IWOM in China - follow up to "China's Blogging War"

In a recent post I covered the corporate battle against bloggers in China and how MNCs will pay PR companies to "seed" good news stories and to cover up negative stories.

Sam Flemming over at CIC blogs writes more on the topic of IWOM. I admit this is the first time I have come across "Internet Word of Mouth" and the acronym IWOM.

Recommended reading. CIC are clearly involved in this arena but are pleading innocence. This quote also introduces to me the WOMMA - another fine association I am sure. Given CIC work with clients such as Nike, Pepsi and L’Oreal it is worth taking a moment to get the "marketeers" take on the Business Week article.

CIC does not seed messages for clients: As I wrote in January, CIC is a member of The Word of Mouth Marketing Association (WOMMA), and we follow WOMMA's code of ethics, which, in short says:
* Honesty of Relationship: You say who you're speaking for
* Honesty of Opinion: You say what you believe
* Honesty of Identity: You never obscure your identity

The other phrase I like is "efluencers". I need to come down from my ivory tower every once in a while.

CIC uses its technology and deep understanding of online community to identify bloggers and efluencers who would have the most interest in developing a meaningful relationship with our clients

I have always wondered how one qualifies as an "efluencer". Perhaps if I start a campaign against or for one of CICs clients and their working practices in China I will get tapped up. Nike strike me as a gold mine of news worthy economic comment related to wages, conditions and other working practices.

The article also includes links for follow up research. Interesting stuff.

Thoughts on recent Business Week article on IWOM in China [CIC blog]

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Dealing with China's Quality Fade

I am currently doing a little work on Quality Fade in China. I will use this post to collect relevant articles. Many articles are from last year but are interesting enough to read again.

Dealing With China's 'Quality Fade' [Forbes Paul Midler 07.26.07, 11:11 AM ET]

Recent media reports detailing a series of quality problems with Chinese-made exports--pet food tainted with prohibited chemicals, toys covered with lead paint and tires that fall apart at high speed--have understandably alarmed the American public and resulted in a number of international product recalls.

But supply chain professionals not directly affected by these recalls remain unusually calm. "Everything will be all right," said one U.S. importer on a buying mission to China. "As the country continues to develop, the quality of its products will naturally rise."

It's the sort of comment that sounds logical, but is not necessarily true. Quality does not always rise over time, as China's own history shows. At the end of the 19th century, the West rushed to buy China's beautiful silk products. Demand quickly expanded, and new players moved into the market. As competition intensified, manufacturers began to cut corners on quality, and silk products out of China soon gained a reputation as inferior goods.

By the beginning of the 20th century, traders were already looking elsewhere, and Japan, which had been building a reputation for delivering a more consistently high-quality product, became an attractive alternative. By 1930, Japan was exporting twice as much silk as China.

One of the problems facing China is that manufacturers continue to engage in a practice I call "quality fade." This is the deliberate and secret habit of widening profit margins through a reduction in the quality of materials. Importers usually never notice what's happening; downward changes are subtle but progressive. The initial production sample is fine, but with each successive production run, a bit more of the necessary inputs are missing.

What is maddening to importers is that quality fade often occurs in the last place an importer thinks to check. One American company had been importing a line of health and beauty care products for over a year when the cardboard boxes that held its product suddenly started collapsing under their own weight. There was no logical explanation for the collapse except quality fade, and the supplier in this case blamed subsuppliers for replacing an acceptable cardboard box with ones that were inferior.

The Case Of The Missing Aluminum

Some quality issues are not all that serious, but others are downright frightening. One of the most disturbing examples I have encountered while working in China involved the manufacture and importation of aluminum systems used to construct high-rise commercial buildings. These are the systems that support tons of concrete as it is being poured, and their general stability is critical.

The American company that designed and patented the system engineered all key components. It knew exactly how much each part was supposed to weigh, and yet the level of engineering sophistication did not stop the supplier from making a unilateral decision to reduce the specifications. When the "production error" was caught, one aluminum part was found to be weighing less than 90% of its intended weight.

