We recently visited three Shanghai-based foreign-invested enterprises (FIEs) involved in the global laptop supply chain. We talked with senior management and walked around their production floors, seeing everything from silver paint being sprayed onto laptop cases to dozens of chips being embedded into motherboards at unbelievable speeds. We were interested in rising costs, and how the firms were coping.
Labour
Despite the high-tech nature of a laptop, the manufacturing process is surprisingly labour intensive. The three companies we visited employ a total of 40,000 people. Eighty per cent are women of 18-22 years old. Two 12-hour shifts a day mean that the production lines can run 24/7 if needed, and demand is currently high. However, the prime driver of wage price inflation is the Shanghai government. At present the minimum wage is RMB690 (US$86) a month, which the firms we spoke to claimed they pay the mass of their production workers, but there are reports of an increase on the way, perhaps by 10 per cent. Shanghai is not alone in pushing through wage hikes. Shenzhen in Guangdong province recently announced it would raise its minimum wage from RMB690 to RMB800-850 (about US$100) in July 2006, a 16-23 per cent increase. Media reports have, however, claimed that many FIEs, particularly large ones, will be unaffected in Shenzhen since they already pay more than the minimum. Perhaps a better tactic in Shenzhen and its surroundings would be to better enforce employer welfare contributions and limits on overtime. These appear to be the major differentiator between labour markets in the east and the south of China.
The firms we visited in Shanghai claimed they were not only paying the minimum wage, but were also paying other costs that Shanghai is now enforcing: (1) RMB300-400 per employee per month for insurance and other welfare contributions; (2) an enforced 12-hours a day limit, two-day-rest-per-week; and (3) a rule that overtime is paid at twice the normal hourly rate (meaning production line workers can earn, say, another RMB400-600 a month). If migrant workers are housed and fed, a common practice, this costs around RMB50-100 per person per month. We were told that provinces such as Guangdong province tend to enforce rules on welfare contributions and overtime less strictly than Shanghai, and allow firms to pay less for overtime. Firms in Suzhou and Wujiang, areas about one hour drive outside Shanghai, are also reportedly allowed to pay only 1.5 times extra for overtime and can get away with six-day weeks. As a result of these extra costs, a rise in the Shanghai minimum wage would have a much bigger impact on firms than one in Shenzhen or even in Suzhou. Enforcing similar standards on firms in Guangdong would also more likely than not mean an end to ‘labour shortage’ stories.
Despite paying ‘only’ the minimum wage, none of our three firms complained of lacking workers, though one said that turnover had risen in recent months – to 10 per cent per month. Another claimed that his turnover was stable at 5 per cent thanks to good training. The largest firm, a laptop assembly plant, did not talk about this issue at all. This is probably because the de facto level of wages and associated benefits is above the equilibrium rate that the market would otherwise set. So the key issue would be another policy hike in the minimum wage, but not wage pressures from below.
How important are wage costs? It partly depends on what type of firm one is operating. For laptop assembly, labour and other overheads make up less than 10 per cent of total costs. So a minimum wage hike of 10 per cent would only increase overall costs by less than 1 per cent. For the metal parts maker, the labour cost component is higher, some 20-30 per cent. It also depends, of course, on the mix of employees – the more skilled workers, the faster the wage inflation, since skills are of a premium, particularly as firms seek to move up the value chain. Another electronics firm manager we spoke to recently, who operates in Wujiang, says that good R&D staff now cost him RMB10,000 (US$1,250) in wages a month.
Land and Utilities
Land costs are rising too, driven more by demand rather than by regulation. Out in Wujiang, manufacturing firms bought land for RMB60m2 three years ago, and it now sells for RMB100m2. But talk of higher land costs forcing companies inland is slightly puzzling since such costs are fixed. Foreign enterprises usually sign and pay for 50-year leases when they set up operations. The incentive to move is rather that the leasehold can be sold on to another firm, and free/super-cheap land leased in another area. None of the managers believed that electricity or water prices were rising significantly. Thus, this issue is more a decision about liquidating an asset and realising an asset gain rather than constraining operating costs.
RMB
With the US$-RMB appreciating at less-than-a-breakneck speed, manufacturers could be forgiven for not worrying too much about this. But obviously some do, and again, the costs vary from firm to firm. One of the firms we spoke to imports 50 per cent (by value) of its components from offshore, mostly Taiwan, and makes these transactions entirely in US$. Its revenues from US and Japanese customers are in US$. But its staff and overhead costs are in RMB, while 50 per cent of its components come from onshore firms who will need to be paying in RMB. It therefore has a partial mismatch between its US$ revenues and RMB liabilities, which means RMB appreciation squeezes its margin (but improves its balance sheet if they have outstanding US$ loans). Some onshore suppliers are agreeing to be paid in US$ – but this reflects the firm’s scale and bargaining power and is not normal practice. The RMB forwards market cannot help much – its prices currently also price in a 3-4 per cent appreciation of RMB vis-a-vis US$.
