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When the GFC hit, China’s manufacturing sector
was exposed to the fallout of declining US and
European markets. Large numbers of the
workforce were laid off and many production
lines became idle. Since the GFC, not much
has changed: the workforce laid off during the
GFC has not returned and production capacity
remains constrained.
Rising cotton prices and increasing labour costs,
known as the “Foxconn effect”, are forcing costs
up, which is impacting Australian retailers and
wholesalers – particularly in the apparel sector,
where they find they are competing with some
of the world’s biggest retailers for product and
production delivery windows. The issue is further
exacerbated by a lack of suitable supply alternatives
for Australian retailers and wholesalers.
Specialty Fashion Group’s CEO, Gary Perlstein, hit
the nail on the head recently when announcing a
37 percent profit fall. “There is a new headwind
that the apparel retailers will have to manage,”
For well over a decade, China has been the primary
source of cheap and increasingly sophisticated
products for many Australian retailers and
wholesalers, as the once-slumbering giant emerged
as the world’s factory. It was a role it ably fulfilled
thanks to large numbers of low-paid workers and
abundant production capacity – the result of China’s
extensive investments in manufacturing facilities.
China Syndrome: Supply crisis for Aussie retailers
Perlstein said. “[It is] the inflationary impact of higher
yarn prices and increasing Chinese labour costs.”
Rising labour costsChina’s labour costs have increased nearly four-fold
over the past 10 years from an average US$1,000
pa in 2000 to US$3,900 pa last year. This steady
growth in China’s per-capita income and the
enforcement of minimum wages by the Chinese
government is giving rise to a middle-class tsunami.
The middle class is currently estimated to be up
to 300 million people (although China’s “middle-
class” standard of living can not yet be broadly
compared to Western cultures).
There are still a significant number of lower-paid
workers – estimated at around 800 million people –
many of whom migrate to wherever the work is. The
problem is that when many factories closed during
the GFC, many of these migrant workers returned
home and have not come back, preferring to find
new and better-paid employment opportunities in
industries servicing China’s own domestic demand.
February 2011
As a consequence, China’s manufacturers are
struggling to attract sufficient numbers of workers
to return to pre-GFC production levels. Across
China, labour costs have risen 105 percent in
a year due to the labour shortage and China’s
increasing cost of living.
Wages in China are generally set at a provincial
level and are subject to annual adjustments.
Consequently, an increasing number of larger
manufacturers are shifting operations to provinces
with lower labour costs. Whilst this reduces labour
costs for manufacturers in the medium to long
term, the cost of re-skilling a new workforce
keeps production costs high.
Cotton prices soared during 2010The cost of cotton doubled in 2010. Unfavourable
weather conditions in the US and China, together
with flooding in Pakistan and Queensland,
have devastated world cotton production.
Cotton is the primary commodity used in the
manufacturing process for apparel – representing
anywhere from 55 percent (denim) to 90 percent
(t-shirts and tops) of a garment’s total cost of
production – this is having a significant impact
on the cost of production. The impact is expected
to continue well into 2011.
Other issues pushing costs upChina’s manufacturers are now in a position to
pick and choose their customers and the orders
they fulfil, steering away from smaller or less
experienced foreign buyers. During the GFC,
retailers worldwide – responding to restricted
purchasing budgets – reduced their inventory
holdings. With production now ramping back up,
Australian retailers are competing against some of
the major international players to secure goods on
a timely basis. In some extreme cases, Australian
retailers are seeing supply terms extended from
six weeks out to six months. These delays often
mean the goods are received too late to be of any
value in their local market, leading to increased
discounting to clear stock.