Where did the missing aluminum go? Into the factory owner's pocket as a cost saving. The only thing passed on to the customer was an increase in product risk. Quality fade is like the straw that broke the camel's back--only in reverse. Suppliers push the limit by taking more and more out of the equation until they are caught, or until disaster strikes.

Even when importers catch suppliers in a quality fade, they frequently don't do much about it. Many quality problems are seen as too minor relative to the difficulties involved in rectifying them. Customers may not notice a product flaw, but they most certainly notice when a product is not delivered on time. The chance of a product failure is usually remote, but the penalty for late delivery is an almost certain loss of business.

Some importers bravely attempt to fight back against quality fade by insisting a supplier replace substandard goods at the factory's expense. A savvy supplier--and most are extremely savvy--can respond to such demands by threatening to terminate the supplier relationship. Or the supplier can respond by raising prices. Importers might then say they will switch suppliers, but the factory owner knows this is an empty threat as finding and cultivating a new supplier can take a long time. And anyway, there is no guarantee that the next supplier won't engage in the same willful behavior as the first.

The factory owner who practices quality fade knows exactly where he stands with his customer in these cat-and-mouse games. He has virtually nothing to lose and only margin to gain--and, having gotten away with it once, no one should be surprised when he goes for it again. When the factory owner offers his most sincere apologies and promises that it won't happen a second time, importers simply close their eyes and hope for the best.

If Adam Smith were around today, he would have had to write a separate chapter on global outsourcing. Because it takes importers a long time to find suppliers and to get them up to speed, importers keep their suppliers a secret. The last thing that an importer wants to do is let his competitors know the source of any supply chain advantage he may have. Even when it is in their collective interest to share information, importers keep to themselves.

As a result, factories pay little, if any, reputational cost for production shenanigans. The invisible hand doesn't work well when the manufacturers themselves are unseen.

This lack of accountability also has legal implications. When a product is recalled in the U.S., the importer pays the cost of that recall. It remains next to impossible to take legal action in China, and only in the rarest case can an importer successfully sue the supplier responsible for a product failure.

Since most suppliers are paid in full well before goods leave the factory, the importer doesn't even enjoy the leverage that comes with owing payment to the supplier. The average importer has far less leverage than imagined.

Outwitting Third-Party Testers

In the wake of quality problems, many are looking to third-party testing as a solution. In theory, testing works well. Prior to exporting a product, the supplier takes a sample and sends it off to a reputable and international testing laboratory, which then checks to make sure the product is safe. Unfortunately, testing doesn't work well when a supplier sets out to circumvent the system.

I recently worked with one supplier that was encountering difficulties making a quality liquid soap for export to the U.S. To get around problems the supplier was having with laboratory results, the supplier created 10 random samples and sent them to the same lab for testing.

Nine of these samples failed, but one passed. The supplier took the one test result marked "passed" and sent it off to the customer. The U.S. company never knew about the failed results, and a purchase order was promptly issued.

Third-party testing is far from fail-safe. Consider one study conducted by the U.S. Consumer Product Safety Commission in 2001. In a review of nearly 200 recalled electrical products from China, the CPSC found that more than 25% had had prior approval by an international third-party testing agency such as Underwriters Laboratories (UL), Intertek Testing Services (ETL) or the Canadian Standards Association (CSA).

Both The Wall Street Journal and the New York Times have suggested that the solution to China's quality problems lies in greater vigilance on the part of importers, but the question remains: If professional third-party testing agencies are failing to catch product failures, how is the average importer expected to do so? After all, third-party testing agencies have far better resources, and their people are much better trained.

Private quality assurance programs may also be put in place, but suppliers can circumvent such controls as well. In one case, after a load of plywood was rejected at one factory, the supplier simply mixed a portion of it with product that was perfectly good in later shipments. Working the bad into the good is a common way for a factory to reduce loss.

A supplier can bury substandard product knowing full well that warehouse workers in the U.S. do not have the time to examine each piece that comes in. And detailed contracts cannot succeed in bridging any moral gap. In order for supplier relationships to work successfully, there must be a basic level of trust.

