Western profits wilt on China's surging wages

Rising wage and production costs in China are eating into the profits of Western companies and may soon set off an exodus of multinational companies to cheaper locations.

A report by Credit Suisse said the vast majority of US and European companies in China are expecting a "margin hit" over the next 12 months and fear they will not be able to pass on the costs to consumers, with the biggest worrries in electronics, clothing, and retail.

The bank said Footlocker, Liz Claiborne, and Office Depot would tip into outright loss in a worst-case scenario, defined as a 20pc rise in costs without any pass-through to customers.

Earnings per share would fall 72pc for Jones Apparel, 50pc for Maidenform Brands and Dollar Tree, 42pc for Macy's, 39pc for Target, and 20pc for Polo Ralph Lauren. Reliance on Chinese plants is suddenly proving double-edged. "We conclude that labour and transportation cost pressures are a major concern for executives that may be under-appreciated by investors," it said.

The US industrial giant General Electric raised eyebrows in May with plans to shift production of its hybrid water heater from China back to Kentucky next year after securing lower wages from US workers. The company cited the narrowing pay gap, lower transport costs, and shorter delivery times.

China's manufacturing wages have vaulted from around $1,000 annually 10 years ago, to $3,900 last year. Pay in the industrial hubs of the Pearl River and Yangtze River deltas are much higher and likely to rise further after a wave of industrial disputes at Foxconn, Honda, Toyota, and Omron.

Bruce Rockowitz, head of the pan-Asian logistics group Li & Fung, said cost pressures are rippling through the region. "It's not just China going up: its everywhere," he said.

It is unclear whether this will drive up inflation for imported goods in the West, reversing the benign phase of globalisation seen over the last fifteen years, or whether multinationals will adjust to constrained demand in the US, Europe, and Japan by slashing margins, or a mixture of the two.

Credit Suisse's survey of executives found that 55pc of foreign firms in China could relocate plant to Bangladesh, Vietnam, Indonesia or other low-cost regions relatively easily, though it would be costly. There are winners too, such as Yum Brands poised to reap the harvest from rising Chinese consumption.

The changing landscape has major implications for Chinese exporters, with an average profit margin of just 3pc. High-tech companies in wind power, solar, and transmission equipment that have recently broken into world markets will face stiffer headwinds. The Shanghai Composite Index of Chinese equities has been lagging all year on fears of a profit squeeze. The bourse is down 20pc since last November.

The erosion of export margins may explain why Beijing is still dragging its feet on a revaluation of the yuan, despite ever louder calls for retaliatory sanctions in Washington. China's currency has fallen slightly on a trade weighted-basis since the dollar-peg was replaced in May by a crawling band, a clear sign that the authorities are worried that the economy is cooling too fast. Beijing has tried cool the property boom with credit curbs but it is hard to use such tools in a surgical fashion without collateral damage. The growth of factory output ground to a halt in July, on a month-on-month basis.

China's foreign investment body SAFE has bought record amounts of bonds from Japan, Korea and other Asian countries over the last three months. While this is part of a normal shift away from the US and Europe, it is also a way for Beijing to hold down its currency against these competitors. It is difficult to separate motives in such a policy.

Higher wages are bringing about the outcome that would have occurred by other means if the currency had been allowed to rise over the years, properly reflecting China's growing trade surplus.

Rising pay is both healthy and natural as China jumps up the global wealth ladder. It is a welcome sign of rebalancing in the world economy, provided that China does not try to resist it by driving the currency lower.

Diana Choyleva from Lombard Street Research said China has a delicate task ahead. Rampant overheating has given way to a "sharp cyclical downswing", yet China cannot easily unleash another stimulus blitz without risking inflation. They are in the "nasty quadrant " of the economic cycle where all choices are hard, though China is not as far gone as over-cooked India.

Beijing may have manoeuvred itself into a policy swamp by relying on tiger-style export growth for so long with a suppressed currency instead of boosting domestic demand. Consumption has fallen from 47pc of GDP in 1998 to 35pc, the flip-side of over-investment in excess capacity. It will be tricky for China to extricate itself smoothly from such extreme imbalances.

Meanwhile, China Daily reports that 70pc of all flats in Hainan, 66pc in Beijing, and 51pc in Shanghai are empty, based on a survey of electricity use. They are presumably owned by investors and speculators.

Given that the "cohort" of young people aged 20 to 30 currently joining the workforce is now contracting as China's demographic crunch starts to bite, this property glut looks all too like the bubble peaks in Taiwan, Hong Kong, and Singapore in the 1990s.