- The Washington Times - Saturday, April 15, 2006

According to recent front-page articles in the New York Times and the Financial Times Asia edition, wages have been steadily rising during the last several years throughout southern China, where the world’s largest manufacturing base is located. Citing “double-digit” increases in Chinese labor costs, executives of the Li & Fung group, a $7 billion Hong Kong-based trade-sourcing company, told the Financial Times last month that the competitiveness of China’s sprawling manufacturing industries seriously eroded last year. William Fung even went so far as to declare that China “is no longer the most cost-effective country in the region,” an assertion that has been seriously challenged.

China’s rising costs have generated recent price increases averaging 2 percent to 3 percent for its goods, Mr. Fung reported. Though relatively small in absolute terms, these price increases nonetheless represent a major reversal of a long-term trend marked by “severe deflation.” That deflation, which reflects falling prices, was especially evident in many consumer durable goods, which are products expected to last three years or longer, such as furniture, household appliances and most electronic goods, all of which China produces in abundance.

The Commerce Department’s price index for all consumer durable goods, for example, has declined by nearly 20 percent since 1995, while the price index for furniture and household equipment plunged more than 40 percent over the same period. The prices for clothing and shoes, nondurable goods in which China specializes, fell 14 percent over the last 10 years. U.S. consumers derived extraordinary purchasing-power benefits from these falling prices, whose anti-inflationary impact has had the added benefit of helping to keep long-term interest rates, including mortgage rates, well below historical levels for years.

The New York Times article attributed China’s rapidly accelerating wages to “persistent labor shortages,” noting that the rising wages were “swelling the ranks of the country’s middle class.” U.S. workers should view this as a welcome development because American exports become far more affordable to Chinese workers whose living standards are rising. However, while the recent upward trend in Chinese wages is indisputable, there is good reason to believe that the trend will not have the long-term impact that experts cited by the New York Times seem to believe. Specifically, it is highly unlikely that rising wages are causing the Chinese economy to undergo “a profound change that will ripple through the global market for manufactured goods.”

Applying “the math of small numbers” to China’s changing wage structure, Stephen Roach of Morgan Stanley recently explained why China and its 1.3 billion people are unlikely to lose their comparative advantage in the manufacture of goods. “Rapid wage inflation off a very low base does little to close the gap with higher-wage economies on a moderate inflation trajectory,” Mr. Roach convincingly argued. Back-of-the-envelope calculations illustrate Mr. Roach’s point. The New York Times reports that the wages paid by multinational corporations in their largest Chinese factories typically average between $100 and $200 a month. (Minimum wages are less than $80 per month.) Given that Chinese manufacturing employees customarily work 10 hours per day six days a week, the upper limit ($200 per month) of wages paid by multinationals translates into 77 cents an hour. By contrast, U.S. workers in goods-producing industries earn an average wage of $17.72 per hour. Now, assume the 77-cent wage increases by 20 percent for each of the next five years. (The 20 percent annual increase would represent a significant acceleration over the 12-percent annual average that has prevailed since 1999.) Next, assume that the average U.S. goods-producing wage increases over the next five years by the Blue Chip consensus inflation forecast of 2.5 percent per year. Five years from now, China’s top wage would be $1.92 an hour, having increased by $1.15. America’s average goods-producing wage would be $20.05 per hour, having increased by $2.33, an absolute rise that is more than twice the absolute increase in the Chinese wage. The U.S.-Chinese wage difference would increase from $16.95 today ($17.72 less 77 cents) to $18.13 five years from now.

Responding to the New York Times assertion that China’s rising manufacturing wages are “threatening at some point to weaken China’s competitiveness on world markets,” Morgan Stanley’s Mr. Roach notes that “[p]roductivity growth in China’s industrial sector — manufacturing, mining and construction — surged at an average annual rate of nearly 20 percent over the 2000 to 2004 interval,” which was “well in excess of the cost pressures implied by 12 percent gains in hourly compensation.” Thus, unit labor costs probably declined over the past five years. At worst, they were very well contained. Mr. Roach finds the “labor shortage in China” argument to be “equally preposterous.” He cites the 60 million workers that have been furloughed by China’s state-sponsored enterprises since 1997. And he points to the fact that China’s rural population totals nearly 750 million, “by far the largest pool of surplus labor in the world.”

So, it is good news that China’s growing middle class is experiencing sizable relative income gains, a trend (if it continues) that will make U.S. goods more affordable to the average worker in China. It is also good news that the combination of soaring Chinese productivity and the continuing large absolute difference between Chinese wages and developed-country wages is likely to keep low-priced, purchasing-power-enhancing Chinese products within easy reach of consumers everywhere.

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