Most people agree that China is losing its labor cost edge. So what will be the country’s next competitive advantage?
In a surprising announcement in May 2011, luxury handbag manufacturer Coach said that it would transfer at least half of its production facilities from China to countries like India, Vietnam and the Philippines where the production costs are much lower. At the time of this announcement, production in China accounted for almost 85% of Coach’s total production and according to CEO Lew Frankfort, the idea was to bring it down to 40-50% of the total. Ironically, the China market continues to be Coach’s most important consumer market outside of its home market of North America, but rising wages in the country are forcing the company to consider other countries.
Coach is not the only one. Several companies are considering relocating manufacturing elsewhere. This is a worrying development for China. According to Ministry of Commerce statistics, foreign direct investment in all sectors fell 2.8% in the first quarter of 2012, to $29.48 billion – the fifth straight month of declines. At the same time, Chinese export investments have surged 94.5%, to $16.55 billion, which the ministry blamed on rising wages and other costs.
That doesn’t mean every company is packing up, or stopping fresh investment. But it does suggest that China’s low-cost labor advantage is diminishing.
If cheap workers are gone for good, what will China now use for a trump card?
A Gradual Loss
A number of factors have begun to make Chinese labor less competitive, says Wang Yijiang, Associate Dean and Professor of Economics and Human Resource Management at Cheung Kong Graduate School of Business.
Inflation in the cities is leading to a decline in migration from the countryside, reducing the supply of new workers. “Ten years ago, they travelled the distance, made a few hundred yuan and were able to save a lot and send money home... But nowadays they say the money you earn here, you have to spend it all so why bother?” he says.
At the same time, taxes and government spending are also crimping the supply. Taxes and fees make profits very thin for most companies, reducing the amount of money left to hire workers or raise wages. Operating on razor-thin margins, businesses lose “this capability to substantially increase labor pay even just to catch up with inflation. So real income, many people tend to believe, has actually declined, or at best, stayed relatively stable and stagnant.”
Inadequate salaries discourage rural people from moving to the city, while welfare programs discourage work. “(Welfare programs) take labor out of the labor market. Many people would rather spend time to play cards and hang around to receive easy money than to work hard to make the nominally higher but inflation-adjusted low-wage income,” says Wang.
Curiously enough, China’s famed one-child policy may also be having an impact, creating a pampered generation that doesn’t want to get their hands dirty. “(The one-child generation) has two parents and four grandparents – everyone pouring resources into supporting them, everyone wanting them to have a happy life… In industries like manufacturing and other businesses that require hard and dirty work, these are not the people to fill the job vacancies,” says Wang.
Restrictive labor laws that went into effect in 2008 may be taking a toll as well. As businesses have a limited ability to fire workers, companies won’t take a chance on training unskilled workers, limiting the supply of skilled workers, and encouraging companies to automate. The automation wave is already sweeping across China, and the scale of automation is unprecedented sometimes. Take for instance, electronics manufacturer Foxconn which recently pledged to replace 1 million of its workers with machines over the next five years.
For all these reasons, manufacturers, especially those at the lower end, may become more interested in Vietnam and other lower-cost markets, says Wang.
Not So Fast
But is the situation as bleak as it sounds? Some say the risk that China will lose its manufacturing base to foreign companies is overstated. Shaun Rein, managing director of the China Market Research Group, and author of The End of Cheap China, argues that the expertise and scale of Chinese factories are now so advantageous that relocation is no longer really possible.
“China will not lose its dominance in manufacturing anytime soon,” Rein says. “It is very hard to move an entire ecosystem of manufacturers from one country to Vietnam. It is more likely that these factories will move to other parts of China, as Intel and Foxconn have already done.” Many of these original equipment manufacturers (OEM) are owned by Taiwanese. It is easier for them to move within China, deal with employees and government officials, than move to new countries that have different languages.
Instead, he argues, rising labor costs plus a government push to wean the economy away from manufacturing exports to services and consumption do mean a major shift is on the way, but not a bad one. “Workers will leave factories and move towards the service sector,” Rein predicts.
[This article has been reproduced with permission from CKGSB Knowledge, the online research journal of the Cheung Kong Graduate School of Business (CKGSB), China's leading independent business school. For more articles on China business strategy, please visit CKGSB Knowledge.]