Low Wages Not Always Key
Success Factor for Overseas Investment
Productivity
Gains from New Technology and Innovation are Necessary
The comparative cost advantage of
taking your business to low wage countries such as China or India, where unit
labor costs in manufacturing are 20 percent lower than in the U.S., are often
not the bargain they seem when wages are adjusted for low productivity,
according to a recently released report by The Conference Board.
This is also true of decisions to
locate in Mexico, Central and Eastern Europe rather than in North America and
Western Europe. “One critical lesson for businesses that benefit from
one-time labor cost benefits when investing in ‘low wage’ countries is that
productivity gains from new technology and innovation have to keep pace with
often fast rising wages of skilled and semi-skilled workers or the ‘cost
advantage’ begins to erode,” says Bart van Ark, Director of The Conference
Board international economic research program and co-author of the report with
The Conference Board Director of Global Demographics, Judith Banister, and
Economist Catherine Guillemineau, formerly of The Conference Board.
Unit Labor
Cost Combines Compensation and Productivity
Unit labor cost (ULC) is defined
as the average labor compensation per unit of output and is measured as the
ratio of labor compensation per employed person (or per hour worked) relative
to output per employed person (or per hour worked) for the aggregate
manufacturing sector in six major emerging economies (China, India, Turkey,
Mexico, Czech Republic, Hungary and Poland) as well as the old European
Union-15 countries and Japan.
With the release of this new
dataset, The Conference Board is the first non-governmental organization to
provide such data on a regular basis. International data on the growth rate of
unit labor costs are widely available, but comparisons of levels are very rare
due to the unavailability of comparable production measures in a common
currency.
This report also marks the first
attempt to estimate the level of unit labor costs in China and India in
comparable U.S. dollar purchasing power parity.
Where Unit
Labor Costs are Lowest
The report finds when adjusting
for productivity gaps, the cost competitiveness of
emerging economies is not as strong as
suggested by wage differences. Because their lower wage cost goes together
with lower productivity, emerging economies still retain a competitive
advantage since in most cases the productivity gap is smaller than the wage
gap.
This is because companies can
benefit from better use of technologies due
to their exposure to international
competition. There are large differences in unit labor cost between emerging
economies.
Among a group of six major
emerging economies, the variation in unit labor costs in manufacturing ranges
from 20 percent of the U.S.
level for China
and India,
to almost equal the U.S. level for
Mexico. “These differences underscore the challenge that even very low wage
countries have in fostering productivity growth that keeps pace with
or exceeds rising wage levels to preserve
their relative global competitive position,” says van Ark.
“The key for emerging economies
is to promote productivity through technological change and innovation to
match wage increases which will undoubtedly happen in a rapidly growing
economy.”
Productivity
Gains Add to U.S.
Advantage
During the past 12 years, the
U.S. has widened its unit labor cost advantage over Europe,
thanks not to lower wages but to continued higher productivity gains.
Japan has succeeded in restoring its
competitiveness by bringing down its manufacturing wage costs below the EU-15
in 2004, which helps boost international competitiveness but has done little
to spur domestic markets.
The report shows that the balance
between wage and productivity gains is not just a challenge for emerging
economies, but for all countries. Says van Ark: “For advanced countries, the
issue is to keep labor compensation in check with productivity. This raises
issues about the balance between net and gross pay, the tax base, and the cost
structure of firms. But it also forces government and business to focus on
exploiting knowledge creation as a means to stay at the productivity frontier
and avoid a race to the bottom in terms of cost competition.”
Compensation
in Emerging Countries Less than 15 Percent of U.S. Levels
The level of labor compensation
in manufacturing in emerging economies is extremely low relative to advanced
economies. On average, the manufacturing sector in Central and Eastern Europe
and Mexico pay between 10 percent and 15 percent of compensation paid in the
U.S. In Turkey, the level is around 5 percent. The manufacturing sector in
India and China only pays between 2 percent and 3
percent of the
U.S. compensation level on average. But these are average compensation levels
for all manufacturing companies.
Global companies
are likely to operate at smaller wage margins among their plants in different
countries, paying wages at much higher levels than domestically owned plants
in emerging economies.
As the gap in labor
productivity between emerging economies and the
U.S. and other advanced
countries is generally smaller than the wage gap, the emerging economies
retain a labor cost advantage. But there are important differences.
For example,
China and India manufacturing
industries have been most successful in keeping labor compensation at the
lowest possible levels, namely 2.5 percent to 3 percent of the U.S. level in
2002. Labor productivity was also far below the U.S. level at 12 percent to 13
percent. But productivity levels exceeded compensation levels by a
considerable margin.
As a consequence,
unit labor costs in
China and India are on average 20 percent lower than unit labor costs in the
U.S. So China and India are by far the most competitive manufacturing nations
in The Conference Board sample. At the other extreme among the emerging
economies is Mexico,
which had labor costs of 11 percent of U.S. levels in 2002. But this was
matched by a similarly large productivity gap. As a result, unit labor costs
in manufacturing were almost equal to those in the U.S.
The U.S. Unit
Labor Cost Advantage Over Europe
During
most of the 1990s, the
U.S. unit labor cost advantage
over Europe was supported by higher U.S. productivity, more than by higher
wage levels. But unit labor costs can change rapidly, particularly when price
levels change. Relative to the U.S. in 2005, unit labor cost in the EU-15 was
significantly higher than in 2002, namely 30 percent higher in 2005 versus
about equal in 2002. By 2005, none of the EU-15 countries, except Finland and
Ireland, had manufacturing unit labor cost below the
U.S.
level.
The increase in
unit labor cost between 2002 and 2005 is, in part, related to the rapid
appreciation of the euro relative to the U.S. dollar which caused a
significant increase in relative labor compensation.
However, relative
unit labor cost between the
U.S. and the EU-15 reflected
not only short-term exchange rate variations, but also a drop-off in labor
productivity in Western Europe. During the past 12 years, the U.S. has shown
continued higher productivity gains. Until 2002, this effect was offset by
increasing labor compensation in the
U.S.
due to the dollar appreciation, but since then the double effect of declining
labor cost and rising productivity has led to a rapid improvement in U.S.
manufacturing labor cost over the European Union.
Japan is
Still Competitive
Unit
labor cost in
Japan today is higher
than in the U.S., as the relative high-level labor compensation levels of past
years are not supported by equally high productivity levels. Presently,
Japanese manufacturing does signal a further improvement in productivity
levels strengthening its cost competitiveness, even though it has done little
to spur domestic markets.
The report is the
first in a series of studies by The Conference Board on competitive
performance among advanced and emerging economies. Future reports will address
the performance of individual industries, and the role of technology,
innovation, and knowledge.
Source: Competitive Advantage of Low-Wage
Countries Often Exaggerated
Executive Action No. 212
The Conference Board
