The end of cheap China
What do soaring Chinese wages mean for global manufacturing?
Mar 10th 2012

TRAVEL by ferry from Hong Kong to Shenzhen, in one of the regions that makes China the workshop of the world, and an enormous billboard greets you: “Time is Money, Efficiency is Life”.
China is the world’s largest manufacturing power. Its output of televisions, smartphones, steel pipes and other things you can drop on your foot surpassed America’s in 2010. China now accounts for a fifth of global manufacturing. Its factories have made so much, so cheaply that they have curbed inflation in many of its trading partners. But the era of cheap China may be drawing to a close.

Costs are soaring, starting in the coastal provinces where factories have historically clustered (see map). Increases in land prices, environmental and safety regulations and taxes all play a part. The biggest factor, though, is labour.

On March 5th Standard Chartered, an investment bank, released a survey of over 200 Hong Kong-based manufacturers operating in the Pearl River Delta. It found that wages have already risen by 10% this year. Foxconn, a Taiwanese contract manufacturer that makes Apple’s iPads (and much more besides) in Shenzhen, put up salaries by 16-25% last month.

“It’s not cheap like it used to be,” laments Dale Weathington of Kolcraft, an American firm that uses contract manufacturers to make prams in southern China. Labour costs have surged by 20% a year for the past four years, he grumbles. China’s coastal provinces are losing their power to suck workers out of the hinterland. These migrant workers often go home during the Chinese New Year break. In previous years 95% of Mr Weathington’s staff returned. This year only 85% did.

Kolcraft’s experience is typical. When the American Chamber of Commerce in Shanghai asked its members recently about their biggest challenges, 91% mentioned “rising costs”. Corruption and piracy were far behind. Labour costs (including benefits) for blue-collar workers in Guangdong rose by 12% a year, in dollar terms, from 2002 to 2009; in Shanghai, 14% a year. Roland Berger, a consultancy, reckons the comparable figure was only 8% in the Philippines and 1% in Mexico.

Joerg Wuttke, a veteran industrialist with the EU Chamber of Commerce in China, predicts that the cost to manufacture in China could soar twofold or even threefold by 2020. AlixPartners, a consultancy, offers this intriguing extrapolation: if China’s currency and shipping costs were to rise by 5% annually and wages were to go up by 30% a year, by 2015 it would be just as cheap to make things in North America as to make them in China and ship them there (see chart). In reality, the convergence will probably be slower. But the trend is clear.

If cheap China is fading, what will replace it? Will factories shift to poorer countries with cheaper labour? That is the conventional wisdom, but it is wrong.

.Advantage China

.Brian Noll of PPC, which makes connectors for televisions, says his firm seriously considered moving its operations to Vietnam. Labour was cheaper there, but Vietnam lacked reliable suppliers of services such as nickel plating, heat treatment and special stamping. In the end, PPC decided not to leave China. Instead, it is automating more processes in its factory near Shanghai, replacing some (but not all) workers with machines.

Labour costs are often 30% lower in countries other than China, says John Rice, GE’s vice chairman, but this is typically more than offset by other problems, especially the lack of a reliable supply chain. GE did open a new plant in Vietnam to make wind turbines, but Mr Rice insists that talent was the lure, not cheap labour. Thanks to a big government shipyard nearby, his plant was able to hire world-class welders. Except in commodity businesses, “competence will always trump cost,” he says.

Sunil Gidumal, a Hong Kong-based entrepreneur, makes tin boxes that Harrods, Marks & Spencer and other retailers use to hold biscuits. Wages, which make up a third of his costs, have doubled in the past four years at his factories in Guangdong. Workers in Sri Lanka are 35-40% cheaper, he says, but he finds them less efficient. So he is keeping a smaller factory in China to serve America and China’s domestic market. Only the tins bound for Europe are made in Sri Lanka, since shipping costs are lower than from China.

Louis Kuijs of the Fung Global Institute, a think-tank, observes that some low-tech, labour-intensive industries, such as T-shirts and cheap trainers, have already left China. And some firms are employing a “China + 1” strategy, opening just one factory in another country to test the waters and provide a back-up.

