bringing unique focus to industry andbusiness issues throughout Asia Pacific

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

For more information about our services, please contact:

Sydney: Steve Sherman +61 2 9286 9905 steve.sherman@fh.com.au

Melbourne: Peter McCluskey +61 3 9604 5109 peter.mccluskey@fh.com.au

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Adelaide: Bruce Carter +61 8 8100 7661 bruce.carter@fh.com.au

Brisbane: Greg Moloney +61 7 3834 9203 greg.moloney@fh.com.au

Indonesia: Rob Jolly +62 21 521 1658 robjolly@ferrierhodgson.co.id

Japan: Kentaro Mochizuki +81 3 3560 8301 kmochizuki@fh-tokyo.jp

Malaysia: Andrew Heng +60 3 2273 6227 aheng@fhmh.com.my

Singapore: Tim Reid +65 6416 1400 tim.reid@fh.com.sg

Or find out more at: www.ferrierhodgson.com

©Ferrier Hodgson 2011

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Related newsletters and articles

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: james.stewart@fh.com.au

Anh Wu Director, Melbournep: +61 9604 5679e: anh.wu@fh.com.au