher transportation costs, and lack of manufacturing automation capabilities. China had developed a reliable global supply chain over the last few decades, and other countries will need to go through a learning curve and significant domestic investment before they can compete effectively.
  • Flexibility and responsiveness: China’s expertise enables it to function as a critical node in the global supply chain. Many companies use China not just as a sourcing hub but also as a distribution node for semi-finished products. The country offers seasonal scale opportunities for businesses that need the flexibility to ramp up or down very quickly, without making large-scale investments. That reliable responsiveness is very difficult to replicate in-house or in other regions.
  • Market potential: China’s growing domestic economy makes it a very attractive market for Western companies, especially given the slowdown in North America and Europe. Firms that use China as a supply base build a strong institutional knowledge of the country’s political and social structures, and therefore can get a leg up in developing China as a potential market.

Talks of a Chinese economic slowdown and the demise of Chinese manufacturing are premature. China’s economy is set for a soft landing, but that is natural given the long-term shift in growth strategy. In terms of manufacturing, we need to measure competitiveness not only on labor costs but across entire supply chains. Other countries need to be part of one’s global sourcing strategy, but China will continue to play a key role for the near future. Also, its growing affluent middle class offers a huge market potential, making China crucial across both supply and demand levers of the global supply chain.

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