But coastal China has enduring strengths, despite soaring costs. First, it is close to the booming Chinese domestic market. This is a huge advantage. No other country has so many newly pecunious consumers clamouring for stuff.

Second, Chinese wages may be rising fast, but so is Chinese productivity. The precise numbers are disputed, but the trend is not. Chinese workers are paid more because they are producing more.

Third, China is huge. Its labour pool is large and flexible enough to accommodate seasonal industries that make Christmas lights or toys, says Ivo Naumann of AlixPartners. In response to sudden demand, a Chinese factory making iPhones was able to rouse 8,000 workers from their dormitory and put them on the assembly line at midnight, according to the New York Times. Not the next day. Midnight. Nowhere else are such feats feasible.

Fourth, China’s supply chain is sophisticated and supple. Professor Zheng Yusheng of the Cheung Kong Graduate School of Business argues that the right way to measure manufacturing competitiveness is not by comparing labour costs alone, but by comparing entire supply chains. Even if labour costs are a quarter of those in China to make a given product, the unreliability or unavailability of many components may make it uneconomic to make things elsewhere.

Dwight Nordstrom of Pacific Resources International, a manufacturing consultancy, reckons China’s supply chain for electronics manufacturers is so good that “there is no stopping the juggernaut” for at least ten to 20 years. This same advantage applies to low-tech industries, too. Paul Stocker of Topline, a shoe exporter with dozens of contract plants in coastal China, says there is no easy alternative to China.

It is fashionable to predict that China’s inland factories will supplant its coastal ones. Official figures for foreign direct investment support this view: some inland provinces, such as Chongqing, now attract almost as much foreign money as Shanghai. The reason why fewer migrant workers from the hinterland are returning to coastal factories this year is that there are plenty of jobs closer to home.

But manufacturers are not simply shifting inland in search of cheap labour. For one thing, it is not much cheaper. Huawei, a large Chinese telecoms firm, reports that salaries for engineers with a master’s degree are not even 10% lower in its inland locations than in Shenzhen. Kolcraft considered shifting to Hubei, but found that total costs would end up being only 5-10% lower than on the coast.

Topline looked into moving inland, but found huge extra costs there. Infrastructure for exports is still shoddy or slow (shipping by river adds a week), logistics are not fully developed and Topline’s entire supply chain remains on the coast. It decided to stay put.

.Inland revenue?

.Moving inland brings all sorts of unexpected costs. Newish labour laws in wealthy places such as Shenzhen make it costlier to shut down plants there, for example. It can cost more to ship goods from the Chinese interior to the coast than from Shanghai to New York. Managers and other highly skilled staff often demand steep pay rises to move from sophisticated coastal cities to the boondocks.

Chongqing has more than 30m people, but it’s not Shanghai. A recent anti-corruption campaign there grew so violent that it terrified legitimate businessfolk as well as crooks.



The firms investing in China’s interior are chiefly doing so to serve consumers who live there. With so many inland cities booming, this is an enticing market. But when it comes to making iPads and smartphones for export, the world’s workshop will remain in China’s coastal provinces.

In time, of course, other places will build better roads and ports and supply chains. Eventually, they will challenge coastal China’s grip on basic manufacturing. So if China is to flourish, its manufacturers must move up the value chain. Rather than bolting together sophisticated products designed elsewhere, they need to do more design work themselves. Taking a leaf out of Germany’s book, they need to make products with higher margins and offer services to complement them.

A few Chinese firms have started to do this already. A visit to Huawei’s huge corporate campus in Shenzhen is instructive. The firm was founded by a former military officer and has been helped by friends in government over the years, but it now more closely resembles a Western high-tech firm than it does a state-backed behemoth. Its managers are top-flight. Its leaders have for several years been learning from dozens of resident advisers from IBM and other American consultancies. It has become highly professional, and impressively innovative.

In 2008 it filed for more international patents than any other firm. Earlier this year, it unveiled the world’s thinnest and fastest smartphones. In a sign that at least China’s private sector is beginning to take intellectual-property rights seriously, Huawei is locked in bitter battles over patents, not only with multinationals but also with ZTE, a cross-town rival that also wants to shift from being a low-cost telecoms-equipment maker to a creator of sexy new consumer products.

