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"Go West" into China ... carefully

Comment
Companies that are considering moving production into China's interior must weigh the trade-offs of lower costs against the impact on their supply chains.

The "go west" idea is nothing new in China's manufacturing sector. The country's central government has been encouraging development of the interior regions for a decade now, but foreign-invested enterprises were reluctant to answer the call because of concerns about lagging infrastructure, limited access to talent, and logistics challenges. Today that situation is changing, and manufacturers are finding the western provinces of the People's Republic of China (PRC) to be conducive and even inviting locations for their businesses.

While traditional barriers such as logistics infrastructure and talent shortages are less likely to plague manufacturers, a new crop of challenges, such as provincial regulations and enforcement, may still hinder success. That is why, prior to making any decision to shift production into China's interior, a company must undertake a thorough and thoughtful due diligence that includes a detailed cost assessment and a complete supply chain assessment.

Reasons to move inland
Economic, governmental, and social factors have converged to make inland manufacturing more attractive and feasible than in the past. A shortage of labor in traditional manufacturing hubs in Eastern China is a commonly cited reason for companies to consider a shift further inland. Since 2008, an increasing number of workers who return to their hometowns for the Chinese New Year Spring Festival are not returning to work in the coastal manufacturing centers. As a result, those centers are suffering severe labor shortages. A survey conducted in Shenzhen before the 2010 Chinese New Year revealed a shortage of 800,000 people, and 90 percent of the surveyed enterprises said they would have an urgent demand for labor within the first two months following the holiday.

Further exacerbating this depletion of coastal labor resources is the combination of a lower effective tax on agricultural production and higher selling prices for agricultural products. The resulting increase in sustainable incomes for farmers has encouraged a growing number of migrant workers to return to the fields, where they also enjoy access to healthcare and education that is only available to them in their hometowns, as outlined in the Chinese Hukou (Household Registration) system.

China's constantly evolving labor laws, coupled with migrant workers' demands for higher wages and employer-sponsored, personalized training, are leading analysts to estimate that labor costs overall will increase by 5 percent in 2010. There is still a notable disparity between regions when it comes to wages, however. Some economists posit that pay scales can be up to 30 percent lower in inland provinces than on the coast.

Operating expenses in traditional manufacturing areas are also rising, due in large part to the higher cost of real estate. A recent commentary by a representative of the commercial real estate firm Colliers International, reported on a Chinese-language website, indicates how much real estate prices have changed in China's coastal business centers. According to the representative, "a few industrial estates in Shanghai with a geographic advantage (i.e., coastal region with easy access to logistics services) are experiencing a 100-percent increase in their [purchase] price ... The lease for these estates has increased by 12.1 percent as compared to 2008, reaching RMB 0.87 per square meter per day."

Moving production inland becomes even more alluring for foreign companies when provincial governments offer incentives to establish operations in their regions. Chongqing, for example, offers local and enterprise income-tax deductions or exemptions for foreign companies operating in its ethnic minority regions; most of those lands are poverty-stricken and have yet to be developed for business use. This win-win situation not only opens up new markets with lower production costs for foreign companies but also allows local governments to engage directly with multinational corporations in an effort to improve their citizens' standard of living—a primary motivation underlying China's "Go West" strategy.

The central government's intent to assist the central and western regions in attracting foreign investments was reiterated in 2009 when Ministry of Commerce spokesman Jian Yao said that "the Ministry of Commerce will continue to formulate and implement policies to optimize the industrial structure and improve the quality of service and infrastructural support so as to attract foreign investment and companies." Yao's remarks clearly signal the central government's support for further development of inland regions, and they suggest that creative measures will be permitted in order to ensure that it achieves its objective of improving the quality of life and access to services within those areas.

Finally, the "Made in China, for China" push to manufacture in-country for domestic markets provides another reason for multinationals to shift operations further into China's heartland, where niche markets are emerging and production costs are lower. The automotive sector has led this trend, with foreign and Chinese automakers building plants and establishing inland operations. The opportunities are so substantial that Changming Xu, senior economist at the State Information Center, has predicted that the growth of inland regions will lead to overall auto sales growth averaging about 20 percent a year.

