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By Aoyu Bai

The recent spate of worker unrest in China hints that the vast supply of low-cost Chinese labour may finally be running out.

It seemingly began at Foxconn (OTCPK:FXCNY), a Taiwanese electronics manufacturer for Western brands such as the iPhone. Despite Steve Jobs’s insistence that it is “not a sweatshop,” a series of worker suicides in Shenzhen created enough local protests and negative press to force the company to raise salaries from 900 yuan ($134.34 CAD) to 2000 yuan ($298.56 CAD) per month. Similarly, Honda (NYSE:HMC) found itself raising workers’ salaries by 24% at an auto-parts factory after worker strikes had stopped production.

This unrest has spread across the industrial belt along costal China. There are no political movements or charismatic leaders; rather, China is fuelled by the fundamental forces of supply and demand in the free market. After three decades of capitalist reforms that lifted millions of people out of poverty, many analysts believe that China is reaching the pivotal stage known as the “Lewis Turning Point.”

Named after Nobel Laureate Sir William Arthur Lewis, the Lewis Turning Point marks a time in the development of an economy when a surplus of cheap labour runs dry. Facing a dwindling factor market, employers push up wages and benefits, creating demand-push inflation. The nation will lose much of its original low-cost competitive advantage as employers look elsewhere. With increased purchasing power, consumption increases as the nation transforms from a producer to a consumer.

In his 1954 Nobel Prize-winning paper en “Economic Development with Unlimited Supplies of Labour,” Lewis argues that developing nations with high unemployment, or a surplus of agricultural labour, can sustain rapid industrial growth without spiralling inflation for years. With such excess supply, demand for low-skilled labour can always be met without increases in factor prices. In essence, Lewis’s model for economic development assumes an infinitely elastic labour supply. Profit in the industrial sector will increase as long as productivity, or capital accumulation, increases. This profit is thus derived from the excess supply of rural or “subsistence” labour. This is the characteristic of a “dualistic economy,” a subsistence and an industrial one.

However, there are two turning points that mark the maturation of an economy. The first marks a point when manufacturing labour force growth exceeds total labour supply growth. Here, urban real wages begin to increase as excess subsistence labour diminishes. This wage increase reduces profit and subsequently capital accumulation growth. The second point occurs when the transfer of labour from the rural subsistence sector to the industrial one reflects not excess supply but differences in the marginal productivity of labour. Here, the two economies begin to merge into one as wages and profits of the entire nation are determined by the marginal productivity of labour.

One of the fundamental assumptions of international trade over past decades was that China has a vast supply of rural workers who are more than willing to migrate to urban factories for any wage. But this assumption is now being challenged by the realities employers face. Today, China appears to be past the first turning point and inching towards the second. A surplus of subsistence labour shrank from 120 million three years ago to 25 million now. Furthermore, with the central government’s initiatives to develop the inner and poorer regions, fewer workers are willing to leave their families and relocate to the coastal cities to work in factories. Adding to the shortage is the aging population, exacerbated by the one-child policy implemented decades ago. The new generation of ambitious youths, many of whom hold university degrees, are less willing to work for factory wages than their parents were.

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Implications

The term “turning point” may be a misnomer, as China’s vast size and regional differences will ensure that the changes will be gradual. The first result of the changes will be inflation; at 3.1% in May, it has already surpassed government targets. This level was the highest in 19 months.

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The most direct result will of course be wages, which have already risen in many factories. The People’s Daily, one of China’s most influential newspapers, has called for a general increase in wages while echoes of an increased minimum wage can be heard loudly across the country. Unlike years ago, this time the bargaining power appears to be with the workers, backed by a sympathetic government that is wary of widespread unrest. Facing rising labour costs, manufacturers may choose to move elsewhere, like India or Vietnam, for the same reasons they set up shop in China decades ago – lower costs. This will give a boost to less developed nations so that one day they will reach the same turning point.

With higher wages, the purchasing power of the Chinese middle class will increase. Prior to the G20, China already announced intentions to raise the value of the yuan. The media has begun to speculate the winners and losers, and they are as zero-sum as they could be. Losers: foreign consumers, Chinese exporters. Winners: Chinese consumers, foreign exporters. With a growing appetite for luxury goods and strong confidence in China’s future, these new consumers may be just what the world economy needs to put itself back on the path towards prosperity. However, this could be a double-edged sword. With bright prospects for growth remaining, speculative capital will pour into a rising yuan, possibly fuelling a bubble.

Finally, as China’s manufacturing sector weakens, its services sector will hopefully strengthen. The most profitable part, and thus the part that the nation may want to develop the most, is financial services. While reports of Washington’s sparring with Wall Street flood the media in North America, no one questions who is in control in China. Chinese banks are among the most strictly regulated in the world, with few options available in terms of shorting and hedging. Months ago, the Chinese government had already loosened some controls over financial products just as the United States tightened them. Right now, the Agricultural Bank of China is undergoing its historical IPO, ensuring that an army of both Chinese and foreign investment bankers remain glued to their monitors for days to come. With a growing services sector, the government may choose to loosen up even more so that one day, Shanghai and Beijing will grow to rival New York City and London.

So far, much of this has been speculation. It is also possible that this is just a spate of worker anger that will soon cool. After letting off some steam, employees may return to their factories in a few weeks or months and everything will be back the way it was. But one thing is for sure: there will come a day when China passes the Lewis Turning Point, changing everything we once knew about the global economy. Perhaps in our generation, the world will watch labels of “Made in China” turn into “Made in Vietnam” and watch Shanghai become the newest hotspot for finance student internships, just as the world saw Japan’s transformation in the previous generation, and America’s transformation generations before.

Disclosure: No position in stocks mentioned

Source: China's 'Lewis Turning Point': Twilight of an Era