.China does not yet have enough Huaweis. But it attracts plenty of bright young people who would like to build one. Every year another wave of “sea turtles”—Chinese who have studied or worked abroadreturns home. Many have mixed with the world’s best engineers at MIT and Stanford. Many have seen first-hand how Silicon Valley works. Indeed, Silicon Valley veterans have founded many of China’s most innovative firms, such as Baidu.

The pace of change in China has been so startling that it is hard to keep up. The old stereotypes about low-wage sweatshops are as out-of-date as Mao suits. The next phase will be interesting: China must innovate or slow down.

March 11, 2012 8:13 pm

Global interest rates: Libor – a benchmark to fix

An investigation into how key financial reference points are set has put some banks in the spotlight

“At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size, just prior to 11am?”

Every day, employees at the world’s leading banks are asked an inelegantly worded question used to calculate the benchmark rates that help determine the price of mortgages, the cost of corporate lending and the interest added to credit card bills.


Their answers are now at the heart of a sprawling regulatory investigation into possible manipulation of the London interbank offered rate, one of the most important reference points of the global financial system.

At least 10 enforcement agencies in the US, Canada, Europe and Japan are examining whether bankers and brokers colluded to rig Libor – the index interest rate used for $350tn worth of financial products – and other widely watched rates to boost profits from their in-house trading positions.

For 18 months, officials have been scrutinising whether some banks, through electronic bids processed in London, submitted artificially low Libor numbers to mask their own mounting financial difficulties as a worldwide credit crisis deepened in late 2007 and 2008.

The probe, in which investigators are still sorting through allegations of criminal intent and regulatory shortfalls, has threatened the best efforts of the banking industry to draw a line under the crisis, which led to taxpayers bailing out the financial system. Proved manipulation of index rates could expose banks to a legal and regulatory bonanza, from big fines to class action lawsuits, several of which have already been filed.

“Any confirmed manipulation of these interest rates would imply a very significant cost to the European economy,’’ Joaquín Almunia, European Union competition commissioner, said last month.

Three of the world’s biggest banks UBS, Citigroup and Barclays – have voluntarily approached regulators with information about possible abuse of the rate-setting process by current and former staff. More than a dozen employees at other institutions, including JPMorgan Chase, Deutsche Bank, Royal Bank of Scotland, HSBC and the interdealer brokers Icap and RP Martin, have been fired, suspended or placed on administrative leave in recent months as the investigation gathers pace.

In Canada, court filings by local competition officials have publicly documented a scheme allegedly used to rig a Libor rate, masterminded by a small group of traders. In Tokyo, Japanese financial regulators have taken action against UBS and Citi over attempts by former employees to “influencebenchmark rates, while in a Singapore court case, a former trader at Royal Bank of Scotland has claimed that requests for certain Libor rates were “regularly made” by employees in recent years to maximise profit.

As investigators probe to see whether a process designed to be impervious to manipulation has been purposefully subverted, the British Bankers’ Association, a trade group that sponsors Libor, last week launched a comprehensive review, acknowledging that the way the rate is set may need updating.

“We are committed to the continuing and ongoing evolution of Libor as appropriate,” says Angela Knight, the BBA’s chief executive.

Prior to the current inquiry, the relatively old-fashioned mechanism used to fix Libor and other benchmark interest rates was of interest only to market practitioners and a small cadre of critics, who argued that it was a poor gauge of banks’ actual borrowing behaviour.

At their simplest level, Libor, Tibor and Euribor, as the main rates are known, are supposed to be daily measures of how much banks are paying to borrow from one another in dollars, euros, yen and other currencies for set lengths of time, ranging from overnight to 12 months.

The rate-setting process, largely unchanged for 26 years, offers a crucial indicator of the overall health of the financial system. A jump in Libor can signal that banks are increasingly reluctant to lend to each other one of the contributing factors in the credit crisis. Libor also serves as the underlying reference for the interest paid on scores of everyday financial products. The average US adjustable rate mortgage, for example, is indexed to Libor, with a premium of 2-3 percentage points tacked on.

