Supply Chain & Logistics Subdue China

The “vox populi” of globalization analysts has spoken decisively. It has determined that China is no longer the leading trending export power to the U.S. market, Mexico is.

Thomas Friedman, Pulitzer Prize winning author of the book “The World is Flat” recently wrote in his N.Y. Times editorial: “In India, people ask you about China, and , in China, people ask you about India. Which country will become the more dominant economic power in the 21st century? I now have the answer: Mexico.”

Joseph Stiglitz, 2001 Nobel Price of Economy laureate said recently in the 2013 World Economic Forum at Davos, Switzerland: “Mexico is more competitive than China. Being competitive means growth. I’m optimistic about Mexico.”

Chris Anderson, the former editor of Wired magazine and the author of “Makers: The New Industrial Revolution” wrote for the N.Y. Times the article: “Mexico: The new China”, in which he contends that given the need for lean, effi cient supply chains and competition in quality and productivity, Mexico is a better option than China for U.S. fi rms.

With this kind of company and the information at hand that we will review in this article, it is safe to “offi cially” declare Mexico as the current frontrunner in the suppliers’ quest for the U.S. marketplace.

The supply chain cost structure and logistics have subdued China’s former formidable export power, while Mexico, in spite of prevailing serious domestic obstacles, has risen to the challenges of swift time-to-market and made-to-order consumer demand.

CHANGING TRENDS

It has been almost 20 years since the inception of NAFTA. Even with its several drawbacks, the agreement to promote economic growth by easing the movement of goods, services and technology between Canada, the U.S. and Mexico has been successful, as evidenced by the current trade between the latter two of almost US$1.5 Billion per day.

Originally, the NAFTA honeymoon surged Mexico’s share of the U.S. import market for manufactured goods from 7% in 1994 to almost 13% in 2001.

But, as shown in Exhibit #1, when China was fi nally accepted as a member of the World Trade Organization in 2001 things changed severely for Mexico.

Without former trade duties and quotas and the launching of China’s “Social Market Economy”, U.S. fi rms fl ocked east to China and Chinese goods swarmed west to the U.S. China double-jabbed Mexico: Not only did hundreds of Mexico based foreign manufacturers relocated to China but Mexico’s share of U.S. imports stalled.

Between 2001 and 2009, China’s exports to the U.S. grew at over 20% annually reaching a peak share of U.S. imports of almost 28% as illustrated in the Exhibit.

After touching bottom at 11% of U.S. imports share in 2005, Mexico started to build a recovery, overtaking Japan in 2006 and Canada in 2008, to reach almost 15% in 2012 in the race for the U.S. import market.

Coincidentally, in 2010, China started to experience the unavoidable law of “diminishing returns” trending towards an eroding U.S. import share of possibly 25% by the end of 2013.

It’s impossible to tell how much of China’s pain has been Mexico’s gain. Both countries have distinct advantages and disadvantages for competing in international trade, but through the years, a reasonable portion of the successes of one country can be attributable to the failures of the other and vice versa.

In any comparison of Mexico and China, let’s keep in mind the relative weight of each country; this is not a competition in an even weight class: China’s population is about ten times that of Mexico’s, and China’s GDP is almost seven times bigger than Mexico’s. China is currently the second largest world economy and according to the World Bank it will be #1 on or around 2040; Mexico is currently #14 and, with the right policies and actions, it should move up to #8 or #7 in the next 25 years or so.

SUPPLY CHAIN AND LOGISTICS COSTS RESTRAIN CHINA

China’s early export booming years were for the most part the result of a large low labor cost advantage, its undervalued currency and its tax incentives for foreign investment. These advantages generally offset the apparent extra costs of transportation and management to supply North American markets.

But as years went by, China’s advantages slowly started to weaken as the disadvantages grew and hidden costs surfaced.

To maintain adequate deliveries from China to the U.S. market, longer supply chains were required with more goods in transit and in inventory, resulting in higher working capital costs for exporters. They were also hit with quality and reverse logistics costs in customer failed deliveries and the risks and expenses associated with supply chain break downs.

Managing the long and remote supply chain eventually surfaced unaccounted for or hidden costs such as expats traveling, living and exhaustion; loss of production control due to reduced agility to solve manufacturing defects and implement engineering changes; and preventive costs to avoid patent infringements or high profi le quality failures due to cultural misunderstandings.

