Is China's Competitive Edge Already Eroding?

In the US, when I mention that I was going to China, I was liable to hear a flood of complaints.  China manipulates its currency to make its goods artificially cheap.  Americans are being forced to compete with cheap Chinese labor who live on practically nothing.  There are no labor and environmental standards.

That last isn't quite true, but it's certainly different from the United States, and it's hard to argue with the former two arguments:  China does manipulate its exchange rate to subsidize exports to the US; and its labor is very cheap.

Both of those factors, however, are changing.  The endless acquisition of US currency is unsustainable.  The sterilization transactions required to keep their foreign exchange operations from turning into inflation have left the banking system positively gorged with low-interest government bonds; and now that the sterilization has eased, the inflation is showing up anyway.  The current official figures are 4.25%, and a bank economist we spoke to yesterday expects something over 5% in the near future.

The wages, too, are starting to rise.  Anecdotally, we're hearing reports of labor costs jumping 15-30% in major urban areas like Beijing and Shanghai.  Importing low-wage workers from distant farms and using the labor cost advantage to dramatically undercut competitors is a strategy that has limits. To see why, look at the map I posted the other day when I wrote about high speed rail:

Thumbnail image for Screen shot 2010-11-21 at 7.32.23 PM.png

China's cities cluster very tightly around good coastal ports, and the Yangtze (that horizontal line in the middle).  I'd argue Shanghai and Beijing are near, as the traffic is close to Manhattan levels; if you can't move people or goods, you can't grow much bigger.  As those other major cities start hitting the limits to their growth, the cost of living will rise sharply in these cities, and even unskilled labor willing to work for poverty wages will cost enough to make large classes of goods, like textiles, mostly unprofitable.

There's a lot of talk about moving further west, where there is untapped land and cities can essentially be built in the middle of nowhere to house new people and industries.  Massive freight rail and port upgrades are underway that will supposedly allow goods to be moved from new growth areas in the hinterlands.

But one person we talked to yesterday, who specializes in helping American companies break into China, said simply, "If you're in an export industry, you want to be next to the port."  Water is the cheapest way to transport goods, and switching between transport modes always adds costs and delays.  If you can just put something on a boat and keep it there, this will always be preferable to driving it to the railhead, loading it into the container, and then reloading that container onto a ship.

Moreover, there is, as someone else told us, "considerable unrest" in the west.  Companies do not like to locate where local riots might disrupt their supply chain.

That means that for China to remain competitive, it is going to have to move rapidly up the value chain.  I'm pretty sure they can and will do this, which means that competition from China will remain.  But it won't be the same kind of competition. It will be less about low price, and more about value added.  For many American companies, this may be even harder to face.  But for American (and Chinese) consumers, it will ultimately be a huge boon.
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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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