By: A.T. Kearney

Lessons Learned from Canada

How is the United States faring in a post-quota world? Whether one subscribes to the view that China is orchestrating a master plan or that local provinces and businesses are maximizing their economic self-interest, the outcome is the same-China is working within the WTO rules to outmaneuver the U.S. government. Canada, however, has taken a different approach and is enjoying a far different outcome. What can we learn from these two countries? That it does not pay to wait for government edicts. Early movers will gain competitive advantage but only if they take action now-both strategic and tactical.

Last year, in the run-up to the elimination of textile and apparel quotas, the United States and Canada adopted very different approaches. The United States favored a protectionist stance, threatening safeguards to shield its apparel and manufacturing industries. It was buckling under strong lobbying from the U.S. textile and apparel manufacturing industries. Each industry accounts for just 400,000 and 240,000 jobs respectively, or less than 1 percent on a combined basis. But their influence has been considerable-even more so than millions of U.S. consumers who are paying higher retail prices as a result. The U.S. government is considering petitions for more than 20 categories, imposing safeguards on 13 major categories with another seven under review, and stands ready to consider imposing even more "market disruptive" actions against China as witnessed by the recent horse trading that took place to induce passage of CAFTA legislation. 1

In contrast, Canada decided to abide by the World Trade Organization's ruling, eliminating quotas on all textile and apparel imports. In fact, Canada went a step further, and no longer employs people to check for imports unless goods were eligible for tariff preferences under limited trade agreements with NAFTA, Chile or Costa Rica. Instead, Canada turned its attention and efforts to retraining employees in preparation for a post-quota world.

At the time, industry analysts wondered if Canada's approach wasn't the equivalent of political and trade suicide. Surely it would not be long before China owned the Canadian market at the expense of all others. The U.S. approach, most analysts thought, would result in fewer imports. China would be reined in and jobs would be created in the United States.

Today the opposite is true. While the U.S. was trying to thwart China by putting up roadblocks in the form of safeguards, it actually took in more imports than Canada on a percentage growth basis. In the first quarter of 2005, the dollar value of Chinese apparel imports into the United States rose 79 percent, compared to 48 percent in Canada. Additionally, apparel imports from all countries rose 20 percent in Canada compared to 11 percent in the United States, which means many countries other than China increased market share in Canada. Through the second quarter of 2005, the story remains the same-the growth rate of Chinese imports in the United States is 97 percent compared to 46 percent in Canada. And in Europe, the story is different yet again (see sidebar: Europe's Stranded Clothing Problem).

What went wrong with the U.S. approach? In our opinion, during the long-negotiated safeguard process, the United States failed to focus on some critical details and provided China with a loophole. In the end, it appears the safeguard process will only slow the inevitable. China will ultimately dominate the U.S. apparel market, and sooner than Washington expected.

Do the Math

Perhaps one reason why China's apparel imports surged so significantly into the United States compared to Canada is because the safeguard process and the mathematics behind it actually encouraged such an outcome. Consider the data from cotton trousers, which is among the most hotly contested safeguard categories (see figure 1).

Prior to imposing safeguards on a category, a country must demonstrate that the elimination of quotas on that category would cause an actual, not potential, "market disruption." Any country accused of causing a market disruption, such as China, then has an opportunity to refute the assertion or negotiate a solution. The issue is not only the time given for a rebuttal but the time required to collect the necessary data to prove the actual market disruption (which is not a defined term in the WTO agreement). For example, when a safeguard is imposed, a 7.5 percent growth-rate ceiling is established, based on the preceding 12-month, not annual, period. The ceiling is prorated for the balance of the year and added to the imports already achieved. By May 2005, when the U.S. government decided to impose safeguards based on demonstrated market disruption statistics for cotton trousers, it had to calculate the 7.5 percent ceiling using data for the 12 months ended February 2005 and then prorate it. That becomes the number that can be sold from June through December, which turns out to be another 4.2 million dozen pairs. This rewards China for aggressively selling into the U.S. market at steep discounts not only in January and February, but also up to the last moment safeguards are imposed.

