Finance- Real economy & exchange rate

The Chinese experience shows the costs of under-valuation are a lot less than the benefits in terms of jobs.

In recent years, as China’s exports have grown rapidly, and the country is registering increasingly larger surpluses on the current account (an estimated $140 billion this year), it has faced a lot of pressure for a “more flexible” exchange rate regime. Instead of openly calling for an upvaluation of the currency, the politically correct euphemism is to use the term “more flexible exchange rate”.

After holding on to a steady yuan-dollar exchange rate for more than a decade, China has engineered a modest appreciation (5.4 per cent) over the last year and a half. China’s exchange rate policy is clearly rooted in the need to create manufacturing employment. China needs to create at least 25 million non-agricultural jobs a year, considering the number of new entrants in the job market, as also the vast immigration from rural to urban areas. Most of these would have to be in the manufacturing industry, and its global competitiveness is, therefore, of crucial importance. 

Hence, the undervalued yuan. Indeed, for many years, the yuan’s fall in real effective terms was even more than in nominal effective terms, because China has had lower inflation than the US for nine years! This is remarkable at a time of surpluses on current account and huge capital inflows (in theory, both generate inflation pressures), resulting into reserves accumulation of a trillion dollars. One advantage China has in sterilising the excess money supply is that domestic interest rates are lower than the dollar or euro interest rates: this means that there are financial gains to the central bank in sterilising the growth in money supply. China is not only keeping domestic inflation low but, as a low-cost manufacturer, is a major contributor to keeping global inflation low despite the very high commodity prices of recent years.

But there is also a major risk in the reserve accumulation. As argued earlier also earlier, given the huge deficit on current account in the US, the possibility of a sharp fall of the dollar can hardly be ruled out. Indeed, diversification of Chinese reserves into other currencies (as Russia, Switzerland, Italy and the UAE are already doing) could itself trigger such a fall: it is Chinese investments in the US treasury market that keep the dollar from falling and the yield curve flat to negative. On the other hand, should the yuan appreciate against the dollar, there would be huge paper losses for the central bank as dollar assets become worth less in yuan terms. Assuming that, currently, 70 per cent of the reserves are in dollar assets, even a 5 per cent yuan appreciation against the dollar would lead to a translation loss of something like 250 billion yuan! Clearly, the authorities are treading on delicate ground trying to balance the needs of the real economy with the possibility of large paper/financial losses if and when the yuan is forced to appreciate in dollar terms.

Arguably, the root cause of the large and increasing surpluses China is registering on the current account, is the savings-investment imbalance. Despite huge investments, the savings rate is so high, above 50 per cent of GDP, that the excess savings result into a surplus on the current account. Interestingly, the household sector savings in China as a percentage of GDP are actually less than in India — this, despite the fact that personal consumption in China per capita is only about 70 per cent higher than in India, while per capita incomes are 2.5 times as large. The real cause of excess savings is the corporate sector: the corporate sector’s savings amount to as much as 30 per cent of GDP, with retained earnings alone contributing two-thirds of that. One reason, it seems, is that Chinese companies do not distribute dividends. 

At the macro level, one way of reducing the excess savings and the politically sensitive surplus on current account, is to get the public sector companies to distribute dividends, and spend the money on needed social services like health care, higher old age pensions, and so on. Sooner or later, we should see some movement in this direction even as the yuan gradually appreciates. Incidentally, the non-deliverable forwards market is factoring a yuan rise of just about 3 per cent over the next 12 months.

One point on which we need to learn from China is the focus on the real, job-creating economy rather than philosophical arguments about market versus managed exchange rate, the cost of sterilisation, and so on. On the second issue, what we often seem to overlook is that the cost to the real economy of an appreciating currency (jobs uncreated or lost, business profitability, forgone GDP growth, and so on) can be far, far bigger than the financial cost of sterilisation. To be sure, these costs are not as easy to calculate as the cost of sterilisation — but are, nevertheless, as concrete and perhaps even more important.

Bucking the trend- The reverse expansive outsourcing

It’s a paradox facing India’s outsourcing industry. Its low cost location is its raison d’etre. But to stay in the game, it also has to be where the customer is, often an expensive site in western Europe or the US. First, India’s IT services industry began to buy western companies. Now, India’s drug makers are following suit.

