For the past two decades, the "China price" has redefined global commerce. The term has become synonymous with ultra-low cost production, fueled by the ready availability of cheap labor. The country’s competitive cost advantage has made it the lynchpin in many a corporation’s global strategy.
Now this model is being called into question. Early in the year factories struggled to rehire enough willing workers at existing wages. Then in May, Taiwan’s Hon Hai Precision Industry (2317.TW; also known as Foxconn), the world’s largest contract electronics manufacturer, said it would double the salaries of its mainland workforce following a rash of high-profile employee suicides. A few weeks later, staff at Honda (HMC.NYSE, 7627.TYO) and Toyota (TM.NYSE, 7203.TYO) plants in China went on strike over wage demands.
It has been suggested that the country has crossed a critical threshold in its economic development where its pool of cheap labor has been exhausted and wages inexorably begin to rise.
Demand and supply
To understand what’s happening, though, it’s important to distinguish between three different segments that make up China’s labor market: unskilled workers, skilled workers, and college graduates.
For the past decade or so, there has been a glut on the high and low end of the spectrum – and there is little reason to believe the dynamics have changed. The supply of unskilled migrant labor, which normally floods coastal provinces, has been temporarily bottled up in stimulus-funded construction projects in the interior, designed to support workers laid off last year. Those projects won’t last forever, and ultimately the workers will be released back into the market. And they will be joined by more rural migrants who exit the farming sector as it modernizes.
The crunch is concentrated almost entirely in the market for more skilled, experienced workers – and it is becoming more acute as manufacturers try to move up the value chain. Virtually all of the high-profile cases where Chinese workers have successfully pressed their demands have involved activities – like automotive or electronics manufacturing – whose skill requirements make qualified employees hard to recruit, expensive to train, and difficult to replace.
That sounds like bad news for Chinese manufacturers; it doesn’t have to be. The day after Hon Hai announced its planned wage increase, the company’s stock price dropped by 5% on fears that it wouldn’t be able to pass those higher costs onto customers. But if investors looked closer, they would see that the company’s success is largely based on an ability to deliver quality and reliability, while ensuring protection of its customers’ proprietary designs and technologies. There are plenty of Chinese companies that could offer lower prices than Hon Hai, but only by compromising these standards.
In my own experiences as a private equity investor in China, I’ve seen numerous situations where Western customers have told me they could get a product cheaper elsewhere, but worked with a proven supplier because they trusted it to deliver greater or more consistent value-add.
As Chinese firms move up the value chain, they may have to pay more to retain skilled employees, but they can pass the value on to customers. That translates into relationships that are more enduring – and profitable – than sales based solely on bargain basement prices.
There’s one more factor to consider. The bulk of foreign firms in China are now looking to produce goods for the domestic market rather than purely for export. As Chinese workers come to command higher wages, their buying power as consumers grows, making the rationale for foreign companies to be in China stronger rather than weaker.
Nearly a hundred years ago, the US found itself at a remarkably similar juncture. The 1920 census was the first to show a majority of Americans living in the city instead of on the farm. When, in 1914, Henry Ford announced he was going to pay his assembly line workers US$5 a day – twice the going rate – critics predicted he would go bankrupt. In fact, by paying higher wages, Ford was able to reduce employee turnover, raise productivity, and create a new class of consumers.
In the US then as in China now, the cost of doing business was increasing. But the rewards increase as well.