Currency move latest sign of China's transformation

China is transitioning away from being the world's discount manufacturer. But it will have to loosen its currency even more to avoid the pitfalls of development.  

China is responsible for about 20 percent of total global manufacturing and the ubiquitous “Made in China” label can be found on an astonishing array of products. But its days as the world’s discount manufacturer may be coming to an end. This weekend's loosening of controls on China's currency is the latest sign of the transformation under way.

China is moving inexorably up the value chain. It boasts some of the most advanced manufacturing firms in the world. As the level of factory and worker sophistication has grown, so have salary expectations. And the pool of workers once thought inexhaustible is, in fact, proving to be limited. Throw in higher fuel prices to ship its good overseas and it's clear that the factors that tilted in China's favor during its dramatic first phase of development are now tilting away from it in its second phase.

While this might help North America’s beleaguered manufacturing sector eventually, at this point it appears other emerging nations are reaping the main benefits from the change in China. Over the past few years, for example, several US toy companies have turned to Vietnam and Indonesia to produce more of their products. Auto parts manufacturers have likewise increased their presence in India where a thriving auto industry continues to build momentum. Even Foxconn, the manufacturing giant that makes products for Dell and Apple, is in the process of expanding its operations in India and Vietnam. These moves will come at the expense of plants the Taiwan-based firm has contracted in China.

The shift is understandable. Chinese wages are going up – and will continue to go up by 19 percent a year, according to a report from Credit Suisse Group AG.  That's explosive growth that's almost double the expected rate of growth in the economy. As a result, Credit Suisse forecasts, wages – which stood at 50.5 percent of China's gross domestic product in 2010 should rise to 62 percent of GDP by 2015.

That's not necessarily bad for China. Richer Chinese will buy more Chinese goods. Credit Suisse expects private consumption, which accounted for 35.6 percent of GDP last year, to reach nearly 42 percent by 2015.

Another reason wages are rising is that the pool of workers is shrinking and companies are having to compete for skilled workers. The old model of factory owners having the upper hand over migrant workers fleeing rural poverty and willing to take on any task at any wage is disappearing. The advantage is slowly turning to the worker.

That, too, is good for China. Employers are being forced to address some of the horrendous working conditions much of the workforce has been forced to endure. Not all abuses have been eliminated by any means, but progress is coming bit by bit.

Chinese manufacturers are also dealing with considerably higher fuel prices, which makes it more expensive to ship goods. Boston Consulting Group predicted a year ago that at the current rate of appreciation for labor and shipping, within the next five years it will be just as cost-effective to manufacture in North America as in China.

China may have no choice but to concede the production of low-margin goods to other countries in order to concentrate on products with sufficient capacity to absorb higher production costs. The transition must be carefully managed, however, as it is paramount for China to maintain growth as the country continues to evolve.

For guidance, China can look to Japan, which faced a similar dilemma.

In the years following World War II, it was Japan that specialized in the mass production of cheap goods as a means to rebuild its economy after the war. By the 1980s, however, Japan had mostly shed its status as a peddler of poor-quality trinkets to become a leader in electronics and automobiles. This ushered in a period of rapid growth that made Japan a global exporting powerhouse.

Alas, heading into the 1990s, the collapse of a wildly out-of-control domestic asset bubble triggered a serious bout of deflation. This period is still referred to in Japan as the “lost decade” and the hangover from this period continues to affect the economy today. China will have to avoid such pitfalls if it is to manage successfully its next period of growth.

Chief among the needed reforms is to allow the yuan to fluctuate freely against other currencies. This is a move China has long resisted as keeping the yuan devalued has helped maintain an export advantage, but Chinese authorities have signaled a new willingness to ease currency controls. The latest action came this past weekend when the People’s Bank of China doubled the yuan intraday trading band from +/- 0.5 percent to a full percentage point.

Despite the greater currency fluctuation authorities are now willing to tolerate before intervening, the yuan’s value is still tightly controlled. The chronic undervaluing of the currency, while helping export sales, is fueling higher price inflation within China’s borders. This has some observers warning that China could be heading for its own lost decade.

– Scott Boyd is a currency analyst with OANDA, a Forex trading company with offices in New York,Toronto, Singapore, and Dubai, and contributes to the company’s MarketPulse FX blog.