Get Rich Quick

In an effort to reduce risk, American companies are also looking to suppliers that are larger and seem more capable. The unfortunate fact about China's larger factories, however, is they charge more for product than smaller factories do. It is as if economies of scale do not apply in China. There are several reasons why China suffers from such a problem, and one has to do with the role government plays in manufacturing.

Where a small factory may have been funded entirely by the government, future expansions are more often privately financed. Making the matter worse are extremely short payback periods on private investment. Many factories hope to pay off investments in as few as three years. One of the worst things an importer can hear is, "We want to show you our most recent expansion." The more a supplier invests, the quicker it raises prices.

There is a sense of urgency in China, the feeling that one must work fast before the window of opportunity closes. For factories, that means taking shortcuts on quality. Many factory owners can't see beyond the next purchase order.

One reason for the short-sightedness may have to do with China's political environment. The one-party government does what it wants, when it wants. And while there may be some advantages to a government that can operate without restraint or controversy, such a system limits predictability and leaves the business sector keenly aware that it is subject to the evanescent whims of officials who may or may not know which policy is best.

The U.S. administration has recently been applying pressure on China to revalue its currency in order to close the growing trade gap between the two countries. To appease the U.S., China has responded by reducing the tax rebates it offers to manufacturers.

For some suppliers, the tax rebates have constituted a major portion of their bottom line. Massive and sudden changes such as these only confirm the factory owner's paranoid suspicions that the manufacturing opportunity could disappear at any moment. No one in China is sure how long anything will last--a situation that keeps many focused on the immediate present.

Chinese manufacturers that engage in quality fade unfortunately subscribe to the view that business is about increasing one's share of the pie rather than growing the pie over time. They often focus on extracting profit through short-term maneuvers that inevitably militate against long-term development. This approach, it should be noted, contrasts sharply with the success strategies of such economies as Japan and Korea, which focus on building market share and developing strategic relationships.

Playing It Short

Some blame quality problems and product recalls on the relentless pursuit of lower prices. Importers most often go to the cheapest supplier, so the supplier who quotes low and quietly cuts corners on quality is the one who wins. Honest suppliers who prefer to quote higher and offer a better quality product lose out. The supplier who obfuscates catches orders first--and most often.

Chinese suppliers are excellent at playing the short game. When an importer discovers a quality problem late, the factory turns around and suggests, "But you signed off on the original production sample yourselves." When goods arrive damaged in the U.S., the factory claims that the importer has been making up the story in order to lower import costs. Arguments like these work in the short term. Over the longer term, however, importers get wise, and alternative markets start to look increasingly attractive.

China's quality situation is by no means hopeless. Japan was known decades ago for making inferior products, but that changed. The key to turning the situation around is to incorporate a habit of quality into the culture. China, however, has not shown that it has any interest in doing so.

Recent accusations of unreliability in Chinese products are now being met with tit-for-tat claims that U.S. products are faulty. This is an unfortunate strategy for China, and it means that we will continue to see quality problems. China will not be able to succeed so long as manufacturers are competing in a race to the bottom.

Paul Midler is the founder and president of China Advantage, a services firm that provides outsourcing and supply chain management to U.S. and European companies. He has been involved with China for more than 15 years, and in the course of his manufacturing career, has had dealings with thousands of Chinese factories.

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The Impact of Chinese Monetary Policy Shocks on East Asia

A recent working paper from the Bank of Finland (who write a surprisingly large amount of papers on China for a northern European central bank) looking at the impact of Chinese monetary policy on the rest of Asia.

The conclusions are unsurprising I am not not a fan of SVAR models myself but it might interest some.

The Impact of Chinese Monetary Policy Shocks on East Asia [SSRN]

TOMASZ J. KOZLUK
Organisation for Economic Co-operation and Development
AARON N. MEHROTRA
Bank of Finland - Institute for Economies in Transition (BOFIT); European University Institute - Economics Department (ECO) April 25, 2008

BOFIT Discussion Paper No. 5/2008

Abstract:
We study the effects of Chinese monetary policy shocks on China's major trading partners in East Asia by estimating structural vector autoregressive (SVAR) models for six economies in the region. We find that a monetary expansion in Mainland China leads to an increase in real GDP (temporary) and the price level (permanent) in a number of economies in our sample, most notably in Hong Kong and the Philippines. The impact could result from intertemporal substitution present in a general equilibrium framework which allows for positive domestic impacts of foreign monetary expansions. Our results emphasize the growing importance of China for its neighboring economies and the significance of Chinese shocks for the design of monetary policy in Asian economies.


