Global Inflation Starts with Chinese Workers

For decades low wages in China helped keep prices at bay around the globe. That era is roaring to an end. As China embraces wholesale wage increases, the world's No. 2 economy may soon drive up costs enough to erode corporate margins and scare inflation-wary investors away from bonds. The government is playing an important role in this shift. When Chinese Premier Wen Jiabao convenes the annual National People's Congress on Mar. 5, delegates will sign off on higher pay scales around the country as part of a plan to boost the domestic economy. All 31 Chinese provinces and regions are likely to boost their minimum wages in 2011 for the second consecutive year, according to Credit Suisse Group (CS).

Economists say an epochal shift is under way. "When historians go back and describe 2010, the big story will be the massive increase in salaries that will redefine the global manufacturing model and redefine the inflation outlook for the next 10 years," says Dong Tao, chief regional economist for non-Japan Asia at Credit Suisse in Hong Kong.

Tao says China is fast approaching the so-called Lewis turning point, named after Arthur Lewis, the Nobel prize-winning economist whose work described that critical moment in a developing economy's rise when its surplus labor supply dries up, and hikes in wages, prices, and inflation ensue. In China's case, demand for workers will outstrip supply by 2014, Tao's team calculated in a January report.

Li Wei, an economist at Standard Chartered in Shanghai, says China may have already hit the Lewis point. If the country "continues to grow 9 percent to 10 percent per year, there will be a wage spiral" that pushes up prices and sends bond yields higher around the world, Li says. China's own inflation is gathering momentum, with inflation running higher than the official 2011 target of 4 percent in each of the past four months, according to the National Bureau of Statistics of China.

Despite the risks, China's government wants to encourage workers to spend, ease pressure on families struggling to afford food, and head off social unrest, says Sun Chi, an economist with Nomura Holdings (NMR) in Hong Kong. Higher pay should also make exports more costly. That would please China's trading partners, who fear being overwhelmed by cheap goods.

Wages are going up even without the government's prodding. The development of China's west has turned interior cities such as Chongqing into production centers that compete for labor with coastal factories. The pay of the migrant laborers who fuel China's export industry rose by 40 percent in 2010, according to Credit Suisse's Tao. It will continue climbing 20 percent to 30 percent in each of the next three years as Chinese leaders pump up domestic demand.

Workers are getting picky. A recent pay hike of more than 10 percent in a Shenzhen bra factory wasn't enough to keep some workers in town. Luo Chenen, a 33-year-old migrant worker who sews bras for Hong Kong-listed Top Form International, says "quite a few" of her colleagues left after the lunar new year for their hometowns. They won't come back because "there are jobs there as well. Right now is not like in the past, when finding a job was difficult." As proof of employers' desperation, the district of Shenzhen where Luo works is plastered with recruitment notices, some promising "High Pay for Urgent Hire."

China's wages now occupy the middle range of labor costs in Asia. Average monthly pay in 2009 for Shenzhen on the southern coast was $235, while Shenyang in northeast China had a mean of $197, both less than Yokohama's $3,099, Seoul's $1,220, and Taipei's $888, according to the Japan External Trade Organization. By comparison, monthly factory wages were $100 in Ho Chi Minh City, Vietnam, $148 in Jakarta, Indonesia, and $47 in Dhaka, Bangladesh.

It's not just in China's big cities where wages are rising fast. In the countryside, where small factories are popping up, per capita net income jumped 10.9 percent in 2010, to 5,919 yuan, according to a National Bureau of Statistics of China report in January. "Rural migrant workers' wages are now rising faster than ever before, and we can probably talk about a wage explosion here," Jonathan Anderson, chief economist for emerging markets at UBS (UBS) in Hong Kong, wrote on Feb. 3.

Policy makers may make changes in the hukou household-registration system, according to UBS analysts, a step that may ease the problems created by labor scarcity. The system, which authorities have already relaxed somewhat, requires Chinese to apply for residency permits when they move and can impede the free flow of workers. The more mobile workers are, the more quickly they can move to parts of the country that need labor the most.

Although reforming hukou will help, China's rising prices soon will feed into inflation elsewhere, if history is any guide. China's consumer price index has in the past decade preceded shifts in the so-called core U.S. rate for goods by about 20 months, according to data compiled by Société Générale and Bloomberg. While he predicts inflation in the U.S. will remain benign into next year, Rudy Narvas, a Société Générale economist in New York, says there is now an "upside" risk, partly because of Chinese costs. U.S. corporate clients are telling him they may start to "test the waters" to see how much of the price pressure from China and elsewhere they can pass along to customers, he says.

Apparel companies and retailers are already feeling the pinch from higher wages in China. Next, Britain's second-biggest retailer, said in January that higher labor costs in China will contribute to an 8 percent increase in its prices in the first two quarters. Trading group Li & Fung of Hong Kong, a top apparel supplier to Wal-Mart Stores (WMT), predicts the price of Chinese exports will rise as much as 15 percent this year as workers earn more. "The pressures aren't subsiding," says Randal J. Konik, an equity analyst at Jefferies & Co. (JEF) in New York, who identifies luxury handbag maker Coach (COH) and women's clothing retailer Chico's (CHS) as having "high exposure to Chinese manufacturing."

Coach started a four-year plan on Jan. 1 that will move some production out of China and into locales such as India, Chief Financial Officer Michael F. Devine III said on a Jan. 25 conference call. Gerry Weber International, Germany's No. 2 maker of women's clothing, is shifting production from China to sites with cheaper labor costs, CEO Gerhard Weber said in a Dec. 7 interview. The company is counting on its ability to move sourcing faster than rivals.

Chico's, too, is seeking to diversify its production base away from China. Higher Chinese wages are a "major factor" behind the shift, says Robert C. Atkinson, head of investor relations at the company, adding, "It's not easy when most of the world is trying to do the same thing."

The bottom line: Over the next decade the inflationary impact of ever-higher wages throughout Chinese industry will raise prices around the world.

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