• While China's CPI appears to be moderating, rising production costs show no sign of easing. Escalating production costs are pressing heavily on the already thin profit margins of Hong Kong manufacturers operating in China, especially the PRD region.
• The continued appreciation of the RMB is one of the major challenges arising from China's changing business environment. What is making the situation worse is the accelerating pace of appreciation. The RMB appreciated against the US dollar by 6.1% (year-on-year) in December 2007, but jumped to 10.6% in June 2008.
• It is estimated that the local content of products made by Hong Kong manufacturers in the mainland ranges from 30% to 50%. A 10% appreciation in the RMB would have translated into a rise in production costs of 3-5% over the past year.
• The problem of a skilled labour shortage in the PRD remains while the growth in wage levels is trending upward. Guangdong's minimum wage increased by an average of 12.9% in April 2008 with Shenzhen growing as much as 17.6%.
• Policy changes in China are also fuelling higher costs. Besides the tightened processing trade policies introduced in 2007, the Labour Contract Law implemented in January 2008 requires full contributions of social security as well as economic compensation to employees whose contracts are not renewed.
• Energy prices are going up as China made a sudden move to raise electricity tariffs by an average of 5% in July 2008. Gasoline and diesel prices also went up by 16.7% and 18.1%, respectively, in June 2008.
• Factors arising from the changing business environment in China, namely RMB appreciation, rising wages and the effect of the Labour Contract Law have resulted in an estimated increase of 8-15% in total production costs over last year.
• US import prices of goods from China are moving up, partly reflecting the fact that more overseas buyers are willing to accept higher prices. The comforting news is that China's share of US imports has remained stable in 2008 compared to a year ago, indicating Chinese goods remain competitive while overall demand slows.

CPI Moderating but not Production Costs

While the accelerating trend of China's CPI slowed from its recent peak of 8.5% in April 2008 to 7.1% in June, rising production costs for manufactured products showed no signs of abating. China's purchasing price index of raw materials, fuels and power rose 13.5% in June 2008 compared with 11.9% in May and 8.9% at the beginning of the year.

Increases in the prices of gasoline and diesel oil in June and electricity tariffs in July this year have put additional upward pressure on producer prices. The rise in raw material and energy prices may not be unique to China, but a number of other major challenges arising from the changing business environment in China are simultaneously exerting pressure on China's production costs, especially in the PRD region, and are pressing heavily on Hong Kong manufacturers' already thin profit margins.

Accelerating Pace of RMB Appreciation

RMB appreciation is at the top of the list of challenges facing Hong Kong manufacturers operating in China. By June 2008, the RMB exchange rate had crept up 20% against the US dollar and 18% against the yen since July 2005 (before China's recent exchange rate reforms). The trade weighted average exchange rate was also up by 11.7%.

Deepening Hong Kong manufacturers' worry is that the pace of RMB appreciation has been speeding up in 2008. For example, the RMB appreciated against the US dollar by 6.1% (year-on-year) in December 2007, but the pace accelerated to 10.6% in June 2008 (year-on-year).

While most Hong Kong manufacturers still receive USD payments for their exports, the appreciation of the RMB means that the part of their production costs settled in RMB would increase in terms of the USD, thus eating into their export margins.

A previous study by the HKTDC showed that the local content (the part of production costs settled in RMB) of Hong Kong companies producing on the mainland ranges from 20-45%, with an average of 30%. According to another recent academic study, the domestic value-added share of China's exports averaged about 50%, with some labour intensive industries such as toys and sports products as high as 51 to 65%.¹

Given that China's production chain is expanding upstream with more local sourcing, it should not be a surprise to find that the share of local content has increased. Assuming that the local content now ranges from 30 to 50% on average, a 10% appreciation in the RMB against the USD would translate into a rise in production costs of 3-5%, on top of other expenses, compared with last year.

Labour Shortage Remains a Headache

The PRD has suffered from a labour shortage in recent years. Despite the fact that wages have continued to increase rapidly and the deteriorating business environment has forced some manufacturers out of business, resulting in less demand for labour, a shortage remains in the overall labour market, particularly for skilled labour. Take the case of Shenzhen, a major location for electronics companies where demand for skilled labour tends to be higher. After the local government took various measures, the labour shortage there was estimated to have dropped in the second quarter of 2008 from the first quarter, but the city was still short an estimated 430,000 workers.

Rise in Labour Costs Unabated

Tracking official minimum wage levels provides a systematic means of observing the rising trend in labour costs. The minimum wages in different cities in Guangdong have risen 12.1 - 21.5% from 2004 to 2006. Effective 1 April 2008, minimum wages in Guangdong have further increased 10.3 - 17.6%, with an average of 12.9%.

Increases in Average Wages Appear to be Accelerating

In most cases, manufacturers need to offer more than the minimum wage in order to attract new workers or retain existing ones. Furthermore, a company needs to employ different levels of staff for different jobs. According to official releases, the average wage of staff and workers in Guangdong Province (consisting of all types of jobs of different levels) increased by 12.4% in 2007. At the beginning of 2008, the average wage of staff and workers in Guangzhou, for example, grew by another 15.3% from a year ago, reflecting an accelerating trend.

Sudden Increase in Energy Prices

Electricity charges account for a relatively small share of total costs, but are on the way up. In Dongguan, for instance, starting from August 2006, peak hour electricity tariffs for large industrial consumers soared by 27% compared with 2004. On 19 June 2008, the Chinese government made a surprise announcement that it would raise national electricity tariffs by 0.025 Rmb/kwh (roughly 5%) effective 1 July 2008.

The Chinese government also declared a moratorium on coal price increases between now and the end of 2008. Although this may prevent further increases in coal-electricity prices, when the moratorium expires, electricity tariffs may resume their rising trend again.

