Unit 4 Macro: Wage Inflation and Chinese Competitiveness and Growth

Unit 4 essay from Max Goswami-Myerscough

China has undergone high levels of wage inflation since the turn of the century. As stated in the extract, a US Bureau of Labour report showed that between 2002 and 2008 real hourly wages more than doubled in China’s manufacturing sector. Comparatively, wages only rose by 20% in the US. In addition to this, according to Jim O’Neill, by 2009 over 5% of the population of China (approx. 65 million) had incomes of around $35,000 p.a. China has been considered to be one of the main outsourcing destinations for cheap labour over the years but this may change if such high levels of wage inflation persist.

One of the key reasons for these high levels of wage inflation across China has been the large shift in demographics since the one-child policy was implemented. According to data, since the one-child policy came into effect, child fertility dropped to between 1.5-1.8. This is much lower than the figure required for a stable population (2.1). In addition to this, data shows that China’s median age has risen significantly and is now at 35.2 years. Contrast this to other countries such as Vietnam (27.4 years) and we can see that the dynamic is shifting dramatically. As the demographic shifts away from inexperienced, young cheap labour towards an older, more experienced workforce, the pressure on wages will rise as higher wages will be demanded. In addition to this, the overall size of China’s workforce looks set to decline as soon as 2015 as a result of this shift. This will have further wage inflationary effects as the supply of labour in China begins to shrink.

Another reason for the rising wages in China is the social and external pressures for fairer, higher wages. As the China has grown and expanded, the government officials have come under increasing pressure to make sure that Chinese workers don’t ‘fall behind’ the economy. To do this they have implemented measures in their most recent five-year plan requiring firms to raise wages by 13% per year in order to combat poverty and inequality. In addition to this, large multinationals based have come under extreme scrutiny from foreign countries, claiming that their working conditions are poor and their wages unfair. One example of this has been in the form of the Taiwanese company Foxconn Technology Group. Based in China and one of its largest private-sector employers, it has come under much criticism for the multiple suicides of it workers (14) over the course of 2010. In fact, in response to this, Foxconn has recently raised wages by between 16-25% illustrating the pressures it and other China-based firms face to increase their wages and reduce inequality.

Demand for Chinese labour has also risen significantly over the years, pushing up wages with it. After years of cheap labour, China has hit the Lewis-Turning Point of its economy, where the surplus of labour has gone and demand for labour is growing faster than supply. This has mainly occurred due to the mass movement of Chinese workers from rural to urban areas slowing down recently. According to Jim O’Neill the number of Chinese citizens working and living in urban areas has risen from 36.2% to 50%. However, although there is still the potential for more rural to urban movement, the initial hype driving this change seems to have died down somewhat and predictions show that this movement will begin to slow.

Addressing whether or not higher wages will be beneficial or not for development and growth in China, rising wages may in fact be a positive for development. Rising wages would lead greater income per head in the economy, provided there is no adverse effect on employment levels. This would help to push China out of its middle-income status and towards that of a high-income economy, avoiding the middle-income trap. In addition to this, rising income levels should lead to a boost in consumption in China, especially for items such as consumer durables. This would help to shift China’s economy away from its heavy dependence on industrial manufacturing and export-led growth and towards the production of higher-value goods and services that developed economies tend to produce.

Rising wages may also be beneficial for productivity in China. For many years China has been investing heavily in capital. While this has led to a strong ratio of capital per workers, the large-scale production of all this capital has led to it being very inefficient. In fact, that Harrod-Domar model predicts that China’s capital-output ratio would only give it growth of 3% p.a. Although this model is inherently flawed it shows that China has become very inefficient through the over-production of capital. Up until now it has relied on its cheap labour to keep costs down and thus produce competitive goods that can dominate the export-market. However, with wages rising so drastically, the Chinese government and firms will have to look towards alternative measures of cutting costs. The most obvious way would be to increase productivity through more up-to-date and efficient capital and technology or by investing in human capital. In addition to this, the theory of efficiency wages also should lead to an increase in productivity. Overall, labour productivity is expected to grow in China during the years 2010-2015 by around 8.3% meaning that growth should be sustained despite the rising wage costs.

However, rising wages might be a cause for concern, especially among firms in China. If productivity cannot be raised to match these rising wages then total costs will increase and profits will fall. Those most likely to be affected are small firms. China’s statistics Bureau has shown that the profit margin for small-scale industries has fallen to 3.9%, a decrease of 0.2% the previous year, and this decrease in profit margins is set to persist unless these small-scale firms can find a cheap way of increasing productivity. In addition to the decrease in profits, rising costs will make Chinese firms less competitive as a whole. Christian Murck, presidentofthe American Chamber of Commerce in Beijing believes that ‘Chinese competitiveness in terms of wage rates will evaporate over the years to come’. China’s currency has also strengthened to 6.49 Yuan to the dollar as a result of this high wage inflation, the first time it has been below 6.50 since 1993. All of this will, in turn, lead to lower levels of growth and a worsening of the trade balance, especially as so much of China’s growth lies in its dominance of the export market.

Rising costs as a result of high wage inflation in China might also lead to less Foreign Direct Investment for the country. Foreign investors may be put off by the large costs of Chinese labour relative to that of Vietnam or India and so might then seek to invest in these countries instead. However, there are many factors that are so unique to China that if there is a shift away from foreign investment in China then it is likely to be a small one. Factors such as its high-levels of infrastructure, transport networks and the large scope for external economies of scale may make the rising labour costs less significant and so investment should not fall by too great an amount.

Finally, the fact that higher wages will push up the incomes of many Chinese workers may lead to a shift in the trade balance of China. As incomes rise, consumers will demand higher-quality, luxury goods that China itself does not produce. This would lead to an increase in imports for the country, at a time when exports may also be falling due to a lack of competitiveness. Data shows that China imported nearly $1.4 trillion in goods and services in 2010, which was a whopping increase of $400 billion from 2009. All of this could evaporate the trade surplus that China has benefitted from for so many years and would lead to higher levels of withdrawals from the economy, dampening growth.

Overall, it seems that rising wages in China are more beneficial for development and long-term growth but can be very detrimental to China’s growth in the next few years to come. It will take time for China to adjust to these rising wages and allocate resources to combat the decrease in competitiveness and move towards producing more higher-quality, expensive products. However, over the long-term, these rising wages should help China break through the middle-income trap, where so many others have become stuck before, and transform itself into a high-income economy.