William Downey, C i h n i a n Has a Ha Lo s L s o t s t Its Co Its C s o t s A v d a v n a t n a t g a e g in e i Die Di Ca e C s a t s i t n i g

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1 William Downey, President Technology Consulting Group Boston, Massachusetts China Has Lost Its Cost Advantage in Die Casting Part 1 of 2 China s Systematic Advantage 2007 In February of 2007, at NADCA s annual Executive Conference in Hawaii, Technology Consulting Group (TCG) reported on the results of a year-long study for NADCA regarding buyers opinions on the American die casting industry. The report remains available through NADCA as, Die Casting In The US - The Buyers Perspective In that report, TCG predicted that within five years, American die casters serving the American market would be costcompetitive with Chinese sources. That forecast was based on the savings OEM buyers realized from China at that time plus our forecast that the currency exchange rate would change over the subsequent five years to make US suppliers more competitive. We believe that this positive forecast has, indeed, come to pass. In 2007, die castings purchased in China were systematically less expensive than die castings produced by US die casters. Now, in 2012, this systematic advantage no longer exists. What do we mean by systematic? When we made our report in early 2007, the Chinese renminbi was trading at per US dollar and US OEM buyers were realizing savings on purchasing die castings in China of between 20 and 40 percent. This was not the result of the Chinese die casting firms being more cost-efficient than American firms: it was the result of a currency exchange rate that gave them a systematic advantage. How do we know that? Purchasing Power Parity analysis is one approach to estimating an exchange rate that will cause a representative market basket of goods to sell for equal value in two countries being compared. TCG s analysis of purchasing power parity in 2007 suggested that an exchange rate around 3.5 would render an equivalent basket of goods of equal value in both the US and China - for this analysis, see, Will China Lose Its Cost Advantage in Die Casting?, LINKS - June An even more telling demonstration of the fact that the currency exchange rate was systematically stacked against American manufacturers was the fact that China needed to make large and constantly growing purchases of US treasury bills. Only by intervening in the currency exchange markets, could China maintain a low valuation for the renminbi. This, of course, gave China an immense, systematic advantage in selling its parts and products to the world. If the exchange rate accurately reflected the relative valuations of the two currencies, China would have had no need to intervene in the currency exchange markets. 2/LINKS June 2012 Cost Savings In China 2006 In 2006, when we did our interviews with US OEM buyers, the deck was stacked against American die casters competing with Chinese suppliers. As one of our OEM interviews said: For a manufacturer, buying parts in China is like going into a store and finding it is having a 40% off sale on everything. We cannot afford not to buy from China. But at the same time, the whole country is pursuing predatory pricing against the United States. If a company here in the US were to do what the Chinese do to us, it would be illegal: the Federal Trade Commission would come after them. This cannot last - so, it won t. The artificially high exchange rate prevailing in resulted in US OEM buyers purchasing die castings from China in large and growing quantities. Although not every OEM buyer saved on every purchase, the majority reported savings of 30 to 50 percent. From our interviews, TCG learned that the savings were proportional to the labor content of the goods purchased. Assembly operations yielded the highest cost savings, but even raw castings gave gross cost savings of 20 percent or more. Not surprisingly, then, America s OEM buyers found it particularly desirable to purchase machined castings from China. Averaging the savings reported by the OEM buyers we interviewed, TCG found that the average gross savings of Figure 1 - In 2006, OEM buyers reported a range of savings on purchasing die castings in China.

