There has been a surge in articles recently about the risks associated with sourcing from China.  With Beijing hosting the Olympic Games, China is the center of attention across the world.   As a result, every aspect of the economy, culture, history and political framework is being scrutinized by opinion leaders around the world.  With China’s massive export industry, it is not surprising that the manufacturing and distribution industry is being examined with a higher level of scrutiny as well.  Yesterday I did an interview with a reporter to discuss the supply chain impacts of the Olympics, which forced me to collect my thoughts on China’s growth and challenges.  So I thought I would take a few minutes to offer my perspective on the situation.

The Past Twelve Months

A series of unfortunate events over the past twelve months have raised attention to the potential risks of supply chains sourcing goods from China:

• Product Safety – Unsafe levels of lead were discovered in toys manufactured in the fall of 2007.  Buyers such as Mattel and Toys R Us initiated massive recalls, which led to factory shutdowns across the country.  The incident, while quickly contained, has left a lasting impression in the minds of foreign consumers who express widespread skepticism about the safety of products manufactured in China.
• Holiday Calendar – The May holiday season was reduced from its historical length of seven days to only three.  News of the change in schedule was not received by some of the buyers who export from China.  Consequently, inventory levels and ordering schedules were not synchronized between foreign buyers and Chinese manufacturers.
• Snowstorm – Heavy snowstorms in Northern and Central China during the late January months led to power outages across the country.  Shortages of coal were cited as the root cause for the brown outs that affected half of the 31 provinces.  Disruptions to ground and air transportation were after effects of the inclement weather and energy shortages.
• US West Coast Port Shutdown – Negotiations between the Pacific Maritime Association, which operates most of the West Coast Ports in the US, and the International Longshoreman and Warehouse Union, which represents the dockworkers, failed to meet their contract renewal deadline of July 1^st.  Mutually agreeable terms were reached shortly thereafter.  However, for several weeks there loomed the threat of a major disruption to goods flowing into US ports from Asia, particularly China.
• Olympic Shutdowns – To reduce pollution in the greater Beijing area during the Olympic Games, Chinese officials have placed temporary restrictions on the operating hours of nearby power plants and manufacturing facilities.  Transportation capacity has been limited in the city of Beijing to minimize congestion and smog.  Exporters purchasing from Beijing and surrounding provinces are concerned that the shutdowns may result in supply chain disruptions.

Massive Snowstorm Hits China

Source: Reuters - Sheng Li

Macroeconomic Changes

The specific incidents outlined above have been compounded by a larger set of macroeconomic changes occurring in the global economy.  These changes are not unique to China, but have a disproportionate effect on the People’s Republic due to its heavy concentration of exports to the US and Europe.

• Rising Transportation Costs – Energy prices have reached all time highs in 2008 with oil peaking at over $150 a barrel earlier this year.  Higher energy prices, of course, translate into higher jet fuel prices for air cargo and higher ocean carrier rates for marine freight.  For instance, the cost of sending a 40 foot container of goods from China to the US has increased by 150% since 2000. 
• Currency Devaluation – The US has proactively devalued its currency relative to the other major world currencies such as Euro and the Yen.  Historically, the Chinese government has tied the valuation of the Yuan to the US dollar.  However, in recent months China has allowed its currency to appreciate relative to the dollar having the overall effect of raising the relative cost of exports.
• Raw Materials Costs – The demand for raw materials, ranging from grain and rice to produce food to steel and aluminum needed for construction, has been rising steadily in recent years.   Many attribute the peaks in demand to the increased consumption of China and India.  Regardless of the cause, the effect is an overall increase in costs to produce finished goods.

Policy Changes

• Tax Policy – China desires to shift its manufacturing focus from labor-intensive, low value added processes to higher-quality, advanced production techniques.  As a result, tax policy is being re-written to encourage investment in higher technology facilities.  One of the new policies affects tax classification for high tech corporations.  To qualify for tax benefits as a high tech manufacturer 60% of global R&D investment must occur in mainland China and 30% of employees must have a college diploma.  Many multi-nationals will no longer qualify for tax incentives leading them to rethink foreign direct investment in manufacturing capacity.
• Rising Wages – As the effects of capitalism continue to propagate throughout Chinese society, new levels of prosperity are being reached by the middle class.  The government has been fostering these trends with new regulation for minimum wages, overtime, severance and pension pay.  Minimum wages in China have grown 250% in the last 10 years.  Yet another factor contributing to the rising costs of exports.