In the past year, three Indian companies — Nicholas Piramal, Dishman Pharmaceuticals and Chemicals, and Shasun — have acquired European contract research and manufacturing (CRAM) outfits. They conduct early stage research and development (R&D) of experimental drugs for large and emerging drugmakers, produce them in small amounts for clinical trials, and do contract manufacturing. The reasons for this are sound: Indian companies have found that Big Pharma is either wary of offshoring some key, patent-sensitive activities to India or lacks adequate incentive to do so. India accounts for barely 1-1.5 per cent of the global CRAM industry. “[Acquisitions] will give the Indian companies access to customers who may not have otherwise considered doing business with them,” says Edward Vawter, president, QD Information Services, a US-based consultancy firm.
The path is not without risk. Though the companies have not been bought at fantastic valuations, the acquisitions come with high labour and manufacturing costs. Managers and scientists are free to leave once their contracts expire. But this is just the beginning. “More Indian companies will be purchasing European companies,” predicts Harry Rathore, US-based vice-president (sales and business development) at leading European contract manufacturer Lonza. The players also say they are open to more deals. So, what is behind this appetite?

Big Pharma is outsourcing like never before. According to Frost & Sullivan, the global pharma outsourcing market is worth $37 billion and growing at almost 11 per cent. Cost and time pressures are forcing customers to turn to China and India. By one estimate, India’s annual labour costs are at $3,000 a head compared to over $50,000 in western Europe. This has no doubt put western incumbents on the backfoot. But even today, most of the outsourcing activity happens there. Fifty per cent of the contract manufacturing market is in North America and just 10 per cent is in Asia, with the balance in Europe. This will not change in a hurry. “While we are an important cog in the wheel, it is never going to be all India and China,” says Ajit Mahadevan, president (custom manufacturing) of the Rs 1,582-crore Nicholas Piramal. This is why Nicholas and its peers have decided to take the battle for market share to the West.

No doubt, India is very much on the radar of the bluest of blue chips. Big Pharma such as Pfizer, AstraZeneca and Eli Lilly have outsourced to India. But business is only trickling in. Take the case of early-stage R&D. “There are some things that will not happen in India for two decades,” claims Janmejay Vyas, managing director, Dishman. Vyas claims that innovators are not comfortable offshoring early stage R&D — developing and scaling up new chemical entities — to India. The country has an untested patent protection law and no data protection. This is partly why the Rs 277- crore Dishman stumped up $74.5 million (Rs 343 crore) to buy Carbogen and Amcis, two sought-after names in the western outsourcing space.

Carbogen synthesises bulk drugs —the key ingredients that lend a drug its potency — for innovators. This includes finding the best possible process to make a bulk drug with the least amount of impurities. It also produces these bulk drugs for human trials. This isn’t rocket science. Indian companies have the skills to do it. But Vyas claims that Big Pharma will very rarely, if ever, offshore this to India. At the bulk drug synthesis stage, a company’s research may not yet be protected with watertight patents. India and China, with their history of copying innovator drugs (legal until recently), are therefore suspect.

Vyas says Dishman’s experience proves this. In spite of landing its first customer in 2002, Dishman only gets contracts to work on intermediates, the building blocks of a bulk drug. This is safer from a customer’s point of view since without knowing what the intermediate goes into, there is little you can do with it. Vyas thinks Carbogen, which works on about 400 products a year, will help Dishman move up the value chain. The other reason is proximity to the innovator. Early-stage R&D requires continuous interaction between scientists. Also, at this stage the drug goes back and forth between the innovator and the outsourcing company several times. “A scientist on the west coast of the US is going to struggle to communicate with someone sitting in Chennai or Mumbai,” says Mahadevan. Last December, Nicholas acquired UK-based Avecia from some private equity investors. Avecia owns 100 per cent in Canada-based Torcan, which is also into early R&D, like Carbogen.

