Has China’s Role as the ‘World’s Factory’ Coming to an End?

Has Europe taken over China’s role as the “new sweat shop”?

Writes Spiegel Online, (bold original)

It used to be that European carmakers opened plants to assemble their cars in China. Now the Chinese have turned the tables with the opening of their first factory in Bulgaria, an EU country with low labor costs and taxes. Increasingly, Chinese carmakers are setting their sights on the European and American automobile markets.

Great Wall this week became the first Chinese automobile manufacturer to open an automobile assembly plant inside the European Union in the latest move suggesting the country's carmakers are seeking to establish a beachhead into the European market.

Bulgarian Prime Minister Boyko Borisov on Tuesday attended the opening of Great Wall's new factory in the northern Bulgarian village of Bahovitsa. The plant is to be operated jointly by Great Wall and the Bulgarian firm Litex Motors.

For years, European carmakers like Volkswagen have established large joint ventures in order to gain footholds in the Chinese market, but now the tables appear to be turning.

"Stepping on the European market is our strategy," Great Wall CEO Wang Fengying said at the opening festivities.

Within three to five years, the company plans to produce an entire line of models in Bahovitsa to be sold in Europe, she said. Test assembly of the Voleex C10 and the Steed 5 pick-up truck, which sell for 16,000 to 25,000 leva (€8,200 to €12,800), began already in November.

In the midterm, Great Wall plans to assemble around 50,000 automobiles per year at the 500,000 square meter plant. The number of workers is expected to grow from the current total of 120 to 2,000. Initially, the company plans to sell its vehicles primarily in Bulgaria and neighboring Eastern European countries like Serbia and Macedonia, but it later plans to expand into other EU countries.

Attractive Labor Market

Bulgaria, the EU's poorest country, is attractive as a labor market because it is an oasis of cheap wages and low taxes. Workers are considered well educated and the country is ideal as the site for a company like Great Wall to launch. Given that wages for factory workers have risen considerably in China in recent years, assembly sites abroad have become increasingly attractive for some manufacturers.

While it may be true that China’s wages have risen over the past years, it is important to put into perspective that there has been an enormous chasm between European wages (yes despite Bulgaria's position as having one of the lowest wage in Europe) and China’s wages.

From Urbanomics

Europe hourly compensation in manufacturing is more than 30 times China!

From Ebandit

Chinese workers would take more than 8 years and 10 months to catch up with the annual European minimum wage earnings.

Even if the wage convergence trend does deepen overtime, where China’s wages continues to increase as Europe’s wages decline, it would take substantial changes, and possibly many many many years, if not decades, for this wage based differential to close.

And while the mainstream loves to tunnel on “wages” or “compensation” as the key reason for any shifts in investments [mainly to justify government’s actions for currency interventions or the imposition of mercantilist-protectionist policies], the reality is that wages are just part of the many factors driving the entrepreneur’s economic and financial calculations or business decision processes, such as access to markets, finance, infrastructure et al…, regulatory costs, tax regime, legal environment, political institutions and etc…

Perhaps too, some Chinese investors may just be courageous and far-sighted enough to use the recent crisis as an opportunity to position or that the same investors appreciates Europe's competitive and comparative advantages and acted to capitalize on these

Besides, one investment shift does not a trend make.

The last point is that this serves an example of how conditions are not fixed (past performance does not guarantee future outcomes) and that the world is highly complex.

Despite High Education Levels, Filipinos Workers Among The Lowest Paid

From the Yahoo news

The ILO's "Global Wage Report 2010" also noted a paradox in Philippine wage trends: Higher education did not correlate with higher wages, contrary to the pattern in many other parts of the world.

The ILO's "Global Wage Report 2010" also noted a paradox in Philippine wage trends: Higher education did not correlate with higher wages, contrary to the pattern in many other parts of the world.

In the Philippines, low pay--particularly among domestic workers--"is partly caused by the lack of proper wage protection, notably the common practice of excluding such workers from the application of minimum wages," said the latest report.

And while low wages are correlated with low educational attainment in most parts of the world, the Philippine case seems to be the opposite.

"Surprisingly, the Philippines seems to represent an interesting exception to this common pattern, registering a high incidence of low wage employment among those with a primary and secondary education," the report said. (all bold emphasis mine)

So what does all these suggest?

Here are some:

In contrast to common wisdom, education per se does not automatically translate into jobs or employment.

There is a great deal of mismatch between the educational output and the jobs demanded in the marketplace. The shift towards the information economy is likely to enhance the requirements for work specialization as niche markets expand.

The investment environment likewise determines employment conditions. Excessive government intervention only serves to reduce opportunities by distorting investment and labor markets.

Low wages does not translate to more employment.

Of course all these have policy ramifications.

Mass (free and compulsory) education and low wages are not optimum policy options that deal with socio-economic development.

Interventionism (via manifold regulations and inflationism) only makes good instruments for the promotion of the interests of politicians and to the specific groups they implicitly represent than of the general public. This applies to public education as well.