2 and what we suggested to America s die casters to render them more competitive, our Buyers Perspective report for NADCA remains pertinent today. US Die Casters Are No Longer Systematically Non-Competitive Figure 2 - The greater the labor content, the greater the savings reported by OEM buyers. Figure 3 - In 2006, OEM buyers purchased primarily machined castings from China. buying from China was 31.7 percent. We also learned that the logistical cost of landing these parts in the USA averaged 12.3 percent, for a net savings of 19.3 percent. We also learned from OEM buyers that they were willing to pay a premium for US parts of, on average, 17.1 percent. Of course, these averages reflected a wide range of individual experiences of US OEM buyers - and cost was not the only factor in their decision. For an in-depth review of what we learned, The good news is that, since our interviews in 2006, we believe that this average savings of 31.7 percent has been eliminated by two mechanisms: first, the change in the currency exchange rate; second, greater inflation in China than in the USA. We will present in this article our analysis of these theoretical reasons for believing US die cast parts are now fully competitive with Chinese die cast parts. We are no longer systematically hampered in our competition with China s die casters from the currency exchange rate - though we expect the exchange rate will continue to decrease. In part two of this article, we will examine not theory but facts: our current interviews with OEM buyers and China vendors, as well as numerous reports on costs and labor rates, have convinced TCG that this is not a mere theoretical mirage. OEM buyers we have recently interviewed report getting similar quotes in China and Chicago. To understand what has changed in the last five (5) years, let s consider a hypothetical die casting available for 100 renminbi in China in January of Given the exchange rate of renminbi per US dollar prevailing in January of 2007, this hypothetical die casting would have cost $12.83 in China. Our hypothetical US OEM buyer could have purchased this same part from a US die caster but most likely would have been quoted a higher cost. Recall that US OEM buyers reported average gross savings of 31.7 percent on parts purchased in China. If the savings on this hypothetical part were, in fact, exactly average, our hypothetical US die caster would have offered the part to our hypothetical US OEM buyer for $ giving the buyer a 31.7 percent gross savings from buying in China. Of course, this part would have needed transportation to the United States, and in the process of loading and unloading it to a hypothetical boat coming across a very real Pacific Figure 4 - Averaging all of our interviews in 2006, OEM buyers reported gross savings of 31.7 percent buying die castings in China rather than sourcing them here in the USA. Figure 5 - To illustrate, consider a hypothetical die-casting, available in January of 2007 for 100 renminbi in China. June 2012 LINKS/3

3 Ocean, logistics would have added an additional cost of, on average, 12.3 percent. This would have given a landed price of $14.41, including the average 12.3 percent logistics cost. As the chart below calculates, a price of $14.41 would have given a net savings of $4.38, that is, a 23.3 percent savings from buying this part in China rather than in the USA. Let s look at what has changed over the last five years, making reference to this hypothetical part. The first consideration is that the exchange rate has declined considerably since When TCG did our interviews with OEM buyers in 2006, the exchange rate was around 8.0 renminbi per US dollar. Based on an examination of the change in the exchange rate from June of 2005 through January of 2007, TCG made a forecast of the future rate of decline in the exchange rate. Also, we calculated that, if the exchange rate dropped to around 6.4 renminbi per US dollar, the net cost savings - including logistics costs - would evaporate. Our forecast from late 2006 appears as the declining purple line on Figure 6. We believed and expected that the roughly 20 percent average net savings to US OEM buyers of buying in China would be gone by late 2009 and even the gross savings of 31.7 percent would disappear by Figure 8 - From mid-2008 until late-2010, the Chinese government maintained a nearly fixed exchange rate of 6.8 renminbi per US dollar. After a nearly two-year period of stability in the exchange rate, since third-quarter 2010, it has again started to fall, making US die castings more and more competitive with die castings from China. Even if this declining exchange rate were the total story, it would still be a cause for celebration at US die casters. Referring to our hypothetical 100 renminbi part, which had net savings of 23.3 percent back in January of 2007, the change in exchange rate alone reduced the net savings to only about five percent by February of Had there been no inflation these last five (5) years, the Chinese part would still have been priced at 100 renminbi. The decreasing exchange rate however, has raised the value of 100 renminbi from $12.83 to $ With logistics, the landed cost would have risen to $ The price of a US part, again assuming no inflation in the US, would have remained at $ and the savings would have been reduced to around 5 percent from around 20 percent. Figure 6 - In 2008, TCG s forecast looked good: the exchange rate had fallen, and Chinese die castings were no longer an irresistible bargain. This forecast looked good through 2008, but then, in the third quarter of 2008, the exchange rate stabilized at 6.8 renminbi per US dollar. Even at that exchange rate, most of the net savings that US OEM buyers had enjoyed back in 2006 were gone. But the gross savings were still real, and US OEM buyers still went shopping in China with the expectation of finding a bargain. Figure 9 - Since 2007, the exchange rate has fallen low enough to nearly eliminate any cost-benefit to OEM buyers from sourcing die castings in China rather than the USA. Inflation In China Makes US Die Cast Parts Even More Competitive Figure 7 - From 2006 to 2009, China s currency increased in value by 16.6 percent and by 2009, there was little net benefit to a US OEM sourcing raw or machined castings in China. 4/LINKS June 2012 Beyond the declining exchange rate, inflation in China has raised the cost of Chinese parts. Of course, infl ation in the USA has also raised the cost of American parts. However, China s inflation has exceeded US inflation consistently since So, infl ation has caused die cast parts manufactured in China to increase in cost proportionately more than parts made in the USA.

