Yuan to Rethink Your China Supply Chain Strategy?

Probably not: Analysts downplay supply chain impact of China's decision to decouple currency from dollar

Probably not: Analysts downplay supply chain impact of China's decision to decouple currency from dollar

Boston — July 22, 2005 — Supply chain executives who spent the last few years formulating and implementing a China supply chain plan as part of their low-cost country sourcing (LCCS) strategies were likely as surprised as anyone this week when the Chinese government announced that it was decoupling the country's currency from the dollar.

But what will the real impact of the currency's re-pegging to a basket of foreign monies be on global supply chains that rely on Chinese suppliers for components and finished goods?

Not much, according to a pair of supply chain analysts.

"Mild" Move

"What they've done is mild," says Kevin R. Fitzgerald, vice president of supply management research at Boston-based advisory firm Aberdeen Group. "It amounts to a little over 2 percent difference, which is nowhere near enough to change the LCCS strategies of U.S. and European companies."

Fitzgerald, who recently released a report entitled "Low Cost Country Sourcing Success Stories," says that most procurement groups save at least 30 percent on costs when sourcing goods in China, though some of that is lost in unanticipated supply chain costs and other costs. "Still," he says, "2 percent is a drop in the bucket."

Kevin O'Marah, vice president for strategic research and communications at technology consultancy AMR Research, also based in Boston, agrees, writing in a research alert this week that the small adjustment was important symbolically, showing that the Chinese government recognizes the need to manage the political risk associated its trade imbalances.

"The 2 percent adjustment announced yesterday was widely applauded as an appropriate symbolic move, but a big way from closing the 40 percent gap in exchange rates that some experts believe is ultimately called for," O'Marah wrote in an alert, "China Revaluation and Supply Chain Risk: Beijing Is Getting It," issued today. "Business customers with big supply chain bets in China can take comfort that political pressure will not be allowed to build until it bursts, and that cherished cost advantages will be protected as long as possible."

Three Choices

Fitzgerald says that this move was inevitable. "It was just a matter of when China would do it, and how dramatically their move would be," he said, noting that, on the one hand, the U.S. and, even more so, the European governments have been putting pressure on the Chinese to fully float the yuan, while the Chinese economy was in danger of overheating, creating internal pressure to adjust the yuan's value.

As a result, Fitzgerald believes that the Chinese had three choices: Do nothing, and risk incurring the wrath of Western governments; convert to a fully free-floating currency, which could have destabilized the Chinese economy, surrounding economies, and even possibly the U.S. and other Western economies, since so much investment has recently been made in China; or take small steps over time to appease the United States and Europe, cool down a red-hot economy and slowly shift toward a free-floating economy. "They picked the last choice, which in my opinion is what they should have done," Fitzgerald says.

O'Marah feels that the move should lower some of the risk associated with doing business in China. "The issue for manufacturers pushing large amounts of their supply base deeper into China's low-cost economy was that a big chunk of the cost advantage was artificial due to the Yuan being pegged to the dollar," he writes. "Business risk was heightened by the political nature of exchange rate determination — something inherently unpredictable, as politics works in its own mysterious ways, often indifferent to the needs of business.

Long Term Implications

In the long run, Fitzgerald sees the Chinese decision potentially having some impact on China's position as a low-cost country. "Long-term, the change will affect the trade imbalance, assuming the Chinese intend to continue to take these baby steps periodically, and I'm quite certain they will now that they've started," he says. "But this will take time, and by the time it makes a significant cost difference, China may no longer be the low-cost country of choice. It may be Brazil or Russia (they have a long way to go, but so did the Chinese a few years ago) or someplace else."

Fitzgerald noted in his recent report on LCCS that today's low-cost country becomes tomorrow's medium-cost and then a high-cost country. "This happened in Japan, which made the big mistake of abruptly changing the yen to free-floating after being directly pegged to the dollar. Economists generally agree that this move contributed to the very long recession in Japan. The Chinese seemed to have learned from this."

Fitzgerald's report is available at http://www.aberdeen.com/summary/report/benchmark/RA_LCCS_KF.asp.

Additional Articles of Interest

— Imminent terrorist attacks or no, your competitive advantage demands that you secure your company's supply chain. Read more in "Supply Chain Security: Is Your Company Complacent or Engaged?," in the February/March 2005 issue of Supply & Demand Chain Executive.

— For a look at how Tyco Fire & Security is tackling trade compliance issues in its global supply chain, see "Turning Global Trade Compliance Into a Competitive Advantage," in the August/September 2004 issue of Supply & Demand Chain Executive.

— For more information on the challenges and opportunities presented by increasingly global supply chains, see the special in-depth report in the August/September 2004 issue of Supply & Demand Chain Executive, which includes the following articles:

— For more information on the global supply chain, with a focus on security issues, see "Building the Secure Supply Chain," the Net Best Thing article in the June/July 2003 issue of iSource Business (now Supply & Demand Chain Executive) magazine.