It is March 5, 2008 and I sitting in the airport in Guangzhou, China. This is my 16th trip to China in eight years. From here, I am going on to the Stone Fair in Xiamen and then back home to Los Angeles.

I wrote The China Factor Part 1 about a year ago. In it I presented what I saw as a significant future impact to USA small fabricators by aggressive Chinese stone companies. How did that play out today? No doubt there was windfall of profit for companies that embrace the prefabricated granite market over the past couple years. Not only did track home builders flock to the savings, but expert installation companies and procurement management brokers made big margins selling at the lowest turnkey pricing they ever imagined.

However, nothing last forever in this world, does it? There are several major current events that are unfolding that we are all aware of, but we must considered their collective impact. Let me share with you what I see and what I am planning to do about it.

The Unfolding Factors:

About 2 hours ago, I was dropped off at the airport after a day of inspecting factories. In the car on the way to airport I mentioned to my host that I was very impressed by the rapid improvements made to the roads in China since my last visit. She replied, “Tom, yes road improvement is a priority in China in order to adequately move products to the ports, but it is hard to be excited when the cost of pork has doubled since three months ago”. She continued, “The only thing not going up is wages!” I knew China was experiencing inflation issues, but still was at a lost for words to respond. Why, because the following is what else I know.

1: The China stock market is way overheated. It is hovering at a Price/Earnings ratio of about 40, while the US stock market is around 15. Investing at this level is like using all your wind to blow up a balloon and then putting the balloon on the nozzle of helium tank. Think about what has happened to the US markets recently. If you want to watch the movement of the Chinese stock market, check out stock symbol FXP, (note that is inversely waged (2x) against the top Chinese company stock prices). If it goes up, the China stock market is going down. It makes a roller coaster look like a merry-go-round. Secondly, we always considered the US Dollar pegged to the Chinese Yuan. Well, in 2007 the Chinese government allowed it to float but limited the increase to no more that 6%. In December of 2007, the rate of increase was raised to 12% per year. What will the next rate increase be? Here is a history currency table to show exactly how the US Dollar is no longer ‘pegged’ on the Chinese Yuan. Here is a graph for you:

(Click image to view full size)

2: A key WTO initiative rolled out in late 2006 and is gaining momentum. The initiative allows foreign banks will be able to conduct local currency business with Chinese individuals from 5 years after accession into the WTO. I believe this will create a major financial earthquake when the confidence level of the Chinese public diminishes. This initiative allows Chinese citizens for the first time in history to put their own savings in banks other than Chinese government owned banks. Through the power of the internet’s free information highway, Chinese citizens are realizing that their saved money stored in Chinese banks is used to give loans to State-owned Enterprises (SOEs). These SOEs have little incentive to be profitable and collapse regularly. So, what holds these banks together? Two things – government subsidies and the fact that Chinese citizens save more of their earnings than any other culture. The average Chinese citizen saves more than any other culture in world, 40% of personal income. It is this collective savings (in those banks) that robs from Peter to pay Paul. Once individuals are allowed to put their money in a safer place like CitiBank (with its strong branches in China’s major cities, the rapid withdrawals of savings will be like millions of straws sucking the water out of the same cup. The Government will come to the rescue but confidence will diminish and so will the stock market. It is my conjecture that many ‘smart suckers’ have already have inserted their straws. There is no greater economic force than human confidence, or lack thereof. If you think the US housing market is making a soft landing, then this event in China will be like Dorothy’s house falling in Oz. Ok, enough with my analogies but know this. Inflation will be fueled by this event.

3: Now back to the stone industry. In the last two years, more than 10,000 new Chinese businesses have entered the stone supply industry in China. More than 90% of these companies do not have factories, but they do have nice web pages! They are import/export companies with an office, a computer, and a fairly educated bi-lingual inexpensive commissioned sales person. This massive intrusion into the supply side of the granite industry provides enormous competition which has kept prices down as well as overall quality. The typical Chinese factory’s overhead is so low that you should not expect them to go away too soon. Out of the 200 Chinese factories that I have personally examined, there are 5 that I consider truly reliable. Working with the other thousands of companies is basically gambling – sometimes they work out, as long as you are prepared to walk away with what is in your pocket.

4: The Olympics are coming! In August 2008, China will usher in the 2008 Summer Olympics. The word for “eight” in Chinese (Pinyin: ba) sounds similar to the word which means “prosper” or “wealth”’. On 8-8-8m China will celebrate greatness! It certainly is not good timing for the Chinese government to deal with their current unpleasant economic issues. Hosting the Olympics is an awesome responsibility and along with should come the glory and national wonders presented to world. Combine that with the overwhelming governmental culture of ‘saving face’ and you get what I call, ‘a stale cupcake with new frosting’. China is not quite a stale cupcake but in August 2008 you will not see below the frosting. I predict that soon after the Olympic a serious downturn will begin, generated from a higher exchange rate, extreme inflation, the foreign economic recessions and financial lack of confidence. All these factors will feed on each other in a downward spiral event. At that point, inflation should be at an all time high, individuals with be increasing their withdrawal of savings from Chinese banks, and the US economy will still be declining.

The state of the Chinese economy and the lives of the folks that live there are in big trouble, but those are issues we can not control. As a stone fabricator in USA, you might think that your world is trivial compared to these big problems but let me give you my advice as to how you catch the next wave for profit or at least not become a small sacrifice in this globally unfolding story.

Step 1: If you are doing multi-family granite work and import from China, qualify your proposals based on the current exchange rate. This used to be a common practice when we all bought from Europe so the big builders should not be too surprised. I believe that a fair qualification is to state, “Costs impacts created by an increase of 5% in exchange rates from time of acceptance of proposal to time of order may affect our price”.

Step 2: Diversify now. Without a doubt, the next big wave in profit is custom residential and hospitality. If you are not trying to take a bite out of these pies, you are not only missing out, you are letting your competitors grab crucial market share and establish relationships. Out of the two, hospitality is the strongest growth path but custom residential is growing because homeowners are now staying at home rather than upgrading to an entirely new residence. Just talk with your local granite suppliers and you will find that the sales of exotic granites are increasing.

Step 3: Reorganize your labor. Consider new ways to itemize your labor cost. If you pay by the hour, consider if paying by the piece is more profitable to you and your employees. This can allow you to get more work done in a shorter period of time.

Step 4: Keep your eyes out for ‘almost new’ equipment. There has never been a better time to buy equipment. There is a ton of good machinery being sold at low prices due to companies going out of business. Check Youtube, Craigslist, Ebay, GraniteStock.com and leasing companies.

Please share your thought with me by writing to me at tcordova@StoneManagementGroup.com

Best wishes to you and your company