Friday, October 17, 2008

China, the World's Factory, and the credit crisis

Image of a warship anchored in Hong KongDear Gentle Reader,

As your humble scribe sits in Hong Kong, reading the daily news and talking to people, he is reminded of 1999 when he left Asia.  

That was two years after the last Asian economic crisis had churned its way through the world; the financial fallout forced your scribe out of Asia.

It was like a financial war had hit the region, and the world. 

My company had failed and so had most of the economies in Asia. 

I left just before the economy turned around and just after my company past the point of no return.

I find the disconnect between what I read on the current global financial crisis, what I see here and now in Hong Kong and China, and what I remember from the 1997-1999 Asian economic crisis disconcerting.

This is not a sub-prime crisis we are in, this is a cash flow crisis.  

A cash flow problem is when you have money coming in, but you don't have it today. 

Today you want to buy fancy clothes, or you have to pay your mortgage or your tuition, or you desperately need to buy supplies to fulfill your contractual requirements to do your next job. Further, if you cannot buy those supplies for your next job, then you cannot  keep the contract, so then you really will be out of money in the future.

Cash flow problems kill most companies. 

That is what all of the talk about the credit crisis means: dead companies and unemployed workers.

Dropping asset prices are not a problem for most of us.  

Dropping asset prices look terrible (stop looking at your investment portfolio), but most people do not finance purchases based on their portfolio.

Dropping asset prices are a massive problem if you rely on your portfolio to finance your life like retirees, charities and foundations, and some public bodies do.

I note that dropping asset prices, when the drop is large and sudden, effect and help create a credit crisis, but I believe that the credit crisis is the real killer in the room. 

The credit crisis is the killer whom you have to avoid if you want to make it alive to the final credits of this financial horror film.

Rising asset prices, such as the 231 million % inflation, as of July 2008 in Zimbabwe, as reported in the NY Times, hurts people. 

Falling asset prices are not so bad, as long as you still have cash coming in. And as long as you are not afraid to spend some of that cash that is coming in.

So, while the news outlets focus on stock market declines, that is not what is really important.

What is important is that the financial intermediaries (banks, insurance companies, and others) who aid in distributing money are now cash poor, because of the way they have handled their portfolios of their own and other people's money.

Today, financial intermediaries can no longer distribute money efficiently, which is the economic purpose of a financial intermediary.

Image of a banknote drawn on the Bank of HellSo cash is scarce.

Credit is tight.

That matters to the consumer if you want to buy a house or a car and cannot get a well-priced mortgage or loan.

This matters much more to companies who generally face stiffer credit applications, who pay much more for credit, and who watch their credit facilities cease to exist much faster. 

Companies need credit because buyers, frequently, pay only after things are made. Sometimes buyers pay manufacturers months after things are made. 

Yet manufacturer's employees expect to be paid every month or every two weeks. 

Smaller sub-contracting factories, generally, also need money sooner as compared to when the "big boys and girls" of the manufacturing world get paid.  

The ability to get credit, to weather cash-flow demands slightly better, along with volume of output, are the two main factors distinguishing between the "big boys and girls" and the "little boys and girls" of the manufacturing world.

Image of an expensive fabric weaving machine
In the old days of Wal-Mart, when I had my business in Asia, Wal-Mart would not pay for a product until a fixed number of months after a product had actually sold from a Wal-Mart store. 

While Wal-Mart might be the statistical outlier in terms of buyer/manufacturer payment schedules, many large retail buyers do not pay manufacturers until a number of months after the buyer has received the goods in the buyer's actual distribution site(s). I know this from my past experience in the industry. 

This means that the manufacturer has to buy all her raw materials, subcontract manufacturing for everything she cannot do herself,  pay those subcontractors, pay the manufacturer's own workforce, and potentially pay for the shipping of the goods to the ultimate buyer.

Then the manufacturer waits until the money from the sale is finally paid to the manufacturer.

As long as there is a continuous flow of production and sales, then there is a continuous flow of cash coming back. 

If the output and the contractual demand are continuously increasing then banks are willing to extend credit, although at a very high cost--much higher than the cost of consumer credit.

