Can China Manufacturers Make the Transition from Products to Services?

Although it might seem counter-intuitive, China's manufacturing sector has emerged strengthened by the global economic downturn and the world’s factory is moving up fast on the services front as well. As I mentioned in a previous post, so says a recent report from PricewaterhouseCoopers (PwC) on the relative attractiveness of emerging markets for foreign investors.

China's manufacturing sector has shot up from 14th position in PwC's index in 2008 to become the fourth most attractive destination in 2009, beaten only by Malaysia, Chile and Bulgaria, which are all much smaller economies. Of the so-called BRIC countries -- Brazil, China, Russian and India -- China was the only one to improve its position.

This strength hides some deeper concerns in the sector. The fact is cost advantages at Chinese factories are disappearing as more companies search for ways to create value by adding services.

Citing a recent report from the American Chamber of Commerce in China, Richard Brubaker, founder and managing director of China Strategic Development Partners in Shanghai recently wrote this passage on his All Roads Lead to China blog:

Even with the current economic conditions, manufacturing in China has become more expensive. Companies reported that costs are still rising – up to 15 percent in 2008 compared to an increase of 10 percent in 2007 – particularly in compensation costs for management, support staff and blue-collar workers as well as raw materials. Although labor and raw materials costs have come down from the premium levels of last summer, they are expected to rise again once market conditions improve.

Following the path of IBM and others, the key question facing some Chinese companies can they transform themselves from sales-driven manufacturers to global service suppliers?

In early 2008, the Chinese government announced plans to invest in the service sector. This investment involved capital bailouts and tax breaks, covering everything from professional services though to IT outsourcing. “And they are encouraging business leaders to become familiar with service business so that they can penetrate the international market in services in a very serious way,” says Laurie Young, a former PricewaterhouseCoopers global marketing partner.

The combination of price pressures and competition brings “margin squeeze” back into the China vocabulary as profit margins begin to erode in many industries. Concerns about inflation are also now becoming more widespread as price pressures mount, says China watcher Jack Perkowski at his Managing the Dragon blog.

According to a recent article in the Wall Street Journal,

manufacturers in China face rising costs as some commodity prices grow, but economists say producers may not pass on the costs to consumers because of fierce competition.

Despite sluggish exports, China's manufacturing expanded in July at its fastest rate in a year as domestic demand, a recent survey showed, highlighting the importance of the central government's huge stimulus in driving the country's economic growth. Hong Kong brokerage CLSA Asia-Pacific Markets said China's monthly purchasing managers index, or PMI, rose to a 12-month high of 52.8 on a 100-point scale where numbers above 50 indicate an expansion. That was up from June's 51.8.

Young says Western companies will soon face a growing challenge from Chinese competitors in his fourth book, From Products to Services: Insight and Experience from Companies Which Have Embraced the Service Economy (Wiley).In a recent interview with China Knowledge@Wharton, Young noted a number of Western manufacturers, such as IBM and Unisys, have not made the transition from manufacturing to services successfully. China-based Lenovo, of course, bought IBM’s struggling PC division in 2005.

As a manufacturing economy, many Chinese seem to approach services with a manufacturing mentality which doesn't help in enhancing service levels.

“In China, there's an awareness-raising process that's just beginning,” says Young. “But I think what you see here in China is a government that is serious about understanding the different dynamics of the service business – what are the strategies, and how do you run it?”

In March, Shandong-based manufacturer Haier announced that it was leaving direct manufacturing and concentrating on building the company’s brand and service network.

China is seeing the beginning of a government-led move to raise awareness of what Young calls “the service opportunity.” Together, this spells an opportunity for Chinese companies to grow global service businesses, in addition to benefiting from an expanding domestic market.

Services, which today makeup between 70 to 80 percent of GDP in Western economies, took 25 years or so to develop. China’s transition is expected to be even faster. Young concludes,

Nowadays, with the dominance of the service sector in so many Western economies, manufacturing companies older than ten or twenty years have to ask if their traditional businesses are dead dogs, and whether they should be moving into services.

Disclosure: None

Comments

[coreopsis:]

A really silly article which must generate lots of guffahs in Beijing. As if the Chinese would prefer to build an economy for 1.3 billion people on 'services', just the recipe for incipient disaster as faces the US.

Just because some companies will shift to lower-cost production ex-China doesn't mean it's a paradigm for an economy. Sheesh, what nonsense. It's too embarassing to even mention as a joke to my Chinese counterparts.

Aug 05 10:19 AM

[Swiftcreek1:]

Two points......

1.) Wealth creation is the result of extraction and utilization of natural resources to actually make something that people want. Service driven economies only shift existing wealth from point A to point B to point C until it's all been taxed away.....

2.) The average Chinese factory worker still makes less in a day than most U.S. workers make in an hour. Given the apparent margins of most Chinese manufacturing companies even a 20% increase in average wages would result in a virtually invisible rise in prices in stores here. As an example: A worker churns out 100 widgets a day that the company then sells for $1.00 each....if that worker gets a raise from $8.00 to $10.00 (per day) the cost of each widget has only risen by 2 cents. They have the option to eat the two cents or raise prices to compensate.

