The big squeeze
The big squeeze
Ahmad al Fayed, the owner of a small import-export business in the United Arab Emirates, has been coming to China to negotiate with suppliers for each of the past five years. This year al Fayed made his trip in early April to Yiwu, a city in Zhejiang province about four hours by rail from Shanghai. There he browsed for new suppliers at the Yiwu International Trade Mart, a colossal building – stretching the equivalent of 14 American football fields – where manufacturers from across China’s eastern seaboard gather. After a few minutes of bargaining with a local saleswoman over small desk lamps, he stepped aside to smoke a cigarette. “Every trip is less fun than the last,” he said with a laugh. “Prices are higher again.”
Al Fayed’s loss is Feng Yuefeng’s gain. An assembly worker at Yiwu Dreamwonder Handicrafts factory, located about half an hour outside of Yiwu, Feng acknowledged that his pay has been rising by “a decent amount.” “But we need higher salaries just to keep up with the cost of living around here,” he said as he slurped up a plate of fried noodles at the factory cafeteria. Feng guessed that the average wage for workers at the factory, which makes shower caps and other apparel, was around RMB3,000 (US$475) a month. Outside the factory, bright red and green leaflets plastered nearby streetlamps, advertising “urgently needed” job vacancies with monthly wages above RMB2,000 (US$317).
As wages rise, some China-based manufacturers seem to be scrambling to move production away from established bases near the coast. Taiwanese electronics manufacturer Foxconn has built new facilities in the western province of Sichuan. Nike switched the bulk of its sportswear sourcing from China to Vietnam in 2010. Last year American luxury designer Coach said that it would move half its production outside of China. Japanese retailer Uniqlo has announced plans to decrease the share of its clothes made in China to around half by 2015.
As China’s economy moves up the value chain, labor-intensive and low-value production will shift elsewhere. But headlines have painted a misleading picture of the pace of change. Over the past three decades, China has built a formidable business ecosystem to feed its manufacturing powerhouse, including cheap and reliable transportation infrastructure, skilled workers and a sprawling network of suppliers of raw and semi-finished goods. Moreover, as manufacturers increasingly looking to sell to Chinese consumers, they are likely to try to extend their stay in China as long as possible.
“China is not going to be transformed overnight, or even within a decade,” said Tim Leunig, a reader at the London School of Economics who studies historical macroeconomic shifts. “We’re talking about 50 years. We’re talking about a generation.”
The tipping point
Many China watchers proselytize about the “Lewis turning point,” a concept pioneered by the 20th century economist Arthur Lewis. According to Lewis, developing countries enjoy rapid economic growth without wage rises as long as factories can draw from a large pool of rural workers. When that pool dries up, wages rapidly inflate and growth cools.
China is almost certainly nearing this point. The influx of migrant workers from inland China to the coastal cities has slowed every year since 2005, and wages have correspondingly risen by around 15% annually. Research by Credit Suisse shows the crunch became especially acute in 2009-10, when wages ballooned by about 30-40% a year.
China’s aging population exacerbates the situation. Credit Suisse projects that the total working-age population will peak around 2017; other economists say that tipping point may have already occurred, depending on the definition of “working age.” In either case, wages appear set to increase by 10-20% annually for years, if not decades, to come.
Besides higher pay, the labor shortage means workers are equipped to demand better working conditions. In some cases, they have developed “an embryonic system of collective bargaining,” according to a report by the China Labor Bulletin. They are also notoriously quick to jump between companies: Some studies claim turnover rates of up to 30% a year. This is especially true of factory workers looking to make the leap into white-collar work, said Michael Austin, CFO of Top Form International, a clothing maker that supplies Wal-Mart. “They go out and see all the big [new] buildings and parks. Who would want to work in a factory?”
Factories often lose workers in droves after the Lunar New Year, when rural migrants travel home for the holiday and sometimes never return. A report released by the Chinese government in February showed the labor shortage on the east coast following the 2012 Lunar New Year was both deeper and longer-lasting than in previous years, a reflection of better employment opportunities inland.
