Foxconn's Economic Exposure in China: How to Stay Globally Competitive

Volatility of the Yuan, changing costs of doing business in China, and how Foxconn should react

Manufacturing in China since 1988, Foxconn Technology Group assembles an estimated 40% of the world's consumer electronics for global brands including Apple, Dell, Nokia, Samsung, Hewlett-Packard, and Amazon employing 1.2 million workers. Being China's largest exporter, Foxconn has significant exposure to the Chinese currency movements, as any depreciation or appreciation of the Chinese Yuan will have a direct impact on our profitability, export value, and ultimately demand of our services. The increasing costs caused by an appreciating Yuan and other costs such as labour, which has experienced significant real growth, have created the need to critically review our course of development in China. This report aims to analyze China's monetary policy and recent changes in the economic environment on Foxconn's business activities in China, and explore the possible actions the company could take to continue to be globally competitive and mitigate risks which threaten our sustainable development.

CHINA'S MONETARY POLICY AND CURRENT MOVEMENTS OF THE CHINESE YUAN

China's monetary policy reflects the country's strategy to grow its economy through exports by keeping the value of the Yuan artificially low. A low value Yuan makes labour and exports cheaper, helping Chinese products to be more competitive in the international market. This has helped China attract FDI through which it creates more jobs and learns best practices from the MNCs coming to do business in the country.

Before 2005 the Chinese Yuan was 'pegged' against the US dollar at an average rate of 8.3 Yuan to the dollar.

Under international pressure to raise the Yuan value according to market dynamics, from 2005 to 2008, the Central Bank of China allowed the Yuan to appreciate 18.5%. To keep the appreciation under control, the central bank bought most of the foreign currency that flows into the country and exchanged them to Yuan. To accommodate this policy it printed more Yuan, causing the inflation rate to rise from 2% in 2005 to above 8% in 2008.

This means that contracts and payments negotiated in the past which were not indexed for FX adjustments would be more expensive to execute. Labour costs increased with due to the high inflation rate and exports were more expensive, both of which have a negative effect on profit margins for of Chinese manufacturers.

However, since July 2008, China has slowed the appreciation of Yuan to aid local exporters impacted by the global economic crisis, keeping the exchange rate of the Yuan relatively constant at 6.83 to the dollar. From June 2010, China resumed appreciation of the Yuan to 6.35 per dollar through 2011 (see figure 1) - this pace is still slow considering China's 8-9% GDP growth over the past few years. The Yuan is anticipated to appreciate by 5 3 percent per year over the next four years .

Figure 1: Historical view of the Yuan appreciation

RATIONALE BEHIND THE YUAN APPRECIATION

As we operate in the high-tech export category, the low value of the Yuan has been beneficial in making our servicesFoxconn more competitive in price. Moving forward, it is important for us to understand the rationale behind China's monetary movements and its trend in the future in order to mitigate against the appreciating Yuan effectively. I believe the appreciation of the Yuan is driven by three key trends:

International pressure

It is estimated today, that the Yuan is still 40% lower than its real value against the dollar , causing imported goods from the U.S., E.U., and developing countries such as India, to be artificially inflated. This beggar-thy-neighbour policy (to develop your economy at the expenses of other countries) will continue to be criticised by other nations, especially by the U.S., and pressure to appreciate the Yuan will continue. However, it is unlikely that the Chinese central bank will allow any major changes to the Yuan exchange rate beyond the stated 5 3 percent annual appreciation, in order to protect domestic businesses.

Shifting from export-led growth to domestic consumer-led growth

Under the impact of the global economic crisis, China's major export markets (E.U., U.S.) are still suffering from the hangover of the recession, which reduces China's export revenues to these countries. Intuitively it is troubling that a country that has an average annual growth of 8-9% relies heavily on export to markets that grow only 2-3% each year. China's Twelfth Five-Year Plan, introduced in 2011 , reflects the country's commitment in shifting its economic model from export-led growth toward greater reliance on domestic demand, particularly household consumption. In 2008, China introduced a RMB4 trillion (US$634 billion) stimulus package in response to the global financial crisis, increased spending on infrastructure, schools, transportation etc . Appreciation of the Yuan and increasing labour wages are also factors that limit export growth as Chinese manufacturing becomes less competitive and stimulate import and consumption.

Considering this trend, it makes sense for manufacturers to consider shifting from serving foreign customers to serving the domestic market, taking advantage of a vast population, a growing middle-income class and a strong Yuan.

Increased domestic competitiveness due to technology convergence and innovation

China is moving out of the developing phase which saw imitation, intellectual property infringements, and low-value manufacturing. With the launch of the twelfth Five Year plan, China has reaffirmed its goal to become a high income country through a strategy which combines increased levels of investment with rapid advances in technology . During the next decade, China is adopting macro and micro policies that enable domestic technology to catch-up to that of more developed nations . One example of such policies is the case of COMAC, the state-owned Chinese commercial aircraft manufacturer . COMAC benefits from various policies to foster the development ofdevelopment of a narrow-body aircraft that aims to compete with Boeing and Airbus. COMAC's stated goal is clear: get as much foreign aviation technology as possible while seeking to develop its own "independent intellectual property rights." This willThis type of 'protecting and fostering' policies will result in gains in productivity derived allowing Chinese businesses to produce their own innovation and original technologies. Foxconn must watch