China is at a crossroads, reinventing itself from a manufacturing powerhouse to a consumer-oriented economy. Due to rising production costs and slowing overseas demand, factories are moving to higher value-added production, while domestic consumption is increasing at a fast pace.
In an interview with Global Sources, Shaun Rein, author of The End of Cheap China: Economic and Cultural Trends that will Disrupt the World, sheds light on the global impact of China’s economic transformation in coming years.
He shares his insight on the key challenges facing the manufacturing industry today, and outlines the strategic changes importers need to make given that China is losing its low-cost advantage.
Shanghai-based Rein is the founder and managing director of the China Market Research Group a market intelligence firm focused on China. He is also a columnist for Forbes and BusinessWeek.
What does the end of cheap China mean for the rest of the world?
For the last several decades, China has been a deflationary force on the global economy. That is about to change as wages and rents in China continue to grow annually in the double digits despite the weakening Chinese economy.
Since China entered the WTO, tens of millions of Chinese workers have been willing to toil for low wages making the products the rest of the world loves like Nike Air Jordans and Apple phones for cheap prices. This has allowed middle class Americans and Europeans to enjoy an increase in standard of living unparalleled in history – the typical American bought three pairs of shoes annually in the 1950s but now buys eight pairs.
Now that wages and rents are rising, China is going to become an inflationary force on the global economy. In 2011, the price of imports into the US from China rose 2.6 percent, the highest on record. Meg Whittman, CEO of HP, said HP might raise prices to the end-consumer in the US because of rising wages in China.
Instead of being the place to make cheap products, China is fast becoming the place to make high value-added products, and emerging to become the market to sell into. Consumers in China bought almost $23 billion of Apple products last year – they have changed from not just making Apple products but are also buying them now.
Are China factories moving up the value chain? If yes, how would this impact global economies?
China manufacturers are fast moving up the value chain and thus competing with manufacturers in Europe and the US on quality and are offering a better price. Ten years ago, China factories caused many apparel factories in the US to shut – I expect the same situation will occur for higher value-added manufacturing.
Right now for instance, China buys more from Germany than it exports there. This is because China companies are buying German equipment.
I expect that in a few years, these China companies will put out of business many smaller German factories and cause unemployment there.
I was speaking with a precision equipment firm from Italy that has been operating for almost a century. They decided to open a factory in Shanghai three years ago because they found workers were well-trained enough. They were able to cut costs and be closer to their customers who had already moved to Asia, and they recently announced they would shut 90 percent of their Italy operations.
China has become overly reliant on export-oriented and investment-led growth. For the country to reduce pollution and get over the middle-income trap countries hit when the average salary is $6,000, it is important for China to move up the value chain in manufacturing and have consumption account for a larger percentage of economic growth. The changes in China’s economy are healthy but it will mean some pain for other countries.
What strategic changes would importers sourcing in China have to make given that the country is losing its low-cost advantage?
Companies need to develop a strategy of sourcing that is not 100 percent reliant on China. I like to call it the China plus strategy. They need to look to markets such as Indonesia, Sri Lanka and Vietnam that have already started to grab market share, especially in the light industries. Nike, for instance, sources 38 percent of products from Vietnam versus 36 percent from China.
For companies that source value-added products, China is going to remain dominant. Even though labor costs in countries such as Indonesia are half or even a quarter of those in China, it is doubtful many factories are going to be able to relocate completely. China still has superior infrastructure and more productive workers, so factories will transfer higher manufacturing costs to their customers.
Companies sourcing from China should expect to pay higher prices and figure out a way to transfer higher costs to consumers in the home market, improve operating costs, or simply have smaller margins.
Is relocating to inland provinces still a viable option for factories looking to lower production costs?
Only large factories will be able to relocate inland and make it worthwhile. It is not easy moving from Guangdong to Henan logistically. I think it is easier to focus on improving worker productivity and automating production lines in existing factories.
Reshoring, or manufacturing moving back to the US, seems to be gaining traction these days. What is your take on this?
I doubt many companies will return the US. For existing operations in China, it makes sense to stay here and improve productivity.
However, I do expect more "greenfields" to open in the US. Google announced that it will make its Google Glass in the US so that it can be closer to the researchers in Mountain View. Many companies will invest more money into new or old operations in the US rather than expand in China because the cost savings are not as high as before, but I do not see too many companies shutting down in China to reshore.