“Before, 80% of the newly-added workforce migrated outside the province [of central Henan] for employment; after the 2008 international financial crisis, every year 80% of newly-added labor force began employment within the province,” the report quoted the human resources director of Henan province, of one the country’s biggest sources of migrant labor, as saying.
Tossing cheap clothes
Higher wages have the strongest effect on low-value manufacturing, such as textiles and furniture assembly. Margins in these segments are low (generally 2-4%), wages make up a majority of costs, and productivity gains are hard to come by. Textile exports require little advanced infrastructure or skilled workers, so can be easily transplanted to other low-cost countries. Unsurprisingly, 86% of executives at big Western apparel companies said they plan to reduce their production in China over the next five years, according to a survey by McKinsey.
Yet while shifts by big textile companies such as Nike and Uniqlo make headlines, their importance to the Chinese economy is overblown. Textiles peaked as a share of China’s overall exports in 1997 and now make up just 15% of the total, according to research consultancy Capital Economics.
Instead, more sophisticated goods are taking their place. For many of these products, efficiency gains from skilled workers have been offsetting wage hikes, said Stephen Roach, a professor at Yale University and former non-executive chairman for Morgan Stanley Asia. “While wages in manufacturing are going up somewhere between 12-15% a year, productivity is rising at about the same rate, so unit labor costs – which are what really drives competitiveness – are not changing that much at all,” he said.
Better workers also bind factories more closely to China. Shaun Rein, managing director of China Market Research (CMR), a consulting and research firm, gave the example of a furniture maker that approached him for consultation two years ago. The company moved to China in the 1990s because wages in the US were too high. When they started to rise in China as well, the firm shifted production to Vietnam and Indonesia, where salaries are about a quarter to an eighth the cost.
But productivity plummeted. Workers in Vietnam and Indonesia often bungled the complex furniture welding and gluing techniques the company’s Chinese workers had mastered. Higher transportation costs owing to poor infrastructure added to the bill. The company eventually relented and moved manufacturing back to China. “You can’t underestimate just how incredible the ecosystem in China is,” Rein said. The country not only has increasingly productive workers and efficient transportation infrastructure, but has also attracted a cluster of small businesses which supply raw and semi-finished inputs for factories, as well as professional services such as legal, accounting and consulting firms, he said. That ecosystem makes it difficult for manufacturers to easily and cheaply relocate.
Even the much-vaunted practice of moving to inland China is more difficult than many assume.
Minimum wages are significantly lower in central and western China compared to the coast. For example, the minimum wage in poorer counties of Sichuan province is RMB800 (US$127) per month, a little over half that of the RMB1,500 (US$240) minimum in Shenzhen. But that doesn’t mean companies can save 40-50% simply by moving inland. Unskilled workers on minimum wage make up only about 60% of total labor costs at most factories, said Ivo Naumann, Shanghai-based managing director at AlixPartners, a consultancy. The rest goes to managers and skilled employees, who are often reluctant to move to poorer areas. “If you’ve got a guy who knows how to run a plant in southern China, getting him to move to Chengdu is not easy,” he said. “Essentially it’s going to cost you a lot of money.”
Coastal cities like Shenzhen have also developed more generous labor laws since 2009: Companies looking to close factories and move inland face steep costs for severance buy-outs and de-contaminating factory grounds. Moreover, shipping from inland China to ports on the coast is expensive and unreliable – adding to costs and ruling out just-in-time supply chains. “If you add it all up, frankly it’s not that evident you’d be saving much money [by moving inland],” Naumann said.
Rather than moving, many manufacturers are coping with rising wages by shifting from labor-intensive to capital-intensive production. Whereas machines were once used only when producers needed to ensure consistency, they are now cheaper than unskilled workers in some parts of the country. Replacing workers with capital equipment is “by far” the most common response to rising wages, according to a Standard Chartered survey of 200 manufacturers operating in the Pearl River Delta.
