Monday, March 10, 2008

Judgment Day

China's new labor law is sealing the end of its heyday as a cut-rate production platform

by Jonathan Adams and Ko Shu-ling
Far Eastern Economic Review, March 2008

At a Taiwanese-owned stainless-steel factory in Dongguan, China, the ax just fell.

Interviewed by phone, the firm’s president—who did not want him or his company to be identified by name—says he just laid off 10 workers from his 100-strong workforce, and wouldn’t rule out more layoffs. The cuts are a bid to soften the impact of a new Chinese labor law that took effect Jan. 1. “The law is hurting business owners a lot, and many are worried,” explains the businessman. “Taiwanese firms must seriously consider lowering personnel costs if they want to stay in business.”

The new law has sent shock waves through the Taiwan business community in mainland China. Downsizing is one survival strategy. The law mandates contracts for all employees, open-ended contracts for long-term employees, and health insurance and other benefits. Unlike past labor laws, it provides more channels for workers to bring complaints against employers.

The net effect, according to businesses, analysts and government officials, is a fundamental shift in China’s production landscape. “The end of rock-bottom Chinese labor is near,” says Cheng Tun-jen, an expert on cross-strait economics at the College of William and Mary. With that comes the end of China as the world’s cut-rate factory.

But if Judgment Day is nigh, not all firms will get bad news. The damned, say observers, are smaller, labor-intensive Taiwan-and Hong Kong-owned manufacturers in southern cities like Dongguan, and their South Korean peers clustered in cities like Qingdao. Such firms were pioneers in establishing coastal China as a cheap production platform for export. But the new labor law is the latest in a series of blows that have pummeled razor-thin margins.

Labor shortages became a problem several years ago in some coastal areas, driving up market wages. Material costs have soared. The yuan has appreciated by some 15% against the dollar since July 2005, making exports more dear. Last summer the Chinese government scrapped or reduced a rebate on a 17% value-added tax for some exports. And as of January this year, China raised taxes on foreign firms’ earnings to the new, uniform rate of 25% for both domestic and foreign firms.

Can’t firms simply raise prices to cope? After all, they’ve done so since 2003 in response to rising wages, as UBS economist Jonathan Anderson recently noted. But he says the days of resorting to price hikes are “coming to a close” because of slowing demand for Chinese products, and the appreciation of the yuan.

Facing that dreary picture, some firms are throwing in the towel. The most dramatic example may be South Korean firms. Some owners of failed companies have fled China in the night to avoid paying debts and back wages, a practice the South Korean media calls “night flights.” A South Korean business association official in Qingdao told the Chosun Ilbo that an estimated 20% of the 5,000 South Korean firms in that city will close down by August due to the harsh new business climate.

The Federation of Hong Kong Industries estimates that 10% of the 60,000 to 70,000 Hong Hong-owned factories in the Pearl River Delta will close this year, and some 1,000 shoe companies in the area have already closed, according to a recent Wall Street Journal report. Numbers for Taiwan firms are also bleak. Chang Hen-won, honorary chairman of the Taiwan Merchant Association in Dongguan, estimates that at least 200 Dongguan-based Taiwanese business owners have left. More are expected to leave as the effects of the labor law and other changes sink in later this year.

The End of an Era

Taiwan firms are typical of low-end manufacturers who rushed into China but are now eyeing the exits. They started moving across the Taiwan Strait in the late 1980s to make shoes, textiles, toys and cheap electronics; that flight turned into an exodus after Taiwan’s government officially allowed China-bound investment in 1991 as cross-Strait relations eased. For such firms, setting up shop in the mainland was a far easier business option than expensive upgrades or paying rising wages at home.

The effect was a hollowing out of the island’s manufacturing sector. Annual employment in Taiwan’s fabled export processing zones dipped sharply to 50,000 in 1994 from 90,000 in 1987. Politicians bemoaned the flight of Taiwanese industry to the mainland, and warned it was making the island too economically dependent on its bitter political rival across the Strait.

Now, economic forces and policy choices in the mainland have begun to blunt that political threat. “There’s no need for the government to have a policy of stopping Taiwan businesses from going to China, because industrial policy is changing there,” says Gordon Sun of the Taiwan Institute of Economic Research in an interview last year. “Labor and land costs are bigger, so naturally [Taiwan businesses] will go somewhere else. Dependency won’t be an issue because now China is changing.”

Many Taiwan firms are seeking greener pastures, moving production to places like Vietnam, the new low-cost platform of choice. They’re also eyeing western China, where Beijing has left some incentives in place to lure foreign money to the poorer hinterland. A Chinese Commerce Ministry official recently announced that China would help Taiwanese firms struggling with higher costs by offering loans and other incentives if they expand inland.

Some have already done so: Contract electronics giant Hon Hai, for example, has opened two “mega sites” for production in inland areas in the past three months. And inland industrial hubs like Chongqing have already attracted investment from Taiwanese firms like chemicals giant Formosa Plastics and memory chip maker Promos.

Meanwhile, the Taiwan government has actively touted alternatives to China. The latest candidate: India. The economics ministry recently announced a public-private partnership to develop a 1,200-hectare industrial zone in Andhra Pradesh state. They are specifically targeting investment from Taiwan firms hit by rising costs in China.

