Editor's note: Seeking Alpha is proud to welcome Mcrid Wang as a new contributor. It's easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to the SA PRO archive. Click here to find out more »
China, with the world's largest population, achieved tremendous growth in the last few decades against the backdrop of globalization. It did so by leveraging its cost advantage in manufacturing to become the factory of the world. However, recent evidence suggests that China's cost advantage is coming to an end with labor supply depleting and wages rising. This can have serious social, political and economic consequences, including changes to the underlying structure of China's economy.
From demographics to the labor market
Various data and reports suggest that China's population is aging and soon will be shrinking. World Bank data shows that China's age dependency ratio reached a turning point in 2010, and has increased sharply since, reaching 40% by 2019. The pace of increase for people 65 years and above as a percentage of the working age population has also picked up since 2010, according to the same source.
UNPD predicts China's median age will become 47 years in 2040, compared to 37 years now. This population aging is seen in both urban centers and (more severely) rural regions. Zeng et al. (2014) projects population 65 years and above will reach 18% in urban areas in 2040, from currently around 9%; and over 32% in rural areas, from currently 15%. As the median age rises and birth rate falls, the total size of the population is expected to shrink. US Census Bureau predicts that China's population will begin to decline at around 2025. This projection is particularly accurate as China's population has a low turnover rate: 80% of the Chinese living in 2040 were already born.
China's demographic problem is unprecedented - it is aging at a speed few countries in history can match. According to the Center for Strategic and International Studies, "while it will take China 20 years for the proportion of the elderly population to double from 10 to 20 percent (2017-2037), this process took 23 years in Japan (1984-2007), 61 years in Germany (1951-2012), and 64 years in Sweden (1947-2011)." What caused China's case to be unprecedented is the aggressive "demographic engineering" by the Chinese state. China first sought to control its population in the 1970s, and introduced the one-child policy in 1980. Subsequently, its fertility rate dropped dramatically from 4.54 in 1973 to 2.29 in 1989, then to 1.05 in 2015 (then the lowest in the world).
The decline in the birth rate nationwide over the half-century's time had a direct consequence on China's labor market. Soon, China is predicted to reach a "Lewisian turning point" where the rural labor surplus is completely depleted, and demand for labor outstrips supply. This tightening of the Chinese labor market in the past two decades is evidenced through data on wage levels. Wages for Chinese workers are rising for all education levels and have outpaced productivity growth. This rate of increase has also exceeded the level in the United States. So Chinese workers have become more expensive both relatively and in real terms.
Cheap labor was an important factor fueling China's growth in the past. In the period between 1982 and 2000, each one percent decrease in the dependency ratio led to 0.115 percent of growth in per capita GDP. In 1982-2000, China's population dependency ratio declined by 20.1 percent and contributed 2.3 percentage points to total 8.6 percent growth in per capita GDP. So as China loses this advantage, its future growth prospect takes a hit. Specifically, according to Stanford Economist Scott Rozelle's human capital model, China's growth rate will drop from now 7% to 3% annually for the next 20 years. American Enterprise Institute's Nicholas Eberstadt obtained similar results using a different model.
What are the predicted effects according to economic models?
The situation in China's labor market - where fewer people are entering the labor force than exiting, is analogous to the effect of emigration (decrease in labor) to a "home country" in the specific factor model and the H-O model under free trade assumption.
Specific factor model
In the specific factor model (short-run model) where the capital is fixed to manufacturing and the land is to agriculture, a decrease in labor: 1) increases marginal product of labor, and therefore increases equilibrium wage; 2) decreases marginal product of capital and land, and therefore decreases rentals; 3) and decreases outputs in both industries. As the capital-labor ratio goes up, the rental-wage ratio goes down. We are already seeing this happening: as the Chinese labor market tightens, wage increase has outpaced corporate profits.
In the Heckscher-Ohlin model (long-run model) where the capital is mobile across industries, a decrease in labor 1) increases labor and capital in capital-intensive industries; 2) decreases labor and capital in labor-intensive industries; 3) causes outputs to adjust (i.e., increases capital-intensive production and decreases labor-intensive production) to maintain constant capital-labor ratio, which 4) leaves relative wage (and relative rental) unchanged (Appendix Figure 6). Therefore, according to this model, China's labor force decline should shift the composition of the economy from more labor-intensive industries to more capital intensive industries while leaving the welfare of workers and capital owners relative to each other unchanged. Are we seeing this happening?
From labor-intensive to capital-intensive manufacturing
Facing rising unit labor costs, manufacturers in China adjust by either offshoring their production to gain a cheaper cost base or reduce the labor intensity in the production process.
Offshoring is the migration of jobs from higher labor cost countries to lower labor cost countries. By moving production to Southeast Asia or Africa, Chinese factories can lower their labor costs. As this happens, the average labor-intensity of the manufacturing sector decreases.
Chinese wage levels have risen higher than some of its Asian peers. Because of this, some companies are moving their factories to lower-wage countries like Vietnam and Cambodia, or at least divide their factory investments between these countries and China. However, this trend is not as pronounced as the fear of it suggests. For most companies, pulling out is not so easy as they have made fixed investments. Furthermore, Southeast Asian countries are still relatively small compared to China. As large factories move in, they can quickly drive up wages to erase the labor cost advantage.
What about Africa? The truth is, offshoring to Africa is still premature as there are additional challenges associated with production in the continent. First, productivity-based labor cost in most African countries is not low. Second, the overall cost of doing business can be high due to unfavorable circumstantial factors such as corruption and poor infrastructure.
