As Wages Rise, Time to Leave China?

Rising wages—together with currency fluctuations and high fuel costs—are eating away the once-formidable "China price" advantage, prompting thousands of factory owners to flee the Pearl River Delta. Much has been written about the more than doubling of wages at the Shenzhen factory of Foxconn (2317:TT), the world's largest electronics contract manufacturer, which produces Apple (AAPL) iPhones and iPads and employs 920,000 people in China alone. "One can talk about a world pre- and post-Foxconn," says Victor Fung, chairman of Li & Fung (494:HK), the world's biggest sourcing company and a supplier of Wal-Mart (WMT). "Foxconn is as important as that."

Foxconn's wage increases are only the most dramatic. Our analysis suggests that, since February, minimum wages have climbed more than 20 percent in 20 Chinese regions and up to 30 percent in some, including Sichuan. At a Guangdong Province factory supplying Honda (HMC), wages have risen an astonishing 47 percent. All this is bad news for companies operating in the world's manufacturing hub, and chief executives should assume that double-digit annual rises—if not on the scale witnessed this year—are here to stay.

Looked at another way, however, wage inflation provides companies with a once-in-a-generation opportunity to rethink radically the way they approach global production—and they should do so sooner rather than later.

Why the urgency? After all, wage hikes in China are nothing new. Since 1990 they have risen by an average of 13 percent a year in U.S. dollar terms and 19 percent annually in the past five years.

Outstripping Productivity Gains

There are two big reasons the situation is different now. The first has to do with productivity. Over the past 20 years, productivity increases have broadly matched wage increases, negating their impact. The pay rises came from a very low base, so while average wages grew 19 percent a year from 2005 to 2010, this amounted to only $260 a month per employee, a sum that could be offset by more efficient production or switching to cheaper sources of parts and materials.

If labor costs continue, however, to increase at 19 percent a year for another five years, monthly wages would grow $623 per month, according to BCG estimates. Such an increase would ripple through the economy in the form of higher prices for components, business services, cargo-handling, and office staff.

The second reason relates to societal change. Until now, it has been easy to lure a seemingly unlimited number of young, low-wage workers to the richer coastal regions and house them cheaply in dormitories until they saved enough to return home to their families in the interior provinces. In the future, though, young workers will be harder to recruit. This is partly because there will be fewer of them: Largely because of the country's one-child policy, the number of Chinese aged 15 to 29 will start declining in 2011. Moreover, with living standards rising across China, fewer of today's rural youth will want to go to coastal regions to toil for 60 hours a week on an assembly line and live in a cramped dormitory.

Where Is Labor Cheaper?

So what can CEOs do in this fast-changing environment? An instinctive reaction is to search for cheaper labor elsewhere. But this is short-sighted and would provide—at best—a short-term fix. Wages are rising everywhere in China, and while some companies have fled to neighboring countries, such as Vietnam, labor there isn't the bargain it appears.

Take one factory in Vietnam, where wages of 80¢ per hour are 31 percent lower than in China. On the face of it, this looks like a good deal—but factor in the differing productivity rates, and the Vietnamese factory's cost edge drops to 14 percent. Furthermore, it won't take long for young Vietnamese to demand the same treatment as their Chinese counterparts. New BCG research shows that the hopes and expectations of the new generation of youth are remarkably similar, whether in China, India, Indonesia, or Brazil.

Another option is to stay in China and try to squeeze out greater productivity gains. The country still has the industrial capacity, world-class infrastructure, skilled workforce, and managerial experience to remain competitive far into the future. We think there is still plenty of room to improve efficiency at Chinese plants with lean manufacturing methods, more automation, and closer collaboration with suppliers, although this will require companies to be creative, shrewd, and bold in their investment decisions.

By staying in China, companies will also be able to serve the rapidly growing domestic consumer market. The country is already the world's biggest market for mobile phones and the No. 2 buyer of PCs and white goods. By our calculation, the number of households earning $6,000 to $15,000 a year will swell more than 40 percent, to 135 million, by 2020. Those making $15,000 or more will increase almost fivefold, to 65 million.

Nearer to the Buyers

A third option is for companies to move all or part of their manufacturing capability closer to the consumer. Those serving the North American market should consider Mexico and low-cost U.S. states. Likewise, those serving consumers in Germany, France, Italy, the U.K., and Spain should consider Eastern Europe.

Whatever companies decide—and it may be a combination of these and other options—they should understand that to thrive in today's volatile world, they need to create an adaptable and diversified approach to global production. Yes, China's wage inflation is wreaking havoc with the economics of doing business today, but it is merely the latest in a series of hard-to-predict scenarios for global companies. Tomorrow, the challenge could be a political crisis. The day after that, the emergence of a new competitor. And after that? Who knows?

The point is that multinational companies need a flexible global supply chain to handle every eventuality. If CEOs can make this the prize of an eroding "China price" advantage, they will have delivered a long-term benefit to their companies.

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