Paradise reconsidered

The cost of labor will continue to increase in China, but exporters and foreign outsourcers should not rush to relocate

Paradise reconsidered

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Labor costs in China are rising fast. Between 1995 and 2008, the average Chinese annual wage increased from RMB5,348  (US$819) to RMB28,898 (US$4426), an average growth rate of 14.2%. Manufacturing labor costs are keeping pace. In the last two decades, manufacturing firms have seen their labor costs increasing annually at 14.8%. Even if the high inflationary period of the early 1990s is excluded, labor costs still grew at about 13% per year.

At the same time, labor shortages have become regular phenomena in China’s coastal regions. That labor shortages exist in a labor-abundant country indicates further upward pressure on wages. While every sector is impacted by higher salaries, the effect on the export-oriented firms is especially strong given the export sector’s particular dependence on labor.

The trend is likely to continue and even accelerate. For Beijing, helping labor represents an opportunity to correct a variety of social and economic imbalances. For China’s exporters, and for foreign firms outsourcing production in China, it necessitates a strategic re-think.

Macro and demo
The reasons for the increase in wages are myriad. At the demographic level, China is running low on workers. From 1950 to 1980, the country’s population exploded from 500 million to one billion. But after almost 40 years of family planning, China’s demographic dividend is close to depleted.

On the economic front, even as salaries have ballooned, workers’ share of GDP has declined steadily. In 1997, labor compensation accounted for 53% of GDP. By the end of 2010, it was less than 40%. In this self-proclaimed "workers’ paradise,” laborers’ share of the income pie has shrunk even as the Chinese economy charges ahead. Capitalists’ share of GDP grew from 20% in 1997 to 31% in 2007. This decline of labor income’s share of GDP has coincided with the decline of consumption relative to investment. Private consumption made up more than half of GDP during the early reform years. By 2009, it was only 36%.

The central government recognizes this fundamental imbalance. Making growth more sustainable is a key focus of the current five-year plan. The emphasis is now on domestic demand to drive the economy, with private consumption playing a more significant role in increasing that demand. For the government, this means implementing reforms to increase household income, and by extension increasing labor’s share of GDP.

To this end, Beijing is increasing the minimum wage, increasing enforcement of the minimum wage law and widening implementation of the collective wage consultation system, which shifts bargaining power back toward labor. At the same time, the new Labor Contract Law passed in 2008 continues to increase the cost of labor for businesses by strengthening protection of workers’ interests.

Even if wage compensation grows at the same pace as China’s nominal GDP, holding labor income’s share to its current level of about 40%, companies in China will still see their wage bills increase by more than three times by the end of this decade. But China’s labor costs are likely to grow even faster than that. The government has targeted a real GDP growth rate of 8% and an inflation rate of 4% a year for the next five years, which implies 12% targeted nominal GDP growth. If the renminbi continues to appreciate at its present average rate of 3-3.5% per year, China’s wage rate in US dollar terms will surpass Mexican wages in the second half of this decade.

Just as significantly, the mainland will close its wage gap with Taiwan in the next 10-15 years.

Where to go?
What should export-oriented manufacturing companies do? Returning home is still not much of an option for Western firms. China’s wage rate is still far cheaper than American salaries. If we normalize the US wage to US$100 per hour, as of 2008 the hourly wage of Chinese manufacturing workers was still only US$4.20. At the current pace of currency appreciation, Chinese wages will remain less than one third of US rates by the middle of the next decade.

What of other developing countries? Here, China may well lose its labor-cost advantage. Some companies are already moving south to Vietnam, Cambodia or Bangladesh to take advantage of their substantially lower wage rates.

But wage rates are only a small part of the equation that companies consider when deciding where to locate production. For example, while labor costs in Vietnam are around one-third less than Chinese labor, Vietnamese labor productivity is also low. In addition, Vietnam has inefficient infrastructure, stifling government regulations and bureaucracy, and higher inflation. The country also lacks complete industrial value chains in many cases, in particular in textiles and fashion. Nor are such countries immune from wage inflation. The Vietnamese nominal wage rate has gone up by 16% per year since 2000, while its labor productivity has only improved by 12% annually. In comparison, even though China’s labor costs have been rising annually over 14%, its labor productivity has been increasing by close to 20% every year. Companies moving south to supposedly cheaper Southeast Asian nations may be ultimately disappointed in the net cost savings they realize.

Staying put
Moving inland is another option, given that the coastal regions have higher labor costs. Some companies have already done so. Intel, for example, built a large manufacturing and testing campus in Chengdu, Sichuan province. APL, a large ocean shipping company, recently relocated its 500-person back-office from Shanghai to Chongqing; the company expects to save around US$1.5 million in the first year following the move.

In 2010, electronics contract manufacturing giant Foxconn (which makes Apple’s line of mobile devices) built a facility in Henan province in central China that employs 200,000. Foxconn expects to save RMB16 billion (US$2.45 billion) in its first year of operation by avoiding Guangdong, its primary hub.

However, moving inland is not a permanent fix: Labor costs are rising faster in the western provinces than on the coast. For example, while Guangdong’s wages increased 12% in 2008, they increased 18.4% in Henan. Any labor cost advantage commanded by the western provinces will be short-lived.

There is another option available to export firms located on China’s coast: staying put. But to stay put without going out of business, companies must stay active. To compensate for higher labor costs, manufacturing firms need to improve and innovate.

A good example of the benefits of such a strategy is Glory Shoes Industry, the largest utility boot manufacturer in the world. Its Pearl River Delta plant employs over 7,000 workers. Glory makes shoes for brands such as Caterpillar, Wolverine, Bates and Timberland.

In 2007, in reaction to rising labor costs on the mainland, the company set up operations in Bangladesh and Cambodia. After three years, Glory found that total per-unit production costs in China were still lower than in either of its foreign locations. Glory has since begun to focus on improving efficiency at home. The company bought better machines, implemented lean production methods and deployed an enterprise resource planning (ERP) system. Before it began running an ERP system, Glory usually held US$15 million worth of inventory on any single day, and turnover time was 45 days. After ERP implementation, daily inventory has been reduced by more than 50%, and its turnover time dropped to 14 days.

Another example is Ramatex Industrial, a Singaporean company with a vertically integrated cotton textile manufacturing facility in the Yangtze River Delta. The processes it uses are highly capital- and labor-intensive. The most labor-intensive part of production is sewing, and if Ramatex had specialized only in sewing, it may have been compelled to move to the interior or another country.

But as an integrated textile firm with most of the production process done by machines, Ramatex is able to cope with the labor cost increase: Its major cost component is materials, not labor. Given that China is the largest cotton producer in the world, Ramatex is staying put, recognizing the excellent logistical support and port access it currently enjoys.

At the moment, therefore, many companies have decided to stay in China by focusing on better process and better technologies, and this is probably wise. But in the next 10-15 years, China will no longer be a nation of cheap labor. Laws and regulations designed to protect labor’s interest will be more rigorously enforced, and the balance of power will shift toward the worker.

The danger, of course, is that by adopting the European welfare state labor model at a time when its population is aging rapidly, China’s comparative advantage in labor cost may erode before it actually moves up the value chain, leaving China stuck in the infamous middle-income country development trap. Let’s hope China manages to re-create a workers’ paradise without putting itself out of business.