All of the above on top of the increase in oil from US$30 per barrel in the early 2000’s to close to US$100 lately, practically doubling the cost of transporting containers from China to the U.S.

On the fi nancial side, a few years ago, China finally conceded to international pressures to gradually revalue its currency, the Renminbi or Chinese Yuan, from an export generous level of RMB8.30 per US$1.00 a decade ago, to a current ratio of about RMB6.20 to US$1.00, effectively making imports from China about 25% more expensive in the process.

And low-cost labor, the flagship of China’s competitiveness did not stay cheap. According to the Boston Consulting Group (BCG), pay and benefi ts for the average factory worker in China rose annually by 10% in the period 2000-2005 and later increased to 19% per year during 2005-2009.

China’s central government has in fact set a target of 13% annual increases in the minimum wage through 2015.

In addition, as a result of substandard and strenuous manufacturing conditions, such as the well publicized woes of Taiwan’s Foxconn in China, labor has become more demanding and organized. Since 2008, Chinese workers have the right to a permanent contract after a year of employment and strikes became more common.

As competition for skilled labor increased in China, pay, benefi ts, training costs, job-hopping and workers’ turn-over followed suit.

The 2013 AlixPartners Manufacturing- Sourcing Cost Index for selected countries predicts that by 2015, the “Total landed cost” in the U.S. marketplace for manufactured goods will be the same for the U.S. and China while Mexico and India will remain competitive. This information is shown in Exhibit #2.

Notice in the graph that during the recession in 2009, the low-cost countries became more competitive as a result of a drop in materials and freight costs and favorable exchange rates.

These cost components stabilized later during the recovery, but China’s kept creeping, and according to AlixPartners, they will continue to do so in the next few years at current wage infl ation trends, an annual 5% strengthening of the Renminbi and 5% ocean freight annual increases.

Does this mean that all manufacturing will come back home to Mexico and the U.S.? Hardly.

In spite of rising costs, China maintains a huge industrial capacity and a healthy growing market and economy. China’s future economic dominance in the world is irreversible and as its cost structure infl ates, China will rely on low-cost manufacturing in neighboring lower cost countries such as Vietnam and India.

But we can identify three related trends that will affect the manufacturing affair of China and the U.S. as follows:

De-shoring: Many U.S. firms will bring back home from China that portion of production which is destined for North American markets. According to a survey by the BCG of U.S. companies with annual sales of over US$1 billion with operations in China, 37% said they were planning or actively considering shifting production from China to North America.

Near-shoring: U.S. companies will increasingly favor manufacturing closer to home. The main drivers evidently include: Lower total landed cost, improved speed to market, fewer supply disruptions, and bettercustom customer service among others.

Smart-shoring: Long-gone is the “low-labor cost myopia” and “follow-thefl ock” times for U.S. manufacturers. The manufacturing sourcing decision process is complex but there is a lot more information and case studies for companies to make smarter shoring decisions. Oftentimes, the best option for U.S. fi rms is staying home or moving to a more competitive location within their own country.

THE BROADER TREND

FAVORS MEXICO We can conclude that the strongest positive force currently favoring Mexico’s growth is the economic phenomenon of Regionalization.

Conceptually, Regionalization is globalization taking a step backwards. Indeed, the world is “de-globalizing” and Mexico stands to be one of the largest benefi ciaries of this process.

Let’s recall that, in an economic sense, globalization refers to the reduction and removal of barriers between national borders in order to facilitate the fl ow of goods, capital, services, labor and technology.

The process of globalization has many positive aspects, such as the emergence of worldwide production and fi nancial markets; and broader, less expensive access to a range of foreign products and services for consumers and companies.

Globalization has been good for the world’s trade and economic growth, resulting in a signifi cant increase in global middle-class population and a general improvement of the quality of life of de veloping nations.

But the development of globalization had a major setback in 9/11, which triggered significant restrictions in the international fl ow of goods and individuals. And recently, the great recession of 2008 helped to further reverse the process of globalization as developed nations activated domestic job protection and import restriction initiatives.

As we have seen, since the price of crude oil started to spike, it became clear that globalization was receding and that world production value chains engaged in a process of restructuring their global footprints, leading the way to a new wave or order that we have labeled as “Regionalization”.

Regionalization is simply the trend of reordering production value chains to better serve regional markets. In this fashion, regional production and logistics supply chains are reshaping and restructuring in Asia, Europe and the American continents. So what we will have in the long-term is smaller, regional manufacturing and logistics platforms to serve the different regional markets.

