China’s unprecedented 25 year economic boom, which has transformed the country from a regional player at best to the world’s second largest economy, has been driven by rapid industrialisation enabled by scale and cost competitiveness. Low labour costs and an attractive exchange rate have been key enablers for China’s position as the go-to location for manufacturing everything from sneakers to solar panels. During this time, China has built economies of scale that have helped ensure competitiveness despite the emergence of even lower wage alternatives countries such as Vietnam, Indonesia and Bangladesh. As China continues to develop economically and its citizens grow wealthier and the next generation feels more entitled, core manufacturing competitiveness will likely continue to erode. China will be faced with the challenge of increasing productivity to compensate for wage growth in order to stay competitive across large parts of its industrial base. This paper looks at three scenarios of China’s competitiveness through 2025 and the likely implications for the country’s development and economic opportunity and the key implications for others.
The Challenge: The Cost of Success is Wage Inflation
In theory as well as practice, as the modern sectors of a low-income country expand, its cheap labour supply (usually from the rural sector’s labour surplus) disappears over time and the country experiences real wage increases. In China, the government has been able to moderate wage growth to a certain extent, due to controlled currency convertibility and the large participation by the state in the private sector. Despite these levers however, as the country gets richer, its increasingly urban population’s expectations of wage levels and working conditions continue to rise, slowly eroding the China cost advantage. The tables below capture wage growth in China and their impact on competitiveness, with Table 1 showing nominal wage growth and Table 2 showing declining competitiveness (defined as productivity/wages).
China’s leaders have clearly recognised this trend and have accordingly been actively rebalancing the country away from investment led growth and industrial manufacturing towards a more consumption-driven and services-led growth model. While in the long run this rebalancing should drive the growth of sectors with higher productivity and enable competitiveness despite rising wages (and an appreciating currency), for a long time to come, China is likely to continue to be highly dependent on industrial output and manufacturing for some time. Given the size of China’s industrial base today, even a rapid expansion of high tech and services may not be able to pick up the slack that is created by manufacturing migration to other countries due to wage inflation. Accordingly, the likely shapes of the wage and productivity curves above remain critical to China’s ongoing development, and China will need to continue to manage one or both of these aggressively. The loss of competitiveness from a failure to do so will negatively impact growth, increase unemployment and likely affect social stability adversely too.
The Scenarios for China’s Cost Structure
Three potential scenarios are sufficient to paint a picture of China’s wage cost and competitiveness from now through to 2025, described below in summary along with their likely drivers and execution considerations. Each scenario considers the potential impact of nominal wage growth, inflation, currency appreciation and productivity on China’s cost competitiveness.
Scenario I: Low Cost Growth - China Remains the World’s Factory. In the first scenario, China manages to keep real wage growth low for the next decade at about 3% annually, and manages to retain a large portion of its current manufacturing scale even while making continuing investments in productivity enhancement, thereby actually increasing competitiveness, regaining a low cost position on par with India’s current one by 2024. Doing so will be challenging however: While the percentage of the population employed by state-owned enterprises will continue to drop, reducing the government’s ability to directly control wages, China today still has a large surplus of potential agricultural labour that has yet to be unlocked. The large influx of migrant labour created by potential agricultural modernisation would serve to keep real wage growth low, while continuing investment would increase productivity, allowing China to maintain a reasonably high rate of competitiveness across a wide range of sectors, including basic manufacturing. However, doing so would require the country to create the social, political and physical infrastructure required to absorb an accelerated flow of migrant workers, something its leadership has struggled to accomplish even at the current levels. Many of the key government reforms being enacted by the Xi regime, the expansion of social benefits (healthcare, pensions, etc.), urbanisation and hukou reform are all closely tied to this issue. Keeping real wages low while maintaining social stability, itself the paramount objective of the Chinese Communist Party, would require it to significantly accelerate the scope and scale of all of these initiatives. It would also require the Party to keep expectations of this new labour pool in check such that they were content to come in to the work force at wages that would be competitive with Vietnam, Indonesia and Bangladesh, to name a few. Given the challenges facing China’s rulers at the current scale and scope of reform in these areas, this acceleration of policy, while strengthening the central control over wages, appears to be unlikely, at least in the short-term.