The impact is not a one-time punch, but a one-two punch-for China's actual 2005 imports through May (12.6 million dozen pair) will now be rolled into the new base for the 2006 calculation. Essentially, China can include in its calculation the pairs it flooded the market with through May and add another 4.2 million dozen pairs (those eligible to be sold June through December) for a grand total of 16.8 million dozen pairs of cotton trousers. Now, compare these numbers to the 2.4 million China would have sold if the process allowed the imposition of immediate safeguards without having to demonstrate an actual market disruption instead of merely the threat of one. With numbers like these, why would China ever agree to onerous restrictions early in the year when it benefits most by prolonging the process?

As figure 2 illustrates, if China continues to pursue its early-surge strategy, it can achieve significant inroads into the U.S. market, even with safeguards. For example, if China were to surge early each year at a 50 percent increase over the prior year, and the U.S. government follows the same timing and calculations as in 2005, then China could conceivably sell an additional 105 million dozen pairs of cotton trousers over the three-year safeguard period.

Many politicians failed to grasp the basics of this business. If China were to achieve early-year surges of 75 percent (the 2005 growth rate was 200 percent), by the end of 2007 it could achieve a 49 percent market share in cotton trousers. From 2005 to 2007, China could sell an extra 134 million dozen trousers. If the surge were 100 percent each year, China could capture a 64 percent market share by 2007. After 2007, when the U.S. government can no longer impose safeguards pursuant to the WTO trade agreement, China can and will build from its projected market share-compared to only 1.5 percent in 2004. Not exactly slow. Is it any wonder then that settlement negotiations between the United States and China broke off without any resolution in late August? We think not.

The only question for China is whether or not it can gear up its manufacturing capabilities enough to capitalize on such a huge opportunity. If history is a gauge, the answer appears to be yes. In 2004, China exported nearly three billion trousers globally, with less than 5 percent of these sold in the United States. In fact, China has been masterful at ramping up production and capturing market share in categories that have gone off-quota. Over the past decade, China has achieved an average "best" three-year market share increase of 21 percent. Its highest three-year gain was more than 80 percent (men's and boy's silk suits), and prior to 2004, China's median share shift was nearly 60 percent among all off-quota categories. With this in mind, going from next to nothing to a 64 percent share of the U.S. cotton trousers market is not so far-fetched.

For the time being, the U.S. industry continues to suffer as companies cannot execute against multiyear strategic plans because no one knows when the market will surge or when the government will cast safeguards on a category. With such uncertainty, many companies have become paralyzed or have delayed rationalizing their apparel supply chains. Europe is enduring a similar fate as some retailers cannot take delivery of China-made clothing and fabrics that are deemed over-quota-the result of the industry simultaneously attempting to "load-up" before the quota window closed pursuant to the EU and China's negotiated settlement.

Has China Been Intentionally Buying Market Share?
All indications are that China is intentionally targeting off-quota categories where it does not have significant market share. For example, China's wholesale selling costs declined 11 percent across all apparel categories based on square meter equivalents (SMEs) in the first quarter of 2005 compared to the same period in 2004. For the rest of the world, excluding China, wholesale costs rose 1.8 percent during the same period.

On the surface, this difference does not appear outsized, since quota costs can account for anywhere from 5 to 25 percent of a garment's landed product costs. A closer look at each category, however, reveals that 10 of the top 25 largest SME cost reductions were in "safeguard" categories-all of which declined 40 percent or more.

No question about it, China has been intentionally targeting U.S. safeguard categories, in essence buying market share (see figure 3). What else could explain the 375 percent increase in newly off-quota categories and a 40 percent drop in SME costs in the first quarter of 2005? Categories under safeguard consideration grew by an astounding 565 percent on similar price reductions. Compare this to the elimination of quotas that took place earlier in the first two phases. In phases two and three, categories that have been off quota since 2001 saw single to low double-digit-growth rates with only modest price declines. A coincidence? Not likely given the safeguard process and our calculations.

China has been saving its biggest cost reductions for those newly off-quota categories where it had the least market share. For example, in apparel categories where China held just 10 percent or less of the market at the end of the first quarter 2005, it cut its average SME costs by nearly 50 percent, thereby achieving an 820 percent blended quarterly growth rate. When China's garment share was 80 percent or more, it increased its SME costs by 1.6 percent, thus registering only a 9 percent quarterly growth rate. Interestingly, the rest of the world also reduced its wholesale prices in categories where China owned 10 percent or less of the market (but by only 3.4 percent) and raised prices by a whopping 25 percent in categories where China owned more than 80 percent market share.

