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Beijing University Professor Fan Gang: Rising labor cost in China not a worry

September 6th, 2010 Leave a comment Go to comments

It’s Labor Day in the U.S.! There has been a lot of sensationalism in the West regarding rising labor costs in China (i.e. Foxconn, Honda, etc.). Just to keep things in perspective, we are talking about instances of factory workers making something like $100 a month to making $150 a month in the richer coastal cities. While it is a whopping 50% jump, that $50/month is easily absorbed by other factors as explained by an economist and Beijing University Professor Fan Gang. He is also Director of China’s National Economic Research Institute, Secretary-General of the China Reform Foundation, and a former member of the Monetary Policy Committee of the People’s Bank of China.

I have read too many “dumbed down” and sensationalized articles in the West about the labor cost issue in China. Here is an intelligent (and I also dare say “boring”, as in Daniel Schorr’s “boring”) view from China (appeared in China Daily as, “Is low-wage China disappearing?“):

Is low-wage China disappearing?
By Fan Gang (chinadaily.com.cn)
Updated: 2010-08-31 13:29

BEIJING — Reports about labor shortages, wage disputes, and wage increases for migrant workers in China have abounded of late. They naturally raised concerns, or expectations, that China’s labor-cost advantages may be disappearing.

It is my hope that China’s comparative advantage as a low-wage producer does disappear — the sooner the better. But why should I, a Chinese economist, wish to see China’s competitiveness reduced through rising labor costs? After all, when a country still lacks real advantages, such as higher education, efficient markets and enterprises, and a capacity for innovation, it needs something like low wages to maintain growth.

While cheap labor has been a key factor in generating high growth over the past three decades, it has also contributed to profound income disparities, especially in recent years. And persistent, widening inequality might cause social crises that could interrupt growth and damage competitiveness. China must avoid such a scenario, and if wages could increase in some meaningful way, it would indicate that the economy might finally reach the next stage of development, during which income disparities would be narrowed.

Unfortunately, China has not yet reached that point — and will not any time soon. Agriculture remains the main source of income for more than 30% of China’s labor force, compared to less than 2% in the United States or 6% in South Korea. Another 30% of the labor force comprises migrant workers, who have doubled their incomes by moving from agriculture to the industrial and service sectors.

Although migrant workers earn only about $1,500 per year on average, the income gap between them and agricultural laborers provides a powerful incentive for the latter to try to find better-paid non-farm jobs. Naturally, this competition in the labor market suppresses non-farm wages: whereas labor productivity in non-farm sectors increased by 10-12% annually in the past 15 years, migrant workers’ real wages have increased by only 4-6% per year. As a result, income disparity between low-end labor, on the one hand, and professionals and investors, on the other, has also increased.

All this means that the process of industrialization in China still has a long way to go. To reduce farm labor to 10% of the labor force (the point at which, judging by historical experience elsewhere, China may achieve worker-farmer wage equilibrium), the economy needs to create about 150 million new non-farm jobs.

Even if the economy continues to grow at 8% per year, China might need 20-30 years to reallocate agricultural laborers and reach “full employment.” But this requires generating eight million new jobs every year, including five million for farmers leaving the countryside.

During this long process of industrialization, wages will increase gradually, but it is very unlikely that they will grow at the same rate as labor productivity. This is bad news for reducing income inequality, as capital gains and high-end wages may grow much faster. But it should be the good news for competitiveness, because Chinese wages will remain relatively low in terms of “wage efficiency.”

Indeed, the wage increases of recent years have not changed the basic cost structure of Chinese companies. An analysis by Goldman Sachs shows that, despite real wage gains, the share of labor costs in total manufacturing costs is lower than it was in 2001 — a trend that continued in the first half of 2010.

To prevent serious social tension, China’s government (at various levels) has begun to intervene by enforcing higher minimum wages, in addition to investing in a social safety net for the poor. In some provinces, minimum wages have increased by more than 30%. But the minimum wage is normally much lower than the effective wage, and thus has not changed the fundamental relationship between wages and labor productivity.

Nevertheless, artificial wage increases enforced by government policies could slow down the process of labor reallocation and make some “surplus labor” permanent. Income disparities will not be fundamentally altered until the market equilibrium wage inches upwards sufficiently to create labor demand at decent wage levels.

So will companies, both multinationals and Chinese, leave for Vietnam, Bangladesh, or Mozambique? Perhaps. But that will happen only if the other countries’ wages are relatively more efficient (i.e., productivity there is ultimately higher than in China), and not just because Chinese nominal wages go up. For now, however, this does not seem to be the case in general.

Evidence that China’s wage efficiency remains high relative to other developing countries comes in the form of continued growth in inflows of foreign direct investment over the past 12 months, despite wage increases. In July, for example, FDI increased by 29.2% year on year, much higher than the global average. There may be many factors behind China’s strong FDI performance, but it does mean that the nominal wage increase itself may not lower the capital gains that concern investors most.

In any case, the Chinese wage story is much more complicated than it might seem. Nominal wages may increase, while real wages stagnate, owing to higher inflation. Even if real wages increase in some coastal cities, “surplus labor” could keep the national average flat. And even a real wage increase on the national level will not undermine competitiveness if labor productivity grows still faster.

So the conclusion seems to be that wage growth will not threaten China’s competitiveness in the next 10 or even 20 years. As China will not complete the process of reallocating workers from agriculture to more modern economic sectors any time soon, it should remain a cost-competitive economy for the foreseeable future.

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