Because the rates are based on banks’ own estimates as opposed to actual loan data, critics have long argued that at times of financial stress, lenders have an incentive to “low-ball” their submission in order to appear healthier.

The Libor investigation has attracted attention in part because it upends a basic assumption of how the market functions. Bankers argue that even if individual traders try to co-ordinate their quotes, the algorithm used to calculate the rate should make it impossible for them to succeed in moving the benchmark index enough to profit from it.

Regulators are piecing together a mosaic of information about how Libor and other rates may have been targeted. No individual has been charged with wrongdoing, and officials involved with the case in different countries caution that fines or other penalties are not imminent.

In some areas, multiple enforcement agencies are co-operating, such as the US Department of Justice, the Federal Bureau of Investigation and the Commodity Futures Trading Commission.

Several lawyers representing individuals involved say, however, that the inquiry is neither as advanced nor as globally orchestrated as some suggest. “As far as I can see, you have two or three regulators floundering around with no co-ordination,” says one UK-based lawyer.

Some banks have been co-operating with regulators – in effect blowing the whistle on their own employees in the hope of securing leniency from future enforcement actions. Their statements, found in court documents and releases, have helped flesh out some of the contours of the multi-pronged investigation.

Barclays, for example, came forward to the European Commission and the UK’s Financial Services Authority after uncovering internal communications that suggested former employees may have breached internalChinese wallsbarring information-sharing between traders and the bank’s rate-setters for Euribor, say two people with direct knowledge of the case.

Philippe Moryoussef, a derivatives trader who left the bank in 2007 and now works at Nomura in Singapore, is one of the former employees being investigated, those people said. He did not respond to requests for comment.

On Friday, Barclays revealed in its annual report that it had been informed by unnamed authorities that it may face regulatory action relating to the probe, and that it was “engaged in discussion with those authorities about potential resolution’’.

A separate but similar development came in the summer of 2010 at Citigroup’s London office. Employees raised concerns about what they saw as attempts by Thomas Hayes, a senior trader in Tokyo, to alter the bank’s daily bids for yen-denominated Libor, according to six people familiar with the case who asked not to be named, citing the sensitivity of the case.

Having recently joined Citi from UBS, Mr Hayes was billed as a star hire who would transform Citi’s fortunes in Japan following a series of clashes with local regulators.

Hired by Christopher Cecere, the former head of rates trading for developed countries in Asia, Mr Hayes had been a big money-maker for UBS, according to people familiar with his employment.

Within less than a year, however, both Mr Hayes and Mr Cecere had left Citi after they were accused in an internal investigation of attempting to influence yen Libor or the separate Tokyo interbank offered rate (Tibor), according to current and former Citi executives with direct knowledge of the investigation.

Instead of attracting big profits, the two men’s trading positions were unwound at a more than $50m loss after they left. At the time, Citi executives say, the trading irregularities seemed both isolated and unusual.

One former senior banker at the US group who was briefed at the time about Mr Hayes’ and Mr Cecere’s actions said colleagues were mystified at what appeared to be an attempt to influence the rate: “It seemed an incredibly dumb thing to do.”

Mr Hayes has not responded to repeated attempts by the Financial Times to contact him directly and through his lawyer. Mr Cecere, who now works for the hedge fund Brevan Howard in Geneva, has told the FT that he was never questioned by regulators and left the bank in good standing.

Japanese regulators barred Citi in December last year from conducting derivatives transactions related to Tibor and yen Libor for 13 days over its failure to prevent the inappropriate approaches to rate-setting staff.

In an official finding by Japan’s Securities and Exchange Surveillance Commission, the regulator said an employee known as “Trader B” had begun targeting Citi staff who submitted yen Libor quotes beginning in December 2009, repeatedly asking them to change the figures. By April 2010, an executive known as “Director A” had been “continuously conductingsimilar approaches to Citi employees who submitted the bank’s quotes for Tibor, the SESC found.

The agency has declined to identify the two men publicly. But six people with direct knowledge of the case have confirmed to the FT that “Trader B” is Mr Hayes and “Director A” is Mr Cecere.

