The WalMart Effect – Who Will Reap the Benefits of Cheap Labor?

[1. http://www.theatlantic.com/business/archive/2013/08/motorolas-new-smartphone-made-in-the-usa-but-not-for-much-pay/278270/.]

Chinas middle class is rising. The aftermath of this not-so-resent acknowledgment will bring unforeseeable changes to our economy. However that did not stop me from giving the following analysis a healthy try. My first perception and the initial question of this article was, that middle-class rise will hold nothing good in store, neither for Chinese domestic economy, nor for world economy. The above title evolved during my research; I am referring to the American retailer who is offering the most competitive pricing in his market segment –  the products that Wall Mart sells are greatly sourced from China, the foundation of its success have been the cheap wages thanks to the former “factory of the world”…

Comparing Dimensions [2. http://www.mckinsey.com/insights/consumer_and_retail/mapping_chinas_middle_class.] – Chinese urban middle class has indeed grown excessively in the last decade; from 4% in 2000 to 68% in 2013.  But it will not be able to keep its pace, till 2022 it is only expected to grow by another 7%. The reason for this; China has used up all their labor resources, cheap workers from thee hinterland cannot fuel the industrialized zones anymore and much of its power supply has been used up. In fact, workers are returning to the mainland where most industries still are to being build up. [3. http://www.economist.com/node/21549956.] Yet, the main reason for the lesser growth is, as it can be seen in the following chart from McKinsey, that the growth is happening within the middle class itself. Former lower-income middle class is expected to make it to the upper middle class segments.

What is middle class? [4. http://go.bloomberg.com/market-now/2013/09/04/is-35000-a-year-middle-class/.] – The definition of middle class obviously differs from country to country. In North America it has been acknowledged that the lower end of the US-middle class (app.$25.000) is struggling with increased living costs and stagnating income ever-since the 2008 financial crisis. Only households with already more than 50.000$ are actually able to fund themselves a comfortable living and improve. Chinese lower middle-class is earning much less than US lower middle class with US$9,000 to US$16,000. They represent 54% of the population of the urbanized areas. Chinese upper middle class can earn as much as $34.000.

Most middle class citizens in the USA now feel increasingly poor, especially with a budget of $35.000 – whereas on the other side of the world middle class aspirations are lifting up heavily.

Why is it not good? – This shift to a high-earning middle class entails major changes to Chinese economy. Most importantly, wages and therefore production costs will rise, but will China also become less competitive?

The global supply chain competitiveness of low-value goods is fairly easy to predict; imagine a 50 cents lightbulb that comprises of mostly just air does not benefit from major costs advantages anymore. Consequently it stops being economic to ship it thousands of miles overseas to its final place of consumption. [5. http://www.economist.com/node/172664.] Chinese middle class rise entails that major costs advantages that existed in the past, are now overruled by the rising wages of middle class employees. The American Chamber of Commerce in Shanghai conducted a survey which concluded that 91% of its members think “rising costs” are one of the biggest challenges for China today. [6. http://www.economist.com/node/21549956.] The effects of this new challenge are already obvious since 2011, when in the Chinese manufacturing sector went down 34%. In return, manufacturers are looking at Vietnam for cheap production and higher returns on their investment. Surprisingly it is not high-tech and capital goods production that grows most in China, but iron and steel (up 186.7%) and plastics (up 144.4%) production that accounted for most growth under the top ten exported products. [7. http://www.worldstopexports.com/chinas-top-10-exports/1952.] This indicates that there is still a strong reliance on low-value goods production in China when it comes to exports. The multinational companies that produce especially labor-intensive products, such as textiles and apparel, now aim to diversify beyond China. Although they do try to establish R&D facilities, many of the facilities lack the creativity to originally produce intellectual-property.

The rise of its middle class entails an even more disadvantages: tourism streams into China will decline because their stay will become more expensive to visitors, or in other words; the purchasinf power parity will increase. More importantly, the outbound flow of Chinese upper middle class citizens into the rest of the world will create an increased national deficit for its economy. Insiders believe that this is one major reason for decreased Chinese GDP growth in 2013. [8. http://www.economist.com/news/china/21596568-china-has-worlds-biggest-trade-deficitin-services-number-great-import.]

 Considering the above chart, it becomes obvious that no Asian country that is considered as developed nation today, was able to sustain their high growth rates. The same development will reach China at least in 2022. Their growth rates will distinctively decline. This is not necessarily something bad. For now I am just implying that China might reach the same economic problems that any other developed nation would reach at that stage, but there is another significant chart that I must be brought up at this point.

[9. http://www.marketthoughts.com/z20080828.html.]

