FT.com / Comment - China's corporate cost advantage is a myth

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China's corporate cost advantage is a myth
>By Joe Zhang
>Published: April 28 2005 20:47 | Last updated: April 28 2005 20:47


China's costs of labour and land are low and its currency is regarded as undervalued and competitive. Yet Chinese companies are making relatively little money and the domestic stock market is at a six-year low. The reason lies in the country's high - and rising - costs of doing business. If the government does not urgently address this issue, the country will not only fail to develop a services industry but will also miss out on the foreign investment its under-employed labour force needs.

In the past decade, three types of costs - operational, regulatory and external - have been suffocating business in China. Even its numerous special economic zones have been affected, in spite of their lower taxes and less onerous regulations. In 2004, China overtook the US to become the world's largest beer market. But the largest three Chinese breweries, which account for a total 35 per cent of the market, made a combined profit of only $100m in 2004 - equal to one-seventh of Heineken's profits and five per cent of Anheuser-Busch's in that year.

Apart from managerial inexperience, high costs drive the disconnect between impressive top lines and anaemic earnings. First are the operational costs. For most manufacturers, costs of imported energy and raw material - on which China is relying ever more heavily - far outweigh those for land and labour. While input costs are rising, overcapacity, falling entry barriers and high tolerance for low returns on investments will continue to depress profit margins. In fact, Chinese manufacturers often have to pay more for energy and raw materials than their overseas counterparts, not only because of shipping costs but also due to import tariffs and 17 per cent value added tax. Over time, this cost disadvantage will probably spread to a larger part of the economy.

While low wages have led to labour shortages in the private sector in China's southern Guangdong province, wages and benefits have exploded in the country's bloated state sector that still accounts for about two-thirds of gross domestic product. In 1990, a typical state-sector employee's take-home pay was less than Rmb200 ($24) per month. The figure is now Rmb1,500 (excluding employers' contributions to housing funds and insurance payments) - representing annual compound growth of 15 per cent, far exceeding productivity gains and consumer price inflation. Of course, Chinese labour costs are still low by global standards, but they are not that low if overstaffing and inefficiency are taken into account. Moreover, there is a real risk that China's state-sector labour costs may run out of control, as there is no real "owner" to exercise restraint.

Second are regulatory costs - a serious burden for Chinese companies that has fuelled uncertainty about government policy. For example, the government keeps the world guessing when it will grant 3G telephone licences and when it will raise electricity prices.

Many Chinese corporate executives also complain of interminable government meetings and endless random "inspections". The first foreign bank set up its Beijing representative office in 1982, but foreign banks are still subject to tight restrictions and it remains unclear when they will be allowed to operate like local banks and recoup their expenses. Another concern for Chinese companies is the need to constantly lobby for government favours including tax holidays, government contracts and business licences. These unproductive and wasteful pursuits clearly add to the mounting costs of business. In the 1980s, a small entrepreneur could start a business with just Rmb10,000 in seed money. Today, local government taxes, fees, licence requirements and convoluted rules have made life much harder for the small entrepreneur.

Finally, there are external costs which, while more subtle, are equally painful. The budding entrepreneur may, for instance, think he has discovered a new formula to make noodles only to find a dozen similar shops selling the same noodles the next day. Weak enforcement of intellectual property rights hurts China in many more ways. Scarce resources do not get channelled into product innovation, but instead wreak havoc on existing well-run businesses. These small operators may not be efficient, but their ability to slash product prices is unlimited.

China's cost advantages today, therefore, are only limited to some simple exporting processing sectors. To nurture indigenous capital formation and attract "smart" foreign investments China must work hard to greatly improve its business environment.

The writer, a managing director and co-head of China research at UBS Securities Asia Limited, formerly worked for the People's Bank of China in the 1980s