Other Risks

There are a number of other political and socio-economic risks that have troubled supply chain planners for many years.  These include on-going political tensions with Taiwan; protests advocating the liberation of Tibet; and the risks of pandemic from possible resurgence of the Avian Flu.  Infrastructure and energy capacity are on-going areas of concern.  In fact, earlier this week there were several newspaper articles questioning whether China’s electrical grid has the capacity to support its power-hungry manufacturing sector?

Mattel’s Toy Recall

A Balanced View

Adding all of these factors up, it is easy to see how North American and European multi-nationals sourcing from China have reason for concern.  It should be noted that many of the factors contributing to uncertainty are no fault of China’s.  Although the PRC boasts the world’s largest population, they are not able to control the timing of inclement weather, rampant inflation in raw materials pricing or speculative behavior in the energy futures market.  Many of the design decisions about the material used in children’s toys were made by foreign buyers.  And while China’s influence on the US economy continues to grow, it cannot control the Federal Reserve policy on currency valuation or the labor negotiations with US port operators.  It is true that some of the issues listed above are, in fact, deliberate policy moves made by the government.  But it is difficult to question the logic in efforts to improve the standard of living of one’s lower class or to proactively make efforts to reduce pollution of the environment.

While none of these issues has resulted in a major supply chain disruption to date, the combined effect is beginning to create a crisis of confidence amongst some North American and European buyers.  The question is what will be the longer term impact of recent events on the sourcing strategies of foreign companies exporting from China.  It is too early to predict exactly how impactful these concerns will be, but one can expect that sourcing decisions will be subject to much higher scrutiny and more rigorous analysis going forward…

In my last post I discussed the issues surrounding labor negotiations at the US West Coast ports.  This potential work stoppage at critical California ports could not come at a worse time.  Suppose, for example, that a work stoppage occurred August 1^st.   

Record Energy Prices 

What are the alternative means of importing goods from Asia to the US?  Re-routing goods to East Coast of Gulf State ports is one option.  Shipping goods via air freight is another option.  However, record high energy prices make these options more expensive than ever.  $150/barrel oil has led to skyrocketing increases in jet fuel and gasoline.  Higher energy prices have not only affected air and ground transportation.   Oil prices have increased the costs of marine freight as well.  The diagram below illustrates the dramatic cost increases for shipping a 40 foot container from Shanghai to the US at various oil prices.

As a result, no matter what contingency plans are followed, importers will pay an unusually high premium to divert shipments around the work stoppage.

Olympics 

The clock in Tiananmen Square is counting down the minutes remaining to the opening of the 2008 Olympics in Beijing on August 8th.  The Olympics present a critical milestone in China’s development.  Government officials want to ensure that while country is showcased to the world during the Olympic Games that outsiders will gain a favorable opinion of China’s progress in recent years.  Among the government’s largest concerns is pollution.  There have been several unconfirmed reports of government actions to curb pollution.  Examples include closing factories, halting construction and limiting automobile use.   For more information see the post on Bryan Larkin’s blog  or the recent articles from AMR Research  or Business Week (An Olympic Loss for Industry).   

The Olympic disruption to transportation and manufacturing is significant in that it could interrupt the flow of exports to the US for several weeks.

Back To School 

Challenged by a recessionary economy throughout the duration of 2008, US retailers are hoping to stage a comeback in the second largest sales period of the year – back to school season.  Overcoming recessionary pressures in consumer spending will not be easy.  US retail sales for June increased by only 0.1%.  Much of the gains are attributed to rising gasoline prices which are included in the sales figures.  Consumers are demonstrating a reluctance to spend even though the US Federal Government has injected over $90B in liquidity into consumer’s bank accounts through its tax stimulus programs this spring. 

The Perfect Storm? 

So back to the original question at the beginning of the post - what would happen if a port strike occurred on August 1^st?  High volume imports of apparel, footwear, electronics, toys, furniture and other consumer products would come to a halt as steamships anchored idly off the California coast.  This comes at a period in which the US is already anticipating decreased flow of exports from China.  Government actions to temporarily reduce Chinese manufacturing and transportation capacity to offset pollution will be occurring throughout July.   Alternative transportation methods such as shipping cargo via air freight and re-routing to East Coast ports with subsequent ground transportation are possibilities, but may be prohibitively expensive due to rising oil prices.  