Still, India has far to go in becoming an investment target on par with China: Taiwan statistics showed $400 million invested by Taiwan manufacturers as of last July, compared to cumulative Taiwanese investment in China that by one government estimate has reached $150 billion.

Taiwan’s government is pushing another option: come home. A decade or two after first moving into mainland, some Taiwan businessmen are responding to that call. They’re taking advantage of free or slashed rent at Taiwan’s industrial parks and other incentives.

Berton Chiu, director general of the Department of Investment Services under Taiwan’s Ministry of Economic Affairs, says that the Taiwan government in September 2006 launched a program to welcome back Taiwanese firms, after hearing complaints about the mainland’s harsher business climate. Since then, 70 mainland-based firms have moved back to Taiwan or plan to. “Compared with 15 or 20 years ago, mainland China isn’t so good for some industries.” says Mr. Chiu. “They feel they’re not as welcome there as before.”

Steven Tsai is one Taiwanese businessman who has come back. Ten years ago he moved to Dongguan, where he started export businesses in porcelain, hardware, souvenirs, computer parts and cell-phone panels. His businesses now employ some 1,000 workers in China. But for Mr. Tsai, the mainland has lost its investment allure. He estimates his costs rose 10% from the new labor law alone and also cites the rising yuan, higher taxes and new environmental regulations as burdens.

While China was getting increasingly forbidding, Taiwan’s government offered him incentives to return. So in September last year, he moved back to Taiwan with his wife and family. He’s not getting rid of his mainland factories, but he has decided there’s very little room for expansion. Instead, he’s invested $90,000 in an “Ocean World” development back in Ilan County on Taiwan’s northeast coast. He’s bullish on the “Ocean World” project because it’s near a new tunnel that opened in 2006, sharply reducing travel time from the capital Taipei, and he’s mulling more investments nearby in hotels or electronics.

Uneven impact

But not all business owners are feeling as much pain in China as Mr. Tsai. Taipei-based ABN AMRO analyst Steven Tseng says in a phone interview that the big Taiwanese contract electronics manufacturers he covers already offer competitive wages and benefits similar to those now mandated. Such firms are clustered in places like the Kunshan special zone outside Shanghai. In the long term, he says, the law could even benefit big firms like Hon Hai and Wistron as smaller competitors get “shaken out.”

Meanwhile, such firms are more likely to pursue a hedging strategy rather than leave. “They may not necessarily move out of China, but clearly they’ll diversify their concentration of risk,” says Mr. Tseng. “They’ll rely a lot on China, but they’re also looking elsewhere—Vietnam, Brazil, Mexico and Eastern Europe.”

Take Quanta Computer, the world’s biggest contract laptop maker. For Quanta, labor costs represent only some 2% of total production costs, according to a company spokesperson, who asks not to be identified by name. The company’s factories are near Shanghai, where wages are the highest in China.

The new law mandates about 840 yuan per month wages in the Shanghai area; Quanta was already paying roughly 800 yuan per month for such workers, according to a company spokesperson. (wages of 500 to 600 yuan are more typical in southern China.) That’s greatly lessened the impact of the new labor law, though Quanta’s suppliers are feeling the pinch.

Quanta said in January that it too is considering increasing production in Vietnam and other locations (Hon Hai started production in Vietnam this summer and has said it will boost investment to $5 billion). “We’ll still expand in China, but we’re keeping our eye on other alternatives,” the Quanta spokesperson says. Vietnam has one major sweetener for Quanta and others: its tax policy. While China has now hiked taxes on corporate earnings for foreign firms to 25%, Vietnam is sharply reducing taxes.

What the Future Holds

The uneven effects of higher China costs point to a longer-term trend. China’s new labor law will likely foreshadow a structural shift in China-bound investment. Flows to low-end manufacturing will dwindle, while investment in high-end manufacturing like Quanta Computer’s, and in services, will rise. In fact, that’s China’s aim, observers say: Beijing is encouraging foreign investment in value-added industries that bring China expertise, technology and better jobs, while slowing inflows of investment into low-end sectors.

National Chengchi University economist Lin Chu-chia says labor-intensive Taiwanese manufacturers who are forced out will likely be replaced by a new wave of investment by Taiwanese retail chains, pharmaceutical firms and high-tech services. “China could change from the world’s factory to the world’s market,” says Mr. Lin.

That won’t happen overnight, of course. And it’s still not clear whether the departure of low-end Taiwanese firms will be a trickle or a stampede. “It will take six months to a year to see how much impact the law will really have,” says Andrew Yeh, chairman of the Taiwan Merchant Association in Dongguan. In the meantime, Taiwanese managers are waiting nervously to see just how bad business will get.

Wu Chin-ching is one. His firms, including Lung Tai Chemical, have exported processed chemical products from the mainland since 1993. He says in a phone interview that he’s had to hike his 600 workers’ wages an average of 70% because of the new law. But the real pain has come from the yuan’s appreciation and higher taxes. Altogether, he estimates production costs have gone up 30%, some of which he’s had to pass on to customers.

As a result, he’s set to shut down any of his factories still bleeding money by July. He doesn’t think he’ll move to Vietnam or inland China, because he would have difficulty finding the materials he needs there, including calcium carbonate and clay. For Mr. Wu, there’s nothing to do but dig in.

“I can grit my teeth and keep my business alive,” says Mr. Wu. “But I’m more worried about my clients, who may find it difficult to cope with rising prices.”

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