China Plus ASEAN and India: Two Key Locations, One Company

As wages continue to rise in China, along with the comparatively high national welfare costs, increasing comment is being made as to the legitimacy of the “China Plus One” scenario. Coined some years ago, this theory – in reality, more of a shrewd observation – suggests that future manufacturing capacity will be placed both in China and externally in another location by the same manufacturer.

In fact, this has been going on for years, most notably between China and Vietnam. But the recent anti-Chinese riots in Vietnam have raised questions about the strategy. They have even prompted Hong Kong Shippers’ Council chairman Willy Lin Sun-mo to state that Hong Kong manufacturers based in the Pearl River Delta are running out of alternative, low-cost factory locations that have ample labor, following recent instability in their two preferred destinations, Vietnam and Thailand.

I wrote about China and the Vietnam and Thai issues – along with a risk analysis for doing business in the rest of Asia – in this article, “Anti-China Vietnam Riots a Passing Phase.” Willy Lin’s comments can also be construed as a mild political point to Beijing that placing oil rigs in disputed waters hurts Hong Kong manufacturers.

But beyond the recent China-Vietnam clashes, what is the real deal behind the China Plus One issue? Why haven’t thousands of China-based factories closed in the face of increasing costs? Where is the economic point at which China wages become non-competitive?

And is China’s superior infrastructure the reason why manufacturing will stay in China?

These are all important strategic questions for both the China-based manufacturer and the foreign investor to be asking.

How High Are Chinese Wages, Really?

This is not such a simple question to answer, firstly because China is a large country with considerable variation in cost of labor on a national basis. Secondly, because the cost of employing staff in China usually involves an additional expense in mandatory social welfare contributions – as is also the case in other countries.

But to get a handle on this, we can compare the average minimum wage in China against the other primary manufacturing destinations in Asia. I have taken the main ASEAN manufacturing nations as well as India to compare (see table below).

Note that these are average figures. That means that they combine lower minimum wage levels in some provinces with the more expensive minimum wage levels in other places – which tend to be precisely where manufacturing labor is required. The average China figure is actually a bit lower than it would be should we just take minimum wages around the manufacturing hubs of Guangdong, Zhejiang and Jiangsu.

In this comparison, China looks competitive when compared with Thailand and Malaysia. However, the minimum wage comparison is only part of the story. There is also the mandatory social welfare component to consider.

These contributions need to be paid by the employer on top of the salary, and are calculated on percentage basis against salary. There is some regional variation here, but not so much as to make huge differences to the mean average (see table below).

At 35%, China has relatively high social welfare compared to the rest of Asia. This means that when trying to get a handle on labor cost comparisons, it is important to take the wage level, and adjust it to take into account the additional welfare costs in each country.

An adjusted chart taking both wages and social insurance into account tells a more accurate story (see table below):

It should also be noted that, in China’s rush to wean the country from being an export-driven economy to become a consumer-based economy, it is state policy to place more money in the hands of Chinese nationals. This means that China is the only country among those shown above that has a specific agenda of raising workers salary levels on an annual basis.

There are some variables concerning salary increases, but over the past five years these have averaged 15% per annum. Any salary increase also impacts upon the welfare costs. These are useful figures that can be utilized to chart future costs in Chinese salaries looking forward.

To make it easier to break down, we can compare regional wages, including the added social welfare component, against China as follows (see table below):

So Why Aren’t China-Based Factories Closing?

In fact, they have been. The Hong Kong Federation of Industries warned back in 2011 that some 16,000 Hong Kong owned factories were at risk of closure. Of those, it is estimated about 30% actually shuttered their doors.

The figures for Taiwanese owned factories are similar. Many have slipped away to Vietnam or elsewhere. But this movement has largely gone unreported in international media as it has not tended to involve Western investors to the same degree.

This is because the business model of many Western-invested factories in China has changed. Instead of limiting their activities to purely export-driven manufacturing, the regulatory environment for foreign-invested manufacturers was altered a decade ago to permit local production to be sold in the domestic China market.

That was a game changer. Such factories are now concentrating on servicing China demand. Many are also engaged in improving their China supply chain and distribution networks.