There have been reports of Chinese
manufacturers cancelling production orders
and selling goods to the highest bidder, with
suggestions that this has increased prices by
20 percent or more. Australian retailers are
0
4,000
3,500
3,000
2,500
2,000
1,500
1,000
500
4,500(US$) The game changer
2000 2009
90%on 2000
9 years
1 year
2010
105%on 2009
195%on 2000
The rise in annual salary over the past decade for the average Chinese worker:
Source: Credit Suisse
0
140
120
100
80
60
40
20
160(US$) Cotton futures prices
Jan
08
Ap
r 0
8
Jul 0
8
Oct
08
Jan
09
Ap
r 0
9
Jul 0
9
Oct
09
Jan
10
Ap
r 1
0
Jul 1
0
Oct
10
Source: TradingEconomics.com
Note: each futures contract represents 50,000 pounds of cotton
US farmers toreduce cotton
acres during 2009
Pakistan flooding(July 2010)
February 2011
increasingly being forced to pay a premium to
secure production ahead of larger, primarily
international, retail chains such as Wal-Mart,
Costco and Tesco. Even orders placed by
Australian department stores (eg: Myer and David
Jones) are likely to be dwarfed by the purchasing
power of international mega-retailers.
This is also having an impact on the timing of
supply out of China. The move by global retailers
to reduce inventory holdings caused demand for
containerships to drop about 10 percent. With
production returning, Australian retailers are
fighting to secure passage on containerships to
reach local markets on time. Early signs of a US
retail recovery are only accelerating the problem.
The current infrastructure boom in China is also
placing significant upward pressure on a range of
other commodities within the Chinese domestic
market, most notably energy and fuel costs.
Increasing fuel costs for freight forwarders are
being passed on, having a further impact on
the landed cost of apparel and other products
destined for Australian retail outlets.
Manufacturing alternativesMany small-to-medium retailers are looking to
alternative sources of supply in other developing
markets, for instance India, Thailand, the
Philippines, Indonesia and Africa. However,
sourcing from other developing markets poses
challenges for retailers such as:
Quality of product – products coming out ■■
of less mature markets can often require
significant rework.
Workforce efficiencies – China’s workforce ■■
is rated the best in the world at 80 percent
efficiency levels compared to India and other
developing markets averaging 55 percent.
Proximity and limitations in production ■■
facilities and supply chains caused
predominantly by a lack of adequate
investments particularly in infrastructure.
Political instability.■■
To a large extent, many Australian retailers and
wholesalers have been able to manage rising
production costs in China by riding the rapid rise
in the strength of the AUD in comparison to the
USD (most transactions in China are made in
USD), but this could change quickly. In the future,
Australian retailers and wholesalers will need to
decide on one of the following strategies:
Increase prices by passing on rising costs to ■■
the end consumer.
Accept a decrease in profit margins.■■
Accept lower quality levels while re-skilling ■■
takes place.
ConclusionWe expect that the Australian retail market has
not yet seen the full impact of the rise in China’s
production costs. Subject to movements in the
Australian dollar, it is likely that 2011 will see this
position change and many Australian retailers and
wholesalers, if not prepared, could be caught out.
As one recent client put it: “China has become like
the Wild West – traditional customer loyalties have
gone and we are very much in uncharted waters.”
In the short to medium term (12-18 months)
we expect to see continued supply problems
for Australian retailers and wholesalers, resulting
in rising prices being passed on to consumers.
However, in the immediate term there is an
expectation that Australian retailers will be forced
to absorb a large proportion of any price increases
in product sourced out of China.
February 2011
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Over the longer term we are optimistic that China’s capacity will
return as factories re-open and resources are reallocated and this
should help to alleviate the current price / supply pressures.
Ferrier Hodgson has a specialist retail team with years of experience
working with clients exposed to the retail sector. We can provide
strategic advice, divestment services, acquisition due diligence,
operational performance reviews, financial health checks,
turnaround management, and management consulting. Ferrier
Hodgson also has extensive experience in retail property services,
including lease negotiation.
Supply and demandKey questions to ask your retail clients:
1 What percentage of product is supplied from China?
2 How strong are relationships with Chinese suppliers?
3 How have price increases and/or supply disruption impacted:
a The ability to meet customer expectations?
b Cashflow forecast performance? For example, have Chinese
suppliers requested upfront deposits, prepayments or LCs to
be provided prior to production?
4 What percentage of product is delivered on time out of China?
5 To what extent have price increases either been absorbed into
profit margins, or passed on to customers?
6 What plans are in place to mitigate supply disruptions or
price increases?
February 2011
James Stewart Partner, Melbournep: +61 3 9604 5642e: [email protected]
Anh Wu Director, Melbournep: +61 9604 5679e: [email protected]