China's Changing Impact On Regional Manufacturing

BMI View: China's endeavours to revamp its industrial structure and will be the primary driving force shaping Asia's manufacturing landscape going forward. Northeast Asian economies stand to be the most adversely affected, with Taiwan likely to be hit hardest as a result of its recent stagnation in the tech sector. Although we expect to see a shift of production facilities out of China and into cheaper neighbouring locales within Southeast Asia, we do not expect a complete exodus of low-cost manufacturing out of the country as businesses increasingly adopt the 'China-plus-one' strategy.

Asia's role within the global manufacturing industry has witnessed a sea-change over the last few decades. Led by Japan post-World War II and followed by the Asian Tigers (South Korea, Taiwan, Singapore and Hong Kong) in the 1960s and 1970s, its rapid transformation from the manufacturing of predominantly textiles and other low-order goods to higher-end goods presently has enabled a number of East Asia economies to become some of the most developed and wealthiest countries in the world. While adopting different paths towards industrialisation, the main thrust behind Asia's move up the global manufacturing chain was the region's progressively greater openness to international trade and thirst for foreign direct investment as a means to speed up economic development from their nascent stages.

With regional economic development presently more divergent, the fundamental forces driving the change in the region's industrial structure are now less endogenous and instead more influenced by external factors. The most salient external influence in our view is that of China's economic restructuring efforts.

Southeast Asia To Start To Play Catch
Asia - GDP Per Capita, US$

China's Changing Impact On Regional Manufacturing

BMI View: China's endeavours to revamp its industrial structure and will be the primary driving force shaping Asia's manufacturing landscape going forward. Northeast Asian economies stand to be the most adversely affected, with Taiwan likely to be hit hardest as a result of its recent stagnation in the tech sector. Although we expect to see a shift of production facilities out of China and into cheaper neighbouring locales within Southeast Asia, we do not expect a complete exodus of low-cost manufacturing out of the country as businesses increasingly adopt the 'China-plus-one' strategy.

Asia's role within the global manufacturing industry has witnessed a sea-change over the last few decades. Led by Japan post-World War II and followed by the Asian Tigers (South Korea, Taiwan, Singapore and Hong Kong) in the 1960s and 1970s, its rapid transformation from the manufacturing of predominantly textiles and other low-order goods to higher-end goods presently has enabled a number of East Asia economies to become some of the most developed and wealthiest countries in the world. While adopting different paths towards industrialisation, the main thrust behind Asia's move up the global manufacturing chain was the region's progressively greater openness to international trade and thirst for foreign direct investment as a means to speed up economic development from their nascent stages.

Southeast Asia To Start To Play Catch
Asia - GDP Per Capita, US$

With regional economic development presently more divergent, the fundamental forces driving the change in the region's industrial structure are now less endogenous and instead more influenced by external factors. The most salient external influence in our view is that of China's economic restructuring efforts.

China The Decisive Force

With a new leadership in Beijing in place and fresh reforms gaining traction, China's economic trajectory going forward will undoubtedly carry significant implications for the region. The central government acknowledges that the country is no longer the low-cost manufacturing paradise it once was and that its heavy infrastructure investment-led model of economic growth is no longer sustainable. The 'one-child' policy introduced in 1977 sowed the seeds for what has now culminated in a rapidly-ageing population. An ageing and increasingly disgruntled workforce, among other factors, means that low wages will no longer feature as a key attraction of China's manufacturing sector. A key plank of Beijing's reform plans in the medium- to long-term is a concerted push of the country's industries up the value-chain and into more sophisticated forms of manufacturing.

What changes can we expect in China's manufacturing landscape? Consolidation will certainly be a dominant theme in the years ahead. Aside from the elements that are causing the shift in its industrial structure, the credit boom in China over the past five years has led to significant industrial overcapacity that has in turn suppressed profitability. Efforts to curb these excesses have either started, or are expected to start, in the shipbuilding, solar power, steel and mining industries. Production facilities will also start to shift away from the Pearl River Delta and further inland where wages are cheaper, although this phenomenon is likely to take shape only when more interior infrastructure starts to come online in the years ahead. We also expect to see the development of more industrial clusters across the country. Until now, the location of production facilities has largely been determined by wage costs. Resultantly, businesses that serve the same supply chain are scattered all over the country, adding not just to transportation costs, but also the risk of supply chain bottlenecks forming, as we have seen in the semiconductor industry. Clustering not only alleviates the pressures on the supply chain, but also aids in the development of other supporting industries and has consequently been prioritised oin the government's 12 th five-year plan.

Throughout the rest of this article, we highlight why we expect the shift in China's industrial economy to adversely impact Northeast Asian economies, while at the same time, open up opportunities for a number of Southeast Asian economies.

