Has China Reached its Peak? 

"*This article was reprinted, with permission, from" High Growth Markets "magazine (April 2011)."


Report by Jamil Anderlini, business editor based in Beijing


"Over 150 million Chinese have moved from country to factory, but now the pool of rural labor - once regarded as virtually limitless - is finally beginning to dry out. Wages are rising, production is relocating, and the "China price” will soon be a thing of the past."


The year 2010 will be remembered as the moment when China's seemingly endless supply of cheap, semi-skilled labor began to run out, and the country's role as the workshop of the world was called into question for the first time. Starting in May last year, a series of strikes at Japanese automobile factories in southern China grabbed headlines as angry workers demanded better working conditions and pay increases of at least 50 percent. Honda and other producers were temporarily forced to suspend production at car-assembly plants across the country, and eventually agreed to raise wages by 30 percent and more in some cases.


Another headline-grabbing labor crisis also broke out in 2010 at Foxconn, the world's largest contract electronics manufacturer, which counts companies such as Apple, Dell, and Hewlett- Packard among its biggest customers. A spate of suicides at Foxconn's Shenzhen factory-cities (which employ more than 400,000 people living in virtually self-contained communities) attracted intense media attention and was followed by Foxconn agreeing to a series of wage increases. Meanwhile, in a less-noticed trend, regional governments in every part of the country quietly raised their regional statutory minimum wage, in some places by as much as 40 per cent.


The big spike in labor costs, particularly in coastal manufacturing centers such as the Pearl River Delta, has led many economists to conclude that China has either already passed or else will soon hit its "Lewisian Turning Point” - the moment when the pool of surplus agricultural labor tapers off, leading to big jumps in industrial wages.


Cai Fang, head of the Institute of Population and Labor Economics at the Chinese Academy of Social Sciences, says that wages for migrant workers rose by 2-5 percent in the early part of last decade and by about 7 percent between 2004 and 2007. But in 2009 they leapt by 16 percent and are expected to have increased by an even bigger percentage last year.


Labor shortages may seem like a strange concept in the world's most populous nation, but today they are discussed in boardrooms all over the world as companies grapple with the implications of the impending end of China's modern economic growth model.


Demographics are probably the most important factor in the drying up of China's previously "limitless” supply of cheap, pliant labor. First, strong economic growth and urban job creation in the last 20 years have already pulled around 150 million people out of the countryside and into the cities to work in factories, on construction sites, or in the services sector. Second, China's one-child policy, introduced in the late 1970s, means that the overall Chinese population is set to start rapidly aging over the next decade, leading many economists to ask whether the country can get rich before it grows old labor supply will peak in 2017, and that by then demand will exceed supply to the tune of 17.6 million workers - equivalent to nearly one-third of Japan's entire labor force. "In our view, China is currently standing at a historical turning point; the best time for China as the world's factory is now behind us and the best time for China as the anchor of global disinflation is now behind us,” says Credit Suisse chief economist Dong Tao.


According to government census data, the number of people between 20 and 30 years old - the people that the manufacturing sector most relies upon - has already started to fall as a result of the one-child policy.


Government policies have also been important in reducing the potential pool of new migrants for the urban labor force. Increased government directed investment in agriculture and rural infrastructure, as well as better social welfare programs, have made migration to the cities for a life of industrial drudgery less attractive. And hukou, China's traditional system of household registration, does not allow rural migrants to gain legal permanent citizenship in urban areas, which means that they are excluded from many social welfare and social insurance programs after they move to the cities.


Mary Gallagher, associate professor of Political Science at the University of Michigan and author of Contagious Capitalism: Globalization and the Politics of Labor in China, argues that as well as becoming scarcer, China's migrant workers are also more demanding, more rightsconscious, and more attuned to the inequality of treatment and opportunity they face as secondclass citizens in China's modernizing cities. In other words, the current generation of single child "little emperors” is simply not willing to "eat bitterness” in the way of its parents' generation.


This means factories must offer much higher wages if they want to attract rural citizens who previously saw migration to coastal manufacturing jobs as the only alternative to rural poverty. Credit Suisse estimates that the salaries of migrant workers rose by an average of 30-40 percent in 2010, and will likely rise by 20-30 percent every year for the following three to five years. This trend is actually encouraged by the Chinese government, which has made a conscious decision to raise workers' wages. While this will add to inflationary pressure and reduce China's future competitiveness as a global manufacturing base, it could also strengthen domestic demand and improve equality of income distribution after 21 consecutive years of declining labor income as a percentage of GDP.