Raw materials pricing is a much bigger issue, which explains why the Chinese are stockpiling commodities when prices are attractive....At least they were smart enough to be in a good cash position to do it.....Unlike the twits who are running things here.

Aug 05 10:41 AM

[huangthomas:]

Imagine China becomes a service-driven society: you cut my hair, I clip your nail......You wash my cloth, I map your floor... China needs to export manufactured goods to accumulate wealth. The wage is much lower than you think. A migrant worker can tell you he makes $150 a month.

Aug 05 11:20 AM

[huangthomas:]

but don't tell you that he works two shifts a day and 7 days a week without paid vacation (except national holidays) or sick leave. You can figure out the hourly wages! Sorry I have some difficulty with this computer.

Aug 05 11:25 AM

[HaavBline:]

Commenters seem to miss the point.

"In early 2008, the Chinese government announced plans to invest in the service sector. This investment involved capital bailouts and tax breaks, covering everything from professional services though to IT outsourcing."

"service sector" in the current context for Chinese goverment, actually mean any business that offers higher margin than factory manufacturing, employs knowledge workers, and moved up the value chains. This include establishing Chinese 'brands' overseas for Chinese manufactured goods, a 'service' aspect of manufacturing industry.

China now has the huge surplus of college graduates to pursue major expansion of more knowledge-intentive survice industry, this will make Chinese economy more balanced and robust in the future. There are high end and low end service industries, from investment services, IT services, healthcare serivce, retirement services to security serivces etc. Servicng industries are big employers that typically higher margined.

Aug 05 06:40 PM

[Brian Schwarz:]

Coreopsis:

If this article is silly, please answer two questions for me:

1. Why have government officials in the city of Shanghai talked so much becoming more competitve in the financial SERVICES sector?

2. Why have government officials in the city of Hangzhou talked so much becoming more competitve in the global outsoucing of financial SERVICES?

I could cite more examples.

Government officials ARE CERTIANLY NOT making jokes about these questions.


On Aug 05 10:19 AM coreopsis wrote:

> A really silly article which must generate lots of guffahs in Beijing.
> As if the Chinese would prefer to build an economy for 1.3 billion
> people on 'services', just the recipe for incipient disaster as faces
> the US.
>
> Just because some companies will shift to lower-cost production ex-China
> doesn't mean it's a paradigm for an economy. Sheesh, what nonsense.
> It's too embarassing to even mention as a joke to my Chinese counterparts.

Aug 05 08:53 PM

[Brian Schwarz:]

Thank you.


On Aug 05 06:40 PM HaavBline wrote:

> Commenters seem to miss the point.
>
> "In early 2008, the Chinese government announced plans to invest
> in the service sector. This investment involved capital bailouts
> and tax breaks, covering everything from professional services though
> to IT outsourcing."
>
> "service sector" in the current context for Chinese goverment, actually
> mean any business that offers higher margin than factory manufacturing,
> employs knowledge workers, and moved up the value chains. This include
> establishing Chinese 'brands' overseas for Chinese manufactured goods,
> a 'service' aspect of manufacturing industry.
>
> China now has the huge surplus of college graduates to pursue major
> expansion of more knowledge-intentive survice industry, this will
> make Chinese economy more balanced and robust in the future. There
> are high end and low end service industries, from investment services,
> IT services, healthcare serivce, retirement services to security
> serivces etc. Servicng industries are big employers that typically
> higher margined.

Aug 05 08:56 PM

[huangthomas:]

Talk is cheap. I like to see what has been accomplished. Set up Shanghai to compete with Hong Kong without a trustworthy, reliable judicial system? That is only a pipe dream.

Aug 05 11:20 PM

[Ben Gee:]

Compared to developed countries, the Chinese service sector is very small compared to the rest of its economy. But it is growing. Health care is growing, the insurance industry is growing, education is growing, tourism is growing, transportation is growing, just to name a few. In most developed countries, the service sector is usually greater than manufacturing. In China, the service sector is much smaller than manufacturing and has much room for expansion.

Aug 06 05:25 AM

[coreopsis:]

You are a true neophyte at global competitive analysis and economic development. Do you think it is possible for an economy to be either/or services/manufacturing? Well, if you admit any economy exists in a continuum of services to manufacturing, then you wouldn't make the kind of simplistic argument you do implying that the holy grail of the modern economy is the US -- ie, services, not production.

I had the chance to just mention the thrust of the article to a high level person last night [in China] who didn't laugh, but just said "you see, this is still the kind of thinking that persists in the West'. Of course, he's oversimplifying as well, as there are many cogent and penetrating analyses of how a balanced economy in China is likely to evolve. This naivete, to put it politely, just isn't one of them.


On Aug 05 08:53 PM Brian Schwarz wrote:

> Coreopsis:
>
> If this article is silly, please answer two questions for me:
>
> 1. Why have government officials in the city of Shanghai talked so
> much becoming more competitve in the financial SERVICES sector?<br/>
>
> 2. Why have government officials in the city of Hangzhou talked
> so much becoming more competitve in the global outsoucing of financial
> SERVICES?
>
> I could cite more examples.
>
> Government officials ARE CERTIANLY NOT making jokes about these questions.
>

Aug 06 09:55 AM