Deutsche Bank Securities: Summary
- For decades, outsourcing of manufacturing and later of services to Asia has defined the trajectory of global production. However, sharp increases in wages/salaries in both China and India have led some observers to question whether or not this dynamic is coming to a close, particularly in view of the renewed competitiveness of US manufacturing.
- We found that the American manufacturing worker is indeed the most competitive in the developed world given the weak dollar and decades of efficiency gains. However, our study suggests that an industry that has moved already to China is unlikely to move back to the developed world. China's main problem is that it needs to move up the value chain even as low-end products are competed away to even cheaper locations. The country's inland provinces are unlikely to protect it against the shift. Unfortunately, China's cost advantage falls in high-end sectors and it will most likely succeed in segments where its large domestic market gives it critical mass.
- India too will find that it has a falling cost advantage in high-end services due to sharp increases in salaries. However, recent experience suggests that it can hold its own as one goes down the value chain. We found that companies have discovered ways to tap a large pool of low-skill workers from the hinterland. If it gets its policy framework right and avoids appreciation of its real effective exchange rate, it could potentially do the same in manufacturing.
- The British worker was found to have improved the most in the developed world although still lagging behind his/her German and French counterparts. Meanwhile, the Japanese worker looks the most vulnerable at current exchange rates."
Here is their summary on China. I was told that Foxconn (makers of Apple products) will move to the interior of China as opposed to cheaper labor markets like Vietnam, due to ecosystem and infrastructure issues.
... The question is whether or not the ten-fold increase in nominal USD wages and the prospect of more increases in the future have made China unattractive for further outsourcing of manufacturing from the developed world. This must be gauged against the fact that Chinese workers have also become far more productive due to education/training, improved infrastructure and so on. Our estimates indicate that the average Chinese hourly wage is now around USD 2.7. Wages in the manufacturing sector are generally lower at around USD 2.4/hour. Our informal survey suggests that the average Chinese worker is at least a third as productive as an American. Thus, we should compare USD 7.2/hour to USD 25.6/hour in US manufacturing. This is still a very large gap even allowing for 15-17% annual increase and perhaps some CNY appreciation.
... The economics of outsourcing manufacturing to China, therefore, varies a lot from product to product depending on the relative importance of each input. On one hand, China now has a number of established industrial clusters with their eco-systems of supply chains, manpower and so on. These clusters are being helped by the fact that China itself is a growing market for many products. These factors give Chinese manufacturing a degree of cushion. On the other hand, real estate prices have spiraled out in China in recent years. There are also concerns about the costs and risks of maintaining long supply chains for products that are still mainly sold in developed markets.
At the risk of generalizing, our overall assessment is that rising Chinese wages in themselves have not closed the case for outsourcing manufacturing to China. An industry that has already moved to China is not likely to move back to the developed world. The real competition in these industries comes from other developing countries. This is particularly true for low-end products with wafer-thin margins. For instance, Vietnam’s wages are half of those in China. Although the quality-adjusted gap is smaller, Chinese wages are rising much faster than Vietnamese wages and therefore making it increasingly worthwhile to shift certain kinds of manufacturing south of the border. It has been argued that China can compete back by encouraging investments in the cheaper inland provinces but we found that the wage gap is not large enough to justify this for products meant for export. The average wage in the large inland province of Sichuan is only 23% lower than in the coastal province of Zhejiang (the gap is much smaller for manufacturing wages). After accounting for the additional logistical cost of moving inland and for future wage growth, we feel that an export-oriented industry that is no longer viable on the east coast will move abroad rather than inland. The inland provinces will mainly succeed in sectors aimed at the domestic market or where there is special government support.
... This is not to suggest that the Chinese cannot compete on innovation and high-value activities. After all, it is a country capable of high-tech nuclear and space programmes. Recent census data also showed that the proportion of college graduates jumped from 3.6 to 8.9 per hundred between 2000 and 2010. Nonetheless, the Chinese cost advantage declines as we go up the value chain. As already shown in the previous section, Chinese MBAs are already half as expensive as equivalent Americans. The gap may be smaller after considering relative productivity and the pace of salary increases. In our view, therefore, the future trajectory of China’s production base will have a strong bias towards activities where the domestic market gives it critical mass. According to Jun Ma, Deutsche Bank’s Chief Economist for China, rising wages will create a big domestic market for equipment and machinery and the country could even leverage this for the export market. At current exchange rates, we think that Japan could be at most vulnerable to such a development. It could even affect Germany in the long run despite its famed ability to compete on design and quality.