Yesterday, a long-term European client of ours asked me about the state of manufacturing in China. In response I asked him if he wanted the long or the short version. When he replied, “short,” my response was “really mixed, but overall really bad.” He then asked me to give him the short version how foreign companies are feeling about China manufacturing “going forward.” My answer was that I’d heard or read dozens of times someone saying the Coronavirus was “the last straw.”
Being a lawyer, being forced to give a short answer left a bad taste in my mouth and so as soon as I got off the phone I resolved to expound on what our international manufacturing lawyers are seeing via a blog post. This one.
China manufacturing is anything but back to normal. Both the media and our own clients are telling us this. The client mentioned above was calling because it had just learned that the widgets its Chinese manufacturer had promised them by the third week of April would not be delivered for an indeterminate amount of time. Seems one its China factory’s suppliers has shut down for good because virtually none of its workers had returned to work and it simply could not afford to keep going. The China factory said it would be able to give our client a new estimated date if and when it finds the component part from another Chinese supplier. I pointed out to my client something it already knew which was that if finding that part was easy, they would have found it by now.
We also keep hearing from clients of Chinese factories at 20 to 40 percent capacity. When they tell me that I say that these sorts of numbers are not as meaningful as they first sound. To digress a bit, I remember being in South Korea during the Asian Crisis and reading in a Korean newspaper how food imports from the United States were down 40 percent (I think that’s the number), but the same story noted that Korean imports of US Apples had barely budged whereas its imports of a couple of fruits (I want to say kumquats and rasberries) had declined 100 percent. The point of this digression is that the actionable information to be gleaned from an overall percentage is oftentimes not terribly helpful for your specific situation.
So let’s break down what it might mean for you if your Chinese factory tells you that it is back to 40 percent capacity and the questions you should ask about that. First off, ask what it means by 40 percent capacity. Does it mean that 40 percent of its workers are at work? Does it mean that it is making only 4 out of its usual 10 products? Does it mean that it is making exactly 40 percent of all of its usual 10 products? Does it mean that 40 percent of its workers are back but it is not making anything yet because it cannot get necessary component parts from its suppliers or because some of its key machinery isn’t functioning because those who repair it will not come by? Or is the factory just flat out lying about its capacity so as to entice you to offer to pay more for its widgets so that you will be among the mythical 40 percent that actually get product? Or is the factory lying about its capacity to get you to send it money it can use to try to get to 40 percent capacity? Or — and I got this example from Walter Ruigu on Linkedin, is your Chinese factory at 40 percent capacity yet still has more than enough widgets to sell to you because Chinese domestic demand has plunged for its widgets due to the tanking of China’s economy?
Now let’s zoom back out to what is actually happening with China’s economy these days. The short answer is that it tanked and is still tanking, at a rate far greater than most analysts had been expecting. In China factory activity shrank at its fastest rate on record , Official Chinese government numbers show that every aspect of China’s economy has been crushed, not just manufacturing:
China’s official Purchasing Managers’ Index (PMI) fell to a record low of 35.7 in February from 50.0 in January, the National Bureau of Statistics said on Saturday, well below the 50-point mark that separates monthly growth from contraction. Analysts polled by Reuters expected the February PMI to come in at 46.0.
The results suggest deepening cracks in an economy already hit by the trade war as the coronavirus forces widespread transport curbs and tough public health measures which have paralyzed economic activity.
A sub-index of manufacturing production nosedived to 27.8 in February from January’s 51.3 while a reading of new orders plunged to 29.3, down from 51.4 a month earlier.
Factories continued to lose jobs at the fastest pace in years as labor conditions remained tight amid the travel restrictions.
Official data showed that only about 30% of China’s small- and medium-sized companies had resumed production as of Wednesday. Some firms that have restarted work are reportedly running below normal capacity.
Even if labor shortages in China start to ease, some factories may run into problems resuming normal production if outbreaks in other countries mean they have trouble sourcing intermediate goods.
China’s services sector activity also posted the deepest contraction on record, with official non-manufacturing PMI dropping to 29.6, from 54.1 in January, a separate NBS survey showed.
A sub-index of construction activity, a key driver of growth, stood at 26.6, down from 59.7 in January.
What does this mean for your manufacturing in China? Most whose livelihoods depend entirely on China are claiming China will recover next week as though nothing ever happened, but that is not at all what we are hearing and not at all what common sense should tell you. If you see someone saying this go back and see what they said about the US-China trade war and I will bet that they claimed that would end quickly as well. Oh, and just for the record, way back in October, 2018, in China, the United States and the New Normal, we stated that the US-China trade war was here to stay and that same month we started beating the drums about foreign companies moving their manufacturing out of China. Would the Last Company Manufacturing in China Please Turn Off the Lights.
Sadly, we still have pretty much nothing but bad news about China manufacturing and its economy.
1. Chinese companies are going out of business and that will continue as foreign companies race for the exit. It should go without saying that when a country’s economy is in tatters, you will see an increase in companies shutting down. We are seeing this with manufacturing companies and we expect this will only get worse as more and more foreign companies move their manufacturing out. Just this week, in China’s ravaged manufacturing heartlands force international firms to speed up exit strategies,Finbarr Bermingham wrote of how companies “are increasingly fleeing China, having seen the coronavirus outbreak as validation of exit strategies made during the US trade war.” Finbarr goes on to say that “having already dealt with rising wages, burdensome governance and a bruising two-year tit-for-tat tariff slug out with the United States, the coronavirus outbreak, which has ripped through the country’s economy and upended the global supply chain, is the last straw.” Or as Kenneth Rapoza, Forbes Senior Reporter for Emerging Markets, put it in his recent article, Coronavirus Could Be The End Of China As A Global Manufacturing Hub: “The new coronavirus Covid-19 will end up being the final curtain on China’s nearly 30 year role as the world’s leading manufacturer.” This is exactly what our international manufacturing lawyers are seeing and hearing from our clients as well.
