The End of Cheap Labor in China

On May 25, U.S. businessman Charles Hubbs made the short trek to Hong Kong from his office just outside Guangzhou, a city in Guangdong province in southeastern China that is known for good reason as the manufacturing workshop of the world. For the 64-year-old native of Louisiana, it was a trip that may have marked the beginning of the end of his successful 22-year run as a China-based exporter of medical supplies.

Hubbs was going to listen to a pitch from the American ambassador in Cambodia, Carol Rodley, and the president of the American Chamber of Commerce in Phnom Penh. Their aim was simple: to get foreign investors, particularly those already with operations in China, to consider setting up shop in Cambodia. Hubbs was all ears. To hear him tell it, the price of labor is on the brink of making his firm, Guangzhou Fortunique, which supplies some of the U.S.'s biggest health care companies, uncompetitive. "We've seen our wage costs in China go up nearly 50% in the last two years alone," he says. "It's harder to keep workers on now, and it's more expensive to attract new ones. It's gotten to the point where I'm actively looking for alternatives. I think I'll be out of here entirely in a couple of years." (See "As China Economy Grows, So Does Labor Unrest.")

He is not alone. In what is supposed to be a land of unlimited cheap labor — a nation of 1.3 billion people, whose extraordinary 20-year economic rise has been built first and foremost on the backs of low-priced workers — the game has changed. In the past decade, according to Helen Qiao, chief economist for Goldman Sachs in Hong Kong, real wages for manufacturing workers in China have grown nearly 12% per year. That's the result of an economy that's been growing by double digits annually for two decades, fueled domestically by a frenzied infrastructure and housing build-out — one that, for now anyway, continues apace — combined with what was for a time an almost unquenchable thirst for Chinese exports in the developed world. Add to that the fact that in the five largest manufacturing provinces, the Chinese government — worried about an ever widening gap between rich and poor — has raised the minimum wage 14% to 21% in the past year. To Harley Seyedin, president of the American Chamber of Commerce in South China, the conclusion is inescapable: "The era of cheap labor in China is over."

Mind you, that doesn't mean that labor costs in China, even in the most expensive parts of the country like Guangdong province, are higher than in most other places, particularly in the developed world. They aren't. The average manufacturing wage in China is still only about $3.10 an hour, (compared with $22.30 in the U.S.), though in the eastern part of the country, it's up to 50% more than that. The hourly cost advantage, while still significant, is shrinking rapidly. For the vast majority of companies, whether small, medium-size or huge multinationals, the decision about where to produce a product is always driven by multiple factors, of which the cost of labor is but one. "For lots of companies over the past two decades, the disparity was such that labor costs often drove the decision," says economist Daniel Rosen, the China director and principal of the Rhodium Group, a a New York City–based consulting firm. "Now, increasingly, that's no longer the case." (See portraits of Chinese workers.)

The ripple effects of this new reality are enormous, and they flow globally. Start with China itself. The push for higher wages, constrained for so many years, sparked a series of high-profile labor protests last year. (Worker discontent was also reflected by 14 suicides at Foxconn, the large manufacturer that produces goods like the iPad.) But higher wages have also improved things in China's western region, where the government has long tried to encourage investment. In the past year, many multinational and Chinese companies have expanded or relocated inland, where labor is still cheap.

From China's perspective, that's exactly the sort of trade-off it seeks. As Andy Rothman, chief China macro strategist at CLSA Securities in Shanghai, says, "People in Sichuan or Henan or wherever can stay closer to home and find a good-paying job" instead of having to flood east each year to live in a company dormitory far away from their families. "How is this a bad thing?"

See China's mining pit.

It's not. Ask Wu Dingli, a 24-year-old from Ziyang, a city in Sichuan, who for five years had been working in a small electronics factory in Dongguan, the huge, dreary factory town between Guangzhou and Shenzhen in the southeast. She was laid off in late 2008, when the global financial crisis temporarily crippled Chinese exports to the West. A year later, she found a job on the production line of a company that supplies electric cables to, among other customers, a Hewlett-Packard personal-computer plant in Chongqing. She says she's making "only a bit less" than she did before, "but life is much easier for me here because I'm closer to home. I much prefer this job to the old one."

The changing economics of Made in China will benefit both the rich and poor world. Countries like Cambodia, Laos, India and Vietnam are picking up some of the cheapest labor manufacturing left by the Chinese. And according to a recent study by the Boston Consulting Group (BCG), there is already evidence of at least the beginning of a shift in manufacturing operations returning to the U.S. Last year, Wham-O, the company that makes inexpensive, albeit iconic, toys, announced it was moving 50% of its Frisbee and Hula Hoop production back to the U.S. from China and Mexico, a move that created hundreds of new American jobs. (See pictures of the making of modern China.)

Toymaking, of course, along with footwear and textiles, was among the first industries to head to China as the cheapest source of reliable production. It's a labor-intensive, relatively low-tech industry — one that most economists assumed would be gone forever once it left. But a look at how the economics have changed over the past decade sheds some light on why companies like Wham-O are deciding to return. According to the BCG study, in 2000, China's average wage rate was 36% of the U.S.'s, adjusted for productivity. By the end of 2010, that gap had shrunk to 48%, and BCG estimates that it will be 69% in 2015. "So while the discussion in the short term favors China," says Hal Sirkin, senior partner at BCG and the author of the recent study, "the spread is getting down to a smaller and smaller number. Increasingly what you're seeing [in corporate boardrooms] is a discussion not necessarily about closing production in China but about 'Where I will locate my next plant?'"

Perhaps the most important effect of rising wages in China is that they will put more money in people's pockets, which is something that's in the interest of everyone — most emphatically Beijing's major trading partners, who urgently need China to increase its consumption in order to reduce drastic imbalances in global trade. As much as higher wages may cut into the bottom line of exporters like Charles Hubbs and thousands of Chinese-owned companies across a wide range of industries, the process is the inevitable result of China's becoming a wealthier country with a stronger currency. "It's exactly what needs to happen," says Rosen. (See "China: The Road to Prosperity.")

Many multinationals, meanwhile, have long since begun to focus their China manufacturing operations on the vast Chinese market. That HP factory in Chongqing produces its laptops only for the home market. In a survey eight years ago, the American Chamber of Commerce in South China found that 75% of its members were focused mainly on export markets. By last year, that number had flipped: 75% of 1,800 respondents now say their manufacturing operations in China are focused on serving the Chinese market. That's mainly because China's workers are steadily getting richer. For them, and pretty much everyone else concerned, that's the rarest of commodities in a troubled global economy: good news.