The Chinese Economy
Why the economy in China has a lot to do with your business.
There is a macroeconomic event on the horizon that has the potential to dramatically affect the nutraceuticals business. This event has to do with the Chinese economy.
There are plenty of stories about China in the media daily, especially with regard to the Chinese economy, but increasingly the stories have focused on a point of increasing friction between the U.S. and China: the exchange rate.
After September 11th, the U.S. economy was beginning to suffer. So part of the Bush Administration’s economic plan was to let the markets devalue the U.S. dollar. The idea was simple: if the exchange rate of the U.S. dollar fell against other major currencies, then American-made products would be cheaper in places like Europe and Japan. This would lead to more exports and growth in the U.S. economy. There was one hitch in the plan though. China’s currency is tied to the U.S. dollar at a fixed rate of 8.28 yuan to the U.S. dollar. In China’s centrally-planned society, they decided not to let their currency, the Renminbi, float in the public markets. They felt instead that if they fixed the exchange rate to the world’s largest economy, they would perform better in the world trade markets.
Well, they were right. China’s gross domestic product (GDP) has grown 7% each of the past five years, which is more than double the historic U.S. average. However, what this has meant for the U.S. economy is that while the price of U.S. goods has fallen for Europeans and the Japanese, already-cheap Chinese goods have become even cheaper. While the weak dollar has helped the U.S. economy avoid a serious recession, the fixed Chinese currency has actually hindered the strength of U.S. economic expansion because the Chinese are so quick to adapt to product demands. Instead of making U.S. goods cheaper, the U.S. has ended up competing more fiercely with the Chinese.
In the nutraceuticals industry, we have already seen the impact of this. For example, there are virtually no U.S. producers of herbal products anymore. In fact, entire supply chains have moved across oceans to China.
The case is very similar in Europe, with a few exceptions. With every ingredient from CoQ10 to echinacea to flaxseed, China is increasingly becoming an important player. Sure, quality is an issue—in almost all sectors of this industry there are complaints about the poor quality of Chinese-sourced products—but this is essentially a free market. In free markets, if companies demanded quality nutraceutical ingredients, they would get quality ingredients. There are a few ingredient segments where suppliers have banded together to set minimum quality and analytical standards, but overall, cash is king and the low cost product is what matters.
The reason this is important to our industry is because the U.S. and international community have been pressuring China to float its currency freely. Nobody knows for certain how overvalued the Renminbi is as a result of being fixed, but most estimates hover around 30-40%.
China is quite large, so it is concerned about what a major shift in its currency would do to its economy. Currently, most negotiations focus on a more gradual reduction, with perhaps a 10% devaluation as a first step. This means that, on average, prices of Chinese products would rise 10% to U.S. producers almost overnight. However, if China floats its currency completely, prices could rise 30-40%. This could change the playing field completely in some nutraceutical ingredients like vitamins and minerals where the Chinese cost advantage is less than 30%. It could move the supply chains again, this time to other new regions like India, or even move some of them back to the U.S. or Europe where larger economies of scale can be realized.
Many people believe the Chinese will just cut prices to counteract the devaluation, but this point of view doesn’t take into consideration a few key nuances. Inflation in Chinese industrial goods and commercial property has been increasing much faster than the rate of the Chinese economy over the past five years, effectively raising the costs of Chinese producers. However, in nearly all industries the Chinese have been reluctant to raise the prices of their goods to match their higher costs. In fact, the price of nutraceuticals like vitamin C from China has even continued to decline! This has already squeezed the profit margins of Chinese producers, so the question is, can China handle cutting its prices to adapt to a currency revaluation?
With a greater burden on raw material suppliers for ingredients of consistent quality, it is doubtful the Chinese will be able to match it perfectly. A majority of U.S. supplement makers have seen improvements in their manufacturing costs since the late 1990s, but that situation will likely change if the Renminbi is devalued. For the past five years, raw material makers have been the ones whose margins have been squeezed. That may change a bit with consumers being unlikely to accept higher prices; it may even end up squeezing the margins of the supplement makers.
The full effect will not be seen until the Chinese government makes its move. But one thing is certain: the Chinese are the dominant supplier of numerous nutraceutical products because of their price. Any devaluation will disadvantage them even if they cut prices to match. In the end, this has the potential to affect hundreds of companies across the nutraceuticals value chain.NW