What are the China issues which will impact the global supply chain?

What should you be thinking about?

A presentation by Michael Lee Serwetz, President, Prophet Business

Services

1.Currency Revaluation and Its Impact on Costs

a. What We Know• RMB-USD exchange rate 2006=8.15; RMB-USD exchange rate

10/25/2010=6.659; Difference=18.3% (since June 2010=1.7%)• Approximate monthly labor cost 2006 (Zhejiang) RMB 750-

1000; Approximate monthly labor cost to retain workers 2010= RMB 2000; Difference 100%+

• Monthly labor cost translated to USD 2006=$92-$123; Monthly labor cost translated to USD 2010=$300; Difference=143-226%

• China is a market with labor shortage so labor rates are not solely determined by government mandated levels. The undeniable fact is that labor, which has been a nearly inconsequential factor for China, will become very dear for manufactured product, especially those of low FOB value such as textiles.

b. What we don’t know (but can guess-ask me)

• Where will RMB-USD exchange rate land 2010-beyond. 6? 5? IF RMB appreciates to 6.5/USD and labor rate for 2011 increases only by the China Labor Contract Law of 2008 mandated 8.3%, monthly wage translated to USD will increase to $333, an increase of 13%.• This will also affect labor-intensive services such as

trucking and transportation.• What will effect be on materials? In dollar terms,

exchange rate appreciation will affect every part of the production process.• UPDATE: Latest inflation numbers have created an

upward push on exchange rates.

The answer

• My prediction on China currency rate 2011: Will pause at this level until CNY (3/2/2011) and after or during holiday period will move gradually to 6.5. This will be combined effort by PBoC with interest rates and reserve ratio to cool prices and inflation.

THIS WILL IMPACT PRICES-WHAT TO DO?

2. What are options for alternative sourcing?

What are your sourcing options outside China?

– In a word-small. There has been a lot of talk in the press about companies finding alternative sources for their products in other Asian countries. Most of these articles are written by reporters who have never been inside a factory or at least never tried to source a product.

– FACT: THERE IS NOT ENOUGH CAPACITY (NOT LABOR) IN ALL THE OTHER COUNTRIES IN ASIA (THAT COULD POSSIBLY COMPETE WITH CHINA ON PRICE) COMBINED TO MOVE A SIGNIFICANT AMOUNT OF PRODUCT AT THIS TIME.

– Also- Depreciation of USD has created appreciation of exchange rates of emerging nations such as Indonesia and Brazil. This plus labor/capacity issues will create upward push on prices from those countries, making them a less attractive alternative.

Here’s an exercise-Let’s compare 2009 exports of China to other countries (source: CIA World Factbook) All in USD:

• China= 1.2 trillion• Vietnam= 56.98 billion• Bangladesh= 15.91 billion• Thailand= 154.2 billion• Indonesia=119.5 billion• India= 164.3 billion• Malaysia= 157.6 billion• Philippines= 37.51 billion

The export number is a true indicator of capacity-a country that exports $50 billion CANNOT absorb too much from a country that exports 1.2 trillion.

OK, did you add it up? ALL THE OTHERS COMBINED=$706 billion.

The point should now be clear.

3. Labor Shortage in China

China Labor Issues Leading to Labor Shortage

– Population aging-Median age 35.2 compared with 27.4 Vietnam, 25.9 India, 27.9 Indonesia (36.8 USA)

– Low birth rate=14/1000 compared with 17.73 Vietnam, 21.72 India, 18.81 Indonesia (13.83 US)

– Younger population does not want to work in factory jobs.– Moving production to other provinces not a viable

solution-Chinese workers are migratory, so they will move to where the production is taking place. Longer term the same shortages will appear everywhere in China.

– Result- Higher costs=Higher prices

4. Political Developments and the Threat of Trade/Currency War

Political Issues– US, European politicians making political fodder out of exchange

rates. US is pushing to label China a currency manipulator and impose punitive tariffs.

– China has already restricted exports of rare earths, and it is an important export market for US and Europe. China also owns more foreign currency reserves than anyone. They have weapons.

– ALL countries are manipulating currencies in one way or another now, including the US. UPDATE: QE2 has polarized the key economies, and negatively affected G20 conference.

– G20=0. There is little chance G20 will agree on a viable solution as it would require coordination of currency and interest rates.

– Result: December 2010 will be a very interesting month.

5. What Should China Do To Cope with these Issues and Preserve Growth?

What do you hope China will do?– Grow the RMB gradually, over several years. Same calendar for

marketizing it.– Stay the course. Continue to develop the internal infrastructure and

economy. Focus on higher tech industries.– Extend road and rail to Middle and Western provinces so these

economies can develop.– Manage energy consumption to minimize shortages. Make maximum

use of solar, wind, hydroelectric, nuclear power.– Adopt a new business paradigm where labor is an issue. Minimize

labor cost and waste, maximize use of technology. – Pay attention to process flow and control.– Pay attention to Quality control to reduce waste of labor and materials.– Result: Continued development of China as viable source

Questions?