The True Story of China Manufacturing Costs

Posted on September 24, 2015

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The “convenient truth” in many business media sources is the fallacy that China’s manufacturing sector is losing its competitive edge and that labor costs in particular are pricing China out of many manufacturing segments. Skimming across the surface of any issue can easily lead to an incomplete analysis that distorts reality. The truth is that careful consideration of the facts and global comparative trends paints a very different picture. China’s manufacturing sector is healthy, climbing rapidly up the technology and quality curve, and can be expected to continue to expand at annual rates well above the global average into the foreseeable future.

To be clear, no country – including China – has ever been or ever will be the best place to manufacture every type of product. Every country has comparative advantages that make various segments more or less advantageous for local manufacturing. Further, that comparative advantage morphs over time, creating advantages and opportunity for other countries. Equally important, no economy – including China – can avoid the effects of business cycles that cause the rates of economic growth to rise and fall periodically.

It is absolutely true that China manufacturing costs have increased in recent years. However, the comparative impact on competitiveness of China versus other countries is a different story. If China’s intrinsic manufacturing cost structure was no longer competitive, China’s exports of goods and services would be declining in favor of other countries. However, China is by far the world’s largest exporting nation, eclipsing #2 – the United States – by over 40%. The table below, published by the United Nations Trade Statistics, presents the 2014 export data for the world’s four largest exporting countries:

Country

Exports in $ Millions

China

$ 2,343,190

United States

$

1,643,410

Germany $

1,505,467

Japan $

811,882

Source: United Nations Trade Statistics

Further, China’s exports are not only large in absolute terms; they have grown consistently throughout this decade, underscoring China’s continued global competitiveness.

Year

China Exports Growth %

2010

$ 1,578,270

2011

$ 1,899,180 20.3%
2012 $ 2,048,940

7.9%

2013 $ 2,210,250

7.9%

2014 $ 2,343,190

6.0%

Source: United Nations Trade Statistics

Why have China’s Export Prices Increased?

Exchange Rate Changes: A superficial, easy and wrong answer would be to point to labor rate increases as the prime reason for price increases. Would it surprise you to learn that labor rates are a smaller factor than exchange rates? While export prices have increased steadily in prior years, prices of China’s exports have generally stabilized since the beginning of 2014, with some export segments actually showing reduction of prices. This coincides exactly with the change in currency value trending. The chart below presents the currency rate at four key dates – ten years ago, the beginning of the decade, the peak RMB value against the USD and the current rate.

Date RMB/USD USD/RMB RMB Value Change Cumulative RMB Change
9/25/05 8.09 0.1236
1/4/10 6.83 0.1464 18.5% 18.5%
1/17/14 6.05 0.1653 12.9% 33.8%
9/11/15 6.37 0.1570 -5.1% 27.0%

Between September 2005 and January 2014, China companies exporting to the U.S. experienced an equivalent 33.8% REDUCTION in their revenue, just from exchange rate movement. Almost all U.S. importers insist that their prices be denominated in USD. When Chinese companies as well as U.S. subsidiaries supplying their parent companies converted their USD into RMB in China – where their bills must be paid – companies realized 33.8% fewer RMB in 2014 than in 2005. Even if all other costs – materials, labor and overhead – had remained unchanged, China’s exporting companies and U.S. subsidiaries would have had to increase prices in USD by 33.8% just to maintain constant prices in RMB.

Productivity Improvement: Productivity improvement across industries in China is the great-ignored factor in the manufacturing cost equation. Over the last decade, Western companies operating in China and those sourcing from China have demanded quality and efficiency improvement. Lean Manufacturing programs were almost unheard of in 2000 but are now wide spread. Continuous improvement is trending toward becoming the same core driver of the manufacturing process in China as in the developed world. One example of the effects of these trends is: China became the world’s largest market for industrial robots in 2013 deploying 20% of the global capacity, according to the International Federation of Robotics.

If wage rates increase 10% and productivity increases 10%, the labor cost per unit of production increases 0%. Focusing only on wage rates overlooks the impact of rapidly improving industrial productivity in China. I am not suggesting net labor costs have not increased. However, productivity gains have offset a significant portion of wage rate increases. Focusing only on wage rates without understanding the whole story yields a distorted picture.

