The Next Frontier of Sourcing: As China Looks West, Should Sourcing Executives Follow?

Sourcing Journal Managing Editor Patrick Lamson-Hall

March 2012

Overview Section I Policies a. b. c. d. Minimum Wage Increases Hukou System Go West, China Currency Markets

Section II Recommendations a. b. c. d. Overhead Capital Costs Technology Partnerships

Section III Country Profiles a. b. c. d. e. f. Conclusion Bangladesh Honduras India Turkey Vietnam Sri Lanka

Overview Sourcing in China is getting more expensive. Wages are rising in all provinces and relocating to the interior is difficult and costly. Manufacture of many goods is moving away from China, to an emerging basket of countries that each offer unique advantages and disadvantages. They all share low wages, and they all lack the sort of industry clustering that has made China such a comparatively simple place to do business. This white paper will discuss some of the factors that are driving the movement of apparel and textile manufacture within China and beyond. It contains country profiles, and information on the benefits and pitfalls of Sri Lanka, India, Vietnam, Bangladesh, Honduras, and Turkey some of the more serious competitors for Chinese manufacturing. It discusses capital costs, capacity issues, specializations, labor conditions, and cultural customs, to insure that the reader of this paper will be successful in a diversifying market. The graph below illustrates the shift by share of US imports, as other countries in Southeast Asia are able to capture a growing portion of the US import market. For most countries listed, the results are short term, influenced by the recession and other factors. For China, however, this represents a long-term trajectory.

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

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, the Hukou system of internal passports, and Chinas plans for westward expansion. Rising labor costs in China are driven both by government policies and the regular functioning 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, Gansu province, to a high of 1500RMB in Shenzhen, Guandong Province. This massive spread gets even wider when the wage in cities outside provincial capitals is taken into 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 increases of at least 17%, not including overtime. However, this targeted increase will likely be exceeded, as severe labor shortages continue in coastal provinces. Wage increases have ranged between 50-100% annually for the last several years, largely driven by regional government action. The central government dictates increases in the minimum wage as it sees fit, in addition to regular increases prescribed in the 5-Year Plan. Generally, ad hoc increases 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 unrest among migrant workers. The government has an official policy of promoting harmony and moderate prosperity and maintains its legitimacy by delivering regular standard of living improvements to its citizens. Minimum wage increases insulate it against accusations of non-responsiveness. Unfortunately, they are a blunt tool, and can disrupt the economics of export-oriented industries. Exports totaled over $1.6 trillion in 2011. To counteract this effect and to encourage microeconomic stability, the government is promoting increased domestic consumption. This, again, is facilitated by a higher minimum wage, which gives Chinese citizens increased purchasing power.

Hukou System The central government maintains a system of internal passports known as the Hukou system. Hukou divides residents into rural and urban classes, and separates them by province.

Workers moving from rural to urban areas or crossing provincial borders lose standard labor protections such as unemployment insurance, health, and pension. The majority of Chinas migratory workers have left their home provinces without obtaining urban status. This is beneficial to employers in the short term, because they are responsible for paying the lions share of those benefits. However, the Hukou system represents a long-term threat to Chinas prosperity, and an immediate threat to its export oriented economy. By removing labor protections for migrant workers, who represent the bulk of Chinas unskilled workforce, the system incentivizes workers to stay within their home province. This creates wage pressure in the coastal export zones something that has been seen for several years, as workers fail to return from the Chinese New Year. This year, labor shortages following the New Year have amounted to as much as 50% of capacity in the garment finishing industry. To avoid these issues, many factories are relocating inland.

Go West, China The Chinese government is pushing to industrialize its interior, away from the coasts. They are improving road and rail links to coastal ports and subsidizing low cost development of industrial space, as well as extending Special Economic Zone rules to all provincial capitals. Conditions in the interior are improving, making it more feasible and desirable for Chinese workers to migrate to regional hubs, rather than 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 on the coasts, and the lower wages of the inland areas do not fully cover the additional cost of overland shipping. As a result, the disbursement of manufacturing throughout China has been accompanied by the movement of factories to other countries in the region Vietnam, Bangladesh, and Sri Lanka are particular favorites. Because of logistics and capacity differences, each country has various strengths, weaknesses, and specialties. There is no reason to believe the labor shortages on the coast will be relieved anytime soon. Factories that are unable to find workers will continue to shift to other countries and into the interior. This means that the days of the one-stop sourcing shop are numbered.