Banks offer short term credit to "bridge" the financing gap between when the manufacturer has to pay her suppliers and workers and when she receives the "final funds" for a sale. 

In China, manufacturers learned to work closer to the wall of financial ruin to keep total costs lower (and therefore sales prices lower) than European or North American firms would dream of doing. (Having run law firms in North America and Europe, I think I am in a good position to make this observation.) 

Why do Chinese manufacturers work right at the edge of financial ruin? Because having "the China Price" is what has driven economic growth in China.  

No one wants the safest product.  Or the most durable product.  

Buyers want the cheapest product because consumers want the cheapest product. That is not a rant, that is reality if you talk to any buyer in Asia.


If a particular Chinese manufacturer cannot provide, or is unwilling to provide the lowest possible price, then her competitor will. 

Her competitor will ignore the risks.  

Why? Because her competitor is foolish?

No, because the real risk is that if you lose a contract then production or sales could falter.  

If your cycle of cash inflows and outflows falter then you have a cash flow problem, and then everything could come falling down. So that Chinese manufacturer lowers her product prices to keep the orders from going to her competitor.

Of course, when there is an external disruption, like should the financial intermediaries be short of cash themselves and therefore unable to offer bridge financing, the manufacturer still has a problem.  Sound familiar?

And banks don't like to hear about problems, even if the bank helped create the problem. Now the bank can say the problem isn't that we, the bank, has no cash on hand, its that you, the manufacturer has an imbalance between your costs and your sales figures...  

Banks do not lend money to a company with problems in the best of times, and right now the banks themselves are in the worst of times.

All of this matters in China precisely because Chinese manufacturing companies operate on razor thin margins. This phrase is so overused and yet it is so accurate. Think back to your oldest memories of your Dad's razor.  If you can't remember Dad using that type of razor, think of the razors used to clean paint off of windows.  

There is not much room to manoeuvre if your margin for error is the thickness of that razor.  That is why the cliche exists.  

Think of having that little room for manoeuvering. A razor's edge. That is what our Chinese manufacturing lady has; not much room to manoeuvre. And, if something makes her slip, that financial razor edge she dances on will slice her and that manufacturer will bleed red ink all over the financial books.

The generic Chinese business model is to produce and sell in massive volumes to create "the China price" which then attracts further production orders and increased sales volumes, so that prices can be lowered further. 

Keep costs to a bare minimum, and generate sufficient sales volumes. That is the mantra that sustains "the China Price".  

Even when you are continuously selling for less and less, if you are selling more, then you can still make good money. But, you can never stop selling.

I used to have a company in Asia. 

We conducted audits of goods, manufacturing processes, and social standards compliance. 

Subsequent to the audits, or sometimes independent of them, we would mediate (help everyone negotiate an agreement they could not negotiate on their own) or arbitrate (act as a private judge and decide the outcome for the parties) disputes amongst all of the parties--manufacturers, contractors, distributors, shippers, and buyers.

I saw a lot of factories throughout Asia. 

After the 1997 currency crisis started in Thailand and then bounced to Russia, cash flow/credit squeeze problems started knocking down financial card-houses, and real factories and real businesses, everywhere else. Sound familiar?

On behalf of my company, I thought that there would be more attempts to cut costs on the manufacturers' side and therefore more disputes over non-conforming goods or products would occur. This would be good news for me because my company thrived on the disputes.

Further, although this extra work would cost the buyers more money, the currency differentials brought on by the currency crisis would minimize the "real" cost, as compared to buyers' apparent costs, when calculated back to their own currency and when compared to the total costs buyers had paid in "pre-crisis" years.

I was wrong and I paid the price.

What I had not expected was that the credit crisis that arose would crunch factories and their production lines out of existence.

I would go on a surprise audit or investigation or just a visit a manufacturer's factory to find the factory shuttered. Closed.

image of a factory machine with dozens of bobbins of thread leading intoOr I would find the factory owners playing cards, in despair, with nothing else to do because they could not afford to buy a couple of hundred dollars of glue. Or rubber. Or thread. Whatever. 

They had all the rest of the components, but they could not afford the last thing, whatever that thing was. 

And no one would give them credit, or cash, to buy that last thing.