Professor Barry Simpson explains,

Public education, with the added feature of compulsion, reduces the cost to politicians of making wealth transfers. The cost of making transfers is diminished by reducing the opposition to transfers. If politicians can reduce the cost of transferring wealth by reducing the opposition to them, then they can continue to authorize transfers to interested parties for a price.

At the end of the day, good intentions don’t square with economic reality. And the Philippine experience is a demonstration of such unintended consequences.

Wage Convergence: Myths And Facts

Dr. John Hussman, in this excellent weekly article, dispels the myth of cheap labor to argue for convergence of wages between the US and developing nations.

Dr. Hussman writes,

(bold emphasis mine)

“Why do workers in developing nations earn a fraction of the wages American workers earn?

``While protective and regulatory factors such as trade barriers, unionization, and differences in labor laws have some effect, the main reason is fairly simple. U.S. workers are, on average, more productive than their counterparts in developing countries. While the gap between U.S. and foreign wages can make open trade seem very risky, it is simply not true that opening trade with developing nations must result in a convergence of wages. The large difference in relative wages is in fact a competitive outcome when there are large differences in worker productivity across countries.

From Korean Times

``The main source of this difference in productivity is that U.S. workers have a substantially larger stock of productive capital per worker, as well as generally higher levels of educational attainment, which is a form of human capital. This relative abundance of physical and educational capital has been a driver of U.S. prosperity for generations. Neither advantage in capital, however, is intrinsic to American workers, and it will be impossible to prevent a long-term convergence of U.S. wages toward those of developing countries unless the U.S. efficiently allocates its resources to productive investment and educational quality. This is where our policy makers are failing us.”

The Top Ten Most Competitive Countries According to the World Economic Forum

So how then will the prospects of wage convergence occur?

By massive interventionism and inflationism.

Again Dr. Hussman

``If we as a nation fail to allow market discipline, to create incentives for research and development, to discourage speculative bubbles, to accumulate productive capital, and to maintain adequate educational achievement and human capital, the real wages of U.S. workers will slide toward those of developing economies. The real income of a nation is identical its real output - one cannot grow independent of the other.”

Dr. Hussman’s observation has important parallels to the prescient work of Dr. Ludwig von Mises who once wrote,

``What elevates the wage rates paid to the American workers above the rates paid in foreign countries is the fact that the investment of capital per worker is higher in this country than abroad. Saving, the accumulation of capital, has created and preserved up to now the high standard of living of the average American employee.

``All the methods by which the federal government and the governments of the states, the political parties, and the unions are trying to improve the conditions of people anxious to earn wages and salaries are not only vain but directly pernicious. There is only one kind of policy that can effectively benefit the employees, namely, a policy that refrains from putting any obstacles in the way of further saving and accumulation of capital.”

Hence, we learn of three indispensable variables as key to higher real wages: savings, capital invested per worker and productivity. Interventionism only achieves the opposite. Everything else is footnote.

Competitive Global Tax Structures As Major Investment Determinant

When you read economic articles from the mainstream media or from popular "experts", one would accrue two significant but misleading impressions:

1. governments are the sole entities that are engaged in trade (from discussions of trade imbalances)

2. low wages are the only criteria that ensures success or economic prosperity (from discussions of currency manipulation)

But of course, such discussions is far from the truth or reality.

Governments generally don't produce anything but generates its revenues by taxation. This means that people through various forms of enterprises, and NOT the government itself, are engaged in trade.

Next, investment is a function of returns: particularly, the rate of return on investments. Of course before establishing the rate of investments, the most important factor would be the return OF investments (via security of property rights).

In other words, expected profits (revenues-costs) determine investment activities.

In contrast to mainstream polemics, the fact is that wages constitute only one of the many variables that adds up to the long list of costs.

Yet there are other factors that determine the profitability of an enterprise among them: as stated above is the varying degree of property rights, different conditions of existing infrastructure, operational institutions, legal framework (which secures contracts and resolves disputes), cultural variables (traditions, superstitions etc.), security, political stability, capital and production structure, access to markets, access to raw materials, access to finance, degree of labor and skills available, education of the labor force, cost of energy, transportation and connectivity, quality of management, regulatory structure, transaction costs, tax policies, degree of economic freedom and etc...

Importantly these cost structures can be nuanced by the operating principles of the comparative advantage and specialization or the division of labor.

Yet all these very important variables are frequently ignored when arguments get oversimplified but cloaked with technical gobbledygook.

Below is an example of a more important factor that influences business activities.

It's about tax structures.

The chart taken from the Economist, highlights on the world's declining corporate tax rates.

The Economist with a tinge of demur from falling tax rates writes, (bold highlights mine)

``CORPORATE-TAX rates in OECD countries have fallen remorselessly over the past 30 years. A survey by Robert Carroll of American University in Washington, DC, found that the top rate in OECD countries (excluding America) had dropped from 51% in the early 1980s to 32% by 2009. Competition among countries to attract business and with it bring employment was fierce in the late 1990s and early 2000s. Ireland reduced its corporate-tax rate to just 12.5% and chose not to raise it last year during an emergency budget. Such differentials may not last long. High-tax European governments have complained in the past about competition from countries such as Ireland and the current economic crisis may lead to more calls for co-ordination of tax policies."

