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The Next Frontier of Sourcing:

As China Looks West, Should Sourcing Executives Follow?

Sourcing Journal

Managing Editor

Patrick Lamson-Hall

March 2012


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Overview

Section I

Policies

a. Minimum Wage Increasesb. Hukou Systemc. Go West, Chinad. Currency Markets

Section II

Recommendations

a. Overheadb. Capital Costsc. Technologyd. Partnerships

Section III

Country Profiles

a. Bangladeshb. Hondurasc. Indiad. Turkeye. Vietnamf. Sri Lanka

Conclusion


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Overview

Sourcing in China is getting more expensive. Wages are rising in all provinces andrelocating to the interior is difficult and costly. Manufacture of many goods ismoving away from China, to an emerging basket of countries that each offer uniqueadvantages and disadvantages. They all share low wages, and they all lack the sort ofindustry clustering that has made China such a comparatively simple place to dobusiness.

This white paper will discuss some of the factors that are driving the movement ofapparel and textile manufacture within China and beyond. It contains countryprofiles, and information on the benefits and pitfalls of Sri Lanka, India, Vietnam,Bangladesh, Honduras, and Turkey some of the more serious competitors forChinese manufacturing. It discusses capital costs, capacity issues, specializations,labor conditions, and cultural customs, to insure that the reader of this paper will besuccessful in a diversifying market.

The graph below illustrates the shift by share of US imports, as other countries inSoutheast Asia are able to capture a growing portion of the US import market. Formost countries listed, the results are short term, influenced by the recession andother factors. For China, however, this represents a long-term trajectory.

This paper was the result of a collaboration between the sourcing solution companyTradeCard and Sourcing Journal.


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Section I - Policy

The Chinese government regulates almost every facet of the business environment.Three policies that have a major impact on exporters are minimum wage laws, theHukou system of internal passports, and Chinas plans for westward expansion.Rising labor costs in China are driven both by government policies and the regularfunctioning of the labor market.

A. Minimum Wage Increases

Chinese minimum wage laws vary widely based on location. In capital cities alone,the monthly minimum wage ranges from a low of 760 RMB in Lanzhou, Gansuprovince, to a high of 1500RMB in Shenzhen, Guandong Province. This massivespread gets even wider when the wage in cities outside provincial capitals is takeninto account. The one thing Chinas wages have in common is an alarming tendency

to increase.

The latest 5-Year Plan on Employment Improvement calls for annual wage increasesof at least 17%, not including overtime. However, this targeted increase will likelybe exceeded, as severe labor shortages continue in coastal provinces. Wageincreases have ranged between 50-100% annually for the last several years, largelydriven by regional government action.

The central government dictates increases in the minimum wage as it sees fit, inaddition to regular increases prescribed in the 5-Year Plan. Generally, ad hocincreases are in response to concerns about inflation in housing and food prices.This inflation has been red-hot in China in recent years, prompting labor unrestamong migrant workers.

The government has an official policy of promoting harmony and moderateprosperity and maintains its legitimacy by delivering regular standard of livingimprovements to its citizens. Minimum wage increases insulate it againstaccusations of non-responsiveness. Unfortunately, they are a blunt tool, and candisrupt the economics of export-oriented industries. Exports totaled over $1.6trillion in 2011. To counteract this effect and to encourage microeconomic stability,the government is promoting increased domestic consumption. This, again, isfacilitated by a higher minimum wage, which gives Chinese citizens increasedpurchasing power.

Hukou System

The central government maintains a system of internal passports known as theHukou system. Hukou divides residents into rural and urban classes, and separatesthem by province.


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Workers moving from rural to urban areas or crossing provincial borders losestandard labor protections such as unemployment insurance, health, and pension.The majority of Chinas migratory workers have left their home provinces withoutobtaining urban status. This is beneficial to employers in the short term, becausethey are responsible for paying the lions share of those benefits.

