Leaving the PRD - Regulations and Market Conditions Forcing

UNCLAS SECTION 01 OF 03 GUANGZHOU 000228

SIPDIS

SENSITIVE
SIPDIS

STATE PASS USTR CHINA OFFICE
STATE FOR EAP/CM

E.O. 12958: N/A
TAGS: ECON EINV ELAB ETRD EFIN CH
SUBJECT: Leaving the PRD - Regulations and Market Conditions Forcing
Some Factories Out

Ref: A) 07 GUANGZHOU 1180, B) GUANGZHOU 121


1. (SBU) Summary: The numbers differ dramatically, with some
investors hyping a massive exodus of factories from the Pearl River
Delta (PRD) while local government officials spout figures that
obscure the scale of the trend. But one thing is clear: many firms
are choosing to move production to new centers of low-wage
manufacturing in other parts of China and elsewhere. Executives
frequently cite China's new Labor Contract Law as the driving force
behind relocations, but it only one in a list of factors that have
weakened the investment environment here and may not even be the
most important one. (In fact, U.S. companies say they are already
compliant with contract law requirements and the new rules will
compel competitors to come up to these standards.) Others include
wages that were already raising steadily, value-added tax and export
processing regulatory changes, and the appreciation of the renminbi
against the dollar. Even as labor-intensive, often Hong Kong- or
Taiwan-invested, factories move, many others are choosing to stay
for reasons that include robust supply chains, well-developed
infrastructure and human capital, which continue to be enduring
advantages of the PRD. The composition of economic development in
the Delta is changing and the difficult choices facing business
today are in large part intentional: the central and local
governments are implementing policies aimed both at spreading
development to other, less-developed parts of China and at creating
space to upgrade industries in the PRD. If the strategy succeeds,
the PRD could once again be in the fore as China moves into a new
stage of economic development. No one wants to contemplate what
failure to change will mean. End summary.

Looking at the Numbers - Media Hype,...
--------------


2. (U) Reports of factories leaving the Pearl River Delta (PRD) have
been spreading in recent months. A Wall Street Journal article
cited estimates by the Federation of Hong Kong Industries that 10
percent of Hong Kong-owned factories in the region will close this
year. Another frequently cited statistic is the Asian Footwear
Association's calculation that 1,000 shoe factories in Guangdong
have closed in the past year out of a total of 5,000 to 6,000. A
China Daily report cited an estimate that 5,000 to 6,000 Hong
Kong-invested companies would close in the PRD by the end of 2008.
One American business leader told us that 1,000 factories had closed
down in Dongguan alone. A Taiwan investor in Dongguan put the
number at 5,000 (ref A).

Official Propaganda,...
--------------


3. (U) Local officials have tried to downplay the reports. In early
March, Guangdong Governor Huang Huahua told reporters that,
according to government statistics, only 244 enterprises had moved
out of the PRD while more than 7,000 new enterprises were
established during the year. Dongguan Party Secretary Liu Zhigeng
recently said that although 289 shoe factories had shut down in
Dongguan during 2007, 501 new ones had opened. More recently,
Guangzhou Bureau of Foreign Trade and Economic Cooperation announced
that 347 foreign-invested enterprises closed or moved out of
Guangzhou in 2007 while 959 new foreign enterprises invested in the
city. However, local statistics may not capture the closure of some
facilities, which the statisticians classify as having "concluded
their contracts." These firms may have signed contracts with local
partners and obtained business licenses that have expired but will
not be renewed, because the foreign investor is no longer interested
in doing business here. They might not appear in the government's
accounting even though they have ceased production in the PRD.

Business Optimism,...
--------------


4. (SBU) Many companies in the PRD, especially the larger, more
successful ones we have more frequent contact with, have indicated
that they continue to believe the investment environment here is
strong. Some of them, like Hong Kong-invested toymaker Silverlit,
have told us they would stay put in the PRD even as their less
profitable competitors moved elsewhere (ref B). Executives at
American toy makers Mattel and Hasbro have emphasized to us that
their long-term investments in China were profitable decisions, and
to relocate production outside of the PRD would be a step in the
wrong direction. A former Dongguan Taiwan Businessmen's Association
vice chair said the PRD was still the best place for him to do
business while lamenting the problems other Taiwan firms faced (ref
A). During a recent visit to Zhuhai and Zhongshan on the western
side of the PRD, executives at Flextronics, a Singapore-based

GUANGZHOU 00000228 002 OF 003


electronics manufacturer; Wiseman Company, a major Chinese garment
maker; and Foxconn, the Taiwan electronics giant, all described to
us ambitious plans to expand operations.

...and Hidden Impact
--------------


5. (SBU) However, there is also downsizing among some firms staying
in the PRD that is not captured in official statistics or other
reports. An executive in the Dongguan Taiwan Businessmen's
Association explained that many Taiwan companies are maintaining
some manufacturing presence in the PRD to hedge their bets even as
they build new facilities or expand operations elsewhere. He
identified one factory in the Humen area of Dongguan that had
downsized from 5,000 to 2,000 employees recently. Despite expansion
in its facility just across the river, Foxconn's massive campus in
Shenzhen continues to reduce employment as it moves manufacturing
operations elsewhere to focus more on research and development and
other high-end processes in the PRD (ref B).

