The China Analyst

Recent developments in the Chinese economy have drawn renewed media attention to rising labour costs in China. More than 50 years ago, economist Arthur Lewis pointed out that with the expansion of the modern sector of a low-income country, the unlimited labour supply (from the rural sector’s labour surplus) would disappear and, as a result, the country will enter into a phase of faster real wage increases. Many countries, including South Korea and Japan, have experienced such a change. What about China—is it already at the Lewis turning point? If so, does this signal the end of cheap labour in China? By Li-Chia Ou

Has China reached the point of no return? (aka the Lewis turning point)

Those that argue that China has already reached the Lewis turning point cite the fact that starting from 2006, wages for Chinese migrant workers have skyrocketed. Based on data from the China Household Income Project, in 2006 and 2007, migrant wages increased by 11.5% and 11.2% in nominal terms, and 10% and 6.4% in real terms. Wage growth slowed in 2008, but resumed in 2009 when migrant wages increased by 16.6% in nominal terms and 17.3% in real terms. In 2011, China’s migrant workers got an average pay increase of around 21% according to data from the National Bureau of Statistics.

However, to conclude that China has already reached the Lewis turning point by looking only at migrant worker salary data ignores certain demographic realities and other broader forces at play in China. For example, in 2011, the agricultural sector accounted for only 9% of China’s total GDP but employed 40% of its labour force. This is an unusually high workforce percentage committed to a sector that accounts for less than 10% of the economy. In comparison, agriculture accounts for 3% of GDP and employs 7% of the workforce in neighbouring South Korea, while in the US, agriculture is only 1% of the economy and employees 2% of the US labour force. This implies that the productivity of China’s agricultural sector is much lower than that of the US or South Korea, which is understandable given that both countries have highly industrialised agricultural sectors and are more developed than China. As China’s economy modernises, so too will its agricultural sector, and in the process, become more productive and mechanised.

Assuming that the modernisation of China’s agricultural sector can reduce the agricultural labour force by 50%, an additional 160 million rural workers will be made available to participate in other sectors of the economy (China’s total workforce in 2011 was estimated to be around 800 million). All this serves to highlight that China has yet to reach the Lewis turning point and is unlikely to anytime soon.

Explanations for rising migrant wages

So if China has yet to reach the Lewis turning point, why have Chinese migrant wages risen so quickly? In theory, the surplus of rural labour in China combined with a fairly underdeveloped agricultural sector should work to suppress migrant wages from going up. To understand why this is happening, one needs to have a broad understanding of China’s socio-political context. Like most central governments around the word, the Chinese Communist Party (CCP) has a mandate to create more jobs for its citizens. However for the CCP, job creation is not just an economic issue, but also a political one; in a one party state like China, high unemployment would undermine the ruling party’s legitimacy to govern and can lead to social unrest. This can partly explain why China remains addicted to infrastructure spending; large infrastructure projects not only stimulate economic growth but also employ thousands of workers over a several year period. This also explains why China has been slow to modernise its agricultural sector. If China were to rapidly adopt a modernised agricultural sector, hundreds of millions of the rural Chinese population would be left without work. This large unemployed workforce would be difficult for the secondary and tertiary sectors to absorb all at once, since the vast majority of these rural workers lack the necessary education and training.

To keep this large rural population employed in agriculture and not flood the cities in search of higher paying jobs, the Chinese government has implemented various direct subsidies to indirectly boost their income. The most drastic measure was taken in 2004, when the government both increased cash subsidies to farmers and abolished agricultural taxes nationwide. These two government actions have created incentives for farmers to increase farm outputs, further adding to their income and applying upward pressure on migrant pay.

Furthermore, while cheap labour has been a key factor in generating high economic growth over the past three decades, it has also contributed to profound income disparities between rural and urban households. If left unchecked, such persistent, widening inequality could lead to social crises that could interrupt growth and damage competitiveness. To alleviate social tension, the Chinese government has begun to intervene by enforcing higher minimum wages along with investing in a social safety net for the poor. As part of the government’s plans to increase minimum wages by 13% annually through 2015, many provinces and municipalities, including Guangdong, Beijing and Shanghai, have raised their minimum wages by double digits in 2011.  While many of these minimum wage increases are occurring in China’s affluent eastern areas, it is clear that the main beneficiaries are the migrant workers who flock to these areas in search of work. Such a re-alignment of rural–urban income, as a result of wage increases for unskilled migrant workers, will reduce overall income inequality over time.

The changing nature of China’s cost competitiveness

Regardless of when China will reach the Lewis turning point, the indisputable fact is that Chinese migrant wages are rising and this in turn is also driving up general labour costs in China. The rise in Chinese wages means that China will no longer be the cheapest supplier of low-end manufactured goods. This will benefit countries such as Vietnam, Indonesia, Pakistan and other developing nations who can expect to see more manufacturing outsourced to their countries instead of China. However in reality, only a portion of total manufacturing will shift from China. Smaller low-cost countries simply lack the supply chain, infrastructure, and labour skills to absorb all of China’s current production volume.

Furthermore, China’s vast landmass and regional differences allows for the country’s central and western provinces to carry on labour-intensive industries, which coastal regions have outgrown. China’s spatial and regional diversity means that China can avoid the common ‘flying geese’ pattern of labour-intensive industries’ moving to less-developed economies by allowing labour-intensive industries to continue growing in the less-developed inland regions. In fact, this trend is already clear. In 2011, employment growth for migrant workers in the western and central regions stood at 8.1% and 9.6%, respectively. In contrast, employment growth in the Yangtze and Pearl River Delta regions was relatively stagnant, increasing by only 0.3% and 1%, respectively. Such a development is possible because China’s capacity for industrial development in the central and western regions has substantially improved as a result of the central government’s implementation of the ‘going-west’ strategy.

It should also be noted that while Chinese wages may be going up, Chinese exports are also moving up the value chain. In 1985, China had a GDP per capita of just USD 290 at current prices and had almost no high-tech exports¹. By 2011, China’s GDP per capita had increased to USD 5,414 with high-tech exports now accounting for roughly 30% of total exports. In contrast, the average GDP per capita of the countries which China then competed with was USD 8,318 in 1985². By 2011, the GDP per capita of these countries had increased to USD 37,291. This means that while wages in China may be going up, the wages of China’s competitors on a product-by-product basis have been rising even faster along with the sophistication of their exports. China might have become expensive for many low-end manufactured goods such as T-shirts and footwear, but it is still comparatively priced for semiconductors, cars and software development. In fact, recent hikes in minimum wages all across China are aligned with the government’s initiatives to accelerate the country’s process of industrial restructuring, since higher labour costs will force enterprises to move up the value chain into more technologically-advanced industries. In other words, various higher-end products currently being produced by South Korea, Japan, Taiwan, Singapore, and the US will face stiffer Chinese competition.

China still has a large untapped pool of migrant workers, but fewer will be working in low-end, labour intensive industries; instead, more will be employed in high-end value-added industries as China continues to move up the value chain, posing a greater challenge to middle- and high-income economies, as it moves towards head-to-head competition across various product categories.

Li-Chia Ou, Senior Consultant
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¹Note: High-tech exports are products classified with high R&D intensity, such as aerospace, computers, pharmaceuticals, scientific instruments, and electrical machinery
²Note: Assumes these countries/territories are the US, Japan, South Korea, Singapore and Taiwan