So the answer to the question of factory closures is that, cheap Hong Kong/Taiwanese labor-intensive factories aside, manufacturing investment in China has evolved to service increasing China demand. Those factories that now focus on servicing domestic consumers are staying put.

When Does China Manufacturing Become Uncompetitive?

This question is actually industry-specific. Many manufacturers in China are doing very well, others not. We wrote about the winners and losers in different types of industry in China recently in this article, “South China’s Balancing Act Between Rising Wages and Keeping Investors Happy.”

How some China based businesses began to become uncompetitive can be traced back to January 2010. This is when the China-ASEAN Free Trade Agreement came into effect.

What this agreement broadly did was to reduce the import and export duties on 90% of all products traded between the ASEAN nations and China. This had an impact specifically on the more advanced manufacturing nations of Indonesia, Malaysia, Philippines, Thailand and Vietnam.

China-based manufacturers had a field day as they suddenly found these markets very close to home completely open. Cheap, labor-intensive factories – many owned by the Hong Kong and Taiwanese investors I mentioned earlier – flooded into these countries.

Since then, what has gradually been happening is the consistent rise in Chinese labor costs. This has meant that countries such as Vietnam have also grown highly competitive when measured against China.

But again, the issue is mainly industry-specific. Many China-based factory operations in high-end electronics and white goods, fashion products and plastic moldings, among others, are still highly profitable and likely to remain so. China is moving up the value chain, and these industries are doing well – for the time being.

Labor-intensive industries or those with thin profit margins for error are, however, at high risk, and this is where the China-Plus-One strategy comes in.

Why China?

The big deal about China is its transition from export manufacturing to a consumer-driven society. Briefly put, the impact of this means that China’s middle class consumer population is expected to rise from approximately 250 million today to 600 million by 2020.

That means an additional 350 million middle-class consumers will emerge across China in the next six years. The question then becomes this: Where is the manufacturing capacity going to be to service those consumers?

The answer is Asia. The existing China operations will evolve, and continue to provide some manufacturing facilities. But they are also changing to become more logistics and planning based, even to the extent of importing, warehousing and distributing products manufactured in a related factory elsewhere in Asia.

The China facility is still needed, but its function is changing. And the big win is in being able to sell to a Chinese consumer market that is more than doubling its existing size.

The real question then is whether the additional manufacturing capacity required to service this market should be added to the existing China facility or based elsewhere in Asia.

Increasingly, the cost dynamics are in favor of it being placed elsewhere in Asia. Hence the “China Plus One” issue.

The Infrastructure Gap

China’s infrastructure, especially in southern China and the Zhejiang/Jiangsu regions, is generally excellent. But this is less so once factories start to move inland. China actually has a serious shortage of central and inland warehousing, distribution and logistics facilities inland.

There is still an infrastructure gap between Shanghai for example and Ho Chi Minh City; Guangzhou and Manila and any other permutations. Operating a factory in many ASEAN countries means having to deal with an infrastructure not as well developed as on China’s eastern seaboard, and this eats into productivity levels. 

As a general rule of thumb, according to Dezan Shira & Associates clients in Vietnam, Indonesia, India, Philippines and elsewhere, it often makes economic sense to place manufacturing capacity into a secondary location if the facility can get production levels up to 70% of the equivalent operation achievable in China.

Tax Issues

Another issue to bring into the equation is the rate of profit tax. This is a moving target in Asia, although the situation in China is quite consistent. Foreign investors who are taking the bulk of their profits in China may also wish to examine the regional alternatives. Dividends taxes apply to foreign investors who wish to repatriate their profits back to their parent company (see table below).

Of these, it should be noted that several countries are set to reduce taxes below that listed above. India, for example, is expected to finally get its tax reform bill through Parliament, and this is likely to see a reduction in corporate income tax (CIT) from 40% down to 30%.

The Philippines too has been discussing the same, with reductions to 25%. Vietnam has already said it will reduce CIT to 20% by 2016. These moves will make the economic debate concerning the placing of additional manufacturing capacity into Asia much easier to acknowledge.

Investment Incentives

China essentially standardized its tax position a decade ago and apart from a few examples, did away with many of the 15% profit tax rates and five-year tax breaks that marked much of the 1980s and 1990s, and which encouraged foreign investment to pour into the country.