What's Driving Them Away?
--------------


6. (SBU) There are several factors that are causing many factories
to consider moving production out of the PRD:

--Labor Contract Law - Many firms and industry associations have
complained loudly about the new law, which went into effect on
January 1. Estimates vary, but the Hong Kong SAR government
representative in Guangdong recently said the law had increased
labor costs by 15 percent. In addition, the law limits the
flexibility employers had previously exercised in hiring, and
especially firing, decisions. Although this law is one of the
causes most often cited in reports about factories leaving the PRD,
it is only one of several having an impact and raising production
costs here. With many factories moving to other locations in China,
it may not even be the most important factor. Investors may
complain more about the effects of the Labor Contract Law because
they calculate it to be the area where the Chinese government is
most likely to offer some redress.

--Rising Wages - Wages were already rising steadily in the PRD
before the new Labor Contract Law and continue to do so. Hewitt
Associate's annual survey of wages in Guangzhou and Shenzhen showed
8-9 percent increases in 2007 and projected similar increases for

2008.

--VAT/Export Processing Reforms - In 2007 the Chinese government
reduced the value-added tax rebates available to exporters in some
industries and locations and started requiring some export
processing firms to pay a guarantee deposit for duties on imported
inputs that are refunded at the time of re-export.

--RMB Appreciation - Ongoing appreciation of the renminbi against
the dollar has squeezed profits for firms making exports for the
U.S. market. The Hong Kong SAR representative estimated that RMB
appreciation was increasing the cost of Hong Kong businesses in the
PRD by an additional 15 percent.

--Other Factors - In addition, firms in the PRD have been hit with
continuing power shortages, rising costs of other inputs and
reported stronger enforcement of environmental regulations.

Who's Moving Out? Who's Staying Put?
--------------


7. (U) These factors are hitting some types of businesses much
harder than others. The labor-intensive, export-oriented industries
that were the main drivers of the PRD's economic boom from the
beginning are most affected. Many of these are Hong Kong and Taiwan
enterprises, but some sources have also reported Japanese and Korean
firms choosing to the leave the PRD too. (In fact, the Korean
Consul General told the Consul General earlier this month that
whether and/or when and/or where to move were subjects Korean
companies were constantly discussing with him.) "Export processing"
industries, which assemble imported inputs into finished exports,
have been disproportionately harmed by recent regulatory and market
trends. Shoe manufacturers appear to be among those that have
suffered the most impact. Many apparel, toy, and hardware
manufacturers have also been seriously affected, according to
Guangdong's Department of Foreign Trade and Economic Cooperation.


8. (U) High-tech manufacturers that rely on more highly skilled
labor are less affected. The same is true for firms that invest

GUANGZHOU 00000228 003 OF 003


heavily in design or marketing their own brand name. In general,
American firms appear relatively unaffected because they are more
likely to fall into these categories. They are generally more
focused on selling to the Chinese domestic market than other foreign
investors, who dedicate more production to exports. In addition,
several contacts have commented that U.S. firms have actually
benefited from the new Labor Contract Law because their practices
were already compliant with the new rules, and now their competitors
must raise their standards as well.

Staying in the Neighborhood
--------------


9. (U) For those firms that are choosing to leave the PRD, anecdotal
reports suggest their preferred destinations are not that far away.
According to one toy manufacturer, many Taiwan firms in the industry
have moved to Jiangxi Province. Other reports identify Guangxi,
Hunan, Fujian, Anhui and some more remote parts of Guangdong as
favored destinations. Vietnam is the most frequently cited option
for companies that are looking to leave China altogether. Some
investors have commented to us that tax policies and other
investment conditions in Vietnam are similar to those of the PRD ten
to twenty years ago. However, other investors have dismissed it and
other Southeast Asian countries as a suitable alternative, citing
smaller workforces and local markets, lack of infrastructure,
cultural differences and other disadvantages.

Why Stick Around?
--------------


10. (SBU) Those companies that choosing to stay in the PRD named the
following factors as enduring advantages:

--Supply chains - Many industries have developed sophisticated
industrial clusters with complete supply chains providing all inputs
in one convenient location. In fact, Toyota established a new
Guangzhou factory in 2005 and is already engaged in an expansion
project that will increase capacity by almost one third. Executives
emphasized the emergence of robust supply chains as one of the most
important factors in the company's decision to expand here.

--Infrastructure - The PRD has a well-developed transportation
system. One investor told us he had looked at moving his factory to
Jiangxi, but calculated that what he gained in lower wages would be
lost -- and then some -- due to higher transportation costs.

--Human capital - The availability of skilled labor is much higher
in the PRD than many cheaper alternative destinations. An executive
at one apparel firm explained to us that she wouldn't be able to
convince the designers she relies on to live in more remote areas.

--Diminishing advantages in alternative locations - Several
manufacturers have told us their research shows that the gap in
wages and tax benefits enjoyed in less-developed parts of China will
diminish within a couple of years relocating to these areas.
Executives from one Hong Kong apparel company said that they opened
a second factory in Jiangxi three years ago when wages were just 60
percent of those in the PRD, but wages had been rising more quickly
than in the PRD and tax incentives had gradually phased out.

All Part of the Plan
--------------


11. (SBU) These complex sets of factors are having a real, but
difficult to quantify, impact on factories in the PRD. Some of this
impact is intentional -- central and local government officials want
to create conditions that will encourage some factories, especially
labor-intensive ones, to move out of the PRD. Changes in the VAT
rebate and export processing regulations target these industries
directly as do some environmental regulatory changes. These
policies are aimed both at spreading development to other,
less-developed parts of China and at creating space to upgrade
industries in the PRD toward services and more advanced
technologies. If the strategy succeeds, the Pearl River Delta area
could once again be in the fore as China moves into a new stage of
economic development. In the meantime, there will be a difficult
adjustment period as the exodus of labor-intensive, export-oriented
factories, which have been the backbone of the local economy for
many years, continues.

GOLDBERG