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07 Mar. 2013 | Comments (0)

Welcome to the next installment of The Conference Board China Center Chart of the Week series, hosted here on the Human Capital Exchange. This week, we’re exploring an unprecedented subject that undermines the conventional wisdom that China’s low-cost labor advantage is functionally limitless.

Chinese wages are rising, fast. However, the challenge for China is not merely focused on how quickly local employers can adjust to cost increases, but whether or not the country can maintain anything close to its current economic model given a systemic decline in overall competitiveness. The problem is not that wages are growing in the Middle Kingdom (this is actually good news for Chinese workers and a sign of a properly developing economy), but the alarm bells are ringing because a commensurate increase in productivity has not been forthcoming. Chinese workers are making more money than ever, but not producing an equivalently increased level of output. This is how the “Unit Labor Cost” (ULC) statistic is derived, and it reflects the approach of an alarming decrease in global competitiveness for China. Chinese labor is still vastly lower-cost than American labor, but if China continues to fall behind in the all-important ULC category, it will make increasingly more sense for manufacturers to either move back to a high-cost, high-productivity zone, such as the U.S., or move their businesses to a less-developed country with labor costs more akin to the Chinese workforce ten years prior.

China can avoid a calamitous unemployment crisis by increasing the productivity of its newly middle-income manufacturing laborers, transitioning its economy to a services- and consumption-led model, or, ideally, both.  However, the rapidity with which China is losing its low-cost labor edge has to be dizzying for leaders in Beijing.

 

  • The blue bars in the chart represent China’s unit labor cost – the average cost of labor per unit of output (ULC) – as a percent of the United States’ ULC. The red line represents the annual growth trend for China’s ULC. Growth in a country’s ULC is a key measure of its competitiveness, particularly in relation to changes in the economy’s labor productivity – an increase in labor efficiency can offset an increase in wages. In relation to the U.S., China’s labor costs have risen rapidly since 2003, despite the fact that China gained significant scale within the world manufacturing market during that time. Because Chinese labor productivity grew quite rapidly during the period, exporters and manufacturers for domestic consumption were able to absorb cost rises through increased production per worker.

  • However, in recent years China’s labor productivity growth has begun to decelerate, despite the fact that the country’s overall labor productivity levels remain quite low compared to more advanced countries – e.g. 17 percent of the U.S. as of 2011. Slower productivity combined with continually rising costs will eventually begin to eat into China’s overall competitiveness. This erosion will manifest in lower profitability for manufacturing and industrial firms – a situation that has become noticeable in 2012. So far this year, profits at China’s largest industrial firms are up only 0.5 percent year over year through October, compared to 25.3 percent in 2011, and 54 percent in 2010. Industrial and manufacturing firms have also been hurt by diminished demand (both at home and abroad) and by high inventory levels throughout this year, but demand is unlikely to return to its previous growth rates in the foreseeable future – due to a weak global economy – even as labor costs continue to rise.

  • Manufacturing wages in China increased 20 percent in 2011, and the government has made increasing wage levels, particularly for minimum wage earners, a priority for the coming years. While this development is certainly positive for workers, lower labor productivity and the resulting reduction in profitability may begin to reduce China’s attractiveness as a manufacturing location. Indeed, “re-shoring” and “near-shoring” have recently become buzzwords among many producers in the developed world. Still, rising labor costs are unlikely to cause an immediate and dramatic shift away from China’s manufacturing sector. While it is an important consideration, labor costs are obviously not the only factor that companies use in determining where to locate their production facilities. Factors such as logistical capacity, quality of infrastructure, and proximity to the vibrant Chinese consumer market all continue to work in China’s favor.

  • The ULC dynamic is natural for China’s maturing economy and underscores the need for China to transition its growth model. China’s economy will continue to slow as productivity gains throughout the economy dissipate and returns on investment diminish – both of which are likely to have a pronounced and lasting effect on manufacturing profitability. With continued upward pressure on costs, manufacturing firms will be forced to become more innovative and value-adding. Service sector production should, thus, become more attractive for capital investors, and the relatively higher wages generated by service industries should act to support consumption and services demand.

This report is part of a series of Conference Board China Center Charts of the Week that we share on the Human Capital Exchange. For more information about the China Center and its research, please contact our China Program Specialist, Ethan Cramer-Flood, at ethan.cramerflood@conference-board.org.

  • About the Author:Andrew Polk

    Andrew Polk

    Andrew Polk is the Co-founder and Head of Economic Research at Trivium/China, a Beijing-based strategic advisory firm.Before founding Trivium, Polk was the China Director at Medley Global Advisors, wh…

    Full Bio | More from Andrew Polk

  • About the Author:Ethan Cramer-Flood

    Ethan Cramer-Flood

    Ethan Cramer-Flood is a Senior Fellow of The Conference Board’s China Center for Economics and Business.  Based in New York City, he helps direct the Beijing-based China Center and supports…

    Full Bio | More from Ethan Cramer-Flood

     

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