Source: When Fast Growing Economies Slow Down: International Evidence and Implications for China

Within the next five years, the United States is expected to experience a manufacturing renaissance with a return of the 'Made in USA' badge, as the wage gap with China shrinks and certain US states become some of the cheapest locations for manufacturing in the developed world, according to a new analysis by the Boston Consulting Group (BCG). Meanwhile, a recently published economics paper says that some of the strongly growing emerging economic powers such as China and Brazil, could face a middle-income trap where growth slows.

Last March we reported that China became the world's biggest manufacturer in 2010, overtaking the US which had held the crown since 1895.

Lawrence Summers, Harvard economist and President Obama's former economic adviser, famously said: "The dramatic modernization of the Asian economies ranks alongside the Renaissance and the Industrial Revolution as one of the most important developments in economic history." There is no need for revisionism on the judgment but with the great leap forward, BCG says as Chinese wages are rising at about 17% per year and the value of the yuan continuing to increase, the gap between US and Chinese wages is narrowing rapidly. Meanwhile, flexible work rules and a host of government incentives are making many US states - - including Mississippi, South Carolina, and Alabama - - increasingly competitive as low-cost bases for supplying the US market.

“All over China, wages are climbing at 15 to 20% a year because of the supply-and-demand imbalance for skilled labor,” said Harold L. Sirkin, a BCG senior partner. “We expect net labor costs for manufacturing in China and the US to converge by around 2015. As a result of the changing economics, you’re going to see a lot more products ‘Made in the USA’ in the next five years.”

After adjustments are made to account for American workers’ relatively higher productivity, wage rates in Chinese cities such as Shanghai and Tianjin are expected to be about only 30% cheaper than rates in low-cost US states. And since wage rates account for 20 to 30% of a product’s total cost, manufacturing in China will be only 10 to 15% cheaper than in the US - - even before inventory and shipping costs are considered. After those costs are factored in, the total cost advantage will drop to single digits or be erased entirely, Sirkin said.

Products that require less labour and are churned out in modest volumes, such as household appliances and construction equipment, are most likely to shift to US production. Goods that are labour-intensive and produced in high volumes, such as textiles, apparel, and TVs, will likely continue to be made overseas.

“Executives who are planning a new factory in China to make exports for sale in the US should take a hard look at the total costs. They’re increasingly likely to get a good wage deal and substantial incentives in the US, so the cost advantage of China might not be large enough to bother - -  and that’s before taking into account the added expense, time, and complexity of logistics,” said Sirkin, whose most recent book, GLOBALITY: Competing with Everyone from Everywhere for Everything, deals with globalization and emerging markets.

BCG says a number of companies, especially US-based ones, are already rethinking their production locations and supply chains for goods destined to be sold in the US. For some, the economics have already reached a tipping point.

Caterpillar, for example, announced last year the expansion of its US operations with the construction of a new 600,000-square-foot hydraulic excavator manufacturing facility in Victoria, Texas. Once fully operational, the plant is expected to employ more than 500 people and will triple the company's US-based excavator capacity. “Victoria’s proximity to our supply base, access to ports and other transportation, as well as the positive business climate in Texas made this the ideal site for this project,” said Gary Stampanato, a Caterpillar vice president.

NCR Corp. announced in late 2009 that it was bringing back production of its ATMs to Columbus, Georgia, in order to decrease the time to market, increase internal collaboration, and lower operating costs. And toy manufacturer Wham-O Inc. last year returned 50% of its Frisbee production and its Hula Hoop production from China and Mexico to the US

“Workers and unions are more willing to accept concessions to bring jobs back to the US,” noted Michael Zinser, a BCG partner who leads the firm’s manufacturing work in the Americas. “Support from state and local governments can tip the balance.”

Zinser noted that executives should not make the mistake of comparing the average labor costs for production workers in China and the US when making investment decisions. The costs of Chinese workers are still much cheaper, on average, than comparable US workers, and some managers may assume that China is a better location. But averages can be deceiving.

“If you’re just comparing average wages in China against those in the United States, you’re looking at the problem in the wrong way,” Zinser cautioned. “Average wages don’t reflect the real decisions that companies have to make. Averages are historical and based on the country as a whole, not on where you would go today.”

“In the US, we have highly skilled workers in many of our lower-cost states. By contrast, in the lower-cost regions in China it’s actually very hard to find the skilled workers you need to run an effective plant,” added Doug Hohner, another BCG partner who focuses on manufacturing.

BCG says even as companies reduce their investment in China to make goods for sale in the US, it is clear that China will remain a large and important manufacturing location. First, investments to supply the huge domestic market in that nation will continue. Second, in the absence of trade barriers that prevent offshoring, Western Europe will continue to rely on China’s relatively lower labor rates since the region lacks the flexibility in wages and benefits that the US enjoys.

Third, even though other low-cost countries - - such as Vietnam, Thailand, and Indonesia - - will benefit from companies seeking wage rates that are lower than China’s, only a portion of the demand for manufacturing will shift from China. Smaller low-cost countries simply lack the supply chain, infrastructure, and labour skills to absorb all of it, Hohner noted.

The Middle Income Trap

It is sometimes said that China will become old before it becomes rich

China's census results show that the world's second-biggest economy is moving towards a demographic watershed that will trigger wage rises, higher inflation and lower growth, a Chinese economist said in comments published last week.

Ba Shusong, a senior economist at the State Council Development Research Center, said the 2010 census data issued in April, together with other data, showed China's supply of abundant cheap labour would start shrinking soon.

"The current data show China has already crossed the Lewis turning point, and at the same time the window of the demographic dividend will soon close," Ba wrote in the Economic Information Daily.

A United Nations' agency report on global population, published last week, said that China, which has a one-child policy could see its population peaking at 1.4bn in the next couple of decades, then declining to 941m by 2100.

A working paper (pdf) produced by Barry Eichengreen, a professor of economics at the University of California, Berkeley, Donghyun Park, an economist at the Asian Development Bank and Kwanho Shin, an economist at Korea University, Seoul, say that periods of high growth in late-developing economies do not last forever. Eventually the pool of underemployed rural labor is drained. The share of employment in manufacturing peaks, and growth comes to depend more heavily on the more difficult process of raising productivity in the service sector. A larger capital stock means more depreciation, requiring more saving to make this good. As the economy approaches the technological frontier, it must transition from relying on imported technology to indigenous innovation.

The economists add: "Using international data starting in 1957, we construct a sample of cases where fast-growing economies slow down. The evidence suggests that rapidly growing economies slow down significantly, in the sense that the growth rate downshifts by at least 2 percentage points, when their per capita incomes reach around $17,000 US in year-2005 constant international prices, a level that China should achieve by or soon after 2015. Among our more provocative findings is that growth slowdowns are more likely in countries that maintain undervalued real exchange rates."

On the impact of undervalued currencies, the authors say: "it may be that countries that rely on undervalued exchange rates to boost economic growth are more vulnerable to external shocks resulting in sustained slowdowns. It may be that real undervaluation works as a mechanism for boosting growth during the early stages of development when a country relies on shifting labor from agriculture to export-oriented manufacturing but not in subsequent stages when growth becomes more innovation intensive, but governments are reluctant to abandon the earlier policy strategy, leaving the economy increasingly susceptible to slowing down. It could be that real undervaluation allows imbalances and excesses in export-oriented manufacturing build up, as in Korea in the 1990s, through that channel making a sustained deterioration in subsequent growth performance more likely."

The economists also found that higher dependency ratios increase the likelihood of a growth slowdown. And they suggest that the data indicate that China is likely to face just such a slowdown within the next ten years.

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