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Updated: March 2, 2011 21:09 IST

Cost, currency and finance dynamics in China

D. Murali
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To those who do not think much about costing, it can be shocking to read in ‘China Inside Out’ about how ‘classified costing information of the Chinese steel companies involved in benchmark negotiations’ allegedly found in Rio Tinto’s hard disks was seen as ‘theft of state secrets.’ While the government accused Rio Tinto of using the information against the Chinese negotiators, the company countered that the databases and reports on the computers were in the public domain, narrates the book’s author Bill Dodson. He adds that the state authorities eventually scaled down accusations against four Rio Tinto employees to mere bribery, with a sentence of 10 years in prison.

Economic information

A chapter called ‘The global sugar daddy’ – in the book sub-titled ‘10 irreversible trends reshaping China and its relationship with the world’ (www.wiley.com) – opens by introducing us to Stern Hu, one of the jailed employees, as ‘a Chinese, a naturalised Australian citizen sent to China to be the lead negotiator representing the interests of Rio Tinto, one of the largest producers of iron ore in the world.’

For much of 2009, Rio Tinto and other major mining players had been in intense negotiations with Chinese steel manufacturers represented by the China Iron and Steel Association about discounts on the global benchmark price of iron ore for large buyers, the author informs. “The association demanded a cut of 40 per cent off benchmark prices; the miners offered only 33 per cent discount…”

The arrest of Hu is still alive in news stories, such as in a posting dated February 19 in http://china.globaltimes.cn about a Beijing court rejecting an appeal by a Chinese-born American geologist who was sentenced to eight years in prison in July for stealing state secrets. “The case highlights China's use of the law to protect its economic information and interests, and came after mining giant Rio Tinto's Chinese-born Australian executive Stern Hu was sentenced to 10 years in prison last year,” observes Zhu Shanshan, the story’s author.

Blunt instruments

While Stern Hu and his associates may have confessed to having been bribed, the consensus within the world business community was that China was an adolescent and vindictive participant in the international marketplace, frets Dodson. He recounts how, in this instance, China had been clearly outmanoeuvred, because it had been pre-empted in bids by Japanese and South Korean iron-ore purchasers, and stonewalled by a foreign company that only months before nearly accepted a rescue package of cash-for-shares from a Chinese state-owned enterprise.

“The arrest and subsequent conviction of Stern Hu and his co-workers in a country rife with institutional corruption and theft left China only looking more immature in the face of the complexity and sophistication of today’s global financial transactions. Four thousand years of history had left the leadership few tools with which to operate in a complex international financial environment. The tools it did have at hand were blunt instruments…”

Currency concerns

In a section on the yuan, the author notes that the best way to gauge the extent to which a currency is undervalued or overvalued is through PPP (the purchasing power parity), which compares the cost of a basket of goods in a standard country with the price paid in the same currency in a different country. A popular example cited in the book is of the Big Mac Index of ‘The Economist,’ which compares the cost of a McDonald’s hamburger with the purchasing price of the same burger across a range of countries.

Going by that index – according to which a Big Mac in the US cost $3.58 in early 2010 as against $1.83 in China – the yuan was nearly 50 per cent undervalued compared with the dollar, states Dodson. He also mentions the estimate of Peterson Institute for International Economics that the yuan is undervalued by 20-40 per cent.

As you may be aware, the undervaluation of a currency acts as a ‘hidden subsidy’ by making that country’s products cheaper when exported. Aptly, the book makes a reference to the estimates of Deutsche Bank – that a 5 per cent appreciation of the yuan reduces the profits of low-end China manufacturers, such as textile and electronics makers, by 5 to 10 per cent.

Cost structure

However, on the common reasoning by the US politicians – that a revalued yuan would make the Chinese products expensive and enable the American manufacturers to compete more effectively with China in terms of production costs – the author’s view is nuanced. Though the Chinese exchange rate does affect the cost of goods that flow from China into the US, the value of the yuan is only one part of the cost structure of products, he reasons.

Operating on margins as thin as the average Walmart supplier’s, and with the cost of materials that go into product manufacture – viz. plastics, metals, and chemicals – tending to be the same around the world, the only costs that Chinese producers can influence are labour costs, avers Dodson. “The cost of material inputs in China rose annually in the double digits from 2004 until 2008, despite the yuan strengthening as much as 20 per cent during the period.”

Labour advantage

Extremely low labour costs in China relative to the country’s wealth as measured by GDP are the main factor behind lower prices for Chinese exports, the author argues. Quoting the US Bureau of Labour Statistics, he writes that Chinese labour costs from 1980 through the mid-2000s averaged about 3 per cent of the average worker salary in the US, even while the average worker salary in Korea and Japan during comparable periods in their respective economic development averaged 30 per cent of US salaries.

Labour costs in China are something Chinese company owners and local governments can control through the level of minimum wages and benefits to which workers are entitled, one learns. Again, with the flow of people from the interior China to factories along the east coast, manufacturers in China were able to hold down labour costs throughout the 1990s until 2008, the author traces.

Decimation of industries

An interesting insight in the book is that when wage levels began to rise in 2007 and then in 2010, by anywhere from 20 to 50 per cent in some cities along China’s east coast, and as a result Chinese manufacturing became less competitive, jobs did not return to the US. Why so? Because globalisation had already restructured jobs and entire industries out of existence in the US in the 2000s, instructs Dodson. “Textile production, toys, shoes, plastics, and a great deal of machining and tool-making had all but become industries of the past.”

Scanning the business horizon in China, the author finds that the east coast of China began to see just such a decimation of the same industries in early 2008, as labour and environmental policies reset the richer regional economy and the work migrated to China’s interior.

He foresees that, one day, those jobs will migrate out of China completely to Bangladesh, Southern India, and Cambodia. For, as Dodson concludes, export businesses will always seek out the lowest salary levels globally to offer international buyers the cheapest goods possible.

Back to borders

If you tend to lose sleep over the growth in Chinese cross-border investments, the book’s prediction that by 2025 the investments will flow back nearer to China’s borders may comfort you. Driving such a movement, in Dodson’s reckoning, will be the large and growing population, the greying ‘bulge’ of citizens that will reduce the country’s productivity, and a mushrooming middle class with high expectations for wealth and consumption.

His advisory to foreign companies invested in China is that they will increasingly find greater and unwanted attention being placed on their activities in the run-up to the next decade; and that the regulatory regime for Western investments in China will become increasingly restrictive for all but the richest multinationals even as state-owned enterprises continue from 2010 to cordon the domestic market from international investors.

The chapter, therefore, wraps up with the sombre forecast that like many of its own government workers, the Chinese economy will have retired to anaemic middle age about 55 years after Deng Xiaoping officially announced in 1978 as supreme leader of China that the nation was once again open for business. “After its economic boom, China will hold much of its wealth nearby – just as its retirees do – through overwhelmingly Asian networks with which it has historical and cultural affinities.”

Imperative addition to any China-watcher’s shelf.

**

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