A few months ago, Steve Dickinson wrote about what would happen to low-tech factories along the coast of China in Factory Closings In South China. All Part Of The Plan:

Low value added/high labor content manufacturers from Wenzhou in Zhejiang down to Zhuhai in Guangdong are undergoing extreme financial stress. The affected sectors are in the traditional outsourcing industries: textiles, toys, shoes and furniture.

The 12th Five Year plan clearly states that a primary goal is to eliminate low value added/high labor content export manufacturing from the entire coast. The intent is to shift to high value added, technologically advanced manufacturing and modern services in this region.

The main question in my mind is: when will this transition be 50% done?

I think we are only 10-20% through it. In Guangdong (the most mature industrial base in China), there are still tens of thousands of low-tech factories. Most of them are still in business, some of them have disappeared, and new ones are set up every day.

Of course, they are feeling the pressure from rising costs, unfavorable government policies, and the competition from factories with a lower cost base. It means most of them make very little profits, and many of them actually lose money.

But Guangdong still has the highest share of low-tech products. Inspection firms will tell you that the highest number of garments and promo items are still made there.

Note that Guangdong province is not the only one involved in this transition. In Wenzhou (Zhejiang province), a few months ago, I heard many small manufacturers were not making enough cash to reimburse their debts and had to close down.

Why is this transition taking so long in Guangdong?

There are many factors at play:

• A supplier base that buyers have taken years to find and train (and that is not easy to replicate somewhere else).
• A dense network of sub-suppliers that are often in the same area as the assemblers, which means faster production runs and lower minimum quantities.
• A supply chain and a logistical environment that are particularly reliable and efficient.
• A high number of buying offices that were set up locally, and the proximity to Hong Kong (which is still involved in a significant part of Chinese exports).

For more information on this topic, you can read What future for Guangdong manufacturing?.

What are the consequences of this transition?

As Steve Dickinson recently wrote in How YOU Must Prepare For It., importers should be more careful then ever while this transition accelerates:

Many companies will fail. Many of these companies will have a long and excellent track record of performance. But they will still fail because their business model no longer works.

In this environment, there are substantial risks that foreign buyers must prepare for with great care:

• Many buyers pay an advance deposit for products. Many failing manufacturers will collect these deposits with no intention of ever manufacturing the product.
• If a manufacturer is struggling, the level of defects will rise to a shockingly high level. Manufacturers that owe a credit or refund from prior defects will not pay. There is also tremendous pressure for the manufacturer to substitute low quality or non-conforming components to save money. Lead content paint on toys or low quality fasteners on clothing are examples.
• Many buyers pay for their product at the time of shipment without doing an inspection of the product. This leads to a great risk of fraud in dealings with a manufacturer who is going to go out of business in a short time. Some standard frauds are as follows:
• The manufacturer simply does not ship the product. Sometimes the manufacturer will convince the buyer to make a payment to a new bank account. Often this bank account is in the wrong name or even in a different country. When the buyer complains that there has been no shipment, the manufacturer claims the buyer is the victim of fraud by someone other than the manufacturer. We are seeing this one a lot, with the “new” bank account being a personal (rather than a business) one.
• The manufacturer takes payment, and then ships an entirely different product or a non-conforming product. For example, a container of frozen fish will turn out to have one layer of fish and the remainder of the container is bricks. Or a container of a frozen food product when unfrozen will turn out to be entirely rotten product. We had a client receive a shipment of frozen salmon that was so rotten that the container was declared a hazardous waste site right on the dock.
• Even where the buyer inspects, we have recently seen a number of cases of outright fraud. In these cases, the buyer watched the product be loaded and the container sealed. The manufacturer then switched the container on the dock and sent an entirely different product to the buyer.

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Related article: The 3 trends of China manufacturing

Yesterday I responded to a question on LinkedIn, and I thought it would be interesting for other readers.

Here was the (quite common) question:

What are some cheaper alternatives to L/C for international trade?

If you want to do business outside of the United States with countries/merchants that do not take credit cards and want also avoid expensive L/C fees while providing both protections against quality of merchandise and fraud, what are the alternatives?

Here was my “20 seconds to read” response:

The most common payment method is a bank wire. It usually works this way:

- You make sure you work with serious people: ask for customer reference, run background checks, and/or perform factory audits.

- You develop samples until you are confident the suppliers knows exactly what you want.

- You wire a 30% deposit before production starts.

- You pay a quality assurance firm to inspect product quality.

- You wire the remaining 70% before shipment.

- The supplier ships the goods and sends you the documents by express courier.

