China's Competitive Edge: Beyond Cheap Labor - Part 1

Includes: FXCH
by: Stock Whiz

Global companies already have been facing higher labor prices in China over the past year, despite a weak global economy, as workers demand a greater share of the country's economic boom. In recent months, the pressure also has intensified in countries across Southeast Asia that have marketed themselves as alternatives for companies seeking to escape China's rising costs, leaving those companies now with fewer places to move.

Average hourly wage, neighboring low-cost countries vs. China (in US dollars per hour):

Click to enlarge.

Source: Accenture.

China has been a low-cost manufacturing gold mine for the past two decades, attracting an increasing number of multinational companies. In 2009, 153 of the largest 200 exporters in China were firms with a foreign stake. However, China's low-labor-cost advantage will not last forever. Indeed, since 2008, the cost differential between sourcing in China and elsewhere has narrowed. Increasingly, global pricing is driving raw materials costs. Government policies in China (including currency revaluation and an increase in the minimum wage) are shifting in favor of improving local workers' welfare and away from maximizing benefits to manufacturers and investors in China.

Average hourly wage, developed economies vs. China (in US dollars per hour):

Source: Accenture.

Beijing raised its minimum monthly wage by 8.6% to 1,260 yuan ($199) starting in January 2012, according to the state-run Xinhua news agency. The following month, the southern boom town of Shenzhen raised its compulsory monthly wage by nearly 14% to 1,500 yuan, and the northeastern port city of Tianjin will raise its minimum wage nearly 13% to 1,310 yuan starting in April. There is a genuine feeling that companies have started moving manufacturing from China to cheaper locations in Asia, such as Indonesia, Vietnam and Thailand.

Investors tend to look at China as an opportunity, and with one of the fastest rates of growth across the world, there are clearly many potential opportunities. But China also presents a competitive threat. Napoleon apparently said after pointing to China on a map: "There, a sleeping giant. Let him sleep! If he awakes, he will shake the world." There are signs that Chinese manufacturing is gaining share, and investors should focus on the threat that this implies for certain sectors. We will look at 8 factors at play that are positively working towards China favor. This is a two-part series. In Part I, we will focus on the non-macro factors at work.

1. Tax rates and export subsidies: It was clear that during 2006 and 2007, when growth was buoyant, China tried to support a more sustainable domestic growth model and reduced export subsidies. With the global recession, the desire to support jobs has dominated and thus we have seen a sharp increase in export subsidies.

Meanwhile, corporate tax rates, which had historically been advantageous for foreign firms investing in China, were aligned at the start of 2008. Under the old legislation, Foreign Invested Enterprises were entitled to a host of tax incentives that were set up to encourage high-level, high-profile investment in the country. As of 1 January 2008, both foreign and domestic producers in China have faced a corporate tax rate of 25% (which compares favorably with the US rate of 40% and is roughly in line with the average for the EU at 23.2%). However, there are a few exceptions. Most notably, a preferential rate of 20% is available to certain low-profit-making enterprises and a 15% rate for new or high-tech enterprises.

2. The technical know-how and patent filings: The number of graduate and undergraduate students in China has grown substantially over the past decade. Moreover, China produces 3 times the number of engineers and scientists than the US. A study from Duke University found that in 2004 (on a like-for-like basis), China graduated 644,000 scientists and engineers versus 222,000 in the US. R.E. Smalley, a Nobel Prizewinning scientist from Rice University, has concluded that by 2010 90% of all Ph.D. physical scientists and engineers in the world will be Asians living in Asia.

Long the workshop of the world, China wants to be the brains as well. China became the world's top patent filer in 2011, surpassing the United States and Japan as it steps up innovation to improve its intellectual property rights track record.

3. Weak enforcement of international IP laws: China has long since acceded to the major international conventions on protection of Intellectual Property Rights. Protection of intellectual property law has been established by government legislation, administrative regulations, and decrees in the areas of trademark, copyright and patent. However, enforcement is weak and this is exacerbated by a relatively unclear legal system. The net result is copyright violations are widespread in China. Chinese counterfeit products are common in pharmaceuticals, electronics, batteries, auto parts, industrial equipment and toys. China tops the US Trade Representative Priority Watch List on the adequacy and effectiveness of intellectual property rights protection by US trading partners.

4. Brand names Recent deals show that Chinese corporates are beginning to acquire internationally recognized brand names. Examples include Lenovo/IBM and Volvo/Geely. This lends further weight to the critical mass argument and adds to China's ability to compete in the global market place. Other examples include

  1. Sany Heavy Industries acquisition of Putzmeister in Germany;
  2. Ferretti in Italy;
  3. General Aircraft Co Ltd (subsidiary of Aviation Industry Corp of China) acquisition of Cirrus Industries in the United States;
  4. China's Bright Food acquisition of Weetabix, UK.

In Part 2 of this article we will discuss on the macro factors and the investment options for this theme.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.