Challenges Pile Up for Chinese Manufacturing

Evidence that the golden age of Chinese manufacturing may be coming to an end continues to mount.

Soaring oil prices raise both the cost of production and transportation to Western markets, eroding China’ cost advantage. This is exacerbated by extra demand for diesel fuel as a result of the recent earthquake.

On top of this, add exchange rate problems and a shortage of skilled labor exacerbating inflation pressures.

Deloitte Economist Sunil Rongala notes that the primary purpose for having a fixed rate policy was to promote exports by making the Chinese renminbi (RMB) more competitive. This fixed rate has made China hyper-competitive; a result is that trade surpluses and foreign exchange reserves have swelled.

Though the fixed rate policy was loosened in 2005, the still interventionist exchange rate policy is not sustainable because it is partly responsible for higher levels of inflation in China.

Inflation in China has been on an upward trend and it was 8.5 percent in April 2008: a near 12 year high (the highest was 8.7 percent in February 2008). The cheap exchange rate is partly responsible because it has led to massive capital inflows because of high trade surpluses, and because speculators have brought in a lot of money into China to make a capital gain from an expected exchange rate revaluation. Banks expect the renminbi to appreciate by 8.5 percent in a year’s time and it is very likely to continue appreciating post that, Rongala writes.

Meanwhile, manufacturing costs in China are going up. The producer price index was up 8.1 percent YoY in April 2008 – the highest it’s been since December 2005. This is understandable given rising commodity prices but manufacturing firms in China typically operate on razor-thin margins and rising costs have forced many manufacturing units to shut shop.

 

Another problem is that labor prices are increasing rapidly because there is a talent shortage in China. Between 1997 and 2006, the average annual wage of the U.S went up by 40.1 percent while China’s went up by a staggering 224.5 percent.

In fact, the annual average wage in China went up by 362.8 percent between 1994 and 2006.

 

Labor laws in China have always been lopsided with employers having a stronger hand. On January 1, 2008, a new labor law, the ‘Labor Contract Law’, went into effect and this law gives labor unions a stronger hand is widely expected to increase labor costs.