4 Figure 10 - The exchange rate alone is only half the story: China s inflation has exceeded US inflation consistently since and this too has reduced OEM savings from buying die castings from China. For our analysis, let s define an Inflation Index, relative to the prevailing costs in January of The China Inflation Index has grown from 100 in January of 2007 to 121 in February of This means, of course, that average costs in China have grown by 21 percent since January The US has also experienced inflation. Let s define a US Inflation Index, also setting it equal to 100 in January of Since January of 2007, the US inflation index grew to 112 by February of The effect is that the average cost in current dollars of parts made in China has grown nine percent more than the average cost in current dollars of parts made in the US. It is an interesting macroeconomic question of whether, in fact, the higher inflation rate in China is in some way caused by the Chinese government s attempt to maintain an artificially high exchange rate. Most likely so - but it is a topic for a different paper. Now we will combine these two effects - a declining exchange rate and an inflation rate in China that exceeds the inflation rate in the US - and see the combined theoretical effect on any systematic cost savings from buying parts in China. We will refer again to our hypothetical part, selling for 100 renminbi in China, in January of In the one-dimensional analysis of figure 9, the price in renminbi remains constant renminbi. The declining exchange rate causes the price of the part made in China to rise in US dollars - but were there no inflation in China, the price measured in Chinese currency would be the same in 2012 as it was in But there has been inflation in China - considerable inflation. A part costing 100 renminbi back in 2007, if it rose in cost proportional to the China inflation index, would now sell for 121 renminbi - as per the cumulative inflation index appearing on figure 11. Converting renminbi to dollars, at the prevailing exchange rate of on February 1, 2012, our hypothetical part that sold for $12.83 in China in January of 2007 would now sell for $ And with logistics costs, the landed price of this Chinese part has grown from $14.41 in January of 2007 to $21.59 in February of Of course, there has also been inflation in the US, but not so much as in China. Here, the US inflation index has grown to 112. So, the hypothetical part that could have been purchased in the US for $18.79 in January of 2007, were it to keep up with the inflation index precisely, would now cost $ The US part at $21.06 is now cheaper than the landed price of the Chinese part at $ Thus, the systematic advantage enjoyed by Chinese die casters has evaporated - both from the rising value of the renminbi and from the higher inflation rate in China than in the US. So, where five years ago it was cheaper to buy a part in China and ship it to the United States, it is now less costly to purchase that part in the United States, made by a US die caster. And that is surely good news for the US die casting industry. Of course, for all the seeming precision of these percentages, exchange rates, inflation rates and costs, these are all averages and estimates. Inflation is not truly a single value - either here or in China. Inflation is measured relative to a market basket of goods, and depending upon what goods are chosen, the inflation rate estimate can vary considerably. For example, labor rates in China have been exploding. TCG has one report from a major US American manufacturer, of labor rates increasing in China in excess of 20 percent per year these last two years. And although Figure 12 - Combining the impact of the declining exchange rate and escalating inflation, die cast parts from China are no longer systematically less expensive than US parts. Figure 11 - From 2007 until now, cumulative inflation in China has exceeded US inflation by 9.0 percent. Figure 13 - As TCG predicted in late 2006, OEM buyers are now better off buying die cast parts in the USA, not in China. June 2012 LINKS/5