Wage Rates: Conventional wisdom is that wages have been increasing across China at double-digit annual rates. It is true that in cities like Shanghai, Beijing, Guangzhou and Shenzhen, rates have risen faster and in some years at rates of 10% or more. However, nationally the rate increase has been far lower. Just as in the U.S. where wages in cities like New York, Chicago and Los Angeles have made manufacturing in those cities uncompetitive, the same has happened in the major cities of China.

Move relatively short distances from these major cities and labor rates are significantly lower and rising at far lower rates. A contributing factor to labor rate increasing at a lower rate away from the large cities is China’s unique Hukou registration system, which controls and limits the pace of labor migration across the country, exerting a major influence on labor availability and costs in various regions – see the Hukou section later in this paper.

Some recent business news pieces have erroneously stated that wage increases over the years have “effectively equalized” wage rates between China and the U.S. According to the U.S. Bureau of Labor Statistics, hourly earnings (excluding benefits) for production workers in the U.S. in 2014 ranged from $12.05 per hour for low-skilled Workers to $19.90 per hour for highly skilled machinists. In contrast, a skilled CNC machine operator in Shanghai earned RMB 6,000 per month. Assuming ~170 work hours in a normal month and an exchange rate of 6.3 RMB per USD, that skilled Chinese CNC machine operator earned $5.60 per hour – 72% less than his American counterpart. That fact is that even comparing China’s highest cost labor market – Shanghai – China’s wage rates are far below the averages in the U.S. Not only have wage rates not equalized yet between the two countries, if U.S. wages were to increase only 2% per year and China’s increase at 10% per year, the math is that equalization will not happen until 2032 – and the U.S. wage increase assumption is low and the national average China increase is very aggressive given actual national average increases.

Commodity Prices: From 2005 through 2014, the world experienced significant – almost constantly upward – volatility in commodity prices. This was not a China issue; it was a global issue impacting manufacturers everywhere. The material cost impact was essentially a level playing field and price increases attributed to material costs were felt fairly uniformly by any country and had minimal (if any) effect on the relative competitive position of China manufacturing versus other countries.

The Hukou Effect on China Labor Markets and Wages

“Hukou” is a major factor in China’s labor markets and yet few Westerners are aware of its impact. Hukou is a government system that registers every Chinese citizen, initially in his or her city of birth. The Hukou system was established in the 1950’s and is today the “control valve” of population migration in China. The Hukou provides each person the right to receive and benefit from the full range of social services in their city of birth but not elsewhere. While Chinese are free to travel around China for tourism and access social services on emergency basis, they are not free to relocate. If job opportunities are attractive in another city, they are not able to simply move to the opportunity like we are in the West. They must have their Hukou transferred or official temporary work status approved. This has major impacts on labor availability and local competitive wage rates.

On one level, the Hukou system is hard for Westerners to accept as fair, but on another level, China has few alternatives. The disparity between affluence in the major coastal cities and more rural areas of China is great. If today there was truly free mobility of people across China, it is likely that 50 million people could descend on Shanghai (or the other cities) next week and there would be social chaos. As a practical matter, until China has developed further and opportunity disparity becomes more equalized, China has few alternatives but to control population migration and the Hukou system is how that control is managed today.

Most business media reporting about China tends to center on the major cities of Beijing, Shanghai, Guangzhou and Shenzhen, because the greatest concentration of Western business investment is in these cities. In each case, the government economic development policy of these cities is discouraging expansion of labor intensive and low technology businesses. These cities are openly moving to transform their local economies to higher technology activities, professional and financial services. These cities are not focused on expanding general manufacturing. Smaller, often more inland cities have been the development beneficiaries of this focus transition in the major cities. To enable and accelerate the transition, China has spent enormous sums on transportation, electrical grid, power generation and general infrastructure enhancements.

A major reason for this shift in development emphasis is due to the fact that certain cities have oversaturated infrastructures. Shanghai has 20 million people, Guangzhou has 13 million, Shenzhen has 10 million, and Beijing has 19 million people. The infrastructures of these cities – where the first wave of foreign manufacturing businesses tended to locate – are not able to handle significantly larger numbers of people. Consequently, it is increasingly difficult for “production associate” level people to obtain approval to relocate permanently to these cities. It should be noted that it is far less difficult for college educated people to obtain approval to relocate because these people align with the skill needs of local development priorities.

