In wake of recalls, cost of Chinese exports will rise

SHANGHAI, China -- Get ready for a new Chinese export: higher prices.

For years, American consumers have enjoyed falling prices for goods made in China thanks to relentless cost cutting by retailers such as Wal-Mart and Target.

But the spate of product recalls in recent months -- Mattel announced another this past week -- has exposed deep fault lines in Chinese manufacturing. Manufacturers and analysts say some of the quality breakdowns are a result of financially strapped factories substituting materials or taking other shortcuts to cover higher operating costs.

Now, retailers that largely had dismissed Chinese suppliers' complaints about the soaring cost of wages, energy and raw materials are preparing to pay manufacturers more to ensure better quality. By doing so, they hope to prevent recalls that hurt their bottom lines and reputations.

But those added costs -- on a host of items including toys and frozen fish -- mean either lower profits for retailers or higher prices for consumers.

"For American consumers, this big China sale over the last 20 years is over," said Andy Xie, former chief economist for Morgan Stanley in Asia who works independently in Shanghai. "China's cost is going up. They need to get used to it."

William H. Wilhoit, president and chief operating officer at Seattle-based Skyway Luggage Co., which makes all of its products in China, said that a year ago retailers wouldn't even consider price increases.

"It's a different story today," said Wilhoit, whose company's bags are carried by many major U.S. retailers. "Now, they are willing to listen."

A 10 percent increase

Although Skyway hasn't yet raised prices for retail buyers, Wilhoit said the company was "at a point where we have to if we want to remain profitable."

Business executives don't anticipate significantly higher prices on store shelves this holiday season, because Christmas goods already have been ordered. But over the next 12 to 18 months, they say, prices for merchandise from China are likely to creep higher.

Already there are signs: The price of imports from China in July rose 0.4 percent from June, the largest monthly increase since the price index was first published by the U.S. Bureau of Labor Statistics in late 2003. Prices had declined steadily in the previous three years, helping tamp down inflation in the United States and elsewhere.

Most economists believe that manufacturing prices will have to rise at least 10 percent to reflect China's current production situation, although it's unclear how much of that could be passed on to consumers. Companies that import goods from China might have to absorb some of the costs or share them with retailers.

And large retailers might be forced to absorb all of the extra costs on Chinese-made products that they commission for their own private labels.

Costco Wholesale Corp., the membership warehouse store with jumbo sizes and bulk prices, has stepped up inspections and monitoring of its private-label Kirkland brand as well as other goods the company imports directly.

That increased vigilance likely will result in modest price increases on some products for sale next spring and summer, said Costco chief executive James D. Sinegal.

"It probably is just a penny here and a penny there, we're not seeing big incremental cost increases, although that may come," Sinegal said. "I don't think we have a choice. A product is either safe or unsafe -- if it is more costly to ensure that the product is safe and being produced properly, somebody has to pay the cost."

Wal-Mart, whose billions of dollars of purchases from China are a key part of the retailer's low-price strategy, has said it is expanding testing and oversight of toys in the wake of the recent recalls but declined to comment on price issues.

Target, in an e-mail reply to questions, said it had expanded testing for its brand of toys but had not made any changes in its sourcing program.

Beyond the problems with toys, there have been recalls of other Chinese-manufactured products in recent months, including toothpaste, seafood, fans, tires and pajamas.

The Chinese government has defended the quality of the nation's exports, saying that 99 percent of shipments meet international standards. By value, 1 percent translates into about $10 billion worth of goods annually.

At Lee Der Industrial Co., which made 1.5 million Mattel toys that were recalled in early August because of lead contamination, the factory's chairman blamed inspection lapses partly on pressures to meet production deadlines. But there also were indications that Lee Der was constrained by costs. A company director said operating costs for Lee Der, like many factories in China's southern Guangdong province, had surged in the past two years.

"But the price we got not only didn't increase, it decreased," said this company director, who spoke on the condition that he not be identified by name.

The stress of the recall drove the factory's boss, Cheung Shu-hung, to hang himself, co-workers said.

Mattel declined to discuss its payments to Lee Der except to say that the majority of Mattel products are new each year and that costs fluctuate depending on what is being manufactured.

"In the past couple of years, costs have gone up -- raw materials and labor -- in our own plants and vendors," Mattel spokeswoman Jules Andres said. "And we have had to increase our price with retailers over the past couple of years."

Mattel reported that its costs for making products in the first half of 2007 rose 8 percent from a year earlier. Both sales and profit increased at even greater rates.

Recalls over the past five weeks have cost Mattel at least $30 million, and some analysts say the final figure could be far higher.

In its latest action, the El Segundo, Calif. -based toy maker Tuesday recalled 840,000 Chinese-made items, including Fisher-Price and Barbie toys, because of unsafe amounts of lead paint. Three weeks earlier, Mattel recalled 400,000 die-cast toys, also because of lead concerns, and 18 million other products because of potential problems with magnets.

The bulk of the world's toys are made in southeastern China, where wages have shot up in the p ast couple of years amid greater competition for workers and increases in minimum wages and living costs. Booming demand has pushed up commodity prices. The appreciation of the Chinese yuan, up 8.8 percent against the dollar in the p ast two years, also has hurt some factories, as they are paid in dollars.

It isn't just toy factories that are struggling. Labor-intensive industries, including producers of garments, furniture and processed seafood, say they are being pushed to the edge.

At Grobest Group's fish-processing operation in Shenzhen, across the border from Hong Kong, dozens of young women stand shoulder to shoulder filleting farm-raised tilapia moving along a conveyor belt. Several young men nearby sharpen knives on a grindstone. Once filleted, the fish are frozen and packaged for export to the U.S. and other countries.

Zhou Qiushu, the plant's general manager, says turnover among his 700 employees is low, but only because wages have gone up 30 percent in the p ast year to an average of about $175 a month.

Zhou's shipping costs have risen 5 percent in that same period, he says, and water and electricity rates by 3 percent. But his U.S. buyers haven't budged on price in the p ast year, which he has accepted because he fears competitors would quickly undercut him. Like many Chinese factory operators, Zhou tries to make up for low prices by boosting volume.

"U.S. customers are very concerned about pricing," he said. "Everything is about pricing, pricing, pricing."

Zhou says he hasn't sacrificed quality as a result, but analysts say many factories have downgraded materials and cut overhead, including quality assurance staff. Their products' buyers, though, sometimes didn't know where the goods were coming from -- and until recently, some didn't care much. Some manufacturers order from unknown sellers at online Chinese auctions, based strictly on price.

But now U.S. companies that buy goods from China are scrambling to identify their subcontractors, requiring audits and spot testing, narrowing their network of factories and, in some cases, replacing longtime Hong Kong and Taiwanese middlemen with their own staffs to build relationships with suppliers.

"We're seeing a maturing of the supply chain," said Kent Kedl, executive director of Technomic Asia, a Shanghai company that consults with foreign companies manufacturing goods in China.