Companies are not just reacting to what they perceive as problems. They are also proactively cementing ties with the biggest outsourcers. Nicholas already had a contract for process development and scale-up of world No.1 Pfizer’s animal healthcare products. But by acquiring Pfizer’s factory in Morpeth, Scotland, Nicholas emerged as its largest supplier in dollar terms. (Pfizer has agreed to source from this factory for the next five years or so). This means Nicholas now sits in on key supplier discussions. “When there is talk of ways to use a new supplier strategically, we are in the process,” Mahadevan says. It was Chennai-based Rs 377-crore Shasun’s existing customers who recommended Rhodia Pharma Solutions, says its CEO and managing director N. Govindarajan. Shasun can now offer a broader range of services to them.

Customers aside, specific skills and technology are also attractions. The low-cost Chinese juggernaut is providing tough competition to Indian companies in the high-volume, low-value business. They need to quickly enter higher barrier-to-entry markets. Technology can make the difference where cost won’t. Amcis, the contract manufacturer that Dishman bought along with Carbogen, is a case in point. Its facilities are small but handle potent and highly toxic material used to make cancer and eyecare drugs, requiring high levels of safety and containment. Although their potency means they are administered in small quantities, their dollar value is far higher — anywhere from $10,000 to $100,000 per kg. Being highly-priced, these are profitable for innovators. Minor cost differences cannot motivate them to change suppliers. “The contribution of manpower cost in a $5,000 product is nothing. What logic says that if I save $10 on a $5,000 product, the customer will be interested?” asks Vyas. Similarly, with Rhodia, Sha sun got access to technologies that it had licensed from Harvard University and MIT to counter low-cost competition from India and China. Nicholas’ Avecia is abile to make toxic products and other high-value drugs such as hormones, and owns fermentation equipment to make drugs more efficiently.

These deals are also about building scale. With Avecia and the Morpeth aquisition, Nicholas’ revenues from custom manufacturing jumped to Rs 920 crore from Rs 220 crore. Nicholas has laid claim to being among the top 10 contract manufacturing companies in the world. With Amcis, Dishman has added $100 million (Rs 460 crore) to its topline. Shasun has got business worth $72 million (Rs 331 crore) from Rhodia. The upshot of all this is that companies are converting fast to the view that to leapfrog a business is to buy it. Says Nimish Mehta, pharma analyst, Edelweiss Capital: “Companies have realised they have to run some part of their businesses outside India.”

But there are concerns. One is that of customers deserting. Often they have another source supplying the same product and could increase offtake from them. This concern has led the Indian acquirers to meet all key customers before they sign on the dotted line. Also, in some cases they have got an assurance from the seller that the customers will honour their contracts.

But losing customers is a business risk. It is not unique to acquisitions. It can happen to any CRAM company. The more pertinent question is: where does all this leave their famed cost advantage? How long can they offer viable solutions to customers with expensive manufacturing sites and high-cost labour? “In the short run, this works out very well but I doubt whether you can sustain it,” says Venkat Jasti, vice-chairman and CEO of Hyderabad-based Suven Life Sciences.

Jasti should know. In 2003, when India didn’t have a product patents law, Suven was the first Indian company in the outsourcing space to purchase a small US laboratory called Synthon Chiragenics that did research for innovators. Synthon did have some technology, but Jasti believed that its value lay in its location — in the innovators’ backyard and far from India. “It was about giving comfort to the customer,” he says. But by 2005, things changed. The same customers came back to Jasti asking for cost benefits from its Indian site. By December 2005, Jasti had closed the lab and moved the equipment to India. He admits it wasn’t difficult — the lab employed 18 people, was located in a hire-and-fire market, and did not have any manufacturing attached to it.

That is not the case with the latest acquisitions. They come with hundreds of workers employed in factories. Redundancies are tough and expensive. This is likely part of the reason why no acquirer is willing to discuss the migration of jobs to India. At least, not yet. “We did not buy these companies to shut them down, scoop up the insides and bring them home,” says Mahadevan. There is another good reason for this. Factories are continuously churning out drugs for their customers and a disruption in supply would prove fatal. Changing a manufacturing site requires regulatory clearance that takes at least a year.