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

the dollar today. In practical terms, this makes buying Chinese goods 24% more expensive due to currency conversion costs. This is coupled with even strong trends against the Euro, where Chinese currency has 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's inability to control its currency in the long term. The 25% increase in currency costs has been a long time coming, as China's central bank is balancing its inflationary concerns with its need to maintain a strong export sector. Alternatives to China also sometimes experience currency fluctuations. Developing nations in particular are subject to sudden spikes and valleys in the value of their currency. However, due to its long-term policy of currency control, the RMB has pent up value that will need to be realized in the next few years, in the form of a stronger currency. While other nations may move up or down in terms of their currency 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 its competitive advantage for RMB denominated transactions.

Section II - Recommendations In an already struggling economy, this changing business landscape will put serious pressure on companies that can't keep up with the times. Many formerly prominent brands have fallen by the wayside because they couldnt balance their costs and revenues, 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 cost savings rapidly disappear when you also need offices in Bangkok, Singapore, and Manila, and youre losing 3% on every conversion. For most small and medium sized companies without insider knowledge, the best way to navigate sourcing from different countries will be to use third party agents and computerized tracking systems. Those will enable an executive to monitor their global 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, computerized payment protocols, bank to bank money transfers, and virtual meetings, will see an advantage on FOBs, because their cost of doing business will be substantially lower. That advantage could prove critical if current discounting trends and raw materials prices persist. Additionally, embracing technology puts pressure on factories to modernize, which will make them more efficient, able to produce quality goods, and respond rapidly to changing designs. One reason China was able to move up the value added chain and capture so much market share so quickly is because Chinese factories rigorously adopted modern technology, in order to increase productivity. Chinese garment output has doubled in the last decade, but the number of workers used has only increased by about 15%. This is less the case in the countries where production is moving, so expect more 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 auto compliance systems at a minimum, and that means factories need independent supplies 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 Chinas ultra stable monetary policy. Unfortunately, even for companies that continue sourcing in China, that era of stability is rapidly drawing to a close. The Chinese need to reduce inflation, and the three ways they can do that are by increasing

worker salaries at a pace that exceeds it, by allowing their currency to float, and by increasing real domestic spending by shifting investment into domestically consumed high value consumer goods. All these things are bad for low-cost export oriented sourcing companies, and they are all already underway. As you move your company through this transition, make sure you have the right partners. You need people on the ground that know local customs and can alert you to potential pitfalls. Ask yourself how you will communicate with your suppliers. How will you pay them? Consider contracting with a PLM or auto compliance company. It may be your cheapest option.

Section III - Country Profiles The trends described above will increase costs in a number of ways. Even for the executive who successfully navigates the diverse regulations, financing needs, and shipping environments of these countries, there are still the simple matters of customs and travel time. In 2005, an executive could fly to Shenzhen and visit five factories in a day, then fly home. Now that same executive needs five days to visit his five factories, and two of them are spent in transit. Meanwhile, behavior when doing business in Bangladesh is not the same as in China. The same customs and travel problems exist for the goods themselves. Despite sporadic talk about a Chinese backed east Asian free trade zone, goods moving between most countries in Asia still have duties and still sit in customs. So if your buttons and fabric are from China and your shirt is stitched in Bangalore, you pay customs and shipping twice - from China to Bangalore, then from Bangalore to the target market. That amount of shipping and customs also lengthens lead times. Here's a quick rundown of some recommended alternatives to china, and why they are more difficult places to do business than China was:

Bangladesh Capacity: Capacity in finished pieces is difficult to assess because the information is proprietary. However, total apparel exports are soon to exceed $30 billion, compared to Chinas approximately $220 billion in 2011. Bangladesh has over 4000 enterprises manufacturing textiles and apparel. Many of these came online before the financial crisis reduced demand in 2008-2009, cotton prices spiked, and a 20102011 local stock market crash reduced available investment and capital. The country is regarded as having poor spinning and weaving capacity due to its relative lack of raw materials. As a result, most of its yarn and fabric come from China, as well as trims. This can add up to 30 days to lead times, because of time needed to order and transport materials. Capital Costs Transacting with suppliers in Bangladesh typically requires using letters of credit. Open account transactions using some of today's cloud-based offerings 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 the banker. In special circumstances it is possible to use Cash Against Documents for payment. The benchmark interest rate is 7.25 percent as of this writing. With that in mind, it is strongly recommended to use open account transactions or third party direct transfers.