However, the Hukou system represents a long-term threat to Chinas prosperity, andan immediate threat to its export oriented economy. By removing labor protectionsfor migrant workers, who represent the bulk of Chinas unskilled workforce, thesystem incentivizes workers to stay within their home province. This creates wagepressure in the coastal export zones something that has been seen for severalyears, as workers fail to return from the Chinese New Year. This year, laborshortages following the New Year have amounted to as much as 50% of capacity inthe garment finishing industry. To avoid these issues, many factories are relocatinginland.

Go West, China

The Chinese government is pushing to industrialize its interior, away from thecoasts. They are improving road and rail links to coastal ports and subsidizing lowcost development of industrial space, as well as extending Special Economic Zonerules to all provincial capitals. Conditions in the interior are improving, making itmore feasible and desirable for Chinese workers to migrate to regional hubs, ratherthan coastal metropolises.

The transition to the interior has been less beneficial for factories than it has been

for workers. Bringing more jobs to inland China is exacerbating labor shortages onthe coasts, and the lower wages of the inland areas do not fully cover the additionalcost of overland shipping. As a result, the disbursement of manufacturingthroughout China has been accompanied by the movement of factories to othercountries in the region Vietnam, Bangladesh, and Sri Lanka are particularfavorites. Because of logistics and capacity differences, each country has variousstrengths, weaknesses, and specialties.

There is no reason to believe the labor shortages on the coast will be relievedanytime soon. Factories that are unable to find workers will continue to shift toother countries and into the interior. This means that the days of the one-stopsourcing shop are numbered.

Currency Markets

Costs of goods from China are also rising due to weakness in global currencymarkets. Despite efforts by the Chinese government to maintain an artificially weakcurrency, the RMB has strengthened from 8.3 to the dollar in 2005 to roughly 6.3 to


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the dollar today. In practical terms, this makes buying Chinese goods 24% moreexpensive due to currency conversion costs.

This is coupled with even strong trends against the Euro, where Chinese currencyhas moved from a low of 11.5 to the Euro in 2005 to a recent high of 8 to the Euro.

This is primarily due to an ongoing crisis in the Euro zone, but is linked to China'sinability to control its currency in the long term. The 25% increase in currency costshas been a long time coming, as China's central bank is balancing its inflationaryconcerns with its need to maintain a strong export sector.

Alternatives to China also sometimes experience currency fluctuations. Developingnations in particular are subject to sudden spikes and valleys in the value of theircurrency. However, due to its long-term policy of currency control, the RMB haspent up value that will need to be realized in the next few years, in the form of astronger currency. While other nations may move up or down in terms of theircurrency strength, they tend to maintain the same relative value over time. The

direction for China, at least for the time being, is only up. This further erodes itscompetitive advantage for RMB denominated transactions.


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Section II - Recommendations

In an already struggling economy, this changing business landscape will put seriouspressure on companies that can't keep up with the times. Many formerly prominentbrands have fallen by the wayside because they couldnt balance their costs andrevenues, or find the next efficiency.

Here are a few tips:

count your capital costs

count your currency conversion costs

keep an eye on overhead.

It may seem cheap to open an office in Pakistan compared to China, but those costsavings rapidly disappear when you also need offices in Bangkok, Singapore, andManila, and youre losing 3% on every conversion.

For most small and medium sized companies without insider knowledge, the bestway to navigate sourcing from different countries will be to use third party agentsand computerized tracking systems. Those will enable an executive to monitor theirglobal sourcing chain in real time without needing to buy a plane ticket.

Competitive companies also need to embrace technology.

Companies that enthusiastically move into electronic tracking, computerizedpayment protocols, bank to bank money transfers, and virtual meetings, will see anadvantage on FOBs, because their cost of doing business will be substantially lower.That advantage could prove critical if current discounting trends and raw materialsprices persist.

Additionally, embracing technology puts pressure on factories to modernize, whichwill make them more efficient, able to produce quality goods, and respond rapidly tochanging designs.

