The modern, low-cost export manufacturing industry was born in Japan, raised by the Asian Tigers, and matured to perfection in China, where it was truly globalized and amplified to an unprecedented level. Yet the cycle continues. China's phenomenal success as the world's factory has emboldened its labor pool, and rising wages signal the end of the country's tenure as a low-cost leader.

The implications of this transition were the focus of our latest research trip to Asia (including mainland China and Southeast Asia). As China begins the process of passing the low-cost manufacturing torch, we highlight Vietnam and Indonesia as the likely contenders to take over the role of the world's factory floor. In the meantime, we believe Western consumers will experience price increases on consumer goods, especially at the low end.

China's explosive macroeconomic growth over the last decade has not been uniformly enjoyed among its citizenry. Most of the benefits have gone to the state and to corporations at the expense of labor. This was most noticeable during China's "Shanghai Internationalist" period, spanning from before China's entry into the World Trade Organization (WTO) in 2001 to shortly thereafter. This period, which occurred under the leadership of Jiang Zemin (president from 1993 to 2003) and Zhu Rongji (premier from 1998 to 2003), was characterized by an embrace of globalism and international trade.

Labor's share of GDP seems to have bottomed in 2004 at about 11% and has remained steady in last few years, although wages in China are beginning to trend upward. A resurgence of traditional, pro-labor, communist doctrine (coming out of Bejing) is thriving in the post-Shanghai internationalist environment. In this milieu, labor unions have felt comfortable in adopting a much more aggressive (and at times militant) stance, and they are gaining ground.

Minimum wage levels are rising strongly even in some of China's inland regions. In fact, we now see only marginal wage differences between first tier coastal cities and interior provinces such as Sichuan and Xinjiang that are critical to China's "Go West" campaign to populate more remote, inland areas. This paltry wage differential is somewhat surprising, because we assumed that the government would depress wage levels in these regions to attract employers.

China's minimum wage is still low compared to some of its neighbors, but our concern is its rate of change and its trajectory. Granted, we admit that minimum wage levels do not necessarily accurately reflect the living standards and total cost structure of a labor market, but they do provide some meaningful insight into different labor markets since minimum wage is the base.

Besides rising wages, there are several other dynamics forcing global original equipment manufacturers (OEMs) – including Chinese OEMs – to search for new low-cost manufacturing hubs. First, while China's labor is seeking to share in the country's overall economic progress, a more sympathetic ruling regime in Beijing is allowing unions to become much more assertive. Next, it is not in China's best interest to remain as the low-cost and low economic-value-added manufacturing hub for global OEMs. For China to advance beyond its current economic status into a middle-income nation, it needs to derive a greater portion of its economic output from high-value-added manufacturing and service sectors.

Against this backdrop, the Association of Southeast Asian Nations (ASEAN)¹ countries, specifically Vietnam and possibly Indonesia, appear perfectly positioned to emerge as an outlet for rising wage pressure in China. Their surplus of young and cheap labor, close proximity to China, and abundance of raw materials for production all give ASEAN countries significant competitive advantages over potential rivals from Latin America and Eastern Europe.

 

ASEAN Countries Present Significant Advantages to Potential Employers
	Real GDP (US$ bil)	Population	Real GDP per Capita (US$)	Average Age	Population Growth
NAFTA2	$17,717	460,986,000	$38,433	34.8	0.9%
EU	$14,660	492,387,000	$29,773	42.2	0.1%
ASEAN1	$3,094	613,760,000	$5,040	27.6	1.6%

Sources: Bloomberg, CIA World Factbook, Saturna Estimates

Further, as today's Asian economic powerhouses seek free-trade-zones and partners to compete with NAFTA² and the EU, ASEAN becomes an obvious choice, as it is strategically located in the middle of the greater Asia-Pacific region.

There are two pivotal transportation infrastructure projects currently underway that are designed to link the upper-ASEAN region to China: the Singapore-Kunming Railroad Link and the ASEAN Highway Network. Once completed, Vietnam stands to benefit from direct links to China's southern transportation hub of Kunming and major seaports along the coast. As a result, Vietnam is poised to emerge as a valuable link in China's manufacturing supply chain.

But why would Vietnam be first in line as a manufacturing hub, ahead of Laos, Cambodia, or Burma, all of which have lower labor costs than Vietnam? The answer lies in an old Chinese military proverb: "Water flows through the path of least resistance." Sun Tzu may have been referring to supply and logistical dynamics of military affairs (supply lines prefer to travel by open terrain, if possible, rather than through peaks and valleys), but this can also apply to today's commercial supply chains. If we consider the geography of the upper-ASEAN region, we notice that other potential manufacturing hubs leading to China do not possess ideal terrain for a land-based supply-chain system: Laos has heavy jungle, and Burma forces the crossing of a mountain pass (the beginning of the Tibet plateau). So, why bother when Vietnam offers low-lying stable coastal terrain for trucks and rail cars?

