Moving Manufacturing from China: Where you Gonna Run?

Many of our clients are considering moving their manufacturing out of China. As they look around S.E. Asia and South Asia (and occasionally elsewhere as well), they often come to us with the following question: to where should we move? In analyzing that question, it is worthwhile to consider why manufacturers were initially attracted to China in the first place, starting mostly in the 90s. The fact is China created a very attractive incentive system that made the move to China make economic sense. Most (but obviously not all) countries in S.E./South Asia are at a level of development similar to that of China in the 90s. So the first question any company should ask is whether there is an incentive program in place that makes it economically sensible to move production to a country at this level of development.

The Chinese system was composed of three interlocking components:

1. Government benefits.

The most important benefit was exemption from taxation. During this period, foreign invested enterprises were completely exempted from corporate income taxation. Wholly foreign owned enterprises and Sino-foreign joint ventures paid zero corporate income tax at the same time Chinese owned enterprises paid a 30% tax. This was not an exemption for a period of years: there simply was no tax imposed. China also did not impose a personal income tax until 1986 and it barely sought to collect on that until many years later. This too reduced the tax burden for both local and foreign workers.

The government provided further benefits to attract foreign manufacturers:

  • Land and factory buildings were provided at reduced rates or virtually without cost.
  • VAT/duties on import of equipment was exempted.
  • VAT/duties on import of raw materials was exempted.
  • Wage and hour protections for workers were relaxed or simply ignored.
  • Electricity, petroleum products and natural gas and other utilities were provided at substantially reduced rates.

Also, no restrictions were placed on the type of manufacturing. Low value added, low technology, high employment manufacturing was encouraged. There were two main criteria for approval of manufacturing . projects: provide employment and generate foreign exchange. If these criteria were met, the benefits were provided. Most important, once granted, the benefits were not taken away.

2. Industrial zones.

The Chinese government pushed foreign manufacturing investment into industrial zones which were operated in conjunction with local governments. These industrial zones would often compete with each other to provide additional benefits that . attracted foreign manufacturers. The most important of these were the following:

  • Pre-built factory, warehouse and office buildings available for immediate occupancy for rent or purchase. Rent was at reduced rates and the purchase price was heavily discounted.
  • Where more complex structures were required, the zones offered to build to suit, again at highly reduced rates.
  • Assistance in finding factory workers and management personnel.
  • Utilities pre-installed and provided at reduced rates.
  • Service and repair facilities provided on-site or in the immediate vicinity.
  • Assistance in obtaining all required government approvals for initial investments and in annual reporting, all handled within the industrial zone.

Chinese industrial zones competed with each other to provide the most benefits and the highest level of service. Zones that succeeded lived up to their promises. If they did not, due to the intense competition, they would be replaced by some other zone. The offer of benefits and incentives was not a “bait and switch”. The successful zones lived up to their promises.

3. Export promotion.

The Chinese system was focused on developing an export led economy. The goal was to create employment and to generate foreign exchange. A VAT rebate system was created to support this focus on exports, made up of two primary components:

First, products exported were partially or completely exempted from the high Chinese VAT rate of 17%. This exemption strongly supported export sales. It led to the often surprising situation where an item manufactured in China was actually far more expensive within China than when purchased outside China. Nike shoes made in Qingdao were cheaper in Taipei than in Qingdao itself.

Second, VAT was exempted on raw materials and components imported into China for use in product manufactured solely for export. This led to the situation where Chinese factories often did little more than assemble components imported from around the world. This left China behind in the development of technology, but it met China’s goal of creating jobs and generating foreign exchange.

These industrial programs were wildly successful and from 1992 to 2002, China went from being a backwater to becoming the factory of the world. There were several reasons for China’s success. First, the above enumerated benefits had real economic impact and they outweighed the disadvantages of manufacturing in an undeveloped country. Second, the benefits were offered to all comers. Low-tech, low-value added, high labor input manufacturing was welcomed. There was no attempt to favor high tech businesses and there was no attempt to force manufacturing into the less-developed regions of China. Manufacturing was located in major urban centers on the East Coast and labor was imported from the less-developed regions. Finally, the benefits were real. The Chinese side lived up to its commitments. When offered, incentives were not removed. Remittance of profits overseas was permitted. Land and buildings were not appropriated by the government. Leases were honored and the low lease rates were maintained.