"For want of a nail, the shoe was lost.
  For want of a shoe the horse was lost.
  For want of a horse the rider was lost.
  For want of a rider the battle was lost.
  For want of a battle the kingdom was lost.
  And all for the want of a horsehoe nail."

Old English proverb, variants are found in many cultures.

In China, when my business was failing, the economy (in the North, especially) devolved into a barter economy, but that was never reported on the news.  

There were riots that I would witness in the hinterlands, as I kept my head down in my car, because neither my driver nor I wanted the authorities to see a foreigner in the car. I never read about these in the news.

These occurrences--these factory failures and these cash flow crises--never made the news then.

And they are not making the news now.  

Chinese manufacturing credit defaults are not making the news.

Many people believe that default and bad debt statistics are not being reported faithfully out of China.  But most people pragmatically know that not much in China is reported accurately if the result is not in China's best interest.

I do not know about riots, today, although I have heard covert whispers of unrest.  But I know about factory closures.

I know that buyers are going to factories, and finding that the owners have disappeared (the official bankruptcy procedure is cumbersome, and when scapegoats need to be found for social ills, people in Chinese custody always worry about the death penalty).  

Anyway, today, buyers are going to factories to place orders or check up on orders and, sometimes, the factory owners are nowhere to be found.

Some factory owners have abandoned everything and everyone.  

The tools, the machinery.  The inventory.  The raw materials.  The tax obligations. The debts to their banks. The payroll.  The contractual obligations to other companies. Everything has been abandoned. It is the easiest way to leave the problem, the owners think.

This is reality. It is not the only reality, but this is happening throughout China. Especially in the South.

The buzz in some of the bars, and the patios, and the clubs, and the private dinners in Hong Kong is over the looming chaos in peoples ongoing commercial interests, because companies are going bust. 

Companies are going bust because companies have no money. The companies are in a pinch, and no one is extending credit. 

Owners either have no free cash, sometimes due to falling asset prices (many owners here in fact live off their investments), or the owners have no cash because they live off the cash flow of their company.

Credit is money, and money is the lifeblood of any company.

Your scribe is worried.

China is and has been a massive driver of global growth. A big explanation for the commodity boom, which we have seen go bust, was that as China kept ramping up production, they needed more and more inputs for their factories.

And before someone says that this serves them right, they did what we demanded.  We demanded, all of us, as consumers, more and more of cheaper and cheaper.


But, because Chinese factories operate on such a tight margins, there is no "fat" to be cut, and there is almost no margin for mistakes, or to deal with external shocks. Like this credit crisis.

Lean operational workplaces are not a consultant's suggestion in China.  That is the reality of every firm.  

Without intense "leanness" these companies could never maintain "the China price", that rock-buttom price that global consumers have demanded in their insatiable quest for cheaper, cheaper, cheaper.

So this credit crisis is already tipping companies into bankruptcy, officially, or unofficially, when factory owners just walk away and disappear.

And as this happens, it affects every other manufacturer, and eventually, many other suppliers and companies outside of China.

Obverse side of the banknote drawn on the Bank of Hell
I saw 1997-1999.  I don't want to discover a repeat of the Great Depression of 1929-1930s (extending even into the 1940s, depending where in the world you lived).

I hope this post helps flesh out a bit more what the credit crunch means in real world terms, especially from the perspective of the Factory to the World, China, as I know it.

And there can be no schadenfreude.

The Chinese are not getting what they deserve.  

For better (or worse, depending on your perspective) the world is interdependent and interlinked.  And China is the biggest industrial driver of economic growth in the world.

As they go, well, so we all will be affected.

Your humble scribe


Elizabeth said...

Well there goes my worry free night.

Jeez too scary!

DJL said...


I have to disagree with you that

"[l]ean operational workplaces are ...the reality of every firm."

Yes, the tendency is ruthless in cost-cutting, but that does not equal "lean". It is very common in China that factories (whether foreign owned, or local) will go to the limit in cutting labor and other expenses, but will still blindly incur the costs of wasted labor, transportation, and stagnant inventory.

My hypothesis is that with costs rising, and credit tight, those companies that most effectively reduce wasted labor, wasted space and stagnant inventory (in other words, going "lean") will be better positioned to survive the downturn.