Labor Supply The minimum wage is approximately $40/month. The nation has a labor supply of 73.8 million and an unemployment rate of 4.8%. The population growth rate is 1.6% per year. The growth rate in industrial production is approximately 6.4% per year. Assuming limited productivity gains, it is safe to say that Bangladesh does not have the potential for rapid labor force transfers to textile and garment production. For comparison, Guangdong Province in China has a population of 104 million. Specialties The country specializes in knitwear, and is attempting to build backward linkages in order to reduce lead times, though this will not solve its fundamental lack of raw materials. Financing Protocol It is possible to obtain L/Cs from government banks such as Janata, Agrani, Sonali and Krishi Bank and 28 private local banks, along with many international banks. However, the financial sector is undercapitalized, so it may be advisable to use alternative payment protocols, such as third party facilitated bankto-bank transfers. Cultural Tips Business customs can be quite formal. Public displays of affection are frowned upon. Keep business cards handy, as they are freely exchanged. English fluency is common, but is by no means guaranteed. Avoid pointing the soles of your feet at people or pointing at anything with your feet.

Honduras Capacity Honduras is the leading ready-made supplier in Central America. It suffered declines in light manufacturing volume in 2009, but has rebounded somewhat in the last two years. It has a total workforce of 2.8 million, and 31% of the national GDP is in light manufacturing such as textiles. Exports grew 19% last year, and are now approaching $2 billion. Honduras receives most of its yarn and fabric from the United States, due to source origin provisions in its FTA that grant it duty free access to the US market. Transport times are relatively short, however the added cost of shipping raw materials, combined with added lead times, nullifies a lot of the advantage Honduras enjoys from 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 to finance orders through foreign banks, however, and the country is trade liberalized with the global banking system, making direct transfers a feasible option as well, for the buyer with sufficient capital. Labor Supply 2.8 million workers live in Honduras, and 1/3 of them are unemployed or underemployed. The workforce is very young generally below age 25 and has a literacy rate of approximately 90%. Unfortunately, the country is

highly strike-prone, with labor unrest frequently halting all economic activity. The minimum wage is approximately $280 USD/month. Specialties Honduras uses a one-stop or Full Package concept, as it is known domestically. The textile industry is structured around manufacturing every part of a garment in country (except the yarn or fabric). This can produce a high value-add and low FOB by streamlining processes. It tends to privilege efficient and precise buyers who desire control over the entire scope of production. Their time zone location favors just in time production for the US market. Financing Protocol L/Cs are standard in Honduras. There is a range of private international banks available, along with a government bank, Banco Central de Honduras. The financial sector is deregulated and it is possible to use L/Cs from banks without a presence in Honduras. Honduran L/Cs generally require a deposit of approximately 30%. Cultural Tips Handshakes are generally limp and prolonged, except among internationally savvy Hondurans. It is normal to use formal titles and last names unless requested to do otherwise. Appointments should be made at least two weeks in 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 25,000 domestic manufacturers and 48,000 fabricators. It is the worlds second largest producer and consumer of cotton (China is first), and is expected to produce $115 billion in goods in 2012. As an example of its capacity, the denim sector alone can produce 650 million meters 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 rapidly increased capacity before the global slowdown of 2008-2009, and has large amounts of equipment that are currently going unused. With this in mind, its highly competitive 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 wool often comes from beyond Indias borders as well. It is important to consider the added cost and lead time issues involved in this, particularly since Indian customs are notoriously difficult, and India lacks free trade agreements with many major raw materials suppliers.

Capital Costs The benchmark borrowing rate for India is 7.5% at the moment. On a letter of credit, expect to pay between 1/8% and 1/2% per quarter. Fees can range from 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 million people currently work in apparel and textiles. The official unemployment rate is 10%, but it is estimated that as much as half of the workforce is underemployed. It is among the youngest workforces in the world and is growing rapidly. Wages are set by 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 a diverse range of specialties. Within the export sector, its most prominent exports are cotton readymade garments and accessories, destined for the European market. Exporters in India have not pursued an integrated production facility model, unlike in China. The supply chain is fragmented and beset with bottlenecks that increase lead times to 45-60 days, versus an international standard of 30-35. In that regard, India might be said to not specialize in on-time production. Financing Protocol Payment is normally through irrevocable letters of credit, and a term of 90 days is standard. Quotations are required to indicate FOB prices, with separate listings for freight and insurance. The Reserve Bank of India supervises a network of scheduled commercial banks, from which it is recommended to obtain financing. Cultural Tips International business practices are widely followed. English is spoken almost universally among the business class. Have lots of business cards handy. Be advised that India has numerous religious and secular holidays that can interfere with product delivery. Sourcing Journal has a calendar that lists all disruptive holidays. In addition to these other factors, punctuality is culturally not valued.