Of course, coordination of tax policies won't work. Competition among governments will still determine investments.

This from World Bank's Paying Taxes 2010

According to Doing Business 2010 (all bold and italics emphasis mine)

``The size of the tax burden on businesses matters for investment and growth. Where taxes are high and corresponding gains seem low, the incentive for businesses to opt out of the formal sector increases.

``A recent study shows that higher tax rates are associated with lower private investment and fewer formal businesses. A 10 percentage point increase in the effective corporate tax rate is associated with a reduction in the ratio of investment to GDP of up to two percentage points and a decrease in the business entry rate of about one percentage point. Other research suggests that a one percentage point increase in the statutory corporate tax rate would reduce the local profits of existing investments by 1.31 percentage points on average and lead to an 18 percentage point increase in average debt-to-asset ratios (part of the reason for the lower reported profits). A one percentage point increase in effective corporate tax rates reduces the likelihood of establishing a subsidiary in an economy by 2.9 percentage points.

``Besides the taxes paid, there are costs of complying with tax laws and of running the revenue authority. Worldwide on average, a standard small to medium sized business still spends three working days a month complying with tax obligations as measured by Doing Business. Where tax compliance imposes heavy burdens of cost and time, it can create a disincentive to investment and encourage informality. Particularly in developing economies, large informal sectors contribute to the creation of an uneven playing field for formal small and medium sized enterprises, squeezed between smaller informal competitors and larger competitors whose greater resources can help win a more effective audience with government and thus greater tax concessions."

``Worldwide, economies that make paying taxes easy tend to focus on lower tax rates accompanied by wider tax bases, simpler and more efficient tax administration and one tax per tax base. They also tend to provide electronic filing and payment systems, which reduce the tax burden for firms while lightening their administrative requirements."

So as the multilateral government institution World Bank points out, tax rates juxtaposed with tax and regulatory compliance plays a major role in the shaping of trade balances among nations and in domestic economic development.

The sub-Saharan Africa has the highest tax rates around the world along with dubious recognition for property rights and mired with political instability ,which offsets its lowest wage framework, hence remains the least attractive venue for investors which has stagnated their economies.

On the other hand, the reasons why Asia and many Emerging Markets has been generating increasing investments is due to the relative advantage of their tax structures.

As we said above competition among governments will ascertain the flow of investments and the recent bubble bust just drove a wedge between responsible and profligate governments.

To wit, the responses by the OECD governments to the recent bubble bust is likely to amplify these differences: higher taxes-lower return for OECD economies as against lower taxes-higher return for Asia and emerging markets.

Guess where investments will flow to?

Quality Of Corporate Management As Barrier To Low Wage Competition

Another main reason why the meme of "low wages abroad steal local jobs" is rubbish- is because of the varying quality of management in different types of companies in different nations.

Stanford's Nicolas Bloom and John Van Reenen in their paper "Why Do Management Practices Differ across Firms and Countries?" enumerates why: (all bold highlights mine) [HT: Econlog]

First, firms with “better” management practices tend to have better performance on a wide range of dimensions: they are larger, more productive, grow faster, and have higher survival rates.

Second, management practices vary tremendously across firms and countries. Most of the difference in the average management score of a country is due to the size of the “long tail” of very badly managed firms. For example, relatively few U.S. firms are very badly managed, while Brazil and India have many firms in that category.

Third, countries and firms specialize in different styles of management. For example, American firms score much higher than Swedish firms in incentives but are worse than Swedish firms in monitoring.

Fourth, strong product market competition appears to boost average management practices through a combination of eliminating the tail of badly managed firms and pushing incumbents to improve their practices.

Fifth, multinationals are generally well managed in every country. They also transplant their management styles abroad. For example, U.S. multinationals located in the United Kingdom are better at incentives and worse at monitoring than Swedish multinationals in the United Kingdom.

Sixth, firms that export (but do not produce) overseas are better-managed than domestic non-exporters, but are worse-managed than multinationals.

Seventh, inherited family-owned firms who appoint a family member (especially the eldest son) as chief executive officer are very badly managed on average.

Eight, government-owned firms are typically managed extremely badly. Firms with publicly quoted share prices or owned by private-equity firms are typically well managed.

Ninth, firms that more intensively use human capital, as measured by more educated workers, tend to have much better management practices.

Tenth, at the country level, a relatively light touch in labor market regulation is associated with better use of incentives by management.

My comment:

In short, there isn't a single type of management, as much as there is no single class of product or markets or labor or capital.

In the above chart, the US ranks the highest so as with other export giants.

So it would be fallacious and oversimplistic to generalize that investments are only sensitive to the cost of wages, when there are myriads of variables affecting investments.