The United States is not the sole target. China is also pursuing newly off-quota categories in Canada, although less aggressively. For example, categories that had been exempt from quotas prior to 2005 rose 28 percent in the first quarter of 2005, while newly off-quota apparel categories in Canada rose 79 percent during the same time frame. These are significant growth rates, but far from the triple digits the United States has experienced.

Perhaps, given Canada's more agreeable stance, China decided it could be more deliberate. Or perhaps the Chinese government decided it needed the production capacity south of the Canadian border to push its U.S. "available for sale" levels in 2005 and beyond, especially given the hard-line tone of its U.S. negotiations. It will be interesting to see if Canada experiences a pick-up in Chinese imports once U.S. embargo levels are reached this summer, and if the trend continues into 2006.

What U.S. Categories Might Be Next?
Clearly, China is working within the WTO rules to outmaneuver the U.S. government. Of course, the United States is partly to blame because it failed to nail down a solid definition for market disruption. Does it mean excessively high growth in a category even when market share is low? Does it mean the largest market share gains? Does it mean the biggest SME cost declines? Does it mean demonstrated job losses in apparel or textile manufacturing? Does it mean who lobbies the loudest? Did China and the United States define this term upfront? It is doubtful.

Today, we should be able to look at past data and predict which categories the U.S. government will safeguard in the future. Unfortunately, there is no clear pattern. Decisions about safeguard categories seem to be random. For instance, only seven out of the top 20 fastest growth categories in the first quarter were placed under safeguards. And when measured by market share gains, only two out of the top 20 categories garnered government intervention. Because there is significant lag time in collecting job-loss data, how the U.S. government decides what apparel categories deserve safeguards appears to have more to do with heavy lobbying and with the popular press. Remember, approximately 97 percent of all garments purchased in the United States are imported-but they add up to only 75 percent of the dollar value. Therefore, it appears the U.S. government is protecting high-cost producers in the United States at the expense of consumers.

Figure 4 lists the top 25 growth categories that are not currently on the government's action or watch list. The top 17 market share shift categories were not originally considered for market-disruption action, although two sweater categories were subsequently added, which is interesting given that there is little sweater-production capacity in the United States today. Other market share shift leaders not on the watch list include suits, coats and accessories.

It is time for the U.S. government to act definitively as Canada has and as Europe has attempted to. The European Union recently negotiated a settlement to have more categories under quota. Although it does not appease everyone, it at least offered some certainty that suppliers, brand owners and retailers can plan around. The current embargo on apparel shipments demonstrates that the EU underestimated both retailer demand and the difficulty of orchestrating an industry-wide cut-off date. The uncertainty created by the U.S. process thus far has produced strategic and operational gridlock at many companies. Recognizing the problem, U.S. executives have begun to clamor for a long-term resolution-through 2007 and beyond-even at the expense of near-term flexibility and having more categories under quota.

With the passage of CAFTA, the Bush administration has expressed a desire, for the first time, to negotiate a more comprehensive solution. Now the key question is: If the United States decides to go the way of Canada, what will free trade look like?

The Face of Free Trade
Recently, A.T. Kearney conducted a "rack check" in Canada to find out what free trade looks like. We found that department and discount stores have begun to plan for and take advantage of their ability to source freely from countries with the most competitive offerings-rather than focusing on quotas. The major chains have significantly increased their sourcing from China, with Hudson Bay Company increasing its mix by 18 percent, followed by Sears at 16 percent.

Interestingly, Wal-Mart Canada sources just 31 percent of its garments from China versus an industry average of 39 percent. Wal-Mart's other leading sources include Bangladesh (24 percent), India (10 percent), Canada (10 percent), Cambodia (6 percent) and Mexico (4 percent). The Bay and Sears source more products from local Canadian companies, reaching 17 to 19 percent versus Wal-Mart's 10 percent. Otherwise, they largely followed Wal-Mart's lead, although The Bay had broader sources including Thailand, Philippines, South Korea and Indonesia.

