Wealth Finance Consulting - China Manufacturing Delivered

We believe that solid information is the backbone of a sound China strategy. To support our friends we're launching a periodic newsletter where we'll focus on important issues relevant to US companies doing business in China.

In this first newsletter, we take a look at how a recent major change in China tax policy impacts the cost of exports as well as how the USD / RMB exchange rate will impact your business.

While we hope this information is useful, there is no one-size-fits-all formula for success in China. To discuss how we can help solve your complex problems in China, contact us anytime at wealthconsultingcn@gmail.com - we're here to help.

Inside this Newsletter
•Changes to Chinese tax law and increased prices of exports to the US
•The quickening RMB appreciation
•Recommendation: Increase communication with suppliers to improve your operational performance

The Changing Chinese Landscape

In 2007, two influential government policy shifts had a major effect on the export prices of Chinese products and the dynamics of US/China commercial relations. The first policy shift was a significant reduction in Value-Added-Tax (VAT) refund rates for exporters. The second was a shift in the government's approach toward the RMB's (Renminbi/Yuan) appreciation against the US Dollar. These two policies, along with 2008's expected trends in continued inflation and increased labor law enforcement will warrant close scrutiny on the part of US buyers from China throughout 2008 and into 2009. The prognosis: it's time to tighten up the relationships with your manufacturing partners in China.

Export Subsidies and Your Bottom Line

The Chinese input VAT is a 17% tax paid on the raw materials purchased by Chinese manufacturers. The Chinese government gives rebates on this tax at the time of export as a way to encourage growth in China's export industry. These rebates favor exports over domestic sales and are in effect a commodity specific export subsidy. Not surprisingly, Chinese exporters typically build the VAT refund into their FOB (Free On Board) price quotes to foreign customers. When the Chinese government wants to affect industrial growth rates and investment in a specific industry, it modifies the VAT refund for exporters of that product. Chinese manufacturers may have very little warning of changes in this tax rebate policy and many have manufacturers may have very little warning of changes in this tax rebate policy and many have recently been blindsided by sudden decreases in their VAT refund rate.

In July 2007, the Chinese government announced a drastic decrease in VAT refunds as part of a raft of policies to discourage exports of energy-intensive, polluting products or products that were seen as exploiting China's natural resources. They lowered or removed entirely VAT refunds for 37% of all product categories (2,800 different products); including many which had not yet been touched by VAT refund rate cuts. Around 80% of the affected products saw their VAT refund rates decrease by 2-8%, causing a corresponding increase in the manufacturer's effective total costs of approximately 1-5%. Combined with other factors such as rising labor costs, increasing energy prices, and rising prices for raw materials, the timing of these VAT refund cuts was very bad for Chinese suppliers and particularly lethal for the many Chinese exporters already working with operating margins of 5% or below. These manufacturers had to choose between operating at a loss and hoping for a miracle, cutting corners on quality (there has been a great deal of media coverage on various quality problems with Chinese made goods), or passing on the increases to the buyers in order to survive. Many manufacturers have recently shuddered in the wake of these changes.

What should US buyers do?

Your team needs to work to develop a detailed understanding and economic model of your supplier's input costs and commodity-specific VAT refund rate to ensure you have a clear picture of how continued VAT changes may affect your products.

The RMB On The Rise

The Chinese government instituted the recent VAT refund cuts in part to cool sectors of the economy it believes are in danger of overheating. The US Dollar has weakened against a range of currencies over the last year, but the Chinese government has allowed the RMB to strengthen against the US Dollar at an unprecedented speed. Beijing unpegged the RMB from the US Dollar in July 2005 and now allows a controlled float of the currency. Since this shift in monetary policy, the RMB has risen significantly against the US Dollar, including 7.1% in 2007 alone, and it will continue to rise. The pace of appreciation increased sharply in the fourth quarter of 2007 and has already risen 4.5% since January 1, 2008.

Although the RMB has already strengthened by 18.5% since its unpegging, most analysts and investors believe that the RMB still remains undervalued relative to the US Dollar and other major currencies and predict a further rise of between 6% and 14% over the course of the next 12 months.

Active management and close communication with your Chinese suppliers will be more critical than ever for US companies looking to minimize the impact of these shifts.

Opportunity Within the Challenge

While many of these trends will continue to put upward pressure on landed savings from China sourcing, almost all of these factors are outside US buyers' control. These eroding system-wide margins place significant strains on the supply relationships and product quality. The bankruptcy of a key supplier or well-intentioned, but unapproved materials substitutions can wreak havoc on your international supply chain.

There is a bright side. By increasing the corporate focus on the China supply chain, opportunities for improvement are often discovered that increase efficiencies in the system, offsetting some of these increasing costs discussed. Doing this entails establishing clear communication and cooperation with the key suppliers and a willingness of all supply chain partners to invest in the future. Keeping an open-mind and developing a better understanding of how China will continue to evolve over time are key to a company's success. Long term profitability is driven by optimizing the entire supply chain to deal with the dynamic manufacturing landscape that China presents.

Successful US companies with eyes and ears on the ground in China don't read about change in the Wall Street Journal – they develop contingency plans and execute them before change strikes.