Is low-wage China 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 labour costs? After all, when a country 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 labour 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 labour force, compared with less than 2% in the US or 6% in South Korea. Another 30% of the labour force comprises migrant workers, who have doubled their incomes by moving from agriculture to the industrial and service sectors.

Though migrant workers earn only around $1,500 per year on average, the income gap between them and agricultural labourers provides a powerful incentive for the latter to try to find better paid, non-farm jobs. Naturally, this competition in the labour market suppresses non-farm wages: Whereas labour 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 labour, on the one hand, and professionals and investors, on the other, has also increased.

All this means the process of industrialization in China has a long way to go. To reduce farm labour to 10% of the labour force (the point at which, judging by historical experience elsewhere, China may achieve worker-farmer wage equilibrium), the economy needs to create around 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 labourers 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 unlikely that they will grow at the same rate as labour productivity. This is bad news for reducing income inequality, as capital gains and high-end wages may grow much faster. But it should be 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 labour 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 at least 30%. But the minimum wage is normally much lower than the effective wage, and thus has not changed the fundamental relationship between wages and labour productivity.

Nevertheless, artificial wage increases enforced by government policies could slow the process of labour reallocation and make some “surplus labour" permanent. Income disparities will not be fundamentally altered until the market equilibrium wage inches upwards sufficiently to create labour 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, foreign direct investment (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 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 labour" could keep the national average flat. And even a real wage increase on the national level will not undermine competitiveness if labour 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.

Fan Gang is professor of economics at Beijing University and the Chinese Academy of Social Sciences, 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.

©2010/PROJECT SYNDICATE

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