Transportation considerations
Taken together, the rising costs and labor shortages in the coastal manufacturing centers plus the local government incentives and greater access to labor and land in the western provinces provide companies with strong reasons to consider locating production in China's hinterland. But it's important that they factor in the supply chain implications when they conduct NPV (net present value) and financial analyses of such an investment. They are likely to find that manufacturing costs will decline, but an inland move may have the opposite effect on logistics costs.

China's central government is certainly aware that it can be difficult to efficiently move goods in the nation's interior. To stimulate the inland regions' competitiveness and ability to attract investment, the National Development and Reform Commission (NDRC) channeled RMB yuan 1.09 trillion (US $160 billion) in fixed-assets funding to the western regions from January to April 2010—a 28.5-percent increase over the same period last year.

Such investment in infrastructure offers reason for optimism about the future of doing business in that part of the country. But optimism must be tempered by both an awareness of the persistent risks and an understanding of the true costs and benefits of going west. Manufacturers still need to weigh the logistical barriers against the opportunities.

Numerous foreign companies remain heavily reliant on exporting goods out of China; those that establish production away from the coast, therefore, should carefully assess export options. This will require analysis of intermodal constraints, transit times, the likelihood of delays, variations in customs activities among different provinces, and the availability of special trading zones.

A related concern is whether it is better to use smaller, closer seaports instead of the very largest ports. The Port of Shanghai is the second-largest in the world (behind Singapore), with a throughput of 11.7 million TEUs (20-foot equivalent units) in the first half of 2009. Its huge scale makes frequent sailings and timely deliveries possible. In contrast, the Port of Ningbo is smaller, with a throughput of 4.6 million TEUs in the first half of 2009, and therefore outbound sailings are less frequent. Although Ningbo has an advantage with its simplified and agile export processing, the lower sailing frequency can translate to delivery delays. Both Shanghai and Ningbo have their strengths and weaknesses, and detailed planning is essential for shipping from the western provinces through any of the coastal seaports.

Transportation costs in China are among the highest in the world. Hinterland shipments, for instance, face higher toll charges and greater probability of damage. Extending transport distances will also result in higher rates charged by third-party logistics companies (3PLs), also referred to as logistics service providers (LSPs). Not everyone employs 3PLs in China. Most are still small-scale and function-specific, therefore they cannot provide a full supply chain service from raw-material procurement to final product delivery. It is very likely that most foreign companies will seek a familiar or incumbent 3PL from their home countries. In turn, these third parties often rely on partner logistics entities, commonly local freight forwarders and carriers, to actually manage the freight movement.

Although more than 80 percent of freight within China moves over the road, companies that are producing in the interior might want to consider the feasibility of using China's underdeveloped rail and barge networks. Rail is an attractive alternative to truck transport for similarly long distances in many Western countries, but the government-run rail system in China makes it difficult to ensure efficiency or adherence to delivery timetables. Furthermore, the lack of intermodal ramps at critical logistics junctions and ports has so far kept trucking as the dominant mode of freight transport throughout China.

As for barge service, the situation along the Yangtze River illustrates the issues at hand. China's "Golden Waterway" stretches 6,300 kilometers (approximately 3,900 miles) through seven provinces and handles 80 percent of the country's inland waterways traffic. River transport provides a lower-cost alternative to rail and truck movements from these regions. It is estimated that the cost of shipping a 40-foot container from Wuhan to Shanghai by barge equals the cost of moving 10 tons by truck. Another comparison of transport options along the Yangtze River shows that the cost of shipping one TEU from Chongqing to Shanghai via truck (RMB yuan 20,000, or approximately USD $2,900) is about 6.7 times greater than that of shipping one TEU by barge (RMB yuan 3,000, or approximately USD $440).

