No joy this season for China’s toymakers by Wenguang Huang @FortuneMagazine December 14, 2011, 2:25 PM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons Zhang Shunlin, a 47-year-old businessman from China’s southern province of Guangdong, talks about Christmas and Thanksgiving year round but has no idea of their origins. He thinks Thanksgiving is a religious holiday when “Westerners thank the blessings of God” and Christmas is just like the Chinese New Year. But he knows their commercial significance all too well. Zhang operates a toy factory and a wholesale store with his sister and brother-in-law in Guangdong province, where 60% of China’s exported toys are made. He says this holiday season has not brought much joy. Orders from his U.S. clients have plummeted 25% from last year. For the first time, he had to decline several long-term orders because of the soaring cost of raw materials and implementing what he calls America’s “unreasonable” laws. His sister and brother-in-law are planning to leave the business next year. Zhang isn’t alone. The Guangzhou Daily recently called this Christmas “the worst” for Chinese toymakers. In the third quarter, the official government statistics show that gifts and toys exported to the U.S. and Europe, which normally make up more than half of the total export volume, fell 20% from last year. At the recent Canton Fair 2011, the largest trade fair in China and a bellwether for China’s export volumes, transaction orders in toys from the U.S. decreased by 24% from last year. Former Treasury official: The U.S. should spend like China Weak demand from global economic uncertainty and rising prices of raw materials like cotton certainly contributed to a sluggish third quarter. But government officials and manufacturers blame a stronger Chinese currency and the high cost of complying with stringent safety standards imposed by the U.S. and EU for compounding the problems and forcing them out of business. Profit margin squeeze The majority of Chinese toy producers are original equipment manufacturers (OEMs), which make products that are sold abroad under a foreign company’s label. In order to stay competitive, they make profit margins as low as 2% to 3%, says Yang Chunmei, a toy manufacturer in the southeast Jiangxu province. “The currency appreciation and any additional costs that have gone into regulatory compliance have the potential to completely wipe out our profits,” she says. Yang specializes in 12 kinds of plush toys and mini-cars. She says the steady stream of orders from large-volume orders from big U.S. retailers have put her in a slightly better position than Zhang. However, compared with last year, her profits have decreased more than 15% partially because the yuan has gained another 2.5% this year. Since 2005, under pressure from Washington, the yuan has risen about 30%. Adding to their troubles are regulations passed by Congress in August 2008, after several recalls of China-made toys containing excessive levels of lead paint. The law requires toy manufacturers and suppliers to reduce in three phases the amount of lead contained in the surface coatings of children’s toys (ages 12 and under) and have their products tested and certified in independent, accredited laboratories. Ikea takes on China “For the paint on each product, we do three tests – a test on the raw materials, another on the finished product and then the client will conduct their own test,” Yang says, adding that costs for training, equipment upgrades, sourcing new materials and multiple testing have added 10% to 15% to her operating costs. Government statistics support Yang’s claims. In the first half of 2011, toy exports rose by 31.5% year-over-year, mostly driven by demand in Asia and Latin America. But their export value rose only 11.54%. U.S. prices Even though the Chinese government has been responsive to the new U.S. safety requirements, they also see it as an overreaction and a technical trade barrier in response to pressure to create more jobs in America. “Each time after we upgrade and improve our safety standards and meet their requirements, the U.S. and EU raise the bar again. The cost keeps going up and seriously harms China’s toy export business,” said Fang Xiang, deputy director of China’s Standardization Administration during an interview with China National Radio. “I don’t think these trade barriers will save any American jobs. Instead, they’ll hurt American consumers.” Although the U.S. rules impact toymakers globally, more than 80% of the toys sold around the world come from China. At present, there are 20,000 toy manufacturers in China, employing more than four million people. ‘Made in China’ makes money for the U.S.A. Benjamin Cavender, associate principal at the Shanghai-based China Market Research Group believes this will lead to consolidation in China in the coming year. “Big professional companies with deeper pockets will start to buy up other companies as they falter,” he says. The pricing pressures will eventually pinch the profits of U.S. retailers and toymakers. “In the past, we kept our prices low because any increase would mean losing the customers,” Yang says. “But now, we really can’t afford it. We have to raise prices or turn down our orders.” As a consequence, U.S. brands that are sourcing from manufacturers in China will have to reduce their own margins in order to maintain production. While this will likely lead to some manufacturing returning to the U.S., Cavender emphasizes that “in all likelihood the bulk of manufacturing is still going to come out of China or other Asian countries.” So far, Americans consumers have benefited from the low prices of Chinese toys. According to the Toy Industry Association, the average price of toys has remained relative steady over the past few years, at around $8. But few believe this will last. Whether the new regulations are necessary safeguards to protect children or an overreaction, American consumers will eventually have to bear the cost.