The China Effect

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Photograph by Rahman Roslan for TIME

Cheaper labor Eyeballing components in Penang

In the midst of a steaming-hot Malaysian jungle, sweat-stained factory workers bend over their looms, threading copper into bales of cable wire that gets so hot, it must snake through culverts of water before it can be touched. The factory floor is awash in tea-colored light from windows smeared with soot. The grinding of machines creates a constant, earsplitting din. There is no air-conditioning. "It would cost too much," says Alvin Mui, president of P.I.E. Industrial, which operates the factory.

The roar from this Dickensian forge in the port of Penang is part of a greater reverberation across Asia. Call it the China Effect. As China progresses from a low-cost manufacturer dependent on exports to a service-oriented economy driven more by domestic demand, wages there are rising. As a result, the lowest-end factory work once done in the Middle Kingdom, like wiremaking, is now being done in neighboring countries, from Malaysia and Thailand to Vietnam and Bangladesh.

After ferociously sucking jobs and investment out of Southeast Asia over the past two decades, the China Effect is now lifting once declining industrial hubs like Penang out of their long economic slump. The northern Malaysian state attracted $4 billion in investment for its manufacturing sector in 2010, according to the Malaysian Investment Development Authority, a 465% jump from 2009. "It's been rocky at times," admits Lim Guan Eng, Penang's chief minister. "But being an underdog has kept us on edge and made us work harder."

Penang's nascent boom is partly fueled by Western manufacturers wary of China's rising costs. It also stems from dramatic changes in China's economy that are redirecting trade flows across the region. Not all of the companies relocating to places like Penang are Western multinationals; in fact, many are Chinese firms. As salaries and spending power in China rise, the Chinese are importing more goods from the rest of Asia. At the same time, those rising salaries are forcing China to outsource more of its low-end manufacturing. According to a 2010 Citigroup ranking of 12 Asian countries by manufacturing wages, China was the seventh least expensive and Malaysia the eighth. "The pure-cost reason for being in China for certain economic activities is being eroded," says Sanjeev Nanavati, CEO of Citigroup Malaysia.

The result is a virtuous trading circle for Asia as the Chinese outsource more to and import more from the region. According to HSBC, intra-Asian trade is forecast to grow at an average annual pace of 12.2% until 2020, 40% higher than the rate by which Asia's trade with the U.S. is expected to grow in the same period. Nearly 50% of Asian exports (excluding Japan's) now go to other Asian countries, according to Credit Suisse. That's more than the current demand for Asian exports in the U.S., the E.U. and Japan combined.

P.I.E. Industrial's copper-wire factory is an example of the growing synergy between China and its Southeast Asian neighbors. The factory is a subsidiary of Taiwanese electronics giant Foxconn International (part of the Hon Hai group), one of the largest assemblers of Apple's iPhone and one of the biggest electronics companies in the world. For a multinational like Foxconn, it is as cheap, if not cheaper, to use factories like P.I.E.'s to assemble low-tech products like cable wire or even products like bar-code scanners and mobile-phone chargers in Malaysia rather than China. Foxconn pays its 1,500 workers in Malaysia and Thailand roughly $260 a month, comparable with the wages it offers in China, and says that over the next few years it plans to grow its Malaysian workforce by a third.

In spite of the near parity between Chinese and Malaysian manufacturing wages at the moment, company executives expect future wage increases in China to significantly outpace those in Southeast Asia. Says Rajesh Purushothaman, managing director of National Instruments' Penang operations: "What mattered to us was the predictability of future costs. We felt there was more predictability in Penang than in China." That's another reason Foxconn is sending more low-end work to places like Penang. "A few years ago, there were a lot of vacant factories around here," says P.I.E.'s Mui, gesturing toward an empty factory building that his company will soon move into. "Now they're full. The tide has started to turn."

Foxconn has seen worker suicides, labor protests and subsequent wage rises at its factories in China. Those experiences, according to Dong Tao, chief Asia economist for Credit Suisse, underscore the fact that "this is the beginning of the end of an era for China as the world's factory." By 2014, China will cease to produce a surplus labor supply for its low-wage factories, according to Credit Suisse. Not even salary hikes of 30% to 40%, the rate at which average factory wages rose in China in 2010, will be enough to alleviate increasingly acute labor shortages from 2017 onward in the southeastern coastal regions where most of China's manufacturing is done.

Will all multinationals flee China as this labor shortage looms? Of course not. To an extent, rising wages on China's southeastern coast will simply prompt companies to move their factories to China's western hinterland, where cheaper labor is available and where the government is building an elaborate infrastructure of roads and railways to speed goods to and from the country's seaports. For makers of certain products — like laptop computers, of which 70% of the world's supply comes from China — it would be foolhardy, if not self-destructive, to leave China completely. Because the chain of components is so heavily concentrated there, leaving would be like cutting off one's own blood supply.

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