For at least the past three years, general managers of China-based manufacturing operations have been sharply aware of tightening labor supply and rapidly increasing labor costs. Indeed, qualified labor availability and sharply increasing wage levels have risen to the top of the list of operating challenges across a wide range of industries and sectors.

In fact, seventy-one percent of respondents to a recently released 2011 Business Climate Survey by the American Chamber of Commerce in China reported that increasing salary and wage expense has had a negative impact on their business operations, while 69 percent report difficulty attracting, developing and retaining qualified employees.

Adding to the mounting evidence of soaring employment costs, the U.S. Bureau of Labor Statistics (BLS) has just released an update of a landmark 2006 study showing surging growth in hourly manufacturing compensation across a broad range of Chinese industries. The study illustrates that growth in average hourly manufacturing compensation jumped from 7.9 percent per year (pre-inflation) in the 2002 to 2005 period to 16.4 percent per year in the 2005-2007 periods. Furthermore, the trend is accelerating.

The growth rate was a sizzling 17.6 percent year-on-year in 2008 and may well have accelerated to over 18 percent per year in the 2009-2010 periods, despite the impact of the global recession in 2009. If sustained, this implies a doubling time for nominal manufacturing labor costs of about five years. Measured in U.S. dollars and driven by appreciation in the value of the RMB, Chinese exporters face comparative employment cost increases of 20-25 percent per year.

The data and analysis, which were prepared by leading China demographer Judith Banister and economist George Cook of the BLS, confirm a trend that global manufacturing companies have reported for the past five years. The data include both urban manufacturing units and rural “Town and Village Enterprises” and cover some 100 million manufacturing workers.

Many Factors Are Responsible

According to Banister and Cook, “…the youth population ages 0-14 has shrunk to an unusually small proportion of the population for a developing country. Indeed, a key determinant of China’s paradoxically tightening labor market is low fertility.” Despite the popular image of China’s huge reserve of available rural labor, government surveys at the village level indicate the supply of qualified manufacturing labor, considering such factors as age range, literacy and skill level, health, and physical characteristics such as manual dexterity and eyesight, may already be tapped out at about 100 million manufacturing workers.

InterChina Consulting, a strategy and M&A advisory firm based in China, has conducted manufacturing cost research suggesting the recent run-up in manufacturing labor compensation is structural in nature. According to InterChina’s Managing Director for Strategy, James Sinclair, “The sharp rise in manufacturing costs in China reflects basic and persistent underlying factors in the Chinese economy: growing labor shortages in the manufacturing sector, rising worker expectations and educational levels, higher levels of unionization, minimum wage increases in many provinces, government labor contract and social benefits policies, pressure to keep up with rising housing and living costs, and growing employment opportunities in lower tier cities.

Indeed, the BLS data support the proposition that China has reached a classic “Lewis Turning Point” in urban wage levels driven by tightening rural labor supply and continuing rapid growth of the urban economy. If true, this trend will also drive up employment costs in high growth non-manufacturing sectors, such as the health care sector.”

What Needs To Be Done

InterChina is betting that rising employment and delivery costs will have a major impact on development strategies of global players in the China market. Corporate development strategy in China has been driven almost exclusively by top-line factors for the past two decades—market access, customer share, distribution channels and revenue growth. Faced with rising costs, the new winners will be companies that can sustain margin and profit levels through higher efficiencies, capital and technology intensive investment, and higher value products and services in a competitive environment more typical of more advanced economies.

There are many signs that rising employment costs and a tightening rural labor supply are having a direct impact on manufacturing operations. Electronics manufacturer Foxconn Technology, which last year doubled worker pay following a sudden wave of suicides in its operations in Shenzhen and Kunshan, recently announced that it would transfer 200,000 jobs to plants in inland areas and third tier cities. In the coastal enclave of Yantai, which is host to the largest General Motors vehicle assembly plant in China, average employment costs for automotive parts suppliers rose more than 20 percent last year. They are competing head-to-head for skilled workers with a huge new Foxconn plant in the Yantai Economic Development Area. When Foxconn moves into a new industrial zone, it advertises for as many as 80,000 jobs at a time.

InterChina believes that multinational strategies to address rising manufacturing costs will include both “re-mapping capacity” by focusing new investments on lower-cost inland cities and also a shift toward more capital-intensive mechanized production. Bell-weather technology companies Intel and Hewlett Packard are examples of “capacity re-mapping” within China. Intel is relocating chip assembly and testing facilities from Shanghai to Chengdu, eliminating 2,000 jobs in Shanghai. HP is building a large new laptop assembly plant in Chengdu. Both companies cite labor costs as part of the rationale for the new inland locations, along with government incentives to “Go West.”

Japanese companies that had relatively high levels of labor intensity in their Chinese plants are starting to move to semi-automatic and integrated mechanized assembly lines. For example, NSK has recently introduced automated transfer lines into Chinese bearing plants while SMC is reportedly mechanizing assembly of pneumatic equipment. Even traditionally labor-intensive domestic Chinese industries like textiles are moving toward a higher level of mechanization to remain competitive, creating a surge in demand for automated textile production equipment.

The Wages of Migrant Workers

Migrant workers support the very bottom of the urban wage structure in the construction and service sectors as well as manufacturing. Migrant worker wages have also risen dramatically in the last two years, doubling from an average base wage of RMB 781 per month in 2003 to RMB 1,348 in 2009 and over RMB 1,500 (US$220/month) last year. Hunan Governor Xu Shousheng has estimated that 500,000-800,000 fewer Hunan workers will migrate to coastal city jobs in 2011 than in previous years, suggesting that tight supply will lead to even greater migrant worker wage increases over the next few years.

Adding fuel to the fire, provincial and municipal governments across China have been raising minimum wage levels at 15-20 percent a year to offset high inflation in food prices, housing prices, and other living costs.

Manufacturing Will Remain Competitive

Despite these dramatic changes in employment costs, China’s manufacturing sector will remain highly competitive for some time to come. Employment costs are rising quickly, but will take decades to overtake Japan, South Korea or Taiwan, let alone the U.S. or European Union countries. Meanwhile, China likely will move up the value-add chain and will reduce the economic impact of labor shortages and rising labor costs through productivity improvements.

What Companies Likely Will Do

Multinationals likely will continue to invest in their China-based manufacturing and service delivery platforms to tap into burgeoning domestic demand and to leverage mature and integrated regional supply chains. Some labor-intensive light industries—toys, apparel, shoes, leather goods, and furniture—have already experienced migration of capacity to lower-cost countries. Luxury leather-goods manufacturer Coach is gradually shifting capacity from China to Vietnam and India. There will even be occasional instances of “re-shoring” of China-based capacity to North America or Europe, such as the recent decisions by Masterlock, General Electric (water heaters), and Wham-O to move some capacity back from plants in China to U.S. production lines. But the basic driver for continued investment in the manufacturing sector in China—access to the fastest growth large market in the world—will remain.

Both domestic Chinese enterprises and their multinational competitors will be forced to focus their investments and operations on productivity, innovation and cost control to remain competitive and profitable at recent levels. Price increases will be difficult to sustain against overcapacity in many industries and the weakness of global growth. Consolidation of highly fragmented industries will accelerate through M&A activities and rising bankruptcy rates among sub-scale enterprises that compete primarily on price.

The China story going forward will be all about sustaining margins in an environment of high cost growth.

This article appeared in Impact Analysis, May-June 2011.

Kim Woodard
About The Author Kim Woodard
Based in Beijing, Kim Woodard is a Senior Counselor with InterChina Consulting, a strategy and M&A advisory firm based in China.

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