Inflation Immediately Ahead

¹²The Bear's Lair: The Asian Inflation Bug

By Martin Hutchinson June 14, 2010 | 18 June 2010

I have been predicting for some time now that the inflation-suppressing effect of globalization would soon come to an end, with unpleasant results for all the cheap-money western economies. The decision by the Taiwanese contract manufacturer Foxconn to raise wages in its 300,000-employee Chinese factory by 30%, with an additional 66% to be paid as bonuses based on output, suggests that the cost revolution in outsourcing is now fully upon us. Needless to say, we are wholly unprepared.

Foxconn's position well reflects the realities of the changing Chinese economy. The trade name of the Taiwanese Hon Hai Precision Industries, Foxconn has grown immense as a contract manufacturer of practically all the electronic gadgetry for which there is such insatiable global demand— for example all three third generation video game consoles: the Xbox 360, Wii, and PlayStation 3. Foxconn made its costs irresistible to western manufacturers not only by manufacturing in China but by making sure that its labor costs were unbeatable even by Chinese standards.

It did this by building a gigantic factory complex in the wealthy Shenzen area, with dormitory and retailing facilities, and then importing workers from impoverished areas of China, where labor costs were much cheaper. Thus even as Chinese coastal wages shot up toward world standards, Foxconn was able to keep its labor costs at subsistence levels. With such low wage costs its products undercut competitive offerings manufactured in the West and were competitive with products from other even cheaper wage economies such as Vietnam.

As the differential widened between Foxconn's wages and those paid in the increasingly wealthy area around its complex, this policy was bound to come unstuck. The spate of suicides in Foxconn's complex was no more than a catalyst for change; after all 10 suicides in a workforce of 300,000 is a public relations problem rather than a real one except for the unfortunates concerned. Nevertheless, Foxconn saw that the public relations problem needed to be addressed, probably by some improvement in working conditions, and then decided that its overall strategy had become both flawed and unnecessary.

With its current dominance of electronic contract manufacturing, Foxconn has become an indispensable part of the supply chain for these products— hence it no longer needs to compete so aggressively on price. Equally, by providing ostentatious pay rises and improvements in working conditions for its workforce, Foxconn can make it very difficult for its customers to switch to cheaper rivals, unless the cost differential from doing so is huge. Since Foxconn recognizes that Chinese wage levels overall are soaring toward at least middle income, it can get PR brownie points without losing business or profits by encouraging a trend that is inevitable anyway.

It's the same judgment that Henry Ford made when he instituted the $5 day in 1914. In an era of rapidly evolving living standards and declining availability of ultra-cheap new workers (from immigration, in Ford's case) it worked superbly then and it will doubtless work superbly for Foxconn now. For Foxconn and for other suppliers of "affordable luxury" goods for the Chinese market, there will be an additional benefit: with far more of the Chinese economic renminbi going to wages, and 1.3 billion potential consumers, the next few years should see an explosion of Chinese consumption of cars, electronic goods, packaged goods and other symbols of modernity.

The past decade has seen only the stratum at the top of Chinese society gaining access to western style consumer goods; spreading that affluence to the remaining 90% of the population will truly be a revolution— and extraordinarily profitable for those companies poised to take advantage of it. Just as Ford's success came with the basic Model T, suppliers into China will find their greatest receptivity at the basic end of the spectrum— the Chinese domestic auto manufacturers such as Chery and Geely, not the foreign manufacturers who have done so well in the last decade. Again however Foxconn, possibly in alliance with local brands, is well positioned to profit.

The implications for the rest of us are, however, almost as important as those for the Chinese workforce themselves. This is particularly the case because similar trends are apparent in India, the world's other great reserve army of cheap labor, with 1.2 billion inhabitants compared to China's 1.3 billion. Indian output has grown almost as fast in the last few years as has China's, and with a society that is much less unequal than China's and an economy that is far less controlled, wage rises and consumption increases are already spreading beyond the elite.

Because a Foxconn labor force strategy is next to impossible in the more open society of India, wages have been rising faster than productivity, producing rampant inflation, food prices in India are currently 16.7% above those of a year ago, while overall wholesale price inflation is rising at 9.6%. As it has been for the Chinese, Indian labor costs are outpacing any possible productivity improvements, with wage rises of as much as 20% in urban areas. Not only does this indicate that Indian interest rates need to rise sharply from their current 3.75%, but it also suggests that outsourcers are going to find India as well as China an increasingly expensive place to do business.

In principle, outsourcers can still migrate from China to other cheaper labor environments. After all, there are still over 3 billion people resident in countries that are on average poorer than China or India. On closer inspection, however, most countries with lower wage workforces have education systems, infrastructure and political and legal environments that are unsuitable for location of anything requiring workforce discipline and skilled labor. There are certain exceptions— one thinks of Indonesia and Vietnam— but those exceptions are relatively small compared with the Chinese and Indian behemoths.

In many middle income countries, particularly in Latin America, in spite of the relative impoverishment of the population, a manufacturer would be going UP the cost ladder from China or India because of the meddling legislation and high unionization in those environments. In any case, relocation of a major facility is itself both time-consuming and expensive— not worth doing for a moderate cost differential. If the two largest sources of cheap labor that provide manufacturing and service capacity for globalized businesses both have high inflation and there are few alternatives available, then the conclusion is inescapable: cost inflation is about to hit Western economies in a big way.

Just as in the 1880s the coming of transcontinental railroads and refrigerated shipping reduced global prices by about 20% over a period of about 15 years, so since 1995 the advent of the Internet, modern telecommunications and the globalization they have enabled has caused costs in many areas to tumble. Goods such as clothing and electronic goods are cheaper in absolute terms than they were 15 years ago, even without taking into account "hedonic" improvements in quality through the continual increase in capacity of electronic products. That has provided Western monetary authorities with a "holiday from history" by which they have been able to expand money supply excessively rapidly and keep interest rates excessively low without being hit by resurgent inflation.

Only in commodities, where rapidly rising Asian demand has upset the traditional supply/demand balance, have normal price pressures been visible, particularly in the last five years. The result has been an explosion of leverage and asset prices, enriching the financial services sector beyond belief but doing very little for the rest of us. Government has also expanded, as the availability of cheap finance to fund deficits, both open and hidden through actuarial sleight of hand, has proved irresistible to politicians of all parties and countries.

The average U.S. worker is able to buy clothes and toys much more cheaply than in 1995, but his overall living standards have stagnated or even declined. Being deterred by receiving negative real interest rates on his savings, he has also stopped saving, so his retirement will be thoroughly miserable (or non-existent.) This is now about to change. The wave of Chinese and Indian-driven inflation will probably take about 6 months to arrive and about 12 months to become unmistakable.

Western central banks will have to put interest rates up, and will have great difficulty doing so fast enough to get ahead of the inflationary pressures. As a side benefit of this, the obligations incurred by governments and in the housing market will become worth considerably less [[a 'benefit' which is likely to result in a higher tolerance of inflation by our financial authorities than otherwise: normxxx]], lightening the debt burden on the Western economies. On the other hand, wages will undoubtedly fail to keep up with the newly virulent inflation, producing a decline in living standards that brings Western economies and emerging markets much closer to equality.

Of course, since emerging markets have been doing all the saving recently, they will have better access to capital, making the wage equalization process even more painful than necessary. Western sentimentalists are rejoicing currently at the 'vast improvements' in living standards for the Foxconn workforce. They should withhold their joy: the long-term costs of those wage increases will be paid in the West.