Wal-Mart is the clear price leader in Canada (see figure 5). While product differences exist between Wal-Mart, Sears and The Bay, 75 percent of growth in the department-store sector in Canada (from 1996 to 2002) has gone Wal-Mart's way. Wal-Mart has increased its market share from 4.6 percent to 7.4 percent-demonstrating that consumers are willing to switch channels.

By comparison, a rack check of Wal-Mart in the United States revealed that less than 5 percent of apparel garments were imported from China. 2 The reason for such a low percentage is that the U.S. process forces large-scale companies to be opportunistic rather than strategic. Wal-Mart in the United States and its suppliers source garments primarily from Mexico, quick-response CAFTA countries and, to a lesser extent, Bangladesh, Swaziland, Indonesia and Kenya.

As a sign of where the market could go, U.K.-based ASDA, which was acquired by Wal-Mart in the 1990s, has continuously slashed the price of its George jeans to an opening price point of about US$5.50 from US$30 five years ago. This has led to a major price war and further channel shifts away from department stores to grocers. With US$25 to US$30 billion in global apparel sales, Wal-Mart will ultimately be able to consolidate its sourcing and drive prices even lower worldwide.

Where Will the U.S. Market Be in 2008?

Wal-Mart is the largest retailer of sportswear and with the aging of baby boomers, it is likely to see demographics work further in its favor. Empty nesters and older boomers account for approximately 42 percent of U.S. sportswear purchases and with the addition of younger boomers, the number rises to 61 percent. Studies show that spending habits decline with age, which means Wal-Mart's price advantage is likely to be even more of an asset-but only if its product quality and presentation improves. One can only imagine where Wal-Mart's prices might go once it is able to plan for and shift more production to China. When that happens, opening price point and moderate segments of the market-including mid-level department stores-are likely to be squeezed even further. True signature brands may hold their value but ultimately quota and migration cost savings (production savings from moving goods to lower cost countries such as China) will be passed along to consumers in the form of accelerated retail price deflation, although high-end brands may never see retail price deflation.

This hypothesis has been validated in Canada. When tailored collared shirts came off quota in Canada, their retail price declined Cdn$2.50. Not incidentally, the quota cost for such a shirt was approximately Cdn$2.00. The further Cdn$0.50 decline in retail prices is likely migration cost savings and competition. Wal-Mart's impact and Canada's prior quota elimination on 40 percent of its apparel is best seen in relation to other retail products. Growth in apparel sales lags almost all commodities at 1 to 2 percent and is well below the average for all goods sold through large retailers in Canada (see figure 6).

By isolating retail apparel price and volume trends in Canada over the past four years, a clear pattern emerges. Although the overall sales growth is positive, individual unit prices for all garments sold actually deflated by -0.5 percent (and only 40 percent of apparel was off-quota during this period). Retailers saw a 4 percent increase in volume over this period as consumers responded to lower prices by buying more clothes. This price/unit pattern was also seen in the U.S. when footwear came off quota back in the mid-1980s. Retailers with business models that support unit growth economies of scale may perform best in a post-quota environment. Other formats, including specialty stores, might have a hard time holding prices to achieve gross profits.

Preparing for a Post-Quota World
Historically quotas made it difficult for brand owners, manufacturers and retailers to source strategically. It was not uncommon for companies to source from 200 or more countries, often with fabric and manufacturing coming from separate continents. Time-to-market considerations coupled with quota constraints often resulted in undisciplined design-to-shelf processes and excessive use of air freight for last-minute fashion changes.

Today, in preparation for the post-quota world, it is important to remember that current U.S. protective actions are focused solely on China. This key point is often overlooked in all the noise about safeguards. Indeed, of the US$65 billion in apparel imported into the United States, 40 percent of the categories (or US$28 billion) are not subject to protectionism and thus can be sourced from China. Of the remaining US$37 billion, only US$2 billion was imported from China in 2004. In total, therefore, more than 95 percent of the U.S. apparel market can be strategically consolidated to low-cost countries other than China without repercussion-this includes countries in the Asian corridor or nearby such as India, Cambodia and Vietnam.