Turkey Capacity Turkey exports $15 billion annually. It is the 6th largest cotton-growing region in the world, and the 2nd largest clothing supplier to the European Union. It has 5% of the worlds long-staple spinning capacity, 3.5% of shuttle less loom capacity, 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. The majority of its raw materials needs are domestically met, though some artificial and synthetic 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%. Fees vary 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 costs covered. The benchmark rate for normal lending in Turkey is 5.75%.

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 its adjacent countries. Productivity has risen sharply in recent years as Turkey has sought greater integration with the economy of the European Union. It is a strikeheavy 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 the European market. Its workers have a high skill level and manufacture mid-range goods with consistency and speed. Shipping times to Europe and Russia are between 5 11 days by road, allowing agile companies to source goods much more rapidly from Turkey than from China or India. Financing Protocol An L/C with favorable credit terms of up to 60-days is expected for exporters. Goods also need to be fully insured on the CIF value for their entire journey. There are four commercial state banks in Turkey and thirteen investment and development banks. The banking sector is liberalized, and many international banks 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 good negotiators. A personal relationship is the basis of a successful business relationship in Turkey. Generally, Turks prefer conservative dress and manners when first meeting.

Vietnam Capacity Vietnam has exports of more than $9 billion annually and boasts 1280 garment companies, 120 spinning companies, and 340 textile ventures. Most raw materials are imported, though the government has a goal of reducing imported content by building capacity in man made fibers. At this point, most buttons, shoulder pads, thread, and interlinings are imported as well. These materials tend to come from China, and add to lead times and overall costs, though China and Vietnam enjoy 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 value chain. However, it faces significant obstacles due to its free market restrictions and workforce 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. The benchmark interest rate from Vietnams four state-owned banks is 9%. However, foreign banks operate within Vietnams special economic zones, and their use is recommended.

Labor Supply Vietnam has a total labor supply of 47 million people. The labor force is generally unskilled repurposed agricultural laborers and workers trained in heavy industry. The unemployment rate is 4.4%, however substantial underemployment is rampant. The country has a young and growing population, but future 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 trading partner 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 been non-delivery / nonpayment issues in Vietnam. It is recommended that you use a third party payment guarantor, in order to insure successful completion of your transaction. Cultural Tips Bureaucratic difficulties are quite common. However, persistence pays off. It is also recommended that relationships be built off of an introduction through a Vietnamese person the society is highly oriented around personal introductions. Gift giving is widely practiced, particularly at the end of a meal or meeting.

Sri Lanka Capacity Sri Lanka employs approximately 330,000 workers in roughly 1100 garment factories. It is an export-oriented low value-added industry, with limited capacity to produce fabric and yarn. It obtains raw materials and inputs from India and China, primarily, and has limited raw materials capacity internally. Its primary focus is on assembly of readymade goods for European and American markets. It generally lacks technical sophistication, though it does boast lead times averaging 21 days, with shipping time to Europe of approximately 16 days and easy access to mainland 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 benchmark interest rate in Sri Lanka is 7.5%, however relatively few loans are issued in the Sri Lankan 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 a result of the conflict, many Sri Lankans lack formal training or skills. The unemployment rate is 5.8%, however most Sri Lankans are severely underemployed. The minimum wage is approximately $40/month.

Specialties Sri Lanka manufactures low-cost readymade apparel primarily destined for the European market. The sector has suffered following the end of the quota 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 due to its strategic location. Financing Protocol Sri Lankans accept both L/Cs and Purchase Order Financing. It is 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 spoken outside international business circles and government. It is important to confirm appointments and meetings in advance, however confirmation does not guarantee punctuality. It is customary to exchange business cards at meetings and also at social occasions. Other Countries of Interest Countries such as Cambodia and Indonesia should also be on the sourcing radar screen. They fall between Vietnam and Bangladesh in terms of level of development, capabilities and costs. When capacity availability starts to become limited 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 of knowledge, technology, partnerships, and vigilance. Skilled sourcing executives will find the efficiencies and opportunities and use them to build diversified global supply chains. Shifting markets are only dangerous to people who dont understand them. Leveraging information systems and attending to costs can facilitate an advantageous understanding that positions companies to move ahead in even the most adverse circumstances.

For more information on sourcing beyond China contact TradeCard at: info@tradecard.com 212 405 1800 www.tradecard.com