Original source: Caixin

Climbing wages and a diminished demographic dividend point to big changes for the manufacturing sector in China

As labor costs rise, China’s manufacturers are facing unprecedented challenges. Some are being forced to move to less expensive regions in the nation’s interior, others are shifting production to Southeast Asia, and some are shutting down.

Manufacturers may have been especially spooked by a report released May 5 by the U.S.-based Boston Consulting Group, which predicted a narrowing wage gap between the United States and China over the next five years. The report said the change will increase the number of Made in USA products appearing on U.S. store shelves at the expense of Made in China products.

Some wonder whether China’s labor-related challenges may threaten the country’s status as the world’s factory. Increasing numbers of manufacturers may relocate plants from China to India, Vietnam, Myanmar and Cambodia, countries that have been stepping up efforts to attract business and investment.

How much should China worry? Actually, the worrying is already over for some enterprises: They’ve closed shop.

An executive in the city of Jiaxing at Zhejiang Youbang Integrated Ceiling Co. Ltd., which makes integrated ceiling, said his firm is among the 90 percent of more than 500 local integrated ceiling enterprises that have managed to survive since wages started climbing last year. Others, though, have not.

“Since last year, there have been reports of enterprises collapsing, one after another,” the executive said. “About 10 percent went out of business.”

Taiwan’s Lovely Creation toy company operates two factories in Ningbo, Zhejiang Province. A company executive surnamed Chen told Caixin that her firm’s wages and raw material costs have increased more than 30 percent since last year.

Textile maker Shandong Feixian Dachang Co. Ltd. faces a similar challenge, according to the company’s regional manager Gao Yongjie. Higher wages contributed 30 percent of their products’ price rises.

‘Out of Control’

Demands for higher wages spread to Chen’s factories after a mid-2010 incident at a Foxconn electronics plant in Shenzhen, where labor unrest prompted the company to promise higher employee wages.

“The overall situation got out of control,” Chen said. “Workers kept on demanding wage hikes.”

Minimum wages have been rising as well. Almost every provincial government has increased its official minimum wage over the past year, with hikes averaging 20.6 percent during the first quarter 2011 in 13 provinces. And every minimum wage increase forces companies to pay more for worker social security.

The American Chamber of Commerce in China (AmCham) in April said in an annual report on U.S. businesses in China cited the challenges of rising labor costs and shortages. These issues have become a top priority for many companies, the report said.

Seventy-one percent of the executives interviewed by AmCham said wage hikes have had a negative impact or have resulted in major losses for their companies. Some enterprises with operations in southern China reported a more than 50 percent in increase in worker wages.

The report’s authors concluded that rising labor costs and worker turnover have weakened the capacity of China’s rapid economic development, as well as its competiveness on the global stage.

Meanwhile, Taiwanese and Hong Kong enterprises, which account for a relatively high proportion of foreign-based manufacturers in China, are increasingly looking toward Southeast Asia. Taiwan-based Foxconn International’s Chairman and CEO Samuel Chin said his firm may shift some plants inland and to northern provinces in China, as well as to new locations in India and Vietnam.

The World Bank has estimated that employers in China will have to pay an addition US$ 1.5 trillion between this year and 2015 in additional labor expenses. Rising wages are expected to raise labor costs as a percentage of the nation’s gross domestic product to 30 percent in 2015 from 15 percent today, it said.

The Chinese government’s economic roadmap for the next five years, outlined in the 12th Five-Year Plan, proposes synchronizing growth for personal incomes and the national economy. It also calls for more closely synchronizing worker compensation growth rates and labor productivity.

The AmCham report said China’s labor shortage is worse than in other parts of Asia in part because it affects the ranks of executives, project managers and skilled technical workers. Not only is this labor gap hindering existing businesses that want to expand in China, the report said, but it’s also making China less attractive to new investors.

Vanishing Dividend

Results from the latest census in China, released April 28 by the National Bureau of Statistics, confirmed forecasts about the nation’s population growth rate, which is declining, and overall aging, which is accelerating. These demographic factors will likely make a difference for manufacturers who in the past relied on China’s low-cost labor.

“Rising wages is not a short-term change, but rather a long-term one,” said AmCham President Christian Murck. “The root cause being the change in population structure.”