Scenario II: Medium Cost Growth – Divergence and Diversification.In the second scenario, wages continue to increase at a moderate rate of approximately 6% with comparable increases in productivity. In this case, average competitiveness would remain largely flat over the period. Average competitiveness however does not paint an accurate picture of China’s regional and industrial diversity. While the average wage is certainly increasing, China’s central and western regions are doing so from a much lower wage level, due to a significant East-West divide in incomes. With the average annual salary of urban non-private (i.e. state-owned and government employed) employees varying by over 70% (and salaries in the private sectors most likely varying even more), Western China is likely to remain a centre for much of the manufacturing that will migrate out of the increasingly expensive Chinese coastal regions. These regions on the other hand will be forced to invest in higher value sectors where labour costs play a declining role in determining competitiveness, in keeping with the central government’s economic rebalancing strategy, or risk being trapped in the middle: unable to compete at the low end due to high costs and unable to compete at the high end due to a lack of skills and productivity. In such a scenario China can leverage its regional divergences through industrial diversification over the short term, while working to close the wealth and development gaps over the long term. As an example, recent hikes in minimum wages all across China are aligned with the government’s initiatives to accelerate the country’s process of industrial restructuring.
Scenario III: High Cost Growth - Managing the Middle Income Trap.In the third scenario, the wages in China continue to appreciate at accelerated growth levels, averaging 9% annually over the next decade. In this scenario, the negative impact of wage increases on industrial competitiveness and inflation are however at least be partially offset by accompanying productivity improvements, but not sufficiently to prevent a decline in competitiveness to below the levels of some ifs advanced industrialised neighbours such as South Korea. China today is actively managing the levers of development to avoid the middle-income trap (in which growth stalls following a period of rapid growth but before reaching the development standards of advanced economies ), among which the increasing investments in R&D and education are the most significant. China has doubled its R&D intensity in the past decade, from 1% to currently 2% of GDP, with a target of 2.2% by 2015 laid out in the 12th Five Year plan. Provided that China is able to continue this R&D build-out and translate its investments into applied innovation, the resulting productivity gains will maintain competitiveness across critical sectors. Assuming a reasonable rate of overall productivity gains, China’s higher cost regions in 2025 will still likely be comparatively priced for high value industrial and post-industrial sectors such as high end automotive, semiconductors and software development. In other words, in a high wage growth environment, the criticality of managing China’s“Costs in China are likely to rise due to systemic factors such as its ageing population, its increasing pension and social security liabilities and rising perception of China risk which in turn will slow down inward capital flows.” industrial transition will only increase. Finally, across all scenarios it is worth noting that costs in China are likely to rise due to systemic factors such as its ageing population, its increasing pension and social security liabilities and the rising perception of China risk which in turn will slow down inward capital flows.
Implications for China in Maintaining its Cost Advantage While Managing the Transition to Higher Value
The three scenarios are perhaps better seen as a picture of the transition of the Chinese economy rather than discrete and sustainable policy choices. To battle to keep China in Scenario I of low costs seems to fight the success that has placed China at the centre of the world’s economic stage, and “It is clear that China is heading towards an early maturing and the dilemma of high cost growth that faces modern economies world over.”in turn delivered political clout. The diversification strategy implied in Scenario II can provide temporary respite but is not a permanent solution, given that wage growth tends to accelerate during industrialisation and the regional wage gap will close faster than it opened. The wage increases implied by Scenario III, with their negative impact on competitiveness, are the likely destination of China. Therefore, China will need to simultaneously build strength in new sectors and industries while managing increasing costs to not relinquish its recent successes too soon. In order to maintain its industrial competitiveness during the transition to a consumption led, high value added economy China will need to accelerate the implementation of three policy objectives, pursued in parallel:
- Psychological Shift: Establishing the Mind-set that Migration to Higher Value is a Means for Achieving Greater Social Equality and Quality of Life.This requires enabling wider public participation in China’s development by expanding services and benefits to allow continued migration from rural agriculture to urban industry while maintaining social stability.
