BEIJING – Looking beyond China's borders, we see increasing uncertainty in the global economy. Europe is sinking further into crisis and has great difficulty in finding solutions. The American economy, though highly efficient and with a famous capacity for reinvention, has a debt ratio around 100%. The measures its government can take are limited.

Chinese enterprises that used to rely on Europe and the U.S. as locomotives will face great problems. The domestic manufacturing sector is also facing a market slowdown, stagnation, overcapacity, increasing labor costs, and a general need to upgrade. Facing all these issues, what is the way out for China's businesses?

At the end of 2011, Midea, a Chinese conglomerate specialized in the manufacture of household appliances, was obliged to lay off its workers. "We expect China's overall home appliance and furnishing sales will be particularly depressed in 2012, so we are taking the layoff decision in advance," one high-rank manager revealed to Economic Observer. "For both the external and domestic markets, there's going to be certain degree of decline in the coming year. Chinese enterprises have to review their business models and make strategic changes if they are to continue rapid growth."

Laying off workers is only one of the difficult solutions being considered. Among the companies we surveyed, more or less all agree that 2012 is going to be a tougher year than 2011. As to how to react, their choices varied. Some are choosing to postpone the startup time of the production line; others are shifting their production lines from the coast to the lower-cost inland areas; some are retreating from the traditional manufacturing sector and restructuring themselves; some have converted from the export to the domestic market.

Cheaper labor

According to Deloitte consultants' most recent China's Competitiveness Report, most southeastern Asian countries' labor cost is about 50% of that of China. The rising average wage of Chinese workers is making China lose its competitiveness in labor-intensive sectors.

Other data shows that China's manufacturing cost, which was 22% lower than that of the U.S. in 2003, was only 5.5% cheaper by the end of 2008 – and continues to decline. Though the principal cause has been the more than 30% appreciation of the yuan, rising wages and housing prices also push up costs.

The trend among European and Japanese enterprises that had once invested in China are now transferring their orders to Southeast Asia. In the past, China relied on cheap labor to occupy the low to middle range markets, whereas the high-end market has always been occupied by American and European manufacturers. Mei Xinyu, a researcher at China's Ministry of Commerce says: "At the high end, China is being blocked by the West, while Vietnam and India are muscling in on the low end. China is being squeezed from both sides."

Apart from the increasing labor cost, there's also the rising cost of raw materials. In the past year, prices of coal and cotton have both gone up 40%, timber 15%, wood pulp for paper 50%, non-ferrous metals 30%, crude oil 32%, iron ore 90%, even agricultural products went up by 26%. All of this helps eat away manufacturers' profits.

Zhu Jiming, Chairman of Shougang Group, one of China's biggest steel companies, told the Economic Observer that profits of China's medium to large sized steel enterprises slid from 7.26% in 2007 to 2.91% in 2010.

Yet, the pressure to appreciate the RMB's is still increasing. Tim Condon of the Netherlands International Group expects the yuan will appreciate 3% during 2012. He predicted that due to European countries' decreasing need for China's exports, the Chinese government's fiscal tightening policy will induce a decline in Chinese consumer spending.

Product and service innovation is the biggest challenge a business faces in maintaining its competitiveness. For this reason, the Chinese government has set up a series of industry development goals and has requested large-size enterprises to set aside 3% of their annual revenues for R&D investment.

The Midea Group has proposed to increase its R&D, aiming to "transfer its attention from the importance of scale to attention to profits." Dong Mingzhu, the President of Gree Electric Appliances Inc., a company which has always taken pride in its innovation, claims to set no limit in the company's investment in R&D, and contributes over 10% of its annual revenues to this end. Other companies seen as models in this effort are Huawei Technologies and ZTE Telecommunication.

Relocation, relocation, relocation

However, according to the report from Deloitte, in practice, large manufacturers' R&D investment lacks specific assessment of effectiveness. Some only use the funds to buy prototypes and conduct external testing, whereas there's little real involvement in core technological systems. In comparison to the relative neglect of R&D in China, large global enterprises' investment in their R&D increased by 4% in the past year.

Relocation is another method of rescuing the Chinese manufacturing sector. Among the 150 companies interviewed by Deloitte, 125 expressed their willingness to relocate abroad, mainly in Vietnam, India, Cambodia and Indonesia, where the labor cost is relatively cheaper than in China. Consumer product companies' foreign investment is relatively higher than the others; some 20% show their interest in investing and building factories abroad. Meanwhile, some Chinese enterprises are also actively moving towards the upper part of the industrial chain. More and more Chinese companies are getting advanced technologies and brand names through overseas acquisitions.

According to data from ChinaVenture, in 2011 China's outbound mergers and acquisitions totaled 30.6 billion euros --among which the Lenovo Group spend 231 million euros in purchasing 36.66% of Medion AG, a German electronics company. In November, Huawei announced an agreement to purchase Symantec for $53 million, which will solidify Huawei's leading position in the computer business. In the first half of 2011, 32 Chinese manufacturers made overseas acquisitions, which nearly doubled those of 2008.

Thus the transformation of Chinese manufacturing is driven by two parallel trends: the relocation of labor-intensive industries to low-cost countries, and the introduction of capital from developed countries for technology-intensive and high-value industry.

But ultimately, says Wei Guo, the analyst of Changjiang Securites, all countries are bound to return to the manufacturing sector, because it remains the foundation for creating wealth, employment and innovation. It is a lesson that China must now learn in a whole new way.

Read the original article in Chinese

Photo - Robert Scoble