While the cost of labour productivity has been rising in the US and Japan, China and other emerging markets offer far cheaper options.
Emerging markets call the shots in world manufacturing
The world is in the midst of the third major transition in the global manufacturing base over the past 250 years. China and other emerging economies are regaining the leadership that was lost to Europe and then the US from the early 19th century onwards.
A key consequence of this process is a convergence in wages between the major emerging market countries and developed market countries. This has profound investment implications that still seem to be underappreciated by many investors. In 1999, total global manufacturing output (value-added) was US$5.38 trillion (Dh19,76tn). Ten years later, even in the recession year of 2009, it had risen by 20 per cent to $6.46tn.
Meanwhile, the number of workers employed rose by 5 per cent, from 301 million to 316 million over the same period. Output per person employed rose by 14.2 per cent, representing a productivity gain of 1.3 per cent per year. A significant change has been an increase in China's proportion of global manufacturing output, from 7.5 per cent of the total in 1999 to 18.6 per cent last year. Of the other major emerging market countries, India's share has increased to 2 per cent from 1.1 per cent and Brazil's share to 2.4 per cent from 1.4 per cent.
The biggest declines have been in the US (from 25.8 per cent to 19.9 per cent) and Japan (from 16.7 per cent to 8.4 per cent). In contrast, the EU's share (at about 28.9 per cent) has been largely unchanged. Over the next couple of years, China is likely to consolidate a leadership position in global manufacturing, overtaking the US. Before the early 19th century, global manufacturing was primarily centred in Asia and other emerging market countries. China, India, Brazil, Mexico, Russia and others accounted for 70 per cent of manufacturing output in 1750.
From 1820, there was a transition to Europe, which dominated global manufacturing production for most of the 19th century. Europe's share peaked in 1900 at 62 per cent. The second transition was towards the US from the 1880s onwards. After the upheaval and disruption of two world wars fought on European territory, the US share of global manufacturing peaked at 45 per cent in 1955. In the ongoing third transition, China, India, Brazil, Mexico and other emerging markets — former Russia and the former Soviet Union — have gained in share of value-added in global manufacturing from 10.5 per cent in 1970 and 14 per cent in 1990, to 37 per cent at present.
The speed of this share gain is unprecedented. In comparison, at its most rapid phase of expansion, Europe's share of global manufacturing rose by 19 percentage points from 1830 to 1860, while the US share rose 16 percentage points from 1900 to 1920. Of the major emerging markets blocs, only Russia and the former Soviet Union have experienced a manufacturing share decline since 1990. Hence, while global manufacturing employment has risen in the past 10 years, all the growth has been in the emerging markets economies.
Despite Chinese restructuring of state-owned enterprises, growth elsewhere in the private sector helped manufacturing employment to rise 1 per cent to 79.5 million last year. During this same period, it has increased faster in Brazil (by 48 per cent to 14 million) and in India (by 13 per cent to 92 million). Meanwhile, the US has declined 22 per cent to 15.5 million and Japan 14 per cent to 11.4 million. Employment has declined more slowly in Europe (by 6 per cent to 38.8 million).
Outsourcing from developed markets to emerging markets and access to developed markets, in particular after China's World Trade Organisation (WTO) accession in 2001, appear to have been important factors in this process. Multinational firms were able to arbitrage significant differences in wage levels, and to operate plant and equipment in a far more diverse range of geographies than was possible before the 1990s.
However, servicing the local market within merging markets has recently become a focus for both foreign and local firms. This appears to be a particularly important driver of the growth in Brazilian manufacturing. The obvious question to ask is whether further changes in the structure of global manufacturing are possible. The answer is likely to be found within productivity relative to labour costs.
Manufacturing in the US produces a value of output per hour worked of $51.2, as opposed to $10.9 in China and just $0.8 in India. Nominal output per hour worked has grown at a compound rate of 14.3 per cent in the past 10 years in China, compared with 4 per cent in the US and 10 per cent in India. There has already been some convergence in wages as firms arbitrage labour cost differentials. Real wage growth per hour in manufacturing in China has averaged 12.7 per cent since 1999. In contrast in the US it has been minus 0.5 per cent.
However, while output per hour worked in China is 21 per cent of the US level, the relative labour cost per hour worked is still only 11 per cent. This suggests that recent increases in the minimum wage in China and 30 per cent-plus wage hikes in manufacturing are a catch-up in labour's share of total output to the dramatic increase in output per hour. Further significant wage gains are likely, in both absolute terms and relative to developed economies. This process may be negative for the profit outlook for certain business models in contract manufacturing.
However, during a period of fiscal and consumer retrenchment in large parts of developed economies, it is a welcome trend viewed from the perspective of global aggregate demand. The conclusion, therefore, is that investors should expect: a) further significant change in the structure of global manufacturing towards China and other emerging markets; and b) further narrowing of the relative wage differentials between the US, Japan and Europe, and China/emerging markets.
The emerging markets consumer has the ability, through rising employment and wages, to be the new engine of growth in the global economy. Investors should focus on industries that benefit from this trend - through consumer discretionary financial services and property firms oriented towards China and other leading emerging markets companies - while avoiding manufactured good exporters in the emerging markets with high wage-sales ratios and dependence on developed markets.
Jonathan Garner is the chief Asian and emerging market strategist at Morgan Stanley