Then Etienne Charlier, from Procur’Asia, wrote this complement to my response:

Adding on Renaud’s information, a possible alternative to L/C is what I call the L/C of the poor:

1. You pay first the down payment that you can negotiate (from 0% to 30%). 30% should be the maximum.

2. Once the supplier confirm the goods are ready, you ask your inspector to check the goods. If everything is OK, you release the goods (allow the goods to be sent to the ship

3. Once the goods are on board of the ship, the supplier gets the Bill or Lading (B/L)

4. You ask the supplier to send you a copy of the B/L

5. If everything is OK on the bill of lading (it is important to check this thoroughly), then you pay the final payment to the supplier

6. Once the supplier receives the payment, they send you the original B/L

This is not fool proof, but the incentives are properly placed:

- if you do not pay the supplier knows you will never get the goods, so there is not much incentives for you not pay

- if the supplier gets the money but does not send you the original B/L, they still do not get any advantage since the goods are sent out, so there is no reason to do that.

However, this is not foolproof. The L/C is the only way to really get some security.

So, it is up to you to evaluate whether the cost related to the risk of losing one shipment you paid for is lower than the cost of a real L/C. The higher the value density of your product, the higher the risk is.

I very much agree with Etienne. I advise all importers to ask for this payment term, when they cannot afford the fees that come with a letter of credit (see Confirming quality when paying by bank wire).

But, unfortunately, small importers (such as the one who asked this question, I guess) often find it impossible to negotiate the final payment AFTER shipment. It is much easier when the supplier knows your company and really wants to work with you…

++++ Update ++++

For a more in-depth look into the risks of paying prior to shipment, read this excellent article on the China Law Blog.

As I explained before in Confirming quality when paying by irrevocable letter of credit, an importer can pay his suppliers through letters of credit (L/C). An L/C triggers the payment once the bank receives a pre-determined list of documents from the supplier.

It protects buyers much more than a regular bank wire, since there is no upfront deposit. Payment happens after shipment!

More specifically, a letter of credit prevents:

• Shipment delays, since the letter of credit has an expiry date (which can be extended by the importer)
• Last-minute cost increases, since prices are written down and can only be modified by the importer
• Product quality issues, if the buyer does not forget to request a certificate from a third-party inspection company

The good thing: L/Cs can be cancelled

Suppliers know that, however hard they try, their documents seldom respect all the requirements listed in the L/C. The buyer’s bank nearly always finds some discrepancies, and then it is up to the buyer to decide whether to waive them or not.

A specialist who has worked on thousands on letters of credit told me the proportion of “clean” L/Cs (with no discrepancy) is below 1%. In practice, it means buyers can cancel the L/C and the purchase order. In this case, the supplier knows he won’t get paid, and the transaction is over.

As a result, the suppliers who accept letters of credit and who know that you can cancel the order (without pissing your customers off) tend to be more cautious and more honest.

The bad thing: payment is triggered before the goods arrive

As I wrote previously, buyers are not 100% protected by a letter of credit. It is entirely possible to pay by L/C and to receive a container of garbage. In that case, it is too late. Payment is done. The transaction can’t be undone.

Remember: banks deal with documents. Not with products. The right way to proceed is to nominate a third-party quality control firm, and to request an inspection certificate from them. And then, to refuse shipment if the QC report is not satisfactory…

I wrote several times that the most organized buyers adopt a project management approach. Mike Bellamy just published a very good video that explains why, and how, importers can follow this approach to manage their production in China.

First, Mike notes that importers should not count on their suppliers’ management system:

While China has some amazing pricing, it is not known for excellent quality or short lead times. This means that the placement of the PO is the start of the supplier management process in China, not the end. It is very rare for suppliers, even ones that are as large as 1000 employees, to have proper project managment software which clearly defines and tracks who is doing what, by when, within their organization.

To the contrary, usually there is an account manager or sales person that takes point on walking your project thru all the steps from production to delivery.

Salespeople are good at sales or can speak English, but most aren’t engineers, certified project managers, or even know their way around a production line.

Very true… The salespeople seldom have a full understanding of the realities and constraints of production. Since they need to speak good English, they all went to college… And not a single one of them has experience working on the production floor.

Worse, they simply repeat what their coworkers tell them without checking. Sometimes, a production has not started in the workshop, but some people sitting in the same building believe it is near completion!

So, what should buyers do? How can they follow their production?

This may sound obvious, but if you and your supplier don’t have a system for project management then you need to be proactive and create one. For example, a simple excel sheet listing action items, project gates, deadlines, and responsible parties is a huge improvement over trying to manage via email. Have this open project list serve as the agenda for periodic conference calls with your supplier. Once the tasks are mutually agreed, save this document for future reference. Keep a record of each week’s agreed steps.

