“Production costs are higher only in Japan, the United States, and Italy”

China’s property and infrastructure bubbles, nurtured by limitless borrowed money, are still swelling up beautifully – whether these structures, even entire ghost cities, are needed or not. Service industries are also growing. In 2011, they outdid manufacturing as largest employer for the first time. In 2012, they made up 46% of the economy. But hot air has been hissing out of manufacturing. Zhang Ruimin, CEO and founder of China’s largest appliance maker, Haier Group, put his finger on the problem. And it doesn’t look good for manufacturing in China.

He should know. In 1984, Zhang was appointed by the city of Qingdao to run Qingdao Refrigerator Factory, a collectively-owned, nearly bankrupt plant that produced about 80 shoddy fridges a month. He hooked up with Liebherr Group, a German manufacturer of mining trucks, cranes of all kinds, other heavy equipment, and well, very expensive fridges. As part of their joint venture, Liebherr offered technology, equipment, and expertise. The brand name would be Qindao-Liebherr (pinyin: Qindao-Libohaier). Hence today’s Haier.

That year, the company had revenues of 3.5 million yuan, at the time about $1.6 million. It took over some local appliance makers, then did what Chinese companies did: it grew exponentially. By 2009, Haier was the world’s number one “Major Appliances” brand based on unit retail sales. In 2012, it had a global market share of 8.6%. But revenue growth, despite a slew of acquisitions, has petered out – up a measly 10.7% to $25.8 billion. Hence Zhang’s desperation.

He fired a warning shot in October 2011, when he explained how he was trying to refocus Haier’s two listed subsidiaries, Qingdao Haier Co. (R&D and manufacturing) and Haier Electrics Group Co. (distribution and channel management). “I’ve been thinking how we could change the operations into a new model that ties R&D directly to the markets, while manufacturing would be taken care of via outsourcing.”

Offshoring!

“In the next 10 years, a major part of our development strategy will be the globalization of our brands and the integration of global resources,” he added. Globalization was suddenly no longer a one-way street for Chinese manufacturers. Now they’d look for the corporate greener grass – lower costs – in other countries. That was October 2011.

“China’s model, which depends on the export of lower-priced products, is coming to an end,” Zhang confessed a few days ago. It wasn’t just wages but the cost of doing business in China. “The world’s factory,” was getting too expensive. The conditions that were the impetus behind China’s phenomenal economic ascend were collapsing.

“We have production plants in 24 locations all over the world,” he said. “But production costs are currently higher only in Japan, the United States, and Italy, compared to China.” These costs would become “a major problem” for his company unless it started building plants in “Southeast Asia and elsewhere” to offshore production. As part of its growth strategy, Haier has acquired appliance makers around the world, including Sanyo Electric Co.’s appliance business in Japan.

Other Chinese manufacturers are doing the same. It shows up in the numbers, from weakening GDP figures, however dubious they may be, to lousy purchasing managers’ indices. Manufacturing, one of the engines of the Chinese economy, has stalled for structural reasons.

It has exposed an industrial nightmare. After years of plowing nearly limitless amounts of borrowed money into building all manner of industrial facilities, these industries are now stuck with backbreaking overcapacity. Prices have collapsed. Entire industries are threatened.

Particularly hard hit are sectors dominated by state-owned manufacturers, abetted by state-owned banks that offered loans for even the most useless projects. Building them contributed to China’s miraculous GDP growth over the years. Now the truth is seeping through the cracks. They’re all in trouble: steel, ferroalloys, electrolytic aluminum, glass, copper smelting, cement, paper, among others, and by golly, shipbuilding (Industry flagship Rongsheng Heavy Industries, deemed too big to fail, already ran aground and is waiting for a bailout).

Overcapacity is such a problem that the government has issued an edict to 1,400 companies in 19 sectors to slash production capacity by December! And it told state-owned banks to work with them – hence loan extensions or more loans. Overcapacity has turned plants into industrial wasteland with no possibility of recouping the investment. Another worrying cloud over China’s magnificent pile of debt.

But at least one industry is still roaring: the auto sector. It was China’s fourth-largest industrial sector by revenue in the first half of 2013, behind iron and steel, chemicals, and communications equipment. It’s dominated by global automakers and their obligatory Chinese partners. Scores of Chinese automakers, some state-owned, are trying to stay relevant. Announcements of assembly plants being built or expanded are a constant refrain. Exuberance dominates. Even moribund French automaker PSA is looking for salvation in China. Sales jumped 14% in the first half of 2013, and profits 20% – to 233 billion yuan ($38 billion). It made the auto sector the most profitable of all 41 industrial sectors!

Without the auto sector, manufacturing would look a lot worse. But for industry insiders, drunk with exuberance, it seems unimaginable that they too could hit a speed bump and veer off the road into overcapacity, a cyclical story that’s as old as the industry itself.

Meanwhile, Japan’s Prime Minister Shinzo Abe skillfully used his economic salvation plan, a religion lovingly dubbed Abenomics, as a platform to catapult his party into power. With the LDP controlling both houses of parliament, real changes, after years of dickering, might now finally be possible. Read…. The Dark Side Of The Guys Who Run Japan Oozes To The Surface

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