Q&A: China’s rising labour costs challenge competitiveness

China’s rapid economic growth in the decade to 2010 was boosted by the success of its manufacturing sector and significant Foreign Direct Investment (FDI) inflows.

Cheap labour costs have been one of the major pulls for investors but costs have been rising in recent years, posing challenges for China’s competitiveness. However, the country retains several advantages which will continue to make it attractive for doing business.

• Why have labour costs risen in China?

• What implications will higher labour costs have for the Chinese economy?

• What will be the impact beyond China?

• What is the outlook for the business environment?

Why have labour costs risen in China?

One of China’s biggest attractions for investors has traditionally been its cheap labour costs and ability to provide economies of scale. However, labour costs have been rising owing to several factors. The trend has become more apparent since 2008 when the government introduced new labour legislation in a bid to protect workers through enforcing contracts, job security and minimum wage compliance.

However, workers have also been demanding higher wages amid rising inflation, with labour disputes in 2010 resulting in pay rises and increases in minimum wages. Inflation affects consumers by reducing their purchasing power and squeezing disposable incomes. Annual inflation in February 2011 was at 4.9% and inflationary pressures are set to continue in 2011 with record world food prices, as well as oil price spikes following the unrest in the Middle East and North Africa.

Furthermore, China suffers from a skills shortage for highly skilled workers, which has exacerbated the problem and is pushing wage demands up. There has also been a slowdown in rural to urban migration as rural workers find more opportunities closer to home. As a result of a combination of these factors, labour costs have risen across China. The average wage per hour in manufacturing, for example, increased from US$1.0 in 2005 to US$2.4 in 2010.

What implications will higher labour costs have for the Chinese economy?

The biggest implication of higher labour costs will be in terms of China’s perceived competitiveness:

• Investors may seek alternative production bases in Asia where labour costs are cheaper. A loss of Foreign Direct Investment will hurt China’s economic growth and reduce employment potential. Alternatively, China’s internal wage variation may result in companies relocating within China to cheaper areas inland or to second tier cities. Employment prospects will decline around the major cities, which will have an impact on regional spending patterns;
• The manufacturing sector, which has driven economic growth in recent years, could be especially hurt by a loss of investment, as businesses are dealing with higher input costs from rising commodity prices at the same time as increasing labour costs. Manufacturing accounted for 30.0% of China’s GDP by origin in 2010, which has remained steady since 2000, but this may decline if other economies take over as cheaper manufacturing bases. Exports would also suffer: 49.2% of China’s exports by commodity in 2010 consisted of machinery and transport equipment, for example;
• However, the country’s economic restructuring may encourage businesses to move up to the production of higher end goods, while cheaper economies elsewhere in Asia take on low cost manufacturing activity. The country’s skills shortage for highly skilled staff could be a problem in the short term in realising this potential but labour costs in China remain much lower than in many advanced economies.