One reason China was able to move up the value added chain and capture so muchmarket share so quickly is because Chinese factories rigorously adopted moderntechnology, in order to increase productivity. Chinese garment output has doubledin the last decade, but the number of workers used has only increased by about15%. This is less the case in the countries where production is moving, so expectmore of a struggle in facilitating early adoption. Still, it's worth it to push. In ten

years, everyone who is serious about their business will be on PLM and autocompliance systems at a minimum, and that means factories need independentsupplies of reliable electricity and broadband Internet access as soon as possible.

A note on capital costs - sourcing executives have grown fat on the back of Chinasultra stable monetary policy. Unfortunately, even for companies that continuesourcing in China, that era of stability is rapidly drawing to a close. The Chineseneed to reduce inflation, and the three ways they can do that are by increasing


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worker salaries at a pace that exceeds it, by allowing their currency to float, and byincreasing real domestic spending by shifting investment into domesticallyconsumed high value consumer goods. All these things are bad for low-cost exportoriented sourcing companies, and they are all already underway.

As you move your company through this transition, make sure you have the rightpartners. You need people on the ground that know local customs and can alert youto potential pitfalls. Ask yourself how you will communicate with your suppliers.How will you pay them? Consider contracting with a PLM or auto compliancecompany. It may be your cheapest option.


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Section III - Country Profiles

The trends described above will increase costs in a number of ways. Even for theexecutive who successfully navigates the diverse regulations, financing needs, andshipping environments of these countries, there are still the simple matters ofcustoms and travel time. In 2005, an executive could fly to Shenzhen and visit fivefactories in a day, then fly home. Now that same executive needs five days to visit hisfive factories, and two of them are spent in transit. Meanwhile, behavior when doingbusiness in Bangladesh is not the same as in China.

The same customs and travel problems exist for the goods themselves. Despitesporadic talk about a Chinese backed east Asian free trade zone, goods movingbetween most countries in Asia still have duties and still sit in customs. So if yourbuttons and fabric are from China and your shirt is stitched in Bangalore, you paycustoms and shipping twice - from China to Bangalore, then from Bangalore to thetarget market. That amount of shipping and customs also lengthens lead times.

Here's a quick rundown of some recommended alternatives to china, and why theyare more difficult places to do business than China was:

Bangladesh

Capacity: Capacity in finished pieces is difficult to assess because the information isproprietary. However, total apparel exports are soon to exceed $30 billion,compared to Chinas approximately $220 billion in 2011.Bangladesh has over 4000enterprises manufacturing textiles and apparel. Many of these came online beforethe financial crisis reduced demand in 2008-2009, cotton prices spiked, and a 2010-2011 local stock market crash reduced available investment and capital.

The country is regarded as having poor spinning and weaving capacity due to itsrelative lack of raw materials. As a result, most of its yarn and fabric come fromChina, as well as trims. This can add up to 30 days to lead times, because of timeneeded to order and transport materials.

Capital Costs Transacting with suppliers in Bangladesh typically requires usingletters of credit. Open account transactions using some of today's cloud-basedofferings can provide visibility for all parties, including financial institutions,eliminating the costs and credit utilization concerns associated with letters of credit.

Payment with a letter of credit in Bangladesh requires a minimum 10% cash margin.The margin can range as high as 100%, depending on the relationship with thebanker. In special circumstances it is possible to use Cash Against Documents forpayment. The benchmark interest rate is 7.25 percent as of this writing. With that inmind, it is strongly recommended to use open account transactions or third partydirect transfers.


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Labor Supply The minimum wage is approximately $40/month. The nation has alabor supply of 73.8 million and an unemployment rate of 4.8%. The populationgrowth rate is 1.6% per year. The growth rate in industrial production isapproximately 6.4% per year. Assuming limited productivity gains, it is safe to saythat Bangladesh does not have the potential for rapid labor force transfers to textile

and garment production. For comparison, Guangdong Province in China has apopulation of 104 million.

Specialties The country specializes in knitwear, and is attempting to buildbackward linkages in order to reduce lead times, though this will not solve itsfundamental lack of raw materials.