The acquirers are, thus, going for the low-hanging fruit. Sweat the existing assets better and squeeze efficiencies out of the supply chain. The first thing that Dishman, Nicholas and Shasun have done is switch raw materials that the Europeans were buying from Europe and the US with Indian and Chinese supplies. Dishman’s Vyas points out that Amcis, for instance, couldn’t be bothered with tapping Asia for incremental savings for its high-value drugs. “But now, if I can save them this money, then why not?” he asks. The second thing is to increase capacity utilisation. Nicholas has done this by moving customers from one-year contracts to 3-5 year ones. Earlier, according to Mahadevan, customers were unwilling to do this since Avecia was seen to be struggling. But the sale to Nicholas has brought stability. This, and new contracts, have improved its capacity utilisation from 60 per cent to close to 90 per cent. Shasun expects to increase Rhodia’s ultilisation by 10 percentage points to 50 per cent for similar reasons.

More importantly, by fitting the large-scale Indian manufacturing back-end into the existing operations, the Indian outsourcers think they offer a proposition that’s hard for customers to ignore. Again, look at Carbogen and Amcis. An innovator works with Carbogen through the early stages of bulk drug synthesis until phase 2 of human trials (Carbogen makes the drug for the trials). By phase 3, the quantities required are much larger since these trials are conducted on large numbers. This is where Amcis — Carbogen’s sister company — a pure-play contract manufacturer, comes in. Since the project manager remains the same, the customer does not feel he is dealing with a different company.

But Vyas found that, thanks to its cost structure, Amcis would turn down any business below a particular value. The innovator had to look for another contractor. Enter Dishman. It can offer to make both phase 3 and launch quantitities of a drug synthesised at Carbogen in its facilities in Bavla, Gujarat. By then, patent protection around a product is sound and the economics makes sense. Importantly, it saves a precious two years of transferring technology from Carbogen to the innovator and from him to his contract manufacturer. Vyas says this one-stop solution lowers the total cost of bringing a drug to market for the innovator and increases Dishman’s revenues. He claims a bluechip customer who found Carbogen too expensive has now signed up, thanks to the India connection. Dishman also sees Amcis able to take on business that requires a far larger capacity — in terms of fermentors, for instance — than what Amcis can currently provide.

Companies would also like to move the production of mature drugs that have reached the end of their patent life into India while retaining the manufacturing of new patented drugs in the UK. Both Nicholas and Shasun want this. Shasun also wants to use the patented process-development technologies that it has aquired, back home. “You have to employ 20-30 chemists to keep trying these technologies. We can do that cost-effectively in India, and that would increase their viability,” Govindrajan says.

In the meantime, all three are marketing their Indian facilities to customers through the acquired companies. They claim that, through this marketing, existing customers are giving them more business and new ones are coming on board. “If you can fill up the plant there and you get a lot of value, including business, coming into India, then why would you want to shift?” asks Mahadevan. Nicholas’ near-term margins have been under pressure due to Avecia’s losses. But a turnaround is expected by the end of this fiscal. Shasun’s Govindarajan also expects Rhodia to post a profit this year.

Industry watchers warn that western Europe is losing the cost battle to India and China. The true test for the Indian acquirers, then, will come a few years down the line when customers start squeezing more out of them. Then these assets and people may harm, rather than help, their business. Getting custom, they may discover, was the simple part.

source -BW

Strategy- BASF, The Chemical company

In German, it is called the Verbund. Jürgen Hambrecht, the chief executive of BASF, describes his company's sprawling complex of pipes, towers and storage tanks as the “ultimate business cluster”. Spread over ten square kilometres (four square miles), it is the biggest integrated chemical site in the world. At first glance, BASF's third-quarter results, out on November 2nd, did not look great. Profits plunged because of restructuring costs at Engelhard, an American producer of catalysts (as in catalytic converters) which BASF bought earlier this year. And, on the same day, BASF announced 2,000 job losses.