This is not to say that the U.S. imports from China will stop altogether anytime soon, but rather that we are going to see, for example, more Audi, Honda, Toyota, Hyundai and BMW plants opening in the U.S. and Mexico to serve the American Continent regional markets.

This is evidenced by the impressive string of new auto projects under way in Mexico boasting over US$10 Billion worth of investment during 2012-2015.

China knows well that its booming years of attracting manufacturing and export capacity will soon be over. So, China has already started a “going-out” industrial policy by establishing value chain platforms outside of its mainland in other Asian regions and farther abroad.

On this side of the world, Brazil and the U.S. have been largely targeted by Chinese investments. And not surprisingly, China’s new global industrial strategy contemplates Mexico as an ideal logistics passage and manufacturing hub for reaching the North American regional market.

China’s investments in Mexico to date are very modest though, with the largest high-tech Chinese presence in Mexico represented by Lenovo’s 5 million PC capacity plant in Monterrey. But doubt not that China will be following Taiwan’s steps and strategy in Mexico.

The savvy Taiwanese electronics contractors learned of the benefi ts of Regionalization much earlier. They started to signifi cantly regionalize their operations in the NAFTA region in 2003-2004, by occupying millions of square feet of light manufacturing space in Tijuana, Ciudad Juarez, Guadalajara and Reynosa primarily to serve the U.S. market.

“Time-to-market” has been a strong driver in Regionalization. Consumers not only demand custom built products but also prompt deliveries. Taiwan’s Foxconn, Asus, Wistron and other international electronics manufacturing contractors such as Flextronics, Jabil and Sanmina knew well that competitive manufacturing costs and adequate time-to-market logistics for the U.S. market were impossible to be attained from Asia, but were quite effi cient from locations in Mexico, avoiding long lead times and immense investments in inventory.

The supply chains from Mexico to the U.S. and Canada are evidently shorter, less risky and have a lower “Total Landed Cost” than those from Asia and Eastern Europe.

The most effi cient supply chains are those that produce and add value to the product in the nearest possible geographical location to the customer and in the shortest possible time from his purchase order.

Extensive traveling and mid-night business phone calls have slowly broken the resilience of many managers and engineers of international firms. Staying closer to home and operating during normal business hours is a growing preference in the minds of many executive and technical U.S. and Canadian workers, and another reason in favor of Regionalization.

Even the masters of round-the-clock work shifts are recognizing the benefi ts of Regionalization: Indian outsourcers Tata Consulting Services Ltd. and Infosys Technologies Ltd. have established Information Technology services operations in Mexico, in line with the strategy of many Indian outsourcers to deliver services to customers from locales in nearby time zones to better serve their regional markets.

As we have seen, currency exchange rates also play a very important role in the wave of Regionalization. This is one of the main reasons behind the remarkable growth of the aerospace industry in Mexico, which has gone from about 50 companies in 2004 to over 300 in 2013.

France’s Safran and Zodiac, Canada’s Bombardier, U.K.’s Triumph, Spain’s Aernova and more recently Brazil’s Embraer have substantial investments in Mexico. In just a few years, global fi rms have built an important aerospace cluster of over 40,000 workers in Mexico.

As the Euro keeps its relative long-term strength over the dollar, many European aeronautical supply fi rms that have dollar denominated contracts are ailing with higher manufacturing costs in Euros. These corporations know that relocating to Mexico, gives them the advantage of a low-cost manufacturing platform as well as the benefi t of shifting their costs to a “dollarized” region.

Regionalization is gradually shifting manufacturing from off-shore locations in Asia and Eastern Europe to near-shore locations to serve North American markets and new windows of opportunity will continue to open for Mexico.

Mexico’s prospects are bright. In addition to having the benefi ts of Regionalization, Mexico has already been able to materialize long over-due labor, education and telecommunications reforms, which shall bring additional competitiveness to Mexico. Other important constitutional reforms are in the making for fi scal, energy and State (political) matters in the short-term.

Mexico has many challenges, but solving three in particular would make a huge difference for its competitiveness and ability to attract more foreign direct investment: Crime, education and infrastructure.

There is a huge opportunity for Mexico to reach the next level of development. But fi rst, the country needs a new brand, a new image and a new vision. The new administration knows this and there have been important steps forward taken already. Mexico needs to come through and surprise the world.