Financing Protocol It is possible to obtain L/Cs from government banks such asJanata, Agrani, Sonali and Krishi Bankand 28 private local banks, along with manyinternational banks. However, the financial sector is undercapitalized, so it may beadvisable to use alternative payment protocols, such as third party facilitated bank-to-bank transfers.

Cultural Tips Business customs can be quite formal. Public displays of affection arefrowned upon. Keep business cards handy, as they are freely exchanged. Englishfluency is common, but is by no means guaranteed. Avoid pointing the soles of yourfeet at people or pointing at anything with your feet.

Honduras

Capacity Honduras is the leading ready-made supplier in Central America. Itsuffered declines in light manufacturing volume in 2009, but has reboundedsomewhat in the last two years. It has a total workforce of 2.8 million, and 31% ofthe national GDP is in light manufacturing such as textiles. Exports grew 19% lastyear, and are now approaching $2 billion.

Honduras receives most of its yarn and fabric from the United States, due to sourceorigin provisions in its FTA that grant it duty free access to the US market. Transporttimes are relatively short, however the added cost of shipping raw materials,combined with added lead times, nullifies a lot of the advantage Honduras enjoysfrom labor cost.

Capital Costs The real interest rate in Honduras is very high, at 12.45%. Obtaining

an L/C from a Honduran bank can therefore be a costly proposition. It is possible tofinance orders through foreign banks, however, and the country is trade liberalizedwith the global banking system, making direct transfers a feasible option as well, forthe buyer with sufficient capital.

Labor Supply 2.8 million workers live in Honduras, and 1/3 of them areunemployed or underemployed. The workforce is very young generally below age25 and has a literacy rate of approximately 90%. Unfortunately, the country is


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highly strike-prone, with labor unrest frequently halting all economic activity. Theminimum wage is approximately $280 USD/month.

Specialties Honduras uses a one-stop or Full Package concept, as it is knowndomestically. The textile industry is structured around manufacturing every part ofa garment in country (except the yarn or fabric). This can produce a high value-addand low FOB by streamlining processes. It tends to privilege efficient and precisebuyers who desire control over the entire scope of production. Their time zonelocation favors just in time production for the US market.

Financing Protocol L/Cs are standard in Honduras. There is a range of privateinternational banks available, along with a government bank, Banco Central deHonduras. The financial sector is deregulated and it is possible to use L/Cs frombanks without a presence in Honduras. Honduran L/Cs generally require a depositof approximately 30%.

Cultural Tips Handshakes are generally limp and prolonged, except among

internationally savvy Hondurans. It is normal to use formal titles and last namesunless requested to do otherwise. Appointments should be made at least two weeksin advance. It is important to bring materials that have been translated into Spanish,though conversational English is quite common.

India

Capacity India has massive capacity for RMG and yarns and fabric production,possessing over 45% of the worlds looms and 23% of its spindles. It has 25,000domestic manufacturers and 48,000 fabricators. It is the worlds second largestproducer and consumer of cotton (China is first), and is expected to produce $115billion in goods in 2012.

As an example of its capacity, the denim sector alone can produce 650 millionmeters per year, and is adding 100 million meters in capacity in the next two years,with 60% of its production directed to its enormous domestic market. India rapidlyincreased capacity before the global slowdown of 2008-2009, and has largeamounts of equipment that are currently going unused. With this in mind, its highlycompetitive garment sector is attempting to stoke internal demand.

As a leading producer of cotton, India enjoys an advantage in raw materials

availability. However, man-made fiber is generally sourced from China, and wooloften comes from beyond Indias borders as well. It is important to consider theadded cost and lead time issues involved in this, particularly since Indian customsare notoriously difficult, and India lacks free trade agreements with many major rawmaterials suppliers.


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Capital Costs The benchmark borrowing rate for India is 7.5% at the moment. On aletter of credit, expect to pay between 1/8% and 1/2% per quarter. Fees can rangefrom as little as $150 USD to as high as $1000, depending on the bank used.