Northeast Asia - Taiwan To Bear The Brunt, But The Risk To Korea Is Rising

Much of the reason why we believe China's industrial shift will have a more pronounced impact on Northeast Asia, particularly South Korea and Taiwan, is the fact that high-tech manufacturing is the backbone of these economies, and happens to be the very direction in which Beijing wants China to move in. Korean and Taiwanese manufacturers are now amongst the global players in the electronics industry, and companies from both countries play significant roles within the global electronics supply chain. Between the two, however, we believe that Taiwan is likely to bear the brunt of the impact from China's endeavours for structural reform.

Taiwan's tech stagnation leaves it with greatest exposure: In an earlier article (see 'China's Economic Shift A Looming Threat', June 28), we highlighted extensively the risks to Taiwan's industrial economy, particularly to its semiconductor and flat-panel sectors, in light of China's imminent rise in the global tech sphere. Comparatively to South Korea, the Taiwanese economy is less diversified and more leveraged to the tech sector, with close to half the country's exports being tech-related. Korea's manufacturing base, on the other hand, extends into automobiles, shipbuilding, steelmaking and petrochemicals, among others. Furthermore, Korea's penchant for R&D has enabled it to progress from being an original equipment manufacturer for foreign brands to creating its own global market leaders. By contrast, Taiwan's push for greater R&D expenditure has stagnated in recent years. Apart from Taiwan Semiconductor Manufacturing Co and a handful of other companies, Taiwanese businesses have been stuck at the lower rungs of the value-chain.

Less Diversified Taiwan To Be Harder
South Korea & Taiwan - Export Profile

Korea's technological supremacy to shield it, for now: This is not to say, however, that Korea is not at risk. Simply put, Korea is merely higher-up the technological ladder than Taiwan and consequently faces a less immediate threat than the latter. China has started to make material headway in the shipbuilding and telecommuincations sectors, key drivers of the Korean economy. At present, South Korea is likely to be buffered by the technological superiority it holds within its core industries. The relative advancement in shipbuilding design technology in Korea allows it to build more complex and higher-margin vessels such as drillships and LNG carriers, leaving China to manufacture cheaper and less profitable bulk carriers. In the global smartphone market, having its own chipmaking technology and capability is one of the key factors behind Samsung's dominance in the global smartphone market. Korea's lead, however, may not last for long.

As highlighted above, consolidation is gaining traction within the Chinese shipbuilding industry. In August, Beijing set in motion a stringent three-year plan to control new capacity and move the industry up the value-chain. Construction of new shipbuilding facilities has been halted, while credit has also been cut. While it is likely to take a protracted period of time for the excesses to be weeded out, strong support by the central government could expedite the process, as we have witnessed before. Also, as China looks to ramp up development of its semiconductor design and manufacturing sector, it could unlock a whole array of opportunities in the broader electronics industry and knock Korea off its perch as an industry leader.

Southeast Asia: 'China-Plus-One' To Gain Traction

The impact of the wage pressures in China is progressively becoming more evident. We have repeatedly highlighted that foreign businesses have either shifted or are looking to shift some of their manufacturing bases out of the country, and into neighbouring Southeast Asia countries. That being said, the change in China's wage structure by no means suggests that a complete exodus of manufacturing from the country should be expected. In our opinion, the trend of firms adopting a 'China-plus-one' strategy will gain increasing traction. This essentially involves businesses maintaining their presence in China, but at the same time establishing bases outside of the mainland. Given the obvious advantage of geographical proximity, and more pertinently, relatively lower wages, Southeast Asian countries such as Indonesia, Vietnam, Philippines and Thailand have become conspicuous choices, with investors also taking an interest in frontier markets such as Bangladesh, Laos, and Cambodia.

SEA A Key Beneficiary
China - Annual Wage Growth, % chg y-o-y

Going forward, much of the manufacturing shift out of China is likely to come from basic manufactures such as textiles and low-cost discrete electronics manufacturers. The production of such goods requires relatively less sophisticated skillsets and is consequently well-suited for Southeast Asia's nascent economies. We expect Indonesia, Vietnam and the Philippines to see a progressively larger presence of electronics components manufacturing, while automobile manufacturing is likely to take on a larger role in driving Thailand's economy. We expect Bangladesh to maintain its global eminence in textile manufacturing, although we also see increasing opportunities in Laos (see 'Textile Prospects Brightening, But Labour Woes A Key Impediment', January 22).

So this beckons the question: Why keep China? Wages may play a significant role, but it is not the determining factor as cheaper Southeast Asia locales, while attractive from a cost perspective, are not without their challenges. Infrastructural deficiencies plague many of these emerging economies and supply chain bottlenecks and disruptions can easily negate the cost savings from wages. Also, the labour forces in these countries have plenty of catch-up to do in terms of matching the relevant skillsets and consequent productivity levels that China can provide. Pertinently, Beijing's centralised structure of governance and penchant for gradual reforms affords businesses with a considerable degree of political stability, a particularly salient risk considering the disruption to the Thailand's economy that was sustained during the public protests in 2006 and 2010. Finally and most importantly, keeping production facilities in China allows businesses to remain close to China's mammoth domestic market.

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