Vietnam also offers a relatively stable political and economic infrastructure compared to Burma, Cambodia, and Laos. Vietnam has worked for many years to attract international investors (gaining full WTO membership in 2007) and offers a much greater pool of educated labor than the others. Burma, a fellow WTO member, has certain advantages, but its current political situation is not conducive to foreign investment.

 

Vietnam's Labor Pool is Attractive to Employers
	GDP per Capita	Labor Force	Median Age	Literacy	Education Level
Vietnam	$3,055	46,210,000	27.8	94%	10 Years
Burma	$1,416	31,680,000	26.9	90%	9 Years
Cambodia	$2,053	8,800,000	22.9	74%	10 Years
Laos	$2,422	3,690,000	21.0	73%	9 Years
Indonesia	$4,200	116,500,000	28.2	90%	13 Years

 

Sources: Bloomberg, CIA World Factbook, Saturna Estimates

Global multinationals seem to agree, and they are voting with their dollars as Vietnam has seen a huge inflow of foreign direct investment since entering the WTO.

Indonesia, too, is a possible winner in the global search for the next great manufacturing hub. Indonesia does not offer direct land access to China, but given its huge and young labor market, low wages, strategic location, and relatively stable political environment, the country is too attractive to ignore. Indonesia is the world's fourth largest country (in terms of population), with over 245 million people, and a member of the Group of Twenty (G-20) with a nominal GDP of US$706 billion as of 2010.³

Indonesia is also set to enjoy a "demographic dividend" of its expanding labor force, as new entrants to its workforce (ages 15 and below) will more than offset its retiring workforce (ages 50 to 64) in the next 15 years.

Despite the potential for Vietnam and Indonesia to become the next great manufacturing hubs, we would encourage investors to curb their expectations and refrain from predicting immediate demise of China as the global center of low-cost manufacturing. China possesses a scale that no country (or collection of a few countries) can match for the foreseeable future.

 

China's Share of Global Production (2008)4
	% Total Global Production
Energy Saving Lamps	90%
Sports Shoes	80%
Small Home Appliances	80%
Air Conditioners	70%
Toys	70%
Glasses	70%
Gifts	60%
Personal Computers	50%
Containers	50%
Shoes	50%
Cell Phones	48%
Electrical Products	45%
Electric Components	39%
Furniture	28%
LCD TVs	19%

 

This means the era of cheap, low-end, manufactured goods may be coming to an end. The days of $7-$8 Walmart t-shirts may no longer be possible. Nor will basic consumer goods companies continue to enjoy 40-50% gross margins manufacturing and importing sneakers. With wage increases in China, a burgeoning middle class of emerging market consumers competing for goods, and the absence of a ready, supplemental workforce and infrastructure to meet demand, the world's consumers should mentally prepare for the eventuality of rising prices.

All is not lost for Western consumers as there are always two sides to every story. A few years ago, a Chinese media outlet was quoted as saying, "Whatever China makes, its price goes down. And whatever China buys, its price goes up." This seems in line with the recent historical norm.

As China moves up through the economic value chain by outsourcing many of its low-cost, low-value-added consumer goods to places like Vietnam and Indonesia and begins producing more value-added products, it is highly likely that prices of these intermediate consumer goods will fall. We are already experiencing this phenomenon with many consumer electronics, for example, as China is becoming the main manufacturing hub of electrical goods.

At least for now, we anticipate that the price levels of basic consumer goods in the West will likely rise in the future, but they will be offset by a decline in the price levels of mid-tier consumer goods. This will benefit the middle and upper-middle income segments of our population at the expense of low-income households.

Copyright 2011 Saturna Capital Corporation and/or its affiliates. All rights reserved. Vol. 5 · No. 7

 

¹ The ASEAN member countries are Brunei Darussalam, Cambodia, Indonesia, Laos, Malaysia, Myanmar (Burma), Philippines, Singapore, Thailand, and Vietnam. For more information, visit asean.org.
² The North American Free Trade Agreement between the United States, Canada, and Mexico became effective
January 1, 1994, and created the world's largest free trade area.
³ Source: International Monetary Fund. www.imf.org
⁴ Cui, D., Zhao, A., and Tian, T. China: Not-so-trivial facts. Bank of America Merrill Lynch. October 22, 2009.

 

 

(c) Saturna Capital Corporation

www.saturna.com