The new attitude in Beijing is summarized by Fan Gang, professor of economics at Beijing University and the Chinese Academy of Social Sciences, and a former member of China's Central Bank Monetary Policy Committee. "While cheap labor has been a key factor in generating high growth over the past three decades, it has also contributed to profound income disparities, especially in recent years, and persistent, widening inequality might cause social crises that could interrupt growth and damage competitiveness,” wrote Professor Fan in a recent essay. "China must avoid such a scenario, and if wages could increase in some meaningful way, it would indicate that the economy might finally reach the next stage of development, during which income disparities would be narrowed.”


The historic end to ultra-cheap labor has forced many multinationals and even some large Chinese companies to consider various alternatives to their current concentration of operations in China's coastal manufacturing belt. India, with its much younger (and relatively poorer) population, overtook China recently as the most attractive overseas investment destination for Japanese manufacturers over the next decade, according to a survey by the Japan Bank of International Cooperation. China has held the top spot in the survey since 1992, and the key reason for its drop in the rankings was the rise in labor costs, although perennial bilateral tensions between Tokyo and Beijing also played a part.


Executives at global companies in Beijing say the previous strategy of concentrating all their attention on building up manufacturing in China has been replaced by a more diversified approach to regional strategy. "We've gone from putting all our eggs in the China basket to looking at distributing them more evenly around the Asian region,” said one China CEO at a top multinational company who asked not to be named because he did not want his relationship with the Chinese government to be harmed. A survey of global business executives conducted late last year by Columbia Business School found that China's growth would likely drop from current rates of 9-10 percent down to around 6 percent over the next decade - in part due to rising labor costs, corruption, and inflation.


But all of this does not mean China's global dominance of manufacturing is about to end tomorrow. International executives stationed in Beijing point out that, even after the recent wage inflation, labor costs are still low in China from a global perspective, and factories are not easily or quickly packed up and moved to new countries. China's comparatively excellent infrastructure is also a huge advantage over a country like India, whose clogged-up roads and decrepit rail system are seen as a major hurdle to economic growth. The Columbia Business School survey found that although India was expected to grow faster than China in the coming years, India's growth would be constrained by poor infrastructure, corruption, and government inefficiencies.


In India and in other developing countries, the failings of public education systems have led to concerns that their economies could miss out on the comparative advantage of huge young populations because new workers may not learn the necessary skills to enter the productive workforce. "Companies will only leave for Vietnam, Bangladesh, or Mozambique if the other countries' wages are relatively more efficient and not just because Chinese nominal wages go up,” says Professor Fan. "For now, this does not seem to be the case in general and the conclusion seems to be that wage growth will not threaten China's competitiveness in the next 10 or even 20 years.” Instead of leaving China, many domestic and multinational companies are shifting manufacturing operations away from the coastal regions inland to places where labor is cheaper and more abundant. Foxconn, the iPhone and iPad manufacturer, has already announced plans to build a new factory in the central Chinese city of Zhengzhou, where it hopes to employ up to 200,000 workers. "In effect, companies are migrating rather than workers,” says Mark Williams, senior China economist at Capital Economics. "The rise in labor costs is pushing this shift, but there is a pull too: if consumption starts to grow again as a share of GDP, many of the strongest growth opportunities will be in rapidly growing inland markets and it will make sense for many companies to locate themselves closer to them.” This logic explains the willingness of Beijing to allow wages to rise as part of a wider push to rebalance the economy and address widening income disparity.


This strategy fits with the goal outlined in China's latest five-year plan, which begins this year, to move the country's manufacturing sector up the technology ladder and encourage companies to produce more high-tech products, ideally ones that include Chinese intellectual property.

Economists say China will remain unmatched by other developing countries for many years to come in terms of efficiency of government administration such as tax rebates and customs clearance as well as infrastructure such as roads, rail, and ports. And the increasingly attractive domestic market, boosted by higher wages leading to greater consumption, will become a much bigger force in convincing companies to retain their manufacturing operations in China.


In the traditional manufacturing centers of the Pearl and Yangtze River Deltas, the shift up the manufacturing value chain is already evident, with factories producing many more high-tech products and research and development investment flourishing. But analysts say the biggest winners in the new era of rapidly rising wages are likely to be in China's service sector - including tourism, online shopping, healthcare, and financial services.


Meanwhile, the rise in Chinese labor costs could come as a shock for a world that has grown used to the "China price” for ever-cheaper consumer goods.


Ten years ago, Andy Xie, an independent economist who was formerly Morgan Stanley's China expert, came up with a formula - whatever China buys, the price will go up, and whatever China sells, the price will go down. "I recently modified that statement,” says Xie. "I would now say that, whatever China sells, the price will go up too, because I expect China's factory wage to quadruple over the next decade.”