China is a vibrant, aggressive and colourful marketplace21 November 2005
One thing for sure, there is 'good news'. Change and growth are in clear evidence and, therefore, so are potential rewards. Many of us have spent years in defensive mode - protecting our markets and trying to find new markets in uncharted territory - this is not so in China. It is a vibrant, aggressive and colourful marketplace, no matter the sector of the leather business, and it has also become one of the most competitive markets on a sometimes unlevel playing field. You need to realise this and move on. You alone will not change it. However, I believe it is changing for all participants in the industry. Not only foreign companies are looking for positive change, so are the more serious Chinese companies. The changes are not and will not occur at an even pace across the country and this must be a major factor in decision making on establishing businesses in China as the distance from the east coast increases the costs of establishment. Maintaining and growing leather business in China is obviously dependent on a number of factors: the market; competition; cost competitiveness; structure of the business; and strategic summary. The most talked about leather business in China is automotive leather; it is probably the most talked up business as well. Despite this, in reality, we are going to see major growth, but at the same time over-capacity in both car and most likely leather production will occur. The government appears to be encouraging the introduction of excess capacity in the auto business. It will also be interesting to see how auto manufacturers and their attitude to Chinese leather suppliers change and what types of leather and standards will be required or accepted. And, will the Chinese market be dominated by the current world players as the business grows? The largest area of auto production in China is Shanghai, followed by Guangdong and Jilin. Shanghai is responsible for 22%; Guangdong 11.5%; Jilin 10%; and others, including Chongqing and Tianjinfrom, from 7% and less. The total market in 2005 is estimated to be 3.5 million vehicles in the light vehicle category (total volume is more than five million units). Growth in the market for 2003/2004 was more than 15% with major growth areas being SUVs and MPVs, while mini cars declined significantly. Also, importantly, these growth categories have a high tendency to favour leather seating. One of the other interesting statistics is the use of cars. When comparing Shanghai with the rest of China, it is clear that the big affluent cities will be the sales areas for leather interiors and, therefore, the brands that have strength in those cities will command the market. The major brands in China: Audi/VW 18% GM 9% Hyundai 6% PSA 5.7% Honda 5% In total, foreign brands make up around 64% of the market. Estimates of the penetration of leather interiors in the Chinese market are high. In 2005, the estimate of leather required for light vehicles is in excess of 100 million square feet and growing over four years by 40%. However, the largest growth area of the use of leather in China in recent years has been the furniture business. This is still set to grow and the competition in both furniture and furniture leather can be described as aggressive - to say the least! Several local governments have seen this sector as saviours of leathergoods manufacturing businesses and have encouraged a shift of business into the sector. It is a very large sector in the Chinese economy and probably one of the long term growth areas for the domestic market as incomes rise. Leather is a desirable product in the eyes of the consumer. The major areas for manufacturing furniture are: Guangdong 60% Zhejiang 20% There are more than 50,000 furniture manufacturers in China and, more importantly, the sector exports goods worth more than $7 billion. Today, more than 20% of the Chinese leather industry is making furniture leather, mostly in Zhejiang and Guangdong. Most of this is mass market production. However, over time there will be development to more sophisticated leathers. As the local market grows there will be a higher number of leather producers in this sector. While this conference is not about shoe leather, one has to recognise that this is the largest sector for leather in the world and definitely in China. If we do not consider this market and the changes occurring, both positive and negative, then it will be at our peril. The shoe industry is made up from more than 8,000 enterprises of which probably more than 1,500 are of a significant size, ie more than US$60 million per annum. The industry employs more than one million people and produces more than 55% of the world's shoes. The major export producers are in Guangdong and are mostly Taiwanese. All the major companies are also involved in production in Vietnam. Wenzhou (Zhejiang) is far more local in its focus. While it is not the topic of this conference, it is important to note the presence of other large sectors which consume leather. Garment manufacturing in China is a very significant sector of business. Many companies in this sector have moved into furniture business in recent years. Competition is an area we are never sure about. Sometimes the main beneficiaries are the machinery manufacturers. There has been a lot of recently installed capacity in China that is under-utilised. This has been the case for many years and may continue. There is not much we can do about, this despite the fact that it is expensive to build a tannery. Another major issue is the ability to switch sectors. This seems more fluid in China than in the developed countries. It is quite common for local governments to encourage the businesses to move into new sectors without real knowledge of the prospects of success. Statistics tell us that there are around 2,500 tanneries in China of which more than 600 represent significant sales of more than US$60 million per annum. The main areas are: Zhejiang Hebei Shandong Guangdong However, there are significant tanneries spread all over China