Tax
FIEs in theory pay 33 per cent corporate income tax, but all three corporates we spoke to (like most others) are still enjoying some kind of preferential tax treatment thanks to their foreign-invested status, their location and/or their export orientation. Two of them
were still in the nationwide ‘two years no tax, three years half tax’ (liangmian sannianban) scheme for FIEs. In this scheme, after the firm becomes profitable it enjoys two years of not paying income tax and then three years of half the normal rate. In special zones like Shanghai Pudong and the Songjiang Export Zone, where the corporate income tax rate is a low 15 per cent this scheme means you pay 10 per cent rather than 7.5 per cent. After the three years firms should pay 33 per cent but there are other preferential rates if one is primarily engaged in export. All three firms expected the preferential treatment to end with the merger of domestic and foreign firm tax rates. We also spoke to a contact in the Shanghai Tax Bureau and he confirmed that although the merged tax rate has not yet been determined (it should be in the region of 20-24 per cent), it should in theory apply to all enterprises and all areas – no more tax breaks for exporters, FIEs, or those situated in development zones. Any locality wishing to apply for exemption will have to apply to central government. The Ministry of Finance (in favour of the merger of tax rates) and the Ministry of Commerce (less keen) are still debating the merged rate and how to phase it in.
Tax rates are not the only worry. The Shanghai authorities also have their eye on transfer pricing. Many firms exporting from China are able to transact with offshore-related firms in order to minimise the profits made onshore. This is called transfer pricing (TP), and obviously worries tax authorities, who in the 1990s launched 1,000-2,000 investigations each year nationwide, although in recent years only 100 or so a year, as TP
investigations have been centralised within the State Administration of Taxation (SAT) in Beijing. At present the SAT is offering large exporters the opportunity of signing advance pricing agreements (APAs). These allow firms to pre-agree the prices they use for related-party transactions – as long as they are near market prices, the firms will then not be investigated. However, because of limited resources and the considerable work involved SAT is currently only accepting 20-30 APAs each year. Sometime later this year, however, the SAT will likely require firms with related party transactions to provide documented details of their pricing and transactions. This is likely to create work and cause TP practices to be further limited.
With Shanghai becoming more expensive across all fronts, therefore, why are firms not moving en masse to Chongqing or even to any of the dozen new low cost manufacturing zones four hours drive outside Shanghai? Labour is likely to be cheaper – thanks to lower minimum wages, laxer enforcement of welfare rules, and the fact that workers can live at home, saving on dormitory costs. Tax can possibly be saved, if poorer localities are still able to offer tax schemes. Land costs can also be recouped. But there are many factors holding firms back too. First, the possibility of national tax treatment clouds the tax picture. Second, logistical practicalities might create problems – it is not just moving goods in and out of a new area, but also management travel time. If you live in Shanghai or Hong Kong and manage factories in the surrounding area, you are commuting a lot already and might resist adding two hours to your journey time. Third, talent – which does not want to move out of the major cities, an issue for everyone, including foreign banks. Fourth, there is a collective action issue. If you are tightly knit into a supply chain based on just-in-time delivery systems, such as laptop manufacturing, you simply cannot move on your own. The assembly plant we visited had a three-day delivery time for an order made in Asia, one week for orders from the US and Europe, so every hour its supplies spend on the road is an hour it cannot afford. It has 19 suppliers, more than a half of whom have facilities nearby, and has been talking to several of its offshore suppliers about re-locating production nearer. This collective action problem is not unsolvable though. When cost pressures become too much, the assembler, which dominates its supply chain through pricing power and stakes in many of its suppliers, will have a lot of influence in determining when and where to move not just itself but also much of the chain. There are other obstacles to a move, but our favourite was the reason why another laptop casing manufacturer decided against repeated attempts by the Dalian (Liaoning province) authorities to attract him north: the seasonal extremes in temperature, which apparently would play havoc with the plastic.
If you cannot move, then going up the value-chain is not a bad second-best option. The metal parts maker we spoke to is pursuing a contract with a high-end, design-focused large customer and is starting laser-wielding for external parts in an effort to insulate it from low-end competition, add value to its products, and make it harder for the customer to understand the real costs involved in what they sell them. But, for most firms, given the pricing power of the assembler and the pressure that the assembler is under from its ultimate customers, the likes of Dell, HP and NEC, going up the value chain is not a panacea.
Move to One Zone
What, however, we think we are likely to see over the next decade is a China that once had a patchwork of different tax incentives and jurisdictions being transformed into a (largely) single tax zone. With the national merger of tax rates, the ability of localities to compete on tax to attract investment will be heavily constrained, although unlikely to be entirely eliminated. In the place of tax, we are likely to see China littered with different minimum wages and land prices, which will in turn partly determine the shape of industrial development. In other words, despite the rhetoric, China’s minimum wage will be less a tool of labour protection and more a tool of local industrial policy. Informally also, overtime rules and other benefit regulations will also vary across localities, although here too the central government is ambitious about unifying the country. Areas such as Shenzhen and Shanghai are now consciously constructing tax and wage environments, which actively push low-end manufacturing out. And, at the same time, inland areas which could be only a few hours’ drive away, rather than the centre of China, are competing with their low and varied input costs.
The government’s hope is clearly that it can use these tools to achieve three tricky objectives simultaneously:
- Create a level playing-field between local and foreign firms;
- Prevent continued agglomeration of industry on the coastline; and
- Push low-value industry not out of China, but into the interior.
These are ambitious plans.