Keywords: monetary policy shocks, Asian production chain, SVAR, East Asia, China

JEL Classifications: E52, F42

The People’s Republic of Cars

Even with rising fuel costs the Chinese have fallen in love with the car. Slick Western advertising is helping them on there way.

The following two clips are from Ted Koppel’s four-part series on Discovery Channel, “The People’s Republic of Capitalism”. Sure to be interesting, if not US biased, material in here.



Here is a clip of Koppel talking about the car industry:

http://www.redlasso.com/ClipPlayer.aspx?id=8aa81aba-9cff-4411-9895-763418c289fc&pid=00000000-0000-0000-0000-000000000000

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Bloggers and anti-bloggers

Last month Business Week published an interesting article on the corporate war against disgruntled bloggers. This article shows the power of the blog and forums to cause corporate embarrassment and to hit profits and why the corporations are fighting back.

Inside the War Against China's Blogs [Business Week]

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Daqi is one of a new breed of company that helps multinationals navigate China's perilous Web. Nike, (NKE) PepsiCo (PEP), McDonald's (MCD), French cosmetics maker L'Oréal (LRLCY), and others have hired the likes of Daqi, fellow Beijing outfit Chinese Web Union, and Shanghai-based CIC. These companies charge $500-$25,000 monthly to monitor postings and squelch negative information or to create positive buzz.

This year has brought the Net monitors plenty of opportunities to win clients as hot-tempered bloggers have attacked global companies for perceived slights to Chinese culture. Coca-Cola (KO) and French retailer Carrefour were lambasted for what was seen as support for Tibetan independence. McDonald's, KFC (YUM), and Nokia (NOK) have been tarred for allegedly being stingy with relief money after the Sichuan earthquake. And Citroën had to apologize for an ad featuring a scowling image of Chairman Mao. "If it touches on nationalism, or if the client clearly made a mistake and disrespected a customer, that's dangerous," says Sam Flemming, CIC's founder.

Paying a company to "seed" good vibes about a company appears to be rather underhand but clearly it goes on. When reading forums it is therefore essential to take the history and reputation of the poster into account and whether they are regulars.

The companies also can help clients win sympathy. Metersbonwe Group, a domestic apparel retailer, faced eviction from its flagship outlet in Shanghai last year when the local government wanted to replace Chinese-owned brands with big names such as Nike and Adidas (ADDDF). Daqi seeded the Net with opinions linking the issue to a simultaneous controversy over Starbucks' (SBUX) presence in Beijing's Forbidden City. While Metersbonwe ended up losing the space, Daqi says the pressure helped the retailer win a lease for a larger store. "In Internet forums we said: A Chinese brand is being pushed out while a foreign brand is still located in the Forbidden City,'" says Daqi's Zhou. "We got intense and rapid response. People were very angry." Metersbonwe confirmed that Daqi helped with the Shanghai case but declined to comment further.

So how much does it cost? A lot less than you would think. This is a cheap way to advertise and create goodwill unless, that is, it backfires when a company is found to be using these low paid bloggers to attack rivals.

Plenty of companies are willing to pay for positive spin. PR outfits hire students to write postings that boost certain brands and criticize the competition, says a staffer at a Western PR firm in Beijing. The job description of one online help-wanted ad reads: "Publicize and popularize [products] via online forums and blogs. Send at least 50 propaganda posts per day." Workers are offered 1.5 cents per post.

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"Hot Money" in China: the noose tightens

Today the FT reports on China's continuing problem with "hot money". The flows are perceived to be hampering China's attempt to curtail the ever increasing inflationary pressures.

The policy of requiring exporters to park money is a backward development and is more red tape to trade. This is a dangerous move and could even have inflationary ramifications in the West if cheap Chinese goods prove harder to come by.

