Is China finished as a low-wage manufacturer?

A string of strikes over demands for higher pay at foreign-owned factories in southern China is prompting investors to ask whether the country's days as the low-cost workshop of the world are numbered.

Here are some questions and answers about the implications of the wage increases.

HOW FAST IS PAY GOING UP?
Some of the recent disputes have brought sizeable rises, including a 66% increase for eligible workers at electronics contract manufacturer Foxconn and 20% or more for some Honda Motor employees.

Various cities are raising their minimum wage by 20%. But multinational companies generally pay well above this threshold in any case. Moreover, the increase is just making up for a freeze in the minimum wage imposed in 2009 to help exporters ride out the global economic crisis.

Drawing on surveys and anecdotal evidence, Tao Wang, UBS's chief China economist, expects average wages across China to rise this year by about 15-20%.

That sounds like a lot, but the economy grew 16% a year in nominal terms between 2004 and 2009 and 12% annually for the five years before that. And wages were not far behind.

"Wages have been rising in urban China by at least 15% per year, every year for the last decade," Nicholas Lardy, a China scholar at the Peterson Institute for International Economics in Washington, said.

CAN EMPLOYERS AFFORD MUCH HIGHER PAY?
On the face of it, yes. Wages make up about 5% of overall manufacturing costs. Thanks to rapid productivity growth, unit labour costs in manufacturing have risen no more than inflation, UBS estimates, thus causing neither a profit squeeze nor an inflation spike.

In support of the argument that firms have been able to cope with steadily rising wages, average profit margins in China's industrial sector have been quite stable in the past decade except for a swoon during the crisis year of 2008.

But it is important not to see rising pay in isolation. Other inputs, such as land, energy, and water, are also getting dearer. The government raised natural gas prices by 25% on June 1. A labour law introduced in 2008 designed to strengthen workers' rights has also added to costs. And China is under pressure to let the yuan resume its rise.

HOW ARE COMPANIES RESPONDING?
Low-value-added industries with slim margins such as textiles, light manufacturing and electronics are moving to cheaper locations in central and western China. This is smack in line with the government's development strategy.

Some firms, Chinese as well as foreign-owned, are also moving production to lower-cost neighbours such as Vietnam, Bangladesh and India — just as Japan, South Korea, Taiwan and others have shifted manufacturing down the years to China.

As China's price advantage is eroded, the incentive will grow for international companies to move part of their production out of Asia altogether, both to save on transport costs and to be able to supply consumer markets more quickly.

Anecdotal evidence suggests that Mexico, eastern Europe and even north Africa are benefiting at the margin from this trend. But for high-volume buyers, China's vast manufacturing capacity, first-rate infrastructure, and clusters of suppliers mean it is unlikely to have a serious rival for years to come.

WHAT'S THE SHORT-TERM IMPACT ON INFLATION AND PROFITS?
Most economists reckon the near-term impact on inflation will be muted because big pay increases are restricted to southern China's export strongholds.

But corporate margins could be squeezed if wage growth exceeds productivity gains this year. That is because the price of Chinese exports is determined internationally and so few manufacturers have the power to pass on higher costs.

Next year could be a whole new ball game. Investment bank CICC says labour market tightness today could give way to serious unemployment as firms turn cautious about hiring and China's 4 trillion yuan ($585 billion) stimulus package is completed.

CICC estimates that government pump-priming created 25 million temporary jobs during 2009-2010. As they are shed, the bank reckons total urban unemployment could reach a staggering 40 million in 2011.

WHAT'S THE MEDIUM-TERM OUTLOOK FOR JOBS AND WAGES?
Even if supply and demand put a lid on wages again next year, the spate of wage increases may be a harbinger of a turning point in the Chinese economy.

Demographers agree that China's working-age population will peak around 2015-2016. Surplus labour will therefore shrink, even as farmers continue to leave the land for better-paying urban jobs.

That will generate structural upward pressure on wages, reversing a steep fall in labour's share of national income to 39.7% of GDP today from 53% in 1999. The figures for the United States and Japan, by comparison, are 57% and 51%, respectively, according to CICC.

In short, Chinese workers will have more money to spend, while the capital share of national income will shrink. This will squeeze corporate profits, which have jumped to 31% of GDP from 19% in 1999.

Japan's experience offers a guide to this likely rebalancing. Japan's ratio of labour income to GDP rose to 55% in 1983 from 39% in 1961, turning household consumption into the major driver of economic growth, CICC said.

The corollary of rising wages is rising inflation. After Japan's workforce started to shrink, its inflation averaged 5.6% from 1960-1972; in South Korea, the comparable figure from 1982-1996 was 5.2%, said Wensheng Peng, chief China economist at Barclays Capital in Hong Kong.

Peng said Chinese monetary policy was likely to accommodate the rising wages that population trends suggest are inevitable. "If the monetary authorities tighten policy to hold inflation at low levels, it may unnecessarily depress the rate of economic growth," he said.