Dr William Fung’s company is a vital cog in almost every major supply chain. But how will soaring costs alter his sourcing strategy? “In the next five years, prices are only going in one direction.”

If you were looking to crown the most influential, best-connected company most people have never heard of, you might start your search at one of the most conspicuous addresses in Hong Kong. Looming over the city’s bustling Sham Shui Po district is the headquarters of Li & Fung, the sourcing and logistics Company that provides the operational heft behind China’s dominance of consumer goods.

Li & Fung does not shout about its achievements, but its value as a power broker in global supply chains inspires awe among its Western rivals. If it is Made in China, Li & Fung knows about it and probably helped it on the journey from factory to shelf.

Founded in Guangzhou, China, in 1906, the company has become increasingly vertically integrated and now offers everything from product design and material sourcing to shipping services for retailers and manufacturers including Walmart, Toys “R” Us and Avon. It distributes in more than 40 countries and turned over US$15bn in 2010, with profits up 27% at US$551m. In July 2011, it announced the acquisition of five companies to boost its design and distribution arms.

Change is in the air, however, for a company that set itself an ambitious (overambitious, say some analysts) target of doubling operating profit in the three years to 2013. Chairman Victor Fung will step down by 2012 to be replaced by his brother, Dr William Fung, currently Group Managing Director. Meanwhile, the landscape is shifting, according to a new report from KPMG International – Product Sourcing in Asia Pacific – which identifies rising manufacturing capabilities in Bangladesh, Vietnam and other fast emerging countries, as well as growth in exports of hard goods from India.

It means multinationals looking to eke out growth in a reshaped economy must consider their options carefully. It also means Li & Fung must stay on top of a changing marketplace while it juggles its own internal restructuring. Which is why ConsumerCurrents visited Dr William Fung to understand where Asian sourcing, and his company, will go next.

How do you view the Chinese economy at present?

Right now, there are fundamental things happening in the market relating to China and how it impacts the world. We are preparing for that transition. There will be changes in what is sourced out of China, the way China looks at its export business and the direction it hopes to take.
How would you define that direction?

What we see coming up in the next three years and beyond is a new era. China seems to work in cycles of 30 years. The first cycle was from the founding of the People’s Republic in 1949 to 1979, when Deng Xiaoping opened up China to the rest of the world. Almost overnight, the world’s workforce increased by around a fifth, impacting every area of labor-intensive manufacturing. From 1979 to 2009, the next 30-year cycle, China fulfilled its first promise: to become the factory of the world.

What we saw in 2009-10 was a second abrupt change in policy after the Foxconn effect [following a series of suicides at Foxconn’s electronics factories]. Foxconn’s response was to double the wages of its workers over a period of three months. The move was tacitly approved by central government and has since become a distinct policy shift as part of the country’s Five-Year Plan, which mandates a 13% annual increase in minimum wages over five years.

What you will see now is the third era of China from 2009 to 2039, in which it will become the world’s largest consumer market. That has implications for many things: both for our company and for China as a sourcing market. It has implications for all our customers around the world.
The Chinese minimum wage is already four times higher than other parts of south east Asia. Will a new wage hike hurt its competitiveness?

China is already the second largest economy, but in terms of the consumption economy it is way behind. It only spends about 40% [of GDP] on consumption, compared to around 70% in the US. If money goes into workers’ pockets, it will help domestic consumption become the second engine of growth in the country.

The real crux, however, is that China has been looking for another, alternative engine of growth. It wants to follow Japan and Korea and make automobiles and high-end electronics, moving away from just the assembly of goods. It’s a long-term strategy: it will use this to push wages up and at the same time force change in its export strategy to focus on high-value goods.
Will China ever compete with Japan in terms of innovation?

Innovation is problematic because China has always manufactured for another market – and until it develops a large domestic market, that’s not going to happen. Japan has cutting-edge design because it has a large domestic market: China has never had that. China was designed as an export market, so what did it manufacture? The tastes of Europeans and Americans.

What is your new China strategy?

Our customers are primarily based overseas, in the US and Europe. The whole strategy is about diversification away from China or, I should say, diversification away from the higher cost centers in China to lower cost centers. After that, we are looking towards the next generation of countries. This is a cycle we have seen many times before – after all, ours is a 105-year-old company.
China suffers from a perception that its infrastructure is insufficient to support growth. Is that still an issue?

It’s only in the last ten years that China has really worked on infrastructure in terms of building roads. And it has built an incredible network – the road system is now bigger than in the US.