2. China’s bad economy will end up encouraging more foreign companies to exit. In the short term China’s bad economy may lead to a reduction in product pricing which may lead some foreign companies to stay with their Chinese manufacturers longer than they otherwise might have. But long term, all sorts of things will happen that will accelerate foreign companies leaving. What will this mean for foreign companies that get their products from Chinese factories?
— It means long term suppliers of critical products and materials will suddenly disappear without notice. Chinese factories have a strong incentive to make a fraudulent sales before shutting down so as to extract a profit from one or more foreign buyers. This profit is then pocketed by the managers who then disappear. This type of scheme has been employed almost as standard procedure in past economic downturns and there is no reason not to expect this type of fraud will be used in 2020. We wrote about the need to watch out for this sort of scam in China Business Scam Week, Part 2: Bricks for Products:
These things happen with companies that want to make a few final sales before they file for bankruptcy or just shut down and disappear. Just imagine the profits to be made from three $350,000 sales for which no product is ever provided. So just imagine the incentive for the owners of the Chinese manufacturing company to sell and not supply to foreign companies right before (or sometimes even right after) they shut their doors for good.
The China lawyers in my law firm call this the bricks for product scam because the first time we ever saw it was more than a decade ago when a U.S.-Norwegian fish company bought about a million dollars in fish from a Chinese company and every container consisted of a thin layer of fish wrapped around a core of bricks. The Chinese company that sent the fish for bricks had shut down and its managers had fled town and were nowhere to be found. Or at least that is what the local government told us. In that case (as in most that we see), there were plenty of warning signs, all of which were ignored.
The standard technique is to offer a discount for a larger than usual sale amount and then deliver nothing or almost nothing. Sometimes nothing at all is shipped. In other cases, a fraudulent shipment is made: a container full of bricks, barrels full of water or sand, or a refrigerated container full of rotten fish or fruit. By the time the foreign company discovers the fraud, the Chinese company (often a local SOE) has already been liquidated and its owners/managers have disappeared. Much of the time, little can be done.
However, if the Chinese company formally declares bankruptcy (which does happen) and if it has some assets left (which also does happen) and if you have a China-centric manufacturing contract (see On SMEs Trusting China Manufacturers. Don’t. Just Don’t.) you at least have a chance at getting some or all of your money back. Even better, of course, is to delay payment until after you have confirmed delivery of conforming product.
I got a call from someone just last week who was out a million dollars after having been convinced by its long-term China supplier to send money early so that it would have sufficient funds to make new product.
Way back in 2011, in China. Smells Like 2008, Gloom And Doom Edition, we wrote about how these “bricks for fish” scams pop up during China economic downturns:
Chinese companies that are going out of business or believe they are going out of business have an annoying tendency to ship bad or fake or no product at all. In 2008, pretty much every week we were getting calls from companies saying that the product they had ordered just was not coming. We handled one case where a company had bought about a million dollars of fish and received containers of cheap bricks surrounded by fish. That fake shipment was the dying gasp of a company that ceased to exist. We have started to get those same sort of calls in large numbers again.
— It means China manufacturers will be a LOT quicker to steal your IP.
Our China trademark lawyers are getting a ton of China trademark theft calls and I am certain these will only increase. Chinese factories are hurting and they desperately want to improve their profit margins. and they see selling your product under your prestigious brand name as a way to do this. See Your China Factory as your Toughest Competitor. Our China IP lawyers usually take the following approaches to fight back against China trademark thefts:
The first thing we usually do is figure out some basis for challenging this Chinese company’s trademark filing. Our favorite challenge is non-usage of the trademark for more than three years. If the trademark challenge does not work, we then try to figure out whether there might be a workaround. For example, we had a lawn equipment company that had its brand name filed as a trademark for 17 things related to lawn equipment but the trademark “thief” failed to file for small engines, like those you find on lawn equipment. So our workaround was to get our client the trademark for small engines and then put its name in steel on the engine and then add a sticker or two to the lawnmowers once they hit the United States and Europe where our client sold its lawn equipment. [NOTE: I changed the type of product to make it impossible to be able to identify the company for whom we did this intellectual property workaround]. If none of these things look like they can work, we then try to purchase the brand your name from the Chinese company that registered it. As a last resort, we seek to purchase the trademark from the Chinese company that registered it.The real key to avoiding the above sort of trademark problem is to secure the Chinese trademark for your brand name before you ever reveal your brand name to anyone in China See China Trademarks: Register Yours BEFORE You Do ANYTHING Else. Oh, and be sure to use a real lawyer for this. See Fake China Law Firms Are The Real Deal and Is This a Real China Lawyer?
In other words, as bad as things are in China manufacturing right now, they are only going to get worse and as they do so a vicious circle will form and as more foreign companies will leave and things will then get even worse.
Where will the manufacturers that leave China go? To Thailand, Vietnam, Malaysia, Taiwan, the Phillipines, India, Turkey, Portugal, Poland, Colombia, Chile, Mexico. All over. But of all these countries, we predict Mexico will be the biggest beneficiary and in part 2 of this series, we will explain why.