Between 2000 and 2010, the population growth rate has averaged 0.57 percent a year, down 0.5 from 1990-2000, census figures show. Experts have called this phenomenon a rapid decline.

Meanwhile, the average age in China is rising at an increasing rate. People who’ve reached age 60 and over accounted for 13.26 percent of the population last November, a 2.93 percent increase since 2000. And those 65 and older accounted for 8.87 percent, up 1.91 percent.

Ba Shusong, deputy director of the Development Research Center at the State Council’s Financial Research Institute, said the latest census figures confirm that China has passed the Lewis turning point, which describes the stage in the development of an emerging economy when labor shortages bring on inflation and slowing growth, and soon the demographic dividend window in China will close.

That dividend has given China an advantage over other countries as a manufacturing center and investment focus.

Harold Sirkin, a senior partner at BCG, expects China’s wages to grow at an annual rate of 17 percent through 2015, based on what’s expected to be appreciation of the yuan currency and comparatively higher labor productivity rates in the United States. That means net labor costs for China’s and America’s manufacturers will be on par by 2015.

“Over the next five years, businesses selling in the United States will reduce their investments in China,” Sirkin predicted. “And everyone will be seeing an increasingly greater number of Made in USA products.”

But that’s not the opinion of Shen Minggao, chief economist for Greater China at Citibank. Shen noted that in 2008 labor costs in China’s manufacturing industry were a mere 8 percent of those in the United States. So even if Chinese labor costs climb 15 percent a year, he said, it will take some time to reach America’s pay scales.

Shen also argued that, due to inadequate infrastructure and smaller market size, countries such as Vietnam and Cambodia cannot be expected to offer a new home for an entire industrial chain now housed in China. And if only part of an industrial chain relocates, various companies with links to the chain may face inconveniences and difficulties.

Productivity Factors

Many companies have found labor productivity rates in some Southeast Asian countries are not very high, Shen said, and that plants in these countries cannot meet rapid delivery and high quality requirements.

Shen thinks China’s manufacturing industry will retain plenty of strengths for some time. “An important reason is China’s strength as a large country,” he said. “Its industrial chain is extremely long, and it would be difficult for Southeast Asian countries to compete in this area.”

Stephen Green, a China economist at Standard Chartered Bank, noted that in addition to labor costs, companies site plants based on infrastructure, regulations, taxation, labor flexibility, and upstream and downstream industrial chains.

Green’s bank recently studied 80 companies that manufacture for export and found only six enterprises had moved from China to escape higher wages. He told Caixin that textile and shoe makers are among the most likely to consider moving to another country.

Meanwhile, many enterprises have chosen to move to inland provinces in China, away from traditional manufacturing bases along the east coast. Standard bank researchers found eight of nine Taiwanese enterprises based in the Shanghai area were considering shifting to production bases in other parts of China.

Many Wenzhou-based enterprises in Zhejiang have been willing to move operations inland, where land is less expensive and local governments offer preferential policies to attract business and investment, said Zhou Shikun, deputy director of the Wenzhou-based People Electrical Appliance Group’s Northwest office. He added that more finished goods are being sold in inland provinces as incomes rise, and that transportation systems are becoming more convenient in these regions.

Fudan University’s Professor Peng Xizhe, vice chairman of the China Population Association, thinks the shift of labor-intensive industries to inland provinces will provide more opportunities over the next five years. But later they may move to India and Vietnam.

AmCham’s Murck says some enterprises will find it difficult to move away, such as those that manufacture notebook computers, for which labor accounts for a very low percentage of overall costs.

The opportunity to tap China’s huge domestic consumer market is also expected to keep some manufacturers from drifting away, said Ting Lu, China economist of Bank of America Merrill Lynch.

Another plus for Chinese manufacturing is that some companies are adapting to labor trends by turning toward automation. Imports of labor-saving machines and equipment have been increasing since the second half 2010, and China is now the No. 1 customer for machine tool equipment exported from Japan. Fixed asset investment in manufacturing rose to 35 percent from previous 30 percent.

Shen thinks raising labor productivity rates are of paramount importance to China, because unless productivity improves “enterprises will leave” China.

Shen estimated labor productivity in China’s manufacturing sector has risen by about 10 percent annually over the past decade. If an annual consumer price index growth rate of 4 percent is factored into the equation, he said, enterprises should be able to a nominal increase in labor costs of about 14 percent annually.