But the underlying trend at BASF is surprisingly healthy, given that it is an old-fashioned manufacturing company in a part of the world where heavy industry tends not to flourish these days. It more than doubled its profits between 2002 and 2005. One-off charges aside, its third-quarter results suggest the company is in line for a 20% increase in turnover this year to over €50 billion ($64 billion), with pre-tax profits up 11%. Although many industries are fleeing from Europe to less costly countries, the efficiencies of the Verbund show how a traditional business can remain highly competitive, even when it operates in an expensive place like Germany. The complex at Ludwigshafen, across the Rhine from Mannheim, comprises up to 250 individual chemical factories turning out 8,000 different products. These range from simple petroleum distillates to sophisticated nanomaterials—tiny particles which can be used to change the properties of plastics or other substances. BASF employs about 36,000 people in Ludwigshafen, where it also has its headquarters. Many travel around the site on red works bicycles, individually numbered.

range from simple petroleum distillates to sophisticated nanomaterials—tiny particles which can be used to change the properties of plastics or other substances. BASF employs about 36,000 people in Ludwigshafen, where it also has its headquarters. Many travel around the site on red works bicycles, individually numbered.

The site's legendary efficiency comes from extracting the last drop of value from every chemical reaction. It makes use of the numerous by-products from each process. At other places these are often sold or shipped from one factory to another for further processing. At the Verbund, what is left over from one process is used only a few hundred metres away to make something else. This saves BASF a fortune. Compared with having, say, 70 separate factories some 100km apart, BASF calculates its cluster enjoys annual savings of €300m ($380m) in logistics, €150m in energy and €50m in infrastructure.

For Mr Hambrecht, the Verbund represents a huge advantage in an industry in which competition is increasing, especially in Asia. So BASF is trying to replicate the benefits of its cluster, not only in other countries but also at the corporate level. Instead of splitting into lots of firms specialising in one chemical, as many giants have done, BASF is seeking to become an even bigger conglomerate.
Mr Hambrecht, who is 60, has spent half his working life at BASF, which was founded in 1865 as Badische Anilin- & Soda-Fabrik. Anilin was once important in making dyes; soda is used in glass, soaps and textiles. Today the company's products end up in goods ranging from cars to electrical goods, cosmetics, sports equipment and medical devices.

Mr Hambrecht enthuses about “the industry of industries”. Indeed, chemicals seem to be in Germany's blood. The country accounts for a quarter of the chemical industry's sales in Europe and a similar share of employment there. Germany supplies more than 12% of world exports of chemicals, the biggest single share. And the German industry spends a higher proportion of its revenue on research and development than that of any other country.In many countries, chemical factories are hardly the subject of civic pride. They are in Germany. In September an “open day” attracted thousands of visitors. Frankfurters, in particular, are proud of the huge chemical complex straddling the river Main at Hoechst, west of the city. Though Hoechst, once the local chemical giant, was absorbed into sanofi-aventis of France in 1999, its Frankfurt site still churns out polymers, pigments and pharmaceuticals. The former Hoechst headquarters, a redbrick relic of the 1920s, is an admired piece of Bauhaus architecture. Yet few sites are as efficient as the Verbund. A recent study of Germany's chemical industry by A.T. Kearney, a consultancy, found that most other production centres had big gaps in their “value chain”: raw materials and by-products had to be shipped around, at extra cost. The reasons are often historical or political. A complex at Leuna in east Germany, for example, was cleaned up at huge expense after German unification. It has never achieved its potential, even though firms such as Dow Chemical, Linde, Total and BASF have operations there. Other sites are too small or are underused, but cannot be closed for political reasons. BASF has recently been adding to its product range in a big way. In March it bought Degussa Construction Chemicals, part of a German maker of specialty chemicals, for €2.7 billion; in May it spent $470m to buy America's Johnson Polymers and in June it paid $5 billion for Engelhard, the cause of the profits crash.

Asia starts producing

Although these European and American additions bolster its business, BASF cannot ignore developments elsewhere. Ever bigger petrochemical and other downstream production facilities are being built in the Middle East. And burgeoning demand in Asia, particularly in China, is resulting in more chemicals being produced locally. Moving into developing regions can have benefits beyond lower production costs. It can allow chemical companies to get closer to both suppliers of raw materials and more potential customers. It nearly always makes sense to produce bulky chemicals, such as washing powder, where they are sold, to keep transport costs low. This puts places like China, which is a long way from the big Western consumer markets, at a disadvantage in exporting some products. But there are plenty of others to be made. Anything that can be conveniently put into a container and shipped cheaply is likely eventually to be made in Asia's low-cost factories.

