China Costs Rise – How Bad Is It for Outsourced Manufacturing?
There were two huge announcements in the last few weeks about costs in China. First we had the announcement from Foxconn that they would raise the base wage in their huge Longhua campus in Shenzhen. They have gone from 900 RMB/month to 1200 RMB/month, and they plan to increase that again later this year to 2000 RMB/month for workers who pass a certification test. Then just last week, the People’s Bank of China announced that they would let the Yuan rise from its current narrow trading band.
Before the Chicken Littles get out their umbrellas, it is important to realize neither of these changes is a complete surprise. In my previous blog post just a few weeks ago before these announcements, I commented on the expected wage inflation and currency appreciation in China. The second thing to note is that these announcements were made for political as well as economic purposes, and neither has actually taken full affect.
On the surface, the wage increase was in response to bad press about working conditions and suicides, but there are other drivers as well. When I spoke with electronics manufacturers during my trip to China in early June, they had already made a salary increase to 1200 RMB/mo ahead of the official increase by Foxconn; so there doesn’t seem to have been any surprise there. They haven’t raised salaries to the level that Foxconn announced for the Fall (with the certification test). They expect they may have to raise salaries again, but they are going to wait and see.
My China trip included a visit to the (in)famous Foxconn Longhua campus. The most striking part of that visit was the visible response to the recent spate of suicides. On all of the taller buildings, they have installed booms at about the second floor level that support netting all around the building. I can’t imagine that one could fall several stories into the nylon rope net without serious injury, but they have certainly created a deterrent.
The Foxconn announcement of the wage increase was clearly coordinated well in advance with key customers and the government. During our visit, we were told that Foxconn is already planning to move jobs out of Longhua – within a year, they plan to go from 450,000 employees to 100,000! That is an enormous change that can’t be done so quickly unless you have already done your homework with the customer and the government. The division we visited plans to transfer most of its jobs to Tianjin. I spoke with a former senior manager at a Foxconn customer and was told that the government provided a very substantial subsidy for the new location.
I heard a few people describe the salary increase as “something that needs to be done for society” as opposed to direct response to the suicides or as a market response to labor shortages. It is interesting to note that at one factory we visited, they had a lot of shipments waiting to go out because of a strike at the port. Automakers in China have also been experiencing labor problems. As much as the wage increase is a rational response to market forces, this is also a government managed answer to perceived social unrest. China is trying to slowly make the transition from an export driven economy to a domestic consumption driven economy, and rising wages will be part of that change.
The wage increase associated with the “certification test” is an interesting approach. Turnover in Shenzhen is running around 5% per month – even more around holidays. If an employee has to work for three months to get the raise, this may help reduce turnover and the associated training costs – or it may lead to a lot of workers being let go after three months before the raise kicks in. It allows Foxconn to claim that they pay well, but it doesn’t necessarily drive up the entire wage base for unskilled labor. Between moving jobs to other regions and the use of the certification requirement, my guess is that Foxconn and other companies will find a way to keep average wages below 2000.
Nevertheless, the increase from 900 to 1200 represents a 33% increase in salary. Honda recently settled their strike in Guangdong by providing a 24% salary increase. These increases will ripple down through the economy in the form of greater inflation. In May, China’s inflation rate accelerated to 3.1%, exceeding the government’s target of 3%, and expectations are for increased inflation. What can be done to help control domestic inflation? Why not kill two birds with one stone and let the currency rise…
Again, the first thing to note is that the Yuan has not risen much yet, and probably won’t rise a lot in the near future. The People’s Bank of China announced “it is desirable to proceed further with reform of the RMB exchange rate regime and increase the RMB exchange rate flexibility.” However, they don’t say when or how much.
Coming the week before the G-20 summit, the political purpose of the announcement was clear: Let’s get the USA off our case about currency manipulation. But the expectation is that the rise will still be slow and controlled. We probably won’t see the 21% rise that occurred between 2005 and 2008 before the current peg was set. The consensus of the analysts and the futures markets is the Yuan will rise only 2.5% by the end of the year to about 6.65 CNY/USD compared to 6.83 before the announcement.
The rise in currency will increase the buying power of the Yuan and should reduce the need for an increase in interest rates to fight inflation. Like the wage increase, this is a necessary change in order to enable a shift from an export economy to a domestic consumption based economy – but it will be a slow change. If the currency appreciation also quells some of the complaints from Chinese trading partners, then that’s a bonus; although some US commentators are already saying that this is not enough.
So what does this double whammy mean for manufacturing in China? The buying power of Chinese consumer is on the way up and the price of imported raw materials will be down (from an RMB basis). So if you sell into the Chinese domestic market, these changes are generally good so long as inflation stays under control.
If you manufacture in China for export, costs are headed slightly higher. We did a quick analysis of the cost structure of a typical outsourced electronics product in China. We started with a base product cost of $100, and divided the cost into Direct Labor, Overhead, SG&A and Profit, and Direct Materials. Then we split each of those categories by how much of those costs are paid in RMB versus USD. The figures below are about average, but you can easily model your own exact structure. To get the expected total cost, we simply apply the expected increases to the RMB denominated costs. Of course, this doesn’t account for any USD inflation, ongoing efficiency improvements, or material reductions, but it shows the relative impact of wages, inflation and the currency.
Cost changes from china currency, wage and inflation variation
An increase of 4.4% may seem small to some readers, but in an industry where customers expect 6-12% decreases in price every year, any increase is a lot. In addition, the manufacturing services provider is probably making less than 4% profit, so if a customer holds the line on price, they are driving the supplier into the red unless there are other changes.
Of course, other than the wage increase, these changes play out over time. To mitigate the increases, we’ll see work transferred to lower cost parts of China, and ongoing efficiency and materials improvements (on our trip, we saw an increase in the use of automation over labor – not a common practice a few years ago). I don’t predict a sudden massive price increase for OEM’s. It’s more likely to manifest as slightly higher starting costs as new products roll in, and smaller cost reductions over time.
An important question is whether the official inflation rate of 3.1% will hold in the face of massive wage increases. In this model, every point of inflation takes the price up about another half point. It’s easy to envision a much higher inflation rate in China.
What should this mean for your manufacturing strategy? If you sell into the domestic China market, keep at it. If you export and are looking at other geographies as an alternative to China, what you need to compare is not the absolute cost in China, but the relative cost versus other locations. The graph below shows the exchange rate versus the USD in SE Asia and Mexico. You can see that with the exception of Vietnam (which has its own currency peg and its own financial issues), the other currencies have also risen versus the dollar, and a 2.5% rise in the Yuan actually leaves it still lower than many of the others. The wage increase is a bigger factor. Wages in coastal China are now equal or greater than wages in other SE Asia countries like Thailand and Malaysia.
Currency comparisions per USD (Jan.-June 23, 2010)
The cost increases in China are not great enough to spur a mass exodus of manufacturing as some have predicted. Countries that already have good supply bases and logistics (such as Malaysia and Mexico) look better as alternatives to China, and should be considered as you evaluate your supply chain. Over time, we expect movement of low cost manufacturing jobs westward in China and slow but steady increase in costs in the developed coastal regions. However, the cost increases will be offset by a growing domestic market and increased investment in manufacturing of higher technology, higher value products.
One of the best quotes I’ve read about the wage and currency increases comes from Bruce Rockowitz, President of Li & Fung, in a NY Times article: “This is not the end of China, but it’s the end of lower prices,” he said.