Labor Supply India has a labor force of 478 million. Approximately 35 millionpeople currently work in apparel and textiles. The official unemployment rate is10%, but it is estimated that as much as half of the workforce is underemployed. It isamong the youngest workforces in the world and is growing rapidly. Wages are setby individual states, but the federal minimum wage is approximately $2.31/day.

Specialties Because of its large domestic market, the textile industry in India has adiverse range of specialties. Within the export sector, its most prominent exportsare cotton readymade garments and accessories, destined for the European market.

Exporters in India have not pursued an integrated production facility model, unlikein China. The supply chain is fragmented and beset with bottlenecks that increaselead times to 45-60 days, versus an international standard of 30-35. In that regard,

India might be said to notspecialize in on-time production.

Financing Protocol Payment is normally through irrevocable letters of credit, anda term of 90 days is standard. Quotations are required to indicate FOB prices, withseparate listings for freight and insurance. The Reserve Bank of India supervises anetwork of scheduled commercial banks, from which it is recommended to obtainfinancing.

Cultural Tips International business practices are widely followed. English isspoken almost universally among the business class. Have lots of business cardshandy. Be advised that India has numerous religious and secular holidays that can

interfere with product delivery. Sourcing Journal has a calendar that lists alldisruptive holidays. In addition to these other factors, punctuality is culturally notvalued.

Turkey

Capacity Turkey exports $15 billion annually. It is the 6thlargest cotton-growingregion in the world, and the 2ndlargest clothing supplier to the European Union. Ithas 5% of the worlds long-staple spinning capacity, 3.5% of shuttle less loomcapacity, and 1.9% of shuttle looms, as well as 5.1% of wool weaving capacity. 24%

of its exports consist of cotton products, from fiber to finished garments. Themajority of its raw materials needs are domestically met, though some artificial andsynthetic fibers are imported, and many of its trims come from China.

Capital Costs An L/C has fees starting at 2.5% and ranging as high as 14%. Feesvary based on the length of the letter, which can range from 30 180 days,depending on the needs of the purchaser. It is standard to receive 75%-85% of costscovered. The benchmark rate for normal lending in Turkey is 5.75%.


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Labor Supply The minimum wage in Turkey is approximately $270 per month.Turkey has a labor force of 25 million, and it is significantly younger than itsadjacent countries. Productivity has risen sharply in recent years as Turkey hassought greater integration with the economy of the European Union. It is a strike-heavy labor force, with extensive protections for workers and a highly formalized

system of social insurance. Unemployment is approximately 8.2%.

Specialties Turkey specializes in quick turnaround readymade goods for theEuropean market. Its workers have a high skill level and manufacture mid-rangegoods with consistency and speed. Shipping times to Europe and Russia arebetween 5 11 days by road, allowing agile companies to source goods much morerapidly from Turkey than from China or India.

Financing Protocol An L/C with favorable credit terms of up to 60-days is expectedfor exporters. Goods also need to be fully insured on the CIF value for their entirejourney. There are four commercial state banks in Turkey and thirteen investmentand development banks. The banking sector is liberalized, and many internationalbanks operate as well.

Cultural Tips It is best not to refuse tea, which is a staple of any business gathering.Pricing and financing are tackled late in negotiations, and Turks are goodnegotiators. A personal relationship is the basis of a successful business relationshipin Turkey. Generally, Turks prefer conservative dress and manners when firstmeeting.

Vietnam

Capacity Vietnam has exports of more than $9 billion annually and boasts 1280garment companies, 120 spinning companies, and 340 textile ventures. Most rawmaterials are imported, though the government has a goal of reducing importedcontent by building capacity in man made fibers. At this point, most buttons,shoulder pads, thread, and interlinings are imported as well. These materials tend tocome from China, and add to lead times and overall costs, though China and Vietnamenjoy liberalized trade, with no additional duties necessary on most raw materials.