Companies that invest in new operations in the US will also gain political brownie points and good marketing optics, which is why I think Apple announced it will invest $100 million in a new factory in the US. In the grand scheme of things, this amount is a minor investment for Apple but it gave them great political backing and marketing.
Will wages in China continue to increase at current rates?
Wages have been growing 20 percent annually in manufacturing hubs such as Guangdong and Zhejiang since 2006. In 2011, 21 of China’s 31 provinces increased the minimum wage on average by 22 percent.
In the latest five-year plan, the government has said they want salaries to continue to grow at 13 percent annually on average to spur consumption and to close the income gap.
If companies are hoping that salary growth will start to plateau here, they are wrong and will be in for a rude awakening. Wage growth will continue as the working age population gets smaller and remaining workers want to realize white collar dreams.
You can find cheap labor in Thailand and other markets in Southeast Asia. Those markets, however, lack the manufacturing ecosystem for many industries.
What are your impressions and expectations for China's second-generation migrant workers?
Second-generation migrant workers are very different from their parents. When I first arrived in China in the mid-1990s, many people were struggling to eat and find decent housing. Now, workers generally are well-fed and are looking to have fun and realize white collar dreams. When you go into the worker dormitories of many large companies, you see very stylish workers, toting smartphones, decked out in fashionable clothing.
Many of them do not want to be blue collar workers forever or, if they are willing, want to work closer to their homes. They do not want to be in Guangdong anymore but in Sichuan or Henan. That is one reason why Foxconn, which makes many products for Apple and Dell, relocated 350,000 workers from southern China to Henan.
Is the shortage of skilled labor in China a serious issue?
Yes, shortage of skilled labor is a serious problem. Part of the issue is that companies have been so desperate for warm bodies that they have been poaching workers from neighboring factories. Even for white collars, it is common for them to have five jobs in five years. The result is that many workers simply do not have the experience and training with one company to really be called skilled, let alone expert.
There is a dearth of talent in China at the mid-level. And this lack of talent is preventing many Chinese firms from becoming truly global players.
Can and should China reinvent itself from a manufacturing powerhouse to a more consumer-oriented economy?
I estimate consumption accounts for 42 percent of the economy, far more than many economists who I think are underestimating the size of the grey economy.
They also do not account for personal purchases by executives that buy goods via a company account as a benefit in order to reduce taxes. This type of personal spending by executives should be accounted for as consumption. For instance, when an executive charges his family’s clothing purchases to the company, it is consumer consumption.
MNCs are already seeing big profits from the China market. Starbucks, for instance, has 30 percent margins in China, versus 22 percent in the US, and China will soon become its second-largest market.
Companies such as Qualcomm and YUM Brands are generating 40 percent to 45 percent of their global revenue from China.
The Chinese consumer will be the greatest growth story in the world in the next three years, so companies need to develop a strategy on how to sell to the Chinese consumer.
What do you expect the average growth rate of China’s economy to be in the coming five years?
As China continues to urbanize, there still is plenty of room for economic growth. I expect GDP to hover around 8 percent over the next five years.
There still are a lot of inefficiencies in the system. If the government can cut through bureaucracy, (such as re-hauling the hukou system which stops migrant workers from spending) it can really unlock growth.
I remain bullish on the economy even though there are some challenges ahead and I do not see the 10 percent to 12 percent growth annually that we have seen in the past. I actually think this is a good thing as too many local officials emphasized growth no matter what, which is why the country is facing such a pollution problem.
Is there a next China?
I do not think any other country will be able to dominate manufacturing the way China has. Countries such as Indonesia and Thailand will take share from China in the light industry, but no single country will be able to completely supplant it. The workers and ecosystem are still too superior.
However, I am fairly bullish on Indonesia. It has such a large worker population that many companies are starting to manufacture there, which, in turn, is creating a growing middle class of consumers.
If I were a 22-year-old foreigner, I would move to Indonesia not China. The opportunities for entrepreneurs in China are limited now as bigger, more established companies have already secured dominant positions. But Indonesia is largely a blank paper. If the government can keep stability and reign in corruption, there will be some great opportunities there.
All price quotes in this report are in US dollars unless otherwise specified. FOB prices were provided by the companies interviewed only as reference prices at the time of interview and may have changed.