The graph above does not only visualize how the Chinese middle class will rise in the near future, but also how it will decline in the long-run. Its expected stagnation and decline will start just when it reached its climax in 2022. The time when Chinese middle class declines, is the time when the effects of three decades of one-child-policy will come into place.

So far I have explained what the negative effects of the rising middle class might be for China. But of course, even though cheap labor diminishes, there are plenty of industries that are not at all affected. The USA is just one good example of how automotive and High-tech manufacturing can still exist in a developed country and continues to be greatly successful.

But when the cost advantage is lost, what major advantage can China hold for western companies to stay an attractive place for investment?

A survey team of the American Chamber of Commerce in Shanghai and Booz & Co. that contacted 1000 foreign manufacturers asked why they came to China. They found out, that while cost advantages were only second in place, the most important reason was that foreign investors need to be able to access the Chinese market. [10. http://businesstheory.com/supply-chain-management-china/.] It makes sense – this market has by itself now become so important that multinationals do not necessarily focus on the export factor anymore, but on domestic production. Volkswagen for example just opened another production facility in Ningbo, China. They plan to boost annual production from 2.6 million to 4 million cars per year and will open even more factories in the future.

Apart from increased domestic consumption, there will another major shift be taking place in the Chinese market – the rising middle class will increase their piece of the pie from added value profits, and they must take it from multinationals. Many products of Chinese export are assembled products with, in fact, much less added Chinese value that one would think. The total production costs of a  Iphone 3G did only include 3.6% added value for China. The actual gain of the Chinese economy for an Iphone that sold for many hundreds of Dollars, was just about 6$. [11. http://www.adbi.org/files/2013.05.08.cpp.sess3.3.xing.supply.chain.iphone.pdf.]

What we will therefore see in the near future is that more and more Chinese companies will try to move up the value chain and boost productivity. The domestic value-added exports (DVAE) share is an indicator to assess more accurately the role of value added activities of export products. It is what is left after subtracting imports that have been used up to produce the exported products. The below chart shows that the DVAE percentage in Chinese export has increased whereas total exports actually declined. Although China is exporting less, it is also is producing relatively more by themselves and therefore reaping more profits from these exports. Please keep in mind that these are growth rates and not total rates.

[12. http://www.mckinsey.com/insights/globalization/a_truer_picture_of_chinas_export_machine.]

Boosting Chinese Car Industry – There is no doubt that the Chinese car market will grow decisively bigger than it is now, but the next step and major aim for Chinese car manufacturers must actually be to export their cars. One of the major producers is Geely. Their Qoros 3 Sedan, which they introduced in 2013 to the European market, became the first Chinese-made car to receive five Stars in the Euro NCAP crash tests. While Geely is still smiled upon by most western consumers and even by many Chinese, some insiders draw parallels to Toyota, which is now the best selling car manufacturer in the USA. Toyota entered the US market in the 1960s. Back then, nobody thought it could reach the level of US manufactures. “Cars from Japan, a nation synonymous with exporting cheap toys, hardly seemed a threat.” [13. http://money.cnn.com/galleries/2007/autos/0710/gallery.toyota_history/.]

The Shift to its Service Industry – John Maynard Keynes described in his book The General Theory of Employment, Interest, and Money the core connections between the middle class and economic growth. Having a stable and prosperous middle class is one of the most important steps for an economy to boost investments and the domestic economy. The final destination of its wealth will be the future power supply of its economy, the service industry. In developed worlds, this industry accounts to more than 70% of the whole economy of a nation. The UNCTAD Secretary-General stated that, “when developing countries grow, they grow through services”. [14. http://unctad.org/en/pages/newsdetails.aspx?OriginalVersionID=68.]

[15. http://www.worldbank.org/depweb/beyond/beyondco/beg_09.pdf.] The services will mainly take place in the government, health and education sectors. So while low-value manufacturing companies might draw out their investments in China, it could be that western healthcare companies are stepping in with their investments. How does this kind of shift look like? One major indicator of it happening right now in China is, that e-commerce is the number one driver of new technologically advanced warehouse spaces being built. This kind of investment has nothing to do anymore with exporting products, but is solely domestically focused. The development shows vividly Chinas’ todays focus – investments that are directed only at production for domestic consumption will increase. [16. http://www.forbes.com/sites/michaelzakkour/2014/02/06/supply-chain-key-to-success-in-china-outlook-2014/.] It will be interesting to see to what extent China will make self-sustained economic growth happen in the future. It will entail a massive boost of consumerism and take Chinese service sector to the next level.