The combined effect could be a perfect storm of logistical challenges that result in an unprecedented volume of out-of-stocks during the mid-August to late August peak shopping season.  Let’s hope the longshoreman and port operators can reach a consensus on the critical issues soon.  Otherwise a depressed retail sector may be stealing headlines from the automotive and banking industries come September…

Bank failures, record oil prices, potential automotive bankruptcies…what next?  How about a major port strike in the West Coast of the United States?  Believe it or not, a strike could happen at any minute now.  The dockworkers who manage the California, Oregon and Washington state ports have been operating without a contract for two weeks as of today.  A series of six months of negotiations between management and unions to resolve terms about working conditions, benefits and compensation failed to culminate on July 1^st when the contract expired.  Since then dockworkers have been continuing to perform their daily responsibilities with a few exceptions.  In the past few days, workers have begun to take coordinated breaks designed to disrupt productivity.  The result has been a 10-15% productivity decrease in port operations, but this is just the beginning…

What are the impacts? 

Imagine if the negotiations reach a stalemate resulting in a temporary work stoppage!  What would be the impacts of a port strike to US retailers such as Wal-Mart, Home Depot, Target, Lowes, Best Buy and JC Penney who are critically dependent upon Asian imports to fill their shelves?

West Coast ports are the critical entry point for inbound ocean containers arriving from China, India, Malaysia, Vietnam and other Asian exporters.  Together the 29 ports in the states of California, Oregon and Washington represent $1.3 Trillion in annual domestic business impacts.  $1.3 Trillion is roughly equivalent to the Gross Domestic Product of the entire country of Canada or Mexico. 

Dockworkers failed to reach a consensus with management during the last round of contract negotiations in 2002.  As a result there was a 10-day shutdown of critical West Coast ports that cost the US economy over $1 Billion per day.   Since 2002, port volume has increased by over 45%, raising the stakes of a potential shutdown even higher.

Who are the players? 

• Pacific Maritime Association – effectively acts as the management entity for the 71 different companies who operate the ports.  Owners include cargo carriers, terminal operators and stevedores.   What is a stevedore?  A stevedore is a company who manages the process of loading and unloading container ships.  Stevedores typically own the equipment used to manage the freight and manage the longshoreman who facilitate the process.
• International Longshoreman and Warehouse Union (ILWU) – is an AFL-CIO organization that is one of two major labor unions in the US for dockworkers.  The other is International Longshoreman’s Association which represents the East Coast, Gulf States and Great Lakes ports.  The ILWU represents over 40,000 members in over 60 unions from Oregon, Washington, California, Alaska and Hawaii.

What are the issues? 

• Compensation and Benefits – Health care benefits and salaries are listed amongst the key issues by the union.  However, statistics provided by Pacific Maritime about dock worker compensation might lead one to side with management.  The average full time employee earns $136,000.  Union members with the title of “Clerk” receive $145,000 and Foreman gross over $200,000.  Members enjoy a benefits package that costs over $50,000 per employee including full health insurance with no deductibles.
• Safety – Compensation and benefits are better understood if you consider the dangerous environment that dock workers operate in.  Over 17 employees have died in the past six years since the contract was renewed.  Many workers claim that pressure from port operators to improve productivity leads longshoreman to take shortcuts that compromise safety.
• Environment – The port facilities are filled with transportation and loading equipment that collectively generates a significant amount of pollution.  A longshoreman’s work is performed amongst trucks, ships, locomotives, tug boats, tankers, barges, yard hostlers, cranes and forklifts.  Pollution not only affects the dock workers during business hours, but it affects friends and family throughout the West Coast region who are subjected to smog and poor air quality.

What can importers do to avoid being impacted by a potential strike?  One strategy is called “port diversification”, which I introduced in a post earlier this year.  Instead of all Asian routing shipments through the US West Coast Ports of Long Beach and Los Angeles, retailers are being to explore alternative options such as:

• Routing of shipments from India through the Suez Canal and into US East Coast hubs such as Baltimore, Savannah or Charleston.
• Routing of shipments south of the US to Mexico.  Intermodal links enable transfers of containers to rail cars for travel to the Midwestern US states of Texas, Oklahoma and Kansas.

But even with re-routing, a port strike would have a massive impact on the US economy adding further turmoil to an already financially disastrous year…