Despite this, it’s still clogged. They are doing all the right things, but the growth is so explosive that they haven’t quite been able to keep up with it. Look at the ports and the airport infrastructure being built: it’s incredible what they’ve achieved, but what is even more incredible is the demand.

If China is no longer the factory of the world, which countries might take its place?

We are always looking for the next market. These include parts of southeast Asia, such as Vietnam and Cambodia, plus a revival in Indonesia. Bangladesh is finally taking its rightful then there is India. There are one billion people in India and 1.3 billion in China – not that much difference. You add Pakistan, Bangladesh and Sri Lanka, and that’s as big as China.

Then, of course, you have the newly developing countries in Africa and Central and South America. A lot of the consumer non-durables we manufacture are labor-intensive, such as garments, shoes and toys. So there are many developing countries that would love to take over what China does not want as it moves from an agricultural to an industrial economy. The march is on. But don’t forget the rest of the world will not react like China. China’s was a centrally planned economy – in 1979, when Deng Xiaoping opened up the country, it changed overnight.

What advantages do the emerging sourcing markets in southeast Asia have over China?

Raw materials. China has a lot of labor, but its Achilles heel is that it doesn’t have many natural resources – it has to import them. South east Asia is beginning to deprive China of raw materials. Countries are saying: “Don’t export timber, don’t export rubber and wood. I want my people to work higher up the value chain, to set up factories to use the raw material.” But although these countries have cheaper labor, China makes up for its higher costs by being super-efficient.

Will Africa ever enter the equation?

We try hard in Africa but it’s hampered by politics. Companies like us will go to Africa and try to find factories, but it will take years to construct infrastructure. Whereas the situation in 1979 in China was totally different. And China was big: nobody can replace that level of production. So the initial short-term effect [of rising Chinese wages] will be an increase in prices.
Are you suggesting the era of low-cost manufacturing is becoming unsustainable?

In 1979, Gap jeans were retailing for US$25 a pair. Today, they are still retailing for US$25 a pair. From 1979 to 2009, prices were kept down by the great abundance of workers in China who were hungry to produce. China subsidized the standard of living around the world, especially in the US, by providing goods every household could afford. But now consumers may have to pay more and as a result will probably consume less. Which is a good thing – now people will not throw away a pair of jeans after wearing them a couple of times.
How are you able to keep your own prices down?

I am asked that question literally every day by my customers: “Can you keep the same prices?” I say I can’t. You have got to live through a period of high prices. Yes, there is more to a product line than merely labor, but unfortunately all the other production processes are going the same way.

On the one hand, China and India, the two most populous countries in the world, are now becoming consumer markets – they are consuming more raw materials and energy, meaning raw material and energy prices are going up. In the short term, energy prices are also being driven up by the problems in the Middle East. Plus, most raw materials are denominated in US dollars and the government is depreciating the dollar. All those trends feed into higher prices and in the next five years there is only one way for prices to go: up.

But don’t think that sourcing is just price, price, price. Look at the whole system holistically. The biggest cost may not be your production costs, it may be the cost of buying the wrong merchandise. The whole idea of a quick-response market is a very important part of sourcing. Turkey is our quick-response market for European customers, and Central and South America are our largest quick response markets for the US.
Which companies do you think are breaking the mold?

Zara. They are buying a lot of their goods in Europe, yet they are making a lot of money. That’s because they are quick to market and manufacture late in the cycle, so they are not producing something they cannot sell. If you go to a Zara store in Hong Kong you see “Made in China” stuff. Those garments were shipped to Spain and then air-freighted back based on demand.

The idea of having one area to hold your inventory, rather than holding it in different countries, is part of their strategy. A lot of retailers are allocating their production and shipment to different countries, meaning their products are locked in there: you can’t sell them and you have to discount them. Zara has a different philosophy. They are revolutionizing retail.
Li & Fung is growing rapidly. How do you manage to retain control?

Well, you lose a few black hairs [laughs]. It’s not a matter of control. It’s more about leading than controlling. It’s about showing the direction and then making sure that everybody else falls in line. You can imagine that in our business of 26,000 people in 40 countries around the world, thousands of different decisions are being made throughout the day. Our managers must be extremely flexible.

The one hallmark of our strategic planning is the ability to take advantage of trends and change – and change sometimes radically, to the point of reinvention. A manager must have foresight, and if the change required is so dramatic as to warrant a reinvention then they have to do that. That is beyond a lot of people, even if they see the change coming.