Chinese Manufacturers Face Challenges in a Credit-Sapped Economy: Surviving the Year of the Ox

David Tsoi, Global Supply Chain Manager, Asia-Pacific Global Trade Services at J.P. Morgan weighs in.

China is widely known as the world's manufacturing hub. Most Chinese coastal small- and medium-sized enterprises (SMEs) are exclusively export-oriented and rely upon foreign customers for their sales. They are especially focused on demand from the United States and Europe. These SMEs are an important pillar of the economy as they generate almost 60% of China's GDP and 68% of China's total exports. However, during the current financial crisis, foreign orders have declined substantially and many SMEs have gone out of business.

Although there are no official statistics, the China Economic Review estimates that 3,631 toy exporters (more than half the industry total) went out of business in 2008. The same study suggests that more than 10,000 export-oriented clothing and textile industries players closed and that others are struggling for survival. As a result, the Chinese government estimates that more than 20 million displaced workers, or 15.3% of rural workers employed outside their hometowns, have returned to their family homes without jobs.

• Four Challenges Faced by Chinese Exporters

A careful review of the current economic landscape and its impact on the Chinese economy reveals four challenges faced by Chinese manufacturers looking to stay in business.

1. Shrinking global demand: This is the biggest concern for most manufacturers as there are not enough sales orders to sustain the industry. The current financial crisis has resulted in a slowdown in trade around the world. The World Trade Organization estimated a record 9% drop in world trade in 2009 — the largest decline since World War II.

2. Currency appreciation: Since July 2005, China's currency, the Renminbi (RMB), is no longer pegged to the U.S. dollar — a change which was intended to ensure that the currency reflects more of a true market price. China reformed the exchange rate regime by moving into a managed floating exchange rate regime based on market supply and demand. Since then, RMB has appreciated about 20% against the U.S. dollar.

Throughout the current financial crisis, the value of the U.S. dollar has risen sharply while RMB has remained relatively stable compared to the currencies of other countries, which have significantly declined against the dollar. Consequently, Chinese exports are now more "expensive" and cannot compete with goods from countries whose currencies have fallen against the dollar. For example, both the Indonesian Rupiah and the Indian Rupee have fallen 18% and the Pakistan Rupee has fallen 13% against the dollar since August 2008, making goods exported from these countries less expensive compared to Chinese exports.

3. Higher labor costs: In January 2008, the PRC government introduced the Labor Contract Law with an aim to enhance workers' rights by setting minimum wages, creating overtime limits and requiring one month's pay for each year worked for dismissed employees. This new law has added a financial burden to companies already struggling to cope with the current state of the economy. In addition, the law is proving to be an obstacle to the hiring of temporary workers — a common practice to cope with fluctuating orders. It is estimated that this law has driven up labor costs by 20%.

4. Difficulty obtaining bank financing: Difficulty in raising capital by SMEs has become a critical bottleneck as commercial banks are generally very cautious about lending to SMEs. According to the China Association of SME, SMEs account for less than 25% of total bank loans. As the cross-border financing industry has been moving payment terms away from traditional Letter of Credit (LC) to the riskier Open Account process, Chinese banks have become more reluctant to provide pre-shipment and/or post-shipment financing to exporters without ways to mitigate buyer risk. Chinese banks find it difficult to extend credit in this financial environment. When banks do extend credit it is usually under very rigid conditions. Some exporters have had to pledge their production lines and factory buildings in order to get financing.

• China Acts to Support Chinese Manufacturers

The shrinking external global demand has caused the closure of Chinese factories and mass exodus of migrant workers who have returned to the countryside without money or job prospects. This situation contributes to the risk of social unrest and has put pressure on the Chinese government to act. The government's reaction has taken the form of three policy measures designed to aid the export industry.