The magnitude of the labor shortage in China is relatively small compared to the total size of the labor force, and the Chinese workers are still very cheap compared to high-income countries. The current levels of production cost differentials have yet to justify large-scale offshoring in light of its associated complexities. So the risk of significant migration of factory jobs from China to Southeast Asia or Africa is low, at least in the near future.
Another way for China to decrease its economy-wide average labor intensity is by decreasing the labor intensity in the production process - this is the idea of an industrial upgrade. Many predict that the looming demographic headwind will push China to leap beyond low-cost manufacturing. To reduce labor costs, Industries transform from low-tech production to high-tech production. Firms replace human labor with robots and move up the value-add chain (e.g., from assembling to product design and engineering). Compared to factories offshoring, this is a more characteristic scenario for what is happening in China.
With rising labor costs, the government is aggressively incentivizing industrial upgrades through technological innovation and integration. The Chinese state has targeted critical industries through Made in China 2025 (MIC 2025) and Internet Plus Plan.
Announced in May 2015, MIC 2025 identified 10 key industries that will update China's manufacturing to lift the country over the so-called middle-income trap.
Announced in July 2015, Internet Plus Plan aims to "integrate mobile internet, cloud computing, big data and the Internet of Things with modern manufacturing." Distinguished from MIC 2025, it specifically targets to integrate manufacturers with China's large and growing internet sector (Baidu, Tencent, Alibaba, etc.).
One of the critical industries in Made In China 2025 is industrial robots. China is the world's largest importer of industrial robots - consuming 40% of total world production (as a monopsony buyer). However, in recent years, the government has been pushing to alleviate its dependence on imports by subsidizing domestically produced robots. This is expected to push down their prices and drive up utilization rates. As China's production becomes increasingly robotically integrated, labor intensity should decrease while labor productivity increases.
From low-end to high-end services
As China moves from labor-intensive (low-tech) to capital-intensive (high-tech) production within manufacturing, the growth driver of the economy is also shifting from manufacturing to the service sector. China's service sector has taken up a much greater share of the economy in the past few decades, growing on average 10.7% annually between 1978 to 2013. Service jobs are also comprising a greater share of labor employment, from 25% in 2000 to 44.6% in 2018.
How does service sector expansion relate to China's labor market conditions? Does this sectorial-level trend, like industrial-level trends within the manufacturing sector, mitigate upward pressures from the surge in equilibrium labor costs? Or alternatively, is shrinking labor force a barrier to service expansion, or service expansion exacerbating wage increase and labor shortage? To answer these questions, we need to take a closer view of the service sector and understand the nature of its labor demand.
The service sector can be divided into low-end services (transportation, distribution, restaurant, tourism, funeral, etc.) and high-end services (consulting, financial and legal advisory, business intelligence sourcing, scientific research, programming, etc.). Expansion of China's service sector in the past is primarily attributed to growth in traditional low-end services. With rising wages and therefore disposable income, Chinese households increasingly spend more on tourism, entertainment, restaurants, and domestic services, and demand higher qualities and greater varieties. The explosion of e-commerce and ride-sharing has also fueled job growth in delivery and transportation.
Low-end services are labor-intensive and therefore also constrained by rising labor costs. And this problem is not new. As early as 2004, restaurants in Shanghai have struggled to hire workers. And over the years, the problem has exacerbated and has pushed up the limits of service labor productivity. Whereas before restaurant customers would be welcomed by a group of waitresses at the door, nowadays the doors are automatic, and each waitress handles a much larger number of tables.
Strong growth in middle-class demand sustained low-end services expansion despite rising labor costs - a tailwind that is unavailable to the less consumer-facing manufacturing. However, compared to manufacturing, labor-intensive services are more difficult to adjust to higher labor costs due to Baumol's cost disease - the idea productivity growth in service is inherently limited. Like manufacturing, low-end services must also eventually transform by, e.g., incorporating advanced robotics to accommodate for rising labor costs. Low-end service expansion has not, and will not be a counter to manufacturing's slowdown.
The implications of high-end services are different. Typically, labor-cost is also a large expense segment for high-end services. However, their expansion is not constrained by China's labor shortage, as their labor-cost shows up not in the form of high labor intensity (a large number of workers employed), but higher productivity concentrated in fewer higher-skilled educated labors. Also for this reason, high-end services do not directly compete with manufacturing for labor and thus do not drive up manufacturing wages.
Expansion of high-end services can facilitate the reduction of labor intensity in manufacturing. Specialized business services improve manufacturing productivity by providing outsourced corporate functions and increasing their rate of technology adoption. As manufacturing firms look to reduce their labor costs and demand, they will increasingly rely on high-end service firms for support and expertise. Furthermore, high-end services are ripe to integrate technologies on their own to reduce labor costs and therefore creating more demand for high-tech manufactured products. So overall, the expansion of high-end services is a net positive for China to shift out of labor-intensive manufacturing.
In summary, China is experiencing a sharp demographic turn that will not reverse course at least in the next 50 years. This is placing sizable cost pressures on labor-intensive manufacturing and service sector companies. For the country to sustain growth into the future, the economy needs to adjust to accommodate for higher labor costs by upgrading the production process.
Looking at the 20-year horizon, future Chinese growth will come from sectors that are best positioned for productivity increase, such as industrial robotics and information technology, as well as scalable high-end services, such as healthcare. Investors seeking long-term China exposure should take note of the growth of these trends.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.