Hence even BASF is having to shed businesses in which it thinks it is no longer competitive. The next to go may be a factory in Minden, Germany, which among other things makes caffeine. The Chinese now offer caffeine, which is easy to ship, to firms such as Coca-Cola at a third of the price that European factories can. Nevertheless, demand in China is so great that it will be many years before the country becomes a net exporter of chemicals, Mr Hambrecht believes. Demand across Asia is strong. Around half of future worldwide demand for chemicals is expected to come from the region. BASF already has almost 19% of its turnover in Asia, up from just 9% in 1995.

As it expands overseas, BASF is trying to replicate the Verbund concept. It has built smaller versions of the cluster in Belgium, Texas, Louisiana, Malaysia and China. The foundations of its Chinese factory in Nanjing were laid in 2001. Last year petrochemical production began there in a joint venture with Sinopec, a Chinese oil company. Mr Hambrecht, who fought internal opposition to the investment, believes that such opportunities in Asia offer European chemical companies their only chance to grow faster than at home. Chemical companies can be highly vulnerable to changes in the price of raw materials. Here too BASF hopes to gain some protection from its cluster effect. As long ago as 1969 it bought Wintershall, an oil producer. It has proved to be a useful hedge against oil-price rises. BASF is now trying to secure its lines of supply from Russia by a joint project with Gazprom to build a gas pipeline across the Baltic. It also has a share in a west Siberian oilfield. BASF was mining coal until the late 1980s, and today even that might again make sense. The company's expansion into energy seems set to continue: it recently announced plans for a joint-venture biodiesel plant in Belgium, which will use rapeseed and other organic material to produce fuel. Indeed, oil and gas provided 40% of the group's profits in 2005.

Other giants in the chemical industry have spun off various divisions to narrow the spectrum of their business . For instance, Bayer, Germany's second-largest chemical firm, listed its specialty chemical division, Lanxess, as a separate company in January 2005. Although the trend in the industry is to put new labels on bits of the business, such as “life sciences”, which includes health and food, or “coatings”, which includes paint, BASF still brands itself as “The Chemical Company”. The one business it has quit is pharmaceuticals, accepting that there is little overlap between drugs and its other products.

The diversity of its operations makes BASF unpopular with some investors because it muddies their view of the firm as a “pure play” on chemicals. Mr Hambrecht is unrepentant. He argues that conglomerates are better overall long-term performers than specialists. Through diversity, he maintains, companies can weather poor performance in one or two of their divisions. The specialist can also be more vulnerable to disruptive technology and the sudden substitution of one material for another. This is a particular risk for the chemical industry in Germany, which is highly exposed to the car business. Almost 70% of the German industry's innovations, such as smarter or lighter materials, go into vehicles. But it is harder to apply the Verbund effect in the developing field of biotechnology. A big handicap for BASF is the German government. Despite vowing in its coalition agreement last year to clear the way for genome technology, the government has since dragged its feet. Bayer is developing genetically modified rice, rape and cotton, but in America not Germany. BASF has the majority of its biotech research in Europe and believes Germany to be an excellent place for genome activities. But, says Mr Hambrecht, the government's attitude risks driving it away.

The virtue of virtuality
Perhaps the biggest danger to the Verbund, and the conglomerate-building which it encourages, is that it could lack the flexibility to cope with rapid market changes. But a variation of the concept might overcome this. This is the “virtual” Verbund; a large chemical site where a number of independent companies could voluntarily work together to achieve the same economies of scale, but use different processes as market conditions change. A.T. Kearney suggests that something like this might be done at some of the chemical sites in Germany where production capacity is underused. A European Union project supported by seven big companies, including Siemens and Degussa, is trying to get the idea going by streamlining test-production. Called Impulse, the project aims to reduce the cost and time of research and development by miniaturising test equipment. This would primarily benefit smaller, more flexible companies. The political objective is to keep jobs and factories in Europe.

Perhaps such initiatives might one day steal away some of the Verbund's advantages. But not yet. For now Mr Hambrecht, whose contract with BASF runs until 2011, is confident in the future prospects of his firm. As he jogs through the vineyards near his Rhineland home in the early morning he can indulge in thinking up new things to make.