Others are looking to move up the value chain, or at least focus their China production on more sophisticated goods. Austin of Top Form said that his firm has moved its basic underwear production to other countries but will continue to make expensive lingerie – which requires more experienced workers – in China.
This is happening on a national scale. The country’s share of labor-intensive low-end exports has begun to fall, while more capital-intensive heavy industry – mostly machinery – has grown from 29% of the total in 2001 to 38.7% today, according to Hong Kong-based GaveKal Research.
However, on a company level Top Form may be an exception. Most firms cannot simply upgrade their products, said Naumann of AlixPartners. “A toy is a toy. There’s only so much you can do with it.”
Other companies are reworking their supply lines to keep production within China, especially domestic producers who are often less comfortable building and managing an international supply chain than their foreign competitors, said Li Jie, head of strategic consulting at Jones Lang LaSalle. They are also more linguistically and culturally at ease with Chinese workers and officials, and like many other firms, are increasingly re-jigging their supply chains to feed into growing consumer demand at home, noted Rein of CMR China.
The final option is to pass on costs to consumers. Rein said that while China has acted as a deflationary force in the US economy over the past three decades, driving down the price of American consumer goods with its seemingly inexhaustible supply of cheap workers, it may soon become an inflationary pressure. “Americans better get used to higher prices at Wal-Mart, at Target,” he said.
Slow and steady
Some factors could speed the transition. As Beijing is keenly aware, a rapid appreciation of the yuan – perhaps due to American pressure or a desire to internationalize the currency – would make China’s producers less competitive overnight, and might lead to widespread lay-offs in the manufacturing sector.
Shipping costs are also a potential catalyst for change. An oversupply of ships has led to ultra-low freight rates for the past two years. The Baltic Dry Index, a gauge of the daily price of using a cargo ship, is at its lowest level since the depths of the financial crisis in 2008, and a mere fraction of its peak in 2007.
These prices are unsustainably low for shipping companies, some of which have been teetering on the brink of insolvency. When prices eventually rise back to their historical norms, it could incentivize manufacturers to place new factories closer to consumers – such as Mexico for exports the US, or Turkey for exports to Europe. These factors aside, however, the shift is likely to be slow and steady. Rather than tearing down old factories and building new ones abroad, change is coming about incrementally, as each new round of investment into machinery and factories is re-assessed for cost-effectiveness.
“China won’t be closing its plants anytime soon,” said Hal Sirkin, senior partner and managing director of the Boston Consulting Group. “But if you are going to put a plant somewhere that will last 20, 30 or even 40 years, you need to do a basic rethinking about location – if it should be in China, the US, Mexico, Indonesia or Vietnam.”
This is in line with other historical transitions away from manufacturing – of which there are plenty, said Leunig of LSE. Japan began its industrial boom with low-value silk and cotton textiles in the early 1900s. Around mid-century rising Japanese wages caused low-value production to shift to Hong Kong, and then on to mainland China. China will undergo the same transition, he said, but the key is time: Change takes decades, not years.
As the country becomes wealthier and growth inevitably tapers, China will ultimately need to make a shift away from manufacturing to maintain full employment, said Roach of Yale University. Exports will probably stay strong – China’s share of global exports actually increased in 2011 – but jobs will migrate to the service sector. “Services-based economic activity in China generates about 35% more jobs per unit of output than does a manufacturing-led model that supports investment and exports,” he said. If China can switch to a consumption- and services-based economy, even lower growth rates can support full employment.
That would no doubt reassure Beijing’s perennial concerns about employment, but it is cold comfort for al Fayed and his Yiwu suppliers. Al Fayed won’t know how much he will spend on the lamps this year until he calculates all the costs involved, including new regulation and compliance measures, shipping, distribution and local agent commissions. But it will almost certainly be more than last year.
Asked if he would consider sourcing from another country if costs grew too high, Al Fayed shook his head. “It’s just a lot easier here,” he said, waving his arm at the crowd of local vendors at the Yiwu International Trading Mart.