Starting in 2005, China began progressively dismantling this system to the point where today China has become a high tax, high expense, heavily regulated place to do business. Chinese government incentives, where they exist, now focus on promoting high-tech, high-value added, low employment products: the exact opposite of its earlier programs. Where low-tech manufacturing is even considered, incentives are entirely focused on pushing manufacturing into the undeveloped Western region of China.

As a result of this change, many manufacturers have forgotten the type of incentive program that allowed China to build its export oriented manufacturing base. Also as a result of this change, for many manufacturers, China is no longer an attractive place to conduct their manufacturing operations. So the move from China was certain to happen. The current tariff dispute with the U.S. has just accelerated a process that was already in place.

So this brings us back to companies considering moving their manufacturing from China. If you are moving to S.E./South Asia, you are moving to a region that is in many respects at the level of China during its early period when the full incentive program was in place. This is important to recognize. The countries in this region are not at the level of manufacturing China is today. So you must expect you will be moving into a region with substantial disadvantages. You must then consider whether the region you are considering offers benefits that outweigh those disadvantages. You cannot simply assume the situation will be the same as for China today.

The analysis should operate on three basic stages:

First, does the country you are considering offer an incentive program similar to the three-part Chinese program described above? This analysis must be done carefully. Many countries in this region claim to offer incentive programs along the lines of the old China model, but when our international manufacturing lawyers at my firm closely examine the incentives, we see that these programs are similar to the current Chinese high-tech, rural development model. They are not similar in any way to the three element, low-tech, high-employment model I describe above.

Second, if no incentive program provides real benefits, then you have to consider whether there are other benefits that will lead to profitability. Usually, manufacturers will consider low wages as a major factor. In our experience, low wages standing alone were seldom reason enough to justify a manufacturing operation in China. So careful analysis of this issue is required for any new region.

Third, if direct manufacturing does not make economic sense, don’t give up. There are many other alternatives. For example, there are various ways contract manufacturing can profitably be used as a viable alternative to direct manufacturing via a wholly foreign owned entity. There are many varieties of contract manufacturing: straight purchases from a local factory, licensed manufacturing on a royalty system, partnerships involving multiple partners in manufacturing, distribution and retail of the product or product line.

Often these “partnerships” involve providing some form of financing to the local factory and in those cases it is important that the financing be adapted to local law and business custom. As an alternative to setting up a wholly owned factory in the region, many companies will choose instead to establish an office in a central location that will manage the operations of locally owned factories. These factories may be located in many different countries, making on the ground management in the region a requirement rather than an option. Many of our clients have been pursuing this tact , often while having their contract manufacturing done in Vietnam, Thailand, Cambodia, Malaysia, Taiwan and/or the Philipines. Oftentimes China remains in the mix as well.

The take away here is that as manufacturers move out of China, they are required to step back and consider how they will operate from an entirely fresh perspective. The Chinese system in place from 1992 to 2005 was a unique system and not likely to be replicated in S.E./South Asia or in any other region of the world. So for manufacturers, moving to a new region means the need to do their analysis from the ground up. There are a lot of great opportunites for manufacturin in SE Asia, but simply taking what you do in China and moving it to a new location is not likely to be a workable solution.  See e.g. Manufacturing Outside China: It’s Thailand’s Time.

9-25 Update. Today two of the best quality control companies in Asia, Insight Quality and Quality Inspection, wrote posts essentially agreeing with the above. In China Still Best For New & Complex Manufacturing Projects, Quality Inspection discussed this blog post and concluded that China is still light years ahead of SE Asia for complex manufacturing. And in Sourcing in Vietnam: a Good Alternative to China? Insight Quality wrote about the complications and “issues” involved with manufacturing in Vietnam that have for the most part already been solved in China. Truth be told, our law firm would LOVE it if everyone were to move their manufacturing from China to some other country in Asia or Europe or Latin America, but it just is not that easy. We would love it because when that happens (and it has been happening a lot lately) we make money helping our clients leave China safely and then we make more money in helping our clients go into their new country. But in the end, we see our job as lawyers to be to help our clients make the right decisions for their business and we realize that is not an easy decision and we have no intention of making it seem easier than it is.

Editor’s Note: I went with Peter Tosh’s Where You Gonna Run because that was what the writer of this post, Steve Dickinson, specified. But had I been left to my own druthers (and as much as I love Peter Tosh) I would have chosen Nina Simone’s Sinnnerman (Where you gonna run to?), which I could not resist adding below. And yes, I realize we also could have gone with Martha and the Vandellas doing Nowhere to Run.

So many great songs, so many great countries for your manufacturing….