and it is a diverse industry. The following is an approximate sector break-up of the tanning industry: Shoe leather 45% Leathergoods 20% Upholstery 20% Auto 2% Other (fur, sole etc) 13% Cost competitiveness The real question for all of us is who is the direct competitor and what are his success factors and his sustainable advantage? We are in a very mature industry and the lines of competitive advantage become very blurred. Competitive analysis is one that requires a lot of thought and constant review due to the changing nature of China's market. It is clear that the installed capacity in the major industry sectors has grown and continues to grow. Reports come regularly of new tannery start-ups in China, especially now that automotive leather is high profile. This requires deep study and strategic planning in both developing and continuing to run a successful leather business. One of the burning questions is the future of China's competitiveness in the world market as the economy grows and affluence grows with it. There are two aspects to consider: Where will our customers potentially go? What is the long-term tannery competitiveness and its customer base? The first question mainly revolves around labour intensive businesses: shoes; furniture; garments; leathergoods. Over the years, these businesses have followed the low cost countries so the real question is: Where will they be in future? If the labour force and population is limited then all will be a short-term fix, eg Vietnam? The second part of this is logistics: what are they within the country of manufacture? The third part is: what is the local market potential for development? Within these questions lies the answer. China certainly has size and local market potential to continue to be a power base for the leather products industries in the future. If we speak about tanning industry competitiveness then we speak about some different aspects. * The tanning industry is a capital intensive industry * The tanning industry requires a relatively industrially skilled based workforce * The industry should be placed close to the customer base It is clear that there are current advantages in using low cost labour. However, the industry has proved that this is not the only determining factor. The closeness to the market combined with product development is more defining. In China, we have a gap that can yet be filled by efficient manufacture and development of a committed workforce that still has a work ethic. However, it is clear that costs are rising not only in labour but in many services that need to be provided. Cost competitiveness is a major hurdle that we need to consider. The structure created for the new business in China will define many of the issues and problems in the future. Setting up in China has been a harrowing experience for many. In the past, the learning process has often been expensive and difficult. At least now we can say the rules are clearer as China opens up to the world. It is important to get a clear view of what the company wants to achieve in China. This may define more clearly what type of business and structure will be necessary to achieve success. It will now be more difficult just to come and hope to evolve a business. The entrepreneurs in the past have done this and mostly lost a lot of money. However, the survivors are still 'in the game'. It is now like buying property at the top of the market: do not make a mistake! Rules of the game I would like to review some of the steps that I have experienced in establishing a stable business in the Chinese leather industry. 1 Culture: For many, the diverse cultures of China are confusing to say the least. The impact of the culture on business is something that needs to be recognised early and a plan to deal with the issue devised. Not only do we have the culture barrier but the language barrier as well for many businesses. My experience is two-fold in being involved in a Taiwanese owned and managed company and latterly a joint-venture with a state-owned entity. The gap between these alone is a major revelation. After several years of the jv start-up, we are still in the process of moulding our staff into a coherent and focused group. The gap between the Chinese style state-owned corporation and the operation of an international public company is quite large. To this end we have invested a lot of time and resources in training our staff and management to get clear operational goals in place. We have concentrated on western standards and blended training and trainers from different backgrounds to develop multi-cultural attitudes. For example, we have bilingual training, Chinese language training for expatriates and English training for specific skills required in the business. At the end of the day we hope to develop a sense of ownership of the business by all the employees. 2 Governance: For a public-listed company, this is not a matter of choice. The management standards of conduct and compliance are always at the forefront of business. With a newly-established business, it is easy to start correctly. However, inheriting a previously state-owned business can bring with it a lot of unravelling that needs to be done. In the past, work practices in China were made to fit the circumstance rather than the laws. It can be a long time before all these circumstances find their way to the surface and become apparent in the daily operation of the business. We can say that law enforcement is now much more likely to occur and many companies will flaunt the law at their peril. For international businesses, this area has been one of the most un-level parts of the playing field. In our area of business, it has been important externally to operate to clear international standards. Our company is audited regularly by international customers with, now, great attention to detail and confirmation of information. This is especially true in the automotive industry as well as the shoe and furniture leather industries. 