Now, one word of caution. Be tactful. As my friend Etienne from Procur’Asia commented in response to a recent article on this blog:

Attitude (at both side) and the way we check and request updates is really important. I have seen many requests for update sent to suppliers by email that are just a one liner and lead to either a one liner ping-pong game or a flaming chain of email. Not the way to project-manage a p.o.

The key is to build the relationship with regular face-to-face meetings. This way, you’ll know how to ask for updates, and you’ll be more likely to receive them. In Mike’s words:

Make sure you communicate with the suppliers on a regular basis. If you aren’t asking for updates, you are unlikely to receive them. Be in contact when there is good news to share so that you don’t become the “headache client” who contacts the factory only when things are bad.

Sounds like excellent advice.

What do you think?

The Global Supply Chain Council organizes a conference called CHaINA live. It will take place on 2 & 3 Nov. in Shanghai.

Several people I respect are either speakers or attendees. For example, my friend Andrew Reich from In Touch will be speaking on the best ways to manage and develop a Chinese factory.

If you attend this event, you will have the choice to focus on topics that are of interest to you. Here are some of these topics:

• Role of Quality in Supply Chain
• Global Sourcing & Procurement 2.0
• China’s structural shift in Global Supply Chain
• Indirect Procurement
• B2C eCommerce Logistics
• Retail Supply Chain
• Warehousing Best practices
• Distribution Network Optimization
• Sales & Operations Planning
• Lean Supply Chain
• Money Talk (even in SCM)
• Order Fulfillment
• Social Media & Supply Chain
• Supply Chain Fraud
• HR in Supply Chain
• Trade Compliance in the Supply Chain
• Sustainable Supply Chain

More information here.

A journalist asked me this question: “Is China over, as a sourcing destination?”

My response was no… but it might be a destination for a different type of sourcing projects.

• No in the very short term, because supply chains can’t be dismantled and relocated easily–especially with so many importers having set up local buying offices and trained local staff.
• No in the longer term (10 years), because China will still have an advantage when cost and speed are factored in.

I gave it some thought, and I see three trends for China in the next 10 years.

Trend 1: changing mix of products

The Chinese manufacturing sector is going through a painful transition, from high-labor-content products (e.g. textile, shoes, decoration, toys) to more complex technologies (e.g. industrial goods, cars, pharmaceuticals…).

I don’t mean that garments won’t be made in China any more, but that only high-quality garment factories will be competitive for export markets in 10 years. Others will be wiped out by the competition of other Asian countries, or will focus on the domestic market.

In the near future, China manufacturers will be competing against German exporters more often than against low-cost Vietnamese of Bangladeshi factories.

Trend 2: higher domestic consumption 

China will consume a higher proportion of its industrial output. Many manufacturers have already noticed that margins are better when they sell on the domestic market. Young graduates don’t want to work in international trade as much as they used to.

The export business will not fall sharply, but it will slowly decline in proportion. Producing in China for selling in China will become more and more common, especially as local manufacturers develop their know-how and their technology, and as IP rights are better protected in local courts.

Trend 3: more factories in inner provinces

Chinese production base is slowly shifting to inland provinces, where labor, land, and electricity are cheaper. It will also become a necessity because the number of migrant workers willing to go to coastal areas is declining.

At the low- and medium-end, domestic consumers are very price-sensitive. There is no sense in producing for China’s market in places that are close to international ports, if costs are lower in less developed provinces.

It will also be a strategy to keep costs down and keep serving export customers. Manufacturers of components might relocate inland, while final assemblers will tend to stay along the coast.

Do you agree?

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PS: if you have time, have a look at the “best of” edition of the China Sourcer magazine (the publication of the China Sourcing Information Center).

Last week I wrote about the future of Guangdong manufacturing. I thought it would be nice to show how an industry gradually moved away from its center in Hong Kong and Guangdong province.

I picked the lingerie (bras and panties for ladies) industry because I know it intimately. I was purchasing and selling lingerie around 2005/2006. And some of my clients are lingerie importers, so I see where the trends seem to be going.

It is an interesting case study because lingerie production necessitates certain unique materials and accessories, as well as a specific know-how (sewing bra cups is done by hand).

Let’s see how production moved away from its base and formed several clusters.

The Pearl River delta, in Guangdong

In the 1980s, the factories located in Hong Kong (in the TaiKokTsui and SheungShaWan areas) moved across the border to Shenzhen and Dongguan, because of the price difference.

