This past week, the WSJ reported that the CEO of alibaba.com, a business to business platform that primarily helps Chinese manufacturers connect with Western buyers, was forced to resign after it was discovered that more than 2,300 sellers registered on the site committed fraud, sometimes with the help of Alibaba’s sales staff. As shocking as this might be, it is hard to pretend like this is a new kind of news story. Corruption in Chinese manufacturing is something we hear about all too often and it is something we have come to expect. We willingly tolerate it in order to have access to the largest manufacturing base ever created.
Even though every day we consume dozens of products that were made in China, we have little collective idea of how those products are made and how they get to us. If you are like me and you are curious about what really is happening behind the scenes of the world’s greatest economic miracle, then I highly recommend that you read Poorly Made in China.
Poorly Made in China is a detailed true story account of an American consultant’s trial and tribulations in the Middle Kingdom. Paul, the protagonist and author of the book, is tasked with managing a partnership between an import/export businessman in the United States who is sourcing shampoo bottles from a start-up Chinese manufacturer. The book takes you through the evolution of the relationship and in so doing reveals all sorts of hidden truths about the world of Chinese manufacturing and Chinese business practices in general.
So how do things play out? Well the relationship between the two – Bernie, the American export/import guy whom Paul is representing and Sister, the Chinese woman who owns the shampoo producing plant, begins wonderfully – at least from the American point of view. Bernie and Paul at the outset are able to negotiate ridiculously low manufacturing prices for the product. At the price they agree to, Sister has no operating margins. At the end of the negotiations Sister feigns like she has been defeated by the power and bluster of the Americans. However, the battle and intrigue has actually just begun.
Sister will get her profits in due time and she is patient at first. The business partnership begins slowly and over time it starts to run reasonably well. However, just as Bernie’s dependence on Sister grows, she begins to employ various tricks. She starts by changing the terms of the deal after orders are placed. She claims that “price go up” for various inputs and therefore she must charge different prices to her wholesaler. When she is called out on it by Paul, she protests and feigns like she has been insulted and lost face. So Paul has to relent and concedes on some of the prices.
When she has pumped all she can from rearranging prices she begins the “quality fade.” She changes the specification of products so that cheaper lower quality inputs are used that can save her money and increase margins further. The shampoo product becomes less shampoo and more like a dangerous mixture of toxins. That continues until she is caught and again she feigns insult and claims loss of face and is able to extract more concessions as a result. She uses tactic after tactic which in most normal operating circumstances in Western countries would be considered incredibly illegal. However this is not a Western country. Time and again, the tactics work and she wins out.
This circus continues until at the end it is clear that Sister has thoroughly won the war. She gets enough revenue from her partnership with Bernie that she can expand the plant and start other lines of businesses and so she no longer needs Bernie. No longer in the position of power Bernie is told by her what to do rather than the other way around.
What is worrisome about the saga of Bernie / Sister is that it is by no means unusual. Many American companies like Bernie were suckered into China by incredibly generous terms. The Chinese government will help finance projects, the Chinese will work for nothing and they will be guaranteed all sorts of end markets in China. Like Bernie, their greed blinds them into thinking that these generous terms are permanent.
They quickly learn differently. They find that Chinese government financing becomes contingent on sharing sensitive intellectual property with a Chinese JV. They find that the Chinese supplier may work for free at first but will quickly change the terms of the contract at the first sign of supplier dependence. Finally those end markets they thought they had access to in China never materialize as the Chinese government ensures through various restrictions that those markets end up in the hands of domestic players. Before the Western company knows it, their cost structure has vastly increased, their IP has been pillaged from them and they are competing with a million Chinese companies that now know exactly how to make their product because they shared that expertise with them. They like Bernie come home after 10 years more or less empty handed.
American companies and the American public in general are just waking up to the fact that our economic relationship with China might not be as costless and beneficial as we imagine. We might be giving them $5 in value for every $1 in value they give us. $6 of value is created by the trade that would otherwise not have existed but the distribution of that $6 is lopsided. There are also longer term risks to generating that value. We are hollowing out our own manufacturing base in return for getting products that are priced artificially low for what may not be a very long period of time. In general, the more dependent we are on them as suppliers, the higher the likelihood that those prices will go up in the future.
Lastly and perhaps most importantly, the products we are getting for these low prices are becoming shoddier and shoddier to the point of becoming downright dangerous. As Paul discovers, the inputs used for the shampoo were becoming so cheap that the shampoo would turn different colors after being shipped out. Quality control was nonexistent or was purposefully violated. At the end of the book, Paul refuses to buy any health care, medicinal or ingestible product manufactured in China. Whether you the reader should continue being shampoo made in China is your choice but the important thing is to remember the price we sometimes pay for low prices.