China to tighten capital controls in clampdown on 'hot money' [FT]

China announced a major strengthening of capital controls last night in an attempt to limit the amount of speculative "hot money" entering the economy and frustrating its efforts to contain inflationary pressures.

In an announcement on its website, the State Administration of Foreign Exchange, the country's foreign exchange regulator, said exporters would be required to park revenues in special accounts while the authorities verified the funds were the result of genuine trade.

The new system risks becoming a cumbersome burden for exporters such as suppliers of cheap goods to western retailers.

Exporters will now be required to provide documentary evidence that their invoices are based on genuine transactions if they wish to change dollars into renminbi. The regulator said the new computer system for checking invoices would be introduced from August 4. A trial period begins on July 14.

Recent leaked figures showed record inflows of capital entering China over the past two months. Officials believe some money came in illegally after companies exaggerated export revenues.

China has become an attractive country for investors and companies because interest rates are now above US levels and the renminbi is expected to appreciate.

According to Reuters, China's foreign exchange reserves increased by a record $114.8bn (£57.6bn) in April and May to $1,800bn. Although it is impossible to calculate how much of that inflow is short-term, speculative capital, the figures were substantially higher than the combined numbers for the trade surplus and foreign direct investment.

The capital inflows have made economic management more difficult because, even though domestic inflation has been high in recent months, the Chinese central bank has been reluctant to raise interest rates for fear of attracting more hot money.

Authorities have so far prevented the inflows from causing money supply to grow too sharply by issuing bonds and lifting bank reserve requirements.

There has been a growing discussion among private sector economists about whether the authorities should introduce a large, one-off appreciation of the currency in order to limit speculation. However, most economists believe that the government would be very reluctant to take such a step as parts of the export sector are already suffering badly because of higher costs, including the stronger renminbi.

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McEconomics: The price of McDonalds in China

Pettis over at China Financial Markets has a nice little comment on the role of McDonalds in China (and Asia generally). In my view he has it spot on making an excellent observation that I think deserves to be retold.

The rest of the article is also interesting.

Inflation? Or stagnation? [China Financial Markets]

Occasionally I like to bring foreign visitors to the neighborhood McDonalds, partly because it always generates a lot of outrage and partly because you are far more likely to find a McDonalds outlet replete with local residents conducting their everyday life than you ever would in Nan Luo Gu Xiang, which is much more likely to be peopled by European tourists and upwardly-mobile Chinese who like to eat and shop in the places foreigners do. McDonalds, on the other hand, is as local as it gets for young urban life in most Chinese cities, and it is rare to see one that is empty.

Sorry for that non-economic digression. I mention all this not because I own McDonalds stock or like the food, but rather as a prologue to the large headline in today’s China Daily: “McDonald's raises prices in ChinaOpen in a new window.” McDonalds, along with KFC and Pizza hut, is extremely popular in most major Chinese cities not just with students but also with middle class families and dating couples. The fast-food outlets are almost always full and often there are lines to get in. Right-thinking Westerners may deplore this, but one of the best young underground bands in Beijing even has a song about how many times McDonalds has saved the singer’s life (mostly because of the clean bathrooms, however). It is a fairly important place to many urban Chinese and so its pricing policies matter, as the China Daily headline indicates. According to the article:

There's no escaping rising inflation - signs of it are everywhere. The latest sign could be in your meal at a fast-food outlet. McDonald's, the world's largest fast food chain, yesterday raised its prices in China, for the second time this year, following measures to increase prices in January.

The US group is not alone in its decision. Many Western food chains are now increasing prices on their menus in China.

The article goes on to say that in the latest price hike, the cost of most items rose by RMB 0.5-1.5 per item (7-21 American cents). I don’t know what the typical item in McDonalds costs, so I don’t know what this means in percentage terms, but I am struck by the fact that they hiked prices in January and then again in May, even though food prices declined in May. This suggests to me that inflation, and possibly wage inflation, has become a serious enough problem for at least the fast food outlets. I don’t know how much of their costs consists of food purchases and how much is non-food, but I would have thought that two price hikes in four months is a lot.

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