Using inland waterways does have drawbacks. For one thing, the trade-off for lower pricing is longer transit times: barge movement takes from 30 hours to 4 or 5 days. For another, there is the risk of unreliable water levels, which could hold up any river voyage indefinitely. Manufacturers do have the option of using inland ports for ship and/or barge calls. One of these is Nanjing—the largest inland port in China and the largest river port in Asia, with estimated annual throughput of 3 million TEUs by the end of 2010. Other large inland ports include Wuhan, which is expected to become the second-largest inland port, and Chongqing, the most significant port on the upper Yangtze, with annual throughput exceeding 1.5 million TEUs. (For more about these ports, see the sidebar "Infrastructure outlook for China's commercial clusters.")

Logistics service providers hesitate
Companies that locate production in China's interior will have to re-evaluate their existing relationships with third-party logistics service providers. It's natural to assume that the incumbent provider will be the best choice for handling logistics in a new location. But that is not necessarily true, and companies may find it necessary to establish relationships with providers that are better positioned in inland regions.

In any event, manufacturers should first assess current and prospective 3PLs' suites of services in the new region—these will rarely match what they can provide in the Tier 1 coastal cities. They should also examine the extent to which the multinational 3PLs rely on local service providers, as well as the benefits and drawbacks of collaboration with each of them. Among the potential negatives of handing business over to a local 3PL are a lack of visibility and less control over product transportation and handling.

One benefit of partnerships between multinational and local 3PLs includes access to local knowledge and provincial relationships that can be helpful in dealing with local officials or customs authorities. One of the greatest challenges for foreign operators in China today is to clearly understand the regulations that exist; understanding how different provinces interpret those regulations poses a different set of challenges. For example, although a particular regulation may be clearly documented and properly distributed, varying levels of enforcement make it difficult to understand how to remain competitive while still operating within the rules.

It may be difficult for now to find a 3PL that can provide the required level of service in China's West. According to the China Logistics Association, about 78 percent of the top 50 privately held logistics firms are concentrated in the coastal regions where the manufacturing centers first emerged.

The 3PLs are cautious when it comes to migrating further inland, and their hesitation to invest in operations further inland is justified. They face the prospect of increased damage and product loss during long transits in areas with poor infrastructure; the availability of skilled labor is questionable; and for many 3PLs, it is too risky to establish operations before a sufficient customer base has arrived. While warehousing and logistics hubs are becoming more prevalent in these emerging inland manufacturing locations, the logistics operators will wait for customer demand to reach viable levels before undertaking any major investments. "We've been hearing about 'Go West' for so long that we won't commit to any capital investments in a western city until we actually witness our customers moving there first," said a general manager for a multinational 3PL with operations throughout China.

Go West with caution
Moving away from China's coast will have implications not only for logistics operations but also for the entire supply chain, requiring careful orchestration of all stakeholders. When production shifts inland, manufacturing is moving either closer to or further away from the supply base and customers. The resulting impact on transit times and lead times mandates a revised supply chain strategy that includes new safetystock levels; improved or relaxed service levels to accommodate longer delivery lead times to the customer base; revamped economic-orderingquantity modeling and adjusted inventory policies; and an assessment of the potential need to vertically integrate the supply chain to support growth in the region.

With a move as significant as this, overseeing logistics—and indeed, all supply chain activities—from overseas can be a dangerous approach. Depending on company size and global strategy, a risk-adverse company should bring in a senior-level manager who has experience in the province as well as with multinationals to oversee everything from selecting 3PLs to outfitting warehouse operations to managing supplier lead times.

Although China's coastal cities have provided golden opportunities for foreign companies to invest in production, rising manufacturing costs have diminished its competitive advantage versus the interior. More and more companies are viewing western and central China as a viable location for production, particularly because this strategy answers corporate calls to leverage cost savings while exploiting the consumer- market opportunities that are becoming increasingly available in inland regions. However, as with any China strategy, the opportunities are not without risk. Companies can minimize that risk by conducting rigorous analysis and modeling to ensure that they get the supply chain component of the equation right before they begin manufacturing in China's interior.

Note: The author would like to thank Alaris analyst Xiaoye "MD" Ma for his contribution to this article.

Pilar Dieter is director for Alaris Consulting in Shanghai, China.

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