a turning point for the Chinese economy

Last Thursday, David Pilling, a columnist for the Financial Times, wrote about the views of Victor Fung, the chairman of the Hong-Kong based supply chain management company Li & Fung.   This is presumably the result of an interview with Mr. Fung, although the article doesn’t say. There are three interesting points in it.

Victor Fung himself is an influential political and business figure in Hong Kong, and a senior member of the Fung family, which has substantial commercial and property interests in Greater China, including the Hong Kong-traded Li & Fung (HK: 0494).  0494 sources garments and other manufactured items, mostly from China, but also from other developing countries, for wholesalers and retailers in the US and Europe.

The three points:

1.  The Foxconn incident signals a change in the way manufacturing is done in China.  If you recall, about half a year ago, Foxconn, a Taiwanese assembly company, had a period of labor unrest in a manufacturing complex in southern China.  Workers protested poor working conditions that had induced a number of employee suicides inside a factory town.  Under pressure from US customers like Apple, Foxconn agreed to, among other things, a 30% wage increase.  The Shenzhen plant continues to have problems, though.

Mr. Fung sees this as marking a decisive turn in manufacturing in Guangdong province in southeast China, which it doubtless is.  This isn’t new news, however.  It’s an illustration of economic forces that have been in motion for the past several years (see my post on China’s economic development model.)

In short, eastern China has run out of cheap labor and has to shift to making higher value-added products there to continue to prosper.  Manufacturers can also move labor intensive operations–as Beijing would like to see happen–to western China, where plenty of unskilled workers are still available.  That would foster greater political stability and help address the sharp income imbalances between the more affluent east and the more rural, agriculture-oriented, and poorer, west.  The gating factors, as I see them, are the availability of reliable transport for finished products to the eastern ports, and infrastructure, like continuous electric power.

More interestingly, Mr. Fung also says that:

2.  Beijing is encouraging the development of labor unions.  A first glance, this seems very odd for a government constantly worried about labor unrest–after all, that’s what Tiananmen Square was all about.  And for a socialist country as well, where criticizing the owner of a factory (that is, the government) could be seen as a political crime.  But the factories in question are typically controlled by some sort of partnership between a regional/local government and a foreign manufacturing company that has the technical know-how.  Beijing has little control over either party.  Unions may be a way to get some.

Also,

3.  For the first time ever, some Chinese clients have asked Li & Fung about sourcing shoes and garments for sale in China from countries like Bangladesh or Vietnam.  The clients are presumably domestic retailers or wholesalers who currently get their wares from unaffiliated factories in China.  This development is good news for Li & Fung, but puts another source of pressure on eastern China manufacturers to lower their costs.

In general, China factories have two possible responses:

–they can lower costs, i.e., move west; or

–they can try to get Beijing to impose tariffs or other protective measures against garment imports.

Given that this would run counter to the central government’s plan to shift labor intensive manufacturing west, I think there’s little chance of the latter happening.  But this is an area to watch.

my thoughts

Developing countries have invariably had difficulties when they have reached the point where all the available unskilled labor is used up.  Typically, the companies that use unskilled labor have developed considerable political power and are also incapable of migrating their firms to higher value-added tasks.  Such firms vigorously defend the status quo.  As a result, they often form an immovable roadblock that destroys the possibility of economic progress for years (think: Malaysia).

China is in a much better position than most.  The country still has lots of unskilled labor left.  And the current administration in Beijing isn’t particularly beholden to the Guangdong-Hong Kong manufacturing interests that, in theory at least, have the greatest interest in defending the status quo.

For an investor, it seems to me the implications of all this are simple.  For someone like me, observing from halfway around the world, there’s no reason to take the risk of owning manufacturing-related companies that derive a significant chunk of their profits from eastern China.  It’s better for now to have less exposure to specific industries/geographical areas in China, and more to the general positive effect of increasing incomes.  Financial services, though not often my favorite sector, comes to mind.

By the way, in poking around the Li & Fung website, which I haven’t done in a while, I stumbled across mention of a study on the gray economy in China which I think has investment implications.  More about this tomorrow.

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