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Rising Labor Costs and Value-Add in China

August 4, 2010

I have an article in this month’s (August 2010) issue of China Economic Review, on rising labor costs in China and their impact on China’s competitiveness.  You can read it here.  My basic argument is that while stimulus project in China’s interior provinces have created a short-term crunch in the overall Chinese labor market, the long-term challenge — and the reason behind rising wages and labor unrest — is a long-standing shortage of more skilled, experienced workers, a bottleneck which is growing more serious as Chinese manufacturers try to boost their value-add.  For companies that adapt successfully, and for the economy as a whole, I write, this isn’t necessarily a bad thing:

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.

It’s worth contrasting my perspective with an excellent news article by Andrew Batson in this week’s Wall Street Journal, under the headline “Rising Wages Rattle China’s Small Manufacturers.”  In it, he reports that small manufacturers all over China are being hit hard by rising wages and fears of a stronger, more expensive currency:

“The cluster-based model is labor-intensive. The real question is whether it can survive in the new environment of labor scarcity and higher labor costs,” says Zhang Xiaobo, an economist at the International Food Policy Research Institute in Washington, who has researched the effect of clusters on rural development. “Right now is a critical transitional period. Some clusters will survive, some will collapse.”

At first glance, it appears that the picture I’m painting in CER, and the one Batson is painting in the WSJ, are entirely at odds.  I would argue that they’re not inconsistent at all, and represent different aspects of the same transformation that’s underway.

Back when I was a private equity professional investing in China, I’d say that 9 out of every 10 opportunities I saw involved what I would call “commodity” manufacturers — factories that churned out a standardized, low value-add product that virtually anyone could make, and competed solely on price.  Even though they accounted for a big chunk of China’s productive capacity, and often were making good money, we did everything we could to avoid such investments.  We figured that, whether in one year or ten, these companies would inevitably lose their purely cost-based competitive advantage as China’s economy developed.  They represented China’s past, not its future.

At least one out of every ten Chinese companies we looked at, though, had more promise.  Either they were making something unique, or they were doing something markedly better than their competitors:  achieving higher quality, reaching more markets, building a brand name, etc.  Often their costs were higher.  Among other things, they had to hire better, more expensive employees, not just in production, but in sales, marketing, and customer service.  They had to invest in training and sometimes even in partnerships with local schools to ensure a steady stream of qualified workers as they expanded.  Like any investment, it was a risk, but it had the potential to pay off by setting them apart from the low-cost, low value-add pack.  These are the companies we were betting would own the future.

For the past 30 years, China has expanded rapidly.  Many companies were able to prosper just by filling the void.  That’s true both of the private and the state sector.  But in a dynamic economy, filling a void doesn’t work for long.  Enterprises — even highly successful ones — have to constantly reinvent themselves to stay on top.  Companies that lack the vision or the resources to adapt get left behind, and end up out of business.

The Chinese economy is changing.  There’s no question that companies that continue to rely on cheap labor to produce low-value, commodity goods — like those ones Andrew describes in his article — will increasingly feel the squeeze.  As forward-looking companies pay more to deliver greater value-add, the opportunity cost of employing labor rises.  That’s good for the economy, and for standards of living, but it means companies that remain stagnant must pay more just to do what they were already doing.  With razor-thin margins based purely on eking out lower costs, many will go under.

The critical question is whether China is willing to embrace this kind of “creative destruction.”  There’s a line of thinking in China — pervasive though rarely articulated — that any business that fails, any industry that loses market share, represents a destruction of the achievements of the past 30 years.  As a result, there’s a strong desire to “freeze in place” the economy’s status quo, at least as a base on which to build.  Furthermore, Batson raises a valid concern in his article: given a banking system that favors state-owned companies and asset-heavy industries, will private entrepreneurs be denied access to the resources they need to adapt and survive?  And if so, where will the dynamism come from to create new value to keep pace with rising wages? 

Personally, from what I’ve seen, I’m optimistic.  Keep in mind that the first generation of Chinese entrepreneurs, the ones who made China’s export-led, low-cost manufacturing economy a success, didn’t have much help from the banking system either.  They made up for it with incredible drive and resourcefulness.  I’m confident that, with or without the help of Chinese banks, the next generation of entrepreneurs — that one out of ten ventures I was always looking for — will find a way to overturn the status quo and surpass their competitors.  The only real question for me is, will a government that fears the turmoil and uncertainty of the market let them?

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