When staff in Tokyo rebuffed the traders’ approaches, Mr Hayes and Mr Cecere contacted rate setters in London, according to people familiar with the case. London employees reported their approaches to internal compliance supervisors, those people say.

Regulators are scrutinising Mr Hayes’ activities at UBS before his move to Citi in 2009, according to public filings and people familiar with the investigation.

Like Citi, UBS was subject to official action by Japanese regulators in December over attempts by a former trader to influence the bank’s rate setters for Tibor and yen Libor from 2007 onwards. While the trader is referred to only as “Trader A’ in those documents, six people familiar with the case said it was Mr Hayes.

The Swiss banking group, having lurched from crisis to crisis in recent years, including an alleged $2.3bn rogue-trading scandal, was the first bank to disclose the existence of a global Libor probe in March 2011. It was also the first to come forward to several regulators with detailed information about potential abuse of the rate-setting process by current and former employees.

Last July, the group revealed it was co-operating with regulators in the US and Japan in exchange for partial immunity over the potential manipulation of yen Libor and Tibor. As the investigation has widened, UBS has suspended some of its most senior traders in Zurich.

Recently filed documents in the Ontario Superior Court by the Canadian Competition Bureau, which is looking at whether Canadian consumers were harmed by the alleged rigging of benchmark borrowing rates, provide the most detailed roadmap yet as to how traders and interdealer brokers may have worked together to manipulate yen Libor.

According to a sworn affidavit from one of the lead investigators in that case, employees at an unnamed bank “were able to move yen Libor rates to the overall net benefit by the participants” by working with interdealer brokers and traders at rival banks in London including HSBC, Deutsche Bank, RBS, JPMorgan Chase and Citi.

In one instance, an employee identified as “Trader Atold an interest rates trader at HSBC “his trading positions, his desire for a certain movement in yen Libor, and instructions for the HSBC trader to get HSBC to make yen Libor submissions consistent with his wishes”, according to an affidavit sworn on May 18 2011 by Brian Elliott, a Canadian law officer.

UBS is not identified in that lawsuit but three people with direct knowledge of the case say it is the institution that provided information about the attempted manipulation of yen Libor. UBS and other banks named in the case declined to comment.

Lawyers and regulatory officials involved with the case warn that the scheme detailed in the Canadian court documents is just one part of a wide-ranging investigation and is not the core focus of enforcement agencies in other jurisdictions.

Traders and brokers who have been suspended or named in various filings may be “people of interest” – those who may have seen rather than participated in any sort of rate fixing – who can help elucidate the scale of the alleged problem, those people say.
“We could,” admits one UK lawyer working on the case, “be just at the tip of the iceberg.”


London’s rate retains the edge

In the 1980s, companies were just beginning to use futures contracts to hedge their interest rate risks and London was emerging as a centre for loan syndication. Both markets, however, were hampered by a lack of standard reference rates.

So they turned to the British Bankers’ Association, the leading trade grouping for financial services, and the Bank of England for help. By 1986, their efforts had morphed into Libor, the London interbank offered rate, for dollars, yen and sterling.

Libor rates are now calculated in 10 currencies with 15 maturities for each currency and have been supplemented internationally by Tibor, the Tokyo-based rate for yen, and Euribor, set in Brussels for euros. In each case, the rates are set by getting estimates from panels of banks, dropping the top and bottom few and taking a trimmed average. But the process has come under criticism from academics and market participants since the financial crisis started in 2007. At that time, bank estimates for Libor began varying widely from one another, particularly for US dollars, and the short-term rates visibly diverged from overnight indexed swaps (OIS), which are tied to actual market transactions.

The BBA responded by adding more banks to its dollar panel and by improving governance with an independent board in 2008. The grumbling has not stopped, however, and the hunt is on for better indices.

So far, traders say, Libor still has the edge, particularly for lending longer than a month, because there simply are not any good alternatives. But the stakes for the BBA’s latest review of Libor, announced last week, remain high. If market participants are not satisfied that the governance and integrity issues have been solved, $350tn in financial products could be looking for a new benchmark.

Copyright The Financial Times Limited 2012