3 Labour force: As mentioned earlier, probably one of the most contentious issues in industry at present, especially on the eastern seaboard, is the availability of labour in China - and costs. We have seen labour demand rising and labour shortages occurring, especially in the Guangdong province and also in the region and cities surrounding Shanghai. In the past, it was possible to find adequate labour from other provinces towards the centre and west of China. However, there is more competition for labour in those regions as well and, therefore, many factories are finding difficulties getting suitable labour at an affordable price and quality. This has been more of a problem in shoe factories where the operations are labour intensive and large numbers are required. This has caused a move of production to Vietnam, along with other reasons of supply to the European Union and balancing risk. It is important to assess the availability and suitability of the workforce in advance of decision-making with new investments. To some extent in tanneries this can be mitigated by labour saving devices that are well-known in the developed world. The Chinese labour pool is generally more work ethic orientated than those of south-east Asian nations and more adaptable (in general) to technology. Despite this, there is a long road of training required to get the workplace into the condition that is acceptable in a quality and discipline orientated business. This applies to all levels of the workforce from senior managers down to the shop floor. It must be taken as a long-term project to bring employees into the standard required for international business. Another issue of the labour force is the social benefit costs of individuals that may be borne by the business. Companies have a high liability of payment of these that add up to more that 30% of the basic salary in general. Add to this, in many cases dormitories have to be provided along with all meals on site. At the start, when becoming involved in any existing business, the liability for social benefits, employment contracts (lifers) and the union need to be investigated. 4 Management skills: Along with a factory labour force comes the need for experienced management and leadership. Most larger companies have a blend of expatriate and local management. The catchword of many businesses today is 'localisation', that is moving expats back home and replacing them with local staff or just simply recruiting locally. The education level in the major cities in China is quite good although there is often a lack of practical application in graduates. In the past, this was not a major disadvantage as university graduates came on the labour market at quite low salaries and worked up to better positions over time. The demand now is much higher due to the growth in China and, therefore, salaries are rising in the major industrial centres at a high rate. This is likely to continue in the near future as expectations of the middle-class increase. 5 Logistics: One of the major considerations of any leather business in China is logistics, along with the status of the business with respect to exporting or doing domestic business. Tax and duty rules may govern where a product is purchased and with long supply chains from overseas business can be quite difficult while purchasing from China internally involves significant VAT on products. Therefore, the decision on location as well as where to purchase becomes a critical part of the business when most raw material, hides, are imported and chemicals may also be of overseas origin. If the business is a closed loop export business then it is further complicated as the operational rules are complex and require a large amount of documentation as well as a complete understanding of the operational rules. 6 Choosing a partner: While today many companies can and do go alone without a partner there is still a significant number seeking local involvement. This needs to be carefully considered when decisions are being made. While things have improved on the business front in China, the expectations of the partners in a jv are generally different from the investor, especially when the partner is possibly a near bankrupt state-owned company. Often the partner cannot participate financially in the jv and, in fact, is only interested in how much money can be gained from the venture. Many such organisations are weighed down with liabilities and social obligations that are important to be left outside the new venture. Such things as unfunded or unpaid staff welfare costs are coming. There are also generally lifetime worker contracts that may become serious liabilities. These are just some of the issues in the start-up and daily operation of business in China. This is only an outline of some of the considerations in the cycle of business. Many companies have floundered at the start-up phase because of the complexity of setting up in China. I have not covered the details required to get into business in terms of approvals firstly to form a company, then operational licences, followed by permits to build and then actually getting a plant in place. Strategic summary There have been many stories of start-ups that show that initial strategies - or lack of - were flawed due to a lack of understanding of the issues involved in establishing a business in China. It is quite interesting that many times the business rule book is thrown out the door in the excitement of the new start-up. The knowledge that 'I need to be in China' is not enough. It is important that a proper strategic plan be put in place to ensure the cost of start-up is contained and the result can be success. The key dynamics of the current scene are: * What are the effects of a large number of new start-ups in the country already creating over-capacity in the business? * Will the customer base in the various sectors continue to grow, especially leather furniture and auto business? * Where is the correct place to site a tannery today? * What does the increasing cost and lower availability of labour mean? * What does the increasing demand and, therefore, rise in costs of services do to cost competitiveness?