As the pool of “production associate” level people in these cities is restricted, the wage cost of this employee pool rises with supply and demand dynamics. Companies located in these cities that want to expand and must rely on factory workers for that expansion are competing for a relatively static supply of labor. Demand exceeds supply and wages increase faster in these cities where the restrictions exist. Move relatively short distances from these cities to well-developed locations where the restrictions do not exist and labor rates and benefit costs are significantly lower and are rising at lower rates than the four major cities.

The Hukou effect is a two-edged sword. The thousands of companies in the major cities that are experiencing wage increase and labor shortages due to the Hukou effect have tough choices. They can morph their dependence on labor through lean manufacturing and automation and most are optimizing in this fashion. They can relocate, but the Hukou system makes it complicated for key people to relocate to lower cost China cities. Opportunities remain plentiful in the major cities and many professional employees will choose not to relocate, which increases the cost and risk of relocating a business. Moving a factory from one city to another is not much different from starting from scratch in a new start-up with all the complications and costs.

This reaction to the Hukou challenge is one major factor driving the phenomenon called “reshoring”, when U.S. companies close China factories and move elsewhere, sometimes back to the U.S. If a company’s business model is to produce low cost products in China for export and not to serve the China market, building products in China is usually a cost play that does not inherently benefit from being in China versus any other country. Faced with the choice between continued rapid increases in costs in the four major cities versus the investment and start-up risk of relocating to a new China city, “reshoring” can be a logical strategy.

More prudently and with an eye to the long term, companies that have the luxury of time on their side can gradually readjust their operation by establishing branch plants in lower cost regions and shift manufacturing over time from the higher cost location to the lower cost factory. Incremental growth and new products can be introduced from the new site, using the established large city base as the training and development platform while capability and staff functional is developed at the new location.

Current “Truths” and Future Expected Trends of China Manufacturing Costs.

While “convenient” to oversimplify the issue and reach a hasty conclusion that China is becoming less competitive as a manufacturing platform, close analysis of the actual situation paints a different picture of China’s current competitiveness and the future prospects:

  • China is by far the world’s largest exporter of manufactured goods and its exports continue to grow – underscoring its continued relative competitive position;
  • Currency valuation has been a major factor over the last decade. Since January 2005, suppliers had to increase USD prices by 27%, just to receive the same RMB revenue;
  • Since January 2014, the currency effect has reversed with the weakening of the RMB and it can be expected that currency valuation will be a less significant factor on prices of manufactured products in the future as the RMB appears to have reached its approximate free market value;
  • While wage rates will continue to increase, these increases will be much lower away from the four major traditional industrial cities of Shanghai, Beijing, Guangzhou and Shenzhen and will rise at significantly lower rates;
  • The Hukou system will reinforce the labor cost and availability between the four major industrial cities and second tier rapidly developing cities – many of them inland;
  • Labor productivity is rising fast in China, offsetting much of the labor rate increases.

Considering all the facts and factors influencing labor markets in China, the balanced conclusion is that China will remain a highly competitive manufacturing environment for the indefinite future. Regional cost and labor market differences will shift manufacturing advantages to various regions away from the four major cities of Shanghai, Beijing, Guangzhou and Shenzhen.

If we only consider the manufacturing influences of the local demand economy, the positive outlook is almost assured. Today there are ~400 million Chinese living in families with the purchasing power equivalent income of $50K USD. While China is a large market with a middle class larger than the entire population of the United States, there remains ~1 billion people who have not yet progressed to this level. The horizon for local demand growth underscores the prospects for high local manufacturing growth well into the next decade and probably beyond for a country that contains 20% of the world’s population.

About the Author

Mike Corkran is CEO and Co-Founder of China Centric Associates. Mike has operated manufacturing and services businesses in China since the early 1990’s in high and medium tech industries. As President of North America and Asia Pacific for RELTEC, a Cleveland-based NYSE-listed telecom equipment manufacturer (subsequently acquired by Marconi), Mike led the start-up and management of five manufacturing businesses and two development centers in five different Chinese cities. Mike earned a B.A. degree in Economics from Dartmouth College and an M.B.A. from the University of Rochester.

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