China isn’t so much of a bargain hunting ground when it comes to such deals nowadays. Incentives are restricted to underdeveloped geographical regions and highly specific technologies.

That’s not case with the rest of Asia. All ASEAN nations as well as India have free trade and special economic and export processing zones, many of them offering the same sort of tax breaks and low tax rates that China did a decade ago.

When it comes to ASEAN and India, there are many tax breaks and investment incentives around just as there used to be in China – so do your research and shop around.

Winners in Asia

Winners in Asia as we stand today include Vietnam, whose planned 20% CIT rate in 2016 will be lower than China’s 25%. With a new government in place, India has both the benefit of an inexpensive, huge and growing labor pool, as well as improving infrastructure.

China has itself recognized the growing importance of India as a manufacturing hub to service the China market. The Chinese government has offered to finance 30% of India’s US$1-trillion infrastructure development requirements to allow this to happen. Plus India also has a massive consumer market – one reason Ford has located its entire non-U.S. auto manufacturing capacity in Gujarat.

It should be noted that India also has a Free Trade Agreement with ASEAN – meaning that 90% of all trade and services between the two are now duty-free. This provides an added incentive to establish an ASEAN manufacturing facility to service not just China, but ASEAN and the Indian markets in one fell swoop.

The Philippines is also likely to do well. Despite the recent row over maritime borders, bilateral trade has been increasing. A booming Manila gambling scene, away from the eyes of the Chinese secret service, and spectacular beach resorts are fuelling a Chinese tourism boom.

And widespread usage of English and, again, an improving infrastructure are helping the Philippines become an Asian investment sweet spot.

Indonesia, too, is also offering a large pool of competent labor, an increasingly educated workforce, and a sizable Chinese diaspora that has seen first-hand management techniques employed in mainland China and setting up similar operations in Java.

There is a lot of truth to the notion that the Indonesian city of Surabaya is set to become that country’s equivalent of Guangzhou – yet how many foreign investors have heard of it?

Malaysia also offers a number of joint venture business parks, run along the proven Chinese model, and these, too, offer incentives and tax breaks that are no longer available in mainland China. Malaysia is politically stable, and provides excellent infrastructure – as anyone who has taken the highway from the airport to downtown Kuala Lumpur will testify.

Caution Required

But Thailand looks set for a period of military rule, which is likely to put off some foreign investors until the country demonstrates political stability. When viewed as a longer term play, Thailand has excellent dynamics and is strategically placed in the centre of ASEAN.

This makes the country an ideal base from which to reach out to ASEAN’s own consumer market, as well manufacture to service China and beyond. This is the reason Volkswagen has decided to base its Asian production facility in Thailand, while retaining existing China operations for the growing Chinese domestic market.

What about Cambodia, Laos and Myanmar? The reality is that none of these countries as yet have any significant infrastructure in place. Salary levels may well be low, but generally speaking, the infrastructure gap is too wide at present to make them viable. Neither are their international tax obligations especially advanced – Cambodia, for example, has signed no double tax treaties at all with anyone.

For the next decade, these countries will remain the preserve of big ticket infrastructure developers and will remain a step too far for many, although over time this will change – just as countries like Vietnam and Thailand will start to become expensive. But that is some way off yet.

Conclusion

Operational and economic trends, as we have seen, dictate that Chinese labor is and will continue to become more expensive, while the Asian infrastructure gap is narrowing. Yet China’s own domestic consumer market is growing, as are those in the rest of Asia – ASEAN and India included.

China Plus One, the strategy of locating a secondary production facility elsewhere in Asia, is not just a theory. It is an economic necessity.

Foreign investors wishing to sell to the China market must now start to compare the economic costs of doing that exclusively from China or placing part of the capacity elsewhere in Asia.

About the Author

Chris Devonshire-Ellis is the founding partner and principal of Dezan Shira & Associates, a specialist foreign direct investment practice that provides advisory services to multinationals investing in emerging Asia. This article was first published in China Briefing and was re-edited for clarity and conciseness. For further details or to contact the firm, please visit www.dezshira.com.

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