- Next Wave of Industrial Policy: Accelerating Central and Western China’s Development and Industrialisation.This would aim to accelerate the industrialisation of central and western China to capture the migration away from China’s traditional manufacturing bases.
- Migration of Economic Strength: Development of Value Added Economy in Central and Eastern China. Initiatives would be required to develop the value added economy and sectors in Central and Eastern China through investments in applied R&D, critical infrastructure and education.
It is clear that China is headed towards an early maturing and the dilemma of high cost growth that faces modern economies world over. The question is how fast will it get there? Assuming a not unrealistic 9% annual wage growth, the average worker in Beijing will earn over US$20,000 per annum before the end of the decade. This short fuse can only add to the urgency facing China’s leaders to complete the implementation of the above policy objectives.
There are more far-reaching implications for China in three areas: social development, trade, and international relations. The headlines of these are obvious once we juxtapose the results of the scenario analysis above with the implications for the rest of the world. Although there is of course time to manage the implications, in general, time compression is a sign of our times.
Far-reaching Implications for the Rest of the World from China’s Falling Cost Competitiveness
Given the China’s stated objective to transition to a higher value economy and the fact of its rising cost structure, the likely loss of China’s industrial competitiveness there are a number of key factors to put high on the agenda of policy makers among China’s trading partners.
- US.The US shale gas finds are projected to dramatically change the cost structure and export strength of the US. The US will also face the choice of enriching the shale gas industry by allowing it to export or enriching the nation by driving its energy cost down by restricting exports.“The advent of a decade with a higher cost China and a lower cost America would shift the global corporate, investment, financing and geo-political scene in America’s favour.”Notwithstanding, the domestic and geo-political considerations that may water-down the impact on US comparative costs, the US stands to gain ground relative to China if it executes swiftly and on scale. The advent of a decade with a higher cost China and a lower cost America would shift the global corporate, investment, financing and geo-political scene in America’s favour.
- Europe.Europe seems unlikely to create any new fundamental drivers that significantly increase competitiveness but it will likely manage to sustain its position in the highest value added sectors over the medium term, at least until China develops the experience and expertise required to re-set the scale of these sectors and effectively commoditises them. Before this happens, Europe has the time to re-examine the economics of its region and determine how best to unlock the value of its bloc.
- Japan.Although Japan’s long term industrial outlook vis a vis China is similar to Europe’s for mass manufacturing sectors, the country benefits from two distinct factors: firstly, world class R&D intensity (at 3% of GDP annually) has ensured that Japan continues to innovate and lead in a number of high value sectors, and; secondly, Japan, as a regional neighbour and a nation that has been on China’s development path within the past 50 years, is a potentially important partner trading and industrial for the country. Both countries clearly have a lot to offer each other. However, unlocking the value of this partnership requires real and sustained rapprochement between the two.
- IV. South and Southeast Asia.These emerging and growing “These emerging and growing economies of Asia are the natural beneficiaries of China’s rising cost structure.”economies of Asia are the natural beneficiaries of China’s rising cost structure, being key destinations for international manufacturers as they diversify away from China in search of lower cost producers. Countries in the region will need to develop the appropriate policies and strategies to attract FDI and know-how to scale the relevant industries, secure natural resources and emulate the development pathways taken by other industrialising countries.
- India.Indian today has the potential and the scale to be a primary destination for international manufacturers and high value added industries as an alternative to China, but only if it can demonstrate investor-friendly policies and a stable economic policy. In this regard, India today still has much to prove. However, many of the country’s current challenges are self-inflicted and the potential path to double digit GDP growth is not as difficult as many have imagined (see last month’s Sign of the Times).
- Brazil, Venezuela, Africa, Middle East and China-Dependent Commodity Supplying Nations. Natural resource rich regions will continue to partner with and serve a resource-hungry China but will also find their customer base expanding to the US as it revives and to the next wave of high-growth low cost countries, particularly as the nature of commodities demand coming from China changes due to more consumption led growth.
Without establishing the conditions for a truly innovative business culture (there is much confusion between business acumen and innovation in the popular analysis of China), it is not clear that China is the economic threat that it has sometimes been seen to be to advanced innovative economies. However, the emergence of China in higher value sectors will shake up those that are pretenders in this space rather than true innovators.