Despite the uncertainty, the time to act is now. Companies should be reevaluating their business models and processes. Those that remain on the sidelines, waiting until 2008 to develop their action plans and to reinvent their internal capabilities, will be at a significant disadvantage.

When free trade happens, will your company be ready? The following questions are offered as a way to begin thinking about your company's readiness for a post-quota world:

Do we source from more than 50 countries? If so, is it possible to trim the list to 10 to 20 best countries? What is the ideal list in 2008 and beyond?

Does our fabric and trim sourcing coincide with our manufacturing footprint? Are they both on the same continent or from the same country?

How many vendors do we use in our largest countries and how many factories do our vendors use in our largest countries? How do these numbers compare to previous years?

Are we partnered with the vendors and factories best positioned to win?

Do economies of scale at the factory level create competitive advantage?

Are we capitalizing on value-added services such as co-location to reduce lead times and costs?

Should we use an intermediary or develop a direct importing capability?

Is our transportation and freight consolidated by region or fragmented?

How efficient is our design-to-shelf process?

Are our divisions or business units coordinating their efforts and spend appropriately?

Are we using time- and money-saving technologies?

How disciplined are our design and reorder processes?

What are our historical hidden costs? Would they disappear if we embraced new models and approaches?

Building an optimal sourcing portfolio requires balancing cost, raw material, lead time, quality and risk. It also considers "as-is" and "to be" costs and trade-offs. Has your company rigorously

evaluated these and other options?

Sidebar: Europe's Stranded Clothing Problem 3

In January 2005, with the end of decades-old import restrictions on textiles and apparel, the European Union faced a decision: Take a protectionist stance and unilaterally impose quotas on textiles and apparel imports from China, or open the floodgates to all textile and apparel imports. After endless lobbying by retail groups, textile manufacturers and politicians who feared that the onslaught of cheap imports from China would destroy Europe's textile industry, trade officials with the European Commission (EC) decided to go with something in between. In June, they sealed a voluntary deal with the Chinese to impose import quotas on 10 types of textile and apparel products, limiting growth in exports to Europe until 2008.

Just six weeks after the papers were signed, the first category-sweaters-reached its quota limit and no more sweaters were allowed into Europe. Within two months, there were some 48 million sweaters stranded on ships, at custom stations in Europe, and on docks in China. By mid-August, five more categories had reached quota-shirts, trousers, bras, blouses and flax yarn-all of which were piling up in warehouses and at ports across the European Union.

The EC seriously miscalculated quota limits and the retail industry's simultaneous efforts to buy before the window closed. While some categories met their quotas and orders continued to flow in, other categories, such as cotton fabrics, were not even close to meeting theirs. Retailers and importers were angry that their orders could not be delivered, and the shortfalls on store shelves throughout the EU were becoming noticeable.

Struggling for a solution, in mid-August, the EC floated a proposal for greater flexibility in the new system for imports of Chinese pullovers, allowing exporters to borrow up to 9 percent of next year's quotas for use this year. Upon hearing the proposal, China officials immediately rejected changing the terms of the original agreement but said they might consider transferring quotas between years.

Stuart Newman, legal adviser for the Brussels-based Foreign Trade Association, said that if no outcome is reached soon, European importers of China-made textiles will be left in a bind. "Some of them are going to lose millions of euros," he told AFXNews, estimating that the biggest retailers already faced costs of more than US$12 million because of stranded shipments.

Finally, on September 7, European Union governments backed a deal to unblock Chinese textiles held at EU borders, ending a trade dispute that saw some 77 million garments pile up after imports broke through 2005 limits.

1 CAFTA is the Central American Free Trade Agreement; NAFTA is the North American Free Trade Agreement.
2 Rack check performed in the first quarter of 2005.
3 Derived from "How EU textile quotas became a Chinese puzzle," FT Online, 23 August 2005 and "China rejects Europe proposal on textile quotas ahead of talks," Forbes and AFXNews, 23 August 2005 and "EU States Back Deal to Unblock Textiles, " New York Times, 7 September 2005.

Consulting Authors:

Sue Field is an associated consultant in A.T. Kearney's San Francisco office.

Dean Hillier is a vice president in A.T. Kearney's Toronto office.

Steve Riordan is a vice president in A.T. Kearney's Plano office.

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