Can China's Economy Stay Strong?

Rising Manufacturing Costs

The increasing labor costs and high commodity prices are taking a toll on Chinese manufacturers. "We've been seeing corporate profitability in the manufacturing sector squeezed by these factors, in particular those industries that are dependent on a high level of labor," says Matthew Lee, head of greater China equities at MFC global in Hong Kong. "And in those industries that rely on raw commodity input, we have seen companies' profit margins squeezed in the last six months."

The pressure on manufacturing costs is severe: Wages in China soared 18% in the first six months of the year, while the RMB has gained 21% against the U.S. dollar since mid-2005, with another 5% appreciation expected in the next year or so. High commodity prices are also a worry, but analysts see the recent spike as cyclical, not structural -- a view that is strengthened by the easing of commodity prices in the past few months.

However, analysts say, the rising costs are not all bad. "In many ways some of these rising costs that China is facing are actually quite a good thing," says Paul Cavey, head of China Economics at Macquarie Securities in Hong Kong. "For example, rising wages are raising incomes across China and boosting welfare, and higher commodity prices are an important spur to begin moving China away from more environmentally unfriendly manufacturing practices."

As part of the government's process of weeding out unwanted factories, it has raised taxes on steel, aluminum and garment companies, and it has boosted incentives for investments in services, agriculture and high-tech. It is encouraging dirty and inefficient factories to merge, and in September, the national legislature introduced a new law designed to put the country on a faster track to sustainable development, with firmer requirements for saving energy and reducing pollution. The new law, to take effect on January 1, 2009, will require manufacturers to meet much stricter -- and more expensive -- energy-saving standards. The balancing act is delicate: Beijing wants to push industries further up the value chain, but at the same time, it must keep an eye on employment and GDP growth.

"The government does not want to provide blanket support to everything," says Peng of Barclays Capital. "They want to combine this support with some structural changes that will support long-term sustainable growth in the economy, so they will not support every sector with the same intensity."

The rise in wages is another trend that seems to have at least some encouragement from the government, because earlier this year a new wage law was introduced that, according to Macquarie, has boosted average labor costs for companies about 5% to 10%.

The most worrisome aspect of higher manufacturing costs is that they raise the price of exports. "The government is concerned about this, because exports are one of the growth pillars for the Chinese economy, and much of the manufacturing output is destined for the export market," says Chum. "If you look at export growth in Guangdong province, which is a good indicator of export growth in China, that has started to come off."

So far, the drop off in exports has been modest, says Jian Zhuang, senior economist at the Asian Development Bank's Resident Mission in China; booming Asian countries have picked up some of the slack. "Resilient demand from developing economies helped offset in part slower industrial-country export orders, so overall export growth was a robust 22% in the first half of 2008, which is down 2% from the second half of 2007," says Zhuang. "Exports will stay at around 18% to 19% growth in 2009, and exports should maintain double-digit growth in the next three to five years."