As is typical of centrally planned economies, Vietnam is trying to move up the valuechain. However, it faces significant obstacles due to its free market restrictions andworkforce issues, which are leading to rising wages. In addition, companies are

often not able to accept low orders.

Capital Costs The cost of an L/C is generally 2% to 3% of face value. Thebenchmark interest rate from Vietnams four state-owned banks is 9%. However,foreign banks operate within Vietnams special economic zones, and their use isrecommended.


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Labor Supply Vietnam has a total labor supply of 47 million people. The laborforce is generally unskilled repurposed agricultural laborers and workers trained inheavy industry. The unemployment rate is 4.4%, however substantialunderemployment is rampant. The country has a young and growing population, butfuture projections indicate that the growth will stall in the next decade and the

population will begin to age.

Specialties Vietnam specializes in finishing low cost apparel. Its major tradingpartner is China, though it has begun to find market share within the United States.Vietnamese quality is often inconsistent.

Financing Protocol Vietnamese firms often resist the use of confirmed L/Cs,because of the collateral requirements and increased cost involved. There have beennon-delivery / nonpayment issues in Vietnam. It is recommended that you use athird party payment guarantor, in order to insure successful completion of yourtransaction.

Cultural Tips Bureaucratic difficulties are quite common. However, persistencepays off. It is also recommended that relationships be built off of an introductionthrough a Vietnamese person the society is highly oriented around personalintroductions. Gift giving is widely practiced, particularly at the end of a meal ormeeting.

Sri Lanka

Capacity Sri Lanka employs approximately 330,000 workers in roughly 1100garment factories. It is an export-oriented low value-added industry, with limitedcapacity to produce fabric and yarn. It obtains raw materials and inputs from Indiaand China, primarily, and has limited raw materials capacity internally. Its primaryfocus is on assembly of readymade goods for European and American markets. Itgenerally lacks technical sophistication, though it does boast lead times averaging21 days, with shipping time to Europe of approximately 16 days and easy access tomainland China.

Capital Costs It is standard to obtain L/C financing from an international bank,whose rates will vary depending on country of origin and terms. The benchmarkinterest rate in Sri Lanka is 7.5%, however relatively few loans are issued in the SriLankan rupee, owing to macroeconomic instability.

Labor Supply Sri Lanka has a labor force of 8 million, and it is young and growing.The country has suffered through a decades long civil war that recently ended. As aresult of the conflict, many Sri Lankans lack formal training or skills. Theunemployment rate is 5.8%, however most Sri Lankans are severelyunderemployed. The minimum wage is approximately $40/month.


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Specialties Sri Lanka manufactures low-cost readymade apparel primarilydestined for the European market. The sector has suffered following the end of thequota export system, due to its failure to provide adequate value for money.However, the rise in costs in China has made it appealing once more, primarily dueto its strategic location.

Financing Protocol Sri Lankans accept both L/Cs and Purchase Order Financing. Itis standard to use an international bank, and quotations are preferred in US dollars.

Cultural Tips Office attire is formal in Sri Lanka. English is not widely spokenoutside international business circles and government. It is important to confirmappointments and meetings in advance, however confirmation does not guaranteepunctuality. It is customary to exchange business cards at meetings and also atsocial occasions.

Other Countries of Interest

Countries such as Cambodia and Indonesia should also be on the sourcing radarscreen. They fall between Vietnam and Bangladesh in terms of level ofdevelopment, capabilities and costs. When capacity availability starts to becomelimited in Vietnam, these are two other countries in the region to consider.

Conclusion

Increased complexity in the sourcing world can be managed with a combination ofknowledge, technology, partnerships, and vigilance. Skilled sourcing executives willfind the efficiencies and opportunities and use them to build diversified global

supply chains. Shifting markets are only dangerous to people who dont understandthem. Leveraging information systems and attending to costs can facilitate anadvantageous understanding that positions companies to move ahead in even themost adverse circumstances.

For more information on sourcing beyond China contact TradeCard at:

[email protected]

212 405 1800

www.tradecard.com
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