China’s next transition provides an opportunity for the world to challenge its own thinking; is China an enduring threat to employment at home, a destination for the world’s products, a difficult wall over which they will not be allowed to climb or another country (albeit much bigger than the Asian economies before it) going through a transition from being poor to wealthy (with all the issues that implies)? At the end of this analysis, we might well find that China’s rise based on its low cost structure was the massive opportunity to invest and to reduce cost structures worldwide that the world has experienced to date; the plateauing of its cost advantage is an opportunity to diversify“China’s next transition provides an opportunity for the world to challenge its own thinking; is China an enduring threat to employment at home, a destination for the world’s products, a difficult wall over which they will not be allowed to climb, or another country going through a transition from being poor to wealthy.” and gain from the rise of many other nations; and the fall of China’s cost advantage and the rise of its consumer is an opportunity to invest in China’s consumer story and selected high value activities rather than its manufacturing base. Clearly this is not and will not be a smooth process and there will be political and economic missteps along the way. However, it is possible that this natural process may have been misread as a global power shift rather than the natural path of economic development. China will also need to consider how best to re-set its relations with the rest of the world in this next phase. The aggressive trading culture required to succeed as an acquirer of natural resources and a low cost exporter will not be valuable for a nation that is a supplier of high value added services, content and product. This has far-reaching implications for China and the world.
China has had one of the most impressive set of leaders over decades leading the country to its current position. The strengths that this team have established should not be under-estimated. These are very difficult to match for any of the contenders. While wages and productivity are clearly key factors in determining whether China maintains an edge in a given set of industries, they are not the only ones. Labour skill, infrastructure, tax and trade policy and the quality of the supply chain are also critical determinants of ultimate manufacturing competitiveness. China has established itself as the global benchmark for many of these factors and accordingly, even in the third scenario, China will not be easily beaten by new players seeking to shift manufacturing away from China. Furthermore, lower-cost countries will lack both the skills and the scale to absorb all of China’s current production volumes. In the absence of scaled and high quality alternatives, even a more expensive China will remain competitive for a while for many sectors. This does not mean that China’s leaders can be complacent in managing the transition to higher value sectors and productivity.
China’s transition to a higher value economy is dependent on changes that are contrary to the things that made it such a great success thus far, namely opening fully to foreign competition by dropping legal and regulatory barriers, and releasing control over information, allowing the free flow of thinking and debate on contentious issues.. In a previous “China has had one of the most impressive set of leaders over decades, leading the country to its current position. The strengths that this team have established should not be under-estimated These are very difficult to match for any of the contenders.”Sign of the Times , the challenges were examined of managing the simultaneous completion of its industrial revolution (in rural and underdeveloped areas) and the acceleration of the services and innovation revolution (underway in urban developed areas) alongside the role of open access to information; the evidence suggested that open access to information and increased liberties was a pre-requisite for a sustainable shift to the next stage of development. This exposes a contradiction in the government’s aim to promote higher value industries while restricting access to information and certain freedoms. It is increasingly likely that China’s leaders will need to resolve this contradiction in the next decade. Whether the China Miracle of the past decades becomes a finite event like the Japan Miracle of the 1980s or serves as a stepping stone to the emergence of a new superpower for the 21st Century depends on howwell China manages this next transition, given it comes at a time when the economic power of the established power, America, is set to be renewed through its technology-based innovation to reinvent its energy cost structure. The implications are far-reaching.
1. Source: China Daily – The average monthly salary in 2011 in Beijing was CNY4672, compared to CNY2732 in Gansu province, an increase of 71%
2. The IMF has identified infrastructure spending, prevention of excessive capital in-(and out)flows, increased R&D and education spending and improving the dependency ratio as four key measures to manage the middle income trap
3. See the August 2013 Sign: Pensions and Social Security in India and China: A c.US$30 trillion Liability in the Making, which estimates that current social security gap in China at US$1.5-2.1bn
4. May 2013 Leader: The Planning and Development Model of China
Creating Prosperity for a Billion People: Re-architecting the System of Wealth Creation