1. Boost domestic demand: In November 2008, China announced an aggressive spending initiative valued at 4 trillion yuan (i.e., USD585 billion), which over the next two years will aim to boost domestic demand. An example of this measure is a subsidy scheme available to farmers to help them buy household appliances (including designated brands) to increase demand for domestically produced TV sets, refrigerators, mobile phones, water heaters, air conditioners and computers. According to the Vice Minister of Commerce, China expects this household appliance purchase subsidy program to help stimulate rural consumption amounting to USD135 billion (920 billion yuan).

2. Support exports by increasing VAT rebate: China has also increased the export tax rebates of approximately 3,500 items in November 2008. This was the third time in the course of a year that China raised its export tax rebate. This rebate affects mainly items produced by labor-intensive industries such as toys, textile, garments and furniture — products which account for 25.8% of China 's customs tariff revenues. This increase in the VAT rebate is expected to ease financial pressure for export enterprises and enhance their competitiveness in the global market, which should help increase exports.

3. Monetary policy — loosened credit: The People's Bank of China has made several changes to its monetary policy to help ease liquidity conditions and boost corporate financing by cutting interest rates, reducing reserve requirements for banks and lifting administrative controls on banks' lending business. These changes have contributed to a sharp growth in RMB loans. In the first quarter of 2009, RMB loans outstanding soared 29.8% compared to the fourth quarter in 2008. This growth rate is the highest on record as banks actively strive to extend credit with the government's encouragement.

• Impact of China's Actions

The implementation of China's policy measures has had a varied impact on the national economy. The subsidy program is helping to boost domestic demand as there is currently a marked increase in demand for household appliances in the rural areas. The limitation of this policy is that it only supports a specific group of manufacturers, not the exporting community as a whole.

In addition, the Chinese government has loosened domestic trading rights, a seemingly attractive avenue for manufacturers, as it opens up the domestic market to many companies that had not previously been permitted to sell domestically. It is now easier for manufacturers to apply for a license granting them access to the domestic market. However, several shoe and textile manufacturers are not interested in the domestic market because it typically generates small profits and non-payment or late payment situations are common.

The export tax rebate is proving to be a direct boon to exporters by helping reduce exporters' costs and to improve the competitiveness of their products. As estimated, the value-added tax reforms could cut companies' costs by USD17.5 billion.

Although there has been an increase in RMB loans, the amount that is actually being lent to SMEs is still an unknown. Some indications are that the majority of RMB loans have been made to government-supported infrastructure projects or for the post-earthquake reconstruction, which would imply that most SMEs are still finding it difficult to get financing from banks.

• How can Global Buyers Help Chinese Manufacturers?

As long as China remains the manufacturing hub of the world it is critical that international buyers support their Chinese suppliers. In today's economic environment there are two sure-fire solutions: Letter of Credit or Supply Chain Financing.

Globally, credit continues to be a scarce resource and not every international buyer has access to a credit facility to issue an LC. However, buyers that do have credit lines should use them to issue LCs to Chinese exporters. In turn, this will help exporters obtain local financing to manufacture the product and, in many cases, this financing will probably be at a lower cost, helping to minimize the amount of finance cost that gets built into the cost of goods.

On the other hand, if an international buyer decides to migrate to the riskier Open Account (OA) payment term, buyers should work with their banks to provide supply chain financing to their suppliers, typically SMEs in China. For example, an apparel firm may have moved all its sourcing from LC to OA two years ago. At that time the global economy was stable and there was no need to provide supply chain financing to its suppliers as they are able to seek financing easily themselves. However, in today's economic environment, this apparel buyer should now offer financing to its suppliers in order to keep them viable and manufacturing needed product — a major concern for buyers with highly specialized suppliers.

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• About the Author

David Tsoi is the Asia-Pacific Global Supply Chain Manager for the Global Trade Services group at J.P. Morgan. Over the course of his 20 year career, David has amassed cross-border trade, credit and financial supply chain experience at several Japanese, European and U.S. financial institutions. David graduated from The Chinese University of Hong Kong and earned his masters degree from The Hong Kong Polytechnic University.