5 these numbers may be good on average, die casters vary in their cost efficiency both in the US and China. So, not every US die caster is more cost efficient than every Chinese die caster. Nevertheless, the well-justified concern that the deck was stacked against us five years ago should now be much relieved. China s high inflation rate and dropping exchange rate has removed any systematic impediment to US die casters competing effectively with Chinese die casters for the US OEM market. Future Changes In Competitiveness There are good theoretical reasons to believe that, in fact, US die casters are likely to become even more cost competitive relative to Chinese die casters in the years to come. The current exchange rate of is probably still too high. It is widely believed that, in the attempt to control inflation, the Chinese government has allowed the exchange rate to fall. Inflation remains a serious concern in China and may require further declines in the exchange rate. Inflation in China is currently running at an annualized rate in January 2012 of around 4.50%, and in February, of 3.20%. But regardless of inflation, Purchasing Power Parity analysis suggests that the exchange rate has a long way to drop. The International Monetary Fund estimates that an appropriate exchange rate would be around 3.95 renminbi per dollar. This approach to computing appropriate exchange rates is, however, subject to considerable debate. It 6/LINKS June 2012 Figure 14 - Purchasing Power Parity analysis between China and the USA, suggests that US die cast parts will likely remain less expensive than parts from China for years to come. nevertheless seems reasonable to believe that the exchange rate between the Chinese renminbi and the US dollar will continue to decrease - and as this happens, America s die casters will become more and more competitive in the world market. Findings From The Field Here ends the theoretical discussion - but what about the actual experience of OEM buyers and China suppliers? TCG has interviewed a few representative buyers to see if this theoretical analysis is vindicated by their actual experience. We will report on these findings in part two of this article. But here is one comment from an OEM buyer, well versed in the Chinese market, that will foreshadow our conclusion: For a while, our prices in dollars held steady even as the Chinese currency increased in value. I knew from our vendors that they were struggling to keep their prices down - but over the last year or so they have started catching up. So, rather than seeing a steady increase in price, we have seen a dramatic increase over the last year - maybe 20 percent. It is not just one vendor - it is across the board. I would not place a new part in China now, even if I got a good price, because I think there will be very little or no cost advantage in another year or so. About the Author Bill Downey is president of Technology Consulting Group (TCG), a firm well-known in the die casting industry. In 1984, TCG performed the first die casting industry market segmentation study for ADCI (a predecessor of NADCA), accurately predicting the critical importance of imports and technology in the die casting industry. In 1997, TCG again published a market segmentation study, forecasting the U.S. die casting market. Five years later, these forecasts proved accurate within 2.5%. In 2000, TCG examined, Future Directions in Die Casting for NADCA, forecasting that only 287 U.S. custom die casters would remain by In 2003, NADCA again called on TCG to peer into the future. TCG s report, The United States Die Casting Industry A Global Future, examined the impact of globalization on the U.S. die casting industry. In 2006, TCG examined The Buyer s Perspective on the U.S. die casting industry and suggested strategies for U.S. die casters to compete in the global market. In 2008, TCG performed the NADCA die casting industry census and found 285 U.S. custom die casters a count less than 1% under the forecast from Downey holds master s degrees in both engineering and industrial management, has published books and articles on renewable energy, die casting and marketing strategy, and has completed assignments in Europe, Pakistan, India, South Africa, Brazil and the U.S. Your comments and questions are welcomed: he may be reached at wtdowney@verizon.net.