Is China the World’s Next Rust Belt?

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Rising labor costs will challenge China’s manufacturing base, but five factors point to opportunities for growth.

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Is China the World’s Next Rust Belt?

  1. 1. ONLINE FEBRUARY 25, 2013strategy+businessIs China the World’sNext Rust Belt?Rising labor costs will challenge China’s manufacturingbase, but five factors point to opportunities for growth.BY JOHN JULLENS
  2. 2. www.strategy-business.com1According to a growing number of media andanalyst reports, China’s days as the world’slargest manufacturing nation are alreadynumbered—only two years after ending the UnitedStates’ 110-year reign. This conclusion has left Chinesebusiness leaders understandably concerned. At lastyear’s World Economic Forum in Tianjin, the chair-man of one of China’s largest firms spoke (off therecord) of the worst manufacturing crisis in the coun-try’s history. Labor costs are on the rise, the demo-graphic dividend is dissipating, and rising oil pricesare making long-distance transportation costs toChina’s major export markets in the U.S. and Europeunsustainable. At the same time, U.S. firms are devel-oping a new respect for the art of manufacturing, andbreakthroughs in shale gas conversion have significant-ly lowered the costs of operating plants domestically.As a result, Gordon Chang wrote in a recent Forbesarticle, China may soon replace Detroit as the world’srust belt.I think that may be an overreaction—the future ofmanufacturing in China has more room for opportuni-ty than many Western pundits would like to believe. Forstarters, although rising labor costs will indeed under-mine China’s export-led development model, they arealso a natural by-product of the country’s economic suc-cess, and, therefore, to be celebrated. In addition, at leastfive factors will likely more than offset the impact ofChina’s eroding labor cost advantage.1. Domestic demand. China’s rapid economic devel-opment will continue to add millions of new consumersto its already huge customer base. The country is, orsoon will be, the world’s largest market for a wide rangeof goods, many of which need to be manufactured closeto where they are consumed. In addition, Chinese tastesare sufficiently particular for it to often be necessaryto design (and manufacture) products specifically forlocal customers. Technological developments, such asminiaturization and 3-D printing, will further enablethese trends.2. Urban–rural divide. China remains a highlydiverse country with a wide gap between urban andrural incomes. In fact, almost two-thirds of its peoplestill earn less than US$5,000 per year. In contrast to thenation’s more developed coastal regions, China’s less-developed inland regions continue to have low laborcosts—suggesting that manufacturing activities couldbe shifted to retain the country’s labor cost advantage.3. Operational excellence. To date, few firms havetruly optimized their Chinese operations. This leavessubstantial room for productivity improvementsthrough, for example, more efficient machines and pro-duction setups, minimization of defects, leaner supplychains, and improved labor productivity.Is China the World’s Next Rust Belt?Rising labor costs will challenge China’s manufacturing base, but five factorspoint to opportunities for growth.by John Jullens
  3. 3. 4. Frugal manufacturing. China’s competitiveadvantage already goes far beyond cheap labor. Forexample, Chinese firms are often quite innovative inreducing costs by redesigning manufacturing processes,substituting cheaper “good enough” materials, andusing simpler off-the-shelf components.5. Investment versus comparative advantage.Economic theory dictates that when labor costs rise,businesses move elsewhere. However, countries can offerinvestment incentives to attract or keep businesses, andI believe that such incentives often trump the underly-ing comparative advantage. China, like Singapore—thecountry it most seeks to emulate—has the financialmeans and the will to wield this tool effectively.Instead of leaving the country en masse, China’smanufacturing base will likely begin to fragment. Someshifts are inevitable. For example, the manufacturing oflightweight, labor-intensive products, including gar-ments and shoes, may indeed migrate to lower-costcountries, such as Vietnam. But China will continue tomanufacture many products, for example, thosedesigned specifically for local tastes and those for whichfreshness is a requirement. China is also likely to con-tinue making products that require strong logistics net-works, the ability to manufacture at very large scale, andthe presence of local supply chains. China offersadvanced capabilities in these areas, whereas Vietnammay not. It would likely take a lot for Apple to walkaway from Foxconn’s expertise in manufacturing largevolumes at high quality levels.The eventual outcome will in no small measure bedetermined by the Chinese government itself. It mustinvest heavily in supply chain infrastructure and logisticsto connect the interior to the rest of the country and toits current export hubs in particular—Shanghai,Shenzhen, and Tianjin. In addition, it must incentivizemultinationals to relocate their activities to China’s inte-rior regions instead of moving them abroad. At the sametime, China must continue to upgrade its remainingmanufacturing base, especially in so-called sunriseindustries. Not surprisingly, this is exactly what the gov-ernment’s most recent five-year plan calls for.China’s transition from an emerging to a developedeconomy will undoubtedly be challenging. But thecountry has an enviable track record in successfullyimplementing its five-year plans, and the financialresources to override other considerations, if necessary.In fact, the U.S. should give serious thought to adopt-ing a more coordinated industrial policy itself toencourage investment in domestic manufacturing.Otherwise, those Midwestern rust belts may very wellstay right where they are. +2John Jullensjohn.jullens@booz.comis a partner with Booz &Company based in Shanghai.He co-leads the firm’s engi-neered products and servicespractice in Greater China. Heblogs at www.johnjullens.com.www.strategy-business.com
  4. 4. strategy+business magazineis published by Booz & Company Inc.To subscribe, visit strategy-business.comor call 1-855-869-4862.For more information about Booz & Company,visit booz.com• strategy-business.com• facebook.com/strategybusiness• http://twitter.com/stratandbiz101 Park Ave., 18th Floor, New York, NY 10178Looking for Booz Allen Hamilton? It can be found at at www.boozallen.com© 2013 Booz & Company Inc.

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