Structural development and political modernization – The rise of Chinese middle class will even more entail two developments, first of all will China step back from being the global factory of the world in the near future and turn into a huge mall for upper middle class consumers. Global goods production will diversify, not only to ASEAN countries like Vietnam or Thailand, but also to back to western consumer countries. In consequence, government strategists must focus on hinterland production and development which also entails increased shipping costs. Cost advantages to ship Chinese products all over the globe will be over.

Potential awaits in the West – Investors in China are likely to focus their investments on the mainland, away from urbanized areas and the huge middle class with its rather expensive wages. The Chinese government is therefore trying to develop and urbanize especially western, less urbanized cities like Chengdu. Philips China is going align with this and announced  its “Go West” strategy in 2011. [17. http://www.chinadaily.com.cn/business/2014-02/14/content_17282481_2.htm.]

We’re building China into one of the key innovation and operation hubs of Philips Global for value creation, a hub with both global reach and influence…

Philips Greater China Chairman, Kong Xianghui

As the political analyst Francis Fukuyama already pointed out in his research, it is economic development that leads to political modernization. The Chinese regime had ranged against the bourgeois middle-classes of the west for almost the whole last century, now it is utmost important for its economy. Funnily, the government therefore decided to calls its middle class “New Middle-Propertied Stratum.” This also points out very well how Chinas’ new economy conflicts with the old political structures. A need for change is without doubt, the only question is how. According to Samuel Huntigton, a new-born middle class acts revolutionary.

[18. http://www.newyorker.com/online/blogs/comment/2013/03/will-the-middle-class-shake-china.html.] . This change, when it comes, will be greater than the small changes we have seen in the past. China today has become much more emancipated from the west. I pointed out that they will not rely on their exports anymore when the middle-class shift is accomplished. Further development entails a drastic change of political relations to the USA – China’s biggest trade partner. It has been exporting US$2.2 trillion to the USA in 2013 and holds money reserves of US$3.2 trillion. I assume that there will be a monetary policy change taking place where China will base the value of the Yuan as far away from the Dollar as possible – yet not by selling their Dollar reserves necessarily.

Who will produce cheap goods for the world? – These changes entail that China will not much longer be the producer for cheap goods and the prices of labor intensive products will therefore increase for western consumers. The question then, however, is who will be taking its place. Bloomberg has just recently reported of the capture of a US businessman in China who announced to shift over the production of his companies medical supplies to India. The reason for that decision – increased wages and exhausted supply of the Chinese labor market. India is commonly known for their disadvantageous infrastructure, hence a new governmental plan foresees to rise up an “industrial corridor” for seven industrial key cities.[19. http://www.businessweek.com/articles/2013-07-12/can-india-replace-china-as-a-manufacturing-hub.]

Referring back to the long-run decline of Chinese middle class starting in the 2020s, it is one country that develops quite contrary – India. When comparing the middle classes of these two countries, estimations today predict that India will overhaul the Chinese supreme economic position in 2045. The most important obstacle for them at this point, however, are their infrastructural problems.[20. http://blogs.reuters.com/globalinvesting/2009/09/22/another-nail-in-the-malthusian-coffin/.]

The American Outlook – An insider concluded that when currency and shipping costs are continuing to rise by 5% and labor costs by 30%, then it will be as expensive to make things in the USA as to make them in China already by the year of 2015. The below chart gives a legitimate impression of the extreme rise of Chinese production costs – already today it is much cheaper for multinational to produce in Mexico or India than there. [21. http://www.economist.com/node/21549956.]

It’s a myth that you can’t bring manufacturing here because it’s too expensive…. We’ve observed that wages in Asia are going up, wages here are relatively steady, consumers care more about where their products are being built, and you have advantages of having design close to your manufacture. Those advantages will well outweigh the costs that we have today and those costs will go down over time… If you look at the automotive industry or home appliances, manufacturing is coming back to the US, and there’s good reasons for it,””

Motorola CEO Dennis Woodside [22. http://www.truthdig.com/eartotheground/item/motorola_ceo_advantages_to_manufacturing_in_us_outweigh_costs_20130911.]

Motorola Production in Texashttp://www.youtube.com/watch?v=YfI_4O8718g

Motorola has recently announced that they are producing the late Moto X model in Texas through the subcontracted company Flextronics and will employ 2,500 new workers on American soil. Assembly positions in the factory are being paid at 9$ per hour – a competitive pricing. Motorola is confident to shift more production to US factories. Producing in western countries will entail that these employees will have to adjust to much lower wages as they are competing with the Chinese middle class. In the case of Motorola, this means wages add up to just below the poverty line.

 

 

 

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