Hong Kong companies also migrated to the other side of the delta, around Zhongshan and Zhuhai (because of the short ferry trips and the higher proportion of local, Cantonese-speaking workers in these cities).

I should also mention there is a very strong concentration of lingerie manufacturers just West of Guangzhou, in the Nanhai district of Foshan city.

The above-mentioned areas are around the Pearl River delta. They now count the highest number of mid-and-high-end lingerie factories. Some of them, like Maniform or Oleno, have even launched their high-end brands on the Chinese market.

And most fabrics & accessories suppliers are also in this area, including a number of foreign microfiber, lace, embroidery, and accessories (rings, sliders, hooks & eyes…) producers. It is still by far the biggest production base for lingerie.

The development of Shantou

Shantou city is to the East of Guangdong province, about 5 hours away from Shenzhen. It is now the hub for cheap bras & panties, both for the domestic market and for overseas importers.

I heard from several factories that their supplier base for fabrics is getting better. Getting materials from the Pearl River delta is not that expensive anyway. And they ship out from the Shenzhen and Hong Kong ports.

Average quality is lower than in Dongguan or Zhongshan. Understanding of customer requirements is often non-existent. Personally I hate the way Shantou people conduct business. But the lower labor cost makes it an attractive destination for buyers at the low end.

Fujian province

Around Quanzhou city (4-5 hours east of Shantou), thousands of workshops produce simple cotton underwear, and some molded bras (the type of bras that needs little sewing know-how).

For these simple goods, prices are even lower than in Shantou. Cotton fabric can be purchased locally for a very low cost.

Most factories don’t do direct business with export customers. They often sell through Xiamen- or Hong Kong-based trading companies.

Zhejiang

There is a lot of seamless underwear around Yiwu, but no deep know-how about sewing of bras. Only a few manufacturers are capable of making the full line of lingerie items.

Inner provinces

I see more and more manufacturers setting up their operations in provinces like Jiangxi, Hunan, and Guangxi. They have to pay transport costs to get the fabrics and the accessories, but the much lower labor cost is very attractive.

The idea is to lure some skilled workers who originally come from these inner provinces to “go back home” and train new, local staff.

However, a tiny proportion of suppliers have made this move inland.

Other Asian countries

Vietnam, Sri Lanka, and Indonesia also possess the necessary knowledge to sew bras. Only Vietnam currently seems able to compete with China on prices. They often purchase their materials from China, which makes the supply chain a bit slower and less agile, though.

Bangladesh and Pakistan are suitable for making simple cotton underwear, but they have trouble facing the competition from the Shantou and Quanzhou clusters.

The case of India is more interesting. Triumph was a pioneer and opened several lingerie factories there around 2006-2007, so the critical know-how might become widespread. Wearing a bra is becoming fashionable in this huge country, so everyone is eyeing this market’s potential and wants to be able to produce locally.

The region of Tirupur, in the South, is the main production base of knit garments. I went there 3 years ago, and some American firms had just make multi-million dollar investments to jumpstart lingerie production.

The trend is clearly for a fragmentation of this industry, a relocation away from Guangdong, and a slow spreading of critical know-how. Exactly like thousands of other industries, right?

Earlier this week, I got a few questions from a European importer who has positioned his brand as “socially and environmentally responsible”.

They asked me how they could make sure their productions are done in conditions they would approve of, and how to check the factories use the right types of materials. Ideally, they would like to know everything about their supply chain.

Traceability of materials and processes

If a buyer wants to discover and control his whole supply chain, it will always be difficult in China. First, let’s say he wants to know the factory that takes care of final assembly. This is not as obvious as it sounds. Suppliers are not producers, and many producers sub-contract the manufacturing in the purchasers’ back.

Let’s also say he wants to know the material suppliers, the dying house, the printer, the accessories suppliers… (see the illustration on this page). That will be a lot of work. A Chinese manufacturer will not disclose the names of its sub-suppliers easily.

Why? Because they want to be able to switch from one to the other (let’s say, to save on price, or because of personal connections) without the buyer’s authorization. Transparency is not in the manufacturer’s interest.

It is POSSIBLE to identify and qualify all these different companies, but it will be a lot of upfront investment in research and auditing. And, if your volumes are small, the suppliers will not accept all your demands gladly.

Social compliance

This one is maybe an ever tougher nut to crack, if the importer’s demands are not realistic. A poorly-designed monitoring policy will have undesirable perverse effects.

In China, less than 1% of factories respect the labor law fully. The most common violation is to work over 40 hours a week. You can try to select factories that are not in severe non-compliance, but you will have a hard time finding one that is 100% in compliance!