The End of an Era in China

It looks like most of the $100 bills lying on the sidewalks of China have been picked up already.

That's how I tend to think about a tremendously important phenomenon that is the subject of a KPMG study released today:

Consumer Companies Look Beyond China for Sourcing as China’s Low-cost Advantage Diminishes

With increasing labor costs and an aging workforce, China is losing its foothold as the world’s lowest cost manufacturer of consumer goods. Rising costs are forcing companies to take a closer look at new sourcing locations across Asia, according to a new report from KPMG International.

A number of countries in South and Southeast Asia are set to benefit from this recent shift, the report notes. While hard goods ranging from consumer electronics to furniture are still being sourced from China, apparel and footwear production is widely dispersed and more mobile across the Asia Pacific region (ASPAC). Clusters of specialized production are emerging, such as footwear in Indonesia and Vietnam and hand stitched fabrics and metalware in India.

“Sourcing goods in China purely because of ultra-low costs is a thing of the past,” said Nick Debnam, KPMG’s Asia Pacific chair, Consumer Markets and a partner in the China firm. “With demand still soft in many Western consumer markets, it is also proving difficult for companies to pass on higher costs to consumers. This changing environment is forcing companies to reassess sourcing strategies.”

For almost 20 years, manufacturing firms have been able to move production to China, employ low-cost but productive labor there, and earn unusual profits. Those were the proverbial $100 bills lying on the sidewalk, which is simply a poetic (at least to economists, who are not known for their poetry) way of saying that there have been arbitrage opportunities available in China to firms that could move production there. Specifically, the opportunitity for arbitrage was the result of a difference between the cost of labor in China (relatively low) and its productivity (relatively high).

Note that such gaps are quite rare in a development context; when countries have cheap labor, they typically have relatively unproductive labor as well. (For further explication and illustration of this point take a look at this classic paper by Stephen Golub (pdf), which provides some international evidence.) Why that gap between compensation and productivity was so large in China prior to the 1990s is an interesting subject to think about, and I suspect it has to do with China's institutions and pre-1990s communist system.

At any rate, as we well know, all arbitrage opportunities are eventually arbitraged away. And that's what's happened in China. The employment of tens (hundreds?) of millions of workers in China's factories over the past two decades has driven up wages -- and, crucially, driven up wages by more than labor productivity has grown. So while it's still possible to find low-cost labor in China, and it's certainly possible to find productive labor there, it's no longer easy to find labor that is low-cost relative to its productivity.

But I disagree with the conclusion of the KPMG study, which was that multinationals will now start moving their production to other Asian countries. They will certainly do so here and there, of course, but production will only start moving to another country in a large-scale and systematic fashion if that country has a similar gap between labor costs and productivity. And I just don't see such arbitrage opportunities in any other major countries in Asia. Maybe Vietnam has some, but I'm doubtful that they exist in Bangladesh, Indonesia, or India, in other than isolated industries or locations.

That's why I'm inclined to think that the massive and rapid development of manufacturing in China over the past two decades was really a once-in-a-lifetime event. It's impossible to understate the importance of that event -- I can't think of many economic changes that have similarly altered the lives of hundreds of millions of people in such a profound and rapid manner -- but a once-in-a-lifetime event it probably was. After all, you really shouldn't expect to find $100 bills lying on the sidewalk every day.