The China Analyst

Squeezed from different angles by the strengthening of the renminbi, rising costs for labour and raw materials, more stringent environmental regulations, push towards industry consolidation, and slack capacity in developed countries, Chinese machinery suppliers have no choice but to move up the value chain. They are producing increasingly sophisticated goods, but are still struggling to increase their efficiency and adequacy of internal support processes. Buyers must be patient and invest more time in building relationships with suppliers to ensure that they can capture the benefits of China procurement while reducing its risks. By Lilian Luca

Gone are the days when the West had the luxury of worrying about low-end textiles and shoe exports from China. The future of exports from China will be led by equipment manufacturers, and although they may not yet be penetrating Western markets, competition in third markets is intensifying.
(EIU, 2011, 'Heavy Duty: China's next wave of exports')

While China has steadily grown its manufacturing and export base over the past 20 years to become the world's largest exporter, a status that has now become firmly entrenched in the minds of procurement managers worldwide, a few worrisome trends emerged last year that depict alterations to the old China sourcing equation. Labour and raw materials costs in China have seen a steady increase to a point where many commodity-type goods such as textiles, toys and simple carbon steel products can no longer be competitively sourced from China, with China losing market share to other Low-Cost Country (LCC) producers. Moreover, as we noted in the September 2011 issue of The China Analyst, the competitiveness of simple, labour- or raw-material-intensive goods made in China has been further eroded by a strengthening Chinese currency, government-imposed export duties and quotas, the closure of old, polluting facilities, and a reduction in subsidies which provide access to cheap land and electricity.

So, since China is becoming more expensive, all one can do is prepare for a lengthy trip to discover new suppliers in exotic Asian locations, right? Wrong. The big picture tells a different story altogether.

The global, long term trend at work here is of course China's transformation into a middle-income country, one that is industrialised, modern and aspires to become a leading producer of high value-added manufactured goods. The government has been promoting this for years, with every five year plan shifting resources to support knowledge-intensive industries, encouraging investment in science and technology education, and discouraging the exports of low-value added, resource- or labour-intensive goods via various policies. As an example of such policies, the 12th Five-Year Plan's list of priority industries includes high-end machinery, energy conservation and clean technology (included among the seven 'Strategic Emerging Industries').

On the other hand, 'discouraged' industries get penalised by reduced export rebates affecting the export price competitiveness, more stringent energy and pollution regulations leading to increasing costs, rising labour and raw materials costs, and currency appreciation. For a few years, Chinese manufacturers in these sectors were able to maintain profit margins by investing in new, more efficient manufacturing processes, but this game is becoming increasingly difficult to play due to rising costs of building new capacity in China, including the rising cost of capital, land and environmental compliance. Thus, facing increased competition at home from both existing producers with outdated capacity and nimbler, more innovative startups, Chinese manufacturers are turning to product innovation and exports as avenues for growth.

An article by the Economist Intelligence Unit¹ cites the evidence of Western manufacturers losing market share in key industries where they still dominate global exports as evidence that Chinese producers are climbing up the value chain. In centrifuges and filtering/purifying machinery, for example, a USD 45 billion global exports market, China doubled its market share from 3.5% to 7.1% from 2007 to 2010, while OECD countries lost market share in the same period, from 82.7% to 80.9%. The same trend is visible in transmissions, gears, bearings, handling machinery and other sectors (see chart above).

Most of these exports from China are, however, not going to OECD markets, but rather to non-OECD countries, an example of the so-called South-South trade relationship. Brazil, Russia, and India are the major importers of machinery from China. Incidentally, with growth stagnating in the developed world in the aftermath of the global financial crisis, China's exports are going to markets that are currently driving world economic growth. They successfully compete in these markets against established Western brands, offering more affordable products with simpler features and specification sets while more sophisticated, feature-laden Western gear gradually lose their appeal to budget-conscious emerging market buyers. In these markets, where secure sources of capital remain scarce and costly, upfront cost considerations often trump lifetime costs of ownership at which OECD machinery exports perform better.

Chinese producers utilise a number of different ways to climb the technology ladder. Many have successfully reverse-engineered (and often improved upon) Western designs; others are beginning to see the fruits of massive R&D spending; and still others are trying their hand at acquiring new technologies through M&A as evidenced by the shopping spree being undertaken at the moment by Chinese firms in Europe's mid-size industrial sector. The heavy equipment industry has some shining examples of leading Chinese innovators moving up the value chain and making inroads into the export markets: XEMC is introducing increasingly sophisticated haul trucks (see picture on previous page), Taiyuan Heavy (TZ) is becoming a world leader in open-pit mine excavators, while ZPMC is the world's top container crane and gantry crane producer.

As machinery exports from China penetrate more markets, the reality is that many Chinese suppliers are still unprepared to adequately service foreign sales. Even though their machinery is often simpler to maintain and less complex than that from OECD countries, quality variability, lack of service and limited spare parts supply networks, and lack of flexibility in commercial terms remain the biggest challenges when dealing with Chinese manufacturers. As the sophistication of buyers in emerging markets gradually increases, so will their demands on Chinese products: availability of customised designs and features, higher specifications and tolerances, availability of credit terms and financing options, transparent tendering processes and pricing, and improvements in customer service are some of the features they will demand in the coming years.

Chinese manufacturers will thus have to upgrade not only their manufacturing capacities and product design and R&D capabilities, but also their supply chain systems (ability to monitor inputs for quality and timeliness), the interface between their engineering departments and manufacturing workshops, capabilities in the tendering departments (sophisticated English-language commercial and legal support, fast design change implementation and cost modeling), and of course will have to put more solid internal quality assurance processes in place which should become the norm rather than the exception.

In the meantime, global procurement managers can already actively investigate and engage with Chinese suppliers offering more sophisticated machinery, high-tech spares and consumables. This entails investing upfront time on researching and traveling to production facilities, establishing good working relations to open ongoing dialogues over features and pricing, discussing service support options, and working with suppliers to ensure a rock-solid quality control process. In these unchartered territories, local support in the form of procurement service providers experienced in commercial and technical China procurement issues is often indispensible and the key to achieving LCC procurement targets within a manageable time frame.

Lilian Luca, MD: Beijing Axis Procurement
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Note:

1. See quotation and reference at the beginning of this article.