A declining labor supply, rising wages and an appreciating currency are among the key reasons production costs are rising fast in China. Increasing land costs and the fact that SMEs find it difficult to obtain capital, are making the situation worse.

China’s youth labor supply has started to decline

It was once popular to talk of China’s endless supply of cheap labor. Not anymore. Labor supply has shrunk dramatically over the past decade.

China’s youth demographic is expected to decline by 44 million over the next 10 years, according to the United Nation’s population projection division. Indeed, the average Chinese national is 35-years-old, compared to the average Cambodian (23 years) and average Bangladeshi (24 years).

The result is massive labor shortages. Officials in the southern Pearl River Delta, for instance, estimate the region suffers a shortfall of 600,000 workers. Or take the example of a major manufacturer of butane lighters who recently remarked to us that in spite of automating part of his factory floor and cutting his employee numbers in half, the average age of his staff has gone from 20-years, to 30-years, and now 50-years, as he struggles to find enough labor.

The situation is especially worse for factories producing low-value goods as they are either unwilling or unable to pay higher wages and it is common to hear of suppliers turning down orders from foreign buyers for fear that they will be unable to attract sufficient staff to fill the order on time.

China’s wages are rising

Labor shortages have contributed to rising wages. Today, China’s average manufacturing wage ranges from $200 to $550 (or higher). Moreover, the total monthly salary is likely higher as benefits-ranging from starting bonuses, performance bonuses, and marriage leave-are rising faster than monthly wages.

The result is that China’s wages are now on par, or significantly higher, than wages in the rest of the region. For instance, monthly wages in Bangladesh are around $55 per month and similarly low in Cambodia ($100) and Vietnam ($100). Only Thailand, among the low-cost producers, has higher wages.

China’s government has added to the pressure by hiking minimum wages in an effort to reduce income inequality, thus adding to wage cost pressure. Minimum wages have, on average, risen from $59 a month in 2000 to $166 a month in 2011. (The figures are calculated at constant 2011 USD/CNY rates; otherwise the increase in wages would be even larger, from $45 to $166).

To be fair, wage rates do vary across the country. Minimum wages are 30% higher in the coastal provinces ($187) than they are in the western provinces ($143). Wages can even differ between cities with minimum wages in Shenzhen at $234 in 2011 as against $203 in the rest of Guangdong province.

Nonetheless, the pressure on wages is clear and growing, whether because of market forces or government policy.

China’s currency is appreciating rapidly

The Chinese renminbi has meanwhile appreciated a median 22% against 13 Asian currencies in the past five years, so impacting the country’s competitiveness. The gains are even larger against some of China’s lowcost competitors. For instance, the Chinese renminbi has appreciated by more than 44% when compared to the currencies of Bangladesh, Cambodia, India, Laos and Vietnam (as the graph shows), a significant move when added to the country’s rising wages costs.

Such rapid appreciation may slow in the coming years, as the trade surplus narrows and the currency nears its fair value. Indeed, while nominal appreciation has been slower than critics in Brussels and Washington might like, real appreciation (adjusting for the country’s relatively faster inflation rate) has been rapid. Nonetheless, the damage is already done and a strong Chinese currency is another reason for the gains made by other low-cost manufacturers.

China’s land and other production costs are rising

China’s economy is also starting to face serious shortfalls in a variety of production inputs, resulting in rising production costs.

For a start, a large share of the population is concentrated along the coastal provinces (27% of the population) intensifying competition for inputs. Export production is even more concentrated, with just three coastal provinces- Guangdong, Zhejiang, and Jiangsu-accounting for 60% of total exports.

Land scarcity has inflated land prices and is pushing manufacturers further into the interior. Of course definitions of the ‘interior’ can differ widely: to some that might mean 100 kilometers west of the city of Guangzhou, while to others it implies moving 1,000 kilometers to an inland province.

Higher land prices are just one reason for the overall rise in China’s production costs. But relocating factories further away from coastal ports also raises transport costs and lengthens supply chains. The latter is especially important given that China’s ability to deliver rapidly is a major competitive advantage.

Restrictions on polluting industries are also tightening in part because of water scarcity. The authorities in southern Guangdong province, for instance, are relocating heavy metal factories to purpose-built industrial parks further inland where waste-water treatment facilities are more readily available.

China’s SMEs find it difficult to obtain capital

Automation is a logical response to rising wages. Yet, most SMEs find it difficult to obtain bank credit, as the state-banks prefer to lend to blue-chip state-owned firms. Indeed, recent surveys show that borrowing from family and friends accounts for 25% of SME financing in Zhejiang province.

Unofficial banks account for 21% of SME financing, but their interest rates can range from between 30% to 100%, or more, implying that such credit is more likely used as working capital to fill orders, rather than finance capital equipment, such as buying arc welders in order to automate production lines.

In the past, firms might more readily invest their free cash flow in capital equipment. But the pressure on margins as a result of rising production costs means there is less cash available. (Equally, many firms would rather invest in the property market where returns were, until recently, much higher.)

Zhou Guanxin, head of Zhejiang’s Federation of Commerce and Industry, summed up the challenges recently while speaking with reporters from the 21st Century Business Herald last month: he noted that China’s SMEs have “no heart to turn, no ability to turn, and nowhere to turn to”.

This is an excerpt from the report “The End of Made-in-China?” published by Silk Road Associates.