China also raised oil product prices, effective 20 June 2008. The base retail price for gasoline was adjusted upward by 16.7% while the retail price of diesel fuel was increased by 18.1%. To PRD manufacturers, these price increases not only mean higher transportation costs, but also put a greater burden on their own power generators as power shortages remain common in the region.

Surge in World Commodity Prices

The prices of individual metals may have risen at different rates over the last year, but the average price level for raw materials has continued a general upward trend amid fluctuations. According to The Economist commodity-price index, general metal price levels in mid-July 2008 rose 103% compared with three years ago and by 18.4% compared with the end of 2007.

The rapid rise in oil prices has had a direct impact on prices of related products such as plastics. In mid-July 2008, Brent oil prices increased by about 80% from a year ago. The price of polypropylene in July 2008 also grew by approximately 50% from a year ago.

Every manufacturing process may involve many different kinds of raw materials. The rise in general metal prices is having a widespread impact across different industries and differs in terms of magnitude. Fluctuations in raw material prices are also causing uncertainties among manufacturers, particularly between the time in which quotations are provided and when formal contracts are drawn up.

Policy Changes in China - Labour Contract Law as Another Blow

In 2007, the Chinese government introduced various measures to tighten the processing trade. These include removing and reducing VAT rebates on thousands of products, as well as expanding the "prohibited" and "restricted" categories of the processing trade.

The removal or reduction of export VAT rebates has already had a direct impact on the cost of export enterprises. Products under the "prohibited" category need to make full tariff and VAT payments for imported materials, resulting in higher costs which would eventually filter to downstream sectors.

While Hong Kong manufacturers operating in the mainland are still adjusting to changes in policies affecting the processing trade, they need to adjust to another major policy change that took effect in 2008. At the start of this year, China implemented the new Labour Contract Law. Under the new law, employers need to sign a contract with every employee. While Hong Kong manufacturers recognise the merits of the law in helping to protect the benefits of workers in general, the new protections also put additional pressure on total labour costs.

According to a survey by the HKTDC among Hong Kong manufacturers², over 80% of the respondents indicated that the implementation of the Labour Contract Law has pushed up direct labour costs by an average of 23.5%. The higher direct labour costs can mainly be attributed to two things: one is strict implementation of social security contributions for all staff; the other is a requirement to give economic compensation to employees, based on their years of service, when their contracts are not renewed.

The Labour Contract Law requires every contracted staff to participate in the social security scheme. There are five types of social insurance premiums: namely basic old-age insurance, basic medical insurance, unemployment insurance, work-related injury insurance and child-bearing insurance.

Taking the case of Dongguan where many Hong Kong manufacturers are located, the total social security contribution by employers roughly equals 18% of the wages paid. This ratio may be higher in cities with higher old-age insurance contribution rates. A full scale implementation of the social security scheme will directly translate into a marked increase in total labour costs.

Regarding economic compensation, although this will only be a factor when the worker's contract is not renewed, some responsible Hong Kong employers have already set aside reserves for such needs. Furthermore, staff turnover is almost inevitable, especially for labour intensive industries with high seasonal fluctuations, such as toys. According to the law, employees working less than one year but for more than six months will receive one full month's wage as economic compensation while those working less than six months will be given half a month's wage. This requirement means manufacturers which have large numbers of seasonal workers with short-term contracts will have to pay additional costs.

Besides direct labour costs, the implementation of the Labour Contract Law requires companies to devote more resources to human resources management, such as maintaining detailed personnel files and planning human resources deployment. Over 70% of surveyed Hong Kong companies indicated that human resources management expenditure has increased by about 20% on average.

More Stringent Quality Standards

For manufacturers of specific products, tightening environmental protection and product safety requirements are also fuelling higher operating costs as well as more complicated work flows. For example, since the publicity about toy safety in overseas markets, additional requirements on product standard testing have been imposed, creating more testing expenses for toy manufacturers.

Mounting Pressure for Further Export Price Rises

Although high food prices in China appear to have had no direct impact on exports, except for processed food items, it should not be overlooked that most Hong Kong manufacturers operating in the mainland, especially the PRD, need to provide dormitories as well as meals to migrant workers. Higher domestic food prices do have an impact on the operating costs of exporters in general. High inflation also raises workers' expectations for wage increases.

Assuming that labour accounts for 15-30% of production costs and that local content ranges from 30 to 50% for manufacturers in the PRD, the rise in wages, RMB appreciation and the implementation of the Labour Contract Law have already resulted in an estimated increase of 8-15% in production costs in general over the last year, not taking into account rises in other input costs.

US Market Share Maintained Despite Higher Prices

Given the shrinking profit margin of Hong Kong manufacturers operating in the PRD, there seems to be a rising trend of overseas buyers being pressed to share more of the burden of cost increases, as evidenced by rising US import prices of products originating from China.

According to the US Labour Department, the average import price of goods from China increased by 4.8% in June 2008, compared with 2.4% in December 2007. However, the rise is still relatively lower than other major suppliers to the US market.

It seems inevitable that part of the burden of escalating costs has to be borne by overseas buyers. Some Hong Kong manufacturers have reflected that, in many cases, overseas buyers are also willing to accept higher prices. That may partly explain why US import prices from China have been rising since mid-2007.

Exporters as well as importers may worry about the competitiveness of Chinese products in overseas markets as prices increase. Nevertheless, the comforting news is that when one looks at US import statistics, the market share of Chinese products in the first five months of 2008 has, at about 18.8%, remained virtually the same as during the same period last year (excluding imports of mineral fuels which may distort the picture, given the recent surge in oil prices), indicating that the competitiveness of Chinese goods has not yet been hard hit by suppliers from other sources.

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