24 June 2010 | Bradley A Feuling

As volatile markets send shockwaves through the economy, Bradley A Feuling examines the implications for the Chinese supply chain

In the past two years, the world’s supply chains have endured significant instability. Commodity shipping – as measured by the Baltic Dry Index – peaked in the second quarter of 2008. Then in 2009 a significant trough was created by the economic downturn. Today manufacturers in China are experiencing record production numbers. This intense variability creates ripples in the country’s supply chains that have and will continue to have an impact on efficiency and costs.

As turbulence in the manufacturing sector has intensified, a dynamic shift in China has also gained momentum. The national government’s promotion of western China has spurned economic growth in more rural provinces. With lower labour costs, foreign investment in the inner provinces is rising. The infrastructure focused stimulus package released in November 2008 has led to job creation in these areas. Factory closures in the south have influenced a percentage of China’s estimated 200 million migrant workers to return to the west.

With an increasing number of Chinese manufacturers integrated into the world’s supply chains, companies must understand how the economic tidal waves of the past two years influence key factors in the China supply chain. Primary considerations are production and logistics capacity, as well as financial flow flexibility. These components of the supply chain will be critical to controlling procurement costs and sustaining a positive bottom line in the months to come.

Demand-driven supply chain

Supply chain efficiency is driven by reducing variability. Demand over the past two years, however, can only be defined as highly erratic. When demand is unstable, production variability also tends to increase. This is not only for finished products, but also component materials, raw materials and even indirect materials. As most manufacturing in China lacks sophisticated knowledge of demand forecasting and planning, current production spikes signal a high probability of inventory building far upstream. The costs of carrying this inventory, namely the cost of capital, will flow downstream unless current demand levels are sustained.

Inventory management in this fluctuating economy has become a major challenge. As forecasts adjusted in 2009, many companies temporarily transitioned to hybrid push-pull systems. This led to a vigorous depletion of inventory. At the same time, upstream production remained low due to uncertainty. This systematic reduction of product flow in the China supply chain is now influencing downstream delays and stock-outs.

Raw material costs

The depletion of inventory for many product segments and industries, combined with a severe lack of continuity in production, will create material cost pressures in the coming months. Take nickel, for example. With growing global demand driven by China’s mass industrialisation and the development of India, inventory levels reached record highs in January 2010. From there, inventory sharply declined, and prices increased by 50 per cent in the first quarter of this year. Over the same period of time, zinc and copper prices have seen similar rapid price increases.

During 2009, significant production capacity remained idle. With increasing material costs and low production utilisation, higher unit costs are often observed. A correlated rebound in manufacturing production is now taking place. In the first quarter of 2010 China’s economy grew 11.9 per cent. Industrial output also grew by 19.6 per cent. Increases in factory and other fixed asset investments went up 26 per cent. Although these indicators are strong, the lowering of raw material prices will lag unless inventory is replenished and demand variability declines.

Production capacity

A key focal point for China supply chains moving forward will be managing capacity. Supply chain capacity can be broken down into a number of areas. Production and logistics capacity have been the most affected over the past two years.

The reduction in production capacity caused by the economic downturn has strained many of the world’s supply chains. In some cases, foreign buyers defaulted on supplier payments leading to manufacturer’s loss of liquidity for expansion and material purchasing. In other cases, manufacturers closed because of declining demand and unprofitable operations.

In January 2009, the Wall Street Journal reported that in the first 10 months of 2008, 15,661 enterprises in Guangdong closed. Driven by a highly export dependent industry, the loss of such capacity presents a major shock, not only to the local economy, but also the downstream assembly, OEM production, and overseas retailers.

The drop in demand also forced a number of Chinese manufacturing operations to reduce their headcount. In February 2009, the New York Times reported over 20 million migrant Chinese workers were unemployed. Some companies used innovative labour scheduling to ensure that following the downturn, production would not be affected. This included balancing production hour requirements and an accrued pool of non-worked hours. These adjustments have served those companies well. For others however, the shortage in manufacturing labour has been severe. In February 2010, the dramatic effects of these reactive measures were felt. In Dongguan, some 150,000 extra workers were needed after the Chinese Spring Festival. Shenzhen had a shortage of 819,000 labourers in the last quarter of 2009. Earlier this year, total labour shortage in the Pearl River delta exceeded two million.

As a result of the reduced production capacity, factory wages have risen as much as 20 per cent in recent months. This is primarily driven by the need to secure production line workers, a competitive market as opportunities are plentiful. This has increased manufacturing overheads, further raising per unit production costs.

Shipping and logistics

China’s export decline has had a great impact on international shipping. The International Air Transport Association reported in March 2009 that cargo volumes fell by 23.2 per cent year-on-year in January 2009, after December 2008’s 22.6 per cent decline. As a result, global cargo carriers were forced to idle significant ship and air freight capacity. One estimate by Alphaliner noted that seven major Asian operators had decreased their freight capacity by 282,000 twenty-foot-equivalent units (TEUs) or 16 per cent of their combined fleet. Bloomberg news reported that around 575 vessels were idle around the globe.

This reduction in capacity has influenced current logistics costs. To reactivate dormant vessels requires a significant investment. Production numbers for many Chinese operations are now strong. International cargo shipment demand rose 28.1 per cent in March 2010 compared to March 2009. Global logistics providers are actively generating capital to restart the once idle capacity. The strategy has included an increase in pricing by nearly 30 per cent following the Chinese May holiday. These steep increases will affect overall logistics costs and profit margins once sales are realised.

Financial flow flexibility

Currency exchange rates have provided relative stability over the past two years. Since July 2008, China’s National government has pegged the renmenbi (CNY) to the US dollar. This has contributed to keeping Chinese exports competitive during the economic downturn. For sterling between June 2009 and April 2010, the change has been relatively small. For the EU, there has been a 9 per cent increase over the same period.

With the economic recovery and international pressure increasing on the debate over currency valuation, a large unknown remains; when will the peg be removed? Once the CNY floats, assumed to be against a basket of currencies as before, gradually costs will increase affecting many supply chains. If combined with higher material and logistics costs, the appreciating currency exchange for exported products may result in significant profit loss.

The challenge of currency exchange is related to financial flows, an often overlooked part of the supply chain. Capital flow management, and in particular currency exchange risk, must be evaluated in China export operations. The Chinese CNY remains a difficult monetary medium of exchange outside of the Chinese mainland. As most companies still manage their Chinese operations externally, capital positioning will be a competitive advantage for those with the ability to hold CNY. As is common in the supply chain, this challenge extends from raw material to finished product, involving material and inventory management.

Economic recovery in the short-term is clear, but the larger questions remains; how will the variability of the past 24 months affect the future global economy? The pull mechanism for production, demand forecasting, will be an essential tool to gauge accuracy and hence stability, in the world’s supply chains. As supply chains become longer, integration of forecasting and production will require more involvement with China operations. The realities of global materials flow require a new thinking in material management, inventory placement and distribution.

As profit generation potential is finite, securing a controlled profit range becomes increasingly vital. With challenges ahead, namely currency exchange movement, a surge in logistics capacity requirements, and high production and purchasing variability, it seems certain costs will continue to increase in the coming months. Inaccuracies in future planning will lead to dramatic ripple effects influencing cost drivers. Competitive operational advantages will be a leading indicator of success, as the uncertainty and risk remain.

Bradley A Feuling is CEO of Kong and Allan (Shanghai) Consulting, based in China