Asia-Pacific | Emerging Markets Regional Review

Structural changes in emerging Asia’s manufacturing-for-export markets are erasing the low-cost advantage.

Asia has become the region where business as usual does not apply. Macau’s casinos overtook Las Vegas as the biggest gambling center in the world five years ago. But lately, the gambling tables in Macau are empty. High-rolling mainland gamblers, once in endless supply, are loath to draw attention to themselves as China’s anticorruption campaign plays out.

Hopper, Strategic Decisions Group: Some [companies] are moving closer to customers in their home markets.

Less money is flowing from China generally. Factory growth, as defined by Purchasing Managers’ Indexes issued by Markit Economics and HSBC, fell to a five-month low in China in October. PMIs applying to services hit a nine-month low. PMIs are drawn from monthly surveys probing what manufacturers have been buying to prepare for upcoming production, and hence serve as a good indicator of demand.

A similar trend could be seen across the Asia-Pacific region in October. In Korea, Taiwan, Vietnam, Indonesia and Australia, PMIs were below the 50-point threshold, signifying that the manufacturing sector was contracting. India had an expansion-friendly figure above 50, but this was still down from July and August.

What’s happening here? Conventional wisdom has long posited that the structural changes and political upsets in China would present a bonus to Asia’s emerging economies, as companies sought to move at least some portion of their supply chains to lower-cost markets like Vietnam, Indonesia, India and Bangladesh, or ‘frontier’ markets like Myanmar and Cambodia.

In fact, manufacturing in general is showing signs of structural change in Asia’s emerging markets. Hong Kongbased HSBC economist Izumi Devalier recognizes that slowing export growth from Asia has much to do with lower demand generally in Europe and the US since 2008. But she says that another possibility is more unsettling: “That is, the idea that Asia is simply losing its competitiveness.” She adds, “After all, most Asian currencies have strengthened over the past three years. Unit labor costs, too, are rising in local currency terms as declining surplus labor pushes up wages faster than the rise of productivity.”

If Asia is indeed losing its competitiveness, she says, “emerging markets exports in Asia will continue to disappoint in the years ahead unless the region moves up the value chain or implements productivity-raising reforms.”

The cost of labor is perennially discussed by chief executives and chief financial officers in Asia. According to Asian Development Bank figures for 2013, the annual minimum wage for China stood at $2,472—or $3,337, when adjusted for employer social insurance contributions. Some of the Asian markets commonly regarded as “emerging” have caught up quickly. Wages in Thailand, for example, stand at 95% of the China figure, while wages in Malaysia are 105% of those in China. In Vietnam and Indonesia, on the other hand, wages are 47% and 36% of the China figure, respectively.

One reason that executives are looking so closely at how the reforms of India’s Bharatiya Janata Party and the administration of Narendra Modi play out is that wages are still markedly lower in India—at 22% of China’s—than in any major market in the world. If Modi succeeds in making India an easier place to do business by easing infrastructure woes and curbing its bureaucracy, manufacturing for export there will grow dramatically. But foreign companies are still waiting in the wings. Reform in India has failed before.

Exports in Asia will continue to disappoint…unless the region moves up the value chain or implements productivity-raising reforms.

~ Izumi Devalier, HSBC

The larger point is that the low-cost labor story is showing signs of having run its course. Consider the “Lewis turning point,” named for St Lucian economist and Nobel Prize winner W. Arthur Lewis. In broad terms, Lewis discussed what happens when societies with a higher number of agricultural workers begins to industrialize. Manufacturing and industry is able to draw from surplus labor in the agricultural sector, but as this process continues, wage pressures build and squeeze profits and the society’s turning point is reached.

China has not yet reached this point, according to Devalier, but signs that it is approaching are “clearly visible.” She argues that the attention focused on China tends to overlook emerging Asia’s position in relation to the turning point. “Demographic dynamics also suggest that pressure on low-skilled manufacturing wages is set to rise over the coming years in many Asian economies—even in those that are considered low-cost,” she says.

The population cohort most involved in manufacturing is that of 15-to-34 years old, who tend to be single and able to work away from home. From the point of view of this group, China reached negative population growth in 2008, according to United Nations data. But Asia’s “Tiger” economies—Hong Kong, Singapore, Thailand, and Taiwan—reached this point a decade ago. Vietnam is a favorite target nation of choice for companies that want to diversify their lower-cost manufacturing bases away from China, but its 15- to 34-year-old population group will reach negative growth this year.

The story is not universal. Again, India is highly favored, as it will reach its turning point in 2035, while the Philippines will hold out until 2056. The point is the pursuit of lower-cost markets has a visible endgame.

Changes in manufacturing globally are interrupting the progress of the “flying-crane formation” of national manufacturing development in Asia. This is a metaphor commonly used to describe how nations have progressed up the value chain. Japan and Korea built their low-cost manufacturing bases early, establishing supply chains in the Tiger economies and eventually China. As Japan and Korea progressed into more sophisticated manufacturing, the low-cost model migrated to the Tigers and China. Today, the same process has brought developing Asia—from Vietnam to Bangladesh—into the formation.

But other forces are at work, explains Peter Hopper, managing director for Asia for Strategic Decisions Group, a consultancy. “Lower energy costs and better automation are prompting companies to reconsider the model,” says Hopper. “Some are moving closer to customers in their home markets. Witness the transfer of some manufacturing supply chains to Mexico for North American companies, as one example.”

Meanwhile, better automation now available in some industries means that rising costs in China can be sustained, if robotics can now accomplish previously labor-intensive tasks. It may make sense to stay in China, where supply chains are fully developed and the infrastructure is superior to most other Asian nations.

The old stories in Asia are changing. You can bet on it.